- •Lecture Notes b.Devlin
- •Introduction
- •Management accounting
- •1 Financial accounting.
- •2 Management accounting
- •To provide information about product costing to be used in financial
- •To provide information for planning, controlling and organising.
- •To ascertain the cost of a product. This information is used to value stock which is required for external reporting .
- •To assist management in the decision-making process.
- •Marginal costing
- •Decision making
- •In the short-run all fixed costs remain unchanged and therefore treated as irrelevant.
- •Variable overhead
- •2 Shut-down decisions
- •3 Make or Buy
- •Variable overheads £2
- •Variable cost of production £7
- •Variable overhead £2
- •4 Limiting factor decisions
- •5 Profit Planning or cost profit volume analysis
- •Cost volume profit analysis
- •It is possible to ascertain these by using a break-even chart or by using formulae.
- •Budgeting
- •1. Sales Budget 19x0
- •Production budget 19x0
- •3. Materials Usage Budget 19x0 (Component usage)
- •4. The Material Purchase Budget 19x0
- •Cash summary December 19x0
- •Depreciation never appears in a cash budget as it is a non-cash expense.
- •In respect to credit transactions time lags have to be built into the cash budget
- •It is useful to have a memo column to record items which will appear in the balance sheet if required. Budgeted Profit and Loss Account for six months ending 30 June 19x1
- •Budgeted Balance Sheet as at 30 June 19x1
- •Investment appraisal methods
- •1 Payback
- •2 Accounting rate of return
- •Investment appraisal compares the cash outflows with the cash returns from the project and these cash flows take place over a lengthy period of time.
- •3 Net Present Value
- •6 Profitability Index
- •The costing
- •Overheads
- •Indirect materials used in Dept. B £35,000
- •Insurance of machinery £5,000
- •In the absorption stage an overhead recovery (absorption) rate (oar) is calculated. The formula used is:
- •30,000 Machine hrs.
- •35,000 Labour hrs.
- •In recent years there has been criticism of the traditional system of costing for overheads ( Kaplan & Cooper ). Traditional cost systems were designed when:
- •Information processing costs were high;
- •Inspection cost:
- •Standard costing
- •Variances represent the differences between standard costs and actual costs. The standard cost is what the cost is estimated to be and this is compared to what the cost is actually.
- •Variable Overhead Variance
- •Variable overhead efficiency variance
- •Responsibility accounting
- •It is a ‘ system of accounting that segregates revenues and costs into areas of personal responsibility in order to assess the performance attained by persons to whom authority has been assigned’.
- •Net Residual Income
3 Net Present Value
A particular rate of interest is used to discount future flows of cash to present values. The discount rate used might reflect the cost of obtaining capital, or a target rate/cut-off rate,or a risk-adjusted rate. Once the future cash flows are discounted to present-day values they are totalled and compared with the cost of the project. If the discounted cash flows exceed the cost the difference is the net cash flow. In general, if the NPV is positive the project is worth considering.
Example:
A company wishes to evaluate a capital project based on the following information. The initial outlay is £100,000 and the project has an economic life of 5 years and realises £5,000 when it is sold at the end of year 5. The profits after depreciation have been estimated as year 1-3 £10,000 and £15,000 in the final two years. The rate of interest is 10%.
|
|
|
|
|
Year |
Cash flow |
Discount factor |
Present value |
Cumulative PV |
|
£ |
|
£ |
£ |
0 |
(100,000) |
1 |
(100,000) |
|
1 |
29,000 |
0.909 |
26,361 |
26,361 |
2 |
29,000 |
0.826 |
23,954 |
50,315 |
3 |
29,000 |
0.751 |
22,939 |
73,254 |
4 |
34,000 |
0.683 |
23,222 |
94,476 |
5 |
34,000 |
0.621 |
21,114 |
117,590 |
6 |
5,000 |
0.564 |
2,820 |
120,410 |
|
|
|
--------- |
|
|
|
|
NPV =20,410 |
|
|
|
|
-------- |
|
Since theNPV is +£20,410, the project is worthwhile.
4 Discounted payback
In the calculation of the NPV in the previous example a column records the cumulative present value of the cash flows. Since the payback method is criticised for ignoring the time value of money it is possible to remedy this shortcoming by using the discounted cash flows to ascertain the payback period.
In this example, the payback period is just over 4years. There is a shortfall of £5,524 which has to be generated in year 5.
£5,524 365 days
--------- x = 17 days
£117,590
The discounted payback period is 4yrs. 17 days.
5 Internal Rate of Return
Sometimes the company wishes to know the internal rate of return (IRR) ie. the yield of a capital project. The company may operate a cut-off point in respect to projects and should a project’s yield be below this target or threshold it will be rejected. The method is to discount cash flows using different discount rates until the NPV = 0. At that point the total present value of the cash flows is equal to the outlay on the project. The discount rate which produces a NPV = 0 is the internal rate of return of the project. In effect, the company could borrow money at a rate of interest equal to the internal rate of return to finance the project and the returns from the project would allow the company to break even. If the company’s target rate of return for capital projects is less than a project’s yield (IRR) the project is worth consideration.
Example:
Using the data from the previous NPV example work out the projects IRR.
At a discount rate of 10% the NPV = +£20,410. To produce a negative NPV a higher discount rate needs to be chosen. The method proceeds on a trial and error basis. What is the result if a discount rate of 20% is used.
Year |
Cash flow (£) |
Discount factor 20% |
Present Value (£) |
|
0 |
(100,000) |
0 |
(100,000) |
|
1 |
29,000 |
0.833 |
24,157 |
|
2 |
29,000 |
0.694 |
20,126 |
|
3 |
29,000 |
0.579 |
16,791 |
|
4 |
34,000 |
0.482 |
16,388 |
|
5 |
34,000 |
0.402 |
13,668 |
|
6 |
5,000 |
0.335 |
1675 |
|
|
|
|
-------- |
|
|
|
|
NPV= - 7,245 |
|
|
|
|
------- |
|
To determine the discount rate which produces NPV = 0 a process of interpolation is used. Alternatively, it may be solved graphically.
The formula for interpolation is:
IRR = A + [ a / a -b ] x ( A - B )
10% + £20,410
---------------- X 20% - 10% = 17%
(£20,410 + £7,245)
The yield or IRR of the project is 17%. If this is higher than the company’s target rate for projects it is worth consideration.