Chapter 1.4 Flashcards
Interpretation of financial budgets and cost models for the control of purchases
Financial Budget
A plan for a defined period, usually twelve months, showing either revenues or costs, or both
Cash flow
The amount of money going into and out of a business
Financial Ratios
Analysis using data from financial statements to identify and monitor trends in performance, for example, profitability, liquidity and debt
Return on Investment (ROI)
A measure of profitability that indicates whether a gain or loss has been generated compared with the initial cost
Return on capital employed
A financial ratio which identifies a business’s ability to generate profit from the capital used
Net present value (NPV)
An accounting term for an amount in the future adjusted to today’s value by a calculation
Define financial modelling
Where an organisation uses historical and assumed financial, accounting and business metrics, such as costs and revenue, to project and abstract forecast of the future state of the company
What is financial modelling used for?
To forecast an organisations future financial performance
Describe financial models
Usually simple spreadsheets that can be used to forecast an organisations future financial performance
What can organisations use to assess the viability of a business case?
Financial ratios, specifically investment ratios
Define investment ratios
Types of financial ratios that can be used to assess an organisations ability to generate a positive and profitable return
Name 4 examples of financial ratios
- Return on investment
- Return on capital employed
- Profitability ratios
- Liquidity rations
What should organisations consider net present value for?
Any investment decisions associated with the business case
What does NPV assess?
The value of a project or investment over time, but with any projected future cash flows converted into the present value
What does NPV enable the visibility of?
The financial viability of the business case over multiple time periods
What can financial budgets be created from?
Financial modelling
What are financial budgets created to show?
The target cost and revenues over a certain time period
What wouldn’t an organisation know without financial budgets? (2)
- Whether it will have the funds to meet obligations
- Whether there will be sufficient surplus finds to reinvest in the business
Name the 3 main activities that are involved in budgeting and managing those budgets
- Planning
- Controlling
- Decision-making
What does it mean to control a budget?
Gathering and analysing data to show how money is being spent against the budget
Name a common way to see how managing a budget should work
Use a cycle of activities called the Plan-Do-Review cycle
Create an overview of the Plan-do-review cycle
- Plan - develop budget based on the business case approved
- Do - monitor variances and take action
- Review - evaluate budget performance and re-plan
Name 2 things required to prepare and manage budgets effectively
- Understand what cost entries apply to the budget
- How and when these affect the organisations cash-flow
Cost model
A process designed to assess and calculate all costs associated with producing or delivering a product or service and arrive at a provable end cost
What’s the overall aim of a cost model
Accurately access all financial information on the resources required to deliver a product or service and transform the data to set a realistic end price for the consumer
What do cost models assess?
Whether the overall investment and resources required to deliver a product or service is proportionate to the end value it creates
What are cost models essential in evaluating?
Evaluating the viability of a potential business venture, by estimating the overall profitability the venture can bring to an organisation
Name 2 key considerations within cost models
- Whole-life costing
- Total cost of ownership
What is critical for a business to survive?
The circulation of funding or cash flow in and out of an organisation
What can be used to create cash flow profiles?
Statement of cash flows
What can cash profiles provide?
Insights into a company’s strategy, life-cycle or any key considerations for its current financial position
What is the variance of the flow of finances in and out of a business dependent on?
Whether the organisation is new or established, profitable or struggling
Explain timing of cash flows
What is paid and when
What does it mean to buy something on credit?
It pays for them a certain number of days after it receives them
Define working capital
The funds in the bank to pay what the business owes before it receives funds from the people who owe it
What can’t a business operate without?
Working capital
Name the 6 steps of the cash flow cycle
- Receive raw materials and components
- Manufacture products
- Store in inventory
- Pay suppliers
- Sell products
- Receive funds from customers
Name 7 characteristics service industries show in the cash flow cycle
- A service cannot be put into inventory to be sold later - this means the workforce cannot be kept busy in slow times and sell the service at a later date when business picks up
- Most services are intangible - the quality cannot be measured in the same way, the quality of services is often measured based on subjective value judgements by the consumer
- Production and consumption by a customer take place at the same time - if there is a short-term imbalance between demand and capacity, either lead times to customers increase or the workforce is idle
- Services often result in a wide variety of ‘products’ from the same cost base - businesses have to be careful that they are not paying for service providers’ overhead costs more than once if they buy multiple services from them
- Customer-provider interface. The quality of the customer-provider interface will have a large bearing on customer satisfaction and repeat purchases
- Can be thought of as generating products - for a hospital, products could be operations
- Deliver products with processes - an example could be a product being the insurance policy and the process is the set of activities that take the initial request and turn it into a policy document
Accrual
An adjustment made to a set of financial accounts to reflect activity that has occurred but for which cash has not yet been received or paid
Name 7 main categories of cost entries
- Revenue
- Direct costs
- Overheads
- Depreciation
- Bank loans
- Investments
- Dividends
Explain direct costs
The costs of the items that are used directly in the manufacture of the product or to deliver the service
Are direct costs internal or external?
Both
Explain overheads
The costs other than direct costs that an organisation incurs, also known as indirect costs
Explain depreciation
Although the assets are bought up front for the full price, they will not retain that value for the whole period in which they are used. A part of the original cost is apportioned to every year the asset is expected to last
Explain bank loans
They create cash flow at the time of draw-down
Explain investments
These may or may not be purchased on credit.
Explain dividends
Payments made to shareholders in return for investing in the company through shares
Mission statement
A written statement of the purpose of an organisation which does not change over time
Vision statement
Sets out the rules and goals by which the organisation will conduct its affairs in order to achieve its mission
Name a key management task
Monitoring the performance of budgets and taking control when actuals deviate from budgets
Name 8 advantages to budgeting and budgetary control
- It compels management to think about the future and to set out detailed plans for achieving targets for each department, operation and manager
- It promotes coordination and communication
- It requires managers to be made responsible for the achievement of budget targets for the operations under their personal control
- A budget is basically a yardstick against which actual performance is measured and assessed. Departures from budget can be investigated and the reasons for the differences can be divided into controllable and non-controllable factors
- It enables remedial action to be taken as variances emerge
- It can motivate employees if they participate in the setting of budgets
- It improves the allocation of scarce resources
- Finally, it economises management time by using the management by exception principle
What can there be a tendency for managers to justify after a budgeting system has been in operation for some time
Justify the following years budget on the basis of adding an amount to the current budget to cover inflation
Zero-based budgets
A method of budgeting in which every expense must be justified starting from a base of zero
Name an advantage of zero-based budgets
They may uncover alternative and more innovative ways to deliver their objectives and so become more efficient and effective
Name a disadvantage of zero-based budgets
The amount of management time it takes to create a zero-based budget and then review it
Name 3 examples of variances that should be looked in to when a budget is monitored
- Price and quantity variances
- Labour variance
- Overhead variance
What 2 elements are the value of a purchase made up of?
- Quantity purchased
- Unit price
Explain labour variance
The difference between the budgeted and the actual wage costs
What can labour variances be broken down into?
A wage rate variance and a labour efficiency variance
Why may wage rate variances occur?
If more overtime than expected is used or a different grade of worker is used compared to the one planned
When do labour efficiency variances occur?
When the time spent on a job is different to the planned number of hours
Explain overhead variance
The cost of overheads can also create a variance from the budget and this can be split into a volume variance and an expenditure variance
When is a volume variance created when overheads are apportioned to products or services?
If production is greater or less than that budgeted
When is overhead expenditure variance created?
When the actual overhead is greater or less than budgeted for the level of output produced
