Management Accounting Flashcards

Question 1

Q

Question 2

Q

Cost unit (definition)

Answer

A

a measurement of output, e.g., a ton of steel, a litre of paint, a kg of sugar.

Question 3

Q

Cost centre (definition)

Answer

A

a part of the business for which a measurement of cost is required.

Question 4

Q

What is the difference between direct costs and indirect costs?

Answer

A

Direct costs

can be specifically and exclusively identified with a given cost object.

Indirect costs

cannot be specifically and exclusively identified with a given cost object.
are assigned to cost objects on the basis of cost allocations.

Question 5

Q

Cost allocation (definition)

Answer

A

the process of assigning costs to cost objects that involve the use of surrogate, rather than direct measures.

Question 6

Q

The distinction between direct and indirect costs depends on …?

Answer

A

The distinction between direct and indirect costs depends on what is identified as the cost object.

Question 7

Q

Product costs (definition)

Answer

A

those that are identified with products and included in the stock (inventory) valuation

Question 8

Q

Cost object (definition)

Answer

A

any activity for which a separate measurement of cost is required (e.g. cost of making a product or providing a service)

Question 9

Q

Period costs (definition)

Not?

Treated as?

Answer

A

not specifically related to the product and are not included in the inventory valuation.
They are treated as expenses in the period in which they are incurred

Question 10

Q

Figure 2.2 - Treatment of period and product costs

Answer

A

Manufacturing cost is a product cost
Non-manufacturing costs are period costs

When a product cost is unsold it is recorded as an asset in the balance sheet but becomes an expense when the product is sold in the profit and loss account

A period cost is recorded as an expense in the profit and loss account in the current accounting period

Question 11

Q

Why is cost behaviour important?

Answer

A

to predict costs and revenues at different activity levels for many decisions.

Question 12

Q

Variable costs (definition)

Answer

A

Costs that vary in direct proportion with activity.

Question 13

Q

Fixed costs (definition)

Answer

A

Costs that remain constant over wide range of activity

Question 14

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Semi-fixed costs (definition)

Answer

A

Costs that are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels

Question 15

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Semi-variable costs (definition)

Answer

A

Costs that include both a fixed and a variable component (e.g. telephone charges)

Question 16

Q

Variables Costs diagrams

Question 17

Q

Fixed Costs diagrams

Question 18

Q

Step-fixed costs diagram

Question 19

Q

Sunk costs (definition)

Opportunity costs (definition)

Incremental cost (definition)

Marginal costs (definition)

Answer

A

Sunk costs

costs that have been incurred and cannot be changed by any decision in the future

Opportunity costs

Costs that measure the opportunity that is sacrificed when the choice of one course of action requires that an alternative course of action is given up

Incremental cost

the difference between costs of alternative courses of action

Marginal costs

the cost of one extra unit of output

Question 20

Q

A cost and management accounting system should generate information for meeting the following requirements: (4)

Answer

A

Inventory valuation for internal and external profit measurement.
Provide relevant information to help managers make better decisions.
Provide information for planning, control, and performance measurement.

A database should be maintained, with costs appropriately coded and classified so that relevant information can be extracted to meet each of the above requirements.

Question 21

Q

There are three main costs that businesses incur:

Answer

A

Materials
Labour
Expenses

Correctly identifying these, working out the right amount of cost and treating them correctly is critical for all
businesses

Question 22

Q

There are two reasons why knowing the cost of inventory is vital:

Answer

A

Value of goods ‘issued’
Value of goods held

Question 23

Q

Material costs – valuation

Actual cost
The First In First out method FIFO (what is it?)
The Last in First out method LIFO (what is it?)
The Weighted Average Cost method WAS (what is it?)

Answer

A

FIFO:

assumes that the oldest items are used first, so that inventory is VALUED at the most recent prices

LIFO:

assumes that the latest items are used first, so that inventory is valued at the oldest prices
(this method is not allowed by IAS Inventories 2)

WAS:

assumes no pattern of the order in which items are used, so all are VALUED at the same value, which is the average one.

Question 24

Q

Labour costs

This can be one of the most expensive elements within the cost of unit, especially for service industries.

Labour costs can be worked out per hour or per unit – read the question carefully.

For example, a question could state that each unit has a labour cost of £20. Or, the question could state that each unit takes 2 hours to make and labour costs are £10 per hour

What factors can affect labour costs? (5)

Answer

A

Wages rates paid by other businesses
National / living wages imposed by Government
Government incentives
Local employment conditions – availability of unskilled and / or skilled workforce
Employer costs above gross salaries (about 20%)

Question 25

Q

What is the difference between relevant/avoidable costs & revenues and irrelevant/unavoidable costs & revenues

Answer

A

Relevant/ Avoidable costs and revenues:

are changed by a future decision

Irrelevant/ unavoidable costs and revenues:

are not changed by a future decision

Question 26

Q

Costs incurred in a manufacturing business diagram

Question 27

Q

Prime cost (definition)

Answer

A

the direct cost of a commodity in terms of the materials and labour involved in its production, excluding fixed costs

Eg. Direct materials + Direct labour = Prime cost

Question 28

Q

Examples of production overheads (5) and non-production overheads (3)?

Answer

A

Production overheads:

Rent and rates
Factory power
Factory heat and light
Factory expenses
Depreciation of plant

Non-production overheads:

Selling and distribution
Advertising
Admin expenses (salaries of office staff and office expenses)

Question 29

Q

Features of manufacturing, merchandising and service organisations

Answer

A

What type of materials are held by businesses will depend on the type of business

Manufacturing:

Raw materials
Work in progress
Finished goods

Merchandising/retail:

Tangible products for resale i.e. finished goods inventory

Service organisations:

Provide a service that cannot be stored, but may have work in progress

Question 30

Q

A cost collection system normally accounts for costs in two broad stages:

Answer

A

Accumulates costs by classifying them into certain categories (e.g. labour, materials and
overheads);
Assigns costs to cost objects.

Question 31

Q

Type of expenses diagram

Question 32

Q

Graph of fixed and variable costs

Question 33

Q

Separating Fixed and Variable costs

Answer

A

It is important to be able to identify the amount of fixed and variable costs. Sometimes the information is given to you but sometimes it is not.
Where total costs are known for two levels of output, the amounts of fixed and variable costs can be worked out using the ‘high/low’ method

Question 34

Q

Separating Fixed and Variable costs

Where total costs are known for two levels of output, the amounts of fixed and variable costs can be worked out using the ‘high/low’ method.

Example of High / Low method:
- At output of 1,000 units, total costs are £7,000
- At output of 2,000 units, total costs are £9,000.

What are the fixed costs?
What is the variable cost per unit?
(Note that this only works when the variable cost per unit is constant)

Answer

A

Variable cost per unit - £2000/1000 = £2.00

For 1,000 units:

Total cost = £7,000
Variable cost = 1,000 x £2 = 2,000
Fixed cost = 5,000

Question 35

Q

Costing systems

Going to consider the situation in manufacturing where the cost
object is a product

What are the 2 types of costing systems?

Answer

A

Job-order costing:

Assume that there are individual products or batches of products
The products or batches incur different costs so that there is a need to keep track of each product or batch

Process-order costing:

Used in industries where masses of the same product are produced in a flow process

Question 36

Q

Cost assignment methods

What happens to direct costs vs indirect costs?

Answer

A

Direct costs - Direct tracing to - Cost Objects
Indirect costs - go under cost allocations to either: - cause and effect allocations (the more we purchase, the more the cost will increase) or - arbitrary allocations (like direct labour hours or machine hours)

Question 37

Q

Overhead absorption

The number of units produced can be used to work out the
overhead per unit.

But this only works if there are static units produced which
are uniform.

In most manufacturing environments, that is not the case, so
another way to allocate overheads is either: (2)

Firstly, the overhead absorption rate (OAR) needs to be
found.
Then this can be applied to the units.

Answer

A

Arbitrary Allocations

Based on direct labour hours or
Based on machine hours

Question 38

Q

OAR – Plant wide rate/blanket overhead rate

This is the ___________ of all methods and applies overheads direct to a production department.

This method is only valid for more _______ businesses who do not
have _________ departments or _________ ________.

What are advantages (2) and disadvantages (3) of this method?

Answer

A

This is the simplest of all methods and applies overheads direct to a production department.

This method is only valid for more simple businesses who do not
have complex departments or multiple products.

Advantages:

Simple to calculate,
low cost to implement

Disadvantages:

Arbitrary,
simplistic,
inaccurate

Question 39

Q

OAR – 2 stage allocation process

This is a more complex method of allocating overheads.
Applies to both traditional methods and ABC systems

Traditional costing system: (4)

Answer

A

Stage 1

Assign all manufacturing overheads to production and
service centres
Reallocate the costs assigned to service cost centres to
production centres

Stage 2

Compute separate overhead rates for each production
cost centre
Assign cost centre overheads to cost objects

Question 40

Q

What might be used as cost centres in a traditional costing system?

What might be used as an activity cost centre in an activity-based costing system?

Answer

A

What might be used as cost centres in a traditional costing system?

Mattress line – border added
Building section – where fillings are added, may include tufting and tape edging.
Delivery

What might be used as an activity cost centre in an activity-based costing system?

Steel frame
Adding border, hand stitching
Building bed – adding fillings
Tufting
Tape Edging

Question 41

Q

OAR – ABC (Activity Based Costing)

This is a much more complex method of allocating overheads.

It identifies activities within a business and assigns costs based on those activities. (3)

Answer

A

Stage 1

Activities are divided into activity cost centres.
The total cost associated with each activity is allocated to
the relevant activity cost centre.

Stage 2

The total cost in each cost centre is then charged to output using a cost driver.

Question 42

Q

Methods of costing (2)

Answer

A

Direct costing = Direct cost tracing only assigns direct manufacturing costs, not fixed manufacturing costs, to products or services

Overhead absorption costing = involves allocating production overheads to
cost objects:

   - Plant wide / Blanket Overhead Absorption Rate – OAR based on machine hours and labour hours – different overhead allocation to the 2 jobs.
   - 2 – stage allocation process for both traditional absorption costing systems and Activity Based Costing systems

Question 43

Q

Under or Over Absorption of overheads in absorption costing

What is the issue? (3)

Answer

A

The OAR is based on budgeted overheads and budgeted activity e.g. number of labour hours.
At the end of the period, we know what the actual activity was and apply the OAR to the actual activity.
The difference between the absorbed overheads and the actual overheads is a period cost adjustment in the financial accounts. The period may be a month, quarter, or year for example.

Question 44

Q

OAR Issues: Budgeted Overheads

There are problems in using actual overheads:

Answer

A

There is a delay in finding product costs, so essential information for decision making is not available until the end of the accounting period

Monthly profit calculations
Inventory valuation
Basis for setting prices
If this is done monthly, then fluctuations in OAR will occur

Seasonality – changes in activity, customers want to know the price

Need to use an estimated normal product cost based on average long-run activity rather than an actual product cost
Establish a budgeted overhead rate based on annual estimated overhead expenditure and activity

Question 45

Q

Under and over recovery of
overheads

It is very unlikely that the actual overheads and / or production levels are the same as the budgeted overheads and production levels used to calculate the OAR

Therefore, overheads will be under or over recovered

Under or over recovery of overhead due to the activity level being different to the budgeted activity level is called a ______ ___________ __________ ____________
Under or over recovery of overhead due to the actual fixed overhead expenditure being different to the budget is called a _______ __________ _______________ __________
Financial accounting regulations require that under or over recovery of overheads is treated as a ______ _____ ____________

Answer

A

It is very unlikely that the actual overheads and / or production levels are the same as the budgeted overheads and production levels used to calculate the OAR

Therefore, overheads will be under or over recovered

Under or over recovery of overhead due to the activity level being different to the budgeted activity level is called a FIXED OVERHEAD VOLUME VARIANCE
Under or over recovery of overhead due to the actual fixed overhead expenditure being different to the budget is called a FIXED OVERHEAD EXPENDITURE VARIANCE
Financial accounting regulations require that under or over recovery of overheads is treated as a period cost adjustment

Question 46

Q

Non-Manufacturing overheads

Financial accounting regulations specify that only ____________ ________ should be allocated to products.

Non-manufacturing costs should be assigned to products for __________-_________ (particularly cost-plus pricing).

Some non-manufacturing costs may be a ________ _____, of the product

Examples: (3)

Generally, aim to select an allocation base/_____ ______ that corresponds to the ___________ of non-manufacturing overhead

For many non-manufacturing overheads, it may be hard to determine an appropriate basis for allocation. A widely used approach is to allocate based on the product’s production costs

Answer

A

Financial accounting regulations specify that only manufacturing overheads should be allocated to products.

Non-manufacturing costs should be assigned to products for decision-making (particularly cost-plus pricing).

Some non-manufacturing costs may be a direct cost, of the product

Examples:

Delivery costs,
Sales commission,
Travel costs

Generally, aim to select an allocation base/cost driver that corresponds to the causation of non-manufacturing overhead

For many non-manufacturing overheads, it may be hard to determine an appropriate basis for allocation. A widely used approach is to allocate based on the product’s production costs

Question 47

Q

Aims of costing

One of the main aims of costing is to establish the cost of one cost unit of work, whatever the work is.

Examples of a cost unit could be:

Answer

A

Manufacturing: per item made
Chemical business: kilogram of chemical
Transport company: passenger mile
Nursing home: resident day
University: student

Question 48

Q

Methods of costing – job costing

Answer

A

Job costing is used where each job can be separately identified from other jobs and costs are charged to that specific job.
All direct costs are easy to identify, and the overheads are added on a predetermined basis, such as labour hours or machine hours.
The overheads are allocated on a predetermined OAR basis.

Question 49

Q

Methods of costing – continuous work – Process Costing

Answer

A

Used where masses of similar products or services are produced in a flow process.
In the manufacturing industry, this could be making food. In this case, process costing is the method used.
In this situation, the total costs of the process for a given period of time are collected together and averaged per unit of output for that period.

Question 50

Q

Marginal and absorption costing

These two costing systems are often used in cost accounting, but for different purposes:

Marginal (variable) costing – ?

Absorption costing – ?

The use of each system is dependent on the informational needs of the business:

‘can we afford to sell 1,000 units of our product at a discount of 20%?’ – this is _________ costing
‘what profit have we made this year?’ – __________ costing

Answer

A

Marginal and absorption costing
These two costing systems are often used in cost accounting, but for different purposes:

Marginal (variable) costing – helps with short-term decision making.
Absorption costing – is used to calculate inventory valuations and profit calculations.

The use of each system is dependent on the informational needs of the business:

‘can we afford to sell 1,000 units of our product at a discount of 20%?’ – this is marginal costing
‘what profit have we made this year?’ – absorption costing

Question 51

Q

Marginal costing (Variable Costing)

What is marginal costing?

What are costs classified by and what is the effect of this?

What is the marginal cost of a unit usually but not always?

What does knowing this cost allow?

The contribution is:…?

Answer

A

Marginal costing is effectively the cost of producing one extra unit of output.

Cost are classified by their behaviour (variable, fixed) so that it is easy to work out the cost of producing one extra unit.

The marginal cost of a unit is usually (but not always) the total of the variable costs of producing a unit of output.

Knowing this cost allows managers to consider the contribution to the business by each unit.

The contribution is: selling price less variable cost.

Question 52

Q

Marginal costing (4,2) vs Absorption costing (3,2)

Answer

A

Marginal costing

Variable costs:

Variable direct materials
Variable direct labour
Variable direct expenses
Variable overheads

Fixed costs:

Fixed direct expenses
Fixed overheads

Absorption costing

Direct costs:

Direct materials
Direct labour
Direct expenses

Indirect costs:

Variable overheads
Fixed overheads

Question 53

Q

Marginal costing vs Absorption costing

Main use?
How does it work?
Main focus?
Usefulness?
Limitations?

Answer

A

Marginal costing

Main use?

To help with short term decision
making

How does it work?

Costs are classified as either variable or fixed
Contribution towards fixed costs
is calculated as selling price less
variable costs

Main focus?

Marginal cost
Contribution

Usefulness?

Concept of contribution is easy to understand
Useful for short term decision
making

Limitations?

Costs must be identified as either fixed or variable
All overheads must be recovered, or a loss will be made
Not acceptable under IAS 2
Inventories

Absorption costing

Main use?

To calculate profit
To calculate inventory

How does it work?

Overheads are charged to output through an overhead absorption rate, often based
on labour hours or machine hours

Main focus?

All production overheads charged to output
Calculating profit
Calculating inventory valuation

Usefulness?

Acceptable under IAS 2
Appropriate for traditional industries where overheads are charged to output based on direct labour or machine hours

Limitations?

Not as useful for short term decision making

Question 54

Q

Marginal costing – Contribution

Once the contribution per unit has been established, the total contribution for the period can be established.
The fixed costs are then ___________ , to arrive at the _________ for the period.

Answer

A

Once the contribution per unit has been established, the total contribution for the period can be established.
The fixed costs are then deducted, to arrive at the profit for the period.

Question 55

Q

Advantages to a marginal costing statement (4,5)

Answer

A

Contribution per unit is clearly identified
Effect on changes to costs easily identified
Effect on changes to selling price easily identified

Helps with short-term decision making such as:

   - Break even analysis
   - Margin of safety
   - Target profit
   - Contribution sales ratio
   - Limiting factors

Question 56

Q

Absorption costing

This method answers the question … ‘What does it cost to make one unit of output?’

The absorption cost of a unit of output is made up of:

Answer

A

This method answers the question … ‘What does it cost to make one unit of output?’

Direct materials
Direct labour
Direct expenses
Production overheads (variable and fixed)
Absorption cost

Question 57

Q

Absorption costing vs variable costing diagram

Answer

A

https://1drv.ms/i/s!AqdQnHr6sa5_xQIa3T5BM1IVbbm7?e=Q1AHmZhttps://1drv.ms/i/s!AqdQnHr6sa5_xQIa3T5BM1IVbbm7?e=Q1AHmZ

Question 58

Q

Marginal and absorption costing

What do they treat differently and what is the effect of this therefore?

Why is this because?

What does IAS 2 Inventories do?

What does absorption costing have to be used for?

Answer

A

Marginal and absorption costing treat fixed overheads differently; therefore, the two methods will produce different levels of profit when there is closing inventory.

This is because:

under marginal costing the closing inventory is valued at variable production cost.
Whereas under absorption costing, there is a share of fixed production costs in closing inventory.

IAS 2 Inventories – provides guidance for determining the cost of inventories and the subsequent recognition of the cost as an expense

Absorption costing has to be used for external reporting

Question 59

Q

Budgets serve several purposes (6)

Answer

A

Planning annual operations
Coordinating activities
Communicating plans
Motivating managers
Controlling activities
Evaluating performance

Question 60

Q

Developing budgets
Different organisations will produce budgets in different ways: (4)

Answer

A

Participatory – managers at all levels are involved.
Zero based budgeting – justify every figure in the budget (can be time-consuming)
Incremental budgeting – start with prior period and adjust the figure (with percentages) (could add budgetary slack and become inaccurate)
Rolling budgets – always have a budget for the next time period e.g. next 12 months

Question 61

Q

Stages in the Budgeting Process

Answer

A

Communicate details of budget policy and guidelines to those people responsible for preparing the budget.
Determine the factor that restricts output.
Preparation of the sales budget.
Initial preparation of budgets.
Negotiation of budgets with higher management.
Coordination and review of budgets.
Final acceptance of budgets.
Ongoing review of the budgets.

Question 62

Q

Types of budgets

Answer

A

Sales
Production including inventory levels
Materials usage
Materials purchase
Labour utilisation
Production overhead budget
Functional budgets - eg. finance, admin
Capital expenditure
Cash flow
Master, budgeted profit or loss and balance sheet

Question 63

Q

Budgetary control

We have already looked at why budgets are produced – the main reason is for _________ ___________.
So, once the budgets are completed, what happens?
The difference between the budget figures and the actual figures can be either a favourable variance or an adverse variance. (what do these mean)

Answer

A

We have already looked at why budgets are produced – the main reason is for control purposes.

They are compared to actual figures over the period so that those responsible can understand how they are performing.

Favourable = sales price increase = increase net profit
Adverse = cost of materials increase = decrease net profit

Question 64

Q

Budgetary control

There can be a variety of reasons for variances:

Answer

A

Poorly set budget
Inaccurate cost behaviour assumptions
Change in suppliers
Government changes – e.g. living wage
International changes – e.g. price of oil
Bad management
High wastage

Answer 58

A

So, once the budgets are completed, what happens?

They are compared to actual figures over the period so that those responsible can understand how they are performing.
The difference between the budget figures and the actual figures can be either a favourable variance or an adverse variance.

Answer 59

A

From the perspective of Net Profit

Favourable
Adverse (unfavourable)

Answer 60

A

Standard costs are target costs for each operation that can be built up to produce a product standard cost.
A budget relates to the cost for the total activity, whereas standard relates to a cost per unit of activity

Establishing standard costs: Two approaches:

past historical records; Labour and Material usage
engineering studies

Answer 61

A

Standard Hours Produced

Used to measure output where more than one product is produced.

Example

Standard (target) times: X = 5 hours, Y = 2 hours, Z = 3 hours
Output = 100 units of X, 200 units of Y, 300 units of Z

What is the Standard Hours Produced?

(100 × 5 hours) + (200 × 2 hours) + (300 × 3 hours) = 1,800 hours

If actual DLH are less than 1,800 the department will be efficient,
If hours exceed 1,800 the department will be inefficient.

Note: Different activity measures and other factors (besides activity) will influence cost behaviour.
Standard Hours Produced

Answer 62

A

Fixed budgets remain the same irrespective of the level of activity.

A flexed budget changes with the level of activity. This is commonly used inmanufacturing businesses because if the level of activity changes, then every comparison between budget and actual will have variances – but this variance could be mainly due to activity levels being different.

Once the flexed budget is produced, the variance analysis can be carriedout.

Note we are looking at variance analysis with a variable costing system

Answer 63

A

This variance handles the change from original budget to flexed budget.
As the only difference between these budgets is the level of activity, this variance considersthat in one figure.

A reduction in sales volume would lead to an adverse variance.
An Increase in sales volume would lead to a favourable variance

Answer 64

A

This variance compares the number of hours budgeted against the actual number of hours taken.

This difference is then shown at the budgeted hourly rate.

A reduction in the number of hours taken would lead to a favourable variance.
An increase in the number of hours taken would lead to an adverse variance

Answer 65

A

This variance compares the budgeted cost per hour with the actual cost per hour.

A reduction in the cost per hour would lead to a favourable variance.
An increase in the cost per hour would lead to an adverse variance.

Answer 66

A

This variance compares the quantity of materials budgeted against the actual
quantity used.
This difference is then shown at the budgeted material cost

A reduction in the quantity of materials usedwould lead to a favourable variance.
An increase in the quantity of materials used would lead to an adverse variance.

Answer 67

A

This variance compares the budgeted cost per unit of material with the actual cost per unit of material.

A reduction in the cost per unit would lead to a favourable variance.
An increase in the cost per unit would lead to an adverse variance

Answer 68

A

In Marginal costing costs are classified as either fixed or variable.
Companies need to know how many units need to be sold to cover all the fixed costs

Contribution per unit (CPU) = Selling price – variable cost

Profit = Contribution per unit x number of units sold) – Fixed costs

Answer 69

A

C = cost of the unit
V = volume of the unit
P = profit made

Breakeven Point (BEP) is the point at which neither a profit nor a loss is made
BEP is the number of units that need to be sold to cover the fixed costs
- BEP = Fixed costs / contribution per unit

Answer 70

A

This is the amount by which the sales exceed the BEP.

It can be expressed as:

Number of units
Sales revenue amount
Percentage: current output – break even output/current output x 100 = % margin of safety

Answer 71

A

Contribution expressed as a % of the selling price.

Contribution sales ratio % = Contribution / Selling price

We can use the CS ratio to find the sales revenue at which the company breaks even, or the sales revenue to give a target profit

Break even sales revenue = Fixed cost / CS ratio

Answer 72

A

Some companies will want (need) to make a certain amount of profit, so this can be inbuilt into the
breakeven analysis to ensure that the right amount of units are produced.

Fixed costs + target profit / CPU = number of units

Answer 73

A

Before starting a new business
When making changes
To measure profits and losses
To answer ‘what if’ questions
To evaluate alternatives

Answer 74

A

Assumes all output is sold
All costs and revenues can be represented by a straight line
Fixed costs remain fixed – and not stepped
-There is a direct relationship between revenue and cost- in some case the more that is produced the cheaper it is per unit
Only applies to the relevant range

Answer 75

A

Limiting factors are those aspects of a business which affect output.

Lack of availability of materials
Lack of availability of labour (especially skilled)
Lack of availability of capital resources (machinery)
Finance
Volume of units that can be sold

Where there are no limiting factors, company should concentrate on the product
making the highest CS ratio

However, when there are limiting factors, production should be based on the highest
contribution from each unit of the limiting factor

Answer 76

A

Reconciliation statements can be used to show the differences between the standard cost of production and the actual cost.

Computing the differences for variable and fixed costs is more complex when using standard costing.

Answer 77

A

Under marginal (variable) costing – fixed costs are ignored.

Therefore, where there is a difference between projected and actual fixed costs, the overhead variance is simply the difference between the two figures.
* i.e. Fixed Overhead Expenditure Variance

Answer 78

A

Under absorption costing – one advantage of standard absorption costing is that the cost for a unit will be a ‘full’ cost and will incorporate a portion of all the costs of production.

If the actual production level is close to the projected level, and all cost estimates are reasonably accurate, then standard cost will be close to the actual full cost

However if this does not occur, fixed overhead variances will need to take into account:

Production volumes and
Overhead costs

Answer 79

A

As we know, the OAR is worked out before production is underway. The OAR is worked out so that, based on a measure, the total fixed overheads are covered by the volume of units expected to be made.

So, what happens if:
Fixed overheads change?
The measure (labour hours, machine hours) change?
Volume of units produced / sold change?

These changes will provide two fixed overhead variances:

Fixed overhead expenditure variance – this is the difference in the actual amount spent on fixed overheads.
Fixed overhead volume variance – this is the difference in the actual volume of output.

The combination of these two variances will result in an overall total fixed overhead variance.

Answer 80

A

Remember that fixed overheads can be apportioned uses a variety of measures. The three main ones are:

actual units,
labour hours
machine hours.

How the OAR has been worked out will change the waythat the fixed overhead variances are worked out.

Answer 81

A

For deeper analysis, the volume variance can also be sub-divided into efficiency variance and capacity variance.

Volume Capacity variance

this compares the time the budgeted production should have taken with the actual hours worked.
(actual hours taken – budgeted hours) x OAR

Volume Efficiency variance

this compares the time the actual production should have taken with the time it actually took to make.
(std hours for output – actual hours for output) x OAR

Answer 82

A

the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information

Answer 83

A

internal users within the organization (management accounting).
external parties outside the organization (financial accounting).
(Drury, 2020)

Answer 84

A

Financial Accounting (not Finance):

provide information to those external to the organisation. Shareholders would be a typical user of this information.
mainly uses historical data and is essentially backward-looking.
very heavily regulated and controlled by parties external to the organisation, such as the IASB.
Financial accounting reports describe the whole of the business

Management Accounting:

seeks to provide information which is for those internal to the organisation.
Managers would be a typical user of this information.
mainly concerned with future planning and is very forward-looking. (Key term: decision making)
not regulated at all. (Although there are guidelines)
Financial accounting reports describe the whole of the business

Answer 85

A

(Drury, 2020)

Answer 86

A

allocate costs between products sold, and fully and partly completed products that are unsold.
provide relevant information to help managers make better decisions.
provide information for planning, control, performance measurement and continuous improvement

(Drury, 2020)

Answer 87

A

Any activity or output for which a separate measurement of costs is desired.

Answer 88

A

Classify costs into categories e.g., by type of expense, by cost behaviour, then assign costs to cost objects.

Choosing an appropriate cost unit is critical within a business as it is to this object that all costs are allocated.

Answer 89

A

Managers require information that will assist them in their decision-making and control activities; for example, information is needed on the estimated selling prices, costs, demand, competitive position and profitability of various products/services that are provided by the organization.
Shareholders require information on the value of their investment and the income that is derived from their shareholding. Likewise, potential investors are interested in their potential returns.
Employees require information on the ability of the firm to meet wage demands and avoid redundancies, their potential for continued employment.
Creditors and the providers of loan capital require information on a firm’s ability to meet its financial obligations.
Government agencies such as the Central Statistical Office collect accounting information and require such information as the details of sales activity, profits, investments, stocks (i.e. inventories), dividends paid, the proportion of profits absorbed by taxation and so on. In addition, government taxation authorities require information on the amount of profits that are subject to taxation. All this information is important for determining policies to manage the economy.

Answer 90

A

Financing decision: Planning and controlling the provision of resources (where funds are raised from)
Investment decision: The allocation of resources (where funds are deployed to)
Dividend decision: the amount and timing of any cash payments made to the firm’s shareholders.

Answer 91

A

Relationship between risk and return
Time value of money

Answer 92

A

Return:

financial rewards gained as a result of making an investment.
E.g., profit, dividend payments, capital gains, interest payments

Risk:

possibility that the actual return may be different from the expected return.
E.g., risky investment (where there is a significant possibility of actual return being different from its expected return)

Relationship between risk and return:

“high risk high return” (Investors and companies demand a higher expected return if they think that the possibility of actual return increases)

Answer 93

A

Time value of money refers to the fact that the value of money changes over time.

particularly important to companies because the financing, investment and dividend decisions made by companies result in substantial cash flows OVER a variety of periods of time.

Time
Inflation
Risk

Answer 94

A

Legal entity
Owned by shareholders
Can make contracts
Carry on a business
Borrow or lend money
Pay taxes but can’t vote

Private company

Shares are not publicly traded

Limited liability

No responsibility for corporation’ debt
E.g. Case of Lehman brothers in 2008

Public company

Own the corporation
Can’t manage & control it
Can sell their shares to new investors via stock market without disrupting the operations of the business

Answer 95

A

Broadly, corporate governance is the way in which organisations are directed, administered and controlled.

It is concerned with the relationship between internal and external stakeholders, with essentially:

         - Internal stakeholders are managers and directors
         - External stakeholders are the shareholders.

Answer 96

A

Investment decision:

Is related to the purchase of real assets
Involves in managing assets already in place
Decides when to shut down and dispose of real assets when they are no longer profitable
Manages and control risks of investments

Financing decision

Is related to the sale of financial assets and securities
Whether to raise money from new and existing owners by selling more shares of stock (equity) or to borrow (debt)
The choice between debt and equity is called capital structure decision
Includes the meeting its obligations to banks, bondholders, and stockholders that have contributed financing in the past. Example: repay debts when they become due. If not, it ends up insolvent and bankrupt!

Answer 97

A

Make the most profit
Pay the highest dividend
Be the best employer
Be the most environmentally friendly
Be the cheapest
Be the biggest
Have the best product

Answer 98

A

Traditionally, the main goal of organisations (public) was the maximise shareholder wealth.
This means capital and revenue returns need to be as high as possible: Capital = share price and Revenue = dividends
To transform that wealth into the most desirable time pattern of consumption
To manage risk characteristics of that consumption plan

However profit maximisation might not be a well-defined objective, for at least two reasons:

A corporation might be able to increase current profit by cutting back on outlays for maintenance or staff training (which have long term added value)
Company may increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. Might not be in shareholders interest if company earns only a modest return on money.

Answer 99

A

Conflicts between shareholders’ and managers’ objectives

Agency problems arise when agents (managers) work for principals (shareholders or owners) – A separation of ownership and control

Answer 100

A

Divergence of ownership and control
Interest conflicts between managers (agents) and shareholders (principals).
Asymmetry of information exists between agents and principals

Answer 101

A

Involve current outlays in return for a stream of benefits in future years
Involve long-term investment (i.e., a significant elapses between the outlay and recoupment of the investment) - normally longer than one-year period
Represent the most important decisions that a corporation makes, because they commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible. Examples: the projected capital expenditure for Tesco plc for 2016 were £2.6 billion.

Are applicable to all sectors of society.

 - Corporate investment decisions: plant & machinery, research & development, advertising & warehouse facilities. 
  - Public investment decisions new roads, school, airports.
  - Individuals’ investment decisions house buying, the purchase of consumer durables, education.

Initially that all cash inflows and outflows are known with certainty, and that sufficient funds are available to undertake all profitable investment. No tax, no inflation!

Answer 102

A

Rule 1: Comparing and Combining Values

It is only possible to compare or combine values at the same point in time.
A dollar($) today and a dollar($) in one year are not equivalent
To compare or combine cash flows that occur at different points in time, you need to convert the cash flows into the same units or move them to the same point in time

Rule 2: To move a cash flow forward in time, you must compound it

Rule 3: To move a cash flow back in time, you must discount it

Answer 103

A

Techniques that take into account the time value of money:

Net Present Value (NPV)
Internal rate of return (IRR)

Techniques that ignore the time value of money

Payback Period (Payback)
Accounting rate of return (ARR)

Answer 104

A

Technique that takes into account the time value of money

Suppose you want to value a stream of cash flows extending over a number of years. For multiple period, we have the discounted cash flow (or DCF) formula:

Net Present Value (NPV) of an investment decision:
𝑵𝑷𝑽=𝑷𝑽(𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔)−𝑷𝑽(𝒄𝒐𝒔𝒕𝒔)

To find the Net present value (NPV), we minus the initial cash flow of investment

Where I0 refers to investment outlay at time t, C refers to future cash flow and r refers to Discount rate

Alternatively, the NPV can be calculated by referring to a published table of present values:

To use the table, simply find the discount factors by referring to each year of the cash flows and the appropriate interest rate.

see miro

Answer 105

A

Advantages:

Assumption of reinvestment, or take into account the time value of money
Consideration of all cash flows
Simple to interpret. Easy to visualise by manager.

Disadvantages

Difficulty in determining the discount rate
Assumes investment returns are static
Difference in size of projects
Extent of risk unknowns

NET PRESENT VALUE lets you know whether the value of all cash flows that a project generates will exceed the cost of starting that particular project. Basically, it will tell you whether your project has a positive or a negative outlook.. That is, whether the project should be undertaken or not

Answer 106

A

Alternative technique for use in making capital investment decisions that also takes into account the time value of money

IRR is the rate of return that gives an NPV of zero

IRR represents the true interest rate earned on an investment over the course of its economic life

Trial and error method: Use a number of discount factors until the NPV equals zero. To calculate IRR, two discount rates are used to calculate the NPV, one giving a positive result and one giving a negative result.

Answer 107

A

Advantages

Take into account the time value of money
Simple to interpret. Easy to visualise by manager
No requirement of finding hurdle rate (required rate of return or discount rate)

Disadvantages

Express the result as a percentage rather than in monetary terms. Comparison of percentage can be misleading as the economies of scale (scale of investment) are ignored.
Where a project has unconventional cash flows, the IRR has a technical shortcoming.
Does not directly address wealth maximisation

Answer 108

A

Technique that ignore the time value of money

It is the length of time that is required for a stream of cash proceeds from an investment to recover the original cash outlay required by the investment.

In another words, it simply considers the time taken for the initial investment to be repaid in terms of net cash flows. It uses CASH rather than account profit.

A simple example: If an investment requires an initial outlay of £60,000 and is expected to produce annual cash flows of £20,000 per year for five years, the payback period will be £60,000/£20,000 = 3 years.

How to calculate it: the payback period is calculated by adding up the cash inflows expected in successive years until the total is equal to the original outlay (initial investment).

Answer 109

A

Advantages

It is widely used in practice because it is particularly useful approach for ranking projects where a firm faces liquidity constraints and requires a fast repayment of investments.
It is appropriate in situations where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are extremely difficult to predict.

Disadvantages

Does not take into account cash flows that are earned after the payback period
Ignore the time value of money: fails to take into account the differences in the timing of the proceeds that are earned before payback period –> discounted payback method
Can result in the acceptance of projects that have a negative NPV

Answer 110

A

Technique that ignores the time value of money

Also known as the return on investment and return on capital employed

ARR = Average annual profits / average investment

Assumption: depreciation represents the only non-cash expense, profit is equivalent to cash flows less depreciation – If straight line depreciation is used, it is presumed that:

average investment = ½initial investment + ½Scrap value

Answer 111

A

Advantages

Is superior to the payback period in one respect: it allows for differences in the useful lives of the assets being compared.
Is used in practice because it is frequently used to measure the managerial performance of different business units within a firm.

Disadvantages

Ignore the time value of money

Answer 112

A

Equity:

is raised through the sale of ordinary shares to investors

(long-term) Debt:

a bank loan or an issue of fixed interest securities such as bonds.(>1 years loan)

Answer 113

A

E.g., a sale of shares to new owners, perhaps through the stock market as part of a company’s initial listing
E.g., a sale of shares to existing shareholders by means of a rights issue.

Ordinary shares are bought and sold regularly on stock exchanges throughout the world and ordinary shareholders (as firm owners want a satisfactory return on their investment)

ORDER:

Secured creditors: debenture holders and banks (entitled to receive in full both unpaid interest and the outstanding capital or principal.)
Unsecured creditors: suppliers of goods and services
Preference shareholders
Ordinary shareholders: are not entitled to receive any of the proceeds of liquidation until the amounts owning to creditors, both secured and unsecured, and preference shareholders have been satisfied in full.

Answer 114

A

Nominal value (par value or face value):

The value shown on the face of the ordinary shares (securities).
It is the original cost of the shares as listed on the certificate.
Ordinary shares of a company must have a par value (nominal value or face value) by law and can’t be issued for less than this amount. E.g., 1p, 5p, 10p, 25p, 50p, or £1

Market value (marketcapitalization):

The value at which the share is traded on the listed stock exchange.
Nominal value bears no relation to its market value. E.g., ordinary shares with a par value of 25p may have a market value (price) of several pounds.
Market value per share = total value of the company in the market / total number of shares issued by the company

NOTE: New shares, whether issued at the foundation of a company or subsequently, are almost always issued at a premium to their nominal value. The nominal value of shares is represented in the balance sheet (one of three main financial statements) by the ordinary share account. The additional funds raised by selling shares at an issue price greater than the par value are represented by the share premium account

Book value:

The value of share in the company’s books.

Book value per share = (total assets – total liabilities)/total number of shares issued by the company

OR

Book value per share = ((Equity share capital + reserves and surplus) /total number of shares issued by the company

P/B (price to book value): highly useful comparison tool while taking an investment decision

Answer 115

A

The portion of a business’s net profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business.

Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce retained earnings (RE).

The formula is: Beginnning Period retained earnings = Net income/loss - (cash dividends + stock dividends)

Should a company retain the profits within the business or pay the profits out in dividends?

Factors affect RE: factors affect net income (e.g.,

sales revenue,
cost of goods sold,
depreciation,
other operating expenses) and
dividends.

Answer 116

A

New shares can be offered to any investors, new and existing.
Usually if the company is newly listing, it will be listed on the FTSE AIM (Alternative Investment Market).
If already listed, then additional shares will be added to the existing ones.
Directors need approval by the shareholders to do this (company law area regarding legality on this) as introducing new shares may have a major impact on the existing shareholders.

Answer 117

A

Suggested answer:

Additional regulation: they will need to produce additional published financial reports. Additional compliance costs often involve more staff to deal with the extra requirements.
Extra capital will be raised, but there will be legal and other professional fees involved. These could be 10% of the total raised, if not higher. If the company is hoping to raise £1,250,000, fees could be £125,000 or more. - This needs factoring into their cash flow workings for the new warehouse.
Directors need to be prepared for the additional scrutiny and PR that surrounds being listed – meeting financial journalists, for example.
Share price may fluctuate which directors need to consider regarding their duty to maximise shareholder wealth.
Impact on dividend payments for the future – 50% increase in the number of shares will affect the level of dividends payable – how will that affect directors’ personal ‘salary’?

Answer 118

A

A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the current market value, in proportion to their existing holdings.

This usually has the effect of diluting the existing share price and hence has an impact for existing shareholders

The issue is expressed as:
1 for XX shares at £X

Shareholders not wishing to take up their rights can sell them on the stock market.

We need to consider the TERP (theoretical ex-rights price) - The new share price after the issue and it is calculated by finding the weighted average of the old price and the rights price, weighted by the number of shares.

TERP (ex-rights price) = (𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑙𝑟𝑒𝑎𝑑𝑦 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒 + 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑓𝑟𝑜𝑚 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒 𝑖𝑠𝑠𝑢𝑒 )/(𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡ℎ𝑒 𝑟𝑖𝑔ℎ𝑡𝑠 𝑖𝑠𝑠𝑢𝑒 (𝑒𝑥 𝑟𝑖𝑔ℎ𝑡))

Answer 119

A

Advantages:

Cheaper than a public share issue
is made at the discretion of the directors, without consent of the shareholders or the Stock Exchange
rarely fails
existing shareholders’ equity stakes are not diluted, provided they take up their rights.

Disadvantages:

There is a limit to how much can be raised through this method as existing shareholders are only willing to invest so much.
Will affect Earning per Share (EPS) which affects Price/Earnings (P/E)
If shareholders do not take up their rights, then their shareholding will be diluted.

Answer 120

A

Bank term loan

A loan from a bank or other financial institution that is repayable on a certain date in the future.
This is simplest form of debt financing and can be arranged by companies of all sizes and types.
The loans are normally secured on the assets of the company.
Repayment of the principal can be at the end of the period, or over of period of time.
The interest rate charged by the bank can be fixed or floating.
The interest rate is fixed by the finance provider, depending on the risk they perceive of the borrower.

Answer 121

A

Bank term loan
Straight bond
Zero coupon
Unsecured bond
Convertible bond
Straight bond with warrants attached
Leasing

Answer 122

A

Straight bond

Straight bond, marketable debt, loan note and debenture basically all mean the same thing.
They refer to a situation where a company issues a - block of debt to investors through the Stock Exchange which is normally secured on the assets of the company.
Therefore, the issuing company must be listed on the stock exchange and the debt is bought and sold through the stock exchange in a similar way to shares.
The debt carries a fixed rate of interest set on the date that the debt is issued.
A crucial difference between this type of debt and bank lending is that an investor buying a bond can sell that bond at any time.
This type of debt is therefore a lot more ‘liquid’ to an investor, than bank lending.

Example: The market price of a straight bond is normally quoted per $100 nominal value of the bond. Interest is calculated on the basis of the nominal value. If a 12% bond was trading as $92 for example, this would mean that an investor would be prepared to pay $92 for a block debt with a nominal value of $100. The investor would then receive 12% x $100 = $12 of interest each year, but at a cost of $92.

Answer 123

A

Zero coupon

This works in principle the same as a straight bond, except a zero coupon bond is one that is issued at a significant discount to the redemption value.
No interest is paid but the investor will obtain a significant known return in the form of a capital gain between the date of issue and the redemption date.
A deep discounted bond is similar except that a small amount of interest is payable each year.
The main benefit of a zero bond is that a company avoids having to pay significant amounts of cash to an investor until the debt is redeemed. This is most useful if a company is financing a long term investment that will not generate cash returns for some time.
However, the overall percentage return that an investor will demand will be higher than the return on a normal bond. It is therefore relatively expensive. The company will also need to find a large amount of cash to redeem the debt on the redemption date.

Answer 124

A

Unsecured bond

This is also known as mezzanine finance. This is a bond issued without security on the assets of the company.
An investor in mezzanine finance would therefore rank below an investor in secured debt in the event of the company going bankrupt or winding up.
High risk debt -> the return that the company needs to offer investors is often extremely high. It is therefore used mainly where companies do not have assets to use as security.

Answer 125

A

Convertible bond

This is a type of bond which provides the holder with the option to convert the bond into a certain number of shares at a future date or alternatively, to have the bond redeemed for a cash lump sum. Interest is paid on the bond each year up to the date of conversion or redemption.
As the investor has the potential to makes a capital growth on the bond through the increase in the share price, the interest payable on the bond tends to be low by comparison to other similar bonds.
The company will therefore benefit from paying less interest over the period of the bond, but there is no detrimental impact on the company irrespective of the share price movement.
If conversion takes place, the company has a huge advantage of not having to find the cash to redeem the bond, but there will be negative impact on the EPS / P/E ratio / share price of the company’s shares.

Answer 126

A

Straight bond with warrants attached

This is similar to the straight bond described above, but when the investor purchases the straight bond, they are also given warrants to buy shares in the company which normally mature on the redemption date of the straight bond.
A warrant is an option to buy shares in the company, issued by the company itself. If the warrant is exercised by the holder, the company issues new share capital for cash.

Answer 127

A

Leasing

Long term leasing of assets is a very useful form of financing for certain types of assets. Most types of non-current assets can be leased or bought.

Answer 128

A

Bank loans
Overdrafts
Venture capital
Business angels

Answer 129

A

Bank loans

This is the primary source of financing for small companies. It could be very almost any time period and usually has quite considerable flexibility, especially over the period of the loan.
A major drawback of loans is that in many cases, the personal assets of the owner(s) of the business are used as security. This means that if something goes wrong, the owner(s) could lose their house as well as their business.

Answer 130

A

Overdrafts

This is also very popular, but tends to be one of the most expensive forms of finance, particularly if used long term.

Answer 131

A

Venture Capital

Venture capital organisations specialise in providing capital to high potential growth, but risky, private companies. High technology and R&D companies are examples. They would normally demand a significant equity stake in the company in return for the finance.
There are various advantages of this method of finance, but companies tend to take it out when there is no other alternative. This is partly because the VC will own a proportion (sometimes significant) of the business and therefore the true ‘owners’ loss control.

Answer 132

A

Business Angels

This refers to wealthy individuals or groups of individuals, who are willing to invest in small businesses. Like VC, they would normally take a significant equity stake.

Answer 133

A

Current assets = assets with maturities of less than one year

E.g., raw materials, work-in-progress and finished goods, trade receivables, short-term investments and cash

Current liabilities = liabilities with maturities of less than one year

E.g., trade payables, overdrafts and short-term loans

(Net) Working Capital = current assets - current liabilities

Answer 134

A

The level of current assets is a key factor in a company’s liquidity position. A company must have or be able to generate enough cash to meet its short-term needs if it is to continue in business.

Therefore, working capital management is a key factor in the company’s long-term success: without the ‘oil’ of working capital, the ‘engine’ of non-current (fixed) assets will not function.

The greater the extent to which current assets exceed current liabilities, the more solvent or liquid a company is likely to be, depending on the nature of its current assets

Answer 135

A

Increase the profitability of a company
Ensure that the company has sufficient liquidity to meet short-term obligation
The twin goals of profitability and liquidity will often conflict since liquid assets give the lowest returns. E.g., cash kept in a safe will not generate a return.

Answer 136

A

An aggressive policy: a company chooses to operate with lower levels of inventory, trade receivables and cash for a given level of activity or sales.
```
 - increase profitability but increase risk 
```
A conservative and more flexible working capital policy for a given level of turnover: would be associated with maintaining a larger cash balance.
```
 - lower risk of financial problems or investment problems but reduce profitability
```
A moderate policy: would tread a middle path between the aggressive and conservative approaches.

Answer 137

A

Overdraft: an agreement by a bank to allow a company to borrow up to a certain limit without the need for further discussion.

   - The company will borrow as much or as little as it needs up to the overdraft limit and the bank will charge daily interest at a variable rate on the debt outstanding. 
  -  An overdraft is a flexible source of finance in that a company only uses it when the need arises.

Short-term bank loans: a fixed amount of debt finance borrowed by a company from a bank, with repayment to be made in the near future, for example, after one year.

  - The company pays interest on the loan at either a fixed or a floating (i.e., variable) rate at regular intervals, for example quarterly.
  - less flexible than an overdraft

Trade credit: an agreement to take payment for goods and services at a later date than that on which the goods and services are supplied to the consuming company.

    - It is common to find one, two or even three months’ credit being offered on commercial transactions
  - a major source of short-term finance for most companies.

Short-term sources of finance are usually cheaper and more flexible than long-term ones.
Short-term interest rates are usually lower than long-tern interest rates

Answer 138

A

CCC: interaction between the components of working capital and the flow of cash within a company

CCC can be used to determine the amount of cash needed for any sales level.
CCC is the period of time between outlay of cash on raw materials and the inflow of cash from the sale of finished goods, and represents the number of days of operation for which financing is needed.
The longer the CCC, the greater the amount of investment required in working capital.

Answer 139

A

The length of the CCC depends on the length of:

Inventory conversion period: the average time taken to use up raw materials PLUS the average time taken to convert raw materials into finished goods PLUS the average time taken to sell finished goods to customers.
Trade receivables collection period: the average time taken by credit customers to settle their accounts
Trade payables deferral period: the average time taken by a company to pay its trade payables (i.e., its suppliers)

CCC = Inventory days + Trade receivables days – Trade payables days

Answer 140

A

When a business has decided on the level of working capital needed, it then needs to decide how this working capital is to be financed.

Three different types of assets:

Non-current assets (NCA): long-term assets from which a company expects to derive benefit over several periods, e.g., factory building, production machinery.
Permanent current assets (PCA): the core level of investment needed to sustain normal levels of business or trading activity, e.g., investment in inventories and average level of a company’s trade receivables.
Fluctuating current assets (FCA): correspond to the variations in the level of current assets arising from normal business activity.

Permanent: this is the minimum net current assets that the business is likely to need to continue to operate. At no point in the business cycle is the level of net current assets likely to fall below this.

Fluctuating: in many businesses, the net current assets will fluctuate between minimum and maximum levels.

Answer 141

A

Three different funding policies:

Matching funding policy: finances fluctuating current assets (FCA) with short-term funds and permanent current assets (PCA) and non-current assets (NCA) with long-term funds. The maturity of the funds roughly matches the maturity of the different types of assets.
Conservative funding policy: uses long-term funds to finance not only non-current assets (NCA) and permanent current assets (PCA), but some fluctuating current assets (FCA) as well  lower risk but higher cost of long-term finance (lower profitability).
Aggressive funding policy: uses short-term funds to finance not only fluctuating current assets (FCA), but some permanent current assets (PCA) as well.  greatest risk to solvency, but highest profitability and increases shareholder value.

Which one is chosen is dependent on:

Companies access to finance
Extent of liquidity issues
Ability to pay finance costs
Other finance commitments

Answer 142

A

Capital is the term used to refer to the financial resource that a company uses to pay for its activities and projects.

Usually, the term “capital” is specifically used to refer to its permanent or long-term finance, rather than its short-term financing.

- Long-term capital is provided by the company’s investors:
- Equity capital is provided by shareholders
- Debt capital is provided by lenders

Answer 143

A

The investors do not provide their capital for free.
Equity capital is provided by shareholders in return for dividends and/or increased market value of their shares (ie capital gains).
Debt capital is provided by lenders. Usually this is in the form of interest. Some forms of market-traded debt can generate capital gains too.
Dividends, interest and capital gains are types of return for the investor.
Dividends, interest and capital gains must be generated by the company to keep the investors happy.

From the company’s point of view, the returns expected by shareholders are referred to as a cost, THE COST OF CAPITAL

Answer 144

A

Cost of debt capital =

the interest rate on the company’s borrowings

Cost of equity capital =

the rate of return the company delivers to its ordinary shareholders

We will then use these two costs to work out the company’s overall average cost of capital. Usually referred to as the weighted average cost of capital (or WACC)

The cost of capital is ALWAYS quantified as a % per year.
It is the annual % return that investors expect/require on the money they put into the company.

Answer 145

A

The cost of debt capital is the annual interest rate%.

With debt the return for lenders is the interest rate %.

Companies pay tax on profits after interest so the cost of debt for the company should be lower because the interest expense reduces taxable profit and therefore reduces the corporate tax charge.

If the interest rate is 6% and the company pays tax at 25% the post-tax cost of debt = 6% x (1-0.25) = 4.5%

Remember with bonds or debentures the interest payable by a company is the fixed coupon (interest) rate multiplied by its nominal value not its market value.

Answer 146

A

We have to ensure that our company engages in activities that can generate enough return to satisfy the investors.
If our investors require 10% returns each year. We know that our company can only invest in projects that generate at least 10%
The cost of capital is therefore used as the discount rate for NPV calculations

Answer 147

A

Most companies are financed by a combination of debt and equity capital. These companies aim to maintain target proportions of debt and equity.

Cost of debt capital: the after-tax interest cost of raising new debt.
Cost of equity capital the rate of return a firm pays out equity investors. It can be calculated by using Capital Asset Pricing Model (CAPM)

Cost of capital: is the average cost of all of the firm’s various sources of finance, weighted according to the proportion each element contributes to the total funding (also called the weighted average cost of capital (WACC)).

Answer 148

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The cost of capital is ALWAYS quantified as a %.
It is the % return that investors expect/require on the money they put into the company.

Answer 149

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Example: Assume that the after-tax cost of new debt capital is 6% and the required rate of return on equity capital is 14%, and that company intends to maintain a capital structure of 50% debt and 50% equity. The overall cost of capital for the company is calculated as follows:

Weighted Average Cost of Capital (WACC) = proportion of debt capital x after-tax cost of debt capital + proportion of equity capital x cost of equity capital = 0.5 x 6% + 0.5 x 14% = 10%.

The overall cost of capital is also called the weighted average cost of capital (WACC).
For the discount rate used in NPV computations, it is (usually) the WACC that is used.
WACC can be measured by using either historical values (ie Balance Sheet) or market values (but only for listed companies)

Answer 150

A

Find cost of equity
Find cost of debt
Find proportions of debt and equity for the company
Average the costs of equity and cost of debt using the market values as weightings.
Use book values if market values are not given (eg if unlisted)

Answer 151

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Advantages

Easier, quicker and cheaper to raise
Interest can be fixed so a bit more predictable
Tax shield on interest payments makes debt finance cheaper
Debtholders bare less risk so cost of debt is cheaper

Disadvantages

Interest has to be paid (dividends don’t)
Reduces the amount of profit that can be distributed to shareholders which can be seen as risky for them, so the cost of equity will raise

Answer 152

A

‘Gearing’ refers to the proportion of a company’s financing that is in the form of debt as opposed to equity. A high gearing percentage indicates a high level of debt.
The term ‘leverage’ is used to refer to gearing in North America.

The calculation of gearing can be done in a number of ways, the two most commonly used are:

Debt/Equity (value of debt divided by the value of shareholders’ funds)
Debt/(Debt + Equity) (value of debt divided by total capital employed)

In FINANCE we prefer to use market values if they are available. In FINANCIAL ACCOUNTING the book values are used.

Capital structure is an alternative term which describes the mix of debt and equity

Answer 153

A

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimising its cost of capital.

The value of a company is like the value of a project or an investment. Its NPV is higher if the discount rate (the WACC) is lower.

To maximise the value of the company, we therefore need to minimise WACC.

Answer 154

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Key factors:

Lenders are guaranteed by law to receive their interest and their capital. Shareholders have no such rights generally.
Lenders must be paid their interest in full even if there is no profit. Dividends can be cut by the directors if there is a shortage of profit and/or cash.
In the event of a liquidation, lenders are more likely to recover their investment than shareholders because lenders rank more highly in the pecking order once the company is in financial difficulty.
As investors, ordinary shareholders bear more risk than lenders.
Shareholders expect a higher return to compensate for this higher risk.
When gearing goes up, the shareholders perceive that as additional risk
Cost of equity is nearly always higher than the cost of debt.
Cost of equity usually goes up when debt is increased.

Answer 155

A

Traditional theory

There is an ideal level of gearing which minimises the company’s WACC

Modigliani & Miller’s theory (no tax)

WACC is unaffected by gearing so makes no difference to the value of the company

Answer 156

A

As debt is increased the company’s cost of debt remains relatively constant as long as any increase in debt is incremental so it doesn’t adversely affect creditworthiness. Only when debt gets very high does the company’s cost of debt begin to rise because lenders start to worry about the company’s ability to pay back debt.
Cost of equity starts to rise too, but debt is a more direct risk to the shareholders’ dividend, so the shareholders begin to demand higher returns on their equity much earlier. Cost of equity increases more dramatically as the gearing increases.
Weighted average cost of capital starts to fall as the much cheaper debt becomes bigger within the capital structure. The cheap debt brings down the average cost of capital. However, past a certain point the increasing much greater increases in the cost of equity starts to pull the WACC up.
Best to have gearing where the WACC is at its lowest.

Answer 157

A

this states that cost of capital is unaffected by gearing. Their theory was that, provided there is a ‘perfect’ capital market (i.e., no tax, no transaction cost and no information asymmetry). ), that:
Two firms in the same sector with the same production potential yielding identical cash flows with the same risk complexity, will have the same total capital value, irrespective of their capital structure.  no optimal capital structure exists for a particular company.
In other words, whether the capital is equity or debt, or a mix, the WACC will remain the same.

Answer 158

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A dividend is a cash payment made on a quarterly or semi-annual basis by a company to its shareholders (owners). It is a distribution of after-tax profit.

The objectives of a company’s dividend policy should be consistent with the overall objective of maximisation of shareholder wealth. Therefore, a company should pay a dividend only if it leads to such an increase in wealth.

A very simple model for analysing dividend payments was put forward by Porterfield (1965), who suggested that paying a dividend will increase shareholder wealth only when:

d1 + P1 > P0

where d1 = cash value of dividend paid to shareholders;
P1 = expected ex-dividend share price (share price after paying dividends)
P0 = market price before the dividend was announced.

If the expression is modified to: d1 + P1 = P0 - this implies that dividends DO NOT affect shareholder wealth and hence, dividends are irrelevant.

Answer 159

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Research suggests that in a real world, a dividend policy does have a significant impact on shareholder wealth. In other words, dividends are relevant. This can be reflected via some theories.

Dividend signalling:

Due to the asymmetry of information existing between shareholders and managers, shareholders see dividend decisions as conveying new information about the company and its prospects.
A dividend INCREASE is usually seen by the market as conveying GOOD NEWS, meaning that the company has favourable prospects.
A dividend DECREASE is usually seen as BAD NEWS, indicating a gloomy future for the company.
However, fuller information could reverse these perceptions.

Answer 160

A

The existence of preferences for either dividends or capital gains means that investors will be attracted to companies whose dividend policies meet their requirements.
Each companies will therefore build up a clientele of shareholders who are satisfied by its dividend policy.
The implication for a company is that a significant change in its dividend policy could give rise to dissatisfaction among its shareholders, resulting in downward pressure on its share price.

Answer 161

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Agency theory:

Board of directors will make the dividend decision
But making it on behalf of potentially diverse range of shareholders – which decision is best for them all?
Decision could be made for the best of the directors instead of best for shareholders.

Answer 162

A

Constant dividend, and constant growth in dividends or steadily increase dividends: the most common policy. This tends to lead to share price stability.

(1) Constant payout ratio: a fixed percentage of earnings is paid out in dividends. It maintains a constant payout ratio.

- Advantages: it is relatively easy to operate and send a clear signal to investors about the level of the company’ performance. 
- Disadvantages: it imposes a constraint on the amount of funds it is able to retain for reinvestment.

This dividend policy is unsuitable for companies with volatile profits which have shareholders requiring a stable dividend payment.

Answer 163

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(2) constant growth in dividend or steadily increase dividends: dividend increases are kept in line with long-term sustainable earnings

It is important for the company to avoid volatility in dividend payments as doing so can help to maintain a stable share price
The drawback of keeping dividend constant or of steadily increasing them is that investors may expect that dividend payments will continue on this trend indefinitely. This can cause major problems when companies wish to reduce dividend payments, either to fund reinvestment or in the name of financial prudence.
Companies tend to increase dividend slowly over time, to reflect the new profit level, when they are confident that the new level is sustainable.

Answer 164

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This helps them:

Identify problems
Control costs
Measure how resources are being used
Measure employee performance
Plan for needed changes
Plan for future (short term, medium term and long term)

Answer 165

A

Liquidity (covered in ACC1010):

current ratio and quick ratio, etc.

Leverage:

this is the gearing aspects and we covered some of this previously. For example: debt/equity ratio, interest cover, etc. these ratios are measures of financial risk.

Activity (covered both in ACC1010 and previously):

inventory days, trade receivables and trade payables days, etc. These ratios are important in the management of working capital

Profitability (covered in ACC1010):

gross profit margin, operating profit margin, return on capital employed, return on assets, return on equity, etc.

When analysing financial performance, it is important to recognise that performance measures and financial ratios in isolation have little significance. In order to interpret the meaning of performance measures and ratios, they must be compared against appropriate benchmarks, of which the following are examples:

- Financial targets set by a company’s strategic plan. E.g., a target return on capital employed or economic profit
- Performance measures and ratios of companies engaged in similar business activities
- Average performance measures and ratios for the company’s operations, i.e., sector averages.
- Performance measures and ratios for the company from previous years, adjusted for inflation if necessary.

Answer 166

A

Non-financial indicators

This is data which is expressed in numbers, but is not financially orientated.

Examples:

Hours worked
Number of employees
Number of customers
Units produced
Units sold
Level of wastage

Qualitative measures

This is data which is not numerically based.

Examples:

Opinions
Judgements
Appraisals
Attitudes

These can be more important measure of performance in a service industry than in a manufacturing one.

Answer 167

A

This is a way of viewing performance from four perspectives:

Financial perspective (How do we look to shareholders?).
Customer perspective (How do customers see us?).
Internal business perspective (What must we excel at to satisfy our shareholders and customers?)
Learning and growth perspective (How can we continue to improve and create value?)

Answer 168

A

There are three core financial themes that drive the business strategy:

revenue growth and mix,
cost reduction and
asset utilization.

specifies the financial performance objectives anticipated from pursuing the organisation’s strategy and also the economic consequences of the outcomes from achieving the objectives speciexpectedfied from the other three perspectives.

Therefore, the objectives and measures from the other perspectives should be selected to ensure that the financial outcomes will be achieved.

Answer 169

A

The figure lists five typical core or generic objectives, and some additional measures (customer value propositions).

should identify the customer and market segments in which the business will compete.

The customer perspective underpins the revenue element for the financial perspective objectives. Therefore, the achievement of customer objectives should ensure that target revenues will be generated.

Answer 170

A

The process value chain consists of three processes:

the innovation process,
the operations process and
the post-sales process.

requires that managers identify the critical internal processes for which the organization must excel in implementing its strategy.

Critical processes should be identified that are required to achieve the organization’s customer and financial objectives.

Answer 171

A

There are three major enabling factors for this perspective:

employee capabilities,
information system capabilities and
the organisational climate for motivation, empowerment and alignment.

The organisation and its employees must keep learning and developing to ensure that an organisation will continue to have loyal and satisfied customers in the future and continue to make excellent use of its resources. Therefore, there is a need for a perspective that focuses on the capabilities that an organisation needs to create long-term growth and improvement.

This perspective stresses the importance of organisations investing in their infrastructure (people, systems, and organisational procedures) to provide the capabilities that enable the accomplishment of the other three perspectives’ objectives.