P2 Flash Cards
8/77777777777777777777777ABC is….
Cost pools, cost drivers, OH per unit
Absorption costing is….
- Based on no. units/hours
- Arbitrary allocation of OH
- not always suitable for modern businesses, so use ABC instead
Advantages of ABC
more accurate costing
more detailed insight
better forecasting/planning
Disadvantages of ABC
No evidence it improves profit
Historic and internally focused
hard to identify cost drivers
Activity Based Management is…
- Classifying activities as value adding / non value adding
- Applying principle of ABC to business management
- Doesn’t reduce costs, but helps managers understand their costs better
- Best in orgs with high overheads e.g. NHS
(ABC emphasis tracing costs to cost objects, ABM emphasises tracing costs & managing processes & work)
Disadvantages of ABM
- too inwardly focused
- not all OH costs are variable
- complicated & expensive to implement
Just-In-Time is
- no inventory
- pull system
- produce when needed
To succeed with JIT you need:
- quality, reliable production
- speed & flexibility
- versatile labour force
- reliable suppliers in close proximity
Advantages of JIT
no cash tied in inventory
less storage space needed
fewer bottlenecks, better coordination
Disadvantages of JIT
- relies on predictable demand
- no buffer inventory if issues
- harder to switch suppliers
Total Quality Management (TQM)
- get it right first time
- cost to prevent less than cost to correct
- continuous improvement, no waste
Types of Quality costs
Conformance: prevention & appraisal
Non-conformance: internal failure & external failure
Kaizen is
small, incremental improvements
all encouraged to make suggestions, bottom up
Business process re-engineering is
- radical redesign of processes to achieve cost reduction, improved quality & customer satisfaction
- not a cost cutting exercise, though long term savings may result
- not a one-off
- strategic outlook required
TPAR=
return per factory hour (TP cont/time needed on bottleneck)
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Cost per factory hour (total factory costs/total time on bottleneck)
Target costing 5 steps
- market research for pricing
- calc required profit per unit
- subtract profit from price to find target cost
- cost gap between actual & target costs
- close cost gap
Standard costing vs target costing
Standard VS target
reactive proactive
cost control cost reduction
internal forces external forces
price pushed to market price pulled from market
4 types of value
- cost value (production cost)
- exchange value (purchase price)
- use value (functionality value)
- Esteem value (increase in status)
Porters value chain
Primary activities (5)
Support activities (4)
Primary activities
- inbound logistics
- outbound logistics
- operations
- marketing & sales
- service
Support activities
- infrastructure
- technology development
- HR
-Procurement
The capital investment process (3 phases)
- creation phase - objective opportunities, assess environment
- Decision phase - initial proj. screening, examine alternatives, financial analysis
- Implementation phase - review investment decisions, post-completion audit
Compound interest formula
end total = initial invesment x (1 + interest rate)^no. periods
Present value formula
present value = end total x 1 / (1 + r)^n
Discount factor = 1 / (1 + r)^n
(assumes initial investment at T=0 and other cashflows start at T=1)
Advantages of NPV
- time value of money
- considers cashflows, rather than subjective profits
- considers whole proj. life
- accounts for risk
Disadvantages of NPV
- fairly complex
- not well understood by non-finance managers
- difficult to determine cost of capital
- does not consider short-term
Annuities
constant annual cash flow for set no. of years
PV of annuity = annual cashflow x annuity factor
Annuity factor = 1- (1+r)^-n / r
Perpetiuities
annual cashflow for the forseeable
PV of perpetuity = annual cashflow / r
Advanced / delayed annuities / perpetuities (when cash flows don’t start at T=1)
Advanced
- cash flows start at T=0
- ignore the T=0 cashflow and add 1 to the discount factor
Delayed
- cashflows start later than T=1
- apply discount factor as usual
- then discount back to T=0 using appropriate discount factor
Internal rate of return (IRR)
- the rate of return at an NPV = 0
- IRR > cost of capital = accept
IRR = R1 + (R2 - R1) x NPV1 / NPV1 - NPV2
Advantages of IRR
time value of money taken into account
understood by managers
don’t need to know cost of capital
if IRR > cost of capital then shareholder wealth increase
Disadvantages of IRR
no consideration of size of initial investment
interpolation - only an estimate
complex
may conflict with NPVs
not a measure of absolute profitability
MIRR formula
(terminal value of inflows / present value of outflows)^1/n - 1
Capital Rationing steps (when insufficient funds for all beneficial projects)
- calc profitability index for each proj.
PI = NPV / initial investment - Rank according to PI
- Allocate funds
Discounted payback profitability index =
(measures no. times proj. recovers initial funds invested)
PV of net cash inflows / initial cash outlay
Accounting Rate of Return (ARR) =
ARR = ave. annual profit (net cash flow - depn / no. yrs)
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ave. value of investment (initial inv + residual value / 2)
3 pros & 3 cons of ARR
+ simple to understand
+ widely used & accepted
+ considers whole proj. life
- ignores time value of money
- not measure of absolute profitability
- uses subjective accounting profits, not cash flows
Inflation on cashflows
(assume values inflated unless told otherwise)
current / real = excludes inflation
money / nominal = includes inflation
to convert cost of capital between money & real:
(1 + money cost of capital) = (1 + real rate of return)(1 + inflation rate)
Capital asset replacement decisions - Equivalent Annual Cost (EAC)
EAC = PV of costs / annuity factor for year n
(calc PV of costs for each replacement cycle, divide PV by annuity factor to find annual cost, select replacement cycle with lowest annual cost)
Price Elasticity of Demand (PED)
PED = % change in demand / % change in price
PED equation of line =
price = maximum price - (% change price / % change quantity) x (quantity demanded)
P= a - bQ
Profit maximisation model/ optimum price (6 steps)
- find a and b (a = max. price) (b = %change price / % change demand)
- determine marginal cost
- MC = MR
- MR= a-2bq so q = MR-a / -2b
- P(optimum price) = a - bq
- total contribution = (p-MC) x q
profit = total contribution - fixed costs
Limitation of profit maximisation model
- demand unlikely to be determined with certainty
- usually aim to achieve target profit, not maximum
- difficult to determine accurate marginal cost (likely to vary with demand e.g. bulk discounts)
Total cost-plus pricing ,how to calc
marginal costs + fixed costs = total prod. cost
+ non-production cost = total cost
+ profit = selling price
3 pros & 3 cons of total cost-plus pricing
+ profit achieved if sales volumes are as budgeted
+ good for contracting industries with low fixed costs
+ can be used to justify price increases
- arbitrary calc of fixed cost element
- profit not achieved if sales volumes lower
- ignores life cycle stages, customers & competition
Marginal cost-plus pricing, how to calc
variable cost + % contribution margin
3 pros and 2 cons of marginal cost-plus pricing
+ can cut price to below total cost
+ good for relevant costing decisions
+ good for scarce resource situations
- no guarantee costs will be covered
- price wars lead to loss making decisions
4 objective of decentralisation
- ensure goal congruence
- increase manager motivation
- reduce head office bureaucracy
- better training for junior managers
Profitability Indicators formulas
1. operating profit margin
2. asset turnover
3. return on capital employed
- operating profit margin = operating profit / turnover x100%
- Asset turnover = turnover / capital employed
- ROCE = operating profit / capital employed x100%
3 pros & 3 cons of ROCE (Or ROI)
+ widely used & accepted
+ relative measure, enables comparison
+ can be broken down for more detailed analysis
- dysfunctional decision making (e.g. wouldn’t accept project with a good ROI if it is less than the depts current ROI)
- different accounting policies confuse comparisons
- manipulation for ROI related bonuses
Residual income =
residual income = controllable profit - (capital employed x cost of capital)
3 pros and 4 cons of residual income
+ resolves dysfunctional aspect of ROI
+ risk can be incorporated
+ cost of financing brought home to divisional mangers
- doesn’t facilitate comparison
- can mislead, as increases over time
- subject to manipulation
- does not relate size of profits to assets employed
Economic Value Added (EVA) =
EVA = economic profit - (economic capital employed x cost of capital)
(measures performance of company in terms of value that’s been added during a period, directly linked to shareholder wealth)
Steps to calc EVA
- profit after tax
ADD BACK: accounting depn, provision for doubtful debts, interest paid, goodwill amortised, development costs
TAKE OFF: economic depn, impairment to goodwill
= economic profit - capital invested = opening cap. employed + net replacement cost
- EVA = economic profit x (capital invested x cost of capital)
Transfer Pricing 6 objectives
- goal congruence
- performance measurement
- record movement of goods
- maintain divisional autonomy
- minimise global tax liability
- fair profit allocation between divisions
minimum price selling division will accept =
maximum price buying division will pay =
minimum price selling division will accept = marginal cost + opportunity cost
maximum price buying division will pay = final selling price - additional variable costs
Standard Deviation =
SD = square root of: sum of (x - x mean)^2 / n
Expected values 3 pros & 4 cons
+ takes risk into account
+ easier decisions with single number
+simple calc
- probabilities are subjective
- little meaning for one-off project (as is a long-run average)
- answer may not exist
- ignores risk attitudes
