Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
*MBA504*
Produced by Division of Learning and Teaching Services, Charles Sturt University, Albury Bathurst - Wagga Wagga, New South Wales, Australia.
First published
Revised
Reprinted
Revised
November 2004
August 2005
April 2006, July 2006, April 2007, August 2007
April 2008, July 2008, April 2009, July 2009, May 2010, September 2010,
May 2011, September 2011, May 2012
ii
Contents
Page
Introduction
vii
Topic 1
Topic 2
Topic 3
Topic 4
Topic 5
Topic 6
Topic 7
Topic 8
Cost-volume-profit analysis
Topic 9
31
27
Readings
All these readings except 5.1 are located on CDROM#1. A hard copy of reading
5.1 is provided in your Study Guide.
1.1
Drucker, P. F. (2001).
Be data literate-know what to know.
1.2
Sheckley, R. (1988).
The accountant.
1.3
Perry, C. (1996).
One of the oldest professions?
1.4
iii
iv
1.5
Mann, G. (1994).
The origins of double-entry.
1.6
1.7
Chatfield, M. (1977).
Accounting in the ancient world.
1.8
2.1
2.2
2.3
2.4
Northcott, P. H. (1993).
Case 4, Cheating: The pressure on Pasquale Vialletta to succeed.
2.5
Northcott, P. H. (1993).
Ethics and the certified practicing accountant: Case studies Presenters notes.
3.1
3.2
3.3
3.4
3.5
Downes, S. (1999).
Stephens guide to the logical fallacies
3.6
(1999).
False dilemma
3.7
Wikipedia (2008).
Digital dashboard.
5.1
6.1
Deegan, C. (2009).
Extended systems of accounting the incorporation of social and
environmental factors within external reporting.
6.2
Ravlic, T. (2004).
Mung bean counters.
9.1
This is a very comprehensive reading list! And you are expected, in some areas,
to have current knowledge from the Internet and other sources.
But you have choice. See the Subject Outline and sample exam for assessment
guidelines including the choice of topics available to you in the final examination.
We have provided these readings to you in PDF format. This means you can load
them onto your netbook or iPad.
vi
Introduction
General comments
As stated in the Subject Outline the textbook does not cover the full range of
topics to be studied. It is for this reason that in the Study Guide some topics are
more detailed and refer to relevant Readings.
The commentaries provided in this Study Guide are intended to act as a guide in
directing your attention to concepts, definitions, fundamentals etc. basic to the
topic of study. These are in no way a substitute for the intensive study and
individual summaries that you will prepare for each topic.
At the beginning of each chapter of the textbook, is a list of Learning Objectives.
This list should guide your study as well as act as a means of self assessment. For
those topics that are not included in the textbook, there are a list of objectives
included in this Study Guide.
vii
Spreadsheet advice
The images and text below provide general advice on the spreadsheet component
of assignments in this subject.
Assignment checklist for spreadsheets? Paste two versions in your document;
paste normal views and formula views; show row and column headings; keep data
and report areas completely separate; save all spreadsheets in one workbook; use
IF functions where appropriate and create correct solutions that can be easily
replicated.
The assignment spreadsheet questions have particular requirements which are
demonstrated in the examples that follow. Also read the assignment requirements
in the Subject Outline very carefully. You can use any spreadsheet software as
long as we can read it with Microsoft Excel. Some of you will use Excel 2003
(sometimes called Excel XP), some will use Excel 2007 and some will use Excel
2010. Open Office http://www.openoffice.org/ works well and has the advantage
of being free! Any Excel version is ok but in later versions of Excel it is not
always so easy to paste spreadsheets into a Word doc showing row and column
headings an assignment requirement. In the past students have had a variety of
experiences with this feature. But a separate and free program, snippy.exe works
all the time.
Note that Snippy allows you to copy and paste a freehand or rectangle shape.
http://www.bhelpuri.net/Snippy/
Another simple program is Plixia.
http://download.cnet.com/Plixia/3000-13455_4-10910988.html
If you come across other freeware that does the same job share your discovery on
the forum.
Use any copy and paste technique/software you wish as long as it works.
You can also use ALT PrintScreen to capture and paste. But this method grabs the
spreadsheet menu as well which takes up space. One improvement minimise
viii
the menu before capture. And consider adjusting the size of the window so you
only capture the part of the screen that is relevant.
Students using Mac computer can achieve the same results.
Here is some advice from Natalie who uses Mac.
Oh Hallelujah!!!! I FINALLY figured it out!! Douglas, you put me on the right
track but there's a few wee differences in 2011...
If anyone else is having trouble with Excel 2011 here it is...........
Select the area you wish to copy. Press [control] + [p] Chose print selected area
at the bottom of the screen click on page setup in here you will find a box which
says row and column headings. Make sure this is ticked and then select ok
then select preview. Your spreadsheet will be displayed ready to print. Now you
can select the image and copy and paste into your word document...
I'm on the 29th floor and i swear, my Mac nearly made it to ground level the fast
way this afternoon!!!!
Hurrah.
For PC users.
How to paste a spreadsheet showing row and column headings in Excel 2007 and
Excel 2010.
i)
Highlight the print area, on the PAGE LAYOUT menu, set the PRINT
AREA, and tick the boxes for HEADINGS
ii)
iii)
Go to your Word doc and then use Ctrl + V to paste the image into your
document
If we share spreadsheet examples on the forum its a good idea to use the Excel
2003 format. That is, save your files as xls files. Then everyone should be able to
open them irrespective of the version they use.
See examples and advice following. Not every example is directly relevant to your
assignments. But some might make your work easier. If you have questions
please raise them on the forum. Remember there is also lots of advice available on
the Internet just Google your question.
And share your discoveries (and questions) on the forum.
ix
The following example is copied and pasted as a picture. The row and columns
box was first ticked in Page Setup in Excel. This works fine in Excel 2003 and
works sometimes (?) in Excel 2007. Discussion on the subject forum is good.
Budget
1
2
3
Data Input
The sales budget for the nine months ended September 30 follows
Quarter Ended
Mar-31
Jun-30
Sep-30
Cash sales
20% $
20,000 $
49,000 $
29,000
8 Credit sales
80% $
87,000 $ 102,000 $
76,000
9 Total sales
100% $ 107,000 $ 151,000 $ 105,000
4
5
6
7
Nine-month
Total
$
98,000
$ 265,000
$ 363,000
10
11
16
17
18
19
20
21
22
23
24
25
Required:
Prepare a budget showing purchases, cost of goods sold and inventory for the nine
months ended 30 September. See template below.
Solution/Report
26
27
28
Beginning inventory
Purchases
$
$
$
$
$
Mar-31
74,900
56,710
131,610
19,000
112,610
Quarter Ended
Jun-30
$ 105,700
$
47,050
$ 152,750
$
56,710
$
96,040
$
$
$
$
$
Sep-30
73,500
50,200
123,700
47,050
76,650
Nine-month
Total
$ 254,100
29
xi
The formula view is gained by toggling the Control + ` key combination (check
Excel Help: Formula View). This is the (grve) key below the ~ (tilde) key on the
top left of your keyboard.
Its an error to
A
Data Input
4
5
6
7
Cash sales
Credit sales
9 Total sales
8
11383
0.2
20000
0.8
87000
=SUM(B7:B8) =SUM(C7:C8)
Quarter Ended
11110
11202
49000
29000
102000
76000
=SUM(D7:D8)
=SUM(E7:E8)
10
11
0.7
16
17
18
19
20
21
22
23
24
25
28
25000
Nine-month
Total
=SUM(C7:E7)
=SUM(C8:E8)
=SUM(F7:F8)
of total sales.
plus
0.3
120000
19000
Required:
Prepare a budg
months ended
Solution/Repo
Cost of goods s
Desired ending
26
27
Budget
1
2
Beginning inve
Purchases
=+C5
=+C6
=+E11*C9
=+D13+F13*D24
=SUM(C24:C25)
=+E15
=+C26-C27
=+D6
=+E11*D9
=+D13+F13*E24
=SUM(D24:D25)
=+C25
=+D26-D27
=+F5
=+E6
=+F6
=+E11*E9
=SUM(C24:E24)
=+D13+(F13*E11*F14)
=SUM(E24:E25)
=+D25
=+E26-E27
29
In the formula view it is the formulas themselves that are important so column
widths can be adjusted and text can be truncated as is done here with several
columns.
And we prefer portrait orientation rather than landscape wherever possible.
xii
Or the spreadsheet can be pasted as a screen capture. Use Alt PrtSC (printscreen)
(or free software such as Snippy.exe http://download.cnet.com/Snippy/300013455_4-10910988.html
Capture and paste the rectangular area you need. If needed, take several snapshots.
For example - one snapshot of the data entry area and another of the report area.
Snippy.exe is free and works all the time! Here is an example using Alt
Printscreen. Notice it captures the menu.
BTW its not good presentation to capture and paste a lot of empty cells.
A question may require a graph or chart. See the following example created using
the Excel chart wizard.
xiii
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
xiv
C-V-P Analysis
Data Section:
Production costs:
Direct materials
Direct labour
Factory overhead
Selling expenses:
Sales commissions
Advertising
Miscellaneous selling expense
General expenses:
Office supplies
Administrative salaries
Miscellaneous general expense
Fixed
180,000
Variable
4.00
5.00
2.00
78,000
142,000
17,000
0.75
55,000
76,000
12,000
$560,000
0.25
$12.00
$40.00
$112,000
Solution
Contribution margin per unit
Contribution margin ratio
Unit sales at break-even point
Dollar sales at break-even point
Unit sales needed to meet target net income
Dollar sales needed to meet target net income
Margin of Safety in dollars
Data for Graph
Units
Sales
10,000
400,000
20,000
800,000
30,000
1,200,000
40,000
1,600,000
Variable Cost
120,000
240,000
360,000
480,000
Fixed Cost
560,000
560,000
560,000
560,000
560,000
$28.00
70.00%
20,000
800,000
24,000
960,000
160,000
Total Cost
560,000
680,000
800,000
920,000
1,040,000
CVP Graph
1,800,000
1,600,000
1,400,000
1,200,000
Dollars
Sales
Variable Cost
1,000,000
Fixed Cost
Total Cost
800,000
600,000
400,000
200,000
0
-
10,000
20,000
Units
30,000
40,000
Same spreadsheet on the next page but captured and pasted in two sections with
Snippy.
xv
xvi
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
Bell Petroleum
Data
Cash & equivalents
Revenues
Notes payable
Long term debt, excluding current portion
Accounts receivable, net
Estimated income tax expense
Other long-term assets
Interest expense
Deferred income tax liability
Retained earnings
Income taxes payable
Cost of sales
Inventories
Prepaid expenses
Common stock
Property plant & equipment, at cost
Accounts payable
Interest income
Goodwill, patents, trademarks
Current portion of long-term debt
Less: accumulated depreciation
Selling and administrative expenses
Additional paid-in capital
254,000
2,200,000
495,000
240,000
160,000
80,000
560,000
45,000
89,000
1,560,000
52,000
1,350,000
78,000
40,000
3,500,000
5,835,738
213,000
65,000
350,000
78,000
170,000
430,000
?
xvii
29
Report
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
$
2,200,000
(1,350,000)
850,000
(430,000)
420,000
Other
Interest income
Interest expense
Total other expenses
65,000
(45,000)
20,000
440,000
(80,000)
360,000
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
Current Assets
Cash & equivalents
Accounts receivable, net
Inventories
Prepaid expenses
Total Current Assets
Noncurrent Assets
Property plant & equipment, at cost
Less: accumulated depreciation
Net book value
Other long-term assets
Goodwill, patents, trademarks
Total non-current assets
Total Assets
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
254,000
160,000
78,000
40,000
532,000
5,835,738
(170,000)
5,665,738
560,000
350,000
6,575,738
7,107,738
495,000
52,000
78,000
213,000
838,000
240,000
89,000
329,000
3,500,000
880,738
1,560,000
5,940,738
7,107,738
OK
xviii
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
Bell Petroleum
Data
Cash & equivalents
Revenues
Notes payable
Long term debt, excluding current portion
Accounts receivable, net
Estimated income tax expense
Other long-term assets
Interest expense
Deferred income tax liability
Retained earnings
Income taxes payable
Cost of sales
Inventories
Prepaid expenses
Common stock
Property plant & equipment, at cost
Accounts payable
Interest income
Goodwill, patents, trademarks
Current portion of long-term debt
Less: accumulated depreciation
Selling and administrative expenses
Additional paid-in capital
254000
2200000
495000
240000
160000
80000
560000
45000
89000
1560000
52000
1350000
78000
40000
3500000
5835738
213000
65000
350000
78000
170000
430000
?
xix
29
Report
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
=+B6
=+B16
Gross Profit
=+B26
Income from operations
$
=C6
=-C16
=SUM(C32:C33)
=-C26
=SUM(C34:C35)
Other
=+B22
=+B12
Total other expenses
=C22
=-C12
=+C40+C39
=C36+C41
=-C10
=C43+C44
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
Current Assets
=+B5
=+B9
=+B17
=+B18
Total Current Assets
Noncurrent Assets
=+B20
=+B25
Net book value
=+B11
=+B23
Total non-current assets
Total Assets
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
$
=C5
=C9
=C17
=C18
=SUM(C49:C52)
=C20
=-C25
=SUM(C55:C56)
=+C11
=C23
=+C57+C58+C59
=C60+C53
=C7
=C15
=C24
=C21
=SUM(C65:C68)
=C8
=+C13
=+C72+C71
=+C19
=+C78-C75-C77
=C14
=+C79-C73-C69
=+C61
=IF(C79=C61,"OK","ERROR")
xx
A
B
1 Biorhythm chart
2
19-May-71
3 birthday
02-Feb-08
4 date
5
offset
day
6
-15
13393
7
-14
13394
8
-13
13395
9
-12
13396
10
-11
13397
11
-10
13398
12
-9
13399
13
-8
13400
14
-7
13401
15
-6
13402
16
-5
13403
17
-4
13404
18
-3
13405
19
-2
13406
20
-1
13407
21
0
13408
22
1
13409
23
2
13410
24
3
13411
25
4
13412
26
5
13413
27
6
13414
28
7
13415
29
8
13416
30
9
13417
31
10
13418
32
11
13419
33
12
13420
34
13
13421
35
14
13422
36
15
13423
37
38
39
40
41
1.50
42
43
44
45
1.00
46
47
48
49
0.50
50
51
52
0.00
53
54
55
56
-0.50
57
58
59
60
-1.00
61
62
63
64
-1.50
65
19
66
67
68
date
19
26
16
physical
0.94
0.82
0.63
0.40
0.14
-0.14
-0.40
-0.63
-0.82
-0.94
-1.00
-0.98
-0.89
-0.73
-0.52
-0.27
0.00
0.27
0.52
0.73
0.89
0.98
1.00
0.94
0.82
0.63
0.40
0.14
-0.14
-0.40
-0.63
emotionalintellectual
0.90
-0.81
0.78
-0.69
0.62
-0.54
0.43
-0.37
0.22
-0.19
0.00
0.00
-0.22
0.19
-0.43
0.37
-0.62
0.54
-0.78
0.69
-0.90
0.81
-0.97
0.91
-1.00
0.97
-0.97
1.00
-0.90
0.99
-0.78
0.95
-0.62
0.87
-0.43
0.76
-0.22
0.62
0.00
0.46
0.22
0.28
0.43
0.10
0.62
-0.10
0.78
-0.28
0.90
-0.46
0.97
-0.62
1.00
-0.76
0.97
-0.87
0.90
-0.95
0.78
-0.99
0.62
-1.00
BIORHYTHM CHART
Physical
26
Intellectual
Emotional
2
16
xxi
A
B
C
D
E
F
G
H
1
Unique Traders
2 Input Data
Year
20X2
3
rate of increase (%)
Sales units
30,000
8%
p.a. compound
4
Sales volume increase is to a maximum of
40,000
p.a. One product only
5
20X3
20X4
20X5
20X6
20X7
6 Purchase
$
5.10 $
5.36 $
5.68 $
6.02 $
6.50
7 cost per unit
Closing Inventory
15% of next year sales
8
Opening Inventory
3,600
Units
Value
$17,640
9
20X3
20X4
20X5
20X6
20X7
10
30%
30%
30%
35%
35%
11 Markup (%)
General and Administrative Expenses rate (%)
14%
of Sales
12
Tax Rate (%)
40%
Dividend Paid Rate (%)
65%
of after tax profits
13
O/B Retained Earnings
$
3,500
Assume FIFO cost flow
14
15 Required: Prepare budgeted income statement and statement of retained earnings for five years
16 Report
20X3
20X4
20X5
20X6
20X7
17 Sales Budget
Units
32,400
34,992
37,791
40,000
40,000
18
Unit Price
6.630
6.968
7.384
8.127
8.775
19
Sales $
214,812
243,824
279,049
325,080
351,000
20
20X3
20X4
20X5
20X6
20X7
21 Purchases Budget
Sales
32,400
34,992
37,791
40,000
40,000
22
Closing Inventory
5,249
5,669
6,000
6,000
6,000
23
Less:
24
Opening Inventory
3,600
5,249
5,669
6,000
6,000
25
Purchase units
34,049
35,412
38,122
40,000
40,000
26
Purchase $
173,650
189,808
216,533
240,800
260,000
27
Purchases
Unit Price
Sales
Balance
28 Inventory Budget
Year
Unit
Amount
29
20X2
4.90
3,600
17,640
30
20X3
34,049
5.10
32,400
5,249
26,770
31
20X4
35,412
5.36
34,992
5,669
30,386
32
20X5
38,122
5.68
37,791
6,000
34,080
33
20X6
40,000
6.02
40,000
6,000
36,120
34
20X7
40,000
6.50
40,000
6,000
39,000
35
20X3
20X4
20X5
20X6
20X7
36 Budgeted Income Statement
Sales
214,812
243,824
279,049
325,080
351,000
37
Less COGS
38
Opening Inventory
17,640
26,770
30,386
34,080
36,120
39
Purchases
173,650
189,808
216,533
240,800
260,000
40
Goods for Sale
191,290
216,578
246,919
274,880
296,120
41
Closing Inventory
26,770
30,386
34,080
36,120
39,000
42
COGS
164,520
186,192
212,839
238,760
257,120
43
Gross Profit
50,292
57,632
66,210
86,320
93,880
44
G & A Expenses
30,074
34,135
39,067
45,511
49,140
45
Net Income
20,218
23,496
27,143
40,809
44,740
46
Tax
8,087
9,399
10,857
16,324
17,896
47
16,286
24,485
26,844
Net Income after tax
12,131
14,098
48
20X3
20X4
20X5
20X6
20X7
49 Statement of Retained Earnings
Opening balance
3,500
7,746
12,680
18,380
26,950
50
Add Income after tax
12,131
14,098
16,286
24,485
26,844
51
15,631
21,844
28,966
42,865
53,794
52
Dividends
7,885
9,164
10,586
15,915
17,449
53
Closing balance
7,746
12,680
18,380
26,950
36,345
54
This budget example uses the IF and ROUND functions. In what cells, I wonder?
xxii
2
3
Data
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
9,000
5 square metres @
3 hours @
Actual Data
Square metres purchased and used
Price per square metre
60,000
$6.70
Hours of input
Labour price per hour
24,000
$8.40
Solution/Report
Actual Quantity
x Actual Price
Direct
Material
60,000 X
$6.70
$402,000
Actual Quantity
x Standard Price
60,000
Standard Quantity
x Standard Price
$6.00
$360,000
Actual Quantity
x Actual Price
24,000 X
$201,600
$8.40
$6.00
-$90,000 Unfavourable
Actual Quantity
x Standard Price
24,000
$270,000
-$42,000 Unfavourable
Direct
Labour
9,000 X
Standard Quantity
x Standard Price
$9.00
9,000 X
$216,000
$14,400 Favourable
$9.00
$243,000
$27,000 Favourable
xxiii
xxiv
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
Account Titles
Trial Balance
Debit
Credit
8,000
6,000
500
2,000
8,000
5,500
3,000
18,258
400
13,742
2,500
600
700
800
$35,000
$35,000
OK
Net Income
Solution
Heaven Corporation - Worksheet for Month Ended March 31, 20XX
Trial Balance
Debit
Credit
Account Titles
Cash
8,000
Accounts Receivable
6,000
Office Supplies
500
Prepaid Rent
2,000
Computer Equipment
8,000
Office Furniture
5,500
Accounts Payable
3,000
Heaven, Capital
18,258
Heaven, Drawings
400
Service Revenue
13,742
Office Salary Expenses
2,500
Advertising Expense
600
Telephone Expense
700
Utilities Expense
800
$35,000
$35,000
OK
Office Supplies Expense
Rent Expense
Depreciation Expense - Computer Equipment
Accumulated Depreciation - Computer Equipment
Depreciation Expense - Office Furniture
Accumulated Depreciation - Office Furniture
Salaries Payable
Cash
Accounts Receivable
Office Supplies
Prepaid Rent
Computer Equipment
Office Furniture
Accounts Payable
Heaven, Capital
Heaven, Drawings
Service Revenue
Office Salary Expenses
Advertising Expense
Telephone Expense
Utilities Expense
Data
HEAVEN CORPORATION
$1,408
83
400
700
100
125
$1,408
OK
83
125
100
400
700
$35,308
83
400
700
100
$35,308
OK
83
125
100
Adjustments
A: Office supplies on hand
B: Prepaid Rent expired
C:1 Computer Equipment cost
Expected life
Residual value
C:2 Office Furniture cost
Expected Life
Residual value
D: Salaries owing but not yet paid
Adjustments
Debit
Credit
6,008
7,734
$13,742
83
400
700
100
2,625
600
700
800
$13,742
OK
13,742
13,742
Income Statement
Debit
Credit
100
700
8,000
5 years
2,000
5,500
5 years
500
125
$29,300
29,300
83
125
21,566
7,734
$29,300
OK
100
Balance Sheet
Debit
Credit
8,000
6,000
100
1,300
8,000
5,500
3,000
18,258
400
-
xxv
The following Job Cost example is a jigsaw puzzle style of problem where data is
missing and the solution must be reconstructed.
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
D E
$
31,000
3,000
36,000
17,000
Overhead is allocated by using a predetermined rate that is set at the beginning of each year
by forecasting the year's overhead and using forecast direct labour hours as a cost driver
All factory workers receive the same rate of pay
An interview with the factory foreman revealed the following additional information:
1
2
3
4
5
6
7
8
9
10
11
12
Accounts Payable are for direct materials only. The balance on 31 August was
Payments for Accounts Payable made during August were
A stocktake after O. Bese's autopsy revealed only one unfinished job in the factory
Source documents showed that the one unfinished job had direct labour
The direct labour hours in the unfinished job was
The direct material in the unfinished job was
The finished goods inventory as at 31 August was
The budget for 20X4 called for total direct labour hours of
Budgeted factory overhead is
Jobs sold during August realised
Direct labour hours worked during August totalled
Finished jobs are priced at a percentage mark-up on manufacturing cost.
$9,000
$37,000
$2,000
800 hours
$4,000
$44,000
167,539 hours
$502,617
$180,000
18,800 hours
50%
Required:
The balance of Materials Control account at 1/8/X4.
REPORT/SOLUTION
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
xxvi
Work-in-Process
Finished Goods
Accounts Payable
Some comments
Derive the solution by using the data to complete the jigsaw puzzle
Plug in all balances first
The ending balance of WIP is direct material + direct labour (both given) + direct labour hours X the overhead rate
The overhead rate is the budgeted overhead amount divided by the budgeted hours
The cost of goods sold is the total sales revenue divided by 1 + the mark-up %
WIP transferred to FG is a missing figure
DM in WIP is a missing figure
And the beginning balance of DM is a missing figure!
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
10
4
9
16
32
6
26
39
24
21
(in millions $)
Plant utilities
Indirect manufacturing labour
Depreciation - plant, building & equip
Revenues
Misc. manufacturing overhead
Marketing, Distribution, Customer-Service Costs
Direct materials purchased
Direct manufacturing labour
Plant supplies used
Property taxes on plant
7
23
8
667
11
88
64
75
5
3
Report/Solution
Helen Reddy Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 20X1 (in millions $)
Direct materials:
Beginning inventory, Jan 1, 20X1
Purchase of direct materials
Cost of Goods available for sale
Ending inventory, Dec 31, 20X1
Direct materials used
21
64
85
4
81
Direct labour
Indirect manufacturing costs:
Plant utilities
Indirect labour
Depreciation - plant, building & equip
Misc. manufacturing overhead
Plant supplies used
Property taxes on plant
Indirect manufacturing costs total
Total manufacturing costs, 20X1
Add beginning work in process, Jan 1, 20X1
Total manufacturing costs to account for:
Deduct ending work in process, Dec 31, 20X1
Cost of Goods Manufactured, 20X1
75
7
23
8
11
5
3
57
213
10
223
6
217
Income Statement
For the Year Ended December 31, 20X1 (in millions $)
Revenues
Cost of Goods Sold
Beginning Finished Goods, Jan 1, 20X1
26
Cost of Goods Manufactured, 20X1
217
Ending Finished Goods, Dec 31, 20X1
9
Total Cost of Goods Sold
Gross Margin
Marketing, Distribution, Customer-Service Costs
Operating Income
667
234
433
88
345
xxvii
This example shows how a spreadsheet can be used to create multiple choice questions.
A
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
End of
20X2
22,000
21,000
18,000
End of
20X3
26,000
20,000
23,000
75,000
25,000
15,000
9,000
11,000
4,000
93,000
29,000
Workings
22,000
75,000
97,000
26,000
71,000
25,000
15,000
9,000
11,000
4,000
39,000
135,000
21,000
156,000
20,000
136,000
A $
135,000
B $
136,000
C $
258,000
D $
71,000
E None of the above
2 Cost of Goods Manufactured
The Michael Connelly Company had the following account balances
End of
20X2
123,456
245,678
23,456
End of
20X3
145,321
345,697
22,134
782,345
567,900
23,654
23,567
98,768
6,754
45,678
36,879
123,456
782,345
905,801
145,321
760,480
567,900
23,654
23,567
98,768
6,754
xxviii
152,743
1,481,123
245,678
1,726,801
345,697
1,381,104
MB A504
WRITING TIME:
3 hours 10 minutes
NUMBER OF QUESTIONS:
VALUE:
70%
INSTRUCTIONS TO CANDIDATES:
1.
Enter your name and student number and sign in the space provided at the
bottom of this page. Also enter your name and student number (in pencil)
on the General Purpose Answer Sheet. Shade in the appropriate circles.
2.
3.
4.
Write your answers to Part A on the answer sheet provided. Write your
answers to Part B in the booklet provided. Students must provide a
signature on the front of each booklet used.
5.
xxix
C.
D.
E.
2.
Honey Sweet Goods is planning to sell 4,500 layer cakes for $8 each and
9,000 pound cakes for $7 each. The production process is such that the
produces the products in this proportion automatically. Variable costs are $5
per unit for the layer cakes and $4 per unit for the pound cakes. Fixed costs
are $45,000. At the break-even point, how many cakes will have been sold?
A.
B.
C.
D.
E.
3.
Mom's Nursery sells garden shears for $7.00 each. Variable costs are 68% of
sales and the break-even point is $243,750. What are total fixed costs?
A.
B.
C.
D.
E.
xxx
4.
$82,000
$78,000
$170,625
$546,000
none of the above.
5.
6.
If the bank mistakenly recorded a $17 deposit as $71, the error would be
shown on the bank reconciliation as a:
A.
B.
C.
D.
E.
7.
B.
C.
D.
E.
9.
8.
Zunilda Travel Company budgets total revenues, total expenses, and net
income for the first four months of the year as follows:
Budgeted revenues
Budgeted expenses
Budgeted net income
January
$84,000
February
$60,000
March
$70,000
April
$83,000
55,000
$29,000
34,000
$26,000
35,000
$35,000
50,000
$33,000
xxxi
10.
A.
Revenues
Increase $12,000
Net Income
Decrease $3,000
B.
Decrease $1,000
Increase $4,000
C.
Increase $3,000
Decrease $2,000
D.
E.
Increase $13,000
none of the above.
Decrease $2,000
The Estefan Guitar Company has budgeted sales for the months of April and
May of $520,000 and $480,000, respectively. Monthly sales are 80% credit
and 20% cash. 50% of credit sales are collected in the month of sale and
50% are collected in the following month.
What are Estefan's budgeted cash collections from customers for the month
of May?
A.
B.
C.
D.
E.
11.
$496,000
$500,000
$288,000
$400,000
none of the above.
The MacGyver Tool Company has forecast sales of its tools for January,
February and March to be $150,000, $225,000 and $180,000 respectively.
MacGyver's policy is to maintain ending inventory of $850,000 plus 20% of
costs of goods sold in the following month.
Budgeted sales for April are $210,000.
Sales are 50% cash and 50% credit.
All accounts receivable are collected in the month following sale.
Cost of goods sold averages 60% of sales.
12.
13.
xxxii
$4,000
$7,000
$1,000
$3,000
none of the above.
14.
15.
The Columbo Lighting Company sells its lamps for $50 per unit. The
beginning inventory is 20,000 units, and the desired ending inventory is
12,000 units. If budgeted production is 54,000 units, what is the forecast
sales revenue from the lamps?
A.
B.
C.
D.
E.
16.
$1,530,000
$2,025,000
$310,000
$630,000
None of the above
During June, the Shasta Lake Company's actual sales were $180,000
compared to budgeted sales of $195,000. Actual cost of goods sold was
$135,000 compared to budgeted cost of goods sold of $136,500. Monthly
operating expenses were $25,000, and budgeted operating expenses were
$28,000. The company also earned interest revenue of $2,500, which was
not included in the budget. The performance report would show net income
for June over (under) budget by:
A.
B.
C.
D.
E.
17.
$43,750
$40,000
$94,400
$89,375
none of the above.
$(13,000)
$13,000
$(8,000)
$8,000
none of the above.
75
35
120,000
If Daltons can achieve a $20,000 reduction in fixed costs, by how much can
the variable costs increase and still allow the firm to maintain the original
break-even point?
A.
B.
C.
D.
E.
xxxiii
18.
19.
20.
A matching principle
B expense recognition principle
C disclosure principle
D comparability principle
E historical cost principle.
xxxiv
understated by $15,000
understated by $20,000
understated by $25,000
understated by $5,000
none of the above.
22.
FIFO
LIFO
standard cost
weighted average
none of the above.
Two separate errors affected the Parmalat Dairy Farms in Year I. The
beginning inventory was understated by $5,000 and the ending inventory
was understated by $20,000. Net income in Year I will be:
A.
B.
C.
D.
E.
21.
A $80,500
B $53,300
C $80,300
D $53,050
E none of the above.
23.
24.
E
F
Savage Art Gallery
Income Statement Projections
For the first six months of 2OXX
JAN
FEB
MAR
APR
MAY
JUN
TOTAL
Sales
Sculptures
Paintings
Lithographs
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
Total Sales
Cost of Sales
Gross Profit
Expenses
Salaries
Rent
Advertising
Telephone
Utilities
Misc
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
Total Expenses
Net profit
B9
C9
B12
Cl2
none of the above.
xxxv
25.
26.
27.
a label
formula
value
operator
an algebraic function.
Merryn Smith, a lawyer, performs bankruptcy services for a client and bills
full fee of $6,000 on September, 20Xl. Smith is uncertain if she will collect
the entire fee. At December 31, 20Xl, Smith had collected $900. Smith
received an additional $2,000 in 20X2. How much service revenue should
Smith report in 20Xl and 20X2, respectively assuming the use of the cash
basis accounting?
A.
B.
C.
D.
E.
xxxvi
29.
105*B9
B9*.05
B9+1.05*B9
l.05*B9
none of the above.
28.
+G8-Gl4
+G12-G14
+GIO-G14
+Gl2+Gl4
none of the above
$900
$2,000
$6,000
$0
$3,000
$3,000
$0
$6,000
none of the above.
30.
31.
32.
Control `
Function ~
Control ~
Alt F7
Alt Page Up
xxxvii
33.
34.
$12,000 F
and
$120,000 F
and
$188,000 UF and
$132,000 F
and
none of the above
$4,000 UF
$80,000 UF
$304,000 F
$76,000 UF
$188,000 F
and
$200,000 UF and
$200,000 F
and
$188,000 UF and
none of the above.
$304,000 UF
$300,000 F
$300,000 UF
$304,000 F
36.
$18,652 UF
$13,040 UF
$16,900 F
$16,900 UF
none of the above.
$50,000
$100,000
$200,000
October
November
December
$300,000
$400,000
$200,000
The gross profit on sales is 60%. Finished goods inventory any month will be
sufficient to cover sales for the next two months. Purchases will be paid for in the
month following purchase. Other expenses are expected to be $50,000 monthly,
including $10,000 depreciation. Expenses will normally paid in the month in
which incurred.
xxxviii
60% of sales are expected to be cash sales. Of the credit sales, 20% are expected
to be collected in the month of sale and 80% in the month following sale.
37.
38.
39.
$180,000
$90,000
$70,000
$100,000
none of the above.
40.
$100,000
$60,000
$68,000
$72,000
none of the above
($67,400)
($88,040)
($56,700)
($340,200)
none of the above
xxxix
For the essay questions, utilisation of the relevant readings and workshop
handouts will be expected. It is important to present well structured answers that
directly address the question asked. In some areas the Internet can provide correct
information.
It is very important to allocate your time appropriately. Answer all questions.
xl
E
C
B
B
A
D
A
C
B
A
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
B
C
C
B
E
C
C
C
B
A
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
A
C
D
B
B
D
B
B
A
C
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
A
A
D
B
B
D
E
A
A
A
xli
xlii
Required reading
Textbook:
Reading 1.1:
Reading 1.2:
Reading 1.3:
Reading 1.4:
Reading 1.5:
Reading 1.6:
Reading 1.7:
Reading 1.8:
You can read Chapter 15 now or at the end of these notes. It provides a
comprehensive introduction to financial accounting and may seem overwhelming
at the first reading because of the many new terms and concepts but dont be put
off by this.
There are always issues about where to start when one is trying to understand this
new language accounting. We are not interested, in this subject, in the nitty
gritty of accounting systems; we are not interested in detail such as comprehensive
journals, ledgers etc. But we need to understand how to use accounting
information and in order to do this we need to have an overall understanding of
how the system works.
The purpose of this topic is to provide an introduction and overview of the
financial side of accounting. Familiarity with accounting concepts, techniques and
conventions is necessary if you as a manager are to extract and make use of the
information included in financial statements. This not only means the statements
relating to your organisation but also the statements for other organisations,
whether they form part of your industry or not.
At this point it is recommended that you read the following excerpt and attempt to
answer the questions raised. You are not required to submit your answer for
marking but it is advisable to write down what you consider to be the main points,
problems etc. There is no single correct answer although several alternative
solutions have been included at the end of these notes.
1.1
Objective
What solution are you able to offer Deyonne and Batonne? Specify any
assumptions you find it necessary to make. Hint: Use sheep or sheep equivalents
as the basis for valuing the assets and liabilities.
The following points are worth noting in addition to the answer supplied.
1.2
Summary points
The question posed related to which of the sheepherders was the more well-off.
1.
2.
Realisation: Should orders received but not yet completed be valued and
completed?
3.
4.
Valuation Principle: Did you value land at the actual historical exchange
price or at a more recent basis of valuation? i.e. replacement cost.
5.
1.3
1.4
Discussion points
1.
2.
3.
There are two solutions to Part II. The first solution measures the changein-net-worth between the beginning and the end of the period and is
consistent with the approach used by the economist J.R. Hicks. This is a
balance sheet approach. The second solution uses the flow concept of
income, the inflow represents revenue and the outflow expenses. The
difference between revenue and expenses is net income.
4.
You have probably valued the cabin, carts and plough in the same number of
sheep at the beginning of the period and the end of the period. This is not a
realistic assumption as each have aged one year and in the case of the carts
and plough have had their useful life reduced by wear and tear. These assets
have been used up to some extent and this process in accounting is called
depreciation. In the flow approach to measuring income it would have been
legitimate to include as an outflow, along with the death of the ox, the sheep
equivalents for the loss in value of the cabin, carts and plough. This has the
effect of reducing net income.
5.
Some of the events recorded in the flow approach (Income Statement) are
regular and normally occurring activities consistent with the businesses
Deyonne and Batonne are engaged in. It is arguable that the death of the ox
is an extraordinary event which should not be included as part of the
normal events from which operating income is derived. As you will see in
later topics in the discussion on the formal accounting statements,
accountants are required to separately disclose events which may be
considered extraordinary to the results from the more normal operations.
For example if Deyonnes sheep had been destroyed in a fire then the
usefulness of the income statement would be enhanced by this separate
disclosure.
1.5
1.6
1.7
Objective
What solution can you offer the two men as to which had the greatest income for
the year?
A Note on the Income Concept
The concept of income refers to how much one has improved his welloffness
(wealth) during a period of time. J.R. Hicks, an economist well known for his
definition of income, has defined income as the amount a man could consume (or
otherwise distribute) during a period of time and still be as well off at the end of
the period as at the beginning.
Two approaches to the solution of Part II are illustrated in the appendix to this
paper.
Alternative views of the income concept.
Income may be viewed either as a change-in-net-worth concept or as a
flow concept (revenues minus expenses). The alternative solutions to Part II
illustrate the validity of both views of income.
Recurring Income vs. Extraordinary Items
The possibility of treating the oxs death as an extraordinary item might be
discussed.
When taken together, Part I and Part II give the student an early glimpse at the
relationship between the income statement and the balance sheet. He then has an
overview of the accounting process before examining its parts in detail.
The use of the game approach generates greater student involvement in the
learning process and better prepares the student for the study of accounting than
do the traditional first lectures in accounting. This approach also gives the student
a much better framework for evaluating later discussions on differences in
accounting methods, and it helps to explain many of the whys of accounting.
1.8
Deyonne
Sheep
Land
Cabin
Carts
Plow
Ox
Goats
400
80
12
4
Total assets
/3
5
0
5012/3
Batonne
360
120
8
2
0
3
31/3
4961/3
Liabilities
Sheep belonging to others
Payable to Tyrone
Total liabilities
Net worth
35
3
38
463
0
496
Solutions to Part II
Part II can be solved in two ways. The first views income as a change in net
worth concept; the other views it as the result of certain flows of resources taking
place during the period. The first method translates Hicks definition of income
into algebraic form. Hicks definition implies that income for an individual is
equal to the change in net worth during the period plus that periods consumption,
or,
Y = NW1 NW0 + C
where Y = Income
NW1 = Net worth at the end of the period
NW0 = Net worth at the beginning of the period
C = Consumption during the period
NW1 is computed below
1.9
Deyonne
Sheep
Land
Cabin
Carts
Plow
Ox
Goats
480
80
12
4
2
Batonne
/3
0
0
5762/3
Total assets
380
160
8
2
0
3
112/3
5642/3
Liabilities
Sheep belonging to others
Net worth
35
541
____
564
5412/3 4632/3 + 7 = 85
Batonne
The income numbers derived above can also be derived by basing the computation
on the inflows and outflows of resources during the period. Most students will
find that this flow based computation illuminates further the understanding of
income which they acquired from study of the change in net worth method.
1.10
Deyonne
Batonne
80
7
3
0
20
18
0
40
10
58
90
78
Goats
Goats received for services
(stated in sheep-equivalents)
Total animals acquired during the year
0
90
81/3
861/3
(5)
Net income
85
86
1.11
Reference
Carlson, M. L., & Higgins, J. W. (1974). A games approach to introducing
accounting. In Accounting education: Problems and prospects
(pp. 365-369). American Accounting Association.
1.2
You should use these study notes in conjunction with your reading of the text.
This section provides a general introduction to some concepts in accounting, to
the accounting profession, and to common accounting financial statements.
The topic is divided into eight sections. They are:
1.
2.
3.
4.
5.
6.
7.
8.
Definition of accounting
Users of accounting information
The development of accounting thought
The accounting profession
Different types of business organisations
Accounting concepts and principles
The accounting equation
Financial statements
Definition of accounting
Accounting is an information system. Its purpose is to provide information to
decision makers, whether the decision makers be inside or outside the accounting
entity.
Definition of Accounting
... the system that measures business activities, processes that information into
reports, and communicates these findings to decision makers.
Horngren & Harrison
Even if the particular persons involved with the business decided they did not
need accounting information, it is required by governments that businesses keep
accounting records for the purposes of calculating income tax. Businesses also
need to know if they are making a profit or not, and how much the business is
worth. These purposes are achieved by using financial statements such as the
Income (Profit and Loss Statement) and the Balance Sheet.
Bookkeeping is not accounting. Bookkeeping is to accounting as arithmetic is to
mathematics. That is, accounting includes bookkeeping. These days most of
bookkeeping activities are performed by computers and computer software
packages. The procedural aspects of accounting are increasingly of less
importance as computers and computer software take over these mundane day-today tasks.
1.12
1.13
Recently, a third book by Pacioli has been discovered covering among other
things, magic. It is thought that Leonardo helped out with the illustrations again.
1.14
For example, it is these two bodies which accredit degrees in Australia and grant
professional recognition.
Full members of the CPA Australia are called CPAs. Members of the Institute of
Chartered Accountants in Australia are commonly called Chartered Accountants.
The two Australian professional bodies represent the profession in discussions
with the governments and also promulgate accounting standards. These standards
are contained in the respective handbooks of the two professions.
Note that details of the structure of the American accounting profession are not
assessable in this subject.
Accountants provide many different services including auditing, taxation
accounting, management consulting, management accounting and, of course,
teaching and research. It is also worthwhile to note that many managers of large
companies have an accounting background. This is understandable when one
realises that the person within an organisation who understands the organisation
best is likely to be the accountant. Many of you have or will discover that, in
order to advance further in the organisation for which you work, a knowledge of
accounting is a distinct advantage. Maybe one day they will make you the boss.
Good luck!
2.
3.
1.15
1.16
Assets = Equities
Assets are the economic resources owned by a business. Equities are the claims
against those assets. There are two main kinds of equities: those which are
internal to the business and those which are external to the business. The internal
equity or economic obligation is called owners equity. The external equities are
called liabilities. Thus we can expand the original equation into:
The Owners Equity category can be further subdivided. The owners equity in a
business is increased by the revenues of the business and decreased by the
expenses of the business. Thus we can further expand the equation:
Your text has examples. Dont just read them work through them on paper.
This is the only effective way to understand this material.
Financial statements
In this introductory chapter the authors introduce three financial statements: the
Balance Sheet, the Income (Profit and Loss Statement), and the Statement of
Owners Equity. It is important to note that each of these statements is
interrelated. It is common practice for the statement of owners equity to be
included as part of the Balance Sheet. It is important to note that the term Profit
and Loss Statement instead of Income Statement is sometimes used in
Australia. Check the examples used in the textbook carefully by recording
solutions on your own paper.
1.17
Self-test questions
Try yourself out with these questions.
i.
Matching
You are required to match the numbered term with the letter of the most
appropriate description.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
____
____
____
____
____
____
____
____
____
____
A.
B.
CPA Australia.
C.
The accounting concept which treats the owner as separate from the
business.
D.
E.
F.
G.
H.
A kind of business organisation that has several owners but is not a separate
legal entity.
I.
J.
1.18
CPAA
ICAA
CPA
Company
Partnership
Entity
Objectivity
Auditor
Budgeting
Luca Pacioli
ii.
Multiple choice
2.
3.
an asset
a liability
owners equity
revenue
none of the above
5.
an asset
a liability
owners equity
an expense
none of the above
4.
revenue
expense
owners equity
an asset
none of the above
an asset
a liability
a revenue
an expense
none of the above
owners equity
a liability
revenue
an expense
none of the above
1.19
6.
7.
If the beginning balance of owners equity was $100, the ending balance
$250, and the net profit for the month $200, and there were no investments
by the owner, how much did the owner withdraw during the month?
A.
B.
C.
D.
E.
8.
$10,000
$12,000
$20,000
$42,000
none of the above
1.20
$73,000
$68,000
$29,000
$47,000
none of the above
10.
$100
$200
$250
$50
none of the above
9.
A = OE + L
OE = A - L
Net Income = R - E
L = OE - A
none of the above
2.
The concept which explains the separation of the owner and the business is
called the ______________________________ concept.
3.
4.
5.
6.
7.
8.
9.
10.
1.21
iv. Exercises
1.
OWNER'S
EQUITY
ACCOUNTS + CAPITAL
LIABILITIES +
=
=
ASSETS
CASH + ACCOUNTS + SUPPLIES + FURNITURE
RECEIVABLE
Cash
Accounts
Receivable
PAYABLE
+
Supplies
Furniture
A.
B.
Accounts
Payable
=
C.
=
+
D.
+
+
E.
+
F.
G.
H.
1.22
Capital
2.
Presented below are the balances in the assets, liabilities, revenues, and
expenses for Kens Cleaning on March 31, X9.
Accounts Payable
$10
Accounts Receivable 15
Cash
5
Ken, Capital
?
Equipment
20
Service Revenue
40
Supplies
10
Prepare a balance sheet for Kens Cleaning for March 31, X9.
Kens Cleaning
Balance Sheet
31 March, X9
Assets:
______
Liabilities:
______
Cash
______
Accounts payable
______
Accounts receivable
______
Total liabilities
______
Supplies
______
Owners Equity:
______
Equipment
______
Dan, capital
______
Total assets
______
______
1.23
3.
The following are the balances in the accounts of Billys Lawn Service on
31 July, X9.
Accounts Receivable
Accounts Payable
Lawn Equipment
Notes Payable
Salaries Payable
Salary Expense
Service Revenue
Supplies
Supplies Expense
Tax Expense
Telephone Expense
Truck Rental Expense
Billys, Capital
$ 500
300
4,000
300
150
2,000
6,500
400
200
150
250
600
150
Prepare an income statement for Billys Lawn Service for the month of July,
X9.
Billys Lawn Service
Profit & Loss Statement
For the Month Ended 31 July, X9
Service revenue
Expenses
Truck rental
Salaries
Supplies
Tax
Telephone
Net profit
1.24
Matching
1 B; 2 G; 3 E; 4 D; 5 H; 6 C; 7 J; 8 F; 9 I; 10 A.
ii.
Multiple choice
1.
2.
3.
4.
5.
E (an asset)
6.
7.
8.
B (42 + 5 + 2 + 24 - 5 = 68)
9.
C (9 + 13 + 20 + ? = 50 + 12)
10.
Revenues.
2.
Entity.
3.
4.
Balance Sheet.
5.
6.
1494.
7.
8.
9.
Mathematics.
10.
Auditing.
1.25
iv. Exercises
1.
Cash
Accounts
Receivable
Supplies
Furniture
Accounts
Payable
Capital
A.
$2,000
$2,000
B.
-600
-600
$1,400
$1,400
C.
$1,400
-100
$100
$1,300
$100
D.
E.
$1,500
$1,500
$1,500
$1,500
$1,400
$1,500
$1,500
$1,400
$1,500
$2,900
$1,500
$1,300
F.
$1,500
$100
$1,500
-300
$1,000
G.
-300
+
50
$1,500
$100
$1,500
$1,200
$2,900
$100
$1,500
$1,200
$2,900
$1,500
$1,200
$2,900
-50
$1,050
$1,057
H.
$1,500
$1,450
-7
$1,450
$93
TOTAL
2.
Kens Cleaning
Balance Sheet
31 March, X9
Assets:
Cash
Liabilities:
$
Accounts payable
Accounts receivable
15
Total liabilities
Supplies
10
Owners Equity:
Equipment
20
Ken, capital
Total assets
1.26
$ 50
$ 10
10
40
$ 50
Service Revenue
$ 6,500
Expenses
Truck rental
$ 600
Salaries
2,000
Supplies
200
Tax
150
Telephone
250
Net profit
3,200
3,300
1.27
Introduction
Double entry
Journals
Ledger
Trial balance
Chart of accounts
Introduction
This section gives an overview of the mysterious Debit and Credit accounting
system. This Debit and Credit accounting system is in essence the same as that
described by Luca Pacioli in his book published in 1494. The terminology used
dates from Paciolis time. For example, the words Debit and Credit are from the
Latin terms. You have probably already noticed, for example, that the word Debit
is abbreviated to Dr, and the word Credit is abbreviated to Cr. Thousands of
accountants throughout the world use these abbreviations daily. Most of them do
not know why they use those particular abbreviations. For example, where is the
r in the word Debit? The answer is that the word Debit comes from the Latin
word Debere. Thus the word Debit, when abbreviated, becomes Dr. Similarly
Credit is abbreviated to Cr, not because of the second letter in the word but
because it is an abbreviation of the Latin term Credere. If you happen to know a
qualified accountant, you might like to test your new knowledge by asking them
why the word Debit is abbreviated to Dr.
1.28
If, in any accounting period, Revenues exceed Expenses, the business has earned a
profit. This profit increases Owners Equity. You may encounter some variations
in terminology from textbook to textbook. For example, Cash is sometimes called
Cash at Bank, or simply Bank. Accounts Receivable is sometimes called Debtors
or Sundry Debtors. Accounts Payable is sometimes called Sundry Creditors or
Creditors. Withdrawals is sometimes called Drawings.
Double entry
Every transaction has a two-fold effect on the records of a business. Thus, when a
business purchases land for cash, two accounts are affected - namely, Cash and
Land. Each transaction can be analysed in terms of its effect on the five main
kinds of accounts. The five main kinds of accounts are: Owners Equity,
Liabilities, Assets, Revenues and Expenses. Thus the purchase of land for cash
must affect the two accounts, Cash and Land. Both of these accounts are assets.
One account is increasing and another account is decreasing. In this example, the
Cash account is decreasing and the Land account is increasing. The Land account
which is increasing is debited and the cash account which is decreasing is
credited. For every debit there is an equal and corresponding credit.
Uses of funds in a business are called debits. Sources of funds in a business are
called credits. Thus the purchase of land is a use of funds and therefore a debit in
the Land account. The source of funds in this example was the Cash account, and
therefore is a credit.
Uses of funds are called debits. Sources of funds are called credits
Let us try another example. The business pays wages. In this example, wages is a
use of funds. Wages is an Expense account and it is increasing and therefore it is
debit. The cash which is used to pay wages is an Asset account and it is
decreasing, so therefore it is credit.
We will now use an acronym which may help you to understand the debit and
credit accounting system. For the sake of the acronym, we will use P for
1.29
DR P A L E R
and
CR P A L E R
Journals
The accounting cycle begins with a transaction. This transaction should then be
recorded in some kind of source document. Then this source document is used to
make an entry into a journal. A journal is a chronological record of an entitys
transactions. In Topic 1.6 we will examine different types of journals. At this
1.30
stage we will assume that there is only one journal. This journal contains
instructions to debit a ledger account and to credit a ledger account. Examples are
given in your textbook.
For each transaction we need to identify the two accounts concerned; then we need
to establish what kinds of accounts each of these two accounts are; third we need
to know if the kinds of accounts are being increased or decreased; fourth, or from
the rule above, we need to determine which is debit and which is credit; fifth, the
transaction can be entered into the journal; and sixth, posted to the ledger.
Ledger
1.31
Let us apply the same analysis to transaction 2: The business paid $20,000 cash
for a computer.
Q1: The two accounts are Computer and Cash.
Q2: Both of these accounts are Assets.
Q3: The Cash asset account is decreasing; the Computer asset account is
increasing.
Q4: The Cash asset account is credit; the Computer asset account is debit.
The PALER rule demonstrated here can be applied to every transaction you may
ever encounter. It is also interesting to note that you really do not have to learn
the complete rule. That is, if you can work out which account should be debited,
then the other account obviously must be credited.
At the end of the accounting period, which may be a week or a month, each of the
ledger accounts is balanced.
Instead of a T account for showing ledger accounts, a four-column account format
may be used. The four column format shows each transaction in a debit or credit
column and then adjusts the debit or credit Balance columns. Normally in this
subject we will not require students to use a four-column ledger account format.
Four-column account formats are wonderful for computers. The computer has no
trouble calculating a new debit or credit balance after each and every transaction.
However, human beings dont like to make this many calculations. A T account
only needs to be balanced once every accounting period. A four-column ledger
account needs to be balanced after each and every transaction. Good for computer
programs but not for human beings. Transaction analysis helps you understand
the underlying rationale in Income Statements and Balance Sheets.
Trial balance
A trial balance is merely a list of all ledger accounts at a particular date. If we
have followed the debit and credit rules consistently, then the trial balance must
balance. If the trial balance does not balance, it means that we have not followed
the debit and credit rules consistently or we have made errors in addition. Note
that, if a trial balance does balance, this does not necessarily prove that we have
not made any errors. For example, if a transaction is omitted completely from an
exercise, then the trial balance will balance, but of course it will be incorrect.
1.32
Chart of accounts
The Chart of Accounts is a classified list of all the ledger accounts in an
organisation. The accounts are usually classified into groups with the headings:
Assets, Liabilities, Owners Equity, Revenues and Expenses. Each account is
usually given a number code within each of these groups. The numbering system
usually permits the addition of new accounts as the need arises. In some countries
in Europe, the numbering systems are so standardised that a particular account
will have the same number in every firm of that kind in the country. This is not
the case in the United States or in Australia. Each firm designs its own chart of
accounts to suit its own particular needs.
This section has introduced the fundamentals of the accounting cycle. By the time
you have finished studying this topic you should understand that every transaction
can be analysed into its two components: the debit and the credit. Then
transactions are entered into journals, posted to the ledger, the ledger accounts are
balanced, and a trial balance is prepared.
Summary
You should have completed the following tasks before proceeding to Topic 2:
1.
2.
Attempt the Sheepherders problem both Parts I and II. Review your
solution against the solution provided in the Solutions Manual. Examine the
discussion points in particular the points relating to Part II. The analysis
distinguished between a balance sheet approach and an income statement
approach to measuring income, the distinction between these two
approaches is fundamental to your later understanding of financial
statements.
3.
Review the questions and solutions from your text which follow.
1.33
i.
Matching
You are required to match the numbered term with the letter of the most
appropriate description.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
____
____
____
____
____
____
____
____
____
____
A.
B.
C.
The term used to describe the transference of information from the journal to
the ledger.
D.
E.
F.
G.
H.
I.
J.
A list of ledger account balances whereby the total of the debits should be
equal to the total of the credits.
1.34
Chart of Accounts
Posting
Entering
Dr
Ledger
Journal
Trial Balance
Debtors
Drawings
Debit
ii.
Multiple-choice
2.
3.
A business purchases land for cash. The correct entry for this transaction is:
A.
B.
C.
D.
E.
5.
When the owner of a business withdraws cash, the journal entry should
include:
A.
B.
C.
D.
E.
4.
Journal
Ledger
Trial Balance
Chart of Accounts
None of the above.
Owners Equity
Assets
Liabilities
Expenses
Revenues.
1.35
6.
7.
8.
The Cash account had total debits for the month of $3,400, and total credits
for the month of $2,700. If the beginning balance of Cash was $400, what is
the new balance at the end of the month for the Cash account?
A.
B.
C.
D.
E.
1.36
An accountant debited Rent Expense for $1,000, and credited Cash $1,000,
in error. The correct entry should have been: debit Prepaid Rent for $1,000,
and credit Cash for $1,000. As a result of this error:
A.
B.
C.
D.
E.
10.
Owners Equity
Assets
Liabilities
Expenses
Revenues.
When cash was received in payment for services rendered on account, the
accountant debited Cash and credited Service Revenue. As a result, there
was an:
A.
B.
C.
D.
E.
9.
Owners Equity
Assets
Liabilities
Expenses
Revenues.
$3,800
$1,100
$2,700
$300
none of the above.
The process of copying information from the journal to the ledger is called
_______________________________________
2.
3.
4.
5.
6.
7.
8.
9.
10.
1.37
Matching
1 G; 2 C; 3 H; 4 I; 5 A; 6 B; 7 J; 8 D; 9 F; 10 E.
ii.
Multiple-choice
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Posting
2.
Right
3.
Chart of Accounts
4.
Expenses
5.
Trial Balance
6.
7.
Sundry Creditors
8.
9.
Computerised
10.
Withdrawals
1.38
2.
3.
What is a computer?
4.
What is hardware?
5.
What is software?
6.
What is the name given to the type of application program which make it
possible to write, edit and format text?
7.
1.39
8.
What is the name given to the class of software which is used to manage
data such as Payroll, Inventory, Sales, etc.?
9.
10.
11.
A transistor that is on has the value 1; a transistor that is off has the value
0. What is the term used to describe these values?
12.
13.
14.
How many bytes are available in a computer that has 512mb of memory?
15.
16.
17.
18.
1.40
19.
A computer may have two types of internal memory. What are they?
20.
21.
What is ADSL?
22.
Which is faster - parallel ports, serial ports, USB 1.1, USB2 or USB3?
23.
What is the name given to the standard layout of keyboards most commonly
found?
24.
25.
1.41
26.
What is a pixel?
27.
28.
What is a mouse?
29.
The following two sentences, taken from The Economist, illustrate the
problems still being experienced with what kind of input device to a
computer?
- This new display can recognise speech.
- This nudist play can wreck a nice beach.
30.
What are the two main classes of display screens used with computers?
31.
32.
1.42
33.
34.
35.
36.
37.
What is a modem?
38.
39.
What is the term used to describe that class of program which combines
various applications such as word processing, database management,
spreadsheets, graphics and communications?
40.
41.
1.43
42.
What is an ASCII file? What do the letters in the term ASCII stand for?
43.
44.
45.
How far should a computer operators eyes be from a screen - 6", 20" or 36"?
1.44
2.
3.
What is a computer?
A computer is, in essence, a data processing machine.
4.
What is hardware?
Hardware is the physical equipment that you use, parts you can touch, drop
or break. It includes the computer itself, keyboard, display screen, and
printer.
5.
What is software?
Software is a set of instructions, often called a program, that is distributed
on magnetic disk.
6.
What is the name given to the type of application program which make it
possible to write, edit and format text?
Word processing software.
7.
8.
What is the name given to the class of software which is used to keep track
of data such as Payroll, Inventory, Sales, etc.?
Database management software.
9.
10.
11.
A transistor that is on has the value 1; a transistor that is off has the value
0. What is the term used to describe these values?
Bits.
12.
13.
1.45
14.
How many bytes are available in a computer that has 512mb of memory?
Approximately 512 million.
15.
16.
17.
18.
19.
A computer may have two types of internal memory. What are they?
ROM (Read Only Memory) and RAM (Random Access Memory).
20.
21.
What is ADSL?
Asymmetric Digital Subscriber Line a method for connecting to the
Internet.
22.
23.
What is the name given to the standard layout of keyboards most commonly
found?
QWERTY, named after the first six keys on the top row of letter keys.
24.
25.
26.
What is a pixel?
Pixels are the small dots on computer screens which make up text and
graphics.
27.
28.
What is a mouse?
A mouse is either a furry rodent or a device containing a laser sensor which
is connected by its tail to the computer or operated wirelessly.
1.46
29.
The following two sentences, taken from The Economist, illustrate the
problems still being experienced with what kind of input device to a
computer?
- This new display can recognise speech.
- This nudist play can wreck a nice beach.
Voice input.
30.
What are the two main classes of display screens used with computers?
Flat panel displays such LCD, or gas plasma screens.
31.
32.
33.
34.
35.
36.
37.
What is a modem?
A modem is a device which enables a computer to communicate to another
computer via telephone lines. The modem is derived from the words
modulate demodulate.
38.
39.
What is the term used to describe that class of program which combines
various applications such as word processing, database management,
spreadsheets, graphics and communications?
Integrated programs.
40.
41.
1.47
42.
What is an ASCII file? What do the letters in the term ASCII stand for?
ASCII files are files saved in a standard format which is recognised by all
computers and all programs. ASCII stands for American Standard Code for
Information Interchange.
43.
44.
45.
How far should a computer operators eyes be from a screen - 6", 20" or
36"?
About 20". Depends on screen size and quality.
1.48
Study questions
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 695-696). Pearson Prentice-Hall.
1.49
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 696-697). Pearson Prentice-Hall.
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 699-700). Pearson Prentice-Hall.
1.50
1.51
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 700-701). Pearson Prentice-Hall.
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 701-702). Pearson Prentice-Hall.
1.52
(40-55 min.)
2.
SRINIVAS COMPANY
Income Statement
For the Month Ended April 30, 20X1
Sales (revenue)
$100,000
Deduct expenses:
Cost of goods sold
$40,000
43,000
12,000
Depreciation
1,000
Total expenses
Net income
96,000
$
4,000
1.53
Exhibit 15-A2
1.54
SRINIVAS COMPANY
Balance Sheet
April 30, 20X1
Assets
Cash
$ 41,000
Note payable
$ 24,000
Accounts receivable
55,000
Accounts payable
7,000
Merchandise inventory
20,000
Total liabilities
$ 31,000
4,000
Stockholders' equity:
Prepaid rent
Paid-in capital
Equipment and fixtures
35,000
$120,000
Retained earnings
4,000
3.
$155,000
124,000
$155,000
Most businesses tend to have net losses during their infant months, so
Srinivas's ability to show a net income for April is good. Indeed, the rate of
return on beginning investment is $4,000 $120,000 = 3.33% per month, or
40% per year. Many points can be raised, including the problem of
maintaining an optimum cash balance so that creditors can be paid neither
too quickly nor too slowly. See the next solution also.
1.55
15B2 Exhibit 15 B2
1.56
2.
PACCAR
Statement of Earnings
For the Month Ended January 31, 2003
(in millions)
Sales
Deduct expenses:
Cost of goods sold
Selling and administrative expenses
Rent and insurance expense
Depreciation
Total expenses
Net earnings
$655
$390
100
90
20
600
$ 55
PACCAR
Balance Sheet
January 31, 2003
(in millions)
Assets
Cash
Accounts receivable
Inventories
Prepaid expenses & other assets
Property, plant, and equipment
Total
15-28
Accounts payable
Other liabilities
Stockholders equity
$1,325
4,827
2,656
Total
$8,808
(15-20 min.)
Dec. 31:
Jan. 1:
Change:
Assets
B125,000
B100,000
B 25,000
- Liabilities
- B55,000
- B40,000
- B15,000
= Stockholders' equity
= B70,000
= B60,000
= B10,000
1.
2.
3.
1.57
15-30
1.
(45-75 min.)
2.
UNIVERSITY WIRELESS
Statement of Income
For the Month Ended October 31, 20X1
Sales
$60,000
30,000
Gross profit
$30,000
Operating expenses:
Rent
Depreciation
Advertising
Wages and salaries
Miscellaneous
Operating income
Interest expense
Net income
1.58
$ 500
50
9,000
11,000
1,510
22,060
$ 7,940
40
$ 7,900
Exhibit 15-30
1.59
UNIVERSITY WIRELESS
Balance Sheet
October 31, 20X1
Assets
Equities
Liabilities:
Cash
$ 5,490
Accounts payable
Accounts receivable
50,000
Notes payable
Inventory
10,000
Prepaid rent
500
5,950
$23,000
5,000
salaries payable
6,000
40
Total Liabilities
$34,040
Stockholders' equity:
Paid-in capital
$36,000
Retained earnings
Total assets
$71,940
1,900
Total equities
37,900
$71,940
UNIVERSITY WIRELESS
Statement of Retained Earnings
For the Month Ended October 31, 20X1
Retained earnings, October 1, 20X1
Add: Net income for October
Total
Deduct: Cash dividends
Retained earnings, October 31, 20X1
3.
0
7,900
$7,900
6,000
$1,900
The picture in this set of financial statements is not unusual for new
businesses. Some of the liabilities are very current: accounts payable,
$23,000 and accrued wages, $6,000. Yet there is a small amount of cash.
Unless much of the accounts receivable can either be collected or discounted
(sold to a bank or other lender) the company may be unable to meet its
payroll and pay its bills on time. Moreover, the inventory badly needs
replenishment if sales are to continue at their current pace. Payment of a
$4,000 dividend may not have been wise.
Many new businesses can show a respectable net income but nevertheless be
at the brink of financial disaster because they are "under-capitalized." That
is, there is insufficient long-term investment capital to sustain a smooth
growth. Too often, creditors and employees need cash far in advance of
when customers provide the cash to the business. This may be such a case,
unless customers pay promptly.
1.60
15-32
(10 min.)
The first sentence is correct. However, credit entries always must be on the
right.
2.
3.
Decreases in assets are shown on the credit side, but decreases in liabilities
and stockholders equity are shown on the debit side.
6.
7.
10.
11.
1.61
1.62
Reading
1.1
Drucker, P. F. (2001). Be data literate know what to know. In S. M. Young
(Ed.), Readings in management accounting (pp. 2-3). NJ: Prentice Hall.
Accounting information has value from its use in decision-making. The vast
amount of data available in the modern age, especially given computing
developments, means that it is paramount that the user of data is able to discern
relevant information for necessary decisions.
This reading can be found on CDROM#1.
1.63
Reading
1.2
Sheckley, R. (1988). The accountant. In E. L. Ferman (Ed.), The best fantasy
stories from the magazine of science and fiction (pp. 125-133). Octopus
Books Ltd.
You will realise that this reading is not examinable but provides a different
perspective on accountants.
This reading can be found on CDROM#1.
1.64
Reading
1.3
Perry, C. (1996). One of the oldest professions? Management Accounting, April,
20-21.
1.65
Reading
1.4
Pacioli, L. (1966 reprint). Double entry book-keeping (pp. 4-7, 11 & 12). The
Institute of Book-Keepers.
An extract from the first book on double entry accounting published in 1494.
This reading can be found on CDROM#1.
1.66
Reading
1.5
Mann, G. (1994). The origins of double-entry. Australian Accountant, July,
17-21.
1.67
Reading
1.6
Weis, W., & Tinius, D. (1992). Luca Pacioli: Renaissance accountant. Australian
Accountant, October, 12-15.
It is interesting to note that in the novel and movie The Da Vinci Code an
illustration by Da Vinci called The Vitruvian Man figures prominently. This
illustration was drawn by Leonardo for a book by Pacioli, the author of the first
book on double entry accounting.
This reading can be found on CDROM#1.
1.68
Reading
1.7
Chatfield, M. (1977). Accounting in the ancient world. In A history of accounting
thought (rev. ed., pp. 3-18). Huntington, NY: Robert E. Krieger Publishing
Company.
1.69
Reading
1.8
Integrate Excel into Word. Accessed August 2011
http://www.computorcompanion.com/LPMArticle.asp?ID=33
This reading may assist you with the assignments in this subject. Part of your
assignment is to include two copies of each spreadsheet in a Word Document.
There are several ways to do this: Some are covered in this online article. But
there are other ways as well. For example a screen dump. If you are using
Excel 2007 you can still paste spreadsheets into word documents but results are
variable, particularly when pasting showing row and column headings, as is
required for your assignments. In Excel 2010 it is somewhat easier. It is easier to
take a picture of the spreadsheet and paste it into Word. Free software works
quite well. See the spreadsheet examples provided at the beginning of the Study
Guide. Discuss with your fellows students and exchange other advice about
spreadsheets. Free software can make the task easier. One example is Snippy.exe.
1.70
Required reading
Textbook:
Reading 2.1:
Reading 2.2:
Reading 2.3:
Reading 2.4:
Reading 2.5:
Learning objectives
On completion of this topic you should be able to:
identify the uses of financial accounting information and understand how the
information may be used;
distinguish between the accrual method of accounting and the cash method
of accounting;
analyse the effect of business transactions on the balance sheet and income
statement;
Note that you are expected to know about cash flow statements but not the details
of creating them.
Australia adopted International Financial Reporting Standards (IFRS) (formerly
known as International Accounting Standards) in January 2005. The adoption of
IFRS involves the introduction of new standards and amendments to many current
Australian Accounting Standards. The US is moving towards IFRS - slowly.
2.1
Background to bookkeeping
A necessary part of any business or organisation is the maintenance of some form of
record keeping. The earliest forms of bookkeeping can be traced back to Babylonia
in 3600 BC. Here scribes would make notes of a merchants sales and purchases of
goods on either slabs of stone or clay tablets. Today we have technology at our
disposal to improve the efficiency and storage ability of bookkeeping.
Financial accounting is concerned with the recording, classifying and summarising
of business transactions. Most societies use money as the symbol of exchange,
and hence, business transactions are recorded in monetary terms. Owners and
managers of businesses need to know the profitability and financial position of
their organisations in order to make important decisions about the operation of
these businesses, and financial accounting provides this information.
Predl (1981, p. 1) outlines the main objectives of accounting:
a.
b.
c.
d.
e.
2.2
property if the business is in financial difficulty. The level of finance to start the
business is limited to the amount the owner can personally raise.
The Partnership
Where two or more owners contribute resources to and operate a business for the
purpose of making a profit, the business is a partnership. The Corporations Law
limits the number of partners to twenty, with the exception of one hundred plus
for professions such as lawyers, accountants and medical practitioners. Each
partner is fully liable for the debts of the business, to the extent of his/her personal
estate. Profits of the partnership will usually be distributed under a predetermined
sharing arrangement, which is often based on the amount of capital contributed
by each owner (although this is not the only basis). If a written agreement is not
made the Partnership Act will determine the regulation of the business. Upon the
death or retirement of a partner, the partnership is dissolved and a new partnership
must be established to continue the business.
The Company
Organisations that raise their finance by means of issuing shares to the public or to
a selected group of the public through invitation are companies (named a public
or proprietory company respectively). In this way large amounts of capital can
be raised to commence the business or to expand. The liability of the owners for
the debts of the company is limited to the amount unpaid on their shares.
Therefore, if a shareholder has bought 1000 shares in XYZ Co. Ltd. at $2.00 per
share, and has paid $1.50 on each of these shares, then the liability to the company
in the event of failure is limited to 50 cents x 1000 shares = $500.
The management of company is undertaken by a Board of Directors, members of
which are voted in by the shareholders, and the guidelines of the Corporations
Law must be strictly followed.
The Trust
A trust is not recognised as a separate legal entity. Four key attributes are needed
for the existence of a trust:
1.
2.
3.
4.
trust property;
trustee;
beneficiary; and
the requirement that the trustee deals with the trust property for the benefit
of the beneficiaries per terms of the trust.
2.3
The Co-operative
A group of people with a common interest may form a venture, either as a
company or as a private organisation, with the purpose of providing a service to
the community. Examples of co-operatives are farmers, dairy or local residents
co-operatives. Profits are usually reinvested in the business or shared between
owners under some agreed arrangement.
Non-profit organisations
Government and semi-government bodies
Government departments operate with the purpose of providing a service to the
public, such as railways, health, education, taxation collection. They are
established by public funds, which are used to provide these services. It is not
their main object to generate a profit to return to owners, as the owners are the
Australian taxpayers who benefit from the service provided by the departments.
Private clubs and societies
Operations created by persons with a mutual interest in order to benefit these
members rather that earn a profit are non-trading bodies. Examples include
service clubs (RSL, Leagues), church groups, sporting clubs, Lions, Rotary and
Apex clubs. Income to support their activities is generated by raffles, donations,
subscriptions by members, social functions, etc.
decision-making
planning
communicating
controlling
reappraising
diagnosis of a problem
search for alternative solutions
quantification and evaluation of alternative solutions
selection of a solution.
Planning consists of developing detailed plans from the master strategy decided
upon. Plans for each level of operations must be made.
Communicating is the process of informing the right people of the plans (top
down communication). The method of communication must take into
consideration personal friction, likely misinterpretation of terms, delays, status
differences and so on.
2.4
Controlling is the process of ensuring that programs and plans are proceeding
satisfactorily; that standards are established; that actual performance is compared
with planned performance and any deviations reported - both favourable and
unfavourable; and finally, the desired action is then taken.
Reappraising is the act of evaluating the original plans in light of external factors that
affect the firm and may cause deviations from the firms plans. Both these plans and
the controlling process may be reappraised and altered if deemed necessary.
How can we tie accounting into this administrative process?
The accounting department is a service department of an organisation which
provides information for the administrative processes. It is concerned with the
identification of financial information, expressing this in quantitative terms and
communicating the information to those who should have the information to make
economic decisions. as well as to other interested parties.
In a well developed accounting system the accountant is concerned with:
a.
b.
c.
d.
RECORDING AND
REPORTING
REMEDIAL ACTION
INTERPRETATION
AND EVALUATION
The Recording and Reporting phase is the phase we are concerned with in this
subject. In it the organisation communicates to those interested in its activities,
the financial position and performance of the organisation.
2.5
Companies are required by law to produce Annual Reports which the public and
shareholders can access. The Tax Commissioner also requires sole traders,
partnerships and companies to submit annual reports showing their asset and
equity values at the end of the year.
2.6
Employees
Another internal party interested in the financial statements of a business
enterprise is the employees. They will be keen to know that the firm is operating
profitably and able to maintain the present level of employment, if not improve it.
External users
Government bodies, Commissioner of Taxation
Bodies such as the Australian Securities and Investments Commission (ASIC), the
Australian Prudential Regulation Authority (APRA), and others are concerned
with adherence to the Corporations Law, the Partnership Act, The Bankruptcy
Act, by the business.
Taxation laws must also be adhered to both at Federal Income Tax level and State
Tax level (e.g. Stamp duty, land tax) as well as other charges such as rates to local
councils.
Competitors
Since public companies must disclose their financial results in a published Annual
Report assessable by the public, competitors are able to appraise the sales levels
and market position of the business. This, hopefully, makes for improved
competition in the market.
Unions
Unions are concerned with the ability of the firm to pay award wages and the
situation of possible above award wage claims. Improved profit is usually
followed by union claims for higher wages.
Creditors/Lenders
Parties that lend money to the business to finance its operations are interested in
the ability of the firm to repay its loans; and meet its credit purchases on time.
2.7
reducing the owners capital contribution and share in the profits. The owner may
be expected to return the withdrawn funds and reinstate his/her capital holding to
the level it was before the withdrawal.
Business transactions
In accounting, the term transaction refers to events that affect the business. In the
activities of acquiring resources, organising and transforming them into goods and
services, and finally selling these goods, the business is involved in hundreds of
transactions. Hence, in accounting, all business activities are reduced to the
perception of transactions as they occur.
Transactions take on two forms:
a.
b.
Internal transactions are those that take place solely within the one organisation,
such as converting crude oil (raw material) into petroleum (the output).
PROCESSING
production into final
goods and services
OUTPUT
Selling and
distribution
Acquiring resources
The resources of the enterprise are called Assets. They are things of value to the
firm and will be used to produce future income. These assets can be acquired
using either cash or credit, such as loans or bank overdraft.
The assets that are injected into the business by the owners to commence
operations make up the Owners Equity or capital. Remember that these assets are
now part of the business, which is a separate accounting entity to the owners. The
value of these injected resources is then, the owners claims on the assets of the
business. For instance, with a partnership, one partner may invest $20 000 and
2.8
another partner $15 000 plus a truck worth $12 000. The assets of the business to
start operations are worth $47 000. The owners claim, together, on those assets,
(owners equity) is also $47 000.
If the assets of the business were acquired through a bank loan or other means of
credit, then these liabilities or things the business owes, are known as external
equities. This is because the providers of the credit have a stake or claim in the
business and expect to be repaid some time in the future.
Therefore, in accounting terms, the relationship between assets and equities is
clear. The Basic Accounting Equation reads as:
ASSETS = EQUITIES
This is something that will be referred to many times over and it is imperative that
you understand the concept of a separate accounting entity.
Selling the output
In a profit motivated business the most important aspect of its activities is to sell
its products or services and make a profit on these. One of the business decisions
made by managers is to determine the selling price for their products. This
involves taking into consideration the cost of raw materials, the cost of conversion
into final product and the cost of selling and distributing the products. This is the
area of concern for managerial accountants.
Another decision to be made in connection with sales is whether the business is
strictly a cash-only business or will allow credit sales to approved customers.
Allowing credit may increase the sales volume but it often brings with it an
increase in debts that are not paid by customers as well as a lengthening of the
time for cash flows to come into the business. Often short term outside credit
finance is needed to continue the cycle of buying more resources to generate more
sales. The recording of these important cash flows is discussed in the next
section.
2.9
2.10
expenses could mean a great disparity between what the business actually earned
during the year and what it actually received from customers. With a large
amount of credit sales, the firm may find that customers do not pay very promptly;
the receipts from a November sale, say, may not occur until January. However,
managers and owners want to know regularly what the company has earned in
sales revenue. If the bookkeeper only had records for the cash received from sales
(regardless when the sale took place) then this so-called sales revenue would be
an inaccurate reflection of the real earnings of the firm during the month or year.
Likewise, the recording of payments as they are made will cause a great disparity
between what the firm has incurred in expenses and what it has actually paid out.
For instance if wages are paid at the end of the month and the manager wants to
know the amount of expenses incurred in generating revenue, the bookkeeper
would only be able to tell the manager the amount of cash that has been spent on
wages. Wages still owing to employees for their services are not recorded in a
cash accounting system.
Another example of disagreement with cash payments and expenses incurred
occurs with the stock of goods not sold to customers. Under a cash system, the
amount of purchases on stock that is deducted from sales revenue when
calculating profit, would be overstated, as some of this stock would be left unsold
at the end of the year.
Cash flows also do not tell us the correct amount of assets and liabilities of the
business at the end of the year. In many cases payments of rates and rent are made
ahead of time, so that cash would be understated at the end of the year or month,
and an extra asset for these prepaid expenses is not recognised under a cash-basis
system. Similarly, with expenses that are still owing (such as the wages) the cash
system omits the existence of the liability to pay this debt.
Therefore, the cash flows accounting system fails to provide us with information
about the firms:
a.
b.
2.11
2.12
2.13
range of subjects in accounting, economics and law. Full members of the CPA
Australia are called CPAs. Members of the Institute of Chartered Accountants in
Australia are commonly called Chartered Accountants. The two Australian
professional bodies represent the profession in discussions with the governments
and also promulgate accounting standards. These standards are contained in the
respective handbooks of the two professions. Consider utilising the websites of
these Australian professional accounting bodies.
Note that details of the structure of the American accounting profession are not
examinable in this subject.
Accountants provide many different services including auditing, taxation
accounting, management consulting, management accounting and, of course,
teaching and research. It is also worthwhile to note that many managers of large
companies have an accounting background. This is understandable when one
realises that the person within an organisation who understands the organisation
best is likely to be the accountant. Many of you have or will discover that, in
order to advance further in the organisation for which you work, a knowledge of
accounting is a distinct advantage. Maybe one day they will make you the boss.
Good luck!
2.14
Assets are the economic resources owned by a business. Equities are the claims
against those assets. There are two main kinds of equities: those which are
internal to the business and those which are external to the business. The internal
equity or economic obligation is called owners equity. The external equities are
called liabilities. Thus we can expand the original equation into:
Assets = Liabilities + Owners Equity
The Owners Equity category can be further subdivided. The owners equity in a
business is increased by the revenues of the business and decreased by the
expenses of the business. Thus we can further expand the equation:
Assets = Liabilities + Original Owners Equity + Revenues - Expenses
You are studying this subject in an MBA program. The subject is not designed to
train you as an accountant but to understand the accounting function and to
successfully interact with accountants. If you are a manager dealing with
accountants you need to understand their advice, their way of thinking and be able
2.15
to ask sensible, informed questions. You can make jokes about debts and credits
but you should have some idea about the working of the double entry system.
Spreadsheet applications
Businesses do not purchase microcomputers for their staff to play games. There
are two main reasons why businesses buy computers. The first is to replace the
typewriter. Most businesses these days use microcomputers as modern electronic
typewriters. Businesses generally regard microcomputers as executive toys until a
software package called a spreadsheet was invented. It is usually agreed that the
first usable spreadsheet software package was VisiCalc. VisCalc revolutionised
the use of microcomputers in business. Spreadsheets are incredibly flexible tools
which have gained tremendous popularity in business and in particular with
accountants. It has made the boring repetitive tasks in accounting much easier. It
has made the use of sophisticated mathematics fun.
The most common spreadsheet in business applications is Microsoft Excel. Most
spreadsheets perform three functions. The three functions are: spreadsheet,
database, and graphs. The database capabilities of spreadsheets are very useful,
but are much more limited than the features available in dedicated database
packages such as Microsoft Access.
2.16
2.
What is a label?
3.
4.
5.
6.
Which key causes you to move to the right in a spreadsheet one full screen
at a time?
7.
How do you move to the left in a spreadsheet one full screen at a time?
8.
9.
If you are preparing a spreadsheet and across the first row you want to show
the years for ten years starting with 2000, then 2001, and so on, which
spreadsheet command would you use to perform this quickly?
2.17
10.
11.
12.
13.
14.
15.
What symbol is used to change a relative cell reference into an absolute cell
reference?
16.
2.18
17.
If you suspect that you have forward references or circular references, what
can you do?
18.
19.
20.
21.
2.19
22.
23.
24.
2.20
2.
What is a label?
In a spreadsheet, a label is nothing more than a string of text characters, i.e.
a word or words.
3.
4.
5.
6.
Which key causes you to move to the right in a spreadsheet one full screen
at a time?
The Tab key.
7.
How do you move to the left in a spreadsheet one full screen at a time?
By pressing the Shift and Tab key simultaneously.
8.
9.
If you are preparing a spreadsheet and across the first row you want to
show the years for ten years starting with 2000, then 2001, and so on, which
spreadsheet command would you use to perform this quickly?
The DATA FILL command.
10.
11.
2.21
12.
13.
What is the purpose of the following functions: =FV, =IRR, =NPV, =DATE?
=FV calculates the Future Value of an Annuity, =IRR calculates the Internal
Rate of Return, =NPV calculates the Net Present Value, =DATE calculates a
unique number for that date.
14.
15.
What symbol is used to change a relative cell reference into an absolute cell
reference?
The symbol is used to change a relative cell reference into an absolute cell
reference is the $ symbol.
16.
17.
If you suspect that you have forward references or circular references, what
can you do?
Press the F9 key several times to observe if there are any changes in your
results.
18.
19.
20.
2.22
21.
22.
23.
24.
2.23
Study questions
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 749-750). Pearson Prentice-Hall.
2.24
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 752-753). Pearson Prentice-Hall.
2.25
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 755). Pearson Prentice-Hall.
2.26
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 756). Pearson Prentice-Hall.
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 757). Pearson Prentice-Hall.
2.27
(25 min.)
This is a good exercise in recognizing items that fit in a Statement of Cash Flows
and placing them in the proper section of the statement. Three items listed in the
problem do not appear in a Statement of Cash Flows: net sales, retained earnings,
and total assets.
WALGREEN COMPANY
Statement of Cash Flows
For the Year Ended August 31, 2002
(in millions)
Cash flows from operating activities:
Net earnings
$ 1,019.2
307.3
22.9
48.2
(162.8)
289.6
75.0
Accounts receivable
(170.6)
30.7
14.3
1,473.8
(934.4)
368.1
14.4
(551.9)
(147.0)
(440.7)
111.1
(12.3)
(488.9)
433.0
2.28
16.9
$
449.9
16-42
(25-30 min.)
This problem is similar to 16-A1 but is more difficult because items not shown in
exhibits 16-1 and 16-5 are included and terminology is varied slightly.
HOKKAIDO Company
Balance Sheet
May 31, 20X1
(in millions)
ASSETS:
Current assets:
Cash and equivalents
31,000
Receivables
22,000
Inventories
29,000
6,000
88,000
Noncurrent assets:
Fixed assets, net
Capital construction fund
28,000
Intangible assets
21,000
Long-term investments
15,000*
281,000
Total assets
*
217,000
369,000
2.29
19,000
16,000
9,000
44,000
Noncurrent liabilities:
Mortgage bonds
84,000
Debentures
77,000
12,000
173,000
Stockholders' equity:
Redeemable preferred stock
15,000
5,000
102,000
16,000
27,000
(13,000)
152,000
369,000
HOKKAIDO Company
Income Statement
For the Year Ended May 31, 20X1
(in millions except net income per share)
Net sales
410,000
(190,000)
Gross margin
220,000
Operating expenses:
Administrative and general expenses
(65,000)
(42,000)
(41,000)
148,000
Operating income
72,000
(12,000)
60,000
Income taxes
2.30
(51,000)
Net income
180,000
9,000
16-52
(20-30 min.)
1.
JUNEAU COMPANY
Statement of Cash Flows
For the Year Ended December 31, 20X2
(in millions)
Cash flows from operating activities:
Net income
$ 60
20
Increase in receivables
(35)
Increase in inventories
(50)
75
$ 70
(190)*
$120*
(6)
114
$ (6)
31
$
25
This assumes that the debt was issued for cash and the cash used to buy the
fixed assets. If the debt were issued directly to the seller of the fixed assets,
the cash outflow for purchase of fixed assets would be $70 million, there
would be no cash from issuance of long-term debt, and a supporting
schedule would have a investment and financing activity of $120 million for
acquiring the fixed assets.
2.
2.31
16-54
1.
(15 min.)
a. FIFO Method:
Inventory shows:
Costs:
$3,000
2,250
400
$5,650
$3,500
800
$4,300
3,500
Purchases:
8,000
11,100
2,250
3,000
Available
Balance
16,750
5,650
Inventory (LIFO)
Balance
3,500
Purchases:
8,000
2,250
3,000
Available
Balance
2.
Revenue
Cost of goods sold
Gross profit
2.32
16,750
4,300
FIFO
$16,000
11,100
$ 4,900
LIFO
$16,000
12,450
$ 3,550
12,450
16-56
(20 min.)
1.
Sales
Cost of goods sold:
Inventory, December 31, 20X0
Purchases
Cost of goods available for sale
Inventory, December 31, 20X1
Cost of goods sold
Gross margin or gross profit
Units
LIFO
FIFO
30,000
$360,000
$360,000
15,000
52,000
67,000
37,000
30,000
90,000
396,000
486,000
246,000 *
240,000
$120,000
90,000
396,000
486,000
291,000 **
195,000
$165,000
*15,000 @ $6 = $ 90,000
20,000 @ $7 = 140,000
2,000 @ $8 =
16,000
$246,000
**32,000 @ $8 = $256,000
5,000 @ $7 = 35,000
$291,000
2.
Gross margin is higher under FIFO. However, cash will be higher under
LIFO by .40($165,000 - $120,000) = .40 x $45,000 = $18,000.
2.33
2.34
Reading
2.1
O'Leary, T. J., & O'Leary, L. I. (2011). Creating and editing a worksheet. In
Microsoft Office 2010. (Ex. 1.1-Ex. 1.87). McGraw-Hill.
This reading may help to get you started on Microsoft Excel. If you need
assistance, then use the help function built into Microsoft Excel.
These days the Internet has lots of advice on how to do spreadsheets - and on
occasions you can discover spreadsheet templates.
This reading can be found on CDROM#1
2.35
Reading
2.2
OLeary T. J., & OLeary, L. I. (2008). Charting worksheet data. In Microsoft
Office 2007 (Ex2.1 Ex2.86). McGraw-Hill.
Comment
This reading will assist you with preparing graphs (charts) in Excel.
Fortunately most spreadsheet software is similar. Excel 2007 has similar functions
to other spreadsheets but has a new ribbon menu system. Excel 2010 continues the
ribbon feature. Use any spreadsheet software you like as long as we can read it
with Excel.
The Internet has many resources/blogs on Excel. If you get stuck try posting a
question through Google chances are you will find an answer.
But be careful you can easily suffer from information overload. In this subject
we are only using some basic features of spreadsheet software. Check the
assignment requirements in the subject outline and the examples in the
Introduction section at the beginning of the Study Guide.
Some Excel Internet Resources
http://en.wikipedia.org/wiki/Microsoft_Excel
http://office.microsoft.com/en-us/excel/default.aspx
YouTube has many, many videos explaining Excel
Here are a few
http://video.google.com/videoplay?docid=432862483444888312&ei=65dKS_nEHYGQwgPSyrnqDA&q=Excel+7#
http://www.dailymotion.com/video/x5nh6t_excel-2007-demo-use-simpleformulas_tech
If you find a useful resource please share it on the forum.
This reading can be found on CDROM#1.
2.36
Reading
2.3
Mautz, R. K., & Sharaf, H. A. (1978). Ethical conduct. In S. E. Loeb (Ed.), Ethics
in the accounting profession (pp. 29-37). John Wiley.
2.37
Reading
2.4
Northcott, P. H. (1993). Case 4, Cheating: The pressure on Pasquale Vialletta to
succeed. In Ethics and the accountant: Case studies, student edition
(pp. 17-18). Sydney: Prentice-Hall.
2.38
Reading
2.5
Northcott, P. H. (1993). Ethics and the certified practicing accountant: Case
studies Presenters notes. Australian Society of Certified Practicing
Accountants, (now CPA Australia) (pp. 30-32). Deakin University.
2.39
2.40
Required reading
Textbook:
Reading 3.1
Reading 3.2:
Reading 3.3:
Reading 3.4:
Reading 3.5:
Reading 3.6:
You should now study the Brewer et. al Reading as well as Chapter 17, Part Two,
of your textbook.
There are a myriad of accounting and finance texts which address the topic of
analysis and interpretation of accounting reports. It is recommended you study
Reading 3.1 and your text because they provide a sound treatment of the more
commonly used ratios and techniques in analysing financial statements. If you
read more widely on this subject you will find that there are many different ratios
which can be extracted from published financial statements. In most cases these
ratios are very similar to or are only variations of the more frequently used ratios,
used by other authors for interpreting results or predicting future outcomes.
The overall objective of the financial analyst is to extract information from the
financial statements for use in assessing profitability, financial stability and
operating efficiency of an entity.
3.1
Learning objectives
Besides equipping you with the techniques for guessing/anticipating the future
results of companies listed on the stock exchange and their share price you should
be able to:
vertical analysis;
horizontal analysis (absolute dollar change as well as percentage change);
use base year analysis and be aware of the criteria for selecting the base
year;
return on assets;
return on shareholders equity;
return on sales;
calculate and comment on the ratios and averages used in the analysis of
financial strength
equity ratio;
(bond) interest coverage;
preference dividend coverage;
current ratio;
quick ratio;
use short-term credit analysis i.e. assess the companys working capital
position;
3.2
appreciate that the published accounting data may have limited usefulness
because of the difficulty in comparing results between firms even in the
same industry (size, range of products, method of operation)
external reports are based on historical costs and each business is very
protective of sensitive commercial information.
3.3
Study questions
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 799). Pearson Prentice-Hall.
3.4
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 804-805). Pearson Prentice-Hall.
3.5
(10-20 min.)
1.
2.
3.
4.
5.
Alternatively, the total asset turnover can be computed after determining net
income and total revenues: $60.7425 billion $27.3 billion = 2.225 times
17-36
(40-50 min.)
a.
Current ratio:
20X1: ( 5 + 70 + 85) 55 = 2.9 to 1
20X2: (30 + 85 + 120) 70 = 3.4 to 1
b.
c.
d.
e.
f.
g.
3.6
h.
i.
j.
Dividend yield:
20X1: 1.50 30 = 5.0%
20X2: 3.00 40 = 7.5%
2.
3.
a.
No, f
b.
No, b
c.
Yes, c
d.
No, g
e.
Yes, i, j
f.
No, d, e
g.
Yes, h
h.
Yes, b, c
i.
No, a
j.
No, j
k.
Yes, g
The company has grown rapidly and profitably (ratios b. and c.). Sales have
tripled; earnings have nearly quadrupled; dividends have increased 500%;
and total assets have increased 64%. Moreover, the large increase in
retained income indicates that the expansion has been financed largely by
internally generated funds. The expansion has been accompanied by
increased liquidity of current assets (ratio a.). The stock is priced
attractively (h.), and the dividend policy seems conservative (i. and j.).
3.7
3.8
Reading
3.1
Brewer, P. C., Garrison, R. H., & Noreen, E. W. (1995). How well am I doing?:
Financial statement analysis. In Introduction to managerial accounting
(2nd ed., ch. 14, pp. 584-629). NY: McGraw Hill.
3.9
Reading
3.2
Crossman, J., Bordia, S., & Mills, C. (2011). Communicating in writing. In
Business communication for the global age (pp. 288-317). North Ryde,
NSW: McGraw-Hill.
3.10
Reading
3.3
Davies, M. R., Kries, K. E., Nutting, J. B., & Tronc, K. E. (1985). Business
reports. In The business of communicating (ch. 8, pp. 212-231).
McGraw-Hill.
3.11
Reading
3.4
Windschuttle, K., &Windschuttle, E. (1989). Rational debate and common
fallacies. In Writing, researching and communicating (ch. 9, pp. 74-81).
McGraw-Hill.
A graduate from CSU who used this reading said later post graduation that
these concepts strongly influenced his thinking and attitude to life.
This reading can be found on CDROM#1.
3.12
Reading
3.5
Downes, S. Stephens guide to the logical fallacies, [Online], viewed
30 March 1999,
<http://assiniboinec.mb.ca/user/downess/fallacy/fall.htm>
Try using a search engine such as Google.com to find more examples e.g. search
on Stephens fallacies or false dilemma and so on.
This reading can be found on CDROM#1.
3.13
Reading
3.6
False dilemma, [Online], viewed 30 March 1999,
<http://www.assiniboinec.mb.ca/user/downes/fallacy/distract/fd.htm>
viewed 29 March 1999,
<http://www.assiniboinec.mb.ca/user/downes/fallacy/posthoc.htm>
viewed 8 December 1998,
<http://arachne.sjsu.edu/depts/itl/graphics/adhom/dilemma.html.
3.14
Reading
3.7
Wikipedia (2008). Digital dashboard. Accessed February 2008.
3.15
3.16
Working capital including cash and inventory are vitally important in the efficient
management of organisations.
The chief sources: The chief sources of working capital are, operations,
additional investments by owners, long-term borrowing and the sale of
assets.
Making sure that the level of current assets maximises the firms
profitability;
4.1
Making sure that there is the best possible balance between long-term and
short-term debt, to keep the average cost of capital as low as possible;
Making sure that funds are not squandered by keeping assets that are not
productive.
In order to achieve these a firm must have the right composition of assets.
Dont keep larger cash balances than you need but have significant available
for emergencies.
Topic 3 examined the use of financial ratios; this topic extends the discussion on
the items which comprise working capital.
4.2
Inventory not only includes stock on hand for resale in the case of retailer,
but for manufacturing businesses it can also include: the raw materials
which are converted or have value added in the processing/manufacturing
system, partly completed goods which havent been subject to the full
application of materials and labour i.e. work-in-progress (W-I-P) and,
finished goods which are stock on hand awaiting sale.
Managing inventory
Inventory is a significant component of working capital. Inventory comprises:
raw materials
work-in-progress
finished goods
Objective
To turn stock over as quickly as possible. (Maintain a store of saleable inventory,
avoid obsolete stock or stock that may deteriorate). Important considerations:
the level of raw materials depends upon production schedules and reliability
of suppliers.
Inventory control
The major objective in inventory planning is to maintain the optimum level of
inventory. See EOQ analysis later in this topic.
Advantages of keeping inventory low:
a.
b.
c.
b.
few re-orders with larger inventories ... saving in administrative costs and
paperwork;
c.
4.3
Which inventory items are worth the cost in time and effort in planning?
small volume, relatively inexpensive, non-perishable;
2.
3.
Determine the economic order quantity for those items which will be subject
to planning;
4.
Problems will vary between industries. Motor vehicle manufacture: average car
10,000 parts; some will be unique and others common to a number of models;
some large, others small; some expensive, others inexpensive.
Special problems
Fashion goods, storage requirements, cost of item.
Use a cost benefit approach in deciding whether or not to use a planning approach.
Inventory planning can be an expensive procedure.
Detailed planning requirement
Involves the calculation of:
1.
2.
3.
4.
5.
lead time;
sales rate;
safety stocks;
average inventory levels;
order quantities.
Lead time
Time taken to receive an order after it has been placed; local v. overseas supplier.
4.4
Sales rate
Annual sales (budget data) expressed as a daily sales rate, sales may not have an
even distribution throughout the year.
If sales rate even and lead time certain, re-ordering would be a simple
matter.
Average inventory level
This is the mid-point between the highest level and lowest level of inventory. A
high is reached when the new order arrives and the low point is immediately
before the order arrives.
if the inventory level is never allowed to fall below 200 units and each order
is for 800 units, then the average inventory level is:
=
Safety stock
A level of stock required because of the uncertainty associated with receipt of
stock to replenish inventory
This cushion (buffer) or margin for safety can be calculated in two ways:
1.
2.
where the lead time is uncertain: (maximum lead time - usual lead
time) average daily usage
4.5
Ordering costs
Administrative expenses associated with ordering, receiving, inspection and
quality control.
Carrying costs
Financing, warehousing, handling, insurance, allowances for loss, damage and
obsolescence; calculated on a per unit per annum basis.
Total ordering costs are lower the less times stock is ordered i.e. re-order in larger
quantities.
By re-ordering in larger quantities the total carrying costs will be increased.
Total costs associated with inventory will be at their lowest where
Total ordering costs = total carrying costs.
The following notes are adapted from Fatseas, V. A., & Williams, J. F. (2008).
Management accounting decisions. McGraw-Hill.
Inventory control
The concern in this part of the topic is with the timing of the placement of orders, or
the set-up of manufacturing runs, and the optimum quantities involved.
Inventory control involves decisions about the level of inventory of different products
to hold. Such decisions traditionally involve a consideration of two countervailing
factors. On the one hand, there is the desire to hold sufficient stocks to meet demand
and retain customer goodwill. On the other hand, there are costs involved in holding
inventories, for example, cost of funds invested, warehousing costs and the costs of
deterioration or obsolescence. In manufacturing settings it can be argued that there are
further costs of holding inventories because they can mask inefficient work practices
and poor quality control. Decisions about the level of inventories to maintain must be
made by wholesalers, retailers and manufacturers.
Purpose of inventory
Wholesalers and retailers hold finished goods inventories (merchandise) to enable
them to supply goods immediately to satisfy customer demand. By reducing the level
of inventories they can reduce the costs of carrying (holding) inventory, but they will
increase the frequency of ordering. This increases acquisition (ordering) costs
because it costs money to prepare purchase orders and place them with suppliers and
then receive the goods and check that the order was properly filled. Lower inventory
levels also increase the likelihood of being unable to meet customer demand
immediately and possibly losing potential sales. For some items, however, it may be
optimal not to hold stocks, particularly when items have a high cost, a low turnover,
or can be obtained very quickly from a supplier. If reliable suppliers can be
established firms can operate a just in time (JIT) inventory system, thus allowing
them to hold little or no inventory.
4.6
4.7
Stockout costs are incurred when firms are out of stock of finished goods, or
when manufacturing operations are disrupted through shortages of raw materials.
These costs include loss of profit on sales lost, and foregone on possible future
sales from customers who have been lost through stockouts, or increased
manufacturing costs and possible lost sales because of shortages of finished
goods.
Various models are available for determining the optimum quantity to order (or
the optimum sized production run), the re-order point signalling the need to place
a new order (to set up a new production run), the effects of quantity discounts, and
the optimum level of safety stocks to carry as a buffer against uncertainty in
demand or lead time. The following analysis concerns any one line of inventory.
Firms with a large range of products would not carry out such analysis for every
line, but only for the more valuable items. Frequently less than 20% of items
account for about 80% of the value of inventory.
A simple model - economic order quantity
The optimum purchase or production batch size is known as the economic order
quantity (EOQ). In the simplest model it is assumed that:
1.
2.
lead time between placement and receipt of an order (or set-up time)is
known and constant;
3.
batches arrive (are finished) just as the old stock is exhausted, and hence
there are no stockouts;
4.
In Figure 11-1 if Q is the order size (or production run size), the lot is reduced at a
constant rate until, just as it is exhausted, a new order is received (or batch is
produced). Hence the average inventory level is half the number of units in the lot
size, that is Q/2.
Let
4.8
Quantity of
Inventory
Average
Inventory
Q/2
0
t0
t1
t2
t3
The objective is to minimise total annual inventory costs. These are represented
by:
TAIC
ordering costs
+
(or set up costs)
DO
Q
carrying costs +
KQ
2
purchase outlay
(or variable manufacturing costs)
DP
(11-1)
The ordering costs are equal to the number of orders per year (D/Q) multiplied by
the ordering costs per order (O). Carrying costs are the product of carrying cost
per unit per annum (K or PI) and the average inventory on hand (Q/2).
We can find the optimum value for Q (the EOQ) by finding the minimum value
for TAIC (given that all other variables are known). Using calculus, we
differentiate TAIC with respect to Q, set the first derivative equal to zero, and
solve for Q:
K
d (TAIC )
DO
=
+
=0
2
2
Q
d (Q)
Q2 K = 2DO
Q =
2DO
K
(11-2)
4.9
2DO
=
PI
2 20 000 5
= 1000 units
1 0.2
Thus the retailer should order in lots of 1000 units, giving minimum total annual
inventory costs of:
TAIC =
=
DO
Q
20 000 5
+
1000
= 100
PI (Q)
2
0.2 1000
2
100
DP
+ (20 000 1)
+
20 000
= $20 200
It may be noticed that both the ordering costs and the carrying costs are $100 per
year. This is no accident. At the EOQ they are always equal, and this is a test of
the accuracy of your calculations. Using Example 11-1 data, we plot the cost
curves showing minimum total cost (excluding purchase outlay which is
irrelevant) occurring directly above the intersection of the curves representing
ordering and carrying costs, in Figure 11-2.
4.10
K
0
500
1000
1500
2000
2500
tc
0
50
200
250
100
100
200
150 66.66667 216.6667
200
50
250
250
40
290
Figure 11-2
2DO
=
K
2 10 000 50
= 1000 units
1
4.11
(11-3)
Given the assumptions in the basic model, both lead time and demand are know
with certainty and are constant.
Example 11-3: Re-order Point
Referring to Example 11-2, suppose there are 200 working days per year.
The lead time between receiving notice from the finished goods store of
the need for a new batch and the scheduling, set-up and completion of a
new production batch is 5 days.
When should the finished goods store place a new order with the
production department?
We need to calculate the daily usage of the motor vehicle part. The annual
demand is 10 000 units, and there are 200 working days. Therefore the daily
usage (based on working days) is
10 000/200 = 50 per day.
Thus, ROP = daily usage x lead time
= 50 x 5 = 250.
Therefore the finished goods store should reorder when the stock level for this part
falls to 250 units.
Model sensitivity
Here we are concerned with how sensitive the EOQ model is to errors in
estimation of the key variables and consequently whether total annual inventory
costs vary significantly with small errors in the EOQ. The two variables which are
most likely to be subject to errors in estimation are ordering costs (or setup costs)
(O) and carrying costs per unit (K). Because of the square root sign in the formula
Q=
4.12
2DO
K
2DO
=
PI
2 20 000 6.25
= 1118,
0.2
= 89.43 + 111.8
= $201.23
Thus an error of 25% in ordering costs results in an opportunity loss of $1.23
($201.23 - $200), or a total ordering plus carrying cost which is within 1% of the
minimum. Note that in calculating ordering plus carrying costs to find the result
of an error in O the true value of O, $5, is used. The initial error in O is reflected
in the wrong value for Q.
The error as a result of underestimating ordering costs results in a lower Q and a
larger opportunity loss. Therefore it is safer to err on the high side rather than on
the low side. It is sometimes maintained that to be within the range Q 25% is
accurate enough, but as shown, it is usually better to err on the high side.
For errors in carrying costs, K, similar results occur. The reader is invited to try a
25% error and follow it through. If the same percentage error occurs in both O and
K, the errors cancel out because one is in the numerator and one in the denominator.
Summary
Inventory control involves decisions about the level of inventory of different
materials or products to hold. The simple EOQ model was examined to determine
the optimum order quantity. Reorder points were also calculated, taking account
of safety stocks where appropriate.
4.13
4.14
Self-test questions
I.
Matching
Match the numbered term with the letter of the most appropriate description.
1.
_____
2.
_____
Stockout cost
3.
_____
Reorder point
4.
_____
Lead time
5.
_____
Safety stock
6.
_____
Ordering cost
7.
_____
Carrying cost
8.
_____
A.
B.
C.
D.
E.
F.
G.
H.
II.
Completion statements
Complete each of the following statements with the appropriate word or words.
1.
2.
3.
4.
5.
4.15
2.
Given:
3.
66 units
490 units
275 units
375 units
None of the above
What is the total inventory system cost at the economic order point for
Penthouse Ltd., given:
Cost of placing an order - $2
Inventory carrying cost - $4 per unit per annum
Annual demand - 4,008,004 units?
(ignore purchase outlay cost)
A.
B.
C.
D.
E.
$8008
$2002
$4004
$1001
$9009
4.16
4.
5.
2,024
640
3,200
160
None of the above
The annual cost of maintaining a safety stock level of 100 units would be
A.
B.
C.
D.
E.
$500
$250
$2000
$1000
none of the above
6.
4.17
7.
Given:
Economic order quantity - 2000 units
Unit selling price - $10
Unit purchase cost - $8
Safety stock level - 300 units
Average cost of capital - 15%
The annual cost of funds invested in this inventory line is
A.
B.
C.
D.
E.
8.
$2,760
$1,560
$1,380
$3,225
$1,950
Given:
250 business days per year
Order lead time - 6 business days
Annual demand - 125,000 units
Safety stock level - 800 units
Unit selling price - $40
Unit purchase cost - $26
Economic order quantity - 10,000 units
The reorder point in units is
A.
B.
C.
D.
E.
9.
2,300
3,800
3,400
2,200
none of the above
E.
4.18
10.
Given:
Daily demand and order lead time are random variables described by the
following frequency distributions:
Daily Demand
Units
Frequency
12
9
13
14
14
31
15
26
20
16
100
70
67.4
467.4
400
96
4.19
Self-test solutions
I.
Matching
1 A; 2. D; 3. H; 4. F; 5. C; 6. E; 7. B; 8. G.
II.
Completion statements
1.
2.
3.
4.
just in time.
5.
4.20
1.
2.
Q = [(2281255)/2] = 375
3.
Q = [(240080042)/4] = 2002
TAIC = (4008004/2002)2 + (2002/2)4 = 8008
4.
Q = [(25120020)/5] = 640
5.
6.
7.
8.
9.
10.
Study questions
P10-6
Quantity discounts
Javid Dones Ltd buys men's shirts from Whitworth Shirts. The number
required annually is 100 000. Each order placed costs $50 and it has
been estimated that inventory carrying costs are 25% of the value of
average inventory. The price of the shirts is $15 each if the order is for
less than 3000, with a progressive reduction of $1 per shirt for each
additional 1000 ($14 for 3000-3999, $13 for 4000-4999 etc.). There is,
however, a minimum price of $10 per shirt.
How many shirts should Javid Dones order at a time?
P10-9
Probability
0.5
0.3
0.1
0.1
ii.
iii.
Set-up time to manufacture the part is 6 hours for each of the five
machines involved in the process, and the operators of these
machines who are paid at an hourly rate of $5.89 effect all
necessary adjustments. Manufacturing overhead for the department
is charged at the rate of $8.00 per machine hour, for every hour that
a machine is committed to a particular job irrespective of whether
the machine is actually running or not. Other costs associated with
a stock replenishment order for the part are not significant and may
be ignored.
4.21
iv.
v.
vi.
The part can be manufactured at the rate of 1000 per day by the
production department.
Required:
a.
b.
c.
4.22
d.
What is the extra annual cost of using the re-order point calculated
in (c) in preference to that calculated in (b)? Explain.
e.
If the re-order point calculated in (c) were used, what rate of stock
turnover would be achieved for this part?
f.
g.
h.
The rollers for manufacture of this new bearing are purchased from
outside sources and it is certain that supplies can always be
received within eight working days from issue of a purchase order.
Fourteen rollers are used in each bearing, and these particular
rollers are not used in any other product made by the company.
Suggest a procedure for purchase of the rollers.
ii.
iii.
b.
c.
Calculate the annual inventory cost for this order size (excluding
purchase outlay).
d.
Compare this with the annual inventory cost of the crude policy of
ordering four times a year.
4.23
Q1-2999 =
O = $50
2DO
=
PI
I = 0.25
P = $15.00 (1-2999)
$14.00 (3000-3999)
$13.00 (4000-4999)
$12.00 (5000-5999)
$11.00 (6000-6999)
$10.00 (7000+)
2x100 000x50
= 1633 units (in range)
15x0.25
Check TAIC for EOQ of 1633, 3000, 4000, 5000, 6000, 7000:
DO PIQ
+
+ DP
Q
2
100 000 50 15x0.25 1633
=
+
+ 100 000 15
1633
2
= 3062 + 3062 + 1 500 000
= $1 506 124
TAIC1633 =
DO PIQ
+
+ DP
Q
2
100 000 50 14x0.25 3000
=
+
+ 100 000 14
3000
2
= 1667 + 5250 + 1 400 000
= $1 406 917
TAIC3000 =
DO PIQ
+
+ DP
Q
2
100 000 50 13x0.25 4000
=
+
+ 100 000 13
4000
2
= 1250 + 6500 + 1 300 000
= $1 307 750
TAIC4000 =
DO PIQ
+
+ DP
Q
2
100 000 50 12 0.25 5000
=
+
+ 100 000 12
5000
2
= 1000 + 7500 + 1 200 000
= $1 208 500
TAIC5000 =
4.24
DO PIQ
+
+ DP
Q
2
100 000 50 11 0.25 6000
=
+
+ 100 000 11.00
6000
2
= 833 + 8250 + 1100 000
= $1109 083
TAIC6000 =
DO PIQ
+
+ DP
Q
2
100 000x50 10x0.25x7000
=
+
+ 100 000x10
7000
2
= 714 + 8750 + 1 000 000
= $1 009 464 *
TAIC7000 =
5000 units
D = Expected daily sales 250
E(daily sales) = 40(0.5) + 50(0.3) + 60(0.1) + 70(0.1) = 48
D = 48250 = 12 000 units
O = set up costs (other replenishment costs not significant)
= 6 hours 5 men $5.89 + 6 hours 5 machines $8
= 30 $13.89
= $416.70
K = $0.40 (given)
Q=
b.
2DO
=
K
2 12 000 416.70
= 5000 units
0.4
816 units
ROP = expected daily sales x expected lead time (days)
E(lead time) = 15(.3) + 16(.15) + 17(.15) + 18(.15) + 19(.15) + 20(.1)
= 17 days
ROP = 48 x 17 = 816 units
c.
912 units
ROP = 48 x 19
= 912 units
4.25
d.
$38.40
TAIC = DO/Q + KQ/2 (+ purchase outlay not relevant)
Whilst Q/2 might be a reasonable expression of the average holding
of stock using the reorder point of 816, the more conservative
policy regarding stockouts amounts to holding a safety stock of
912-816 or 96 units. The average holding would be better
represented by Q/2 + 96. Therefore the extra annual cost is 96K =
96(0.4) = $38.40.
e.
4.62 times pa
As stated in (d) the average holding of stock using 912 as the
reorder point is Q/2 + 96 = 5000/2 + 96 = 2596
Expected annual sales = 12 000
Rate of stock turnover = 12 000/2596 = 4.62 times/year
f.
584 units
To ensure that a stockout never occurs a lead time of 20 days in
conjunction with a daily sales of 70 units must be considered.
Total possible sales during 20 days lead time = 20 x 70 = 1400
units
Normal ROP as in (b) = 816
Therefore safety stock = 1400-816 = 584 units
g.
$3.08 approx
Set-up costs calculated in (a) = $416.70
Allocating to batch size of 5000 gives $416.70/5000 = $0.08
(approx)
Unit cost exclusive of set-up costs = $3.00 (given in v)
Full cost = $3.00+$0.08 = $3.08 (approx)
h.
4.26
1000 bearings per day can be made. The lot size of 5000 units
takes 5 days + 1 day for set-up = 6 days. If rollers can be obtained
in 8 days or less the requisition for purchase of rollers could be
initiated immediately a requisition for bearings is received and no
stocks need be carried. This, however, might reduce flexibility in
production scheduling. It would be better to trigger order of rollers
perhaps 8 days before a requisition is due for bearings. If using 816
as reorder point for bearings, it would assist production scheduling
if an order for rollers were triggered when bearing stocks fall to 816
+ (8x48) = 1200. At that time 70 000 (14x5000) rollers (plus extra
quantity based on expected waste or faulty rollers minus any on
hand) should be ordered.
P10-12 a.
i.
15 000 units
8%
8%
7%
10%
20%
45%
300 tyres
Q=
c.
2DO
=
PI
2 15 000 37.80
= 300 tyres
12.60
$3780
DO PIQ
+
Q
2
15 000 37.80 12.60 300
=
+
300
2
= 1890 + 1890
= $3780
TAIC =
4.27
d.
TAIC =
4.28
Required reading
Reading 5.1:
Managers should be aware that there are certain attributes of accounting systems
which will allow them to perform their responsibilities more efficiently and
effectively. Horngren & Harrison identify a number of administrative and
accounting controls which, aided by a system of internal controls, promote
efficiency and effectiveness and satisfaction of the organisations goals.
Controlling the business includes:
1.
2.
3.
maximising the wealth of the owners through the efficient use of the
companys scarce resources;
4.
The features and design of an effective accounting system are outside the scope of
this subject. One form of internal control which should be adopted by all
organisations is a bank reconciliation. This recommendation applies equally to
charitable or profit oriented organisations both large and small.
Cash is an asset which is subject to a high degree of risk. In addition to the
separation of duties and proper supervision of staff who handle cash or make the
adjustments to the accounting records, the Bank Reconciliation will provide
evidence of the reconciliation between the internal records of the organisation
(Cash at Bank Account) and the external records of the bank (a Bank Statement).
The internal accounting records of the business relating to cash follow these rules:
If cash is available the account is in debit balance, and would be regarded as a
normal balance.
Account overdrawn: the Cash Account is in credit balance.
5.1
Note: These are the opposite to the records of the bank. If your bank account has
money available then the banks record of your account or the Bank Statement
will show a credit balance. If your account is overdrawn then the bank statement
will show a debit balance.
You should now read Reading 5.1
Learning objectives
On completion of this topic you should be able to:
Review question 1
Dot Smith regularly has her accountant perform a reconciliation between the
balance of her Cash at Bank account and the balance of her bank account as
shown on the bank statement. This month her accountant is on holidays and you
have been asked to perform the reconciliation.
The following details are provided for the month of May;
1.
2.
The total of cash receipts for May was $56,374.33 and the total of cash
payments for May was $54,376.28. These amounts have not been posted to
the Cash at Bank ledger account.
3.
4.
5.
A credit entry in the bank statement revealed that a direct deposit of $760
had been made to Dots account. This had not been recorded in the books of
the business.
6.
7.
An error has been detected in the accounting records; cheque no. 501 for
$159.20 being payment for rent was incorrectly recorded as $195.20 in the
Cash Payments journal.
Check answer
Adjusted balance in the reconciliation should be $3,628.72.
5.2
Balance
ADD: Direct deposit
Adjusted balance
Step 2
56,374.33
760.00
57,134.33
Balance
ADD: Bank fees
Returned Chq
54,376.28
50.00
203.75
54,630.03
LESS: Adjustment for chq No. 501
36.00
54,594.03
Step 3
May 1 balance
Cash receipts May
1088.42
57,134.33
58,222.75
3,628.72
Step 4
54,594.03
3,628.72
58,222.75
3,321.16 Cr
742.80
4,063.96
435.24
3,628.72
5.3
5.4
5.5
5.6
5.7
5.8
c
d
3.
4.
c
d
5.
6.
c
d
7.
8.
c
b
9. b
10. d
Explanations:
Adjusted cash balance is $650 ($770 Service charge
$20 NSF check $100)
8. b.
S 8-8
The cash in the cash drawer will be $500 lower than the total amount recorded by
the cash register.
E 8-14
a.
b.
c.
Weakness. The sales clerk should not have access to the total recorded by the
machine. The clerk could steal cash and delete a cash receipt from the
machine record.
d.
Weakness. The officer should examine the payment packet to ensure that the
payment is for the correct amount.
5.9
E 8-17
D.J. Hunter
Bank Reconciliation
September 30, 20XX
BANK:
Balance, September 30
Add: Deposit in transit
Less: Outstanding checks:
Check No.
626
627
Adjusted bank balance
BOOKS:
Balance, September 30
Less:
Correction of book error
Recorded $68 check as $58
Cost of checks
Service charge
Adjusted book balance
$ 431
1,209
$ (75)
(275)
(350)
$1,290
$1,330
$ (10)
(18)
(12)
(40)
$1,290
5.10
P 8-32B
TO:
Adam Klaus
FROM:
Consultant
RE:
Internal Control
5.11
P 8-34B
Dunlap Dollar Stores
Bank Reconciliation
April 30, 2008
BANK:
Balance, April 30
Add:
$18,080
1,390
19,470
$ 630
3120
1,670
3121
100
3122
2,410
(4,810)
$14,660
BOOKS:
Balance, April 30
Add:
$13,640
300
1,300
540
2,140
15,780
5.12
$ 200
900
20
(1,120)
$14,660
Reading
5.1
Horngren, C. T., Harrison, W. T., & Oliver, M. S. (2012). Internal control and
cash. In Accounting (9th ed., ch. 7, pp. 355-403). Sydney: Prentice-Hall.
Cash is the most liquid of assets and good management and adequate controls are
vital. The bank reconciliation is a technique that should be regularly performed
and allows for prompt identification and correction of errors and accurate records.
Note that this chapter is from a text with online support. Earlier editions have
more accessible resources for students.
5.13
5.14
Required reading
Reading 6.1:
Learning objectives
Upon completion of this topic, students should:
understand the potential role of the manager, the financial accountant and
the management accountant.
understand both old and new approaches to best practice social and
environmental management.
6.1
Introduction
Corporations can achieve good operating results by ignoring the damage being
done by the enterprise to society and the environment. In the systems of reporting
currently in use by most enterprises, there is no attempt to measure the harm done
by the release of poisonous by-products into waterways or by the scarring of the
land by open-cut mining. Neither is credit given for social and environmental
benefits provided by businesses. Social and social and environmental accounting
is about considering the impact of a corporations activities on the environment
(e.g. pollution), on the community, on occupational health and safety issues (e.g.
asbestos) and on energy use.
It has been suggested that society should no longer neglect to account for favourable
and unfavourable social and social and environmental actions. Public activist groups
and agencies of government are expressing concern for the impact of business
enterprises on the environment. Corporations can no longer look to income
determination as the sole measure of effectiveness. Increasingly, business in Western
societies is operating in a New World where society expects improvement in the
environment and sanctions for those businesses harming the environment.
Enterprises with a sense of social and social and environmental responsibility are
incurring costs beyond those of their competitors and are unwilling for these
penalties to be continued.
On the other hand, when an enterprise ignores its responsibilities to society and
deliberately persists in polluting the environment, it is able to report favourable
results because the costs of rectification are not being incurred.
6.2
Role of accountants
Accountants have been reluctant to widen their role to embrace measurement of
social and social and environmental issues, claiming that the objective of a
business is the maximisation of income, and that any attempt by business to
become socially responsible may divert attention from the profit motive and cause
harm to the economy. It has been suggested that social and social and
environmental activities are a function of government and that businesses should
conduct their activities within the laws imposed upon them by the government to
protect society. Agreement on this matter is unlikely in the near future.
A company engaged in social and social and environmentally desirable projects
require information to enable the effectiveness of such projects to be gauged. Four
approaches to accounting and reporting on projects have been suggested:
Inventory approach
This involves the reporting of a comprehensive list of social and environmentally
responsible actions. It would be ideal if a list of irresponsible actions were also
furnished. This method has the obvious drawback that intercompany comparisons
are impossible, but it is the approach, which is at, present the most popular.
Cost approach
This approach involves an addition of the cost of each social and social and
environmental responsible action. Although this approach is superior to the
previous one, the data published must be interpreted with caution. High benefits
do not necessarily result from large expenditures. The effectiveness of
expenditures is ignored.
Program management approach
Under this approach disclosure is made of the extent to which the objectives of a
companys actions have been attained. There is no indication of the amount of
social benefit derived from the attainment of the objectives.
Cost-benefit approach
Under this approach socially responsible activities are disclosed as well as
expenditures on them and the resulting benefits to society. The major difficulty is
the definition and measurement of benefits. It is difficult to place a dollar value on
the protection of a wilderness area so that the survival of a species of frog is
ensured.
6.3
6.4
Source:
The term social and social and environmental audit is frequently encountered in the
literature. Although occasionally used to mean the examination and certification of
the social and social and environmental report by an independent party, it is generally
used to refer to reports on the environment, which are not attested. An examination of
social reports presently published discloses that unfavourable item are rarely revealed.
It has been suggested that those included were probably known to the public at large
at the time of publication. An interesting development in the United States was the
inclusion by the Phillips Screw Company of a pollution audit in its annual Report.
The independently prepared audit indicates instances where pollution standards have
been exceeded and the costs involved, in obtaining compliance. The question has
been asked, Does this signal the emergence of pollution auditors? Will there be
other specialised auditors concerned with internal human resources, employment
practices, industrial safety, charitable contributions, and product safety? Only time
will tell.
The growing emphasis on social and social and environmental issues is not
going to subside;
6.5
6.6
instance, land had been purchased and homes built with full knowledge that the
adjoining land was zoned for industrial development.
Despite these conflicting views, it is not an adequate response, nor even a practical
response, for industry to ignore community concerns. To do so is likely to
engender political, legislative or customer reactions that could be very detrimental.
A more sensible approach may be to recognise the adverse social and
environmental effects of their activities and processes, to rectify past damage and
to establish policies and procedures to eliminate or minimise future damage.
Customers, as members of the community, are demanding social and
environmentally responsible products, which minimise or eliminate waste and
pollution. These demands are, in part, idealistic but, in part, highly practical. The
user pays principle, for example, applied to domestic energy and water usage has
emphasised the need for individual households to conserve resources, which are
limited or can be expanded only at considerable cost. In turn, customers expect
firms producing the items they buy to be similarly responsible. Increasingly, too,
corporations are expected to ensure that their products do not place usage and
disposal problems and costs on the customer.
Government policy and legislation
Community concerns are reflected in governmental actions. For example, social
and environmental protection agencies have been established in the various states,
along with the passing of a number of social and environmental laws affecting
business. The major thrusts of legislation have been:
more stringent enforcement of, and lower thresholds for, emissions; and
the introduction of the polluter pays principle which links market forces
and social and environmental protection.
Around the world, there has been a shift from standard setting and enforcement as
the basis of social and environmental legislation. Some governments and
regulators now see these methods as having adverse effects on international
competitiveness in addition to being expensive to enforce and, at times,
counterproductive as they emphasise a pollution control, rather than a pollution
prevention, ethos. Co-regulation with industry, the use of economic instruments
(e.g. recycling credits, taxes) and the encouragement of self-regulation by industry
are techniques being added to sanctions as a basis of social and environmental
regulation. These changes in approach are now occurring in Australia.
6.7
Management
style
Organisational
structure
Community
access
6.8
New
Pollution prevention
Continuous Improvement - audits,
financial incentives
Sophisticated set of social and
environmental indicators
High level of responsibility within
company CEO, CFO
Participative control and solution
making
Strong, integrated relationship
between Organisational Health and
Safety, Social and environmental
Controls and Production Management
Open door, accept right to know
This definition, while hardly complete, is broad enough to embrace the physical,
biological, social and economic aspects of our world.
6.9
investors/owners;
lenders;
customers;
corporate management.
a social and environmental policy and objectives, and a plan for achieving
them;
6.10
waste reduction;
waste disposal;
product labelling;
product packaging;
energy use;
6.11
A management audit is one instigated by the firm as part of its social and
environmental management plan. The aim is to identify risks and opportunities,
currently existing or potential, in addition to compliance. The output of a
management audit is desirably a social and environmental plan, which would
preferably be audited at regular intervals as part of the continuing auditing
program.
A diagnostic audit is a high-level review of a corporations response to social and
environmental issues and is undertaken as part of the financial audit or as a
separate audit aimed at board members.
There is an argument that social and environmental considerations should not be
distinguished as a somewhat peripheral appendage to organisational activities but
be an integral part of all the firms strategic decisions, product planning and
processes. More advanced firms have reached this stage. Businesses, however,
which have not to date consciously taken into account the effect of their activities
on the environment can find an audit an appropriate place to start.
What are social and environmental costs?
Social and environmental costs are those costs incurred in compliance with, or
prevention of breach of, social and environmental laws, regulations and company
policy. They may be grouped under a number of headings:
General and administrative costs
Costs incurred in connection with compliance, and the monitoring of compliance,
with existing social and environmental regulations (e.g. costs of permits,
inspections, legal and consulting fees).
Fines and penalties
Government regulatory agencies are empowered to impose fines and penalties on
companies not in compliance with social and environmental regulations. These
can be substantial and are intended, not as a revenue raising exercise, but as a
powerful incentive for firms to comply.
Disposal of waste
In Australia, permits are granted to firms to dispose of hazardous wastes at certain
specified sites. The amount charged varies with the amount and type of waste. In
addition to these fees, there are costs associated with transportation of waste, often
over considerable distances, and control procedures to ensure that waste has been
correctly disposed.
In some cases, hazardous waste is difficult to dispose of and is, consequently,
stored on site. Costs in these instances include the provision of safe storage,
maintenance costs and supervisory costs.
6.12
In other instances, laws and regulations may require a company to install or upgrade
devices to remove hazardous materials from liquid and solid waste before disposal.
Remediation costs
Remediation of polluted sites may be affected by the nature, location and volume
of waste; the hazardous nature of the waste; the remediation regulations; and the
process selected. Remediation may, for example, involve the removal and
treatment of source material, treatment of ground and water contamination,
disposal or destruction of waste material, containment of contamination, etc.
Costs associated with remediation include the actual remediation process and all
the associated soft costs, e.g. the cost of outside legal, consulting and
remediation project management fees, incremental in-house costs, site closure
costs and post-remediation monitoring costs.
There are many firms which have engaged in practices and processes which have
contaminated their sites. Unless legislation requires clean-up immediately, these
firms are inclined to let the issue rest until it is intended to dispose of the site.
Clean-up is completed prior to disposal as the property, if designated as
contaminated, will lose much of its value. More than one company, too, has
unwittingly purchased a site which proved afterwards to be polluted. Remediation
is generally required before, for example, the building of facilities.
Capital costs
Costs incurred in upgrading facilities in order to comply with regulations, e.g.
waste water collection and treatment on site, new technology to reduce emissions,
noise-reducing measures, the provision of afterburners to destroy odour, etc.
Social and environmentally related costs may also be incurred, not in the cause of
compliance, but in the pursuit of increased efficiency and competitive advantage,
e.g. on process change, R&D. These are voluntary costs which are unlikely to be
incurred unless the prospective benefits (which may include difficult-to-quantity
benefits such as an enhanced good citizen profile) are expected to exceed the
expenditures.
Are social and environmental benefits available to firms? How can
these be obtained?
There are undeniable benefits to be obtained from an social and environmental
consciousness on the part of firms. Our discussions with firms have indicated that
the need to comply or the desire to reduce social and environmental costs have
been the inspiration for:
6.13
more stringent social and environmental laws and regulations in the future
may have a deleterious effect on the profitability of the business or sections
of it;
a firm may have exposure to legal claims for personal injury as a result of,
for example, spills, explosions or health-damaging products and, in addition
to financial consequences, suffer long-term damage to its reputation;
companies and their officers may face substantial fines and penalties for
failing to exercise due diligence.
6.14
Third, control the risk. Can the risk be eliminated, avoided or reduced? Where
possible, implement a program of control.
Fourth, finance the risk. What proportion of the risk can be sustained? Can the
remainder of the risk be transferred contractually, e.g. to another business or to an
insurer?
Fifth, monitor and review. How effective is the risk control program? Should it be
reviewed?
What is the relationship between Total Quality Management (TQM)
and social and environmental management?
The four guiding principles of TQM are:
customer satisfaction;
the elimination of waste;
empowerment of employees;
continuous improvement.
An effective social and environmental management plan will incorporate all these
principles.
Stakeholder analysis
This involves the identification of all parties who have an interest in the operations
of the business. These are listed in the previous chapter. The organisation must
address the concerns and information needs of all stakeholders and develop (a)
systems to collect the required data and (b) reports suitable to various groups.
Setting social and environmental policies and plans
The aim is to articulate the basic values of the firm in relation to social and
environmental issues and to clearly state these values as organisational policies
and objectives. The policies and objectives must guide the organisations planning
6.15
and set out values that management, employees and other groups, such as
suppliers, are expected to strive to achieve. Of necessity, the board of directors or
other governing body must demonstrate leadership and a strong commitment to
social and environmental policies. Senior management should also be involved.
Designing and executing an implementation plan
Translating policies into strategies and thence to operational plans is a major task.
It requires:
6.16
It is often said that what is measured, is managed. The setting of targets and the
measuring of performance against those targets is an important part of the process
of achieving best practice social and environmental management.
The preparation of reports for external users the role of the
financial accountant
It is important when developing reporting systems for social and environmental
matters that the various users and their needs are clearly identified. The federal
government, for example, carries responsibility for all Australians and is subject to
a variety of political pressures. The ministry concerned needs to be well informed
and will obtain a wide range of social and environmental information and seek a
variety of opinions regarding social and environmental matters of concern to the
electorate. State governments have the responsibility for social and environmental
legislation within their own areas and will be seeking advice and opinion on a
state-wide basis in order to determine the desirability of legislative action. A
glance through Australian legislation indicates, however, that not all legislation
applies to whole states: several Acts relate only to very specific areas within a
state. State governments, then, will often narrow their focus to specific areas,
problems affecting specific sections of the public, or quite specific aspects of the
operations of an individual organisation. Similar conflicts in legislation are likely
to prevail in any country that has different levels of government.
In contrast, participants such as employees will be more interested in an indication
of the companys overall social performance (e.g. in organisational health and safety
in addition to the environment). Suppliers may legitimately be concerned about the
end-use of inputs to manufacture by another firm. Investors will be concerned with
the overall profile of the company in which they invest and in the existence of social
and environmental risk which may, in the near or distant future, affect the
profitability of their equity share. Lenders, too, would wish to ensure that the
security of their finance will not be threatened by potential (perhaps undisclosed)
liabilities resulting from social and environmentally undesirable practices.
Many of these interested parties can obtain the information they require directly
from individual firms. Others, however, must rely on general purpose reports.
What, then, should general purpose reports include?
A description of the business entity, its activities and the period covered by
the report.
6.17
6.18
Today, the management accountant has left his or her office and is a fully fledged
participant in the determination of resource use and a value-adding contributor to
team-based management.
The environment is a resource, like any other used by the firm. As with human
resources, technology and, indeed, finance, it has to be managed. Management
accountants have a key role to play in ensuring that social and environmental
resources are used for the benefit of the firm and in accordance with the principle
of Sustainable Development. Yet there is anecdotal evidence that management
accountants in industry and commerce are unsure of the contribution they can
make. The list below is suggestive.
Participation in strategy formation
6.19
Investment/project appraisal
Ensure the inclusion of costs associated with present and potential laws and
regulations.
Investigate the potential for profiting from waste, e.g. by sale of waste.
6.20
Managing change
Organisation design
Ensure that KEPIs are easily measurable factors which describe the principal
relationships between the company and the environment.
Incorporate KEPIs into the budgeting and forecasting process and monitor at
least monthly.
The specific nature of KEPIs will depend on the type of business but would
normally include:
6.21
Conclusion
In the third millennium we are at last becoming, albeit slowly, aware of the fact that
human activity, including business operations, can have a deleterious effect on
future quality of life on this planet. Accountants and managers have a role to play in
measuring and controlling the impact of human activity on the environment.
6.22
Self-test questions
Using the information contained in this study guide attempt the following
questions:
i.
Matching
You are required to match each term to its definition by placing the letter of the
most appropriate description in the space provided.
1.
Descriptive report
2.
Inventory approach
3.
Cost-benefit approach
4.
Closed door
5.
Environment
6.
Stakeholders
7.
EIA
8.
Due diligence
9.
Remediation cost
10.
Compliance audit
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
6.23
ii.
Multiple choice
2.
Which of the following terms means the design and location of facilities is
conformance with surroundings and with pleasing architecture and
landscaping?
A.
B.
C.
D.
E.
3.
6.24
inventory approach
liability approach
cost approach
program management approach
cost-benefit approach.
aesthetics
resource allocation
eugenics
program management
none of the above
stringent enforcement
public consumer
companies competitors
scarce resources
user pays principle
professional pressure groups
resources technology
policy legislation
A.
B.
C.
D.
E.
I, II, III, IV
III, II, VII, IV
VI, II, III, VII
II, III, VII, VIII
None of the above
4.
5.
6.
government
social and environmental activities
customers
investors
none of the above
7.
statutory cost
remediation cost
waste disposal cost
capital cost
none of the above
prepare reports
perform stakeholder analyses
develop supportive corporate culture
set social and environmental policies and plans
develop standards and measures of performance
design and execute an implementation plan
A.
B.
C.
D.
E.
6.25
8.
9.
KEPIs are:
A.
B.
C.
D.
E.
10.
iii. Exercises
1.
List and briefly describe six current social and environmental issues. Choose
two of these and discuss how accounting measurement processes might
assist in dealing with the problem.
2.
3.
Conduct a web search for social and environmental accounting and related
terms. Summarise your research findings in 500 words and attach hard
copies of web pages as an appendix.
6.26
Self-test solutions
i.
Matching
1. F; 2. I; 3. C; 4. H; 5. A; 6. G; 7. E; 8. D; 9. J; 10. B.
ii.
Multiple choice
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
iii. Exercises
Answers will vary. The important thing is to focus on accounting and
measurement issues, rather than being caught up in emotional debate. CPA
Australia and the Institute of Chartered Accountants in Australia have relevant
resources.
6.27
6.28
Reading
6.1
Deegan, C. (2009). Extended systems of accounting the incorporation of social
and environmental factors within external reporting. In Financial
accounting theory (3rd ed., ch. 9, pp. 378-457). Australia: McGraw-Hill.
6.29
Reading
6.2
Ravlic, T. (2004). Mung bean counters. Australian CPA, September, 33-35.
Tom Ravlic writes on triple bottom line reporting. TBL can be relevant to social
and environmental accounting - as can Balanced Scorecard. Google (Bing ?) TBL
and Balanced Scorecard. Wikipedia provides a succinct discussion. Interestingly,
Tom who writes prolifically for accounting publications in Australia, is an
accounting graduate of CSU.
This reading can be found on CDROM#1.
6.30
Required reading
Textbook:
Group Manager
Marketing Manager
Division Manager
Area Manager
Plant Manager
Process Manager/Assembly Line Manager
Foreman.
7.31
you should have now realised that managerial accounting data in the form of
a budget is more useful to management for internal decision making.
Contrast this with financial accounting data which provides an historical
evaluation; this year versus last year.
The chapter also explores the role of the accountant in organisations. The titles of
some positions e.g. President is used in the American context. This is equivalent
to positions titled General Manager or Managing Director in Australia.
The importance of ethics to the profession and as a basis for business cannot be
overemphasised. The global nature of business means that the ramifications of
unethical behaviour reverberate through the world economy. This was evident in
collapses such as Enron. It is crucial to understand the central nature of ethical
behaviour to survival in the long term. Please refer to Reading 7.1.
Cost-benefit analysis
This is a theme which runs through this subject and the textbook. All decisions
involve a choice between alternatives. In choosing between accounting systems
and accounting methods a cost benefit approach would be adopted. The selection
will be based upon the decision makers perception of the expected incremental
benefits in relation to the incremental costs.
information has not only a benefit but also a cost and this economic
consideration should not be overlooked.
7.32
Behavioural aspects
An important consideration in the development of a management accounting
system is its impact upon the individuals within the organisation, and in particular,
the likely effect on their performance. The chapter briefly addresses the function
of budgeting and how this forces management to plan. Evaluation of performance
and information in the form of feedback are necessary if individuals are to be
motivated positively.
7.33
Study questions
Source:
Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 31). Pearson
Prentice Hall.
Source:
Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 38). Pearson
Prentice Hall.
7.34
Source:
Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 38-39).
Pearson Prentice Hall.
7.35
2.
3.
4.
5.
6.
7.
8.
Attention directing. Variances point out areas where results differ from
expectations. Interpreting them directs attention to possible causes of the
differences.
9.
Problem solving. Aids a decision about where the parts should be made.
10.
1-46
1.
2.
3.
This is a difficult ethical problem, one that deserves discussion. Two ethical
standards apparently conflict. Confidentiality would lead to nondisclosure,
provided there was no legal requirement to do so. But objectivity would
indicate that the information about the additional losses should be used in
making the earnings prediction. The authors think that objectivity should
take precedence here, but others might disagree.
4.
The standard of competence, and to some extent the standard of integrity, would
lead one to research the tax law before deciding whether to deduct the item.
7.36
1-48
1.
2.
Chen has a staff position, providing advice to the controller. His main
conflicts will probably arise with the chief accountant and the managers
under him. He reports to the chief accountants superior, but he prepares
reports that affect the operations in the chief accountants area of
responsibility.
Paperman is in a staff position because accounting is not directly involved
with sales or delivery of leasing services. He provides counsel and advice to
all the line managers and most of the staff managers in the company.
Conflicts may arise if he tries to exert authority instead of just giving advice
or if the other managers ignore his advice.
Hodge is in a line position because she is an integral part of the companys
main line of business, leasing equipment. Her main conflicts are likely to
arise in areas such as requisitioning of equipment and billing of customers
where she must rely on other departments over which she has no authority.
Burgstahler is in a staff position and offers advice to most other managers in
the company. Conflicts might arise if managers perceive her advertising of
positions or screening of candidates as not fulfilling their needs, or if she tries
to exert her preferences instead of the hiring departments preferences into the
advertising and screening activities. Conflicts can also arise in the
performance evaluation functions, where she may be enforcing an unpopular
policy.
7.37
7.38
Required reading
Textbook:
15,000
5,000
Type of Cost
Total
Cost $
Average
Cost Per
Unit $
Total
Cost $
Average
Cost Per
Unit $
Total
Cost $
Average
Cost Per
Unit $
Fixed Costs
10,000
1.00
10,000
0.67
10,000
2.00
Variable Costs
14,000
1.40
21,000
1.40
7,000
1.40
8.1
2.
the total for variable costs varies in direct proportion to changes in the
volume of production;
3.
the average cost per unit for the fixed component decreases or increases with
changes in activity;
4.
2.
Breakeven analysis
The term breakeven can be a little misleading. Firms seek to make profits not just
breakeven. This analysis is used in the planning process, in making operating
decisions and is an indicator of risk.
Breakeven analysis is based on the following assumptions:
1.
2.
the volume of output is within the relevant range i.e. fixed costs do not alter
within this range.
8.2
CVP Analysis
In many decisions concerned with product and profit planning there is a need to
carefully analyse the behaviour of costs, revenues and profits in response to changes
in sales volume. The selling prices of a firm's products are usually known, or else
based on cost plus a markup. It is the sales volume which tends to involve the
greatest uncertainty, and, of course, the number of units sold affects profit levels.
Cost-volume-profit (CVP) analysis is a technique for assessing the effects of changes
in volume on expected profits. CVP analysis is strictly a short-run analytical
technique because in the longer term cost structures change, as well as prices.
CVP relationships are very useful, and are often used implicitly by small business
traders who have had no formal training in their use, and who may never have
heard of the expression CVP analysis. Nevertheless, they realise that they must
generate a certain level of sales dollars to cover expenses before they begin to
make a profit in any given period. A small businessman who marks up goods by,
say, 100% on cost, can readily determine the success of a period's trading using
CVP techniques.
Single Product CVP Analysis
Basic Model
Assume a firm produces and sells a single product, for a price p, which is given.
We assume that the firm is a price-taker, and cannot significantly influence p.
Each unit produced and sold has a variable cost (or cost of resources supplied as
used), b, which covers all variable production and distribution costs. Assume also
that there is a fixed cost (or cost of resources supplied in advance of usage), a, for
the period, covering the capacity cost to produce, store and sell the product. For
simplicity, assume also that the quantity produced is equal to the quantity sold (no
change in inventories).
8.3
Hence the total cost of producing and selling x units (TCX) in a given time period
is represented by
TCX = a + bX
(9-1)
The total revenue from selling x units (TRX) is the product of price per unit and
units sold:
TRx = px
(9-2)
The profit from producing and selling x units (X) is equal to total revenue (TR)
minus total costs (TC):
X = TR - TC
= TR - FC - VC
= px - a - bx
= (p-b)x - a
(9-3)
The expression (p-b), that is unit selling price minus unit variable cost, is known
as the contribution margin per unit. It is called contribution margin because
each unit sold contributes (p-b) towards the recovery of fixed costs and earning of
profits.
Example 9-1
Data for month of January:
Required:
p = $10
b = $6
a = $8000
= (p-b)x - a
= (10-6)x - 8000
= 4x - 8000
Note that the unit contribution margin (p-b) is $4. X = 4X-8000 represents the
firm's profit equation and clearly, the value of X depends on the unit sales
volume, x.
Breakeven Point
A particular volume level which is of interest is the point where the firm breaks
even - earns zero profit, neither a profit nor a loss. Most firms (except for nonprofit institutions) wish to do better than break even, but the breakeven point is of
interest because it is an important milestone on the way to profits.
8.4
a
p-b
(9-4)
From equation (9-4) we see that the breakeven point (BEP) in sales units is equal
to the fixed costs divided by the unit contribution margin, and is often memorised
in the form:
BEP =
FC
CM
Using the data from Example 9-1, we can calculate the breakeven sales volume:
BEP =
FC 8000
=
= 2000 units
CM
4
meaning that 2000 units have to be produced and sold during January just to break
even. Any sales volume in excess of 2000 units during January will earn positive
profits.
PV Chart
A graph of the equation X = 4x - 8000 is known as a Profit-Volume Chart, and is
shown in Figure 9-1. The y-intercept represents the period fixed costs ($8000)
and the x-intercept (2000 units) is the breakeven point in units. The slope of the
line is equal to the contribution margin (4). From this chart the profit resulting
from any particular sales volume can be read off directly.
8.5
Profit
8000
6000
4000
Profit
2000
0
-2000
1000
2000
3000
4000
-4000
-6000
-8000
x
a+
p-b
(9-5)
That is,
Required Volume =
=
Using the data from Example 9-1, how many units must be produced and sold to
earn a net profit of $2000?
Required Volume =
FC +
CM
8000+2000
4
10 000
4
= 2500 units
8.6
So 2500 units must be produced and sold to earn a net profit of $2000. This can be
verified in another way. Breakeven point is 2000 units. Therefore the contribution
margin on all units in excess of 2000 is all profit. 2500 units is 500 in excess of
BEP. A contribution margin of $4 on each of 500 units gives $4 x 500 = $2000
profit. The excess of 500 units above BEP is known as the margin of safety.
Breakeven point and target level of profit in sales dollars
Often there is interest in the breakeven point in terms of sales dollars rather than
sales units. For example, a shopkeeper is more likely to know the sales receipts
(cash plus credit sales vouchers plus cheques) than the unit sales. There are two
approaches to this problem. We could calculate BEP in units, and then multiply
the units by the selling price. Using Example 9-1 data, the BEP was 2000 units.
In terms of dollar sales, the BEP would be
2000 units x $10 = $20 000.
The second, more direct approach, is to modify the unit breakeven equation (9-5)
by multiplying both sides by price, p:
BEP (units): x =
BEP ($): px = p
FC
a
or
CM
p-b
FC
a
or
CM ratio
(p-b)/p
(9-6)
BEP($) =
FC
8000
=
= $20000
CM ratio
0.4
FC+
CM ratio
8000+2000
0.4
This excess of sales dollars over breakeven sales dollars ($25 000-$20 000) is
known as the margin of safety. The margin of safety can be expressed in terms of
sales units or sales dollars.
8.7
The contribution margin ratio can also be calculated from aggregate data instead of
unit data. For example, a direct (or variable) costing income statement would show
Sales and Total Contribution Margin (or Variable Profit). The contribution margin
ratio would simply be Contribution Margin (or Variable Profit) divided by Sales.
Profit from selling given volume
In relation to Example 9-1, a typical question might be, What profit would be
earned from selling 3000 units?
The answer to this question can be approached in two ways. First, we could
substitute 3000 for x in the profit equation:
X = 4x-8000
= 4(3000)-8000
= $4000.
Alternatively, we could reason that BEP is 2000 units. Sales of 3000 units is 1000
units in excess of BEP. Therefore the profit is the contribution margin of $4 times
the 1000 units = $4000.
Effects of income tax
Income taxes do not affect the breakeven point because no tax is paid on zero
profit. However, income taxes can affect target profit calculations. Suppose a
firm is interested in the number of units required to be sold to earn a certain net
profit after tax. The before-tax profit equation is
= (p-b)x-a
To earn $ after tax requires a higher profit before tax. Therefore we multiply the
right hand side by (1-t) where t is the tax rate:
(After tax) = (1-t)[(p-b)x-a]
1-t
= (p-b)x-a
a+
x=
1 t
p b
FC+
or Required Volume =
8.8
1-t
CM
To illustrate, using Example 9-1 data, how many units must be sold to earn a net
profit after tax of $6000, given a tax rate of 40c in $?
6000
1-0.4
4
8000+
Required Volume =
=
8000+10 000
4
= 4500 units
Breakeven charts and financial risk
In addition to product risk firms are exposed to financial risk associated with
various strategic options. There are various types of financial risk. The source of
funding is one type. Equity funds provide the lowest possible financial risk from
the users point of view. Borrowed money, that is debt, represents much higher
financial risk. If an organisation finances the launch of a new product with debt
this would represent a combination of two types of risk: a high business risk
combined with high financial risk.
The cost structure of the business represents another source of financial risk.
Firms with high fixed costs, eg from automation or robotics, are exposed to high
risk. Because variable costs tend to be low, and hence contribution margin high,
high profits are earned above breakeven point, but high losses are incurred below
breakeven activity level.
40000
35000
Sales
Sales/Costs
30000
Profits
25000
20000
Total cost
15000
Losses
10000
5000
0
0
500
8.9
25000
Sales
Sales/Costs
20000
Profits
15000
10000
Total cost
High variable cost
5000
Losses
0
0
The breakeven chart shown in Figure 9-2 illustrates the situation. The breakeven
point is 1500 units. Below breakeven losses are the vertical distance between the
sales revenue line and the total cost line, while profits are made above breakeven
point. Clearly high profits will be made when activity levels are above breakeven,
but high losses will be incurred below breakeven. Returns will be very volatile
and this would be a high risk strategy.
Alternatively, fixed costs may be kept lower but variable costs are higher, eg from
outsourcing. This strategy results in the same breakeven point of 1500 units, as
seen in Figure 9-3. Variable costs tend to be high, and hence contribution margin
low, resulting in significantly lower levels of profits or losses for the same
variation in sales activity. The risk of high losses has been reduced at the cost of
the opportunity for high profits. Some of the risk has been transferred to the
supplier who demands a higher return for bearing this risk.
Multi-product CVP analysis
Our analysis now turns to the more usual case where a firm produces and sells
more than one product. To illustrate the problem we will consider the twoproduct case, which can be generalised to any number of products.
Example 9-2
Assume that two products are produced using common production
facilities, with period fixed costs of $20 000 which are common to the
two products. Other data are:
Product
P1
P2
8.10
pi
$10
15
bi
$6
10
Thus the contribution margins for the two products are $10-$6 = $4 for product P1
and $15-$10 = $5 for product P2. The profit equation for the firm is
= [(pibi)xi] a
= 4xi +5x2 20 000
where xi = number of units of product Pi. For breakeven, = 0, so
4x1 + 5x2 - 20 000 = 0,
i.e. 4x1 + 5x2 = 20 000
(9-6)
Equation (9-6) is the equation of a straight line which can be graphed as shown in
Figure 9-4. With x1 on the horizontal axis and x2 on the vertical axis, we can plot
two points on the line and join them. If x2 = 0, then 4x1 = 20 000, and hence x1 =
5000. This gives us the point (5000,0). Alternatively, if x1 = 0, then 5x2 = 20 000,
and thus x2 = 4000. This gives the point (0,4000). We then join the two points,
ignoring the extensions into the second and fourth quadrants because either x1 or
x2 would be negative, and negative production or sales is not meaningful.
What the graph shows is that there is no unique breakeven point. The two
extremities are both possible breakeven points:
(5000,0): = 4(5000)+5(0)-20 000 = 0
(0,4000): = 4(0)+5(4000)-20 000 = 0
5000
x2
4000
4x1+5x2=20,000
3000
2000
1000
0
0
2000
4000
6000
x1
But any other point on the line is also a breakeven point, meaning that there are
multiple breakeven points. Such other points are linear combinations of the two
extremities, and can be calculated using the expression
g(S1)+(1-g)(S2)
where S1 is solution 1: x1 = 5000, x2 = 0,
S2 is solution 2: x1 = 0, x2 = 4000,
and g can take any positive value in the range 0g1.
8.11
So we can find other breakeven points by selecting different values for g between
zero and one. For example, suppose we let g = 1/5. Then we have another BEP:
1/5(5000,0)+4/5(0,4000)
The new x1 value = 1/5 of the x1 value from S1 plus 4/5 of the x1 value from S2,:
x1 = 1/5(5000)+4/5(0) = 1000.
Similarly, the new x2 value = 1/5 of the x2 value from S1 plus 4/5 of the x2 value
from S2:
x2 = 1/5(0)+4/5(4000) = 3200
Hence we have discovered another breakeven point (1000,3200). To verify:
= 4(1000)+5(3200)-20 000 = 0.
Not only is there no unique breakeven point, but there are multiple solutions for
the required volume to earn a target level of profit. Suppose we are interested in
earning a net profit of $5000. Then all points on the line
4x1+5x2 = 20 000+5000
= 25 000
are possible solutions. For example, (6250,0) or (0,5000) or any point along the
line between them is a solution. The graph of this line would be parallel to, but
above the breakeven line.
Of course, this graphical technique is restricted to the case of two products, but the
general principle of multiple solutions holds for more than 2 products.
A given mix
A unique solution can be obtained, however, if the multiple products are produced
and sold in fixed proportions (that is there is a given product mix). For example,
suppose that products P1 and P2 are sold in the ratio x1:x2 = 5:1, meaning that for
every 1 unit of P2, 5 units of P1 are produced and sold. How many units of each
product are required to break even?
We calculate a weighted average contribution margin, based on the given mix, to
use in the breakeven formula. With a ratio of 5:1, P1 will constitute 5/(5+1), or
5/6 of sales, while P2 will constitute 1/(5+1), or 1/6 of sales. Hence,
Average CM = 5/6($4)+1/6($5)
= (20+5)/6
= 25/6
8.12
Then,
BEP =
FC
20 000 120 000
=
=
= 4800 units
Av.CM
25/6
25
These 4800 units represent a mix of P1 and P2, and the individual components
are:
x1 = 5/6(4800) = 4000
x2 = 1/6(4800) = 800
It can be easily proved that (4000,800) is a breakeven point:
= 4(4000)+5(800)-20 000 = 16 000+4000-20 000 = 0.
Similarly, given the mix x1:x2 = 5:1 we could calculate the required volume to
earn a given net profit, say $5000:
Required Volume =
That is,
FC+
20 000+5000 25000 6
=
=
= 6000 units
Av. CM
25/6
25
This type of analysis, given the sales mix, can be used for any number of products.
Limitations of CVP analysis
Although CVP analysis can be very useful, and can answer many questions, it is
not a maximising technique. That is to say, CVP analysis does not answer such
questions as, How many units of each product do I need to produce and sell in
order to maximise profits? Linear programming, the topic of the next chapter,
was designed to answer such questions.
8.13
Harry
Joe, you said you put in these peanuts because some people ask for
them, but do you realize what this rack of peanuts is costing you?
Joe
It aint gonna cost. Sgonna be a profit. Sure, I hadda pay $25 for a
fancy rack to holda bags, but the peanuts cost 6 cents and I sell em for
10 cents. Figger I sell 50 bags a week to start. Itll take 12 weeks to
cover the cost of the rack. After that, I gotta clear profit of 4 cents a
bag. The more I sell, the more I make.
Harry
Joe
Huh?
Harry
Joe
Harry
Look, Joe, the cook is in the kitchen, the kitchen prepares the food, the
food is what brings people in here, and the people ask to buy peanuts.
Thats why you must charge a portion of the cooks wages, as well as
a part of your own salary to peanut sales. This spreadsheet contains a
carefully calculated cost analysis which indicates the peanut operation
should pay exactly $1,278 per year toward these general overhead
costs.
Joe
Harry
Its really a little more than that. You also spend money each week to
have the windows washed, to have the place swept out in the
mornings, and to keep soap in the washroom. That raises the total to
$1,313 per year.
Joe
Harry
(With a sniff) Hes not an accountant. Do you actually know what the
portion of the counter occupied by the peanut rack is worth to you?
Joe
Aint worth nothing - no stool there - just a dead spot at the end.
8.14
Harry
The modern cost picture permits no dead spots. Your counter contains
60 square feet and your counter business grosses $15,000 a year.
Consequently, the square foot of space occupied by the present rack is
worth $250 a year. Since you have taken that area away from general
counter use, you must charge the value of the space to the occupant.
Joe
Harry
Right. That raises their share of the general operating costs to a grand
total of $1,563 per year. Now then, if you sell 50 bags of peanuts per
week, these allocated costs will amount to 60 cents per bag.
Joe
What?
Harry
Joe
Somethings crazy.
Harry
Not at all. Here are the figures. They prove your peanut operation
cannot stand on its own feet.
Joe
Harry
Joe
Harry
Joe
How?
Harry
Move to a building with cheaper rent. Cut salaries. Wash the windows
bi-weekly. Have the floor swept only on Thursday. Remove the soap
from the washrooms. Decrease the square foot value of your counter.
For example, if you can cut your expenses 50%, that will reduce the
amount allocated to peanuts from $1,563 down to $781.50 per year,
reducing the cost to 35 cents per bag.
Joe
8.15
Harry
Much, much better. However, even then you would lose 26 cents per
bag if you charge only 10 cents. Therefore, you must also raise your
selling price. If you want a net profit of 4 cents per bag, you would
have to charge 40 cents.
Joe
(Flabbergasted) You mean after I cut operating costs 50%, I still gotta
charge 40 cents for a 10 cent bag of peanuts? Nobodys that nuts about
nuts. Whod buy em?
Harry
Joe
(Eagerly) Look! I got a better idea. Why dont I just throw the nuts out
put em in a trash can?
Harry
Joe
Sure. All I got is about 50 bags of peanuts cost about three bucks
so I lose $25 on the rack, but Im outa this nutsy business and no
more grief.
Harry
(Shaking head) Joe, it isnt quite that simple. You are in the peanut
business! The minute you throw those peanuts out, you are adding
$1,563 of annual overhead to the rest of your operation. Joe, be
realistic can you afford to do that?
Joe
Harry
Summary
Cost-volume-profit analysis is a technique for assessing the effects of changes in
volume on expected profits. We can calculate the breakeven point for a product in
units and dollars, as well as the required volume in units or dollars to earn a target
level of profit. Profit from selling a given volume can also be calculated.
Breakeven charts are useful for illustrating and analysing financial risk.
CVP analysis can also be applied to multiple products. There is no unique
breakeven point unless the product mix is specified.
8.16
Study questions
P8-3 Single product CVP analysis: comprehensive set of questions
BE Ltd manufactures and sells a single product for $10 per unit. Variable
costs are $5 per unit to manufacture and $2 per unit to distribute. Fixed
costs are $30 000 per month.
Calculate:
a.
b.
c.
d.
e.
f.
g.
h.
Buy Machine A to make the product. Fixed costs would be $800 000
per year, but variable operating costs would be only $20 per unit.
2.
Buy Machine B. Fixed costs would be $200 000 per year and variable
operating costs would be $80 per unit.
Required:
a.
Calculate the breakeven points using (i) Machine A, and (ii) Machine
B.
b.
Suppose that production and sales in the first year are 1000 units.
Calculate the profit before tax using (i) Machine A, and (ii) Machine
B.
c.
Suppose that production and sales in the second year are forecast to be
15 000 units. Calculate the profit before tax using (i) Machine A, and
(ii) Machine B.
d.
8.17
Low grade
Medium grade
High grade
Variable Cost
$0.60
0.70
1.00
Required:
a.
b.
Given this sales mix, how many of each grade should be sold to
break even on skateboard bearings?
ii.
Given this sales mix, how many units of each grade should be
sold to earn an after-tax profit of $10 000 on skateboard
bearings, given a company tax rate of 40c in the doll
p-b $10-($5+$2) $3
=
=
= 0.3
p
$10
$10
b.
CM ratio =
c.
BEP =
d.
e.
8.18
CM = p-b = $10-($5+$2) = $3
FC $30 000
=
= 10 000 units
CM
$3
1.
or
2.
BEP$ =
FC
$30 000
=
= $100 000
CM ratio
0.3
f.
Required volume =
$10 000
$30 000+
1-t =
1-0.45 = $160 606 (rounded)
Required sales =
CM ratio
0.3
FC+
g
h.
P8-7 a.
b.
P8-9 a.
i. $400 000
i.
ii.
d.
1. L = 22 500 M =
0
2. L =
0 M = 11 250
3. L = 1/3(22 500)+2/3(0) = 7500
M = 1/3(0)+2/3(11 250) = 7500
8.19
b.
i.
ii.
8.20
8.21
Solution
8.22
Study questions
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 68). Pearson
Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 72). Pearson
Prentice Hall.
8.23
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 74). Pearson
Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 77). Pearson
Prentice Hall.
8.24
(20-25 min.)
1.
Let N
Sales
$1.00 N
$.20 N
N
Let S
S
.20 S
S
= number of units
= Fixed expenses + Variable expenses + Net income
= $6,000 + $.80 N + 0
= $6,000
= 30,000 units
= sales in dollars
= $6,000 + .80 S + 0
= $6,000
= $30,000
In dollars
($6,000+0)
Fixed costs + Net income
=
= $30,000
$0.20
Contribution margin percent
2.
Increment
Total
30,000
10,000
40,000
$30,000
$10,000
$40,000
24,000
8,000
32,000
6,000
6,000
Total expenses
$30,000
$8,000
$38,000
2,000
$ 2,000
Volume in units
Sales
Deduct expenses:
Variable
Fixed
8.25
3.
or 37,760 x $1.00
4.
= $37,760 sales
New contribution margin is $.18 per unit; $6,000 $.18 = 33,333 units
33,333 units x $1.00 = $33,333 in sales
5.
2-34
1.
The quick way: (40,000 - 30,000) x $.16 = $1,600. On a graph, the slope of the
total cost line would have a kink upward, beginning at the break-even point.
(15 min.)
$23. To compute this, let X be the variable cost that generates $1 million in
profits:
($48 - X ) x 800,000 - $19,000,000
= $1,000,000
($48 - X) = ($1,000,000 + $19,000,000) 800,000
$48 - X = $200 8 = $25
X = $48 - $25 = $23
2.
Loss of $600,000:
($48 - $25) x 800,000 - $19,000,000
= ($23 x 800,000) - $19,000,000
= $18,400,000 - $19,000,000
= ($600,000)
2-42
1.
(15 min.)
Let X = amount of additional fixed costs for advertising
(1,100,000 x 13) +300,000 -.30(1,100,000 x 13) - (7,000,000 + X) = 0
14,300,000 + 300,000 - 4,290,000 - 7,000,000 - X = 0
X = 14,600,000 - 11,290,000
X = 3,310,000
2.
8.26
2-50
1.
(40 min.)
Let N = the number of people to be admitted for the season
Revenue:
Rights for concession
Admissions
Percentage of bets
$60,000
$1.00N
10% of $25N = $2.50N
$ 150,000
20,000
20,000
40,000
100,000
810,000
$1,140,000
Variable costs:
Parking is $4.80 per car or $.80 per person
(6 persons attend for each car, so $4.80 6 = $.80)
Total expense = $1,140,000 + $.80N
a.
Break-even point:
$60,000 + $3.50N - $1,140,000 - $.80N = 0
$2.70N = $1,080,000
N = 400,000 people
b.
Desired operating profit $270,000:
$60,000 + $3.50N - $1,140,000 - $.80N = $270,000
$2.70N = $1,350,000
N = 500,000 people
2.
$1,140,000
576,000
60,000
None
1,800,000
$1,860,000
$1,716,000
$ 144,000
8.27
3.
$1,140,000
810,000
$1,950,000
8.28
Required reading
Textbook:
Learning objectives
On completion of this topic you should understand:
relevant costing;
Before studying this chapter you should ensure that you understand the
following basic manufacturing terms:
direct materials
direct labour
factory overhead
indirect costs.
This topic examines the concept of relevant costing; accountants are expected to
collect and report data to decision makers,
be aware that qualitative factors may also be relevant to the decision. These
are aspects which will have a bearing on the decision but for which it is
difficult or imprecise to measure in dollars and cents i.e. quantitatively e.g.
the decision to undertake a tertiary course may be based upon the anticipated
future stream of income following graduation plus other benefits which are
not quantifiable - status, quality of life, satisfaction etc.
9.1
Special decisions
Can be distinguished from the regular or typical operating decisions. Special
decisions are atypical or unusual and generally occur less frequently than those
associated with normal operations. Examples of special decisions would be
whether to accept a special order, buy-in or manufacture a component, repair or
replace an item of capital equipment.
Relevant information is the expected future data that will differ among
alternatives. Note: The emphasis is placed upon future rather than historical
(financial accounting) costs, and that there is a difference between the alternatives.
Work through the Cordell Company problem in your text. Recognise how the
contribution approach for constructing the income statement assists in analysing
the data because it distinguishes between variable and fixed costs. In the Cordell
example fixed expenses do not change between the alternatives being considered.
Absorption costing
Is the generally accepted method of costing which assigns all types of
manufacturing costs (direct materials and labour, as well as variable and fixed
overhead) to units produced. Sometimes called full costing.
Variable (direct) costing
Is a method of cost allocation that assigns only variable manufacturing costs to
product and treats fixed manufacturing costs as period costs (not product costs).
The text does not provide a clear explanation of the differences between product
and period costs. Product costs (also referred to as inventoriable costs) are those
costs which are included in the cost of the product produced by the firm. The
reason the term inventoriable is used, is that if the product is not sold but carried
forward to the next period then the manufacturing costs associated with the
production carried forward must also be carried forward. You will recall from the
balance sheet studied in financial accounting that there is a valuation shown for
the current asset, inventory; this is how that valuation is derived. Period Costs are
those costs which are expensed in the period in which they are incurred. These are
normally classified as non manufacturing costs except for fixed manufacturing
costs under the variable costing system which are classified as period costs.
9.2
Manufacturing Costs
Direct Material
Direct Labour
Product
Yes
Yes
Yes
*
No
**
Non-Manufacturing Costs
Variable Selling & Admin.
Fixed Selling & Admin.
No
No
Yes
Yes
*
**
Note
When the product is sold either in the current or subsequent periods the cost of the
product is recognised as an expense e.g. Cost of Goods Sold.
Consider the section headed Incorrect Analysis in your text. Ensure that
you understand how this has occurred to make sure that in a similar situation
you do not treat the fixed component of a manufacturing cost as though it
behaved in a variable manner.
You will recall previously we distinguished between unit costs and total
costs when we initially studied variable and fixed costs; re-read this section
of the text to reinforce your understanding of the differences.
In the text you are introduced to the terms avoidable costs and unavoidable
costs. Firms are often required to make special decisions, for example, as to
whether a particular department or branch should continue operating.
Avoidable costs are those that will not continue if certain action is taken
whereas unavoidable costs are common costs which will continue despite
the decision to change operations.
9.3
If you read more widely in this area you may discover different stories about who
originated the Panoptic concept - Jeremy Bentham or his brother Samuel.
Macintosh credits Samuel; others credit Jeremy. It is usually the more famous
brother Jeremy who is given credit. But Samuel came up with the architectural
plan first - in Russia.
Samuel conceived of a work place/building (factory) whereby a supervisor could
monitor many workers. It was Jeremy who took this idea back to England and
named it the Panopticon and presented the concept as an ideal structure for a
prison. That was back in the 18th century.
9.4
In the last twenty years or so there has been a re-examination of the Panoptic
concept and has resulted in an extensive literature in management control and also
in electronic surveillance.
Susan Bryant (p. 2) describes this re-examination of workplace monitoring.
I must stress that I am not in any way suggesting that workplace monitoring is in itself a
new practice; in fact, work has always been monitored to some degree in the capitalist
workplace (and with heightened success in this century through the application of
Scientific Management). The key issue here is that the nature of at least some
computerized surveillance technologies permits a more extensive, and importantly,
intensive (i.e., directed to a single area or subject) degree of information gathering. In
the past, employers gathered data about the quantity and quality of products produced
by a whole department or unit. New information technologies enable employers to
gather and analyze highly detailed performance-related data, not just a bout the work,
but about each individual worker - in many cases on a minute-by- minute basis and
often without the employee necessarily being able to detect the watching.
<http://www.wlu.ca/~wwwpress/jrls/cjc/BackIssues/20.4/bryant.html>
For our purposes, the last sentence is most important. Modem management
accounting performance and control systems comprise a modem panoptic
surveillance and control system.
9.5
Figure 2: This is how a Panoptican prison would look from the inside
Source: <http://www.ric.edu/rpotter/panorama.html>
Figure 3: This is Jeremy Bentham - or rather his skeleton with a wax head
on top. It has been suggested a web cam should be pointed at this
auto-icon to emphasise his panopticon concept.
Source: <http://doric.bart.ucl.ac.uklweb/Nina/JBentham.html>
9.6
Figure 5
9.7
Who owns the Panopticon idea? Well Jeremy Bentham invented the prison
architecture while Michel Foucault used the Panopticon as a metaphor for control.
The relevance in this topic is that Management Accounting Control Systems
serves a similar control function as the panopticon prison.
9.8
9.9
Two other principles attached to the panoptic in the specific context of the
penitentiary. One was the solitude or isolation of inmates, the other was to allow
the prison to be run as a private enterprise by outside contractors. Solitude would
extend even to having private toilets for prisoners, and to holding chapel services
from a central position above the inspection lodge, without prisoners moving from
their cells. Inmates were to be atomised, secluded. As for running the prison by
contract, this would possible enable profit to be made and prison governors to be
held in unaccustomed esteem.
Bentham cheerfully defended his Panopticon from any misplaced liberal attack.
Might it be thought despotic, or might the result of this high-wrought
contrivance be constructing a set of machines under the similitude of men? Let
people think so if they wish. Such criticisms miss the point, namely, would
happiness be most likely to be increased or decreased by this discipline? Here is
control, and clean control at that. Much better, he commented, than something like
Addisons bizarre sounding proposal to try virginity with lions. There you saw
blood and uncertainty: here you see certainty without blood. Of course,
uncertainty still exists for those subjected to the Panopticon regime. Indeed, the
machine depends on it. Certainty resides in the system, and, one might add, with
the inspector, the one in the know.
This kind of certainty, sought by Bentham in the Panopticon, epitomises for Foucault
the social disciplines of modernity. Whereas in earlier times the failure of social
control would result in punishment that was public and brutal, modernity introduced
clean and rational forms of social control and punishment. The unruly crowd is
rendered manageable; no plots of escape from prison, no danger of contagion if they
are sick, no mutual violence if they are mad, no chatter if schoolchildren, and no
disorders or coalitions if workers. The crowd is replaced by a collection of separated
individualities. As Foucault says, Bentham made visibility a trap.
In the following important quotation Foucault summarises his understanding of
the major effect of the Panopticon:
to induce in the inmate a state of conscious and permanent visibility that assures the
automatic functioning of power. So to arrange things that the surveillance is
permanent in its effects, even f it is discontinuous in its action; that the perfection of
power should tend to render its actual exercise unnecessary; that this architectural
apparatus should be a machine for creating and sustaining a power relation
independent of the person who exercises it; in short, that the inmates should be
caught up in a power situation of which they themselves are the bearers.
9.10
9.11
Study questions
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 230). Pearson
Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 230-231).
Pearson Prentice Hall.
9.12
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 236). Pearson
Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 237). Pearson
Prentice Hall.
9.13
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 239-240).
Pearson Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 278-279).
Pearson Prentice Hall.
9.14
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 282). Pearson
Prentice Hall.
9.15
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 283-284).
Pearson Prentice Hall.
9.16
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 288-289).
Pearson Prentice Hall.
9.17
(10 min.)
Contribution margins:
Plain = $66 - $50 = $16
Professional = $100 - $70 = $30
Contribution margin ratios:
Plain = $16 $66 = 24%
Professional = $30 $100 = 30%
2.
a.
b.
3.
5-A4
1.
Plain
2
$16
$32
$640,000
Professional
1
$30
$30
$600,000
For a given capacity, the criterion for maximizing profits is to obtain the
greatest possible contribution to profit for each unit of the limiting or scarce
factor. Moreover, fixed costs are irrelevant unless their total is affected by
the choice of products.
(15-20 minutes)
Revenue ($360 x 70,000)
Total cost over product life
Estimated contribution to profit
Desired (target) contribution to profit 40% $25,200,000
Deficiency in profit
$25,200,000
16,600,000
$ 8,600,000
$10,080,000
$ 1,480,000
9.18
$16,600,000
1,120,000
$15,480,000
$ 9,720,000
$10,080,000
$
360,000
3.
$15,480,000
380,000
15,100,000
$10,100,000
$10,080,000
$
20,000
5-36
1.
(20 min.)
These warehouse stores attempt to maximize profits by cutting prices and
increasing turnover. Since profit is the product of contribution margin and
total sales, it can be affected by changing either. Total profit can be increased
if the added turnover brought about by a lowering of price brings in more
contribution margin than was lost by the price cut. They also try to minimize
fixed costs by limiting their investment in buildings and equipment.
Characteristics: (a) choose product lines and sizes that move quickly and
avoid stocking slow-moving items and sizes; (b) stock lower cost, lower
quality items; (c) rely heavily on self service; and (d) attempt to cut costs by
providing fewer services, and (e) build low-cost buildings in a place where
property costs are not too high.
2.
5-40
1.
(15 min.)
Assuming that total fixed costs are the same at production levels of 6,000
and 10,000 units, the analysis can focus on contribution margins:
CM@ $12:
CM@ $10:
9.19
2.
5-48
Subjective factors include image in the marketplace (higher price may give
image of quality), market penetration (satisfied customers may become
repeat customers), and effects on the sales force.
(15-20 min.)
1.
Year to
Grand Date
Totals
Tuition revenues
Costs of courses
Contribution margin
General administrative
expenses
Operating income
2.
Final Course
Enrollment
30
10 More
$2,000,000
800,000
1,200,000
$6,000
4,000
2,000
$1,000
600
400
$2,007,000
804,600
1,202,400
400,000
$ 800,000
0
$2,000
0
$ 400
400,000
$ 802,400
The same general considerations influence pricing decisions in profitseeking and nonprofit organizations. The exception is price-setting by many
government-owned entities, which often is heavily affected by legislative
bodies. The familiar three Cscustomers, costs, and competitiondo
influence price setting.
Executive education is highly competitive; the rates for top-flight teachers
are relatively high; and customers often do without or conduct their own inhouse training. The offering of discounts is often risky. It may alienate fullpaying customers, may lead to widespread price-cutting, and may encourage
the particular customers to bargain hard regarding course after course.
The setting of tuition in private universities is similar to setting prices in
private industry. Customers may go to the competition to other private or
public universities. Costs must be recovered if the institution is to survive.
Of course, tuition is only one part of a universitys revenue. Private
institutions are especially dependent on endowment income and on
donations from friends and alumni.
6-34
(20-25 min.)
9.20
$85,000
30,000
60,000
60,000
$235,000
$15,000
Per Bottle
$.085
.030
.060
.060
$.235
$.015
Buy
Total
Per Bottle
$250,000
$.250
________
$250,000
_____
$.250
6-48
(15-20 min.)
The data are placed in the format of the income statement, and the unknowns are
computed as shown:
Sales
Variable expenses
Direct materials
Direct labor
Variable factory overhead
Variable manufacturing cost of goods sold
Variable selling and administrative expenses
Total variable expenses (970 - 200)
Contribution margin
Fixed expenses
Fixed factory overhead
Fixed selling and administrative expenses
Operating income
1
2
3
6-52
$970
$210
170
110
490 1
280 2
770
200
90 3
100
190
$ 10
(35-50 min.)
There are several ways to approach this problem. The easiest is probably to
concentrate on the difference in the total contribution margin. The total
fixed costs of $780,000, before considering the increase in advertising, will
be unaffected and may be ignored. Production and sales will decline by
10%, from 60,000 to 54,000 units:
60,000
Units
$5,400,000
4,200,000
$1,200,000
54,000
Units
$5,292,000
3,780,000
$1,512,000
Difference
$312,000
9.21
2.
If the total fixed costs do not change, the company will need a total
contribution margin of $1,200,000 from the two products together. How
many units of the new product can be sold? The clue to the production
capacity of the plant is in how fixed factory overhead was unitized:
$300,000 $6 per unit = 50,000 units of expected sales.
New product budget @ 50,000 Units:
Sales at $40
Variable costs at $30*
Contribution margin, new product
*
Direct material
Direct labor
Variable factory overhead
Variable selling expense, 10% $40
Total variable costs per unit
$2,000,000
1,500,000
$ 500,000
$ 6
12
8
4
$30
$5,400,000
700,000
$4,700,000
540,000
$4,160,000
Sales
Variable costs
Contribution margin
Fixed manufacturing costs
Fixed selling costs
Total fixed costs
Operating income
9.22
Old
$5,400
4,200
$1,200
300
480
$ 780
$ 420
Difference
$2,000
2,000
$
$
$
-
New
Product 1 Product 2
$5,400
$2,000
*
4,700
1,500
$ 700
$ 500
300
380**
100**
$ 380
$ 400
$ 320
$ 100
**
This allocation uses the $2.00 unit cost figure for the new product and
assigns the remaining fixed costs to the old product. Note, however,
that how the total fixed selling costs are allocated is irrelevant because
total fixed costs are unaffected by allocation methods or by how such
costs are assigned to products.
6-64
1.
(30-40 min.)
Minnetonka Corporation should make the bindings.
Cost saved by purchasing bindings:
Material, 20% $30
Labor, 10% $35
Overhead, 10% $5*
Total
Cost to buy per pair
*
$ 6.00
3.50
.50
$10.00
$10.50
2.
Minnetonka Corporation would not pay more than $10 each because that is
the cost to make the product internally.
3.
At a volume of 12,500 pair, Minnetonka should buy the bindings. The cost
of buying 12,500 pair is $131,250. The cost of making 12,500 pair is:
12,500 $10
Added fixed costs
Total
Buying the bindings will save
$125,000
10,000
$135,000
$ 3,750
Making the bindings saves variable costs of $.50 per pair. If sales exceed
$10,000 $.50/pair = 20,000 pair, it is cheaper to make the bindings.
4.
$100,000
26,250
$126,250
9.23
9.24
Reading
9.1
Macintosh, N., & Quattrone, P. (2010). Management accounting and control
systems: An organizational and sociological approach (pp. 3-5, 18-22,
286-289). Chichester, West Sussex: John Wiley.
1.1
1.2
2.3
10.2.1 "If I cannot see it, I cannot manage it!" - MACS and the Panopticon.
(pp. 286-289).
9. 25
9.26
Required reading
Textbook:
a budget being a financial plan that is used to estimate future results and
assist in controlling future operations.
advantages;
types;
the components of, and how to construct a master budget.
cash flow predicaments are the cause of many small business failures.
The construction of the master budget is one of the most important planning
functions within an organisation The worked example in the text is good in that it
clearly identifies the likes between the various schedules and components of the
master budget.
One of the principal reasons for business failure is poor cash management. The
preparation of a cash budget will at least alert management to the need for
arranging debt finance or reviewing internal policy re-credit to customers.
In covering this topic you should become familiar with the method for compiling a
master or static budget. The steps are clearly defined and to an extent procedural.
The text acknowledges the behaviour ramifications for budgets but only in a
limited way. You may be aware of the dysfunctional aspects of budgets,
particularly where they are based on unattainable standards or goals and have been
developed without consultation with the participants or employees concerned.
10.27
To balance the topic from a behavioural perspective Reading 10.1 has been
included.
in the previous section all the budgets were static or inflexible in that they
were prepared for one level of activity say 50,000 units.
This section also discusses Standard Costs and Variance Analysis and demonstrates
uses of the analysis in terms of responsibility, control, feedback and trade-offs.
Chapter 8 is structured so that you can study this topic in two parts:
Flexible Budgets, and
Flexible Budget Variances.
The following aspects of budgeting are provided to complement your study of this
topic:
variances for labour and material can be analysed in respect of its two
components:
1.
2.
price
quantity (the term efficiency is used the text).
the diagram shown as Exhibit 8-6 provides a general approach for the
analysis of direct material and direct-labour variances; refer to this if you
have difficulty in following the discussion.
10.28
how to construct a flexible budget and its relationship to the static budget
perfection standards
how to analyse and interpret the results so that the aspects of responsibility
and controllability are considered.
11.29
10.30
11.31
10.32
11.33
10.34
Study questions
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 321-322).
Pearson Prentice Hall.
11.35
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 325). Pearson
Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 325). Pearson
Prentice Hall.
10.36
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 328-329).
Pearson Prentice Hall.
11.37
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 361-362).
Pearson Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 364). Pearson
Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 369). Pearson
Prentice Hall.
10.38
(60-120 min.)
2.
The cash budget and balance sheet clearly show the benefits of moving to
just-in-time purchasing (though the transition would rarely be accomplished
as easily as this example suggests). However, the company would be no
better off if it left so much of its capital tied up in cash it has merely
substituted one asset for another. At a minimum, the excess cash should be
in an interest bearing account the interest earned or forgone is one of the
costs of inventory.
January
February
March
$62,000
$75,000
$38,000
$37,200
7,500
2,500
$47,200
$45,000
18,600
2,500
$66,100
$22,800
22,500
6,200
$51,500
December
January
February
March
$39,050
12,500
$51,550
16,000
$35,550
$ 6,000
31,000
$37,000
39,050
$
-
$ 6,000
37,500
$43,500
8,050
$35,450
$ 6,000
19,000
$25,000
6,000
$19,000
$35,550
$35,450
$19,000
11.39
Exhibit I
VICTORIA KITE
Budgeted Statement of Cash Receipts and Disbursements
For the Three Months Ending March 31, 2005
Cash balance, beginning
Minimum cash balance desired
(a) Available cash balance
Cash receipts and disbursements:
Collections from customers
(Schedule b)
Payments for merchandise
(Schedule c)
Rent
Wages and salaries
Miscellaneous expenses
Dividends
Purchase of fixtures
(b) Net cash receipts & disbursements
Excess (deficiency) of cash before
financing (a + b)
Financing:
Borrowing, at beginning of period
Repayment, at end of period
Interest, 10% per annum
(c) Total cash increase (decrease) from financing
(d) Cash balance, end (beginning balance + c + b)
January
February
March
$ 5,000
5,000
0
$ 5,100
5,000
100
$37,692
5,000
32,692
47,200
66,100
51,500
(35,550)
(8,050)
(15,000)
(2,500)
(1,500)
$ (15,400)
(250)
(15,000)
(2,500)
$ 48,350
(35,450)
(250)
(15,000)
(2,500)
$(15,400)
$ 48,450
$27,992
$ 15,500
$ 15,500
$ 5,100
$
(15,500)
(258)
$(15,758)
$ 37,692
Exhibit II
VICTORIA KITE
Budgeted Income Statement
For the Three Months Ending March 31, 2005
Sales (Schedule a)
Cost of goods sold
(Schedule c)
Gross margin
Operating expenses:
Rent*
Wages and salaries
Depreciation.
Insurance
Miscellaneous
Net income from operations
Interest expense
Net income
* (January-March sales less $10,000) x .10 plus 3 x $250
10.40
$175,000
87,500
$ 87,500
$17,250
45,000
750
375
7,500
70,875
$ 16,625
258
$ 16,367
(3,000)
$(4,700)
$
$32,992
Exhibit III
VICTORIA KITE
Budgeted Balance Sheet
March 31, 2005
Assets
Current assets:
Cash (Exhibit I)
Accounts receivable*
Merchandise inventory (Schedule c)
Unexpired insurance
Fixed assets, net: $12,500 + $3,000 $750
Total assets
$32,992
22,700
6,000
1,125
$62,817
14,750
$77,567
$19,000
16,500
1,500
$37,000
40,567
$77,567
*February sales (.10 x $75,000) plus March sales (.40 x $38,000) = $22,700
**Balance, December 31, 2004
$25,700
Add: Net income.
16,367
Total
$42,067
Less: Dividends declared.
1,500
Balance, March 31, 2005
$40,567
7-32
(10-15 min.)
Collections from:
January sales:
February sales:
March sales:
Total cash collections
$300,000 12%
$400,000 10% 99%
$400,000 25%
$450,000 50% 99%
$ 36,000
39,600
100,000
222,750
$398,350
11.41
7-34
(20-25 min.)
2.
July
August
Purchases budget
Ending inventory*
Cost of goods sold, 60% of sales
Total needed
Beginning inventory
Purchases
166,200
180,000
346,200
200,000
146,200
198,600
168,000
366,600
166,200
200,400
231,000
204,000
435,000
198,600
236,400
120,000
29,240
149,240
116,960
40,080
157,040
160,320
47,280
207,600
10.42
7-42
(50-90 min.)
These spreadsheets contain data from the problem in the top of the spreadsheet
space. Computations of operating expenses are accomplished with formulas that
reference the table. Comparing the summary calculations of operating expenses
(labelled Total operating expense) allows the user to assess the effects of
alternate scenarios.
1. Table of budget data
Cost behavior
Cost
17 Displays
15 Displays
Indirect
Packaging
Shipping
Total operating expense
Sales forecasts
Fixed
$40,000
$8,000
$8,000
$19,206,000
Variable
$100
$40
$16/component
$4 / display
$2 / display
17 Displays 15 Displays
Sales mix
Sales growth
3,200
2,400
5,600
3,200
3,200
2,400
2,400
2,800
1
1
3,200
2,400
5,600
3,200
3,200
2,400
2,400
2,800
1.25
1
4,000
3,000
7,000
4,000
4,000
3,000
3,000
3,500
Operating expenses
Month
Components
1 October
$2,400,000
2 November
1,800,000
3 December
4,200,000
4 January
2,400,000
5 February
2,400,000
6 March
1,800,000
Totals
$15,000,000
Indirect
$616,000
472,000
1,048,000
616,000
616,000
472,000
$3,840,000
Packaging
$36,800
29,600
58,400
36,800
36,800
29,600
$228,000
Month
1 October
2 November
3 December
4 January
5 February
6 March
7 April
8 May
Quantity / display
5
5
Shipping
$22,400
18,800
33,200
22,400
22,400
18,800
$138,000
Total
$3,075,200
2,320,400
5,339,600
3,075,200
3,075,200
2,320,400
$19,206,000
11.43
Fixed
$40,000
$8,000
$8,000
$16,639,680
Sales forecasts
Sales mix
Month
1 November
2 December
3 January
4 February
5 March
6 April
7 May
Sales growth
2,400
5,600
3,200
3,200
2,400
2,400
2,800
Operating expenses
Month
Components
1 November
$1,620,000
2 December
3,780,000
3 January
2,160,000
4 February
2,160,000
5 March
1,620,000
6 April
1,620,000
Totals
$12,960,000
Indirect
$428,800
947,200
558,400
558,400
428,800
428,800
$3,350,400
10.44
Variable
$100
$40
$16 / component
$4 / display
$2 / display
Quantity / display
5
5
17 Displays
1
0.9
2,160
5,040
2,880
2,880
2,160
2,160
2,520
15 Displays
1.25
0.9
2,700
6,300
3,600
3,600
2,700
2,700
3,150
Packaging
$27,440
53,360
33,920
33,920
27,440
27,440
$203,520
Shipping
Total
$17,720 $2,093,960
30,680
4,811,240
20,960
2,773,280
20,960
2,773,280
17,720
2,093,960
17,720
2,093,960
$125,760 $16,639,680
Fixed
$40,000
$8,000
$8,000
$18,240,600
Sales growth
5,600
3,200
3,200
2,400
2,400
2,800
0
0
Indirect
$1,048,000
616,000
616,000
472,000
472,000
544,000
$3,768,000
Variable
$100
$40
$16 / component
$4 / display
$2 / display
Quantity / display
5
5
17 Displays
1
0.9
5,040
2,880
2,880
2,160
2,160
2,520
0
0
15 Displays
1.5
0.9
7,560
4,320
4,320
3,240
3,240
3,780
0
0
Packaging
$58,400
36,800
36,800
29,600
29,600
33,200
$224,400
Shipping
$33,200
22,400
22,400
18,800
18,800
20,600
$136,200
Total
$5,171,600
2,979,200
2,979,200
2,248,400
2,248,400
2,613,800
$18,240,600
11.45
8-A3
(20 - 30 min.)
1.
Direct materials:
Direct labor:
Total
2.
The standard costs expected are based on actual output achieved, not
scheduled or budgeted output.
A
Actual Cost
Incurred:
Actual Inputs
Actual Prices
In general:
Direct
Materials
10.46
B
Flexible Budget
Based on
Actual Inputs
Expected Prices
C
Flexible Budget
Based on
Expected Inputs
for Actual
Outputs Achieved
Expected Prices
$xxx
$xxx
$xxx
Price variance
Usage variance
(A - B)
(B - C)
Flexible-budget variance (A - C)
Direct
Labor
3.
8-30
1.
A
B
C
2,850 hr $26.00 =
2,850 hr $25.00 =
525 units 5 hr
$74,100
$71,250
$25.00 = $65,625
Price variance
Usage variance
(A - B) =
(B - C) =
$74,100 - $71,250 =
$71,250 - $65,625 =
$2,850 U
$5,625 U
Flexible-budget
variance (A - C)
$74,100 - $65,625 =
$8,475 U
b.
c.
11.47
Actual Hours
Expected Price
Standard Hours
Expected Price
1,750 hrs.*
1,750 hrs.*
1,955 hrs.
$14.58
$14.00*
$14.00*
= $25,515
= $24,500
= $27,370
1,750* $.58
205 $14.00*
= Price variance, $1,015U* = Usage variance, $2,870F
Flexible-budget variance, $1,855F*
8-43
(25-30 min.)
Direct
materials
Direct
labor
Variable
overhead
Flexible Budget
Based on
Standard Inputs
Cost Incurred:
Flexible Budget
Allowed for Actual
Actual Inputs
Based on Actual Inputs
Outputs Achieved
Actual Prices
Expected Prices
Expected Prices
3,300 lbs $.96
3,300 lbs $1.00
3,000 lbs $1.00
= $3,168
= $3,300
= $3,000
3,300 ($.96 - $1.00) = (3,300 - 3,000) $1.00
=
Price variance $132F
Usage variance $300U
Flexible-budget variance, $168U
5,500 hrs $7.60
5,500 hrs $8.00
5,000 hrs $8.00
= $41,800
= $44,000
= $40,000
5,500 ($7.60 - $8.00) = (5,500-5,000) $8.00 =
Price variance $2,200F Usage variance, $4,000U
Flexible-budget variance, $1,800U
5,500 hrs $.86 *
5,500 hrs. $.80
5,000 hrs. $.80
= $4,730
= $4,400
= $4,000
5,500 ($.86 - $.80)
(5,500-5,000) $.80
= Spending variance,
= Efficiency variance,
$330U
$400U
Flexible-budget variance, $730U
U = Unfavorable, F = Favorable
*
10.48
The average variable overhead price is unnecessary to comply with the requirements of the
problem. It was computed by dividing $4,730 by 5,500 hours.
Required reading
Textbook:
Learning objectives
This topic introduces procedures which you can apply to your personal
circumstances (financial position) as well as to selecting investment projects for
an enterprise. The techniques with which you will become familiar are:
11.1
The discounted cash flow model is a type of capital budgeting model and in this
model the time value of money is especially recognised.
in simple terms, as a recipient of cash would you rather receive $100 now or
$100 in a year hence? Of course you would require more than $100 in a
years time to compensate for the loss of purchasing power.
The DCF model is in widespread use in the commercial world. The two main
variations of this model which are examined in this chapter are:
These two techniques are discussed in the text and the worked example is set out
in exhibits 11-1 and 11-2 respectively.
you may need to work through several of the review questions to ensure a
thorough understanding of these concepts and gain familiarity with the use
of the financial tables.
Net Present Value is the discounted or present value of all cash inflows and
outflows of a project or from an investment at a given discount rate.
The Internal Rate of Return is the discount rate that equates the net present value
of a stream of cash inflows and outflows to zero.
Study Appendix B of the text. Work through the examples described in the
appendix and make sure you understand how to use the present value tables
(both Table 1 and Table 2). Make sure you understand the concept of an
annuity.
2.
Attempt the questions listed in the Study schedule. These exercises are
good revision for using the tables and the answers are provided at the end of
the Chapter.
3.
4.
The learning objectives of the text provide a useful guide to the expected
outcomes for this topic. The use of a diagram in depicting the flow of cash
over time is often a good starting point as this approach will assist you in
identifying all cash flows.
11.2
The IRR, NPV, accounting rate of return and payback models each have particular
advantages and disadvantages depending upon the investments being evaluated
and the criteria for selection.
Generally speaking the DCF is the preferred approach because of its explicit
recognition of the time value of money.
You should also appreciate that the capital budget is an integral part of the master
budget which was studied in an earlier topic. Failure to make provision for the
cash flows resulting from investment decisions can have a major influence on the
cash budget. The chapter also discusses the use of sensitivity analysis; there are
many entrepreneurs in Australia at the present time who now understand the
significance of this technique and if applied in investment appraisals may have
resulted in different decisions or less optimistic predictions re cash flows and
interest rates.
The following notes are adapted from Fatseas, V. A., & Williams, J. F. (2008).
Management accounting decisions. McGraw-Hill.
11.3
Few organisations have sufficient capital funds to simultaneously undertake all the
capital projects they would like to. Hence there is a need for capital rationing, by
ranking proposals in order of merit, and choosing only the most attractive, or else
raising additional funds, or both. Thus an evaluation of capital expenditure
proposals involves a consideration of profitability (the rate of return on funds
invested) as well as liquidity (the timing of large cash outlays and future cash
inflows generated by projects).
There is a number of methods for evaluating the desirability and financial
consequences of capital investment decisions. The more simple techniques do not
have regard for the time value of money, while other techniques specifically do
so through the use of discounting techniques. Five techniques will be considered
here: the accounting rate of return, the payback period, the net present value, the
internal rate of return, and the payback reciprocal. Firstly, it is assumed that there
are no taxes on profits. Subsequently this assumption is relaxed.
No income taxes
Accounting rate of return
The accounting rate of return (ra) is a profitability measure which calculates return
on investment, based on accounting concepts of income and investment. In
general, the accounting rate of return is equal to the increase in annual net profit as
a result of the capital investment decision, expressed as a percentage of the capital
expenditure incurred. There are, however, slight variations in its calculation. The
two most common measures are:
1.
ra =
ra =
and
2.
accept project if ra k
reject project if ra < k
where k is the required rate of return for a project of that risk. This rule is used for
(i) accept/reject decisions, and (ii) ranking mutually exclusive proposals. To
illustrate the calculation we use the data from example 8-1.
Illustrative example 8-1
Cost of new machine
$120 000
Useful life
4 years
Residual value after 4 years
$20 000
Increase in annual net profit
(after charging $25 000 depreciation) $12 000
Cost of capital, or required ROI
10%
11.4
12 000
= 0.1 or 10%
120 000
12 000
12 000
=
= 0.171 or 17.1%
70 000
0.5(120 000 + 20 000
Using the first measure the project is just acceptable (k = 10%), while it
comfortably passes the test of acceptability using the second measure. Clearly,
using average investment as the base increases the rate of return. In fact, if there
were no residual (or salvage) value for the machine, the accounting rate of return
would be exactly doubled when average investment is used in preference to initial
investment [ra = 12 000/0.5(120 000+0)=0.2].
Note that in this example the net profit each year was constant. If the net profit
varies from year to year we would have to calculate the average annual net profit
for the numerator.
The major criticism of the accounting rate of return is that it ignores the size and
timing of cash flows. Accounting profit will differ from net cash flow because of
11.5
Where annual net cash inflows from a project are equal, the payback period (in
years) is calculated as follows:
C
Payback period =
R
where C = initial cash outlay
R = annual net cash inflow
If the annual net cash inflows are not equal the payback period may be calculated
by adding the net cash inflows in consecutive years until the amount of the initial
outlay is recovered. It is assumed that the cash flow occurs uniformly throughout
the year to facilitate the calculation when the payback period is not a whole
number of years.
Using the data from example 8-1 we can calculate the payback period. First, we
need to calculate the annual cash inflow by adding back the non-cash depreciation
expense to net income:
Annual cash inflow = net income + depreciation
= $12 000 + $25 000
= $37 000.
Payback period =
120 000
= 3.24 years
37 000
As well as being a direct test of liquidity, the payback period is a guide to risk, there
being less risk involved with projects which promise a short payback period. In fact,
if there is risk of early obsolescence of the capital asset being considered, a short
payback period is very desirable. Although the payback period ignores differences
in expected project life, and profitability, it is a useful screening device use the
payback period as a first test, then examine profitability. The payback period also
ignores the time value of money, although it is possible to calculate the discounted
payback period using the present value of the cash inflows.
The time value of money
One of the criticisms of the accounting rate of return and the payback period
calculations is that both of them ignore the time value of money. The next two
techniques to be considered (net present value and internal rate of return) are, it is
argued, theoretically superior approaches to investment appraisal because they
specifically consider the time value of money. Before looking at these two techniques
we digress briefly to discuss the time value of money and discounting techniques.
The time value of money rests on the ability of money to earn interest. $1000 cash
held now is preferable to an expectation of $1000 cash in the future, because the
$1000 now can be invested and earn interest, thus accumulating to more than
$1000 in the future. Conversely, $1000 to be recovered in the future is worth less
than $1000 in the hand now.
11.6
The time value of money is not synonymous with the concept of inflation. The
time value of money derives from economic utility theory, specifying that people
have a preference for money now rather than money in the future, irrespective of
inflation. While inflation can impact on capital investment decisions, as we shall
see in later sections of this chapter, it is not to be confused with the time value of
money.
To illustrate, suppose an investor invests $1000 now at an interest rate of 10% per
annum (compound). At the end of years 1, 2 and 3 the investor would have
future sums of:
End of year 1: $1000 x 1.1 = $1100
End of year 2: $1100 x 1.1 = $1210
End of year 3: $1210 x 1.1 = $1331.
In general, the future sum in n years time, Sn of P dollars invested now at an
interest rate of i percent is given by the formula:
=
S n P (1 + i ) n
(8-1)
Thus, the future sum of $1000 invested at 10% for, say, 3 years is
S3 = 1000(1 + 0.1)3
= 1000(1.1)3
= 1000(1.331) = $1331.
It is argued that, given a risk free interest rate of 10%, an investor is indifferent
between $1000 now and $1331 in three years time.
Alternatively, we can find the present value of a future sum. Dividing both sides
of equation (8-1) by (1 + i)n gives
P=
Sn
(1 + i ) n
(8-2)
So, for example, the present value of $1000 to be received 3 years from now at an
interest rate of 10% is
P=
1000 1000
=
= $751.31
1.13
1.331
This means that an investor who could invest risk free at 10% pa. would be
indifferent between receiving $751.31 now or $1000 in 3 years time because
$751.31 invested now at 10% would have a future value of $1000 in 3 years time.
In other words, the present value of $1000 in 3 years time is $751.31, which is
quite a deal less than $1000. We say that the $1000 has been discounted to
reflect the time value of money.
11.7
11.8
An =
S
S
S
S
+
+
+ +
2
3
(1 + i ) n
1 + i (1 + i )
(1 + i )
(8-3)
Thus,
a (1 r n )
1
, where r in (8-3) would be
.
1+ i
1 r
S
1 n
[1 (
) ]
1 + i = S [1 1 ]
=
An 1 + i
1
i
(1 + i ) n
1
1+ i
(8-4)
So the present value of an annuity of $1000 each year for 3 years at 10% is
=
A3
1000
1
[1 3 ] = 10 000 - (10 000/1.331) = $2486.85
0.1
1.1
There are also discount tables available showing the present value of an annuity of
$1 (see Table E in the appendix). Under the 0.10 column of Table E in the row
corresponding to 3 periods we find the factor, F, of 2.4869. Therefore the present
value of an annuity of $1000 for 3 years at 10% = 1000 2.4869 = $2486.90
(rounding error because discount factor is rounded to 4 decimal places).
Using Excel
=PV(rate,nper,pmt)
where rate is the interest rate as a decimal, nper is the number of
periods, and pmt is the periodic payment. Here we must specify
pmt as a negative.
Thus, =PV(0.1,3,-1000) returns the value $2,486.85
R1
R2
Rn
+
+ ... +
C
n
2
1 + k (1 + k )
(1 + k )
(8-5)
11.9
In the case of an annuity (R1 = R2 = ... = Rn), so that the NPV for an annuity is:
R
R
k
C
NPV =
k (1 + k ) n
The decision rule is:
(8-6)
In the remainder of this chapter it is assumed that all cash flows occur at the end
of the year to which they relate. This is a simplifying assumption, but does not
significantly affect results.
Internal Rate of Return (r)
The internal rate of return, r, is the discount rate which equates the present value
of the net cash inflows with the initial investment outlay. That is, r is the discount
rate which would give a NPV of zero.
In the case of unequal cash flows the internal rate of return is calculated by solving
for r in equation (8-7) below:
C=
11.10
R1
R2
R3
Rn
+
+
+ +
2
3
1 + r (1 + r ) (1 + r )
(1 + r ) n
(8-7)
where C
Rj
r
n
= initial investment
= predicted annual cash flow in year j
= the internal rate of return
= life of the investment (years)
(8-8)
Having determined r, we then compare it with the cost of capital, k, using the
decision rule:
accept project if r k
reject project if r < k.
In example 8-1, although the annual cash flows are equal for the first three years,
in the final year there is also a recovery of the residual value of $20 000.
Therefore it does not represent a straight annuity. Internal rate of return
computations can be complex if done by hand, using a trial and error basis. We
start by taking a guess at r. Because there was a positive NPV using a discount
rate of 10%, we know that r must be greater than 10%. Lets guess at 12%. Then,
using the discount tables (Tables D and E) the present value (P.V.) of the cash
flows is calculated:
Year
1-4
4
P.V.
$112,383.80
12,710.00
$125,093.80
This gives a present value of $125 093.80 which is greater than the initial
investment of $120 000 (i.e. there is a positive NPV of $5093.80). Therefore our
guess was too low, because r needs to be larger still. We try 14%:
Year
1-4
4
P.V.
$107,806.90
11,842.00
$119,648.90
This gives a present value of $119 648.90 which is just a little less than the initial
investment of $120 000 (i.e. there is a negative NPV of $351.10). Therefore 14% is a
trifle too high, but near enough for our purposes. We compare this 14%
(approximately) with the cost of capital of 10%, and find the project acceptable (r>k).
11.11
Using Excel the cash flows are tabulated in the range B2:B6, beginning with Year
0 as now when the investment of $120 000 is made and Years 1 to 4 as the four
years of returns.
A
Year
0
1
2
3
4
1
2
3
4
5
6
B
Cash Flow
-120,000
37,000
37,000
37,000
57,000
C 120 000
=
= 3.2432
R 37 000
which the observant reader will recall is the payback period calculation. We now
enter the annuity table (Table E) in the row corresponding to n (i.e. 4 years) and
read across until we find the closest factor. The closest is 3.3121, corresponding
to 8%. Thus r would be approximately 8%, so the project would be rejected (less
than required 10%).
Apart from the tedious manual calculations when there are different cash flows
each year (in practice spreadsheets or other computer routines are used) the
internal rate of return also has the disadvantage that it can produce multiple rates
of return (when there are sign changes to cash flows from year to year - from
inflows to outflows or vice-versa).
11.12
Payback reciprocal
R
C
If there are equal annual cash inflows and the project has a useful life of at least
twice the payback period, then the payback reciprocal is a close approximation to
the internal rate of return.
In example 8-1, again ignoring the residual value, the payback reciprocal is
R 37 000
= = 0.31 or 31%
C 120 000
which is over twice the internal rate of return. In this case it is a poor estimate of r
because its life is too short vis-a-vis the payback period.
With income taxes
Where income taxes exist the analysis should be performed on an after-tax basis. Thus
both the cost of capital and the cash flows must be expressed on an after-tax basis.
The cost of capital, or required rate of return, k, must be on an after-tax basis. If k
is expressed as a before-tax return it may be converted to an after-tax form:
k (after tax) = k (before tax) (1 - tax rate).
For example, if the required rate of return is 20% before tax and the tax rate is 45
cents in the dollar, then
k (after tax) = 0.2(1 - 0.45) = 0.11 (or 11%).
Cash flows should include taxation payments, or reductions therein. Thus it is necessary
to calculate taxable income attributed to a project so that the tax payment (cash outflow)
can be determined. Calculating taxable income often involves considering expenses
which do not involve outlays of cash. The most common of these is depreciation, which
is a non-cash expense, but nevertheless, it reduces tax payable. The depreciation rate
used, of course, must be the rate allowed for tax purposes. Further, depreciation for tax
purposes should be based on original cost with no regard for predicted salvage value.
This is different from the accountants calculation of depreciation which deducts salvage
value from cost to determine the annual depreciation. There are two common methods
of calculating the taxation payments. To illustrate, assume a net annual cash inflow
from operations before tax of $10 000, annual depreciation expense for tax purposes of
$3000, and a tax rate of 40 cents in the dollar:
1.
Accounting method
Cash inflow before tax
Less Depreciation
Taxable income
Tax at 40c in $
Net income after tax
Add back Depreciation
Cash inflow after tax
$10 000
3 000
7 000
2 800
4 200
3 000
$7 200
11.13
Note that depreciation is deducted to determine taxable income (profit), so that tax
can be calculated. Tax is a cash outflow and reduces net cash inflow. After
determining net income after tax, we add back the non-cash item depreciation, to
get the net cash inflow. Depreciation is added back because it was deducted in the
first place simply to calculate tax payable it must then be added back to cancel
its deduction because it is not a cash flow.
Method 1. is a safe method which is least likely to lead to errors. Many people,
however, prefer to use the second method which is far quicker:
2.
$10 000
6 000
1 200
$7 200
[10 000(1-0.4)]
[3000(0.4)]
As you can see we get the same answer, $7200, with fewer calculations. The first
step assumes that no depreciation exists, and that the cash inflow equals net profit.
Thus we multiply by (1 - tax rate) to get the net cash flow after tax. This understates
the net cash flow, however, because we do have depreciation which is an expense
allowable for taxation and must adjust for it. In effect, the depreciation expense
reduces tax payable by 40 cents (the tax rate) for every $1, because each $1 of
depreciation reduces taxable income by $1. Thus the so-called depreciation tax
shield [depreciation x tax rate = 3000 0.4] is added to give $7200.
While this second method is quick, students sometimes become confused as to
whether they should be multiplying by t or (1-t), and whether they should add or
subtract. Further, the second line produces a figure of $6000 which defies
description - it is meaningless. Finally, it can lead to errors if there is insufficient
income before tax in any year to sustain a full deduction for depreciation. And
since the method does not calculate net income before tax the aforementioned
problem is not obvious. Consequently, unless the reader feels particularly
confident of using method (2) (s)he should stick to method (1).
On termination of projects, or when old capital assets are sold, disposal values can
lead to gains or losses on disposal which increase or reduce taxes, thus affecting
the cash flow associated with disposal. For example, an asset with a book value
of $1000 is sold for $1500. There is a taxable gain on disposal of $500, so that
the net cash inflow is $1500 (cash received) minus the tax on the gain on disposal
of $500 (cash to be paid to the taxation authorities).
It is generally assumed that tax payments or savings occur at the same time as
corresponding cash flows. In practice, however, if tax payments lag behind the
cash flows to which they relate then the primary cash flows and the consequent tax
payments will need to be calculated separately.
11.14
$180 000
$20 000
Years 1 to 3
Years 4 to 8
Revenue
$120 000
$210 000
11.15
Table 8-1
Ocean Dumping Pty Ltd Solution
Purchase barge
Modification
Revenues
Cash operating costs
Net cash inflow before tax
1
Less depreciation
Pre-tax profit
Tax (40%)
After-tax profit
Add back depreciation
Net cash inflows after tax
Sale of barge at end of 8 years
2
Tax on gain on disposal
3
PV Factors
Present values
Net present value
Accept project
Year 0
-180,000
-20,000
-200,000
1
-200,000
Years 1-3
Years 4-8
120,000
-80,000
40,000
-10,000
30,000
-12,000
18,000
10,000
28,000
210,000
-130,000
80,000
-10,000
70,000
-28,000
42,000
10,000
52,000
28,000
2.2459
62,885
52,000
2.0977
109,080
Year 8
150,000
-12,000
138,000
0.3050
42,090
14,056
Notes
1
Depreciation = (180,000+20,000)/20 = 10,000
2
Cash proceeds before tax
150,000
WDV [200,000 - 8(10,000)]
120,000
Gain on sale
30,000
Tax on gain (0.4 * 30,000)
12,000
3
PV factor for an annuity for years 4-8 = PV factor of annuity for 8 years minus PV factor
of annuity for 3 years: 4.3436-2.2459=2.0977
11.16
Direct labour
Indirect labour
Materials
Depreciation
Power
Old Machine
$34 000
7 000
12 000
5 000
7 000
New Machine
$14 000
7 000
9 500
13 000
10 000
The tax rate is 40% and the company requires a rate of return of 18%
after tax on investments.
In using a total project approach for example 8-3 we have a situation in which all
the cash flows (except for disposal of old machine) are outflows. These outflows
are reduced by the tax they save as deductions for expenses. A comparison of the
two negative PVs leads to selection of the smaller of the two, the difference
representing the NPV of the preferred action. Tables 8-2 (keep existing machine)
and 8-3 (replace existing machine) show the calculations.
11.17
a.
Table 8-2
ABC Company - Solution using Total Project Approach
KEEP EXISTING MACHINE
Years 1-3
$
Direct labour
-34,000
Indirect labour
-7,000
Materials
-12,000
Power
-7,000
Net cash operating outflow before tax
-60,000
Depreciation
-5,000
Total expenses before tax
-65,000
Tax effects (reduction) 40% x 65,000
26,000
Total expenses after tax
-39,000
Add back depreciation
5,000
Net cash operating outflow after tax
-34,000
Sale of machine end year 3
Tax on gain on sale 40%($3000-$0)
-34,000
PV factors
2.1743
Present value
-72,830.72 -73,926.2
Year 3
$
3,000
-1,200
1,800
0.6086
1,095.48
Table 8-3
ABC Company - Solution using Total Project Approach
REPLACE EXISTING MACHINE
There is an advantage in favour of replacement of $3 701.59 [(72,830.72) (69,129.13)]. That is, the NPV of the action replace is $3 701.59.
11.18
b.
Incremental approach
Under the incremental (or differential) approach only the difference between the
two alternatives for each item is entered. For example, if the machine is to be
replaced we would enter the costs of purchasing the new machine and proceeds
from the sale of the old machine. The difference in costs or revenues would be
entered: e.g. the reduction in the cost of direct labour with the new machine.
When there is no difference between the two alternatives the item is not even
entered: e.g. indirect labour is the same under both alternatives so is omitted.
Finally, because the old machine would be disposed of now (under the replace
alternative) rather than at the end of Year 3 if it were not replaced, we must
include this forgone source of revenue in Year 3 as a cost, together with the tax on
the gain on sale avoided as a revenue. The calculations are shown in Table 8-4.
Table 8-4
ABC Company - Solution using Incremental Approach
REPLACE MACHINE
Year 0
Years 1-3
Purchase new machine
-35,000
Rearrange production line
-4,000
Sale of old machine
9,000
Tax reduction - loss on sale
2,400
1
Savings in direct labour
20,000
1
Savings in materials
2,500
2
Increase in power
-3,000
Reduction in pre-tax cash outflow
19,500
Less increase in depreciation
-8,000
Reduction in pre-tax expenses
11,500
Increase in tax [40%(11,500)]
-4,600
Reduction in after-tax expenses
6,900
Add back increase in depreciation
8,000
Reduction in after-tax cash flow
14,900
Salvage in Year 3 on old machine forgone
Tax on gain on sale avoided
-27,600
14,900
PV factors
1
2.1743
Present values
-27,600.00 32,397.07
NPV
$3,701.59
Replace machine because NPV is positive.
Year 3
-3,000
1,200
-1,800
0.6086
-1,095.48
Notes
1
Reduction in costs with new machine. e.g. DL:$34,000-$14,000=$20,000
2
Increase in costs with new machine: $7,000-$10,000=-$3,000
11.19
Effects of Inflation
Inflation is the process of rising prices in the economy. This has an impact on
capital investment decisions because they involve estimates of future cash flows
and interest rates, typically over several years. There are two established ways of
dealing with inflation in capital budgeting:
or
=
R
1+ N
1
1+ I
To illustrate, suppose that the nominal rate is 26% and the inflation rate is 5%.
Then the real rate is
=
R
1 + 0.26
1.26
=
1
=
1 0.20 = 20%
1 + 0.05
1.05
Alternatively, given that the real rate is 20% and the inflation rate is 5%, then the
nominal rate is
N = (1 + 0.20)(1 + 0.05) 1 = 0.26 = 26%
The reader will observe that the nominal rate (26%) is higher than simply the sum
of the real rate (20%) and the inflation rate (5%). This is because the nominal rate
also takes account of the decrease in purchasing power of the real rate:
Real rate of return
Inflation rate
Inflationary effect on real rate
Nominal rate of return
11.20
0.20
0.05
0.01
0.26
[0.05 x 0.20]
When evaluating capital investment proposals we should use either all nominal
rates (i.e. for cash flows and discount rates) or all real rates. Never mix the two,
say by estimating future nominal cash flows but using a discount rate reflecting
real interest rates.
Using nominal rates, we would estimate future cash flows that we actually expect
to receive, i.e. incorporating expectations about inflation. These should then be
discounted by the nominal required rate of return.
If we use real rates, we estimate future cash flows in real terms (deflated for
inflation) and discount them by the real rate of return. One way to do this is to
simply deflate the nominal after-tax cash flows by dividing by (1+I)n , and then
use the real rate of return in the discounting process. This is probably unrealistic
because if we knew the nominal cash flows we might as well work with them.
We would be more likely to use real cash flows if we estimated future cash flows
in todays dollars.
The solutions to example 8-4 demonstrates these differences. The solution using
nominal rates is completed in the usual way, as shown in Tables 8-5(a) and 8-5(b).
The solution using real rates can be obtained by simply converting the nominal
after-tax cash flows to real after-tax cash flows by deflating them by the inflation
rate as described in note 1 of Table 8-6(a), i.e. dividing by (1+I)n. Then the real
discount rate is calculated as explained in note 2 of Table 8-6(a), using the
formula R = [(1+N)/(1+I)]-1. Finally the real after-tax cash flows are discounted
using the real discount rate. This should result in the same present values for each
year and the same NPV, as shown in Table 8-6.
Illustrative example 8-4
Cost of new machine
Useful life
Residual value
Increase in annual net profit
before depreciation
Annual depreciation
Nominal rate of return
Inflation rate
Taxation rate
$50 000
4 years
zero
$20 000 in todays dollars
25% on cost
10% pa after tax
3% per annum
40%
Required: Evaluate proposal using (1) nominal rates, and (2) real rates
11.21
Year 0
-50,000
-50,000
-50,000
Year 1
Year 2
Year 3
Year 4
20,600
-12,500
8,100
-3,240
4,860
12,500
17,360
15,782
21,218
-12,500
8,718
-3,487
5,231
12,500
17,731
14,654
21,855
-12,500
9,355
-3,742
5,613
12,500
18,113
13,608
22,510
-12,500
10,010
-4,004
6,006
12,500
18,506
12,640
6,684
Assuming profits will increase at the general rate of inflation the profit before depreciation is
n
given by 20,000(1.03)
Year 1
Year 2
Year 3
Year 4
20,600
12,360
5,000
17,360
15,782
21,218
12,731
5,000
17,731
14,654
21,855
13,113
5,000
18,113
13,608
22,510
13,506
5,000
18,506
12,640
6,684
Assuming profits will increase at the general rate of inflation the cash inflow before tax is
n
given by 20,000(1.03)
Using the depreciation tax shield method, Table 8-6(a) demonstrates that we can
simply deflate the nominal after-tax cash flows to get real cash flows and then
discount these by the real rate. The first 5 lines of Table 8-6(a) are identical to the
first 5 lines of Table 8-5(b).
In Table 8-6(a) it will be noted that the deflation of the after-tax nominal cash
flows means that even the depreciation tax shield is deflated. This is the key to
working with real cash flows as shown in Table 8-6(b). Because depreciation is
based on the cost of the capital asset now, the depreciation tax shield in future
years has to be deflated to express the tax savings in real dollars.
11.22
-50,000
-50,000
-50,000
NPV
Buy machine
1
2
Year 1
Year 2
Year 3
Year 4
20,600
12,360
5,000
17,360
16,854
15,782
21,218
12,731
5,000
17,731
16,713
14,654
21,855
13,113
5,000
18,113
16,576
13,608
22,510
13,506
5,000
18,506
16,442
12,640
6,684
Year 0
-50,000
-50,000
-50,000
Year 1
Year 2
Year 3
Year 4
20,000
12,000
4,854
16,854
15,782
20,000
12,000
4,713
16,713
14,654
20,000
12,000
4,576
16,576
13,608
20,000
12,000
4,442
16,442
12,640
6,684
Depreciation has to be deflated by the inflation rate to reflect loss of purchasing power in tax
savings.
Real rate = (1.10/1.03)-1 = 0.067961
Uncertainty
Emphasis has been placed on quantitative techniques for evaluation of long-term
investment proposals. Such emphasis assumes that organisational decision
making follows the rational model of choice. The making of good long-term
investment decisions is not, however, quite so straightforward as a study of the
quantitative models might suggest.
Varying degrees of uncertainty will be associated with the inputs to the decisions uncertainty as to (i.) the economic life of the project; (ii.) the future cash flows,
particularly for the more remote time periods; (iii.) incremental cash flows; and
(iv.) the appropriate discount rate. Each of these uncertainties will affect the
results obtained from the different models. Sensitivity analysis (varying different
inputs and seeing the effect on the output) might be useful in coping with some of
the possible sources of uncertainty. The use of probability estimates would enable
simulation tests (see Chapter 4) on results. Increasing the hurdle rate is a common
approach to uncertainty, as well as requiring a shorter payback period.
11.23
Feasibility
The techniques presented provide a quantitative approach to evaluating projects in
terms of their desirability, having regard to the objective of obtaining maximum
return on funds employed. Desirability, however, is not the only test. Feasibility
also must be considered. The investment cash outflows and net cash inflows must
be estimated period by period and incorporated into the periodic cash flow
forecasts for the whole organisation. This would reveal any need for additional
financing, and possible sources of such finance could be explored. In addition,
profit and loss and balance sheet effects of the project should be estimated for
each period and again, consolidated into forecasts for the organisation as a whole,
to ensure that future reported figures are likely to be acceptable for each period.
The feasibility study should also examine technical aspects of the project,
availability of management skills and other personnel requirements for successful
execution of the project.
Isolation of incremental cash flows
Even for a project which is largely independent of other activities of the
organisation there will be some uncertainty associated with the estimation of
incremental cash flows. In cases where the proposed investment will have indirect
effects on existing programs, isolation of incremental effects will be even more
difficult. A division of a company might plan to expand its activities into two
remaining States to give it complete national coverage. Estimates for the activities
in the two extra States could be made. A strategic aspect of the decision,
however, may be that ability to provide complete national coverage would enable
the division to win the accounts of some large national customers, thus affecting
cash flows in existing state branches. There could also be a flow on of some
beneficial effects to the other divisions, and some general enhancement of
company image. Such effects may be very difficult to quantify.
Qualitative aspects
Qualitative aspects of a decision refers to those aspects which, though relevant,
cannot be quantified or expressed in financial terms with any meaningful degree of
accuracy. Consider, for example, a proposed large expenditure for installation of
safety equipment and safety training in a plant with a bad record of industrial
accidents. Here moral values enter into the decision. Is it a worthwhile objective in
itself to reduce the number of employees who may suffer death or disabling injuries?
To what extent will this desirable aim be achieved? How should the benefit be
measured or quantified? How should this alternative be compared with other
financially beneficial alternatives? Clearly qualitative factors are important, but
equally clearly it is no easy task to combine qualitative and quantitative benefits.
11.24
Behavioural dimensions
Besides the quantitative techniques examined above for evaluating projects,
writers often refer to urgency and persuasion as criteria which are used to
justify projects. The use of persuasion smacks of political interference which
often is a fact. The safety officer in a large organisation would seek to emphasise
the moral aspects of creating a safer work place. Yet the fact that large
expenditures for this purpose might increase the importance and status of his own
position would not be absent from his mind. Similarly, divisional managers are
motivated to act in the best interests of their own divisions. The future career
prospects of a division manager are likely to be contingent on the size and
performance of his own division. He may be motivated to advocate acceptance of
his own divisions investment proposals, without being too much concerned that
marginally better investments are being proposed by other divisions.
The effects of persuasion are important because:
qualitative factors may cloud the issue of selection of the projects which are
best for the company; and
11.25
11.26
Summary
Capital investment decisions involve the acquisition of capital assets which
involve large outlays of money and are typically retained for a considerable
number of years.
Capital investment proposals can be evaluated by simple methods such as accounting
rate of return and payback period. Both of these ignore the time value of money.
Discounted cash flow techniques explicitly incorporate an allowance for the time
value of money. The two common methods are the net present value method and
the internal rate of return method.
Because of the long time period over which capital assets are held, inflation will
impact on the forecast cash flows over the life of the asses. The effects of
inflation can be dealt with either by using nominal cashflows and interest rates
(i.e. actually incorporating inflation) or real cashflows and interest rates).
Care has to be taken in evaluating proposals for investment in modern technology.
Conventional NPV or IRR figures must be treated with caution.
11.27
Self-test questions
i.
Matching
Match the numbered term with the letter of the most appropriate description.
1.
_____
payback
2.
_____
3.
_____
NPV model
4.
_____
IRR
5.
_____
6.
_____
7.
_____
payback reciprocal
8.
_____
capital rationing
9.
_____
qualitative aspects
10.
_____
incremental approach
A.
Annual cash inflow divided by initial cash investment, given uniform annual
cash inflows.
B.
Uses a required rate of return to discount cash outflows and inflows to give
their net difference.
C.
D.
E.
Calculates the difference between the present value of the cash flows of each
of two projects.
F.
Equates the sum invested at a given date with the present value of the
expected cash inflows from an investment.
G.
Calculates the annual differences in cash flows between two proposals and
then evaluates those differences.
H.
I.
J.
11.28
ii.
True/false
2.
3.
When the NPV of a project is negative the IRR would be lower than the
discount rate used to compute the NPV.
4.
When two similar projects are compared, the one with the shorter payback
period would tend to have the lower IRR.
5.
The IRR of a project is the discount rate that would produce a zero NPV.
6.
The net cash effect of $80,000 depreciation per year, assuming a 30% tax
rate, is a $56,000 cash inflow per year.
7.
When there is zero inflation the nominal interest rate is equal to the real
interest rate.
8.
The nominal rate of return is equal to the sum of the real rate of return and
the inflation rate.
9.
Residual value is the present value of a business beyond the forecast period.
10.
15.0%
13.6%
6.8%
16.7%
7.5%
11.29
2.
3.
0.20
0.10
0.075
0.0625
none of the above
outflow of $320,000
inflow of $320,000
outflow of $480,000
inflow of $480,000
none of the above
4.
5.
Given a tax rate of 40%, the net after-tax cash flow from the sale of
equipment was
A
B
C
D
E
11.30
$20,000 gain
$18,000 loss
$10,000 gain
$10,000 loss
$18,000 gain
$32,400
$36,800
$37,200
$51,200
$54,800
6.
If the real rate of return is 10% and the inflation rate is 4% then the nominal
rate of return is (to one decimal place)
A
B
C
D
E
7.
5.8%
6.0%
14.0%
14.4%
none of the above
If the nominal rate of return is 30% and the inflation rate is 10% then the
real rate of return is (to one decimal place)
A
B
C
D
E
18.2%
20.0%
40.0%
43.0%
none of the above
9.
$1000
10% per year
20%
40%
15%
12%
18%
($38)
$132
$193
$220
none of the above
What is the residual value (to the nearest dollar) at the end of 19X1?
A
B
C
D
E
$583
$733
$1,222
$5,555
None of the above
11.31
2.5 years
4.0 years
7.38 years
6.67 years
6.86 years
Self-test solutions
i.
Matching
1. J;
ii.
2. I;
3. B;
4. F;
5. D;
6. E;
7. A;
8. H;
9. C;
10. G.
4. F;
5. T;
6. T;
7. T;
8. F;
9. T;
10. F.
True/false
1. F;
2. T;
3. T;
B.
NP =
=
ARR =
2.
D.
NP =
=
ARR =
3.
C.
4.
E.
11.32
5.
B.
6.
D.
N=(1+R)(1+I)-1 =
=
7.
A.
8.
E.
(1+0.1)(1+0.04)-1
(1.1)(1.04)-1 = 1.144-1 = 0.144 (14.4%)
15
12
27
105
9.
B.
Residual value
10.
E.
11.33
Study questions
8-15 Personal investment: government loan versus rental property
An individual who has a personal taxable income in excess of $40 000 per
year has $50 000 available for investment. He is considering investing that
sum in a government guaranteed loan with a 10 year term and interest
payable annually at a rate of 14% per annum.
It has been suggested to him that the following investment should be more
attractive:
The personal income tax rate is 60 cents on each $1 in excess of $35 000 per
year. There are no capital gains taxes.
Required:
Using a net present value approach, compare the two investments.
8-25 Competing investment proposals: investment in working capital and
gain/loss on disposal
Pacioli Ltd has developed a unique product which it intends to market world
wide. Two proposals for the necessary manufacturing equipment have been
prepared. One, Plan X, entails the use of general-purpose equipment. This
equipment could easily be sold on the active used equipment market if the new
product is not a success. Plan Y envisages using highly specialised equipment,
which would have to be scrapped if the new product is not a success.
Costs for each plan (assuming an output of 40 000 units per year) are as follows:
11.34
Plan X
$
2 300 000
Plan Y
$
5 300 000
67
49
24
l9
32
l9
700 000
299 000
800 000
600 000
Additional Information:a.
b.
When the equipment is sold, under either plan, any additional working
capital required, with the exception of the inventory of replacement
parts, will be recovered. It is expected that the replacement parts for the
general purpose equipment can be scrapped for 80% of their outlay cost
but that replacement parts for the special purpose equipment can be
expected to realise zero value when scrapped. Replacement parts
should be amortised in the accounting records, but written off as used
for taxation purposes (included in other cash overheads).
c.
d.
Predicted salvage values if the machinery is sold are as follows:At end of year
1
2
3
4
5
6
7
8
9
10
Plan X
$
1 800 000
1 400 000
1 000 000
1 000 000
800 000
800 000
600 000
400 000
400 000
200 000
Plan Y
$
300 000
300 000
250 000
200 000
200 000
175 000
150 000
100 000
100 000
100 000
e.
f.
Income tax rates are expected to be 40% of income. (For the purpose of
this analysis, assume, that tax is paid in the years in which the income is
earned).
g.
11.35
Required:
Perform a Net Present Value analysis to show which plan is financially more
attractive, assuming that 40 000 units are sold each year, that the product
will be manufactured for five years only, that all gains and losses on
disposal have a tax effect and that the minimum desired rate of return is
18% after taxes. Clearly include the following (for each project) in your
analysis:
1.
2.
3.
Fixed Costs
4.
5.
6.
7.
Available hours per week - 80 (based on 2 shifts per day and a 5 day
working week)
Based on the firm's existing product range and mix, the net cash flow
per operating hour is expected to be $500.
The firm requires an after-tax internal rate of return of 12% per annum on
investments of similar risk characteristics. The tax rate applicable to the
firm's income is 40 per cent.
11.36
Required:
Prepare a schedule showing the net cash flow per annum for this proposal,
and calculate its net present value.
PART B
The production engineering department has become aware of a computer
integrated manufacturing (CIM) facility which represents much more up to
date manufacturing technology than the renovation and refurbishment
discussed above. It has a number of apparently favourable and unfavourable
features.
Perhaps the most notable favourable feature is the much higher investment
outlay required. It is estimated that the CIM facility will cost $10 million
for purchase and installation ready for use. It is expected to have a useful
life of 10 years, and while it may have some net salvage value at the end of
this period it is difficult to estimate because of the uncertainty attaching to
the new production technology. For taxation purposes the cost of the CIM
facility is to be depreciated on a straight line basis over 5 years.
Among the advantages of the CIM facility are the ability to produce more
reliably to product specifications, faster throughput rates, reduced labour and
operating costs, reduced setup times, and the ability to introduce variations of
existing products and even new products more easily and quickly.
Since there is little relevant historical information available the production
engineers in conjunction with the management accounting department have
prepared the following estimates:
Available hours per week - 80 (based on 2 shifts per day and a 5 day
working week)
Operating usage factor - 40 per cent. The remaining time, other than
idle time, is spent on repair and maintenance, and setting up for
production runs. The out of pocket costs associated with this time
(R & M and setups) is estimated to be $400 000 per annum.
Based on the firm's existing product range and mix, the net cash flow
per operating hour is expected to be $1200.
11.37
Required:
a.
Prepare a schedule showing the net cash flow per annum for the CIM
proposal and calculate its net present value.
b.
Based on the financial calculations which you have made, should the
firm invest in the first alternative (renovation and refurbishment) or the
second alternative (CIM facility)?
c.
Assume that while the estimates of the cash flows for the first
alternative are believed to be reasonably reliable, those of the second
alternative are much less so. What level of annual net operating cash
flows before tax for the second alternative would be required to produce
the same net present value as the first alternative?
Purchase unit
Annual gross rental
Annual cash expenses
Net cash flow before tax
Tax at 60%
Sale of unit
PV @ 5.6%
NPV
Year 0
-50,000
Yrs 1-10
Year 10
4,000
-800
3,200
-1,920
-50,000
-50,000
11,794
1,280
9,602
90,000
90,000
52,192
The home unit appears to be a much better proposal, with the following
reservations:
i. The 5.6% after tax return on the loan is risk free, whereas the home unit
cash flows are estimates and far from risk free. For example, on what
basis do we estimate the resale value of the unit in 10 years' time?
ii. Further risk is involved in the tax treatment of the $40,000 capital gain
expected on the unit. What if a capital gains tax is brought in? [Note:
This question was designed before capital gains tax was introduced in
Australia]
11.38
Plan X
-2,300,000
-392,000
Plan Y
-5,300,000
-256,000
-25,000
163,333
-2,553,667
-100,000
106,667
-5,549,333
Plan X
220
140
Plan Y
220
70
80
3,200,000
150
6,000,000
3.
Cash Fixed Costs
Supervision
Insurance, r & m, and other overhead
Total cash fixed costs
Plan X
-700,000
-299,000
-999,000
Plan Y
-800,000
-600,000
-1,400,000
4.
Depreciation for tax purposes
Depreciation [0.1*2.3m, 0.2*5.3m]
Plan X
-230,000
Plan Y
-1,060,000
5.
Annual Operating Cash flows
Variable profit
Less fixed costs
Less depreciation
Pretax profit
Tax 40%
After tax profit
Add back depreciation
Annual operating cash flows
Plan X
3,200,000
-999,000
-230,000
1,971,000
-788400
1,182,600
230,000
1,412,600
Plan Y
6,000,000
-1,400,000
-1,060,000
3,540,000
-1416000
2,124,000
1,060,000
3,184,000
2.
Variable Profit
Selling price per unit
Unit variable cost [67+49+24],
[19+32+19]
Unit contribution margin
Variable profit [x 40,000]
11.39
6.
Cash Flows on Termination
Salvage
Tax on gain or loss:
[800,000-(2,300,000-5*230,000)]*0.4
[200,000-0]80.4]
Recovery of raw material inventory
Reduction in suppliers credit
Sale replacement parts [0.8*25,000], [0]
Tax on loss on disposal of parts:
[0.4*(25,000-20,000)], [0.4*100,000]
7.
X: $2,384,226
Y: $4,542,792
Plan X
800,000
Plan Y
200,000
140,000
392,000
-163,333
20,000
-80,000
256,000
-106,667
0
2,000
1,190,667
40,000
309,333
Plan X
Cash flows
PV Factors (18%)
Present Values
NPV
Year 0
-2,553,667
1
-2,553,667
2,384,226
Yrs 1-5
1,412,600
3.1272
4,417,442
Year 5
1,190,667
0.4371
520,451
Plan Y
Cash flows
PV Factors (18%)
Present Values
NPV
Year 0
-5,549,333
1
-5,549,333
4,542,792
Yrs 1-5
3,184,000
3.1272
9,956,913
Year 5
309,333
0.4371
135,212
11.40
Yrs 6-10
1,152,000
-100,000
0
1,052,000
-420,800
631,200
0
631,200
2.0454
1,291,086
PART B
a.
NPV = -$2,223,538
CIM Facility
Purchase CIM
Net cash flow from operations
[48*80*0.4*$1200]
Repairs and maintenance
Depreciation [0.2*$10,000,000]
Profit before tax
Tax 40%
Profit after tax
Add back depreciation
Net cash flow after tax
PV Factors (12%)
Present Values
NPV
Year 0
Yrs 1-5
-10,000,000
Yrs 6-10
1,843,200
-400,000
-2,000,000
-556,800
222,720
-334,080
2,000,000
-10,000,000 1,665,920
1
3.6048
-10,000,000 6,005,269
-2,223,538
1,843,200
-400,000
0
1,443,200
-577,280
865,920
0
865,920
2.0454
1,771,193
b.
c.
$2,101,542
NPV Renovation
NPV CIM Facility
Difference in NPV
Annual difference in cash flow after tax
Annual difference in cash flow before tax
8,331
-2,223,538
2,231,869
395,005
[2,231,869/5.6502]
[395,005/(1-0.4)]
658,342
Second alternative requires annual net operating cash flows before tax of:
1,843,200-400,000+658,342 = $2,101,542
11.41
Study questions
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 504). Pearson Prentice-Hall.
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 504). Pearson Prentice-Hall.
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 505). Pearson Prentice-Hall.
11.42
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 506). Pearson Prentice-Hall.
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 506). Pearson Prentice-Hall.
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., p. 508). Pearson Prentice-Hall.
11.43
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 514-515). Pearson Prentice-Hall.
11.44
8
$10,000
$40,776a
14%
$ 5,613
18
$13,749b
$80,000
20%
($13,835)
20
$ 9,000
$65,000
12%c
$2,225
28
$ 8,000
$30,000
25%
$ 1,938d
11-36
1.
(10-15 min.)
a.
b.
$50,000 2.3216
$100,000 1.6467 .6750
Total
Less initial investment
Net Present Value (NPV)
$116,080
111,152
$227,232
215,000
$ 12,232
Various other approaches would reach the same answer, but they would
involve more computations.
2.
The NPV is positive because at a 12% rate, the present value of the net
inflows will be higher than at 14%, so NPV will increase.
11.45
2.
3.
ARR =
2.
$3,000 x 5.7466 = $17,240. The company should buy because the net
present value is a positive $17,240 - $12,000 = $5,240.
3.
ARR =
11.46
$15,600
9,750
1,500
3,760
1,598
$32,208
$58,500
$39,000
$94,000
$35,000
Revenue
Expenses
Year 1
$58,500
- $32,208
Year 2
58,500
- 32,208
Year 3
39,000
- 32,208
Year 4
39,000
- 32,208
Year 5
74,000
- 32,208
Present value of cash flows
=
=
=
=
=
Net Flow
$26,292
26,292
6,792
6,792
41,792
PV
PV of
Factor Cash Flows
.9091
$23,902
.8264
21,728
.7513
5,103
.6830
4,639
.6209
25,949
$81,321
Since the present value of the annual cash flows is $12,679 less than the initial
investment of $94,000, the proposed lighting system should not be installed. If
significant increases in revenue were predictable, the plan might become attractive
to Ms. Bogey.
11.47
$(73,600)
(7,200)
32,320
$(48,480)
$(174,761)
8,229
3,673
$(162,859)
11.48
$(88,000)
35,200
$(52,800)
$(190,333)
$40,000
34,560
$ 5,440
(2,176)
37,824
$(152,509)
$(58,400)
(7,200)
26,240
$(39,360)
(141,885)
57,922
$50,000
0
$50,000
20,000
$30,000
17,022
37,824
$(209,117)
Using the MACRS schedule for tax depreciation, the depreciation rate
for each year of a 3-year asset's life is shown in Exhibit 11-6:
Depreciation
Year
Rate
1
2
3
4
$(180,000)
33.33%
44.45%
14.81%
7.41%
Tax
Savings
PV
Factor
.8929
.7972
.7118
.6355
Present
Value
$21,428
25,514
7,590
3,390
$57,922
Among the major factors are (1.) the range of expected volume (both large
increases and decreases in volume make the purchase of the parts relatively
less desirable), (2.) the reliability of the outside supplier, (3.) possible changes
in material, labour, and overhead prices, (4.) the possibility that the outside
supplier can raise prices before the end of five years, (5.) obsolescence of the
products and equipment, and (6.) alternate uses of available capacity
(alternative uses make Alternative B relatively more desirable).
11.49
11.50