Professional Documents
Culture Documents
&Applied Finance
(MAAF) 315
September 2015
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Dear Candidate,
Welcome to the Management Accounting & Applied Finance (MAAF) module of the Chartered
Accountants Program. Oncompletion of this module you will be one step closer to becoming a
Chartered Accountant. Inside this pack you will find your Candidate Study Guide (CSG), which
includes the core content, the scenario and task for the activities and the readings for each unit. For
those new to the Chartered Accountants Program, we would like to take this opportunity to direct you
to some of the key resources available online through myLearning:
Announcements
The Announcement area is our primary point of contact with you, where we provide directives on
assessments, virtual classrooms, etc. It is important that you log in immediately on commencement of
the module and read any messages. Pleaseensure you check the announcements regularly.
Module orientation
Study support tools getting started, tools and techniques for successful completion of the
module.
Assumed knowledge, Module outline and Module plan.
Candidate code of conduct.
Learning materials
CSG, worked examples, activities and their solutions.
Adaptive learning lesson (Unit 7).
Unit quizzes for self-assessment.
Discussion forums
Technical issue of the week.
Unit forums, where you can discuss individual units with module leaders and your peers.
An informal peer-to-peer forum where you can interact with other candidates.
Virtual classrooms
Timetables and links to resources for virtual classrooms.
Online assessments
Short, graded tests (multiple choice) that count towards your final mark.
Practice tests (multiple choice), to help you prepare for assessments.
Exam
Exam tips, techniques and administration information.
Past exam papers, and exam preparation series questions.
My Grades
Results for online assessments and exams.
Online learning is an exciting way to learn, and the best part about studying online is that education
comes to you no matter where you are. Above all, work hard to achieve the exam results you want and
to set yourself up for a successful career as a Chartered Accountant wherever your career may take
you around the globe.
Yours sincerely,
Introduction
Introduction
Welcome to the Management Accounting & Applied Finance (MAAF) module. This module will
provide you with the opportunity to understand key concepts and to practise applying your
understanding to a variety of practical business scenarios.
Learning model
The Chartered Accountants Program (the Program) material has been constructed applying the
learning principles of tell, show, do to learning outcomes devised for each unit. Each unit is
made up, primarily, of core content, worked examples, activities and a unit quiz.
TELL SHOW DO
Tell me the relevant + Show me how to + Can I do the task
theory do the task unassisted?
Introduction Page i
Management Accounting & Applied Finance Chartered Accountants Program
can read a worked example and think you understand the concept. However, we have
found that candidates struggle with transferring that knowledge to a new fact pattern and
to what may be required in exams.
You will find that as you work through the worked examples in myLearning you will
be required to actively participate in completing the task, by responding to a range of
questions. For example, you may be required to do a calculation or to select an appropriate
response from a range of options. As you respond to these questions, you will be provided
with feedback confirming your answer or explaining why the response made is incorrect.
The questions asked (i.e. the interactivity component) focus on areas that candidates
have typically struggled with in past exams. You are encouraged to complete the worked
examples online to help maximise your understanding and application of the theory.
In addition to interactive worked examples, you will find additional non-interactive
examples within some units which you can download and review, to support your learning.
Selected activities in addition to being included in the CSG, some of the activities are
also available online. For these activities, the scenario and task is provided in the online
environment and you will be required to answer three questions about the activity or the
learning outcomes to which it relates. Once you have answered these questions, you will
unlock a tip aimed at providing you with guidance in your exam preparation.
Activity solutions copies of suggested solutions for all activities are provided to allow
you to assess your knowledge. In addition to the solutions, you will find Excel spreadsheets
for certain activities, which are provided to help you work through these activities in an
efficient manner as well as enabling you to explore common uses of Excel within a business
environment.
Unit quiz all units have a quiz with up to 10 questions aimed at checking your
understanding of the learning outcomes for the unit. Feedback is provided on both the
correct and the incorrect responses. These questions are to ensure you have understood key
aspects of the unit content, but they are often simpler than the online assessment questions.
Technical issue of the week within the discussion forums, the module leader will
regularly post questions for candidates to consider and discuss. These questions are
designed to help candidates explore their understanding of key topic areas within MAAF.
Past exams copies of the MAAF115 main and supplementary exams are available in
myLearning. These papers are made available to help you further test your knowledge and
identify any knowledge gaps you may have prior to the exam. Solutions and feedback on
these papers are also available.
Exam preparation series these are exam-style questions. The feedback on these questions
is based around the type of answer an exam marking panel would expect from a merit list
candidate in answering each of these questions. The series is released after the final online
assessment.
Adaptive learning lesson This is only available online and allows candidates to explore
a business simulation in an online space. For MAAF315, this lesson is contained in Unit 7,
which can be accessed from the Unit 7 folder in myLearning.
Discussion forums
In myLearning you will be able to access a number of discussion forums. Some of these forums
are designed for you to communicate with your peers who are also undertaking MAAF while
others are designed for you to ask technical questions and receive feedback and support from a
module leader.
The peer-to-peer forums are great for helping you establish study groups and linking with
your fellow candidates. The unit forums are best used to get help when you are having
difficulty with content, examples or activities. Do not underestimate the benefit you can gain by
participating in these forums.
Page ii Introduction
Chartered Accountants Program Management Accounting & Applied Finance
Additional support
In addition to the material listed above, ensure you regularly read the announcements in
myLearning, as this is our primary source of communication with candidates.
To get started, we suggest you download the module plan (available in myLearning). This
module plan provides a suggested timeline for completing each unit within the allocated
12weeks of study. It has been devised around the key assessment dates for the module. The
module leaders for this module will also assist you in working through the material, with
regular posts providing guidance.
Learning outcomes
Learning outcomes provide an outline of the expected knowledge and skill level achieved
on completion of the unit. Each learning outcome commences with a verb, such as explain,
calculate, demonstrate, etc. These task words, are defined in the Exam tips and techniques
document, which is available in the exam area.
All learning elements are written based on the learning outcomes for the unit. Each learning
element starts by identifying the learning outcome(s) being explored by the material. To
succeed in the online assessments and the exam, you should ensure you understand the topic
the learning outcome is covering and also the level you are expected to achieve.
Date convention
In some cases, the dates within certain worked examples and activities for the current decade
are expressed as 20XX, the preceding decade are expressed as 20WX and future years outside
of this decade dates are expressed as 20Y3. For example, if a date given in an example is 20X6,
20W6 would be 10 years earlier and 20Y6 would be 10 years in the future. All years are treated
as having 365 days. In other cases, real years have been used as these are more appropriate for
the example or activity.
Assumed knowledge
Each unit has been constructed based on levels of assumed knowledge relevant to the topic
area being covered in that unit. Details of the assumed knowledge for the module are identified
in the module outline document, which is available online. You can complete an assumed
knowledge quiz, which is also available online, to check on your initial understanding of the
content prior to commencing the module. Should you have any gaps in your knowledge we
recommend that you refer to your university notes or appropriate text(s).
To optimise your learning it is recommended that you complete each unit sequentially. As you
progress through the module, the material covered in a unit may be written assuming you have
the understanding of the content from an earlier unit. It will also ensure that you have covered
the material which will be examined in the online assessment tasks.
Assessment
To pass the module, you must pass the exam and pass the module overall. The assessment
components are outlined below:
Online assessment 20% Three (3) online assessments. Each assessment will consist of
10 single response, multiple-choice questions
The exam makes up 80% of your assessment. To pass the module you must pass the exam
(achieve 50% or more of the available marks) and pass the module overall (achieve at least
50/100). It is therefore critical to practise your exam technique and make the most of the time
that you have. The exam is:
based on content covered in the learning elements
supervised
three (3) hours writing time, plus 15 minutes reading time
made up of four (4) compulsory, written, multi-part questions
open book
centrally marked
critically important, as you must pass the exam in order to pass the module.
Six-month rule
Legislation changes constantly. In the Program modules, you are expected to be up to date with
relevant legislation, Standards, cases, rulings, determinations and other guidance as they stand
six months before the exam date unless otherwise stated.
Candidates should note that MAAF is cross-jurisdictional and therefore rates of tax (both
income and goods and services) are scenario-dependent.
You are always encouraged to be aware of developments in all areas.
Good luck!
The Chartered Accountants Program is challenging. It is designed to be the best educational
product it can be for you, the future practitioners in this profession. As it constantly evolves,
Chartered Accountants Australia and New Zealand will continue to seek your feedback to
ensure the Program meets the learners needs now and for future development.
We hope you find your journey through the Program a rewarding and enjoyable experience and
encourage you to work steadily through the material in the recommended way. If you require
further assistance, post your questions, in a professional manner, on the relevant discussion
forum.
Finally, best of luck with your studies.
Page iv Introduction
Chartered Accountants Program Management Accounting & Applied Finance
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Case study 1
Accutime Limited
A case study for use in Management Accounting & Applied Finance (MAAF)
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1. Introduction
Since being founded by Bruce Massey in 1972, Accutime Limited (Accutime) has risen from
modest beginning to where it is now a world leader in the development of frequency control
products. Accutime has been at the forefront of crystal and oscillator technology for many years.
It has leading market positions in the supply of crystal oscillators to the global positioning
systems (GPS), telecommunications network timing/synchronisation, wireless, base station and
aerospace markets.
Under Bruce Masseys leadership, Accutimes annual sales level has increased to approximately
A$227 million (financial year ended 30 June 2012). He led the company to a successful
Australian Securities Exchange (ASX) listing in 2007.
Bruce has over 25 years experience in the design and manufacture of crystals and oscillators. He
led the team that created the worlds smallest 1 part per million (ppm) ultra stable temperature
compensated crystal oscillator (USTCXO) in 1990, and went on to lead the development of
the first high sales volume 0.5ppm temperature compensated crystal oscillator (TCXO) in
2003. Both these developments were years ahead of competitive products and enabled the GPS
industry in particular to achieve significant steps forward in terms of performance and market
growth. His leadership has driven the development of Accutimes core TCXO business, which
is the basis of the companys success today, supplying TCXOs to over 50% of the worlds GPS
market.
Over the last 20 years, the GPS market has evolved from a low volume niche applications to
a high volume, consumer-based market. Accutime has maintained market leadership and
share, and the company prides itself in transforming high precision, niche technology into high
volume, cost-effective products, while still maintaining the highest performance and quality.
Accutimes leadership has been achieved through unique proprietary processes, continual
innovation, expert consultation and constant technological advancement.
Accutime backs its ingenuity with high quality control, achieving the highest international
manufacturing standards. Close customer relationships are very important to the business, with
many top customers enjoying a relationship of 10 years or more.
Today, Accutime outsells many competitors, mainly due to its technological superiority and its
very competitive prices. Its products are found in the worlds leading mobile phones and GPS
devices. A number of Fortune 500 companies use Accutime products.
In July 2011 Accutime completed a production joint venture with Timecalc in Wuhan, China. In
December 2011 Accutime acquired the frequency control products division of BAC Technology
(BACTech) in the UK. It was expected that the BACTech acquisition would make an immediate
contribution to Accutimes net profit; however, the Chinese joint venture was not expected to
contribute positively until the 2012/2013 financial year.
Accutimes head office, research and product development activities are in Sydney. Sydney
is also the base for some of Accutimes manufacturing operations, with others in the United
Kingdom (UK), Germany and Malaysia. Marketing and technical support offices are located
throughout the world.
2. Company strategy
Accutimes vision is to be the global leader for frequency control products. When the company
issued its initial public offering (IPO) in 2007, it translated this vision into some specific business
strategies, which are outlined below:
Continue to develop industry-leading quartz crystal-based products that deliver
performance and features that add value to GPS products.
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Continue to develop new production and test equipment, providing Accutime with a
competitive advantage.
Expand the leading edge crystal and oscillators production facility in Sydney to ensure
flexibility, low production cost and continuity of supply.
Establish Accutimes GPS products in the market and develop next generation GPS
receivers in partnership with leading GPS manufacturing companies.
Expand marketing and technical support in the major European and Asian markets.
Achieve and maintain the highest quality and environmental standards to exceed customer
expectations.
By 2012, this strategy had resulted in some specific achievements, along with navigating the
difficulties of the global financial crisis (GFC) of 20082009. These achievements included the
expansion of its product range and the opening of operations in European and Asian markets
including the UK, Germany, Malaysia and China.
Commenting on Accutimes strategy in an interview, Graham Anderson, chief financial officer
(CFO) stated:
Our brand reputation has been built on quality, innovation and specification. Originally, Accutime was
regarded as a high price, high quality company, but many of its products, particularly GPS products,
are now more commoditised. We obviously had to address this. Now our strategy is to broaden our
product range, while at the same time moving commoditised products to lower labour cost countries
and closer to our markets, and maintaining R&D and technology development in Sydney, the UK and
Germany. We need to do this to continue to be a world leader.
In executing its strategy, Accutime believes it has a competitive advantage in the design,
production and marketing of high performance crystals and oscillators. This competitive
advantage has five elements.
1. Proprietary technology and process
Accutime believes it is the only crystal/oscillator manufacturer in the world that has the
technology to provide 100% temperature screening of high technology production to
ensure that non-performing crystals and oscillators are eliminated. The technology, which
comprises equipment and software, is developed and maintained by Accutime.
2. Depth and breadth of experience
Accutime has a long history and has extensive intellectual property in the specification,
design and production of crystals and oscillators for high performance applications.
3. Strong customer relationships
Accutime deals with most of its customers directly (rather than through third party
representatives or distributors) and is focused on building strong relationships with
customers at a technical engineering level to ensure it anticipates and understands market
trends and requirements.
4. Highly skilled and innovative engineering team
Accutimes management has developed a culture of continual innovation and improvement
throughout the company, with a focus on proactive market development. A strong research
and development (R&D) team has been established to support this process.
5. Brand and reputation for quality
The Accutime brand has become well-known among manufacturers of high performance
electronics as a source of the highest performance crystals and oscillators.
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Low Consumer goods Computers, TVs, High volume, Crystals used in these
performance audio equipment, low price applications do not require
network televisions, high performance and usually
television decoders have larger dimensions and
layout (form factor) than
higher specification crystals
High High-end Cellular phones: GPS, High volume, Products are manufactured to
performance communications navigation, wireless, medium price small form factor. Producers
and commercial data, satellite radio in this segment have made
applications significant contributions
to industry-wide product
miniaturisation
Accutimes primary focus is developing and supplying high quality, sophisticated components
for high performance and very high performance applications. The intellectual property is also
used in less sophisticated mass produced items, thereby leveraging the R&D investment and
generating cash flow to invest in further innovation. Accutimes business is well-diversified in
that it straddles the high-end communications and high-end industrial and military/aerospace
market segments. Production covers a broad range of products from simple quartz crystals to
high performance TCXOs.
In discussing Accutimes market share, Graham Anderson commented:
The total market for TCXOs is around US$800 million, of which we have about US$140 million. We
also operate in the oven controlled crystal oscillator (OCXO) market, where we have about 20% of the
US$300 million market. Our current presence in the voltage controlled crystal oscillator (VCXO) market
is quite small, but we are seeking to grow this. One of the biggest markets is for crystals themselves,
but many of these are high volume, low specification. We have only about US$20 million of the
US$1.3billion world market for crystals.
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Positioning (GPS)
As the only frequency control company to initially specialise in products for GPS and
positioning, Accutime has led the way in the GPS industry since commercialisation in the early
1990s. It maintains a technology and market leadership position with over 50% market share in
GPS and 80% in emergency positioning indicating radio beacons (EPIRBs). Higher performance
and lower costs mean volumes are continuing to grow and more uses are emerging with such
applications as geotagging and location-based social networking.
Accutime first entered the positioning market in 1991 with what was, at the time, the worlds
smallest 1ppm stability oscillator for emerging handheld and marine GPS applications.
Through close partnerships with customers, Accutime quickly learned how critical the
frequency reference (oscillator) was to GPS. Its stability affected the systems ability to locate,
track, maintain lock and acquire weak satellite signals. Through many years of collaboration
with leading manufacturers in the industry, Accutime has found the optimal way to design and
manufacture oscillators that address the unique requirements of GPS devices.
Even with GPS volumes growing from a few thousand to tens of millions a month, Accutime
continues to lead the world in the supply of specialised GPS oscillators. Accutime does this
through developing an understanding of the applications requirements and backing this with
unique proprietary processes, innovations and technology.
Accutime continues to work closely with its customers and continues to develop next
generation products for both conventional and emerging applications for positioning. For
example, the integration of GPS into cellular phones and cameras is posing interesting
challenges for GPS designers and Accutime is well-positioned to assist them.
Accutime is still the only frequency control company to specialise in GPS products and it still
has the worlds smallest GPS oscillator. These days, it is more than twice as stable and measures
about 0.25% of the size of the original GPS oscillator from the 1990s.
Mobile
Accutime first entered the cellular phone market in the 1990s, supplying TCXOs to some of
the original mass market cellular phones. Since those days, Accutime has turned its focus to
the more demanding and booming GPS market, although it has always kept a presence in the
phone market.
The introduction of location-based services (LBS) into cellular phones indicates that now is an
ideal time for Accutime to re-enter the market in a stronger way.
Accutime is a leader in creating high volume, low cost, high performance products that
enable GPS to work in difficult environments. The cellular phone is one of the most difficult
environments in which GPS can operate, with high interference, small antennae and challenging
operating environments.
Increasing the capability of GPS phones requires constant innovation and increasingly higher
performance. People want their location to be available anywhere they use their phone.
However, this enhanced functionality must be achieved without impacting cost.
Accutimes Spear integrated circuit (IC), released in 2009, enables TCXOs with up to five
times better performance than conventional cellular phone oscillators and is designed to ensure
minimal cost implications for the handset developer. Technology like the Spear IC is enabling
GPS to be more accessible, more reliable and more useful for consumers.
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Telecommunications
The worlds telecommunications infrastructure is in a constant state of change. Modern, fast-
paced lifestyles are changing the way we communicate and people are demanding higher data
speeds and connectivity anywhere, any time.
Accutime has developed several unique and world-leading products to address the needs of
the telecommunications market, from its single OCXOs, which perform better than competitors
much more expensive double oven products, through to TCXOs that push the boundaries of
conventional performance limits. The company continues to develop innovative products for
the telecommunications market.
Customers
Accutimes customers include major players within the following industry segments:
Telecommunications
Communications infrastructure
Military and aerospace applications
Survey and car navigation GPS receivers
Land, marine and aviation GPS receivers.
Competitors
The market for Accutimes products is competitive and evolving rapidly. Competition has
intensified since 2008, largely due to new market entrants and the impact of the GFC. This
resulted in price reductions and margin squeeze. Accutime has attempted to address this by
focusing on production efficiency and cost reductions, as well as broadening its product range.
There are a number of competitors operating in the space occupied by Accutime. The most
significant of these are based in Japan, Taiwan and the USA.
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4. Locations
Accutime is a global company with market and applications support offices based around the
world. In addition to this, Accutimes design and manufacturing model is highly distributed,
with plants located in Europe, Asia and Australia.
Germany (Heidelberg)
The companys German subsidiary company team are experts in OCXO and stress cut (SC)
crystal design and manufacture. The German team has a long history of successful innovation
and specialises in new product design, new product introductions, and high performance,
customised products. Specialised low volume manufacturing is carried out on site, with high
volume designs transferred to the lower cost Malaysian facility.
There are approximately 100 staff in Heidelberg.
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The oscillator manufacturing capacity in the Sydney plant is about 10 million per month,
whereas the maximum crystal manufacturing capacity is lower. As a result, Accutime fulfils its
crystal requirements by sourcing additional volume from other qualified suppliers.
There are approximately 460 staff at the Sydney facility, including management. Of the 460
staff, around 260 are technically skilled local operations staff and/or skilled immigrants. In
addition, there are about 100 specialist design engineers involved in product design, product
development and product engineering.
5. Manufacturing process
A significant amount of product is still manufactured at the companys Arndell Park plant in
Sydney. The following is a description of a typical production process from growing the quartz
through to performance evaluation.
Clean room
When required, the wafers are transferred to a clean room where they are finished, mounted
and glued on to bases using special purpose robotic equipment.
The testing process is thorough. The resulting crystals are tested before leaving the clean room,
and then later electrically tested before going into the crystal oscillator production process.
The clean room processes are highly capital-intensive, using sophisticated machines and robots
worth many millions of dollars.
TCXO manufacturing
The crystals are surface-mounted onto oscillator circuit boards using high speed pick and
place machines. The oscillators are then 100% tested in proprietary temperature chambers
which measure the crystals frequency stability characteristics over a wide temperature range.
Accutimes proprietary process enables high volume GPS TCXOs to achieve an accuracy of
better than 0.5ppm at a very low cost.
Other techniques for compensating the oscillator can be used to achieve either higher precision
or lower costs, depending on customer and product requirements.
The oscillators finally must pass a fully automated 100% electrical and visual inspection before
being loaded into reels and shipped to the customer.
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Management accounting
Aside from the normal monthly financial reporting there are some important aspects of
management accounting at Accutime.
Product costing
A rough breakdown of the cost of production of a typical Accutime product is:
Product component %
Direct labour 5
The cost breakdown above is indicative only some products attract less manufacturing
overheads while others more. As can be seen from the above cost breakdown, materials are
a large proportion of the total cost of most of Accutimes products. Accordingly, the bill of
materials (BOM) is the cornerstone of the product costing system. For some products the BOM
runs to three pages. Direct labour is tracked to individual products via machine time, and
manufacturing overhead is allocated on an appropriate basis. In commenting on the product
costing system, Graham Anderson and John Williams (Australian operations general manager)
made the following statements:
Graham: We have a complex BOM structure all costs are attached to the BOM. We also face an issue
of how to handle co-products and by-products, including when does a by-product become a
co-product?
John: One of the key things is yield. First pass yields are very important to the actual product cost,
as we have incurred a lot of costs up to that point. The better the yield we get, the lower the
product cost on a per-unit basis.
Graham: Labour costs are allocated on the basis of work centres, how much labour we have in each
work centre, and then for each product, how much machine time does it consume. Machine
time is driving how we allocate labour.
Graham: We also calculate directly attributable manufacturing overheads, things like factory space,
power and what have you. These costs are allocated to the products by saying: here is a pool
of costs that we attribute as allocable to a given area of the operation. Then we calculate how
many products we are putting through this area and that leads to a unit allocation.
John: But there are some things we do not cost in. For example, depreciation is not costed in, nor
are the costs of design engineers. These are significant numbers, but we prefer to account for
them below the line.
Product pricing
Accutime operates in a highly competitive environment, and there is continual pressure on
prices. It would be fair to say that the pricing model is one that is market-driven (target cost
pricing). That said, the company has a range of products selling at a very wide range of prices.
For example, the selling price of a strip of AT-cut crystal is no more than 30 cents, whereas the
market price of a stress cut crystal is about 20 euros.
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In discussing pricing policy, Graham Anderson observed:
In the early days of GPS, Accutime had to take a military grade spec and fit it into a Japanese consumer
product footprint. We probably could have got away with selling at higher prices, but decided to keep
some degree of relativity for two reasons: one, to keep competition out to some extent, and second, you
do reach a point where the customer will not buy the product even if it is demonstrably better.
Also, as much as 10 years ago, Accutimes CEO and marketing director anticipated that the GPS
phone was going to be huge, and through careful planning Accutime had opportunity to claim the cost
leadership position within this lucrative consumer market.
Operating performance
Operating performance is monitored on the basis of critical measures. These include:
Yield and throughput on a daily basis and a shift basis.
Quality measured by yield and product returns (ppm defects).
On time delivery.
Each of these metrics is monitored daily, weekly and monthly.
6. Financial results
As can be seen in the summarised financial results for the last two financial years, the company
has emerged from the GFC in reasonable shape. After suffering a loss in the first half of 2010,
the situation began to improve in the second half of that year, and this improvement continued
into 2011 and 2012.
In commenting on the 2012 financial results, managing director Bruce Massey stated:
As we expected, our results in the second half of the year were much stronger, as demand grew
strongly across our entire business, which helped deliver an A$4 million improvement in net result
after tax. We have also enhanced the capability of our global platform and broadened our product range
significantly.
In the second half of the 2012 financial year, demand for products targeted at consumer GPS
were well above levels for the same period of the previous year. This positive trend is expected
to continue into the 2013 financial year. Average sales prices stabilised, after the significant
erosion suffered during the GFC. Importantly, Accutime increased its share of the mobile phone
market as significant production volumes began to ship to new tier one customers during the
latter part of 2011 and into 2012.
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Non-current assets
Trade and other receivables 4,498 3,967 3,529
Investment in shares 0 892 892
Property, plant and equipment 94,842 52,038 50,054
Intangible assets 43,146 46,801 39,319
Investment in associates 0 0 0
Interest in joint venture 38,828 29,820 22,977
Deferred tax assets 2,008 0 0
Total non-current assets 183,322 133,518 116,771
Total assets 322,912 233,618 203,996
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Non-current liabilities
Bank borrowings 24,000 9,437 0
Other liabilities 0 18,421 0
Provisions 3,900 2,707 2,062
Deferred tax liabilities 0 479 0
Total non-current liabilities 27,900 31,044 2,062
Total liabilities 76,952 67,675 44,677
Net assets 245,960 165,943 159,319
Equity
Share capital 191,291 121,865 121,865
Retained earnings 54,669 44,078 37,454
Total equity 245,960 165,943 159,319
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Appendix A
Bruce Massey
Chief executive officer (CEO) and managing director
Bruce Massey was the founding CEO and managing director at Accutime and he continues in
that role today. Bruce also leads the technical engineering team, remaining involved in leading
the design of new products and processes. Under Bruces leadership, Accutime has grown from
sales of approximately A$1 million in 1986 to the current level of approximately A$227 million
per annum. In May 2007, he led the company to a successful Australian Securities Exchange
(ASX) listing.
Donald Agnew
Executive director, sales and marketing
Donald Agnew was appointed executive director of sales and marketing at Accutime in 1991.
Donald has over 25 years sales and marketing experience at Accutime and has driven sales for
Accutime through exploring new markets, applications and establishing arrangements with
many top Fortune 500 companies. In December 2011, Donald played a key role in Accutimes
successful acquisition of the frequency control product division of BACTech, one of the leading
manufacturers of frequency references for the telecommunications industry. This acquisition
led to Accutime becoming the fifth largest crystal and oscillator company in the world. Donald
completed his Diploma in Export Marketing at Melbourne Technical Institute in 1981.
Graham Anderson
Chief financial officer (CFO)
As CFO, Graham is responsible for Accutimes finance, human resources and information
systems. Graham joined Accutime in November 2005 and was closely involved with the
companys ASX listing and the subsequent investments in Europe and Asia. He joined Accutime
following 10 years in a range of finance positions in the US and Australia. Graham has also
previously worked for a Big 4 accounting firm. Graham holds a Bachelor of Commerce from
The University of Sydney and is a Chartered Accountant.
Mary Chen
Global business development and applications director
Mary Chen has 13 years experience in timing technologies, with global responsibilities spanning
the US, Europe and Asia. Since joining Accutime in 2002, Mary has worked in a variety
of business development and marketing roles. Mary has contributed to multiple facets of
Accutimes prominent success in wireless and wired telecommunications infrastructure, as well
as GPS-enabled consumer electronics, including mobile phones. Mary holds BS, MS, and PhD
degrees in Electrical Engineering, as well as a Master of Business Administration (MBA).
Henrietta Thomson
General manager, global sales
Henrietta Thomson joined Accutime in December 2006 as general manager of global sales. In
this capacity, she manages a team of approximately 60 sales and support staff located in 10
worldwide sales offices. Prior to Accutime, Henrietta spent 22 years with Datameg Corporation,
a NASDAQ-listed US company. At Datameg, Henrietta spent eight years as vice president of
worldwide sales. Henrietta relocated back to Australia in 2005 after more than 25 years working
in the US in various sales roles.
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John Williams
General manager, Australian operations
John Williams has been involved in the quartz industry with Accutime for 10 years and has
35 years experience in electronics manufacturing and design, in both Australia and Europe.
In his current role, John is responsible for the operational parts of the business in Australia
(production, purchasing, stores and production planning, as well as quality and facilities
engineering). Earlier roles saw him responsible for product engineering, finance, information
systems and human resources. John holds a Bachelor of Engineering degree in Electronics,
is a member of the Electrical College of Engineers Australia, and a Member of the Australian
Institute of Directors.
Dr Philip Jones
Business unit manager, UK
Dr Philip Jones joined Accutime in December 2011 following the acquisition of the BACTech
frequency control product (FCP) business. He is responsible for the manufacturing operations,
quality assurance (QA), purchasing and human resources functions of the Reading, UK site.
He has also recently taken on the responsibility for the product management of Accutime
UKs portfolio. During his 11-year tenure at BACTech he held a range of operational, sales and
engineering positions. Prior to this he worked in program management for UK Semiconductors
and process engineering and engineering management at BFA Limited. Before this, Philip
worked for two years at the University of Manchester Institute of Science and Technology,
investigating the properties of a range of magnetic materials. Philip holds a Bachelor of Science
degree and a PhD in Physics, both from the University of Wales.
Helga Steinbeck
Business unit manager, Germany
Helga Steinbeck joined the German plant of Accutime 12 years ago, originally in the role of
technical manager. At that time, the German company was operating under the brand MEPE
and it was the frequency products subsidiary of Thalen. After Accutime acquired MEPE from
Thalen, Helga moved to the position of operations manager. The German operation has focused
on the development and manufacture of SC crystals and the design and manufacture of OCXOs
for telecommunications, military and space applications. Before being involved in frequency
products, Helga spent 17 years in the semiconductor business working at Thalen. Helga holds a
degree in Electronic Engineering and a PhD in Semiconductor Physics.
Dean Rollings
Regional manager, North Americas
Dean has over 30 years experience in the electronics component industry, with almost 25 of
those years being in the frequency area of the industry. Dean started as a local salesperson
affiliated with a US mid-western sales representative company back in the 1970s, and has
progressed through a variety of roles including sales engineer, marketing manager and sales
management. His position prior to joining Accutime in 2002 was as vice president of sales and
marketing with a leading Chicago-based VCXO manufacturer. Dean has a background in a
wide variety of quartz-based products, ranging from discrete crystals, clock oscillators, VCXOs,
TCXOs, and OCXOs. Deans experience includes the far reaches of the global markets, spanning
Asia, Europe and the Americas. Dean has a BA in History from Indiana University.
Dee Ibraham
Regional manager, Asia
Dee joined Accutime in March 1992 as a QA manager in Sydney, Australia and was successful
in certifying Accutime to international quality standards by obtaining ISO 9001 and ISO 9002.
Dee was then appointed general manager, based in Singapore, before progressing to his present
position as Asia sales manager, based in Hong Kong. Dee has been working in the electronics
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industry for over 19 years in a number of positions. He started in production engineering at
Astec Europe (manufacturer of switch mode power supplies, UK) and Navstar (manufacturer
of civil and military GPS navigation systems, UK) and has worked in positions right through to
manufacturing management and sales management. Dee holds a BSc(Hons) in Technology from
Leicester Polytechnic in England.
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Appendix B
CEO/MD
Bruce Massey
Global business
CFO development & Sales & marketing
Operations
Graham Anderson applications Donald Agnew
Mary Chen
Germany
Treasury Helga Steinbeck
Asia
Dee Ibraham
North Americas
Dean Rollings
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Glossary
Term Definition
AT-cut A specific angle which a quartz wafer is cut from a bar of quartz with reference to
its Z-axis
First pass yield The initial number of good units coming out of a process divided by the number
of units going into that process
IC Integrated circuit
Quartz crystal A silicon dioxide solid with a highly regular atomic structure
SC crystal Stress cut crystal a three-dimensional cut on the quartz crystal blank
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Case study 2
SDT Solutions
A case study for use in Management Accounting & Applied Finance (MAAF)
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Overview
SDT Solutions (SDT) was established in 2003 by two friends, Richard Waugh and Philip
McCaw. Richard and Philip started SDT with the purpose of providing software development
and testing services. The business commenced operations in Melbourne, Australia and has
since expanded into Brisbane, Australia and Auckland, New Zealand. Its head office is based in
Melbourne.
Coming out of the global financial crisis (GFC), SDT has found that business growth and
development have been strong, with many exceptional business opportunities arising.
Consequently, SDT has been targeting a number of large organisations looking to upgrade their
technology platforms to provide them with greater competitive advantage.
The main services offered by SDT are:
Software development: working with a client or group of clients to refine the scope of
what they want to achieve with a piece of software, managing the creation of the code and
ensuring the software meets specifications.
Business intelligence: working with clients to create business intelligence data analysis
and reporting platforms. Currently, SDT has expertise in the use of a number of different
business intelligence tools across various data platforms.
Software testing: testing of new software or software changes to ensure that these work in
accordance with specifications and do not contain any bugs.
SDT is a quality-focused organisation and provides a guarantee for all work performed. Where
an issue is found within six months of completing an assignment, SDT will provide relevant
resources to resolve the issue at no cost to the client. If a client purchases tools or software from
SDT, they get free access to all upgrades for the next 12 months.
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Corporate structure
Richard Waugh and Philip McCaw are the only owners of SDT and structure the business
through a unit trust which owns the business operations in both Australia and New Zealand.
The structure is as follows:
SDT Unit
Trust
Richard Waugh
(CEO)
Payroll
IT support
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Management Accounting & Applied Finance
Management Accounting & Applied Finance Chartered Accountants Program
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Professional staff
Details of current professional staff within SDT are as follows:
Position Melbourne Brisbane Auckland Market Market SDT Aust SDT NZ list
salary salary list day day charge
range Aust. range NZ charge out out rate
(A$000s) (NZ$000s) rate (A$) (NZ$)
General
Business intelligence
Development
Testing
88 26 25
The current market for staff is extremely difficult. Staff turnover amongst professional staff in
the industry is averaging 30% per annum, with significant pressure on wage levels. SDT has
commenced a recruitment drive in Europe, offering sponsorship status in Australia (this enables
immigration to Australia on a special working visa). People recruited through this process are
also able to obtain significant taxation concessions.
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Insurance Manufacturing
Legal
Manufacturing
State Government
Dividend policy
Based on discussions held at the December 2012 board of advice meeting it was decided
to implement a dividend payment policy of 40% of profits before taxation to shareholders.
The remaining 60% would be allocated to cover any taxation payable, with the balance to be
reinvested in the business to take advantage of future opportunities.
Productivity bonuses
All staff are eligible to receive productivity bonuses. Client-facing staff (including heads of
business operations), become eligible for the productivity bonus when their business area
achieves an annual utilisation rate of above 75%. For each 1% that the utilisation rate exceeds
75%, the productivity bonus pool accrues at 10% of revenue.
The formula to calculate the available pool (for client-facing staff) is:
Revenue (utilisation rate 0.75) 0.1
Productivity bonuses for head office staff are based on them achieving a number of agreed KPIs
and are capped at 7.5% of salaries.
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Committees
The following groups/committees exist within SDT.
Board of advice
This group comprises Richard Waugh, Philip McCaw and three independent, external advisors.
They meet on a quarterly basis, with a view to discussing strategic issues for SDT.
Finance/risk committee
This group comprises Richard Waugh, Charlene F. OShay (CA) and Elizabeth Little (FCA),
SDTs external accountant. This group meets bi-monthly to consider all financial and risk
management areas of SDT. Other members of the senior management team are often required to
attend these meetings to discuss aspects of the business.
As part of these meetings, the committee reviews the status of all current jobs with a value
of more than $100,000 to assess whether there are any issues that may result in the job being
delivered late or not to the required quality standard. Also, any job with an estimated value
of greater than $25,000 which has commenced since the last meeting is discussed in order to
determine key risks/issues.
Remuneration committee
This group comprises Richard Waugh, Philip McCaw, all heads of business operations,
Charlene F. OShay and Jonathan Wilmot. This group meets in June and December to consider
all proposed promotions and salary increases. Based on a recommendation from the finance/
risk committee, a pool of funds is made available for salary increases.
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
Revenue $1,105 4,064,632 $1,150 1,669,800 5,734,432 $1,000 484,000 336,667 6,101,099
Business line margin reports
Less: COGS
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Management Accounting & Applied Finance
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Page CS2-12
SDT Solutions Development Services
Management accounts for the year ended 31 December 2012
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
Revenue $1,120 7,330,400 $1,075 1,121,010 8,541,410 $1,025 1,262,800 956,667 9,408,077
Less: COGS
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
Revenue $1,250 605,000 $1,400 215,600 820,600 $1,150 708,400 536,667 1,357,267
Less: COGS
Productivity bonus 0 0 0 0 0 0
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Management Accounting & Applied Finance
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Page CS2-14
SDT Solutions General Services
Management accounts for the year ended 31 December 2012
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
Revenue $1,475 4,578,695 $1,375 1,028,500 5,607,195 $1,320 1,626,240 1,232,000 6,839,195
Less: COGS
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
Revenue $1,200 16,578,727 $1,188 4,034,910 20,613,637 $1,145 4,081,440 3,092,000 23,705,637
Less: COGS
Allocated costs
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Management Accounting & Applied Finance
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Page CS2-16
SDT Solutions consolidated result
Management accounts for the year ended 31 December 2012
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
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Management Accounting & Applied Finance
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Page CS2-18
SDT Solutions consolidated result
Management accounts for the year ended 31 December 2012
Details AUD Details AUD Details AUD Details NZD AUD Details AUD
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Current assets
Non-current assets
Current liabilities
GST collected Paid monthly 192,865 Paid monthly 48,655 36,860 229,725
Employee entitlements A/L, S/L 918,153 A/L, S/L 156,043 118,215 1,036,367
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Non-current liabilities
Equity
Dividends paid/provided 40% of profits (1,298,927) 40% of profits (115,455) (87,466) (1,386,393)
Financial tables
3 1.061 1.125 1.191 1.260 1.331 1.405 1.482 1.561 1.643 1.728 1.816 1.907 2.000 2.097 2.197 2.300 2.744 3
4 1.082 1.170 1.262 1.360 1.464 1.574 1.689 1.811 1.939 2.074 2.215 2.364 2.520 2.684 2.856 3.036 3.842 4
5 1.104 1.217 1.338 1.469 1.611 1.762 1.925 2.100 2.288 2.488 2.703 2.932 3.176 3.436 3.713 4.007 5.378 5
6 1.126 1.265 1.419 1.587 1.772 1.974 2.195 2.436 2.700 2.986 3.297 3.635 4.002 4.398 4.827 5.290 7.530 6
7 1.149 1.316 1.504 1.714 1.949 2.211 2.502 2.826 3.185 3.583 4.023 4.508 5.042 5.629 6.275 6.983 10.541 7
8 1.172 1.369 1.594 1.851 2.144 2.476 2.853 3.278 3.759 4.300 4.908 5.590 6.353 7.206 8.157 9.217 14.758 8
9 1.195 1.423 1.689 1.999 2.358 2.773 3.252 3.803 4.435 5.160 5.987 6.931 8.005 9.223 10.604 12.166 20.661 9
Chartered Accountants Program
10 1.219 1.480 1.791 2.159 2.594 3.106 3.707 4.411 5.234 6.192 7.305 8.594 10.086 11.806 13.786 16.060 28.925 10
11 1.243 1.539 1.898 2.332 2.853 3.479 4.226 5.117 6.176 7.430 8.912 10.657 12.708 15.112 17.922 21.199 40.496 11
Financial tables
12 1.268 1.601 2.012 2.518 3.138 3.896 4.818 5.936 7.288 8.916 10.872 13.215 16.012 19.343 23.298 27.983 56.694 12
13 1.294 1.665 2.133 2.720 3.452 4.363 5.492 6.886 8.599 10.699 13.264 16.386 20.175 24.759 30.288 36.937 79.371 13
14 1.319 1.732 2.261 2.937 3.797 4.887 6.261 7.988 10.147 12.839 16.182 20.319 25.421 31.691 39.374 48.757 111.120 14
15 1.346 1.801 2.397 3.172 4.177 5.474 7.138 9.266 11.974 15.407 19.742 25.196 32.030 40.565 51.186 64.359 155.568 15
16 1.373 1.873 2.540 3.426 4.595 6.130 8.137 10.748 14.129 18.488 24.086 31.243 40.358 51.923 66.542 84.954 217.795 16
17 1.400 1.948 2.693 3.700 5.054 6.866 9.276 12.468 16.672 22.186 29.384 38.741 50.851 66.461 86.504 112.139 304.913 17
18 1.428 2.026 2.854 3.996 5.560 7.690 10.575 14.463 19.673 26.623 35.849 48.039 64.072 85.071 112.455 148.024 426.879 18
19 1.457 2.107 3.026 4.316 6.116 8.613 12.056 16.777 23.214 31.948 43.736 59.568 80.731 108.890 146.192 195.391 597.630 19
20 1.486 2.191 3.207 4.661 6.727 9.646 13.743 19.461 27.393 38.338 53.358 73.864 101.721 139.380 190.050 257.916 836.683 20
21 1.516 2.279 3.400 5.034 7.400 10.804 15.668 22.574 32.324 46.005 65.096 91.592 128.169 178.406 247.065 340.449 1,171.356 21
22 1.546 2.370 3.604 5.437 8.140 12.100 17.861 26.186 38.142 55.206 79.418 113.574 161.492 228.360 321.184 449.393 1,639.898 22
23 1.577 2.465 3.820 5.871 8.954 13.552 20.362 30.376 45.008 66.247 96.889 140.831 203.480 292.300 417.539 593.199 2,295.857 23
24 1.608 2.563 4.049 6.341 9.850 15.179 23.212 35.236 53.109 79.497 118.205 174.631 256.385 374.144 542.801 783.023 3,214.200 24
25 1.641 2.666 4.292 6.848 10.835 17.000 26.462 40.874 62.669 95.396 144.210 216.542 323.045 478.905 705.641 1,033.590 4,499.880 25
26 1.673 2.772 4.549 7.396 11.918 19.040 30.167 47.414 73.949 114.475 175.936 268.512 407.037 612.998 917.333 1,364.339 6,299.831 26
27 1.707 2.883 4.822 7.988 13.110 21.325 34.390 55.000 87.260 137.371 214.642 332.955 512.867 784.638 1,192.533 1,800.927 8,819.764 27
28 1.741 2.999 5.112 8.627 14.421 23.884 39.204 63.800 102.967 164.845 261.864 412.864 646.212 1,004.336 1,550.293 2,377.224 12,347.670 28
29 1.776 3.119 5.418 9.317 15.863 26.750 44.693 74.009 121.501 197.814 319.474 511.952 814.228 1,285.550 2,015.381 3,137.935 17,286.737 29
30 1.811 3.243 5.743 10.063 17.449 29.960 50.950 85.850 143.371 237.376 389.758 634.820 1,025.927 1,645.505 2,619.996 4,142.075 24,201.432 30
35 2.000 3.946 7.686 14.785 28.102 52.800 98.100 180.314 327.997 590.668 1,053.402 1,861.054 3,258.135 5,653.911 9,727.860 16,599.217 130,161.112 35
40 2.208 4.801 10.286 21.725 45.259 93.051 188.884 378.721 750.378 1,469.772 2,847.038 5,455.913 10,347.175 19,426.689 36,118.865 66,520.767 700,037.697 40
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Management Accounting & Applied Finance
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Table 2: Present value of $1
Periods 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 40% Periods
1 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.862 0.847 0.833 0.820 0.806 0.794 0.781 0.769 0.758 0.714 1
2 0.961 0.925 0.890 0.857 0.826 0.797 0.769 0.743 0.718 0.694 0.672 0.650 0.630 0.610 0.592 0.574 0.510 2
3 0.942 0.889 0.840 0.794 0.751 0.712 0.675 0.641 0.609 0.579 0.551 0.524 0.500 0.477 0.455 0.435 0.364 3
4 0.924 0.855 0.792 0.735 0.683 0.636 0.592 0.552 0.516 0.482 0.451 0.423 0.397 0.373 0.350 0.329 0.260 4
5 0.906 0.822 0.747 0.681 0.621 0.567 0.519 0.476 0.437 0.402 0.370 0.341 0.315 0.291 0.269 0.250 0.186 5
6 0.888 0.790 0.705 0.630 0.564 0.507 0.456 0.410 0.370 0.335 0.303 0.275 0.250 0.227 0.207 0.189 0.133 6
7 0.871 0.760 0.665 0.583 0.513 0.452 0.400 0.354 0.314 0.279 0.249 0.222 0.198 0.178 0.159 0.143 0.095 7
8 0.853 0.731 0.627 0.540 0.467 0.404 0.351 0.305 0.266 0.233 0.204 0.179 0.157 0.139 0.123 0.108 0.068 8
9 0.837 0.703 0.592 0.500 0.424 0.361 0.308 0.263 0.225 0.194 0.167 0.144 0.125 0.108 0.094 0.082 0.048 9
Management Accounting & Applied Finance
10 0.820 0.676 0.558 0.463 0.386 0.322 0.270 0.227 0.191 0.162 0.137 0.116 0.099 0.085 0.073 0.062 0.035 10
11 0.804 0.650 0.527 0.429 0.350 0.287 0.237 0.195 0.162 0.135 0.112 0.094 0.079 0.066 0.056 0.047 0.025 11
12 0.788 0.625 0.497 0.397 0.319 0.257 0.208 0.168 0.137 0.112 0.092 0.076 0.062 0.052 0.043 0.036 0.018 12
13 0.773 0.601 0.469 0.368 0.290 0.229 0.182 0.145 0.116 0.093 0.075 0.061 0.050 0.040 0.033 0.027 0.013 13
14 0.758 0.577 0.442 0.340 0.263 0.205 0.160 0.125 0.099 0.078 0.062 0.049 0.039 0.032 0.025 0.021 0.009 14
15 0.743 0.555 0.417 0.315 0.239 0.183 0.140 0.108 0.084 0.065 0.051 0.040 0.031 0.025 0.020 0.016 0.006 15
16 0.728 0.534 0.394 0.292 0.218 0.163 0.123 0.093 0.071 0.054 0.042 0.032 0.025 0.019 0.015 0.012 0.005 16
17 0.714 0.513 0.371 0.270 0.198 0.146 0.108 0.080 0.060 0.045 0.034 0.026 0.020 0.015 0.012 0.009 0.003 17
18 0.700 0.494 0.350 0.250 0.180 0.130 0.095 0.069 0.051 0.038 0.028 0.021 0.016 0.012 0.009 0.007 0.002 18
19 0.686 0.475 0.331 0.232 0.164 0.116 0.083 0.060 0.043 0.031 0.023 0.017 0.012 0.009 0.007 0.005 0.002 19
20 0.673 0.456 0.312 0.215 0.149 0.104 0.073 0.051 0.037 0.026 0.019 0.014 0.010 0.007 0.005 0.004 0.001 20
21 0.660 0.439 0.294 0.199 0.135 0.093 0.064 0.044 0.031 0.022 0.015 0.011 0.008 0.006 0.004 0.003 0.001 21
22 0.647 0.422 0.278 0.184 0.123 0.083 0.056 0.038 0.026 0.018 0.013 0.009 0.006 0.004 0.003 0.002 0.001 22
23 0.634 0.406 0.262 0.170 0.112 0.074 0.049 0.033 0.022 0.015 0.010 0.007 0.005 0.003 0.002 0.002 0.000 23
24 0.622 0.390 0.247 0.158 0.102 0.066 0.043 0.028 0.019 0.013 0.008 0.006 0.004 0.003 0.002 0.001 0.000 24
25 0.610 0.375 0.233 0.146 0.092 0.059 0.038 0.024 0.016 0.010 0.007 0.005 0.003 0.002 0.001 0.001 0.000 25
26 0.598 0.361 0.220 0.135 0.084 0.053 0.033 0.021 0.014 0.009 0.006 0.004 0.002 0.002 0.001 0.001 0.000 26
27 0.586 0.347 0.207 0.125 0.076 0.047 0.029 0.018 0.011 0.007 0.005 0.003 0.002 0.001 0.001 0.001 0.000 27
28 0.574 0.333 0.196 0.116 0.069 0.042 0.026 0.016 0.010 0.006 0.004 0.002 0.002 0.001 0.001 0.000 0.000 28
29 0.563 0.321 0.185 0.107 0.063 0.037 0.022 0.014 0.008 0.005 0.003 0.002 0.001 0.001 0.000 0.000 0.000 29
30 0.552 0.308 0.174 0.099 0.057 0.033 0.020 0.012 0.007 0.004 0.003 0.002 0.001 0.001 0.000 0.000 0.000 30
35 0.500 0.253 0.130 0.068 0.036 0.019 0.010 0.006 0.003 0.002 0.001 0.001 0.000 0.000 0.000 0.000 0.000 35
40 0.453 0.208 0.097 0.046 0.022 0.011 0.005 0.003 0.001 0.001 0.000 0.000 0.000 0.000 0.000 0.000 0.000 40
Chartered Accountants Program
Financial tables
Table 3: Compound amount of annuity of $1 in arrears
Periods 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 40% Periods
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1
2 2.020 2.040 2.060 2.080 2.100 2.120 2.140 2.160 2.180 2.200 2.220 2.240 2.260 2.280 2.300 2.320 2.400 2
Financial tables
3 3.060 3.122 3.184 3.246 3.310 3.374 3.440 3.506 3.572 3.640 3.708 3.778 3.848 3.918 3.990 4.062 4.360 3
4 4.122 4.246 4.375 4.506 4.641 4.779 4.921 5.066 5.215 5.368 5.524 5.684 5.848 6.016 6.187 6.362 7.104 4
5 5.204 5.416 5.637 5.867 6.105 6.353 6.610 6.877 7.154 7.442 7.740 8.048 8.368 8.700 9.043 9.398 10.946 5
6 6.308 6.633 6.975 7.336 7.716 8.115 8.536 8.977 9.442 9.930 10.442 10.980 11.544 12.136 12.756 13.406 16.324 6
7 7.434 7.898 8.394 8.923 9.487 10.089 10.730 11.414 12.142 12.916 13.740 14.615 15.546 16.534 17.583 18.696 23.853 7
8 8.583 9.214 9.897 10.637 11.436 12.300 13.233 14.240 15.327 16.499 17.762 19.123 20.588 22.163 23.858 25.678 34.395 8
9 9.755 10.583 11.491 12.488 13.579 14.776 16.085 17.519 19.086 20.799 22.670 24.712 26.940 29.369 32.015 34.895 49.153 9
Chartered Accountants Program
10 10.950 12.006 13.181 14.487 15.937 17.549 19.337 21.321 23.521 25.959 28.657 31.643 34.945 38.593 42.619 47.062 69.814 10
11 12.169 13.486 14.972 16.645 18.531 20.655 23.045 25.733 28.755 32.150 35.962 40.238 45.031 50.398 56.405 63.122 98.739 11
12 13.412 15.026 16.870 18.977 21.384 24.133 27.271 30.850 34.931 39.581 44.874 50.895 57.739 65.510 74.327 84.320 139.235 12
13 14.680 16.627 18.882 21.495 24.523 28.029 32.089 36.786 42.219 48.497 55.746 64.110 73.751 84.853 97.625 112.303 195.929 13
14 15.974 18.292 21.015 24.215 27.975 32.393 37.581 43.672 50.818 59.196 69.010 80.496 93.926 109.612 127.913 149.240 275.300 14
15 17.293 20.024 23.276 27.152 31.772 37.280 43.842 51.660 60.965 72.035 85.192 100.815 119.347 141.303 167.286 197.997 386.420 15
16 18.639 21.825 25.673 30.324 35.950 42.753 50.980 60.925 72.939 87.442 104.935 126.011 151.377 181.868 218.472 262.356 541.988 16
17 20.012 23.698 28.213 33.750 40.545 48.884 59.118 71.673 87.068 105.931 129.020 157.253 191.735 233.791 285.014 347.309 759.784 17
18 21.412 25.645 30.906 37.450 45.599 55.750 68.394 84.141 103.740 128.117 158.405 195.994 242.585 300.252 371.518 459.449 1,064.697 18
19 22.841 27.671 33.760 41.446 51.159 63.440 78.969 98.603 123.414 154.740 194.254 244.033 306.658 385.323 483.973 607.472 1,491.576 19
20 24.297 29.778 36.786 45.762 57.275 72.052 91.025 115.380 146.628 186.688 237.989 303.601 387.389 494.213 630.165 802.863 2,089.206 20
21 25.783 31.969 39.993 50.423 64.002 81.699 104.768 134.841 174.021 225.026 291.347 377.465 489.110 633.593 820.215 1,060.779 2,925.889 21
22 27.299 34.248 43.392 55.457 71.403 92.503 120.436 157.415 206.345 271.031 356.443 469.056 617.278 811.999 1,067.280 1,401.229 4,097.245 22
23 28.845 36.618 46.996 60.893 79.543 104.603 138.297 183.601 244.487 326.237 435.861 582.630 778.771 1,040.358 1,388.464 1,850.622 5,737.142 23
24 30.422 39.083 50.816 66.765 88.497 118.155 158.659 213.978 289.494 392.484 532.750 723.461 982.251 1,332.659 1,806.003 2,443.821 8,032.999 24
25 32.030 41.646 54.865 73.106 98.347 133.334 181.871 249.214 342.603 471.981 650.955 898.092 1,238.636 1,706.803 2,348.803 3,226.844 11,247.199 25
26 33.671 44.312 59.156 79.954 109.182 150.334 208.333 290.088 405.272 567.377 795.165 1,114.634 1,561.682 2,185.708 3,054.444 4,260.434 15,747.079 26
27 35.344 47.084 63.706 87.351 121.100 169.374 238.499 337.502 479.221 681.853 971.102 1,383.146 1,968.719 2,798.706 3,971.778 5,624.772 22,046.910 27
28 37.051 49.968 68.528 95.339 134.210 190.699 272.889 392.503 566.481 819.223 1,185.744 1,716.101 2,481.586 3,583.344 5,164.311 7,425.699 30,866.674 28
29 38.792 52.966 73.640 103.966 148.631 214.583 312.094 456.303 669.447 984.068 1,447.608 2,128.965 3,127.798 4,587.680 6,714.604 9,802.923 43,214.343 29
30 40.568 56.085 79.058 113.283 164.494 241.333 356.787 530.312 790.948 1,181.882 1,767.081 2,640.916 3,942.026 5,873.231 8,729.985 12,940.859 60,501.081 30
35 49.994 73.652 111.435 172.317 271.024 431.663 693.573 1,120.713 1,816.652 2,948.341 4,783.645 7,750.225 12,527.442 20,188.966 32,422.868 51,869.427 325,400.279 35
40 60.402 95.026 154.762 259.057 442.593 767.091 1,342.025 2,360.757 4,163.213 7,343.858 12,936.535 22,728.803 39,792.982 69,377.460 120,392.883 207,874.272 1,750,091.741 40
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Page FT-3
Management Accounting & Applied Finance
FT
Page FT-4
Table 4: Present value of annuity $1 in arrears
Periods 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 40% Periods
1 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.862 0.847 0.833 0.820 0.806 0.794 0.781 0.769 0.758 0.714 1
2 1.942 1.886 1.833 1.783 1.736 1.690 1.647 1.605 1.566 1.528 1.492 1.457 1.424 1.392 1.361 1.331 1.224 2
3 2.884 2.775 2.673 2.577 2.487 2.402 2.322 2.246 2.174 2.106 2.042 1.981 1.923 1.868 1.816 1.766 1.589 3
4 3.808 3.630 3.465 3.312 3.170 3.037 2.914 2.798 2.690 2.589 2.494 2.404 2.320 2.241 2.166 2.096 1.849 4
5 4.713 4.452 4.212 3.993 3.791 3.605 3.433 3.274 3.127 2.991 2.864 2.745 2.635 2.532 2.436 2.345 2.035 5
6 5.601 5.242 4.917 4.623 4.355 4.111 3.889 3.685 3.498 3.326 3.167 3.020 2.885 2.759 2.643 2.534 2.168 6
7 6.472 6.002 5.582 5.206 4.868 4.564 4.288 4.039 3.812 3.605 3.416 3.242 3.083 2.937 2.802 2.677 2.263 7
8 7.325 6.733 6.210 5.747 5.335 4.968 4.639 4.344 4.078 3.837 3.619 3.421 3.241 3.076 2.925 2.786 2.331 8
9 8.162 7.435 6.802 6.247 5.759 5.328 4.946 4.607 4.303 4.031 3.786 3.566 3.366 3.184 3.019 2.868 2.379 9
Management Accounting & Applied Finance
10 8.983 8.111 7.360 6.710 6.145 5.650 5.216 4.833 4.494 4.192 3.923 3.682 3.465 3.269 3.092 2.930 2.414 10
11 9.787 8.760 7.887 7.139 6.495 5.938 5.453 5.029 4.656 4.327 4.035 3.776 3.543 3.335 3.147 2.978 2.438 11
12 10.575 9.385 8.384 7.536 6.814 6.194 5.660 5.197 4.793 4.439 4.127 3.851 3.606 3.387 3.190 3.013 2.456 12
13 11.348 9.986 8.853 7.904 7.103 6.424 5.842 5.342 4.910 4.533 4.203 3.912 3.656 3.427 3.223 3.040 2.469 13
14 12.106 10.563 9.295 8.244 7.367 6.628 6.002 5.468 5.008 4.611 4.265 3.962 3.695 3.459 3.249 3.061 2.478 14
15 12.849 11.118 9.712 8.559 7.606 6.811 6.142 5.575 5.092 4.675 4.315 4.001 3.726 3.483 3.268 3.076 2.484 15
16 13.578 11.652 10.106 8.851 7.824 6.974 6.265 5.668 5.162 4.730 4.357 4.033 3.751 3.503 3.283 3.088 2.489 16
17 14.292 12.166 10.477 9.122 8.022 7.120 6.373 5.749 5.222 4.775 4.391 4.059 3.771 3.518 3.295 3.097 2.492 17
18 14.992 12.659 10.828 9.372 8.201 7.250 6.467 5.818 5.273 4.812 4.419 4.080 3.786 3.529 3.304 3.104 2.494 18
19 15.678 13.134 11.158 9.604 8.365 7.366 6.550 5.877 5.316 4.843 4.442 4.097 3.799 3.539 3.311 3.109 2.496 19
20 16.351 13.590 11.470 9.818 8.514 7.469 6.623 5.929 5.353 4.870 4.460 4.110 3.808 3.546 3.316 3.113 2.497 20
21 17.011 14.029 11.764 10.017 8.649 7.562 6.687 5.973 5.384 4.891 4.476 4.121 3.816 3.551 3.320 3.116 2.498 21
22 17.658 14.451 12.042 10.201 8.772 7.645 6.743 6.011 5.410 4.909 4.488 4.130 3.822 3.556 3.323 3.118 2.498 22
23 18.292 14.857 12.303 10.371 8.883 7.718 6.792 6.044 5.432 4.925 4.499 4.137 3.827 3.559 3.325 3.120 2.499 23
24 18.914 15.247 12.550 10.529 8.985 7.784 6.835 6.073 5.451 4.937 4.507 4.143 3.831 3.562 3.327 3.121 2.499 24
25 19.523 15.622 12.783 10.675 9.077 7.843 6.873 6.097 5.467 4.948 4.514 4.147 3.834 3.564 3.329 3.122 2.499 25
26 20.121 15.983 13.003 10.810 9.161 7.896 6.906 6.118 5.480 4.956 4.520 4.151 3.837 3.566 3.330 3.123 2.500 26
27 20.707 16.330 13.211 10.935 9.237 7.943 6.935 6.136 5.492 4.964 4.524 4.154 3.839 3.567 3.331 3.123 2.500 27
28 21.281 16.663 13.406 11.051 9.307 7.984 6.961 6.152 5.502 4.970 4.528 4.157 3.840 3.568 3.331 3.124 2.500 28
29 21.844 16.984 13.591 11.158 9.370 8.022 6.983 6.166 5.510 4.975 4.531 4.159 3.841 3.569 3.332 3.124 2.500 29
30 22.396 17.292 13.765 11.258 9.427 8.055 7.003 6.177 5.517 4.979 4.534 4.160 3.842 3.569 3.332 3.124 2.500 30
35 24.999 18.665 14.498 11.655 9.644 8.176 7.070 6.215 5.539 4.992 4.541 4.164 3.845 3.571 3.333 3.125 2.500 35
40 27.355 19.793 15.046 11.925 9.779 8.244 7.105 6.233 5.548 4.997 4.544 4.166 3.846 3.571 3.333 3.125 2.500 40
Chartered Accountants Program
Financial tables
Chartered Accountants Program Management Accounting & Applied Finance
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Core content
Unit 1: Introduction to management
accounting (including ethics)
Learning outcomes
At the end of this unit you will be able to:
1. Describe the role that the management accounting and treasury functions play within
anorganisation.
2. Determine stakeholders, explain their different objectives, information needs, and how
these can best be satisfied.
3. Outline generic strategies that organisations use.
4. Describe and analyse organisational structures.
5. Determine the appropriate responsibility centre type for organisations.
6. Identify professional (ethical) issues that may arise for Chartered Accountants in business.
7. Outline relevant ethical standards and appropriate safeguards for ethical issues that arise.
Introduction
Management accounting is dynamic. There are no set rules governing what a management
accountant does the role varies depending on the organisation and the industry in which it
operates.
Management accountants add value in any organisation no matter whether they are working
in, for example, the finance department, within a business unit or in a treasury function.
Wherever the management accountant is situated, their role is to produce information for
decision makers (or stakeholders) that:
Assists them with day-to-day operations.
Enables them to make effective decisions on the future operations or strategic direction of
the business.
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Management accountants use various techniques, tools and frameworks to obtain, interpret and
present information in order to enhance the decision-making process.
Like all Chartered Accountants, management accountants must undertake their roles
ethically, and this unit considers the ethical requirements applicable to Chartered Accountants
undertaking the role of a management accountant.
Learning outcome
1. Describe the role that the management accounting and treasury functions play within
anorganisation.
Purpose of Help managers make decisions to fulfil an Communicate organisations financial position
information organisations goals and objectives to investors, banks, regulators and other
outside parties
Primary users Managers and decision makers within an External users, such as investors, banks,
organisation regulators and suppliers
Focus and Future-oriented (e.g. budget for 20X5 Past-oriented (e.g. reports on 20X3
emphasis prepared in 20X4) performance prepared in 20X4)
Rules of Internal measures and reports do not have Financial statements for reporting entities
measurement to follow Accounting Standards, but are must be prepared in accordance with
and reporting based on cost-benefit analysis Accounting Standards and be audited by
external independent auditors
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Time span and Varies from hourly information to Annual and half-yearly financial reports,
type of reports 1520 years, and can include financial primarily on the company as a whole
and non-financial reports on products,
departments, territories and strategies
Behavioural Designed to influence the behaviour of Primarily report economic events, but
implications managers and other employees also influence behaviour, as managers
compensation is often based on reported
financial results
This table illustrates that financial accounting information is primarily developed for people
external to an organisation (e.g. shareholders and regulators), and is therefore governed by
external codes (e.g. Accounting Standards, relevant legislation, stock exchange rules and tax
regulations).
It also illustrates that management accounting information is used by decision makers internal
to an organisation. It focuses on current or forecast information that meets internal decision
makers needs.
While financial accounting information is required to be accurate and independently verifiable,
management accounting information needs to be timely and fit for purpose.
The process of management accounting involves the following:
1. Understanding the business information requirements of key stakeholders by clearly
defining the issue (or management request).
2. Gathering the information necessary to produce a report that meets the business
requirements (which will come from a number of sources).
3. Analysing and interpreting the information gathered.
4. Drawing conclusions based on analysis.
5. Presenting information and making recommendations to management.
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The diagram below provides a high-level overview of this process.
Management accountant
UNDERSTANDING BUSINESS REQUIREMENTS
GATHERS Payroll Business Financial Annual
INFORMATION data reports reports reports
ANALYSES AND
INTERPRETS
INFORMATION Frameworks Tools Techniques
DRAWS
CONCLUSIONS Financial Non-financial
consequences consequences
PRESENTS
INFORMATION TO Key Written Balanced
DECISION MAKERS performance reports scorecard
indicators
INFORMED DECISION
Understanding the key drivers of a business, the critical success factors and the competitive
environment allows the management accountant to understand the decision(s) being made and
therefore the information required.
Building productive, high-trust relationships with internal stakeholders to enable effective
knowledge-sharing is an integral part of a management accountants role.
The following table illustrates examples of the activities undertaken by management that
require the support of a management accountant. It highlights that management accounting
information is required to support a range of decisions, from high-level strategic to low-level
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operational. The management accountant can best support the decision maker by asking
questions to clarify the goals and needs of decision makers.
Planning What will I do? Current financial position of the organisation (baseline)
Forecast of future sales volumes, economic environment,
costs and revenues
Competitor analysis
Customer analysis
Organisational capability
Organising How will I carry out my Current resources used and costs of operation (baseline)
plan?
Future performance data (e.g. planned costs, efficiencies and
quality levels)
What-if analysis to show different outcomes depending on
the approach taken
2. Gathering information
The process of gathering information is dependent on business requirements and what the
management accountant has been asked to do.
Key considerations when gathering information include:
Is the information easily obtainable?
Is it reliable?
Will it meet stakeholder requirements?
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There are a number of analysis tools and techniques that can be used to examine the
information gathered, including:
benchmarking
cost-volume-profit (CVP)
cost-benefit
customer profitability
economic value added (EVA)
net present value (NPV)
product profitability
ratios
return on investment (ROI)
scenario
sensitivity
supply chain
strengths, weaknesses, opportunities, threats (SWOT)
target costing
time series
value chain
variance.
The method of analysis used allows for additional understanding and interpretation of the
information. For example, a management accountant might produce a report that shows the
variance between budgeted and actual performance for a month. Sales have exceeded the
budget as a result of an advertising campaign (favourable result); however, distribution costs
have increased to an even greater extent due to new remote outlets demanding the product
(unfavourable result). The net of the two impacts means that profit is actually below budget.
Using analytical tools, the management accountant would better understand and therefore be
able to explain these results, highlighting the interrelationship between the two variances.
A number of these tools and techniques, and when they should be used, will be explored in
more detail in later units.
The decision maker may or may not adopt the recommendations, but the input from the
management accountant has provided additional information to assist their thinking and aid
the decision-making process.
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The following table illustrates the information requirements for an effective management
accounting report.
Information Description
needs to be
Accurate To support decision-making, it is imperative that stakeholders can rely on the accuracy of the
information presented
Accuracy and completeness go hand in hand. Incomplete information is inaccurate, as it is
misleading by omission
The information should clearly identify the basis and assumptions for the analysis, and thus
the recommendations and conclusions
The report should be concise and to the point or the intended recipient may misinterpret the
information
Cost-effective Decision makers will not consider information valuable if the cost of obtaining it or
to obtain maintaining the systems to produce it outweighs the benefits of having the information. For
example, it would not make sense to invest significant time and money in developing an IT
system to capture overtime costs if overtime is rarely worked. Similarly, changing the format of
reports or reporting systems should be done in the light of a cost-benefit analysis
In establishing how to access, prepare and present reports, consider how often the information
will be required. For example, it may be better to automate regular reports, such as weekly
sales reports showing product sales for the previous week, by product grouping against sales
targets for that period
Consistent A lot of management reporting is performed on a routine basis (e.g. monthly). Hence, it is
important that the information be defined and presented in the same way each time to
facilitate accurate comparison
For example, if overtime was included in salaries and wages one month but excluded the next,
this could give a misleading picture of trends in staff costs
Timely The sooner information is available, the sooner a stakeholder can act on it. Delays in obtaining
and providing information may reduce its usefulness
For example, if an operational manager receives weekly overtime reports three weeks after the
overtime has been worked, the delay may render the information redundant. Due to the time
delay, the manager may not recall why the overtime was worked, or may wrongly assume that
the cause of the overtime has already been addressed
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Further reading
Hope, J 2006, Reinventing the CFO, Harvard Business Review Press, Boston. Jeremy Hope was one
of the worlds top thought leaders in the field of performance management. He was the author of
a number of articles and books on performance management and associated leadership issues.
He also co-authored articles relating to topics such as beyond budgeting and, prior to his death in
September 2011, he was an active member of the Beyond Budgeting Round Table group.
In the following interviews, Jeremy Hope discusses his ideas in Reinventing the CFO around the
accounting functions within organisations:
Jeremy Hope, Reinventing the CFO Part 1, YouTube 2008.
Jeremy Hope, Reinventing the CFO Part 2, YouTube 2008.
Jeremy Hope, Reinventing the CFO Part 3, YouTube 2008.
Although the role of treasury continues to evolve, with business demands for more responsive
cash management solutions, there are two overriding concepts central to its function within an
organisation:
1. Advising management on the optimum capital structure based on the organisations
objectives.
2. Managing the financial risks faced by the organisation.
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TREASURY MANAGEMENT
Further reading
Institute of Chartered Accountants in Australia, Business briefing series, 20 issues on the increasing
significance of corporate treasury.
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Advantages Disadvantages
The business units can be charged market rates By measuring performance on profit, there is a
for the service received and, hence, make their temptation to speculate in the market, which could
operating profit more realistic increase risk exposure unnecessarily
The treasury department could be more motivated Considerable management time may be spent
to make a profit and, hence, this contribution to the adjudicating between treasury and the business
bottom line would benefit the organisation units in regard to charge-outs
Additional administrative costs
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The Group mainly sells commodities it has produced and also enters into third party
transactions and physical swaps on alumina to balance the regional positions and to
balance the loading on production facilities.
The Group has a diverse portfolio of commodities and operates in a number of markets,
which have varying responses to the economic cycle. The relationship between commodity
prices and the currencies of most of the countries in which the Group operates provides
a further natural hedge in the long term. Production of minerals, aluminium and alumina
is an important contributor to the gross domestic products of Australia and Canada,
countries in which the Group has a large presence. As a consequence, the Australian and
Canadian currencies have historically tended to strengthen when commodity prices are
high. In addition, US dollar floating interest rates have historically also tended to be high
when commodity prices are high, and vice versa, and hence the Groups interest rate policy
is to generally borrow and invest, after the impact of hedging, at floating interest rates.
However, in certain circumstances the Group may decide to maintain a higher proportion
of borrowings at fixed rates. These natural hedges significantly reduce the necessity
for using derivatives or other forms of synthetic hedging. Such hedging is therefore
undertaken to a strictly limited degree, as described below.
Treasury operations
Treasury operates as a service to the businesses of the Group and not as a profit centre
[emphasis added]. Strict limits on the size and type of transactions permitted are laid down
by the board and are subject to rigorous internal controls. Senior management is advised
of corporate cash and debt positions, as well as commodity, currency and interest rate
derivatives through a monthly reporting framework.
Treasury policy
Rio Tinto does not acquire or issue derivative financial instruments for trading or
speculative purposes; nor does it believe that it has material exposure to such trading or
speculative holdings through its investments in equity accounted units. Derivatives are
used to separate funding and cash management decisions from currency exposure and
interest rate management. Bank counterparty exposures are managed within allocated
credit limits. Investment, funding and cash management activities are managed and co-
ordinated by Treasury.
Source: Rio Tinto website, accessed 31 July 2015, www.riotinto.com Annual Report 2014 extract
of note 30.
Outsourced Some organisations make the strategic decision to outsource treasury due to the following
reasons:
Increasing complexity of financial products
Not being able to monitor financial markets 24 hours a day
Complex systems required to monitor financial exposures. However, even when
outsourcing, there still needs to be monitoring mechanisms for the third partys
performance and the board is still responsible for the choice of policies used
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Decentralised Decentralised treasury units provide a quicker response to local management needs based
on a superior understanding of the local business
Combination of A combination of centralised and decentralised treasury functions, where activities such as
centralised and policy and risk management can be centralised while operating activities are performed
decentralised locally within strict group guidelines
Stakeholders
Learning outcome
2. Determine stakeholders, explain their different objectives, information needs, and how
these can best be satisfied.
Management accountants must do several things to be effective in their role: they need
to determine who their key stakeholders are, consider the information needs of their key
stakeholders, undertake analyses to satisfy those needs and communicate the information
concisely and in a timely manner.
Determining stakeholders
A stakeholder is a person, group or organisation that has a direct or indirect stake in a
decision(s) or the outcome of a decision(s) because they can affect or be affected by the actions,
objectives, and policies associated with those decisions.
Key stakeholders for a management accountant may include internal personnel, such as
business unit/divisional managers, functional managers, the chief executive officer (CEO), chief
financial officer (CFO) and the board of directors. Depending on the organisation, external
stakeholders may include government (and its agencies), suppliers, unions, banks, creditors,
customers and the community from which the organisation draws its resources.
Given the broad range of stakeholders, it is often useful to separate them into primary
stakeholders (also referred to as key stakeholders) and secondary stakeholders. Primary
stakeholders are those who are directly impacted by the decisions of an organisation. Secondary
stakeholders are those who are indirectly affected by the decisions of an organisation.
The following examples illustrate the difference between primary and secondary stakeholders.
Example 1 considers the upgrade of a major retail property while example 2 considers
the potential closure of a fruit juice manufacturing plant by a large, listed multinational
organisation.
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Existing retail store holders Current store operations may be impacted by the upgrade
Existing customers Upgrade may cause inconvenience. How will shopping experience
change after the upgrade?
Retail property management How will responsibilities change during and after the upgrade?
team
Property owners What is the cost and future financial benefit of the change?
Local residents How will upgrade works (traffic changes and different types of
vehicles) impact on them?
State Government Additional revenues and taxes resulting from the upgrade
(in some jurisdictions) (e.g.payroll tax)
National Government Additional revenues and taxes resulting from the upgrade (e.g. GST)
Example 2 Potential closure of a fruit juice manufacturing plant by a large, listed multinational
organisation
Production plant employees Are likely to lose their jobs and become unemployed
Organisation management Need to make decision and then manage closure if required
Existing customers Need to understand whether supply will come from another
location or if they need to find an alternative source of supply
Juice consumer May not notice change of source of supply or may be required to
change brands
National Government Changes to revenues and taxes (e.g. loss of tax revenues if plant
goes offshore)
State Government Shift to other state driven by lower state taxes (e.g. payroll tax)
(in some jurisdictions)
Once the management accountant has identified their key stakeholders, they can then find out
stakeholder needs and develop systems and reports to meet those needs.
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The following table provides an overview of typical information required by different
stakeholders:
Strategic Board of Strategic information is generally at a high level and can be based on historical
information directors data or predictive forecasts
For example, a board of directors generally requires strategic information
because it operates independently of day-to-day management and uses
information to make decisions about the direction of the business as a whole.
The board determines the high-level strategic plan
Monitoring A cost centre Monitoring and measuring performance involves tracking and understanding
and manager with trends (what is happening) and measuring them against the plan (what was
measuring responsibility expected to happen)
performance for managing
Managers in an organisation are responsible for assessing the efficiency
staff
and effectiveness of their departments. They monitor and measure the
performance of individuals and teams, while also being monitored and
measured by their superiors. Managers require information to monitor
performance so that they can readily identify when performance deviates from
plan and initiate changes to address the issues identified
Such information may highlight which customer types, segments or sales
channels are performing well against targets, and which are underperforming
For example, consider managing staff levels to ensure budgets are not
exceeded:
Changes would be monitored by reviewing reports on recruitment
Actual staff at month end would be measured, taking into account all
recruitments and resignations, and the result compared to budget or
approved numbers
Routine A cost centre Some management reports are prepared and presented on a regular basis
reporting manager (e.g.daily, weekly, monthly or quarterly). This consistency allows users to make
with budget regular and informed comparisons on the information
responsibility
For example:
A treasury
Routine monthly profit and loss (P&L) comparison to budget reports for
officer with
monitoring performance
cash flow
responsibility Weekly cash flow forecast reports for monitoring operational cash
requirements
Ad hoc A project Other management accounting reports are one-off responses to requests for
reporting manager information. Alternatively, they may provide information at a more detailed
who requires level than a particular stakeholder would normally require
support to
For example:
prepare a
cost-benefit An ad hoc report could be a cost-benefit analysis to support a major plant
analysis for a purchase
project A detailed report could be to cross-check project personnel costs through a
full analysis of year-to-date staff number movements, when normally only
month-end actual full-time equivalents (FTEs) are required
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Consider, for example, the stakeholders of a management accounting team of the retail
division of a bank. The job of this team is to provide management accounting information for
one division, being a subsection of the total bank. The responsibility of the retail division is to
provide banking products and services to retail customers (individuals requiring retail deposit
and retail lending products, and personal foreign exchange products).
The purpose of the following table is to illustrate the interrelationships between stakeholders
objectives and their information requirements, and the diverse nature of management
accounting requests.
Page 1-16
Retail bank management accounting stakeholder analysis
Key stakeholders Role objectives in context Information needs Level of detail required Time frame Presentation of information
of the retail division
Board of directors To make decisions about the Total retail assets High-level with: Monthly actuals Summary figures
direction and performance
Total retail liabilities regional split Quarterly competitor analysis Graphs and tables
of the business
New retail business product split Rolling forecast for next 12months, Written reports
updated quarterly
Distribution efficiency
Three-year strategic plan, updated
Operational efficiency
Management Accounting & Applied Finance
annually
Competitor analysis
CEO Responsible for all areas As for board of directors, plus: High-level, but with more As for board of directors, plus: Summary (with drill through)
detail than for board of
Delegates responsibility product profitability weekly new business Graphical (with drill through)
directors
for divisions to general project performance weekly portfolio change (change Balanced scorecard
managers in total retail liabilities (deposits)
operating results against plan
and retail assets (lending)) Written reports
To assess the performance and forecast
of the retail division staff/FTE analysis project performance reported
monthly
explanation of key issues/
variances
General manager To assess the performance For the retail division only, the High-level, but with the As for CEO, plus: Summary (with drill through)
retail division of the retail division in total same information as that provided ability to drill down if
daily new business results Graphical (with drill through)
to the CEO, plus: required
To assess the performance weekly portfolio change Balanced scorecard
of the departments within ad hoc investigations Some requirements may
weekly competitor analysis
the division steering committee support be detailed (e.g. reports Detailed financial results
on ad hoc investigations delivery time frame negotiated
To assess whether projects for ad hoc requests Written analysis supported
or analyses of specific
are on track by graphs and tables
issues)
Written variance report
Written status report
Chartered Accountants Program
Key stakeholders Role objectives in context Information needs Level of detail required Time frame Presentation of information
of the retail division
Department heads To assess the performance As for general manager, but Detailed As for CEO, plus: Summary (with drill through)
Revenue centre To assess the performance Results and variance analyses Detailed Monthly actuals by third business Access to summary and drill
and cost centre of their revenue or cost for their particular area of day of month to allow time for through as relevant to their
Where variances are
managers centre responsibility revenue or cost centre manager to area
significant, explanations
provide analysis to incorporate into
trend analysis for all major items to transaction level Detailed financial results
corporate finance reporting
ad hoc investigations and follow- Level of detail will depend Written variance report
up on general ledger or payroll Delivery time for ad hoc requests
on specifics of request
queries negotiated (noting that month end Written status report
and beginning are often dedicated
support in compiling budgets
to delivering the prior months
and forecasts
results)
Delivery dates for quarterly forecast
review and annual budget set by
corporate finance
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Page 1-17
Management Accounting & Applied Finance
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Page 1-18
Retail bank management accounting stakeholder analysis
Key stakeholders Role objectives in context Information needs Level of detail required Time frame Presentation of information
of the retail division
Corporate To assess the performance Actual results compared to plan and High-level for operating Monthly actuals by sixth Summary financial results
finance, who of the retail division forecast results, FTE analysis and business day of month, including
Written variance report
rely on divisional sign-off consolidated analysis from revenue
Receive input for regulatory Staff/FTE analysis
information or cost centre managers Graphs and tables as
reporting Regulatory input at a level
Project performance appropriate
required by regulators Delivery time for regulatory
Confirm corporate finance
Explanation of key issues/variances reporting requests negotiated Regulatory, in the form
policies are complied with
Management Accounting & Applied Finance
Human resources Confirm HR policies are Compliance sign-off High-level for FTE analysis Monthly actual Summary FTE results
(HR), who rely complied with and sign-off
Staff/FTE analysis Delivery time for regulatory Written variance report
on divisional
Receive input for external Regulatory input at a level reporting requests negotiated
information Input for regulatory reporting, such Graphs and tables as
reporting required by regulators (noting these will normally be on a
as work cover appropriate
regular predictable basis)
Chartered Accountants Program
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Financial reports
Financial reports include numerical data. Examples include:
Sales reports by customer and/or product.
Monthly management accounts.
Written reports/commentary
Written reports are generally narrative in style. Examples include:
Interpretation of operating results/explanation of data (e.g. monthly/quarterly results).
Request for approval (e.g. budget, capital acquisition or project finance).
Traffic-light reports
Traffic-light reporting is a hybrid of graphical, written and financial reports that flags positive
and negative results. This style of reporting highlights key items or issues by shading in three
colours, as shown in the diagram.
Sometimes characterised by a
Indicates poor performance
(i.e. negative or unacceptable)
Improvement required
Urgent attention required
Sometimes characterised by
Indicates neutral warning used to
identify results which are neither
positive nor negative but highlighted
for monitoring or further investigation
Sometimes characterised by a
Indicates results which are positive,
improved or favourable in nature
When using traffic-light reporting, it is important to use appropriate criteria to identify when
each colour is relevant and also to include a key so that the stakeholder can interpret the results.
When using this type of report, management accountants need to be mindful that while an
aspect of the business may be green at the top level, this does not mean there are no issues at
lower levels. For example, on a large-scale IT project, while the program of work may show
green (i.e. that it is progressing according to schedule), there may be sub-projects that are in the
red. Therefore, an assessment of the sub-projects detail may be required to be presented in the
report so that the appropriate decision can be made. The project manager will need to make an
assessment as to the status of the overall project based on the remediation in place.
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Generic strategies
Learning outcome
3. Outline generic strategies that organisations use.
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Competitive advantage
Competitive advantage is the superiority that an organisation aims to gain over its competitors
by providing customers with greater value for money or by more streamlined operations
(and therefore from a lower cost base). This may be achieved by the business having a single
attribute, or multiple attributes in combination. Examples include access to natural resources,
technology patents, highly skilled personnel, or innovative processes and systems.
To determine its strengths and areas of competitive advantage, it is important for an
organisation to identify its core competencies and strategic resources.
Core competencies
Core competencies are part of what makes an organisation unique. They are things that an
organisation does well, and that have strategic value within the industry in which it operates.
Being able to do something well, however, is of limited value if it adds little or no value to your
industry. Often, core competencies eventuate through an organisation creating combinations of
its available resources.
Sustainable competitive advantage eventuates when an organisation can utilise its core
competencies in such a way that it would be difficult for its competition to copy its success in
the short to medium term. It would be expected that the organisation should be able to use this
competitive position to earn above-average financial returns.
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A broad
cross-section Overall Broad
of buyers low-cost differentiation
provider strategy
strategy
Best-cost
provider
strategy
Focused Focused
low-cost differentiation
A narrow strategy strategy
buyer segment
(or market niche)
Type of competitive
advantage being pursued
Source: Thompson,
Source: Thompson,Strickland andGamble
Strickland and Gamble 2007.
2007.
A cost leadership strategy runs the possible risks of not being unique or sustainable, or being
easily copied by competitors. To successfully maintain this strategy, an organisation needs to
remain the lowest cost provider in its market.
An example of an organisation employing a cost leadership strategy is the furniture retailer
IKEA. Its stores provide goods specifically designed to meet a targeted cost of production,
allowing IKEA to be price-competitive, with its products available to the mass market.
Differentiation strategy
An organisation using a differentiation strategy gains a competitive advantage where its
products or services differ from those of their competitors in a way that is valued by customers.
This difference allows the product or service to be sold at a higher price than those of its
competitors (i.e. at a premium price).
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To successfully pursue a differentiation strategy, an organisation competes by using one or
more attributes:
Its ability to deliver high-quality products or services.
Effective sales and marketing, creating a market perception that its product or service offers
benefits that outweigh those of the competition (brand appeal).
Research, development and innovation.
An example of a differentiation strategy is that followed by the worldwide fashion and luxury
goods retailer Louis Vuitton, which has a strong brand identity of offering high-quality,
exclusive merchandise.
Focus strategy
A focus strategy is used by organisations to gain competitive advantage by tailoring its goods
and related marketing to meet the specific needs of a smaller target market. Of itself, a focus
strategy is not a separate strategy, but describes narrowing the scope over the targeted market,
based on either cost leadership or differentiation. This narrowing may occur on a geographic,
demographic, religious or other basis.
Through understanding its customers needs, an organisation using this strategy can offer either
uniquely low-cost or well-specified products for their chosen market. A focus strategy targeting
a niche market, and concentrating on distinct market segments with unique needs, utilises one
of two strategies:
Cost leadership: Examples include Costco supermarkets (in Australia), and PAK'nSAVE
supermarkets (in New Zealand), both of which target value-conscious shoppers by utilising
a limited range of in-house brands and/or sourcing low-cost options to reduce product
costs.
Differentiation: Examples include companies such as Rolls-Royce, Ferrari and Rolex,
which use a focus differentiation strategy to market their prestige luxury brands in order
to capture a niche market of sophisticated, high-performance products that command
premium prices. Another example is that of a boutique furniture store, which differentiates
itself through the services it provides to customers, such as interior design, colour
coordination and personalised sales service.
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not care about costs it simply means that cost is not the primary driver of decisions within the
organisation.
Larger corporations often resolve this conflict by creating different business units or brands
that pursue different strategies. Some of these companies have evolved to employ both cost
leadership and differentiation strategies. For example, Toyota pursues cost leadership in the
general motor vehicle mass market under its Toyota brand, while in the niche luxury motor
vehicle market it pursues a differentiation strategy with its Lexus brand.
A number of organisations have successfully used a combination of generic strategies to
create a fifth generic strategy known as a best cost provider strategy. This strategy seeks to
differentiate a low-cost offering by providing specific benefits in addition to the cost benefit,
in order to provide greater value to the customer. Best-cost provider strategies are commonly
pursued by internet-based businesses.
These businesses share common characteristics, such as easily available information, fast
delivery times, transaction security and convenient payment methods. Although an internet-
based business is able to provide products and services at a lower cost, this factor can be easily
duplicated and does not assure of itself sustainable cost leadership. Therefore, hybrid strategies
such as best-cost provider strategies are common in these businesses, which often adopt both
a differentiation and a cost strategy. An example is Amazon.com, which exhibits both cost
leadership in product and delivery costs, and differentiation through the way in which it
analyses customer preferences and makes suggestions for further purchases.
These concepts are explored further in the Capstone module.
Learning outcome
4. Describe and analyse organisational structures.
As an organisations objectives are derived from its overall strategy, an organisations structure
is also closely linked to its strategy. As such, if management makes a significant change to an
organisations strategy, its structure needs to be modified to accommodate and support the
change.
As a management accountant, you can play a pivotal role in the success of an organisation
by providing insightful analysis on organisational structures and responsibilities. By
understanding the different ways an organisation can be structured you can help decision
makers operate their business effectively.
What is an organisation?
An organisation is made up of a group of people who work together in an organised way for
a common purpose. It is inherently a social group that distributes tasks among individuals to
achieve a collective goal.
There are many types of organisations: partnerships, corporations, government and non-
government organisations, multinational organisations, charities, not-for-profit organisations
and cooperatives. Some organisations, known as hybrid organisations, operate concurrently
in both the public and private sectors, fulfilling public duties and carrying out commercial
activities.
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According to Daft (2012, p. 12), organisations are:
1. Social entities. Organisations are made up of people who interact with each other to
perform essential functions in the organisation. People are the building blocks of the
organisation.
2. Goal-directed. An organisation exists for a specific purpose: to achieve common goals.
Without this purpose, the organisation would cease to exist.
3. Deliberately structured and coordinated activity systems. This simply means that
organisations are made up of deliberately subdivided work units that perform different
designated tasks in a coordinated manner.
4. Linked to the external environment. Organisations interact with external individuals,
groups and organisations. They consume inputs from this environment, transform or
consume those inputs, and then transfer goods or services back to the external environment.
Organisational structures
An organisation's structure will:
Designate formal reporting relationships.
Group people and departments within an organisation.
Define responsibility centres (e.g. business units or segments) across an organisation.
Attempt to ensure effective coordination, communication and integration of effort across an
organisation.
Organisational structures provide frameworks for top management to delegate duties and
responsibilities across an organisation. In so doing, top management must ensure that
responsibility centre managers make decisions that are congruent with the organisations
overall goals and objectives. Management incentive schemes can be structured in such a way
that bonuses are earned when the goals of both the organisation and the manager are achieved.
Dysfunctional behaviour arises when the goals and objectives of an organisation and its
managers are at odds; that is, in the absence of congruent goals. While competition between
parts of an organisation can be healthy, it can also create internal difficulties.
Organisational charts
An organisations structure is reflected in its organisational chart. This is a visible representation
of the hierarchical structure of responsibility centres and positions that manage business
operations.
The chart usually illustrates relationships between people who have authority to manage an
organisations resources. These relationships are indicated by lines and position: vertical lines
show direct relationships (i.e. the chain of command), while horizontal lines show relationships
between different roles and divisions on the same hierarchical level, known as lateral
relationships. In lateral relationships, parties hold equal positions and cannot command one
another.
In a standard organisational chart, solid lines represent a formal and direct relationship between
positions. A dashed line indicates an indirect or advisory relationship. The following diagram is
an example of an organisational chart:
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Source: Australias Academic and Research Network, May 2013 Organisation Chart.
Source: Australias Academic and Research Network, May 2013 Organisation Chart.
In the organisational chart, a wide span of control results in a flat organisation; that is, one
in which a large number of employees report to one supervisor. Span of control refers to the
number of people who report to a single manager or supervisor (Daft 2012, p. 287). Where
many employees perform similar activities, the span of control can be increased. A narrow span
of control results in a tall organisation; that is, one in which a small number of employees
report to one supervisor, necessitating a larger number of supervisors.
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Functional structure
In a functional (or unitary) structure, activities are grouped together by common function
from the bottom to the top of the organisation (Daft 2012, p. 110). These are the activities
and functions that an organisation must perform in order to carry on its business. Functional
organisations consolidate people and activities into specialised units of knowledge and skills. In
a functional structure, departments, or responsibility centres, report through separate chains of
command, and are joined only at the top.
An example of a functional structure is illustrated below:
CEO
The organisation in this example has been separated into marketing, human resources,
information technology, finance and operations departments, which carry out these
organisational functions. Staff in these functional areas report to department managers, who in
turn report to the CEO. For example, all human resources staff report to the human resources
manager, who reports to the CEO. The CEO is responsible for coordinating internal efficiency
and technical specialisation.
This structure is best suited to organisations that operate within a relatively stable external
environment, involving routine tasks, enduring technology, and minimal interaction between
functions. Typically, the structure works best in small- to medium-sized organisations.
Divisional structure
In a divisional structure, separate responsibility centres are created based on the grouping of
organisational outputs; for example, product lines, services, geographical locations, customer
categories, profit centres or divisions. Divisions are usually headed up by one executive.
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An example of a divisional structure is illustrated below:
CEO
IT IT IT
In this example, each product division has its own separate functional department for
marketing, human resources, information technology, finance and operations. This maximises
coordination across these departments within each of the three product divisions.
The divisional structure is suited to large organisations in an environment of moderate to high
uncertainty. It typically works best in organisations that have multiple product lines or services
and enough personnel to staff their separate functional departments. Divisional structures
require high levels of interaction between functional departments due to their high level of
interdependence. Divisional structures are usually assessed as profit centres; that is, they are
assessed based on both revenues and expenses for planning and budgeting.
Geographical structure
The divisional structure can also be organised so that functional departments are based in the
geographical location or region of a divisions users or customers. This allows divisions to:
Employ staff locally and establish personal relationships with the communities that they
serve.
Better understand the tastes and needs of their markets across the world.
Employees in this type of organisation will often physically work alongside staff from other
functional departments at their respective location. By grouping employees in this way, strong,
collaborative teams that work well together and engage in joint planning and decision-making
are formed.
An example of a geographical divisional structure is illustrated below:
Head office
Western Europe/
Americas Brazil Asia/Pacific Middle East
North Japan
America
Latin
America Australia
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Matrix structure
The matrix structure is a combination of functional and divisional structures. Unlike the vertical
hierarchies that are characteristic of both these types of structures on their own, functional and
divisional structures intersect in the matrix structure: the divisional structure is horizontal,
while the functional structure is vertical.
In a matrix structure, individuals report to both a functional manager and a divisional manager.
In this way, the structure encourages cooperation between functional departments and
divisions; however, lines of responsibility can become blurred. Further, organisations that use
matrix structures tend to be larger because there is a duplication of resources across divisions.
The diagram below reflects a typical matrix structure. The solid lines represent primary
reporting lines while dotted lines represent secondary reporting lines.
CEO
Human
Operations Marketing resources IT Finance
Region to product
manager A
Region to product
manager B
Region to product
manager C
Region to product
manager D
Most organisations find that some variation of either the functional or divisional structure
provides the best horizontal linkages to achieve their goals. In some circumstances, however,
organisations may require a combination that gives priority to both functional activities and
product lines simultaneously. The strength of the matrix structure is its ability to facilitate the
necessary coordination of these two dimensions when an organisation has numerous complex
and interdependent activities.
A matrix structure is best suited to organisations that:
Need to share resources across product lines or geographical regions.
Have organisational goals that involve two or more critical functional and product outputs,
which require a dual authority structure.
Operate in an external environment that is both complex and uncertain.
Have organic structures that facilitate discussion and adaptation to unexpected problems.
Are moderately sized with few product lines.
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may have adopted a divisional structure while others may have adopted a functional structure.
This structure is focused on achieving client satisfaction and functional efficiency.
A hybrid organisational structure is often preferred over either a pure functional or divisional
structure. It overcomes many weaknesses of these structures while providing the advantages of
both.
Horizontal structure
A weakness of the vertical organisational models based on functions or divisions is that they
focus on functional goals instead of on winning customers and delivering value. In addition,
important information can be lost as transactions travel up and down an organisations levels
and across functional departments. Performance objectives may also become fragmented
due to multiple goals, and the creativity and initiative of workers at lower levels stifled.
Further, hierarchical organisations can become slow or unresponsive to change in the external
environment in which it operates.
Today there is a shift toward flatter, horizontal organisational structures. Horizontal
organisations are organised around core work processes and end-to-end work the information
and material flows that provide direct value to customers. Traditional departmental boundaries
disappear. This type of structure recognises that customers drive the organisation and,
consequently, work processes must focus on meeting their needs.
In a horizontal structure, teams constitute the fundamental units or building blocks of an
organisation and are largely self-directed. They are given the skills, tools and autonomy to do
what is necessary to accomplish tasks.
An example of a horizontal organisational structure is illustrated below:
Top
management
team
Market Product
analysis
Research
planning
Testing CUSTOMER
Analysis Material
Purchasing
flow
Distribution CUSTOMER
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Source:
Source:Daft
Daft2012,
2012, p. 127.
p. 127.
Designing organisations
Contingency theory says that to be effective an organisations structure must fit the conditions
of the external environment. What works in one setting may not work in another. Some
organisations operate in a stable environment, use routine technology and desire efficiency.
For such organisations, a functional and bureaucratic (highly formalised) structure may
be appropriate. Likewise, informal management processes are best suited to uncertain
environments that are characterised by changing technology.
Information technology and globalisation have had a significant impact on organisational
structures. Traditional structures based on bureaucratic principles no longer provide solutions
to the challenges that are posed by the external environments organisations encounter
today. Flexibility, adaptability, creativity, innovation, knowledge and the ability to overcome
environmental uncertainties are among the biggest challenges facing many organisations.
The result has been that vertical (tall) structures are being replaced by horizontal (flat)
structures, and mechanistic structures are being transformed into organic structures. These
shifts reflect a clear departure from centralised to decentralised decision-making, from chains of
command to consensus-based self-control.
Control
Control is an important element in the management process, which involves the steps that
managers must take to ensure that organisational strategies are implemented or modified. This
means monitoring the effectiveness of actions and plans, and taking remedial action to correct
deficiencies.
A major part of managements control function involves influencing the behaviour of
employees to ensure that they are aligned to the organisations aims and objectives. Without an
adequate control system, employees may not act appropriately or in the organisations interest.
At the minimum, a failure to maintain adequate control will result in diminished organisational
performance; at the extreme, organisational failure.
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Plan
Execute Correct
Monitor Evaluate
Source: Atkinson
Source: Atkinsonetetal.
al 2007.
2007.
The five stages in the cycle of control are outlined below:
Stage 1 Planning
The first stage involves developing and setting an organisations desired goals and objectives
in an organisational strategy, and then selecting appropriate activities to achieve that strategy.
Standard performance measures to determine whether these objectives are being met are also
determined. These may include budgets, key performance indicators, non-financial measures,
etc. This stage is carried out by the executive level of an organisation.
Stage 2 Executing
In the second stage, senior management coordinates, communicates and implements the
strategy. In addition, it communicates the standards of performance in a quantitative form.
Stage 3 Monitoring
In the third stage, the organisations current performance is measured against the standard or
budget measures that were established in the planning stage. A reporting system is established
to ensure that information is accurate, relevant and timely so that management can properly
identify deviations from the measures.
Stage 4 Evaluating
The fourth stage involves comparing the organisations actual performance to planned
targets. This requires managers to interpret and evaluate information that was provided in
the monitoring process, in order to ascertain the organisations progress, as well as reveal
deviations and identify their probable causes.
Stage 5 Correcting
In the final stage of the cycle of control, corrective action is taken to rectify any circumstances
that have led to a failure of organisational objectives or targets, or other negative deviations that
were identified during evaluation. Corrective action requires considering what can be done to
improve an organisations performance and reviewing its control system.
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Further reading
Daft, RL 2012, Organization theory & design, Chapter 3.
Responsibility centres
Learning outcome
5. Determine the appropriate responsibility centre type for organisations.
Controllability principle
The controllability principle states that the evaluation of a managers performance should
be based only on those factors that they can significantly influence. The application of the
controllability principle to divisional performance measurement results in the need to
distinguish between the performance of divisional managers and the economic performance of
divisions themselves.
An inherent requirement is to distinguish between controllable and uncontrollable factors.
Drury and El-Shishini (2004, p. 5) propose that:
Uncontrollable factors can be classified into the following categories:
costs that are uncontrollable by divisional managers such as group head office general and
administrative costs, taxes, interest and corporate costs; and
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be classified by their focus on costs or expenses, margin or profit, or return on investment.
Financial measures should include any revenue or cost that unit managers can affect, despite
not having complete control over all revenues, expenses or investments.
Revenue centres
Revenue centres are held accountable for revenue, but not for the manufacturing or acquisition
costs of a product or service. Their performance is measured against quotas or budgets.
Revenue centre managers may also be accountable for unit expenses, but their performance is
primarily measured on revenue.
Cost/expense centres
A cost centre manager has control over costs, but not revenue. There are two types of cost
centres:
1. Engineered cost centres. In these centres (found in manufacturing operations or units that
perform repetitive tasks), right and proper cost amounts can be determined with reasonable
reliability, which enables the development of standard costs. Managers are able to decide
on the mix of inputs that is required to maximise output for a given budget. Engineered cost
centres are not evaluated on cost alone. Managers are also responsible for product quality
and volume, as well as efficiency.
2. Discretionary cost centres. In these centres, no right or proper cost amounts can be
objectively determined, since the difference between budgeted and actual costs is not
a measure of their efficiency. They do not incorporate the value of the output. Costs
incurred by these centres depend on what management judges to be appropriate in the
circumstances. Discretionary cost centres include administrative and support units, research
and development units, and marketing activities.
Profit centres
Profit centres are business units that are accountable for both revenue and costs.
A business unit might be responsible for both manufacturing and marketing. In that case, the
manager makes decisions regarding revenue and expense trade-offs. For example, they may
increase marketing expenses in the expectation that this will lead to an even greater increase in
sales revenue and margin.
Decision-making on revenues and expenses should only be delegated to lower level managers
when those managers have access to relevant information for them to make such decisions
and the effectiveness of any trade-offs they make can be measured. Determining where these
conditions exist in an organisation is key. Ultimately, an organisations management must
decide whether the advantages of assigning profit responsibility to unit managers more than
offset the disadvantages.
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Anthony and Govindarajan (2004) identify the following advantages and disadvantages of
profit centres.
Advantages include:
The quality of decisions may improve because they are being made by managers who are
closest to the issues involved.
The speed of decisions may increase since they do not have to be made by top management.
Top management is relieved of day-to-day decision-making and can concentrate on
strategic issues.
Managers are free to exercise their creativity and initiative.
Profit centres provide an excellent training ground for general management. Managing profit
centres is similar to managing companies. Managers gain experience in a range of functional
areas, while top management is able to evaluate their potential for higher level positions.
Profit consciousness is enhanced.
Profit centres provide top management with ready-made information on divisional
profitability.
Because their output is so readily measured, profit centres are particularly responsive to
pressures to improve their competitive performance.
Disadvantages include:
There is a loss of control due to decentralised decision-making and greater reliance on
management reports rather than personal experience.
There may be greater friction in the organisation due to disagreements over appropriate
transfer prices, the assignment of common costs and credit for revenues that were formerly
generated jointly by two or more business units working together.
Organisational units that once cooperated may now compete with each other.
Duplication of activities, which incurs additional costs.
Profit centre managers may make decisions that focus on short-term rather than long-term
profitability.
Investment centres
Investment centre managers have responsibility for both unit profits and investment decisions.
These centres have all of the advantages and disadvantages of profit centres. They also have the
additional responsibility of evaluating decisions to invest in assets.
The use of measures such as return on investment and economic value added are ways of
evaluating the performance of investment centre managers. These are considered in more detail
in the unit on performance reporting.
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Ethics
Learning outcomes
6. Identify professional (ethical) issues that may arise for Chartered Accountants in business.
7. Outline relevant ethical standards and appropriate safeguards for ethical issues that arise.
Professional accountants should want to do the right thing for their organisation, fellow
professionals, society and themselves. At its core, ethics is struggling with the question What
should one do? It is a personal struggle, which is influenced by a persons background, culture
and religious beliefs.
It is also determined by individuals commitment to maintaining an ethical stance, their
awareness of the need to maintain an ethical radar and to perceive ethical implications, and
their competency in addressing ethical issues and making sound ethical judgements to develop
practical problem-solving options.
Chartered Accountants in business are sometimes confronted with dilemmas where they need
to reflect on this question. Often there are competing interests, depending on which stakeholder
is considered and the desire to minimise harm to all parties. In many of these ethical dilemmas
there is no right option, and the accountant must come to a decision that leads to the best
outcome.
Despite the cultural and social influences to ethical decision-making, there is a broad
ethical framework that a Chartered Accountant needs to adhere to. It is important that all
Chartered Accountants are aware of their ethical responsibilities as these apply to their area of
specialisation.
The following examples present ethical dilemmas that can arise for management accountants:
While participating in a tender for a supply of product, the management accountant
is offered an incentive to present information that would lead to a more favourable
recommendation than the facts would support.
The management accountant is required to prepare the performance reports for the board of
directors to use for salary reviews. Their best friend (the production manager) asks if they
could ensure that the production results look good.
The management accountant has been requested to provide revised product cost
information based on closing a factory and opening a new factory offshore. The
management accountant has relatives who currently work in the factory.
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The management accountants own salary is up for review and they believe they are worth
more than they currently earn, especially since they know from the payroll that the sales
representatives earn more than they do.
The management accountant becomes aware that their employer is operating in a manner
that may not be in line with good business practices, but they are also aware that this
behaviour is necessary to maintain sales and thus the viability of the company.
Ethical standards
Like many professional bodies, the accounting profession is regulated by a code of ethics that
governs professional behaviour. These ethical principles and guidelines are set out in the
International Ethics Standards Board of Accountants Code of Ethics for Professional Accountants
(IESBA Code).
The IESBA Code is a framework that assists professional accountants to make ethical
judgements and resolve ethical dilemmas. It provides a process for accountants to:
Understand the issue or dilemma and the stakeholders affected.
Compile information to make an informed decision.
Analyse and understand how the various stakeholders are affected.
Decide on an appropriate course of action.
Given that the management accountant is normally working within a business, then Parts A and
C would be more applicable to their roles and responsibilities. The IESBA Code provides:
Definitions and examples of the fundamental principles: integrity, objectivity, professional
competence and due care, confidentiality and professional behaviour.
Definitions and examples around appropriate safeguards for mitigating ethical issues.
Details of the obligations of Chartered Accountants in business.
Definitions and examples of key threats, including: self-interest, self-review, advocacy,
familiarity and intimidation.
The IESBA Code also highlights the need to use professional judgement in applying the
framework.
While the ethical decision-making tools and techniques outlined in the IESBA Code cannot
provide the answers to every possible ethical dilemma faced by Chartered Accountants working
as management accountants, they provide a good framework for exploring issues that might
arise.
In addition to the IESBA Code, management accountants are often governed by a code of
conduct within their organisation. Many organisations provide policies, procedures and ethical
codes in order to guide ethical decision-making. For example, most larger organisations have
formal policies relating to accepting gifts.
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Increasingly, organisations and their key decision makers are being held legally accountable for
their actions and decisions, along with those of their staff. This has even extended to situations
where they are indirectly responsible.
The following table illustrates some consequences of unethical behaviour:
Risk Consequence/examples
Loss of confidence Unethical behaviour can lead to the loss of faith or confidence in management,
other employees or investors (as illustrated by Tyco executives who were found
guilty of stealing millions of dollars of company funds)
Decline in company value Unethical behaviour can lead to a decline in the share value of the company
(as illustrated by the Australian Wheat Board after it was made public that it
had been making payments to the Iraqi Government to facilitate the sale of
Australian wheat despite UN sanctions)
Company failure Unethical practices may lead to the downfall of a business (such as Lehmann
Brothers) or the downfall of a government (such as in Iceland), both as a result
of unregulated lending practices that contributed to the sub-prime lending
crisis
Required reading
International Ethics Standards Board of Accountants, Code of Ethics for Professional Accountants,
paras 100.1150.2, 300.1300.15 and 340.1340.4.
Quiz
[Available online in myLearning]
ACT
Activity 1.1
Understanding the role of a management
accountant
Introduction
Management accounting is dynamic. There are no set rules governing what a management
accountant does the role varies depending on organisational complexity and the industry.
However, the key purpose of a management accountant is to produce information for
management and decision makers within an organisation. This information should:
assist management with the day-to-day operations
enable management to make effective decisions on the operations and future or strategic
direction of the business.
At the end of this activity you will be able to describe the role of a management accountant
within an organisation.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are a contract management accountant working for Charlene OShay, SDTs CFO.
Charlene feels overstretched. Her finance team is small, with relatively limited experience.
There are simply not enough hours in the day for her to complete all the analyses and reports
that the business needs.
She has raised the issue with Richard Waugh, the CEO, who agreed she should employ a
management accountant to help improve the level of reporting and business analysis within the
organisation.
Task
For this activity you are required to prepare a job description for the new permanent
management accountant.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 1.2
The role of the treasury function
Introduction
As organisations grow, the role of the treasury function changes and develops. The skills
and resources required to run an organisation are also refined, and in such environments
management accountants need to be able to advise on the most practical and appropriate
organisational structures.
This activity links to learning outcome:
Describe the role that the management accounting and treasury functions play within
an organisation.
At the end of this activity you will be able to describe the alternatives available to businesses to
structure their treasury functions.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are a management accountant at SDT and report to the CFO, Charlene OShay.
Richard Waugh, Philip McCaw and SDTs board of advice are examining the purchase of a
business in the USA. The objective of this acquisition is to continue the growth of SDT and
allow the organisation to leverage its intellectual property into new markets. Due diligence for
the acquisition is almost complete.
The US organisation has a slightly different business model to SDT: it regularly provides
services in other North American countries (i.e. Mexico and Canada), with invoices issued in the
local currency. Margins in this market are also less than those that currently exist in Australia
and New Zealand.
SDT expects to finance this acquisition through a mix of equity (cash provided from Australia)
and debt funding in the form of rolling 90-day bank bills provided by a local US bank. Both
Richard and Philip plan to take a direct hand in the management of the US business to ensure
that required targets are met.
The finance/risk committee is considering the implications of the subsequent integration, which
would make the combined business large enough to have a treasury function.
Task
For this activity you are required to prepare a recommendation for the finance/risk committee
on the treasury structure for SDT. You should consider:
Whether the treasury function would be most appropriate as a profit centre or a cost centre
at SDT.
ACT
The applicability of each of the following treasury structures at SDT (and make notes on
each):
Outsourced.
Centralised.
Decentralised.
The most appropriate structure for treasury within SDT and make a recommendation.
ACT
Activity 1.3
Managing stakeholders
Introduction
Management accountants deal with many stakeholders, including the board of directors, senior
management and managers throughout an organisation. An effective management accountant
is able to determine the information needs of their stakeholders, undertake analyses to satisfy
those needs and communicate the information concisely.
This activity links to learning outcome:
Determine stakeholders, explain their different objectives, information needs, and how these
can best be satisfied.
At the end of this activity you will be able to identify stakeholders, determine their information
needs and produce management accounting information that responds to those needs
effectively.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are a management accountant working for Charlene OShay, SDTs CFO. Charlene is
concerned that primary stakeholders are not getting the information they require in relation to
SDTs operations.
She is particularly concerned about sales and gross margin information.
Task
For this activity you are required to create a table that identifies the primary stakeholders for
sales and gross margin information and their information needs.
Your table should:
Identify the primary stakeholders (or stakeholder groups) for sales and gross margin
information at SDT.
Explain their different objectives.
Outline their information needs, including:
what information they need
the level of detail they require
the time frame they require it in.
Recommend how sales and gross margin information could be presented to meet
stakeholder needs.
ACT
Activity 1.4
Identifying generic strategies
Introduction
The generic strategy framework developed by Michael Porter is a useful tool to analyse the
competitive strategies of organisations. Understanding an organisations strategic goals and
objectives is an important step in adding value as a management accountant to ensure all
analysis and advice is aligned to those objectives.
This activity links to learning outcome:
Outline generic strategies that organisations use.
At the end of this activity you will be able to outline the characteristics of each of the generic
strategies and identify which strategy is being pursued by an organisation.
It will take you approximately 20 minutes to complete.
Scenario
You have recently applied for a position as a management accountant at Wanderlust Travel
Insurance (Wanderlust), reporting to the CEO, Albert Mangels.
Wanderlust provides budget travel insurance policies exclusively over the internet. It aims to
be Australias biggest travel insurance provider and has a limited range of policies targeted at
travellers who want coverage for the essentials (e.g. medical expenses), but not all the extras
(e.g. cover for extreme sports or hijacking).
Wanderlust boasts that its premiums are 30% lower than the average premium paid by
travellers. Its website is maintained offshore in the Philippines, and its call centre, which
handles customer service (including initial claims enquiries), is based in India.
The actual processing of claims is outsourced to a specialist travel insurance claims provider,
which assesses and manages the claims for a fixed fee per policy sold. The Australian office has
some management, product development, and finance and risk management staff.
You have a job interview with Albert tomorrow and are researching Wanderlust to understand
its business strategy. You want to familiarise yourself with Wanderlusts business and impress
Albert in the process.
Task
For this activity you are required to identify which of Porters generic strategies Wanderlust
appears to have adopted. Justify your conclusion.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 1.5
Analysing organisational structures
Introduction
As a management accountant you will be required to consider how an organisations structure
reflects its chain of command, and how this is mirrored by the responsibility accounting system.
For this activity you are required to assess different organisational structures, how they affect
the flow of information to CEOs and, as a corollary, responsibility reporting.
This activity is linked to learning outcomes:
Describe and analyse organisational structures.
Determine the appropriate responsibility centre type for organisations.
At the end of this activity you will be able to distinguish between different organisational
structures and assess how these structures may affect the flow of information and managerial
roles.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) and Accutime Limited (Accutime) case
studies.
You are the new management accountant at Accutime. Having previously worked at SDT, you
are keen to understand the differences between the organisations so that you can adapt your
role accordingly.
Task
For this activity you are required to identify the differences between SDT and Accutime. You
should consider:
The organisational structures of both Accutime and SDT.
How each organisations structure affects the way in which the respective CEOs will be able
to access information and make effective decisions on a timely basis.
Any risks inherent in the respective structures.
The different responsibility reporting requirements of John Williams at Accutime, and the
head of business operations for SDT Solutions, Melbourne. Think about what organisational
centres each would be responsible for.
ACT
Activity 1.6
Identifying responsibility centres
Introduction
As a management accountant you can play a pivotal role in the success of an organisation
by providing insightful analysis on organisational structures and responsibilities. By
understanding the different ways an organisation can be structured, you can help decision
makers operate their business effectively.
This activity links to learning outcomes:
Describe and analyse organisational structures.
Determine the appropriate responsibility centre type for organisations.
At the end of the activity you will be able to identify different business structures and their
corresponding responsibility centre types.
It will take you approximately 30 minutes to complete.
Scenario
You are a management accountant at Steaming Cup, a chain of coffee shops. You report to
Aime Prez, the financial controller.
The head office of Steaming Cup is located in Melbourne, with all stores positioned on the
eastern seaboard of Australia. Steaming Cup has just opened its 18th store at Sydneys Circular
Quay.
The company has plans to expand in the next year or so by introducing franchising
arrangements.
The head office manages the entire operation other than the day-to-day operation of the shops.
Role Operation
Head office Determines all Steaming Cup shops food and beverage menus (including pricing)
Selects sites for all new shops
Determines the completed fit-out
Supplies (on a cost basis) all necessary equipment for the shops to function
Purchases products, such as coffee beans and sugar, in bulk for all shops
Develops and coordinates all marketing activities
Shop manager Serves the same food and beverage menu as all other shops, as determined by head office
Conducts marketing activities as determined by head office
Orders food and beverages from head office
Decides on the staffing requirements and quantities of food and beverages to be ordered
Determines the shops hours of operation
The senior management team of Steaming Cup has concerns that the new shop in Circular
Quay was not a good choice of location and has asked Aime to determine whether the shop is
a revenue centre or a profit centre.
Aime has asked you to help her with her review.
ACT
Task
You are required to identify whether Steaming Cups shop at Circular Quay is a revenue centre
or a profit centre and then:
Assuming that the Circular Quay shop is a revenue centre, outline how this might impact
on the management of the shop.
Assuming that the Circular Quay shop is a profit centre, outline the information you believe
the shops manager should receive in order to have and maintain financial control.
ACT
Activity 1.7
Managing ethical issues
Introduction
In undertaking their work, accountants in business are likely to encounter ethical dilemmas that
have an impact on themselves, internal stakeholders and occasionally external stakeholders.
Chartered Accountants working in business may be more frequently exposed to situations
where their own personal ethics are challenged. Ethical issues in these cases arise from the
management accountant holding a position that is deeply embedded within the organisation.
Here their behaviour and actions can be influenced by the culture and key performance
indicators (KPIs) of the organisation.
The consequences of a management accountant not acting ethically within a company include
loss of investor faith and exposing the company to reputational risk that could lead to ongoing
viability issues.
This activity links to learning outcomes:
Identify professional (ethical) issues that may arise for Chartered Accountants in business.
Outline relevant ethical standards and appropriate safeguards for ethical issues that arise.
At the end of this activity you will be able to identify ethical dilemmas and outline appropriate
safeguards to manage the threat to fundamental principles.
It will take you approximately 20 minutes to complete.
Scenario
You are a Chartered Accountant and the management accountant at Enterprise Limited
(Enterprise). For the past five years you have worked as the manager of finance and
administration.
You are currently facing a number of ethical dilemmas.
Ethical dilemmas
Dilemma Details
Dilemma one As part of your role with Enterprise, you are responsible for the supplier negotiations for
all office stationery. One of the major suppliers, Max and Max Supplies, has invited you to
attend an all-expenses paid fishing trip, including overnight accommodation and evening
entertainment. The formal invitation stated We want to celebrate with you the achievement
of our most profitable year
Your Max and Max Supplies contact has advised you that CEOs and CFOs from many top
organisations will be attending, so it will be a good opportunity for you to network and to
hand out your rsum
Dilemma two You have been to a confidential meeting about the future plans of the company. The plans
include a proposed restructure, which involves closing down a major part of the nearby
factory. You personally know many of the factory workers and some of their financial
hardships, as you have often been used in the past by some of the factory staff as a budget
advisor and counsellor
In the meeting, the CFO asked you to prepare cost-saving calculations for the proposed
restructure, including identifying 70% of the factory workers to be included in potential
redundancy packages
ACT
Ethical dilemmas
Dilemma Details
Dilemma three In preparing the current months financial results, you notice a material error you have made
in a previous month that no-one has noticed
You have received a warning for careless mistakes in the past
Tasks
For this activity you are required, for each ethical dilemma, to:
Describe the key ethical issues.
Identify the fundamental principle(s) at risk, in accordance with the International Ethics
Standards Board of Accountants Code of Ethics for Professional Accountants (IESBA Code).
Identify the key threats to compliance with the fundamental principle(s).
Describe possible safeguards to eliminate the threats or reduce them to an acceptable level.
Readings
Required reading
International Ethics Standards Board of Accountants, Code of Ethics for Professional Accountants,
2015 edn, International Federation of Accountants, paras 100.1150.2, 300.1300.15 and
340.1340.4, accessed 23 July 2015, www.ifac.org Publications & Resources 2015Handbook
of the Code of Ethics for Professional Accountants.
Further reading
Business briefing series, May 2012 (20 issues on the increasing significance of corporate
treasury), Institute of Chartered Accountants in Australia, Sydney, accessed 11 March 2014,
www.charteredaccountants.com.au News & Media Reports & insights Business
briefing series.
Hope, J 2006, Reinventing the CFO, Harvard Business Review Press, Boston, USA.
In the following interviews, Jeremy Hope discusses his ideas in Reinventing the CFO around the
accounting functions within organisations:
(a) Jeremy Hope, Reinventing the CFO Part 1, YouTube 2008, www.youtube.com Jeremy
Hope, Reinventing the CFO Part 1 (accessed 30 July 2015).
(b) Jeremy Hope, Reinventing the CFO Part 2, YouTube 2008, www.youtube.com Jeremy
Hope, Reinventing the CFO Part 2 (accessed 30 July 2015).
(c) Jeremy Hope, Reinventing the CFO Part 3, YouTube 2008, www.youtube.com Jeremy
Hope, Reinventing the CFO Part 3 (accessed 30 July 2015).
Daft, RL 2012, Organization theory & design, 11th edn, SouthWestern/Cengage Learning, Mason,
OH, USA, Chapter 3.
References
Ideas for this unit were sourced from the following references:
Anthony, RN and Govindarajan, V 2004, Management control systems, 11th edn, McGraw Hill/
Irwin, Boston/London.
Atkinson, A, Kaplan, R, Young, M and Matsumura, E 2007, Management accounting, 5th edn,
Pearson Education Inc., Upper Saddle River, NJ, USA.
Atkinson, A, Kaplan, R, Young, M and Matsumura, E 2012, Management accounting: information
for decision-making and strategy execution, 6th edn, Pearson/Prentice Hall, Upper Saddle River, NJ,
USA.
Australias Academic and Research Network, May 2013 Organisation Chart, accessed 1 July
2013, www.aarnet.edu.au About Us Overview Organisation Chart.
Burns, T and Stalker, GM 1961, The management of innovation, Tavistock, London.
Daft, RL 2012, Organization theory & design, 11th edn, SouthWestern/Cengage Learning, Mason,
OH, USA.
Daft, RL 2006, Organization theory & design, 6th edn, SouthWestern/Thomson, Mason, OH, USA.
R
Drury, C and El-shishini, H 2004, Applying the controllability principle and measuring
divisional performance in UK companies, Research Executive Summaries Series, vol. 1, no. 8,
Chartered Institute of Management Accountants,.
Eldenburg, LG, Brooks, A, Oliver, J, Vesty, G and Wolcott, S 2011, Management accounting,
2ndedn, John Wiley & Sons Australia, pp. 326332.
Hoque, Z 2003, Strategic management accounting: concepts, processes and issues, 2nd edn, Pearson
Australia, pp.108111.
Horngren, C, Wynder, M, Maguire, W, Tan, R et al. 2011, Cost accounting: a managerial emphasis,
1st Australian edn, Pearson Australia, pp. 125132, 671695.
Miller, D 1992, The generic strategy trap, Journal of Business Strategy, vol. 13, no. 1, pp. 3742.
Porter, ME 1980, Competitive strategy, Free Press, New York, USA.
Porter, ME 1985, Competitive advantage, Free Press, New York, pp. 3343.
Polk, P and Klusek, I 2010, Centralization of treasury management, pp.1214, 2128, accessed
11March 2014, http://aei.pitt.edu search for Centralization of treasury management.
Proctor, R 2009, Managerial accounting for business decisions, Pearson Education, Harlow, UK.
Rio Tinto company profile, Rio Tinto website accessed 31 July 2015, www.riotinto.com
About us About Rio Tinto.
Rio Tinto 2014 Financial statements (note 30), Rio Tinto website accessed 31 July 2015,
www.riotinto.com Annual Report 2014 extract of note30.
Simons, R 2000, Performance measurement and control systems for implementing strategy, Prentice
Hall, NJ, USA.
Thompson, AA, Strickland, AJ and Gamble, J 2007, Crafting and executing strategy: concepts and
readings, 15th edn, McGraw-Hill, New York, USA.
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Core content
Unit 2: Analysing business operations
Learning outcomes
At the end of this unit you will be able to:
1. Classify value chain activities in accordance with Porters value chain classifications.
2. Identify an organisations competitive advantage using value chain analysis and
recommend strategies to improve it.
3. Apply appropriate decision models to short-term decisions such as outsourcing, product
line development, product mix and supply chain analysis.
Introduction
In an ideal world, management identifies and uses the most efficient means for its organisation
to meet customers needs and thereby maximise profits. However, the reality is that
inefficiencies do exist and new opportunities present themselves, therefore an organisation
needs to continuously reinvent itself and look for areas to improve. Value chain analysis is a
powerful tool for helping to analyse business operations as part of this process.
As discussed in the unit on the introduction to management accounting (including ethics), itis
essential for an organisation to identify its core competencies and strategic resources in order
to determine its strengths and areas of competitive advantage. The business should analyse
its value chain, as this will assist in the design of strategies aimed at creating resource value.
Porter sees this as the framework for deconstructing all the activities in which the organisation
engages.
The management accountant adds value to this process through having a detailed
understanding of the organisation, including how the business operates and its core
competencies.
maaf31502_csg
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Learning outcomes
1. Classify value chain activities in accordance with Porters value chain classifications.
2. Identify an organisations competitive advantage using value chain analysis and recommend
strategies to improve it.
Example A successful value chain built upon the organisations generic strategy
A low-cost provider in the airline industry such as Virgin will ensure that the value chain reflects
the lowest costs possible in order to be able to provide customers with tickets at the lowest
price. This is reflected in the fact that, for example, meals have been excluded from the value
chain. Customers who wish to consume food on the plane pay extra to include the meal as part
of their flight experience. This means that customers will not systematically pay for any value
chain activities that they do not require or value.
Porter argues that the ability to perform particular activities or to manage the linkages between
these activities more efficiently than a competitor is a potential source of competitive advantage.
Such linkages, which include flows of information, as well as goods and services, are crucial to
an organisations success.
Value chain analysis describes the activities that an organisation performs and the interlinked
activities of organisations with which it interfaces. These linkages support the organisations
competitive position. Information from the value chain analysis can be used to create a
competitive advantage for the organisation/s and add value for all stakeholders (including, but
not limited to, customers, employees and shareholders).
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Other examples of value chain decisions include:
Transferring responsibility for the delivery of products to the customer (the customer picks
up or pays for transport).
Creating a global network of low-cost suppliers (purchasing from the most economic
suppliers and taking into account location, quality and price for example, a cooperative for
sourcing products, effectively increasing the buying power of the organisation).
Offering technical assistance to suppliers (thereby ensuring components supplied are
tospecification).
Customers refilling their own car with petrol versus full-service petrol stations.
Value-added considers what value the product or service brings to the customer. Within the
value chain, some of the components may add value from the customers perspective while
others may not they may simply add cost.
Example of a value-added decision: Add-on accessories in the auto industry, where extra items
such as satellite navigation or a sunroof add value, from the customers perspective, to the final
product. This may lead to increased profits for the organisation through increased sales volume
and/or increased sales price.
Other examples of value-added decisions include:
Employing specialist staff and adding entertainment in a childrens hairdressing
environment, thereby ensuring a less stressful service experience for which customers are
prepared to pay a premium.
An airline providing various classes of waiting lounges and in-flight service depending
onthe status of passengers.
After-sales support for computer purchases.
The illustration below shows how the concepts of value chain and value-added are applied
inthe sale of motor vehicles.
STANDARD OPTIONAL
FEATURE EXTRAS
ABS Sat nav
Air-conditioning Sunroof
Air bags Tinted windows
DESIGN MANUFACTURE SHIPMENT RETAIL 4WD
By combining value chain and value-added analysis, opportunities may be identified to either
remove cost from a product or service (by removing non-value-adding steps), or increase the
value of a product to the end-consumer (which may allow for an increase in the selling price).
Not all value chain activities add value from the customers perspective. Examples of value
chain activities that often do not add value, but may be required to get the product or service
tothe customer, include:
transport of components
storage of inventory
packaging.
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Primary activities those directly related to the organisations output.
Support activities those enabling the organisation to efficiently complete its primary activities
and indirectly related to the organisations output.
PRIMARY ACTIVITIES
Operations
After-sales
Outbound
Marketing
and sales
Inbound
logistics
logistics
services
MARGIN
Administrative infrastructure
CUSTOMER
ACTIVITIES
SUPPORT
HR management
Technology development
Procurement
Primary activities: Inbound logistics ordering fuel, energy, raw materials, parts, components,
merchandise, and consumable items from vendors; receiving, storing and disseminating
Primary activities
inputs from suppliers; inspection and inventory management
have a direct link to
providing goods or Operations converting inputs into final product (i.e. production, assembly, quality
services assurance)
Outbound logistics physically distributing the product to buyers/customers
(i.e.finished goods warehousing, order processing, order picking and packing, shipping)
Marketing and sales sales force efforts (e.g. advertising and promotion, establishing
and maintaining a network of dealers and distributors, and market research)
After-sales services providing assistance to buyers/customers, such as installation,
spare parts delivery, maintenance and repairs, warranty claims, technical assistance,
buyer enquiries and complaints management
Support activities: Administrative infrastructure office of the CEO, accounting and finance, legal, risk
management, regulatory affairs, strategic alliances, property services, safety and security,
Support activities
management information systems and overhead functions
improve the
efficiency with HR management recruitment, industrial relations, training, management of work
which primary health and safety, employee support, performance management
activities are
Technology development product R&D, process R&D, process design improvement,
delivered (i.e. they
equipment design, telecommunication systems, computer-assisted design and
support primary
engineering, database capabilities, and development of computer support systems
activities)
Procurement strategic sourcing, contract negotiation and supply tendering
Some activities can overlap categories or may be more appropriate under a different category,
depending on the organisation. In these cases, classification should consider the functional area
responsible for the activity. For example, payroll could be considered under Administrative
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infrastructure if prepared by Finance, but would be more appropriately classified as HR
management if prepared by Human Resources.
1. How much value does the product or service add for customers today?
For any given product specification, customers generally do not simply look for the cheapest
product from the cheapest supplier. Rather, they look for the best value supplier of a product
of the desired quality, taking account of all the costs of dealing with that supplier. These costs
involve much more than the sale price and are not always measured in dollars; for example,
experiencing frustration or being served poorly at any point of contact has a cost but no dollar
measure.
This question takes into account every point of contact between the customer and supplier,
including more than just the physical process of transferring the product to the customer.
Points of contact could include the sales process, the transfer of the physical product or service,
payment systems, and after-sales service. Costs associated with any of these points will detract
from the organisations attractiveness as a supplier.
It is important to realise that the value within this question is from the customers perspective,
and is not the same as customer profitability analysis, which looks at a customers profitability
from the suppliers perspective.
When assessing how much value the product or service adds for the customer, an analysis
would include an industry review identifying both cost and differentiation advantage (see
the discussion on generic strategies in the unit on introduction to management accounting
(including ethics)). More specifically, it would also include the basic structure and sources
of cost advantage within the industry, competitors and their competitive positioning, and
an appraisal of the organisations own position. This evaluation assists the organisation in
developing cost or differentiation strategies to enhance its own competitive advantage.
Example: Bread suppliers that supply products directly to supermarkets know that consumers
value fresh bread and, therefore, they typically deliver daily to every supermarket and stack the
shelves themselves. This gives the bread supplier control of the quality of product being sold,
and saves the supermarket the need to monitor stock levels and stack shelves. In many cases,
there is also a direct link to the supermarkets point-of-sale system, meaning the bread supplier
is able to monitor stock movements and plan accordingly.
By contrast, suppliers of most other supermarket products deliver in bulk to the supermarkets
central warehouse. The warehouse distributes the products to the individual supermarkets,
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which then put the products on the shelf. This double handling and warehousing adds cost but
does not add value from the consumers perspective.
2. How can costs that do not add value for the end-customer be stripped from the value
chain?
In many organisations there is scope for removing activities along the value chain that do
not add value to the end-customer. These activities usually occur at points where different
organisations in the value chain intersect.
The diagram below illustrates opportunities to remove costs that do not add value to the
endcustomer from the value chain.
SUPPLIER 1 2 3 4
END-CUSTOMER
The end-customer only wants a quality product available when required. If it were possible to
produce the product on demand and deliver direct to the end-customer, then nonvalueadding
activities (in this instance, the material handling, warehousing, packing and unpacking costs)
can be eliminated and costs can be stripped out of the value chain without affecting the
endcustomer.
Where processes are interlinked between organisations, making changes requires cooperation
between the parties involved. (Arguably, cooperation is more likely when both parties share the
benefits of the cost savings.) Where good measurement and management systems are in place
(and therefore processes are understood), negotiating change is easier because there is shared
understanding and an objective basis for discussion and inter-company cooperation.
3. How can a value chain perspective provide extra value for customers?
Beyond identifying cost savings, value chain analysis can also be used to identify opportunities
to create new value or eliminate or bypass non-value-adding links.
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While not part of this unit, note that identifying ways of saving costs or enhancing value does
not determine how the resulting benefits are shared between the various parties in the value
chain. For example, will it lead to higher prices and/or enhanced profit for the supplier, or lower
prices and/or enhanced utility for the customer, or some mix of both? The ultimate split in
value-add will depend largely on the bargaining power of the various parties.
Worked example 2.2: Using value chain analysis to assess competitive advantage
[Available online in myLearning]
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Learning outcome
3. Apply appropriate decision models to short-term decisions such as outsourcing, product line
development, product mix and supply chain analysis.
Following an analysis of an organisations value chain, the next step is to identify areas of
business opportunity or process improvement. Resulting programs may include cost-reduction
initiatives to reduce or eliminate non-value-adding activities not related to competitive
advantage. Other opportunities include strategic alliances with suppliers or customers
to explore supply chain or product innovations. Management need to determine which
alternatives to pursue first and what actions provide the greatest long-term benefit to the
organisation. In order to do this effectively, management need to employ appropriate decision-
making models.
Decision-making models
Decision-making is the act of weighing up two or more alternatives and selecting one course of
action. A decision produces one final choice.
A decision-making process involves the following steps:
1 2 3 4 5 6 7
Identify and Identify what Generate Evaluate the Make a Implement Monitor
agree the the ideal possible alternative decision based the decision the decision
problem solution would alternative solutions on the
be and the solutions according evaluation
criteria by to the criteria
which this
would be
measured
2. Identify what the ideal To articulate what the organisation hopes to achieve by addressing the
solution would be and problem, and what an ideal end-state would be
the criteria by which this
To provide measures to ensure there is a rational basis to evaluate potential
would be measured
solutions
3. Generate possible To explore the range of options available and not be locked into existing
alternative solutions thinking (it is not possible to solve a problem with the same thinking that
created it in the first place)
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4. Evaluate the alternative To formally review each alternative and ensure that a rational assessment
solutions according to the ismade of each
criteria
To rank and present the various alternatives based on ability to solve the
problem according to the criteria set
This is where the management accountant will provide substantial input.
Thereare many frameworks and financial models available to evaluate
financial problems
5. Make a decision based on To formalise the point at which one alternative is chosen and a commitment
the evaluation made to it
6. Implement the decision To make the changes necessary and implement the solution that will resolve
or mitigate the original problem
Note that an effective implementation means putting the right people
in charge of managing it, and these may not be the same as those who
identified the problem
7. Monitor the decision To determine whether the decision is effective and, if not, to revisit and take
remedial action. This may involve going back to Step 2 and changing the
decision made; or it may involve going back to Step 4 and changing the
decision or revisiting and finetuning aspects of the decision
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1. Can the activity be performed To maximise profit, the A heavy engineering organisation
or produced at a lower cost, organisation requires the best may outsource the production
more efficiently, or to a better value supply of a product or of an electronic part requiring
quality by outside suppliers? service of the desired quality, sophisticated electrical engineering
taking into account all the expertise that it does not have
costs of the product or service.
Theonly proviso would be subject
toprotection of core competencies
and competitive advantage of the
business
Best value supply may be to
produce internally or to purchase
externally
2. Is the activity a part of The organisation would not want A fast food franchise with a
the organisations core to give away its trade secrets or particular recipe that makes its
competencies? control of activities, which are key product unique and desirable
to delivering its customers value would not want to lose control of
and to its competitive advantage this trade secret
Consider, for example, what would
occur if your competitor also
outsourced the same aspect of its
business to the same supplier
3. Does the activity rely on Unless the core competency of the Many computer manufacturers use
rapidly changing technology? business is in the development Intel processors in their products.
of rapidly changing technology, Intel does all of the product
it is unlikely to be cost-effective research and development and has
to develop this expertise and a reputation for a quality product
capability in-house
Computer manufacturers leverage
the strong Intel brand as part of the
value their product brings to the
customer
4. Will outsourcing the activity To ensure the best use of limited It may be possible to enter into
result in business process resources, if outsourcing an activity a vendor-managed inventory
improvements such as will lead to process improvements agreement where the outsource
reduced lead time, greater and cost savings, then it should be vendor takes total responsibility
flexibility or reduced inventory considered, subject to protection for the supply of stock. In the
levels? of core competencies and case of supply to retail outlets,
competitive advantage of the the agreement may extend to
business restocking and display of inventory.
An outsource supplier may agree
The business should always be
to keep a buffer inventory of
open to initiatives such as reduced
raw materials and components,
lead time, shared warehousing,
thus ensuring rapid delivery of
greater flexibility and reduced
requirements
inventory levels
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Direct materials
Direct labour
In the make-or-buy analysis, the costs to make are compared to the full cost of sourcing from an
external vendor; that is, purchase price plus inward freight and any other costs.
To quantify a make-or-buy decision, two decision models are commonly used the relevant
and differential cost model and the opportunity cost model. Each model takes a different
focus:
Combination
Note that in some circumstances an analysis combining the results of the two models would be appropriate.
For example, when evaluating the outsourcing of component manufacture (cost reduction), which would free
up capacity to allow the manufacture of a new product (opportunity cost).
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During the latest year, AEL manufactured 3,000 gearbox cogs, and it projects that demand for
the current year will be the same.
The costs of these 3,000 gearbox cogs currently made in-house by AEL during the latest year
are calculated as follows:
Total 390,000
Make Buy
* Allocated administrative fixed overhead is not included in the relevant avoidable cost calculation
because these costs will continue to be incurred irrespective of the make or buy decision taken.
Non-financial issues that need to be considered
The financial difference in favour of the buy alternative is relatively small (only about 3% of
relevant costs), and there may be qualitative issues that lead to a make decision.
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Below are examples of qualitative issues that Daniel would need to consider:
Expected future demand and whether AEL has any capacity constraints. If so, what is
the fixed cost of moving to the next level of production capacity? Any restrictions in the
quantities Tinwald Engineering would be able to provide if AEL decide to outsource? Break-
even point is 3,500 gearbox cogs.
Whether there are any current quality issues that could be encountered/resolved through
outsourcing?
Whether a buy decision will lead to additional costs such as:
ordering
inward freight
warehousing space
working capital for additional inventory holding
vendor contract negotiation, management and quality monitoring?
Whether a buy decision will cause increased lead times or disruption to continuity of
supply?
Whether AEL should continue to make the cogs in order to maintain control over any
intellectual property in the design and manufacture of them?
What is the financial strength and track record of Tinwald Engineering?
The risk that Tinwald Engineering could increase the price after it has gained the contract also
needs to be managed. To minimise this risk, companies usually enter into long-term contracts
with suppliers, specifying not only price, but also quality and delivery schedules.
Further reading
Horngren et al. 2011, Cost accounting: a managerial emphasis, pp. 125132.
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There is a capacity constraint on the regular machine of 2,000 hours per year (50 weeks
40 hours), but there is no binding capacity constraint for the high-precision machine. The
budgeted fixed manufacturing overhead costs of the high-precision machine include an
annual operating lease payment of $15,000. Due to alternative customers for the high-precision
machine, the operating lease may be cancelled at any time without penalties. All other fixed
manufacturing overhead costs are truly fixed and cannot be changed.
In order to make the optimal product mix decision the company management accountant
must determine:
How many units of regular and superior couplings will maximise the companys profit?
The calculations below provide the answer:
On the basis of contribution margin per unit, it would seem (superficially) that Tinwald
Engineering may be better off producing only the regular couplings. However, this ignores the
impact of the capacity constraint on the regular machine. Therefore, the next step is to calculate
the contribution per hour of the constrained resource of the regular machine:
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On the basis of contribution per hour on the constrained regular machine, it would seem that
Tinwald Engineering should devote all production to the manufacture of superior couplings.
While this may ultimately be the correct decision, it fails to take account of one further
factor the avoidable fixed overhead costs relating to the cancellable operating lease on the
highprecision machine. The correct numerical analysis is shown below:
Total contribution from selling regular only (2,000 hours $50) $100,000
Total contribution from selling superior only (2,000 hours $60) $120,000
The final analysis shows that the optimum product mix is still to make and sell superior
couplings only, but the difference is small.
In practice, there may be other considerations before a final decision is made. For example,
would dropping the regular product line have an adverse effect on sales of the remaining
superior product? Or, is it possible to remove the constraint on the regular machine by working
asecond shift or purchasing another machine, and therefore enable the company to make and
sell both products to earn more profits in total?
Further reading
Atkinson, A, Kaplan, R, Matsumura, E and Young, M 2012, Management accounting information
for decision-making and strategy execution, pp. 7896.
CONVEY TRANSPORT
DEVELOP EXTRACT PROCESS COAL
COAL COAL TO
SITE SURFACE COAL to customer
or port
Then consider the interrelationships between the underground coal mining operation and those
organisations that are suppliers to and customers of it. The following diagram illustrates the
different supply chains and shows how suppliers and customers are often interlinked and have
to work together to achieve the end goal of producing goods and services to satisfy end-user
requirements:
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Set up and
Set up and
maintain power
maintain mill
plant
Transmit Steel
electricity transportation
THERMAL COKING
COAL COAL
UNDERGROUND
CUSTOMERS
COAL MINING CUSTOMERS
OPERATION
Inbound logistics
receive steel
+ equipment
+ goods & services
Develop and
maintain site
Convey coal to
surface
Process coal
Thermal coal
Coking coal
Transport coal
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By understanding the value chain and seeking opportunities to enhance their supply chain,
companies have the opportunity to improve strategy, cut costs and create value. Examples of
how this might be done include sharing warehouse facilities, co-locating so that transportation
costs are eliminated, and undertaking joint process improvement studies. The above illustration
highlights how when companies are interrelated such improvements are symbiotic all parties
benefit from the change.
The large American retail chain, Wal-Mart, is an example of an organisation that has built its
growth and success around its supply chain. Over the past couple of decades Wal-Mart has
developed, used and refined its supply chain to achieve significant cost advantage that has
underpinned its dominant everyday low price strategy.
This is demonstrated in Wal-Marts handling of its supply chain in the delivery of fruit and vegetables
to its customers. Here, Wal-Mart planned to cut $1 billion in costs through supply chain changes
involving sourcing, packaging, and transportation. One way of achieving this was by establishing more
direct relationships with farmers to achieve more consistent prices and by re-examining relationships
with supply chain service providers such as produce brokers, transportation suppliers and logistics
providers.
Source: Wal-Mart Cooks Up Supply Chain Savings, The Journal of Commerce, 31 January 2011.
As a result of the above strategy, Wal-Mart developed more direct relationships with suppliers,
helping to develop more consistent prices and improve supply processes. Other reported
examples of Wal-Marts supply chain initiatives include establishment of distribution centres
close to retail stores, streamlining procurement processes, use of point-of-sale retail data and
flow-through distribution.
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3. Internal failure costs result from unsatisfactory quality within the company, including
losses from materials and products that do not meet specification.
4. External failure costs result from unsatisfactory quality outside the company. This covers
all measurable costs associated with inferior quality products shipped to customers.
Cynthia Rose is a management accountant working for Real Toys who has been asked to
undertake the following tasks:
(a) Calculate the predicted quality cost savings from the design engineering work.
Cynthia calculates the result of each of the savings provided, and then totals them to determine
the expected total savings.
111,000
(b) Real Toys spent $60,000 on design engineering for the new toy robot. Calculate the
net benefit of this preventive quality activity.
Cynthia calculates the net benefit of the preventive quality activity as $51,000 (expected total
savings of $111,000 less the cost of the design engineering $60,000).
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(c) Outline the major difficulty Real Toys managers would have had in implementing this
COQ approach. Identify an alternative approach they could use to measure quality
improvement.
Cynthia determined that it would be difficult to measure the cost-of-quality approach because:
Estimating some costs, such as the cost of design engineering to improve the quality of
aparticular product, may require the allocation of engineers salaries.
Estimating other costs, such as the cost of lost sales, would not be recorded in the accounts
and would be difficult to predict.
In order to measure COQ properly, Cynthia noted that it will also be necessary to monitor
nonfinancial measures of quality (e.g. number of machine breakdowns and number of
customer complaints) and attempt to improve them.
Source: Adapted from Horngren et al. 2004, Accounting: International edition, 6th edn, ExerciseP25-6A.
Attribute Benefit
Production processes are carried out Cost savings through co-location, being reduced handling and
in groups of machines to minimise the more streamlined processes
amount of materials movement and
handling. These groups of machines are
often called manufacturing cells
Suppliers of raw materials and components Cost savings through elimination of the need for raw material
are chosen for their ability to deliver stock on hand
quality items in a timely manner. In some Cost savings through improved quality of raw materials
cases this may be daily or even several
Reducing waste
times a day
Reducing the need for rework
Increasing customer satisfaction with fewer complaints due
toquality issues
Workers are multi-skilled and capable Cost savings through improved employee job satisfaction
of performing a variety of operations, athaving more variety in their work
including routine machine maintenance Cost savings through reduced staff turnover
Cost savings through more knowledgeable and empowered
staff having the ability to detect and correct below-standard
production
Cost savings through less machine breakdowns, with staff
having the ability and being empowered to undertake routine
machine maintenance
Increased staff satisfaction due to reduction in repetitive work
Machine set-up times are reduced as far Cost savings through machines being available when required
as possible, thus eliminating unnecessary Cost savings through ability to achieve higher utilisation
waiting time ofmachines
Defects are located as soon as possible Cost savings through early detection of below-standard
by trained, multi-skilled workers, thus production, leading to early correction
reducing the downstream effects of Cost savings through reduced waste due to early detection
defective production ofbelow-standard production
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Attribute Benefit
Effective forecasting and planning systems Cost savings through eliminating the need to hold finished
are used to manage production to align goods pending orders
with demand Cost savings through better ability to plan for full utilisation
ofmachines
Cost savings through ability to plan and optimise staff
resources
Increased communication across the organisation
Often, JIT results in inventory levels being pushed back down the supply chain. Not all
organisations have a sufficiently strong bargaining position to be able to insist that suppliers
take on this additional cost. While JIT can provide benefits to an organisation, it is not
appropriate in all situations. Where the organisation or its suppliers do not have linked systems,
the process to establish and undertake JIT may be clumsy and expensive to administer. The size
of the company may also mean that it is not worth the required systems investment. As with
all process improvement initiatives, a cost-benefit analysis should be undertaken to evaluate
whether the change will add value to the organisation.
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Service level agreements (SLAs) are used to formally define the level of service to be delivered
and document agreements reached regarding quality, timeliness and the basis of the
relationship. SLAs formally record what services are to be provided, priorities for delivery,
responsibilities of each party, guarantees in regard to delivery, and warranties from the
supplier. SLAs generally include very specific measures so that delivery within standard can
beobjectively measured and penalties for non-delivery applied.
Where these questions cannot be answered affirmatively, the company risks not only stock-out
issues leading to loss of sales (and reputation), but also missed opportunities to leverage off the
suppliers expertise and technologies to create competitive advantage.
Relationships
Developing effective relationships within a supply chain alliance involves a number of key
elements, including:
trust
shared vision
shared objectives
mutual benefits
commitment to the goal of a long-lasting relationship
information sharing
shared commitment to continuous improvement.
Partnerships (or alliances) among members of the supply chain are not easily created and
require work to be maintained. Research has found common themes in the reasons for failure.
A survey of 455 CEOs by the Conference Board identified the top eight reasons for failure of alliances:
They were (1) being overly optimistic and (2) characterized by poor communications; there was
a (3) lack of shared benefits, (4) slow payback results, (5) lack of financial commitment, and (6)
misunderstood operating principles; and there were (7) cultural mismatches along with (8) lack of
alliance experience.
Source: Speckman, RE, Isabella, LA, and MacAvoy, TC 2000, as cited in Joel D. Wisner, G. Keong Leong,
Keah-Choon Tan 2005, Principles of supply chain management a balanced approach, South-Western, Ohio.
Location
The key question to be asked is whether the physical location of the participants in the supply
chain is adding to or detracting from long-term competitive advantage. For example, if
distribution facilities are not in close or appropriate proximity to customers, logistic timeliness
and costs will be additional issues passed on to members of the chain, potentially without
adding value. Again, Dell Inc. provides a good example of setting up multiple production
facilities close to market so that distribution of final product is quick and easy.
Another method of overcoming location disconnects is for suppliers to provide consignment
inventory, meaning the manufacturer or retailer does not have to bear the holding cost and
obsolescence risk on additional stock that needs to be held to ensure supply. The supplier does
not bear warehousing costs.
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Consignment inventory is where the purchaser has physical possession of the goods, but does
not take ownership of (or liability for) the goods until they are either sold or used. Depending
on the supply arrangement, unused goods may be able to be returned to the supplier.
Quality assurance
Key questions to be asked include:
Can the quality of the product be assured?
How are defects identified, corrected and communicated among those operating within the
supply chain?
Are all members of the supply chain seeking opportunities for continuous improvement?
Having a clear definition of what is expected and documented performance measures provide
the framework for quality assurance.
Further reading
Horngren et al. 2011, Cost accounting: a managerial emphasis, pp. 10, 684687.
Quiz
[Available online in myLearning]
ACT
Activity 2.1
Value chain analysis
Introduction
Porters value chain provides a framework for considering the way that a business operates and
how activities interrelate.
The first stage of a value chain analysis involves classifying business activities according to the
value chain components.
This activity links to learning outcome:
Classify value chain activities in accordance with Porters value chain classifications.
Scenario
You are a management accountant working at Island Adventures, a boutique airline focused on
taking holiday travellers to and from the Pacific Islands. The airline offers a premium product,
the target market being executive couples and families. Many clients enjoy being part of the
airlines Premium Club, a frequent flyers program that ensures the holiday experience begins
early in the trip.
With new entrants to the market and discounted holiday packages, Island Adventures is under
significant pressure to discount seats to ensure that flights are full. As such, profitability is
suffering and the company has embarked on a business improvement program, looking for
opportunities to improve its competitive advantage and profitability. The program commences
with analysing the business using Porters value chain classifications to identify and group
company activities.
Task
You have been asked to classify Island Adventures activities according to Porters value
chain classifications and then present your findings to the project director for the business
improvement program.
You have been given the following list of activities:
Aircraft maintenance.
Aircraft supply tenders.
Baggage handling.
Ongoing website development.
Finance functions.
General management.
Negotiation of fuel supply contracts.
New in-flight entertainment.
Online ticket sales.
ACT
Ordering of fuel supplies.
Passenger boarding.
Passenger check-in.
Payroll functions (performed by human resources).
Pre-flight checks.
Premium Club.
Provision of flight information.
Receipt of beverage supplies.
Receipt of food supplies.
Receipt of fuel supplies.
Recruitment.
Refuelling aircraft.
Securing personalities for advertising campaigns.
Sponsorships of events.
Training.
Travel agent ticket sales.
Treasury.
TV advertising.
Union management.
You are required to classify each of the activities according to Porters value chain
classifications.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 2.2
Outsourcing transactional finance activities
Introduction
As a management accountant you may be required to help make decisions within a company
about whether or not to outsource certain activities.
For this activity you are required to assess the viability of a company outsourcing a function.
This activity links to learning outcome:
Apply appropriate decision models to short-term decisions such as outsourcing, product
line development, product mix and supply chain analysis.
At the end of this activity you will be able to apply the decision-making processes involved in
assessing whether or not to outsource certain activities.
It will take you approximately 45 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
Following the value chain review undertaken earlier in the year, SDTs chief financial officer,
Charlene OShay, has been contemplating outsourcing SDTs transactional finance activities
(accounts payable, accounts receivable and payroll processing). She suspects that processing
them internally is not adding value to the company.
Charlene has approached you, the management accountant, for advice on this issue. Assume
SDT can borrow at 9%.
Tasks
For this activity you are required to do the following:
1. Describe the two decision-making models available to guide the decision on whether to
outsource SDTs transactional finance activities.
2. Determine the most appropriate model to use for evaluating this decision. Justify your
selection.
3. Determine which aspects of SDTs transactional finance activities should be outsourced.
Show all calculations.
ACT
Spreadsheet
Note: In order to complete Task 3, you have been supplied with additional information
and an answer template in an Excel spreadsheet [Activity 2.2.xls] containing the following
worksheets:
HO Costs & Staff (background).
Accounts Payable (background).
Accounts Receivable (background).
Payroll (background).
Answer template.
Please access myLearning to view the spreadsheet.
ACT
Activity 2.3
Value and supply chain analysis for
decisionmaking
Introduction
The ability to correctly undertake value chain and supply chain analysis within businesses is
an important skill for management accountants as it allows them to identify opportunities to
improve a companys competitive advantage and profitability.
For this activity you are required to prepare and analyse a value chain and supply chain in a
manufacturing company, and to identify opportunities for business improvement from that
analysis.
This activity links to learning outcomes:
Classify value chain activities in accordance with Porters value chain classifications.
Identify an organisations competitive advantage using value chain analysis and
recommend strategies to improve it.
Apply appropriate decision models to short-term decisions such as outsourcing, product
line development, product mix and supply chain analysis.
At the end of this activity you will be able to prepare and analyse supply chains and value
chains, and apply your analysis to make profit-enhancing decisions.
It will take you approximately 60 minutes to complete.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
Graham Anderson (CFO) has decided to analyse the companys value chains and supply chains
to identify opportunities to improve competitive advantage and profitability. While Accutime
has a strong position in the global market, Graham knows that, in order to sustain this,
continuous innovation and improvement in all areas of the business are necessary.
You are the group head of management accounting at Accutime. Graham has asked you to
prepare a preliminary analysis of the companys value chains and supply chains, and to identify
any opportunities and potential benefits of offshoring. As part of this preliminary analysis you
have obtained the following additional information:
The joint venture with Timecalc in Wuhan, China provides quartz crystals to Accutime
locations in Australia, UK, Germany and the JV in Malaysia.
Timecalc manufactures synthetic quartz blanks in small bars which are then supplied to the
JV to make the quartz crystals.
Australia obtains electronic components from other external offshore and onshore suppliers.
UK obtains electronic components from other external suppliers.
Germany obtains electronic components from Japan and Taiwan.
JV in Malaysia obtains electronic components from other external suppliers.
ACT
Task
In order to get an overall sense of the value chain and interactions between the different parts of
the business, Graham has asked you to do the following:
1. Prepare a high-level value chain analysis by country for primary activities.
2. Summarise the potential benefits and issues with offshoring Sydney production and supply
of TCXOs.
3. Summarise the potential benefits and issues with offshoring Sydney marketing and sales,
and after-sales support of TCXOs.
4. Prepare a financial analysis evaluating the option of offshoring Sydney TCXO production
and support activities.
5. Describe the control issues of offshoring.
6. Determine whether Accutime should offshore Sydney TCXO production and support
activities.
Spreadsheet
Note: In order to assist you in completing these tasks, you have been supplied with
additional information and pre-filled templates in an Excel spreadsheet [Activity 2.3.xls]
containing the following worksheets:
Task 1 template.
Task 2&3 template.
Task 4 background.
Task 4 template.
Task 5 template.
Task 6 template.
Please access myLearning to view the spreadsheet.
Readings
Required reading
There are no required readings for this unit.
Further reading
Atkinson, A, Kaplan, R, Matsumura, E and Young, M 2012, Management accounting information
for decision-making and strategy execution, 6th edn, Pearson Prentice Hall, Upper Saddle River,
New Jersey, pp. 7896.
Horngren, C, Wynder, M, Maguire, W, Tan, R et al. 2011, Cost accounting: a managerial emphasis,
1st Australian edn, Pearson Australia, pp. 10, 125132, 684687.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit:
Atkinson, A, Kaplan, R, Matsumura, E and Young, M 2012, Management accounting information
for decision-making and strategy execution, 6th edn, Pearson Prentice Hall, Upper Saddle River,
New Jersey, pp. 8296.
Eldenburg, LG, Brooks, A, Oliver, J, Vesty, G and Wolcott, S 2011, Management accounting,
2ndedn, John Wiley & Sons Australia Ltd, pp. 326332.
Hoque, Z 2003, Strategic management accounting: concepts, processes and issues, Pearson Australia,
2nd edn, pp.108111.
Horngren, C, Wynder, M, Maguire, W, Tan, R et al. 2011, Cost accounting: a managerial emphasis,
1st Australian edn, Pearson Australia, pp. 125132, 671695.
Porter, ME 1985, Competitive advantage, Free Press, New York, pp. 3343.
Speckman, RE, Isabella, LA, and MacAvoy, TC 1999, Alliance competence: maximizing the value
ofyour partnerships, The Free Press, New York, p. 7.
Wisner, JD, Keong Leong, G and Tan, K-C 2005, Principles of supply chain management a balanced
approach, South-Western, Thomson Corporation, Mason, Ohio, pp. 6174.
The Journal of Commerce 2011, Wal-Mart cooks up supply chain savings, The Journal of
Commerce, vol. 12, issue 5, 31 January 2011, p. 6.
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Core content
Unit 3: Activity-based costing
andmanagement
Learning outcomes
At the end of this unit you will be able to:
1. Apply activity-based costing (ABC) to provide information for decision-making
(activitybased management (ABM)).
2. Assess the advantages and disadvantages of traditional and activity-based costing
approaches and when each should be used.
Introduction
Providing products or services necessitates undertaking activities that require resources.
Activity-based costing (ABC) is the process of allocating costs incurred in supplying the product
or service based on the amount of activity required to produce it.
Before the advent of ABC, traditional costing systems were used to allocate the cost of labour
and materials used in production directly to products. Then the small (relative to the value of
other costs) pool of overhead costs were allocated to products based on a single plantwide
measure (e.g.labour hours or total direct costs).
In the 1980s, the automation of manufacturing processes led to significant increases in the
proportion and dollar amount of overhead expenses. As machines replaced manual labour,
using labour and material statistics to allocate overhead costs was no longer appropriate as the
strong relationship between the two had been broken.
Traditional costing systems therefore led to an incorrect calculation of indirect costs per unit.
It followed that unless overhead costs were allocated to products on a basis that more closely
reflected the resources that were consumed in making them, unprofitable products would be
produced and sold, and sometimes at the expense of others that were profitable. It was out of
this dilemma that ABC evolved.
This unit examines the use and relevance of ABC, and explains the process of implementing its
methodology.
maaf31503_csg
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Learning outcome
1. Apply activity-based costing (ABC) to provide information for decision-making
(activity-based management (ABM)).
The ABC allocation process involves allocating costs over two steps:
To activities undertaken to supply products or services.
To products or services (i.e.cost objects) supplied.
RESOURCES
Goods, services and assets required to undertake activity
ACTIVITIES
Tasks completed in order to produce cost objects
COST OBJECTS
Products or services supplied
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Due to higher levels of support activity required for Factory #2, its monthly support costs are
$80,000 greater than those of Factory #1.
The support costs of Product A in Factory #1 are $1.80 per unit ($18,000 10,000), whereas
in Factory #2 they are $9.80 per unit ($98,000 10,000). The difference is caused not by
production volume, but by the number of activities that are undertaken.
Often, batch-related costs are the same for all batches. Once a machine is set for a production
run, no further set-up costs are incurred, regardless of whether 100 or 10,000 units are
produced. Hence, the set-up costs allocated to each unit of a product will be much lower for
products that are manufactured in long production runs.
So far, this example has assumed that all products in Factory #2 require the same level
of support that is, the amount of additional support activity occurs equally over all of
Factory#2s products. However, if 75 of its 100 products are simple and so similar that there
is no significant additional support required, while the remaining 25 are complex and require
more complicated processes, ABC will more accurately apportion costs to the products that use
them. Using these new assumptions, the comparison using an ABC system becomes:
Summary
Note: The per unit cost for Factory #1 with only one product and one batch run is still less
expensive than it is for the simple products of Factory #2. However, splitting the simple and
complex products has provided insight into the cost differences.
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While ABC was initially developed for manufacturing operations, it is now widely used in
distribution and service industries, where overhead costs are proportionally high and direct
material and labour costs proportionally low. In a high-overhead environment, understanding
what is driving the level of activity, and what product or service the activity is supporting, are
both critical for accurate product pricing and investment decisions.
ABC indicates that the way in which a business undertakes its activities is the main driver
of cost. It provides objective data that is significantly more robust than data obtained from
traditional costing systems, to support decision-making.
Cost hierarchies
4 Facility-sustaining Activities required for the For most companies: senior management
overall business to operate salaries, head office occupancy costs, and
insurance
(Costs in this category are not directly related
to any product or service and need to be
allocated on a fair and rational basis)
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Knowing how costs build up allows management to make more informed decisions on
improving processes, since this knowledge provides a clear outline of what costs can be
influenced and what the impact of change may be. ABC facilitates an objective understanding
of costs and removes subjectivity from decisions, such as where to allocate limited resources;
what sales price is appropriate; whether a product is profitable; and whether key performance
indicators (KPIs) have been met.
Cost objects
A cost object is the thing (usually a product or service) that is being provided. For example, in
a fast food outlet the cost object could be a burger; in a computer manufacturer, the cost object
could be a fully assembled computer; and for an accounting firm, the cost object could be a
specific client engagement. So ABC is relevant for both manufacturing and service industries.
ABC examines the costs of the various activities that need to be performed in order to deliver/
provide a cost object.
Unit Individual cartons Bottles, caps, labels, water, run-time labour and
cartons
Batch Batch of 1,000 cartons Labour to set up batch (setting up assembly line and
preparing materials)
Labour to clean up after completion of batch
manufacture
Quality control costs for each batch, including testing
that product meets specifications
Storage of completed batch of products in the
warehouse
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Resources
Activity
centre
Activities Resource Cost
and activity driver element
cost pools
Activity
cost driver
Cost objects
As the diagram shows, resources are first allocated to cost pools using resource drivers (which
should be based on how a cost pool consumes that resource). The value of these resources is
shown in cost elements (or expense lines) within cost pools. The total costs that are accumulated
within a cost pool are then allocated to cost objects using activity cost drivers. Again, these
activity cost drivers need to be based on the consumption of cost pool resources by cost objects.
A resource driver represents an appropriate method for allocating the costs that are associated
with a resource to a cost pool. For example, the number of computers is a resource driver that
may be used to allocate a share of IT activity support costs to a cost pool.
An activity driver represents an appropriate method for allocating the accumulated total costs
within a cost pool to a cost object. For example, the number of support calls received for a
product line is an activity driver that may be used to allocate the costs for technical support to
each product line (i.e.cost object).
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The following table provides a summary of the relevant ABC components:
Components of ABC
Component Summary
Cost object This is the thing to which costs are ultimately attached. The cost object could be a product or
service, or even a customer
A cost object needs to be clearly defined in order to provide a clear basis for the creation of
appropriate cost pools and cost drivers
Cost pool A cost pool is the accumulation of costs incurred (i.e.resources used) in performing a
particular activity. There may be a number of different activities that are necessary to produce
a cost object, which therefore means a corresponding number of cost pools. A cost pool is
allocated to cost objects that consume its resources using a cost driver
The term cost pool is often associated with overheads. However, a cost pool could be directly
related to production that is, it comprises only direct costs (i.e.labour and/or materials) and
is therefore directly assigned to a cost object
Cost driver A cost driver relates to the cause or consumption of a cost, and is used to allocate a
proportion of the costs within a cost pool to a cost object. There should be only one cost
driver per cost pool
To calculate the unit value of a cost driver, the total value of the cost pool is divided by the
total number of cost driver units:
In the majority of cases, the value of the cost pool and the number of driver units are based
on budget estimates
Determining a cost driver can be complex. It requires working closely with operating
managers to understand the relevant activities and deciding on the appropriate cost driver
A practical issue when designing an ABC system is deciding on the ideal number of cost pools
and drivers to use. While a higher number of cost pools and corresponding drivers are likely
to enhance costing accuracy, it will also significantly increase the complexity of the system and
cost of administering it, as well as quickly lead to an overload of information. The objective is
to find a balance whereby the maximum amount of valuable information is achieved using the
minimum number of pools and drivers.
The ideal number of cost pools and drivers can be assessed by examining the explanatory
power of each individual cost pool or driver for a cost object. This often involves a process
of trial and error to examine how the end product/service cost changes in response to each
additional cost pool or driver. Once an additional cost pool or driver is shown to cause minimal
change to the end product/service cost, they are probably accurate enough.
Likewise, where there are two or more pools with a similar nature and drivers, it may be
possible to combine them and thereby reduce the number of pools and drivers. For example,
the cost of a payroll department is likely to be driven by the number of employees it supports,
as are the costs of the recruitment and organisational development teams. These three activity
pools may be able to be combined and designated as one pool for example, Human resources
support.
Given the cost of implementing and maintaining an ABC system, it is better to start small and
expand as necessary, rather than starting with a large and sophisticated system and have it
fail due to its complexity. Research suggests that the main reason why ABC systems fail is that
organisations underestimate the amount of work that is required to implement and maintain
such systems.
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Applying ABC
Many businesses consider implementing an ABC system because they know that the
information obtained from their traditional costing system is providing distorted results.
Due to the complexity and cost of implementing an ABC system, organisations often commence
a potential ABC implementation with a pilot study. The number of products/product lines or
services that are chosen for a pilot study will depend on the scope of the project. When planning
such a study, choosing the right products to investigate is more important than trying to cover
as many products as possible. At least one product that is chosen should involve a complex
process and demand a high level of indirect support activity. This product is then compared
against a product or products involving a simple process and low level of indirect support
activity.
For the remainder of this unit, the example of Plumbob Limited is used to illustrate the
stepbystep application of an ABC pilot study in a manufacturing firm.
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Carol then determines the amount of activity (i.e.number of cost driver units) that is consumed
by each of the three products:
Next, Carol multiplies the cost driver rates by the driver usage for each product to arrive at the
manufacturing overhead per product:
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With a more accurate allocation of overhead costs incurred by each product, a management
accountant can then recalculate the total profitability of each product by deducting this figure
from the contribution margin.
She then tabulates the results from both the traditional system and the ABC system, and
compares the profitability by product under each system:
The analysis shows large differences in the results for Product 1 and Product 3, which is indicative
of a significant distortion in the product costs that are provided by the traditional system.
This has significant implications for management of the companys product lines, particularly
the pricing of Products 1 and 3. Specifically, the sales price of Product 1 when based on costings
calculated under the traditional method may be significantly lower than it should be to cover
true costs and earn a profit. In contrast, the sales price of Product 3 may be higher than it
should be and, as a result, Plumbob may be sacrificing market share if competitors are pricing
their products at a lower rate.
When comparing the profitability that is calculated using each method (traditional versus
ABC), significant changes in the profitability of individual products are often observed. In
many cases, it is clear that the traditional system provides distorted signals, meaning that the
relative profitability of products is misunderstood.
Often, unknown distortions have significant implications on the management of an
organisations product lines and pricing. This phenomenon is termed product costing
crosssubsidisation.
A misconception about ABC is that it allocates all overhead costs to cost objects. Often, for
both manufacturing and non-manufacturing overhead costs there is no valid basis to allocate
overhead costs to the cost objects. A good example of this is the factory manager salary. The
factory may produce hundreds of different products, with the factory manager having no
activities they undertake that link to a specific product or range of products. In this case, the
costs can be separated from any ABC calculation and included in the Total cost column
under a heading of Common costs.
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So, referring back to the previous example of three products using ABC, the analysis of product
profitability using ABC (on the basis of an additional $150,000 of manufacturing overhead for
the factory manager) would appear as:
The decisions made about product profitability need to be based on the ABC analysis excluding
common costs. However, it remains important to show the total costs, including costs that are
not allocated to the cost objects.
Activity-based management
When management conducts an ABC pilot study, it compares the costs and profitability of
products using its existing costing system with the results from ABC. Such comparisons are
often enlightening and provide many insights into ways of improving profitability.
When managers base decisions on ABC information, they are engaging in activity-based
management (ABM).
ABM draws upon ABC as a major source of information. It uses ABC information to set and
implement strategic priorities; analyse and measure performance; identify low-cost product
designs, cost-reduction opportunities, potential for improvements in quality, waste in supplier
relationships; and redirect capital expenditure toward the most profitable activities.
Generally, because of the more accurate product costs derived from the use of ABC and the
analysis of the cost pools, drivers and activities, it is accepted that through ABM the following
types of management decisions are enhanced:
1. Modifying product prices. As a result of the more accurate product costs, companies are
able to establish the selling price to ensure that each product line contributes a gross profit
in line with the strategy of the company.
2. Modifying product or customer mix. This allows the company to assess the product lines
sold and the profit contributions of each. In the event that the selling price cannot be adjusted,
then the company can make more informed decisions about the product mix and whether to
drop a product or product line. In some instances, by applying ABC to the distribution and
ordering costs associated with the customers, management is also able to review and decide
on customer mix (this is also referred to as customer profitability analysis).
3. Cost-cutting through:
(a) Changing suppliers. The completed analysis on cost pools, activities and drivers
enables the company to assess whether its overheads are non-value-adding or are
excessive, and make decisions in relation to the suppliers used.
(b) Altering product design. By reviewing the designs associated with the product, after
having reviewed the activities, costs and drivers, a company can redesign its product to
reduce costs. An example of this is the use of target pricing where the price that the end
consumer is willing to pay, the product design, and the production process are engineered
to allow the company to make the product in line with the ultimate selling price.
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(c) Altering production processes. By analysing the cost pools, drivers and activities, a
company can review the production process and eliminate non-value-adding activities
where possible.
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In recognising that there are differences between manufacturing and service environments,
there should still be no fundamental difference between analysing the expenses of each of their
respective support departments.
The three processes involved in analysing support department expenses in a service
environment are:
1. Determine what causes the work in support departments.
2. Link these causes to cost pools that reflect the activities performed.
3. Determine the drivers (measurable attributes of the causes) in order to attribute the costs
in these pools to the various services (or products i.e.cost objects) according to the
consumption of those activities.
Applying ABC in service environments is often more complex than in manufacturing
environments because of the variability in cost objects (i.e.customer requirements) involved. In
service environments, demand for activities is typically driven by individual customer needs,
whereas in manufacturing it is driven by product design demands. Therefore, more judgement
is needed to make an ABC system work in a service environment.
For example:
The activity nursing care in a hospital may need to be segmented to reflect the variable
demands that different types of patients place on the hospitals nursing services (depending
on the patients status, physical and mental capabilities, and any illnesses).
The product mortgages in a bank may need to be segmented into sub-products to reflect
the varying demands that different types of mortgage customers place on the banks
systems, as well as the skills that are required to meet those demands. For example,
managing 10 separate residential mortgages of $500,000 each would place different
demands on a banks resources than managing one commercial mortgage of $5,000,000.
Where it is economic (i.e.the benefits outweigh the costs) to implement ABC, it will lead to
more accurate allocation of costs in both manufacturing and service organisations.
Learning outcome
2. Assess the advantages and disadvantages of traditional and activity-based costing
approaches and when each should be used.
While using ABC provides insightful analysis to inform decision-making, implementing and
maintaining it can be expensive. Analysis is required as to whether to implement such a system,
and, if so, to what extent. The cornerstone of this analysis is understanding the advantages and
disadvantages to an organisation of using either a traditional or an ABC approach within its
existing operating environment.
Advantages of ABC
The major advantages of ABC over the traditional cost allocation method include:
ABC captures the complexity of product or service operations by identifying cost drivers
that have a cause-and-effect relationship with the activities that are performed in providing
those products or services.
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Traditional costing systems distort product costs because they apply overhead costs using a
single average rate to each unit of output. The ABC approach is more accurate, as it applies
a different overhead rate for each activity (cost pool) that is involved in producing the
output.
ABC provides objective input into decisions on product pricing and product mix. Using
the traditional approach, product costing cross-subsidisation can result from applying
broadbased assumptions.
ABC provides objective input into cost-reduction and process-improvement analysis.
ABC provides greater transparency and insight into cost structures to allow any cost-
reduction and process improvement analysis to occur.
ABC provides objective input into decisions on product design through showing that new
designs may reduce costs that is, by identifying value-adding and non-value-adding
activities.
All of the above advantages lead to greater accuracy in product/service costs and, by
association, to product/service profitability as well.
Disadvantages of ABC
The disadvantages of ABC compared to the traditional method include:
Data collection can be time-consuming and expensive. ABC requires sourcing significantly
more data than traditional systems to form the basis of overhead cost allocation to products.
This can often necessitate restructuring the way costs are recorded in the general ledger to
enable the data collection, and reporting in a way that is consistent with the requirements of
ABC.
Data analysis systems need to be established. These can be developed in-house using
spreadsheets, or an ABC software package can be purchased. Either way, a cost will be
incurred.
Not all costs have a relevant allocation basis to cost objects and should remain in a common
cost (e.g. factory manager salary).
Managers need to be educated in ABC. Where an ABC system involves significant change,
there may be some resistance, especially if the ABC results reflect poorly on an area of the
business or a product.
An ABC system will need to be aligned with the budget and other financial controls. This
may be time-consuming and costly to achieve.
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Will the financial benefits gained from an ABC system outweigh the cost of its No Yes
implementation?
Does the organisation have the competencies and readiness to implement a No Yes
new system?
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Once it is up and running, the cost of maintaining an ABC system can be significant. It is
necessary to continuously evaluate the ongoing costs against the ongoing benefits, to ensure
that ABC remains a value-adding asset to an organisation. Management accountants must
know who uses ABC and what their needs are, to ensure the system delivers the right level
of accuracy and sophistication. For example, if costing information is being used for periodic
inventory valuation purposes, it may not need to be as accurate as when it is used for short-
term pricing decisions.
There is a relationship between the level of accuracy required and the complexity of the system.
Increased accuracy of information will require a more complex system (i.e.more cost pools and
cost drivers). The optimal number of cost pools and drivers is the minimum amount needed to
achieve the required level of accuracy. Basic statistical knowledge (correlation analysis) is useful
in confirming whether the right cost driver is being used that is, whether changes in the cost
driver are significantly correlated with changes in the cost pool.
The cost of administering ABC will depend on the difficulty of:
Consolidating costs into a given cost pool, especially where costs from different cost
centres need to be aggregated (e.g.the cost of shipping may include export documentation,
material handling and insurance, each of which may be located in different cost centres).
Obtaining cost driver data (data collection). This is especially problematic where data is
not readily available. It can also be difficult when ABC is managed within an accounting
department, which depends on information that is sourced from operational areas over
which the management accountant has little direct control. Problems can arise where
operational areas attach a low level of priority to providing this information on a regular
and timely basis. This can be even more difficult when those providing the data do not
perceive any benefit from the ABC system.
Management education. Problems may arise when senior management support and buyin
has not been provided from the inception of an ABC project. In these situations, the project
may be seen by other parts of the organisation as being one that only affects the finance
department, and thus no expertise is offered.
Obtaining broad employee acceptance. Resistance to change and employees feeling
threatened by ABC may occur when management does not have the necessary skills to
deal with negative responses to change (e.g.employees may not understand the inefficient
processes, or unprofitable products that are highlighted by an ABC costing system are often
the fault of inadequacies of the former traditional costing system, and not a result of their
own actions or ineptitude).
Aligning an ABC system with budgeting, forecasting and other financial systems. To be
compatible with ABC, budgets and forecasts also need to be prepared on an activity basis.
Undertaking the pilot study. ABC systems are rarely implemented without a pilot study,
which increases the total cost of implementation.
Activity 3.4: Apply both traditional and ABC approaches to a manufacturing company and
compare results
[Available at the end of this unit]
Quiz
[Available online in myLearning]
ACT
Activity 3.1
Preparing a cost hierarchy
Introduction
As a management accountant you may be called on to evaluate the feasibility of implementing
an ABC system, and also to deliver it. The starting point of any ABC review is to consider the
activities undertaken by the business and then prepare a cost hierarchy classifying them.
A cost hierarchy is a stepped classification of costs, from those directly traceable to the final
product or service to those that have an indirect connection and need to be allocated. Under a
cost hierarchy there are four levels, beginning with those activity costs directly relating to the
output (the unit-level) through to organisational overheads (facility-sustaining costs).
This activity links to learning outcome:
Apply activity-based costing (ABC) to provide information for decision-making
(activity-based management (ABM)).
At the end of this activity you will be able to complete a cost hierarchy for a manufacturing
organisation.
It will take you approximately 20 minutes to complete.
Scenario
This activity is based on the Accutime Ltd (Accutime) case study.
You are a management accountant working for Accutime and you report to Graham Anderson,
the CFO.
Graham is thinking about implementing an ABC system for Accutime. To begin the pilot study,
he has asked you to prepare a cost hierarchy for Accutimes manufacturing plant in Sydney.
ACT
Task
For this activity you are required to use the table provided and:
1. Categorise each activity cost according to the cost hierarchy.
2. Prepare a table presenting your analysis, including your rationale for the category assigned
to each activity.
Table of activities
ACT
Activity 3.2
Determining cost pools and cost drivers
Introduction
The process of ABC involves allocating costs incurred in making a product or providing a
service based on the actual costs incurred in producing it.
ABC involves allocating costs over two steps. The first allocation is to the activity being
undertaken; the second to the product or service being produced. Cost drivers are used in a
cascading process, driving resources through to activities resource cost drivers drive resource
costs to activities; activity drivers then drive activity costs to outputs (products or services).
Determining cost pools and cost drivers is an initial and fundamental stage in performing an
ABC analysis.
This activity links to learning outcome:
Apply activity-based costing (ABC) to provide information for decision-making
(activitybased management (ABM)).
At the end of this activity you will be able to identify cost pools and cost drivers in a service
industry.
It will take you approximately 30 minutes to complete.
Scenario
Sunshu Limited (Sunshu) owns and operates several health resorts across Australasia. Sunshus
Dandenong resort service comprises accommodation, a restaurant, a gymnasium, tailored
fitness programs, a health-orientated educational program, and spa and holistic health facilities.
Each guest is accommodated in their own stand-alone cottage located within the five-hectare
property.
You are the management accountant at Sunshu and have been asked to identify the activity
pools and cost drivers for the Dandenong property.
ACT
From the service brochure and cost analysis for the Dandenong resort you have the following
details of the package options and current costings.
Weekend Friday lunch to Sunday brunch 1,375 1,100 Accommodation and all buffet-
style meals
Use of fitness facilities
Fitness assessment on arrival
Two spa treatments
Week Sunday lunch to Friday brunch 2,750 1,100 Accommodation and all buffet-
style meals
Use of fitness facilities
Fitness assessment on arrival
Fitness and educational program
Three spa treatments
Current costing
ACT
Task
For this activity you are required to use the table provided and:
1. Identify the activity cost pools for each cost hierarchy category.
2. Identify the activity cost driver for each cost pool.
Unit-level (guest) 1. 1.
2. 2.
3. 3.
4. 4.
Batch-level (package) 1. 1.
2. 2.
Product-sustaining 1. 1.
2. 2.
Facility-sustaining 1. 1.
2. 2.
3. 3.
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Activity 3.3
Applying ABC
Introduction
This activity links to learning outcome:
Apply activity-based costing (ABC) to provide information for decision-making
(activitybased management (ABM)).
At the end of this activity you will be able to identify the relevant cost pool and cost driver for a
particular part of a business and use the ABC information obtained for decision-making.
It will take you approximately 25 minutes to complete.
Scenario
Richard Douglas owns a newsagency in the western suburbs of Melbourne. There are two
parts to his business: a retail store (which sells newspapers, magazines, stationery, small gifts,
confectionery and has a lottery office agency) and a delivery run (which delivers newspapers to
the home or office of subscribers).
Some of the key costs within the business are:
Salaries and 340,000 Two part-time delivery drivers, each paid $30,000 per annum, who
wages each do a delivery run seven mornings per week
Two full-time retail assistants, each paid $50,000 per annum
One administration officer, paid $60,000 per annum, who spends
20% of her time administering the deliveries; 20% placing orders
for retail inventory; 60% general bookkeeping (not impacted by the
amount of work in the deliveries or retail store)
Richard Douglas, owner and manager, paid $120,000 per annum.
Richard is not involved with the delivery runs
Overtime 11,000 The two part-time delivery drivers work additional hours to complete
deliveries when required
On-costs 49,140 Superannuation at 9.25% and payroll tax at 4.75% on salaries and wages
superannuation and overtime
and payroll tax
Petrol costs 23,000 Two delivery vans use 300 litres per week in total
Delivery vehicle 10,000 Covers servicing, repairs, etc. for the two delivery vans
running costs
Packaging costs 20,000 Newspapers are rolled in plastic wrap and/or wrapped into a bundle for
delivery to the customers
A bundle might have anything from one to ten newspapers in it. A
delivery to a customer might include more than one bundle
ACT
Office supplies 10,000 These are consumed in line with the time spent on the activities of the
administration officer
Mobile phones 4,000 The two delivery drivers and Richard Douglas have phones. Richard
utilises 50% of the total cost
Other expenses 306,000 These relate to the operation of the retail store
Number of delivery runs (i.e. the number of times a delivery vehicle picks up from the 1,144
store and returns having completed all deliveries)
The newspaper companies pay Richard Douglas $1 (plus GST of 10%) for the delivery of each
paper.
Tasks
For this activity, using ABC, you are required to:
1. (a) Identify the costs that should be included in the cost pool for the delivery function.
Calculate the total value of this cost pool.
(b) Identify the appropriate cost driver for the delivery cost pool and calculate the
activitybased cost allocation rate.
2. From a quantitative perspective, evaluate whether it is worthwhile for Richard to continue
with his delivery run. Justify your response.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 3.4
Apply both traditional and ABC approaches
to a manufacturing company and compare
results
Introduction
This activity links to learning outcomes:
Apply activity-based costing (ABC) to provide information for decision-making
(activitybased management (ABM)).
Assess the advantages and disadvantages of traditional and activity-based costing
approaches and when each should be used.
At the end of this activity you will be able to make decisions on when to apply traditional or
ABC costing and why.
It will take you approximately 90 minutes to complete.
Scenario
You are a management accountant at Power Tools Limited (Power Tools) and report to Ramesh
Patel, who is the newly appointed financial controller. Power Tools manufactures 30 different
types of power tools.
Ramesh is interested in examining the use of ABC to gain better insight into the costs of
the companys products. He decides to carry out a pilot study on three products from the
handheld tools division and asks you to conduct the pilot for him.
Ramesh has selected the following products for the pilot study:
Rotary hammer.
Finishing grinder.
Cordless drill.
To prepare for the pilot study, Ramesh has already gathered data from the financial and
manufacturing systems. Before you begin, he tells you that he has some concerns about the
existing allocation of costs.
Rameshs concerns
In analysing the data collected, Ramesh notes that the companys traditional costing
system allocates manufacturing overheads to products on the basis of direct labour hours.
The company also treats selling and administrative overheads as a lump sum, below the
manufacturing margin line. Ramesh is concerned because:
He suspects many of the overhead costs are not directly related to labour hours and that
there are other relevant cost drivers.
He also suspects that some products require more selling and administrative overheads
than others.
Ramesh is concerned that the combined effects of these distortions are leading to an inaccurate
picture of the profitability of individual products.
ACT
Available information
To assist you with conducting your pilot study, Ramesh has provided you with the following
information:
Financial data
$ $ $ $
Procurement 225,600
Packaging 225,600
1,880,000
Distribution 245,000
Administration 163,000
408,000
Packaging Shipments
ACT
Tasks
For this activity you are required to:
1. Calculate the profitability of the three products in the pilot study, using the traditional
method of cost allocation.
2. Calculate the profitability of the three products using ABC.
3. Prepare a summary of how the ABC information may be used to improve managerial
decision-making (activity-based management (ABM)).
4. Identify and explain key practical issues that may be faced by Power Tools in implementing
ABC for all of its products.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
There are no further readings for this unit.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit.
Atkinson, A, Kaplan, R, Matsumura, E, and Young, M 2012, Management accounting: information
for decision-making and strategy execution, 6th edn, Pearson/Prentice Hall, Upper Saddle River,
New Jersey, USA, Ch. 5.
Cooper, R and Kaplan, RS 1991, The design of cost management systems: text, cases, and readings,
Prentice Hall, Englewood Cliffs, New Jersey, USA.
Horngren, C, Datar, S, Foster, G, Rajan, M et al. 2011, Cost accounting: a managerial emphasis,
1st Australian edn, Pearson/Prentice Hall, Australia, Frenchs Forest, NSW.
Kaplan, R and Atkinson, A 1998, Advanced management accounting, 3rd edn, Pearson/Prentice
Hall, Upper Saddle River, New Jersey, USA, Ch. 5.
Rotch, W 1990, Activity-based costing in service industries, Journal of Cost Management, vol.4,
no. 2, Summer.
Reeve, JM (ed.) 1995, Readings and issues in cost management, Warren, Gorham & Lamont/
SouthWestern College Publishing, Cincinnati, Ohio, USA, p. 156.
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Core content
Unit 4: Pricing decisions and models
Learning outcomes
At the end of this unit you will be able to:
1. Evaluate both the qualitative and quantitative factors impacting a pricing decision.
2. Apply models for determining an organisations pricing structure.
3. Apply discounting models and assess their impact on an organisations profits.
4. Demonstrate how target sales pricing can be used to maximise an organisations profits.
5. Demonstrate how yield-based pricing can be used to maximise an organisations profits.
Introduction
Management accounting often focuses on managing costs rather than revenue. To optimise its
value, an organisation needs to focus on both revenues and costs.
Revenue management considers:
What to sell.
Who to sell to (i.e. target customers).
What price to sell at.
Terms of sale.
Potential for lost revenue.
This unit focuses on the pricing aspect of revenue management. It examines the key factors that
impact on pricing decisions, and demonstrates the application of a variety of pricing models.
Learning outcome
1. Evaluate both the qualitative and quantitative factors impacting a pricing decision.
There are many factors that impact on an organisations pricing decisions. Customer demand,
competition, cost, time horizon, supply, regulation and strategic intent are all important
considerations. As the saleability of individual goods or services is directly affected by pricing
decisions, they are among the most complex and important decisions that management faces.
maaf31504_csg
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ORGANISATIONAL PRICING
Customers
Customers impact price via their willingness to pay for goods and/or services. This is based on
the features of the good or service, and what customers perceive their quality and desirability
to be. Prices that are too high in customers eyes will result in them choosing competing or
substitute goods, while prices that are too low will result in a loss of profits and/or a negative
customer perception in terms of quality and/or value. The level of demand for goods or services
also influences their price.
Elasticity of demand refers to the responsiveness of demand for goods or services to changes in
the price of those goods or services. The more price impacts on demand, the more price elastic
those goods or services are said to be. For example, where a small change in price has a large
impact on demand, the goods or services are said to be price elastic. Where any change in price
has a limited impact on demand, the goods or services are said to be price inelastic.
Competitors
Competition in a market can have a significant impact on pricing. An understanding of
competitors offerings and pricing will help an organisation determine the price that potential
customers would be willing to pay for a particular standard of quality. Similarly, competitors
marketing and promotional activities will impact an organisations pricing deliberations. The
higher the level of competition, the lower the opportunity for setting higher or abovemarket
prices. However, in situations where there is little or no competition, an organisation is able to
set higher prices.
Globalisation also impacts on pricing decisions; for example, international factors such as
foreign exchange rate fluctuations affect pricing. If the Australian or New Zealand dollar
strengthens against the United States (US) dollar, US goods and services will be more
competitively priced for Australian and New Zealand consumers.
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Costs
In order for an organisation to remain viable in the long term, it must, at a minimum:
Cover its costs.
Price its products so as to make a profit.
A good understanding of costs is necessary to ensure that pricing decisions do not lead to goods
or services being sold at unsustainable prices; for example, by applying heavy discounting or
selling them at a loss. Pricing decisions involve not only setting list prices, but also discounting.
By understanding the cost of goods or services, an organisation can set prices that are
acceptable to customers and maximise profits.
The different cost bases that can be used in pricing models are discussed later in this unit.
Time horizon
The time period for which prices are set can have a significant impact on pricing decisions.
It is likely that, for a number of reasons, the price of goods or services will change over their
lifetime, including changes in the three Cs.
When goods or services are first introduced to the market, they could be initially discounted
to gain customer awareness before reverting to their planned regular price point (i.e.higher
prices). Conversely, they could be priced higher initially, as is often the case with technology
products for which customers are prepared to pay more to obtain them before others do, or
initial stocks run out.
Many of the costs that must be considered in pricing will be fixed or unlikely to change in the
short term. Therefore, short-term pricing decisions made in response to short-term supply and
demand conditions should focus only on costs that are expected to change in the short term.
Prices that are set for the short term can afford to be more opportunistic than those set for
the long term, allowing organisations to reduce their prices in order to stimulate demand or
increase prices when demand is strong.
Long-term pricing involves making strategic decisions to enter into long-term customer
relationships that are based on stable pricing. However, in order to deliver appropriate returns
in the long term, future fixed and variable costs must be managed. Long-term pricing decisions
should also allow a reasonable profit to be made over that period.
Supply constraints
The availability of resources and operational capacity are also factors that influence pricing
decisions. When an organisation has a lack of resources, it is unlikely to reduce its prices.
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Similarly, when an organisation has excess capacity, it is able to be more flexible in its approach
to pricing. Having this unused capacity simply means that revenue is not being generated by
those resources in the short term, and that incremental revenue (and margin) would help cover
fixed costs and improve profitability. The excess capacity could be used to fill a special order
or tender for work at reduced margins. Capacity is usually an influence on short-term pricing
only; in the long term, operational capacity can be adjusted.
Corporate strategy
An organisation can pursue competitive advantage in two different ways:
Differentiation.
Cost leadership.
An organisation that employs a differentiation strategy is more likely to be able to price its
products higher than its competitors, since it is offering a quality or feature that customers are
willing to pay for.
An organisation that employs a cost leadership strategy leverages its cost advantage (the
third C) so that its pricing maximises profit, by either offering lower prices (to maximise sales
volumes) or generating a superior margin.
These strategies are discussed in detail in the unit on introduction to management accounting
(including ethics).
An organisations strategy for how it competes in the market can also impact on pricing. For
example, in order to grab market share from its competitors, a company might decide to take
an aggressive approach by reducing its prices. This might be done to create economies of scale,
which would allow lower prices in the long term; or it might be a tactic to induce customers into
trialling a product or service, which might lead to them becoming long-term customers.
Pricing regulations
Most countries, including Australia and New Zealand, have legislation that governs goods and
services pricing; for example, in Australia the Competition and Consumer Act 2010 (Cth) (which
contains the Australian Consumer Law and Prices Surveillance Act 1983 (Cth)), and in New Zealand
the Commerce Act 1986.
These laws are generally aimed at a number of anti-competitive practices, including:
Predatory pricing, which entails a company setting a price for goods or services that is well
below what would be considered commercial with a view to forcing competitors out of the
market. If successful, the company is then able to raise the price of the goods or services
significantly.
Dumping excess goods, by selling them into a market that the company does not normally
compete in at a price that is well below the market price in order to derive revenue.
Price-fixing, which involves an agreement between competitors to set the prices of their
common goods or services, in order to maximise their joint returns from the market. There
were a number of successful prosecutions for price-fixing in New Zealand in 2012, involving
major international airlines engaging in price-fixing in relation to air cargo commissions.
Customer psychology
Customer behaviour also influences price-setting. For example, price points are the points
on a scale of possible prices that a consumer is likely to pay for a particular good or service.
Pricing an electronic item at $99 (under $100), for example, is a popular price point that could
significantly increase the items sales volume (with the additional sales volume offsetting a
lower profit margin per unit).
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Pricing models
Learning outcome
2. Apply models for determining an organisations pricing structure.
While pricing is often thought to be a function of the marketing department, the reality is that
managers often base prices on accounting information. This is because many organisations
sell numerous product lines (i.e. goods or services), and performing a thorough marginal cost
analysis and survey of demand for every individual product would require extensive resources.
An organisations finance team (including the management accountant) is therefore often
responsible for providing and interpreting cost and price data.
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Cost-based pricing
Cost is a key influence on pricing decisions. Calculating a selling price based on cost is one price
setting model. The method behind this model can be summed up as follows:
Depending on the basis used to calculate the cost, the mark-up amount might differ
significantly, but should deliver an acceptable profit margin.
In the cost-based pricing model, there are several cost bases that can be used to calculate a
selling price, which are based on:
Variable (or marginal) costs.
Full cost.
Manufacturing costs (absorption costing).
Activity-based costing (ABC).
Target return on investment (ROI).
The benefit of using variable costs as a basis for determining price is that the sales function will
not be inhibited should additional fixed costs be allocated to a good or service due to variations
in volume (i.e. the price ignores the allocation of fixed costs to a product. Any variation in the
allocation of fixed costs thereby doesnt influence pricing).
Full cost
Full cost is the sum of all direct and indirect costs that are involved in the production of goods
or services. Direct costs (i.e. direct materials, direct labour and direct overhead) are those
costs that are initially assigned to goods or services. A fair share of indirect costs (i.e. indirect
manufacturing overheads, service departments and administration costs) is then allocated.
Pricing based on full cost plus mark-up will cover the long-term costs and return a profit
(assuming the volume of sales that is required to recover all the fixed costs is achieved):
Manufacturing
Direct materials + Direct labour + + Mark-up = Selling price
overheads
Activity-based costing
ABC is a full costing approach that uses an objective basis to allocate overhead costs to goods
and services. This provides a more accurate calculation of the full cost per unit than traditional
methods, which use a broad basis for spreading indirect costs across goods and services.
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As with full cost, a mark-up is added to the price to cover unallocated costs and profit. This
approach can be summed up as:
Indirect costs
Direct costs + + Mark-up = Selling price
(allocated using ABC)
(Note that where goods are sold, COS may be replaced by COGS.)
Incorrectly applying these two concepts can have a significant impact on an organisations
pricing decisions.
In dollar terms, the mark-up and the margin amounts are identical. However, the formula to
calculate each is different, as is the way in which they are applied in pricing decisions.
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The table and graph below provide a visual comparison between margin and mark-up, and
demonstrate the importance of clearly understanding each term and its application:
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As illustrated by the graph below, the incorrect application of mark-up or margin and
associated calculations can have dire consequences for an organisations financial performance.
%
1000
Mark-up (%)
800
Margin (%)
600
400
200
0 10 20 30 40 50 60 70 80 90
Demand-based pricing
Demand-based pricing (also known as value-oriented pricing) attempts to maximise revenue
and profit through customer segmentation. This is the division of markets into segments of
customers based on the varying levels of customer willingness to pay for particular products.
These levels of willingness to pay are based on customers capacity, desire, or both. Where an
organisation provides high-quality or prominent brand name goods or services, this model is
more likely to maximise profits than cost-based pricing.
By extensively analysing customer demand in a market, businesses can choose a strategy that
maximises the opportunities presented by that demand to capture as much of the market as
possible, and thus increase revenue. Demand-based pricing requires an understanding of
consumer responses to a range of price points in order to determine the highest price that is
acceptable to consumers the price they are willing to pay. This pricing model is therefore
based on perceived value from a customer perspective.
Organisations can only apply demand-based pricing where there are observable prices in
a reasonably active and competitive market. The housing market is a good example of this.
Individual consumers approach purchasing opportunities with their own perceived value of a
property, which takes into account what is being physically offered (i.e. location, size, quality
and amenities), as well as their ability to pay for it. In another example, a jeweller who makes
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their own jewellery is able to charge premium prices for their designs where consumers are
willing to pay for the goods based on the jewellers reputation.
Successful demand-based pricing relies on:
The ability to charge different customers different prices.
Clear segmentation in order to exploit different levels of willingness to pay the more
effective the segmentation, the greater the returns.
Effective segmentation
Effective segmentation (i.e. maximising total revenue with a view to maximising contribution
margin) relies on an organisations ability to control pricing conditions and keep segments
separate. For example, a movie theatre will seek to fill its capacity for a slow day of the week
(inAustralia, usually Tuesdays) by reducing ticket prices to attract otherwise unlikely patrons.
Key to effective segmentation is the ability to optimise sorting mechanisms so that customers
with the greatest need and least flexibility pay higher prices, while those with more flexibility
and a lesser need pay lower (discounted) prices (i.e. discounting is used to sell excess capacity).
Type of customer Impact if full price used Impact if discount price used
In taking advantage of this knowledge, an airline company will divide its market into segments
and charge different prices for different segments without any physical changes to the service
being offered that is, it will charge a lower price for a ticket with a fixed departure time and a
higher price for a ticket that allows a customer to make flight changes.
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These two models apply an understanding of Porters value chain (refer to the unit on analysing
business operations in which this topic is covered) and a products life cycle to segment pricing
decisions (we will also discuss the product life cycle in greater depth in the unit on management
of revenues and costs).
As a product moves through these stages in its life cycle, the market exhibits different
characteristics. The success or failure of a pricing strategy therefore depends on an
organisations decisions to vary prices and tactics to suit particular and changing market
conditions.
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In price skimming, an organisation charges a higher price for a product when it is first
introduced to the market. Customers pay a premium to have first access to the product, and
this higher price is justified by the investment made by the organisation in the research and
development phase. As competitors enter the market, the price of the product is likely to
be reduced. Pricing can be maintained, however, through the addition of enhancements in
subsequent releases of the product.
An example of price skimming is the marketing of the Apple iPad. This product was sold at
a premium on its release, but the price was reduced as competitor items entered the market.
Apple has added enhancements to the iPad in subsequent releases, which helps to maintain its
pricing.
Penetration pricing involves setting a low initial price for a new product in order to gain
market share. This can be a legitimate tactic to encourage customers to trial a new offering. If
the tactic is designed to eliminate competition, however, it constitutes predatory pricing, which
is illegal in most markets. An example of where penetration pricing is often used is when an
airline opens a new route and offers significantly discounted airfares to promote the new route
and encourage customers to try their offering.
Stage Description
Introduction Production commences and the product is made available for sale to customers
The pricing strategy followed in this stage depends on the product and its market
Given buyer ignorance of the product, an organisations primary goal is to educate potential
buyers on the products worth
Consequently, the regular or list price for a new product should be set at a level that
communicates its value to the market
The price should reflect what the seller believes satisfied buyers would pay for a repeat
purchase
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Stage Description
Growth Once a product gains a foothold in the market, issues around pricing begin to change
Repeat buyers are certain of the products value based on their previous experience.
First-time buyers rely on reports from the products developer and existing users as they
disseminate information to the market
This stage is characterised by rapid increases in sales and production
If penetration pricing was used in the introduction stage, this stage will support higher
prices. If price skimming was used, the price may fall slightly as the market strengthens
An organisation using a differentiated product strategy directs its marketing efforts towards
developing unique attributes for the product
Where the differentiated product strategy is focused on particular customer segments, the
organisation profits from applying price skimming to the segment that values the product
most highly
Where the differentiated product strategy is industry-wide, the organisation sets neutral or
penetration prices to increase sales volume
If the organisation pursues a cost leadership strategy, penetration pricing often plays an
important role. When the anticipated cost advantage is dependent on large sales volumes
(linked to economies of scale), the organisation sets low penetration prices to gain a
significant market share during this stage
Maturity Many products do not achieve market maturity because of their failure during the growth
stage to achieve a strong competitive position through offering differentiated products or
developing a cost advantage
Effective pricing at this stage results from an organisation capitalising on the competitive
advantage it achieved during the growth stage
As the product matures, its price and costs may decrease due to knowledge the organisation
acquired in the earlier stages
Slight changes are typically made to the original product in an effort to continue to attract
both new and repeat buyers
Careful cost analysis is necessary to identify unprofitable products and customers from the
organisations point of view. If a product requires a disproportionate sales effort, that should
be reflected in its incremental sales cost and price
If demand for a product cannot support a high price, the organisation should consider
dropping it from the product mix
Product revamping or upgrading is often undertaken to extend product life. This can
sometimes result in a shift back to an earlier stage in the life cycle
Decline This stage involves the downward trend in demand for the product, which results in
declining revenues for the entire industry
Typically, organisations seek business at the expense of their competitors by cutting prices.
However, price-cutting at this stage seldom stimulates sufficient additional demand to
reverse the decline, resulting in reduced profitability for the whole industry
At this stage, there is generally a marked reduction in the number of competitors, with only
a few organisations ultimately remaining in the market
The products price often increases at this point due to the fact that the reduced number of
customers who demand the product remain loyal
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Learning outcome
3. Apply discounting models and assess their impact on an organisations profits.
For an organisation to continue operating, it must sell its products at a profit. A key area of
pricing difficulty for organisations is that of discounting, whether it involves a reduction
from the list price for a specific customer group or is part of a short-term promotion. Where
discounting is not supported by an organisations operational or strategic objectives, it may
simply reduce revenue and profits and not provide any benefit to the organisation.
Role of discounting
Discounting is a pricing tactic that is used to generate demand. Generally, as prices come down,
demand increases. The elasticity of the demand indicates how much of an increase in demand
is achievable. Discounting is only effective when a products price is an important factor for
customers.
If an organisation competes mainly on the basis of price, it is effectively saying to customers that
its product is a commodity that is, it is the same as its competitors products, except for the
price. This type of price-based strategy is rarely effective in the long term and often results in
business failure. In order for a discounting strategy to succeed, it must have a specific objective
that will lead to increased profit in the long term.
Objective Example
Move perishable stock When grocery store items are nearing their expiry
dates
Move stock that is close to being superseded Technology-related items that have a life of six to
12months
Quickly reduce inventory in order to boost cash flow When organisations experience seasonal cash flow
shortages
Promotion to increase market share Retail discounting of products to gain exposure, which
would normally be linked to an advertising campaign
Discounting issues
Discounting can be a useful strategy, particularly to drive sales volumes. However, it can also
impact on other aspects of a business, including:
Profit margins.
Storage or retail space requirements.
Staffing (to service increased sales volume).
Public perception of the business customers may start to see the business as a discount
provider, rather than one that offers premium products.
Unintended negative consequences to avoid these eventuating, discounting should be
aligned with an organisations operational or strategic objectives.
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Petrol discounting. The petrol price in Australian capital cities moves up and down in a
regular weekly or fortnightly cycle. Many consumers anticipate these movements, buying
on the low-price days and avoiding purchases on the high-price days. As there are a fixed
number of petrol bowsers, this results in queuing and a high demand for resources on days
when the price is lower, and low demand on days when the price is higher. From a retailers
perspective, this cycle creates peak demand, which is not ideal for resource planning.
These discounting cycles may initially have delivered some of the benefits of discounting, such
as shifting inventory, boosting cash flow or increasing market share. However, they have also
delivered undesirable customer behaviour, such as waiting for sales events before making
purchases.
As discussed above in the section on demand-based pricing, customers also expect discounts
when paying in advance for certain goods or services; for example, when purchasing airline
tickets well in advance of travel. The benefit of paying in advance is known as consumers
surplus: the gain the consumer makes when the full price of a product is discounted for
advance purchasing.
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A matrix that can be used to assess proposed price changes for other products that have a
different margin to the Amazon espresso beans.
FBCCs management accountant has prepared the following matrix, based on a selling price of
$100 (elements related to the Amazon espresso beans are highlighted using white-on-black):
Product group A B C D E
Standard margin > discount % > 10% > 20% > 30% > 40% > 50%
$ $ $ $ $
5 95 95 95 95 95
10 90 90 90 90 90
15 85 85 85 ** 85 85
20 80 80 80 80 80
Discount percentage
25 75 75 75 75 75
30 70 70 70 70 70
35 65 65 65 65 65
40 60 60 60 60 60
* Current selling price.
** Planned discounted selling price
COGS
Product group A B C D E
$ $ $ $ $
Base COGS 90 80 70 60 50
Product group A B C D E
Standard margin > discount % > 10% > 20% > 30% > 40% > 50%
$ $ $ $ $
Base margin 10 20 30 * 40 50
5 5 15 25 35 45
10 0 10 20 30 40
15 (5) 5 15 ** 25 35
30 (20) (10) 0 10 20
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Sales volume percentage increase required to maintain level of total dollar profit
Product group A B C D E
Standard margin > discount % > 10% > 20% > 30% > 40% > 50%
% % % % %
0 0 0 0 0 0
5 100 33 20 14 11
10 100 50 33 25
15 300 100 60 43
20 200 100 67
30 300 150
35 700 233
40 400
Amazon espresso beans currently earn a gross profit of $30 on a selling price of $100, which
means it fits into product group C in the analysis above. A 15% discount on this selling price
would reduce that gross profit to $15. In order to maintain the same level of profit and for this
promotion to be successful, sales volumes of Amazon espresso beans would need to increase
by a minimum of 100%. This is calculated as:
Old gross profit New gross profit
New gross profit
$30 $15
= $15
= 100%
If additional costs such as marketing (to promote the relaunch) were also included, the sales
volumes would need to increase even further.
Note: The matrices highlight in light grey the discount levels for those product categories,
where the discount would have no impact or a negative impact on profitability. This is because
their gross margin is not high enough to cover the discount. For example, offering a 15%
discount on a product with a 10% margin will deliver a loss to FBCC regardless of sales volumes,
since the new gross margin would be negative.
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Pricing waterfall
The pricing waterfall is a useful tool for graphically presenting and understanding discounts,
allowances, specials and other benefits provided to customers. As demonstrated below, a
pricing waterfall clearly illustrates the erosion of a list price to pocket price (i.e. what is actually
effectively being charged):
Pricing waterfall
120
100
80
$ 60
40
20
0
List
price
Order size
discount
Competitive
discount
Early
payment
price
Annual volume
rebate
Cooperative
advertising
Promotional
allowance
Freight
Warehousing
stock
Consignment
stock
Pocket
price
Invoice
Competitive discount
Competitive discount is an additional discount provided by an organisation due to increased
levels of competition in the market.
Early payment
Organisations may allow settlement discounts for early payment of invoices.
Invoice price
Effective invoice price is equal to the list price less order size, and competitive and early
payment discounts.
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Cooperative advertising
An organisation may offer a payment to a customer for advertising its product in their
catalogue. This cooperative advertising allowance is usually offered by organisations that sell to
retailers.
Promotional allowance
Organisations that supply products to retailers may, for example, offer a discount where their
products are offered at special prices as part of store promotions. Retailers may also be paid a
shelf-space fee for stocking an organisations product in a particular area of their store.
Freight
Organisations may offer pricing that is free into store (FIS) where the supplier is responsible for
payment of freight.
Warehousing stock
An organisations customers may require additional levels of stock to be held in order to
guarantee supply (i.e. safety stock). This effectively results in a price discount through savings
in warehousing for the customer.
Consignment stock
Consignment stock is inventory that a supplier provides on consignment to a customer, legal
ownership of which (and thus liability), passes to the customer only when the stock is used, not
when it is delivered. This supply basis can delay invoicing and result in the supplier holding
excess levels of stock. This effectively provides a price discount through savings in interest cost
by the customer.
Further reading
Bertini, M and Wathieu, L 2010, How to stop customers fixating on price, Harvard Business Review,
vol.88, no.5, May, pp. 8491.
This article discusses pricing moves that can be used to highlight value, including:
Using a price structure that clarifies your advantage.
Using overpricing to create interest.
Partitioning prices to highlight benefits.
Equalising price points to crystallise personal relevance.
A copy of this reading can be accessed using the Business Service Corporate search accessed via
the member Knowledge Centre on the ICAA website.
Learning outcome
4. Demonstrate how target sales pricing can be used to maximise an organisations profits.
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Market research techniques are used to understand what product attributes customers value,
and how much they are willing to pay for those attributes. These techniques can also involve
trialling goods or services in a limited market to ascertain whether the price is appropriate.
Setting a target sales price involves considering a products life cycle. Target prices are often
set during the development stage, but can also be used effectively when revamping an existing
product.
Required reading
Horngren, et al. 2011, Cost accounting: A managerial emphasis, 1stAustralian edn, Pearson
Australia, Frenchs Forest, NSW, p. 437.
Review the example describing how IKEA has used target pricing to support its business strategy.
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Yield-based pricing
Learning outcome
5. Demonstrate how yield-based pricing can be used to maximise an organisations profits.
Charging different prices for products to maximise sales volumes enhances profitability. If only
one price is charged, revenue will be lost.
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Variations in demand
Variations in customer demand for goods or services impact on an organisations choice of
pricing strategy. One strategy that is used to accommodate cyclical customer demand is to
increase prices when demand is high, and reduce them when demand is low, as illustrated in
the following example:
4pm7pm 4.00
7pm6.30am 2.50
Source: New South Wales Government Roads and Maritime Services, Time of day tolling, accessed 5 August 2013,
www.rta.nsw.gov.au Using roads Motorways and tolling Time of day tolling.
Peak load pricing is a form of yield management that is based not only on variations in
customer demand but also constraints on capacity. Organisations or industries charge different
prices at different times due to constraints on capacity. Common examples are electricity and
telephone companies, internet service providers or toll roads, which often charge lower prices
during off-peak periods.
Market/customer segmentation
Yield management also involves differentiating between various market or customer segments.
An example is a hotel that distinguishes between business and leisure travellers in its room
tariff rates. Including a Saturday night in their stay may allow travellers to access lower tariff
rates, which allows the hotel to charge different prices for the same product: a higher price for
business travellers, a lower price for leisure travellers.
Quiz
[Available online in myLearning]
ACT
Activity 4.1
Calculating alternative pricing methods
Introduction
This activity requires you to use alternative pricing methods for a food and beverage outlet.
This activity links to learning outcomes:
Evaluate both the qualitative and quantitative factors impacting a pricing decision.
Apply models for determining an organisations pricing structure.
At the end of this activity you will be able to produce various pricing options and make a
recommendation about an organisations pricing.
It will take you approximately 45 minutes to complete.
Scenario
You are a senior accountant at EBA Financial Services, and one of your clients, Supreme Coffee,
is looking to open a new coffee shop in a busy retail area. The owner (Jumbo Hiro) of Supreme
Coffee has asked for your help in setting prices.
Jumbo has informed you that he would like to explore various pricing options using Supreme
Coffees espresso range as an example. He has collected some competitor data and other related
information to assist you.
The new shop lease allows Supreme Coffee to be open seven days a week.
Supreme Coffees applicable cost information for its espresso range of products is as follows:
Other costs
Page 4-24
Current competitor pricing (excluding GST) was found to be as follows:
Competitor Glorious Jeans Michaels Patties CupCake King Rancours Caf Deluxe
Coffee size Small Medium Large Regular Large Super Small Medium Large Diminutive Media Expansive
$ $ $ $ $ $ $ $ $ $ $ $
Filtered 2.50 3.00 3.50 2.25 2.50 3.00 2.25 2.50 3.00 3.00 3.50 4.00
Espresso 3.75 4.25 4.75 3.50 3.80 4.20 3.50 3.80 4.20 4.00 4.50 5.00
Mocha 4.00 4.50 5.00 3.75 4.00 4.50 3.75 4.00 4.50 4.50 5.00 5.50
Hot chocolate 3.75 4.25 4.75 3.50 3.80 4.20 3.50 3.80 4.20 4.00 4.50 5.00
Extras
Dine-in 1.00
Quality rating
Chartered Accountants Program
Activities Unit 4
Chartered Accountants Program Management Accounting & Applied Finance
ACT
Tasks
For this activity you are required to prepare an analysis of various pricing alternatives for
Supreme Coffee (ignoring GST).
You have been asked to complete the following tasks:
1. Determine appropriate pricing levels for Supreme Coffees range of products taking into
account existing competitor prices, and assuming that your client expects the new coffee
shop to be a 44.5 star business (without reference to costs).
2. Determine appropriate pricing levels using variable costs for espresso coffee only, assuming
a 140% mark-up.
3. Determine appropriate pricing levels using full cost for espresso coffee only, assuming a
100% mark-up and expected daily sales of 300 cups of espresso coffee. Espresso sales are
expected to represent 15% of Supreme Coffees revenue.
4. Given the following additional information for large espressos, calculate the price at which
Supreme Coffee should sell its large espresso.
3.50 200
3.75 175
4.00 150
4.50 100
5.00 75
5.25 50
5. Outline factors other than margin that Supreme Coffee would need to take into
consideration before deciding on the price of its large espresso coffee.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 4.2
Price discounting
Introduction
This activity requires you to apply price discounting in a manufacturing environment.
This activity links to learning outcomes:
Evaluate both the qualitative and quantitative factors impacting a pricing decision.
Apply discounting models and assess their impact on an organisations profits.
At the end of this activity you will be able to assess the impact of discounting on the
profitability of an organisation and determine the most appropriate pricing policy.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
You are a management accountant at Accutime and have been asked by Graham Anderson,
the chief financial officer (CFO), for advice relating to the release of its Version 5 temperature
compensated crystal oscillator (TCXOv5) in approximately six months.
More details are provided below:
1 0% 7 months 75,000
2 5% 7 months 40,000
4 10% 7 months 0
5 15% 6 months 0
ACT
Tasks
For this activity you are required to provide Graham with recommendations regarding the
pricing options for the TCXOv4.
You have been asked to complete the following tasks:
1. Determine the gross profit Accutime would make under each option, and recommend the
preferred option.
2. Outline other factors that could influence your recommendation.
3. If the research and development (R&D) team had a history of delivering projects one to two
months late, explain how your answer would change.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 4.3
Target pricing
Introduction
This activity requires you to demonstrate your understanding of target pricing.
This activity links to learning outcome:
Demonstrate how target sales pricing can be used to maximise an organisations profits.
At the end of this activity you will be able to demonstrate how target sales pricing is used to
manage an organisations launch of a new product.
It will take you approximately 40 minutes to complete.
Scenario
You are a management accountant who has recently commenced work with TechCentra, an
Australian-based technology organisation looking to make and distribute a new tablet PC.
Based on your research, you have discovered that while the Lime computer tablet is the
dominant player in the market, there are a number of other manufacturers who are seeking to
cash in on the shift away from desktops and notebook computers to tablets. The table shows the
retail price range (excluding GST) of the various brands of tablet computers currently on the
market:
Lime 550750
Pacer 550750
Sus 700850
Blueberry 550800
BC 550700
Slovon 525650
Oxford 550750
TechCentra is planning to offer three versions of its new tablet, called the Plate, with the
following features:
Wi-Fi
4G
Forward camera
Rear camera
Telephone capable
ACT
DVD slot
Serial port
USB port
External keyboard
Office apps
TechCentra currently plans to manufacture all Plate tablets in Australia, with a number of
components sourced overseas.
Details for each model are as follows:
All sales are to be made direct to the consumer, either via the web or telephone, with goods
to be couriered to the consumer. Return on investment (ROI) values are based on an expected
annual return of 15%.
TechCentra has set its target prices based on the market conditions.
Tasks
For this activity you are required to advise TechCentra on the pricing of its new products.
You have been asked to complete the following tasks:
1. Determine which of TechCentras new Plate tablets will meet its required gross margin
targets.
2. Determine which of TechCentras new Plate tablets will meet its required ROI targets.
3. Based on your answers to Tasks 1 and 2, assess TechCentras gross margin and ROI targets
and how they could impact TechCentra going forward.
4. Given that pricing is fixed due to market conditions, identify the options available to
TechCentra to achieve its desired financial goals.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 4.4
Yield management
Introduction
This activity requires you to demonstrate your understanding of yield management within a
service-based environment, and how it can be used to improve organisational profitability.
This activity links to learning outcome:
Demonstrate how yield-based pricing can be used to maximise an organisations profits.
At the end of this activity you will be able to demonstrate how yield-based pricing can be used
to maximise an organisations profits.
It will take you approximately 45 minutes to complete.
Scenario
You are a management accountant for Eagle Airlines, a new Australian domestic airline focused
on providing flights along Australias eastern seaboard route, between Cairns, Brisbane, Sydney
and Melbourne.
The managing director has asked you to analyse the pricing of seats between Brisbane and
Melbourne. The first flight you have decided to look at is flight AE4516, departing Brisbane at
8:30am on Wednesday.
The aircraft scheduled for this flight is an Airbus 330-300. The table below shows the details of
the flight:
Description Details
Brisbane airport peak usage fee (applied to flights $300 per take-off/landing
using the runway between 7am and 10am)
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Description Details
Variable airplane costs (meals, entertainment system, $60 per passenger business class
baggage)
$30 per passenger economy class
Business 1,450 15
1,300 20
1,100 25
900 35
Tasks
For this activity you are required to analyse the pricing of seats for Eagle Airlines flight
AE4516, departing Brisbane at 8:30am on Wednesday.
You have been asked to complete the following tasks:
1. Determine both the variable and fixed costs for flight AE4516.
2. Determine the price schedule that Eagle Airlines should use for flight AE4516 on
Wednesday morning for all three ticket types.
3. Based on the proposed price schedule, determine the profit that Eagle Airlines would expect
to derive from flight AE4516 on Wednesday morning.
4. Based on the information provided, calculate the minimum number of passengers required
to make flight AE4516 viable.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
Horngren, C, Wynder, M, Maguire, W, Tan, R et al. 2011, Cost accounting: A managerial emphasis,
1st Australian edn, Pearson Australia, Frenchs Forest, NSW, Australia, p. 437.
Further reading
Bertini, M and Wathieu, L 2010, How to stop customers from fixating on price, Harvard
Business Review, vol. 88, no. 5, May, pp. 8491.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit.
Atkinson, A, Kaplan, R, Matsumura, E and Young, A 2012, Management accounting: Information
for decision making and strategy, 6th edn, Pearson Education Inc., Upper Saddle River, NJ, USA,
pp.227232.
Brooks, A, Eldenburg, L, Oliver, J, Wolcott, S and Vesty, G 2008, Contemporary management
accounting, John Wiley and Sons Australia Ltd, Milton, Qld.
Ellickson, PB and Misra, S 2008, Supermarket pricing strategies, Marketing Science, vol.27,
no.5, SeptemberOctober, pp. 811828.
Hamilton, R and Srivastava, J 2010, Slicing and dicing your pricing, Harvard Business Review,
JanuaryFebruary.
Horngren, CT, Datar, SM, Foster, G, Rajan, M and Ittner, C 2009, Cost accounting: A managerial
emphasis, 13th edn, Pearson Education Inc., Upper Saddle River, NJ, USA, pp. 435436.
Horngren, C, Wynder, M, Maguire, W, Tan, R et al. 2011, Cost accounting: A managerial emphasis,
1st Australian edn, Pearson Australia, Frenchs Forest, NSW, Australia.
Jagels, M 2007, Hospitality management accounting, 9th edn, John Wiley and Sons, Hoboken,
NJ,USA.
Maguire, W and Rouse, P 2006, Revenue and cost management for service organisations, Pearsons
New Zealand, Auckland, NZ.
Netessine, S and Shumsky, R 2002, Introduction to the theory and practice of yield
management, INFORMS Transactions on Education, vol. 3, no. 1, September.
New South Wales Government Roads and Maritime Services, Time of day tolling, accessed
5August 2013, www.rta.nsw.gov.au Using roads Motorways and tolling Time of day
tolling.
OConnor, P and Murphy, J 2008, Hotel yield management practices across multiple electronic
distribution channels, Information Technology and Tourism, vol. 10.
Proctor, R 2009, Managerial accounting for business decisions, 3rd edn, Pearson Education Limited,
Harlow, UK.
Rannou, B and Melli, D 2003, Measuring the impact of revenue management, Journal of Revenue
and Pricing Management, vol. 2, no. 3, pp.261270.
R
Stanford Graduate School of Business 2003, Hyundai Motor Company, Case SM-122, accessed
24March 2014, www.gsb.stanford.edu Faculty & Research Cases Case No. 122
SM122 Hyundai Motor Company View the document (pdf).
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Core content
Unit 5: Management of revenues and costs
Learning outcomes
At the end of this unit you will be able to:
1. Determine the costs and benefits of a product or service using life-cycle costing.
2. Apply target costing.
3. Prepare a CVP analysis.
4. Prepare a customer profitability analysis.
Introduction
This unit examines the different tools and techniques that can be used to improve business
profitability through measuring and managing revenue and costs. Such tools and techniques
have been developed in response to the challenges of the current business environment,
characterised by intense competition, rapidly changing technology and the increased
expectations of customers and shareholders.
Life-cycle costing a method of managing costs over the whole of a product or services life
isexamined first. This is contrasted with traditional accounting, which focuses on managing
costs during the production phase only, and on period costs and results.
Cost-volume-profit (CVP) analysis, a key tool for understanding the relationship between
revenue, costs and sales volume is then examined, together with customer profitability analysis
(assessing the profitability of the business on a customer-by-customer basis), and target costing
as applied to new product introductions.
Life-cycle costing
Learning outcome
1. Determine the costs and benefits of a product or service using life-cycle costing.
As discussed in a number of marketing texts, all products and services have a life-cycle,
proceeding from development through to decline. While marketing has traditionally considered
a product or service across its lifetime, traditional accounting focuses on costs within designated
periods.
maaf31505_csg
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As the following diagram highlights, sales volumes increase at the introduction of the product
or service, then plateau before declining, until the product or service is eventually discontinued.
The time frame of this life-cycle can vary greatly. Consider, for example, the difference between
the life-cycles of Coca-Cola and an Intel chip.
BASIC PRODUCT LIFE-CYCLE
INTRODUCTION
DEVELOPMENT
SALES
MATURITY
GROWTH
DECLINE
TIME
Traditional cost accounting often neglects the significant costs that can be incurred both before
production commences (such as research and development (R&D) costs), and after production
ceases (such as the costs of decommissioning a production facility or mine). It also tends
tofocus on minimising the costs of each step of the product life-cycle, rather than attempting
to minimise costs across the whole life-cycle. For example, reducing the level of development
expenditure may lead to production costs being higher than necessary.
95%
100%
85%
75%
66%
50%
TRADITIONAL COST
ACCOUNTING FOCUS
25%
0%
PRODUCT PLANNING, PRELIMINARY DETAILED DESIGN PRODUCTION DISTRIBUTION AND
CONCEPT DESIGN DESIGN AND PROTOTYPE LOGISTIC SUPPORT
Source: Raffish1991.
Source: Raffish 1991.
As this diagram highlights, in modern manufacturing industries it is not uncommon for a very
high proportion (80% or more) of the total cost of the product over its life-cycle to be incurred,
or at least committed, during the pre-production phase. This is because decisions made during
the design stage have consequences for the cost of production that will be difficult, if not
impossible, to change during the production phase without incurring other significant costs.
Production costs are therefore, to a large extent, locked in as a result of decisions made atthe
pre-production phase. It is also likely that some post-production costs (such as after-sales
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service and warranty costs) will also be affected by early design stage decisions, since these
impact on the reliability of the product.
Life-cycle costing involves estimating and accumulating all of the costs of a product or service
over its entire life-cycle, from inception to eventual discontinuation. This approach enables
managers to assess whether the profits generated during the production phase are sufficient
tocover all of the costs incurred over the products life and to decide whether an increase
ininitial costs would result in a reduction in future (production) costs.
Design alternatives
Spout Pour Hot Pour
Year 0 Design costs already incurred $100,000 $150,000
Years 24 Expected sales quantities per annum 10,000 units 10,000 units
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As can be seen from the preceding analysis, Hot Pour provides the highest amount of
cumulative profit over the life of the product ($450,000, compared with Spout Pours $400,000).
This is despite Hot Pour costing twice as much toproduce as Spout Pour. By investing more
in the initial phase of the product life-cycle, SteamCup can develop anelectric kettle of a
higher quality and therefore demand a higher selling price, which reduces the expected level
ofwarranty costs.
The lifetime return on investment (cumulative profit divided by the value of the investment)
would be: Spout Pour 200% ($400 $200), versus Hot Pour 150% ($450 $300).
Whether profit or return on investment (ROI) are considered more important will depend
on the organisations priorities and strategic objectives. These could also be influenced by
remuneration incentives provided to the organisations executives.
Phase 1 Pre-production
This phase includes research and development, product design, production set-up and
preproduction marketing. There is normally little or no revenue generated; however, the
results yielded often have a significant impact on the cost structure of the product or service
during the production phase. At each step of the pre-production phase, the future viability
ofthe product or service should be assessed.
Phase 2 Production
This phase normally includes the product launch, and therefore requires the product or service
to move into production/manufacturing. Marketing activity also usually increases at this time,
in order to create public awareness and to stimulate demand.
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Phase 3 Post-production
As the product or service approaches the end of its life-cycle, production and sales slow down,
until eventually the product/service is removed from the market. At this point, the organisation
will need to honour its remaining after-sales service obligations (e.g.warranty claims) and
decommission existing production facilities. Revenue also tends to decline during this phase,
and the product or service usually becomes a cash drain on the organisation.
Target costing
Learning outcome
2. Apply target costing.
Target costing can be defined as the process of designing a product to meet a specific cost
objective. It was developed in response to the recognition of how life-cycle costs are committed
and incurred at different phases through the life of a product or service. Target costing isatool
for managing life-cycle costs through the pre-production phase, when opportunities for
achieving substantial cost savings are greatest.
A key feature of target costing is the involvement of multifunctional teams exploring alternative
options for achieving the target cost in order to ensure that no single function (such as
engineering design, purchasing, production or marketing) unduly influences the process.
As target costing tends to be market-driven (working from the sales price backwards), each
ofthe functional areas (marketing, R&D and finance) need to work together to achieve the
desired outcome.
Target costing provides a mechanism that allows a cost control technique to set the maximum
amount that a particular product should cost to manufacture or buy. Consider the car industry,
where components are purchased at a specific price. Suppliers to Ford, for example, must offer
a12to 36-month fixed price for the items they manufacture. This allows Ford to set a planned
selling price for its vehicles.
As discussed in the unit on pricing decisions and models, there is a strong link between
target pricing and target costing. While target pricing is reliant on target costing, there may
besituations where target costing is applied without target pricing. For example, this may occur
where services are provided internally: a level of service is agreed to for a specific cost that the
supplying department must deliver on.
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Key points in identifying potential avenues for cost reduction include:
Considering larger cost items first (it is easier to make an impact by changing a large cost
component than a number of small costs).
Identifying which costs are fixed and cannot be changed.
Assessing the impact of a potential cost reduction decision on the final product or service.
For example, if a lower quality material is used, how will this impact the quality of the final
product and its market perception?
Using tools such as value chain analysis (refer to the unit on analysing business operations).
Learning outcome
3. Prepare a CVP analysis.
Cost-volume-profit (CVP) analysis is a management accounting tool that helps determine the
business activity required to achieve a break-even or desired level of profit. By understanding
these levels from a unit and revenue perspective, management is better equipped to make
decisions regarding pricing, marketing and cost management.
CVP analysis also helps managers understand the relationship between sales revenues, costs
and sales volume. It is particularly useful for addressing the following key questions:
What level of sales is required to break even?
What level of sales is required to achieve a target profit (or return on investment)?
What will the impact on profits be of a particular change in volume (sensitivity analysis)?
The principles underlying CVP analysis can also be adapted to help managers identify the
optimal mix of products or services when a resource/s is in short supply (a constrained
resource). The resource may be materials (due to supplier issues), labour (workforce
availability), machinery (limited number of available hours or throughput rates), or even
distribution (a limited number of available vehicles).
CVP basics
The key formulas for CVP analysis are derived from the general relationship:
where:
Total costs = (Variable costs per unit Unit sales volume) + Fixed costs
Profit = (Selling price Unit sales volume) [(Variable costs per unit Unit sales volume)
+Fixed costs]
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The formula can also be restated to incorporate the concept of contribution, which represents
the difference between the sales price and the variable costs per unit. This difference represents
the amount of surplus generated by the sale of a product, which, after fixed costs have been
met, then provides profit for the business:
Contribution margin per unit ($) = Selling price Variable costs per unit
At the break-even point the profit is zero, which can be restated as follows:
Profit = (Contribution margin per unit ($) Unit sales volume) Fixed costs = 0
Therefore, the break-even sales volume in units (BEP units) is calculated as follows:
Fixed costs
BEP (units) = Contribution margin per unit ($)
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Therefore, the break-even sales value in dollars (BEP dollars) is found as follows:
Fixed costs
BEP (dollars) = Contribution margin ratio (%)
An alternative approach is to multiply the break-even units by the sales price per unit.
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For a business to achieve a certain level of profit, the dollar amount of contribution generated
by the business must exceed the level of fixed costs by the amount of profit required. Therefore,
the relationships for determining the sales volume in units and sales value in dollars required
toachieve a target level of profits are adapted as follows:
+
= $2m$4$1m
= $3m
$4m
= 750,000 units
+
= $2m40%$1m
= $3m
40%
= $7.5m
Note: The desired or target profit is often linked to the investment made by an organisation,
and therefore may be described as a desired rate of return on investment, either before
orafter tax. For example, if an organisation requires a return of 7% after tax on an investment
of$1,000,000, and assuming that a tax rate of 30% applies, this would require a pre-tax return
of 10% (7%0.70). This means that a before-tax profit of $100,000 ($1,000,000 10%) would
berequired to achieve the target profit.
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Therefore:
Volume of sales required to achieve a target profit after tax (units)
= 1$1m
0.3
= $1m
0.7
= $1.429m
The volume of sales in units required to achieve a target profit after tax of $1 million is found
asfollows:
Volume of sales required to achieve a target profit after tax (units):
Fixed costs + Target profit before tax
= Contribution margin per unit ($)
+
= $2m $$41.429m
= $3.429
$4
m
= 857,250 units
The value of sales in dollars required to achieve a target profit after tax of $1 million is found
asfollows:
Value of sales required to achieve a target profit after tax (dollars):
Fixed costs + Target profit before tax
= Contribution margin ratio (%)
+ $1.429m
= $2m 40%
= $3.429m
40%
= $8.573m
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The sales mix is the proportion of sales revenue contributed by an individual product to an
organisations total sales. This may be expressed as either a percentage or dollar amount.
Notethat since a change in the relative sales mix will have an effect on both the break-even
point and the sensitivity of profit to changes in volume, the assumption in CVP analysis is that
the sales mix remains constant during the period.
An organisations break-even point is calculated by using a weighted average contribution
margin.
While applying CVP analysis in a business with a single product or service is relatively
straightforward, applying the analysis in a multi-product environment requires some care,
asthere will usually be some fixed costs that cannot be allocated to each individual product line
other than on an arbitrary basis.
To avoid this situation, the following four-stage approach should be applied:
1. Calculate the contribution margin per unit of each individual product.
2. Use the estimated future sales mix to determine the contribution per standard batch
(orbundle) of sales.
3. Apply CVP formulas to determine the required break-even sales volume in terms of the
number of standard batches.
4. Convert the solution found in Step 3 into the required combination of sales (in units
ordollars) of each individual product using the sales mix.
Alpha Beta
$ $
Sales price 100 120
Units Units
Therefore, the standard sales mix would be four (4) units of Alpha for each one (1) unit of Beta.
1. Calculate the contribution margin per unit of each individual product.
Alpha Beta
$ $
Sales price 100 120
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2. Use the estimated future sales mix to determine the contribution per standard batch
(orbundle) of sales.
Contribution per standard $20 4 = $80 $30 1 = $30 $80 + $30 = $110
batch
3. Apply CVP formulas to determine the required break-even sales volume in terms of the
number of standard batches.
BEP (batches)
Fixed costs
= Contribution per batch
$5m
= $110
= 45,455
4. Convert the solution found in Step 3 into the required combination of sales (in units
ordollars) for each individual product.
The break-even point in units is determined as follows:
Break-even number of standard batches = 45,455
Each standard batch is made up of four units of Alpha and one unit of Beta
Therefore, the number of units of Alpha = 4 45,455 = 181,820, and the number of units
ofBeta = 1 45,455 = 45,455
Break-even revenue = Alpha (181,820 $100) + Beta (45,455 $120) = $23,636,600
CVP assumptions
CVP analysis is based on the following assumptions:
1. Volume is the only factor that causes revenues and costs to change.
2. There is either a single product (or service) or a constant sales mix.
3. Costs can be accurately divided between fixed and variable elements.
4. Profits are determined on a marginal costing rather than an absorption costing basis.
5. Revenues and costs are linear.
6. The CVP analysis applies to the relevant range only. (The relevant range is the range
ofvolume over which the assumed relationships between revenue, costs and volume can
beassumed to be realistic.)
7. The analysis can only be used in the short term.
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As the income tax and GST rates vary between jurisdictions, care should always be taken
toensure that the correct rates are applied to all problems being solved.
Example Determining the optimal mix of products or services when one of the resources required bythe
business is in short supply
ABC produces three different products: Standard, Advanced and Premier. Next month, there will
be a shortage ofavailable machine hours, which will be limited to 2,500 hours. The companys
management wishes toidentify the mix of products that would maximise profits. $20,000
offixed costs are incurred per month. Further information relating to each product is provided
below:
Variable costs:
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Ranking 2 3 1
3. Advanced* 3 400
*There are no machine hours available for the production of any units of the Advanced product.
4. Determine the amount of profit generated from the optimal mix.
$ $
Contribution:
Advanced (0 $40)
Profit 20,500
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Learning outcome
4. Prepare a customer profitability analysis.
Overview
While management accounting has traditionally focused on measuring the relative profitability
of a companys products or services, in recent years there has been an increasing emphasis
onthe analysis of a companys profitability by individual customers or customer groups.
Key to such analysis is the allocation of selling, general and administrative (SG&A) costs, which
can be attributed to customers according to how they consume the costs. This is typically
achieved using the principles of activity-based costing, as covered in the unit on activity-based
costing and management.
Customer profitability analysis enables management to identify not only which are its most
and least profitable customers, but also, and more importantly, to identify the reasons why this
is so. This can lead to a clearer understanding of the value that customers place on the various
activities performed by the company, which then allows management to explore alternative
options for improving customer profitability. These might include seeking to change customer
behaviour where customers are currently not prepared to pay a price that adequately reflects
the cost to the company of supplying a product or service. For example, where a customer
places frequent, low-value orders but is not prepared to pay a higher price to reflect the
additional cost that this creates, a minimum order quantity could be introduced.
Creating and maintaining customer profitability databases is expensive, and they are rarely
able to be purchased as off-the-shelf software without some modification to suit the individual
company. A further practical difficulty with customer profitability models is that data is usually
not static; for example, cost data needs regular updating, including expense data from the
general ledger and cost driver information from other sources.
Notwithstanding these drawbacks, organisations with robust customer profitability models are
likely to have a competitive edge over others that do not. It is important to assess whether the
target market segments and various customer groups will generate profitability, cash flow and,
ultimately, value for the organisation.
The method used to attribute the selected resources to customers and/or market segments
is typically based on a user pays system. This means that those customers and/or market
segments that actually consume the resource should bear its cost or be credited with its revenue.
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A customer profitability analysis normally involves two key steps:
1. Calculating the net profit for each customer or customer group.
2. Analysing the customer profitability calculation to identify opportunities to improve future
profits.
Gross profit X X X
Net profit X X X
Revenue and cost of sales information is usually sourced from the organisations sales
information system. The allocation of other costs is normally undertaken using activity-based
costing principles.
Customer A B C
Number of sales orders 300 100 200
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Customer A B C
$000 $000 $000
Sales revenue 1,000 875 200
Sales order costs (300; 100; 200) $250 (75) (25) (50)
Sales visit costs (50; 10; 20) $500 (25) (5) (10)
Total attributable selling, general and administrative costs (140) (40) (76)
Customer A B C
Sales revenue per order $3,333 $8,750 $1,000
This analysis reveals that, relative to the value of sales, Customer B places a smaller
number oforders, receives a smaller number of sales visits and requires a smaller number
of deliveries relative to the value of sales. Incontrast, Customer A and, in particular,
CustomerC, require more SG&A costs relative to the amount of sales value generated.
Possible actions for improving the profitability of Customers A and C might include:
1. Reducing the number of activities provided to these customers; for example, a
minimum sales order value might be introduced to reduce the number of sales orders
that require processing.
2. Reducing the cost of activities provided to all customers. In this case, it may be possible
to reduce the cost ofprocessing sales orders, making sales visits and delivering goods
tocustomers.
3. Increasing prices, particularly to Customer C, to cover the additional costs of supplying
to this specific customer. This could be achieved by introducing an order fee where
orders are less than acertain value.
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Quiz
[Available online in myLearning]
ACT
Activity 5.1
Life-cycle costing
Introduction
Life-cycle costing is a process to determine the lifetime financial return on an investment
(including new products), with the objective of maximising the lifetime return to the
organisation.
Management accountants are often involved in the preparation of detailed financial analysis for
life-cycle costing, including identifying opportunities to improve long-term performance.
This activity links to learning outcome:
Determine the costs and benefits of a product or service using life-cycle costing.
At the end of this activity you will be able to compare two alternatives using life-cycle costing
and recommend which alternative an organisation should pursue.
It will take you approximately 60 minutes to complete.
Scenario
You are a management accountant working at Tech Centra, a manufacturer of computing
goods. You report to Nigel Hayek (CFO). The company is currently assessing two alternative
development options regarding their new Oval Plate tablet, and would like to make a decision
by the end of the month.
The following information is available on the two alternatives:
ACT
Tech Centra has a 30 June year end and uses full absorption costing. The company expects its
products to achieve a minimum gross margin of 40% and an average return on investment
(ROI) of15% per annum for the life of its products.
Tech Centra has adopted a just-in-time inventory management system that results in no
inventory of finished goods being held at period end (i.e.all items produced are sold in the
month of production).
All warranty claims are expected in the year of sale.
Tasks
Nigel has asked you to complete the following tasks to enable a decision to be made about
which development option the company should pursue:
1. Prepare a financial analysis for each alternative.
2. Identify three (3) key pieces of information which are relevant to deciding which alternative
Tech Centra should select.
3. Identify two additional factors that Tech Centra should consider in making its decision.
4. Recommend which alternative Tech Centra should select. Justify your selection.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 5.2
Target cost for a special order
Introduction
Target costing is a tool for managing life-cycle costs through decisions taken during the
preproduction phase of a product or services life, when opportunities for achieving substantial
cost savings over the life of the product are greatest.
Target costing can also be used to identify opportunities for reducing the cost of providing
existing goods and services to customers.
This activity links to learning outcome:
Apply target costing.
At the end of this activity you will be able to review a cost structure and determine
opportunities to reduce costs in order to achieve required cost levels.
It will take you approximately 45 minutes to complete.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
You are the group management accountant at Accutime, where Graham Anderson, the chief
financial officer (CFO), has asked you to provide support to the sales and marketing department
regarding a recent opportunity.
Accutimes newly released TCXOv5 has been a great success, and sales are up 15% on the
previous model, the TCXOv4.
Accutime has been approached by one of its customers, Special Orders, which does not
normally purchase items in the TCXO range. Special Orders has an order for a new toy that
requires a component similar to the TCXOv5. The toy is a one-off Christmas special, and
istherefore not expected to be made again.
Special Orders has said that for it to meet its customer price point, it would need to be able
tobuy the TCXOv5 from Accutime at $0.50 each. Based on Special Orders contract, it needs
topurchase 120,000 units.
From a review that was undertaken by the finance department in March, you have been able
toextract the following information in relation to the TCXOv5 and TCXOv4.
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COGS
Note: Accutime has target gross margins of 30% and net profit margins of 15% for all its products.
Tasks
For this activity you are required to:
1. Determine if Accutime should accept Special Orders order, based on the March analysis.
2. Describe two options Accutime could explore in order to reduce the cost of supply
toSpecial Orders.
3. Calculate the impact of the two options identified above, and determine whether this would
change your view on accepting the order.
4. Before accepting Special Orders order, identify two other non-financial issues that
Accutime should consider.
ACT
Activity 5.3
Cost-volume-profit analysis
Introduction
Cost-volume-profit (CVP) analysis is used to determine the level of sales at which total revenue
and costs are equal, and above which profit is made. CVP analysis can be used to make
decisions regarding product and service supply, including whether or not to accept special
arrangements.
Management accountants are often involved in the preparation and interpretation of CVP
analysis.
This activity links to learning outcome:
Prepare a CVP analysis.
At the end of this activity you will be able to prepare a CVP analysis for an organisation in the
hospitality sector and determine whether it should accept a corporate booking.
It will take you approximately 90 minutes to complete.
Scenario
You have recently joined Sunsu Pty Ltd (Sunsu) as an assistant management accountant
reporting to Hiroko Watanabe. Sunsu owns and operates the world-famous chain of Sunsu
Health Resorts in Australia and New Zealand. As of December 2013, there were six (6) resorts
operating in Australia and two (2) in New Zealand.
The basic service offered by the resorts comprises accommodation, use of restaurant facilities,
tailored fitness programs, a gymnasium, health-orientated educational programs, and a spa and
holistic health facilities. Each guest is accommodated in individual, stand-alone cottages located
within the respective property.
You have been assigned to provide advice to Sunsus Dandenong, Victoria property.
Guests at the Dandenong property are provided with two stay options:
ACT
The Dandenong property has 50 cottages available. Of the guests staying at the resort,
70%ofrooms are provided based on single accommodation.
Hiroko has also supplied you with the following cost structure for the property:
Cost structure
Area Service Fixed costs (monthly) Variable costs
Accommodation Servicing rooms $10,000 $150 per room per day
Sunsu uses a 4/4/5 week reporting cycle that is, months 1 and 2 are four weeks, and month3
isfive weeks, resulting in 13-week quarters.
Tasks
Hiroko has asked you to complete the following tasks:
1. Based on the above information, calculate the break-even revenue and the break-even
percentage of room occupancy for one quarter.
2. Large Corporate (a professional services firm) has requested the exclusive use of the Sunsu
Dandenong resort for two weeks during June 2015. This is normally a slower month, with
occupancy levels averaging 65%. Large Corporate has said it expects each person to have
their own room and that they require all 50 rooms, with each guest to enjoy the normal
benefits of staying at Sunsu.
(a) Calculate the lowest total charge at which you would be willing to make the property
available to Large Corporate for the two weeks.
(b) Describe key qualitative factors you would need to consider before accepting this
booking.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 5.4
Throughput costing and material shortages
Introduction
This activity demonstrates how throughput costing can be used to influence decisions and
maximise financial performance.
It links to learning outcome:
Prepare a CVP analysis.
At the end of this activity you will be able to use throughput costing to determine optimum
output given resource constraints.
It will take you approximately 75 minutes to complete.
Scenario
You are a management accountant at Crunchy Pty Ltd (Crunchy) and report to Michael Denise,
the chief financial officer (CFO). Crunchy manufactures a wide range of cereal and snack foods.
It is 31 December 2013. The forecast trading results for the snack food division, which
manufactures three products, are shown below:
Forecast trading results snack food division year ending 31 December 2014
Product A Product B Product C Total
Selling price per packet $2.50 $3.50 $4.50
Production is continuous throughout the year, and demand for each of the three products
remains constant. Due to the relatively short shelf life of the products, no stock of work
inprogress or finished goods is carried.
The commercial manager of the snack food division has today been informed that, due toafire
in one of the companys warehouses, the majority of the organisations stockpile of a raw
material used in the manufacture of each of the three products has been destroyed.
Additional quantities are unavailable locally due to the seasonal nature of the raw
material, while a global shortage means that the next shipment will not arrive for 13weeks.
Nosubstitutes for the raw material are available.
Further investigation by an external insurance assessor reveals that only 37,500kg of the
material can be salvaged from the warehouse and is suitable for use in production.
ACT
The estimated consumption of the salvaged material per product is:
Product A 200g per packet.
Product B 150g per packet.
Product C 75g per packet.
Pre-existing contracts with customers require Crunchy to supply, at a minimum, the following
amounts of each product during the 13 weeks wait for the raw material:
30,000 packets of product A.
50,000 packets of product B.
5,000 packets of product C.
Failure to deliver these guaranteed minimum quantities will impose heavy financial penalties
on the company for non-performance.
Michael prefers to use the throughput costing approach and has discussed this with you, while
you have proposed the traditional costing approach due to the storage of the raw material.
Michael has agreed to both approaches being used; however, you will need to explain any
differences in the findings.
Task
For this activity you are required to determine the financial impact of the disaster on Crunchys
profit for the next quarter using both the throughput and traditional (full absorption) costing
approaches.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 5.5
Customer profitability analysis
Introduction
A customer profitability analysis provides an organisation with information regarding which
customers and customer groups are providing superior and inferior levels of profit to an
organisation, and aims to improve future performance levels.
Management accountants are often called on to undertake product and customer profitability
analyses, and to work with management to identify opportunities for future improvement.
Thisactivity links to learning outcome:
Prepare a customer profitability analysis.
At the end of this activity you will be able to undertake a customer profitability analysis for a
product-based organisation.
It will take you approximately 50 minutes to complete.
Scenario
MyCoal Limited (MC) is an Australian-owned, publicly listed coal miner, with its flagship
thermal coal mine, BeMine (BM), located in the Hunter Valley region of New South Wales.
The company aims to maximise shareholder value through efficient organic growth and
acquisitions, while maintaining the highest safety standards for all MC employees and
contractors. There is also a strategic focus on advanced coal mining technology and investing in
cleaner coal production techniques.
BMs customers include one (1) local and two (2) overseas electricity generators, from Korea and
China.
The following financial and management accounting information is for the year ended
30June2015:
ACT
The sales contract for the Chinese customer is up for renewal in late 2015. With continued
downward pressure on the market price of thermal coal due to oversupply, MCs management
is uncertain about whether it can maintain the current pricing level to them.
The local customer obtains almost 100% of its coal input from MC; however, new government
legislation setting targets for clean energy production to be achieved within five (5) years means
that there may be pressure on current volumes in favour of renewable energy sources such as
solar and wind power.
The previous method of allocating overhead costs to customers allocated all costs (after
production costs) on a pro-rata basis by revenue.
For the purposes of this activity, ignore GST.
Tasks
For this activity you are required to:
1. Calculate the profitability of the three (3) customers to BM using the customer profitability
information.
2. Analyse these customer profitability calculations and discuss and explain the results.
3. Calculate the respective profitability to BM of the three (3) customers using the overhead
allocation method of allocating all overhead costs for the customers on the basis of revenue.
4. Analyse and explain the differences between the results calculated in 1 and 3 above.
5. Based on the information provided and your analysis in 1 and 2 above, identify and
explain two (2) key customer cost/profit issues requiring MCs attention for 2015 and
beyond.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
There are no further readings for this unit.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit.
Atkinson, A, Kaplan, R, Matsumura, E and Young, SM 2012, Management accounting: Information
for decision-making and strategy execution, 6th edn, Pearson, New Jersey.
Bhimani, A, Horngren, C, Datar, S, and Foster, G 2008, Management and cost accounting, 4thedn,
Prentice Hall, Essex, England.
Bizmanualz 2005, Theory of constraints, available online at www.bizmanualz.com, accessed
5August 2013.
Bushong, J and Talbott, J 1999, The CPA in industry: An application of the theory of
constraints, The CPA Journal, April, available online at www.cpajournal.com, accessed
14March 2014.
Horngren, C, Wynder, M, Maguire, W, Tan, R, Datar, S et al 2011, Cost accounting: A managerial
emphasis, 1st Australian edn, Pearson Australia, Sydney.
Jagels, M 2007, Hospitality management accounting, 9th edn, John Wiley & Sons, New Jersey.
Raffish, N 1991, How much does that product really cost?: Finding out may be as easy as ABC,
Management Accounting, March, pp. 5154.
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Core content
Unit 6: Performance reporting
Learning outcomes
At the end of this unit you will be able to:
1. Apply return on investment (ROI) as a management decision-making tool.
2. Apply EVA as a management decision-making tool.
3. Compare the results of ROI and EVA analyses.
4. Review and analyse draft management reports.
Introduction
Management accountants use a number of measures to evaluate performance. This unit focuses
on return on investment (ROI) and economic value added (EVA), two financial measures
that management accountants often use to assess aspects of financial performance, both at an
organisational and a business unit level.
The unit also focuses on the communication of performance expectations and results via
performance reporting, including dashboard reporting. Management accountants are normally
the authors of these reports and must choose a format that meets the performance reporting
needs of stakeholders.
Learning outcome
1. Apply return on investment (ROI) as a management decision-making tool.
ROI is a common financial ratio used to evaluate financial performance and provide a level of
financial control. Its relative ease of calculation and understanding has made it a popular choice
in assessing and reporting economic performance across a broad spectrum of industries and
organisations.
maaf31506_csg
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For simplicity and ease of understanding, this unit will primarily use EBIT for income, and total
asset value for investments.
When comparing the ROI across business units or organisations, consistency in calculations is
key to ensuring that subsequent analysis is useful.
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Operating income
ROI = Investment
The ratio of operating income to sales is a measure of efficiency. This ratio is commonly
referred to as the EBIT margin, sales margin or return on sales. It reflects an organisations
ability to convert sales into profit by controlling its costs.
The ratio of sales to investment the asset turnover ratio measures productivity. It reflects
an organisations ability to generate revenue at a certain level from its investments in assets.
NB: Itshould be noted that the asset turnover ratio is a theoretical value for the number of
times assets are turned over in comparison to sales. Productivity does not consider the actual
purchase and sale of assets, simply the value of the investment in assets at the end of the period.
Since ROI is the product of organisational efficiency (Operating income/Sales) and productivity
(Sales/Investment), it can be improved by increasing either or both of its components. The
efficiency component recognises the need to increase profits with every dollar of sales. The
productivity component recognises that assets should be used to maximise sales.
A company could improve its ROI in two ways:
By increasing its total gross profit. This could be achieved by increasing selling prices,
reducing cost of goods sold (COGS) or increasing sales volumes without acquiring any
new assets. For example, if a cinema increased its admission price by $0.25 per ticket sold
(assuming that this does not impact sales volume), this would result in an increase in total
sales revenue (gross profit) and, therefore, the EBIT margin (efficiency measure). Given
that this decision would not require any further investment, it would also improve the
productivity component. This decision would result in an overall increase in ROI.
By reducing the level of investment required to achieve EBIT. For example, selling excess
land (assuming that this is not used to produce sales) would reduce the level of investment
without impacting operating income, and would result in an increase in ROI through
improving the productivity of retained assets. In practice, reducing working capital is
normally easier to achieve than reducing long-term investments.
Assessing efficiency
The formula to assess efficiency is:
Operating income
Sales
The calculation of the ratio of operating income to sales revenue is a high-level analysis of an
organisations or business units efficiency in converting sales into profit.
However, efficiency can be further assessed by breaking this ratio into its subcomponents.
For example, to better assess the drivers of efficiency, a management accountant might assess
various types of costs in an organisation against the level of sales.
Comparing manufacturing, selling, shipping and administration costs to sales may provide
further insight into where improvements could be made to improve ROI, particularly where
negative trends are identified.
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Assessing productivity
The formula to assess productivity is:
Sales
Investment
The calculation of the ratio of sales revenue to investment (asset turnover ratio) is a high-level
analysis of an organisations or business units ability to maximise revenue according to the
level of assets employed.
This too can be analysed further, by calculating productivity or turnover ratios for the major
classes of assets, which might include working capital ratios or fixed asset turnover ratios.
Again, this level of analysis allows areas of improvement to be identified, particularly when
these are compared to other similar operations.
The following diagram illustrates how the DuPont model breaks down the efficiency and
productivity elements into their constituent components. Improving the performance of a
component (while other aspects remain constant) will result in an overall improvement in ROI.
Manufacturing
cost
Sales
Operating minus Selling
income cost
Efficiency divided by Costs
Shipping
Sales cost
Return on multiplied by
investment Administrative
cost
Sales
Cash and
Productivity divided by working Inventories
capital assets
Total
investment plus Accounts
receivable
Permanent
investments
Cash
The view of working capital illustrated in the diagram is different from that used in the unit
on working capital management, as the example above is focused on the investment or asset
component, and therefore the liability side of working capital has not been included.
The DuPont model shows how ROI can be improved by:
Increasing sales.
Reducing costs (manufacturing, selling, shipping and administration).
Decreasing inventory levels.
Decreasing accounts receivable.
Decreasing permanent investments (fixed assets).
The secret to success is ensuring that, by improving one variable, this does not adversely affect
another by more than the improvement. For example, if sales increased by $250,000, but costs
increase by more than $250,000, then ROI will fall.
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Example SDT Solutions (Part 1): ROI and DuPont method of profitability analysis
This example illustrates how an ROI calculation and DuPont method of profitability analysis are
performed.
All figures used are taken from the SDT case study.
Tasks
(a) Calculate ROI for SDT Solutions in Australia and New Zealand.
(b) Apply the DuPont method to the Australian and New Zealand ROIs.
(c) Compare the performance of Australia and New Zealand and identify three (3) areas where
the New Zealand operation could improve its performance.
Suggested solution
(a) Calculate ROI using the following formula:
Operating income
ROI = Investment
ROI for Australia is 47.06%, calculated as:
Trading profit + management fee received
ROI = Total asset value
$2, 592, 642 + $463, 800
ROI =
$6, 495, 169
ROI = 47.06%
Note: An adjustment has been made for the management fees so that the EBIT used reflects the total operating
revenue and expenses of each country. As the calculation is a ratio, Australian and New Zealand dollars have been
used respectively.
(b) Applying the DuPont method, Australia and New Zealands ROI can be broken down into
the following components:
Operating income $2, 592, 642 + $463, 800 = $787, 764 $612, 216 =
Efficiency = Sales 14.83% 4.30%
$20, 613, 637 $4, 081, 440
(c) Comparing and contrasting the ratios shows that Australia is clearly the stronger performer.
While the difference between the two business units productivity component is not
dramatically different (although Australia is ahead), it is the efficiency ratio that significantly
affects New Zealands poorer performance. Almost 15% of Australias sales revenue is
converted into operating income, while New Zealand converts to less than 5%.
The DuPont method highlights three areas to improve ROI for New Zealand:
1. Improve revenue, keeping assets and operating income as a percentage of revenue
constant. SDT Solutions New Zealand could improve revenue by driving more sales
and increasing the staff utilisation rate to a level similar to Australia. This, in turn, would
grow operating income and improve the trading profit.
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2. Reduce costs to increase operating income, keeping revenue and assets constant.
Overhead costs (such as rent) appear to be disproportionately high as a percentage
of revenue when compared to the Australian operation. Reducing these costs would
improve operating income.
3. Decrease assets while keeping revenue and operating income constant. One of New
Zealands largest assets is trade debtors, and debtor days appear to be significantly
higher in New Zealand compared to the Australian operation (73 days compared to 55).
New Zealand should start a program aimed at reducing the level of debtor days.
Limitations of ROI
While ROI is a common measure of financial success, like any measure used in isolation it has
its limitations. The following diagram includes details of the five key limitations of ROI, each of
which are discussed further below.
ROI
Targets versus Risk of
cost of capital investment
Initial investment
returns
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Risk of investment
Another issue with ROI is that it does not incorporate a factor relating to the risk associated
with an investment. In managing financial investments, it is expected that higher risk
investments should generate a higher rate of return. The calculation of ROI encourages
management to pursue higher risk activities, particularly in the short term, if it is used in
isolation.
Learning outcome
2. Apply EVA as a management decision-making tool.
Economic value added (EVA) was developed by Stern Stewart & Co. to address some of the
deficiencies with ROI and other, similar financial performance measurement tools. While not as
simple to use as these other tools, it is favoured by larger organisations in particular to evaluate
business performance.
In developing EVA, Stern Stewart & Co. were attempting to provide a measure that assessed
organisational performance against the minimum level considered appropriate to provide an
acceptable return to shareholders.
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Calculating EVA
Organisations adjust the various components of EVA to reflect what they are trying to achieve
when assessing performance. The following provides a brief overview of the basic formula used
to calculate EVA.
Economic value added (EVA) is calculated as:
EVA = net profit after tax [WACC (total assets current liabilities)]
Note: Net profit is calculated as an after-tax figure, to encourage managers to consider the
taxation implications of their investment decisions. Note also: WACC (which is explored further
in the unit on investment decisions) is the weighted average cost of capital. This is calculated
considering both long-term debt and equity. The cost of these two elements should also be an
after-tax calculation.
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EVA analysis indicates how much shareholder wealth is being created. This formula can
be broken down into the profit that a business is making, minus the capital costs associated
with making the profit. Anything remaining is an increase in the value of the business. Note,
however, that value is only created when the net profit after tax is greater than the cost of
investing.
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Example EVA
Assume that an organisation has a WACC of 10%, total assets of $105,000 and current liabilities
of $5,000.
At a net profit level after tax of $9,000:
EVA = 9,000 (10% (105,000 5,000))
= ($1,000) meaning the organisation is returning less than WACC and shareholder value is
being eroded.
At a profit level after tax of $10,000:
EVA = 10,000 (10% (105,000 5,000))
= $0 meaning the organisation is returning the equivalent of WACC.
At a profit level after tax of $11,000:
EVA = 11,000 (10% (105,000 5,000))
= $1,000 meaning the organisation is returning in excess of WACC and shareholder value is
being created.
For Australia
EVA = $2,273,122 (12.5% ($6,495,169 $3,566,561))
= $2,273,122 (12.5% $2,928,608)
= $2,273,122 $366,076
= $1,907,046
Note: Australian dollars were used for each calculation to make the exercise of comparing and contrasting easier. While
the EVA for New Zealand could validly be calculated in New Zealand dollars, the exchange rate between Australia and
New Zealand would need to be taken into consideration when making the comparison.
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(b) EVA in both instances is a positive number, and therefore, both the Australian and New
Zealand operations are creating shareholder value.
As the results are being compared in Australian dollars, it is apparent that the Australian
operations are creating a greater return for shareholders than the New Zealand operations.
Clearly the comparative size of the two operations is impacting on this.
The calculation of New Zealands EVA is somewhat unusual, as current liabilities exceed
total assets. This means that, in effect, there isnt a cost of capital employed but a benefit.
This is due to the reliance on the Australian operations for funding.
(c) The calculation of the cost of investing in the New Zealand operations is distorted by the
fact that they are not operating independently of the Australian operations. There is a
related entity loan in New Zealands current liabilities of AUD850,000. For the purposes of
the EVA calculation, it may be more appropriate to treat this loan as a non-current liability
(particularly if there is no intention for it to be repaid in the near future, and Australia
intends to continue to support the New Zealand operations).
(d) Given the difference in size of the operations, the potential difference in tax rates between
the jurisdictions and the dependency of New Zealand on the Australian parent, using EVA
as a stand-alone measure of financial performance might be misleading. Therefore, if SDT is
to use EVA as a measure of financial performance, it should be used in combination with
other tools such as ROI.
In practice, consulting firms are often used to help determine an appropriate basis for EVA
calculations within organisations. This could be because the managers being assessed against
this measure dont really understand how EVA is calculated and how best, therefore, to
enhance their performance.
In addition, it is difficult to determine at what level of the organisation EVA should be applied.
Ideally, EVA works best at an investment centre level (refer to the unit on introduction to
management accounting (including ethics)), as managers would have control over the elements
being measured. Pushing EVA down to a profit centre level could mean that multiple
assumptions need to be made.
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Where this reduction in economic value is equivalent to the loss of present value of the project
during that period (the annuity depreciation rate), the EVA is equivalent to the NPV of the
project. However, in practice, these values rarely align, and given that EVA is not commonly
used, NPV tends to make a more effective assessment tool for projects.
Learning outcome
3. Compare the results of ROI and EVA analyses.
ROI and EVA are both valid measures of financial performance. They are best used in relation
to investment centres, where management has control of revenues, costs and the investment
decisions being made.
ROI is more commonly used than EVA to assess performance, due to its relative ease of
calculation and the level of managerial understanding of what the measure means in terms of
key performance drivers.
ROI and EVA, however, both have their flaws when used to evaluate performance. While ROI
allows comparison of business units of different sizes, it tends to look unfavourably at business
units with new or increased assets.
EVA cannot be used to compare divisions that differ in size, but it does provide a reasonable
way to calculate the value of assets used by business units to generate income.
The following table provides a comparison of ROI and EVA:
ROI EVA
Comparability across organisations High level, since it is a ratio Low level, due to organisations
making different adjustments to
components
Link to shareholder expectations No link to expected returns; Expected levels of return are
however, it can be compared to an incorporated into cost of capital
expected level to determine level
of performance
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Example SDT Solutions (Part 3): comparing ROI and EVA results
This example illustrates the differences between ROI and EVA.
Review SDT Solutions example (Part 1) on ROI and SDT Solutions example (Part 2) on EVA
shown earlier in this unit. A summary of the results from these examples is shown below:
Tasks
(a) Explain the results of the ROI and EVA analyses conducted.
(b) Determine which measure (ROI or EVA) would provide SDT Solutions management with
the better tool to assess the financial performance of the Australian and New Zealand
operations. Justify your response.
(c) Outline which measure (ROI or EVA) would provide SDT Solutions Australian management
with the better tool to assess the financial performance of the Brisbane and Melbourne
offices. Justify your response.
Suggested solution
(a) In both the ROI and EVA analyses, the Australian operations have been assessed as being
the better performer. In terms of the absolute return of value to shareholders, the EVA
analysis shows that Australia has delivered $1.66 million more return than New Zealand.
Inrelative terms (removing size), the ROI analysis indicates that the Australian operations
are providing a return more than three times that of New Zealand.
(b) Based on the analyses performed earlier in the unit (refer to Parts 1 and 2 of the SDT
Solutions examples) it would appear that the ROI calculation provides a more robust
measure of financial performance. There are doubts about the basis of the EVA calculation
for New Zealand, as the Australian business is providing a high level of support in the form
of a current loan. The ROI calculation ignores the impact of the loan and instead assesses
operational performance.
(c) A significant proportion of expenditure is incurred at the Australian head office level. For
an effective EVA calculation to be completed, this expenditure should be allocated to
the individual offices. Similarly, total assets and current liabilities would also need to be
allocated, and this would clearly be a difficult and time-consuming exercise. While the ROI
calculation still requires Investment (total assets) to be calculated at an office level, this is
likely to be more straightforward. If a decision were made not to apportion certain costs,
arelative measure would still need to be developed that would allow for a fair comparison
to be made. The EVA calculation does not adjust for size, so the comparison between the
locations would be unlikely to be fair.
Further reading
Stewart, B 2009, EVA momentum: The one ratio that tells the whole story.
This article discusses EVA as a measure of performance in comparison to a number of other
commonly used measures.
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Learning outcome
4. Review and analyse draft management reports.
The unit on introduction to management accounting (including ethics) addresses the different
objectives and information needs of stakeholders. It discusses the numerous alternatives for
presenting that information graphically, numerically or in a written report and describes
how it is often a combination of these that will be most effective in meeting stakeholder
preferences and needs.
Prior to developing reports, management accountants need to consider the best way to report
information concisely.
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While in most cases this would reflect the balance at the close of trade on the previous day, in
some organisations this information may be updated on a more regular basis (e.g. sales may be
updated hourly).
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Quiz
[Available online in myLearning]
ACT
Activity 6.1
Applying ROI using the DuPont method
Introduction
This activity uses the DuPont method to analyse the ROI of an organisation, with a view to
understanding the difference between actual and expected levels of performance.
This activity links to learning outcome:
Apply return on investment (ROI) as a management decision-making tool.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
You are the group head of management accounting for Accutime. Graham Anderson, the chief
financial officer (CFO), has asked you to assess the financial performance of Accutime based on
ROI.
Tasks
To complete this activity you will need to carry out the following tasks:
1. Calculate Accutimes ROI for 2012 and 2011.
2. Use the DuPont method to explain the key reason for the variance in performance between
the two years.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 6.2
Performing an EVA calculation
Introduction
The ability to perform and interpret an EVA calculation is an important skill for management
accountants and will aid them in providing advice to management on how to improve an
organisations performance.
This activity links to learning outcome:
Apply EVA as a management decision-making tool.
At the end of the activity you will be able to perform an EVA calculation, analyse the results
and use that analysis to identify ways to improve performance.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
You are the group head of management accounting for Accutime. Graham Anderson, the CFO,
has asked you to review the financial performance of Accutime and consider whether the
company could use EVA to assess the performance of each of the geographical business units.
For the purposes of this activity, assume that Accutime uses a weighted average cost of capital
(WACC) of 10.7% and that the effective company tax rate is 30%.
Tasks
For this activity you are required to:
1. Review the financial performance of Accutimes operations by:
(a) Calculating EVA for 2012 and 2011.
(b) Explaining the variance in EVA performance between the two years.
(c) Identifying how Accutimes EVA could be improved in the future.
2. Assess whether Accutime should use EVA to measure the financial performance of each of
its geographical business units by:
(a) Explaining whether this proposal is practical and any key issues that may need to be
considered.
(b) Outlining the implications of using a WACC specific to each of the business units.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 6.3
Comparing ROI and EVA results
Introduction
This activity requires you to review the results of previous analysis to calculate ROI and EVA,
and then compare the results in order to understand the difference between them as tools of
analysis.
This activity links to learning outcome:
Compare the results of ROI and EVA analyses.
At the end of this activity you will be able to understand the difference between ROI and EVA
as analytical tools. You should complete Activities 6.1 and 6.2 prior to attempting this activity.
It will take you approximately 20 minutes to complete.
Scenario
You are a management accountant reporting to Graham Anderson, CFO at Accutime Limited
(Accutime). Accutimes management is reviewing which is the best tool to assess its financial
performance at a group, as well as an international, business unit level. The options under
consideration are ROI or EVA.
Graham has tasked you with investigating the choices and has supplied you with the following
information for Accutime, based on previously undertaken analysis:
2012 2011
Tasks
Graham has asked you to assess the financial performance of Accutime. You should have
already completed ROI and EVA calculations (refer to Activities 6.1 and 6.2 respectively) and
analysed their results.
1. Determine which measure (ROI or EVA) would provide Accutimes management with the
better tool to assess performance at the consolidated group level. Justify your response.
2. Outline which measure (ROI or EVA) would provide Accutimes management with the
better tool to assess the financial performance of its international business units. Justify your
response.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 6.4
Analysing dashboard management reports
Introduction
This activity requires you to review a management report presented in the dashboard format
and analyse the information.
This activity links to learning outcome:
Review and analyse draft management reports.
At the end of the activity you will be able to analyse a dashboard report and determine
key trends and relationships in the information, with a view to highlighting key areas for
managements attention.
It will take you approximately 30 minutes to complete.
Scenario
You are the management accountant for an operating division of XYZ Insurance (XYZ),
reporting to the CFO, Sonal Chen. XYZ is a large insurance group operating in Australia and
New Zealand, and sells insurance policies across a wide range of categories covering both
commercial and retail customers.
Within the industry it is considered to be a well-run business, and is acknowledged for
providing high-quality cover, good customer service and superior claims handling.
Insurance policies are sold in two ways:
By insurance brokers (agents) who are paid a commission for arranging an insurance policy.
Via the XYZ website.
The policies sold over the web are slightly different from those sold by insurance brokers, and
offer less cover for a lower premium.
The primary categories of expenditure for the business include:
Claims paid under the insurance policies issued.
Commissions paid to insurance brokers when they sell an XYZ policy.
Claims handling costs, being XYZs staff costs incurred in managing and assessing claims.
Costs associated with maintaining the website.
Administration costs incurred supporting the operations of the business.
ACT
The organisations dashboard is as follows:
Task
As part of the review of XYZ Insurances annual dashboard report for 2013, Sonal has asked
you to analyse the performance of the organisation over the past four years, and identify any
interrelationships in the data contained in the dashboard report.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
Stewart, B 2009, EVA momentum: The one ratio that tells the whole story, Morgan Stanley
Journal of Applied Corporate Finance, vol. 21, no. 2, Spring 2009, (accessed 28 January 2014),
www.charteredaccountants.com.au Training Resources Knowledge-centre
Businesssource-corporate
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit.
Atkinson, A, Kaplan, R, Young, M and Matsumura, E 2012, Management accounting, 6thedn,
Pearson Education Inc., Upper Saddle River, NJ, USA.
Brooks, A, Eldenburg, L, Oliver, J, Wolcott, S and Vesty, G 2008, Contemporary management
accounting, John Wiley & Sons Australia Ltd, Milton, Queensland.
Duxbury, P and Masud, Z 2009, Seven mistakes in dashboard implementations, Business
Finance, vol. 15, no. 6, Sep/Oct 2009, pp. 2834.
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(accessed 28 January 2014), www.juiceanalytics.com Juice Analytics Writing Breaking
free of the one-page dashboard rule.
Hetherington, V 2009, The dashboard demystified: What is a dashboard?, Dashboard Insight,
(accessed 28 January 2014), www.dashboardinsight.com Dashboard Insight Articles
Digital dashboards fundamentals The dashboard demystified: What is a dashboard?.
Wise, L 2010, A closer look at dashboards, Dashboard Insight, (accessed 28 January 2014),
www.dashboardinsight.com Dashboard Insight Articles Digital dashboards
fundamentals A closer look at dashboards.
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Core content
Unit 7: Working capital management
Learning outcomes
At the end of this unit you will be able to:
1. Explain why cash, liquidity and the management of working capital are critical to an
organisation.
2. Assess working capital components and apply appropriate working capital management
techniques within an organisation.
Introduction
There is a saying in business that cash is king, which highlights the critical importance of cash
flow and the proper management of working capital for the ongoing viability of a business.
Businesses need to ensure they have sufficient cash to be able to pay their debts as and when
they fall due. If they do not, the business will fail. This potential failure is linked to cash, not
profit there are many profitable businesses that experience financial distress and bankruptcy
because they do not have sufficient available cash to continue funding day-to-day operations.
Hence, managing cash and the levers that optimise an organisations liquidity is critical to its
success. The administration of these components is known as working capital management,
and management accountants are closely involved in analysing an organisations working
capital position, identifying ways to improve working capital, and monitoring and reporting on
working capital drivers.
This unit explores a variety of ways that the components of working capital can be effectively
managed.
Learning outcome
1. Explain why cash, liquidity and the management of working capital are critical to an
organisation.
To use a metaphor, cash is to a business what oil is to a machine. Take the oil out of a machine
and it will seize up; likewise, take the cash out of a business and it will grind to a halt.
maaf31507_csg
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In order for a business to operate, it needs to raise cash to invest in three separate areas: fixed
assets for the infrastructure of the business, research and development of new products and
services to expand and refresh the business, and day-to-day operations (purchasing inventory,
selling goods and services to debtors and making payments to creditors for supplies). Ensuring
that funds are available for each of these activities when required is a critical function.
The type of capital used to fund each of these three critical requirements is outlined in the
following table.
Fixed capital This represents the funding required to acquire fixed assets. The required funds are
usually tied up for long periods of time often for the life of a business
Growth capital This represents the funding required for a business to grow. It is not assigned as part of
the dayto-day operations of the business, but is allocated for new product developments
or new projects. This type of capital is usually tied up for the medium to long term
Working capital This represents the short-term funding required to support business operations on
a day-to-day basis. Depending on the nature of daily operations, the working capital
requirement may be fairly stable or it may be erratic. Businesses that have a constant
and consistent turnover of stock, debtors collection cycles and creditors payment cycles,
as well as a stable level of operating expenses, will also have a fixed or stable working
capital requirement. Businesses whose requirements vary depending on seasonal or
other factors will have a fluctuating working capital requirement (e.g.retailers often need
to increase levels of inventory in the lead-up to Christmas)
Note: Fixed capital and growth capital are covered in the unit on long-term financial
management.
Liquidity refers to an organisations ability to convert an asset into cash. The greater the
liquidity of an organisations assets, the greater the ability of that organisation to generate cash.
Liquidity is important when considering working capital, as it links to the organisations ability
to convert inventory and debtors into cash.
Learning outcome
2. Assess working capital components and apply appropriate working capital management
techniques within an organisation.
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The management of working capital tends to focus on inventory, accounts receivable and
accounts payable. Other components of current assets and liabilities (e.g.prepayments, accruals
and deposits) are usually less significant than the three main components noted above.
Effective working capital management involves understanding and managing each component
to determine the operational cash flow requirements for an organisation. The balance between
these components is different for each organisation, and is dependent on factors such as
the nature of the industry, organisational size, and the specific nature of an organisations
operations and strategic objectives.
When using reported current assets less current liabilities as the measure of working capital,
external business analysts often assume that a high number means that working capital is being
effectively managed. This may not be correct, however, and may indicate overinvestment in
assets that are not providing a sufficient return. Often, a low number for this ratio is a better
indicator of effective working capital management, as it shows that the business is cycling its
available cash effectively. It is important when using this measure to consider the lifecycle of the
organisation and the volatility of its earnings (factors which generate cash flow), and how these
may be reflected in the working capital ratio and cash requirements.
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Collection of 4
Accounts
accounts
Cash inflows receivable
receivable
1 Cash outflows
Payment of
Raw materials Payment of conversion costs
purchased on accounts 3
credit payable Labour
Equipment
Finished
Sale of goods
goods
or services
inventory
The typical cash conversion cycle begins with cash outflows for new materials and conversion costs and goes
through several stages before these resources are turned back into cash. The cash conversion cycle reflects the
average time from the point that cash is used to pay for raw materials until it is collected on the accounts
receivable associated with the product produced with those raw materials. One of the main goals of a financial
manager is to optimise the time between the cash outflows and cash inflows.
Adapted from: Parrino, R et al. 2011, Fundamentals of corporate finance, Australasian edn, John Wiley & Sons
Australia Ltd, Milton, Qld.
Effective working capital management requires a good understanding and regular monitoring
of an organisations cash conversion cycle. On face value it would appear that a short cash
conversion cycle, whereby an organisation quickly converts its inventory and debtors into cash
and shortly afterwards pays for that inventory, is ideal.
The challenge is to optimise working capital and the cash cycle, but not to the point that it
jeopardises operations. Examples of taking the management of working capital to an extreme
are shown in the following table.
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Eliminate inventory holdings or reduce There would not be enough inventory to satisfy sales demand and
them to minimal levels therefore sales would be lost
Only make sales on a cash basis Some customers would not be prepared to operate on a cash basis,
and potential sales would be missed
Stop paying creditors or extend the Creditors would stop supply and therefore the business would be
payment period beyond agreed terms unable to produce goods and services for sale
Strategy Description
Conservative Use long-term funds for both permanent and variable working capital. Using
long-term funds only is usually the more expensive option as organisations tend
to borrow more to achieve their goals
Aggressive Use permanent and short-term funds to finance variable working capital. This
should lower interest costs. However, the variability in financing costs and/or
the potential inability to obtain refinancing for the debt results in a risk for the
organisation regarding either higher costs or a lack of capital. This point was
emphasised during the global financial crisis, when many organisations of varying
sizes struggled to obtain financing and went into administration or liquidation as
credit markets dried up
Matching Use short-term funds for temporary working capital requirements and longer
term funds, or cash from retained earnings, for permanent working capital
requirements. This matches debt with the lifespan of the investment
There are trade-offs, and therefore risks, attached to getting the balance right between ensuring
that sufficient funds are available for operational needs and maximising profits. The optimal
level of working capital for an organisation will reflect its attitude towards risk and return. A
lower investment in working capital is likely to lead to higher risk for the business, as it has
fewer resources available to meet operating requirements. The higher risk would generally
equate to a higher potential return on investment. An increase in working capital for no increase
in profitability reduces the return on investment.
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Effective management of debtors, inventory and trade creditors leads to the successful
management of working capital. While not part of the definition of working capital above,
decisions regarding prepayments and accruals, such as whether to pay for a service upfront or
via instalments can also have a significant impact on working capital.
Managing working capital is particularly important when an organisation is experiencing
significant growth. As the business expands, its investment in working capital will also
normally increase. Management accountants usually prepare for expansion or development by
forecasting additional working capital requirements and managing the working capital balance,
in order to avoid cash flow problems.
It is easy to see how a successful organisation that has expanded too quickly can fail because
it is not generating enough cash to fund its growth investment along with its ongoing
operations. One of the keys reasons this issue arises is managements focus on its growth plans
and the generation of new sales opportunities, which often results in neglect of the resulting
accumulation of working capital.
Aspect Measures
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Suggested solution
1. Calculate the additional working capital that Accutime has had to fund over the past
12months, and identify a potential key cause for this increase.
As can be seen from these figures, Accutime has had to fund $11,305,000 in additional
working capital. This significant increase could be due to the acquisition of BACTechs
frequency control products division in December 2011, and/or the stated company strategy
for continued expansion of its GPS products in the market, in addition to expansion into
European and Asian markets.
2. Calculate the ratios for the three key drivers of working capital that should be
monitored on at least a monthly basis.
The key working capital ratios for Accutime are:
Debtor days = average trade debtors # 365 ' sales
73.7 days = 6^$55, 050 + $36, 724h ' 2 # 365@ ' $227, 177
This is equivalent to a turnover of 4.95 times per year.
Inventory days = average inventory # 365 ' COGS
138.7 days = 6^$65, 909 + $49, 465h ' 2 # 365@ ' $151, 854
This is equivalent to a turnover 2.63 times per year.
Creditor days = average trade creditors # 365 ' purchases)
76.0 days = 6^$46, 789 + $23, 324h ' 2 # 365@ ' $168, 298)
*Purchases = Cost of goods sold (COGS) + Closing inventory Opening inventory
$168,298=$151,854 + $65,909 $49,465
Working capital days is therefore:
73.7 + 138.7 - 76.0 = 136.4 days
2011 2012
3. Comment on the ratios calculated in light of the fact that most of Accutimes suppliers
offer 45-day terms, and that Accutime extends these same terms to its customers.
These ratios seem, on face value, to be quite high. If suppliers and customers are both
on standard 45day trading terms, then debtor days of 73.7 and creditor days of 76.0 are
substantially higher than that. There is no information in the case study that offers an
explanation for this. It would therefore appear that there is scope to improve the working
capital position of Accutime.
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Creditor days have extended to mirror the debtor days, and so working capital is not being
further strained as would be the case if the creditor days were closer to terms and the
debtor days remained at 73.7. Depending on whether suppliers are becoming disgruntled,
Accutime may be able to maintain creditor days at their current level, while improving
debtor days, resulting in an improved cash position.
Inventory days are high relative to creditor days, requiring stock to be funded for 63
inventory days without support from suppliers. Investigation should be made for
opportunities to reduce these days, to enable a reduction in cash required for permanent
working capital needs.
It should also be noted that although these ratios appear high, they are a significant
improvement on the prior period, indicating that Accutime management is taking action to
address the working capital issues.
4. Comment on:
(a) Accutimes ability to pay its debts as and when they fall due.
With its level of working capital and $17 million cash and cash equivalents balance,
it would appear that Accutime is in a solid position to be able to pay its debts as and
when they become due.
(b) Accutimes safety net in case of unexpected circumstances.
The amount of cash and cash equivalents suggests that Accutime is holding a
reasonable safety net that is quite liquid, should it be necessary to respond to
unexpected circumstances.
(c) Accutimes ability to invest in emerging business opportunities.
The amount of cash and cash equivalents may not be sufficient to take full advantage
of any emerging opportunities that require a reasonable amount of funding. However,
it would appear that with a relatively low amount of debt compared to the equity in
the business, Accutime should be in a reasonably good position to secure additional
longterm borrowings if necessary.
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The credit terms that an organisation provides to its customers are influenced by a number of
factors, including:
The industry in which the organisation operates.
Competitive or marketing considerations, such as retailers who offer interest-free periods.
The creditworthiness of the customer.
The ability to influence the customer that is, the ability to dictate the terms of trade.
The extension of credit terms to customers requires strong credit and collection processes and
procedures. The following table presents a number of management strategies for managing
accounts receivable.
1. Establish a credit policy (a) Screen customers before providing credit: By having potential
customers complete a credit application, an organisation can gain an
insight into their ability to pay for its goods and services
(b) Check credit references: This can be done by checking with existing
suppliers to a potential customer, or by using a credit checking agency
(such as Veda or Dun & Bradstreet), which charges a fee to produce a
report on the credit history of a potential customer
(c) Establish credit terms: This includes establishing when payments will
be due, and the penalties that can be enforced if payment is overdue
(e.g.interest and/or late charges)
2. Make invoicing clear to (a) Accuracy is important to ensure on-time payment. There should be
facilitate payment no reason for a customer to dispute an invoice. For example, include
purchase order numbers where applicable, so that customers can
easily trace their purchase history. Ensure that all additions and other
calculations are correct, product descriptions link to the customers
purchase order, and that the goods and services being invoiced have
been provided
(b) Highlight the balance due and the due date, and include details of how
payment can be made
(c) The most cost-effective method of receiving customer payments is by
direct transfer to a bank account or by BPAY*. These details should be
included on the invoice
(d) Include contact details for customers who have a query
4. Reduce time to receive Encourage customers to use direct funds transfers and BPAY* arrangements
payment to speed up time between payment by the customer and receipt
5. Offer early settlement Customers can be encouraged to make payments earlier if they receive a
discounts discount. An organisation needs to assess whether the benefit of having the
cash early outweighs the cost of the discount
* BPAY is a form of electronic payment used in Australia, where the payer transfers funds directly to the recipient.
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7. Know the customers For major clients, establish a relationship with the person responsible for
paying the account, and keep in contact so that the organisation is kept
informed about when payment will be made or if there will be a delay in
payment
8. Monitor and report on the This might be in a number of forms, including debtor days ratios, ageing
progress of debt collection ratios, amounts overdue and so on
9. Stop credit Establish policies for stopping a customers credit and deliveries where
accounts have not been settled as required
10. Security Establish trading terms whereby title to inventory does not pass until
payment has been received, or a customer is required to provide director
guarantees
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1. Making payments only Note the payment terms and due dates and only make payments when they
when due are due
2. Prioritising suppliers Some suppliers are more critical to the ongoing operations of an organisation,
and so it is important that good trading relations are established and
maintained
3. Checking invoices before Sometimes invoices are received for goods and services that have not been
paying them provided. It also might be inappropriate to make payment for a good or
service where there has been an issue. Checks should also be performed to
ensure that the price being charged is in accordance with the purchasing
agreement
4. Negotiating with suppliers It may be possible to negotiate a longer than standard time to pay an
for extended credit terms account, particularly when a supplier is keen to get or retain the customer
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5. Considering the benefit of Organisations should consider the savings offered by taking the discount,
accepting early payment compared to the cost of interest forgone on cash balances. A discount of 1%
discounts for paying 7 days early is equivalent to an effective annual interest rate of
52%. This is discussed in further detail in the unit on short-term and medium-
term financial management
6. Ongoing discussions with If the supplier is made aware of any difficulty in paying according to terms, it
the creditors may be more amenable to an extension of credit
7. Seeking alternative supply The use of consignment inventory (where the supplier is not paid for the
arrangements products until after they are sold or used, thereby delaying payment) may be
an alternative method for purchasing inventory, but this is dependent on the
ability of the supplier to support such arrangements
8. Reporting Ensure that appropriate systems, processes and reporting are in place to
monitor payables, terms and available discounts
Inventory management
In managing working capital, an organisation needs to determine the optimal amount of
inventory to have on hand without risking losing sales. While it may seem straightforward to
hold a high amount of inventory to ensure that all sales demands can be met, there are costs
involved. These include the cost of funds invested in inventory, warehousing costs, and the
costs of deterioration or obsolescence. In manufacturing settings, there may be additional
costs involved, because such a strategy often hides inefficient work practices and poor quality
control.
The organisation also needs to ensure that it has the right inventory on hand. Often
organisations find that, due to poor planning, they have an excess of some items and stockouts
of others. The total value of their investment in inventory may be right, but the allocation
between each item can be very wrong if they do not get their forecasting and planning right.
Associated with the costs of holding inventories is the investment of working capital required
to hold them. The higher the levels of inventory, the longer the cash conversion cycle and
the greater the requirement for working capital in the form of lower cash reserves or higher
borrowed funds. Further, the higher the borrowing levels, the higher the risk, and therefore the
higher the interest cost to the business.
By reducing the level of inventory, carrying costs and levels of working capital are reduced.
However, this may lead to an organisation needing to place orders for inventory more
frequently, along with the associated costs of ordering.
Cost of inventory
The three costs that inventory management aims to minimise in aggregate are ordering costs,
carrying costs and stock-out costs. Each is explained in more detail below.
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Ordering costs
Ordering costs are incurred in ordering and receiving inventories. These include:
Preparing and approving purchase requisitions and purchase orders.
Receiving goods into store (including inspecting them for quality and returning them when
they do not meet specifications).
Transporting goods into store (these are especially important if goods are imported).
Settling accounts.
It is often difficult to estimate such costs because of the need to allocate common costs. At the
very least, it is important to try and identify those costs that vary with the number of orders
placed.
By ordering larger quantities (or having larger production runs), fewer orders (or production
runs) are required per time period, resulting in lower ordering (or set-up) costs, but higher
carrying costs for holding larger inventories.
Conversely, by ordering smaller quantities (or having smaller production runs), more frequent
orders (or production runs) are required, resulting in higher ordering (set-up) costs, but lower
carrying costs because there are fewer units on hand.
Carrying costs
Carrying costs are the costs of holding inventories until they are sold or used. These include:
Warehousing costs (e.g.wages, rent or rent forgone, light and power, heat, refrigeration and
other employment costs).
Insurance.
Interest on borrowed funds or forgone on own funds invested in the purchase of inventory
held (cost of capital). This is often expressed as either expected or required return, return on
investment or WACC.
Spoilage, deterioration, obsolescence or theft.
Some of these costs may be difficult to estimate, as they can be common costs or opportunity
costs.
Stock-out costs
Stock-out costs are incurred when organisations run out of stock of finished goods, or when
manufacturing operations are disrupted through shortages of raw materials or machinery
breakdowns. These costs include:
Loss of profit on lost sales.
Loss of sales on other items.
Profit forgone on possible future sales from customers who have been lost through
stockouts.
Potentially higher manufacturing costs and possible lost sales because of shortages of
finished goods.
The need to process rush orders.
An accumulation of backorders.
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The length of time it takes to receive inventory or get it into a condition ready for sale (lead
time).
The organisations ability to forecast demand accurately.
Fluctuations in the level of demand (seasonality/promotions).
The visibility of current inventory levels.
Desired service levels (on time and/or in full).
Quantity price discounts.
The shelf life of a product.
The restocking policy (make to order or make to stock).
The seasonality of supply.
where:
D = demand in units (for a specific time period). It is often useful to consider demand on an
annual basis as costs are normally provided on this basis.
P = ordering cost per purchase order.
C = carrying cost per unit of stock (for the specific time period).
EOQ must be stated based on whole units of the designated order quantity.
The EOQ formula uses the ordering and carrying costs that are affected by the quantity of
inventory ordered.
Several assumptions underlie this model:
The same quantity is ordered every time at the reorder point.
Demand, ordering costs and carrying costs are fixed.
The lead time is known with certainty.
The cost of goods purchased is not impacted by the order quantity.
There is no seasonality in demand for the product.
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2. Identify any issues that may be relevant to the franchise in using the information
calculated in (1) above.
Issues to consider include:
Do the buns keep well enough to maintain quality requirements using the EOQ model?
Is there any seasonality in the usage that needs to be considered?
Can the business be sure that the supplier can deliver when required by the franchise
owner, or will the deliveries occur when the supplier can deliver?
500
400
300
REORDER REORDER
200
100 LEAD
0 1 2 3 4 5 6 7 8 9 10 11
Weeks
In the graph, the EOQ is 500 units. The point where the carrying costs are minimised can be
seen, with the inventory falling to zero just as a new order is received. However, this approach
leaves no margin for error, and increases the risk of a stock-out.
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Safety stock
During an operating cycle, a stock-out may arise due to:
Fluctuations in demand from customers.
Inaccurate forecasting of demand.
Suppliers not having the stock to meet an order, extending the lead time.
Transportation delays that might impact on lead time.
In order to mitigate this risk, companies often maintain a base level of stock known as safety
stock.
When a level of safety stock is maintained, the reorder point is adjusted to reflect this. The
formula for calculating the reorder point, factoring in safety stock is:
Further reading
Piasecki, D, Optimizing economic order quantity (EOQ).
Stock-out costs
Safety stock carrying cost loss of profit on lost sales
purchasing cost profit forgone on possible
warehousing costs future sales due to customers
insurance lost through stock-outs
interest on funds invested increased manufacturing
in additional inventory held costs due to shortages of
inventory
spoilage, deterioration or
obsolescence
The key to managing safety stock is to determine the optimal level of safety stock to hold so as
to minimise the overall cost to the company.
The following steps outline how to determine the cost of expected stock-outs at a specified level
of safety stock (zero (0) or more units):
1. Consider the probability of a stock-out occurring. As demand levels often fluctuate, the
probability of it occurring might also change. This variability is factored into the analysis by
weighting each level of demand with the probability of it occurring.
2. Calculate the number of units of stock-out at each level of demand (demand units reorder
point safety stock).
3. Calculate the cost of a stock-out at each demand level by multiplying the unit cost of a
stock-out (whether that is the cost of an urgent delivery or a lost sale) by the number of
units of non-available stock.
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4. Calculate the total cost of a stock-out for a period of time by multiplying the cost
determined in Step 3 by the number of orders in that period.
5. Multiply the total cost of a stock-out for a period by the probability of it occurring.
6. Sum the weighted cost for each level to determine the final cost.
To calculate the cost of carrying the safety stock, multiply the units of safety stock by the
carrying cost per unit.
By adding together the carrying costs and the stock-out costs for a specified level of safety stock,
the total cost to the business can be seen. By comparing this cost at different levels of safety
stock (from nil to an amount that guarantees there would not be a stock-out), the optimal level
of safety stock can be determined.
Quality assurance
Can the quality of the product be assured to allow effective JIT management?
Supplier reliability
Can the supplier always ensure they will have the product available to ship when it is ordered?
Seasonality
Is there a seasonality issue with the product being bought, and can the supplier adjust to this?
Geography
Are there costs associated with purchasing (e.g.costs of airfreight to achieve JIT)?
JIT could be considered to be a pull system, where the inventory level is dictated by actual
requirements. It is therefore better suited to situations and businesses where lead times are
short.
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Further reading
YouTube clip (interview) on working capital management: Cash is king, so work your working
capital.
Kevin Kaiser and S. David Young surveyed many companies for their Harvard Business Review
article and found that the traditional business focus on the bottom line actually ties up working
capital, setting managers on a death march towards bankruptcy. They have come up with a
strategy to squeeze more funds from business balance sheets, which identifies the pros and cons
for businesses of trying to extract the cash trapped in the balance sheet (in particular, working
capital).
Quiz
[Available online in myLearning]
ACT
Activity 7.1
Managing accounts receivable
Introduction
In this activity you will assess how an organisation is performing in terms of managing its
working capital. You will achieve this by examining the accounts receivable function and
identifying how improvements can be made in credit control and collections processes.
The activity links to learning outcome:
Assess working capital components and apply appropriate working capital management
techniques within an organisation.
At the end of this activity you will be able to assess the performance of the accounts receivable
function, and identify improvements that can be made to the credit control and collections
processes.
It will take you approximately 45 minutes to complete.
Scenario
This activity is based on SDT Solutions (SDT).
You are a management accountant at SDT, reporting to Charlene OShay, the CFO.
SDT has recently tendered for a large software development contract (worth $250,000) with a
potential new customer. As part of its initial feedback, the new customer has indicated that the
successful supplier will need to provide 45-day credit terms.
SDTs standard credit terms are 30 days. In recent months, SDT has had a number of similar
requests for extension of trading terms but has declined them. Given the current trading
conditions, however, Philip McCaw, the chief operating officer (COO), believes it is only a
matter of time before SDT begins to lose business due to its lack of flexibility regarding this
issue.
Assume the cost of capital for SDT is 12.5%.
Tasks
You have been asked by Charlene to prepare a review of SDTs credit and collections processes.
For this activity you are required to:
1. Assess the implications for SDTs working capital and business operations of providing the
potential new customer with 45-day credit terms instead of SDTs standard 30-day terms.
2. Identify which of SDTs business areas appears to be better at managing its debtors.
3. Identify any potential reasons for the apparent variations between the two business areas.
4. Discuss specific actions that management could take to improve SDTs working capital
position through managing its debtors better.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 7.2
Managing inventory
Introduction
Understanding the importance of inventory management and assisting in the management of
an organisations investment in inventory as part of its working capital are important skills of a
management accountant.
This activity links to learning outcome:
Assess working capital components and apply appropriate working capital management
techniques within an organisation.
At the end of this activity you will be able to apply inventory control models to an organisations
working capital.
It will take you approximately 60 minutes to complete.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
Graham Anderson, the CFO, has been reviewing Accutimes financials and its significant
investment in inventory. He is interested in identifying whether Accutime could better manage
its inventory levels to help improve its working capital position.
You are a newly qualified Chartered Accountant and have been asked to help develop a plan to
improve Accutimes inventory management at its Sydney plant. You have been asked to focus
on a number of critical components of Accutimes inventory so that the management team
can identify opportunities that can then be applied across the organisation. As part of your
review, it has been decided that you should concentrate on two items initially Chem-248 and
sulphuric acid.
Chem-248
Your initial review considers a compound, Chem-248, one of the key raw materials used in
the manufacturing process. It has a shelf life of three months from manufacture, and is only
available from a specialist laboratory located in the United States. Given its volatile nature,
Chem-248 cannot be airfreighted to the manufacturing facilities. A new batch of this chemical
requires the machinery it interacts with to be cleaned and sterilised prior to use, in order to
avoid contamination. On receipt of an order, a technician inspects each batch to ensure that
safety mechanisms have not been tampered with, and that it matches the purchase order raised.
Materials are then transferred to a secure, climate-controlled chemical room in the plants
warehouse.
Chem-248 costs A$25 per litre and must be ordered in five-litre lots. Accutimes Sydney plant
uses 20,000 litres (including wastage of 2%) per month on average. Stock usage is maintained
at this level for half of the year, and for the rest of the year is evenly spread across a range,
from 5%10% under to 5%10% over this level. These variations in monthly stock usage are
summarised in the following table:
ACT
Shipping costs to Australia are A$5 per litre, and it takes five weeks on average for orders to
arrive following placement of the purchase order. Inspection of the product costs $350 each time
an order is received.
Other handling costs are $250 per order.
The cost of space in a chemical storage room is estimated at $1.50 per five-litre container.
The cost of a stock-out represents $0.50 per litre of Chem-248.
Sulphuric acid
Sulphuric acid is another material used as part of the production process. A quantity of
50,000litres is used by the Sydney plant each month, at a cost of $2.50 per litre. Currently,
Accutime places 100 orders for sulphuric acid each year. The supplier of the acid has indicated
that it is prepared to supply Accutime on a JIT basis, for an increase of 1% in the price per litre.
This would increase the number of orders placed each year to a daily basis (the plant is open
6days a week, 52 weeks a year).
While there are currently no stock-out costs as the lead time is certain, you believe that there
will be stock-outs arising from moving to a JIT strategy. In those instances, the acid would be
purchased from an alternative supplier at $2.70 per litre. It is expected that these purchases
would total 5,000 litres per year. The ordering costs would remain unchanged at $15 per order,
and the other carrying costs (insurance and so on) would be $10 per litre per year.
Return on investment
For the purpose of this exercise, Accutime requires a 12% annual rate of return on investment
(ROI).
ACT
Tasks
You have been asked to complete the following tasks as a part of your review:
1. Identify the different types of costs associated with carrying Chem-248 in inventory, and
specify which are likely to be the more significant.
2. The supplier of Chem-248 is planning to introduce web-based ordering for its product.
Outline the implication of this for Accutime, including any potential costs or savings that
may result.
3. Calculate the optimal order quantity of Chem-248 using the EOQ model. Identify any
potential risks with using EOQ.
4. Identify the factors that Accutime should take into account in estimating the costs of a
stockout of Chem-248. Calculate the most cost-effective reorder point for Chem248 using
the stock-out cost of $0.50 per litre.
5. Accutime is considering implementing a JIT strategy for the purchase of the sulphuric acid
used in the manufacturing process.
(a) Calculate the financial implications for Accutime of using JIT to purchase the sulphuric
acid.
(b) Outline any qualitative factors that Accutime should consider in making this decision.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
Kaiser, K and Young, SD, Cash is king so work your working capital, YouTube clip (interview)
on working capital management, accessed 10 February 2014, www.youtube.com Kevin
Kaiser and S. David Young.
Piasecki, D, Optimizing economic order quantity (EOQ), Inventory Operations Consulting LLC,
accessed 10 February 2014, www.inventoryops.com Optimizing EOQ.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit.
Brooks, A, Eldenburg, L, Oliver, J, Wolcott, S and Vesty, G 2008, Contemporary management
accounting, John Wiley & Sons Australia Ltd, Milton, Qld.
Horngren, C, Datar, S, Foster G, Rajan, M et al. 2011, Cost accounting: A managerial emphasis,
1stAustralian edn, Pearson Australia, Frenchs Forest, NSW.
Parrino, R, Kidwell, DS, Au Yong, H, Morkel-Kingsbury, N et al. 2011, Fundamentals of corporate
finance, Australasian edn, John Wiley & Sons Australia Ltd, Milton, Qld.
Proctor, R 2009, Managerial accounting for business decisions, 3rd edn, Pearson Education, UK.
Van Horne, JC and Wachowicz, JM Jr 2008, Fundamentals of financial management, 13thedn,
Prentice Hall, UK.
Zimmerer, T and Scarborough, N 2008, Essentials of entrepreneurship and small business
management, 5th edn, Pearson Education, NJ, USA.
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Core content
Unit 8: Business planning (including
budgeting and forecasting)
Learning outcomes
At the end of this unit you will be able to:
1. Outline the business planning and budgeting processes.
2. Assess which planning tools are most appropriate to a situation.
3. Identify and apply the most appropriate budget methodology.
4. Analyse the key factors, constraints and assumptions in developing a budget or forecast.
5. Apply sensitivity analysis to business planning.
Introduction
Business planning involves formally developing an organisations short-term and long-term
goals and objectives, and includes detailed financial analysis to support the desired strategic
outcomes. Developing the supporting budgets and forecasts requires assessing a variety
of scenarios and plans. Therefore, budgeting and forecasting form core components of the
management accountants skill set.
Management accountants have a key role in the business planning process, developing plans
and budgets for a business or business unit and analysing scenarios. Once the budget has been
finalised, they then review actual results against it and are able to produce forecasts as the year
progresses.
maaf31508_csg
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Learning outcome
1. Outline the business planning and budgeting processes.
Business planning
In the unit Introduction to management accounting (including ethics), the development of
an organisations strategy was discussed. Strategy development is based on the organisations
understanding of the market environment, its competitors, and its strengths and weaknesses.
Apreferred strategy will be selected according to how the organisation believes it can best
achieve and sustain its perceived competitive advantage.
An organisations strategy defines how it will meet both its vision and mission, and a number of
specific objectives and targets. Implementation of a strategy may take several years and require
periodic re-evaluation and refinement to ensure that the organisation is on track and able to
meet any changes in market conditions. This process of analysing and determining objectives,
goals and strategies is part of the business planning process. A key output of this process is the
business plan.
A business plan sets out the goals and objectives of the organisation and outlines its strategies
to achieve them. Having identified the factors critical for success, the business plan is translated
into financial plans. Initially, these might be presented at a summarised level; however, as plans
develop, they will become more detailed and will comprise a number of aspects, including
budgeted income statements, balance sheets and cash flows. A business plan will also usually
include an indication of the funding required to achieve the strategic goals and objectives.
Budgeting
Translating business plans into anticipated financial performance is done through the creation
of financial plans, budgets and forecast. These formalised financial plans for an organisations
operations for a specified period of time should reflect its strategic goals and objectives and
allocation of resources.
An organisations budget is its road map (usually for a year), and is used to communicate the
organisations high-level strategy and goals. As the various parts of an organisation complete
their own budgets, these communicate how each will contribute to the organisations overall
strategy from a financial viewpoint.
Budgets also relay information on the allocation of available resources to different parts of an
organisation, and facilitate the coordination of activities. For example, a sales team might aspire
to significantly grow sales, but without manufacturing capacity to deliver the product/s this
cannot be achieved. Understanding the interrelationships between operating activities allows
potential conflicts to be identified and resolved.
Budgets are a key management control tool. They play a role in monitoring performance
(by assessing actual performance against budget) and maintaining financial control. The
achievement of budgets is also often a key element in staff remuneration, and therefore has an
important effect on motivation and performance levels. The multipurpose use of budgets can
be a source of conflict, especially where they are used to assess individual or team performance
and set realistic expectations of achievement.
As budgets are a snapshot of the annual financial plan, rolling forecasts are used throughout the
year to make full-year financial projections and can be used to facilitate the review of business
plans. Longer term forecasts (e.g. three, five, seven or ten-year forecasts) are also an integral
part of linking an organisations financial planning to its goals, objectives and strategies.
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Budgets and forecasts do not solely focus on financial measures; non-financial indicators are
usually a key input into the budgeting process.
Together, these tools provide important input to an organisations performance management
system.
Actual performance
Rolling forecasts
Example TechScreen: How a chosen strategy can be the basis for business planning and budgeting
This example illustrates the interrelationship between strategy and budgeting.
TechScreen is an importer of high-end computer equipment and accessories to Australia.
Its business is split into a number of divisions, including one that is focused on the sale of
highresolution computer monitors. TechScreen currently sells three different monitor models.
The monitor division has identified two strategies to grow and expand the business: expansion
into New Zealand and developing new products.
Plans have been developed to appoint a distributor in New Zealand to sell TechScreens
monitors under a licensing arrangement. A new monitor model, known as the Integrity, is
currently being designed and will be released to the market on 1 July 20X5.
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The strategies and the corresponding plans to grow and expand the business would directly
impact its budgets as follows:
The appointment of a distributor in New Zealand: The estimated start date of the
arrangement, terms of the arrangement and estimated revenue, costs and profit would
all be included in the budget. TechScreen would need to consider whether it will be able
to obtain enough monitors to fulfil demand in Australia and New Zealand. In addition,
there might be additional costs involved in managing the relationship (e.g.travel to New
Zealand).
The new product line: The expected sales volume, estimated selling and purchase prices,
and required inventory levels, as well as the impact of the new model on the sales of
existing models would need to be reflected in the budget.
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It is essential that the budget owner has sufficient authority to ensure that budget guidelines
and policies are complied with throughout the organisation. This authority extends to ensuring
that operational areas consult the finance team on significant budgeting issues, particularly new
budget initiatives.
The involvement of lower management in constructing budgets does not end when those
managers have submitted their component of the budget. Once budgets are consolidated,
changes are invariably required to accommodate resource constraints or evolving priorities.
When this occurs, it is important that the relevant managers are consulted and understand
why changes have been made. This collaboration engenders greater levels of trust within the
organisation and aids in the communication of strategy and business priorities.
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Organisational strategies
Operating budget
Sales and revenue
Cost of sales
Direct materials budget
Direct labour budget
Direct overheads budget
Overhead expenses budget
Cash budget
Cash receipts
Cash payments
Bank balance
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In this unit, it is assumed that you can prepare operating, cash and balance sheet budgets.
Asshown in the flow chart above, the three budget types all interrelate, so that factors affecting
one will also potentially affect the others. The starting point is always the strategic goals,
objectives and strategies of the organisation, which have been outlined in the business plan
(asdiscussed earlier).
The TechScreen example is continued below, to help demonstrate how strategic and operational
plans are translated into budgets.
Example TechScreen (continued): Identifying the elements of the budget process impacted by
operational plans
TechScreen is planning on entering into a distribution agreement to expand into the New
Zealand market. Having decided on this strategy, management would have established
operational targets, in particular for the number of units they would expect to sell. The
expected terms of the agreement would include:
The distributor is responsible for sales to customers.
The distributor to pay a fixed fee per annum (designated in Australian dollars) for the right
to be the sole distributor in New Zealand, in addition to a royalty of 5% of the selling price
(in New Zealand dollars) on each monitor sold.
TechScreen to arrange for the product to be supplied to the distributor under the same
terms and conditions it has for its Australian operations, with goods to be shipped directly
from the supplier to the distributor and the supplier invoicing the distributor directly.
TechScreens no discounting policy to apply, and all sales to be at the list price set in New
Zealand dollars, as agreed with TechScreen.
The distributor is responsible for all its business costs, including staffing, marketing, local
distribution and warehousing.
These would be reflected in the operating budget as follows:
The revenue budget would reflect the 5% royalty on expected unit sales and unit prices
(converted from New Zealand dollars to Australian dollars) as well as the fixed fee.
The cost of sales budget would not be impacted as the goods are shipped direct from the
supplier to the distributor, with the distributor being responsible for the sales to customers.
The other operating expenses budget would reflect the costs involved in managing the
relationship with the distributor (e.g. legal fees, travel to New Zealand).
The cash budget would reflect the expected timing of cash receipts of the royalty and fixed
fee as outlined in the agreement. Cash outflows related to the operational expenses of
administering the distribution agreement would reflect their expected timing and the terms on
which they would be paid (cash or credit).
The balance sheet budget would reflect the closing cash position from the cash budget and
debtors to show the amount of unpaid royalties and fixed fees (based on the budgeted revenue
and terms).
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Not-for-profit organisations
The use of budgeting and forecasting techniques is not limited to organisations focused on
profit. Not-for-profit entities, including governments and their agencies (and even individuals),
can all improve their business planning and performance measurement by using budgeting and
forecasting.
Not-for-profit organisations are focused on delivering services or providing for socially
desirable needs in the community. They are accountable to their stakeholders in ensuring their
funds are only used for their intended purpose. Not-for profit operations may be funded by
the receipt of grants, donations, fund-raising activities and membership fees, or, in some cases,
bytrading activities.
Creating a budget allows not-for-profit organisations to test whether their strategic plans can
be translated into sustainable financial plans, as well as providing a reporting framework to
monitor their strategys progress. Budgeting especially cash budgeting is critical for these
organisations, which need to ensure they have adequate cash reserves for their continuing
operations. Not-for-profit organisations often find it difficult to predict revenues from year
toyear, which makes expense control an important area of their budgeting.
Budgets are normally prepared for an annual cycle, but not-for-profit organisations often
need to budget for part-year or multi-year funding or programs. In such cases, the budget
period should be adjusted to run over a shorter or longer time period. In some instances, these
organisations provide their various programs with discrete income and expense items that each
require a separate budget.
Government entities
In government entities, the focus is on balancing planned outflows against appropriations.
Appropriations are allocations of funds from the overall government budget, and these set
the limit that a government agency can spend. The total amount of appropriations needs
to bebalanced against government revenues being raised (commonly in the form of taxes),
resulting in either government budget surpluses or deficits.
Planning tools
Learning outcome
2. Assess which planning tools are most appropriate to a situation.
Budgets are the most common planning tool used by organisations. However, they are not the
only tool that is employed. Other tools, including forecasting, have been developed and these
tools are often used together to provide a robust business planning process.
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Criticism Argument
Demands an inordinate amount of Budgeting can be a lengthy and iterative process that involves
management time that could be better much internal communication, negotiation and reworking, taking
employed on other activities organisational focus away from key business objectives
Budgets often become quickly out- If reporting continues to use traditional budget-to-actual variances,
of-date, particularly in fast-changing time is wasted on explaining meaningless variances rather than
business environments, rendering them focusing on forward trends
ineffective as a control mechanism
Focuses attention on achieving short- This focus can be reinforced by budget-focused remuneration
term financial targets rather than incentives that divert attention from longer term drivers such as
on key value creation drivers for an innovation, investment in brands and adaptability to competition
organisation
Usually focuses on a one-year time Many resourcing decisions span more than one financial year, or
period, which can be afalse decision have lumpy (seasonal) cash flows
time frame
Reinforces a hierarchical structure, Power is concentrated at senior management levels, restricting lower
which stifles innovation and level managers from being proactive
adaptability
Inhibits creative thinking Budgeting encourages comparison with the prior year, especially
when incremental budgeting methodologies are used
Reinforces a silo mentality Data normally collected by, and relevant to, different functional
areas, rather than data that considers the organisation as a series of
customer-focused processes
Perpetuates resource allocation Managers have an incentive to protect budgets by ensuring all
decisions over time, even when no allocations are spent, regardless of need, for fear of losing them in
longer appropriate for an organisation future years (the use it or lose it mentality)
Encourages dysfunctional behaviours Process encourages managers to build slack into budgets so that
budget targets can be met without significant effort
Beyond Budgeting
Proponents of the Beyond Budgeting approach advocate abandoning traditional budgeting.
They propose a broader, more integrated approach to business planning. Suggested approaches
involve the use of continuous planning tools, such as rolling forecasts and relative targets. In the
Beyond Budgeting approach, these tools replace or enhance traditional fixed budget measures.
Performance measures emphasise non-financial key performance indicators (KPIs), such as
market share and customer satisfaction. These are presented on scorecards or dashboards,
which identify targets to be achieved over the short and long term. These targets are often
demanding and are developed by benchmarking an organisations performance against world-
class businesses.
The Beyond Budgeting model moves away from the centralised and fixed control focus of
traditional budgeting to a more delegated approach, which allows businesses to be more
innovative and adaptable in the contemporary business environment. It promotes a more
questioning attitude to business costs and operations through increased transparency, and the
tailoring of financial incentives to relative targets rather than against budget targets.
Beyond Budgeting principles have been adopted by organisations such as the Toyota Motor
Corporation, Aldi, UBS, and the Swedish bank Handelsbanken. The Beyond Budgeting
Roundtable website (www.bbrt.org) provides an outline of various case studies and white
papers on the model.
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Despite many criticisms, budgeting remains a widely used planning tool. In practice,
organisations often retain budgets but supplement them with other management control tools,
such as rolling forecasts, balanced scorecards and benchmarking.
Decision factors Determine targets, priorities, sources Consider current status, likely
of income and resource allocation outcomes and actions that need to be
taken
Planning horizon Prepared on an annual basis (usually Prepared on a regular basis, and reflect
broken down into months) and span the latest actual monthly/quarterly
the length of the financial year results
Level of detail Details based on financial statements, Focused on key drivers and measures
often down to the account level (i.e.higher level than budget)
Time frame Lengthy process frequently over one A quick process, often within days of
ormore months actual results or events
Completed before the beginning of Updated several times throughout
the financial year year
Forecasting tools
Forecasting is most effective when it is used as a tool to swiftly respond to changes in market
conditions. It is not a means of restating targets but of providing a continuous view of the actual
position and short-term outlook. Forecasts are usually prepared with a view of the baseline
business and then adjusted for known discrete events. By using key drivers and summarised
data, the forecasting process is quick and prompt.
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Approaches to forecasting
Organisations choose varying time frames for forecasts, based on factors such as reporting
cycles and planning horizons. Depending on the dynamics of an organisations industry, it may
complete monthly or quarterly forecasts. Alternatively, it may forecast using a combination
ofmonthly in near term months and quarterly in the later periods. Some organisations focus
onforecasts to the end of the current financial year, whereas others may adopt rolling forecasts
for a specified period (e.g. 1218 months) that extend into future financial years.
As an example, the planning time frame that is used by the Volvo Car Corporation reflects
the long-term decision-making and high-capital intensity of the motor vehicle industry.
The forecast information rolls into the next phase of the planning cycle and provides key
information on monthly performance, development and strategy.
The following table provides examples of a number of different types of forecast:
Type of forecast
Rolling forecasts
The term rolling describes an ongoing process in which an organisation is continually looking
forward for a fixed period of time. This is achieved by continuously adding a new period to
the forecast at the same rate that the time is passing. The following figure illustrates a quarterly
rolling forecast framework.
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
1st REVIEW
2nd REVIEW
3rd REVIEW
4th REVIEW
Forecast Actual
Assuming the organisation using this framework is approaching the end of the first quarter
(Q1) in Year X, the management team will review the draft figures for that quarter and then
begin a review of the four quarters ahead. Four of those quarters will already be in the existing
forecast and only require updating. However, an additional quarter needs to be added (being
the second quarter (Q2) of the next year). By the fourth review at the end of the third quarter
(Q3), the rolling forecast will provide a baseline plan for the following year.
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The rolling forecast is used to analyse trends and identify any gaps between actual and forecast
results that require remedial action. This can be seen in graphical presentations, which are
useful in highlighting the accuracy of forecasting. Plotting a moving average total (MAT)
smooths out the variations and indicates prevailing trends.
The following graph plots the trend in a KPI by showing actual and forecast results, and the
progress being made towards the aspirational targets.
45
40
35
Actuals/forecast
30 KPI target/budget
12 month MAT
25
Actual Forecast
20
J F M A M J J A S O N D J F M A M J
Learning outcome
3. Identify and apply the most appropriate budget methodology.
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The main budget methodologies used are:
Zero-based.
Incremental.
Top-down.
Bottom-up.
A combination of top-down and bottom-up.
Budget methodologies
Incremental Previous periods Quick to prepare Risk that the budget In a stable business
figures taken will be incorrect environment
as a base, and a as changes have When
percentage applied not been fully experiencing
to allow for inflation contemplated established and
or other expected expected trends
changes that are expected
to continue
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Budget methodologies
The following example shows how to identify the most appropriate budget methodology in
aprofit-focused organisation.
The budget methodologies discussed above can equally be applied in not-for-profit and
government entities; however, these types of entities may have a preference for particular
methodologies given the nature of their operations.
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Not-for-profit entities
Not-for-profit organisations may prepare budgets using a zero-based methodology, particularly
for new or specific programs or projects. Ongoing activities are usually budgeted incrementally,
although it is considered good practice to construct zero-based budgets from time to time
toensure that service delivery costs are fully justified.
Government entities
The methodologies for preparing a budget covered in this unit (zero-based, incremental,
top-down, bottom-up, and a combination of top-down and bottom-up) will be the same
methodologies applied by government entities in the preparation of their budgets. In many
cases, these entities rely on an incremental approach. The steps followed in preparing the
budget remain the same as for commercial organisations, although the requirement for sales
and manufacturing elements is rare.
Learning outcome
4. Analyse the key factors, constraints and assumptions in developing a budget or forecast.
Historical performance
An organisations past performance can provide a reasonable starting point for the budget
process, particularly for a stable and established business. For example, an organisation
that has consistently generated a gross margin of 25% over the past five years would need
to substantiate any deviation from this margin in the budget. This is not to say that the
organisation will not experience an increase or decrease in gross margin. It would, however,
bereasonable for it to start with its historical margin and then consciously allow for the impact
of other factors, such as changes to strategy, increased competition or reduced costs, to vary this
figure in the new budget.
A review of historical performance may also reveal the interrelationships between costs and
revenue, providing an organisation with greater confidence when developing its budget.
Forinstance, a correlation between the level of promotional expenditure and a change in
sales volumes would indicate that sales may well be impacted if an organisation were to seek
toreduce costs through a reduction in promotional expenditure.
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A review of an organisations historical performance against its budget will assist in
understanding where variances have arisen in the past. This historical analysis is useful for
tworeasons:
1. To identify the areas of the organisation that are driving major variances in the new budget
(as these variances might indicate an underlying change in the business).
2. To assist the organisation in assessing the accuracy of past budgeting and any consistent
tendencies to optimism or pessimism.
Reliance on historical performance is the basis of the incremental budgeting approach, which
uses immediate past period performance to build the next budget.
Seasonality
Many businesses are subject to seasonal variations, and it is important to reflect this accurately
in the budget. Budgets are normally prepared on a monthly, or even a weekly, basis in
industries such as retail, and the correct reflection of periodic trends enhances analysis against
actual performance. Seasonality can also have a major impact on cash flows, and therefore
directly influence an organisations short-term funding strategies.
The application of seasonality relies on good quality past period information, and
managements sound understanding of the variations this factor produces in financial
performance. Seasonal factors that need to be considered include:
Weather for example, beer or ice-cream sales are budgeted at higher levels in summer
months based on known sales patterns.
The timing of variable holiday periods, such as Easter or the Chinese New Year.
The timing of school vacation periods.
A leap year, which can add an extra days trading to an organisation with minimal impact
on fixed costs.
Trading periods for example, the impact of university semester timetables, or farming
periods around planting and harvesting.
The impact of seasonality also needs to be reflected in resource planning. Industries with peak
demand periods may need to budget for staff overtime, or a build-up of inventory if they are
manufacturing businesses or in the retail sector.
New investments
An organisation may have made new equipment, technology or other investments in the
current year that will significantly impact on the upcoming budget. Examples include
manufacturing organisations that invest in new plant and equipment to improve productivity
and cost structures.
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Constraints in budgeting
All organisations operate within constraints that prevent them from achieving maximum
performance. Constraints may arise because of shortages in materials, labour or available
capacity, or even from restricted access to capital.
Some budget constraints can be addressed by the supply of additional resources that
increase an organisations capacity; for example, investing in new plant and equipment
orsubcontracting extra labour. However, this may not be possible where constraints arise from
scarce resources, such as a skilled labour supply in certain locations, or where there is a finite
supply of raw materials. Ultimately, if one limiting factor is able to be addressed then another
will emerge, albeit at a higher level of output.
As constraints must be considered in all budgets, it is important that they are identified and
understood by all participants in the budget process.
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Budget assumptions
In budget planning, it is important to ensure that all parts of an organisation prepare budgets
in a consistent manner. Budget guidelines should list the key assumptions integral to the
organisation.
Assumptions often address uncertainties in the external environment. Examples of these
uncertainties include:
Market growth.
Wage and salary increases.
Commodity prices.
Interest rates.
Foreign exchange rates.
An organisations budget assumptions may also address internal factors, such as:
Pricing policies.
Employee numbers.
Capital expenditure.
Marketing spend.
The TechScreen example is continued below so that you can understand how key factors and
assumptions are identified.
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Some donors or grantors may impose conditions on the use of funds they provide. This can lead
to budgets being created for programs individually to determine if they are viable on a stand-
alone basis.
Expected revenues may impose constraints on the level of service that a not-for-profit
organisation is able to offer. The budget process may facilitate the prioritisation of decisions by
management, particularly if budgeted revenue is unable to finance all planned service offerings.
The strategic plan and objectives of a not-for-profit organisation will determine the resources
required to deliver planned services. Expense drivers such as timing, seasonality, program
assumptions and employee pay rates will need to be considered.
Learning outcome
5. Apply sensitivity analysis to business planning.
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Sensitivity analysis is often expressed as a technique to determine how a percentage change
in a key budget variable can impact an organisation. For example, if a business is exposed to
exchange rate risk, it can be useful to understand the profit implications of a one-cent change in
the exchange rate.
Sensitivity analysis can also be used to highlight the impact of a business decision. For example,
the impact of the introduction of a new product or service on profitability can be calculated.
This may be expressed as different levels of sales achieved to illustrate the range of possible
effects on the overall operating budget.
Quiz
[Available online in myLearning]
ACT
Activity 8.1
Limitations of the budgeting process
Introduction
Although budgeting is a useful tool in business planning it does have limitations, particularly
in dynamic and competitive business environments. In such cases, forecasts are often used to
supplement or even replace the budgeting process.
For this activity you are required to assess some of the limitations of the budget process and
understand the difference between a budget and a forecast.
This activity links to learning outcomes:
Outline the business planning and budgeting processes.
Assess which planning tools are most appropriate to a situation.
Scenario
You are a management accountant at Electric Avenue (EA), reporting to the CFO, Edward Grant.
EAs background
It is January 20X5. EA is a large retailer of electrical goods and appliances, operating a number
of stores across Australia and New Zealand. Historically, EA has been a star performer in
the retail sector, growing faster than its competitors. Its fast growth has been attributed to
competitive pricing, which the company has been able to deliver due to its buying power and
low-cost store formats.
Economic environment
The Christmas period is normally EAs strongest sales period; however, this year EA has
suffered its worst Christmas trading period on record. Consumer confidence has been
undermined by some significant corporate failures and an increase in the unemployment rate.
Retailers, including EA, attempted to combat this by commencing their annual clearance sales
earlier than normal.
A major issue is the strong exchange rate of both the Australian and New Zealand dollars
against major currencies (in particular, the US dollar), with consumers increasingly purchasing
online from overseas retailers, thus avoiding payment of GST.
Budget process
EAs financial year is from 1 July to 30 June, with its budget process commencing in mid-
February. Each of EAs store managers must submit their stores draft budget by the end of
March in order for EAs head office to consolidate and approve them before the beginning of
the new financial year.
ACT
Head office provides high-level guidance, including expected sales growth targets and the
anticipated cost price for key product lines. Each store is responsible for developing its full
operating budget (to profit and loss level), and does so knowing that budgeting for a profit less
than its most recent forecast for the current year will not be acceptable to EA head office.
Tasks
Because the retail sector is facing challenging times, Edward has asked you to analyse
the limitations of the current budget process in an attempt to improve its usefulness to
EAmanagement.
You are required to:
1. Identify and explain the key limitations of EAs annual budget process.
2. Consider EAs budget process and explain whether it is likely to have been an effective
management control tool to date. Justify your response.
3. Explain how forecasting would address management control deficiencies in the FY20X5
budget.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 8.2
Business planning in a not-for-profit context
Introduction
Business planning is an important tool for aligning an organisations strategic plans and
objectives with the outputs and financial outcomes of its ongoing operations. As a management
accountant, a solid understanding of the principles of business planning will allow you to assist
businesses, including not-for-profit entities, in implementing a business planning process.
For this activity you are required to demonstrate the interaction between strategy, planning and
budgeting.
This activity links to learning outcomes:
Outline the business planning and budgeting processes.
Identify and apply the most appropriate budget methodology.
Scenario
You are a management accountant working for B-There Foundation (B-There), a not-for-profit
organisation. You report to the general manager, Maya Patel.
ACT
Administration
B-There aims to keep its overheads and administration costs low (to less than 7% of revenue) by
having sub-region nursing staff work from their homes, and most of the fundraising work done
by local community volunteers.
A small administration team is based in a rented office in Mackay (North Queensland).
Tasks
Prior to commencing the development of the operating budget for the upcoming financial year,
Maya Patel has set you the following tasks:
1. Outline how the B-There strategy would be reflected in its operational plans and operating
budget.
2. Identify the most appropriate budget methodology B-There should use to develop its
operating budget. Justify your response.
3. Explain the basis upon which B-There should develop budgets for the new geographic
subregions.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 8.3
Key factors and constraints in developing
abudget
Introduction
The translation of operational plans into financial plans in the form of budgets and forecasts is a
key aspect of a management accountants role. Identifying and understanding the implications
of the key variables is essential in developing a robust budget or forecast.
For this activity you are required to identify key drivers, constraints and assumptions affecting
a not-for-profit entitys budget.
This activity links to learning outcome:
Analyse the key factors, constraints and assumptions in developing a budget or forecast.
Scenario
This activity follows on from Activity 8.2.
You are a management accountant working for B-There Foundation (B-There), a not-for-profit
organisation, reporting to the general manager, Maya Patel.
ACT
Administration
B-There aims to keep its overheads and administration costs low (to less than 7% of revenue) by
having sub-region nursing staff work from their homes, and most of the fundraising work done
by local community volunteers.
A small administration team is based in a rented office in Mackay (North Queensland).
Tasks
Prior to commencing the development of B-Theres operating budget for the upcoming financial
year, Maya Patel, has set you the following tasks:
1. Identify the key factors, both internal and external to the organisation, that you should
consider in preparing the operating budget. Justify your choices.
2. Identify and explain the key constraints to be considered in developing the operating
budget.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 8.4
Analysing a budget
Introduction
Operational plans are translated into financial plans in the form of budgets and forecasts. The
ability to critically analyse a budget or forecast is essential in determining whether operational
plans are realistic.
For this activity you are required to analyse a budget against a current year forecast to identify
the initiatives reflected in the budget and the key drivers of performance.
This activity links to learning outcome:
Analyse the key factors, constraints and assumptions in developing a budget or forecast.
Scenario
You are a management accountant working at the head office of Green Coat Group (Green
Coat), a marketing and promotional group that develops innovative ways to connect consumers
to advertisers and their products. The business units that make up the group have submitted
their budgets for 20X4, and you have been asked to review their submissions and provide
feedback to group management.
In completing their budgets, the business units were given the following guidance from head
office:
Inflation is expected to be 3% for 20X4.
Salaries and wages will increase by the rate of inflation.
Market revenue for traditional media advertising (such as print, television and outdoor
signage) is expected to decline, with advertisers moving that expenditure to digital
advertising.
Given the expected pressure on revenue, business units should look for ways to reduce their
costs so that profitability shows significant improvement on the disappointing forecast for
20X3.
One business unit in the group publishes a free weekly magazine, Spree, targeted at female
readers who love to shop. The magazine is distributed to commuters at major transportation
hubs in Brisbane, Sydney and Melbourne each Wednesday afternoon (except for the Christmas/
New Year period). It is a premium product, and advertisers consider it to be an effective
marketing tool. After printing and distribution costs, salaries and wages (editorial and
advertising staff) are the next largest expense of the business unit.
ACT
Spree Magazines operating budget submission, completed in Green Coats required format,
which includes key operational statistics, is shown below.
Issues 49 49 0 0.0
Copies printed and distributed (per issue) 1,271,000 1,273,000 2,000 0.2
Task
You have been asked to appraise Spree Magazines budget submission, analysing its budgeted
performance for 20X4 compared to the forecast for 20X3. Your observations should be
summarised in a report to Green Coats executive management, outlining Spree Magazines
operational plans for 20X4 and their anticipated financial implications, while clearly evaluating
the key drivers of the business units financial performance.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 8.5
Analysing forecasts and sensitivity analysis
Introduction
Rolling forecasts are often used in lieu of fixed budgets, while sensitivity analysis allows the
organisation to consider various impacts on interrelated activities as a result of changes to the
assumptions. It can be applied to either budgets or forecasts to determine the impact of changes
in key variables on the expected outcomes.
This activity will assist you in analysing a forecast and help you to understand the
interrelationships between the different business performance drivers for a department. You
will also assess the sensitivity of the businesss margin to a change in one of those key drivers.
This activity links to learning outcomes:
Analyse the key factors, constraints and assumptions in developing a budget or forecast.
Apply sensitivity analysis to business planning.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are SDTs management accountant and report to Charlene OShay, the CFO.
It is early January 2013 and the management team of SDTs Brisbane office has prepared its
forecast for the next 12 months. The Brisbane office is under pressure to improve its gross
margin percentage, which is the lowest in the group.
Their rolling forecast for the Testing services department for the next 12 months is provided
below.
31.12.2012 Q1 Q2 Q3 Q4 31.12.2013
Average staff for period 11.00 13.00 12.00 11.00 11.00 11.75
Available working days per 220.00 55.00 55.00 55.00 55.00 220.00
person
ACT
31.12.2012 Q1 Q2 Q3 Q4 31.12.2013
Less: COGS
Productivity bonus $0 $0 $0 $0 $0 $0
Tasks
Charlene has asked you to assist in analysing the Brisbane offices rolling forecast for the Testing
services department for the next 12 months.
You are required to:
1. Using the 31 December 2012 management accounts as a basis, appraise the 12-month rolling
forecast, identifying the key factors, variables and assumptions that underlie the forecast.
2. Assess the impact of a 1% increase in utilisation on the profitability of the testing business
line, in order to understand how sensitive the rolling forecast will be to changes in key
assumptions.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
There are no further readings for this unit.
References
Ideas for this unit were sourced from the following references:
Atkinson, A, Kaplan, R, Young, M and Matsumura, E 2012, Management accounting: information
for decision-making and strategy execution, 6th edn, Pearson/Prentice Hall, Upper Saddle River,
New Jersey, USA.
Beyond Budgeting Round Table, accessed 24 February 2014, www.bbrt.org.
Brooks, A, Eldenburg, L, Oliver, J, Wolcott, S and Vesty, G 2008, Contemporary management
accounting, John Wiley & Sons Australia Ltd, Milton, Queensland, Australia.
Chan Kim, W and Mauborgne, R 2004, Creating new market space (HBR OnPoint enhanced
edition), Harvard Business Review, July 2004.
Horngren, C, Datar, S, Foster, G, Rajan, M et al. 2011, Cost accounting: a managerial emphasis,
1stAustralian edn, Pearson/Prentice Hall, Australia, Frenchs Forest, New South Wales, Australia.
McWatters, C and Zimmerman, J 2008, Management accounting: analysis and interpretation,
Pearson Education, Harlow, UK.
Miller, D 1992, The generic strategy trap, Journal of Business Strategy, vol. 13, no. 1, pp. 3742.
Porter, ME 1980, Competitive strategy, Free Press, New York, USA.
Proctor, R 2009, Managerial accounting for business decisions, Pearson Education, Harlow, UK.
Thompson, AA, Strickland, AJ and Gamble, J 2007, Crafting and executing strategy: concepts and
readings, 15th edn, McGraw-Hill, New York, USA.
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Core content
Unit 9: Performance analysis
Learning outcomes
At the end of this unit you will be able to:
1. Evaluate financial ratios and trends used to analyse the financial performance of an
organisation.
2. Calculate and analyse variances to determine their causes.
3. Demonstrate the use of variance analysis to manage performance.
4. Apply the initial steps of the benchmarking process to determine what parts of a business
are appropriate to be benchmarked.
5. Design appropriate benchmarking measures and assess the outputs of a benchmarking
exercise.
Introduction
Analysing performance is one of a management accountants key tasks. There are numerous
techniques a management accountant can use to analyse, and hence better understand, the
performance of an organisation.
This unit focuses on the use of trend analysis, financial ratios and benchmarking as methods
to assess an organisations performance, together with determining variances. A management
accountants role, however, is not solely to calculate variances. It is also to delve into them, in
order to understand the reasons why actual performance is different to expectations, to analyse
the underlying causes and make recommendations to management.
Learning outcome
1. Evaluate financial ratios and trends used to analyse the financial performance of an
organisation.
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Trend analysis
Trend analysis is a tool that is used by management accountants to analyse an organisations
financial performance over a period of time.
A common comparison that is made to assess performance is between one years results and
those of the previous year. This comparison could be on an absolute dollar or percentage
change basis. Often, both are required in order to reach a sensible conclusion. For example, a
30% increase in an expense item of $1,000 does not appear to be of as much concern as a 30%
increase on $10,000. However, the nature of what you are looking at needs to be considered
the 30% increase on $10,000 may be one that was expected (e.g. in line with sales), while the
30% increase on $1,000 may be inconsistent with expectations and, therefore, worthy of further
investigation.
By looking at comparisons that extend beyond a period of two years, it may be possible to
identify trends in the performance of a business and see the effects of its strategic initiatives.
Trends do not need to be assessed on a consecutive calendar basis (e.g. monthly or yearly). A
more appropriate basis might be seasonal. Consider an ice cream store. Its sales will be highest
over the summer months and lowest during winter. A trend analysis that is conducted over
a 12-month period would reflect this. However, a more useful trend analysis might be one in
which the stores financial performance during summer over a number of years is compared.
This type of analysis would allow the business to understand its performance over its peak
periods.
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For example, using the Qantas trend analysis above, if 2009 was used as the base year for an
analysis of Qantas profit or revenues it would provide a misleading result. This is because 2009
was an unusual year due to the impact of the global financial crisis. If 2011 only was compared
to 2009, it could be concluded that the result was not too bad. However, when 2011 is compared
to 2007 or 2008, the analysis suggests a different answer.
Rolling data
More recently, trend analysis has been considering an organisations data in a different way.
Take, for example, the concept of a rolling year. Trend analysis in a rolling year is one in which
the results of a business for the previous 12 months, regardless of the current month, are
assessed. When these results are graphed, a better understanding of the organisations general
performance trend can be gained.
For example, the monthly data on an organisations sales and profit for December 2009
December 2012 on a rolling annual trend basis is graphically presented as follows:
$5
$4
$3
$2
$1
$0
Data interrelationships
Comparing data over time is a useful analytical tool. Similarly, comparing two (or more) sets of
data for a specific period can also provide insights. For example, looking at the sales of an ice
cream store against the average maximum seasonal temperatures provides an understanding of
the stores performance and its drivers.
Combining a trend analysis with an analysis of how multiple sets of data interrelate can yield
strong insights into financial performance. This may indicate what the key drivers behind the
current results are and highlight those of future performance.
The key to finding interrelationships in data is being able to identify a common element. Often
in financial analysis, this is the time period to which the data relates. For example, comparing
a retail stores revenue results, percentage margin achieved and consumer confidence index
for the same time period (or over the same time frame, when comparing trends) will provide
insight into performance.
Particular care needs to be taken when analysing a graphic representation of multiple sets of
data to ensure that the common element in each is consistently reflected in the graph. A clear
understanding of the degree of correlation between the two sets of data is critical in using these
relationships to their greatest advantage.
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Ratio analysis
Ratio analysis is a quantitative analysis tool used to analyse financial and management reports.
Rather than having to assess the many numbers in financial reports, ratios can provide a quick
insight into an organisations financial performance. There are a multitude of financial ratios
that can be used in this form of analysis. Some of the key ratios that management accountants
use are outlined in this section.
Ratios should be treated as a starting point in analysis. They are best used as indicators of
areas in a business that needs to be investigated further. Other sources of data (e.g. industry
benchmarks, industry trends, organisational changes and economic factors) should be
considered, together with organisational analysis, to make informed judgements about
performance and to develop plans.
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Profitability ratios
Profitability ratios measure an organisations use of its resources to generate profit, including:
Ratios that assess profitability.
Ratios that assess an organisations ability to generate income from its resources.
As can be seen from each of the formulas above, these ratios are measured as a percentage of
sales.
Ratios that assess an organisations effectiveness in generating income from its resources
Profitability ratios that assess an organisations effectiveness in generating income include:
EBIT
Return on assets (ROA) = Average total assets
Care needs to be taken when comparing ROA across different industries. A capital-intensive
industry will have a lower ROA than a technology or service industry due to its higher
investment in fixed assets.
Total dividends to ordinary shareholders
Dividend payout =
Net profit after tax Preference dividends
Dividend payout ratios vary widely across organisations. Large, blue-chip companies tend to
issue larger dividend payments while growing organisations seek to retain their cash to fund
future expansion.
Activity ratios
Activity ratios deal more with how effectively a businesss income-producing assets are
working. Commonly used ratios that assess the various types of assets include:
Sales
Asset turnover = Average total assets
Sales
Fixed asset turnover = Average fixed assets
Sales
Working capital turnover = Average working capital
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Liquidity ratios
Liquidity ratios assess an organisations ability to pay its short-term debt by comparing its
most liquid assets to its short-term liabilities. Generally, the higher the level of coverage (i.e.the
greater the difference between the level of short-term assets and liabilities) the better. This
indicates that an organisation can pay debts as and when they fall due, and continue to fund
ongoing operations.
The two most common liquidity ratios are the current and quick ratios.
Current assets
Current ratio = Current liabilities
In general, the higher the current ratio is, the better; however, this can be misleading. The
current ratio is based on all current assets being converted to cash to fund current liabilities,
and does not take into account the working capital required for an organisation to continue
operating as a going concern (e.g. inventory is a current asset that is continually required for
a retail store or wholesaling business to operate and a certain level needs to be maintained).
It also does not take into account the amount of time it takes to convert current assets, such as
debtors or inventory, into cash.
While an acceptable current ratio is greater than 1, it is often the case that service-based
organisations and organisations with a short cash cycle can have a lower current ratio and still
be considered as having an appropriate liquidity position.
Cash assets ^and equivalents h + Short-term investments + receivables
Quick or acid test ratio = Current liablities
The quick ratio addresses the issue of inventory impacting on liquidity analysis. The numerator
is often quickly calculated as current assets less inventory.
Financing ratios
Financing ratios provide a useful indicator of returns to those who have financed the
organisation (i.e. returns on shareholders equity). They are also an indicator of the financial risk
associated with the way in which the organisation is financed (e.g. leverage and interest cover
ratios).
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A debt ratio is used to consider how an organisation is financed and its ability to service its debt
by comparing its liabilities against other financial aspects of the business.
Total liabilities
Debt ratio = Total assets
A low debt ratio indicates that an organisation is not highly leveraged, while a high debt ratio
indicates that it relies strongly on debt funding. (Note that the definition of debt used in the
ratios discussed in this section includes operational liabilities as a source of funding, not just
borrowed funds. In later units on applied finance a narrower definition of debt is applied where
only borrowed funds are used.)
Total liabilities
Debt equity ratio = Total shareholder funds
An organisations debtequity ratio also reflects its financial leverage position, but measures the
investment made by suppliers and lenders against what shareholders have committed. Larger
companies with strong credit ratings are often able to maintain a larger liability component on
their balance sheet and to push this ratio well over 100%, while smaller companies are unable to
do this.
EBIT
Interest coverage ratio = Interest (expensed and capitalised)
The interest coverage ratio (also referred to as times interest earned) reflects the ease with
which an organisation can pay its interest expense on outstanding debt. When an organisations
interest coverage ratio is 1.5 times or less, this can indicate a challenge for the organisation in
meeting its future interest obligations, especially if interest rates rise.
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Lou Graham, F&Hs chief financial officer, has asked Adam to analyse the ratios he has already
developed, and provide an opinion on both the financial performance and financial position
ofF&H.
Adam reviews the ratios and makes notes on the main areas that he thinks need further
consideration.
Sales growth
Sales are growing, but at a declining rate (evidenced by the 20X3 sales growth being 5% of the
prior years, but 20X4 sales growth being 4.8% of 20X3 sales).
Cost of sales
Cost of sales is increasing, as demonstrated by the declining gross margin ratio.
Earnings before interest and tax (EBIT)
EBIT is improving over time, indicating that cost savings have more than compensated for the
decline in gross margin.
Debtor days
Declining debtor days (down 20%) along with increasing sales (up 10%) indicate that the
accounts receivable balance is decreasing.
This could reflect improved customer collection processes or changes in credit terms.
Inventory days
The inventory days ratio is quite high, suggesting that there has been an increase in inventory
and/or obsolete inventory.
The level of inventory should either increase in line with sales or at a lesser rate. F&H inventory
has increased at a greater rate than the level of sales.
The increase in inventory is likely linked to the new overseas distributorships. This is likely to
have created a need to hold more inventory which has not yet converted into additional sales.
F&H are also likely to be required to hold additional inventory due to extended lead times
associated with overseas supplies.
Return on assets
Return on assets is increasing as EBIT is improving based on the EBIT margin. However, the 20X4
ratio is lower due to the purchase of fixed assets (supported by a decline in the fixed assets
turnover ratio).
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Debt ratio
From 20X2 to 20X3, the debt ratio declined. Given the movements in current and quick ratios, it
would appear to be linked to a reduction in term fixed debt components rather than in trading
liabilities.
From 20X3 to 20X4, the debt ratio increased significantly. Given the fall in fixed asset turnover
(despite a sales increase), it would appear that F&H has borrowed funds to invest in new fixed
assets, as well as to finance the significant increase in inventory (as reflected in the increase in
inventory days).
Return on equity
Return on equity is declining. While profits have increased (refer to EBIT above), this ratio has
declined, indicating that ordinary shareholder funds have increased.
This might indicate that profits generated are being retained in the business, rather than being
paid out as dividends.
Form an opinion
Now that Adam has reviewed and noted the key areas of business performance, he needs to
summarise his overall view for Leo.
Adam notes that while sales are up, gross margin has declined. However, with control of
overhead costs, there has been an improvement in profit, suggesting a good performance.
Management of the balance sheet and cash has not been as effective as profit performance,
and this will need to be addressed.
Variance analysis
Learning outcomes
2. Calculate and analyse variances to determine their causes.
3. Demonstrate the use of variance analysis to manage performance.
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By continually drilling down into variances, management accountants can get to the true
source of a difference in performance versus expectations.
Master/static budget
Before the commencement of a period, most organisations will set a budget or forecast that
outlines the expected performance for that period. This budget is subsequently compared to the
actual performance for the period, and is referred to as the master budget. It is also known as
the static budget because it is developed for a specific, single-output level (e.g. the number of
units sold or produced).
The static budget variance is formulated as follows:
The static budget variance is the highest level variance (Level 1) that can be calculated.
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COGS
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LEVEL 1
Static budget
LEVEL 2
Flexible budget variance Sales volume variance
Flexible budget
At the end of a period, it is likely that the actual level of output will differ from the planned
level of output for that period. The actual level of output is likely to be the driver for many costs
(e.g.direct materials, direct labour and variable overheads). To better analyse the results, the
master budget should be revised to reflect the actual level of output, using the same revenue
and costs per unit that are contained in the static budget. This is known as the flexible budget,
and the process of creating it is called flexing the budget.
For the purposes of financial control, an organisation prepares a flexible budget at the end of a
period, when the total work done or the actual output level for the period is known. Variable
revenue and costs are proportionately adjusted to reflect the actual level of output, but fixed
costs remain unchanged.
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Flexible budgets are most useful in assessing short-term financial performance. Using flexible
budgets and per unit standard costing enables management to understand the underlying
reasons for any effect on short-term operating profits.
When determining which variable to flex around, consider what is being made or sold.
COGS
This shows that for the 77,500 bottles sold, Cool Juice would expect to make a gross profit
of $7,005.
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Sales volume variance is the difference between the flexible budget and the static budget.
Independently, it can be calculated as:
It is the variance that arises solely from the fact that there is a difference between planned and
actual sales. When a different number of units are sold, it is both the total revenue and the total
variable cost that flex with the change in volume.
Further drilling down into this variance will be undertaken later in the unit.
Flexible budget variance analysis compares actual results to the flexible budget, which is based
on actual levels of output.
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The variances in the difference column in the table above can be used in subsequent analysis to
reconcile the variances for each line.
The flexible budget variance can be further broken down into the following components:
Sales price variance.
Standard cost variances.
Selling and administrative expense variances, which are made up of indirect cost variances.
The sales price variance is the variance in sales revenue that results from changes to the selling
price, as the impact of volume changes has already been considered in the sales volume variance.
The formula for the sales price variance is:
Note that for the Cool Juice example the selling price variance is zero as the actual and
budgeted selling price are the same.
Further sales variances are discussed later in the unit.
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The standard cost variances are the direct cost variances for materials, labour and overheads
that are included in the total cost of the product or service. These can be driven by a
combination of higher quantities or higher prices for the components that make up this total
cost.
Materials variances
In order to understand the flexible budget variance further, the materials costs are split into
price and efficiency (or usage) variances (Level 3 variances).
The materials price variance is the difference between the actual and budgeted price of the
materials purchased, and is formulated as follows:
The materials efficiency variance is the difference between the actual and budgeted input
quantity used, and is formulated as follows:
Budgeted (or
Actual input Standard unit Efficiency
standard) input =
quantity price variance
for actual output
The materials price variance monitors the price being paid for the materials and the materials
efficiency variance monitors the amount of materials being used.
The standard calculations are illustrated in the following figure:
DIRECT Actual input quantity Actual input quantity Budgeted input for actual output
MATERIAL
Actual unit price Standard unit price Standard unit price
Note: Standard equates to budget in the Management Accounting & Applied Finance module
(asthe
LABOURstandard would
Actual inputnormally
quantity be Actual
basedinput
on budget).
quantity Budgeted input for actual output
Labour variances
Actual unit price Standard unit price Standard unit price
In order to understand the flexible budget variance further, the labour costs are split into price
and efficiency variances (Level 3 variances).
Price variance Efficiency variance
The labour price variance is the difference between the actual and budgeted labour price, and is
formulated as follows: Source: Horngren et al 2009
The labour efficiency variance is the difference between the actual and budgeted labour
quantity used, which is normally measured in labour hours, and is formulated as follows:
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Price variance Efficiency variance
The standard calculations are illustrated in the following figure:
LABOUR Actual input quantity Actual input quantity Budgeted input for actual output
Actual unit price Standard unit price Standard unit price
The variable overhead efficiency variance monitors the change in the DLM or DMH driver as
appropriate.
VARIABLE Actual input quantity Actual input quantity Standard input for actual output
OVERHEAD
Actual rate Standard rate Standard rate
Fixed overhead spending variances (also referred to as fixed overhead budget variances)
typically
FIXED arise when the annual budgeting process does notStandard adequately
inputprovide
for actualfor the factors
output
OVERHEAD
that impact overheads (e.g. council rate increases, depreciation relating to new capital spending,
and management salary
Actual increases or bonuses).
costs incurred Budgeted It is calculated as theStandard
costs difference
rate between the
actual amount of overhead fixed costs incurred less the amount in the flexible budget.
The volume variance only arises if the organisation uses a standard costing system, otherwise it
is zero.
DIRECT Actual input quantity Actual input quantity Budgeted input for actual output
MATERIAL
Actual unit price Standard unit price Standard unit price
79,050 $0.6215 77,500 $0.6215
$49,011 = $49,130 = $48,166
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Spending variance
$120 U
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Causes of variances
It is simply not enough to just calculate all the variances and identify them as favourable or
unfavourable. The driver or cause of that variance which will be specific to the circumstances
needs to be identified so that management can take appropriate action to address the issue.
Some of the common causes of cost variances are set out in the table below:
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The causes of cost variances should not be analysed in isolation. The cause of a variance in one
part of the value chain (e.g. an unfavourable material efficiency variance) could be the result of
an issue in another part of the value chain (poor quality supplies that might have been provided
at a lower price).
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Sales variances
An organisation that focuses all its attention on cost variances is really only analysing half the
story. It is just as important to anlayse the sales variances. Examining these variances enables
organisations to understand their competitive effectiveness. Did the organisation achieve the
objectives of its sales and marketing strategy? Did the additional promotional expenditure
produce the desired result? Understanding the outcome will help organisations make necessary
changes to their strategies to ensure future growth. As with analysing the cost variances, the
management accountant needs to be thorough in order to find the underlying causes. Are they
the result of effective or poor marketing strategy? Are they the result of market forces outside
the organisations control? Did the organisation capitalise on market forces? Were pricing
decisions appropriate?
The following diagram summarises the sales variances:
Total sales
variance
Total sales variance represents the difference between actual and budgeted total sales.
The sales price variance was addressed earlier in the unit. In conjunction with the other sales
variances, it is used by the management accountant to assess the impact of pricing policies on
revenue. Did the price drop result in the desired increase in volumes and increase revenue as
budgeted? Did the price rise result in increased revenue or was demand impacted such that
revenue suffered?
The sales volume variance was also covered earlier, and for an organisation selling multiple
products can be further broken down into the sales mix variance and the sales quantity
variance.
Budgeted
Actual total Actual sales mix Budgeted sales
contribution Sales mix
sales units of all percentage of mix percentage =
margin per unit of variance
products this product of this product
this product
The sales mix can be impacted by poor forecasting or changes in consumer tastes.
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Budgeted
Actual total Budgeted total Budgeted sales Sales
contribution
sales units of all sales units of all mix percentage = quantity
margin per unit of
products products of this product variance
this product
SALES
VOLUME Actual total sales units Actual total sales units Budgeted total sales units of all
VARIANCE of all products of all products products
Actual sales mix Budgeted sales mix Budgeted sales mix
percentage percentage of percentage
of this product this product of this product
Budgeted Budgeted Budgeted contribution
contribution contribution margin per unit
margin per unit margin per unit of this product
of this product of this product
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Drinking yogurt 9,600 ($3.75 $4.00) Unfavourable Due to the weather conditions, Rich
= $2,400 Yogurt was unable to sell at the
budgeted price of $4.00 per unit,
and $2,400 in revenue was forgone
on the 9,600 units of sales
Yogurt tubs 23,040 ($9.00 $8.00) Favourable Yogurt tubs were able to be sold at
= $23,040 $1.00 more than budgeted, which
allowed $23,040 in additional
revenue to be made
Frozen yogurt 15,360 ($4.50 $5.00) Unfavourable Due to the weather conditions, Rich
= $7,680 Yogurt was unable to sell at the
budgeted price of $5.00 per unit,
and $7,680 in revenue was forgone
on the 15,360 units of sales
Drinking yogurt (9,600 10,000) $1.50 = Unfavourable Due to the weather conditions, Rich
$600 Yogurt was unable to sell desired
volumes
Yogurt tubs (23,040 25,000) $3.00 = Unfavourable Price rise may have affected
$5,880 demand, together with weather
conditions
Frozen yogurt (15,360 15,000) $2.00 Favourable The price drop enabled Rich
= $720 Yogurt to exceed sales volume
expectations for frozen yogurt
Note: It is not possible to reconcile the sales price variance and the sales volume variance to the difference
arising between actual and budgeted total sales, as the sales volume variance is being calculated on CM,
not price.
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Drinking yogurt 48,000 (20% 20%) N/A No CM was lost on this product, as
$1.50) = $0 the percentage of drinking yogurt
sales budgeted was maintained
due to price drop
Yogurt tubs 48,000 (48% 50%) Unfavourable $2,880 of CM was lost on this
$3.00 = $2,880 product, as the percentage of
yogurt tubs sales budgeted was
less than the actual percentage
Yogurt tubs (48,000 50,000) 50% Unfavourable Price increase for yogurt tubs
$3.00 = $3,000 combined with weather conditions
resulted in expected volumes not
being retained
Frozen yogurt (48,000 50,000) 30% Unfavourable Price drop for frozen yogurt
$2.00 = $1,200 changed expected volumes of this
product
Reconciliation
Product Sales mix variance Sales quantity variance Sales volume variance
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Market variances
Market variances can arise from:
Changes in an organisations share of the market where the actual market share differs
from the budgeted market share (e.g. its actual market share is 70% compared to the
budgeted 65%). The market share variance measures the impact on the organisations
profits caused by such fluctuations. This variance is considered to be within the managers
control and is used for performance evaluation purposes. It provides a comparison against
industry rivals.
Changes in the overall size of the market, where the actual market size differs from the
budgeted market size (e.g. the size of the toothpaste market is 60,000 kilolitres versus a
budget estimate of 57,000 kilolitres). The market size variance measures the impact on the
organisations profits caused by such fluctuations. This variance is considered to be outside
the control of managers as it can be affected by economic factors, changing consumer tastes
and in some industries weather conditions, for example.
Budgeted
Market
Actual market Actual market Budgeted contribution
= share
size in units share market share margin per
variance
composite unit
Budgeted
Market
Actual market Budgeted market Budgeted contribution
= size
size in units size in units market share margin per
variance
composite unit
SALES
QUANTITY Actual market Actual market Budgeted market
VARIANCE size in units size in units size in units
Actual Budgeted Budgeted
market share market share market share
Budgeted Budgeted Budgeted
contribution contribution contribution
margin per margin per margin per
composite unit composite unit composite unit
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SALES
QUANTITY 461,539 10.4% 461,539 10% 500,000 10%
VARIANCE $2.40 = $2.40 = $2.40 =
$115,200 $110,769 $120,000
$4,431 F $9,231 U
Market share variance Market size variance
$4,800 U
Sales quantity variance
Total $2.40
Further probing of the market share and market size variances is important. For example,
could the unfavourable market share variance be due to a competitor launching a new product,
investing in a comprehensive media campaign, lowering its prices, providing a better service
or offering improved value for money? Will the increase in market size continue? Reliable
information on market share and market size is available through organisations that sell
syndicated data (e.g. the Nielsen Company or Aztec Australia) for many fast-moving consumer
goods markets, such as the pet food, toothpaste and hair care markets. For most businesses, the
calculation of these market variances may not be an exact science, but performing this analysis
can lead to useful insights that can be used when undertaking strategic analysis.
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that is, investigate and review only those items for which there are significant variances. This
information, including the analysis of variance drivers, can then be used to make changes to
processes or inputs to obtain the desired results.
The following figure illustrates the variance analysis cycle:
Monthly
operating cycle
after corrective
actions
Prepare
summary of
Receive issues
explanations
in response to
issues
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For example, a manager might have a target to reduce the number of defective products that
are sold. To achieve this goal, they might increase the number of quality inspection officers
who check the products before they leave the manufacturing site. A favourable variance in the
number of faulty products that are returned may result in an unfavourable variance in salary
costs that are associated with quality activities.
Learning outcomes
4. Apply the initial steps of the benchmarking process to determine what parts of a business
are appropriate to be benchmarked.
5. Design appropriate benchmarking measures and assess the outputs of a benchmarking
exercise.
Benchmarking is the process of evaluating the performance of one organisation against that of
another. Reviewing processes or performance metrics (KPIs) against a benchmark encourages
an organisation to review and adopt new ideas, processes and practices in order to improve its
own effectiveness, efficiency and performance.
What is a benchmark?
Generally, a benchmark is a standard against which an aspect of a business is measured. The
level at which this target or benchmark should be is not always clear at the outset. Hence,
organisations undertake benchmarking exercises to identify best practice processes or metrics
that they then work towards achieving.
Benefits of benchmarking
To be successful in todays competitive environment, organisations aim for continuous
improvement in their operations. These improvements may relate to enhanced efficiency,
offering increased value to customers, or developing new initiatives. Benchmarking is a
mechanism whereby organisations can identify areas for improvement.
Some of the specific benefits of benchmarking are that it:
Helps to identify specific problem areas and eliminate guesswork.
Enables management to prioritise improvement opportunities.
Can be used to generate incremental change and reform.
Can be used to educate and train management and employees on the latest and best
practices being used and achieved.
Challenges employees to work smarter instead of harder.
Shows that performance targets are achievable (since others are already achieving them).
Serves as a performance measurement tool.
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Step 3 Collect and analyse data to identify areas performing below best practice
This is often the most difficult part of the process, as it is not always easy to collect the
information required. Why would a company, especially a competitor, provide information on
its performance when, in doing so, it could give away a competitive advantage?
Some information, such as industry statistics, is publicly available; however, it may be out of
date by the time it is released. Often, industry statistics are issued many months after the period
to which they relate. With the rate of change occurring in many industries, this knowledge
might be interesting but is redundant in the current environment. Technological advances, as
well as changes in consumer tastes, can also reduce the usefulness of any information gathered.
Another risk of relying on publicly available information is that not all the information that is
needed for the benchmarking exercise is available. For example, a publicly listed company has
to disclose its revenue dollars by segment, but does not have to disclose the volumes of units it
has sold.
Sometimes, within organisations, benchmarking is performed on products that are at different
stages of their life cycle, or benchmarking partnerships are formed with other companies to
share such information. However, these can be difficult to establish due to the level of trust that
is required in sharing confidential information.
The following websites provide access to some benchmarking information at no cost:
Australia and New Zealand Banking Group Ltd (ANZ), Industry analyser, accessed
4April2014, www.anz.com Small Business Tools, forms and guides Benchmark
your business Industry analyser.
Australian Taxation Office, Small business benchmarks, accessed 4 April 2014,
www.ato.gov.au.
Benchmarking exercise
In a benchmarking exercise, it is not necessary for the participants to share the same
organisational attributes, such as size, industry or geographic location. However, it is important
to consider the influence of these factors on the measures developed.
As an example, consider McDonalds Australia (McDonalds) completing a global
benchmarking exercise. The time taken to complete a customer order is fairly comparable across
the McDonalds groups stores around the world. However, comparing the US dollar-equivalent
selling prices of a particular hamburger would provide less insight into performance due to the
fact that exchange rates fluctuate. It is therefore important to understand how a measure is to be
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used to ensure that the measure developed provides an understanding of performance. When
using international organisations as benchmarking targets, it is best to eliminate the impact of
foreign exchange variations from the metrics that are used.
Similarly, two organisations may be in the same industry but so different in size as to make
publicly available information (e.g. annual reports and industry association data) less useful.
For example, a small beverage producer should not benchmark itself or its processes against
Coca-Cola, as it could never achieve the same economies of scale.
Despite some of the disadvantages of benchmarking partnerships, it is important to recognise
that different organisations can still learn from each other. If it is possible to remove the impact
of size when developing a measure, useful knowledge can be obtained. Returning to the
example of McDonalds, store sizes for the chains outlets vary dramatically across Australia
and New Zealand. Therefore, adjusting the measure sales per store to sales revenue per
square metre would provide a better insight into the sales performance of each outlet and
whether investing in a larger store would be profitable.
Definition of measures
Consistent definitions of benchmarking measures need to be agreed on when benchmarking.
For example, when using the number of employees as part of a benchmarking measure, a
number of questions need to be asked:
Is this the number of full-time equivalents, or the overall number of people the organisation
employs?
Are part-time employees counted as one employee, or as a fraction that represents the
amount of time they spend in the role?
Are contract staff included in the employee count?
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Further reading
Purdum, T 2007, Benchmarking outside the box in IndustryWeek, Penton Media Inc., 8 February.
This reading discusses the benefits that can be gained from benchmarking against a disparate
organisation.
A copy of this reading can be found within the Business Sources Corporate data library within the
Knowledge Centre in the CA ANZs website.
Quiz
[Available online in myLearning]
ACT
Activity 9.1
Ratio analysis
Introduction
This activity requires you to calculate, interpret and analyse financial ratios, evaluate the
financial performance of the company, and recommend courses of action for the chief financial
officer (CFO).
This activity links to learning outcome:
Evaluate financial ratios and trends used to analyse financial performance of an
organisation.
At the end of this activity you will be able to evaluate an organisations financial ratios and
identify the actions management need to take to improve future performance.
It will take you approximately 45 minutes to complete.
Scenario
You are the management accountant at Tycon Limited (Tycon), reporting to CFO Sally Lin.
Tycon has been in the retail business for 30 years and has established and maintained a strong
corporate brand. The brand is associated with providing quality products at a reasonable
price. Tycon extended the retail business eight (8) years ago with the acquisition of an existing
business of retail stores selling sports equipment, sports clothing and sports footwear. Now the
stores are in a separate division, under the Hit brand. The company operates two (2) divisions
Tycon, which sells homeware products, and Hit, which sells sports-related products. There are
a total of 36 stores nationwide, with four (4) new stores across the two divisions added during
the 2015 financial reporting period. Imported purchases represent approximately 90% of the
products sold.
You have obtained the following information on the 2015 financial performance:
Promotional plans had to be changed in light of a slow start to the winter period and lower
demand. Seasonal stock had, however, already been committed and stock levels could not
be adjusted to reflect the lower demand.
The proportion of sports-related products, especially sports apparel, in the product mix
increased in comparison with the previous year.
A new inventory system is planned for full implementation in 2016. The initial pilot testing
of the system in four (4) stores identified a number of significant issues to address. These
issues are expected to be resolved before implementation in 2016.
The gross margin increased, supported by a strengthening local currency.
Online sales were static. The expected growth in this segment did not occur.
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The following financial information for Tycon Limited has been obtained:
Balance sheet 2015 2014 2013
($000) ($000) ($000)
Current assets
Non-current assets
Current liabilities
Provisions 16 15 17
Non-current liabilities
Other liabilities 10 10 10
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The following table shows Tycons financial ratios for the past three years.
Item Description 2015 2014 2013
Current ratio Current assets 41,321 40,968 41,039
Current liabilities 14,482 13,945 13,822
72.28 days
Creditor days Average creditors 365 Calculate Calculate Calculate
purchases
Return on equity NPAT 12,234 Calculate 12,982
Average ordinary shareholders funds 45,383 40,097
27.0% 32.4%
35.4%
Debt to equity ratio Total liabilities 14,691 Calculate 14,019
Total equity 50,078 40,192
0.29: 1 0.35: 1
Net margin Net profit after tax 12,234 12,392 12,982
Sales 185,162 176,755 175,198
Tasks
For this activity you are required to:
1. Calculate the financial ratios that are not shown in the above table (i.e. in the table cells
marked calculate)
2. Analyse the results of the ratios, margins and trends over the period 2013 to 2015.
3. Evaluate the performance of Tycon Limited, and provide the CFO of Tycon with
recommendations.
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Activity 9.2
Variance analysis
Introduction
One of the key functions of a management accountant is to understand and interpret an
organisations performance. In reviewing performance, managers and management accountants
alike compare actual results against expectations and then seek to understand the reasons for,
or causes of, any differences between them. This type of analysis is called variance analysis.
Variance analysis involves the comparison of actual performance to an expectation or target.
This could be a comparison to historical performance, budget, forecast or the performance of
competitors.
This activity links to learning outcome:
Calculate and analyse variances to determine their causes.
Demonstrate the use of variance analysis to manage performance.
At the end of this activity you will be able to calculate and analyse variances at different levels
within a services environment.
It will take you approximately 60 minutes to complete.
Scenario
You are the management accountant at Willies Wagyu Restaurant (Willies). This restaurant
chain has recently opened a new restaurant in the CBD of Adelaide. The manager of the chain
wants to ensure this new outlet is monitored very carefully as there is a new restaurant manager
who is not familiar with Willies control systems.
All dishes comprise a 250g wagyu steak served with a selection of vegetable or salad sides for
the customer to choose from. These sides are usually seasonal in nature and serve the dual
purpose of keeping costs down and providing a changing menu for the customer. All meals are
priced at $50.
Variable overhead is allocated based on direct labour hours (DLH).
The details for May are as follows:
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Tasks
1. Prepare a detailed variance analysis for Willies Adelaide restaurant for the month of May.
2. Outline potential causes for each variance.
3. Explain the implications of the variance analysis and causes completed above for the new
restaurant manager.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 9.3
Identifying appropriate benchmarking
partners and issues
Introduction
This activity requires you to follow the initial steps of the benchmarking process to determine
what parts of a business are appropriate to be benchmarked, and identify appropriate
benchmark partners to use.
The activity links to learning outcomes:
Apply the initial steps of the benchmarking process to determine what parts of a business
are appropriate to be benchmarked.
Design appropriate benchmarking measures and assess the outputs of a benchmarking
exercise.
At the end of this activity you will be able to identify appropriate benchmarking partners and
issues.
It will take you approximately 30 minutes to complete.
Scenario
You are the management accountant for InsideHome.
InsideHome is an Australian-owned chain of homeware stores which sells its own brand
product range, as well as other well-known brands.
It has 21 stores across Australia in both cities and regional locations, with more planned for the
next year.
InsideHome has also just launched an internet site that contains product information and a
limited range of products for sale.
InsideHome is considering a benchmarking exercise to measure its performance and provides
the following information:
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Product pricing
While head office has a recommended price list, each store can price its products according to
the level of local competition.
At the end of the season, any unsold items are returned to head office at the same cost they were
transferred to the store for. They are then disposed of at InsideHomes outlet store.
Customer service
InsideHome prides itself on its customer service.
It assesses the performance of its stores by using mystery shoppers (fake customers posing as
real customers who go into stores to make purchases). It also operates a customer email list
advising customers of sales and special offers exclusive to email list subscribers.
Competitors
The well-known homeware brands that InsideHome sells are also available in department
stores and other homeware stores.
InsideHomes biggest direct competitor is Baywares, a US publicly listed company, with 150
stores worldwide. Its product range is entirely comprised of its own innovative designs, which
are manufactured exclusively in China.
Other information
Each store manager determines the staffing level required, including the mix of permanent and
casual employees.
Head office pays all employees and suppliers, as well as locating and setting up new store
locations.
Tasks
For this activity you are required to complete the following tasks:
1. Identify products, services or processes that InsideHome could benchmark.
2. Identify the different benchmark partners, both internal and external to the organisation,
that could be used in a benchmarking exercise, explaining the benefits and risks of using
each partner identified, and linking the partners you have identified to the specific
products, services or processes identified in Step 1.
3. Specifically consider the online store and:
(a) Identify the issues in benchmarking the online store against the physical retail stores.
(b) Outline how you would use benchmarking to assess the performance of the online store.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 9.4
Applying the initial steps of benchmarking
Introduction
This activity requires you to assess proposed benchmarks, develop benchmark measures and
consider the potential pitfalls associated with the outputs generated from a benchmarking
exercise.
This activity links to learning outcomes:
Apply the initial steps of the benchmarking process to determine what parts of a business
are appropriate to be benchmarked.
Design appropriate benchmark measures and assess the outputs of a benchmarking
exercise.
At the end of this activity you will be able to assess proposed benchmark measures.
It will take you approximately 30 minutes to complete.
Scenario
You are a management accountant at RCF Insurance (RCF) head office.
RCF is a general insurance company operating in Australia. It sells three types of insurance
across three respective divisions: motor, property (both of which RCF has been selling for a
number of years) and travel (a highly competitive market which RCF aggressively entered 18
months ago). RCFs insurance policies are sold only to domestic consumers (not to businesses)
through a call centre or via the companys website.
Claims costs include the amount paid to consumers in claims, as well as the cost of assessing
and processing the claims. Sales staff are on a fixed salary and, for any policies they sell, they
receive 8% commission calculated on the premium earned. Administrative costs are all incurred
at head office and then allocated to the divisions.
In an effort to evaluate its performance in the insurance industry, RCF is considering a
benchmarking exercise. The following two measures have been proposed to benchmark RCFs
performance across the three divisions for domestic consumers:
Premium per policy in a number of key geographic locations.
Percentage of premium paid as claims.
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In addition, the chief financial officer of RCF has a friend working for an insurance company in
New Zealand who has offered to partner with RCF in the benchmarking exercise.
Tasks
For this activity you are required to complete the following tasks:
1. Determine whether the two proposed measures are appropriate.
2. Suggest additional key measures (other than those specified in Task 1) that you believe
should be benchmarked across the three divisions, explain why you believe it would be
equitable to benchmark these measures, and how each result would be helpful in improving
the performance of RCF.
You should select measures that assess different components of the operations.
3. Identify the potential pitfalls that should be considered in partnering with the New Zealand
insurance company in a benchmarking exercise, and explain why each is a potential pitfall.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Readings
Required reading
There are no required readings for this unit.
Further reading
The following publication provides additional reading for those seeking a greater
understanding of concepts within this unit. A copy of this reading can be found in the Business
Sources Corporate section of the Knowledge Centre in the CA ANZ website.
Purdum, T 2007, Benchmarking outside the box, IndustryWeek, Penton Media Inc., 8February.
Also available online in the document database in the CA ANZ website.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit.
Atkinson, A, Kaplan, R, Young, M and Matsumura, E 2007, Management accounting, 5thedn,
Pearson Education Inc., Upper Saddle River, NJ, USA.
Atkinson, A, Kaplan, R, Matsumura, E and Young, S, 2012, Management accounting: Information
for decision-making and strategy execution, 6th edn, Pearson Education Inc., Upper Saddle River,
NJ, USA.
Bhimani, A, Horngren, C, Datar, S and Foster, G 2008, Management and cost accounting, 4thedn,
Financial Times Press/Pearson, Harlow, UK. Garrison, R 1991, Managerial accounting, Irwin,
USA.
Horngren, C, Datar, S, Foster, G, Rajan, M and Ittner, C 2009, Cost accounting: A managerial
emphasis, 13th edn, Pearson Education Inc., Upper Saddle River, NJ, USA.
Horngren, C, Datar, S, Foster, G, Rajan, M et al. 2011, Cost accounting: A managerial emphasis,
1stAustralian edn, Pearson Australia/Prentice Hall, Frenchs Forest, NSW, Australia.
Murby, L 2008, Benchmarking topic, Gateway Series no. 11, Chartered Institute of Management
Accountants, London, UK, accessed 3 April 2014, www.cimaglobal.com/Documents/
ImportedDocuments/cid_tg_benchmarking_july06.pdf.
Purdum, T 2007, Benchmarking outside the box, IndustryWeek, Penton Media Inc., 8February.
Roy Morgan Research 2014, Market share narrows between Coles and Woolworths, while ALDI
makes important gains, accessed 26 November 2014, www.roymorgan.com/findings/5427-
market-share-narrows-between-coles-woolworths-while-aldi-makes-gains-201402120013
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Core content
Unit 10: Performance measurement
andmanagement
Learning outcomes
At the end of this unit you will be able to:
1. Outline a framework for an appropriate performance evaluation system.
2. Develop appropriate key performance indicators.
3. Develop and apply the balanced scorecard performance management model.
4. Explain the impact of remuneration packages and performance measurement on
behaviour, motivation and decision-making.
Introduction
This unit focuses on a number of ways that performance can be assessed in an organisation. It
also shows the influence that performance measurement systems have on employee motivation
and performance, and overall organisational performance.
Management accountants are often involved in the development of systems to capture
performance data, and in analysing and reporting results from that data. A management
accountant therefore has a direct role in performance evaluation and motivation within
organisations.
Learning outcome
1. Outline a framework for an appropriate performance evaluation system.
In order to successfully deliver its strategy, an organisation must have in place mechanisms
to monitor performance. Without a system to do this, managers will potentially be unaware
whether or not their decisions align with the organisations goals and objectives.
maaf31510_csg
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Visibility of what is important to an organisation helps focus employee effort. The alignment of
employees personal goals with those of the organisation will ideally optimise achievement of
the organisations strategic objectives.
This alignment will be further enhanced if employees understand their performance measures
and how the results are calculated. If an employee cant make the link between how their
behaviour impacts on performance, then it is unlikely their performance will be optimised.
Similarly, if employees participate in the development of the performance evaluation system,
they are more likely to be committed to it, thus driving its success.
For a performance evaluation system to effectively drive performance, it should have these
attributes:
Employees understand the system.
Employees can clearly drive actual performance.
Performance targets are seen to be realistic and achievable.
The standard of performance expected is clearly communicated to employees.
The reward for meeting performance targets is understood by employees.
Performance objectives
Setting performance objectives provides a mechanism for an organisation to assess how its
strategic and operational plans are being achieved. They should reflect the factors which are
considered critical to the organisation successfully executing its strategic and operational goals.
Performance measures
In order for performance measures to demonstrate precisely how success in achieving a
particular performance objective will be achieved, they must be quantifiable.
For example, an organisation might have a performance objective to improve quality. While
this might be critical to an organisations success, quality isnt quantifiable. However, it can
be translated into a measure, such as number of defects, which clearly measures quality. It is a
direct measure of the objective, with no ambiguity regarding what quality is.
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Key performance indicators (KPIs), discussed later in this unit, are an example of a commonly
used performance measure. The alignment of performance measures with organisational
objectives is essential to the delivery of an organisations strategic plan.
Performance targets
Once a performance objective is translated into a performance measure, a target for future
performance can be set. This target should reflect the expected level of performance and be
aligned with what is required to meet the organisations strategic objectives, both in the short
and long term.
DEFINE
PERFORMANCE
OBJECTIVES
Understand the
strategy
Identify critical
success factors
Translate into
objectives
SET PERFORMANCE
TARGETS
Set performance
expectations
required to meet
performance
objectives
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Having taken into consideration performance measures, targets, evaluation and feedback in
the design of an effective evaluation system, it should also be linked to the remuneration and
reward of employees (as discussed later in the unit).
Learning outcome
2. Develop appropriate key performance indicators.
What is a KPI?
Key performance indicators (KPIs) are measures that a business uses to track employee
performance and measure outcomes.
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SMART criteria
SMART is an acronym for:
S M A R T
ACTION-
SPECIFIC MEASURABLE REALISTIC TIMEBOUND
ORIENTED
Specific
This criterion confirms that the KPI developed links to a desired outcome or goal, is clearly
defined and easily understood, and does not contain multiple variables.
An organisation might have the goal to expand into new markets. A KPI of expansion into
new markets is vague, and raises the question of what expansion would look like for this
organisation:
Is expansion merely selling a product or service to a customer located in a territory not
previously sold into?
Does it mean having an independent sales agent represent the organisation in a new
geographic region?
Does it mean having the organisations sales staff permanently based there?
In contrast, a measure such as number of new sales offices opened per annum clearly
articulates how the goal will be achieved.
Measurable
To provide an effective performance management mechanism, the KPI must be measurable, and
achievable in a timely and efficient manner. Measurability assesses not only whether the KPI
can be measured (i.e. could data be gathered to measure it) but also whether it is practical and
cost-effective to gather the information.
It would be inappropriate to suggest a measure of customer satisfaction, because customer
satisfaction cannot be directly measured. Some organisations might undertake a survey of
customer satisfaction, and therefore a KPI such as customer satisfaction score per the annual
customer survey might be appropriate; however, few organisations have the funds to invest in
such an expensive exercise, and it is unlikely any organisation would use this alone to obtain
feedback from customers.
A KPI such as number of customer complaints per month provides better feedback. The
number of complaints can easily be counted without a significant investment in datacapturing
mechanisms. In addition, it can be measured on a timely basis without significant cost.
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Action-oriented
A KPI needs to inspire an action or behaviour. It is important to consider whether it is an action
that those being measured by the KPI can then undertake to change results.
Measuring an IT developer on quality issues per month doesnt make much sense, as the
actions they need to take to address the issue are not clearly defined. The quality issues could
relate to a number of things, many of which could be outside their control. However, a measure
such as number of days delay in implementing system developments per month clearly
indicates actions both within their control and necessary to ensure timely delivery.
The mere fact that an aspect of the organisation is being measured and reported on will
influence behaviour, which may have undesirable or unforeseen effects, so care should be taken
to ensure that the behaviour being driven aligns with expectations.
A sales representative who is measured on sales revenue per month will be focused on driving
sales volumes. While this might be entirely appropriate in one organisation and result in an
increased focus on closing deals, in another it might drive undesirable behaviour (e.g. selling
at a low margin or below cost). If the desired behaviour was to ensure sales margin targets
are achieved, then an appropriate KPI could be dollar sales margin per month. Both of these
measures are action-oriented, but will drive different actions.
Realistic
The KPI should be based on facts. In addition to the need for the data to be collectable, it needs
to be relevant to the organisation and the target(s) being set also need to be achievable.
A KPI which measures quality via number of defects per month would only be a realistic
measure if a quality control procedure is in place to measure defects. If no such mechanism is in
place, a more realistic measure might be number of items returned due to defects per month.
The number of defects per month is not relevant to organisations in the financial services
industry, for example, and so this KPI would not be realistic when used in this context.
Timebound
All KPIs are measured over a period of time so it is important for the time period to be clearly
defined to allow for analysis of the results.
A KPI could be monitored daily, weekly, monthly, quarterly or yearly. Alternatively, the
period of time could be industry-specific for example, per season in fashion, or per
semester in education. Regardless, determining an appropriate time period needs to take
into account the regularity of the reporting underpinning it, while allowing sufficient time
between measurements to ensure enough data can be collected to make the measuring process
worthwhile. However, the time period should not be so long as to render the data out of date
and corrective actions ineffectual.
An example of this can be seen in measuring employee turnover per week, which would
be too short a time frame in most organisations, whereas measuring employee turnover per
quarter might be more useful (particularly in industries where it isnt particularly high), as it
would be often enough to gather useful data and take remedial action.
In contrast, measuring sales revenue per annum is likely to be considered a poor KPI, as most
organisations would want to measure this on a more regular basis so that adjustments to plans
can be implemented on a timely basis. Therefore, sales revenue per week or sales revenue per
month are more likely to be seen in practice.
As can be seen from these examples, appropriate time frames will vary depending on the nature
of the KPI and the reasons why it is being measured.
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In these cases, the measure is assessed against a target at a specific point. Alternatively, the
KPI could also be analysed over a period of time to identify trends. For example, if number
of customer complaints per month was being measured, the results over the course of a year
could be analysed to assess whether there has been deterioration or improvement in the result.
Factor Explanation
Trends or variances An example of a KPI which is a trend is increase in sales revenue per month. A
better measure would be sales revenue per month, as the results gathered from
this measure could be used in a number of ways, including comparison against
a target or budget, or analysed over a period of time to determine a trend. The
information is captured just once, but can be used to analyse performance in a
number of ways
Percentage changes (this Percentage (%) change in temporary staff costs per month is another example
turns the measure into a of a KPI measuring a trend. The key aspect being measured is the cost of
trend) temporary staff and while the percentage change might be useful information
to have, capturing this as an absolute amount ($ cost of temporary staff per
month) allows a greater understanding of the size of this expense. Assessing
the result of this KPI might be misleading: for example, a 100% increase might
appear concerning as an indicator; however, the additional knowledge that the
absolute cost of the temporary staff was only $1,000 would provide the context
that this increase is not key
Comparisons to budgets or Profit versus budget per month is actually a variance. While this could be
other targets (this makes the a useful comparison to make, using it as a measure eliminates the ability to
measure a variance) assess against other targets (e.g. forecasts), and the message of the absolute
result is lost (there could have been a loss budgeted which would not show
whether a loss had, in fact, still been made). During the global financial crisis,
many organisations found that performance benchmarks that had already
been set had to be reassessed in light of the changed economic conditions,
and measures based on comparisons would not have been useful in such
circumstances
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Percentage-based KPIs
As discussed above, where a KPI is expressed as a percentage change it is considered a trend,
and therefore not a valid KPI; however, some ratios developed in the form of percentages might
also be appropriate. For example, measuring the percentage of on-time arrivals per month in
the airline industry, or the percentage of orders delivered on time per month for a logistics
organisation, would be valid measures. These SMART ratios are describing a proportion of a
total population.
Categorising KPIs
KPIs can be developed to measure any aspect of a business and its operations. However, one
measure alone will never provide a complete picture of performance. In practice, a mix of
measures is often used.
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KPIs can be developed to focus on:
Financial
versus
non-financial
performance
Short-term
Lag versus
versus
lead
indicators
KPIs long-term
performance
Operational
versus
strategic
result
Gross margin $
per month
Sales $
This would also be considered a financial measure as it is measuring the financial performance
of an organisation.
In developing a mix of measures, some aspects will be better assessed as a financial measure
while others provide more useful information as a non-financial measure. For example, profit
per month is difficult to communicate in a non-financial way; however, injuries occurring in
the workplace is better assessed as number of injuries per month that is, as a non-financial
rather than a financial measure.
A mix of financial and non-financial measures will provide a more complete picture of
performance and alignment to strategy (as is seen in the balanced scorecard covered in the next
learning outcome).
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new products per quarter, will lead to the sales director identifying new market and product
opportunities, resulting in overall growth in sales revenue for the organisation. This is a leading
indicator.
Leading measures, however, often use historical information as an indicator of likely future
performance. In developing a good leading measure, there should be a correlation between
historical and future performance, that is, past events provide some evidence as to what
performance in the future might be. For example, customer complaints can be considered a
leading indicator even though the data it is based on is historical. This is because if customer
complaints increase, the likelihood of customers moving to a competitor increases, which
results in future reductions in sales, revenue and profits.
The use of a combination of leading and lagging measures in evaluating performance will
reward achievement to date, but also, more importantly, reward contribution to future success.
Number of stock-outs per week Lagging and leading Non-financial Short term
Most of these KPIs are lagging indicators as they reflect past events; however, some of the past
events provide evidence of future performance, as in the case of the number of product lines
held. The more product lines held, the more likely it is that sales will occur in the future due to
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the increased level of variety provided to customers. It may also be an indication of capacity
issues at the warehouse, which would again potentially impact future performance.
Number of stock-outs could be a leading or lagging indicator depending on how the measure
is being used. It is a lagging indicator of a failure to have the right amount of stock on hand, but
it could also be a leading indicator of future lost sales (if a customer cant get the product they
want from Electronics2U, they are likely to go elsewhere).
Most of the indicators are also non-financial measures, with the exception of the stock loss
measure, which quantifies loss due to theft, obsolescence or damage in dollar terms.
All of the measures are short term in nature; none focus on factors driving long-term
profitability.
Two additional KPIs have been proposed to assess the warehousing and distribution managers
performance:
Distribution costs as a percentage of sales revenue per month.
Temporary labour costs versus budget per month.
Distribution costs as a percentage of sales revenue per month might be useful measure to
assess the relativity of distribution costs to sales revenue, as a ratio it is not a fair measure of
the managers performance, since the result is impacted by both the distribution costs and the
sales revenue. It is reasonable to expect there is a fixed proportion of cost within distribution
expenses (i.e. a component which wont vary with sales) and it would be misleading to judge
the warehousing and distribution manager on this when there is a significant component of
the measure sales revenue outside their control.
The KPI is not specific or action-oriented in its current form. By adapting the measure to
become distribution costs per month, it becomes a SMART KPI against which it would be
appropriate to assess the warehousing and distribution manager.
Temporary labour costs versus budget per month, in its current form, is a variance and
therefore is not a SMART KPI. Removing the variance component versus budget will make it
a pure measure, which then can be used in a number of ways to assess performance. If the KPI
is amended to temporary labour costs per month, it could then be compared to budget, as well
as other aspects, which would provide more insight. For example, did the temporary labour
cost increase in line with an increase in the number of orders processed?
Two further KPIs have been developed to assess whether Electronics2U is achieving its
objective to minimise inventory holding costs (with the aim of improving long term
profitability):
Inventory turnover per month
This measures the conversion of inventory into sales. Continually turning over inventory
should mean that less stock is being held, thereby reducing holding costs, which improves
cash flow and, ultimately, profitability over the long term.
Number of inventory lines without a sale in the past 30 days
This measure highlights inventory lines which are slow moving, and action should be taken
to generate sales of these items (e.g. promoting, discounting or phasing out the line). There
is an investment attached to holding the inventory (in the form of working capital), which,
if minimised, will improve cash flow and long-term profitability.
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Balanced scorecard
Learning outcome
3. Develop and apply the balanced scorecard performance management model.
One of the more popular performance measurement systems used in organisations is the
balanced scorecard. Developed by Robert S. Kaplan and David P. Norton in the early 1990s,
it provides a framework for developing financial and non-financial measures to monitor the
achievement of an organisations strategic objectives.
A balanced scorecard measures organisational performance across four perspectives of the
organisations strategy. Each of the perspectives contains a number of measures which are
interrelated by cause-and-effect relationships.
When developing a balanced scorecard in practice, the measures are often expressed in the form
of SMART KPIs.
A scorecard becomes a balanced scorecard when it translates an organisations strategic
objectives into multiple perspectives. The strategic analysis of an organisation from these
perspectives will result in a mixture of measures (as discussed earlier in this unit), all of which
link to the achievement of an organisations strategy:
Financial and non-financial measures.
Short-term and long-term focused measures.
Lead and lag measures.
FINANCIAL CUSTOMER
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Financial perspective
Depending on the strategies an organisation has in place, the KPIs in the financial perspective
should measure all or some of these factors.
Remember, while most financial ratios tell the story of the past performance of an organisation,
they can also provide useful information about trends, highlight financial strengths and
weaknesses in the organisation and demonstrate to management the impact of decisions.
Examples of KPIs which are commonly found in the financial perspective include:
Profit per month.
Sales revenue per month.
Gross margin (%) per month.
ROI per annum.
Customer perspective
How can we tell if our customers are happy with us and we are creating value for them?
Customer perspective measures should reflect the organisations goals relating to customers
and the markets it operates in. These measures can relate to any or all of the following aspects:
Customer satisfaction.
Customer retention.
Customer acquisition.
Customer profitability.
Market share.
Individual customer share of sales.
Many customer perspective measures are leading indicators of future financial performance.
Consider, for example, how an increase in customer satisfaction levels or a slowdown in
gaining new customers impacts on current and future financial performance. There may be little
impact apparent in the current results, but these measures might be indicating future financial
improvement or decline.
Examples of KPIs commonly found in the customer perspective include:
Customer complaints per month.
Number of repeat customers per month.
Number of new customers per month.
Percentage of market share per quarter.
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Regardless of which processes are considered critical to the organisations strategy, the key to
having the right measures in this perspective is to ensure that they are measuring the process
and not the outcome.
These may be some of the longest term measures in the balanced scorecard. For example, an
increase in the training and development budget will not significantly improve next years share
price or profit; in fact, it may have a negative impact due to the funds invested. Similarly, the
new skills that employees learn in training might not impact on the quality of work until some
time later.
Measuring learning and growth can be difficult. Some organisations use the time devoted to
training programs as a KPI (e.g. training hours per quarter); others use surveys to measure
employee motivation (e.g. employee satisfaction score per annual survey). Alternatively,
employee turnover can be used as a measure of the loss of knowledge and learning
(e.g.employee turnover per quarter).
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Other KPIs that may be found in the learning and growth perspective include:
New products developed per quarter.
New menu items per month.
Staff absenteeism per month.
Assessing your measures against the following perspectives (or quadrants) of the balanced
scorecard should help to ensure that KPIs are in the correct perspective:
FINANCIAL CUSTOMER
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measures such as repeat purchases), and should ultimately lead to increased sales and profits
(financial perspective). Another example is where an improvement in production efficiency
(measured in the internal process perspective) should lead to an improvement in asset
utilisation (financial perspective).
Each of the measures included should be a driver or an outcome of success. The wrong
measures on a balanced scorecard can mean that the business is focused on the wrong things.
A balanced scorecard is not a fixed document. As an organisations strategy evolves, so should
its balanced scorecard. As outcomes are achieved, new measures should be added to the
scorecard to ensure that it mirrors the plan to implement the organisations strategy.
The following diagram illustrates the types of links that exist between the different perspectives
of the balanced scorecard:
FINANCIAL CUSTOMER
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Kaplan and Norton used the example of Metro Bank to demonstrate how a balanced scorecard
can be created from a strategy map. Metro Bank had a two-pronged strategy:
1. To grow revenue by introducing additional products to existing customers.
2. To improve productivity by transitioning unprofitable customers to more cost-effective
service channels (e.g. to electronic banking).
These strategies were then translated into objectives in each of the four balanced scorecard
perspectives as shown below:
Improve
returns
Increase
employee
productivity
Source: Kaplan, RS and Norton, DP 1996, The balanced scorecard, Harvard Business School, Boston, p.152.
For the strategy to grow revenue to be successfully executed, existing customers had to want
to purchase additional products. Metro Bank learnt its existing customers didnt consider the
bank for services such as credit cards or financial advice. To succeed with this strategy, Metro
needed to shift customer perceptions, hence the inclusion of the objectives to increase customer
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satisfaction and customer confidence. It also needed to develop new products to sell (with
processes supporting innovative product development) and have sales processes in place to
allow relationship selling. This in turn required staff to have the skills to sell in this way, along
with access to the necessary information in order to personalise advice, as seen by the objectives
identified in the learning and growth perspective in the diagram above.
Each of these strategic objectives was then translated into strategic measures, as shown below.
The mix of lead or lag indicators allowed Metro Bank to monitor and understand its progress in
executing its strategy.
As an example, two measures were developed for Metro Bank to assess the cross-selling
process, identified as being a key objective in the internal perspective: a cross-sell ratio (a lag
indicator) and hours spent with customers (a lead indicator). As a final step, these measures
were then translated into KPIs, such as average number of products sold to a customer per
quarter and hours spent with customers per month respectively.
STRATEGIC MEASUREMENTS
STRATEGIC OBJECTIVES
(Lag indicators) (Lead indicators)
I1 - Understand our
customers
I2 - Create innovative New product revenue Product development cycle
products
I3 - Cross-sell products Cross-sell ratio Hours with customers
I4 - Shift customers to Channel mix change
cost-effective channels
I5 - Minimize operational Service error rate
problems
I6 - Responsive service Request fulfilment time
Source: Kaplan, RS and Norton, DP 1996, The balanced scorecard, Harvard Business School, Boston, p. 155.
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Typically, each perspective of the balanced scorecard will contain four to seven measures,
creating a scorecard with, potentially, over 25 measures. Twenty-five independent measures
would be too many to focus on; however, when they are all linked to the organisations
strategy, they interrelate and become the framework for the strategys implementation plan by
respective departmental heads for example, the marketing and sales departments typically
take ownership of KPIs within the customer quadrant.
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Analyse the organisations Using the four perspectives to interpret an organisations strategy,
strategy from the four this is the translation of strategy into objectives and measures as
perspectives to develop outlined above
performance objectives
and measures
Construct a strategy map This one-page diagram helps to ensure the cause and effect
to reinforce links between linkages between the objectives and the perspectives are
measures understood
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Further reading
Atkinson et al. 2012, Management accounting, 6th edn, Pearson Education Inc., Upper Saddle River,
pages 3642.
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The following diagram illustrates balanced scorecard quadrants in a not-for-profit or
government entity:
FINANCIAL CUSTOMER
The linkage and cause-and-effect relationship between the quadrants and organisational
strategy remains in the following diagram; however, the flow may be slightly different, as
demonstrated.
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MISSION
(constituent)
SUPPORT
PROCESS
LEARNING AND
GROWTH
FINANCIAL
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Learning outcome
4. Explain the impact of remuneration packages and performance measurement on behaviour,
motivation and decision-making.
Many organisations talk about their employees being the backbone of the organisation.
Without their support, it becomes difficult for an organisation to achieve its strategic objectives.
Performance evaluation systems are used to align the performance goals of both employees
and the organisation. Linking remuneration and rewards to the achievement of the objectives
and measures included in the performance evaluation system is one way this alignment can be
achieved.
The measures included in a performance evaluation system send a clear message to employees
about what is important.
However, while focusing on certain aspects can encourage certain behaviour, it might also have
unintended consequences.
For example, sales-focused organisations have found that introducing a sales target as part of
a remuneration scheme is an effective way to focus sales staff on closing a sale. This positive
behaviour, however, may have a downside. Sales staff might compete with each other to the
point of creating a hostile working environment, with an unintended consequence of reducing
profits; for example, some sales staff may discount heavily to increase sales at the expense of
gross margin, making it difficult for fellow sales personnel to maintain higher prices. They
might ignore some of their other responsibilities (e.g. after-sales service), or they may oversell
to a customer who then returns the goods at a later date. Alternatively, they may, if a target for
a period has been achieved, be tempted to smooth their sales figures by carrying forward sales
into the next period.
Hence, when a performance evaluation system is used to measure and reward performance, it
is important to consider not only the desired behaviours, but also contemplate and monitor any
unexpected outcomes.
The use of multiple measures is one way to ensure focus on the multiple aspects of an
employees role, and provides a balanced picture of their behaviour. Many organisations build
a balanced scorecard for the organisation and then cascade it down to the various business
units and employees, to ensure alignment between stakeholder objectives and employee
performance.
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is often linked to the financial performance of the organisation, and, in particular, to the share
price.
The transparency between performance measurement and remuneration or reward is
important:
For the employee, so that they understand how they will be recognised.
For the organisation, so that there is an alignment to desired behaviours and outcomes.
(Potentially) for shareholders, so that they can assess the remuneration of executives
compared to the market and their performance.
Communication of the performance evaluation system, the measures, the targets and the results
achieved is important to driving desired behaviour and motivating performance.
Merit pay
Skills- Individual
based incentive
pay
TYPES OF
REMUNERATION
SYSTEMS
Gain-sharing,
group Profit-
incentives sharing
and team
awards
Ownership
Merit pay
In merit pay programs, annual pay increases are usually linked to performance appraisal
ratings. This means that a component of an employees pay is linked to their individual
performance against specified performance criteria.
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Profit-sharing
Under profit-sharing arrangements, payments are based on a measure of organisational
performance, and the payments do not become part of the base salary. This scheme encourages
employees to think more like owners. Labour costs are reduced during difficult times and
wealth is shared during good times.
Ownership
A variation of profit-sharing is offering employees shares or share options. Employees will be
interested in seeing the share price increase and are therefore more likely to act in ways that
benefit the organisation as a whole.
Skills-based
The idea of skills-based remuneration is to reward employees when new skills and capabilities
are acquired.
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Attraction Pays higher Pays higher All Can help All Attracts
performers performers employees lock in all employees learning-
more more are attracted employees are attracted oriented
employees
Costs Requires High Relates costs Cost not Ongoing Can be high
a well- maintenance to ability to variable with maintenance
developed pay performance needed
performance
appraisal
system
Organisational Helped by Many Fits any Fits most Fits small Fits most
structure measurable independent company companies stand-alone companies
jobs and jobs work units
work units
Adapted from: De Cieri, H, Kramar, K, Noe, RA, Hollenbeck, JR et al. 2003, Human resource management in Australia,
McGraw-Hill Education, Sydney.
Quiz
[Available online in myLearning]
ACT
Activity 10.1
Developing KPIs
Introduction
In this activity you will learn how to develop leading and lagging, financial and non-financial,
and strategic and operational KPIs.
This activity links to learning outcomes:
Outline a framework for an appropriate performance evaluation system.
Develop appropriate key performance indicators.
At the end of this activity you will be able to develop KPIs, ensuring that they meet SMART
criteria.
It will take you approximately 30 minutes to complete.
Scenario
You are a management accountant at Noir Insurance (Noir).
Noir is a travel insurance company that sells policies via two channels through its website and
through telephone agents in a call centre. Noir is keen to continue to grow website sales while
maintaining the current operating profit at the call centre.
Noirs website
The website is now the most cost-effective way to sell policies and is seen as the long-term
future of the business.
Established criteria are used to determine whether a traveller fits Noirs risk profile, and then
a premium quote for the policy is automatically calculated based on the information input by
the traveller. With the completion of some personal details and payment from either a debit or
credit card, the travel insurance policy is issued.
Noir encourages web bookings by offering a 5% discount on policies booked via the website. A
higher discount rate is available to past policyholders who havent made a claim. This discount
is managed through the issue of a promotional code, 30 days after a traveller returns from a trip.
Call centre
The call centre sells 25% of the policies issued, although, as a proportion of total policies sold,
this is steadily decreasing. Policies sold via this channel are primarily to more mature-age
travellers who have less confidence in making payments using the internet.
Call centre sales staff obtain a premium quote for the client by entering details into Noirs
computer system. Sales staff can apply some discretion over the premium as the system allows
them to override the computerised premium calculation when they believe it is appropriate,
within specified limits.
Noir has found that the average claim paid increases as the age of the traveller increases.
ACT
Call centre staff earn a commission of 5% of the premium of every policy they sell. Given the
declining volume of bookings through the call centre, the number of staff working in the call
centre has decreased in recent times, leading to issues with morale and customer service.
Tasks
For this activity you are required to complete the following tasks:
1. Develop four (4) KPIs that management could use to measure the successful growth of the
website. Explain how each of these indicators measures a factor critical to Noir successfully
achieving its growth objective for the website. Ensure that your KPIs include a mix of
financial and non-financial measures, and leading and lagging measures.
2. Develop four (4) non-financial KPIs that the call centre manager could use to measure the
operational performance of the call centre staff. In your response, explain:
(a) How each KPI would be used to assess performance.
(b) How the information needed to measure each KPI would be obtained.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 10.2
Linking the balanced scorecard to an
organisations strategy
Introduction
In this activity you will develop a balanced scorecard and strategy map, including KPIs,
for a retail business. You will also assess the impact of different forms of remuneration and
performance measures on employee motivation.
This activity links to learning outcomes:
Develop appropriate key performance indicators.
Develop and apply the balanced scorecard performance management model.
At the end of the activity you will be able to develop a balanced scorecard for an organisation,
showing the links to the organisations strategy, and cascade the scorecard to lower levels
within the organisation.
It will take you approximately 50 minutes to complete.
Scenario
You are the management accountant at Design Delight Retail Limited (DDR) reporting to the
CFO, Mark Newson.
DDR is a company listed on the Australian Securities Exchange. DDR has eight stores across
Australia and New Zealand, with its flagship store situated in central Melbourne. Its stores
stock luxury clothing, footwear and accessories, as well as cosmetics and beauty products for
both men and women.
DDRs strategy is to be the leading retailer of luxury goods in Australia and New Zealand,
providing the best of lifes luxuries to customers and a superior return to shareholders as it
continues to expand and grow the business.
The company has a reputation for stocking the best quality and range of products. Careful
consideration is given at a senior management level to the product lines and brands stocked, to
ensure that the companys reputation is maintained.
The following information is provided to assist you with completing the tasks below.
Product range
DDR stocks an extensive range of many well-known luxury brands (e.g. Chanel, Gucci and
Burberry). It also stocks a number of lines under exclusive agreements with suppliers, ensuring
it is the sole local retailer. As a result, approximately 30% of product stocked by DDR is not
available anywhere else in Australia or New Zealand. DDR head office employs a highly skilled
buyer to manage its stock lines and to determine customer pricing. Although the company
does stock a number of locally designed and made product lines, the majority of its stock is
imported.
ACT
Purchasing
A key area of focus for the board relates to the purchasing of stock. Depending on the nature of
the product, lead times between placing a non-cancellable order and receiving the stock can be
significant. For example, clothing collections often need to be ordered 12 months in advance.
In-store experience
Similarly, the in-store experience of customers is considered pivotal for DDR, particularly
in light of the increasing popularity of online retailers. Sales staff are trained to provide a
personalised shopping experience for each customer. Many of the sales staff have developed
close relationships with their customers who they have been serving for many years, and who
buy most of their wardrobes from DDR. The ambience of the store, which refreshes its displays
regularly, is seen as critical to attracting new customers and retaining existing customers.
High-value existing customers are issued with a DDR gold privileges card and their preferences
are recorded in a customer database. While in the store, they are served coffee or champagne.
All other customers are offered a bronze privileges card, if they do not show a card at time of
purchasing.
Tasks
For this activity you are required to complete the following tasks:
1. Develop a balanced scorecard for DDR at the organisation level by:
(a) Identifying DDRs strategic objectives and the perspective they correspond to.
(b) Identifying any linkages between the objectives by creating a strategy map.
(c) Developing a measure in the form of a KPI for each objective.
2. Now apply the balanced scorecard you have developed at the store level. (You have
recognised that the measures appropriate for each store may differ from those developed at
the organisational level.)
(a) Describe why internal perspective measures that are appropriate at an organisational
level may not be appropriate at an individual store level.
(b) Develop two (2) new KPIs which would be appropriate to include in the internal process
perspective of a balanced scorecard for the individual stores.
(c) For each measure included explain how it links back to DDRs strategy.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 10.3
Balanced scorecard not-for-profit entity
Introduction
This activity uses the balanced scorecard framework in the not-for-profit environment, where
the primary objective is assisting the needy, rather than maximising the return to shareholders.
It links to learning outcome:
Develop and apply the balanced scorecard performance management model.
At the end of this activity, you will be able to develop a balanced scorecard for a not-for-profit
entity.
It will take you approximately 30 minutes to complete.
Scenario
The Food Spirit Foundation (Food Spirit) is a not-for-profit organisation whose vision (mission)
is to improve the quality of life of the homeless by providing a hot meal and counselling and
support to people without accommodation who live on the streets of Sydney.
Food Spirit operates a number of food vans in the inner city every night of the week. Meals
are cooked at premises in an inner-city suburb by a team of volunteers. Another group of
volunteers drives the vans and delivers the meals to people in need. These volunteers have had
training to also provide counselling and support to those who need it. Where appropriate, they
will direct people using the food vans to other organisations that provide different services;
for example, temporary accommodation or medical care. Many of the people using the meals
service are keen to have someone to talk to while enjoying what is often their main meal of the
day.
The volunteers are primarily university students who have flexible routines, which enable them
to work in the kitchen in the afternoon or on the vans in the evening. Unfortunately, once these
students finish their studies, many of them find it difficult to juggle this volunteer work with
their careers. As a result, new volunteers constantly need to be sourced and trained.
Most of the ingredients used in the preparation of meals are donated, often from supermarket
chains, food wholesalers or manufacturers who give products that are nearing the end of their
shelf life. When the provision of essential ingredients is low, these are purchased from financial
donations. The prepared meals are simple but highly nutritious.
Financial donations are critical, as they provide funding for administrative costs to run the
vans, maintain the premises that contains the kitchen and a small office, pay the small number
of employees, and provide training to the volunteers. Food Spirit aims to keep expenditure for
administration (i.e. funds spent outside of meals preparation and delivery) to a minimum, to
maximise the number of people it can assist.
Financial donations are received from both corporate and individual donors, with the bulk
received from the foundations annual Christmas appeal. This appeal includes volunteer
collectors who door knock homes and attend major events seeking donations. A number of
media organisations donate advertising space, which Food Spirit uses throughout the year to
appeal for donations.
ACT
With the high turnover of volunteers at Food Spirit, the CEO is keen to use a balanced scorecard
(BSC) to communicate with and align all of the foundations stakeholders. They plan to
update the BSC on a quarterly basis and publish it on the website as well as post it on internal
noticeboards and in their vans.
You are a volunteer who is helping to provide accounting advice to Food Spirit, and have been
asked to assist in developing the BSC.
Tasks
For this activity you are required to complete the following tasks:
1. Develop a BSC for Food Spirit, including two (2) KPIs in each BSC perspective (and within
the customer perspective including each category of customer).
2. Explain how each KPI will help Food Spirit achieve its vision.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 10.4
Commission schemes and behaviour
Introduction
In this activity you will learn how a simple commission arrangement can impact on
performance and motivation in an organisation.
This activity links to learning outcome:
Explain the impact of remuneration packages and performance measurement on behaviour,
motivation and decision-making.
At the end of this activity you will be able to explain how the use of commissions as a form of
remuneration can influence employee behaviour.
It will take you approximately 15 minutes to complete.
Scenario
This activity is based on the scenario of Activity 10.1. You should refer to this in order to
complete this activity.
You are a management accountant at Noir Insurance (Noir).
Task
For this activity, you are required to consider the call centre sales commission scheme at Noir,
and:
(a) Outline how its design might impact on the behaviour of the call centre staff.
(b) Describe the potential impact of this behaviour on the achievement of the call centres profit
objective.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 10.5
Remuneration and motivation
Introduction
In this activity you will assess the impact of different forms of remuneration and performance
measures on employee motivation.
This activity links to learning outcome:
Explain the impact of remuneration packages and performance measurement on behaviour,
motivation and decision-making.
At the end of this activity you will be able to assess the potential impact of remuneration
arrangements on employee behaviours.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the scenario for Activity 10.2, to which you should refer to complete
this activity.
You are a management accountant at Design Delight Retail Limited (DDR), reporting to the
CFO, Mark Newson.
Mark has asked you to help assess the current remuneration and motivation scheme at DDR.
Tasks
For this activity you are required to complete the following tasks:
1. The DDR store managers receive a quarterly bonus based on their respective stores
performance as reflected by the balanced scorecard measures. Outline why the store
managers might have reservations about this being equitable.
2. Explain the impact on the store managers behaviour if they receive their bonuses based
solely on either:
Their stores profit.
Their stores revenue.
Consider both positive and negative aspects of each of these measures in your response.
3. DDR staff receive an hourly wage plus a commission on all sales that they personally make.
Outline two (2) positive and two (2) potentially negative implications of this arrangement.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
The following publications provide additional reading for those seeking a greater
understanding of concepts within this unit.
Atkinson, A, Kaplan, R, Matsumura, E and Young, M 2012, Management accounting, 6thedn,
Pearson Education Inc., Upper Saddle River, USA, pp. 3642.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit. It is provided for copyright purposes.
Atkinson, A, Kaplan, R, Matsumura, E and Young, M 2012, Management accounting, 6thedn,
Pearson Education Inc., Upper Saddle River, USA.
Brooks, A, Elderburg, L, Oliver, J, Wolcott, S and Vesty, G 2008, Contemporary management
accounting, John Wiley & Sons Australia Ltd, Milton, Qld.
De Cieri, H, Kramar, K, Noe, RA, Hollenbeck, JR et al. 2003, Human resource management in
Australia, McGraw-Hill Education, Sydney.
Horngren, C, Datar, S, Foster, G, Rajan, M, Ittner, C, Wynder, M, Maguire, W, and Tan, R 2011,
Cost accounting: A managerial emphasis, 1st Australian edn, Pearson Australia, Frenchs Forest,
NSW.
Kaplan, RS, and Norton, DP 1996, The balanced scorecard, Harvard Business School Press, Boston,
USA.
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Core content
Unit 11: Investment decisions
Learning outcomes
At the end of this unit you will be able to:
1. Calculate and apply weighted average cost of capital (WACC).
2. Apply capital budgeting techniques to assess investment decisions.
3. Assess investment decisions by performing sensitivity analysis.
4. Assess behavioural influences, as well as other qualitative issues that impact on investment
decision-making.
Introduction
Managers of organisations continually assess opportunities to acquire real assets, such as plant
and equipment or buildings, or to invest in a new business. These initiatives are typically
referred to as investment projects or capital projects. The amount of capital involved can be
significant and, frequently, requires a long-term commitment on the part of the organisation.
Investment decisions require managers to assess potential investment projects and make
decisions about which capital expenditure opportunities will maximise shareholder value. A
poor investment decision can have a negative impact on an organisations profit, efficiency,
productivity and strategy for years afterwards.
Determining an organisations cost of capital is integral to investment decision-making.
This unit begins by focusing on the minimum rate of return a new investment project must
earn, and then reviews various capital budgeting techniques and their respective merits and
shortcomings.
A range of methodologies is available to assist in analysing these investment opportunities.
There is particular emphasis on discounted cash methods since these take into account the time
value of money when evaluating investment decisions.
The unit concludes by examining the other qualitative and behavioural issues that managers
should consider as part of the capital budgeting process.
maaf31511_csg
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Learning outcome
1. Calculate and apply weighted average cost of capital (WACC).
Cost of capital
The cost of capital is the rate of return that an organisation must earn on its capital invested
in projects to satisfy its investors. It is the cut-off rate that separates viable from non-viable
investment opportunities. Organisations must be able to offer the prospect of a return greater
than the cost of capital in order to attract funding.
The cost of capital usually provides the basis for setting the required rate of return for the
investment decision. To determine the cost of capital, an organisation will look to the cost of
its existing debt, the cost of its equity and the cost of any additional debt or equity that may be
used to fund the investment.
One of the methods most commonly used to calculate the cost of capital is the weighted average
cost of capital (WACC). This represents the average after-tax cost of debt and equity prorated on
the basis of the debt-equity proportions used by an organisation.
k 0 = k d ^1 t c h V + ke V
D E
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Cost of debt
The cost of debt measures the current cost to the organisation of borrowed funds. Almost every
company has some form of debt overdrafts and bank loans are common examples. Larger
companies also issue bonds to the public. All forms of debt incur costs for an organisation.
It is generally accepted that only long-term funds should be included in the cost of capital
calculation and that the cost of capital should be representative of the overall pool of capital.
The overall cost of debt for an organisation is a weighted average of the costs of its individual
sources of debt. The WACC generally employs the after-tax cost of debt in recognition of the tax
deductibility of interest. The formula for the cost of debt is:
Cost of debt = kd ^1 tc h
Multiplying the pre-tax cost of debt by (1 tc ) gives the after-tax cost of debt.
Where the market value of debt is not readily ascertainable, there are two main options for the
calculation:
Find a proxy for the pre-tax cost of borrowing faced by organisations from the same
industry or from organisations with a similar credit rating that is, estimating what the
market rate of debt payable by the company will be.
Assume that the book value of a debt is the same as its market value. This will not work,
however, if the organisation has experienced a fall in credit rating.
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Cost of equity
The cost of equity measures the rate of return that shareholders require on their investment
in an organisation. It is the rate that the organisation must offer its shareholders in order to
maintain its current share price in the case of listed companies.
The equity rate is generally higher than the debt rate because equity holders bear a higher risk
by having only a residual claim on the corporate assets. In addition, from an organisations
perspective, the cost of debt is also reduced by the tax deductibility of interest payments
(referred to as the tax shield). The effect of more debt capital and higher financial gearing on the
WACC is considered in more detail in the unit on long-term financial management.
The required rate of return for shareholders can be determined by either of the following:
Dividend valuation models, or
Capital asset pricing model.
This is the constant or general dividend valuation model. By rearranging the terms, the cost of
equity can be calculated as:
D
ke = P 1
0
where ke = cost of equity
D1 = expected future annual dividend
P0 = ex-dividend price of the ordinary shares
If the shares are cum-dividend (i.e. with the entitlement to the dividend attached), then the
dividend should be removed from the share price.
Example Calculating the cost of equity using the constant dividend valuation model
Que Limited pays its shareholders an annual dividend of $0.40 and has indicated an intention
to do so into the future. The current price of Que Limiteds shares is $4.00 ex-dividend. The cost
of equity can be calculated as:
= $0.40
ke = 0.10 = 10%
$4.00
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D D ^1 + gh
ke = P 1 + g = 0 P +g
0 0
where P0 = ex-dividend price of the ordinary share
D0 = annual dividend for the immediately preceding year
g = expected annual percentage rate of growth in dividends
The calculation has a non-negativity constraint such that the cost of equity must be greater than
the estimated rate of growth that is, ke > g.
Example Calculating the after-tax cost of equity using the dividend growth valuation model
B Limiteds shareholders receive an annual dividend of $0.30 per share. The dividends are
expected to grow at a constant annual rate of 10%. The current price of B Limiteds shares is
$5.00 ex-dividend.
The existing shareholders rate of return (the cost of equity) can be calculated as:
$0.30 ^1.1h
ke = + 0. 1
$5.00
= 16.6%
Example Calculating dividend growth rate and cost of equity (by extrapolation)
Dee Limited has declared a dividend of 28 cents per share. Dee Limiteds current share price is
$4.00. Previous dividends are as follows:
4 years ago 20.0 cents
3 years ago 21.5 cents
2 years ago 23.5 cents
1 year ago 25.5 cents
The first step in calculating the cost of equity is to determine g for input into the formula. In
this example, a dividend series has been provided from which to extrapolate g. Dee Limiteds
growth rate can be calculated as:
D0 ^1 + gh4 = D1 , where D0 represents the first dividend in the series and D1 represents the last.
^1 + gh4 = 0.28
0.20
g = 1 .4 1
4
g = 8.78%
Note: that D0 and D1 have a different meaning here than in the dividend growth valuation
model. Here they denote the first and last dividends in the series.
Having now determined the value of g, the cost of equity can be calculated using the dividend
growth valuation model formula as:
0.28 # 1.0878 +
ke = 4.00 0.0878 = 16.4%
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Example Calculating dividend growth rate and cost of equity (by formula)
C Limited has paid a dividend of 25 cents per share, which represented 60% of earnings per
share. C Limiteds earnings per share are 30% of net assets per share and its current share price
is $1.50 ex-divdend.
g = br = 40% 30% = 12%, where b = 100% 60%
0.25 # 1.12 +
ke = 1.50 0.12 = 30.7%
The advantages of using the growth model for determining the cost of equity include:
It is good for valuing stable-growth, dividend-paying companies.
It is simple and clear and helps in understanding the relationships between the total market
value of the company (V), the rate of return on investment (r), the growth rate (g), and the
market value of the companys debt (MVd).
It can be used as a component in more complex growth models.
ke = rf + e ^rm r f h
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Beta (e)
Beta is an estimate of the systematic risk of a security. It measures the volatility of the return
on a security relative to movements in the market as a whole (as measured by an index).
By definition, the market index has a beta of one. A security with a beta greater than one is
considered more risky than the market, whereas a security with a beta less than one is less risky.
For listed companies, the beta of their securities is available from various financial information
providers. Equity analysts typically estimate the beta of a listed companys securities using
regression analysis that is applied to monthly returns on the shares, and the market index over
the most recent three- or five-year period.
The betas of unlisted companies present a greater challenge. Possibilities for equity analysts
include:
Using the beta of a listed company that closely resembles the unlisted company in question.
Using an industry beta (i.e. based on an average of the betas for listed companies in the
same industry as the unlisted company in question).
One disadvantage of using other betas to estimate an unlisted companys beta is that other betas
do not always reflect the same gearing levels as the company in question. In such instances, an
unlevered beta is calculated and then re-levered to match the gearing levels of that company.
This is discussed in the unit on long-term financial management.
Hybrids
If an organisation uses hybrid securities, the approach used should remain the same; that is,
calculate the expected cost after tax of each security type. For example, preference shares often
have a fixed dividend rate paid in perpetuity. These dividends are not tax deductible; therefore,
the cost is straightforward.
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The required return on a preference share with a fixed dividend rate can be calculated as:
D
kp = P
0
Weighting
The WACC formula assumes that an organisations current financing mix of debt and equity
will remain relatively stable in order for it to continue to fund its business according to the
same proportions. This assumption may or may not be true. Another alternative is for the
organisation to use target weightings that its management feel are more appropriate and will
therefore facilitate more accurate decisions about the future.
In computing weights, the current market values of a companys securities should be used. This
is because the company will be issuing new securities at their current market value, and not at
book (historical) values.
For the purpose of this unit, where long-term investment decisions are being made, you should
only include long-term interest-bearing debt when computing the weighting.
Item
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1 ^1.06h
MVd = 2 > H+
10
40
0.06 ^1.06h10
= $2 million # 7.3601 + $22.336 million
Therefore, the market value of the debentures = $37.1 million (rounded to one decimal
place).
Notes
1. The market value of the debentures is based on the 12% current yield of similar rating debentures,
not on the coupon rate.
2. As interest is paid half yearly, there are 10 payments at 6% (12% 2).
3. While the first part of the numerical calculation looks different from the base formula, it is actually
the same mathematically, but just the inverse.
The after-tax cost of debt is calculated by multiplying the current yield on the debentures
(12% p.a.) by (1t), where t is the corporate tax rate, as follows:
kd.AT = kd.BT ^1 t h = 12% ^1 0.3h = 8.4%
The market value of the preference shares is $4 million (i.e. current market price number
of shares = $41,000,000 = $4 million). The after-tax rate of return for a preference
shareholder is:
= D $0.50 =
ke P= 12.5%
0 $4.00
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The market value of the ordinary shares is $42 million (i.e. current market price number
of shares = $4.20 10 million). Using the CAPM, the after-tax required rate of return by
ordinary shareholders is:
ke.AT = rf + j ^rm rf h = 6.5% + 1.9 # 7% = 19.8%
Financial risk
Higher debtequity ratios lead to a higher risk of variability in earnings after interest paid to
debt holders. This requires a premium over the risk-free rate to cover this perceived additional
financial risk.
In addition, the particular capital raised to fund a new investment may substantially change an
organisations capital structure. For example, borrowing to fund such a proposal may lead to an
increase in the debtequity ratio. This would subsequently change the perceived financial risk
of the proposed investment. The additional risk would also modify the current WACC.
In these instances the beta should be adjusted to reflect the new risk profile of the company.
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Learning outcome
2. Apply capital budgeting techniques to assess investment decisions.
Investment proposals
Investment proposals typically include:
A brief description of the proposal.
A statement indicating why the project is desirable or necessary.
An estimate of the amount and timing of the cash flows.
An estimate of when the proposal will come into operation.
An estimate of the projects economic life.
Using cash flow and other data obtained from an investment proposal, an economic or financial
evaluation of the proposal is made. Several techniques can be used to analyse this data: NPV,
IRR, the payback period method (also the discounted payback period), and the accounting rate
of return (ARR) approach.
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If the answer to both questions is yes, the item is an incremental cash flow. If the answer to
either question is no, the item is irrelevant to the analysis.
The following lists indicate typical investment cash inflows, outflows and exclusions (although
it should be noted that the only definitive test is the one outlined above).
Cash inflows typically include the following:
Increases in revenue.
Cost savings.
Residual value (or salvage value) of the investment.
Decreases in working capital.
Depreciation tax shield amounts.
Exclusions from cash inflows and outflows typically include the following:
Sunk costs (costs that have already been incurred by the organisation).
Allocated/common costs (unless there is an increase or decrease in the costs due to the
project).
Accounting depreciation.
Interest or financing charges (since these represent financing costs that have been
incorporated into the WACC used to evaluate the investment project).
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This cash inflow is often referred to as the depreciation shield or tax shield.
3. An assets disposal value is greater than its written-down value for tax purposes, but less
than its acquisition cost (i.e. profit on sale of asset, but nil capital gains as sold for less than
original cost). When an asset is sold for an amount in excess of its current written-down
value for tax purposes but less than its historical acquisition cost, a taxable gain on disposal
results. The taxable gain means an increase in the organisations taxation liability and,
therefore, an incremental cash outflow.
The incremental cash outflow is an amount equal to the difference between the proceeds of
the sale and the written-down value of the asset multiplied by the tax rate that is expected
to apply in the period of the disposal. Accordingly, the net cash inflow from the disposal is
calculated as:
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4. An assets disposal value is greater than its written-down value for tax purposes, and
greater than its acquisition cost (i.e. capital gain on sale of asset). A final situation arises
when an assets disposal is likely to recoup an amount greater than its acquisition cost. This
results in a potential taxable capital gain (i.e. an incremental cash outflow) that would be
calculated according to the CGT provisions in the relevant jurisdiction as applicable.
The net cash inflow from the disposal is calculated as:
The tax treatment of capital gains is beyond the scope of this unit.
NPV method
Four steps are needed to complete an NPV analysis of an investment proposal:
1. Prepare a table showing the cash flows during each year of the proposed investment.
2. Calculate the present value of each cash flow, using a discount rate that reflects the
weighted average cost of acquiring investment capital.
3. Calculate the NPV, which is the sum of the present values of the cash flows.
4. Evaluate the proposal.
Calculation
The NPV of a project can be calculated using the following formula:
n
NPV = C0 + / ^1 C+t r ht
t=1
where NPV = net present value
Ct = annual net cash flow in period t
C0 = initial net cash flow
n = project life
r = required rate of return (WACC)
Therefore, when making an investment decision using NPV, the decision rule is:
Accept a project if the NPV is positive.
Reject a project if the NPV is negative.
A high NPV is preferred over a low NPV. When choosing between mutually exclusive projects,
an organisation should choose the project with the higher NPV. Mutually exclusive projects
is the terminology used to describe when an organisation has two or more projects to chose
between but only has sufficient capital to undertake one.
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Year 0 1 2 3 4
As such, the project requires an initial cash outflow and is then expected to produce four cash
inflows over its four-year life. If the projects required rate of return is 10% p.a., is it a worthwhile
investment? Applying the NPV rule requires calculating the present value of all the cash flows:
$25 + $30 + $35 + $40
NPV = $100 +
^1.10h1
^1.10h2 ^1.10h3 ^1.10h4
= $100 + $22.73 + $24.79 + $26.30 + $27.32 (rounded)
= $1.14
Since the investment has a positive NPV, it will add value to the organisation, and should
therefore be undertaken.
IRR method
1. Prepare a table showing the cash flows during each year of the proposed investment.
2. Calculate the IRR for the proposed investment.
3. Evaluate the project.
Calculation
The IRR can be calculated, by solving for r, using the following formula:
n
NPV = / ^1 C+t r ht C0 = 0
t=1
where NPV = net present value = 0
Ct = annual net cash flow in period t
C0 = initial net cash flow
n = project life
r = the IRR
When making an investment decision using IRR, therefore, the deciding rule is:
Accept a project if the IRR exceeds the organisations WACC.
Reject a project if the IRR is less than the organisations WACC.
A high IRR is preferred over a low IRR. Therefore, when choosing between mutually exclusive
projects, the organisation should choose the project with the higher IRR.
A projects NPV and IRR are closely related. If a project has a positive NPV, its IRR will exceed
an organisations WACC. Similarly, if a project has a negative NPV, its IRR will be below the
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WACC. The criteria for both DCF evaluation techniques are therefore consistent and will give
the same accept or reject decision result for a project.
Year 0 1 2 3 4
IRR = 20% + ;
$35.494 # ^25% 20%hE = 21.95%
$35.494 ^ $55.360h
This is quite close to the 21.86% figure calculated by spreadsheet. Note that 20% and 25% have
been used for the interpolation as these figures are either side of the IRR determined in the
previous example.
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The formula above will yield more accurate results with no more than 5% difference between
the discount rates. Since it is a linear approximation, the IRR estimated for a typical project will
be slightly higher than the actual IRR.
Limitations
The IRR technique has several limitations, including:
Some projects can have multiple IRRs. This can arise when a project generates a negative
cash flow at some future date many investments require large negative cash flows in the
final year of a projects life (e.g. reclamation works for mining sites).
The IRR and NPV techniques can produce conflicting rankings when used to evaluate
mutually exclusive projects. This is likely to happen when the projects exhibit significant
differences in their initial outlays or the time pattern of their cash flows. In these
circumstances, the NPV technique is preferred.
The NPV method assumes that cash flows over the life of the project are reinvested in
projects that earn at least the WACC. The IRR, however, assumes that those cash flows can
be reinvested at the IRR. The NPVs reinvestment rate assumption is better and, therefore,
considered superior to that of IRR.
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Year 0 1 2 3 4 5
This project requires an initial cash outlay of $100. After one year, the project has paid back
$30 of the $100. After two years, the project has paid back $70. After three years, $120 has been
paid back. This means that the projects payback point is reached somewhere during the third
year.
At the beginning of the third year, another $30 is required for the project to be fully paid
back and a cash flow of $50 is generated during the year. Thus, the payback period is two full
years plus a proportion (30 50) of the third year. In this case, therefore, the payback period is
2.6years.
However, while the payback period method is a simple, intuitive method for screening
proposals, it ignores both the time value of money and the cash flows that may be received
beyond the payback period. The payback period method gives equal weight to all cash inflows
regardless of when they occur. Because of the time value of money, however, earlier cash flows
are actually more valuable. Ignoring cash flows after the payback also ignores the principle of
shareholder wealth maximisation, since investors desire more benefits rather than less. Due to
these inherent problems, the payback period should not be the sole criterion for evaluating a
project. If an organisations objective is to maximise shareholder value, the focus should be on
NPV.
Year 0 1 2 3 4 5
Discounted cash flow ($) (100) 27.27 33.04 37.55 37.565 37.26
This project requires an initial cash outlay of $100. After one year, the project has paid back
$27.27 of the $100. After two years, the project has paid back $60.31. After three years, $97.86
has been paid back. Thus, the discounted payback period is three full years plus a proportion
(2.14 37.565) of the fourth year. In this case, therefore, the discounted payback period is
3.06years.
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Like the payback period method, the discounted payback period technique still has limitations:
Determination of the organisations maximum payback period remains an arbitrary
decision. This decision affects which projects are accepted or rejected. While the discounted
payback period method incorporates the time value of money in its calculations, the
usefulness of the information is limited due to the subjective nature of the cut-off point.
It still makes no allowance for the cash flows received after the payback period.
Year 1 2 3 4
Therefore, the average after-tax profit is ($15 + $20 + $25 + $30) 4 = $22.5.
To calculate the average investment:
Year 0 1 2 3 4
$ $ $ $ $
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The advantage of the ARR measure of project evaluation is its consistency with financial
accounting methods. The approach typically uses the same numbers that are used to evaluate
managers on their own performance. It uses familiar terms and provides a measure of
accounting profits per average dollar invested.
The disadvantage of the ARR technique is that it ignores both cash flows and the time value of
money.
Sensitivity analysis
Learning outcome
3. Assess investment decisions by performing sensitivity analysis.
Sensitivity analysis is a useful tool for finance managers to see how projects behave when
the variables that determine their success or failure are altered. The purpose of the analysis
is to determine which variables have the most impact. It directs management attention to
critical variables in the project. A small change in a critical variable may make the project not
financially viable.
For example, the level of a projects variable costs might be altered to see how sensitive the
projects NPV is to these variations. A small increase in variable costs could have a profoundly
negative impact on the NPV. The same process might be followed to investigate the NPVs
sensitivity to variations in the discount rate. Sensitivity analysis may be conducted on a projects
sensitivity to variations of single or multiple factors.
Sensitivity analysis helps managers gain a better understanding of the nature and degree of risk
that is associated with a project. It can be viewed as a form of break-even analysis, in which the
point at which the NPV is equal to zero is the break-even point. Sensitivity analysis reveals the
margin of safety that is associated with each key variable relating to a particular project. This
enables managers to devote their attention to confirming or firming up the estimates for those
variables in order to reduce risk.
Managers benefit from sensitivity analysis because it can provide answers to what if questions
they may have in relation to a project and the forecasts and assumptions used to complete the
capital budgeting analysis. Such what if questions could include:
What if inflation is different to forecast?
What if the expected sales cannot be achieved?
What if the useful life of the equipment is not as forecast?
What if the WACC used in the capital budgeting analysis should change?
What if the costs associated with the project differ from the forecast costs?
What if the government changes the tax rates?
What if the exchange rates change?
A sensitivity analysis will also show how sensitive a project is to a change in the forecasts and
assumptions used in the capital budgeting analysis, and thus may allow the project to proceed
on the understanding that management of a particular assumption or forecast cash flow item is
critical to ensuring its success.
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Learning outcome
4. Assess behavioural influences, as well as other qualitative issues that impact on investment
decision-making.
Behavioural influences
The use of relatively sophisticated decision tools such as discounted cash flow analysis gives
the impression that investment decisions are largely a technical issue and the result of a logical
process. In other words, that management simply needs to identify a number of investments
that are then impartially evaluated in order to determine which will be the best investments.
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This view is too simplistic because individuals are almost always involved in investment
decisions. Consequently, it is necessary to consider the behavioural and emotional influences on
those individuals, including the following:
Predicting inputs to the DCF. While some inputs to the DCF (e.g. costs of labour and the
investment) may be relatively objective and easy to estimate, other inputs may be less
objective and certain (e.g. changes to interest rates and future tax rates). Other inputs may
appear to be derived in an objective manner, but most are ultimately subjectively derived
(e.g. demand/sales forecasts, residual values of assets, and the effect of learning on costs).
This provides scope for individuals to overestimate/underestimate a projects returns.
Pet projects. Managers can become personally and emotionally involved with investments
to such an extent that they cannot separate their own performance from that of the
investment. This can lead managers to persist with an investment long after it should have
been abandoned (known as escalation of commitment).
Investment evaluation as a ritual. The evaluation process is sometimes described as a mere
ritual because so few investments are actually rejected by a formal financial evaluation.
Arguably, few projects are submitted by lower-level managers, unless they stand an
excellent chance of being approved. This is because there is too much embarrassment and
loss of face associated with an investment being rejected, especially when a critical level of
momentum has gathered and managers reputations are on the line.
Risk-seeking and risk-averse behaviour. Individuals differ in terms of the levels of risk
they are prepared to accept. Consequently, two individuals can arrive at two different
conclusions about the same investment.
Qualitative issues
After the quantitative analysis is complete, management must decide which projects to
implement. While the aim of maximising shareholders wealth guides managements decision-
making, qualitative issues may also be relevant to the evaluation of a project.
These issues involve items that are non-quantifiable in dollar terms but that may impact on
capital budgeting analysis. They include such issues as:
Effect of changes on the workforce.
Effect of a project on an organisations brand name and marketing position.
Whether there are adequate storage facilities for new equipment and additional inventories.
What will be done with additional space if the manufacturing process is halted.
Again, these are the types of questions and issues that need to be considered when evaluating a
project there is no strict list or defined set of items to follow. Each investment decision must be
reviewed independently based on the individual facts of the case.
Quiz
[Available online in myLearning]
ACT
Activity 11.1
Applying weighted average cost of capital
(WACC)
Introduction
This activity requires you to analyse the weighted average cost of capital (WACC) for Accutime
Limited (Accutime). You will also contrast Accutimes WACC with the minimum return
demanded by the board of directors and outline possible implications.
This activity links to learning outcome:
Calculate and apply weighted average cost of capital (WACC).
At the end of this activity you will be able to calculate and apply the WACC in relation to
investment decisions.
It will take you approximately 45 minutes to complete.
Scenario
This activity is based on Accutime.
You are a management accountant working for Accutime and you report to Graham Anderson,
the chief financial officer (CFO).
At the last board meeting, it was stipulated that the minimum required return on all projects for
the coming year must be 18%.
The minutes from the meeting document discussions surrounding the continued intense
competition, exchange rates and the general malaise in the economies of Accutimes key
markets as reasons for the 18% minimum return.
The minutes also record one director as stating: The high return of 18% will ensure only the
best projects are accepted and enable us to provide the superior returns our shareholders
demand of us.
Graham is unhappy with the boards final decision of a minimum return of 18% and has
requested that a review be completed of Accutimes WACC. In particular, he wants you to
calculate the WACC and assess whether a single rate is appropriate across all regions. Graham
has stipulated that the CAPM approach be used to estimate Accutimes cost of equity.
ACT
Tasks
For this activity you are required to:
1. Determine Accutimes weights of debt and equity for 2012.
2. Estimate Accutimes WACC using the following information. (Calculate to one decimal
point based on book values.)
To determine the costs of each source of finance, you have identified additional information
that you will use to estimate Accutimes WACC.
Bank borrowing represents an interest-only, five-year bank term loan at a fixed 7.8%
interest rate until maturity, which was drawn down in January 2012 to help fund the
BACTech acquisition.
A beta of 1.10, which is consistent with proprietary financial information sources that
estimate betas for listed companies.
The market risk premium is between 4.5% and 7.0%. Based on your understanding of
the return required by the shareholders of Accutime, you decide to base your initial
WACC calculations assuming a market risk premium of 6.0%.
The risk-free rate is 4.6%, and the company tax rate is 30%.
Trading information
4. Assess whether the board has made the correct decision to use an 18% minimum return on
all projects in the context of the WACC analysis.
5. Assess the implications of the boards stipulated minimum return of 18% on new projects.
[Solutions to activities are available online. Please access myLearning to view]
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Activity 11.2
NPV and payback methods
Introduction
A limitation of the payback period method of project evaluation is that it ignores the time value
of money. To overcome this limitation, some organisations use the discounted payback period
method for capital investment decisions. The discounted payback period method is similar
to the payback period method except that it uses discounted cash flows when calculating
the payback period. Using this method, the acceptreject decision is made by comparing the
discounted payback period with the desired payback period.
This activity links to learning outcomes:
Calculate and apply weighted average cost of capital (WACC).
Apply capital budgeting techniques to assess investment decisions.
At the end of this activity you will be able to generate information to make an informed
potential investment decision by calculating the discounted cash flow and both the payback and
discounted payback periods.
It will take you approximately 45 minutes to complete.
Scenario
You are the senior management accountant in the head office of TightFitt, a large fitness group.
You report to the financial controller, Lara Lycra.
TightFitt currently owns and runs 25 gyms throughout Australia and New Zealand. Lara
informs you that the marketing department would like to add a climbing wall to the facilities in
each of its gyms, all of which have sufficient room to build this additional facility.
Based on a prototype created within one of the Adelaide gyms, the marketing department has
provided the following estimates for your use in analysing discounted cash flow, payback and
discounted payback periods. All price and cost estimates are exclusive of GST.
WACC 14%
Taxation TightFitt has substantial carried forward tax losses and is not
expected to pay income tax for 10 years
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Tasks
For this activity you are required to:
1. Calculate the net present value of the climbing wall within one of TightFitts gyms.
2. Calculate the payback period.
3. Calculate the discounted payback period.
Based on each calculation, recommend whether TightFitt should proceed with the investment.
[Solutions to activities are available online. Please access myLearning to view]
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Activity 11.3
Errors in capital budgeting calculations
Introduction
In any organisation, capital investment decisions are significant as they need to maximise the
entitys future returns, maintain competitive advantage and align with its strategic direction.
As the amount of capital involved can be significant, a poor investment decision can have a
negative impact on results for a number of years. Therefore, it is important for management of
an organisation to critically assess the various investment opportunities available. This includes
considering both the quantitative and qualitative factors influencing an investment decision.
This activity links to learning outcomes:
Calculate and apply weighted average cost of capital (WACC).
Apply capital budgeting techniques to assess investment decisions.
Assess behavioural influences, as well as other qualitative issues that impact on investment
decision-making.
At the end of this activity you will be able to recommend whether to proceed with an
investment opportunity based on a net present value (NPV) calculation and a payback
calculation, as well as identify the qualitative factors influencing the decision.
It will take you approximately 30 minutes to complete.
Scenario
You are the senior management accountant within the head office of B Limited, an import and
distribution business. You report to the financial controller, Barry Bringit.
B Limited is currently renting a warehouse for use in its import and distribution business. The
company currently has surplus cash of $2,500,000, and it has been told that it could build a
warehouse equivalent to the rented one, thus saving future costs and, ultimately, making the
business more profitable.
The following NPV has been prepared to assist in analysing the proposal.
Year 0 1 2 3 4 5
$000 $000 $000 $000 $000 $000
Disposal value
After tax cash flow (2,500.0) 52.5 52.5 52.5 52.5 52.5
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Barry has also provided you with the following additional information to use in analysing the
proposal prepared by the production manager:
A. The period of five years represents the lease period applicable to the current rental
agreement renewal for the warehouse.
B. It is currently unknown what B Limited would do with the building after five years, but one
possibility is to sell it. The estimated selling price would be $1.250 million.
C. B Limited has been told that depreciation of $250,000 per year would be available for the
company to use for additional tax deductions.
D. B Limiteds current WACC is 14.0%.
Note: The discount rate figures have been obtained from the PV table located at the beginning
of the CSG.
Tasks
For this activity you are required to:
1. Identify the obvious errors or omissions in the NPV calculation as presented.
2. Identify the qualitative issues that may affect the decision to build the warehouse.
3. Redo the NPV calculation correctly.
4. Based on the available information calculate the payback period for building the new
warehouse.
5. Based on all of the above information, state whether you would accept the proposal or not.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 11.4
Investment decisions
Introduction
The objective of this activity is to highlight common mistakes or pitfalls when creating
discounted cash flow models.
The activity links to learning outcomes:
Apply capital budgeting techniques to assess investment decisions.
Assess investment decisions by performing sensitivity analysis.
Assess behavioural influences, as well as other qualitative issues that impact on investment
decision-making.
At the end of this activity you will be able to evaluate a capital investment project using
incremental cash flow analysis in a real-world setting. You will also be able to provide guidance
on additional considerations and alternative approaches that may assist with the analysis of the
project.
It will take you approximately 60 minutes to complete.
Scenario
This activity is based on Accutime Limited.
Sam Lewis has a business internship with Accutime Limited (Accutime) during the summer
university break, and you have been given the task of overseeing Sams work. You have decided
that Sam should construct a discounted cash flow model to analyse a new packaging system at
the Reading (UK) plant.
As production has increased over recent years, the existing packaging system has struggled to
cope. This is creating a bottleneck and has resulted in increased levels of work-in-progress and
finished goods inventories on hand. Overall, Accutime expects the new system to improve the
Reading plants delivery capacity. This would improve the profit contribution by $1,580,000 per
annum. Other changes (not included in profit contribution) include annual salary savings of
$78,000 and an immediate $300,000 reduction in inventories.
The purchase price of the assembly system is $2,000,000 and it will cost $100,000 to install. The
entire cost will be financed with a bank term loan at an interest rate of 7.9% per annum. The
new system could be sold for $320,000 at the end of Year 4. The tax authority allows 15%prime
cost (straight line) depreciation on assembly lines and the same rate would be used for financial
accounting purposes. All figures are in Australian dollars. The Accutime board has declared that
it will only accept projects where the net present value (NPV) exceeds an 18%return.
Accutimes organisation-wide effective tax rate is 30%.
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Sam has forwarded her summary of relevant cash flows to you for review:
Tasks
For this activity you are required to:
1. Analyse Sams summary of relevant cash flows to identify the line items that you think
should be checked and/or corrected.
2. Using this analysis, create a revised incremental cash flow analysis.
3. Identify potential alternative methods for analysing the financial performance of the project.
Indicate which of these would be appropriate if Accutime is not interested in the time value
of money when making its capital budgeting decisions, and create another summary of
relevant cash flows to illustrate additional analysis.
4. Identify the additional qualitative, quantitative and behavioural issues that may impact the
decision to proceed with the investment.
5. Perform a sensitivity analysis to determine the impact of a 10% increase and 10% decrease
in profit contribution. Recalculate the NPV based on these two adjustments using the same
cash flow format used in the previous steps.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
There are no further readings for this unit.
References
The following is a summary of all other sources referred to in the preparation of the content for
this unit.
Booth, P and Schulz, AK 2004, The impact of an ethical environment on managers project
evaluation judgments under agency problem conditions, Accounting, Organizations and Society,
vol. 29, pp. 473488.
Brealey, RA, Myers SC and Marcus AJ 2009, Fundamentals of corporate finance, 6th edn,
McGrawHill/Irwin, New York, USA.
Bruner, RF, Eades, KM, Harris, RS and Higgins, RC 1998, Best practices in estimating the cost
of capital: survey and synthesis, Journal of Applied Finance (formerly Financial Practice and
Education), vol. 8(1), Spring/Summer, pp. 1328.
Copeland, TE and Weston, JF 1988, Corporate finance: Theory and policy, 3rd edn, Addison-Wesley,
New York, USA.
Frino, A, Hill, A and Chen, Z 2009, Introduction to corporate finance, 4th edn, Pearson Education
Australia, Frenchs Forest, NSW.
Hathaway, N 2005, Australian market risk premium, Capital Research, accessed 1 April 2014,
www.capitalresearch.com.au.
Lally, M and Marsden, A 2004, Tax adjusted market risk premiums in New Zealand:
19312000, Pacific Basin Finance Journal, vol. 12(3), pp. 291310.
Officer, R and Bishop, S 2008, Market risk premium: A review paper, prepared for Energy
Networks Association, Australian Pipeline Industry Association and Grid Australia, accessed
10 November 2012, www.ena.asn.au policy/submissions ENA submissions ENA
submissions for 2008 Appendix G Market Risk Premium Value Adviser Associates
Professor Bob Officer and Doctor Stephen Bishop.
Petty, JW, Titman, S, Keown, AJ, Martin, JD, Martin, P, Burrow, M, Nguyen, H 2012, Financial
Management Principles and Applications, 6th edn, Pearson Education, Frenchs Forest, NSW.
PricewaterhouseCoopers 2002, New Zealand equity market risk premium, accessed 9 November
2011, www.pwc.co.nz Appreciating value Technical note and disclaimer NZ market
risk premium paper (pdf).
Rutledge, RW and Karim, KE 1999, The influence of self-interest and ethical considerations on
managers evaluation judgments, Accounting, Organizations and Society, vol. 24, pp. 173184.
Shapiro, AC 1985, Corporate strategy and the capital budgeting decision, Midland Corporate
Finance Journal, Spring, pp. 2236.
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Core content
Unit 12: Short-term and medium-term
financial management
Learning outcomes
At the end of this unit you will be able to:
1. Demonstrate understanding of the role of short-term and medium-term finance in the
capital structure of a business.
2. Outline the nature and features of short-term finance.
3. Outline the nature and features of medium-term finance.
Learning outcome
1. Demonstrate understanding of the role of short-term and medium-term finance in the
capitalstructure of a business.
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Compared to long-term financing sources such as equity raising, and debentures and
longterm loans from commercial banks short to medium-term financing is more flexible
and generally easier to access. Smaller organisations that require funding in a hurry typically
dont have access to equity and bond markets and other more structured sources of finance,
and so short to medium-term financing is a practical solution for these businesses. Applications
for short to medium-term finance are processed quickly and efficiently, and funds are made
available in a very short time frame.
The diagram below illustrates the different types of financing available for the short and
medium term.
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A companys choice of matching strategies will depend on managements risk appetite (covered
in the unit on risk management), and whether cash flow stability or profitability is more
important.
Learning outcome
2. Outline the nature and features of short-term finance.
The major sources of unsecured short-term finance are trade credit, extended payments,
consignment stock, and accrued wages and taxes. Banks, finance companies and debt factoring
services are the main sources of secured finance. Financial institutions may also offer unsecured
finance, for example, overdraft facilities.
SHORT TERM
(typically one year or less)
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0 15 45
days days days
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not taking the early settlement discount can prove costly. Consider, for example, a $100 invoice
that needs to be paid on the above terms. The company has two choices:
1. Settle on 15 days, benefit from the discount, and pay $97.50 (i.e. $100 less 2.5%).
2. Settle on 45 days and pay $100.00.
If the company elects to settle on 45 days that is, it chooses Option 2 then it is obtaining
an extra 30 days credit on $97.50 from the supplier for an extra cost (which can be considered
as interest) of $2.50. The 2.5% cash discount is essentially the interest cost of extending the
payment by 30 days. The principal amount is $97.50 as of the 15th day of the credit period, after
which time the cash discount is lost. This can be expressed as a nominal interest rate cost of
2.6%, calculated as follows:
2.50 =
97.50 # 100% 2.6%
Initially, this looks cost-effective; however, this is the rate for a 30-day loan. In a year there are
365 30 = 12.17 thirtyday periods. To calculate the effective annual interest rate, 2.6% for 12.17
periods needs to be compounded. This is done by calculating the effective annual interest rate
as a consequence of taking the discount using the following formula (where i is the discount
obtained and n is the number of days of extra credit):
This result indicates that the business should take the discount unless it can earn a 36.7%
return on any alternative use of its funds. It is clear that not taking the early payment discount
is potentially very expensive. If the organisation can borrow short-term finance with equivalent
flexibility at a rate less than 36.7% p.a. (e.g. via an overdraft facility), then it should do so and
take the discount. Also, note that once the discount period has passed that is, after the 15th
day there is no reason to pay before the final due date (45 days).
Note also that while in theory it is the supplier that specifies credit terms, in practice many
large companies dictate the terms under which they are prepared to do business with
suppliers. Smaller business creditors often have their payment terms unilaterally extended by
larger businesses. In this case, smaller businesses are effectively providing funding to larger
businesses. This is particularly prevalent in food retailing where large supermarket groups are
often in a very powerful position compared to the small farmers and food producers who supply
them. Supermarket chains may pay on lengthy terms that could be between 60 and 90 days.
Suppliers are prepared to tolerate this on the basis that the supermarket group will potentially
take the vast majority of their produce, but it is the supplier that incurs the finance costs until
payment is received.
Extended payments
A further potential source of finance associated with payables is the negotiation of extended
payment terms with a supplier. If willing, the supplier would normally charge a fixed
percentage premium for this service. This premium is effectively the interest rate on the loan,
and can be annualised in the same way as settlement discounts.
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Extended payment terms can be convenient, flexible and informal, but they are a very
expensive source of finance to use on a regular basis when compared to other alternatives such
as overdrafts or short-term loans.
Consignment stock
In the context of short-term financing, consignment stock (i.e. stock that is held by the customer
and owned by the supplier) can be helpful in delaying the creation and, consequently, the
settlement of trade payables. With consignment stock, a supplier places some of its inventory in
the possession of the customer (i.e. in their shop or warehouse) and allows the customer to sell
or consume directly from this inventory of stock. The customer is deemed to have purchased
the inventory only after it has been resold or consumed, and it is only at this point that a
payable is created in the books of the business. The payable is then settled on normal payment
terms. At the end of an agreed period, any unused stock is returned to the supplier.
Consignment stock can be useful as a negotiation and risk-sharing tool. For example, in
franchise operations, new franchisees are typically more concerned with managing cash
flow than the level of profit margin created. For the first year of the franchise agreement, the
franchisor or retailer may offer the franchisee stock on a consignment basis. This allows the
franchisee to delay payment, reducing the cost of capital tied up in stock, and lessening the risk
associated with over ordering stock. In return, the franchisee is happy to pass more of the profit
margin back to the retailer.
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fall in accord with the companys actual sales and, hence, the deferred amount of taxes will
increase and decrease automatically, providing a source of funding.
Note: In Australia, from 1 January 2014 businesses with turnover in excess of A$20 million are
being progressively transitioned (over a four-year period) to monthly PAYG payments. This
will change cash flow requirements, and therefore some businesses may need to reassess their
funding needs.
Bank overdrafts
A bank overdraft allows a business to run its current (cheque) account into deficit. It is a loan
from a bank to the business. An overdraft occurs when money is withdrawn from a bank
account and the available balance falls below zero: the account is then overdrawn. If the
amount is within the banks agreed limit, then it charges interest on the outstanding amount at
an agreed rate that is charged monthly or quarterly in arrears. If there is no prior agreement,
or the amount exceeds the agreed limit (and if the bank honours the cheque), then additional
fees and higher interest rates may be charged. Overdrawn accounts are usually at call, which
means that the bank can require repayment at any time. However, this right is rarely exercised.
The overdraft facility is a highly flexible and convenient source of short-term finance. It can
usually be arranged for a period ranging from a few days to a year, and is then renegotiated at
the end of the term. The key features of an overdraft facility are explored in the table below:
Feature Description
Cost Interest on overdraft accounts is usually charged based on the daily balance of the amount
overdrawn
At the time of writing, interest rates are generally more than those on equivalent sources of
long-term finance, and are usually linked to the current base rate of interest
Overdraft interest rates depend on factors such as the borrowers credit history and the
reasons why an overdraft is sought
Flexibility The borrowing organisation can draw down on the facility as and when required, and can
pay back the facility at short notice without incurring redemption fees
Fees Establishment fees are often charged, but these are typically far less than those associated
with more structured long-term financing. Before the financial crisis, many banks had waived
establishment fees altogether in an attempt to attract customers. Recently, however, these
fees are becoming increasingly common
An account service fee may also be charged to cover the banks transaction costs. In
addition, a fee may be charged on any unused portion of the overdraft limit it reflects the
cost to the bank of maintaining extra funds available in case the borrower decides to draw
down their account
Penalty fees A key area of risk, especially for a small organisation, arises if it inadvertently breaches the
agreed facility limit. In such cases penalty fees are often severe
Security While some businesses will be granted an overdraft without having to provide security, in
many cases the bank will require that a security interest be registered
The terms of the overdraft may depend upon the security offered by the borrower
The bank may also place restrictions on the borrower in order to reduce the likelihood that
the borrower will encounter further short-term liquidity problems
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Debt factoring
Debt factoring is a source of short-term finance based on the inherent value of cash tied up
in trade receivables. This funding enables a business to access monies owed by customers,
primarily by using the accounts receivable ledger to secure a loan. A finance company
offering debt factoring services buys the receivables balance from a company and collects the
outstanding cash on behalf of the company. In other instances, the debt factor will often provide
an immediate payment to the company in the region of 80% of the value of the receivables. The
remaining 20%, less fees and interest, is paid to the company when its customers eventually
pay. This can provide a business with the means to resolve short-term or even medium-term
cash flow problems.
The process map below summarises this approach:
The selling The agreed The factoring The customers The factoring
organisation receivables company makes pay their bills as company pays
sells its goods balance is sold an immediate normal but remaining
and services to to the factoring cash advance to directly to the balance (minus
customers as company the selling factoring fees and interest
normal and organisation company charge) to the
issues invoices based on the selling company
value of
receivables
acquired
There are a number of different conditions and charges associated with a typical debt factoring
deal, as outlined below:
The debt factoring company will charge interest to the company on the total amount
advanced at the beginning of the agreement, as this is essentially a loan secured on the value
of the receivables balance.
The debt factoring company will also charge a fee (expressed as a percentage of the value
of the receivables balance taken on) to cover sales ledger administration and collection
services.
The debt factoring company is usually very selective about the amount and type of
receivables balance taken on. Old, poor quality debts and those in dispute are usually not
taken on, as they are deemed too risky.
Most factoring arrangements are made on a non-recourse basis, which means that, after
adjusting for poor quality debts as noted above, the debt factoring company accepts
the risk that some remaining customers will not pay. The alternative is a with recourse
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arrangement whereby bad debts are passed back to the company. Non-recourse
arrangements are typically more expensive in terms of fees and charges than recourse
arrangements.
Invoice discounting
Invoice discounting is closely related to debt factoring, and, in practice, most finance houses
offer both services to clients. The key distinctions are as follows:
Individual invoices or groups of invoices (rather than the entire sales ledger) are pledged
tothe finance house in return for an immediate payment of up to 90% of the face value of
the invoices.
The company retains control of collection and management of the invoices. When the due
date is reached, the company hands over the total invoice amount to the finance house.
In return, the finance house passes the remaining 10% to the company, minus interest and
any service charge.
Unlike debt factoring, customers have no contact with the finance house and are usually
completely unaware that their invoices have been discounted. The arrangement is normally
with recourse to the company (again unlike factoring). The company takes the risk that its
customer may pay late or not at all, but it must pass the full amount to the finance house on the
due date regardless of whether it has received payment. Fees associated with this service tend
to be lower, as the company retains control over sales ledger administration.
Learning outcome
3. Outline the nature and features of medium-term finance.
It is comparatively rare for Australian and New Zealand companies to directly issue debt
securities (such as debentures and unsecured notes) as a means of financing their operations.
Instead, there is a tendency to borrow from financial intermediaries such as banks and finance
companies. Typically, this borrowing is for periods of between one and five years, but it may
be longer. The term of the loan usually matches the economic life of the asset acquired. For
example, a loan to finance the purchase of a motor vehicle is often repaid over a period of three
to five years, which is roughly in accord with the economic benefits derived from the use of the
vehicle.
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MEDIUM TERM
(typically one to five years)
Term loans
Leasing
Hire purchase
The main forms of medium-term finance are term loans, leases and hire purchase.
Term loans
The borrower of a term loan enters a contract with the lender to repay the loan over a specified
term. Term loans can carry a fixed or variable interest rate. A fixed interest rate fixes the
repayments for the duration of the loan. For variable (or floating) interest rate loans, the
interest rate is determined by the lender and is usually set as a margin to a base reference rate
or index. Interest is compounded each business day and is payable at the end of each period or
term of the loan (usually for periods of one, three or six months). The interest rate is therefore
effectively calculated on the principal plus the interest on every business day, but is only paid at
maturity.
Much lending in Australia and New Zealand is at variable rates. For example, a loans interest
rate might be priced at several hundred basis points above the rate on 180-day bank bills.
The disadvantage is that the borrower does not know the quantum of their future cash flows.
Movements in interest rates are a source of risk for a business, and interest rate fluctuations can
adversely affect a companys profitability. This topic is covered in the unit on business risk.
Types of loans
Lenders classify term loans into two categories:
Intermediate-term loans
Usually running less than five years, these loans are generally repaid in monthly instalments,
sometimes with balloon payments (particularly large payments due at the end of the loan) from
a companys cash flow. Repayments are often tied directly to the useful life of the asset being
financed.
Long-term loans
These loans are commonly set for more than five years. Most are between 3 and 10 years, and
some run for as long as 20 years. Long-term loans are collateralised by a companys assets and
typically require quarterly or monthly payments. These loans usually carry wording that limits
the amount of additional financial commitments the business may take on (including other
debts, but also dividends or principals salaries). Long-term loans are covered in the unit on
long-term financial management.
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Loan approval
There is an abundant and highly differentiated supply of fixed-term loan products in the
Australian and New Zealand markets. Initial negotiation for a loan may be directly between
the applicant and the financier or it may occur via a finance broker. However, the degree of
financial strength required to receive loan approval can vary tremendously from bank to bank,
depending on the level of risk the bank is willing to take on.
Approval for a loan of a relatively small amount, particularly in cases where the lender knows
the applicant, may be rapid. Where the loan is for a comparatively larger amount, the approval
process is likely to involve much greater scrutiny by the financier. If the funds are for a project
that could materially impact upon the future of the applicants organisation, the financiers
credit assessment could include examination of financial statements, business plans, past
performance and experience of the companys senior management. The purpose is to evaluate
whether future cash flows and profitability will be sufficient to enable the applicant to repay the
debt and service interest costs.
Depending on what financial information the borrower can provide, a commercial loan
approval may be achieved through either of the following loan types:
Full Documentation (Full Doc): Commercial loans for borrowers who are able to
demonstrate that they can service the loan principal with up-to-date detailed financial
statements covering at least the last two years.
Light Documentation (Lite Doc): Commercial loans for borrowers who fall just outside the
Full Doc criteria and who can clearly demonstrate serviceability through information such
as financial statements spanning less than two years or rental income.
Low Documentation (Low Doc): Commercial loans designed for borrowers who cannot
demonstrate serviceability through traditional means but can obtain an accountants letter
confirming that they can service the debt.
No Documentation (No Doc): Borrowers who cannot provide any income verification and
also cannot obtain an accountants letter to confirm that they can service the debt may still
obtain a commercial loan by signing an affordability statement which confirms that they
understand the amount of the repayments and that they can afford the debt.
A lender will typically require collateral in the form of security interests over the borrowers
plant and equipment or other goods, land and buildings, or by requiring personal guarantees
from directors and taking security interests over their real property assets.
Loan repayments
Once the rate, term and amount of the loan have been agreed, the loan repayments can be
calculated. These factors relate to the present value of an annuity, and for a loan for which both
principal and interest are to be repaid in arrears in instalments over the term of the loan, the
calculation for repayments is:
PV = PMT # ^PVIFAhi,n
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Repayment schedule
It can be seen that the repayments extinguish both the interest and principal owing to the
lender over the term of the loan.
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This can be contrasted with a term loan that requires repayments of both principal and interest:
such a loan would require monthly instalments in arrears of $888,486. Note that this payment is
calculated as the present value of the loan ($10 million), divided by the PVIFA of $1 in arrears at
an interest rate of 1% for 12 periods (i.e. $10,000,000 11.2551).
On an annualised basis this is illustrated in the following table:
Hence, a developer whose major cash inflow occurs when the project is sold is likely to prefer
the former alternative.
Note: The emphasis of this example is on the contrast in timing of repayments between the
two loan types and not the detailed calculations themselves.
Alternatively, borrowers may negotiate relatively low repayments during the loan term that
repay part of the principal with a large residual value or balloon payment (or simply, a
balloon) at the end of the loan. A balloon payment reduces the amount of the regular monthly
repayments in exchange for owing the financier a lump sum at the end of the loan. For example,
if a business borrows $50,000 over five years and elects to have a $12,500 (25%) balloon payment
on their loan, then their monthly repayments will be lower than if they had no balloon payment;
however, they will still owe the financier the balloon payment of $12,500 at the end of the
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fiveyear loan. The amount of a balloon payment may be represented as an absolute dollar value
or a percentage of the borrowed amount.
The primary benefit of a balloon payment is the reduction in the size of the regular monthly
repayments due over the term of a loan. This, in turn, can provide a range of additional benefits
to the borrower, such as increasing affordability and maximum loan size, assisting with cash
flow management, and more closely matching the repayment of the loans principal with the
economic benefits of the asset being acquired over time.
Balloon payments are popular for motor vehicle loans since they reduce the cash outflows
required to service the loan and, often at the end of the loan, the vehicle is sold, with the
proceeds used to pay the residual and finalise the loan. If the borrower wishes to retain the
vehicle, then they could also choose to refinance the balloon payment into another loan. If the
borrower wishes to change cars, they can sell their current vehicle and use the sale proceeds to
pay the balloon payment and finalise their current loan.
Loan fees
Banks charge businesses fees on loans. The two main types of fees payable are an establishment
fee, usually charged upfront as a dollar amount, plus an ongoing line of credit or service fee
(usually a percentage amount).
Recall our previous loan repayment example in which a business negotiates a loan to borrow
$30,000 at an annual rate of 10%, which will be repaid in annual instalments in arrears over five
years. If the bank charges a $500 establishment fee on the loan, then the fee, in effect, reduces
the proceeds of the loan available to the borrower, who would receive only $29,500.
The effect of the establishment fee is to increase the effective or implicit interest rate on the
loan. To calculate the effect on the rate, we use $29,500 as the present value of the loan whose
payment remains as $7,913.92.
Thus, $29,500 = $7,913.92 (PVIFAi,5),
and PVIFAi,5 is equal to 3.7276 (i.e. $29,500 $7,913.90).
Using a financial calculator, or trial and error, this equates to an implicit interest rate of about
10.7%. This means that the borrowing is comparable to a loan without any establishment fees of
10.7%.
Leasing
Leasing is a key source of medium-term finance for an organisation. A lease conveys the right
to use an asset in return for a regular series of payments over an agreed period of time. A wide
variety of assets can be leased. Physical assets such as land, plant and equipment, and motor
vehicles are very common, but intangible assets such as patents and mineral rights can also be
leased.
Under a lease, the lessee does not acquire the asset, but instead acquires the right to use the
asset for an agreed period of time in return for regular payments. The owner of an asset is
called the lessor and the user of the leased goods or property is the lessee. This means that,
during the term of the lease, the lessee is never the legal owner of the asset.
At the end of the lease agreement, the lessor may allow the lessee to purchase the asset. This
contrasts with term loans, where the borrower is the owner, and the lenders rights to the asset
are limited to security for the loan. Finance companies and banks are the main sources of lease
finance in Australia and New Zealand.
Lease payments are generally payable in advance, meaning that they are paid at the beginning
of each period. This, too, contrasts with term loans, where payments are made at the end ofthe
period. Leases are for specific assets; a term loan may be used to finance the purchase of an
asset or may be used to generally fund the business. A lease typically features a guaranteed
residual or balloon payment at the end of the term.
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Finance leases
A finance lease is an agreement where the lessee incurs most of the risks and receives most of
the rewards from the asset being leased. Typically, the term of a finance lease is four to five
years, but it can be considerably longer. The lessor is usually a financial institution such as a
bank or a finance company. The role of these institutions is to provide finance rather than to
rent out assets, and so it is more advantageous for them if the lessee acquires the asset at the
end of the lease term or bears the fair value risk related to the disposal.
Usually, the lease term is for the major part of the economic life of the asset. Under a finance
lease, ownership is typically transferred to the lessee at the end of the lease term at an agreed
amount. Finance leases are usually non-cancellable, or cancellable only if the lessee pays costs to
the lessor, with the lessee often also responsible for maintenance costs.
The sum of the repayments for finance leases is usually larger than the value of the asset being
leased. This means that part of these repayments can be thought of as an interest charge, similar
to that on a term loan, and that the lease is a form of lending by the lessor. As a form of lending,
a lease is a substitute for other forms of borrowing on the part of the lessee. In most lease
agreements the interest rate is actually not specified. This is usually required to be calculated by
an accountant and is referred to as the implicit interest rate.
Under a finance lease, the lessee usually guarantees and/or agrees to pay a lump-sum payment
at the end of the lease. This is known as the residual value and is akin to a balloon payment at
the end of a term loan. Payment of the residual value to the lessor will usually result in transfer
of asset ownership to the lessee, however, the lessee is not obligated to take ownership. The
residual value in a finance lease typically ranges from 10% to 40% of the original purchase cost
of the asset. Finance lease providers must be careful not to set the residual value above the
estimated fair value of the asset at the end of the lease term.
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There are various ways of organising finance leases, as shown in the table below:
Finance leases
Type Details
Direct financing lease In this type of lease the lessor is simply the financier. The lessor is not the manufacturer
or a dealer, but purchases the asset and leases it to the lessee. The lessors main
source of revenue is through interest included in the lease repayments received. This
transaction is an alternative to lending arrangements where a borrower uses loan
proceeds to purchase an asset
Sales-type lease Under this type of lease the lessor is also the vendor. For example, a computer
manufacturer may lease out its own equipment, thereby competing with an
independent leasing company. It is accounted for in the same way as a direct finance
lease, except that profit on the underlying sales transaction is recognised at the time
of sale
Sale and leaseback Under a sale and leaseback arrangement, the owner of an asset sells the asset to
arrangement another party, usually a financial institution, for an amount that is equal to its current
market value. The asset is then immediately leased back to the owner, who has
given up title to the asset in return for access to cash and agrees to the regular lease
payments. This is common with real estate and is a way of generating cash, that is,
borrowing without having to give up use of the property. Many commercial buildings,
shopping centres, factories and marinas have been subject to sale and leaseback
agreements
Leveraged leasing In a leveraged lease, the lessor borrows funds from a lending institution to finance the
purchase of the asset being leased. It differs from other forms of lease arrangements
because it involves three or more parties, rather than two, and allows risk sharing on
very large projects where the lessor does not wish to assume all of the risks. Leveraged
leases are tax-oriented because the lessor enjoys all the tax benefits of ownership,
such as depreciation, while the lessee claims the lease payment as a deduction
Operating leases
An operating lease is, essentially, a rental agreement, and is normally offered by suppliers of
assets and by specialist financing companies. It differs from a finance lease because substantially
all the risks and rewards incidental to the ownership of the leased asset remain with the lessor.
This is a common form of lease arrangement for computer equipment and telephones.
Under an operating lease, ownership of the asset does not pass from the lessor to the lessee.
Most operating leases are short-term arrangements, and no asset or liability is recorded in the
balance sheet of the lessee. The lease payments are simply recorded as expenses in the profit
and loss statement.
Operating leases may be cancellable by the lessee, provided that sufficient notice is given, at
little or no cost. They enable a business to obtain the use of an asset that is required for only a
short period. In addition, they may also stipulate that the lessor is responsible for maintaining
the asset, insuring it and for paying any relevant government charges. The fact that the risks
and rewards of ownership remain with the lessor is reflected in operating leases in the form of
higher rentals.
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Therefore, the impact on the financial statements depends upon whether a lease is classified as
a finance lease or operating lease. The overriding test to determine whether a lease should be
classified as a finance lease or an operating lease is the economic substance of the transaction,
not the legal form of the agreement. If the lease agreement transfers substantially all the risks
and rewards of the asset from the lessor to the lessee, then the lease is a finance lease. All other
leases are operating leases.
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As the total payments on the lease exceeded the fair value of the leased asset, then the lease
implicitly incorporates an interest component, and so it is really a substitute for other forms of
debt.
At the end of the lease, the lessee will be required to pay out the guaranteed residual of
$11,500. At this time, the lease liability will be extinguished in the books of the lessee.
The lease asset will be depreciated over a six-year period since the lessee will take ownership
at the end of the lease term. If the lessee did not expect to take ownership of the asset, then
the leased asset should be depreciated over the shorter of the lease term or its useful life.
Each year, a depreciation expense of $5,000 will be recorded (i.e. $30,000 6 years). While the
depreciation expense is recorded for accounting purposes, it is not an allowable deduction for
tax purposes. Generally there would be a deduction for the lease payment.
At the end of the first year of the lease, assuming that the lease agreement was entered into
on the first day of the accounting period, the profit and loss and balance sheet will show the
following amounts:
Expenses
Non-current assets
$25,000
Current liabilities
Non-current liabilities
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The diagram below separates out cash flows associated with the investment decision versus
those of the financing decision.
Investment Financing
cash flows cash flows
Net cash inflows
generated by asset
Lease
Lease payments
Maintenance,
insurance and repair
costs (if lessee
responsible)
Tax savings
Buy
Purchase cost
Maintenance,
insurance and
repair costs
In the example above it is easy to calculate the NAL. In more complex analyses it is necessary
to calculate the PVL and the PVB using discounted cash flow analysis. This type of analysis is
covered in detail in the unit on investment decisions.
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The PVL is calculated as the present value of the future lease cash flows. It should equal the
upfront value that the lessee receives from entering the lease agreement. The PVB is the
present value of the future lease cash flows discounted at the interest rate of an equivalent
loan. It is discounted at the rate that the business would have to pay on a loan, since this
indicates how much a lender would be willing to lend if the companys future cash flow
commitments were identical to those on an alternative lease.
Advantages of leasing
The advantages of leasing versus the outright purchase of assets include the following:
Small initial outlay for the lessee when compared to asset purchase, improving liquidity.
Generally easier and quicker to arrange than if borrowings were required to purchase an
asset outright. In particular, the lessee may avoid many of the restrictive covenants usually
included as part of term loans.
Unlike an overdraft facility, this source of finance provides relative certainty. As long as
contractual payments are made, the finance cannot be withdrawn.
For smaller companies in particular, this source of finance is often available when other
more structured loan facilities are not.
Fixed rate interest payments are often agreed as part of the contract, allowing for more
certainty in cash flow forecasting.
There are tax advantages associated with the tax deductibility of lease payments.
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Features of hire purchase financing are:
Flexible contract terms ranging from one to five years.
Residual value (balloon payment or final instalment) may be placed on contract, which
lowers instalments over the term of the contract.
The interest rate and monthly repayments are fixed.
The finance is usually secured against the asset, allowing lower interest rates.
The tax treatment may be different from the accounting treatment.
Quiz
[Available online in myLearning]
ACT
Activity 12.1
Lease versus buy decisions
Introduction
Lease versus buy decisions involve analysing the incremental cash flows and determining the
best alternative for each decision based on quantitative analysis. Before making a final decision,
the management accountant will also assess the qualitative aspects.
This activity links to learning outcome:
Outline the nature and features of medium-term finance.
At the end of this activity you will be able to make decisions on whether to lease or buy
equipment using quantitative analysis.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
You are a management accountant at Accutime reporting to Graham Anderson, the chief
financial officer (CFO).
Accutime needs to invest in extra capacity at its Sydney plant, and an additional Sakikawa SX
robot is required to achieve this objective. The board of directors have already approved the
required $1 million investment in the robot, which is to be installed in unutilised space within
the clean room.
It has been established that the robot could be entirely financed by drawing down an existing
bank loan facility at an annual interest cost of 7.8%.
Three of the largest and most reputable finance companies that provide capital equipment
leases have been contacted, but unfortunately two of them have declined to offer a lease due to
their lack of knowledge of such specialised equipment. This has resulted in only one lease offer
to compare with the bank loan facility.
The terms of the lease include annual lease payments of $205,000 due at the beginning of each
year, for five years. Under this particular lease, there is no option for Accutime to purchase the
asset at the end of the lease term, as ownership remains with the leasing company. In contrast,
under the terms of the loan facility agreement, Accutime would own the robot outright at the
end of five years.
Additional costs directly related to the acquisition of the robot include electricity costs of up to
$50,000 per annum and 1.5 extra full-time salaried positions at an annual cost of $165,000. There
would also be an estimated immediate increase in net working capital of $170,000. The salvage
value of the Sakikawa SX robot is expected to be $225,000 at the end of five years. The allowable
depreciation rate for tax purposes is 12.5% using the prime cost (straight-line) depreciation
method and the effective company tax rate is 30%.
ACT
Task
For this activity you are required to determine whether the Sakikawa SX robot should be
financed by a lease or bank loan facility.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
There are no further readings for this unit.
References
The following is a summary of all other sources referred to in the preparation of the content for
this unit.
Australian Taxation Office, accessed 7 February 2014, www.ato.gov.au Sitemap General
PAYG instalments In detail Monthly PAYG instalments Monthly pay as you go
instalments.
Dun & Bradstreet 2013, 60% of invoices paid late, accessed 7 February 2014, www.dnb.com.au
News 60% of invoices paid late.
Miniwebtool PVIFA Calculator, accessed 7 February 2014, www.miniwebtool.com Financial
Calculators PVIFA Calculator.
Schwartz, C, Hampton, T, Lewis, C and Norman, D 2006, A Survey of Housing Equity
Withdrawal and Injection in Australia, accessed 7 February 2014, www.rba.gov.au
Publications Research Discussion Papers Archive 20012010 2006 A Survey of
Housing Equity Withdrawal and Injection in Australia.
CC
Core content
Unit 13: Long-term financial management
Learning outcomes
At the end of this unit you will be able to:
1. Compare the major types and sources of long-term finance.
2. Apply the major theories and practical tools to the evaluation of capital structure decisions.
3. Apply the major theories and practical tools to the evaluation of dividend decisions.
Introduction
Long-term financial management focuses on an organisations financial planning, with a typical
time frame of five years or more. Investment decisions should be aligned to the achievement
of the organisations long-term goals, usually outlined in its strategic plan. Investments can be
funded through equity or debt, or a combination of the two. This unit examines the different
types of long-term financing methods and their associated rationales.
The diagram below summarises the main sources of long-term finance discussed in this unit.
It is not an exhaustive list; however, it provides a summary of the typical financial instruments
available in the finance markets.
LONG-TERM FINANCE
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Learning outcome
1. Compare the major types and sources of long-term finance.
Businesses require money (otherwise known as funding or capital), to pursue their objectives.
Funding may be required at the commencement of a business, and is usually needed over the
course of its existence.
There are two broad sources of funds: equity and debt. Equity, denominated by the issuing
of shares, reflects the fact that the shareholders share in the assets and profits or losses of the
business. Debt, evidenced by a loan arrangement between two parties, reflects a commitment
that the principal and interest will be repaid by the borrower to the lender. Most organisations
look to employ a combination of debt and equity for their long-term financing. However,
debt can only be used if there is sufficient equity in the business to make borrowing a safe
proposition from the lenders point of view.
Ordinary shares
Ordinary shares, whether traded publicly or privately, are a businesss primary source of
capital. Ordinary shareholders purchase an ownership interest in a company that entitles them
to vote on matters put before shareholders. Their percentage ownership determines the weight
of their vote.
Ordinary shareholders can receive a proportional share of the organisations profits in the form
of dividends, should one be declared for ordinary shareholders. Companies are not obliged to
pay a dividend, but when they do the dividend reduces the value of shareholder claims against
the company.
In Australia and New Zealand dividends are no longer required to be distributed solely from
profits; however, they may only be paid if certain solvency and other tests are met. Upon
payment of a dividend, the market value of the company will, in theory, fall by the value of
the cash paid out. There is no change in the wealth of the shareholders, just a change in its
nature. Prior to the dividend payment the shareholders hold their wealth as shares, while after
payment they hold their wealth both in shares and in cash.
Ordinary shareholders are also entitled to share in the companys assets should the business
be wound up. However their interest is a residual one, since, in the event of liquidation,
they are entitled to a return of capital only after all other obligations to claimants have been
settled. The issue price of an ordinary share indicates the limit of a shareholders liability to
contribute towards payment of the companys debts in the event the company is wound up.
The shareholder is not personally liable for the debts and obligations of a company limited by
shares.
The advantages of issuing ordinary shares include:
Shares have no maturity date.
Shares can be sold or liquidated at any time by the share owners (subject to any restrictions).
There is no requirement for a company to return the shareholders investment, in contrast to
investors who provide debt finance to a company.
Raising equity by issuing ordinary shares lowers the interest rate that a company will have
to pay on debt finance. The higher the proportion of equity in a companys capital structure,
the less risk there is that debt holders will not be repaid. Consequently equity has a higher
cost to the company.
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The disadvantages of issuing ordinary shares include:
Equity finance is more expensive than debt finance.
There is a potential dilution of ownership and control when new shares are issued. Existing
shareholders must outlay additional cash or face dilution of their ownership interest.
There are high transaction costs. The process of actually issuing the shares and raising
money can be difficult and the costs high.
Preference shares
Preference shares are a security that gives the holders preference over ordinary shareholders
regarding the payment of dividends. In the event of liquidation they are repaid before ordinary
shareholders. Preference shares are currently not a major source of finance for companies, but
tend to be used as a special purpose method of financing, where one or more of the equity and
debt features can be used to the advantage of the issuing company.
In addition, a company can only pay preference dividends from its income after the interest
on its debt has been paid and before the payment of dividends to ordinary shareholders. This
is the essential distinction between a preference share and a debenture. Debenture holders are
not owners of the company and must be paid their coupon interest irrespective of whether the
company has had a good or bad year.
Redeemable preference shares may have a fixed or optional redemption date on which the
shareholders are repaid the face value of their shares. These shareholders receive a fixed return
on their investment but do not have the opportunity to share in the growth (i.e. profits) of the
company. Redeemable preference shares have many of the characteristics of debt, despite being
shares.
Preference shareholders may have limited voting rights in specific circumstances.
The types of preference shares include:
Cumulative dividends, including prior unpaid dividends, must be paid before ordinary
dividends can be paid.
Non-cumulative prior unpaid dividends do not have to be paid.
Participating preferred shareholders receive the dividends plus additional earnings based
on specified conditions.
Convertible the preference share can be exchanged for a specified number of ordinary
shares.
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Retained earnings
Retained earnings represent an internal source of equity financing. This takes the form of
surplus cash in the business derived from profits that the company has decided not to pay as
dividends or return of capital. Sourcing retained earnings is very common for private startup
companies that do not yet have a sufficient financial history to obtain other sources of funding.
This type of funding is, however, usually limited to a short period of time and does not fully
satisfy the companys growth objectives as there is often a need for additional funding.
Private equity
The private equity market is a source of funding for smaller and riskier companies, and tends
to be a long-term funding investment decision for the shareholder. Private equity can be more
attractive than listing on a stock exchange, and, in some cases, the amount of capital being
raised may be too small to justify a stock exchange listing. The securities issued to investors in
the private equity market are not publicly traded.
When a private company decides to raise equity, it can seek funding from several potential
sources, including family, friends, angel investors, venture capital firms, and institutional and
corporate investors as follows.
Family and friends For many start-up companies, the first round of private equity
financing is often from family, friends or acquaintances of the entrepreneur.
Angel investors These include individual investors who buy equity in small private
organisations.
Venture capital firms Professional investment firms that specialise in raising money to
invest in the private equity of start-up organisations. Often, institutional investors such as
superannuation funds are investors in the venture capital firm. A venture capital firm can
provide substantial capital for companies and, in return, demand a great deal of control.
They often use their control to protect their investment and may thereby perform a key
monitoring role for the company.
Institutional investors These can include superannuation funds, insurance companies,
investment companies and charities that manage large quantities of money. They may
invest directly in private companies or via venture capital firms. Institutional investment
in private equity has grown in recent years, and today many superannuation funds have
exposure to private equity as a discrete asset class.
Corporate investors A corporation that invests in a private company can be known as a
corporate investor, corporate partner, strategic investor or strategic partner. Along with
a desire for investment returns, a corporate investor may invest for strategic reasons. An
example of this is Microsoft Corporation which, as part of a strategic partnership, invested
US$240 million in 2007 in the social networking site, Facebook. This deal, together with a
1.6% stake in Facebook, gave Microsoft control over its banner advertisement placement
outside the United States.
The following diagram illustrates the number of private equity transactions as a percentage of
total transactions across the globe during the financial years (FY) 20092013.
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PE as a % of total transactions
Number of PE transactions as a % of total transactions Value of PE transactions as a % of total transactions
15% 30 %
14 14 14
13 13 13 13 13
12 12 24
23 23
11
10% 10 20%
9
9 17
16
8 15 15
7 14
13
6 6 6
11
5% 5 5 5 10%
9 9 9
8
7
3
2 2 4
3 3 3
2
FY2009 FY2010 FY2011 FY2012 FY2013 FY2009 FY2010 FY2011 FY2012 FY2013
Australia New Zealand UK US Australia New Zealand UK US
Source: AVCAL (2013), Market Observations Australia and New Zealand, www.avcal.com.au Statistics & Research
Publications & Data Market Observations.
Private equitys contribution to overall transaction activity in Australia and New Zealand still
has room to grow compared to the levels observed in the United States (US) and Europe. Private
equity transactions in FY 2013 made up 14% in both the US and Europe of the total mergers and
acquisitions volume, compared to 5% and 6% in Australia and New Zealand respectively.
Further reading
The Australian Private Equity & Venture Capital Association Limited (AVCAL) 2013, Market
Observations Australia and New Zealand.
Public equity
The markets for shares in publicly listed companies exist in a large number of jurisdictions.
Stock exchanges have become very sophisticated and provide a reliable, secure, liquid and
cost-effective forum for trading shares in listed companies. On any typical trading day, prices at
which investors are willing to buy and sell shares (bids and offers) are available for the majority
of the companies listed.
Public equity investors typically fall into two groups:
Private individuals or retail investors who invest directly for themselves.
Institutional investors investors who invest large amounts of money on behalf of others,
such as superannuation fund managers.
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Institutional investment it is easier to attract institutional and professional investors.
Provides an exit strategy for early-stage investors a mechanism for founders of a company
or family interests to exit their investment.
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1. Rights issues
Rights issues are a popular seasoned equity offering in Australia and New Zealand. A rights
issue is a secondary issue made to the existing shareholders in proportion to their existing
holdings. With a rights offer, the company offers the new shares to existing shareholders
only. It therefore protects existing shareholders from dilution of their control of the company.
Rights issues are typically renounceable, which gives shareholders the right to sell their
entitlement to purchase the new shares to another investor. Some rights issues, however, are
nonrenounceable. In this case, shareholders must either exercise their rights or let them lapse;
they cannot sell the rights to another investor.
There are three key dates in a rights issue:
The announcement date. On this date the company will announce the terms of the rights
issue. The underlying share is said to be trading cum-rights (i.e. with the rights attached).
The ex-rights date. On this date the rights are issued to the holder of record. The following
day the rights will begin trading separately from the underlying shares. The shares are also
said to be trading ex-rights at this time (i.e. without the rights attached).
The expiration date. The rights expire at this point. The holders of the rights, whether they
were issued the rights or have purchased them on-market, have until this date to exercise
their rights.
Rights trading
Rights will only be valuable when they commence trading if they entitle the holder to purchase
additional shares at a price below the current market price of the share; i.e. the subscription
price must be below the ex-rights share price. This discount is typically in the region of 10%
to 25%. The risk the company faces is that the market price of the shares falls below the
subscription price of the rights issue. If this happens, shareholders will be reluctant to take
up their entitlements to purchase new shares and the equity raising will fail. Any shareholder
wanting to increase their stake in the company would opt to buy additional shares on the
market at a price lower than the subscription price. Companies can mitigate this risk by having
the rights issue underwritten whereby the underwriter will be obligated to exercise the rights
shareholders have allowed to lapse.
The number of new shares a company must sell to raise the equity capital is:
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The theoretical value of a right is the difference between the theoretical ex-rights share price
(i.e. the market price after the rights issue) and the subscription price. It is determined by the
following formula:
N ^Pcum Sh
R=
N+1
When the shares begin trading on an ex-rights basis (i.e. without the rights attached), the share
price will decline by the value of a right (which would have been reflected in the cum-rights
share price) (V). This price adjustment is given by the following formula:
R
V= N
Pex = Pcum V
These formulas have been derived under the assumption that shareholder wealth under a
renounceable rights issue is not affected by the terms of the issue, or by whether the shareholder
sells or exercises the entitlement to purchase new shares.
The example below demonstrates how to calculate the theoretical right issue value, and also
shows that shareholder wealth remains unchanged regardless of whether shareholders exercise
or sell their rights.
= 1.00
V = 5 $0.20
Now consider a shareholder owning 100 shares on the announcement date. This shareholder
is offered the right to purchase 20 additional shares at a subscription price of $7.00. The
alternative is to sell the 20 rights at $1.00 each.
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The advantage of a rights issue is that it is cheaper than other SEOs regarding the fees that
have to be paid to lead banks and other intermediaries involved in the transaction. However,
the nature of rights issues, i.e. issuing to existing shareholders, does not help to diversify a
companys shareholder base.
2. Placements
A placement is a secondary share issue offered to a select group of shareholders, institutions or
companies that is not made available to all existing shareholders. Placements enable an issuer
to raise capital relatively quickly and in a cost-effective manner from targeted investors, and are
often preferred over rights issues for that reason.
The advantages of placements include:
No prospectus is required. They can be undertaken without a prospectus, although some
level of disclosure is still common.
Underwriting can often be avoided.
Speed and certainty: sometimes placements can be closed in a matter of days.
They can be made at a price close to market value.
The limited requirement for documentation is due to the fact that placements are made to
sophisticated investors, who are treated differently to public investors in terms of the legal
disclosure requirements. Placements are often conducted together with a share purchase plan
(SPP) to facilitate participation by smaller, existing security holders.
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Under an SPP, in both Australia and New Zealand, listed entities can issue a maximum of
$15,000 in new securities to each existing shareholder in any 12-month period (ASIC Class
Order CO 09/425; Securities Act (NZX Share and Unit Purchase Plans) Exemption Notice
2010). SPP issues are often conducted in conjunction with a placement to institutional investors,
and are designed to give public investors an opportunity to participate in the companys capital
raising.
Number 140 21 57 61
Equity raised $44.8 billion $15.2 billion $30.1 billion $8.0 billion
Average size $320 million $723 million $543 million $131 million
Fees $788 million (1.76%) $365 million (2.4%) $720 million (2.32%) $23 million (0.3%)
Source: Connal S and Lawrence M 2010, Equity capital raising in Australia during 2008 and 2009, ISS Governance Series.
Note: Average dilution and average expansion are calculated as the percentage increase in issued capital based on the
issued capital at the time the placement was announced. The fee percentage is calculated by dividing the fees paid by
the amount of equity raised.
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Convertible notes
The convertible note has been the most common form of convertible debt security issued in
Australia and New Zealand. The underlying security is an unsecured bond type instrument that
pays the holder a regular coupon amount and a face value amount at the end of the note term. It
also provides an option to convert the face value of the note into ordinary shares.
Features
The conversion ratio is the stated number of ordinary shares the security can be converted
into.
The conversion value is the conversion ratio multiplied by the market price of the shares
when the holder converts the securities.
The value of a convertible security is the price the convertible debt or preference shares
would sell for in the absence of its conversion feature.
The conversion premium is the difference between the market price of the convertible note
and the higher of the security value and the conversion value.
Further reading
Hanrahan, A 2011, Hybrid securities? Whats that?.
Bayley, P 2012, Hybrids: Why take bond returns for equity risks?.
Corporate debt can be either a private debt negotiated directly with a bank or small group of
investors, or a public debt, which trades in a public market.
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Private debt
Private debt is that debt which is not publicly traded, and is a common source of finance for
both private and public companies.
The advantage of private debt is that it avoids the cost and delay of registration with regulatory
bodies such as the Australian Securities and Investment Commission (ASIC) in Australia
and the Securities Exchange Commission (SEC) in the US. The main disadvantage is that it
is illiquid, meaning that it is hard for a holder of the organisations private debt to sell it in a
timely manner.
The private debt market is larger than the public debt market, and comprises several segments,
including bank loans and private placement.
Bank loans
Banks provide private debt in many forms, including term loans, syndicated bank loans,
revolving lines of credit and asset-backed lines of credit. Term loans were covered in detail in
the unit on short and medium-term financial management. These loans last for a specific period
of time and require repayment of the principal at expiry of the term. A syndicated bank loan
is a single loan funded by a group of banks rather than just one bank and usually involves a
member of the syndicate (the lead bank) negotiating the terms of the loan.
A revolving line of credit is a credit commitment for a specific period of time, typically two
to three years, which a company can use on a needs basis. An asset-backed line of credit is a
type of credit commitment where the borrower secures a line of credit by pledging an asset as
collateral.
Private placement
This is a bond issue that does not trade on a public market, but rather is sold to a small group of
investors. A private placement does not need to register with regulatory bodies such as ASIC in
Australia or the SEC in the US. It is less costly to issue and often a promissory note is sufficient.
Public debt
Companies are able to borrow by creating and issuing long-term securities to the public called
corporate bonds. There can be important differences between these securities, but they are
all essentially the same in terms of their cash flow pattern. They are issued at face value, after
which time the borrower makes regular coupon (interest) payments and the principal is repaid
in full at maturity.
The principal or face value of the bond is denominated in standard increments, usually $100
or $1,000. Corporate bonds pay coupons (an interest payment) to bond holders, usually semi-
annually. For example, a $100 bond with a coupon rate of 8% will pay $8 a year in instalments
of $4 every six months, or $2 every three months (per quarter).
Historically, corporate bonds are issued with a wide range of maturities. In the US it is
not uncommon to see maturities of 30 years, while most corporate bonds in Australia have
maturities of 10 years or less.
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Secured debt can include asset-backed bonds. These bonds can be secured by a pool of
mortgages or car loans for example.
The following example illustrates how a company used corporate bonds to raise additional,
long-term finance.
Obtaining overseas finance is a means of diversifying funding sources and achieving exposure
to foreign currencies. However, this potentially introduces exchange risk in addition to interest
costs.
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Equity The capital is not redeemable and the The cost of financing equity is high, and
company is not required to repay to investors expect a higher rate of return on
investors funds invested
The risk of financial distress is lowered, Raising additional equity capital can dilute
with no requirement to meet ongoing cash the share price and correspondingly reduce
flow commitments (i.e. interest/principal the overall market value of the company
repayments)
In practice, once a company establishes its
There is no requirement to pay annual dividend policy, it is often difficult to change
dividends it as both the shareholders and the market
have a set expectation that the dividend
Controlling and substantial shareholders are
payout ratio will continue
able to control/influence decision-making
within the organisation by virtue of their It can often be an expensive and lengthy
voting power and power to appoint the process to raise equity in public markets
board of directors
In the event of bankruptcy, equity holders
Note: Minority shareholders in public rank last in receiving returned capital
companies have little influence over the
companys actions
Debt The cost of debt finance is cheaper than The more debt a company carries, the higher
equity finance that is, the required rate the risk of financial distress and impact on
of return to shareholders is higher than profitability due to high interest payments
interest/coupon rates
Requires ongoing cash flow commitments
A company is able to obtain a tax deduction with interest and principal repayments;
for interest payments but cannot do so with thereby minimising cash available for other
dividends paid projects/investments
It spreads the risk for shareholders of large Debt holders have no voting rights so they
private companies. Debt can be used to fund cannot influence decision-making within the
growth plans. In the event the company company
experiences financial difficulty, the risk is
Debt facilities often have covenant
shared by debt/equity holders
requirements placing restrictions on a
Debt issuers have priority over equity company, such as a requirement to maintain
holders for repayment in the event of the a specified working capital ratio or interest
company liquidation cover ratio
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Growth phase of company The source of finance will depend on whether a company is in
the start-up, growth or mature phase of its life cycle. As mentioned earlier in this unit, start-
ups often rely on angel investors for funding. As a company grows, it may seek outside
sources of equity via an IPO process. Mature, established public companies tend to have
more options, accessing finance either through reissuing more shares, offering a rights issue
or accessing public and private debt markets.
Learning outcome
2. Apply the major theories and practical tools to the evaluation of capital structure decisions.
Capital structure refers to the proportions and types of investment of an organisation. It is the
mix of debt and equity used to finance activities. It is a vital element of a companys financing
decisions, and can have a significant impact on the organisations value and stability. An
organisations capital structure should be planned, as it is typically difficult to alter, especially
in the short term. This section focuses on the key theories of capital structure, and helps
demonstrate how the choice between debt and equity financing can impact value.
A term commonly used to define the capital structure of an organisation is the debt-to-value
ratio that fraction of an organisations total value that corresponds to debt: D(E+D).
High levels of gearing (or leverage) occur when debt is large in proportion to equity in an
organisations capital structure.
By increasing debt finance, an organisation reduces the earnings available to shareholders due
to the claim on the cash flows of the organisation in the form of interest and loan repayments.
Debt increases the variability of cash flows to shareholders and increases the risk of their
investment. New investors will require a higher return on equity to compensate for the
increased risk.
The level of gearing can affect both an organisations cost of capital and its dividend decisions.
An organisations decision to issue debt, equity or other securities to fund a new investment
presents many potential consequences. By far the most important question for a financial
manager is whether (and how) different choices will affect the value of the organisation.
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distress drive up the cost of debt and equity, pushing up the WACC and driving down the
value of the organisation. The compromise view is often referred to as the trade-off theory
because it views the optimal capital structure as reflecting a trade-off between the advantages
and disadvantages of debt.
The trade-off theory states:
Organisations should increase their gearing until it reaches the maximising level (the point
at which the costs and benefits of adding another dollar of debt are exactly equal).
The tax savings that result from increasing gearing are offset by the increased probability of
incurring the costs of financial distress and therefore maximising company value.
With higher costs of financial distress, it is optimal for the organisation to choose lower
gearing.
An optimal capital structure can exist, but will vary across companies in different industries.
The compromise view reflects that the value of an organisation does reflect its financing
structure. This is represented by the formula:
The value of a company equates to the present value of operational after-tax cash flows that
both equity and debt holders expect to receive in the future. When a company is 100% financed
by equity, that is an ungeared organisation (VU ), the value of the company is the maximum
available to equity holders as a dividend. This is shown in the following formula:
The total value of the geared organisation (VG ) equals the value of the equivalent ungeared
organisation (VU ), plus the present value of tax savings from debt which is expressed in the
following formula:
VG = VU + DT C
VG = VU + DT C PV financial distress
The expanded formula suggests that leverage has costs as well as benefits. Organisations have
an incentive to increase gearing to exploit the tax benefits of debt; however, with too much
debt, they are more likely to risk default and incur financial distress costs. However, what costs
should be included in financial distress is subject to differing views, but can include increased
interest costs, for example.
The diagram below summarises the key features of the traditional views, M&M I and M&MII,
as well as a compromise view of the M&M theories that brings them back into line with the
traditional position.
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Optimum Gearing
capital structure
Cost ke
M&M I 1958
Value is a function of the investment
decision, rather than the finance decision.
Two identical businesses with dierent
k0 (i.e. WACC) gearing should have identical values
and WACCs.
On gearing up, no force dominates.
kd The increased use of debt finance is
balanced exactly by an increasing cost
of equity, leaving the WACC unchanged.
In a perfect market there is no optimum
Gearing gearing level. Companies should focus on
the investment decision only.
Gearing
Source: Adapted from Cornelius, I 2002, WACC attack, CIMA Insider, March, p. 23, www1.cimaglobal.com Search
WACC attack Cost of capital final.
Required reading
Lynch, P 2009, Optimum capital structure in ACCA Student Accountant.
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G
U =
1 + ^1 t c ha E k
D
The following formula is then used to re-gear the asset beta using the revised D/E ratio. The
resulting equity beta represents the equity beta of an organisation with a gearing ratio of(D/E)*.
G = U :1 + ^1 t c ha E kD
D
By using these equations it is possible to adjust the cost of equity to reflect the gearing of
the organisation and then calculate an appropriate WACC. The basic WACC formula can
be theoretically adjusted to deal with differing business and finance risks, and to create
riskadjusted costs of capital suitable for any situation.
* Note: These formulas are appropriate in a classical tax system. They are also based on the
assumption that the beta of debt is zero.
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Example: Using the beta de-gearing and gearing formulae to recalculate the cost of equity
A company has an equity beta of 1.25 and is financed by a 65% debt/35% equity mix (in market
value terms). Its investment bank suggests that the market would be more comfortable with
a 50% debt/50% equity mix (in market value terms) and is recommending an equity issue to
repay some bank debt. What will the impact be on the companys cost of equity if the risk-free
rate is 5%, the market premium is 6% and the effective company tax rate is 30%?
The companys current cost of equity can be calculated as:
ke = rf + G ^rm rf h
= 0.05 + 1.25 ^0.06h
= 0.125 or 12.50%
The companys ungeared or asset beta under the current capital structure of 65% debt/35%
equity is:
G
U =
1 + ^1 t c ha E k
D
= 1.25
1 ^0.70h` 0.35 j
+ 0.65
= 1.25
2.3
= 0.54
The companys equity beta under the proposed capital structure of 50% debt/50% equity will
be:
G = U :1 + ^1 t c ha E kD
D
Note that the reduction in gearing reduces the equity beta from 1.25 to 0.92. This will reduce
the cost of equity. The cost of equity under the proposed capital structure will be:
ke = rf + G ^rm rf h
= 0.05 + 0.92 ^0.06h
= 0.1052 or 10.52%
That is, the proposed restructuring will reduce the cost of equity from 12.50% to 10.52%.
Required reading
Cornelius I, 2002, If the CAPM fits .
Important clarification: The author has advised that the beta of XYZ plcs corporate debt should
have been given as 0.2.
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The fact that most cited financial flexibility and credit ratings as important suggests that
maintaining spare debt capacity, and avoiding distress and a credit downgrade is a major
consideration for CFOs. Earnings volatility was also an important consideration for many and
this is consistent with the trade-off theorys prediction that organisations use less debt when the
probability of bankruptcy is higher.
The survey showed that the most important factors considered in the decision to issue common
stock (i.e. ordinary equity) were:
EPS dilution.
The magnitude of equity overvaluation/undervaluation.
Selling stock at high prices.
Providing shares to employee bonus/option plans.
Maintaining target debt/equity ratio.
Diluting holdings of certain shareholders.
Interestingly, EPS dilution was the most important consideration. This factor plays no role in
formal capital structure theory. CFOs again showed support for the trade-off theory when a
majority (52%) indicated that they would issue equity to maintain a target debt/equity ratio.
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Financial flexibility
Financial flexibility refers to the impact of alternative financing choices on the ability of the
company to raise funds in the future. This usually means ensuring that the company has spare
debt capacity so that it is in position to take advantage of unexpected opportunities or overcome
unforeseen problems. A company that lacks the ability to raise additional debt finance might be
forced to raise equity at a time when the share price is very low - an expensive way of raising
equity.
Risk
Risk refers to the impact of alternative financing choices on the ability of the company to meet
fixed financial commitments such as interest, principal repayments and preference dividends,
even in adverse circumstances. Taking on more debt increases the risk of the organisation failing
to meet these commitments, particularly if the operating cash flows are volatile. In general, the
greater the volatility of operating cash flows, the less debt the organisation can handle.
Income
Income refers to the impact of alternative financing choices on returns to shareholders as
measured by EPS or return on equity (ROE). For example, interest costs reduce the reported
accounting profits (or earnings). Many managers are concerned with the earnings per share
(EPS) they report because they believe that it affects the share price. If the earnings/price ratio%
(the inverse of the P/E ratio) is lower than the after-tax cost of debt (%), EPS will be higher
under an issue of ordinary shares than under a debt issue that raises an equivalent amount of
funding, as it will reduce the risk of the organisation and interest expense.
Control
Control refers to how the alternative financing choices affect control of the organisation.
Management might be reluctant to pursue a placement of equity to new investors since this
will dilute the ownership interest of existing shareholders. The alternative might be a rights
issue allowing existing shareholders to maintain their proportional ownership of the company.
Control is also a consideration in the use of debt financing. For example, covenants in loan
agreements can restrict the activities of the company. In an extreme case, the excessive use of
debt could cause financial distress and lead to shareholders losing control of the company to
creditors.
Timing
Timing refers to the impact of current economic conditions and the environment in capital
markets on the merits of alternative financing choices. These may make one source of financing
more attractive than another. For example, low share prices would discourage equity issues
while low interest rates would encourage the use of long-term debt instruments such as bonds.
Other
Other refers to anything else that is relevant to the financing decision, and factors specific to
the organisation. For example, how quickly are the funds needed? Should the market for the
companys shares be widened? If bonds are issued, should they be subordinated?
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Example Using the FRICTO framework to determine the best source of financing
David Smith is an accountant for an ASX-listed global infrastructure fund that has investments
in Australia, New Zealand and Europe. The fund has an opportunity to acquire a significant
stake in a several European airports that are being privatised. The fund must decide whether to
finance this acquisition through either the issue of an equity or debt instrument.
The funds assets include electricity and gas transmission networks, ports and railway lines, toll
roads, prisons, hospitals and schools. Revenue would be derived from regulated tariffs on a
cost plus basis and long-term government concessions. The relative stability of the underlying
cash flows would normally allow the fund to operate with a relatively high level of gearing,
but the current level of gearing is only moderate. In recent presentations to investors, fund
management has highlighted that the fund is well-positioned to take on additional debt.
Rating agencies have indicated they would be comfortable with a higher level of gearing.
Discussions with financial advisors have suggested that tightness in debt markets means that
the minimum pre-tax cost of debt would be 9%. The company tax rate is 30%.
The share price has grown steadily and the stock is trading at a historically high P/E ratio of
18.5, making an equity issue attractive. The three major institutional investors, however, have
advised that they will not support a pro-rata rights issue due to their own financial constraints,
nor do they favour a placement to new investors.
David applies the FRICTO framework to support his recommendation on the best source of
financing for the fund.
Financial flexibility
The funds moderate level of gearing suggests that it has significant capacity to take on
additional debt. This supports a recommendation of debt funding.
Risk
The fund has a moderate level of gearing and the ratings agencies are comfortable with
additional debt being taken onto the balance sheet. The relative stability of infrastructure cash
flows should ensure that interest payments will be met. This supports a recommendation of
debt funding.
Income
The P/E ratio of 18.5 implies an E/P ratio of 5.4%. A pre-tax cost of debt of 9% implies an
aftertax cost of debt of 6.3%. Since the E/P ratio is lower than the after-tax cost of debt, EPS will
be higher under an equity issue than under a debt issue. This supports a recommendation of
equity funding.
Control
Institutional investors are opposed to an equity placement that would dilute their ownership
stake. A debt issue is unlikely to come with onerous covenants that would jeopardise
management control of the funds activities. This supports a recommendation of debt funding.
Timing
The high share price means that the time is right for an equity issue. However the market
might view an equity issue as opportunistic. Institutional investors are not in a position to take
part in a rights issue. Debt markets are also tight but access is not an issue. This supports a
recommendation of debt funding.
Other
There are no other factors to be considered.
Overall, the FRICTO analysis suggests that the fund should proceed with the debt issue (with
the flexibility, risk, control and timing factors suggest that debt is preferable to equity).
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Learning outcome
3. Apply the major theories and practical tools to the evaluation of dividend decisions.
Dividend policy
Dividend policy is concerned with establishing the profits that should be paid out to the
shareholders of an organisation on (usually) an annual or semi-annual basis.
The issue to be addressed is whether the value to shareholders can be increased by altering this
policy, and therefore the pattern of dividends paid to shareholders.
It is important to appreciate that what is being discussed is the pattern of dividends, not the
size of the total dividend over the life of the company. Obviously, if dividends over the life
of a company are larger, the value will be greater. This section is concerned with whether the
pattern chosen to distribute this set dividend will influence value and, as such, considers issues
such as:
1. Whether a policy of high payouts in the short term, followed by a reduction in dividend
growth thereafter, may be superior to a policy of zero or low growth now, followed by
rapid growth later.
2. Whether a steady, stable growth rate in dividends is preferable to a volatile one that varies
year to year depending on the organisations internal need for funds.
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This will, of course, result in a volatile dividend policy year-on-year, as the dividend will
depend on the amount of positive NPV projects available in that year. M&Ms view is that this
volatility should not concern shareholders precisely because dividend policy is irrelevant to
value.
The residual dividend theory predicts that growth companies will have lower payout ratios
than companies in mature low-growth industries because they are faced with more attractive
investment opportunities and will have no spare cash with which to pay a dividend. This is
consistent with market observations where many growth companies pay no dividend, or at best
a very small dividend, during their phase of rapid growth. As the industry matures and more
intense competition makes profitable investment opportunities difficult to find, payout ratios
will rise as companies have nothing better to do with their cash.
A modified version of residual dividend policy introduces capital structure into the setting of
the dividend. Under this approach, an organisation will continue to make the investment of
cash in all positive NPV projects its first priority. Its second priority, however, will be to ensure
that the organisation maintains a target capital structure by adjusting its mix of debt and equity.
These two considerations then determine what cash is available for return to shareholders. An
organisation following this approach may even allow its debt/equity mix to deviate from its
optimal level in the short term if it is faced with many profitable investment opportunities and
does not want to make a drastic cut to its dividend payout. This approach is referred to as a
smoothed residual dividend policy.
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If Transpac plans to maintain its debt/equity ratio of 1:1, its investment program must be
financed by a mix of 50% debt and 50% equity. Transpac must therefore raise $96 million 0.50
=$48 million in debt. The remaining $48 million will come from equity.
Transpac would then need to determine the total funds available for payment of a dividend.
The sum of after-tax earnings of $56 million and $48 million of borrowing is $104 million.
The planned investment program of $96 million leaves a surplus of $8 million ($56 million in
aftertax earnings less $48 million of equity investment) available for payment as a dividend.
This is a payout ratio of 14.3%, calculated as a dividend paid of $8 million divided by after-tax
earnings of $56 million.
Dividend under a smoothed residual dividend policy
This policy allows deviation from the target debt/equity ratio so as to avoid a drastic cut to
dividend payout. If Transpac is prepared to finance the planned investment program using a 2:1
debt/equity mix, it must be financed by a mix of 66.7% debt and 33.3% equity. Transpac must
therefore raise $96 million 0.667 = $64 million in debt. The remaining $32 million will come
from equity.
Transpac would then need to determine the total funds available for payment of a dividend.
The sum of after-tax earnings of $56 million and $64 million of borrowing is $120 million. The
planned investment program of $96 million leaves a surplus of $24 million ($56 million in
aftertax earnings less $32 million of equity investment) available for payment as a dividend.
This is a payout ratio of 42.9%, calculated as dividend paid of $24 million divided by after-tax
earnings of $56 million.
Clientele effects
Some shareholders prefer a dividend pattern that matches their desired consumption pattern.
There may be a clientele of investors, such as insurance and pension schemes, drawn to
organisations with high, stable, dividend payout ratios. Alternatively, there could be a clientele
of long-term investors who are attracted to organisations with lower payouts and higher
reinvestment rates. Clientele theory suggests that it would be dangerous for a company to
modify its dividend policy for fear of disrupting its clientele.
The counter-argument against the clientele theory is that shareholders can create a dividend
stream that matches their consumption pattern by buying or selling shares, as discussed above.
This could only be achieved if there were no transaction costs, which is not the case in reality.
Taxation
Depending on the tax regime of the country and the personal circumstances of the individual
shareholder, the marginal tax rate on capital gains is unlikely to be equivalent to that on
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dividends. This means that investors are unlikely to be indifferent to the two, and will be drawn
to a dividend policy that rewards them in the most tax-efficient way. In Australia and New
Zealand, franking credits are also potentially an influencing factor for investor decisions.
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Two major approaches are:
1. Constant growth dividend policy dividends are increased at a constant rate each year.
2. Constant payout ratio a constant percentage of earnings are paid each year.
Both of these suggest a belief that in the real world market, imperfections make dividends a
relevant driver of the value of an organisation, in particular due to the information that they
convey about the financial health of the organisation.
Taking all of the above into consideration, most organisations adopt a pragmatic approach
to dividend policy that combines the thinking of M&M on the importance of the investment
decision with the real-world, practical considerations that might lead shareholders to prefer one
specific dividend policy over another.
A compromise solution is as follows:
1. Try to maximise the after-tax payout to shareholders. Buy-backs and dividends may be
taxed differently, and one can have an advantage over the other.
2. Special dividends are useful for making large, infrequent distributions to shareholders. It
does not imply any expectation of repeated payouts.
3. Starting and increasing a regular dividend is seen by shareholders as an implicit
commitment to maintain this regular payout indefinitely. Only set regular dividend levels
that can confidently be maintained.
4. As dividends are seen as implicit commitments, they send a stronger signal of financial
strength to shareholders than do infrequent distributions such as repurchases. This signal
comes with a cost, however, as regular payouts reduce an organisations financial flexibility.
5. Be mindful of future investment plans and the preference to fund projects internally
through retained cash flows as opposed to raising new capital.
6. The retention of cash versus dividend payout policy needs to be offset against agency costs,
as managers may be tempted to spend excess cash on inefficient investments.
Further reading
Servaes, H and Tufano, P 2006, The theory and practice of corporate dividend and share
repurchase policy.
Simshauser, P and Catt, A 2012, Dividend policy, energy utilities and the investment megacycle.
Quiz
[Available online in myLearning]
ACT
Activity 13.1
Raising funds by a rights issue
Introduction
This activity examines using a rights issue to raise funds for a research project.
This activity links to learning outcome:
Apply the major theories and practical tools to the evaluation of capital structure decisions.
At the end of this activity you will be able to understand the implications of a rights issue on
share price.
It will take you approximately 15 minutes to complete.
Scenario
You are the management accountant for Biogeno Limited (Biogeno), a biotechnology company.
Biogeno plans to raise $130 million in a rights issue offer to fund a new research project. The
companys 10 million shares are currently trading at $75 per share. Biogeno is planning to set
the subscription price at $65.
Task
For this activity you are required to calculate the:
(a) Number of existing shares that would be required to purchase one new share, assuming
that the rights issue offer will be fully subscribed.
(b) Theoretical market value of one right.
(c) Theoretical ex-rights price of each share.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 13.2
Impact of leverage on company value
Introduction
This activity examines the impact of leverage on company value. It links to learning outcome:
Apply the major theories and practical tools to the evaluation of capital structure decisions.
At the end of this activity you will be able to understand the impact of using debt in a
companys capital structure.
It will take you approximately 30 minutes to complete.
Scenario
You are the management accountant for Waterfall Limited (Waterfall) and you report to Bill
Oxley, the chief financial officer (CFO).
Waterfall operates a mango farm in Australia that generates $200 million pre-tax cash flow per
annum from its business.
The company tax rate applying to Waterfall is 30%.
The appropriate discount rate for a company such as Waterfall is 11%.
The company is currently 100% funded by equity.
Waterfall is considering its capital structure, and in particular the impact on its company
value of increasing its debt levels.
You have been asked by Bill to investigate the effect of increasing Waterfalls debt levels.
Tasks
For this activity you are required to complete the following tasks:
1. Use the information provided to calculate the entity value of Waterfall under the following
three finance options:
(a) If it is 100% funded by equity.
(b) If it is funded by $636 million debt (based on the information that you produced in (a)).
(c) If it is funded by $954 million debt (based on the information that you produced in (a)).
2. Calculate the value of the equity in Waterfall based on options (b) and (c).
3. Identify and explain some of the key qualitative factors that Waterfall should consider
before going ahead with financing option (c).
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 13.3
Cost of equity and WACC for a new
investment
Introduction
An organisations capital structure refers to the mix of long-term sources of funds employed.
The fixed costs of debt and preference share finance increase earnings per share and also
increase the variability (risk) of those earnings. It is important to understand whether a
company can affect its overall cost of capital (either favourably or unfavourably) by varying the
mix of long-term financing sources it uses.
This activity links to learning outcome:
Apply the major theories and practical tools to the evaluation of capital structure decisions.
At the end of this activity you will be able to use the beta de-gearing and re-gearing formulas to
calculate the cost of equity and WACC for a new investment.
It will take you approximately 30 minutes to complete.
Scenario
You are the management accountant for Weldup Limited (Weldup), an Australian company
manufacturing parts for electric arc welding equipment. Weldups debtequity ratio (in market
value terms) is 0.60, and the current cost of its debt finance is 13.75%. Weldup is currently
looking to diversify its business operations. Opportunities exist for expansion into weld-testing
technology, but Weldup has little idea of what return it should expect from this investment.
Weldups priority is to determine the weighted average cost of capital (WACC) for a typical
business in the weld-testing sector.
Weldup has identified Specific Australia Limited (SAL) as a company in the business of
weldtesting technology. SAL has a debtequity ratio (in market value terms) of 0.25, and a beta
of 1.21. Its shares are regularly traded on the Australian Securities Exchange (ASX). Weldup also
estimates the risk-free rate at 7%, and a market risk premium of 8%. The corporate tax rate is
expected to remain at 30%.
Tasks
For this activity you are required to assist in analysing the return required from the potential
move into weld-testing technology.
Complete the following tasks:
1. Calculate Weldups required rate of return (i.e. WACC) on this investment, using the capital
asset pricing model (CAPM) to calculate the cost of equity. Assume Weldup intends to
employ the same amount of leverage in the new venture as it presently employs.
2. Outline whether the figures calculated are likely to be realistic estimates of the required rate
of return on the investment. Identify any other actions you might take in order to improve
the analysis.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 13.4
Financial restructuring
Introduction
This activity illustrates the impact of changes in the capital structure on key ratios of a business.
This activity links to learning outcome:
Apply the major theories and practical tools to the evaluation of capital structure decisions.
At the end of this activity you will be able to calculate the impact of a change in capital structure
on key ratios of a business.
It will take you approximately 30 minutes to complete.
Scenario
You are employed as an accountant for a large construction company, and report directly to the
chief financial officer (CFO). Construction activity has been declining in recent years, reducing
earnings and pushing the share price down. The market is concerned about the amount of
maturing debt that needs to be refinanced within the next 18 months. A recent research report
by a leading broker commented that the company was too highly geared for the current stage
of the business cycle. Analysts have also made the point that lower gearing would also put
the company in a better position to take advantage of any opportunities to make value-adding
acquisitions that were likely to emerge in the near future.
The CFO has developed a plan for a more conservative capital structure that should assuage
investor concerns, provide continued access to credit markets on acceptable terms and increase
financial flexibility.
They plan to reduce gearing from around 45% to a target level of 35%. The capital structure
initiative includes raising $400 million in a private placement of equity to institutional investors
and $50 million under a share purchase plan. These funds would be used to repay maturing
debt of $450 million. This debt bears an interest rate of approximately 8.0%. Shares are to be
sold at $8.00, a 6.1% discount to the current market price $8.52.
ACT
The most recent financials, in abbreviated form, are as follows:
$ million
EBITDA 653
EBIT 431
Interest 161
Tax (30%) 81
Cash 85
Number (million)
The CFO has asked for an analysis of the impact of the proposed capital structure initiative on
key ratios. They are particularly interested in the impact of the capital structure initiative on
two ratios specified in the debt covenants:
EBIT/Interest.
Senior net debt/EBITDA.
The debt covenants specify that the company must maintain the EBIT/interest ratio above 1.75
and the senior net debt/EBITDA ratio below 3.0.
They have also asked for an analysis on two ratios of interest to the market:
Net debt/(Net debt plus equity).
EPS.
For the purposes of the analysis you should assume that additional earnings are distributed as
dividends.
Note: Senior debt includes the bank debt and private placement debt. Net debt is defined as
debt less cash and cash equivalents; therefore, the difference between them in this activity is
the subordinated bonds which would rank below bank debt and private placement debt in a
windup situation.
Tasks
For this activity you are required to complete the following tasks:
1. Calculate the four ratios required by the CFO under the current capital structure and the
proposed capital structure.
2. Critique the overall impact of the financial restructuring.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 13.5
Dividend policy in practice
Introduction
This activity illustrates the factors that affect an organisations dividend decision.
This activity links to learning outcome:
Apply the major theories and practical tools to the evaluation of dividend decisions.
At the end of this activity you will be able to identify the key factors that affect the dividend
policy of a company.
It will take you approximately 20 minutes to complete.
Scenario
You are employed as an accountant for a large petroleum refiner in Australia and the chief
financial officer (CFO) has asked you to analyse the latest announcement by Caltex on its
dividend policy, a significant competitor in the industry. Specifically, the CFO wants you to
analyse Caltexs dividend policy from the perspective of dividend policy theory.
Caltex has announced the closure of the loss-making Kurnell Refinery in Sydney and its conversion
into a major import terminal. The company considers that the configuration and scale of the plant is
such that it cannot remain competitive with newer, larger plants in Asia. The company expected to
incur closure and remediation costs with a present value of $430 million. Caltex also announced plans
to invest approximately $250 million to convert the existing storage facilities at Kurnell into a major
transport fuel import terminal. The company announced that, in the short-term it would reduce its
dividend payout ratio from the 40% 60% range to a lower range of 20% 40%. Caltex planned to
restore the payout to the 40% 60% level once the closure of the Kurnell Refinery was completed in the
second half of 2014. The company also announced that it was evaluating a number of capital raising
initiatives to strengthen the Caltex balance sheet with the aim of maintaining its BBB+ credit rating from
Standard and Poors.
Source: Adapted from ASX/Media release Caltex announces supply chain restructuring, 26July 2012
Task
For this activity you are required to identify the linkages between Caltexs recent statement on
dividend policy and the theory and practice of dividend policy.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
The following publications assist with the understanding of concepts in this unit and may be
examinable.
Cornelius I, 2002, If the CAPM fits ... CIMA Insider, April, pp. 2425, accessed 27 February 2014,
www1.cimaglobal.com Search CAPM fits Management accounting financial strategy
If the CAPM fits.
Important clarification: The author has advised that the beta of XYZ plcs corporate debt
should have been given as 0.2.
Lynch, P 2009, Optimum capital structure in ACCA Student Accountant, June/July, vol. 6,
pp.7884, accessed 27 February 2014, www.accaglobal.com Students Student Accountant
Student Accountant magazine archive 2009 Archive June/July Archive Optimum
capital structure.
Further reading
The following publications provide additional reading for those seeking a greater
understanding of concepts within this unit.
Australian Private Equity & Venture Capital Association Limited (AVCAL) 2013, Market
Observations Australia and New Zealand, September 2013, accessed 27 February 2014,
www.avcal.com.au Statistics & Research Publications & Data Market Observations.
Bayley, P 2012, Hybrids: Why take bond returns for equity risks?, Eureka Report, 23April 2012.
Hanrahan, A 2011, Hybrid securities? Whats that?, The Australian, 9 November 2011.
Servaes, H and Tufano, P 2006, The theory and practice of corporate dividend and share
repurchase policy, Deutsche Bank Liability Strategies Group, February 2006.
Simshauser, P and Catt, A 2012, Dividend policy, energy utilities and the investment
megacycle, The Electricity Journal, May 2012, vol. 25, Issue 4, pp. 6387, particularly ss 57 that
analyse dividend policies and equity raisings in the Australian energy utilities industry.
References
The following list provides a summary of all other sources referred to in the preparation of the
content for this unit. It is provided for copyright purposes.
Barclay, MJ and Smith, CL 2005, The Capital structure puzzle: the evidence revisited, Journal of
Applied Corporate Finance, Winter 2005, vol. 17, no. 1, pp. 817.
Berk, J, DeMarzo, P and Harford, J 2011, Fundamentals of Corporate Finance, 2nd edn, Pearson/
Prentice Hall, Boston, MA.
Connal, S, and Lawrence, M 2010, Equity capital raising in Australia during 2008 and 2009,
ISSGovernance Series.
Graham, J and Harvey, C 2002, How do CFOs make capital budgeting and capital structure
decisions?, Journal of Applied Corporate Finance, Spring 2002, vol. 15, no. 1, pp. 823.
R
Miller MH and Modigliani, F 1961, Dividend policy, growth, and valuation of shares,
JournalofBusiness, vol. 34, no. 4, pp. 411433.
Modigliani, F and Miller MH 1958, The cost of capital, corporation finance and the theory of
investment, American Economic Review, vol. 48, no. 3, pp. 261297.
Modigliani, F and Miller MH 1963, Corporate income taxes and the cost of capital: a correction,
American Economic Review, vol. 53, no. 3, pp. 433443.
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Core content
Unit 14: Business risk
Learning outcomes
At the end of this unit you will be able to:
1. Identify common business risks to which an organisation may be exposed.
2. Apply the risk management process.
3. Assess business risks for an organisation and apply strategies to treat these risks.
Introduction
All organisations are exposed to risk. The nature and size of the organisation and the markets in
which it operates will determine the likelihood and impact of these risks.
Risk management is integral to organisational management and the role of a management
accountant. It supports the achievement of an organisations objectives, the exploitation of
opportunities, effective resource allocation and provides reassurance to stakeholders. Risk
management also ensures that risks are addressed in a practical and accountable way.
This unit examines the risk management process by assessing an organisations risk exposure
based on its risk appetite, and understanding what each risk may mean to an organisations
long-term financial health.
Management accountants are actively involved in the risk management process and add value
at all stages. This involvement includes the following:
Risk identification.
Risk assessment.
Development of risk management treatments.
Monitoring and reporting.
maaf31514_csg
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Learning outcome
1. Identify common business risks to which an organisation may be exposed.
What is risk?
While there are many definitions of risk available, this module will refer to one of the foremost
used by the Australian and New Zealand business community, and which is contained in
AS/NZS ISO31000:2009 Risk Management Principles and Guidelines. This Standard defines risk
as The effect of uncertainty on objectives.
In a business context, it should be remembered that although the effect of a risk may be
negative, it may also create business opportunities.
All aspects of an organisations operations have an element of uncertainty. This uncertainty may
be a lack of knowledge or comprehension of an event, or a misunderstanding of the likelihood
of an event occurring and its possible consequences. Alternatively, while the results of research
and development (R&D) can be rife with uncertainty, the opportunities created by successful
outcomes can be very rewarding.
Business risk can, therefore, be defined as any risk that may impact on an organisations future
operational and financial performance.
Identification
The first step to developing an effective risk management strategy is to adequately identify the
risks to which a business is exposed. Although this may appear to be a simple process, it is not
necessarily as intuitive as it may seem. It is for this reason that organisations use a variety of
tools for this purpose. For example:
Physical inspections Inspection by an expert can reveal safety hazards not previously
identified. For example, fatigue fractures in an aircraft wing.
Contract review Review of supply and service contracts can lead to the identification
of risks not previously identified, such as a legal review in order to determine the most
appropriate way to break a three-year supply contract due to perceived non-performance
issues.
Historical analysis Examination of the causes of historical losses to determine if
reoccurrence is possible. For example, an analysis of customer complaints to determine key
causes and issues.
Compliance review A compliance review will identify areas of exposure to regulatory
requirements. For example, a lawyer examining an employment contract for compliance
with the Commonwealth of Australia Fair Work Act 2009.
Insurance analysis An analysis of existing policies to determine which risks are insured
and which are not. For example, does the organisation have flood cover at all locations?
Internal controls review This review, including flow-charting processes, pinpoints
gaps that represent potential risks. An example of a process that would be covered is the
approval and processing of supplier payments.
Market and competitor analysis Understanding what competitors and the market are
doing enables an organisation to recognise risks and opportunities. This can be achieved
through benchmarking and industry forums, for example.
Internal analysis Using tools such as SWOT enable an organisation to recognise risks and
opportunities.
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In addition to identifying business risks as part of the organisations risk management
strategy, it should be noted that understanding a clients business risks is also an integral part
of conducting an audit. Understanding a clients business risks enables the auditor to better
assess the risk of material misstatement in the financial reports and to structure the audit
appropriately. This should lead to lower audit risk that is, the risk of the auditor not detecting
material misstatements.
Sources of risk
Classically, risks arise from two main sources: those internal to the organisation and therefore
within the organisations control, and those external to the organisation and so outside its
control.
Internal risks come from:
People, processes, policies or structures. Examples include the risk of an employee making a
mistake or misjudgement, a breakdown in control or a gap in a business process.
The impacts of these risks can affect the bottom line. They can be either positive or negative in
nature, and, in a worst-case scenario, impact the organisations survival.
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Potential changes to our portfolio of assets through acquisitions and divestments may have
a material adverse affect on our future results and financial condition.
Increased costs and schedule delays may adversely affect our development projects.
If our liquidity and cash flow deteriorate significantly it could adversely affect our ability to
fund our major capital programs.
We may not recover our investments in mining, oil and gas assets, which may require
financial write-downs.
The commercial counterparties we transact with may not meet their obligations, which
may negatively impact our results.
Cost pressures and reduced productivity could negatively impact our operating margins
and expansion plans.
Unexpected natural and operational catastrophes may adversely impact our operations.
Our non-operated assets may not comply with our standards.
Breaches in our information technology security processes may adversely impact our
business activities.
Safety, health, environment and community impacts, incidents or accidents and related
regulations may adversely affect our people, operations and reputation or licence to
operate.
Climate change may impact the value of our Company, and our operations and markets.
A breach of our governance processes may lead to regulatory penalties and loss of
reputation.
Source: Adapted from BHP Billitons 2014 Annual Report.
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Opportunities
Innovation in products, services and operations.
Emerging market demand growth.
Investing in process, tools and training to achieve greater productivity.
New marketing channels.
Improving execution of strategy across business functions.
Investing in IT.
Excellence in investor relations.
Leveraging CSR and public confidence.
Investing in clean tech.
Global optimization and relocation of key functions.
Source: Ernst & Young 2013, Business Pulse Global Report 2013.
By comparison, the following list of common risks for smaller businesses has been adapted
from the NSW Governments small business website:
Key man risk.
Breakdown of machinery and equipment.
High staff turnover or loss of a key staff member, especially if they have unique skills.
Security of data and intellectual property.
Theft.
Increased competition.
Failure to comply with legislation, regulation and/or standards.
Poor credit management, bad debts and negative cash flow.
Natural disasters such as fires and storms.
Poor internet connectivity.
Internet fraud and scams.
Inadequate insurance coverage.
Lack of innovation and capitalisation of opportunities.
Source: NSW Government website 2012, Common small business risks.
The above lists illustrate the wide variety of potential risk sources related to many factors,
including business size, type of industry, the environment and people.
Categories of risk
Risk permeates every aspect of an organisations operations, and can arise from internal and
external sources. The following provides a framework for considering the different categories of
risk for an organisation.
The diagram below shows the seven different categories of risk that will be used in this unit.
Together, these categories comprise business risk.
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BUSINESS
RISK
Strategic risk
This risk stems from an organisations goals, objectives and strategies. Strategic risk is the big
picture or high-level risk resulting from or impacting on decisions made in the boardroom.
This category is not associated with the day-to-day execution of the organisations plan. The
following table provides examples of internal strategic risks:
Source Example
Inappropriate strategies developed to For example, David Jones realised that the level of customer service
achieve an organisations goals provided in its stores was incompatible with its strategies and
refocused this area
Inconsistency between goals and This can occur if an organisations remuneration system is not effective
corporate culture (e.g.where a managers bonus is based on annual KPIs but the
organisations strategy is based on more long-term achievements)
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Strategic decisions made in the boardroom are also responses to changes in the external
environment. The following table provides examples of these:
Source Example
Competitors Entrance of new competitors into the market and the introduction of substitute
products (e.g.overseas online retailers shipping to Australia and New Zealand have had
a big impact on local retailers)
Government policy Climate change policies are an example affecting businesses that continue to evolve
(e.g.solar energy policies)
Financial Determining long-term funding facilities for an organisation with operations in multiple
countries, given fluctuations in interest and exchange rates
Innovation Loss of innovation momentum. For example, consider the implications for future profits
if the R&D departments of technology companies stopped developing new ideas, or
pharmaceutical companies ceased to develop new medicines
Stakeholders The ageing population is one group of stakeholders (i.e.customers whose changing
profile will have a big impact on the health industry)
Operational risk
This broad category encompasses the risks arising from the organisation carrying on its
business that is, risks stemming from processes, people, systems or events.
Operational risks for banks are particularly well documented due to regulatory prudential
requirements. Rogue traders are one example of operational risks in the banking environment.
The following table gives an overview of the different categories of operational risk and some
examples:
Operational risks
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Operational risks
Anything emanating from the production process is considered an operational risk as defined.
Leyland experienced the following operational risks during its production of the P76:
Quality control issues, such as water leaks and ill-fitting doors.
Disruptions to production due to power cuts.
Production breakdowns.
Supply issues created by strikes at component suppliers.
Compliance risk
Sometimes referred to as legal and regulatory risk, compliance risk is associated with
complying with relevant legislation and regulations. Compliance risk arises both internally and
externally.
Internal compliance risk relates to complying with an organisations own policies and
procedures. Examples include human resources and security policies.
External compliance risk relates to complying with government legislation and regulations.
Examples include the following:
Non-compliance with Work Health and Safety legislation.
Non-compliance with Australian Securities Exchange or New Zealand Exchange listing
rules.
Non-compliance with taxation laws.
Reputational risk
This is the risk of damage to an organisations image or brand. Some recent examples include:
The impact of the Gulf of Mexico oil spill on BPs reputation and brand.
The decision by Qantas to suspend its operations while in the midst of industrial action.
The Toyota product recall for sticky gas pedals on eight models in the US. This undermined
consumer confidence regarding the brand.
Environmental risk
This is the risk that a businesss actions will result in a negative environmental impact.
Examples include:
Mining operations that affect local flora and fauna.
The use of non-renewable energy resources that impact air quality.
Transport has its own environmental risks depending on the mode of transport used and
the type of goods being carried. A recent specific example is the MV Rena striking a reef in
the Bay of Plenty, New Zealand, which caused oil slicks and resulted in the loss of wildlife.
Disaster risk
This is the risk of exposure to natural and man-made disasters. Natural disasters include
cyclones, earthquakes, bushfires and floods. The agricultural industry is particularly vulnerable
to disaster risk. Crops are susceptible to cyclones, drought, frost, hail, fire, locust plagues and
disease. For example, the severe shortage of bananas in Australia after Cyclone Larry wiped out
90% of the local crop in 2006.
Man-made disasters include terrorism and civil conflicts, such as the impact on tourism of the
Arab Spring uprisings in the Middle East.
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Financial risk
Financial risk results from participation in the financial markets.
Risk can arise from:
Transacting in foreign currencies (giving rise to foreign exchange risk).
Raising debt (giving rise to interest rate risk).
Having surplus funds to invest (giving rise to interest rate risk).
Selling or using commodities, such as gold or fuel (giving rise to commodity risk).
All of these events may have an adverse effect on the cash flows of an organisation and affect
profitability and solvency. The financial conditions resulting from the global financial crisis
(GFC), for example, caused deterioration in the health of many organisations, both large and
small. Car manufacturers, for example, were badly hit.
EQUITY COMMODITY
RISK RISK
CREDIT INTEREST
RISK RATE RISK
FINANCIAL
RISK
LIQUIDITY FOREIGN
RISK EXCHANGE
RISK
Liquidity risk
This is the risk that a company will not have sufficient financial resources to meet its liabilities
(creditors and borrowings) as they fall due.
This includes the risk that borrowed funds may not be available when the company needs them,
or they will not be available for the required term or at an acceptable cost (sometimes called
funding risk). There is also the risk that borrowers may lose credit lines from banks if they fail
to comply with loan covenants.
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Credit risk
This is the risk that the other party to a financial transaction will not meet its obligations on
time, or at all.
Equity risk
This is the risk that movements in stock market prices will adversely affect investor returns.
This can arise from both market factors and individual stock factors.
Commodity risk
This is the risk that a change in the price of a key commodity, necessary for an organisations
operations, will adversely affect the companys performance.
Both Qantas and Air New Zealand are exposed to price fluctuations in aviation fuel, for
example. OceanaGold Corporation and Newcrest Mining are both exposed to volatility in
the gold price. There are many other examples of companies subject to commodity risk in the
Australian and New Zealand economies due to their reliance on commodities.
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The diagram below shows the impact of rising interest rates. It illustrates the concept that the
greater the rise in interest rates, the larger the bite, or risk, to the organisation. Therefore, a
minor interest rate rise has a small impact on profits, but the profit impact rises exponentially
with the size of the interest rate rise. For example, a 0.25% interest rate rise over 12 months on
a AUD50 million loan will require an additional AUD125,000 to cover this expense. In contrast,
a 2% rise over the same period would require an additional AUD1,000,000 to be found, and so
take quite a bite out of the organisations profits.
In times of slow economic activity, interest rates fall as measures are taken to stimulate activity
within the economy. During such times, organisations benefit from having floating rate interest
exposures. However, as the economic view improves, interest rates tend to increase in order to
reduce growth and inflationary pressure. Depending on an organisations exposure (level of
debt) and type of facility (variable versus fixed), the impact of these changes can be magnified.
Interest rate volatility has substantially increased interest rate risk since the deregulation
of financial systems around the world in the 1980s. An organisation needs to be aware of
the impact on its profitability and cash flow of possible changes in interest rates. Proper
management of this risk can add to the profitability of the organisation.
The historical volatility of Australian and New Zealand interest rates can be seen in the graphs
below:
0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Time - January
Data for creation of graph sourced from Reserve Bank of Australia Cash rate target, interest rate
changes, accessed 30June 2015, www.rba.gov.au Statistics Cash Rate Target.
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0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Time - January
Data for creation of graph sourced from Reserve Bank of New Zealand Official cash rate (OCR)
decisions and current rate, accessed 30 June 2015, www.rbnz.govt.nz Monetary Policy
MonetaryPolicy Statement.
In the above graphs volatility is the risk pertaining to the magnitude of fluctuations in the
interest rate. The greater the quantum and frequency of movement, the higher the level of
risk for businesses exposed to interest rate risk. The large fall from January 2008 to 2009, for
example, corresponds with lower interest rate policies set in response to the GFC.
The diagram below further explains the effects of interest rate rises.
Increase in
working
capital costs
DEMAND FALLS
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While many organisations, such as exporters and retailers, experience falling profitability in
a rising interest rate environment as depicted in the diagram above, others gain. Insurers,
for example, improve their profitability, as they are able to obtain higher returns on their
investments. Rising interest rates usually indicate a stronger currency, and so importers
profitability is boosted by the resulting increased sales and lower costs.
This is the risk resulting from normal business activities involving conversion of foreign
currency receipts or payments into the home currency.
2. Translation risk
This is the risk resulting from the conversion of long-term foreign currency assets and
liabilities into the home currency at regular intervals for financial reporting purposes.
3. Economic risk
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Parity
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Time - January
Data for creation of graph sourced from Reserve Bank of Australia Exchange rates, accessed 30June
2015, www.rba.gov.au Statistics Exchange Rates.
0.9
0.8
0.7
0.6
0.5
0.4
NZD/AUD
0.3 Exchange Rate
0.2 NZD/USD
Exchange Rate
0.1
0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Time - January
Data for creation of graph sourced from Reserve Bank of New Zealand B1 Exchange Rates, accessed
30June 2015, www.rbnz.govt.nz Statistics Exchange rates.
In these graphs volatility is the risk pertaining to the magnitude of fluctuations in a currency.
The greater the quantum and frequency of movement, the higher the level of risk for businesses
exposed to foreign exchange risk. At the peak of the market uncertainty caused by the GFC,
the AUD for example dropped 6 cents in a week against the USD (McTaggart 2010). The above
graphs show 12-month moves. Note that the historic volatility in the NZD/AUD rate is a lot
lower than the NZD/USD rate. This is because the NZD/AUD exchange rate is one of the most
stable currency pairs, and therefore represents less risk.
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The diagram below shows the impact of a rising domestic currency.
While many industries, such as commodity exporters, domestic tourism, education and
manufacturing, lose in a rising domestic currency environment as depicted in the diagram
above, others gain. Importers, for example, experience increased sales and lower costs, boosting
profitability. In addition to unfavourable profit impacts, foreign exchange risk can lead to
increased variability in an organisations results and has the potential to impact the future
viability of the business.
As organisations grow and change over time, the types of financial risks and the levels of
exposure continue to evolve. The process of identifying the financial risks to which a business is
exposed and their quantum requires continual monitoring.
Transaction 1 Accutime has just ordered a custom piece of manufacturing equipment from a
supplier in Germany. The converted cost at the time of ordering was AUD250,000. The
agreement with the German supplier is that delivery and payment will be made six
months from the date of order, and that settlement will be in euros
Transaction 2 The main consumer market for the sale of the TCXOs and crystals is the United States.
Products are shipped from Sydney free on board, and take six weeks to reach New
York. Each shipment has a selling price of USD50,000, and the customer in New York
settles the account in USD three months after the products are shipped from Sydney
Transaction 3 Accutime has a five-year overseas loan of USD5 million, with a variable interest rate of
6% per annum
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The following table analyses each transaction to identify the financial risks that apply.
Foreign exchange risk When Accutime When Accutime exports Accutimes variable
purchases the exclusive containers of TCXOs and interest rate loan
piece of manufacturing crystals to the United of USD5million is
equipment from States, the agreed denominated in USD.
Germany, it will be six price per shipment is If the Australian dollar
months from date of USD50,000; however, falls it will cost Accutime
order to date of delivery by the time they are more Australian dollars
and payment delivered and paid for, to repay the principal
the Australian dollar and interest
If the converted cost
may have risen 5%. In
of the manufacturing
this case, the amount of
equipment was
revenue will have fallen
AUD250,000 when
by 5% as a result of the
ordering, and the
change in the foreign
Australian dollar was
exchange rate
to fall 10% in the
six months prior to
delivery, the payment
due in euros for the
equipment would then
cost AUD275,000. This
would add AUD25,000
to the actual cost of
the manufacturing
equipment
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Learning outcome
2. Apply the risk management process.
The risk management process is the structure used to control risk within an organisation. It
involves activities covering the setting of risk appetite and the selection of an appropriate
framework for the process to operate within.
Risk appetite
A starting point in understanding the risk management process is coming to terms with the
concept of risk appetite.
Individuals have different risk appetites when it comes to investments. Some will have a more
conservative portfolio with less risky investments, while others will pursue higher returns and,
hence, take higher risks. For example, individuals closer to retirement tend to adopt a more
conservative investment approach to their superannuation than those who have decades to go.
As with individuals, organisations must also determine the right amount of risk to take in order
to achieve the desired level of return. This is referred to as an organisations risk appetite.
An organisation should always be considering events and risks that might impact upon the
achievement of its strategic objectives. Management then needs to manage the risk within the
parameters of the organisations risk appetite.
An organisations risk appetite acknowledges that its operations will not be perfect and that
there will be inefficiencies or errors that may arise and these might result in a financial loss. The
size of an organisations risk appetite considers the size of the loss it is prepared to accept. It is
managements responsibility to evaluate all the risks and decide which risks to pursue or retain.
This means that an organisation will tolerate particular risks if the cost of managing them is
more than the expected financial loss should the risk eventuate.
For example, a manufacturer of business shirts would not normally quality check every shirt
that comes off the production line as the cost of doing this would far outweigh the benefit
received (for example, additional sales); however, they would sample randomly to check and
identify errors. Conversely, a manufacturer of hearing implants might test every one of their
products to ensure it is working properly, as the reputational and financial consequences of
having a defective product in the marketplace would likely be unacceptable.
Risk appetites will vary among organisations and even across business units within an
organisation. The level of sophistication used to establish the amount of risk appetite is also
diverse, ranging from basic calculations and qualitative factors to complex models. Regardless
of the method used to determine risk appetite, the most important element of an effective risk
management process is to ensure the risk appetite is effectively communicated and adhered
to in all decision-making, from everyday operations to strategic decisions at board level.
Therefore, measurement of management performance should be linked to compliance with an
organisations risk appetite.
Risk management
In the current financial climate, the importance of risk management has evolved rapidly due to
large corporate collapses such as Enron and Barings. As a result, organisations have become more
aware of the less obvious risks they are operating under, as well as common or familiar risks.
Organisations are held to account for risk management by external stakeholders, including
shareholders, financiers and regulators, and need to have processes in place to identify risks
and manage them in accordance with the organisations risk appetite.
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In order to grow shareholder value, management needs to adhere to a basic framework, which
is often represented as follows:
1. Seeking risk, or exploring avenues for growth, through, for example, new investment
opportunities, such as mergers and acquisitions, or via innovation.
2. Managing the risk that is, following the right growth path and making the correct risk
decisions. Going down the wrong path is inferior to not growing at all.
3. Generating opportunities across the organisation as a whole.
Using the risk management process in this manner establishes an apparatus that provides the
organisation with a competitive advantage.
Source: Adapted from Standards Australia 2009, AS/NZS ISO 31000:2009 Risk Management Principles and
Guidelines.
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These parameters should be considered when risk management policy and risk assessments are
undertaken, but will also provide a context for how an organisation perceives risk. This is in
essence its risk appetite.
Treatment plans bring risks within an organisations risk appetite, and examples are provided
later in the unit (refer to the table titled Treatment options).
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Risk treatments
Learning outcome
3. Assess business risks for an organisation and apply strategies to treat these risks.
Risk assessment
Two commonly used tools for assessing risks are risk scorecards and risk matrices.
Risk scorecards
The risk scorecard enables management to measure the size and importance of the risk by
looking at two variables: the likelihood and the impact.
1. The likelihood of the risk is the probability of the risk occurring.
2. The impact of the risk is the cost should the risk occur.
It is important to note that the cost is not always defined as the financial consequences or
potential loss arising. It could, for example, be the cost in terms of human life.
Once these parameters have been established, the level of risk is calculated as:
The following is an example of a risk scorecard used to rank certain business risks that could
apply to a number of organisations. It should be noted that, while some of the risks may be
common, the resulting risk score will be organisation-specific.
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Having calculated the risk score for each of the identified risks, the next step is to rank them.
Those risks with the highest score are considered the highest risk and those with a very low
score would be considered low risk. Using such a ranking system allows management to
prioritise which risks need attention first, and enables them to allocate resources for appropriate
treatment, as seen below.
The example scorecard has used a numeric scale to rate the likelihood and impact of the risks
identified. Alternatively, businesses can use a predefined scale to allow for the risks to be
graded. The probability and severity of a risk is usually categorised into comparative levels,
as neither can usually be estimated with complete accuracy. Regardless of the metrics, it is
important for an organisation to define the scale being used so that it can be consistently
applied throughout.
Risk matrices
A risk matrix is another mechanism used to categorise risks.
A risks likelihood and impact can be plotted on the risk matrix, allowing categorisation for
an appropriate response. When used like a graph, a numeric scale such as the one used on the
risk scorecard can be added to the matrix to present a visual representation of an organisations
risks.
The following illustration is an example of a risk matrix.
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The risk scores from the previous risk scorecard have been taken and plotted on a risk matrix
as follows:
10
8
D
7
6
LOW MEDIUM HIGH
5
3
E
LOW LOW
2
C B MEDIUM
1 A
0 1 2 3 4 5 6 7 8 9 10
Regardless of the mechanism chosen, the result is that management will now be aware of the
key risks and the order in which they need to be addressed.
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Linking back to Step 3 of the diagram adapted from AS/NZS ISO 31000:2009 Risk Management
Principles and Guidelines, contained in Learning outcome 2, examples of risk treatment options
are included in the table below:
Treatment options
Reduce Implement controls, processes or systems Reduce penalties for late completion of
to either eliminate or reduce the impact construction projects, i.e. liquidate damages,
of the risk implement project timelines/milestones
and monitor adherence/achievement on a
progressive basis
Transfer Move the risk to another entity Can be achieved through insurance policies
or by using subcontractors
Avoid Cease doing something because the level Sell high-risk subsidiary
of risk is too high and it cannot be treated
Abandon high-risk projects
to come within an acceptable level
Tolerate Accept risk and do nothing to address A business may not be big enough to have
it, or acknowledge nothing can be done appropriate segregation of duties
to address the risk as it is too difficult or
costly to do so
Exploit Take advantage of the opportunity the risk Update IT systems so that online ordering
presents does not crash. Creates an opportunity if
competitors are still experiencing such issues
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Using the risk matrix, an appropriate response can be established based on the risk rating. The
following illustration provides an indication of what might be an appropriate response given
the level of risk assessed. The levels of risk have now been replaced with predetermined actions
to treat the risk.
By overlaying the risk scores from the previous example onto this matrix, it emphasises how
each risk should be considered by the organisation.
10
3
Accept risk E
no action
2 required C B Manage
and monitor
Could accept risk
1 with monitoring A
or manage
0 1 2 3 4 5 6 7 8 9 10
Referring to the previous examples of risks from the risk scorecard, appropriate responses can
now be aligned with the risk categorisation:
Risk Response
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Cause Treatment
Physical damage to the IT Backup system and offsite storage of backup data
equipment (e.g. caused by fire, Disaster recovery plan in place and tested
sprinkler system, flood, sabotage)
Security systems limit access to server rooms
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Residual risk
Residual risk is the risk remaining after a risk treatment plan has been implemented. The level
of risk remaining should be within an organisations risk appetite.
The plan includes: Formalising with customers the scope of work to be performed prior to
commencement
A policy that requires the documentation and agreement of any changes to the
scope of work prior to the work being undertaken
Software testing team to test software developed by the software
development team or business intelligence team prior to delivery
Management review and sign-off prior to delivery of solutions to customers
Professional indemnity insurance cover to the value of A$5 million
The following table lists possible improvements identified by Charlene and also highlights the
strengths of the current plan.
Possible Standardised contractual agreements with customers (which have been reviewed
improvements by legal advisors)
Presently, the plan does not include a process to manage complaints or settle
disputes with customers. Having a process allows potential claims to be
addressed prior to them developing into insurance claims
User acceptance testing prior to completion of contract
Contract sets out roles and responsibilities of both parties
Contract to include KPIs to ensure contract delivery on target
Ensure contract contains a time restraint clause on claims
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What is hedging?
Hedging is a risk treatment available for financial risks. It is essentially the same as taking out
an insurance policy. Hedging can be used to protect against interest rate, foreign currency,
commodity and equity risks.
Reasons to hedge
Reasons to hedge include:
Provides increased certainty to forecasts, profit figures are reliable and investor confidence
is greater.
Reduces the volatility of corporate cash flow, which enhances the probability of lenders
providing debt.
Reduces the volatility of corporate cash flow, and therefore the probability of an
organisation with debt experiencing financial distress and failing.
Management has a lower risk appetite than shareholders. Consideration of other
stakeholders besides shareholders may influence this.
Management has superior knowledge compared to shareholders concerning the risk
environment. Therefore, management can make better hedging decisions than shareholders,
and thus protect and increase shareholder value.
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For organisations that choose to hedge, the hedge can be achieved using either a natural hedge
or financial market instruments, commonly called derivatives.
Natural hedge
Some organisations are fortunate to have some or all of their financial risks reduced via a
natural hedge. A natural hedge forms when an exposure to one risk is counteracted by a
converse exposure to the equivalent risk. For example, a New Zealand company with significant
sales in the United Kingdom has a natural hedge if it also has expenses in that currency.
Others choose strategies to create a natural hedge. For example, an Australian company may
have US assets of sizeable value. A natural hedge is created when these assets are financed in
the same currency.
Natural hedges do have the disadvantage of not being able to be reversed very quickly should
organisational circumstances change.
Financial markets
One way of managing the financial risk of an organisation is to adopt hedging strategies using
derivatives. In order to perform this role, the management accountant needs to understand the
global financial markets from which the financial risks flow and to have an understanding of
the derivative tools available.
Derivatives
A derivative is a security whose price is dependent upon (derived from) one or more
underlying assets such as shares, bonds, interest rates and currencies. Examples of derivatives
that can be used to treat financial risk include forward contracts, swaps, futures and options.
Derivatives can be divided into two broad categories: exchange-traded derivatives and over-
the-counter (OTC) derivatives.
1. Exchange-traded derivatives
These are traded on an exchange and have standard terms and conditions such as contract size,
maturity date and the underlying asset or index on which the derivative is based. The example
below further explores these derivatives.
2. Over-the-counter derivatives
These are instruments tailored to the needs of the user and are directly negotiated between two
parties. They are normally negotiated with banks and other financial institutions.
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Most treasurers examine and apply hedging strategies for interest rate risk and foreign
exchange risk, as these represent the most common financial risks to which businesses are
exposed. In view of this, the remainder of the unit will focus on hedging strategies available for
these risks.
Analysis of the above would form part of the interest rate risk assessment undertaken as part
of the risk management process as discussed earlier in the unit. The treasurer would then seek
board approval for the resulting interest rate risk management policy.
Before using risk treatments involving the use of derivatives, a simple risk treatment for interest
rate risk on loans is to determine whether to enter into a fixed or variable interest rate loan.
When negotiating with a financier, the fixed rate is normally higher than the initial floating rate.
In times of rising interest rates, fixed rates are commonly locked in; however, regard should be
paid to the length of the loan. The longer the loan, the more interest rate cycles will be passed
through.
Depending largely on the organisations risk appetite the types of hedging that could be used to
manage interest rate risk include:
No hedging.
Natural hedging.
Selective hedging (for example, hedging 45% of a particular risk).
Hedging particularly risky exposures as opposed to other less risky ones.
100% hedging.
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An interest rate swap involves only the exchange of interest cash flow streams between two
parties. In order to simplify things, the cash flows are normally net settled (that is, rather than
one party paying the $500,000 due and the other party paying $530,000, the counterparty that
owes the most net settles the $30,000). The swap involves interest cash flows, on defined terms,
based on a notional principal amount. The principal amount is never exchanged, only the
interest obligations or receipts, at agreed dates and under defined pricing terms.
Interest rate swaps permit a borrower to shift from fixed to floating rate borrowing (or vice versa)
to align with interest rate cycles and perceptions regarding fundamental underlying interest rates.
Such action permits access to rates prevailing at the shorter end of the market, while retaining
the required long/short-term liability ratios. In this instance, the swap effectively separates the
funding decision from the management of interest rate risk.
Interest rate swaps are used to:
Tailor the transaction to meet the exact requirements of both parties.
Lower the funding costs on new issues by taking advantage of anomalies between capital
markets.
Diversify the funding sources.
Cover existing interest rate exposures.
Improve returns on particular assets by taking advantage of credit arbitrage that is, the
difference in rates of interest on the same asset between different markets.
Commonly cover longer-dated interest rate exposures, usually for a period of three to ten
years for example, one transaction can cover a ten-year loan.
Provide well-defined funding costs.
Company X Company Y
Note: BBSW bank bill swap rate, a common benchmark rate used in banking.
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Company X can borrow 0.50% cheaper in the floating rate market and 1.10% cheaper in the
fixed rate market. The net differentials (60 basis points or 0.60%) drive the swap.
Each company will borrow in the market where it has a comparative cost advantage. Company
X borrows at a fixed rate of 4.90% through (for example) a bond issue, and Company Y borrows
at a floating rate of BBSW plus 0.50%.
Through the bank, the two counterparties exchange interest obligations based on the
notional principal (which is not exchanged) at agreed dates. This example uses annual interest
payments, but in practice interest payments are likely to be more frequent. Both parties will
gain access to cheaper funds, with the agreed swap rate at somewhere between Company Xs
4.90% and Company Ys BBSW plus 0.50%.
Company X (the more creditworthy company) converts its five-year medium term cost of
borrowing to the short-term rate and Company Y (the less creditworthy company) gains access
to the fixed rate capital markets at a rate cheaper than if it borrowed in its own name.
In this instance, the pricing of the transaction could end up as follows:
Company X Company Y
*0.50% of the floating rate leg plus a negotiated 5.25% fixed interest paid in the swap.
Floating Floating
interest interest
BBSW BBSW
COMPANY BANK COMPANY
X Fixed Fixed Y
interest interest
5.20% 0.05% 5.25%
LENDER LENDER
INVESTOR INVESTOR
The difference between the 5.25% and the 5.20% fixed interest rates (0.05%) is the banks
spread for brokering the transaction and accepting the risk. Note that the banks gross dollar
income from the transaction is AUD100,000 (AUD20 million 0.05%).
The advantages of interest rate swaps are that contracts can be tailor-made to suit the
individual cash flow requirements of borrowers and investors, and they may be available for
longer terms (e.g. up to ten years).
The disadvantages of interest rate swaps are that they involve considerable credit risk
(mitigated to a great extent by using an intermediary such as a bank) and they require certain
cash flows.
Interest rate swap contracts are useful for hedging a series of cash flows over a long period
where the treasurer wants to manage the companys interest rate risk within defined parameters.
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Possible impacts
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A cap is commonly used by borrowers exposed to floating rate debt. The buyer is protected
if the interest rate rises above the cap rate. A floor is the opposite of a cap and is used by
investors with floating interest rate portfolios to protect against falling interest rates.
The option effectively caps Quartzmites borrowing cost at a maximum of 7.75% but allows the
company to take advantage of any fall in interest rates.
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Capped
3 interest rate
Rate paid
2
without hedge
0 1 2 3 4 5 6 7 8 9 10
Futures
A futures contract is a legally binding agreement to buy/sell a commodity or financial asset at a
fixed price at a specific time in the future.
All futures contracts have the following features:
Standardised.
Traded on an exchange.
Prices are quoted.
Settled with a clearing house.
When hedging, determining whether to buy or sell futures should follow an organisations
position in the physical market. For example, if issuing debt in the physical market in six
months time, the organisation needs to be selling interest rate futures now.
In order to protect the financial stability of the market, clients are first required to post an initial
margin. The amount varies per contract type depending on price volatility. Variation margins
are then used to cover adverse price movements.
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Advantages Disadvantages
Liquid market due to the large volumes traded, it is easy Contracts are standardised; therefore, an
to get in and out of the market quickly if required, because organisation is unlikely to cover its physical
volumes are traded on the one market position every time in volume, and as further
future contracts are in designated months,
timing can be an issue
Leverage the margin paid is only a small percentage of Margin payments must be met. If the position
the underlying contract, which creates leverage and allows is making a loss, more capital must be outlaid
participants to make large profits from small capital outlays;
conversely, if the market goes against the participant, it can
mean large losses
Cash settlement or physical delivery (depending on contract The leveraged nature of the product can lead
specifications e.g.with ASX wool futures delivery can be to substantial losses
made with real wool, in accordance with the stipulated
criteria)
Futures and physical price converge near the end of the Management time is required to monitor
contract (it should be noted that they do not always meet and positions regularly. A significant level of
the difference is referred to as basis risk) infrastructure would also be required to
handle the margins
Low transaction costs compared with over-the-counter (OTC) Basis risk can arise. This is the exposure that
products such as forwards can result from using products for which the
underlying is not an exact match
Market is regulated
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September On last trading day, buy 50 September futures contracts at 95.20 (4.8%)
50 # 1, 000, 000 # 365
Present value =
365 + ` 100 j
4.8 # 90
This profit is used to offset the interest payment on the physical 90 day BABs above.
From the above calculations, it is evident that the treasurer has secured a significant interest
saving (AUD66,320.06) by using futures to hedge the companys interest rate risk.
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In practice, organisations use derivatives that suit their interest rate risk management strategy
and risk appetite. Below is Air New Zealands interest rate strategy, which focuses on using
interest rate swaps when required. Later in this unit there is an example based on Coca-Cola
Amatil Limited, showing how that group uses interest rate swaps, and options to hedge interest
rate risk.
Source: Air New Zealand, Company profile, accessed 25 November 2014, www.airnewzealand.com.au
Company information Company profile.
Extract from Air New Zealands Annual Financial Results 2014
18. FINANCIAL RISK MANAGEMENT
... Interest rate risk
Interest rate risk is the risk of loss to Air New Zealand arising from adverse fluctuations in interest rates.
Air New Zealand has exposure to interest rate risk as a result of the long-term borrowing activities which are
used to fund ongoing activities. It is the Groups policy to ensure the interest rate exposure is maintained to
minimise the impact of changes in interest rates on its net floating rate long-term borrowings. The Groups
policy is to fix between 70% to 100% of its exposure to interest rates, including fixed interest operating
leases, in the next 12 months. Interest rate swaps are used to achieve an appropriate mix of fixed and floating
rate exposure if the volume of fixed rate loans or fixed rate operating leases is insufficient.
In the year to 30 June 2014, there were no interest rate derivatives in place, nor any impact on earnings
(30June 2013: Nil).
Source: Air New Zealand 2014, Annual Financial Results 2014, accessed 25 November 2014,
www.airnewzealand.com.au Company information Annual & interim reports Latest annual &
interim reports 2014 Annual Financial Report.
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Derivative Reasons
tools
Interest rate An interest rate swap can be tailor-made to Accutimes position, swapping
swaps its floating rate exposure to a fixed one. This will give the company certainty
regarding its cash flows, as required by Graham
Forward rate FRAs would not be appropriate as they are normally written for relatively short
agreements terms of up to one year, and so are used for short-term interest rate risk hedging.
Accutimes loan is for 3 years not 12 months
FRAs can be valuable in making temporary adjustments to long-term financial
positions. For example, a company that has swapped floating rate debt to fixed
can use FRAs to improve the swaps performance in the short term, when short-
term rates are expected to decline. In this instance, FRAs protect the value of
future swap floating rate receipts from the impact of falling rates
OTC interest Accutimes CFO prefers interest rate certainty. An OTC interest rate option will only
rate options provide certainty about the highest rate paid, i.e.the cap. As OTC options are not
standardised, there is no secondary market such as the ASX, although a buyer
may be able to sell back to the financial institution that arranged the contract. This
means that Accutime could possibly be locked into the option and its only choice
would be to exercise the option or not
Futures Using futures will require additional capital to pay the initial margin, plus any
subsequent margin calls for the duration of the position. Given that the loan
is being used for the acquisition of new robotic equipment and to provide
additional working capital, this would not be the most appropriate use of funds
and, hence, not the most appropriate derivative tool
Accutime does not have the systems in place required to manage daily
movements in positions, nor the management time to administer and monitor it
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Rather than hedge, is it possible to pass the effects of the foreign currency rise on to the
consumer?
For example, car importers and the fuel industry have historically used this strategy.
Foreign exchange risk can be grouped into three categories transaction, translation and
economic as discussed earlier in the unit. The potential consequences of these are depicted in
the table below:
Transaction exposure Risk of lower net cash inflow or higher net cash outflow
could lead to: Risk of lower profits
Translation exposure Corporate balance sheet risks Reduction in the reported value of foreign assets or
could result in: an increase in the cost of foreign currency liabilities, leading to lower net worth
Corporate income statement risks Risk of lower reported profits and lower
earnings per share in the home currency
Analysis of all the above would form part of the foreign exchange risk assessment undertaken
as part of the risk management process. The treasurer would then seek board approval for the
resulting foreign exchange risk management policy. The role of the treasurer is discussed in the
unit on introduction to management accounting (including ethics).
A treasurer who does nothing (a policy of neglect) may be speculating to a greater extent than
a treasurer who actively manages the companys foreign exchange exposure. Depending on
the organisations risk appetite, the types of strategies that could be used to manage foreign
exchange risk include 100% hedging, selective hedging (e.g.hedging 45% of a particular risk),
hedging particularly risky exposures as opposed to other less risky ones, or no hedging at all.
As with hedging interest rate risks, hedging foreign exchange risks can provide increased
certainty to forecasts, making profit figures more reliable and improving investor confidence. It
also can reduce the volatility of cash flows, which makes lenders more comfortable to provide
credit.
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Limitations of FECs
If the exchange rate moves favourably for the company prior to maturity of the FEC, the
company is still committed at the agreed rate.
FECs are best used for specific transactions for a known quantity of currency. They are more
difficult to use for transactions where the outcome, timing, or amount of the currency are
uncertain. A foreign currency option is usually a better instrument in that instance.
Example A FEC
Quartzmite Limited (Quartzmite), an Australian company, is expecting to pay GBP15 million to a
UK supplier in three months time.
The current spot rate for AUD/GBP is 1 AUD = 0.7 GBP. If the payment was made at the spot
rate, the amount would be AUD21,428,571 (15m 0.7). However, Ken Hopeton, the treasurer
of Quartzmite, is of the opinion that the AUD will fall over the next three months, in which case
the amount payable will rise. Ken therefore wishes to lock in an exchange rate now to provide
cash flow certainty. He remains unconcerned by expected unfavourable fluctuations in the
AUD/GBP.
The treasurer enters into a FEC for 1 AUD = 0.71 GBP for three months time. Ken now knows for
certain that the amount Quartzmite will pay is AUD21,126,760 (15m 0.71). In three months
time the spot rate is 1AUD =0.68 GBP, representing a fall as forecast and the treasurers
decision is justified.
AUD
NZD
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When options are purchased, a call buyer and a put buyer have diametrically opposed
expectations about foreign exchange rate movements. A call buyer anticipates that foreign
exchange rates will increase in the future, thereby improving the value of the call position.
A put buyer anticipates that foreign exchange rates will decline, which increases the value of
the put position. Options are generally used for hedging purposes when there is uncertainty
regarding the future movement of the underlying exchange rates. Since the holder has a
choice as to whether to exercise or not, this allows the holder to take advantage of any upside
in movements. With other derivative tools, the holder is locked in and any upside occurring
during the term of the instrument is forgone.
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Cross-currency swaps
A cross-currency swap refers to the exchange of cash denominated in two different currencies,
by agreement between two parties (the counterparties). These agreements involve the
exchange of cash and may be for both principal and interest attaching to debt and investments,
or for medium to long-term trade receivables and/or payables.
The most common application for the cross-currency swap is to support a domestic borrower
wishing to obtain funds from overseas. A cross-currency swap normally consists of three stages:
A spot exchange of principal, either as part of the swap agreement or as a spot transaction
with the market.
Exchange of interest payments during the term of the swap (this in effect represents a series
of forward trades during the term of the swap contract).
Re-exchange of principal on maturity. This is done at the same exchange rate as the spot
rate used at the beginning of the swap.
There are three important elements in a cross-currency swap which must be agreed between the
two parties:
1. The period of the agreement.
2. The two currencies involved.
3. The principal amount of each foreign currency and the exchange rate (likely to be close
to the spot rate when the agreement is made); and the basis for the exchange of interest
payments.
Swaps are medium to long-term arrangements, usually at least two years, and can be as long as
ten years. At the end of the agreement, the principal is re-exchanged.
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As noted previously, organisations use derivatives that suit their foreign exchange risk
management strategy and risk appetite. The example on Coca-Cola Amatil Limited shows that
group uses forward foreign exchange contracts, cross-currency swaps and options.
The results of hedging strategies adopted by a business need to be evaluated regularly in order
to see if the policies adopted are contributing to the organisations objectives as expected. Such
reviews should also consider changes to the underlying business, and market conditions and
modifications to policy should be made accordingly.
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Activity 14.6: Strategies for managing foreign exchange risk service industry
[Available at the end of this unit]
Quiz
[Available online in myLearning]
ACT
Activity 14.1
Identifying and classifying business risks
Introduction
Risk management is an integral part of managing all businesses regardless of size. Risk
management supports the achievement of an organisations goals and objectives, its ability to
exploit opportunities, effective resource allocation and stakeholder reassurance. As businesses
grow, risk management evolves into a more structured framework. Management accountants
are actively involved in the risk management process and add value at all stages.
This activity links to learning outcome:
Identify common business risks to which an organisation may be exposed.
At the end of this activity, you will be able to identify common non-financial business risks for a
service-based organisation and categorise those risks as either strategic or operational.
It will take you approximately 15 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are a Chartered Accountant working for SDT and you report to Charlene OShay (the CFO).
The finance/risk committee at SDT has decided that the company has grown large enough to
require the implementation of a risk management framework.
Charlene has been tasked with devising and implementing it.
Tasks
For this activity you are required to:
1. Identify the key sources of business risk that Charlene should consider.
2. For each risk source identified in Task 1, determine whether the source is internal or
external.
3. For each risk source identified in Task 1, outline key business risks to SDT.
4. Classify each risk outlined in Task 3 as either strategic or operational.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 14.2
Identifying non-financial business risks
Introduction
Businesses are exposed to a variety of risks from both internal and external sources.
Managing risk is an important skill and management accountants are often called upon to
identify risks and how they may arise as a part of the risk management process.
What is important to understand is that the ability to identify risks confidently and efficiently is
the first stage in being able to manage risks competently within a risk management framework.
This activity links to learning outcome:
Identify common business risks to which an organisation may be exposed.
At the end of this activity you will be able to correctly identify non-financial business risks to
which a manufacturing business may be exposed.
It will take approximately 30 minutes to complete.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
You are the new group head of management accounting employed by Accutime. Graham
Anderson, the CFO, has asked you to assist the executive team of Accutime as it completes a
risk review of Accutimes operations.
Tasks
For this activity you are required to:
1. Identify the key strategic risk facing Accutime and explain your response.
2. Identify and explain the strategic risks Accutime faces with its joint venture operations in
Malaysia and China.
3. Provide examples of how Accutime could face:
(a) reputational risk
(b) compliance risk.
4. Identify four (4) operational risks in the operations of the Clean Room at the Sydney plant.
Explain the potential implication of each of the risks on Accutimes operations.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 14.3
Identifying financial risks in an organisation
Introduction
Part of a management accountants role is to aid management to understand and, where
appropriate, develop treatment plans to deal with the risks that their organisation is exposed
to. In particular, they need to help identify financial risks so that they can advise management
on appropriate policies and procedures, including the use of hedging strategies, with a view to
improving organisational performance.
For this activity you are required to identify and explain the potential financial risks an
organisation may be exposed to.
This activity links to learning outcome:
Identify common business risks to which an organisation may be exposed.
At the end of this activity you will be able to identify financial risks within a business and
explain how the risks arise.
It will take you approximately 30 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are a Chartered Accountant working for SDT and you report to Charlene OShay (CFO).
The finance/risk committee at SDT has decided that the company has grown large enough to
need the implementation of a risk management framework.
Charlene has been tasked with devising and implementing it.
Task
For this activity you are required to identify and explain the potential financial risks faced by
SDT.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 14.4
Identifying sources and impacts of
reputational risk
Introduction
Risk management is an integral part of managing all businesses, regardless of size. Risk
management supports the achievement of an organisations objectives, its ability to exploit
opportunities, effective resource allocation and stakeholder reassurance.
As businesses grow, risk management evolves into a more structured framework. Management
accountants are actively involved in the risk management process and add value at all stages.
Reputational risk is one form of risk that needs to be considered, given its potential impact on
the organisations brand and image.
This activity links to learning outcomes:
Identify common business risks to which an organisation may be exposed.
Apply the risk management process.
At the end of this activity you will be able to identify sources and impacts of reputational risk
for a service-based organisation.
It will take you approximately 15 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are a Chartered Accountant working for SDT and you report to Charlene OShay (CFO).
The finance/risk committee at SDT has decided that the company has grown large enough to
need the implementation of a risk management framework.
Charlene has been tasked with devising and implementing it.
Tasks
For this activity you are required to:
1. Identify two (2) potential sources or causes of reputational risk for SDT Solutions.
2. Rate each risk in terms of the likelihood and impact as high, medium or low.
3. Justify your ratings and determine an overall risk rating.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 14.5
Using different risk treatments
Introduction
There are a variety of risk treatments available to management accountants to address the
diversity of financial risks faced by organisations. Management accountants need to be familiar
with more than derivative tools as hedging strategies; they need to be able to think outside the
box to find the most appropriate risk treatment given the organisations risk appetite and the
circumstances in which the risk arises.
For this activity you are required to identify the risks arising in a given scenario and
recommend the most appropriate risk treatment.
This activity links to learning outcomes:
Identify common business risks to which an organisation may be exposed.
Assess business risks for an organisation and apply strategies to treat these risks.
At the end of this activity you will be able to identify financial risks in a given scenario and
recommend hedging strategies, including derivative tools and other risk treatments.
It will take you approximately 30 minutes to complete.
Scenario
You are the group treasurer working for KDY Contractors Limited (KDY) reporting to the CEO,
Dan Crothers. KDY is listed on the Australian Securities Exchange and provides engineering
and construction services on a global basis. Its major clients include governments and mining
companies.
KDY has been awarded a contract by the New Zealand Government to upgrade Greymouth
Harbour in the South Island. The fixed price of this contract has been set at NZD25 million,
with project completion within 18 months. Progress payments will be received by KDY upon
completion of various milestones detailed in the contract. Before work commences you, as
group treasurer, are to evaluate the issues to be addressed arising from the contract in an
uncertain interest rate environment.
Tasks
For this activity you are required to:
1. Determine in which market the working capital for this contract should be financed. Justify
your response.
Note: Working capital is needed to cover the construction costs incurred in undertaking the
project.
2. Having decided where to fund the working capital using a short-term loan, identify the
remaining financial risks of the contract and recommend appropriate risk treatment(s) for
each.
3. Upon successful completion of the project KDY will transfer the profits back to Australia,
giving rise to foreign exchange risk. Recommend an appropriate risk treatment for this
transaction.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 14.6
Strategies for managing foreign exchange
risk service industry
Introduction
In the current global economic environment, management accountants find that many
companies they are associated with are exposed to foreign exchange risk.
As every company has a different level of risk appetite, management accountants need to
understand a variety of strategies to manage this risk so that they can provide advice on the
optimum strategy.
For this activity you are required to examine two alternative hedging strategies for a given
scenario and recommend to management the most appropriate.
This activity links to learning outcome:
Assess business risks for an organisation and apply strategies to treat these risks.
At the end of this activity you will be able to examine alternative foreign exchange hedging
strategies and apply the most appropriate treatment.
It will take you approximately 40 minutes to complete.
Scenario
This activity is based on the SDT Solutions (STD) case study.
During the current financial year, an American company approached SDT for a quote for a large
software development project.
After considering the brief and the specifications, SDT quoted a price of USD220,000. This quote
was accepted on 1 July, and the following payment terms were agreed:
10% deposit on acceptance of the quote (i.e. immediately).
40% payment on 30 September.
Final 50% payment on 31 December.
While comfortable that SDT can earn a good return on the job, the CFO, Charlene OShay, is
concerned about possible volatility in the AUD/USD exchange rate over the six-month period.
You are a management accountant working in the finance department of SDT. Charlene has
asked that you research and advise her on the alternatives for SDT to manage the FX risk on this
job.
You decide to explore two alternatives to hedge the FX risk.
ACT
1. Alternative one
Enter into two separate forward foreign exchange contracts (FECs); one to sell USD88,000 on
30September at 0.90, and another to sell USD110,000 at 0.95 on 31 December.
2. Alternative two
Buy two OTC put options from SDTs bank; one to sell USD88,000 on 30 September at 0.90, and
another to sell USD110,000 at 0.95 on 31 December. The cost of the two put options would be
AUD2,000 and AUD4,000 respectively.
In order to explain these two alternatives to Charlene, you have chosen the following AUD/USD
FX spot rates based on discussions with SDTs bank:
AUD USD
Note: You will need to inform Charlene that these rates are illustrative only, and are chosen to
stress the impact of exchange rate changes.
Tasks
For this activity you are required to prepare notes for a report to Charlene OShay. The notes
should address the following:
1. Analyse Alternative 1 and discuss the potential impact of the two FECs.
2. Analyse Alternative 2 and discuss the potential impact of the two OTC foreign exchange
options.
3. Recommend the most appropriate alternative for managing FX risk.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 14.7
Hedging strategy for overseas acquisition
Introduction
Businesses may be exposed to numerous sources of financial risk that management accountants
need to understand.
Identifying financial risks around acquisitions is an important part of the management
accountants role, as is recommending an appropriate hedging strategy to address the risks
identified, and the derivative tools to be used to achieve this strategy.
This activity links to learning outcomes:
Identify common business risks to which an organisation may be exposed.
Assess business risks for an organisation and apply strategies to treat these risks.
At the end of this activity you will be able to identify financial risks arising from an overseas
acquisition and recommend an appropriate hedging strategy.
It will take you approximately 45 minutes to complete.
Scenario
KDY Contractors Limited (KDY) is listed on the Australian Securities Exchange (ASX). The
company provides engineering and construction services on a global basis. Its major clients
include governments and mining companies.
You are the group treasurer for KDY and you report to the CEO, Dan Crothers. KDY has been
looking to expand its presence in Canada as it sees opportunities for growth supporting mining
companies in this resource-rich country. Its business development team has been working on
an acquisition, the cost of which will be CAD300 million. Following an extensive due diligence
process and submissions to the board of directors, the deal was approved and announced to the
ASX yesterday.
The acquisition date will be in three months time on 31 October. The terms of the agreement
require the payment of CAD200 million upfront and two instalments of CAD50 million
payable on an earnout basis subject to the satisfactory achievement of certain KPIs. The earnout
payments, if required, will be in 12 months and 24 months respectively from the acquisition
date.
The acquired entity will not pay KDY any dividends for three years.
The funds that will be used to pay for the Canadian acquisition are currently invested in
Australian money market securities as interest rates are higher in Australia than in Canada. The
current AUD/CAD exchange rate is at parity and historically has been quite volatile.
The CEO has advised you that the financial risk tolerance for this transaction, including the
potential instalments, is zero, and certainty is required for Group budgeting purposes for the
initial payment of CAD200 million.
ACT
Tasks
Dan Crothers has asked you to investigate the following:
1. Identify the three separate transactions involved in the acquisition.
2. Identify the key financial risk involved in the acquisition.
3. Recommend the optimal hedging strategy for each transaction.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
There are no further readings for this unit.
References
The following is a summary of all other sources referred to in the preparation of the content for
this unit.
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~dadams/CorporateHedging.pdf.
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This guide was published by the three main risk management organisations in Britain: Airmic
(Association of Insurance and Risk Managers in Industry and Commerce), Alarm (Public Sector
Risk Management Association), and IRM (Institute of Risk Management
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Home Switzerland Corporates & Institutions Corporates Financing Hedging Interest
Rate Risks.
Crouhy, M, Galai, D and Mark, R 2006, The essentials of risk management, McGraw-Hill, New
York, Appendix to Chapter 1 Typology of Risk Exposures, pp. 2536.
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deloitte.com.au search for FX hedging strategy: without the benefit of hindsight.
Deloitte, Hedge Strategy Does your policy shape up?, accessed 4 February 2014, www.deloitte.
com.au search for Hedge strategy does your policy shape up?.
Ernst & Young 2011, The evolving IT risk landscape, accessed 3 February 2014, www.ey.com
search for Insights on IT risk: Evolving IT Landscape.
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search for Business pulse top 10 risks and opportunities.
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QUT, University of Queensland, accessed 4 February 2014, www.uq.edu.au search for
Sustainability and environmental risk management at UQ and QUT.
Further details on all derivatives can be obtained from the ASX website (accessed 4 February
2014), www.asx.com.au Products.
Further details of the New Zealand interest rate derivatives and details of other market
derivatives, including energy futures and options, can be obtained from the ASX website
(accessed 4 February 2014), www.asx.com.au Products.
Information regarding exchange-traded derivatives traded on the New Zealand Exchange is
available on the NZX website (accessed 3 February 2014), www.nzx.com Markets NZX
Derivatives.
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com search for Understanding and articulating risk appetite 2008.
KPMG Risk Consulting 2011, Using risk appetite to drive value, accessed 4 February 2014,
www.kpmg.com search for Using risk appetite to drive value.
McTaggart, D, reviewed by Duane, R 2010, Australian Dollar Drivers and the Impact on Grain
Prices, Farmanco Facts, vol. 30 no. 6, July 2010, accessed 4 February 2014, www.farmanco.com.
au Agronomy Products Farmanco Facts Australian Dollar Drivers and the impact on
grain prices.
Macquarie Group, Futures Product Disclosure Statement, accessed 4 February 2014,
www.macquarie.com.au Personal Financial advice Stockbroking Futures
Brochures & forms Futures Product Disclosure Statement (PDS).
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Corporate Finance, vol. 18, no. 4, Fall, accessed 4 February 2014, www.fisher.osu.edu search
for Enterprise risk management: theory and practice.
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2014, www.dpc.nsw.gov.au search for Risk based compliance.
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smallbiz.nsw.gov.au search for Common small business risks.
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http://praxiom-rm.com search for Top 10 methods for identifying business risks.
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30June 2015, www.rbnz.govt.nz search for Official cash rate (OCR) decisions and current
rate.
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search for B1 Exchange rates.
Roland Berger strategy consultants, Trojan horses of decline: study on strategic risk management,
Part 1, accessed 4 February 2014, http://turnaroundfinance.nl Publicaties.
Standards Australia 2009, AS/NZS ISO31000:2009 Risk Management Principles and Guidelines.
State of Queensland Treasury 2011, A guide to risk management: A case study, accessed 4February
2014, www.treasury.qld.gov.au search for A guide to risk management.
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4February 2014, www.thebusinessowner.com search for Eleven steps to smart risk
management.
Valenzuela, Rebecca 2011, Joy and sorrow in the rising dollar, The Age Education Resource
Centre, accessed 29 May 2013, http://education.theage.com.au Economics Economics
archive 2011 Joy and sorrow in the rising dollar.
van den Brink, Dr Gerrit Jan 2004, Strategic risk: Can it be measured?, accessed 29 May 2013,
www.financeventures.nl search for Strategic risk: can it be measured?.
Webtrade 2005, The P76 story Why it sank, accessed 4 February 2014, http://webtrade.com.au
Auto & Marine P76 search for The P76 story Why it sank Leyland P76 - Australias
Own Car - Magazine Articles Why it sank.
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4February 2014, www.westpac.com.au search for Interest Rate Swap Product Disclosure
Statement.
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Core content
Unit 15: Introduction to business valuation
Learning outcomes
At the end of this unit you will be able to:
1. Outline the different types of valuations undertaken and their purpose.
2. Summarise the income, market and cost valuation methodologies, and explain their
respective strengths and weaknesses.
3. Prepare valuations using both the income and market approaches.
4. Evaluate the impact of size, control, marketability and liquidity issues on a valuation.
Introduction
The ability to value a business is an important skill for the management accountant. Business
valuations are required in many of the strategic and operational decisions that an organisation
makes. During valuations management accountants will find themselves working with a wide
range of stakeholders, from senior management through to operational staff. The management
accountants role is to provide objective, practical and balanced analysis to support the decision-
making process.
Valuing a business draws on a number of management accounting skills, including:
Investment decisions: A business valuation is, in essence, an investment decision. A key
business valuation technique is discounting future cash flows associated with the business
at an appropriate discount rate.
Business planning: The robustness of a business valuation will rely on the quality of the
financial forecasts (both cash flow and net income).
Long-term financial management: The mixture of debt and equity financing within a
business is an important ingredient of the eventual valuation. It is important to understand
whether the valuation is of the business as a whole, or limited to the equity element.
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Learning outcome
1. Outline the different types of valuations undertaken and their purpose.
Business valuations are undertaken to determine the worth of the whole or a part of a business.
A valuation may include tangible assets such as land and buildings, or intangible assets such as
brands, trademarks and patents. Alternatively, it may be limited to a share or equity valuation.
The valuation itself can also be undertaken from a number of different perspectives, such as the
buyer, the seller and the lender.
Possible reasons for undertaking a business valuation include:
Acquiring or divesting assets.
Improving the intrinsic value of the business.
Raising finance.
Evaluating an equity investment.
Preparing a legal submission.
Preparing an initial public offering (IPO) (company float on a stock exchange).
When acquiring a business, the purchaser should undertake a detailed due diligence process.
Due diligence is the process through which the purchaser validates representations made by
the seller and their own assumptions during the negotiation and investigation stages of an
acquisition. The due diligence process should be a continuing process that starts from the time
discussions commence and concludes when the final contract is signed.
There are a variety of strategic, operational and financial decisions that can benefit from a
business valuation. The valuation approach chosen will depend on the size, complexity and
purpose of the valuation.
The following diagram illustrates the various valuation approaches:
VALUATION APPROACHES
It is important to appreciate that no one approach is correct. They all have their strengths
and weaknesses; all make assumptions about the future, and each is only as good as the
assumptions and the quality of the data used to determine the valuation.
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Different valuation approaches are used in different circumstances. The following table shows
a number of situations where valuations are used, their purpose, and the appropriate valuation
approach.
Divesting a business unit or To dispose of a business that is Cost-based approaches can help
division either underperforming or no set a minimum balance sheet price
longer strategically important, that would be acceptable for a quick
thereby releasing cash for sale. Combining this approach with
investment elsewhere income-based approaches can help
justify higher prices, by factoring in the
synergies that a buyer might be able to
access
Improving the intrinsic value To understand the key operational An income-based valuation is
of a business factors that can be focused on to appropriate here. Sensitivity analysis
increase shareholder value testing the robustness of the valuation
by varying the FCF drivers can help
identify whether strategies such as
improved margin management, fixed
capital efficiency or working capital
efficiency would have a significant
impact on shareholder value
Evaluating an equity To inform current and potential Market-based valuations are helpful to
investment investors whether they should buy, assess the relative value of a business or
hold or sell shares in the business business unit, by comparing it to other
organisations or business units
Initial public offering, also Setting price expectations for Market-based valuations are helpful to
known as a public float owners and the market assess the relative value of a business
or business unit, by comparing it to
other organisations or business units.
Income-based approaches are helpful
to demonstrate sustainability of cash
flows and profitability
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2. Equity value
This is the value of the equity only. Dividing it by the number of shares on issue will give the
value of an individual share.
One of the most common mistakes encountered in practice is the confusion between enterprise
valuations and equity valuations, particularly when carrying out income-based valuations
(covered in the following section). Clarity in what is being valued is vital in order to ensure an
enterprise value is not being compared to an equity value, or in a standalone case, an enterprise
value is not assumed to be an equity value.
In its simplest form:
Learning outcome
2. Summarise the income, market and cost valuation methodologies, and explain their
respective strengths and weaknesses.
While this unit focuses primarily on the valuation of an entire business, the techniques
described here are, for the most part, applicable to the valuation of a single business unit or
individual assets.
There are three main methods of conducting a business valuation: income-based, market-
based (or multiple-based) and cost-based (also known as asset-based). Each technique will be
explained in more detail in subsequent sections.
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The strengths, weaknesses and applicability of each method are outlined in the following table:
Income-based In essence, an income- based The most complex technique in The core technique used
valuation is a net present terms of both execution and the for valuing both business
value (NPV) calculation ability of operational managers acquisitions and disposals.
based on discounted future to understand the result Extremely useful for
cash flows understanding the value of
A large range of assumptions are
a business as is, and then
Often considered to be the required regarding forecasting
pricing in synergies that
most technically robust future cash flow, and therefore
might be created as part
approach, as it focuses on identification and justification
of the acquisition process.
the true economic drivers of these assumptions is vital to
Helpful for understanding
of value, being future cash provide a meaningful valuation
how the value of a
flows and risk
Prone to the effects of business can be affected
Captures both tangible forecasting errors due to by operational decisions,
and intangible value by subjectivity of assumptions such as changes to margin
considering the total cash applied and working capital
flow generated by the management
Estimating an appropriate
business
discount factor is difficult, and
Lends itself well to sensitivity relies on a constant proportion
analysis of key assumptions, of debt/equity applied to the
by changing individual FCF business when using weighted
drivers average cost of capital (WACC)
Cost-based Simple and quick The balance sheet is based on Often carried out at the
the historic cost convention, beginning of a valuation
Data readily available in the
so there is no guarantee that assignment to obtain a
form of a balance sheet
the book valuation will reflect preliminary view of the
Has an element of certainty, current values base value of a business
as it is based on assets that
Adjustments will be required The replacement cost
are owned
based on the assessed current valuation method examines
value of assets; for example, if a the value of a business
manufacturing business is selling in relation to the cost of
its business for $2million but the replacing its assets with
machinery and other assets can alternative, but similar
be replaced for $1.5million, then assets
the replacement cost method
Helpful in its own right
would value the business at
to establish a liquidation
$1.5million
value where all assets of
May significantly undervalue a a business are sold and
business, as the value generated liabilities are repaid
from intangible assets (such as
Used to value excess assets
brand and intellectual property)
within a business
are often ignored
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Business valuation is not a precise science. A pragmatic approach to valuations recognises that
all valuation techniques make assumptions about the future and are therefore, by definition,
uncertain. Management accountants who understand this often use a combination of techniques
to value a business, and calculate a range of values. Rather than asserting, for example, that the
value of a business is $10 million (suggesting spurious accuracy), they will instead conclude
that its value is between, for example, $8 million and $11 million, and provide supporting
assumptions for the range.
This broader view of the value of a business allows scope for negotiation between the buying
and selling parties. The sellers objective will be to get the highest price possible, while the
buyer will be aiming to acquire the business for the lowest price possible. If each party comes
to the table with a range of acceptable values, the deal is more likely to come to a mutually
acceptable position.
At the final assessment, valuation techniques merely provide guidance as to an acceptable range
of valuations. The ultimate value of anything is what a willing buyer is prepared to pay, and
this will be settled in negotiation with the seller rather than via a numerical figure calculated on
a spreadsheet.
Learning outcome
3. Prepare valuations using both the income and market approaches.
Income-based valuations
Income-based valuations use the discounted cash flow (DCF) method to value future cash flows
the business is predicted to generate. This approach to valuing a business is the method that
most accurately reflects the fundamental drivers of value.
There can be no value without cash, and DCF methodology requires an estimate of the future
free cash flows that a business will generate, adjusted for risk by a process of discounting. (This
approach accords with the way that shareholders think about value.)
A note of caution regarding the DCF method: it is the most complex of the valuation tools
discussed and it does have limitations. DCF valuations can fluctuate widely due to the
subjectivity associated with the free cash flow forecasts and discount rates used. Future
financial information and events are being estimated, and there is an inherent risk of
uncertainty, bias and error with this approach. The method works best when there is a high
degree of confidence about future cash flows, whereby assumptions can be measured with
some reliability. Sensible, pragmatic DCF analysis, incorporating sensitivity analysis, will
provide a range of values given a number of different assumptions. Indeed, DCF is well suited
to sensitivity analysis, rather than one single value.
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There are two approaches to DCF business valuations, one of which delivers enterprise value
and then, by deduction of debt, an equity value; and the other, which delivers equity value
directly. These are summarised in the diagram below:
Enterprise value
Less debt
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Item $
Sales X
FCF X
Fixed capital refers to investments in the long-term fixed assets of the business. An increase in
fixed capital results in a cash outflow, while a decrease (via sale of redundant assets) would
result in a cash inflow.
Working capital refers to inventory plus receivables minus payables. Any increase in this
number reduces cash flow, as more cash is tied up (e.g. through increasing stock or debtor
levels). A reduction in working capital increases cash flow, as previously tied-up cash is
released back into the business (e.g. through decreasing stock or debtor levels). Working capital
is explored in detail in the unit on working capital management.
The calculation of FCF for valuation purposes is often carried out using what is known as a
value-driver approach (FCF driver approach), which simplifies the calculation of FCF and
lends itself to sensitivity analysis testing the key assumptions.
Five key FCF drivers are required to predict FCF over the forecast period of a business
valuation:
Sales growth rate.
Operating profit margin.
Income tax rate.
Incremental investment in fixed capital rate.
Incremental investment in working capital rate.
All of the above must necessarily take into account inflation or deflation in the rates set. As can
be seen, determining a driver is not simply a matter of applying a percentage on a roll-forward
basis expected future impacts on the FCF driver rates must also be factored in.
Stage 1
Define an explicit forecast period within which it is believed FCF drivers can be estimated. FCF
can be calculated using the FCF driver approach during this period, typically up to ten years.
Stage 2
Define a fade period during which returns are driven down to the WACC (being the minimum
return required by investors) by competitive pressure.
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Stage 3
Define a continuing period into infinity to which a constant growth (or abatement) rate is
applied. This is used to calculate the terminal value of the FCF in the continuing period (which
is defined in detail in the next section). During the continuing period, returns stabilise to equal
the cost of capital.
This process is illustrated in the diagram below:
Terminal value
Terminal value represents the future FCF beyond the explicit forecast period of the business
(i.e. for the fade and continuing periods), and is calculated using a constant growth rate. The
constant growth rate is also called the stable growth rate and cannot be higher than the growth
rate of the industry and economy within which the business operates.
Given that the terminal value is being calculated for periods after the explicit forecast period,
the FCF in the numerator is the FCF for the final year of the explicit forecast period grossed up
by the expected growth rate. The denominator is the required WACC less the expected growth
rate.
The formula is expressed as:
FCFN ^1 + g h
Terminal valueN =
WACC g
where: N = the final year of the explicit forecast period
Terminal value = the discounted cash value of the FCF into perpetuity, valued at period N
FCFN ^1 + g h = the FCF at period N grossed up by the constant growth rate to represent
the FCF of the first year into perpetuity
WACC = the weighted average cost of capital assumed in the DCF model
g = the stable growth rate, being the assumed growth rate into perpetuity
Once the terminal value has been calculated, the management accountant assesses it for
reasonableness. As with any modelling, if incorrect drivers are input, incorrect results will be
derived. If the terminal value looks unreasonable (i.e. either too high or too low), the factors
driving the result will need to be re-examined and adjusted if necessary. As with all future-
based analyses, reasonableness tests need to be applied.
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This discussion of income-based valuations demonstrates that DCF valuations are sensitive
to the assumptions input into the model. A range of values with a number of different
assumptions need to be calculated.
Sensitivity to assumptions should not distract from the fact that DCF is by far the most
theoretically correct and practical method to use to value a business. It focuses on the true
drivers of value, namely the potential of the business to generate future cash flows. It is widely
used in acquisition and divestment decisions, where FCF drivers can be adjusted to reflect
different potential levels of synergy.
The DCF technique can be used to help focus business managers on the key drivers of value
that they should aim to improve. As the true driver of value in any organisation is its ability to
generate cash flows for its investors, the DCF method has the potential to be more accurate than
other methods. Market-based and cost-based valuations are often used to support income-based
DCF valuations, but it is the DCF method which will always provide the most fundamental and
rigorous valuation.
Market-based valuations have traditionally been popular in the financial community, as they
allow companies to be classified as either overvalued or undervalued. Extreme care needs to
be taken when using multiples in this way, however, as they have a number of limitations and
assumptions associated with them (outlined below).
Two major multiple-based approaches are considered here:
Price/earnings ratio (P/E).
Enterprise value/earnings before interest, tax, depreciation and amortisation (EV/EBITDA).
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Price/earnings ratio
The P/E ratio is calculated by taking the market capitalisation of a company (number of shares
times market price per share) and dividing that figure by the companys earnings (profit after
tax). The earnings in the P/E ratio can be measured on a trailing basis using current earnings,
or on a forward basis using expected (or next years) earnings. A P/E ratio of 10, for example,
indicates that investors are currently prepared to pay 10 times the companys earnings for a
share. The P/E ratio will vary by company and by industry, the differences often being related
to perceived risk levels.
Once calculated, the P/E ratio is compared to the P/E ratios for similar companies within the
same industry and also against the industry average. A similar company is one that has a
comparable growth rate, risk profile, financial leverage and dividend payout policy. To avoid
evaluating a company against itself, care must be taken when selecting indices to ensure that
the target company is not part of the pool used to calculate the indices.
The classic interpretation is that a share in a comparable organisation with a higher P/E ratio
is considered to be more valuable than a share in an organisation with a lower P/E ratio. It
suggests that businesses can be classified as overvalued or undervalued relative to the sector.
The reality is, however, that few companies are really comparable in size, risk, current projects
and, in some cases, accounting treatments; therefore, any comparisons must be used with
caution.
Note the timing difference in the P/E ratio: price/value is about future expectations, while
earnings are historic. It follows, therefore, that a high P/E ratio indicates the market expects
greater future earnings, or above-market performance.
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The EV/EBITDA multiple has become a popular complementary multiple valuation technique
in recent years. Its perceived advantages over the P/E ratio are outlined as follows:
EBITDA is a figure that more closely approximates to cash flow from business operations.
EBITDA is derived higher up the income statement than equity earnings, and therefore
should capture organisations that are making net operating losses.
As EBITDA is calculated before interest, it is not distorted by the different financing/capital
structures of organisations, and focuses purely on operating performance.
It should be noted that EBITDA is still derived from accounting data. Although depreciation
and amortisation have been added back, the metric is capable of distortion by other accounting
policies, such as revenue recognition and provisions. It is also not a true measure of operating
cash flow, as it ignores cash movements derived from the balance sheet, such as increases/
decreases in working capital, and asset purchases/disposals.
EBITDA, by definition, is calculated before interest, and so belongs to both debt and equity
providers. Therefore, when equated to an appropriate comparable multiple, it will deliver an
estimate of the enterprise value of the organisation in question. Deducting the value of debt will
give the equity value, which can then be compared with the equity value calculated using the
P/E ratio approach.
Cost-based valuations
Cost-based valuations revolve around establishing appropriate balance sheet values for assets,
and then deducting the market value of debt to determine equity.
It needs to be emphasised that there is a difference between accounting for an asset and
valuing an asset. The financial accounts are not a statement of value. They are prepared using
accounting principles that may lack meaning for valuation purposes. For example, some
organisations choose to revalue plant and equipment to present value, while others record
assets at historical cost.
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Without making any adjustments, the balance sheet suggests that the enterprise value is
$100million ($118 million less current liabilities), and the value of the equity is $60 million. This
approach, while simple, is not particularly useful. The balance sheet is based on historic cost
accounting principles, and there is no guarantee that those costs reflect current market values.
The cost-based approach becomes useful when valuing a business for a quick sale (e.g. in the
case of liquidation). Adjustments are made to the historic costs to convert them into liquidation
values.
Consider the following additional information:
The land and buildings are in a prime location, and their current market value is $65 million.
The plant and equipment is extremely specialised, and no active market exists for resale.
The best that can be hoped for is a scrap valuation of $5 million.
The net realisable value of inventory for a quick sale is $6 million.
A review of receivables shows that all potential bad debts have been identified and
provided against.
An adjusted balance sheet that reflects a price that might reasonably be attained for the
business on liquidation would now look like this:
$million $million
Current liabilities
Inventories 6 Accruals 3
Receivables 20
Cash 10 Equity 48
The enterprise value is now $88 million ($106 million less current liabilities) (reduced by
$12million), and the value of the equity is $48 million (reduced by $12 million). Note that the
value of debt does not change.
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Learning outcome
4. Evaluate the impact of size, control, marketability and liquidity issues on a valuation.
When valuing a business, consideration should be given to specific features about the business
and the proposed transaction. Some common considerations include organisation size, whether
the transaction is for a controlling interest, and whether the organisation is privately owned.
Impact of marketability/liquidity
Marketability is concerned with how quickly and efficiently an interest in a company can be
liquidated (converted into cash). Quoted company investments are typically more marketable
than non-quoted company investments, as there is a ready-made marketplace (the stock market)
to trade the shares. Because of this, the value of a quoted company investment is usually taken
to be worth more than the value of an equivalent, non-quoted company investment.
This mismatch becomes a particular issue when using valuation methodologies such as
multiple-based approaches, where quoted company data is often used to value non-quoted
businesses, even though the non-quoted business does not have the benefit of liquidity. In these
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circumstances, the practical solution is to apply a discount to the basic valuation. Academic
studies (based on historical transactions analysis) suggest that this discount could be anywhere
between 15% and 40%, depending on the specific circumstances involved. This is obviously a
highly subjective area, and wherever possible this issue should be avoided by carrying out a
more fundamental, income-based valuation on the business involved.
Quiz
[Available online in myLearning]
ACT
Activity 15.1
Income-based valuation
Introduction
Income-based valuations use the discounted cash flow (DCF) method to value the future cash
flows a business is predicted to generate. This approach to valuing a business is the method
that most accurately reflects the fundamental drivers of value: there can be no value without
cash. The DCF methodology requires an estimate of future cash flow (FCF) that a business will
generate, adjusted for risk through discounting.
This activity uses the income-based method of valuation and links to learning outcomes:
Summarise the income, market and cost valuation methodologies, and explain their
respective strengths and weaknesses.
Prepare valuations using both the income and market approaches.
At the end of the activity you will be able to calculate the valuation of an organisation using the
income approach.
It will take you approximately 60 minutes to complete.
Scenario
This activity is based on the SDT Solutions (SDT) case study.
You are a contract management accountant working for Charlene OShay, SDTs CFO. Charlene
has mentioned that SDT owners Richard and Phillip are interested in exploring SDTs value,
should they decide to sell their interest and move on to something else. Charlene has been
reading about the different methods of valuing a business, and has determined that the income
approach is the most appropriate to value SDT.
To help prepare SDTs valuation, Charlene collects the following additional information.
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Non-current liabilities
Employee entitlements 48,956 54,865
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The following table outlines the different factors to be taken into account in valuing SDT.
Tasks
For this activity you are required to:
1. Outline why an enterprise-based income approach would be the most appropriate method
to value SDT Solutions.
2. Calculate the enterprise value of SDT Solutions using the income approach.
[Solutions to activities are available online. Please access myLearning to view]
ACT
Activity 15.2
Business valuation using income and
marketbased approaches
Introduction
As a management accountant you may be required to help value a company that is being
considered for purchase.
For this activity you are required to assess the value of a company using income and market-
based approaches.
This activity links to learning outcome:
Prepare valuations using both the income and market approaches.
At the end of the activity you will be able to value a company using income and market-based
approaches.
It will take you approximately 60 minutes to complete.
Note: Throughout this activity all figures are in AUD.
Scenario
This activity is based on the Accutime Limited (Accutime) case study.
The board of Accutime has recently received a communication from the board of Sharp Investor
Limited, a well-known listed venture capital organisation.
The board of Sharp Investor has issued Accutimes board with an off-market takeover bid. The
bid states Sharp Investors intention to acquire 100% of the shares in Accutime at an offer price
of $1.20. Prior to the market being informed of the offer, Accutime shares were trading at $1.05.
The board of Accutime has sought your advice regarding whether Sharp Investors offer
represents value for money for shareholders and whether it should recommend shareholders
accept or reject the offer.
To assist your analysis, the board has provided you with the following information.
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Tasks
For this activity you are required to:
1. Calculate the enterprise and equity values of Accutime using the income-based approach.
2. Calculate the equity value of Accutime using the existing market share price and the Sharp
Investor offer price.
3. Advise the board of Accutime whether they should recommend shareholders accept or
reject Sharp Investors takeover offer.
[Solutions to activities are available online. Please access myLearning to view]
Readings
Required reading
There are no required readings for this unit.
Further reading
There are no further readings for this unit.
References
The following is a summary of all other sources referred to in the preparation of the content for
this unit.
Christensen, CM, Alton, R, Rising, C and Walbeck, A 2011, The big idea: The new M&A
playbook, Harvard Business Review, March.
Holloway, C, Grousebeck, H and Tauber, A 1998, Valuation techniques, Stanford Graduate School
of Business, Case No. E53, November.
Luehrman, TA 2005, Corporate valuation and market multiples, Harvard Business Review,
October.