CIMAEx PP1

Notes
CIMA Paper P1
Performance Operations
For exams in 2011
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CIMA P1 Performance Operations
Contents
About ExPress Notes
1. 2. 3. 4. 5. Cost Accounting Systems Forecasting and Budgeting Techniques Project Appraisal Dealing with Uncertainty in Analysis Managing Short Term Finance
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ExPress Notes
Chapter 1
Cost Accounting Systems
START The Big Picture

This section addresses the different main systems concerning production costs. The techniques mentioned are useful in assisting businesses in determining the: Cost of production (for both decision-making and reporting purposes); Valuation of inventories; Pricing of products
KEY KNOWLEDGE Absorption Costing

This is one method which seeks to make the link between overheads and (product) cost units. The focus is on production. Overhead costs that are not incurred at the time of production do not find their way into inventory. It is useful to think of production costs as being those that end up as part of the inventory (valuation) while other (non-production) costs are incurred outside, and normally after the product leaves inventory.
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KEY KNOWLEDGE Contribution

Contribution is defined as the difference between Sales revenue and the marginal cost of sales, or Contribution = Sales Variable costs (both production and non-production)
KEY KNOWLEDGE Marginal Costing

A marginal approach to costing focuses on the variable (marginal) costs generated in a business and considers fixed costs as period costs. This allows the company to be able to quantify the amount by which its costs rise, if it produces/sells an additional unit of output. Inventory is valued at the full production costs. Summary of Absorption costing and Marginal costing formats Absorption Costing Revenue Less: Cost of Sales Variable/Fixed production costs Gross profit Less: Expenses Variable/Fixed non-production costs Net Profit Fixed production/ non-production costs Variable production/ non-production costs Contribution Marginal Costing
KEY KNOWLEDGE Throughput accounting

This method is also consistent with a JIT environment and focuses on the bottlenecks in a production process; by eliminating these bottlenecks, it raises the amount of output that can flow through the process (assuming there is demand for the output the idea is not to produce for inventory!).
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ExPress Notes
The throughput accounting approach itself considers all costs (including direct labour) as fixed and treats only direct materials as being variable in the short term.
KEY KNOWLEDGE Activity Based Costing (ABC)

ABC is a method that seeks to group overhead costs according to the activities causing those costs. The activities giving rise to the costs are called cost drivers. By linking costs to activities (cost drivers), it becomes possible to charge costs to the agents undertaking those activities.
ABC -- EXAMPLE
A factory clinic with total annual costs of $500,000 serves two Workshops A and B. Workshop A has 200 employees and Workshop B has 300 employees. A conventional way of apportioning the cost would be on the basis of employees: Workshop A: (200/500) x 500,000 = 200,000 Workshop B: (300/500) x 500,000 = 300,000 500,000 An ABC approach might look at the number of visits to the clinic by the employees of A and B. Workshop A: 150 visits p.a. Workshop B: 70 visits p.a. In this case, the apportionment could be: Workshop A: (150/220) x 500,000 = 340,909 Workshop B: ( 70/220) x 500,000 = 159,091 500,000 The different levels of usage may reflect different degrees of occupational hazard present in the two workshops. ABC advantages: provides a more precise way to determine costs per unit of output, especially since not all overhead costs are driven by production volumes.
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Budgetary planning, pricing decisions and managing performance are all facilitated by ABC. ABC disadvantages: it can be complex and costly to implement. It is not a plug-in-and-go system! It is therefore imperative that management carefully weigh the costs against the (expected) benefits from ABC before deciding to implement it.
KEY KNOWLEDGE Basic Variance Analysis -- Example

The following data is from a manufacturing company Budget Production: Sales: Sales Price: 1,100 units 1,000 units $120 / unit
Actual results Production: 1,000 units Sales: 950 units Materials: 4,900 kg, $45,025 Labour: 3,100 hrs, $19,050 Variable O/Hs: $9,250 Fixed O/Hs: $17,000 Sales price: $115 / unit Cost card (per unit) Materials (5kgs x $9 per kg) Labour (3hrs x $6 per hr) Variable O/Hs (3 hrs x $3 per hr) Fixed O/Hs (3 hrs x $5 per hr) 45 18 9 15 87
Variance calculations Sales volume variance (Absorption costing) Budgeted sales volume Actual sales volume Sales volume variance @ standard margin ($120-$87) 1,000 950 50 (A) $1,650 (A)
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Sales volume variance (Marginal costing) Budgeted sales volume Actual sales volume 1,000 950
Sales volume variance 50 (A) @ standard contribution ($120-$72) $2,400 (A)
Sales price variance 950 units should have sold @$120 Actual revenues (950 units x $115) Sales price variance Material variances (i) Material price variance Materials used (4,900 kg) should have cost @ $9 Materials (4,900 kg) did cost Materials price variance (ii) Material usage variance 1,000 units should have used @ 5 kg 1,000 units did use Materials usage variance @ standard $9 Materials total variance: 5,000 kg 4,900 kg 100 kg (F) $900 (F) $ 25 (A) 44,100 45,025 $925 (A) 114,000 109,250 4,750 (A)
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Labor variances (i) Labor rate variance Labor (3,100 hrs) should have cost @ $6 Labor (3,100 hrs) did cost Labor rate variance (ii) Labor efficiency variance 1,000 units should have taken @ 3 hrs 1,000 units did take Labor efficiency variance @ standard $6 Labor total variance: Variable O/H variances (i) Variable O/H expenditure variance 3,100 hrs should have cost @ $3 3,100 hrs did cost Variable O/H expenditure variance (ii) Variable O/H efficiency variance 1,000 units should have taken @ 3 hrs 1,000 units did take Variable O/H efficiency variance @ standard $3 Variable O/H total variance: 3,000 hrs 3,100 hrs 100 hrs (A) $300 (A) $ 250 (A) 9,300 9,250 50 (F) 3,000 hrs 3,100 hrs 100 hrs (A) $600 (A) $ 1,050 (A) 18,600 19,050 $450 (A)
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Fixed O/H total variance (Absorption costing) Overhead actually incurred Overhead absorbed (1,000 units x $15) Fixed O/H total variance $17,000 $15,000 $ 2,000 (A)
This can be broken down into two components: (i) Fixed O/H expenditure variance Budgeted O/H should have cost (1,100 units x $15) 16,500 Actual O/H cost Fixed O/H expenditure variance (ii) Fixed O/H volume variance (Absorption Costing) Budgeted production Actual production Fixed O/H volume variance @ standard $15 Interpreting variances Calculating variances is just the first step in analyzing their causes and taking remedial action steps to achieve improvements. 1,100 units 1,000 units 100 units (A) $1,500 (A) 17,000 $500 (A)
KEY KNOWLEDGE Mix and Yield Variance

When materials are combined in the production process in standard proportions, with the possibility of substituting one for the other, then the materials usage variance can be broken down into two further measures: Mix: This examines the (monetary) impact of altering the proportions of the two materials.
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ExPress Notes
Yield: This focuses on the total amount of inputs to produce the output achieved. The sum of the mix and yield variances is equal to the materials usage variance.
KEY KNOWLEDGE Planning and Operational Variances

Due to changing market and technical circumstances, standards may become outdated. In such cases, it may be necessary to alter a standard, even during a budget period already in progress. Planning and operational variances capture these changes in two steps: Planning variance: Compares results based on the revised standard compared to the initial standard. The result is usually considered to be outside the area of control of management. Operational variance: Compares actual results with the budget based on the revised standard. This is often considered to be within the control of management. The distinction above between controllable and uncontrollable factors is critical insofar as it relates to the idea of responsibility accounting, i.e. expecting people who have delegated authority to take responsibility for decisions within their area of control.
KEY KNOWLEDGE McDonaldization

Efficiency: Achieving optimal outputs relative to inputs; Calculability: Emphasis on quantity (over quality); Control: Substitute automation wherever feasible; Predictability: Uniformity of service (no surprises)
KEY KNOWLEDGE Benchmarking

Systematic analysis of own performance against that of another organisation, with a view of improving own performance by learning from others experience
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Categories External: o Competitive: against a best in class competitor o Functional: against best in class functions Internal (against a best in class similar business unit within the organisation)
KEY KNOWLEDGE Back-flush Accounting

This is a simplified costing method which can be used in conditions of short operational cycles and low inventories. Companies working on a Just-In-Time (JIT) basis may practise it, as it avoids the detailed tracking of costs during production; instead, it records costs when goods are completed. These costs are then back-flushed through the system based on standard costs.
KEY KNOWLEDGE Just-In-Time (JIT)

JIT is more than an inventory management model; it is a manufacturing philosophy which puts at its core minimization of inventories on the basis that most of inventoryrelated activities are non-value-added. JIT is a pull system (in the sense of output being pulled through production based on current demand) rather than a push system (in which output is pushed through production based on anticipated demand) JIT is a realistic approach if it goes along with implementation of TQM (zero defects, zero machine breakdowns); it necessitates o Factory re-organisation to permit lean production (machines that produce a given output are grouped in semicircles around a multi-skilled worker) Employee empowerment (employees should be empowered to stop or adjust the flow).
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ExPress Notes
o Strategic teaming agreements with carefully chosen suppliers, capable of internalizing part of the inventory management processes and if required ensure continuous replenishment of products (CRP)
JITs ultimate objectives are increased competitiveness and higher profits through higher productivity (output per unit of time), better product quality and lower operating costs.
KEY KNOWLEDGE Total Quality Management (TQM)

Basic objectives are: Customer satisfaction, get it right first time and continuous quality improvement, cost savings mainly through complete elimination of waste, promotion of teamwork.
TQM cost/benefit analysis involves:

Calculation of conformance costs o Prevention costs: incurred to prevent defects along the production process o Appraisal costs: incurred in making quality checks on the finished products Calculation of non-conformance costs o Internal failure costs: incurred in rectifying defects discovered before shipment to customers o External failure costs: warranty costs and loss of customer goodwill when defects become apparent after shipment Monitoring through a series of non-financial product quality related KPIs (e.g. defects ratio, manufacturing cycle efficiency defined as processing time divided to total manufacturing lead time, delivery cycle time defined as time from order receipt to delivery, customer response time)
KEY KNOWLEDGE Enterprise-wide Resource Planning (ERP)

ERP is the latest development in computerised business management. Organisations information systems are integrated into one central database, linked to all of organisations other applications. Thus, information about an item is input once into the central database, and all functions have access to it, as necessary.
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ExPress Notes
Chapter 2
Forecasting and Budgeting Techniques

Management accounting is premised on forward planning. This is achieved through, among other means, budgetary processes, using various techniques.
KEY KNOWLEDGE Time Series

Analyzing time series The goal of time series analysis is to identify and extract a systematic pattern from a series of data observed over time and to use this understanding to prepare forecasts. In establishing the systematic pattern, one must: Minimize or eliminate the impact of random noise or irregular variations in the data which cannot be predicted; and
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ExPress Notes
Focus on two main components: Trend: This refers to the long-term path/direction of the data; Seasonality: This refers to systematic variations which occur around the trend line during a particular period of time, usually one year
Smoothing: Involves the local averaging of data so as to reduce the impact of random individual observations. Two techniques for analyzing the trend and seasonality of a time series are: Additive model Multiplicative model
Additive model Observed (time) series = Trend + Seasonal impact + Random impact Note: The impact of random influences will be ignored for the purpose of the analysis. The Seasonal impact is expressed in the same units as the trend. Multiplicative model Observed (time) series = Trend x Seasonal impact factor x Random impact factor Note: The impact of random influences will be ignored for the purpose of the analysis. The Seasonal impact is expressed as a factor which acts on the trend.
KEY KNOWLEDGE Cost Categories

Direct vs. Indirect costs Direct costs: are costs that can be directly attributable to a product. Indirect costs: these are costs that cannot be directly attributable to a product.
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Fixed vs. Variable costs Fixed costs: are costs that remain constant regardless of the volume of production. A variety of indirect costs are fixed. Variable costs: vary in proportion with the volume produced. Direct costs are by their nature variable in behavior. Other types of costs Mixed costs: these are costs that contain a fixed and a variable element. Step costs: costs that remain fixed within a defined range of production, but at a certain level of output increase in a significant way to a new (fixed) level.
KEY KNOWLEDGE Budgets

A budget is a quantitative plan addressing the future. Budgetary control systems seek to monitor performance against the budget in a timely way so that deviations can be identified and rectified. The system can only work as well as the care and thought that went into defining performance targets to be measured, and the incentives (and sanctions) that follow from achievement (or not) of those targets. Goal congruence at all levels of the organization corporate, divisional and individual must exist for a budget, and its attendant control systems, to be effective. Problems frequently encountered when using conventional budgets: They invite gaming of the system; They can be inflexible; They are often imposed from the top Top Down; There is an indirect connection with the companys strategy; They are used for too many different purposes; They reinforce centralizing tendencies in the company; There is a lack of goal congruence between corporate, divisional and individual goals
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KEY KNOWLEDGE Types of Budgets

Fixed A fixed budget is not adjusted to the actual volume of output (activity level) Flexible vs. Flexed The distinction is sometimes overlooked: Flexible: designed to change according to actual volumes of output; usually done before the start of the budgetary period as a sort of scenario planning; Flexed: This is done after the fact and is based on the actual level of activity achieved.
Zero-based (ZBB) Each year, budget owners must justify the entire budget (build it from zero) At odds with incremental budgeting (where only changes need justification, hence encouraging the spend it or lose it mentality) A three-step approach to ZBB: (i) Define decision packages (i.e. activities that result in costs or revenues), distinguishing between mutually exclusive packages (alternative activities to achieve the same result) and incremental packages (base level of input needed + additional inputs) (ii) Evaluate and rank packages (based on the benefit to the organisation) (iii) Allocate resources across packages, considering ranking and seniority of responsible managers Activity-based (ABB) No budget owners (departments, functions), but budgeted activity cost (ABC costing) Budgeted activity cost = demand for activity * unit cost of activity More detailed and accurate than traditional budgets, especially regarding indirect costs Incremental Such budgets are based on what went on during the period before. Typically, this approach results in modest changes and adjustments to the earlier budget. At worst, they retain and perpetuate inefficiencies and old assumptions. This might be termed the lazy mans budget.
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ExPress Notes
Chapter 3
Project Appraisal
START The nature of investment decisions and the appraisal process

The appraisal process is predicated on the fact that capital expenditures are investments which will (hopefully) confer future benefits, referred to as the payback. The payback may be a lengthy (and risky) one. In contrast, revenue expenditures benefit only the current period (e.g. expenses).
KEY KNOWLEDGE Non-discounted cash flow techniques

Payback method Initial Investment: 40,000
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ExPress Notes
Cash flows (A) Year 1 Year 2 Year 3 Year 4 Year 5 Total Payback 5,000 6,000 12,000 13,000 15,000 51,000 Year 5 Cash flows (B) 15,000 13,000 12,000 6,000 5,000 51,000 Year 3
Accounting Rate of Return ARR is an accounting-based measure of return on investment. Its definition varies. Here are some: 5 year project Initial Investment (20% p.a. depreciation) Avg. Investment 40,000 20,000 Profit Before Depreciation Year Year Year Year Year 1 2 3 4 5 10,000 13,000 18,000 20,000 12,000 Profit After Depreciation 2,000 5,000 10,000 12,000 4,000 6,600
Avg. profit (p.a.)
(1)
ARR =
Avg. profits Avg. Investment Avg. profits Total Investment
6,600 20,000 6,600 40,000
33%
(2)
ARR =
16.5%
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ExPress Notes
(3) ARR = Total profits Total Investment = 33,000 40,000 = 82.5%
Note: Always use the accounting profit after deduction of depreciation In the case where the asset has a residual value of 5,000, then the calculation is: 5 year project Initial Investment (20% p.a. depreciation) Residual value Avg. Investment Total profit before Depreciation Total depreciation Total profit after Depreciation Avg. Profit (1) ARR = Avg. profits Avg. Investment Avg. profits Total Investment Total profits Total Investment = 7,600 22,500 7,600 40,000 = 40,000 5,000 22,500 73,000 35,000 38,000 7,600 33.8%
(2)
ARR =
19%
(3)
ARR =
= 38,000 40,000
95%
Whats wrong with this measure? 1) It is using an accounting measure of profit (not cash) 2) It does not take the timing of cash flows into consideration.
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ExPress Notes

KEY KNOWLEDGE Discounted cash flow (DCF) techniques

The preeminence of cash
Cash both its receipt and possession lies at the basis of economic value. Cash is used to pay the bills and bonuses. It is a better indicator of wealth when compared with measures defined by accounting conventions, such as accounting profit.
Timing and value

Tracking and measuring cash flows on a time-adjusted basis is critical: cash received quickly can be used to repay debt (avoiding interest costs) or invested (earning interest). Cash paid with a delay can reduce costs (as long as penalties are not incurred). It follows that the longer one waits for a receipt of cash, the less that cash is worth in todays terms. Among other factors, its purchasing value may diminish due to the effects of inflation. Instead of receiving USD 100 today, assume it will be received after one year. To compensate for the delay, what should the value be after one year? Present Value (PV) 100 Future Value (FV) 100 x ( 1+r )
Interpreting r: As opportunity cost: what we sacrifice by not having it now. As risk-adjusted rate: representing the riskiness of not getting the money back. As cost of capital rate: representing the return that capital providers expect From a companys point of view, this is the rate of return that the business must generate for its capital providers (shareholders and lenders). If a company has to raise the necessary cash for its activities, then this is the rate it must pay. It reflects the opportunity cost to the investors (what investment alternatives they have) on a risk-adjusted basis.
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ExPress Notes
Discounting The above relationship between PV and FV: can be re-arranged to: with r representing the discount rate. The above refers to one-period discounting, with r corresponding to the period. If discounting is done over more than one period, then the discounting effect will be: PV = FV (1+r)n where n refers to the number of periods. PV x (1+r) = FV PV = FV (1+r)
Net Present Value (NPV) To add meaning to the future cash flows, we can include the amount invested (which gives rise to the FVs): Year: Investment: FV: PV: (200) 0 (200) 100 90.9 100 82.6 125 93.9 105 71.7 140 86.9 1 2 3 4 5
Year 0 amounts denote the present and are automatically = PV. The NPV of the above cash flows is therefore = 226.
Discounted Payback
We can apply the concept of discounting to the Payback method in order to capture the time value of money element.
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Year: Investment: FV: PV: (200) 0 (200) 100 90.9 100 82.6 125 93.9 105 71.7 140 86.9 1 2 3 4 5
In the table above, the (simple) payback period is in Year 2; The Discounted Payback period is longer (Year 3).
Relevant Cash Flows

When evaluating projects, cash flow projections must meet the criteria of relevance. Relevance refers to cash flows that are relevant to the decision whether to accept a project or not. Cash flows that are created (or discontinued) as a result of taking the decision (to undertake the project) are relevant; these are also called incremental cash flows. Included in relevant cash flows would be any investments in equipment and working capital required by the project. More subtle, but no less important, are any opportunity costs incurred as a result of accepting the project. Cash flows which occur whether the project goes ahead or not are not relevant. Also not relevant are: Sunk costs; Committed costs; Allocated (overhead) costs; Non-cash expenses Depreciation is an example of a non-cash expense. One may need to work with depreciation, however, if they are related to a calculation of taxes due. Any change in the amount of taxes paid is a very relevant cash flow!
KEY KNOWLEDGE Internal rate of Return

The internal rate of return (IRR) is defined as the discount rate (r) at which the net present value (NPV) of a stream of cash flows will be equal to zero. In other words, If, at a discount rate r, NPV = 0, then IRR = r
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ExPress Notes
The IRR includes among its assumptions the following: any cash flows generated in the course of a project being evaluated are calculated as being reinvested at the IRR rate. This is illustrated thus: Time 0 1 2 Cash flows (20,000) 5,000 30,000
The IRR of the above cash flows (using interpolation or calculator) is 35.61%.
Comparison of NPV and IRR methods

The following decision rules apply to appraisal methods: NPV: Positive NPV projects are acceptable; the higher the better. IRR: An IRR in excess of a hurdle rate (set by the company) indicates acceptability; the higher (the IRR) the better.
NPV vs. IRR -- EXAMPLE

Year A B 0 -5,000 -7,500 1 6,000 8,850 IRR 20% 18% NPV: 10% 454 545 14% 263 263 16% 172 129
Intuitively, IRR should be preferable, as it relates return to amount invested. Equal investment amounts do not necessarily remove the ambiguity.
EXAMPLE
Year A B 0 -500 -500 1 100 500 2 600 155 IRR 20% 25% NPV (9%) 97 89
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KEY KNOWLEDGE Allowing for inflation and taxation in DCF

Inflation Price increases reduce the purchasing power of money. If inflation is 7% p.a., then the same amount of goods can be purchased with: USD 100 (today) or USD 107 (in one year)
We can express the same idea the other way around: USD 100 received in one year will buy as much as USD 93.46 does today.
The nominal rate is calculated according to the Fisher formula which is used to convert real interest rates to nominal rates (and vice versa): (1 + Nominal rate) = (1+ Inflation rate) x (1+ Real rate)
In our example, Nominal rate = (1.05) x (1.10) 1 = 15.5 % It is conceptually more straightforward to use nominal values when forecasting cash flows, particularly if there are differential inflation rates applying to the future cash flows, i.e. if there is no uniform (single) price change for revenues and various cost categories (materials, labor, etc.).
Years Wages Growth: 4% p.a. Raw materials Growth: 7% p.a.
0 4,000 6,000
1 4,160 6,420
2 4,326 6,869
3 4,500 7,350
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ExPress Notes
The numbers above are discounted at nominal discount rates. Alternatively, a 20-year utility project may make long-term projections in real rates:
EXAMPLE
Customer tariffs (revenues) are projected to be USD 6,000,000 p.a. in real terms for the next 20 years. To arrive at a PV, USD 6,000,000 would have to be discounted at the companys cost of capital expressed in real terms.
Taxation
Taxes represent another cash outflow when projecting cash flows. Care must be taken to calculate the tax impact correctly. A company can reduce its taxable income if it can make use of tax allowances on its fixed assets. This will reduce taxes.
EXAMPLE
a) A company invests 50,000 in a piece of equipment and expects to generate net operating revenues (cash) of 35,000 p.a. over the next 3 years. The taxes on the net operating revenues are: Year Net operating revenue Tax (35%) Net operating revenue after tax 1 35,000 (12,250) 22,750 2 35,000 (12,250) 22,750 3 35,000 (12,250) 22,750
b) The capital allowance on the equipment is available at a 25% rate on a reducing balance basis. The equipment will be scrapped at the end of 3 years for 20,000.
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ExPress Notes
The calculation of the Written Down Allowances (WDA) are shown below. (WDV = Written Down Value) Year 0 1 2 3 20,000 Investment 50,000 12,500 9,375 4,375 3,281 2,844 37,500 28,125 8,125 Disposal WDA (25%) Tax Relief (35%) WDV
The tax relief amounts (in bold) act are cash benefits to the operating tax charges. Project cash flows: Year Net operating revenue Tax (35%) Net operating revenue after tax Investment Tax Relief (WDA) Disposal (proceeds) Net cash flow Discounted (or Adjusted) Payback We can apply the concept of discounting to the Payback method in order to capture the time value of money element. Year: Investment: FV: PV: (200) 0 (200) 100 90.9 100 82.6 125 93.9 105 71.7 140 86.9 1 2 3 4 5 0 1 35,000 (12,250) 22,750 4,375 (50,000) 27,125 2 35,000 (12,250) 22,750 3,281 26,031 3 35,000 (12,250) 22,750 2,844 20,000 45,594
(50,000)
In the table above, the (simple) payback period is in Year 2; The Discounted Payback period is longer (Year 3).
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ExPress Notes

KEY KNOWLEDGE Asset replacement decisions

Consider the following situation: A skating rink operator has an ice-cleaning machine costing USD 20,000 with the following data: Year 1 2 3 4 Operating costs 2,000 2,500 3,000 3,500 Resale value 14,500 8,000 7,000 6,000
The company wishes to determine how often to replace the machine. Its cost of capital is 10%. The best method to use is to convert all the cash flows into a single figure! Look at how to do this: 1. The NPV of replacing the machine after 1 year Year 0 1 Purchase price Operating costs Resale value USD 20,000 2,000 (14,500) PV (10%) 20,000 1,818 (13,181) 8,637
/0.909 = 9501
2. The NPV of replacing the machine after 2 year Year 0 1 2 Purchase price Operating costs Operating costs Resale value USD 20,000 2,000 2,500 (8,000) PV (10%) 20,000 1,818 2,066 (6,612) 17,272
/1.736 = 9949
3. The NPV of replacing the machine after 3 years Year 0 1 Purchase price Operating costs USD 20,000 2,000 PV (10%) 20,000 1,818
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2 3 Operating costs Operating costs Resale value 2,500 3,000 (7,000) 2,066 2,253 (5,259) 20,878
/2.487 = 8394
Profitability Index: Application to single-period, divisible projects

For projects that require single period investments and where projects are divisible, the Profitability Index can be applied: Profitability Index (PI) = PV of cash flows Investment Rule: If PI > 1; If < 1, Reject
PI -- EXAMPLE
Investment Angola Burundi Chad Djibouti (30,000) (20,000) (15,000) (10,000) PV of Inflows 40,000 29,000 21,000 16,000 NPV 10,000 9,000 6,000 6,000 PI 1.33 1.45 1.40 1.60 Ranking 4 2 3 1
Investment limit: 25,000. Under conditions of: a) Divisible projects b) Non-divisible projects
What is capital rationing?

Ideally, a company should like to pursue all projects that generate a return in excess of its cost of capital. This may not be practically possible, as funding sources may be limited, in which case the company is forced to employ its scarce capital resources optimally according to a clear decision rule.
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Soft rationing
This refers to internal, self-imposed, limitations on projects undertaken by a corporation. These limits may have the effect of frustrating consideration of projects that would otherwise be NPV-positive. The limits may be practical, such as scarce management time or lack of specialist skills.
Hard rationing
This exists when the market imposes constraints on a companys access to capital in cases where projects would otherwise be NPV-positive. The implication is that the market suffers from imperfections. This is rare, however, in highly sophisticated markets.
KEY KNOWLEDGE Non-financial factors for investment appraisal

Although the financial case for making an investment is a vital part of the decision-making process, non-financial factors can also be important. Key non-financial factors may include: Complying with legal/regulatory requirements (health/safety, etc.) Conforming to industry standards and good practice Impact on staff morale Impact on reputation Impact on relationships with other stakeholders (suppliers, and customers, local community) Developing skills/capabilities of the business (experience in new areas or strengthening management systems) Anticipating and responding to future threats (e.g. protecting intellectual property against potential competition) Environmental impact assessment
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Chapter 4
Dealing with Uncertainty in Analysis

Anticipating and making assumptions concerning the future is the trickiest part of planning.
KEY KNOWLEDGE Risk and Uncertainty

Risk and Uncertainty
These are commonly used interchangeably, but there is a formal distinction. Risk: whichever way it is defined, is a quantification of probability. In other words, it is susceptible to measurement, statistically or mathematically. Risk may be viewed as relating to objective probabilities. Uncertainty: in contrast to risk, is not capable of being quantified. It has also been referred to as subjective probability (or unmeasurable uncertainty).
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Sensitivity Analysis This asks the following question: What happens to the NPV of a project if certain key variables are altered. It is a one-dimensional approach as it isolates and alters each (key) variable in turn in order to measure the impact.
EXAMPLE
The following cash flows have been projected for a business. Years Investment 0 1 2 (12,000) 36,000 36,000 (26,400) (26,400) Cash sales Variable costs Net Cash Flows (12,000) 9,600 9,600 DF (12%) PV
1.0 (12,000) 0.893 8,571 0.797 7,651 4,224
We can perform the following sensitivities: Investment: Would need to increase by 35% (by 4,224 to 16,224) to reduce the NPV to zero; The cost of capital would have to rise to 38%;
Sales price and sales volume sensitivities are a bit more complex to calculate: Taking sales, we can ask the following question: How much do sales have to drop in order to make the NPV = 0? The same can be applied to the other variables. Alternatively, one can work within likely ranges of variable movements (i.e. sales not likely to drop by more than 10%; costs not likely to vary beyond a certain level; interest rates are likely to stay stable +/- 1.0% within the next 12 months.
Scenario Analysis
One can also go beyond determining project sensitivity to a single variable and define scenarios, in which several variables move simultaneously (as outlined in the previous paragraph). Based on these scenarios, the NPV outcomes can be evaluated.
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Simulations This technique goes one step further than scenario analysis and uses computer modeling to run many variables simultaneously in repeated scenarios based on randomly generated variables to produce a probability distribution of outcomes. Expected Value The expected value is the probability-weighted sum of possible outcomes. It is expressed as EV = p X (read: p multiplied with X) Where p = the probability of an outcome, and X = the value of that outcome
EXAMPLE
Profit/(Loss) 340 766 278 450 -230 Probability 10% 20% 50% 18% 2% 100% Expected Value 34.0 153.2 139.0 81.0 -4.6 402.6
EXERCISE
Determine the expected value of the following (2 year) project requiring an investment of $100,000 and a scrap value at the end of two years of $5,000. The expected cash flows are estimated to be: Year 1/Year 2 cash flows: $ 60,000 in each of the two years, with a probability of 60%; or $ 50,000 in each of the two years, with a probability of 40% Just as importantly, what route did you take in making your calculations?
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Chapter 5
Managing Short Term Finance

The final section of the Paper addresses the short-term elements of the balance sheet and related considerations of cash flow andprofitability.
KEY KNOWLEDGE Working Capital

This is a core function of management which has day-to-day implications. Working capital definition: Current assets Current liabilities This is an accounting definition. The discussion and analysis of working capital management focuses on the operating elements of current assets and liabilities: Cash Inventory Receivables Payables
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KEY KNOWLEDGE Cash Operating Cycle

These elements are linked through the Cash conversion cycle, also known as the Cash Operating Cycle. Raw materials received Receipt of cash Payment to supplier
Sale of goods
Conversion into finished goods
The above diagram shows the operating cash flows for a typical manufacturing company converting raw materials into finished goods for sale. The company needs its own cash to pay the supplier and can only recover this from the sale of the finished goods. The cash invested in inventories and receivables represents a cost to the company. This is most directly obvious in opportunity cost terms: the cash could be earning interest, reducing interest-bearing debt, or ultimately find its way into shareholders pockets as a dividend payment. The presence of payables indicates that cash payments (outflows) are delayed; this is beneficial to the company as long as it is not overdue on its payments, as late payment could lead to penalties or damage to the companys reputation (creditworthiness). Managing the individual parts of working capital means managing the whole picture in an optimal way; doing this well can give a firm a significant competitive advantage over its competitors.
KEY KNOWLEDGE Ratio Analysis

Liquidity ratios
The relationship between current assets and current liabilities is used as a measure of liquidity in the firm:
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Current ratio = Current assets Current liabilities Quick ratio = Current assets - Inventories Current liabilities
Turnover ratios
1. Trade debtors (receivables) Trade Debtors X 365 Sales 2. Inventory turnover Inventory COGS X 365
3. Trade creditors (payables) Trade Payables COGS X 365
Sales revenue/net working capital ratio Sales____ Working capital This ratio establishes the link between the level of sales and the amount of working capital a business needs to maintain. It is useful for cash flow forecasting. The ratio need not remain constant as sales grow, but alternate assumptions should usually be based on arguments specific to the business.
KEY KNOWLEDGE Economic Order Quantity (EOQ)

Within a company, there is a natural temptation to accumulate buffer stocks (raw materials and semi-finished goods) so that production is never interrupted. Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful level of finished goods. All of this costs money.
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The EOQ is a method which seeks to minimize the costs associated with holding inventory. To determine the total costs, the following data is required: Q = order quantity D = quantity of product demanded annually P = purchase cost for one unit C = fixed cost per order (not incl. the purchase price) H = cost of holding one unit for one year The total cost function is as follows: Total cost = Purchase cost + Ordering cost + Holding cost which can be expressed algebraically as follows: TC =PxD + C x D/Q + H x Q/2 It is this total cost function which must be minimized. Recognizing that: PD does not vary; Ordering costs rise the more frequently one places (during the year); and Holding costs rise the fewer times one places orders (due to larger quantities being ordered each time) From the above, one can derive the optimal quantity (Q) to be ordered:
EOQ EXAMPLE
A trucking company uses disposable carburetor units with the following details: Weekly demand 500 units Purchase price USD 15 / unit Ordering cost USD 40 / order Holding cost 7% of the purchase price Assume a 50 week year. What is the optimal order quantity?
KEY KNOWLEDGE Assessing Creditworthiness

When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 Cs of credit, later expanded to the 5 Cs. They are:
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1. Character: Focuses on the reputation of the principals/decision makers at a company; credit checking agencies and bank references assist to this end; 2. Capacity: Examines the companys cash flow generation in the context of managements ability to perform competently and reliably in meeting their obligations, based on an examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point); 3. Capital: Identifies and assesses the financial staying power and resources of the business; how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the pain factor); 4. Collateral: Assesses what (if any) security the company is willing to provide in support of the intended transaction. Banks refer to this as providing additional exits (ways out) from a transaction. 5. Conditions: This is a general review of the economic environment to appreciate to what extent a customer may be affected by a decline in general business conditions (business cycle influences).
EXAMPLE
A downturn in housing construction will affect a range of other businesses, from plumbers to building material producers and companies leasing earth-moving equipment. Anyone selling to such businesses needs to keep the big picture in mind so as not to be over-exposed to secondary influences.
Early Settlement discounts

The objective of granting a settlement discount is to give customers a financial incentive to pay their bills more quickly (before the standard due date). A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs.
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EXAMPLE
Redwood Co. currently gives payment terms of 3 months to its customers. If it shortens this to one month by offering a 2% settlement discount, calculate what the impact will be if sales of USD 5m remain unchanged and all customers elect to take advantage of the discount. The companys cost of capital is 15%. Cost of financing receivables for 3 months: 5,000,000 x 3/12 x 15% Cost of financing receivables for 1 month: 5,000,000 x 1/12 x 15% Savings in financing costs Cost of settlement discount: 5,000,000 x 2% = 100,000 = = 62,500 125,000 = 187,500
The discount is worth implementing as the company achieves a net benefit of USD 25,000.
Factoring and invoice discounting

Note the distinction between factoring and invoice discounting: Invoice discounting is effectively a short-term loan in which a company borrows against its outstanding receivables. The unpaid sales invoices are pledged as collateral to the company (or bank) provides the financing. The borrowing company receives less than the face value of the invoice, the difference being the cost of borrowing, or discount. Factoring involves the administration of debt collection, in which the factor buying a receivable manages the process. The factor may do so on a recourse or non-recourse basis. Recourse: In the event a debt is written-off, the factor has the right to demand payment from the company from which it acquired the debt/receivable; Non-recourse: The factor bears the full credit risk of the debtors failure to pay.
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EXAMPLE
Achilles Ltd. is considering whether to engage a factor to assume management of its receivables. Currently, bad debts (write-offs) are running at 1.5%. The factor will charge a fee of 2% of (Achilles) annual turnover and savings to Achilles are estimated to be USD 1m p.a. Achilles has annual sales of 100m and a cost of capital of 12%. Evaluate the factoring solution.
Collection of debts
A company must have in place a clear policy on the collection of debts. Even if a good screening/assessment procedure is in place for accepting and reviewing customers, late payments are a fact of life and must be handled pro-actively. Much time can be spent in chasing late payments and if this process is not well-organized, management may come to the conclusion that it is not worthwhile. This is especially true in cases where a company is growing very quickly and celebrates the signing of contracts and issuance of invoices as signs of success. If, however, these invoices are not collected in due time (or at all), then the company is throwing away the rewards of success.
Financial implications of different credit policies

Evaluating a change in a credit policy requires the identification of relevant cash flows structured as before (the change) and after scenarios.
EXAMPLE
A company has current annual sales of USD 3,000,000 of which 50% is cash and 50% on 2 month credit terms. The contribution on credit sales is 25% of the selling price. The company is considering reducing its credit terms to 1 month and expects all (credit) customers to accept it with a 2% discount. No change in sales volume is anticipated. The company uses a 15% cost of capital. Analysis: Contribution USD - Before modification of terms: 375,000 (25% x 1.5m) - After modification: 345,000 (23% x 1.5m) Net change: (30,000)
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Receivables USD - Financing cost before modification: 37,500 (1.5m x 2/12 x .15) - After modification: 18,750 (1.5m x 1/12 x .15) Net change: 18,750 The change is not worthwhile.
KEY KNOWLEDGE Determining working capital needs / funding strategies

The level of working capital required in a business depends on the industry it operates in, the length of its working capital cycle and the range of funding options open to it. Retaining flexibility is a key requirement. While overdraft financing is expensive, it does permit spontaneous drawdowns and rapid repayments. Funding strategies are guided by the following considerations: Temporary cash shortages can be funded short-term, while Permanent shortages should be funded long-term The matching principle can be applied to the assets being financed: Fixed assets are generally funded long-term, along with the permanent portion of current assets (e.g. buffer stocks); Current assets of a fluctuating nature can rely on short-term finance (e.g. seasonal upswings in inventories / receivables) Cash surpluses, on the other hand, can be dealt with based on whether they are: Short-term: in this case they may be invested in short-term, low-risk, liquid investments (e.g. Treasury bills or marketable securities); Long-term: Make acquisitions; Reduce debt; Pay extraordinary dividend, etc.
(end of ExPress Notes)
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Notes

START About ExPress Notes

At the start of the learning phase

The night before the real exam

At the door of the exam room before you go in.

START About The ExP Group

Cost Accounting Systems

START The Big Picture

KEY KNOWLEDGE Absorption Costing

KEY KNOWLEDGE Contribution

KEY KNOWLEDGE Marginal Costing

KEY KNOWLEDGE Throughput accounting

CIMA P1 Performance Operations

KEY KNOWLEDGE Activity Based Costing (ABC)

KEY KNOWLEDGE Basic Variance Analysis -- Example

Sales volume variance 50 (A) @ standard contribution ($120-$72) $2,400 (A)

KEY KNOWLEDGE Mix and Yield Variance

KEY KNOWLEDGE Planning and Operational Variances

KEY KNOWLEDGE McDonaldization

KEY KNOWLEDGE Benchmarking

KEY KNOWLEDGE Back-flush Accounting

KEY KNOWLEDGE Just-In-Time (JIT)

KEY KNOWLEDGE Total Quality Management (TQM)

TQM cost/benefit analysis involves:

KEY KNOWLEDGE Enterprise-wide Resource Planning (ERP)

Forecasting and Budgeting Techniques

START The Big Picture

KEY KNOWLEDGE Time Series

KEY KNOWLEDGE Cost Categories

KEY KNOWLEDGE Budgets

KEY KNOWLEDGE Types of Budgets

START The nature of investment decisions and the appraisal process

KEY KNOWLEDGE Non-discounted cash flow techniques

Avg. profit (p.a.)

Avg. profits Avg. Investment Avg. profits Total Investment

6,600 20,000 6,600 40,000

KEY KNOWLEDGE Discounted cash flow (DCF) techniques

Timing and value

Relevant Cash Flows

KEY KNOWLEDGE Internal rate of Return

CIMA P1 Performance Operations

Comparison of NPV and IRR methods

NPV vs. IRR -- EXAMPLE

KEY KNOWLEDGE Allowing for inflation and taxation in DCF

Years Wages Growth: 4% p.a. Raw materials Growth: 7% p.a.

KEY KNOWLEDGE Asset replacement decisions

Profitability Index: Application to single-period, divisible projects

What is capital rationing?

KEY KNOWLEDGE Non-financial factors for investment appraisal

Dealing with Uncertainty in Analysis

START The Big Picture

KEY KNOWLEDGE Risk and Uncertainty

1.0 (12,000) 0.893 8,571 0.797 7,651 4,224

Managing Short Term Finance

START The Big Picture

KEY KNOWLEDGE Working Capital

KEY KNOWLEDGE Cash Operating Cycle

Conversion into finished goods

KEY KNOWLEDGE Ratio Analysis

3. Trade creditors (payables) Trade Payables COGS X 365

KEY KNOWLEDGE Economic Order Quantity (EOQ)

CIMA P1 Performance Operations