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Lecture 5: Capital Expenditure Appraisal 1 Profit-based Technique Accounting Rate of Return (“Return on Investment”) ARR= Average Annual Operating Profit Average Investment ARR= Average Annual Operating Profit Initial Investment Average Investment = Cost of Machine+ Disposal Value 2 Example 1 A team...

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Lecture 5: Capital Expenditure Appraisal 1 Profit-based Technique Accounting Rate of Return (“Return on Investment”)

ARR=

Average AnnualOperating Profit Average Investment

ARR=

Average AnnualOperating Profit Initial Investment

Average Investment =

Cost of Machine+ DisposalValue 2

Example 1

A team decides to potentially invest £1,000,000 in building a new factory. They expect the project to be 4 years long.

( 350 + 550 + 350 + 50) /4 years 1,000,000(at start∧fully depreciated at Yr 4)/2 Example 2

=

275 500,000

= 51.4% ARR

Average EBITDA =

(20,000+ 40,000+ 60,000+60,000+20,000) = 40,000 per year 5

Depreciation = £100,000 - £20,000 (disposal) / 5 = £16,000 £40,000 - £16,000 = Average investment per year £24,000

initial investment +20,000 (disposal Value ) ¿ Average Investment = = 60,000 100,000¿ ¿ So,

24,000 / £60,000 = 40% ARR 24,000/100,000 = 24% ARR

Cash-Based Approaches Payback Method Shows how quickly a project generates sufficient net cash flows Example

400,000 / 800,000 = 1.5, therefore it would take 1.5 years to payback. This approach takes no account of the expectations of funders, the required rates of return. The required rate of return is often called the ‘cost of capital’

Discounted Methods Net Present Value “Cost of Capital” = Target Rate of Return A positive NPV shows the investment will yield a return higher than the cost of capital.

Year 0 = (£100,000)/1 Year 1 = £20,000/(1.15)^1 Year 2 = £40,000/(1.15)^2

Year 3 = £60,000/(1.15)^3 Year 4 = £60,000/(1.15)^4 Year 5 = £20,000/(1.15)^5 NPV = SUM(all above) = £31,337 The positive figure reflects the increase in shareholder wealth that will be generated from the investment, assuming the 100,000 was equity…

Advantages - Can make comparisons with other NPV appraisals - Time Value of Money - Represents increase in shareholder wealth from result generates Disadvantages - Hard to choose discount rate - Time values may misinterpret NPV values – may argue that another investment shows higher profit Internal Rate of Return (IRR) Cash-Based The NPV calculates present values using the discount at a target rate of return (cost of capital). The IRR calculates the precise NPV rate of return which the project is expected to yield (where NPV =0) -

The Lower the Discount Rate, the higher the rate of return (Positive NPV) The Higher the Discount Rate, the lower the rate of return (negative NPV)

Formula

= 19.02%

This tells us the return on this particular project averages out at 19.02% per annum over the three years. The IRR gives us an average measure of the Return on Investment and uses the rule that the project should be accepted if the IRR is greater than the cost of capital.

Overheads above total £333,200

Lecture 7: Capital Expenditure 2 IRR

NPV Original Cost of Capital at 10%

Cost of Capital at 20%

The IRR must therefore be between 10% and 20%

Sensitivity Analysis

Assumptions made must be sensinble = ‘what ifs’. Identify items with greatest impact. Scenario Analysis – when one or more key input variables are grouped together and tested.

If forecast sales figure decreased by 3% each year.

If forecast Variable Expenses (£500) increased by 3% in each year

What if the Forecast Fixed Costs increase by 3% in each year?

Expected Net Present Values Risk is assessed using statistical opportunities It is the weighted average of the possible outcomes of a project based on the probability of each likely outcome. Example 1

Example 2

The possible cash flows have been forecast:

Example 3 Exercise 8.8, page 325 (Part A)

Weighted Average Cost of Capital Example 1 Assume Total funding is £100 80% Equity 20% Debt

(£80) – shareholders require 20% return (£20) – Lenders require 10% interest

It is not 20% + 10% /2 = 15% Imagine the tax rate is 20%... The ‘real’ interest rate = original 10% - 20% tax relief (of that 10% = 2%) = 8% WACC = (20% * 80%) + (8% * 20%) = 17.6% 80% = weight of equity 8% = weight of debt after tax shield Example 2 Funding is £100 60% = Equity (£60) – Shareholders want 5% return 40% = Debt (£40) – Lenders want 4% interest (return) Equity = (5% * 60%) = 3 + Debt = (4% interest – 20% tax shield = (0.8%) = 3.2% Therefore, 3.2% * 40% = 1.28

WACC = 4.28%

Lecture 8: Costing and Cost Management in a Competitive Environment Traditional approach was Full Costing e.g. Direct Labour Hour or Machine Hours. Overheads were a relatively low proportion of total costs… DL now support machines DM are a higher proportion of Total Cost Service industries have grown – (traditional costing methods are based on manufacturing) Activity Based Costing (ABC) Provides a different approach to determine overhead costs. -

Identify ‘Cost Drivers’ (things that cause costs to rise) Identify ‘Cost Pools’ (areas of activity where overheads are assigned)

These cost pools (groups of overhead costs) are charged to products based on measurements derived from the cost drivers.

Traditional approach -

Overheads are assigned to product cost centres Overheads are absorbed by cost units, based on an overhead recovery rate (DL hours or Machine Hours) for each department.

ABC Overheads are assigned to cost pools and then cost units with overheads – to the extent they drive the costs in various pools ABC Process 1) 2) 3) 4) 5)

Identify different activities of the business Create cost pools by calculating the total cost of each activity Identify a cost driver for each activity Calculate the cost diver rate (average cost of one cost driver) Attach the activity costs to products according to their demand for each activity

Example 1 A company makes 2 similar products – Standard and Deluxe - Each product requires a special part = 1 for Standard and 4 for Deluxe - Each product is made in different batches and each new batch require production facilities to be ‘set up’ The details are below:

The company is trying to get customers to move from standard to deluxe. The following overhead costs for the company are provided below.

Calculate the Profit Per Unit and Return on Sales for both products using: 1) Traditional Direct Labour Method

Apply these figures to following formulas:

= Overhead recovery rate (per hour) = £6.17

Direct Cost = total DL and DM for each product DL: Standard = 2 * £8 (Labour Cost per Hour) = £16 and Deluxe = 2.5 hrs * £8 = £20 DM: Standard £22 and Deluxe £32 (just given)

Calculate the Profit Per Unit:

Calculate the Return on Sales:

2) Activity Based Costing 1: Trace all OVH (fixed) costs to activity pools

Set up Cost = £73,200 Driver = Number of Set ups For standard – they make 1000 units in one batch and in total produce 12,000 units. Therefore 12 batches are needed. The number of set ups for standard is 1 per batch, therefore 12 set ups are needed in total For Deluxe – They make 240 batches (12,000 / 50 units per batch). For each unit, 3 set ups are needed, therefore 240 batches * 3 set = 720 set ups in total. 720 + 12 = 732 set ups in total for the two products. Set up Cost = 73,200 / 732 = £100 per set up

Special Part Handling = £60,000 Cost Driver = Number of special parts For Standard, 1 special part * number of units = 12,000 for the year. For Deluxe, 4 special parts * number of units = 48,000 for the year. In total, 60,000 special parts are made for the year across both products. £60,000 / 60,000 special parts = £1 per special part Customer Invoicing = £29,000 Cost Driver = Number of Invoices For Standard, 50 invoices per year For Deluxe, 240 invoices per year In total, 290 invoices across the two products £29,000 / 290 invoices = £100 per invoice Material Handling Costs = £63,000 Cost Driver = Number of Batches For Standard = 12 For Deluxe = 240 In total 252 batches across both units. £63,000 / 252 batches = £250 per batch Other Overheads = £108,000 Cost Driver = Labour hours

54,000 Direct Labour hours in total across both products. £108,000 / 54,000 DL = £2 per Labour Hour

Standard

Deluxe

Overall:

Return on Sales

ABC -

More reflective of the overheads between two different products. Allocates more of the overhead to a product that is causing a certain activity/cost pool. A volume-based approach like labour hours doesn’t

Limitations - Sometimes a cost pool may have more than one cost driver (may result in different product costs) e.g. setting up a machine could use either the number of set ups or the number of set up hours… - Some costs may apply to more than one cost pool – causing a subjective allocation base and a loss of ‘causation’ link in costs. - ABC is more complex and resource demanding.

The Philosophical concepts in costing Total Lifecycle Costs Traditional costing methods usually ‘write off’ set-up and development costs as incurred – before an activity even commences. This leads to the ignoring of the cost-reduction issues associated with development We are not talking about valuing your products, this is about making sure that all the costs that are incurred e.g. starting a new business to sell a product before you even sell it you will incur costs like manufacturing, patents, prototypes etc before you have even started selling the product. AND After you have finished selling it, you will still have to offer your customers some services… e.g. if something breaks. You can still get parts of cars that are 30 years old! Life-Cycle costing says we should take all of that into account!

Target Costing Usually, Start with a cost and add a little on-top of the cost to have a selling price = %markup. What Target Costing suggests is, rather than starting with a cost and doing the above, why not start with a selling price? “If I can sell it for this, if I can make it for less I will make some money” = target costing. A little bit like what Elon Musk did with his SpaceX -

Based upon the price you think the market can bear for your product or service.

If the selling price is lower than the cost, then targets are set for costs to enable a profit to be made. Cost reduction strategies then become a way of life – particularly as part of total life-cycle costing. Fast moving electronics industry (book) suggests things are going to change very quickly. You need to grab a large market share quickly. Target costing allows us to do this by setting a low price.

Kaizen Costing “Total Quality Management” Concept – getting things right the first time Based upon continuing improvement On-going target reductions, period by period to reduce costs. Basically, continuous improvement through small changes. Everyone in the organisation has to be involved.

Lecture 9: Budgeting and Accounting for Control The Pyramid of Purpose Imagine a firm, that organisation has a: Vision = (long-term stratospheric) a bit up in the air and needs realism Mission = sets up the kind of business you are going to be in – what values? What products? Objectives = What do I need to reach in order to achieve my vision? How much return on capital do I need? E.g. 20% return on capital employed and I need a 15% in market share. Set up objectives in years 1,2,3,4,5 etc… map out the journey with figures/objectives per year… Strategy Formulation = the journey itself, there are many different ways of getting to year 10… look at the different strategies and pic one. Strategy Implementation = the staff, the skills the infrastructures etcc Day to Day Targets and Activities = move from the long term perspective to a short-term perspective… Get units, teams, sections and departments.

It moves from the strategic long term view at the top to the shorter term operational level at the bottom. At the mini pop level we are thinking about the resources we need to carry out the activities to achieve our targets – here is where the budgets come into play: - What are we going to achieve and how much will it cost us to achieve?

The planning and control process

We can compare what actually happened in the real world than what we budgeted for. Collect information on the actual performance and compare against the budget. If something has gone the wrong or a variance have occurred, we must exercise control to correct it. The budget is a short-term financial plan and is prepared in the framework of the strategic plan Control can be exercised through the comparison of budgeted and actual performance Where divergence emerges, some form of corrective action should be taken. If the plan is wrong (bad assumptions) it might be necessary to revise the budget! What are the benefits of budgeting? Promote forward thinking – identify short-term problems earlier? Help coordinate various parts of the business Motivation for better performance Provides a basis for a system of control – if things are going on, we need to be aware and correct them Provides a system of authorisation – spend on agreed resources you need to achieve your activities Where do budgets start? -

Usually the return required by shareholders – (achieve ROCE) Therefore, carry out business and set a target sales figure. This will be a limited factor as the volume of sales will be limited (as much as you would like to sell everything to everyone, you cannot e.g. competition) - Once you have identified a limiting factor, everything else will flow (see below) e.g. if I know my sales target, I know what resources I need e.g. desks etc. - other limiting factors could be space, funding, skilled staff, materials etc… You have to account for the limiting factors when setting the target sales. The interrelationship of various budgets

Cash budget – pays labour, overheads, trade creditors, asset repairs (capex) If we are buying material’s we need a materials purchases budget We also need trade debtors for cash coming in to pay our creditors. But the cash that they have is from our sales budget… to produce that we need to make things to sell and have a production budget

NB – the sales budge usually comes from the required returns on investment and is a limiting factor

How might we set the budget for next year? Incremental Budgeting Too common Starts with last year’s figures + inflation Makes people susceptible for playing games – you get to the end of the year, you had a budget for £107,000 and you have spare cash, people will feel inclined to spend it. This is known as the ‘Hockey Stick trick’

Empire building - people think bigger budgets are symbolic of their progress in organisations, even if they don’t need a bigger budget.

Often used in discretionary budgets with no tangible outputs*

Zero Base Budgeting Setting (ZBB) Periodically, use it to overcome the limitations of incremental budgeting. A common limitation of incremental budgeting is there is no incentive to change - ‘tomorrow will be the same as today’ but in a world of constant change that is wrong. Periodically, it says, ‘let’s forget about last year’ what are we trying to achieve this year? It might be different and therefore a different budget. - Starts at zero - Sets targets for next year - Identifies activities needed to achieve targets - Costs those activities Encourages a more questioning approach but it is costly to implement and sometimes employees feel threatened.

Behavioural issues of budgetary control -

Budgets tend to improve performance Demanding, yet achievable, budget targets tend to motivate better than less demanding targets Unrealistic targets have an adverse effect on managers’ performance The participation of managers in setting their targets tends to improve motivation and performance

Making Budgetary control effective All managers should take the budget system seriously Clear boundaries between managerial responsibility Challenging, yet achievable budget targets Established data collection, analysis and reporting routines Producing reports aimed at individual managers Fairly short reporting periods Variance reports being produced shortly after the end of the relevant reporting period. Actions being taken to gain control over operations

Budgetary Feedback & Control: Variances Firms prepare budgets in advance

On-going monitoring of budget takes place on a monthly basis Monitoring compares actual monthly figures to the budgeted. Variance is the difference between the two.

If worse than budget, it is a negative (adverse) variance. If better than budget, it is a favourable or positive variance Variances are explained through differences in planned and actual performance relating to activity/volume cause and rate/spend causes. For non-manufacturing companies, this broad category analysis is usually sufficient, but manufacturing companies often go further and apply robust forms of budgetary control through ‘Standard Costing’ Budgets & Variances and Flexed Budgets

Flexing the budget (below) is a way to find out what caused the variances. Explores what he budget would have been for the budget would have been for the actual level of activity that occurred. A way to

Flexed budget will identify variances in each item - Some will be negative (adverse) and some will favourable (positive). - Can be used to reconcile the budget Also helps explain why the difference between budgeted and actual performance figures occur…

What variances to look out for? Sales Volume Variance The difference between the profit in the original budget and profit shown in the flexed budget £20,000 - £16,000 = (£4,000) adverse variance Sales Price The difference between the actual Revenue (sales) figure and the flexed budget Budget Revenue (sales) figure) £92,000 (actual) - £90,000 = £2000 (favourable) variance.

Total Materials variance Direct materials usage Actual direct materials cost – flexed budget direct materials £36,900 - £36,000 = £900 more (adverse) This quantity is multiplied by the budgeted direct materials price (37,000m – 36,000m) * £1 = £1,000 (adverse) Direct materials price Difference between: actual cost of DM used – DM cost allowed (actual budgeted materials used * budgeted DM price) £36,900 – (37,000 * £1) = £100 (favourable) Total direct labour variance Direct labour efficiency Part1 Actual Cost of DL – DL cost according to flexed budget £17,500 - £18,000 = £500 (favourable) Part 2 Actual cost of DL * DL cost allowed (actual budgeted DL hours * Budgeted DL hour rate) £17,500 – (£2,150 * £8) = £300 (adverse) Direct labour rate

Fixed Overhead Spending Actual Overhead costs – Flexed Budget overhead cost (fixed = both flexed and original budget) £20,700 - £20,000 = £700 (adverse)

Reconciliation – Budgeted and Actual Profits

So, Flexed Budgets and Standard Costing Standard Costing (SC) sets out the standard cost of doing something. - Used in manufacturing where margins are low and efficiency is important It measures the actual cost and then compares those with standard costs Highlights the differences between actual and standard costs (variance) Overall helps give explanations for the variances – to improve cost and control Setting standards - Using appropriate standards is essential - These are calculated and shown on a ‘standard cost card’ Using the wrong standards leads to GIGO A Standard Costing system may use: 1) IDEAL Standards Assume maximum efficiency and effectiveness from everyone 2) Attainable Standards Make ‘allowances’ for life

Standard Costing Example The scorecard for a company (per unit) is below:
...