chapter 7

The business's finance

function
Contents

Introduction
Examination context
Topic List
1 Introduction to the finance function of the
business
2 What does the finance function do?
3 The structure of the finance function
4 Management accounting
5 Managing the finance function
6 The value of information
7 Establishing financial control processes
Summary and Self-test
Answers to Self-test
Answers to Interactive questions

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Introduction

Learning objectives Tick off

 Specify the extent to which financial information:

– Provides for accountability of management to shareholders and other stakeholders

– Reflects business performance

– Is useful to users in making economic decisions

– Meets the information needs of national, social and economic contexts (e.g. national
statistical information)
 Specify how accounting and finance functions support businesses in pursuit of their objectives

 Specify how a strategic plan is converted into fully integrated business and operational plans

 Identify the main considerations in establishing and maintaining accounting and financial
reporting functions and financial control processes
 Identify the accountant's role in preparing and presenting information for the management of
a business

Specific syllabus references are: 1g; 3a, b, c, f.

Practical significance
The role and management of the finance function is of key importance to any business and to any
accountant involved with that business.

Stop and think

What actually happens in the finance function of a business, as opposed to its marketing,
production/operations and human resources functions? How does the finance function fit in, and how does
it support the other functions and thereby help the business to achieve its strategic objectives?

Working context
As you build up your exposure to different organisations in audit or other professional engagements, you
will see what there is in common in finance functions, and where any differences lie.

Syllabus links
The topic of what the finance function does and how and why it does it are developed as well in
Accounting, Financial Accounting and Financial Reporting, in Assurance, and in Management Information and
Financial Management at the Professional stage, and in the Advanced stage.

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FUNCTION

Examination context

Examination commentary
Questions on the finance function could easily appear in the exam.

Exam requirements
Questions are likely to be set in a scenario context. Knowledge-type questions are also likely, set on
particular principles or definitions.

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1 Introduction to the finance function of the

business
In Chapter 2 we saw that the four main functions of a business are marketing, operations/production,
human resources and finance. This reflects the model of the business as taking three basic types of resource
– materials, labour and money – to produce goods and services which generate profit. It is a major part of
the finance function's role to look after the business's money.

2 What does the finance function do?

Section overview
 The finance function’s tasks are: recording transactions, management accounting, financial reporting
and treasury management.

 The finance function supports the business’s pursuit of its strategic objectives by providing
information to measure performance and support decision making, and by ensuring the business has
sufficient funds for its activities.

2.1 The tasks of the finance function

The finance function is involved in four specific, but often interrelated, tasks.

Definitions
Recording financial transactions: Ensuring that the business has an accurate record of its revenue,
expenses, assets, liabilities and capital.
Management accounting: Providing information to assist managers and other internal users in their
decision-making, performance measurement, planning and control activities.
Financial reporting: Providing information about a business to external users that is useful to them in
making economic decisions and for assessing the stewardship of the business's management.
Treasury management: Managing the funds of a business, namely cash and other working capital items,
plus long-term investments, short-term and long-term debt, and equity finance.

The separate parts of the finance function carry out the following tasks:
 Recording financial transactions:

– Recording financial transactions (credit sales, credit purchases, and cash receipts and payments) in
the books of original entry

– Entering summaries of transactions in the permanent records (nominal, receivables and payables
ledgers) from the books of original entry

– Ensuring that resources are properly controlled (stewardship)

 Management accounting:

– Preparing financial information for internal users (internal reporting for planning and control to
those charged with management and with governance)

– Identifying or determining the unit cost of the goods and/or services produced by the business,
including classification into fixed and variable costs, or direct and indirect costs (cost accounting)

– Planning ahead by preparing forecasts and budgets

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– Assisting management decision-making (cost-volume-profit (CVP) analysis, including breakeven

and limiting factor analysis)

– Preparing performance measures and identifying reasons for good and bad performance, including
variance analysis

– Analysing capital investment decisions

– Determining sales and transfer prices

 Financial reporting:

– Preparing financial information including financial statements for external users (external
reporting) to enhance good corporate governance (see Chapters 12 and 13)

– Tax reporting to National Board of Revenue (NBR)

– Regulatory reporting
 Treasury management (see Chapter 9):

– Preparing and monitoring cash budgets

– Managing surpluses and deficits in cash balances

– Managing working capital from day to day so as to optimise cash flow, including inventory,
receivables and payables management

– Analysing short-term and long-term financing decisions

– Managing investments

– Managing foreign exchange

– Managing financial risk

– Raising long-term finance (debt and equity)

2.2 How does the finance function support the pursuit of business
objectives?
 By providing information to measure performance and support decisions (financial reporting
and management accounting)

 By ensuring there is finance available for the business's activities (treasury management)

3 The structure of the finance function

Section overview
 Many businesses centralise some if not all of the finance function’s tasks.
 All aspects of the finance function’s tasks depend on the efficient and effective initial recording of
financial transactions.

How the finance function is organised depends on the size of the business and its overall organisational
structure. In many businesses, even very large ones, some if not all of the finance function's tasks are
centralised. This is particularly helpful with respect to overall management of cash and to external reporting,
but it is not so helpful with respect to making sure that local operational managers get all the information and
support they need (internal reporting). Total centralisation is even more problematic when the business
operates in global markets, where exchange rates and time differences make the structure unwieldy.
A typical finance function which performs all the tasks set out above would be structured as in Figure 7.1.
Note that the data and information provided by those responsible for recording financial transactions feed
into each of the other three sections.

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Against some items we have noted where you will encounter detailed coverage elsewhere in the ICAB
Professional syllabus. We refer to:
ACC Accounting, Financial Accounting and Financial Reporting
MI Management Information
FM Financial Management
TAX Principles of Taxation and Taxation

In this chapter we provide an overview of the finance function; some areas are developed further elsewhere
in this Study Manual, as indicated.

Finance function

Recording financial transactions (ACC):

– Books of original entry
– Ledgers
See also Chapter 6

Management accounting: Treasury management: Financial reporting:

– Cost accounting (M1) – Cash budgets (MI) – Financial statements (ACC); see
– Budgeting (M1) – Long-term finance decisions (FM) also Chapter 6
– Management decision-making – Managing financial risk (FM) – Tax (TAX)
(M1) – Raising investment finance (FM) – Provision of information to
external regulators (ACC); see also
– Performance measurement (see – Management of cash, including
Chapter 6
Chapter 8) foreign exchange (see Chapter 9)
– Capital budgeting and decision – Management of working capital
making (See Chapter 9)
– Pricing

External reporting
Internal reporting

Figure 7.1: The finance function

4 Management accounting

Section overview
 Management accounts provide information to assist managers with making decisions, with planning
and with control.

 Management accounting incorporates cost accounting, which involves: gathering information on the
cost of each item produced; setting standard costs and budgets, then measuring actual costs against
these; analysing actual performance.

 Not all costs are relevant for decision-making, which itself falls into two categories: decisions about
allocating resources in the short to medium term, and decisions about long-term investment.

 When making decisions about allocating resources, managers may need information generated by:
cost-volume-profit (CVP) analysis (breakeven analysis; contribution analysis; limiting factor analysis);
pricing analysis.

 When making decisions for long-term investments, managers need information based on: capital
budgeting; capital investment appraisal.

 Forecasting, budgeting for and measuring performance are central to managers’ linked tasks of
planning and control.

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4.1 What is management accounting?

Definition
Management accounting: Providing information to managers within organisations, to assist decision-
making, planning and control.

4.2 What is cost accounting?

Definition
Cost accounting: Gathering information about costs and attaching it to each unit of output (a cost unit);
establishing budgets, standard costs and actual costs of operations, processes, activities or products; and
analysing variances and profitability.

The managers of a business have to plan and control the resources used. To carry out this task effectively
they must be provided with sufficiently accurate and detailed information, provided by the cost accounting
system, to assist in:
 Establishing asset valuations (for example, for inventory)

 Planning (for example, providing forecast costs at different activity levels)

 Control (for example, providing actual and standard costs for comparison purposes)

 Decision-making (for example, providing information about actual unit costs for the period for
making decisions about pricing)

4.2.1 Cost classification

Definition
Cost classification: The arrangement of cost elements into logical groups with respect to their nature or
function.

For inventory valuation and profit measurement, the cost of each unit of output (the unit cost) must be
calculated. This is made up of three cost elements classified by the nature of the expenditure:
 Materials
 Labour
 Expense (such as local property taxes, interest charges and so on)
Cost elements are also classified by the function of the expenditure: each heading may include material,
labour and expenses:
 Production/operations cost (cost of sales)
 Administrative expenses
 Distribution costs
When costs are classified by function it is common for a business to have cost centres for which specific
costs are ascertained, such as a building, a business unit or a machine.

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Definition
Cost centre: A function or location for which costs are ascertained.

4.2.2 Direct and indirect costs

 A direct cost is a cost that can be traced in full to the product, service, or department that is being
costed.
– Direct material costs are the costs of materials that are known to have been used in making
and selling a product (or providing a service)

– Direct labour costs are the specific costs of the workforce used to make a product or provide
a service. Direct labour costs are established by measuring the time taken for a job, or the time
taken in 'direct production work'

– Other direct expenses are those expenses that have been incurred in full as a direct
consequence of making a product, or providing a service, or running a department
 An indirect cost (or overhead) is a cost of materials, labour or expenses that is incurred in the
course of making a product, providing a service or running a department, but which cannot be traced
directly and in full to the product, service or department.
Total expenditure may therefore be analysed as follows.

Materials cost = Direct materials cost + Indirect materials cost

+ + +
Labour cost = Direct labour cost + Indirect labour cost
+ + +
Expenses = Direct expenses + Indirect expenses
Total cost = Direct cost (prime cost) + Overhead cost

4.2.3 Cost behaviour: fixed and variable costs

Definitions
Fixed cost: A cost incurred for an accounting period that is unaffected by fluctuations in the levels of
activity.
Variable cost: A cost that varies with the level of activity.

Semi-variable cost: A cost containing both fixed and variable components and thus partly affected by a
change in the level of activity.

Interactive question 1: Variable costs [Difficulty level: Intermediate]

Your colleague has stated to you that a particular cost is a direct cost, and therefore it must be variable. Is
your colleague correct?
See Answer at the end of this chapter.

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4.2.4 Controllable and uncontrollable costs

Definitions
Controllable cost: A cost which can be influenced by management decisions and actions.

Uncontrollable cost: A cost which cannot be affected by management within a given time span.

Most variable costs are controllable in the short term because managers can influence the efficiency
with which resources are used, even if they cannot do anything to raise or lower price levels.

4.2.5 Who controls costs?

 A cost which is not controllable by a junior manager might be controllable by a senior manager. For
example, there may be high direct labour costs in a section caused by excessive overtime working.
The first-line manager may feel obliged to continue with the overtime to meet production schedules,
but the manager to whom he or she reports may have the authority to reduce costs by hiring extra
full-time staff, thereby reducing the requirements for overtime.

 A cost which is not controllable by a manager in one section may be controllable by a manager in
another section. For example, an increase in material costs may have more than one cause: buying at
higher prices than expected (controllable by the purchasing section) or excessive wastage (controllable
by the production section).

 Some costs are non-controllable, such as increases in expenditure items due to general levels of
inflation.

 Some costs are controllable, but in the long term rather than the short term. For example, processing
costs might be reduced by the introduction of new software, but in the short term management must
attempt to do the best they can with the resources and technology at their disposal.

4.3 Costs for decision making

One of the key roles of the information produced by cost accounting is to assist managers in decision
making.
A decision involving resources generally means deciding whether or not to incur some new costs, or raised
levels of cost, in order to generate new or raised revenues. Costs that have yet to be incurred by the
business are termed future costs. We can contrast them with the costs of resources that have already
been acquired, or sunk costs.
Costs that may be saved by not adopting a particular course of action are termed avoidable costs. We
can contrast these with unavoidable costs, which cannot be saved whether the particular course of action
is taken or not.
In many decisions the issue is whether to increase output from the existing level. It is useful here to
concentrate on the difference in total costs between the new and existing levels (the differential or
incremental cost), rather than just on the total costs at the two levels of output. The idea of differential
cost leads onto that of marginal cost, namely the additional cost of one extra unit of output.
A final cost to consider is the value of the best alternative course of action that is not chosen, or the
opportunity cost of the resources. It is what best could have been done with those resources; it
represents opportunities forgone.

Worked example: Opportunity cost

If a person has a job offer that pays CU25 for an hour's work, and instead chooses to take a nap for an
hour, the actual cost of the nap is zero; the person did not hand over any money in order to nap. The
opportunity cost of the nap is the CU25 that could have been earned working.

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Only some costs are relevant costs for the decision-making process, namely those future costs that will
be changed by the decision made now. Costs that will remain unchanged whatever decision is made are
irrelevant costs for decision making.
Management decisions fall into two categories according to whether they are about the allocation of
resources in the short to medium term (normally taken to be less than one year), or about
investment in the long term (normally taken to be after one or more years). We shall look at each of
these in turn.

4.4 Making resource decisions in the short to medium term

When making resource allocation decisions for the next week, month or even year we can assume in
simple terms that managers want to spend as little as possible to earn the most amount of
revenue: they want to maximise revenue and minimise variable costs so that the profit is as large as
possible. This amount then helps pay the business's fixed costs: the profit is a 'contribution' towards those
costs.
What we have outlined here are the linked concepts of marginal costing and contribution.

Definitions
Marginal costing: Including only variable costs in unit cost when making decisions or valuing inventory
(the marginal cost of a unit of inventory excludes fixed costs or its 'share' of overheads).
Contribution: Unit selling price less marginal cost.

Marginal cost and contribution are used to help answer many of the resource allocation questions that
arise, such as:
 How many units must we sell of a new product to cover the fixed costs we will incur?
 Which of two new products should we choose to go ahead with?
 If we reduce our selling price and sell more units, what will be the effect on profit?
 We've got increased fixed costs – how many additional units do we need to sell?
 Our variable costs are going up – what should we do?
 We have limited amounts of resource – what is the best use we can make of them?

4.4.1 Cost-volume-profit analysis

All the questions listed above relate to the relationship between:

 Changes in activity or output (volume) and

 Changes in total revenue, cost (variable and fixed) and therefore profit

Definition
Cost-volume-profit (CVP) analysis: Establishing what will happen if a specified level of activity
fluctuates, based on the relationship between volume and sales revenue, costs and profit in the short term
(one year or less), when the output of the business is restricted to what is available from its current
operating capacity.

Volume has two meanings in this context:

 Sales volume, which is extremely difficult to forecast
 Output volume, which needs to be planned
When sales and output volume are not the same, inventory levels are affected but it is a key assumption of
CVP analysis that all production in a period is sold.

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In the short term, some inputs can be increased, such as materials, but some – such as the capacity of
machinery – cannot. It takes investment in the purchase of long-term assets to increase capacity.

4.4.2 Breakeven analysis

CVP analysis helps us to understand the relationships between costs, volume and profit and allows
managers to identify critical output levels, such as the breakeven point.

Definition
Breakeven point: The level of production and sales at which, after deducting both fixed and variable costs
from sales revenue, neither a profit nor a loss will occur.

Analysing plans in terms of the breakeven point (breakeven analysis) allows the business to make
decisions as to whether to go ahead with a new product, and on what scale. It is thus an important
calculation from a decision-making point of view.
When performing breakeven analysis, the key calculation is of the contribution that each unit of product
will make to fixed costs.

4.4.3 Contribution analysis

We saw above that a unit's contribution is its selling price less its marginal (variable) cost. Calculating what
would happen if the amount of contribution per unit or total fixed costs changed is a branch of CVP analysis
called contribution analysis.

Worked example: Contribution analysis

An item's contribution is CU4.80 per unit and the fixed costs associated with production of all such items is
CU12,000. The breakeven point is CU12,000/CU4.80 = 2,500 units. If we can reduce variable costs or
increase sales price, however, so that contribution is CU5.00 per unit, then the breakeven point falls to
2,400 units. Reducing fixed costs to CU11,520 and keeping contribution per unit the same will have the
same effect: CU11,520/CU4.80 = 2,400 units.

4.4.4 Limiting factor analysis

Contribution analysis is particularly helpful when the decision to be made involves a choice between, say,
making either one product or another because the business has limited amounts of a certain factor of
production, such as material or labour, available. What we do is:
 Calculate how much contribution each product makes per unit of the limited factor (or scarce
resource), then

 Choose the product which makes the most contribution per unit of the limiting factor.

4.5 Pricing
Another key decision that managers need to make is the price at which products or services are to be sold.

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In Chapter 2 we saw that there are a number of factors inside and outside the control of the business that
affect customer demand for the business's products or services, the ones within the business's control being
components of the 'marketing mix'. One of the components is price, and by producing information to
support a manager's decision on how to price goods and services, the finance function plays an important
role.
In Chapter 14 we shall look at the economic theory behind demand, supply and price. Here we shall
look at the information that is needed in order to make a decision about price.

4.5.1 What factors affect demand?

Within the control of the business (see Chapter 2):
 Price Four Ps
 Marketing research – Product
 Product research and development – Price
 Advertising – Promotion
 Sales promotion – Place
 Training and organisation of sales force Plus
 Effectiveness of distribution Three service Ps
 After-sales service – People
 Granting of credit to customers – Processes
– Physical evidence
Outside the control of the business (see Chapter 14)
 Price of substitute goods (items to which the consumer will switch if the price changes)
 Price of complementary goods (items which the consumer buys as a result of buying the goods, such
as blades for razors)
 Consumers' income
 Taste and fashion

4.5.2 Influences on the business's pricing policy

Costs: In order to make profits a business should ensure that its products are priced above their total cost,
including their share of overheads. In the short term it may be acceptable to go below this if the price is still
above the variable cost of producing one unit, thus ensuring a positive contribution towards the cost of
overheads.
Competitors: Only a monopoly can set any price it wants. In very competitive markets the individual
business has no choice, with the price being dictated by the market. The reality is usually somewhere
between these two extremes. Relative pricing is extremely important in many markets, that is the price
must be comparable to those of competitors.
Customers: As with all other marketing decisions, a consideration of customer expectations is essential in
setting prices. If possible, a business should try to determine exactly how customer demand is affected by
changes in price (price elasticity), and therefore how many sales will result at a given price. We shall look at
this in more detail in Chapter 14.
Corporate objectives

Possible pricing objectives are:

 To maximise profits

 To achieve a target return on investment. This results in an approach based on adding something to
the quantified cost to the business of providing the product

 To achieve a target revenue figure

 To achieve a target market share

 To match the competition, rather than leading the market, where the market is very price-sensitive

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The management accounting section of the finance function has great involvement in setting prices,
especially in relation to costs and corporate objectives.

4.6 Making investment decisions for the long term

The second category of management decision is about investment in the long term, say to increase
capacity following difficult decisions made in the short term because resources were limited.
There are two basic issues at stake:

 Does the business have enough long-term funds to make a long-term investment (capital
budgeting)?

 Is the long-term investment worthwhile (capital investment appraisal)?

4.6.1 Capital budgeting

The business should prepare a capital budget, setting out what funds will be available and how they will be
used over a time period of, say two years. Capital inflows will be funds from:
 Retained earnings (annual net profits less dividends)
 Share issues
 New loans or debentures
 Sales of non-current assets
Capital outflows will be in respect of:

 Purchases of non-current assets including investments

 Repayment of loans
 Redemption of debentures
Any projected shortfalls of capital will have to be covered by raising new long-term loans or issuing
shares; cutting dividends or selling underutilised assets are also options. If the budget shows that
there will be capital unused (a so-called 'cash mountain') this will also have to be managed. Loans could
be repaid early, or dividends increased; more likely, new investment projects could be sought out.

4.6.2 Capital investment appraisal

If the business identifies a possible capital investment opportunity, it needs to evaluate or appraise the
project to make a decision as to whether to go ahead with it.
Some businesses use a very simple approach to capital investment: they expect the capital outlay to be 'paid
back' within a certain period of time. This payback method favours projects which generate cash in the
shorter term, so that there is less risk to the overall level of funding in the business.
Another appraisal method is to calculate whether the project will make a profit over its lifetime. This is
important but it ignores that fact that:
 Profits are arising over a long period of time
 Profits may not be realised in the short term in the form of cash flows
To address these two problems, when looking at long-term investment we need to look both at cash flows
and at the 'time value of money'.

Definition
Time value of money: The value of a cash flow at an identified time in the future is measured in terms of
cash held now.

If somebody offered you CU10,000 now or CU10,000 in one year's time, you would opt for the money
now. This is for two reasons:

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 Taking the money now means you are avoiding the risk that in fact it will not be paid in one year's
time

 During the year you can put the money in a deposit account and earn interest on it.

Taking the point about putting money on deposit a step further, we could say that since the CU10,000 will
earn, say, 4% over one year, you would only be indifferent about whether to take the money now or in one
year's time if you were offered CU10,000  1.04 = CU10,400 in one year's time or CU10,000 now.
In order to make these decisions the business needs to use discounted cash flow.

Worked example: Discounted cash flow

A business has CU50,000 which it can invest risk-free at 4% per annum in a deposit account. It also has an
opportunity to invest the funds now to receive back a total of CU55,650 in 12 months' time; because this
investment is not risk-free the business expects a return of 5% on it. What should the business do?

Solution
We can see that CU55,650 is more than the CU52,000 that the business would receive back if it put the
money straight on deposit (CU50,000  1.04), but what about the extra risk it is taking? What we need to
do is to discount the amount of money expected in 12 months' time at the rate of interest that the business
expects of the investment. If this discounted amount – known as its 'present value' – is more than the
CU50,000 the business currently holds, the investment would appear to be worthwhile. We discount by
using the inverse of the calculation to calculate interest:
CU55,650/1.05 = CU53,000

Interactive question 2: Discounted cash [Difficulty level: Intermediate]

flow
Explain what the business in the worked example above should decide and why.

See Answer at the end of this chapter.

A business which has as its primary objective the maximisation of shareholders' wealth will choose
investments which maximise the present value of its future cash flowsError! Bookmark not
defined..
Discounted cash flow is a very important investment appraisal technique which you will see in a great deal
more detail as you progress in your studies. It is related to the techniques of:
 Net present value (NPV) and
 Internal rate of return (IRR)

4.7 Forecasting
A key element of the work of the management accountant is to look into the future to answer these two
questions:
 What is going to happen? Forecasts for the future are needed on the basis of known amounts, and
estimates for areas of uncertainty

 What are we planning to do? Budgets are needed to assist in planning and control

Forecasting involves predicting what will happen in the future given what we already know about the
present. It is particularly important regarding:

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 Sales volumes
 Costs
 Economic factors (interest and exchange rates)
 Other environmental factors such as regulation, technological developments and taste
Information from external sources is very important when forecasting. Various mathematical
techniques can help to make forecasts more sophisticated and more reliable, and these help to make the
forecast realistic and up-to-date.

4.8 Budgets and budgeting

We saw in Chapter 4 that the strategic planning process results in the business making plans that eventually
become detailed budgets for each area of operations.

Definition
Budget: A plan expressed in monetary terms.

4.8.1 Budgetary process

The preparation and use of budgets are processes that must be effectively managed. The key point is that
budgets should not just be 'one-off' documents that are prepared and then placed in a file to gather dust;
the process should be a continuous one. It is in fact a 'budget cycle'.

 Establish objectives

 Identify potential strategies Strategic planning – see Chapter 4

 Evaluate options and select course of action

 Prepare plans and standards

 Prepare budgets for implementing the plan

 Implement the long-term plan via budgets Budgeting

 Monitor actual outcomes and respond to deviations

4.8.2 Preparing budgets

Budgets are usually prepared over a period of time such as one year, broken down monthly. There is
usually a departmental budget for each separate function or operation in the business, such as for:
 Sales (volume and value): sales are often the principal budget factor for the business as a whole,
since it is the volume of sales which determines the level of activity in each of the business's functions

 Production/operations (volume and value): resources are allocated to achieve the sales budget, and
plans are made for how much the resources cost, how effectively they are used and how much
inventory is to be kept

 Expenses (value): support activities such as logistics and human resources also need expenditure
budgets
To prepare a set of departmental budgets and amalgamate them into the business's master budget the
following steps must be followed:
 Decide on course of action and communicate to people responsible for preparing budgets
 Determine the factor that limits output (the principal budget factor, which is usually sales volume)
 Prepare budgets for the principal budget factor

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 Prepare drafts of other budgets

 Negotiate budgets with managers
 Co-ordinate and review all budgets
 Accept budgets
 Review budgets over time (see below)
A cash budget should also be prepared to ensure that sufficient cash is available at all times to meet the
level of operations outlined in the various departmental budgets. We shall see more about cash budgets in
Chapter 9 on treasury management.

4.8.3 Types of budgeting

Most businesses use a system of incremental budgeting. This means that they take the experiences they
have had of direct costs and support activities in the past year and use these as the base for preparing the
next year's budget, adjusting it for changes or increments (such as to inflation, product mix, volumes and
prices) that are expected to occur in the new budget period.

Example: Incremental budgeting

Incro Ltd included an allowance for overheads in its 20X1 budget of CU20,000. Inflation in 20X2 is
expected to be 3%, so the overheads budget for 20X2 is set as CU20,600.

The major problem with incremental budgeting is that 'the costs of non-unit level activities become
effectively fixed, so past inefficiencies and waste inherent in the current way of doing things is perpetuated'
(Drury, Management Accounting for Business Decisions).
To address these problems with the incremental approach the business can implement zero-based
budgeting (ZBB), which:
'requires that all activities are justified and prioritised before decisions are taken relating to the amount of
resources allocated to each activity'
(Drury, Management Accounting for Business Decisions).

4.8.4 Keeping budgets relevant to users

 Flexible budgeting involves adjusting the budget for a period to reflect actual levels of activity in
that period. If, for instance, volume was budgeted in January at 100 units but in fact 200 units were
produced and sold, a flexible budget system allows the management accountant to adjust all aspects of
January's budget so it relates to the new, higher volume. This 'flexed' budget can then be compared
with actual results via variance analysis (which we shall see further in Chapter 8), to see how far
actual performance was in line with what would have been expected.
 A rolling budget system means that, as each month goes by, the budgets for the months ahead are
reviewed and, if necessary, revised so that they remain relevant for the remainder of the budget
period.

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4.8.5 Purposes of budgets

Budgets are thus crucial in helping manager s to plan and control the business's performance.
Purposes of budgets Comments

Guiding managers on how to Without a detailed plan the achievement of the business's
achieve objectives principal objective will be left up to chance
Helping to compel planning The process of preparing, monitoring and amending budgets
is a rigorous one

Allocating resources Every business has finite resources, at least in the short term,
and the process of preparing budgets helps to identify what
resources are limited and how best to use those

Setting targetsError! Bookmark not The budget identifies what is expected of each area of the
defined. and allocating business and therefore of each manager
responsibility
Budgets set out a plan for which different resources –
Helping to co-ordinate activities materials, people and capacity – need to be co-ordinated

Numbers in a budget state plans very succinctly, assuming

Communicating plans that the people to whom it is being communicated have been
trained to understand what they denote in operational terms
Budgets that are kept relevant allow regular, accurate and
Enabling control timely comparison of actual performance against the budget,
so that problems can be identified and control action taken
Managers and other employees are reassured that there is a
Helping to motivate employees plan in place, and are keen to see it achieved
Many businesses link achievement of the budget with pay, in
the form of bonuses or commission
Specific reasons for failure to meet targets can be identified,
so managers can focus on particular areas for improvement
Assuming that the budget was realistic to begin with and was
Helping to evaluate performance properly communicated, it can be used to assess how well
the enterprise and its managers performed – as we shall see
in Chapter 8

4.9 Measuring performance

Budgets form the basis of one very important aspect of performance measurement and evaluation that is
carried out by the management accountant, namely variance analysis. We shall come back to this in
Chapter 8.

4.10 Strategic management accounting

The traditional focus of management accounting has been to provide information for use internally by
managers. This is not to say, however, that management accountants are not concerned with information
gathered outside the business itself.

Definition
Strategic management accounting: Providing and analysing financial information on the business's
product markets and competitors' costs and cost structures, and monitoring the business's strategies and
those of its competitors in these markets over a number of periods.

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Strategic management accounting therefore extends the internal focus of traditional management
accounting to include external information about:
 Competitors

 The business's strategic position

 How to gain competitive advantage by decreasing costs and/or enhancing the differentiation of the
business's products

5 Managing the finance function

Section overview
 As with any other of the business’s functions, the finance function needs to be effectively organised
and led, with its performance properly planned and controlled.

We saw above that a typical finance function might be structured as in Figure 7.1. The optimum structure
for any particular business will be affected by all the factors considered in Chapter 3. Particular factors to
consider are the business's:
 Form (sole trader, partnership, company)
 Size and geographical dispersion, including the degree of centralisation required
 Markets
 History and ownership
 Culture (human relations, open systems, internal process or rational goal)
Within the finance function its managers are responsible for ensuring that the function is properly managed
and achieves its objectives. The way in which they do this is to perform the tasks of management that we
saw in Chapter 2.

5.1 Planning and control

The overall direction of the finance function's work needs to be planned and controlled, including:
 Forecasting what is needed (the reports and finance that will need to be available)
 Evaluating available resources, such as qualified staff and robust information systems
 Developing objectives, plans and targets
 Implementing the plan and monitoring performance
 Using feedback from monitoring to make necessary amendments to the plan

5.2 Organising and leading

Time and effort in the finance function need to be organised so that its objectives and targets are met,
including:
 Defining what processes, technology and people are required
 Allocating and co-ordinating work
 Generating effort and commitment in finance staff

6 The value of information

Section overview
 Information is valuable if the benefits it produces exceed the costs of its production.
 Valuable information comes from a reliable source, is easy to assimilate and is accessible.

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6.1 Cost-beneficial information

As so much of the output from the finance function is in the form of information, it will only successfully
support the business if it performs its tasks efficiently and effectively. This means that the benefit of the
information and other outputs that it produces must outweigh the cost of its production (the second C of
the ACCURATE mnemonic that we saw in Chapter 6).
Information is a very valuable resource, and a key tool in the quest for competitive advantage. Easy
access to information, the quality of that information and speed in exchanging information have become
essential elements of business success.
Unlike certain commodities the value of information in general is not based on scarcity: indeed the
most frequent complaint of many modern managers is that there is far too much of it.
Moreover, the value of information is in the eyes of the beholder to some extent: information about a
new type of plastic may be of keen interest and value to a car manufacturer, but of no value whatsoever to
a software house.

6.2 What makes information valuable?

 Its source
If external information comes from a source that is widely known and respected for quality,
thoroughness and accuracy (Reuters, say, or the BBC) it will be more valuable to users than
information from an unknown or untested source, because it can be relied upon with confidence. If an
internal source is known to be accurate, efficient and reliable, the information it produces will be more
valuable to its users.
 Ease of assimilation
Information can be presented using not only words and figures but also colour, graphics, sound
and movement. This makes the receipt of information a richer and so more valuable experience,
and it means that information can be more easily, and more quickly, understood.
 Accessibility
If information can be made available in an easily accessible place (such as the internet) users do not
have to commit too much time and effort to retrieving it.

6.3 Assessing the cost and value of information

Information which is obtained but not used has no actual value to the person that obtains it. It is only
the action taken as a result of a decision based on information which has actual value for a business. An
item of information which leads to an actual increase in profit of CU90 is not worth having if it cost CU100
to collect.
Whether it is worthwhile having more information depends on:
 The marginal benefits expected from getting it, and
 The extra costs of obtaining it
Its value can be measured in terms of the difference it would make to management decisions if the
information were made available.
As we saw in Chapter 6, a management information system (MIS) is used to produce a wide variety of
information so the cost of an individual item of information is not always easy to quantify.

Interactive question 3: Information cost [Difficulty level: Intermediate]

A manager uses particular enquiry software to enquire into her company's MIS. What is the cost of this
enquiry?
See Answer at the end of this chapter.

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Just as the costs of an item of information are harder to assess than might appear superficially, so too the
benefits are often hard to quantify. While nobody doubts that information is valuable, it is not always
easy to construct an economic assessment of this value.
 A monthly variance analysis will only generate economically consequential decisions if there is some
control failure leading to variances, but control failures are not easy to predict.
 The economic consequences of a decision are also not always easy to predict.

7 Establishing financial control processes

Section overview
 In the finance function there need to be effective financial controls. These depend on an effective
control environment, risk assessment, control activities, effective information and communication,
and good monitoring.

7.1 Why are financial control processes needed?

The central importance of the finance function and the risks it faces mean that specific financial control
processes need to be implemented by its managers. Financial control is a form of internal control.

7.2 What is internal control?

The Committee of Sponsoring Organisations (COSO) of the US Treadway Commission has aimed since
1985 to:
 Identify the factors that cause fraudulent financial reporting
 Make recommendations to reduce its incidence and
 Establish a common definition of internal controls

Definition
Internal control: A process, effected by an entity's board of directors, management and other personnel,
designed to provide reasonable assurance regarding the achievement of objectives in the following
categories:
 Effectiveness and efficiency of operations
 Reliability of financial reporting
 Compliance with applicable laws and regulations
(COSO)

From this definition we can see that internal control:

 Is a process: it is a means to an end, not an end in itself
 Is effected by people, not merely by policy manuals and forms

 Can be expected to provide only reasonable assurance, not absolute assurance, to an entity's
management and board that operations are effective and efficient, financial reporting is reliable and
laws and regulations are being complied with

 Is geared to the achievement of objectives in one or more separate but overlapping categories

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7.3 Effective internal control

According to COSO, internal control consists of five interrelated components which together provide an
effective framework for describing and analysing the internal control system implemented in a business.

7.3.1 Control environment

The control environment sets the tone of a business and the control consciousness of its people. It
provides discipline and structure. Control environment factors include:
 The integrity, business ethics and operating style of management
 How far authority is delegated
 The processes for managing and developing people in the business

7.3.2 Risk assessment

We saw in Chapter 5 that every business faces a variety of risks from external and internal sources, and
these must be adequately assessed so they can be managed.

Definition
Risk assessment: The identification and analysis of relevant risks to the achievement of assigned
objectives.

7.3.3 Control activities

Having assessed risks the business needs to take the necessary control activities to address those that
threaten achievement of its objectives.

Definition
Control activities: The policies and procedures that help ensure management directives are carried out.

Control activities occur throughout the business, at all levels and in all functions – not just the finance
function. They include:
 Approval
 Authorisation
 Verification
 Reconciliation
 Review of operating performance
 Security of assets and
 Segregation of duties
Segregation or separation of duties is important where power could be abused if only one person was
responsible for a transaction or asset from beginning to end. An example would be the purchase of a non-
current asset such as a car. If only one person had the power to:
 Authorise its purchase
 Record the amount payable and/or pay the bill and
 Have custody of the car
then there is nothing stopping that person from buying the most expensive car possible then absconding
with it.

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7.3.4 Information and communication

Information systems produce reports, including operational, financial and compliance-related information,
that make it possible to run and control the business. In a broader sense, effective communication must
ensure information flows down, across and up the business. Effective communication with external parties,
such as customers, suppliers, regulators and shareholders, is also important for control.

7.3.5 Monitoring
Internal control systems need to be monitored to assess the quality of the system's performance over time.
This is accomplished through ongoing monitoring activities or separate evaluations. Deficiencies in internal
control that are detected through these monitoring activities should be reported to more senior managers.
Corrective action should be taken to ensure continuous improvement of the system.

7.4 Financial control processes

In Chapter 13 we shall look at the Code of Corporate Governance, which contains a main principle that:

'the board should maintain a sound system of internal control to safeguard shareholders' investment and the
company's assets'.
It states that internal controls include financial, operational and compliance controls.

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Summary and Self-test

Summary
Plan + Organise/
Control Lead

Management

Value of Financial
Finance function
information controls

Treasury Management Financial

management accounting reporting

Allocating Measuring Cost Investment

Budgeting Pricing Forecasting
resources performance accounting decisions

Cost classification
CVP – Direct
Capital Investment
– Indirect budgeting appraisal
Cost for decision
Limiting making
Breakeven Contribution – Relevant costs
factor Payback
analysis analysis DCF
analysis
Cost behaviour
– Fixed
– Variable

Controllable/
uncontrollable
costs

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 Business and finance

Self-test
Answer the following questions.

1 Linus is an accountant for Magna Ltd, which is considering a substantial new project. Linus has been
asked to assist in determining whether it should be financed by retained earnings, equity, loans or a
mix of all sources. It would appear that Linus is employed by Magna Ltd’s finance function’s
A Transaction recording section
B Treasury management section
C Financial reporting section
D Management accounting section
2 In order to value inventory, the most important information which the management accountant
supplies is
A How many units are in inventory
B The direct cost of each unit
C Unit costs
D How many cost centres there are
3 Primus Ltd is planning to increase the level of its activities from 1 January 20X8. In the management
accounts for the six months ended 30 June 20X7, which of the following costs are likely to have been
affected by the expansion?
A Fixed costs only
B Variable costs only
C Both fixed and variable costs
D Neither fixed nor variable costs
4 Hobo Ltd is considering a project which has been recommended by its engineers. The engineers’
report, which cost CU10,000 to produce, states that increased revenues of CU100,000 per month will
flow from an investment now of CU200,000, plus monthly outflows of CU60,000. Irrelevant costs for
making this decision are
A CU10,000
B CU60,000
C CU100,000
D CU200,000
5 Mush Ltd is considering a new product which will incur substantial additional fixed costs for the
business. Yolande, an accountant for Mush Ltd, has been asked to report on the minimum number of
units of the product that will need to be sold. Which of the following is Mush Ltd expecting Yolande
to use when making her report?
A Payback analysis
B Breakeven analysis
C Limiting factor analysis
D Discounted cash flow analysis
6 Strand Ltd operates in the fast moving consumer goods market, where it is a medium-sized player.
When determining how much to charge its customers for one of its established products, the main
influence on Strand Ltd will be its
A Customers
B Costs
C Corporate objectives
D Competitors

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7 Quantock Ltd is considering a substantial investment for which it will need to raise considerable
quantities of cash. It is not yet sure whether or not it should make the investment, as it appears to
have a high level of risk attached to it. The most important technique that Quantock should use in
relation to this investment at this point is
A Cash budgeting
B Discounted cash flow
C Capital budgeting
D Payback
8 Briar Ltd’s managers have been asked to produce budgets for their departments. Raji has submitted a
budget for the next year based on this year’s actual performance plus an allowance for inflation of 3%,
less an allowance for performance improvement of 2%. The method used by Raji is
A Zero-based budgeting
B Flexible budgeting
C Rolling budgets
D Incremental budgeting
9 Which of the following statements about the value of information is true?

A It is always a measure of its scarcity

B It is subjective
C It is undermined if it is too accessible
D It is independent of its source
10 Moody Ltd is reviewing its internal control system. Its control activities should be directed at
controlling
A Threats to its operations
B Its operations
C Threats to achievement of its objectives
D Achievement of its objectives
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.

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Answers to Self-test

1 B
2 C How many units are in inventory (A) would be determined by the transaction recording section.
Total unit costs (C) are more complex than simply the direct cost per unit (B). How many cost
centres there are (D) is irrelevant for inventory valuation

3 D As at 30 June 20X7 the expansion is still six months away, so no costs will yet have been affected

4 A The engineers’ report is a sunk cost and so should not be considered when evaluating whether
this project should be pursued

5 B
6 D FMCG are highly competitive markets so the prices charged by competitors will in the end be
the greatest influence

7 B Cash budgeting (A) is primarily concerned with working capital. The company is not really
concerned with capital budgeting (C) currently because it already knows it will need to raise cash.
It will need to prioritise DCF over payback because of the element of risk in the project

8 D Although Raji has made allowances for future changes (inflation and performance improvement),
he is still basically using increments in past experience as the basis for his budget

9 B The value of information is in the eye of the beholder, i.e. there is no objective valuation of it. It
is not always valued in terms of its scarcity (A) as even information that is available to all can be
very valuable. Information is undermined if it is not accessible enough (C), and its value is very
much dependent on its source (D)

10 C

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FUNCTION ©
A
M

Answers to Interactive questions

Answer to Interactive question 1

Costs can be classified as direct or indirect costs, or as fixed or variable costs. These alternative
classifications are not mutually exclusive but are complementary to each other. Some direct costs
are fixed
(although they are usually variable) and some indirect costs are variable. For example, the basic
salaries of
production staff are effectively fixed direct costs. Expenditure on power varies with levels of output
or use,
but this is usually treated as an indirect variable cost.

Answer to Interactive question 2

Since the present value of the investment is more than the amount invested, we say it has a positive

net
present value (NPV) of CU53,000 - CU50,000 = CU3,000. This NPV is higher than the CU52,000 -
CU50,000 = CU2,000 NPV of the deposit account alternative. Generally, the project with the higher
positive NPV should be accepted, so the investment in the 12-month project should be made.

Answer to Interactive question 3

The information already exists anyway, as it is used for a number of different purposes. It might be
impossible to predict how often it will be used, and hence the economic benefits to be derived from
it.
The enquiry software and MIS which are used to process these requests have also been purchased,

so its
cost is largely fixed. The cost of each individual enquiry is effectively zero.
7

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