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Contents
Study Text
Chapter 1: Management Information
Chapter 2: Introduction to Costs
Chapter 3: Cost Behaviour
Chapter 4: Budgets and Variances
Chapter 5: Reporting
Chapter 6: Materials
Chapter 7: Labour
Chapter 8: Other Expenses
Chapter 9: Job and Batch Costing
Chapter 10: Service Costing
Chapter 11: Absorption Costing 1
Chapter 12: Absorption Costing 2
Chapter 13: Marginal Costing
Chapter 14: Process Costing, Joint Products and Further Processing
Chapter 15: Cost-Volume-Profit Analysis
Chapter 16: Short-Term Decision Making
Chapter 17: Introduction to Capital Investment Appraisal
Chapter 18: Discounted Cash Flow Analysis
Chapter 19: Cash and Cash Flow
Chapter 20: Cash Management
Chapter 21: Cash Budgets
Chapter 22: Investing and Financing
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CHAPTER 1: Visual Overview

1.1 Organisations

Definitions

Organisation – An entity or group working together to achieve a common objective.

Business organisation – An entity or group working together to achieve commercial goals.
MA2 looks primarily at different types of business organisations including sole traders,
partnerships, and companies.
Sole traders and partnerships are when a person or group of people work together to run a
business. The business cannot be separated from the owners.
A company is a business organisation with a legal identity separate from its owners
(shareholders). Directors run a company on behalf of the owners.

1.2 Types of Business Information and Their Uses

Definition

Management Information – Information used by managers to help organisations achieve

their goals.
Management information can be:
• Financial (for example, numbers relating to sales or costs)
• Non-financial (for example, customer reviews about a product or social trends that might
affect sales).
Different types of organisations have varying goals:
• Business organisations have the primary goal of making a profit
• Not-for-profit organisations try to make the world better in some way.
All organisations achieve their goals through their employees’ work and managers’ actions.
Managers need the correct information to ensure that their actions benefit the organisation.
Accountants help managers to obtain, record, summarise and understand financial information.

Activity 1: Discussion
Think about some of the actions managers would take and the financial information they
would need for the scenarios below:
• The manager of a retail business with five shops is considering whether to open another shop
in a new location.
• The production manager in a large computer manufacturer plans how many computers to
make next year.
• The manager of a large charity call centre wants to control costs.1.
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2.1 Planning, Decision-making, and Control

Managers require information for three essential activities:

Managers plan a course of action for the future.

• Setting objectives, such as a sales target for a product
• Selecting the best method of achieving the objectives.
Planning • Plans can be financial, like a budget.

Managers use information to check how the organisation performs compared to their plans.
• Comparing actual results with planned results (variance)
Control • Reviewing strategic plans when circumstances change.

Managers use information to help them make decisions about the organisation:
• Preparing information for investment decisions (such as whether to invest in new plant and
equipment)
Decision- • Making decisions on actions to take: how much of the product to make, what price to set, how
making to reduce costs etc.

2.2 How Do Managers Make Plans, Checks and Decisions?

Managers use relevant information and a logical process to make plans, check progress and make
decisions effectively. The aim is to determine if taking a course of action will benefit the
organisation.

The company sets objectives and decides what it wants to achieve. An example could be
Set Objectives
launching a new bicycle for teenagers by the end of the year.
(Direction)

The company identifies the different ways in which the goal could be achieved. For example, the
Consider
new bicycle might be an update to one of the existing products, or the company could start the
Options
design process for a brand-new idea.
(Planning)
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The company gathers all of the relevant information about the options. This could include the
Gather
costs of producing the bicycle, the number of potential customers and the price customers are
Information
willing to pay.
(Planning)

Choose Option
The company decides which options are most likely to achieve its goal. Having thoroughly
(Decision-
researched and costed options improve the quality of decision-making.
making)

Implement
The company implements the option it has chosen.
Action

Compare
Information about the product’s actual performance is collected and compared with the predicted
results
results.
(Control)

Correct
If the actual results are not in line with the predicted results, the company acts to correct
Variances
performance, for example, by reducing the bicycle’s price or increasing production staff.
(Control)

3.1 Financial and Non-financial Information

Management
information Financial Non-financial

Measurement unit Usually in currency (such as $) Almost any unit of measure.

• Organisation’s management information

system
Primary source Organisation’s accounting system • Other sources, internal or external.

• Sales revenue • Sales volume

• Production costs • Production volume
• Depreciation • Material usage
• Asset values • Labour efficiency
• Prices • Quality measures
Examples • Profit or loss • Customer ratings
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• Receivables collection period

• Measuring financial impact • Budgeting and Forecasting

• Financial reporting • Quality control
• Computing financial ratios • Variance analysis
• Budgeting and forecasting • Performance evaluation
• Reviewing financial performance • Customer goodwill analysis
• Performance evaluation and • Process efficiency
control • performance evaluation and control.
Uses • Variance analysis • Process improvement

3.2 Sources of Information

Origin of
information Internal External

Obtained from outside the

Description Generated from within the organisation. organisation.

• Newspapers and other news

• Accounting system portals
• Information system • Government bodies
• Production records • Social media
• Inventory records • Industry journals and other
• Employee records publications
• Quality system • Market research firms
• Employee statements • Search
• Board minutes • Professional and academic
Sources • Source documents such as letters, invoices, journals
timesheets, etc. • Economic data portals
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Activity 2: Discussion

Discuss the information needed in the scenarios given and where this information may be
obtained.
1. Determine if the company can afford to buy new computers for a department.
2. Calculate how much tax the company owes for last year.
3. Determine how much the company currently pays for 1kg of materials (copper components).

3.3 Characteristics of Useful Information

Information should have specific attributes that make them helpful to managers. This is easily
remembered by the mnemonic ACCURATE:

Information provided to managers should be free from significant errors.

In most circumstances, an insignificant error will not affect the information's overall adequacy, but
Accurate the accuracy level needs to be enough for its purpose.
For example, it may be appropriate to round up in the thousands if lesser figures are insignificant.

Information should include all relevant information.

Complete
Correct information which excludes something important is of little value.

The financial benefits or value of the information must outweigh the costs of obtaining that
information.

Cost-effective For example, the cost of additional staff time to produce the information.
However, establishing the value of information is not always easy: how would the value of a
‘better-informed decision’ be calculated?

Information should be tailored to meet the needs of the recipient.

User-
targeted For example, some managers may require additional information on specific business areas.

Only information directly related to the decision being considered should be provided.
Relevant Managers can suffer from information overload, making it difficult to find and focus on the most
relevant information.

The source of information should be reputable and reliable.

Authoritative For example, a rumour about a new product released by a competitor should be investigated and
verified before being accepted as accurate information.
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The reliability of the source must also be considered. This is even more important nowadays with so
much information freely available online.

Information must be received in time for it to influence a decision.

Timely
Information received too late is worthless, no matter its other qualities.

Information should be concise, presented clearly, and communicated using an appropriate

communication channel.

Easy-to-use For example, relatively detailed financial information is easier to use and absorb if communicated
using a digital or paper document rather than in a spoken conversation.
Some information may be more easily understood if presented visually, such as with a graph.

4.1 Financial and Management Accounts

Type of Financial Management

accounts

Primarily for external users:

• Shareholders
• Government authorities Primarily for internal management use and is not
User • Investors shared publicly.
• Financial institutions

Reporting Reported information is usually historical Information may be recorded or about the future
timeframe (happened in the past) (such as forecasts and budgets)

There is a legal obligation to maintain There is no legal obligation to maintain

financial accounts for financial reporting. management accounts.
Financial reports must be prepared according An organisation's management accounts depend
Requirement to legal and accounting standards. on management’s needs and resources.

Financial accounts reflect all activities of the Management accounts are maintained for areas
Coverage organisation deemed necessary by management.
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Activity 3: Classification

Classify the documents below as either financial or management accounts:

Document Financial or management accounts

Statement of profit or loss and other comprehensive income (SPLOCI)

Five-year financial plan

Annual budget

Cash flow forecast

Statement of financial position (SOFP)

5.1 Computerised Accounting Software

5.1.1. Data Cycle
In accounting, computerised systems are primarily used to process transactions, create
documents (such as invoices) and produce information (such as management reports).
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5.1.2. Integrated Accounting Software Packages

Some larger computerised accounting systems include different modules for different tasks. For
example, a non-current assets module, a payables module and a general ledger module.
These more effective, multi-module systems are often described as integrated accounting
software packages. “Integrated” refers to how the different modules are linked and interact.
All computerised accounting software packages have several functions and features:
• Enforces accountancy rules
• Separate modules
• Real-time processing
• Links between modules
• Automates period-end routines
• Queries and Reporting

5.1.4. Advantages of Computerised Systems Over Manual

Speed and efficiency

Accuracy

Availability

Easier to produce reports

Up-to-date information

.
5.2.1. Data Input

• Typed entries:
• Barcode readers
• Online banking
• Smart cards
• Mobile devices.
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5.2.2. Data Storage and Processing

• Servers: Data is usually stored on a server, a central computer that can be accessed by a
network of other computers and devices.
Servers are now often accessible via 'the cloud', which means they are accessible from any
device in any location using an internet connection. The mechanisms for data storage and
access are constantly developing.
• Portable data storage: Extracts from the complete data set may be saved onto external
memory devices, such as memory sticks and solid-state drives.

5.2.3. Data Output

• Reports: Data is typically extracted from a management information system in tables or

spreadsheets. Regular reports can be scheduled and produced automatically.
• Dashboards: Modern management information systems may also produce data in a
dashboard, an interactive visual interface that summarises key measures, data, ratios, and
other information into easy-to-understand graphics.
• Remote Access: Reports can be received on any device – for example, a desktop computer, a
laptop, a tablet or a mobile phone. Reports produced by the management information system
are usually spreadsheet documents or condensed into summarised reports or dashboards.
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7.1 Responsibility Accounting

Definitions

Responsibility accounting – Accounting method for costs according to the manager responsible for those costs.
Responsibility centre – An activity or area of responsibility in an organisation a manager is responsible for and has
control over.
Controllable cost – A cost that is within the control of a manager.
Uncontrollable cost – A cost that is beyond the control of a manager.

7.2 Cost Centres

Definition

Cost centre – An activity or area of responsibility in an organisation that generates costs but is not responsible for
generating revenue or producing direct profit.

A cost centre only incurs costs, which must be collected and analysed.

Activity 5: T-Shirt Co (Cost Centres)

Indicate whether the following elements of T-Shirt Co are cost centres or not.
Mark “Yes” if the element is a cost centre; Mark “No” if it is not.

Element Cost centre?

Yes or No

The sewing department

The sales function, including the T-shirt Co boutique

The delivery department ( distribution cost )

Finance and administration

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7.3 Profit Centres

Definition

Profit centre – An activity or area of responsibility in an organisation to which costs and revenue can be attribu

Classify the elements as either a cost centre or a profit centre.

Element Cost centre or profit centre

The research and development function

A hand car wash service

A ‘factory shop’ attached to the factory selling directly to the public.

A local branch of a cell phone retail organisation

The finance function

7.4 Investment Centres

Definition

Investment centre – An activity or area of responsibility in an organisation to which costs and revenue can be
attributed and capital deployment.

Definition

Business unit – A particular activity or area of responsibility in an organisation that has a degree of autonomy in
deciding plans and processes for generating profits.
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Cost centre Profit centre Investment centre

Generates costs ☑ ☑ ☑

Generates revenue ☑ ☑

Non-current asset procurement ☑

Classify each statement to the responsibility centre it most applies to.

Statements may apply to more than one responsibility centre.

Cost centre, profit centre,

Statement
or investment centre

The manager has responsibility for both costs and sales.

The manager has the authority to make capital expenditure decisions.

The manager is not responsible for revenue.

The responsibility centre does not generate any revenue.

The responsibility centre provides a basis for control at a very senior level.

The responsibility centre generally the lowest within the organisational

hierarchy.
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Summary and Quiz

• Sole traders and partnerships are when a person or group of people work together to run a
business. The business cannot be separated from the owners.
• A company is a business organisation with a legal identity separate from its owners
(shareholders). Directors run a company on behalf of the owners.
• Management Information – information used by managers to help organisations achieve their
goals.
• Managers require information for three essential activities: planning, control, and decision-
making
• Managers use relevant information and a logical process to make plans, check progress and
make decisions effectively. The aim is to determine if taking a course of action will benefit
the organisation.
• Management information may be financial or non-financial and from internal or external
sources.
• Useful information should have specific attributes that make them helpful to managers. This
is easily remembered by the mnemonic ACCURATE:
o Accurate
o Complete
o Cost-effective
o User-targeted
o Relevant
o Authoritative
o Timely
o Easy-to-use
• Financial and management accounts have different users, obligations, standards, coverage,
and reporting requirements.
• Accountants widely use computers to input data, analyse it, and generate reports.
• A trainee accountant will be involved in various tasks, including routine processing and
higher-level analysis, providing a rounded experience to help them progress in their careers.
• The principle of responsibility accounting is that managers should only be judged or held
accountable for costs they can influence or control.
• A cost centre is an activity or area of responsibility in an organisation that generates costs but
is not responsible for generating revenue or producing direct profit.
• A profit centre is an activity or area of responsibility in an organisation to which costs and
revenue can be attributed.
• An investment centre is an activity or area of responsibility in an organisation to which costs
and revenue can be attributed and capital deployment.
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CHAPTER 2: Visual Overview

1.1 Costs and Costing
Definitions

Cost – The amount paid to buy or make something.

Costing – Method of understanding the costs of an item.

The costs for an organisation can be collected, categorised and allocated to products in many
ways. This is known as cost accounting or costing.
Management accountants help develop the right costing methods for their organisation.
Costing allows us to answer some critical questions about an organisation, such as:
• How much does the product cost to produce?
• Is the product profitable?
• What price should be charged for a product?
• How much is our inventory worth?

1.2 Cost Units

Definition

Cost unit – A unit of product or service with which costs are associated.
In cost accounting, a cost unit is a unit of a product or service with which costs are associated.
Different organisations use different cost units. The following are some possible cost units for
organisations:

Organisation Possible Cost Unit

Microchip manufacturer A unit of microchip

Train operator Kilometre travelled

University Full-time student

Restaurant Meal served

Bakery A loaf of bread

A cost unit is not always a single item. It might also be calculated in batches.
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1.2.1. Cost Unit Information

Managers need to know the cost and resources required to produce cost units to make well-
informed decisions. This information can be used in several different ways.
• To determine a selling price
• To decide what to produce
• To help with cost control
• To plan and budget

Definition

Budget – A plan expressed in monetary or quantity terms.

1.3 Cost Categories

Category Description

Costs can be classified according to their related business function—for example, production
Function
sales and marketing costs, or finance costs.

Costs can be classified according to the person responsible for their control. For example, a
Responsibility
manager might be responsible for the expenses incurred at their branch.

Costs can be classified by their behaviour. For example, whether they increase if activity incre
Behaviour
(variable costs) or stay the same regardless of the activity level (fixed costs).

Costs can be classified by the item or activity that incurs them. For example, they may relate t
Type
work performed (labour) or the cost of items used in production (materials).

Costs can be classified by how closely they can be traced to a specific cost unit. For example,
Traceability
whether it is easily traceable (direct cost) or not easily traceable (indirect cost).

1.3.1. Responsibility

Definition

Responsibility accounting – accounting method for costs according to the manager responsible for those
costs.
Responsibility centre - an activity or area of responsibility in an organisation a manager is responsible
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Definition

for and has control over.

Controllable cost – a cost that is within the control of a manager.
Uncontrollable cost – a cost that is beyond the control of a manager.

Definition

Cost centre – an activity or area of responsibility in an organisation that generates costs but is not responsible
for generating revenue or producing direct profit.
Revenue centre - an activity or area of responsibility in an organisation that generates revenue. May also be
responsible for directly attributable selling costs.
Profit centre - an activity or area of an organisation responsible for costs and revenue.
Investment centre – an activity or area of an organisation responsible for costs, revenue, and capital
investment.

1.3.2. Function

Production Non-production

• Other costs not attributable to production of goods and services

• Selling
• Distribution
• costs incurred in the production of • Adminstration
goods and services • Finance = interest on borrowing

1.3.3. Behaviour

Definition

Cost behaviour – The changes in cost according to the level of activity.

Variable costs – Costs that change according to the level of activity
Fixed costs – costs that remain constant despite changes in activity level.
Mixed costs – costs that have both variable and fixed components. Also known as semi-variable
or semi-fixed costs.
Stepped fixed costs – costs that remain constant for a range of activity; will increase to a higher constant
for a higher range of activity.

For an increase in activity:

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Cost
Behaviour Fixed Variable Mixed Stepped fixed

Decreases within range of activity.

Remains Increase if activity range is exceeded, then
Cost per unit Decreases constant Decreases decreases again.

Remains constant within a range of activity

Remains Increases to a higher constant if activity ran
Total cost constant Increases Increases exceeded.

1.4 Classifying Costs

Key Point

Depending on the management's perspective, a specific cost may be classified in many ways.

2.1 Direct and Indirect Costs

Definitions

Direct costs – Costs that can be measured reliably and directly traced to a specific cost unit.
All other costs are indirect costs.
Prime costs – The total sum of direct costs, also known as the total direct cost.
Indirect costs – Costs that are not directly traceable to a cost unit; also known as overheads.

Activity 1: Classification

Classify the costs as either direct or indirect.

Cost Direct or Indirect

Machine operator

Product packaging
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Wages for factory supervisor

Rent for factory

Raw materials

Components bought from other suppliers (such as buttons to decorate a t-shirt)

Electricity used to light a factory

Manager’s salary

3.1 Cost Card

Definition

Cost card – A record of the costs associated with producing and selling a single product or service.
3.2 Methods of Costing

MA2 requires an understanding of various costing methods, which will be covered in subsequent
chapters:

Method Description Suitable for: Chapter

Values production at full

Absorption inventory cost, including fixed • Compliance with financial reporting standards
11
costing production overheads. • Understanding the full cost of production

Marginal Values production at marginal

13
costing (variable) production costs. For short-term decision making.

Costs jobs that have unique

Calculating the specific cost of a job. 9
Job costing criteria

Costs batches, which have

9
Batch costing homogenuous units in each batch Calculating the cost of batches.

Process Costs units produced from a Costing of processes that run continuously
14
costing continuous process producing homogenous output.
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4.1 Types of Systems

A computerised accounting system would have modules that record and support different
business transactions. This may include;
1. Sales
The system would capture sales details from orders received or electronically and produce
the necessary documents to pick goods, deliver them, and issue customer invoices.
2. Purchases
The purchases system would enable employers to requisition and authorise purchases
electronically and monitor payables to ensure payments are made on time and discounts are
fully utilised.
3. Wages
The wages system would enable employees to record their work electronically, linking
directly with payroll to calculate earned gross pay and necessary deductions automatically.
Payroll would be authorised electronically, and payment orders automatically sent to finance
for payment.
4. Cash/Bank
The cash system may automatically link up with the entity’s bank or finance provider to have
a real-time overview of available cash balances and sources of finance. Payments may be
authorised digitally via authorisation tokens or transaction codes.

4.2 Source Documents

Definitions

Source document – A record containing the details to prove a business transaction. Examples include supplier
invoices, bank statements, deposit slips and employee time cards.
Bookkeeping – Recording financial transactions.
Management accounting – Provision of information to managers to operate efficiently and effectively.
Financial accounting – Recording, analysing and reporting the organisation's financial transactions.

4.3 Purchasing System and Process

4.3.1. Purchase Requisition Form
A purchase requisition is a formal document requesting that the organisation buys the items
listed. Its primary purpose is to prevent people from buying goods and services for their use at
the company’s expense.
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Procedures may differ across organisations, but generally, a purchase requisition for materials is
initiated in the stores department. The stores department may be combined with the production
department in a small organisation.

4.3.2. Sample of a purchase requisition:

4.3.3. Purchase Order

Once a supplier has been selected – usually by considering a combination of price, service and
quality – the person responsible for purchasing then prepares and sends a purchase order (PO) to
the supplier, formally ordering the goods or service.
Procedures may differ across organisations, but generally, copies of the PO are required by:
1. The supplier (so they know what goods or services to supply)
2. The accounts department (to compare with the invoice when it arrives)
3. The person who initially raised (filled in) the purchase requisition
4. The storekeeper who is responsible for the inventory held in the stores or warehouse (if the
purchase order is for materials used in production)
5. The purchasing department (responsible for buying and making purchases) should also keep a
copy on file.
It should be noted that copies of the purchase order sent to 3 and 4 may not include purchased
items’ prices for control purposes.
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4.3.4. Sample of purchase order

4.4 Purchase Process

4.4.1. Receiving Goods

A goods received note (GRN) is completed by the person or department who gets the goods to
confirm what has been received. For example, the GRN would be completed by the storekeeper
when raw materials are received in stores.
Procedures may differ across organisations, but generally, copies of the GRN are held by:
1. The accounts department (to compare with the supplier’s invoice to confirm that payment
should be made)
2. The warehouse or stores function (to update inventory records)
3. The purchasing department (to confirm that the order has been fulfilled)
4. In some large organisations, the goods inward department (is matched against a copy of the
supplier’s delivery note).
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4.4.2. Sample of Goods Received Note

4.5 Processing Purchases

4.5.1. Invoice
Once the goods, services or raw materials are received, the supplier will send an invoice. A
standard invoice is formatted as follows:
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4.5.2. Processing a Received Invoice

The purpose of the invoice is to start a process that will result in the supplier being paid.

4.6 Wages System and Process

4.6.1. Types of Labour Costs
Labour costs are the costs incurred to pay the workforce for work performed.
In most organisations, payments to employees make up most labour costs. Other labour costs
might include fees for temporary workers and contractors.
They include:
• Wages (paid periodically in days or weeks)
• Salaries (usually paid monthly)
• Overtime payments (paid to employees that work more than the agreed number of hours in a
period).
• Bonuses
• Sick pay
• Holiday pay
• Other incentives
4.6.2. Payslips
Employees are provided with a document outlining their payments and deductions. This is a
payslip, which may be in paper or electronic format. Collectively, payments to employees are
known as the payroll.
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4.6.3. Sample of a payslip

4.6.4. Employee Records

Organisations maintain several different records detailing how employees spend their time. This
ensures that employees are paid correctly, that labour costs are charged to the correct cost
code(s), and that wages are analysed correctly.

Document Description

·The data held on an employee record card will vary across organisations; it will
typically include the following:
• Employee name, address and contact details
• Employee number
• Taxation number
• Benefit contribution number
• Bank details
• Date employment started
• Position in the company
• Working hours
Employee • Pay grade and salary arrangements
record card • Holiday entitlement.

Employee
An employee attendance record shows the number of absences due to sickness,
attendance
holidays, or other reasons (such as training courses or bereavement leave).
record

Employee
A clock card system provides a record of hours worked by each employee.
clock cards
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Employees swipe a physical card through a reader (or stamp a time card) when
arriving and departing from the workplace. This keeps track of core hours worked
and overtime due.
Controls are required to prevent people from clocking in for others. More advanced
systems will verify the employee’s identity through fingerprint and ID.

In many organisations, employees complete timesheets. A timesheet records hours

worked, the type of work performed, and the job(s) worked on.
The details recorded on a timesheet will differ across organisations; details of
multiple jobs and tasks are usually included.
For example, the timesheet of an office assistant may include tasks such as filing,
reception duties and customer queries.
Employees and managers should sign timesheets to confirm and approve the
information provided. Computerised systems include electronic equivalents for
Employee
signatures and authorisation.
timesheets

A job card is used to collate costs associated with a specific job. This can either be
on a physical card or a computerised record which groups all items coded with the
same job code.
If more than one employee works on a job, the job card will contain entries for
each employee.
The job card will also show entries for the materials allocated. For example, if T-
Shirt Co received an order for custom T-shirts, the job would be assigned a job
card. The materials issued to the job and the time spent by each employee working
on the job would be entered on the job card. Once the job is complete, the job card
will provide a full record of this information.
Job cards

5.1 Codes and Coding Systems

Definitions

Code – A unique set of characters used to identify an item, consisting of numbers, letters, or other
symbols.
Coding system – System by which codes are created, managed and used.
Below is an example of a barcode and a barcode reader.
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Characteristics of an effective coding system are:

Logical Based on an easy-to-understand structure to facilitate learning and application.

Concise Codes should be just long enough to hold the necessary detail.

The coding structure should be consistently applied across the organisation. Haphazard code
Consistent applications must be avoided.
For example, two identical products should have codes that can illustrate their similarity.

Unique Each code should be unique and applicable only to a specific item.

The coding system should have sufficient room for expansion and additional detail. Codes
Expandable
created should have adequate characters to contain the necessary information.

5.2 Types of Coding Systems

Definition

Chart of accounts – A document that contains comprehensive details on the classes of codes and the accounts
and items they identify.

The coding system used by an organisation is often determined by the computerised accounting
software package, which may come with a ready-made chart of accounts and suggested codes.
Five different coding systems are examined:
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5.2.1 Sequential
Sequential (or progressive) coding systems allocate a standard numeric code to each item in a
sequence.
Example of sequential chart of accounts:

Code Description

001 t-shirt, small, black

002 t-shirt, small, white

003 t-shirt, medium, black

004 t-shirt, medium, white

005 t-shirt, small, black

5.2.2 Block
Block (or group classification) coding systems group similar items together in a block. This
system is often applied to the chart of accounts in an accounting system.
Example of block chart of accounts:

Code Description

1000 Non-current assets( car 1001 , building 1002)

2000 Current assets

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3000 Non-current liabilities

4000 Current liabilities

5000 Equity

6000 Revenue

.
5.2.3 Faceted
A faceted code is broken down into facets (or groups), each representing a different
characteristic. For example, consider a furniture manufacturer using a three-faceted coding
system:

Facet 1 2 3

Code XX - XX - XXXX

• Two digits long • two characters long • Four digits long

Description • Represents the department, • Represents different • Represents the cost
function or cost centre. • types of cost. • item.

5.2.4 Hierarchical
The following chart of accounts shows a four-digit code with up to 4 hierarchies:

Hierarchy Description

1 3 X X X t-shirt

2 3 1 X X Small t-shirt

3 3 1 1 X Small t-shirt, white

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5.2.5 Mnemonic
A mnemonic coding system uses an abbreviation or other memory trigger to help identify the
meaning of the code. An example is the three-letter system used to identify airports in the travel
industry:

Code Airport Name

BNE Brisbane

LHE Lahore

LAX Los Angeles

5.3 Using Codes

Items classified using codes include:

Item

Customers

Suppliers

General ledger accounts

Products

Cost centres

Employees

Jobs

Materials
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Summary and Quiz

• The costs for an organisation can be collected, categorised and allocated to products in many
ways. This is known as cost accounting or costing.
• Cost unit – a unit of product or service that costs are associated with.
• Budget - a plan expressed in monetary or quantity terms.
• Responsibility accounting – accounting method for costs according to the manager
responsible for those costs.
• Different organisations will use different cost classifications depending on how they operate.
• Direct costs – Costs that can be measured reliably and directly traced to a specific cost unit.
All other costs are indirect costs.
• Cost card – a record of the costs associated with producing and selling a single product or
service.
• Various computerised systems handle business transactions.
• Financial accounting is the systematic recording, reporting, and analysis of the financial
transactions of a business.
• Financial reporting focuses on producing financial statements for publication outside the
business.
• Management accounting focuses on providing information for internal use by managers to
help the organisation operate more effectively.
• A code is a unique set of characters (numbers, letters or symbols) used to identify an item,
such as a customer or a type of material.
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CHAPTER 3: Visual Overview

1.1 Cost Behaviours
We can classify or categorise costs in many ways. One way to group costs is their behaviour
when the output volume (activity level) changes – for example when a greater quantity of units is
produced.
1.2 Fixed Costs

Definition

Fixed cost – A cost that remains the same irrespective of the output level.
On a total cost over output graph, the cost behaviour is shown as a horizontal straight line
regardless of output.
In the illustration below, the building insurance cost of $5,000 is constant regardless of the
output level.

1.3 Variable Costs

Definition

Variable cost – A cost that changes in direct proportion to the output level.
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1.4 Mixed (Semi-Fixed) Costs

A mixed cost has both variable and fixed costs. It is also known as semi-variable or semi-fixed
cost.
In the illustration below, the fixed utility of $150 is payable regardless of consumption. The total
cost increases by $2 per unit consumed.
The variable cost per unit is also the gradient of the cost line.

1.5 Stepped Fixed Costs

A stepped-fixed cost is fixed within a range of output (activity) and increases to a higher fixed
constant when that range is exceeded.
In the illustration below, the warehouse cost of $20,000 is constant for up to 10,000 units and
steps up to $40,000 when that range is exceeded due to the need to acquire additional warehouse
space.
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Activity 1: Cost Behaviour

Determine the most likely behaviour of the costs of T-Shirt Co below.

Cost Behaviour
(Variable, Fixed, Stepped, or Mixed)

Thread ( direct material )

Factory rent ( overhead )

Factory supervisor’s salary( overhead )

Mobile phone bill ( overhead )

2.1 The High-Low Method

Example 1: High-Low Method

T-Shirt Co had the following total costs for one department over the last six years:

Output volume Total cost

Year (units) ($)

20X1 25 750

20X2 40 900

20X3 55 1,050

20X4 30 800

20X5 45 950

20X6 50 1,000

What will be the total cost in 20X7 if the output is 58 units?

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2.2 Limitations
The high-low method provides a quick way of getting an approximate cost when you do not have
access to more detailed information.
There are some limitations to the approach:
• The high-low method only estimates the costs: the actual costs might differ.
• We also must assume that each unit of material costs the same, whereas, in reality, the
supplier might offer a discount for large volumes.
• If possible, the costs should be analysed based on quotes from the supplier, which show the
fixed and variable amounts, so that the figures you use are more accurate.
• The high-low method uses the most extreme figures observed, which may not be typical of
how most production costs behave.
• Making projections using high-low or any method using historical information assumes that
the cost rates in the future will be the same as they were in the past. Inflation, technological
improvements and many other factors may make this untrue.

3.1 Fixed Costs into Stepped-Fixed Costs

Over the long term, with a wide range of activity, fixed costs may behave as stepped fixed costs.
For example, rent in the short term would behave as a fixed cost, as shown on the total cost
graph below:

Over a more extended period, rent costs may exhibit many steps at increasing activity levels.

Key Point

In the long term, all costs are variable. ( rent is not fixed , changes )
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3.3 Capped Charges

There is a maximum limit on the cost incurred.
An example might be a public transport card, where the total cost of trips is up to the maximum
day rate; no further charges are incurred for additional trips.

3.4 Minimum Charge

An example is a taxi fare, with a minimum charge up to a certain distance travelled; the fare then
increases in proportion to the extra distance travelled.

3.5 Volume Discount

For example, a supplier charges $50 per kg. If orders exceed 1,000 kgs, all kgs will be priced at a
discounted rate of $45 per kg. The discounted rate applies to additional kgs purchased as
[Link] results in a drop in total cost when the threshold is exceeded, and the total cost will
increase at a lower gradient than before the threshold.
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3.6 Labour Overtime

When labour is scarce, employees may be required to work additional hours. These extra hours
may be paid at a higher rate. The total labour cost will show a higher gradient for hours
exceeding regular hours.
For example, Company E workers are usually paid $10 per hour for up to 40 hours a week. Any
hours they work beyond 40 hours are paid $15 per hour, resulting in a higher gradient.

Summary and Quiz

• A fixed cost that remains the same irrespective of the output level.
• A variable cost that changes in direct proportion to the output level.
• A mixed cost has both variable and fixed costs. It is also known as semi-variable or semi-
fixed cost.
• A stepped-fixed cost is fixed within a range of output (activity) and increases to a higher
fixed constant when that range is exceeded.
• Semi-variable costs have fixed and variable elements. We can use the high-low method to
separate these elements and predict how these costs will behave at different activity levels.
• There are limitations to the application of the high-low method.
• Over the long term, with a wide range of activity, fixed costs may behave as stepped fixed
costs, which might be described as variable.
• Capped charges have a maximum limit on the cost incurred.
• Minimum charges have a minimum cost that must be incurred. The cost will remain constant
until a threshold activity is reached, after which it behaves as a variable cost.
• A discount is given upon reaching a certain activity threshold (units purchased), reducing the
cost per unit on all units purchased. Any additional units purchased will be at the discounted
rate.
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CHAPTER 4: Visual Overview

1.1 Budgets

Definition

Budget – A financial plan; that shows income and costs for a period.
Budgets let us:
• Communicate the activities of the organisation
• Coordinate the plans of the organisation
• Control the performance of the organisation.
Budgets are often set as targets for what the organisation wants and a detailed plan of how the
business intends to make that happen.

Term

Vision

Goal

Objectives

Action plan

Budget
1.2 Creating a Budget
The organisation will produce several different budgets, including:
• Sales
• Production
• Cash (Chapter 22)
1.2.1. The format of a budget
Budgets are internal documents, and there are no rules about what format to use. Instead,
organisations create their templates based on what is helpful to them.
1.3 Forecasts

Definition

Forecast – An estimate of future performance, usually created referring to actual results for the period.
Whereas a budget is a financial plan, a forecast predicts the future. It is the expected financial
results for a future period.
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1.3.1. Problems with forecasting

The further a prediction is into the future, the more difficult it is to get it right. For example,
accurately predicting how much a chocolate bar will cost tomorrow accurately is easy. However,
the price of the chocolate bar 12 months into the future is more uncertain.
1.4 Flexible Budgets

Definition

Flexible budget – A budget that can change to reflect multiple activity levels.
A flexible budget can be adjusted for factors where the actual outcome differs from what was
initially expected.
For example, if sales volume is higher than expected, the costs contained within the budget that
would be expected to vary with sales volume would be updated.
2.1 Comparisons
Managers compare sets of information to put that information into context. Without a
comparator, it cannot be determined if the data showed good, bad or indifferent performance.
Comparisons can be:
• Financial – such as a comparison of budgeted costs versus actual costs (what the
organisation thought it would spend versus what it spent)
• Non-financial – such as comparing customer awareness of two brands (is the T-Shirt Co
brand more famous than the Gucci brand?)
Let’s look at some of the various financial comparisons (or comparators) that could be used for
the actual results for the current year.
Activity 1: Matching
Match the information with the most appropriate comparator from the options given.
(Previous period, corresponding period, budget, or forecast)
(Previous period, corresponding
Comparator period, budget or forecast)

Annual financial accounts for a limited company

(SOPL , SOFP)

Monthly management accounts for a heating oil

company

Monthly management accounts for a newly launched

product
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3.1 Variances

Definition

Variance – A difference between budgeted and actual results.

Managers often compare actual results to budget, set information in context, and judge and
manage performance.
Differences between actual and budgeted results are called variances.

Example 3: Variances

Comparison of actual costs to budgeted costs

“F” is Favourable, “A” is Adverse
Budget Actual
20X1 20X1 Variance Notes
($) ($) ($)
Production (units) 1,000 1,000

Direct materials ended up costing $300 more tha

Direct materials 6,000 6,300 300 A expected.

Direct labour 13,000 13,000 0

Direct expenses were also $10 more than the

Direct expenses 1,000 1,010 10 A original budget predicted.

Prime cost 20,000 20,310 310 A

Production
overheads 5,000 4,900 100 F Production overheads were $100 less than expec

Other overheads 10,000 10,000 0

TOTAL COST 35,000 35,210 210 A

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Activity 2: Variances

Fill in the appropriate figures in the spaces given to complete the variance statement.
“F” is Favourable, “A” is Adverse
Budget 20X1 Actual 20X1 Variance

($) ($) ($)

Production (units) 1,000 1,000

Direct materials 6,000 6,100

Direct labour 13,000 200 A

Direct expenses 1,000 1,030

Direct cost 20,000 20330

Production overheads 4,900

Other overheads 10,000 10,000 0

TOTAL COST

3.2 Flexing Budgets

If the actual and budgeted activity level (output) is different, it is not meaningful to directly
compare actual results to the budget.

Budget 20X1 Actual 20X1

Fixed ($) ($)

Production (units) 1,000 1,200

Direct materials 6,000 6,600

Direct labour 13,000 16,800

Direct expenses 1,000 1,080

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Budget 20X1 Actual 20X1

Direct cost 20,000 24,480

Production overheads 5,000 5,100

Fixed overheads 10,000 11,000

TOTAL COST 35,000 40,580

3.2.1. Use the Cost Card

Using a cost card, recalculate the budget based on the actual level of activity (volume of
production in this case) for all the variable costs.
T-shirt unit cost card $

Direct materials 6

Direct labour 13

Direct expenses 1

Total direct (prime) cost 20

3.2.2. Recalculate the Budget

multiply the cost card figures by the number of units produced to flex the budget. The overheads
are fixed, so they do not change when activity levels change.
Flexed Budget 20X1

($) Calculation

Production (units) 1,200 Actual activity level

Direct materials 7,200 $6 × 1,200

Direct labour 15,600 $13 × 1,200

Direct expenses 1,200 $1 × 1,200

Direct cost 24,000

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Production overheads 6,000 Variable

Fixed overheads 10,000 Fixed cost

TOTAL COST 40,000

3.2.3. Compare Flexed Budget to Actual Results

The flexed budget costs can be compared to the expenses incurred producing 1,200 t-shirts rather
than 1,000 t-shirts.
Flexed Budget 20X1 Actual 20X1 Variance

($) ($) ($)

Production (units) 1,200 1,200

Direct materials 7,200 6,600 600 F

Direct labour 15,600 16,800 1,200 A

Direct expenses 1,200 1,080 120 F

Direct cost 24,000 24,480 480 A

Production overheads 6,000 5,100 900 A

fixed overheads 10,000 11,000 1,000 A

TOTAL COST 40,000 40,580 ,580 A

4.1 Comparing Budget Data with Actual Data

Variances indicate to managers when actual performance varies from plans. Variance reports
help managers to control the performance of an organisation.
In management accounting, start with the budget (the plan) and compare the actual figures as
they become available to the budgeted figures.
If the actual is less than budget:
• For sales revenue, this is an adverse variance: the business has earned less money
• For costs, this is a favourable variance: the business has had to pay less.
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4.2 The Impact of Favourable and Adverse Variances

Variances let managers know that things are not going according to plan.
Adverse variances should be investigated, and favourable variances are not always beneficial for
the organisation.
In the T-Shirt Co example: a favourable variance in raw materials arises if the price of cotton
was lower than budgeted. However, the quality of the cheaper cotton may be worse than the
more expensive cotton. This might mean customers become unhappy with the t-shirts, and sales
drop.
4.3 Variance Calculations
Activity 4 Sales Variances
T-Shirt Co had the following budget and actual figures for 20X0:

Budget Actual

Sales units 100 110

Selling price per unit $80 $95

(a)What is the sales variance using budgeted activity?

(b) What is the flexed sales variance?

5.1 Exception reporting

Exception reporting ensures that managers only get the information they need to act on by
reporting the significant variances.
The organisation will determine when a variance is “significant”. For a charity, which must
report back to donors, $5 might be significant. For a large multinational company, $10,000 might
be the threshold. A percentage is often used, so variances over a certain percentage are reported
to the managers.

5.2 Controllable and Non-Controllable Variances

It is essential to consider whether a variance is controllable or non-controllable. The manager can
correct controllable variances, but factors beyond the manager’s control cause non-controllable
variances. Managers may have to explain non-controllable variances and adjust their plans
accordingly.

5.3 Investigating Variances

When should variances be investigated?
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• When the variance is significant (exceeds the threshold %)

• When the variance is controllable
• When the variance investigation is cost-beneficial – in other words, it would not cost more to
investigate than the cost implications of the variance.

Activity 5: Investigating Variances

Match the scenarios of T-Shirt Co with its effect on cost variance (favourable or adverse)
Effect on cost
variance
Scenario (F or A )

T-Shirt Co was given an unexpected discount on a batch of cotton for their loyalty to a
supplier.

T-Shirt Co ordered cheaper dye than it usually uses to save on material costs. However,
the more inexpensive dye was less effective at colouring the cloth than the regular dye, so
much more dye than usual had to be used.

A market-rate increase meant that T-Shirt Co had to increase wages for their staff.

T-Shirt Co decided to change suppliers and use better quality fabric in production. Labour
efficiency increased as the new material was easier to work with.

6.1 The Planning and Control Cycle

Organisations set goals and objectives and then create budgets to help them plan how to achieve
them.

Control step

Set goals

Set objectives and action plans

Budget

Implement

Monitor( control )

Review and forecast

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6.2 Feedback and Feedforward Control Systems

Managers use two control systems within the planning and control cycle: feedback control and
feedforward control.
6.2.1. Feedback Control ( budget and Actual= Compare )
Managers compare actual results with relevant control data, analyse the variances and act to
bring future results into line with the plan. Feedback action occurs after something has gone
wrong, and variance has already happened. Most budgetary systems provide feedback.
An example of feedback control is comparing actual to budget and resolving issues that have
already affected past performance and will affect future performance.
6.2.2. Feedforward Control ( Budget ~ Forecast )
Budget figures could be compared with a forecast. This is useful because it lets managers know
where expected future variances will likely occur. This allows them to act to prevent an adverse
variance in the future or at least alert management to the need to be ready to explain adverse
variances by the period-end. This type of control, which helps prevent future problems, is known
as feedforward control.
An example of feedforward control is comparing budget to forecast and resolving issues that will
happen in the future and affect future performance.

Summary and Quiz

• Budgets are financial plans showing income and costs for a period.
• An organisation's vision statement sets out what it would like to achieve.
• Goals are general statements of what the organisation wants to do to achieve its vision.
• Action plans are detailed plans to achieve objectives and the resources required.
• Budgeting relies on the principal budget factor. This is the element that limits the activities of
the organisation.
• A forecast predicts the future. It is the expected financial results for a future period.
• Managers compare sets of information to put that information into context. It may highlight
areas for improvement.
• Some comparators are budget,forecast, corresponding period, or previous period.
• Differences between actual and budgeted results are called variances.
directly compare actual results to the budget.
• The budget may be flexed to actual activity levels to make the comparison more meaningful.
This would mean adjusting costs that change with activity level.
• Variances indicate to managers when actual performance is different to planned performance.
Variance reports help managers to control the performance of an organisation.
• Exception reporting ensures that managers only get the information they need to act on by
reporting the significant variances.
• It is essential to consider whether a variance is controllable or non-controllable. The manager
can correct controllable variances, but factors beyond the manager’s control cause non-
controllable variances.
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CHAPTER 5: Visual Overview

1.1 Data Versus Information

Definitions

Data – Raw, unprocessed facts, figures, characters, or words.

Information – Data that has been processed to have meaning.
Raw data is a collection of figures, characters, or words. Information is the interpretation of that
data that turns it into something meaningful.

1.2 Useful Information

Management information must help managers make informed decisions or take effective action
to be of use.
Information that does not influence behaviour (including confirming that current behaviour
should continue) is of no use or value.
The mnemonic ACCURATE helps to describe beneficial characteristics of information.

Accurate

Complete

Cost-effective

User-targeted

Relevant

Authoritative

Timely

Easy-to-use
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1.3 Direction of Communication

Communication is how managers receive and send information relating to their organisation.
1.3.1. Internal and External Communication
Internal Communication:

External Communication:

1.3.2. Formal and Informal Communication

There are various communication channels in organisations, some formal and some informal.
Formal communication involves using established channels, such as memos, reports, scheduled
presentations, and formal meetings, and what is communicated is usually documented and
archived.
Informal communication is all other communication that is not formal communication, including
gossip (the “grapevine”).

1.3.3. Vertical and Horizontal Communication

Vertical communication is up or down the hierarchy in the organisation.
Horizontal communication is between members of the same team, for example, at a team
meeting where they're there to discuss actions in the department.
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Vertical Communication:

Horizontal Communication:

Methods of Communication

• Videos/podcasts
• Signs
Visual • Posters
• Body language.

• Formal reports
• Blogs
• Internet/intranet
• Letters
• Emails
Written • Manuals
• Social networking.

• Telephone calls
Oral • Face-to-face meetings.
• Virtual meetings
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Suitable Formats
1.7.1. Emails
Emails are widely used in business as they are fast, cost-effective, verifiable (the sender is
known), and able to disseminate information quickly and effectively.
1.7.2. Memorandums (Memos)
Memorandums are concise formal statements issued to communicate something important to the
intended recipient. They may be public or confidential.
Memos are usually written in plain English, with efforts to reduce jargon and clearly state their
contents and next course of action.
The elements of a memo are like a report.
1.7.3. Reports
Organisations produce different reports for different purposes:
• Standard reports are produced regularly, for example, monthly reports on performance
against budget
• Ad hoc reports are produced to respond to a single situation or problem, for example, a report
on the impact of a new product that a competitor has launched.
The format of a report contains some crucial elements.
Report Format

To: MA2 Students

From: ACCA

Date: 1st Feb 20X1

I
INTRODUCTION
This report details the key elements of a report, including terms of reference and limitations.

II Sections
The following sections should be included in a report:
1. Heading
2. Distribution list and date
3. Introduction
4. Body of the report
5. Summary and conclusions
6. An appendix might be attached to the report if there is detailed information that would be
useful for the users of the report to refer to.
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III SUMMARY
It is important to structure a report clearly so that the users can understand the information that is
being communicated.
ACCA students should use this format when writing reports.

Signed: [ACCATraining officer]

2.1 Data Visualisation (Charts)

Charts (graphs) and tables are helpful ways of quickly highlighting relationships and trends
within data.

Format
Name Example Description

Line charts are useful for showing

trends over time, such as sales
revenue growth.
Line
chart

Bar charts help show comparisons.

For example, a company might
wish to compare budget
expectations against actual results.

Bar chart

Pie charts can show a relative

comparison to a whole, such as
sales in different regions.

Pie chart
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Scatter graphs show results over

two axes, which helps identify
correlations and trends.

Scatter
diagram

Tables help show precise

A B C D numerical data, such as financial
statements.
April 250 350 280 370

May 300 200 320 410

June 600 340 380 470

July 620 560 470 560

August 730 420 560 650

September 760 330 640 740

October 820 380 750 800

Table

Definitions

The following elements are crucial for effective charts:

Chart Title – Name of the chart, describing its contents and purpose.
Axis Title – Defines the axes of the chart.
Legend (key) – Provides context data points displayed on the chart.
Gridlines – Lines on the chart to assist the user in comparing data points to axes.
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Activity 1: Charts
Select the best format to present the information given in each scenario. (Line chart, bar
chart, pie chart, scatter chart, or table)
Best format
(Line chart, bar chart, pie
chart, scatter chart, or
Information table)

A company wants to understand how production costs respond to changes in

activity.

An organisation has just received the final figures for its actual material price
costs last year and wants to compare them to the budget’s original estimates.

A company wants to know which product segment contributes the most

revenue relative to total revenue for the period.

A company wants to display the results of a detailed survey of inventory costs

for different products, showing the current month, prior month, prior year and
% changes.

A company wants to compare recorded employee time spent on producing a

product unit and its final quality score to determine if there is any link.

2.2 Presenting and Interpreting Data (Bar Charts)

Bar charts are drawn with two axes: the independent variable on the x-axis and the dependent
variable on the y-axis.

2.2.1. A Single Data Series Over Several Periods (Simple Bar Chart)
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The data series may also be presented horizontally, with the axes reversed.

2.2.2. Multiple Data Series In A Single Period (Simple Bar Chart)

2.2.3. Multiple Data Series Over Multiple Periods (Compound/Clustered Bar Chart)
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This compound bar chart shows the sales of four divisions over time.
2.2.4. Stacked Bar Chart

A stacked bar chart shows a data series’ proportions to a total figure better than a compound bar
chart. In this example, total sales and its upward trend are easily identified.

2.2.5. 100% Stacked (Component) Bar Chart

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2.3 Presenting and Interpreting Data (Line Charts)

Line charts are drawn with two axes, usually with the independent variable on the x-axis and the
dependent variable on the y-axis.
2.3.1. Simple Line Chart

This example shows a gentle increase in the sales trend over five years. Note that it is drawn
from the origin.
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2.3.2. Line chart with Multiple Data Series

2.4 Presenting and Interpreting Data (Pie Charts)

Pie charts are excellent for showing the proportions of multiple data series at a single period or
point.

2.5 Presenting and Interpreting Data (Scatter Diagram)

Scatter diagrams plot data points on a chart with two variables for each axis. A line of best fit
may be drawn to ascertain the trend.
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There appears to be a positive correlation between output units and total costs (more output,
higher cost). Note that some cost variation occurs at some of the output levels.
A line of best fit can be drawn.

Summary and Quiz

• Raw data is a collection of figures, characters, or words. Information is the interpretation of
that data that turns it into something meaningful.
• The mnemonic ACCURATE helps to describe beneficial characteristics of information.
o Accurate
o Complete
o Cost-effective
o User-targeted
o Relevant
o Authoritative
o Timely
o Easy-to-use
• Charts, graphs and tables are helpful ways of quickly highlighting relationships and trends
within data.
• The communication method selected will affect how other people absorb and use
information. That communication can either be internal or external.
• Formal communication involves using established channels, such as memos, reports,
scheduled presentations, and formal meetings, and what is communicated is usually
documented and archived.
• Informal communication is all other communication that is not formal communication,
including gossip (the “grapevine”).
• Choosing a suitable medium of communication is essential. Consider the nature of the
information, how confidential it is, how well the recipient is known, how they're likely to
receive it, and whether they need a written record.
• Organisations produce different reports for different purposes.
• Charts (graphs) and tables are helpful ways of quickly highlighting relationships and trends
within data.
• It’s essential to use the proper visualisation to convey the appropriate meaning to the user.
The wrong chart type will be misleading and may lead to dysfunctional decision-making.
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CHAPTER 6: Visual Overview

1.1 Classifying Materials
Materials are classified in four main ways:

Material category Description

Raw materials are goods purchased to be made into products for sale.
Raw materials For T-Shirt Co, raw materials would include cotton and thread.

Bought-in components are parts purchased from an external supplier for

assembly.
Bought-in For T-Shirt Co, these might be buttons, badges or other accessories that need
components to be sewn onto the material.

Work in progress Products that are partly made but unfinished are known as work in progress
(WIP) (WIP).

Finished goods are products that are ready for sale.

Finished goods For T-Shirt Co, these would be finished T-shirts.

1.1.1. Direct and Indirect Materials

Materials also fall into these two categories.
• Direct materials are materials that are directly attributable to a production unit. Raw
materials are direct materials: for example, cotton cloth can be seen in a specific t-shirt.
• Indirect materials are not directly attributable to a production unit. For example, the
lubricant used to keep the sewing machines in good working order cannot be seen in a
specific t-shirt.

Inventory is all the raw materials, work in progress (part-finished products) and unsold
finished products held by an organisation.
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2.2 Accounting Entries for Materials

Bookkeeping is the recording of financial transactions. Movements of materials (buying
materials, moving them from stores to production or back from production to stores) are
recorded in the materials control account.
Opening inventory is a debit balance in the materials control account. A summary of the
transactions involving it are:

Transaction Debit Credit

Purchases Materials control Bank or payables

Issues to production (direct) Work-in-progress Materials control

Issues to production (indirect) Production overhead Materials control

Returns from production Materials control Work-in-progress

Returns to supplier Payables or bank Materials control

Differentiating direct materials and indirect materials is essential because they are accounted for
differently:
2.2.1. Accounting for Direct Materials
Direct materials would be directly accounted for in work-in-progress.
• Issue of direct materials to production
Dr Work-in-progress
Cr Materials control
2.2.2. Accounting for Indirect Materials
Indirect materials would be transferred into a Production overheads account for subsequent
absorption into work-in-progress.
• Issue of Indirect materials to production
Dr Production overheads
Cr Materials control

2.2.6. Material Control (T-account)

The accounting entries for the issue and return of materials can be displayed in a T-account
format.
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Materials control ( aseets )

Dr $ Cr $

Bal b/d X
Work-in-progress control Work-in-progress control X

(direct materials returned) (direct materials issued)

Purchases X Production overheads control X

(materials purchased) control

X Goods returned X

(materials returned to suppliers)

Bal cd *****
3.1 Calculating Material Requirements

Material input requirement = Output material + Expected waste

Example 1: Material Input Requirement

In 1 kg of paint produced (output), there is 1 kg of Material X.

15% of Material X input is lost in production.
This means only 85% of Material X input is found in the final product.
How much paint is produced from 50 kg of Material X input?
Solution:
The calculation is as follows:
% Kg

Material X input 100 50.0

Wastage (losses) 15 7.5 50 × 15%

Output 85 42.5
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4.1 Considerations
Organisations may frequently buy the same item but pay varying prices at different times.
For example, a clothing manufacturer will buy a lot of plain white cotton cloth at different times
and pay varying prices; it may be challenging to keep track of the value of fabric used in
production and the remainder in its warehouse.
So how much is the cloth in their warehouse worth?
100 untis buy $ 10
100 units buy $8
20 units sold
Closing invetnory (100 untis * $8) + (80 untis * $10 )
There are several different methods of calculating inventory value:
• First-in, first-out (FIFO)
Issue of inventory=== oldest price
Closing inventory === latest price

• Last-in, first-out (LIFO)

Issue of iventory === latest price
Closing ivnetory === oldest price
• Cumulative weighted average pricing (CWA)
Issue of inventory / closing inventory === average price

• Periodic weighted average pricing (PWA)

Issue of inventory / closing inventory === average price

4.2 FIFO and LIFO

FIFO assumes that the inventory purchased first is sold first. So, the materials in stock at the end
of a period are valued using the most recent prices paid to suppliers.
LIFO assumes that the inventory purchased last is sold. So, the materials in stock at the end of a
period are valued using the oldest unit prices paid to suppliers.

FIFO LIFO

Goods sold Oldest first Newest first

Closing inventory valued at Latest prices Oldest prices

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4.3 FIFO Calculation

Example 3: FIFO Calculation

The following material movements have been recorded:

Quantity Total Value ($) Balance (Units) Balance ($)

1 May Raw materials opening balance 20 $100 ($5 ) 20

12 May Receipt of raw materials 30 $180($6) 50

13 May Issue of raw materials (25) Nil 25

20 May Receipt of raw materials 20 $160 ($8 ) 45

26 May Issue of raw materials (35) Nil 10

Closing balance 10
Compute the value of issues and closing inventory for May using FIFO
Answer:
Value of purchase/issueClosing inventory balance
$ per Value Balance $ per Balance
Date transaction Quantity unit ($) (Units) unit ($)
1 May Raw materials opening balance 20 20 5 100
12
May Receipt of raw materials 30 6 180 20 5 100
30 6 180
Issue of raw materials (25
13
units)
May (20) 5 100 NIL 5 NIL
(5) 6 30 25 6 150
(25) 130
20
May Receipt of raw materials 20 8 160 25 6 150
20 8 160
Issue of raw materials (35
26
units)
May (25) 6 150 NIL 6 NIL
(10) 8 80 10 8 80
(35) 230
10 8 80
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4.4 LIFO Calculation

Example 4: LIFO Calculation

Compute the value of issues and closing inventory for May using LIFO.
Answer:
Value of purchase/issueClosing inventory balance
$ per Value Balance $ per Balance
Date transaction Quantity unit ($) (Units) unit ($)
Raw materials opening
1 May balance 20 20 5 100
12
May Receipt of raw materials 30 6 180 20 5 100
30 6 180
13 Issue of raw materials (25
May units) 20 5 100
(25) 6 150 5 6 30
(25) 150
20
May Receipt of raw materials 20 8 160 20 5 100
5 6 30
20 8 160
Issue of raw materials
26
(35 units)
May 10 5 50 10 5 50
5 6 30 NIL 6 NIL
20 8 160 NIL 8 NIL
35 240
Closing
• balance 10 5 50
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4.5 Weighted Average Methods (CWA and PWA)

The cumulative weighted average approach calculates the average cost per unit every time a
new material receipt occurs by dividing the total cost of held inventory by the total number of
units in stock. This price is used to value all issues to production until another delivery is
received. The closing inventory is valued using the most recently calculated weighted average
price.
The periodic weighted average calculates a single weighted average cost per unit at the end of
each accounting period (rather than whenever inventory is purchased). This single weighted
average price is used to value all the issues to production and the closing inventory for the
period.

(COST OF ALL RECEIPTS FOR THE PERIOD + COST OF OPENING INVENTORY)

÷ (UNITS RECEIVED FOR THE PERIOD + UNITS OF OPENING INVENTORY)
= PERIODIC WEIGHTED AVERAGE PRICE

4.6 CWA Calculatio

Example 5: CWA Calculation

Compute the value of issues and closing inventory for May using CWA.
Answer:
Value of purchase/issueClosing inventory balance
Date transaction Quantity $ per unit Value ($) Balance (Units) $ per unit Balance ($)
1 May Raw materials opening balance 20 20 5.00 100.00
12 May Receipt of raw materials 30 6.00 180.00 50 5.60 280.00
Issue of raw materials
(25 units)
13 May 25 5.60 140.00 25 5.60 140.00
20 May Receipt of raw materials 20 8.00 160.00 45 6.67 300.00
Issue of raw materials
(35 units)
26 May 35 6.67 233.33 10 6.67 66.67
Closing balance 10 6.67 66.67
Observations:
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4.7 PWA Calculation

Example 6: PWA Calculation

Compute the value of issues and closing inventory for May using PWA.
Answer:

Quantity Value ($)

1 May Raw materials opening balance 20 100

12 May Receipt of raw materials 30 180

20 May Receipt of raw materials 20 160

Total 70 440
PWA price per unit = $440 ÷ 70
PWA price per unit = $6.29
Value of closing inventory = $6.29 × 10
Value of closing inventory = $62.86
Value of issues:

Quantity $ per unit $

13 May Issue of raw materials (25) 6.29 157.14

26 May Issue of raw materials (35) 6.29 220.15

Observations:
• Purchases are aggregated with opening inventory, and a periodic weighted average (PWA) price is compute
the period.
• Issues are valued at the PWA price
• Closing inventory is valued at the PWA price.
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4.8 Practice
Activity 1: T-Shirt Co

T-Shirt Co has had three deliveries of cotton in the last month:

Units $ per unit

1 January 50 70

15 January 20 85

30 January 35 80

On 2 January, 30 units were issued (from T-shirt Co's storage warehouse) to production.
On 16 January, 30 units were issued to production.
On 31 January, there were 45 units left in inventory.
Calculate the value of the 45 units in closing inventory using the following methods:
1. FIFO
2. LIFO
3. Cumulative weighted average
4. Periodic weighted average

4.9 Other Considerations

4.9.1. Just-in-Time
Holding inventory incurs expenses. It must be stored, financed, secured, and kept in good
condition.
Ordering 'just-in-time' (only when production is ready to use the materials) minimises inventory
holding costs. Production should only make as many units as can be sold. There will be no
inventory of raw materials or finished goods.
However, this increases the risk of “stock-out”, where no inventory is available for production or
sales.
To mitigate this risk, companies build robust, integrated relationships with their suppliers or
diversify their sources of supply.
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5.1 Cost of Sales Calculation

Cost of sales (CoS) affects profit calculations and is also known as the cost of goods sold
(CoGS).

Sales (Revenue) − Cost of sales = Gross profit

The basic calculation is as follows:

$

Opening inventories X

Purchases or Costs of production X

Less Closing inventories (X)

Cost of sales X

6.1 Uses of Different Inventory Valuation Methods

The method that will most benefit decision-making is used for management accounting purposes.
6.2 FIFO

Advantages Disadvantages

• Used in the statutory accounts, according to

IAS2
• Reflects actual practice. The first items
purchased will probably be the first items used
in the production process • Awkward to administer as each set of items
• Easy to understand and explain purchased needs to be identified separately
• Closing inventory value is based on the most • Managers are charged varying prices for the
recently purchased items, so it will be close to same materials at different times, which means
the cost of replacing the inventory that comparisons are difficult to make
6.3 LIFO

Advantages Disadvantages

• LIFO is awkward to administer as each

consignment needs to be identified separately
• Does not reflect actual practice. It is more likely
that the first items purchased will be used first
• With LIFO, the issue price is close to the in the production process
current market value as the last items purchased • Managers are charged different prices for the
are assumed to be the ones used first same materials at different times
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6.4 Weighted Average

Advantages Disadvantages

• Weighted average pricing is easy to administer as

each consignment of purchases does not need to be
identified separately
• Using weighted average pricing means that price • Using weighted average pricing means that
fluctuations are smoothed out, making it easier for the issue price will not be the actual price
managers to use the information that has been paid

6. 7.1 Inventory Costs

Inventory
cost Description

Purchase The price paid for inventory.

cost Includes the price paid and any applicable taxes and charges.

Ordering Costs incurred for ordering inventory

cost Includes transport and administration costs.( delivery , phonebill)

Costs incurred for holding inventory.

Includes storage, finance costs( interest ), insurance, obsolescence, deterioration, spoilage,
Holding cost theft, etc ( rental of warehouse , elecitrucity , secruity cost )

Costs are incurred if inventory is unavailable.

Includes price premiums for emergency supplies, lost sales revenue, and incentives to retain
Stockout cost dissatisfied customers.

7.1.1. Obsolescence

Definition

Obsolescence – Reduction in inventory value due to it becoming irrelevant to the organisation’s needs.
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7.1.2. Deterioration

Definition

Deterioration – Reduction in inventory value due to degradation in its qualities.

Reduction in the value of inventory due to degradation in its qualities.

For example, fresh produce degrades rapidly after harvesting and would be unusable after a few
days if not kept fresh with refrigeration or further processing.
Obsolete and deteriorating inventory would eventually be discarded and written off.

8.1 Inventory Control Levels

Organisations must pick an optimum amount of inventory to hold that minimises their overall
inventory cost.

Definition

Lead time – The waiting time to receive goods after placing an order.

Example 8: Inventory Control Levels

The following information is available for a decorative button used in a t-shirt design at T-Shirt Co:

Average usage 1,000 per day

Minimum usage 800 per day

Maximum usage 1,300 per day

Lead time for replenishment 5 to 15 days ( 5 + 15 ) /2 = 10 average

Reorder quantity 20,000 units

Reorder Level
The level of inventory at which more should be ordered. This is to ensure there is enough inventory to supply
maximum production.
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Example 8: Inventory Control Levels

Reorder level
= Maximum usage × Maximum lead time

For T-shirt Co,

Reorder level
= 1,300 × 15
= 19,500
Minimum Level
The inventory level indicates a high risk of stockout. Often used as the buffer inventory level.

Minimum Level
= Reorder level − (average usage × average lead time)

For T-Shirt Co,

Minimum level
= 19,500 − (1,000 × 10)
= 9,500
Maximum Level
The maximum level warns that inventory holding is too high and more expensive than necessary.

Maximum level
= Reorder level + Reorder quantity − (Minimum usage × Minimum lead time)

For T-Shirt Co,

Maximum level
= 19,500 + 20,000 − (800 × 5)
= 35,500
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Example 8: Inventory Control Levels

Average Level
The inventory level is midway between minimum and maximum levels.

Average level
= Minimum level + (reorder quantity / 2)

For T-Shirt Co,

Average level
= 9.500 + (20,000 / 2)
= 9,500 + 10,000
= 19,500

Activity 3 Inventory Control Levels

The following information is available for raw materials:

Average usage 200 per day

Minimum usage 150 per day

Maximum usage 280 per day

Lead time for replenishment 8–10 days ( 8+ 10 )/2 = 9

Reorder quantity 3,000 units

Calculate the inventory control levels:

1. Reorder level

2. Maximum inventory level

3. Minimum inventory level

4. Average inventory level

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9.1 Economic Order Quantity (EOQ)

Economic order theory helps find the best order quantity to minimise costs.

9.2 EOQ Formula

EOQ is calculated using the following formula:
EOQ =.

Variable Description

CH cost of holding one unit of inventory for one time period

Co cost of ordering a consignment from a supplier

D Demand during period

Example 9: EOQ

A department store sells 10,000 t-shirts a year. The cost of placing one order is $5. The cost of holding a t-shirt
inventory for one year is $10.
What is the EOQ?

Activity 4: EOQ and Inventory Costs

1. A car manufacturer sells 75,000 cars a year. Each vehicle needs five tyres. The cost of
placing one order for tyres is $10. The cost of holding a tyre in inventory for one year is $25.
What is the EOQ?

2. A manufacturing company has an EOQ of 1,000 for Component A. It uses 15,000 of these
components a year. The minimum inventory level is 4,000. The cost of holding one
component in inventory for a year is $0.60.
What is the total cost of holding inventory for the component for a year?

3. A company uses 65,000 units of raw material each year. It places orders in batches of 1,500,
which is its EOQ. The minimum inventory level is 2,000. The cost of holding one unit in
inventory for a year is $0.25.
What is the total cost of holding inventory for the component for a year?
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Summary and Quiz

• Materials are classified into four categories:
o Raw materials
o Bought-in components
o Work-in-progress
o Finished goods
• Direct materials are materials that are directly attributable to a production unit.
• Indirect materials are not directly attributable to a production unit.
• Manufacturing companies usually follow a specified purchasing process when acquiring
materials.
• Movements of materials are recorded in the materials control account.
• Inventory control is managing the amount of each item and knowing where it is.
• The material input requirement considers how much of a material is needed to create a
product (including expected wastage).
• Some types of wastage are avoidable with management intervention.
• There are several different methods of calculating inventory value.
o First-in, first-out (FIFO)
o Last-in, first-out (LIFO)
o Cumulative weighted average pricing (CWA)
o Periodic weighted average pricing (PWA)
• If prices are stable, all inventory valuation methods will provide the same answer. It is only
in times of changing prices that there is a difference.
• Obsolescence is the reduction in inventory value due to it becoming irrelevant to the
organisation’s needs.
• Deterioration is the reduction in inventory value due to degradation in its qualities.
• Managing the different inventory costs is a balancing act, as all the costs depend on each
other.
• There is an inverse relationship between inventory holding costs and ordering costs, driven
by order size.
• Organisations must pick an optimum amount of inventory to hold that minimises their overall
inventory cost.
• Economic order quantity (EOQ) is the order size where holding costs and ordering costs are
equal (assuming zero buffer inventory).
• Stocktaking involves physically counting the materials held and checking the figures against
records detailing how many materials the organisation should have.
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CHAPTER 7: Visual Overview

1.1 Direct and Indirect Labour
Employees expect to be paid for their work. Companies try to motivate their staff through
remuneration, incentives , and other benefits.

1.1.1. Classifying Labour as Direct and Indirect

Labour may be classified as direct or indirect. This classification depends on the primary activity
of the business.

Definitions

Direct labour – Labour whose work is directly attributable to producing a product or service.
Indirect labour – Labour not directly attributable to the production of a product or service.

Activity 1: Classifying Labour

Classify the labour as either direct or indirect.

Labour
Classification (Direct or Indirect)

Sewing machinist at a clothes manufacturer

Factory manager

Hairdresser that cuts hair at a salon

Office receptionist

Mechanic who fixes cars at a car workshop

Mechanic who fixes trucks at a logistics firm

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1.2 Classifying Labour Costs as Direct or Indirect

Generally, the basic pay of direct workers is a direct cost, and all other costs of direct workers
are indirect costs. All costs of indirect workers are indirect costs.

Key Point

Only hours spent directly producing a product/service are considered direct labour costs.
All other costs are indirect, even if paid to direct workers.
A bonus paid to direct workers is an example of an indirect cost paid to direct workers.
Direct worker ( eg factory worker )
Basis salary === direct cost
Bonus , incentive , sick pay , holiday pay === indirect cost

Indirect worker ( eg accountant )

Basis salary = indirect cost
Bonus , incentive , sick pay , holiday pay === indirect cost

Activity 2: Direct and Indirect Costs

Classify the following labour costs of T-Shirt Co as either direct or indirect.

Direct or
Cost element indirect

Holiday pay to direct workers

Pay for hours spent delivering orders to customers.

Pay for hours spent producing T-shirts to direct workers

Overtime premium paid due to holiday cover to direct workers

Pay to direct workers for additional hours of work carried out after regular production
hours to produce an order of customised T-shirts for a customer at short notice.
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1.3 Calculating Direct and Indirect Costs of Direct Workers

Example 1: Direct Workers

The following information is available regarding direct workers of a company:

Hours worked Hourly rate ($)

Basic hours (including 50 hours of idle time) 900 ( 850) 7.50

Overtime( gerneal ) 150 10.50

Calculate the amount to be classified as direct and indirect labour costs.
Answer:
Direct labour cost Indirect labour cost
$ per hour $ $ per hour $
900 basic hours:
850 active hours 7.50 6,375
50 idle time hours 7.50 375
150 overtime hours:
150 active hours 7.50 1,125
150 hours of overtime premium 3.00 450
Total 7,500 825
Observations: 150 specific ovetime 10.5. 1575

1.4 Calculating Direct and Indirect Labour Costs of Indirect Workers

Example 2: Indirect Workers

The following information is available regarding the workers of a company:

Hours worked Hourly rate ($

Basic hours, direct workers (including 50 hours of idle time) 900(850) 7.50

Overtime, direct workers 150 10.50( P $3)

Basic hours, indirect workers 350 6.00

Overtime, indirect workers 50 8.50

Calculate the amount to be classified as direct and indirect labour costs.
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Example 2: Indirect Workers

Answer:
Direct labour cost Indirect labour cost
$ per hour $ $ per hour $
900 direct worker basic hours:
850 active hours 7.50 6,375
50 idle time hours 7.50 375
150 direct worker overtime hours:
150 active hours 7.50 1,125
150 hours of overtime premium 3.00 450
350 indirect worker basic hours
350 hours 6.00 2,100
50 indirect worker overtime hours
50 hours 8.50 425
Total 7,500 3,350
Observations:
• The cost of indirect workers is indirect.

2.1 Remuneration.
There are different methods of determining payment for employees. These can be grouped into
two main categories:
• Time-based
• Output- or performance-based.

2.2 Types of Remuneration

2.2.1. Time-based schemes
There are some distinctions to make when it comes to how employees are paid:
• Salary: Organisations pay salaried employees an agreed amount per month
• Wages: Waged employees are paid based on an agreed hourly rate, depending on how many
hours they work
• Overtime premiums are paid to persuade workers to work longer hours than normal. An
overtime premium will be in addition to the standard pay rate.
Salary, wages and overtime are time-based remuneration systems: payment is based on the time
employees work.
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Advantages Disadvantages

• In time-based systems, there is no incentive for

• Time-based payment systems are simple employees to be efficient
to administer • Everyone is paid the same regardless of performance
• One standard rate applies to all • More supervision is needed because employees are not
employees in the same role (which seems as highly motivated as they are when working under
fairer to employees) an incentive scheme

2.2.2. Incentive schemes

The previous activity also demonstrates how organisations use incentive schemes. Incentive
schemes can be either output- or performance-based remuneration schemes. They are designed to
encourage employees to work harder or more efficiently.

Incentive type Description

Payment is a fixed amount for each item (each piece of work) completed,
regardless of how long it takes.
This means that more efficient workers get paid more than inefficient workers.
This method can guarantee the cost per unit for organisations, which helps planning
Piecework accuracy.

A monetary incentive based on the performance of an individual, group, or whole

organisation.
Employees could receive a bonus based on their performance, or all employees
Bonuses might receive a share of a group bonus.

Commissions are paid based on a successful outcome.

Commission They are often used in sales as a percentage of the sales amount.

Profit-sharing
schemes Employees are given a share of the profit made by the organisation in the year.
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Advantages Disadvantages

• Help to increase production while controlling costs per

unit, which helps the accuracy of planning • Incentive schemes are more
• More efficient employees are paid more than inefficient or expensive to administer
less hardworking employees • Quality control is needed to ensure
• May attract more skilled workers output meets standards.

4.2.1. Paying Wages

• Payment of net pay to employees
Dr Wages control
Cr Bank / Cash (net pay)
• Payment of employee deductions and employer contributions to external entities
Dr Wages control
Cr tax PAYE / employee benefits
Pay-as-you-earn (PAYE) are monthly deductions from employee paycheques remitted to external
entities. PAYE may be required for income tax and mandatory insurance contributions.
4.2.2. Accounting for Labour Costs in Wages Control
• Accounting for costs of labour (including employer contributions)
Dr Work-in-progress / production overheads / employer contributions
Cr Wages control
4.2.3. Accounting for Direct Labour Costs

Direct labour costs would be directly accounted for in work-in-progress.

• Direct labour costs associated with production
Dr Work-in-progress
Cr Wages control
4.2.4. Accounting for Indirect Labour Costs
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Indirect labour costs would be transferred into a Production overheads account for subsequent
absorption into work-in-progress.
• Transfer of indirect labour costs to production overheads
Dr Production overheads
Cr Wages control

4.2.5. Absorption of Production Overheads

Production overheads (which include all indirect production costs) would be absorbed into
production.
• Absorption of production overheads into production
Dr Work-in-progress
Cr Production overheads

4.2.6. The Wages (Labour) Control Account

Wages Control Account
$ $

Bank X Work-in-progress X

Payment of net wages Direct labour costs

Payables (tax, National insurance, X

etc.)
Production overheads
Mandatory deductions and X
contributions Indirect labour costs
Statement of profit and loss X

Other labour costs (like employer

contributions, etc.)

5.1 Labour Turnover

Labour turnover is the rate at which employees leave an organisation.
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5.1.1. Costs of Labour Turnover

The costs of labour turnover can be put into two categories:
• Preventative costs: the costs involved in encouraging employees to continue working at the
organisation
• Replacement costs: the costs involved in recruiting and hiring new employees.
Examples of preventive and replacement costs:

Preventative costs Replacement costs

• Loss of output due to the time gap between an

old employee leaving and a new employee
starting
• Cost of recruitment (advertising, recruitment
agency fees)
• Cost of benefits and incentive schemes • Costs of training (training courses and existing
• Cost of development training to encourage staff providing instruction)
employees to progress in their careers at the • Lower production volumes while new
organisation employee learns how to do the job

Organisations measure labour turnover and try to keep it as low as possible to minimise
replacement costs.
5.1.2. Measuring Labour Turnover
Organisations measure labour turnover and compare it to a base rate. This is so that the company
can understand if its turnover rate is unusual or in line with expected rates.
The labour turnover rate measures the number of employees leaving in a period and expresses
this as a percentage of the total labour force.
The formula is: Labour Turnover rate = Replcemnet no of employee / avg no of employee *100
The average number of employees = (Opening employees + Closing employees) ÷ 2

Activity 3: Labour Turnover Rate

1. T-Shirt Co had 300 employees at the beginning of 20X0. At the end of 20X0, there were 500
employees. 45 employees resigned in the year and were immediately replaced. An additional
200 employees were recruited for new jobs during the year.
What is the labour turnover rate?
1. Sweater Co had 15,000 employees at the beginning of 20X0 and 11,000 employees at the end
of 20X0, following a downturn in its business. In addition to the redundancies, 1,500
employees resigned in the year and were replaced immediately by new employees.
What is the labour turnover rate?
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5.2 Preventing High Labour Turnover

Organisations try to keep labour turnover low to avoid its associated costs.
Employer actions to reduce labour turnover include:
• Paying higher salaries and offering better benefits
• Creating a better working atmosphere
• Offering development training
• Offering clear career progression
• Offering flexible working arrangements.

6.1 Labour Ratios

An organisation's production is seen as efficient if it produces as many, or more, products than
expected within a certain period. Production is seen as inefficient if an organisation produces
fewer products than expected.
6.1.1. Efficiency Ratio
The efficiency ratio measures whether the production output for a period took more or less direct
labour time than expected.
A ratio of > 100% indicates greater labour efficiency than budgeted.
A ratio of < 100% indicates poorer labour efficiency than budgeted.
6.1.2. Capacity Utilisation Ratio
The capacity utilisation ratio measures whether the total direct labour hours worked were greater
or less than budgeted.
A ratio > 100% indicates more labour hours were worked than budgeted.
A ratio of < 100% indicates fewer labour hours were worked than budgeted.
6.1.3. Production Volume Ratio
The production volume ratio measures how the actual production output for a period (in direct
labour hours) compares with the budgeted output.
A ratio > 100% indicates higher than budgeted performance.
A ratio of < 100% indicates a lower-than-budgeted performance.

6.1.4. Relationship Between Labour Ratios

The relationship between the ratios is:

Efficiency ratio × capacity utilisation ratio = production volume ratio

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Example 4: Labour Ratios

T-Shirt Co budgeted to make 100 units of output in June. Each unit was expected to take 3 hours of direct labou
The actual production volume in June was 110 units, which took 350 hours of direct labour.
For June,
1. What is the labour efficiency ratio for T-Shirt Co?
2. What is the capacity utilisation ratio for T-Shirt Co?
3. What is the production volume ratio for T-Shirt Co?
4. Show the relationship between the ratios.
Solution:
1. Efficiency ratio = ((110 × 3) / 350) × 100% = 94.29%
2. Capacity utilisation ratio = (350 / 300) × 100% = 116.67%
3. Production volume ratio = (110 × 3) / 300 × 100% = 110%
4. Efficiency ratio × Capacity utilisation ratio = Production volume ratio 94.29% × 116.67% = 110.00%

7.6.2 Idle Time

There are times when employees cannot perform their work. In a factory, that might be because
there is a stockout of raw materials. In an administrative job, they might need to wait for
information or authorisation, or their equipment might have broken down. This is known as idle
time.
6.2.1. Idle Time Ratio
The idle time ratio shows the proportion of available hours lost due to idle time.
The idle time ratio is expressed as:

Example 5: Idle Time Ratio

T-Shirt Co budgeted to make 100 units of output in June. Each unit was expected to take three hours of direct la
The actual production volume in June was 110 units, which took 350 hours of direct labour. The total available
labour in June was 380 hours.
What is the idle time ratio for T-Shirt Co in June?
Solution: Idle time ratio
= (Idle hours / Total hours) × 100%
= (380 − 350) / 380 × 100%
= 7.89%
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Summary and Quiz

• Labour may be classified as direct or indirect. This classification depends on the primary
activity of the business.
• Direct labour is employees whose work is directly attributable to producing a product or
service.
• Indirect labour is employees whose work is not directly attributable to producing a product or
service.
• Generally, the basic pay of direct workers is a direct cost, and all other costs of direct
workers are indirect costs. All costs of indirect workers are indirect costs.
• Direct labour costs are usually active hours spent by direct workers producing output
multiplied by their basic rate.
• There are different methods of determining payment for employees. These can be grouped
into two main categories:
o Time-based
o Output- or performance-based.
• Organisations use a payroll system to calculate and organise labour costs every time
employees are paid. This is usually every week or every month.
• Direct labour costs would be directly accounted for in work-in-progress.
• Indirect labour costs would be transferred into a Production overheads account for
subsequent absorption into work-in-progress.
• Labour turnover is the rate at which employees leave an organisation.
• The costs of labour turnover can be put into two categories:
o Preventative costs
o Replacement costs
• The efficiency ratio measures whether the production output for a period took more or less
direct labour time than expected.
• The capacity utilisation ratio measures whether the total direct labour hours worked were
greater or less than budgeted.
• The production volume ratio measures how the actual production output for a period (in
direct labour hours) compares with the budgeted output.
• The idle time ratio shows the proportion of available hours lost due to idle time.
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CHAPTER 8: Visual Overview

1.1 Expenses

Definition

Expense – Decreases in economic benefits during the accounting period in the form of outflows, depletions
of assets, or incurrences of liabilities.

Expenses result in either:

• The decrease in an asset such as cash in the bank account when items are paid for
immediately, or
• The increase in a liability – such as an account payable or creditor when items are paid for
on credit.

Material and labour costs are types of expenses. Other expenses are not materials or labour costs
– for example, the rent paid for an organisation's factory and offices, insurance and electricity.
Other expenses are referred to as ‘expenses' in this chapter.
1.2 Classifying Expenses by Function
A method of classifying expenses is grouping them by the departments (function) they are
associated with, such as production, finance, human resources and sales.
Some examples are below:

Function Expenses

• Rent
• Utility bills (gas, electricity, water)
• Telecommunications (phones, internet)
Buildings management • Taxes on property.

• Repairs
• Maintenance
Production department • Lease (hire) costs.

• Advertising
• Customer service
Selling and distribution • Delivery.

• Interest charges on loans

• Legal fees (for example, on agreeing to a contract)
• External audit
Finance and legal • Insurance.
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1.3 Direct and Indirect Expenses

Expenses may be classified as direct or indirect, similarly to materials and labour costs:
• Direct expenses are incurred on a specific product and are part of the direct (or prime) cost
of the product
• Indirect expenses cannot be attributed to a specific product and are also known as
overheads.

Activity 1: Direct and Indirect Expenses

Classify the expenses as direct or indirect.

Classification (Direct or
Expense Indirect)

Fuel for a concrete mixer used by a construction company to build a new

factory

Lease costs for a specialist embroidery machine used for a particular batch
of products

Purchase of customised design software needed to design a skyscraper for

a customer project

Employer's pension contributions for direct labour

Insurance costs for the warehouse where inventory is held

Rent costs for the factory where production processes are carried out

The warehouse manager’s monthly salary

Costs for cleaning and maintaining the factory for a T-shirt manufacturer

2.1 Asset Expenditure ( capital expenditure )

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Asset expenditure occurs when a new non-current asset is bought or existing non-current assets
are improved.
It also relates to replacing a non-current asset that has come to the end of its useful life.
An example of asset expenditure is a company buying a new truck or modifying an existing truck
so that it can carry heavier loads.
Asset expenditure is shown on the Statement of Financial Position as an asset.

2.1.1. Accounting Entry

Generally, the accounting entry would be:
Dr Asset (Statement of Financial Position)
Cr Cash / Bank / Payables (Statement of Financial Position)

2.2 Expenses ( Revenue expentiure )

Expenses occur when paying for the ongoing costs of running the organisation. It is expensed in
the period revenue is generated from it (matching concept= accrual concept ).
Expenses are shown on the Statement of Profit or Loss.

2.2.1. Accounting Entry

Generally, the accounting entry would be:
Dr Expense (Statement of Profit and Loss)
Cr Cash / Bank / Payables (Statement of Financial Position)

2.3 Classifying Expenditure as Asset Expenditure or Expenses

Expenses is reflected in the Statement of Profit or Loss immediately, reducing profit. Asset
expenditure does not affect the calculation of profit.
2.3.1. Impact of Misclassification
Suppose an expense is incorrectly shown as asset expenditure. In that case, expenses will be
understated (shown as being lower than they should be), meaning that profit will be overstated
(shown as being higher than it should be).
If asset expenditure is incorrectly classified as an expense, expenses will be overstated. This
means that profit will be understated.
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Activity 2: Expense Classification

Identify whether the calculated profit is correct, understated, or overstated for the given
expense classifications.
Calculated Profit
Expense (Correct, Overstated,
or Understated)

T-Shirt Co has purchased five new computers for $3,000 each. The computers
will be used for three years before being replaced. The entire cost has been
posted to expenses.

T-Shirt Co has purchased $25,000 of cotton for use in production. Since it is a

large volume, the cost has been capitalised.

T-Shirt Co purchased a used lorry for $5,000 to make deliveries. Since the lorry
is not new, the cost has been charged to other expenses

T-Shirt Co has hired an industrial sewing machine. The rental costs for the year
have been charged to expenses.

3.1 Depreciation Principles

Depreciation is a way to match expenditure on non-current assets to the period when the assets
are used (matching concept).
Depreciation is an expense shown on the statement of profit or loss in the period the asset is used
to generate revenue.
Depreciation is a non-cash item (no cash is paid when charging depreciation).
3.1.1. Matching Period of Depreciation with Useful Life
The period depreciation is charged should match the asset’s useful life.
For example, depreciation should be charged over five years if a purchased truck is used for five
years.
3.1.2. Residual Value and Scrap Value

Definition

Residual value – The value of the asset after the end of its useful life. Also known as scrap value.
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3.1.3. Depreciable Amount

The depreciable amount is the asset’s value to be depreciated over its useful life.
It is calculated as:

Depreciable amount = Cost of Asset – Residual value or Scrap value

For example, a truck is purchased for $60,000 and has a residual value of $10,000 after five
years.
The depreciable amount of the truck would be $60,000 − $10,000 = $50,000
3.1.4. Annual Depreciation

Definition

Annual Depreciation – The depreciation charge for the year on the asset.

A simple method to calculate annual depreciation is dividing the asset’s depreciable amount by
its useful life.
For example, if the truck with a depreciable amount of $50,000 has a useful life of five years, the
annual depreciation would be $10,000 ($50,000 ÷ 5)
3.1.5. Accumulated depreciation

Definition

Accumulated Depreciation – The total depreciation charged up to a point in the asset’s useful life.

For example, if the annual depreciation of the truck is $10,000, and the truck has been used for
two years, the accumulated depreciation would be $20,000 ($10,000 × 2)
3.1.6. Carrying Amount

Definition

Carrying amount – The asset’s value is reflected in the accounts. It is the cost of the asset less accumulated
depreciation.

The formula for NBV is:

Carrying amount = Cost – Accumulated depreciation

(or ) = Carrying value at start year – annaul dep
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4.1 Methods of Calculating Depreciation

There are different ways to calculate depreciation:
• Straight-line method: equal charge amounts each year
• Reducing balance method: charge most in the first year and then less and less as the asset
gets older
• Machine hour method: charge according to how much the asset is used each year
• Product units method: charge according to how many product units will be made using the
asset.
You will be told which method to use to calculate depreciation in the exam.

4.2 Straight Line Method

Straight-line depreciation is where the annual depreciation charge is the same throughout the
asset’s useful life.
The annual depreciation is calculated

Annual depreciation
= (Cost – Residual value) ÷ Useful life

Example 1: Straight-Line Method

A company buys a truck for $60,000 and uses it for five years. After five years, the truck is sold for $10,000. Th
company uses the straight-line method to calculate depreciation. A whole year’s depreciation is charged in the y
of purchase.
Show the amounts reflected in the financial statements for each of those five years.
Solution:
Annual depreciation
= (60,000−10,000) ÷ 5 years
= $10,000 per year

4.3 Reducing Balance Method

The reducing balance method recalculates the annual depreciation by applying a
percentage to the carrying amount.
The formula is:

Annual depreciation
= Carrying amount × Depreciation rate %
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Example 2: Reducing Balance Method

A company buys a truck for $60,000 and uses it for five years, after which it has a residual value of $11,000. Th
company uses the reducing balance method at a 30% rate to calculate depreciation.
Show the amounts reflected in the financial statements for each of those five years.
The carrying amount in the Statement of Financial Position and depreciation charge to the Statement of Profit a
Loss is shown:

Statement of Profit and

Loss
Statement of Financial Position

Accumulated Carrying
Year Cost depreciation amount Depreciation charge Calculation

$ $ $ $

0 60,000 NA 60,000 NA

1 60,000 (18,000) 42,000 (18,000) 60,000 ×

2 60,000 (30,600) 29,400 (12,600) 42,000 ×

3 60,000 (39,420) 20,580 (8,820) 29,400 ×

4 60,000 (45,594) 14,406 (6,174) 20,580×

reduce to resi
5 60,000 (49,000) 11,000 (3,406) v

In the final year, depreciation is calculated to reduce the carrying amount to residual value. This ensures that the
asset is fully depreciated.

4.4 Practice
Activity 3: Straight-Line Method

A company buys an asset for $120,000 which has a useful life of three years and no residual
value. A whole year’s depreciation is charged in the year of purchase. The company uses the
straight-line method to calculate depreciation.
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What amounts will be shown in the financial statements in each of those three years?
Statement of Profit and Loss
Statement of Financial Position

Accumulated
Year Cost depreciation Carrying amount Depreciation charge

$ $ $ $

0*

Activity 4: Reducing Balance Method

A company buys an asset for $120,000, with a useful life of three years and no residual value.
The company uses the reducing balance method at 60% to calculate depreciation.
What amounts will be shown in the financial statements in each of those three years?
Statement of
Profit and Loss
Statement of Financial Position

Accumulated Carrying Depreciation

Year Cost depreciation amount charge Calculation

$ $ $ $

3
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5.1 Machine Hour Method

the annual charge is calculated according to how much the asset is used each year.

Depreciation per machine hour

= (Cost – Residual value) ÷ useful life in hours
Annual depreciation
= Depreciation per machine hour × Actual usage hours

Example 3: Machine Hours Method

A company buys a truck for $60,000, which is used for five years. After five years, the truck is sold for $10,000
Usage over the five years is expected to be:

Year Days

1 140

2 160

3 85

4 75

5 50

Total 510

Show the amounts reflected in the financial statements for each of those five years.
Solution:
Depreciation per machine hour
= ($60,000 – $10,000) ÷ 510 days
= $98.04 per usage day
The carrying amount in the Statement of Financial Position and depreciation charge to the Statement of Profit a
Loss is shown:
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Example 3: Machine Hours Method

Statement of Profit and

Loss
Statement of Financial Position

Accumulated Carrying
Year Cost depreciation amount Depreciation charge Calculation

$ $ $ $

0* 60,000 NA 60,000 NA

140 ×
1 60,000 (13,725) 46,275 (13,725) $98.04

160 ×
2 60,000 (29,412) 30,588 (15,686) $98.04

3 60,000 (37,745) 22,255 (8,333) 85 × $98.04

4 60,000 (45,098) 14,902 (7,353) 75 × $98.04

5 60,000 (50,000) 10,000 (4,902) 50 × $98.04

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5.2 Product Unit Method

the annual depreciation charge is calculated according to how many production units will be
made using the asset in that year.

Depreciation per production unit

= (Cost – Residual value) ÷ Expected production units
Annual depreciation
= Depreciation per production unit × Actual units produced

Example 4: Product Units Method

A company buys a machine for $60,000, which is used for five years. After five years, the truck is sold for $10,000.
Production over the five years utilising the machine is expected to be:

Year Units

1 400

2 500

3 320

4 290

5 180

Total 1,690

Show the amounts reflected in the financial statements for each of those five years.
Solution:
Depreciation per production unit
= ($60,000 – $10,000) ÷ 1,690 units
= $29.59 per unit
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Example 4: Product Units Method

The carrying amount in the Statement of Financial Position and depreciation charge to the Statement of Profit and
Loss is shown:

Statement of Profit and

Loss
Statement of Financial Position

Accumulated Carrying
Year Cost depreciation amount Depreciation charge Calculation

$ $ $ $

0* 60,000 NA 60,000 NA

400 ×
1 60,000 (11,834) 48,166 (11,834) $29.59

500 ×
2 60,000 (26,627) 33,373 (14,793) $29.59

320 ×
3 60,000 (36,095) 23,905 (9,467) $29.59

290 ×
4 60,000 (44,675) 15,325 (8,580) $29.59

180 ×
5 60,000 (50,000) 10,000 (5,325) $29.59
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Activity 7: Machine Hours Method

A company buys an asset for $120,000.
The asset has a useful life of three years and no residual value.
The company uses the machine hours method to calculate depreciation.
Usage over the three years is expected to be:

Year Days

1 140

2 160

3 85

Total 385

Show the amounts reflected in the financial statements for those three years.
Statement of
Profit and Loss
Statement of Financial Position

Accumulated Carrying Depreciation

Year Cost depreciation amount charge Calculation

$ $ $ $

3
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Activity 8: Product Units Method

A company buys an asset for $120,000.
The asset has a useful life of three years and no residual value.
The company uses the product units method to calculate depreciation.
Production over the three years utilising the machine is expected to be:

Year Units

1 700

2 800

3 720

Total 2,220

Show the amounts reflected in the financial statements for those three years.
Statement of
Profit and Loss
Statement of Financial Position

Accumulated Carrying Depreciation

Year Cost depreciation amount charge Calculation

$ $ $ $

3
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Summary and Quiz

• Expenses are decreases in economic benefits during the accounting period in the form of
outflows, depletions of assets, or incurrences of liabilities.
• A method of classifying expenses is grouping them by the departments (function) they are
associated with, such as production, finance, human resources and sales.
• Expenses may be classified as direct or indirect, similarly to materials and labour costs.
• Asset expenditure occurs when a new non-current asset is bought or existing non-current
assets are improved. It also includes replacing a non-current asset.
• Expenses occur when paying for the organisation’s ongoing costs.
• An expense is shown on the statement of profit or loss immediately, reducing profit. Asset
expenditure does not affect the calculation of profit.
• Depreciation is a way to match expenditure on non-current assets to the period when the
assets are used (matching concept).
• Depreciation is a revenue expense shown on the statement of profit or loss in the period the
asset is used to generate revenue.
• There are different ways to calculate depreciation:
o Straight-line method
o Reducing balance method
o Machine hour method
o Product units method
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CHAPTER 9: Visual Overview

1.1 Job Costing Principles

Definition

Job costing is the process of calculating the costs of a specific job.

A job is a cost unit that consists of a single order or contract. Compared to continuous
production, it is usually limited in scope and period.

1.2 Job Costing Process

1.3 Job Records

Once a job has been agreed upon, the company carrying out the job carries out the following
steps:
1. Each job is given a unique code
2. All direct costs associated with the job are coded directly to the job code
3. A share of the overheads is calculated and charged to the job
4. The job cost is calculated, usually on a job cost card.
5. The difference between the actual costs and the agreed selling price is the profit.
Key Point

Job cost cards are usually created and held electronically in the computerised accounting system.

1.4 Job Costing

Job costing is collecting all the cost information relating to that job.
When a job is planned, a cost card will be prepared with the expected costs:
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Job cost card $

Direct materials X
Direct labour X
Direct expenses X
Total direct costs( prime cost ) X
Production overhead X
Total production costs X
Administration overhead X
Selling overhead X
Total job cost X
The cost card will be used to create a budget for the job. The actual costs will be recorded in the
accounting system.

2.1 Cost-Plus Pricing

The cost-plus pricing method adds the required profit to the total cost of the product or job.
1st cost. = $100 , 2 nd profti = $20 , 3rd selling price = $120. ( cost plus pricing )
1 st selling price = $700, 2 nd price = $100, 3rd estimated cost $600 ( target pricing ) competitive
The required profit may be expressed as:
• Mark-up % ( cost 100%)
A percentage of the cost.
• Margin %. ( selling price 100% )
A percentage of the selling price.

Activity 1: Margin and Mark-Up

1. The total cost of a job is $45,000. The markup is 30%.

What is the selling price for this job?

1. The total cost of a job is $500,000. The markup is 15%.

What is the selling price for this job?

1. The total cost of a job is $45,000. The profit margin is 30%.

What is the selling price for this job?

1. The total cost of a job is $500,000. The profit margin is 15%.

What is the selling price for this job?
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3.1 Batch Costing Principles

Batch costing is like job costing; the only difference is that the job’s output is several units rather
than a single unit. The units within a batch are homogeneous (identical to each other).

Cost per unit = total batch cost / number of units in a batch

Example 5: Batch Costing

A company manufactures buttons. Production of 500 green buttons, produced in Batch G24, had the following c

Direct materials $800

20 hours of heating at $20 per hour

Direct labour 30 hours shaping at $15 per hour

The cost of hiring special safety equipment was $100.

Production overheads were absorbed at $9.60 per direct labour hour.
Selling and distribution overheads were $300.
What was the cost per unit (per button) for Batch G24?
Solution: Total cost for Batch G24:
$ $
Direct material 800

Direct labour
Heating 400 20 hours × $20

Shaping 30 hours × $15

450
850

Direct expense
100
Prime cost 1,750

Production overheads $9.60 × 50 hours

480
Production cost
2,230
Selling and administrative costs
300
Total cost
2,530
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Example 5: Batch Costing

Cost per unit for Batch G24

= $2,530 ÷ 500 units
= $5.06 per unit.

3.2 Set-Up Costs

The equipment used for batches often needs to be cleaned and set up for the next batch to be
processed. This is because the next batch might require different production inputs and settings.
For example, a large-scale manufacturer might produce a batch of detergent and then clean and
reconfigure the same machinery to produce bleach.

3.3. Reducing Set-Up Costs

Set-up costs may be reduced by:
• Keeping subsequent batches as similar as possible to the initial batch, minimising changes to
the set-up.
• Regular maintenance of production machinery, reducing downtime.
• Increasing batch size (without compromising quality) produces more units per set-up.
• Examining the set-up requirements and designing the process to reduce set-up costs and
downtime.

Summary and Quiz

• A job is a cost unit that is an individual order or contract.
• Jobs are distinct from each other, and the delivered product or service will have features that
are particular to the client.
• Job costing is collecting all the cost information relating to that job, usually on a job cost
card.
• The figures from the job account are compared to the budget so that the manager can identify
any variances and see if the job was completed on budget.
• The cost-plus pricing method adds the required profit to the total cost of the product or job.
The profit may be calculated as:
o A mark-up (% of the cost); or
o Margin (% of the selling price). Target pricing
• A batch is a specific quantity of standard units. The units that are made in each batch will all
be the same.
• Managers regularly monitor the costs incurred by an organisation and take actions to try to
ensure that the organisation is not spending more money than it needs to.
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CHAPTER 10: Visual Overview

1.1 Characteristics of Services
Services usually demonstrate five essential characteristics, as illustrated below with an example
of a lawyer:

Characteristic Description

Intangibility services are not physical

Perishability services cannot be stored for future use

Inseparability
(Simultaneity) the service provider cannot be separated from the service

Inconsistency
(Heterogeneity or
variability) each instance of the service is unique

Involvement the customer is involved in the service delivery.

No transfer of ownership The service is not owned, and cannot be sold to a third party.

Some examples of service providers are:

• Accountancy firms: providing audit services
• Banks: providing financial services such as bank accounts, loans and credit
• Dentists: providing tooth cleaning services
• Universities: providing an education
• Lawyers: providing legal expertise and advice.

Activity 1: Classification of Services

Classify the items below as either a good or a service.
Classification
Item (Good or Service)

Shampoo

Pillow
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Haircut

Stay at hotel

Childcare

Bicycle

Theatre performance

Bus journey

Textbook

Language class

1.2 Service Organisations and Internal Services

Service organisations are companies and not-for-profit organisations which sell or provide
services to customers.
However, services are also provided within service organisations and those selling goods. These
are service departments or cost centres, for example:
• Maintenance: repairs and upkeep of property and machines
• Libraries: organisations may have knowledge resources available to staff
• Canteens: factories and many government organisations provide subsidised meals for
workers.

These are internal services.

2.1 Problems in Service Costing

Costing for services may be challenging due to their nature.

Challenge

Difficult to identify a cost unit to which costs are allocated.

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Indirect costs are often a more significant percentage of a service’s cost than a physical product. This makes
a meaningful and fair allocation of shared costs necessary.

The number of inputs for each cost unit may be unique.

3.1 Service Cost Units

Description Example
Cost Unit

• Haircut per customer

Each provision of the service is similar in • Gigabyte of mobile data
Simple cost unit nature and provided to one customer at a time. • Car wash session
• Subscription fee

• Hotel Room-night
Composite cost Made of two parts related to the service’s • Hospital bed-night
unit extent. • Charge-out rates (associate hour or partner
hour)

Service is unique, personalised, and complex, • Cost to argue a legal case in court
with many cost elements. • Contractor services for
Complex services construction/refurbishment of buildings.
It may include both simple and composite cost
(by job or • Other complex service provisions
units.
engagement) (maintenance contracts, etc.)

Activity 2: Identifying Composite Cost Units

Select the most appropriate cost unit for the organisation.
Options:
• Bed-day
• Student-semester
• Passenger-kilometre

Organisation Composite cost unit

School

Hospital

Bus service
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4.1 Service cost card

A service cost card would be like a job cost card, with each cost element separately identified.
4.1.1. Cost Card Example
The following cost card is an example of a patient’s hospital stay.
$ $

Direct materials
(medicine) 500

Direct labour (nurses

and doctors) 1200

Direct expenses 0

Total direct (prime) 1700

cost

Service overhead 200

(hospital rent, cleaning)

Total service cost 1900

Administration
overhead 100

Cost of service 2000

4.2 Calculating Total Cost per Service Unit

The following formula is used to calculate the cost per service unit:

Labour cost in services is usually higher than materials, and indirect costs are likely to make up
more of the total cost of services than for physical products.
The following is an example of how to approach calculating the total cost of a night’s stay at a
hotel. The composite cost unit of occupied room-night is used.

If a hotel has 10 rooms with a 70% yearly occupancy rate, the number of room-nights would be:
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= 10 room × 365 nights × 70%

= 2,555 room-nights per year.
If fixed hotel costs are $63,875 per year, the cost per room-night would be:
=$ 63,875 ÷ 2,555
= $25 per room-night
Total cost of hotal = $ 100,000
Cost per room per night = total cost / total room and nights
= $100,000 / 2555 rooms-night
= $39.14 per room -night

Activity 3: Calculating Service Costs

1. A hospital has 100 beds. In one week, the average bed occupancy was 67%. The cost of
running the hospital for the week was $90,000.
What was the cost per patient per night for the week?

2. A school has 250 students. In one year, the cost of running the school is $880,750.
What was the cost per student per year?

3. A local government is responsible for 40,000 kilometres of roads( 40 kilimo per day).
The maintenance costs for the year were $350,000.
What was the maintenance cost per kilometre per year?

Summary and Quiz

• Services usually demonstrate five essential characteristics:
o Intangibility
o Perishability
o Inseparability
o Inconsistency
o Involvement
• Providers of services generally offer customers expertise or the use of facilities.
• Service organisations are companies and not-for-profit organisations that sell or provide
customer services.
• As economies develop, there is a trend towards higher numbers of service organisations
rather than manufacturing organisations.
• Service cost units may be simple or compound (with two parts).
• A service cost card would be like a job cost card, with each cost element separately
identified.
• Labour cost in services is usually higher than materials, and indirect costs are likely to make
up more of the total cost of services than for physical products.
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CHAPTER 11: Visual Overview

1.1 Absorption Costing Principles
Absorption costing is a method of sharing and absorbing indirect costs – overheads – into the
total cost of a unit of product or service.
1.1.1. Overheads
Overheads are the indirect costs involved in producing a product or service. They are necessary
for production but not directly traceable to a single unit of product or service.
1.1.2. Overhead Absorption
Overhead absorption is calculating the overhead costs that should be included in the total cost of
a product or service.
Overhead absorption enables us to include the cost of using production facilities in the total cost
of the product.
1.2 Why Calculate Overhead Absorption?
Include overhead costs in the total cost per unit of a product or service to ensure that the total
cost per unit is accurate. This is necessary for two reasons:
• To calculate a reasonable selling price and determine whether a product is profitable.
• To calculate inventory value accurately.
1.2.1. Selling Price and Profitability
1.2.2. Inventory Valuation

Key Point

Cost of sales = Opening inventory + Cost of production – Closing inventory

2.1 Absorption Costing Process

Step Description

Allocation Allocation of entire cost items to cost centres.

Sharing of common costs to production cost

Apportionment (and re- centres
apportionment)

Absorption Absorbing shared costs into cost units

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2.2 Production and Non-Production Activities

The activities and departments of a manufacturing organisation can be categorised into
production and non-production activities/departments.

2.3 Cost Centres

A cost centre is a department or division that incurs costs. The organisation can decide what cost
centres to use. A cost centre could be a team or department, a single person or even a machine.

2.3.1. Production Cost Centre

A production cost centre is a department or activity directly producing the cost unit.
Production cost centres in a manufacturer are likely to include activities such as:
• Assembly
• Mixing
• Painting
• Packaging
• Ageing (holding products to mature)
• Molding
2.3.2. Service Cost Centre
A service cost centre is a department or activity that provides ancillary services to support
production cost centres.
In a manufacturer, these may include the following:
• Logistics and warehouse services
• Security
• Staff canteen and other human resource services
• Maintenance
• Cleaning

2.4 Whole Costs and Common Costs

2.4.1. Whole Costs( allocatiaon )
Whole cost items are overheads (indirect costs) attributable to a single cost centre. They are
allocated to a single cost centre.
For example, at T-Shirt Co, the salary of the warehouse manager is a whole cost item as it relates
only to the warehouse cost centre.
2.4.2. Common Costs
Common costs need to be shared among different cost centres.
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3.1 Allocation
Allocation involves charging whole overhead cost items to cost centres.
Activity 1: Allocation
T-Shirt Co has identified four of its cost centres:
• Assembly
• Design
• Purchasing
• Maintenance
Allocate the cost elements below to the appropriate cost centre.
Cost centre allocated to.
Cost (Assembly, Design, Purchasing, or Maintenance)

Sewing machine depreciation Assembly

Computer-aided-design (CAD) software Design

Purchasing Assistant salary Purcahing

Engineer's salary Assembly

Assembly supervisor’s salary Assembly

Designer’s salary Design

Sewing machine operator training Maintainence

Travel to suppliers Puchasing

Quality control checks Maintainnce

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4.1 Apportionment Principles

Apportionment, the second stage in absorption costing, is sharing common overheads between
cost centres.
Examples of common costs:
• Building lighting (shared by all cost centres in the building)
• All the cost centres also share rent, insurance, and utilities (water and electricity) in the
building.

4.2 Bases of Apportionment

An apportionment base must be identified to apportion common costs among cost centres:

Apportionment base Applicable common comavosts

Floor area Rent, cleaning, utilities, building maintenance

Number of employees Canteen, health and safety, parking costs, training

Volume (unit ) Heating

4.3 Calculating Apportionment

The steps are:

Example 1: Apportionment

A company has total production overhead costs of $246,100:

Cost item $

Equipment depreciation 50,000

Heating 13,600

Rent 170,000

Equipment maintenance 12,500

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Example 1: Apportionment

The following information about the cost centres of the company is available.

Production cost centres Service cost centres Total

Assembly Finishing Maintenance Purchasing

Floor space (m2) 4,000 1,500 800 500 6,800

Value of equipment ($) 150,000 80,000 15,000 5,000 250,000

1. On what bases should the overhead costs be apportioned between the four cost centres?
Two apportionment bases are available. Select the base that will give the fairest result in apportioning
the common cost.

Cost item Basis of apportionment

Equipment depreciation Value of equipment

Heating Floor area

Rent Floor area

Equipment maintenance Value of equipment

2. How much overhead should be apportioned to each cost centre?

Use the bases identified earlier to split the total overhead cost between the departments.
Apportion Depreciation and Maintenance by Value of equipment
Total cost Total value of equipment Cost per $ Production cost centres Service cost centres

Complete apportionment of production overheads is as below:

Total Cost apportioned to cost centres

Basis of overhead
Item of cost apportionment cost Assembly Finishing Maintenance Purchasing
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Example 1: Apportionment

$ $ $ $ $

Depreciation Value 50,000 30,000 16,000 3,000 1,000

Heating Floor area 13,600 8,000 3,000 1,600 1,000

Rent Floor area 170,000 100,000 37,500 20,000 12,500

Maintenance Value 12,500 7,500 4,000 750 250

Total 246,100 145,500 60,500 25,350 14,750

Activity 2: Apportionment

A company has the following overhead costs totalling $10,000:

Cost item $

Rent 5,000

Heating 3,000

Lighting 1,000

Water 1,000

The following information about the cost centres of the company is available:

Production cost centres Service cost centres Total

Mixing Bottling Cleaning Canteen

Floor space (m2) 120 100 10 20 250

Calculate the overhead amounts to be apportioned to each cost centre.

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5.1 Reapportionment
Reapportionment is the process of dividing the costs that have been allocated and apportioned
from service cost centres to production cost centres.
5.1.1. Methods of reapportionment
Similar to apportionment, a suitable reapportionment base is chosen to share the costs using that
base.
MA2 requires an understanding of two methods:
• Direct
• Step-down

5.2 Direct Reapportionment Method

The direct reapportionment method is when service cost centre overheads are only apportioned
to production cost centres. Services provided to other service cost centres are ignored.

Example 2 Direct Reapportionment

The overhead costs of a manufacturing firm have been allocated and apportioned as follows:
Production cost centres Service cost centres

Assembly Finishing Maintenance Purchasing

$ $ $ $

Allocated overheads 1,800,000 760,000 147,500 80,500

Apportioned overheads 145,500 60,500 23,350 14,750

Total overheads 1,945,500 820,500 172,850 95,250

The maintenance department spent the following time on the other cost centres:

Assembly 600 hours

Finishing 200 hours

Purchasing 50 hours

The purchasing department completed the following number of purchase orders for the other cost centres:
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Example 2 Direct Reapportionment

Assembly 110 orders

Finishing 75 orders

Maintenance 25 orders

Calculate the total overhead costs charged to the production cost centres after using the direct
reapportionment method to reapportion service cost centre overheads.
The direct method ignores services provided to other service cost centres
Service cost centre Basis of apportionment Assembly Finishing Total cost

$ $ $

Maintenance Maintenance hours 129,638 43,212 172,850

Purchasing Number of orders 56,635 38,615 95,250

186,273 81,827 268,100

Previously allocated and apportioned costs 1,945,500 820,500 2,766,000

Total overhead 2,131,773 902,327 3,034,100

5
Example 3 Step-Down Reapportionment

Assembly Finishing Maintenance Purchasing

$ $ $ $
Previously allocated and apportioned costs 1,945,500 820,500 172,850 95,250
Service cost centre Basis of apportionment
Maintenance Maintenance hours 122,012 40,670 (172,850) $10,168
Purchasing Number of orders 62,681 42,737 NIL (105,418)
Total overhead 2,130,193 903,907 NIL NIL
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5.4 Reapportionment Practice

Activity 3 Reapportionment

The overhead costs of a manufacturing firm for the week have been allocated and apportioned as
follows:
Production cost centres Service cost centres

Mixing Bottling Cleaning Canteen

$ $ $ $

Allocated overheads 10,000 15,000 1,500 700

Apportioned overheads 4,800 4,000 400 800

Total overheads 14,800 19,000 1,900 1,500

The cleaning department spent the following time on the other cost centres:

Mixing 200 hours

Bottling 150 hours

Canteen 50 hours

The canteen served the following number of meals to each department:

Mixing 50 meals

Bottling 35 meals

Cleaning 10 meals

1. Calculate the total overhead costs charged to the production cost centres after using the
direct reapportionment method to reapportion service cost centre overheads.
2. Calculate the total overhead costs charged to the production cost centres after using the
step-down reapportionment method to reapportion service cost centre overheads
(Reapportion cleaning costs first).
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Summary and Quiz

• Absorption costing is a method of sharing and absorbing indirect costs – overheads – into the
total cost of a unit of product or service.
• Overheads are the indirect costs involved in producing a product or service. They are
necessary for production but not directly traceable to a single unit of product or service.
• Overhead absorption is calculating the overhead costs that should be included in the total cost
of a product or service.
• A cost centre is a department or division that incurs costs. The organisation can decide what
cost centres to use. A cost centre could be a team or department, a single person or even a
machine.
• A production cost centre is a department or activity directly producing the cost unit.
• A service cost centre is a department or activity that provides ancillary services to support
production cost centres.
• Whole cost items are overheads (indirect costs) attributable to a single cost centre. They are
allocated to a single cost centre.
• Common costs need to be shared among different cost centres.
• Allocation involves charging whole overhead cost items to cost centres.
• Apportionment, the second stage in absorption costing, is sharing common overheads
between cost centres.
• An apportionment base measures how much the cost centre should be charged for the
common cost. It should be fair and measurable.
• Reapportionment is the process of dividing the costs that have been allocated and
apportioned from service cost centres to production cost centres.
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CHAPTER 12: Visual Overview

1.1 Overhead Absorption Rate (OAR)
The final step of absorption costing is to charge the production overheads to output.
• Direct labour hours would be the driver for production that is labour-intensive.
• Machine hours would be the driver for production that is machine-intensive.
Key Point

OAR is typically calculated using budgeted activity and overheads.

1.2 Calculating OAR

Overhead Absorption Rate (OAR) is typically calculated as follows:

OAR = Total overheads of production cost centre / total cost driver

Activity 1: OAR
A company has two production departments – A and B. The company makes three products –
Product 1, Product 2 and Product 3. The following information is available relating to Product 1:

Department A B

Overhead $100,000 $60,000

Labour hours 10,000 15,000

Machine hours 40,000 5,000

Product 1: labour hours per unit 1.5 hours 3 hours

Product 1: machine hours per unit 6 hours 1 hour

Overheads in department A are to be absorbed based on machine hours.

Overheads in department B are to be absorbed based on labour hours.
How much overhead would be included in the cost of a unit of Product 1?
*Please use the notes feature in the toolbar to help formulate your answer.
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Activity 2: OAR
A company has two production departments (Mixing and Bottling), making one product. The
following information is available relating to the product:

Department Mixing Bottling

Overhead $25,000 $40,000

Labour hours 750 500

Machine hours 2,000 1,000

labour hours per unit 45 minutes 40 minutes

Machine hours per unit 5 hours 15 minutes

Overheads in Mixing are to be absorbed based on machine hours.

Overheads in Bottling are to be absorbed based on labour hours.
How much overhead would be included in the cost of a unit of the product?

3.1 Calculating Over- and Under-Absorption

Over- or under-absorption occurs when actual overheads are not as budgeted.
• Over absorption: more might be charged in overhead costs than the organisation incurs
• Under absorption: less might be charged in overhead costs than the organisation incurs.
The formula is:

$
Overheads absorbed X
Actual overheads (X)
Over-/under-absorption X / (X)
Example 2:

Consider the following information:

• Actual overheads were $690,000
• Budgeted overhead absorption rate was $50 per machine hour
• Actual machine hours were 14,000.
Were overheads over-absorbed or under-absorbed?
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Example 2:

Solution:
$
Overheads absorbed 700,000 $50 × 14,000
Actual overheads (690,000)
Over-/under-absorption 10,000 Over-absorbed

Summary and Quiz

• The overhead absorption rate is the rate at which total production overhead costs are added to
the cost per unit of each product.
• An absorption base must be determined to calculate the absorption rate. This base, also
known as the cost driver, should be linked to the main activities that incur the overheads.
• OAR approximates overheads incurred, calculated using budgeted activities and overheads.
• Over- or under-absorption occurs when actual overheads are not as budgeted.
• Over absorption: more might be charged in overhead costs than the organisation incurs
• Under absorption: less might be charged in overhead costs than the organisation incurs.
• Non-production overheads are not absorbed into the product costs and are expensed against
profit for the period.
• Absorption costing for services is the same as for manufactured goods.
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CHAPTER 13: Visual Overview

1.1 Marginal Costing
1.1. Marginal Costing
Marginal costing is a costing method used for short-term decision-making. It facilitates this by
recognising costs according to their behaviour.
This means that fixed and variable costs are treated differently, especially in inventory valuation.

The marginal cost of a product usually consists of the following:

• Prime costs:
o Direct materials
o Direct labour
o Direct expenses
• Variable production overheads

Activity 1: Classification
Classify the statements as relating to either marginal costing or absorption costing.
Classification
(Marginal costing or
Statement Absorption costing)

Fixed costs are written off in total in the period they relate to

Costing is based on the cost of producing one more unit

Fixed costs relating to the previous period could be carried

forward in the cost of the opening inventory

Fixed costs are included in the cost of inventory

Costing is based on the variable costs of production

If there is closing inventory, a portion of the fixed costs are

carried forward into the next period
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2.1 Contribution
Contribution is the portion of revenue after subtracting variable costs. It covers fixed costs, with
any remainder being the profit earned.
Contribution is calculated using the formulae:

Total contribution = Total revenue – Total variable cost

Total contribution = Contribution per unit × Sales volume;
Contribution per unit = selling price per unit – variable cost per unit

2.1.1. Contribution Graph

Contribution v. Profit /
Point Fixed cost Loss Note

Contribution < Fixed Losses incurred as insufficient contribution to

A cost Loss cover fixed costs.

Contribution is equal to fixed costs, resulting in

Contribution = Fixed Break- neither profit nor loss.
B cost even Sales volume is known as the break-even point.

Contribution > Fixed Contribution exceeds fixed costs, resulting in

C cost Profit profit earned.

3.1 Absorption and Marginal Costing

Absorption and marginal costing are two different methods of dealing with production
overheads. They produce profit figures for an accounting period that differ from each other.

Absorption Costing Marginal Costing

All production costs

Valuation of (including production overheads) Variable production costs only.

production (finished Variable production + fixed Fixed production overheads are
goods) production not included.
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Treatment of fixed Absorbed into cost units

production (included in the value of finished Expensed off for the period as
overheads goods) a cost (period cost).

Relationship with the Selling price − absorption cost = Selling price − marginal cost =
selling price Gross profit contribution.

The marginal cost of

The total cost of production; helps production is the cost of
set a selling price that covers all making one additional unit.
Description production costs. Useful for decision-making.

3.1.1. Absorption costing cost card

$ per unit

Direct materials [X]

Direct labour [X]

Direct expenses [X]

Variable production overheads [X]

Fixed production cost [X]

[X]
Unit cost under absorption costing

3.1.2. Marginal costing cost card

$ per unit

Direct materials [X]

Direct labour [X]

Direct expenses [X]

Variable production overheads [X]

[X]
Unit cost under marginal costing
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3.3 Marginal Profit Calculation

Under marginal costing, inventory is valued at variable production costs only.

Marginal Costing Profit Statement $ $
Sales X
Opening inventory X
Production X
Less: Closing inventory (X)
Cost of sales (X)
Variable non-production overheads
Contribution X
Fixed production overheads (X)
Fixed non-production overheads (X)
Marginal Profit X
Example 1: Marginal Profit Calculation

T-Shirt Co has a product with the following budgeted price and costs for a month:
• Direct labour cost per unit of $7.00
• Direct material cost per unit of $3.00
• Variable production overhead cost per unit of $5.00
• Each unit requires one hour of direct labour
• The sales price is $40.00
• There are no opening inventories
• Budgeted production in the month is 500 units
• Fixed production costs are $2,000
Calculate T-Shirt Co’s monthly marginal profit if 400 units were sold.
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3.4 Absorption Profit Calculation

Under absorption costing, production is valued at total production cost.

Absorption Costing Profit Statement $ $
Sales X
Opening inventory X
Production X
Less: Closing inventory (X)
Cost of sales (X)
Non-production overheads (X)
Absorption profit X

3.5 Practice
Activity 2: T-Shirt Co
T-Shirt Co produces 1,000 units of product X per month.
On February 1, there were 80 units in the opening inventory.
Each Product X requires 2 hours of labour and 2 square metres of material. Labour costs are $10
per hour, while material costs $5 per square metre.
Fixed production overheads are $2,000 per month.
Each Product X sells for $50.
February sales were 1,000 units. In March, sales were 900 units.
a) Calculate absorption and marginal costing profit for February and March.
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Absorption Costing Profit Statement Template

February March

Absorption Costing Profit Statement $ $ $ $

Sales

Opening inventory

Production

Less: Closing inventory

Cost of sales

Absorption costing profit

Use an absorption costing cost card to calculate the value of a unit Product X.
Marginal Costing Profit Statement Template
February March

Marginal Costing Profit Statement $ $ $ $

Sales

Opening inventory

Production

Less: Closing inventory

Cost of sales

Contribution

Fixed Overheads

Marginal Costing Profit

Use a marginal costing cost card to calculate the value of a unit of Product X.

4.1 Marginal and Absorption Profit Reconciliation

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The difference is due to the treatment of fixed costs and may be reconciled using the following
formula: Closing more , absropition profit /. Opening more , marginal profit
$
Marginal costing profit $10000
+ ([closing inv1000. − opening inv1000.] 0× overhead absorption rate$2 0
Absorption costing profit 10000

Opening vs Closing Absorption costing (AC) profit vs Marginal costing (MC)

Inventory profit

Opening = Closing AC profit = MC profit

Opening > Closing AC profit < MC profit

Opening < Closing AC profit > MC profit

4.2 Practice

Activity 3: T-Shirt Co

T-shirt Co has supplied the following information for February and March:

February March

Absorption costing profit ($) 18,000 16,200

Marginal costing profit ($) 18,000 16,000

Opening inventory (units) 80 80

Closing inventory (units) 80 180

The fixed production overhead absorbed per unit is calculated as $2.

Reconcile T-Shirt Co’s absorption and marginal costing profit for February and March.
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5.1 Advantages

Advantages of absorption costing Advantages of marginal costing

• The inventory value complies with the

relevant accounting standards for external
financial reporting.
• Considers all costs, providing a better • Highlights contribution, which helps
understanding of the whole picture. management focus on a decision’s short-
• More appropriate when considering long- term financial impact.
term decisions because it considers long- • Focuses on the immediate and direct
term fixed costs. impact of an action or decision.
• For example, the company may need to • More appropriate for short-term
move offices if a factory is not profitable decision-making because it focuses on
over the long term because of high fixed the costs likely to change in the short
costs such as rent. term due to the decision.
5.2 Disadvantages

Disadvantages of absorption costing Disadvantages of marginal costing

• The inventory value produced is

unsuitable for financial accounting
(as it does not comply with the
• Overemphasises the importance of costs that relevant accounting standards).
do not change regardless of the course of • By ignoring fixed costs, decisions'
action, which may lead to inappropriate long-term impact and broader
decisions, especially in the short term. implications are not considered.

5.3 Practice
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Activity 4 Characteristics of Absorption and Marginal Costing

Classify the statements as relating to absorption costing (AC) or marginal costing (MC).
AC or
Statement MC

Fixed costs are charged against the profit of the period in which they are
incurred.

Closing inventory value includes a share of fixed production costs.

Considered more appropriate for short-term decision making

Produces an inventory valuation suitable for use in the external financial

accounts

Results in the higher inventory valuation of the two methods

Results in a higher profit figure for the period when inventory volumes decrease
Fixed cost / units decrease = fixed cost per unit increase , profit decrease( AC )

Focuses on the importance of contribution to fixed overhead and profit

Summary and Quiz

• Marginal costing is a costing method used for short-term decision-making. It facilitates this
by recognising costs according to their behaviour.
• Marginal costing expenses fixed costs against profit for the period, not retaining any fixed
costs in the inventory valuation.
• Contribution is the portion of revenue after subtracting variable costs. It covers fixed costs,
with any remainder being the profit earned.
• The difference between absorption and marginal costing is the treatment of fixed costs. This
affects profit and inventory valuation.

CHAPTER 14: Visual Overview

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1.1 Process Costing

1.1. Process Costing
Some organisations produce a large volume of production output through a continuous process –
for example, oil refining or chemical manufacturing. In this case, it is not practical to track the
cost of each output unit separately.
These organisations use a system called process costing.

Materials that have entered the production process but have not yet been output are part of the
work in progress.

2.1 Multiple Products

Multiple products produced from a process are known as joint products( main product ) or by-
products.( second product , not intention , saleable , low ).

2.2 Common Cost Apportionment

A process’s common costs may be apportioned to joint products using the following methods:
• By physical measurement (quantity, weight, or volume)
• By market value
• By net realisable value( Selling price – further cost )
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2.2.1. Apportionment by Physical Measurement

Common costs are apportioned among joint products by their proportion of physical output.

Joint product unit cost = Common costs $ / (total joint product units)
Joint product cost = joint product unit cost × joint product units

2.2.2. Apportionment by Market Value

Common costs are apportioned among joint products by their proportion of sales value.

Joint product unit cost = Common costs $ / (total joint product sales value)
Joint product cost = joint product unit cost × joint product sales value

2.2.3. Apportionment by Net Realisable Value (NRV)

Sometimes a joint product is not saleable at the separation point and can only be sold after
further processing..

Joint product net realisable value = Joint product sales value after further processing – further processing costs.
Joint product cost per $ of sales = total pre-separation costs / total net realisable value
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2.3 Practice
Activity 1: Common Cost Apportionment

1. Apportion the common costs between Product A and Product B by physical

measurement.

2. Apportion the costs between Product A and Product B by sales value and calculate their
gross margin %. ( Gross profit/ Sale ) * 100

Activity 2: Net Realisable Value

• Product A may be sold after process 1, or it may be turned into Product AA with further
processing
• Product B cannot be sold at the split-off point: it must be further processed into Product BB
to be saleable.
Calculate the common costs apportioned by net realisable value to Products A and B and
their profit margin %.
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Activity 3: Further Processing

Joint products A and B are outputs of a single manufacturing process. Each product could be
sold at the split-off point or processed further. The following information about the two products
is available to help us make the decision:

Product A B

$ per unit $ per unit

Share of common costs 50.00 50.00

Selling price at the split-off point 46.00 68.00

Cost of further processing 12.50 24.00

Selling price after further processing 64.00 82.00

Determine whether it is worthwhile to process Products A and B further.

Summary and Quiz

• Multiple products produced from a process are known as joint products or by-products.
• A process’s common costs may be apportioned to joint products using two methods:
o By physical measurement (quantity, weight, or volume)
o By market value
• Organisations must determine if it is profitable to process joint products further. This is done
by comparing the incremental revenues and costs of further processing.
• By-products are produced as a side-effect of making something else. By-products have a less
significant sales value than joint products, but they do have a value and are not waste
products.
• The net realisable value of by-products is subtracted from common costs before
apportionment to joint products.
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CHAPTER 15: Visual Overview

1.1 Introduction
Cost-volume-profit (CVP) analysis analyses how production and sales volume affect costs and
profit. This is helpful for short-term planning decisions.
Some scenarios where CVP analysis is applicable are:
• What will be the impact on profit if sales are ten per cent lower than expected?
• What will be the impact on profit if staff costs increase?
• What will be the impact of matching a competitor’s lower selling price?

1.2 Key Concepts

1.2.1. Assumptions
CVP analysis in MA2 has the following simplifying assumptions:

Key Point

Total costs and total revenue are linear functions of output.

1.2.2. Break-Even Point (BEP)

A core principle of CVP analysis is the identification of the break-even point.
The break-even point is the measure of output at which the business’s revenue covers all the
costs, but profits haven't yet been made.
Below the break-even level of output, losses will be made by the company, and above that point,
profits will be made.
Businesses need to identify the break-even point of their products/services and judge whether it
is viable or not.
The break-even point is the level of output identified in two ways:
• When total revenue equals total costs
• When contribution equals fixed costs

Revenue – Variable cost = Contibution – Fixed cost = Net profit

$100. - $60. = $40 - $40 = $0 ( Break – even Point )

Total revenue = $100

Varaible cost = $60 + fixed cost $40 = $100

1.2.3. Contribution
Contribution is revenue net of variable costs. Any contribution above fixed costs is profit.
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1.2.4. Margin of Safety ( between BEP and actual sales )

The margin of safety is the measure of output between actual/budgeted sales and the break-even
point.
A high margin of safety indicates a high probability of profitability.

1.3 Break-Even Point Equation Method

The BEP in units is calculated as follows:

BEP units (Q) = $ Fixed cost / $ Contribution per unit

Contibution per unit = selling price– variable cost per unit
Contibution per unit = Total contibution / total units

This is derived from the profit equiation.

1.3.1. Profit Equation

Profit = Total revenue ($ Total revenue) – $ Total costs

$ Total revenue = $ Unit selling price × Quantity sold (Q)
$ Total cost = $ Total variable costs + $ Fixed cost
$ Total variable cost = $ Unit variable cost × Q

Expanding the profit equation:

Profit = Revneu ($ Unit selling price × Q) – variable cost ($ Unit variable cost × Q) - $ Fixed cost

The break-even point would be the value of Quantity sold (Q) or $ Total revenue, where Profit =
0

Example 1: Jackets

A business makes jackets that can be sold for $100 each.

Each jacket incurs variable costs of $40 per unit.
Total fixed costs for the business are $600 per month.
Calculate the break-even point in units for the month.
Solution:
$ Unit selling price = 100
$ Unit variable cost = 40
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Example 1: Jackets

$ Fixed cost = 600

Contibution per unit = selling price – varaible cost per unit = $100 - $40 = $60
BEP units = Fixed cost / Contribution per unit
= $600 / $60 = 10 units
The break-even point in quantity (BEP (Q)) is 10 units.

Activity 1: Profit Equation Method

1. A business sells a single product. The selling price is $10. It has fixed costs of $300,000 and
variable costs per unit of $5.
How many units does the business have to sell to break even?

2. A business sells a single product. The selling price is $40. It has fixed costs of $546,000 and
variable costs per unit of $26.
How many units does the business have to sell to break even?

2.1 Break-Even Point on Graph

Sales untis = 50000 units , total revenue = ( 50000 * $40 ) = $2000,000
Total varaible cost =( $26 * 50000 untis )= $1300000
Total cost = V +F =1300,000 +546000 = $1846000
A graph could be plotted to calculate the break-even point.
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Activity 2: Break-Even Graph

Identify the features of the break-even graph as indicated by the letters.

Item Letter

Total revenue line

Total costs line

Break-even point

Fixed costs line

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3.1 Contribution Method

3.1.1. Contribution Equation
Understanding the following profit equation:

Profit = ($ Unit selling price × Q) – ($ Unit variable cost × Q) - $ Fixed cost

Unit contribution can be expressed as:

$ Unit contribution = $ Unit selling price – $ Unit variable cost

Therefore:

$ Contribution = $ Unit contribution × Q

$ Contribution = ($ Unit selling price – $ Unit variable cost) × Q

Rewriting the profit equation:

$ Profit = (($ Unit selling price – $ Unit variable cost) × Q) – $ Fixed cost
$ Profit = ($ Unit contribution × Q) – $ Fixed cost
$ Profit = $ Contribution – $ Fixed cost

The break-even point would be the value of Quantity sold (Q) or Total revenue ($ Total
revenue), where Profit = 0

Q (BEP) = $ Fixed cost / $ contribution per unit

The break-even point is also the measure of output when contribution equals fixed costs.

Example 2: Trousers

A business makes trousers that can be sold for $80 each.

Each pair of trousers incurs variable costs of $30 per unit.
Total fixed costs for the business are $600 per month.
1. Calculate the contribution per unit for the month.

2. Calculate the BEP in units and break-even contribution for the month.
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Activity 3: Contribution Method

A business sells a single product. The selling price is $22. It has fixed costs of $750,000 and
variable costs per unit of $14.
1. How many units does the business have to sell to break even?

2. What is the break-even contribution?

3.2 Identifying Contribution on Graph

On a CVP graph, contribution is the gap between Total revenue and Variable cost lines.

4.1 Contribution to Sales (C/S) Ratio

The contribution/sales (C/S) ratio is the proportion of contribution to sales expressed as a
percentage. It can be calculated either per unit or in total.

Contribution/sales ratio (C/S ratio) = $ Unit contribution / $ Unit selling price

Contribution/sales ratio (C/S ratio) = Contribution / $ Total revenue

Eg sale = $1000, varaibel cost = $600, contibution = $400

Cs ratio = contibution / sales * 100 = 400/ 1000 * 100 = 40%
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4.2 Using C/S Ratio to Calculate BEP

Using the C/S ratio to calculate BEP:

BEP units = Fixed cost / Contibution per unit

BEP Revenue = Fixed cost / Cs ratio

Example 4: C/S Ratio

A business sells a single product. The selling price is $22. It has fixed costs of $750,000
and a C/S ratio of 36%
Calculate the business’s BEP in sales quantity and revenue.

Activity 4: C/S Ratio

1. A company sells one product. It has the following information about its plans for the next
year:
The selling price per unit is $50
Variable costs are $30
Fixed costs are $200,000
What are the C/S ratio and break-even sales quantity?

2. A company sells one product. It has the following information about its plans for the next
year:
What are the C/S ratio and break-even sales quantity?

3. The C/S ratio of a company is 15%. The company has fixed costs of $100,000. The selling
price of the product is $20.
What is the break-even sales quantity?

5.1 Margin of Safety (Margin of safety)

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The margin of safety (Margin of safety) is the difference between expected sales and the BEP.
The higher the Margin of safety, the lower the risk of making a loss.
MOS in units = Actual sales untis – BEP units
MOS revenue = Actual sale revneue – BEP revenue
(or ) MOS revenue = MOS untis * selling price
MOS% = MOS units / sales untis * 100 (or ) MOS revnue / sales revneue *100

Example 5: Margin of Safety

A business sells a single product. The selling price is $30. It has fixed costs of $700,000 and variable costs per u
of $20. Budgeted sales are 125,000 units.
What is the margin of safety in units and %?
Solution:
MOS units = Actual sales units – BEP units
= 125000 units – 70000 units = 55000 units
BEP units = Fixed cost / contibution per unit
= $700,000/ $10 = 70000 units
Contibution per unit = selling price – varaibel cost = $30 - $20 = $10
MOS% =MOS untis / sales units = 55000/ 125000 * 100 = 44%

Activity 5: Margin of Safety

A business sells a product for $5.50 a unit. It has fixed costs of $487,500 and variable costs per
unit of $2.25. Budgeted sales are 170,000 units.
What is the margin of safety in units and %?

5.2 Margin of Safety on CVP Graph

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6.1 Target Profit

CVP analysis can calculate the sales quantity or revenue required to achieve a target profit.
Apply the profit equation to find the target sales (Q):
Sales unit to get target profit = Fixed cost + target profit / Contibution per unit
Sales revneu to get taget profit = sales unit to get traget profit * selling price
(or ) = ( Fixed cost + target profit ) / cs ratio

Example 6: Target Profit

1. A business sells a single product. The selling price is $30. It has fixed costs of $700,000 and variable costs p
unit of $20.
The business wants to make a profit of $100,000.
What sales volume is needed for the business to make the target profit?
Solution:
Sales units to get target profit = ( fixed cost + target profit ) / Contibution per unit
= ( $700,000 + $100,000 ) / ( $30 - $20 = $10 )
=80000 units

2. A business sells a single product. The selling price is $10. It has fixed costs of $300,000 and
a C/S ratio of 50%.
The target profit is $20,000.
How many units does the business have to sell to make the target profit?
Solution:
Sales unit to get target profit = ( Fixed cost+ target profit ) / Contibution per unit
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Example 6: Target Profit

= ( $300,000 + $20,000 ) / $5
=64000 units

Cs ratio = conibution per unit / selling price

50% = contibution per unit / $10
Contibtuin per unit= $5

Sales reveneu to get taget profit = ( fixed cost + target profit ) / cs ratio
= ( $300,000 + $20,000 ) / 50%
= $640000
(or ) sales units to get target profit * selling price = 64000 untis *$10 = $640,000

6.2 Target Price

CVP analysis may calculate the target unit price to achieve target profit at a specified sales
quantity.
This is done by re-arranging the profit equation:

Selling price to get taget proift = ( Fixed cost + variable cost + target profit ) / sales units

Example 7: Target Price

A business has:
• Fixed costs of $500,000
• A required profit of $100,000
• Variable costs of $12 per unit.
The business wants to produce and sell 30,000 units a year.
What selling price should the business set for its product?
Solution:
$ Unit selling price (target) = ($ Fixed cost + Profit + ($ Unit variable cost × Q)) / Q
$ Unit selling price (target) = (500,000 + 100,000 + (12 × 30,000= $360,000)) / 30,000
$ Unit selling price (target) = 960,000 / 30,000
$ Unit selling price (target) = 32
30,000 units must be sold at $32 per unit to earn the target profit.
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8.1 Profit-Volume Graphs

Profit/volume graphs are simpler than break-even graphs. They illustrate the relationship
between profit and sales volume – in other words, between profit and the number of units sold.

Key Point

Graphs are also known as charts. The terms may be used interchangeably.
The profit line shows the profit or loss at different levels of output. This graph’s vertical (y) axis
continues below 0 to show the losses. The intersection of the profit line and the X-axis, where
the Y-axis is zero, is the BEP.

The following information can be obtained from the graph:

• The fixed costs are $15,000 per period (shown by the loss at zero sales volume)
• The break-even point is 1000 units (the contribution line is at zero on the Y-axis)
• The unit contribution is $15 ($15,000 / 1000 units at BEP).
If the fixed costs or unit contribution changes, the slope of the profit line and the BEP point will
change.

Summary and Quiz

• Cost-volume-profit (CVP) analysis analyses how production and sales volume affect costs
and profit. This is helpful for short-term planning decisions.
• CVP analysis in MA2 has the following simplifying assumptions:
o Within the range of activity under consideration, total cost behaves as a strictly linear
semi-variable cost:
▪ fixed costs remain fixed within the range;
▪ total variable costs change proportionally with volume.
o Unit selling prices do not change with volume.
o Costs and income are matched (i.e., no significant change in inventory).
o Levels of efficiency and productivity do not change (as this would affect linearity).
o There is only a single product.
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CHAPTER 16: Visual Overview

1.1 What are Limiting Factors?

Definition

Limiting Factor –A factor that limits an organisation’s activities; examples include sales demand or resource
scarcity.
The most common limiting factor for a business is sales demand – the number of products
customers buy will limit the sales revenue and profit the company achieves and the number of
products it makes.

Example 1: T-Shirt Co

What are some of the limiting factors that would affect T-Shirt Co’s ability to produce enough t-shirts to meet
demand?
• Labour: Not enough employees to produce the required number of t-shirts.
• Raw materials: Not enough fabric to produce the required number of t-shirts.
• Machines: Insufficient machine capacity to sew the required number of t-shirts.

1.2 Maximising Use of a Limiting Factor

1.2.1. Demand as Limiting Factor
If demand is the only limiting factor of a business, it should produce as many goods/services as
demanded to maximise profit.
1.2.2. Single Product with a Limiting Factor
Suppose there is a limiting factor preventing a single-product business from meeting demand. In
that case, it should make as much product as possible from the limiting factor to maximise
demand.
1.2.3. Multiple Products with a Limiting Factor
In that case, it should plan for production that maximises contribution earned per unit of
limiting factor.
This is known as an optimal production solution.
The steps to produce an optimal production solution are as follows:
1. Identify the limiting factor
2. Calculate the contribution per unit of each product
3. Calculate each product’s contribution per unit of limiting factor
4. Rank products by contribution per unit of limiting factor.
5. Make products with the highest contribution per limiting factor, up to maximum demand, until
the limiting factor is exhausted.
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Example 2: Optimal Production Solution

T-Shirt Co makes three different kinds of t-shirts in the same factory: blue, green and silver. The following
information is available about the production of the t-shirts:
Blue Green Silver

Selling price 100 115 125

Direct materials
(in $, at $10 per metre) 35 40 45

Direct labour
(in $, at $20 per hour) 15 20 10

Variable production overhead ($) 11 11 11

Total production cost ($) 61 71 66

Demand 500 700 900

9,000 metres of fabric and 1,400 hours of labour will be available.

Calculate the optimal production solution for the period that maximises profit.

Activity 1: Optimal Production Solution

A company makes Product A and Product B. The following details are available:
Product A B

Direct material
(in $, at $50 per kg) 80 60

Direct labour
(in $, at $15 per hour) 30 45

Variable production overhead ($) 25 25

Total production cost ($) 135 130

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Demand (units) 750 580

Selling price per unit ($) 210 200

1,750 kg of material and 3,250 hours of labour will be available.

Calculate the optimal production solution that maximises profit for the period.

2.1 Relevant and Irrelevant Costs

Definition

Relevant costs – Costs that change as a result of a decision. It also includes opportunity costs.

Relevant costs are costs that change as a result of a decision. Managers identify and analyse
relevant costs to support decision-making that will benefit their organisation.
Irrelevant costs do not change due to the decision, so they are not relevant to the decision.
Therefore, they can be ignored in decision-making.
Another way to approach relevant costs is that they are avoidable cashflows, whereas non-
relevant costs are unavoidable.

Relevant/
Cost Irrelevant Description

Sunk cost
Irrelevant Costs already incurred with not change regardless of future decisions.
(past cost)

Committed cost Irrelevant Costs that must be paid regardless of a decision are irrelevant to that decision.

Unchanging costs Irrelevant Costs that do not change regarding a decision can be ignored.

Costs that change (increase or decrease) regarding a decision are relevant and
must be considered.
Incremental costs Relevant Incremental costs may be fixed or variable.

The benefit forgone from the next best activity is a relevant cost to the
Opportunity cost Relevant decision.
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2.1.1. Opportunity Costs

Example 3: Opportunity Cost

A business has been asked to quote for a job (Job 1). Job 1 will need 10 hours of skilled labour, which costs $30
hour.
Labour is in short supply, so to have the workers do Job 1, they must be taken off another job (Job 2), which als
requires 10 hours of skilled labour. The business would have to forgo $50 of contribution per hour from the skil
labour on Job 2.
What is the relevant cost of taking workers off Job 2 to do Job 1?
Solution:
$

Labour rate 300 $30 × 10 hours

Opportunity cost 500 $50 contribution forgone × 10 hours

800

Activity 2: Relevant Costs

Light Co is a company that installs lighting for commercial clients. Light Co's potential
customer, Dark Co, requires lighting in its new offices.
Light Co needs to determine the minimum price it could charge Dark Co for the new lighting.
Classify the following cost elements as either relevant or irrelevant to Light Co’s costs for
Dark Co’s project.

Classification
(Relevant /
Cost Element Irrelevant)

Three engineers are required for the installation. They are paid a fixed monthly salary of
$4,000 per month.

The three engineers need to move from another project, Contract X. They would have
earned Light Co $5 contribution per hour from Contract X. They would have worked 40
hours per person on Contract X.
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Light Co’s technical advisor would need to spend eight hours on this job. He is working
at full capacity, so he would have to work overtime. He is paid an hourly rate of $40 and
a rate of $60 an hour for overtime.

One of Light Co’s sales managers has visited Dark Co to show them samples and take
Dark Co’s directors out for lunch. The cost of this was $400.

Light Co’s quality assessor would need to spend one day at Dark Co. He is paid a
monthly salary of $1,500.

100 light switches would need to be supplied to Dark Co. The current cost of these is $10
each. Light Co has 80 in inventory. These were bought for $8 each, and they are the most
popular model on the market and are frequently requested by Light Co’s customers.

1,000 metres of cable would be required for the system. The cable is used frequently by
Light Co and has 200 metres in inventory, which cost $1 per metre. The current market
price for the cable is $1.50 per metre.

Dark Co will need a computerised central control system. Light Co has a system in
inventory which was ordered by mistake two months ago. Light Co has no other use for
this system. The current market price is $5,450, but no resale or scrap value exists.

3.1 Deciding to Make or Buy

Key Point

To make in-house means the organisation produces the component/service itself.

To outsource means to buy the component/service from an external party.
Organisations can make a component they need in-house or buy it from a supplier (outsource).
A make-or-buy decision evaluates the financial impact of making the component in-house or
outsourcing it. This is done by comparing the relevant costs of making the component with
buying them.
3.1.1. Make-or-Buy with No Limiting Factor
If no limiting factors influence the decision, the comparison is directly between the incremental
costs of making or buying.
For example, if the relevant cost to make a set of buttons is $4, while buying them externally
would cost $3, outsourcing the buttons would be more profitable.
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3.1.2. Make-or-Buy with a Limiting Factor

If there is a limiting factor, such as a shortage of materials or labour, the cost savings per limiting
factor need to be considered for each component.
Components that cost the most per limiting factor should be outsourced.
An optimal production solution will need to be calculated to compare costs accurately.

Example 5: Make-or-Buy Optimal Production Solution

A computer manufacturer makes four components – A, B, C and D –used in different computers. However, all
components are made with the same machines.
Production information and external purchase prices are in the following table:
Component A B C D

Direct materials ($) 6 9 7 4

Direct labour ($) 12 7 5 4

Variable overhead ($) 4 3 2 2

Fixed overhead ($) 5 3 2 1

Total production cost ($) 27 22 16 11

External supplier’s price ($) 26 27 20 15

Machine hours per unit (hours) 6 10 8 2

The computer manufacturer needs 3,000 units of each component a week. The maximum machine hours a week
58,000, but the total machine hours required is 78,000 (machine hours per unit multiplied by units required).
Machine hours are, therefore, a limiting factor.
Calculate the optimal production solution for the required components that would minimise costs.
Solution:
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Activity 3: Make-or-Buy optimal production solution

A manufacturer makes two components, X and Y. All the components use the same raw
material.
Production information and external purchase prices are in the following table:
Component X Y

$ $

Direct materials 70 100

Direct labour 50 80

Variable overhead 20 15

Fixed overhead 40 35

Total production cost 180 230

External supplier’s price 170 210

Raw materials per unit (kg) 7 10

The manufacturer needs 850 units of each component a week.

The maximum raw material available is 12,000 kg.
Calculate the optimal production solution for the required components that would
minimise costs.

Summary and Quiz

• A limiting factor is a factor that restricts an organisation’s activities.
• If demand is the only limiting factor of a business, it should produce as many goods/services
as demanded to maximise profit.
• Suppose a limiting factor prevents a single-product business from meeting demand. In that
case, it should make as much product as possible from the limiting factor to maximise
demand.
• A business that makes multiple products facing a limiting factor should make a plan for
production that maximises contribution earned per unit of limiting factor.
• optimal production solution maximises profit by prioritising products with the highest
contribution per limiting factor.
• Relevant costs are costs that change as a result of a decision.
• Irrelevant costs do not change due to the decision, so they are not relevant to the decision.
• Opportunity cost is the benefit forgone from the next best alternative.
• A make-or-buy decision evaluates the financial impact of making the component in-house or
outsourcing it. This is done by comparing the relevant costs of making the component with
buying them.
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CHAPTER 17: Visual Overview

1.1 Simple Interest
A bank usually pays interest on deposits (principal).
A bank will charge interest on money borrowed (loans) from it.
The deposit or loan amount is known as the principal.
If the yearly interest amount is the same, it is simple interest.
1.1.1. Calculation
The formula for simple interest is
s=P×r×n
s = interest $
p = principal amount $
r = nominal interest rate % per year
n = number of periods (years)
The formula for the future value (principal + interest) of an investment, using simple interest,
would be:
FV = P × (1 + (r × n))

Example 1: Simple Interest

Sam puts $55,000 into the bank at a rate of 5% simple interest per year.
How much will Sam have at the end of 4 years?
Solution:

Year Opening balance $ Interest charge $ (5%) Closing balance $

1 55,000 2,750 57,750

2 57,750 2,750 60,500

3 60,500 2,750 63,250

4 63,250 2,750 66,000

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Example 1: Simple Interest

Future value formula:

P = 55,000
r = 0.05
n=4
FV = P × (1 + (r × n))
FV = 55,000 × (1 + (0.05 × 4))
FV = 55,000 × (1 + 0.2)
FV = 55,000 × 1.2
FV = 66,000
Sam will have $66,000 after four years.

1.2 Compound Interest

With compound interest, the interest is calculated based on the principal plus the interest earned
every year. The interest stays in the account and is reinvested, so additional interest is earned on
interest. (therefore, a bank account paying compound interest will grow deposits faster than one
paying simple interest)
The formula to calculate the future value of an investment earning compound interest is:
FV = P × (1 + i)n
FV = Future value $
P = Principal $
i = nominal interest rate % per period
n = number of compounding periods

Example 3: Compound Interest

Sam puts $55,000 into the bank at a rate of 5% interest per year, compounded yearly.
How much will Sam have at the end of 4 years?
Solution:
Simple interest table:
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Example 3: Compound Interest

Year Opening balance $ Interest charge $ (5%) Closing balance $

55,000.00
1 2,750.00 57,750.00
(principal)

2 57,750.00 2887.50 60637.50

3 60,637.50 3031.88 63669.38

4 63,669.38 3183.47 66852.84

Future value formula:

P = 55,000
r = 0.05
n=4
FV = P × (1 + r)n
FV = 55,000 × (1 + 0.05)4
FV = 55,000 × 1.2155
FV = 66,852.84
Sam will have $66,852.84 after four years.

Activity 1: Simple and Compound Interest

Jo is deciding between three investment options:

1. Invest $10,000 at a 4% compound interest rate per year for four years.
2. Invest $9,000 at a rate of 6% simple interest for five years
3. Invest $11,000 at a 5% compound interest rate for three years.
Calculate the future value of each investment at the end of their terms (to the nearest whole
number).
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2.1 Nominal and Effective Annual Rates

2.1.1. Nominal Interest Rate
The nominal interest rate is the stated interest rate without compounding.
For example, an investment may quote an interest rate of 10% per annum, compounded daily.
The nominal interest rate is 10% per year.
Here are some more examples:

Quote Nominal interest rate

5% per year, compounded daily 5% per year

12% per year, compounded monthly 12% per year

8% per year, compounded quarterly 8% per year

2.1.2. Effective Annual Rate (EAR)

Compound interest can be compounded yearly or more regularly (quarterly, monthly, weekly,
daily).
The more frequent the compounding period, the higher the actual annual interest earned.
The effective annual rate (EAR) changes the nominal interest rate at its compounding frequency
into an equivalent yearly rate that can calculate the interest received in the year.
This allows for easier comparison between quotes of interest rates with different compounding
periods.
The formula for EAR is:

Activity 2: Effective Annual Rate

Hal wants to buy a car that costs $5,000. He has two financing choices:
1. Taking out a loan, which has a simple interest rate of 5% a year
2. Paying with his credit card will incur an interest rate of 2% per quarter.
Hal will be able to repay the loan or credit card in two years.
Which option gives him a better interest rate?

Activity 3: Future Value of Loan

Ana needs a short-term loan and sees a rate of 3% per week advertised in the paper. She needs to
borrow $150 for seven weeks.
How much would she have to repay at the end of seven weeks?
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3.1 Future Value of Investments (Compounding)

Calculating the future value of investments is the same as calculating the future value of bank
deposits.
A fundamental assumption is that cash flows from the investment are reinvested at the same rate
as the investment.
For example, if a baker invests in a machine to make cakes for three years, any cash earned from
selling cakes in the first year will be used to continue using the device to make cakes in the
future.
The future value formula is:
FV = P × (1 + i)n
P = principal $ (initial investment)
i = nominal interest rate per compounding period %
n = number of compounding periods

Activity 4: Future Value of Investment

What is the value of $40,000 invested for six years at an interest rate of 10%?

3.2 Present Value of Investments (Discounting)

Discounting is the opposite of compounding. Instead of finding the future value of the
investment in the future, the principal (present value) needed to invest now is calculated.
3.2.1. Time Value of Money
Cash inflow available immediately is more valuable than cash inflow in the future.
3.2.2. Present Value Formula
The present value formula is a re-arrangement of the future value formula:
PV = FV / (1 + i)n
PV = present value of investment $
FV = future value of investment $
i = nominal interest rate % per compounding period
n = number of compounding periods
It can also be expressed as:
PV = FV × (1 / (1 + i)n)
(1 / (1 + i)n) is the formula to calculate a discount factor.
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Example 5: Discounting

What is the present value of $70,000 received at the end of year six if interest rates are 10%?
Solution:
FV = 70,000
i = 0.1 (10% per year)
n = 6 (6 years)
PV = FV × (1 / (1 + i)n)
PV = 70,000 × (1 / (1 + 0.1)6)
PV = 70,000 / 0.5645
PV = 39,513.18

3.3 Discount Rate and Discount Factors

3.3.1. Discount Rate
A discount rate is the interest rate used to convert the future value of investments to their present
values.
3.3.2. Discount Factors
Discount factors convert the future value of an investment to its present value for a fixed number
of periods at a specific discount rate.

Example 6: Discounting

A company will earn $20,000 in 5 years. The cost of capital is 5%. What is the present value of the future
earnings?
The 5% discount rate, rounded to 3 decimal places, is 0.784.
Solution:
FV = 20,000
PV = FV × (1 / (1 + i)n)
PV = 20,000 × 0.784
PV = 15,680
The present value of future earnings is $15,680
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3.4 Calculating PV of Annuity or Perpetuity not starting on Year 1

3.4.1. PV of Perpetuity or Annuity Starting Immediately (year 0)
The fomula to caluclate the PV of an annuity or perpetuity starting immediately is:
PVperpetuity = (annual cash inflow / i) + annual cash inflow
PVannuity = annual cash inflow × (AFn−1 + 1)
n-1 means the annuity period – 1 year. So 6 year annuity starting immediately will use an
annuity factor for year 1 to 5.
Example 7

Fred receives $70,000 a year for six years. Interest rates are 10% and the first payment starts immediately.
What is the present value of the money Fred receives?
Answer:

Annual cash inflow: $70,000

PVannuity = annual cash inflow × (AFn-1 + 1)
PVannuity = $70,000 × (AF6-1 + 1)
PVannuity = $70,000 × (AFyear 1 to 5 + 1)
PVannuity = $70,000 × (3.791 + 1)
PVannuity = $70,000 × 4.791
PVannuity = $335,370
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Activity 5
A company will receive $70,000 a year for six years. The first payment will be at the end of year
4. Interest rates are 10%.
What is the present value of the total receipts?

Summary and Quiz

• If the interest earned on the principal is the same every period, it is simple interest.
• With compound interest, the interest is calculated based on the principal plus the interest
earned every year.
• The nominal interest rate is the stated interest rate without compounding.
• The effective annual rate (EAR) changes the nominal interest rate at its compounding
frequency into an equivalent yearly rate that can calculate the interest received in the year.
• Discounting is the opposite of compounding. Instead of finding the future value of the
investment in the future, the principal (present value) needed to invest now is calculated.
• This phenomenon of valuing immediate cashflows higher than future cash flows is known as
the time value of money.
• A discount rate is the interest rate used to convert the future value of investments to their
present values.
• Discount factors convert the future value of an investment to its present value for a fixed
number of periods at a specific discount rate.
• A perpetuity is a consistent cash flow every period till infinity
• An annuity is a consistent cash flow every period for several periods.
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CHAPTER 18: Visual Overview

1.1 The Difference between Net Cash Flow and Profit
• Profit is revenue minus costs for the period.
• Net cash flow is cash inflows minus cash outflows

There are four main reasons for looking at cash flows rather than profit in investment appraisal.
1. Cash flow is crucial for organisations.
2. The time value of money is considered.
3. Cash flow is a more objective figure than profit.
4. Cash flow is a better long-term indication of value.

1.2.1. Importance of Cash Flow

Cash flow is vital as the lifeblood of a business. A business goes bankrupt when it no longer has
enough cash to meet its financial obligations. This can occur even if it is profitable.
The measure of having enough cash for operations is known as liquidity.
1.2.2. Objectivity of Cash Flow
Cash flows are more objective figures than profit, as they are not susceptible to interpretation. A
cash payment of $100 cannot be classified any other way.
In contrast, accounting profits are subject to interpretation (i.e. capitalisation of expenditure) and
estimates (i.e. depreciation charges).
Calculating the present value of expected relevant cash inflows from an investment helps to
determine if it is a good use of available funds.
2.1 Time Value of Money
As a reminder, the value of immediate cash inflow is more valuable than cash inflows in the
future.
3.1 Net Present Value
The NPV is the sum of the present values of an investment’s relevant cash flows.
NPV considers:
• Cash outflows (payments out of the organisation)
• Cash inflows (payments received into the organisation)
• The time value of money.
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As a reminder, the formula to calculate the present value (PV) of a cash flow is:
PV = FV × DF
FV = future cash flow
DF = Discount factor (for a specific period, at a specific discount rate)
DF = (1 + i) −n
i = discount rate (usually the required rate of return)
n = number of years from present.
Discount and annuity factors may be looked up from tables.

3.1.1. Calculating NPV

NPV Impact of investment Decision

Breaks even; investment does not Investors would be indifferent to the decision.
=0 increase nor decrease investor’s wealth (financial impact of choice does not matter.)

>0 Increases investor’s wealth Investment should be accepted.

<0 Decreases investor’s wealth Investment should be rejected.

If an organisation chooses between two or more projects, it will accept the project with the
highest NPV.
3.1.2. Assumptions
• All cash flows occur at the year’s start or end.
• The initial investment happens at Year 0 (today).
Year 0 means the point of the first cash outflow.
• All the other cash flows take place in Year 1 or later.
3.1.3. Templates
Two templates may be used to calculate NPV:
Year Net cash flow Discount factor NPV

0 (XXX) XXX XXX

X XXX XXX XXX

Total XXX
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The above template is helpful for simple NPV calculations; it discounts yearly net cash flows.
Year 0 1 2 3

$ $ $ $

Cash flow item (XXX)

Cash flow item XXX XXX XXX

Cash flow item (XXX) (XXX) (XXX)

Net cash flow (XXX) XXX (XXX) XXX

Discount factor 1.000 XXX XXX XXX

Present value (XXX) XXX (XXX) XXX

NPV XXX

3.2 Calculation

Example 3: T-Shirt Co

T-Shirt Co is considering investing in a new piece of machinery. The investment would start immediately and la
for six years. The following information about the investment is available:
• The machine will cost $320,000 and have a resale value of $80,000 at the end of year 6. Depreciation is
calculated using the straight-line method.
• Annual costs relating to the investment will be $125,000. The company uses a discount rate of 10%.
• Sales resulting from the investment are:
Year Sales units Sales price ($)

1 20,000 12

2 20,000 12

3 18,000 14

4 18,000 14

5 16,000 16

6 16,000 16
• All sales are on a cash basis.
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Example 3: T-Shirt Co

• Assume cash flows occur at the end of the year.

Calculate the NPV of T-Shirt Co’s potential investment (to the nearest $000).
The discount factors for a 10% discount rate are:
Year Discount factor
0 1.000
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
6 0.564
Solution:
• Depreciation is ignored as it is a non-cash item.
Year 0 1 2 3 4 5 6
$000 $000 $000 $000 $000 $000 $000
Machine purchase and disposal (320) 80
Annual costs (125) (125) (125) (125) (125) (125)
Sales W1 240 240 252 252 256 256
Net cash flow (320) 115 115 127 127 131 211
Discount factor 1.000 0.909 0.826 0.751 0.683 0.621 0.564
Present value (320) 105 95 95 87 81 119
NPV 262
The NPV of the project is $262,000 (rounded to $000). As the NPV is positive, T-shirt Co should accept the
investment.
W1: Sales

Year Sales units × Sales price ($) = Total sales ($000)

1 20,000 12 240

2 20,000 12 240

3 18,000 14 252

4 18,000 14 252

5 16,000 16 256

6 16,000 16 256
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Activity 1: NPV
A company is appraising a project that will require the purchase of machinery costing $780,000,
which will have no resale value at the end of the project.
Annual costs relating to the investment will be $240,000, increasing by 15% each year. The
company uses a discount rate of 7%.
Sales resulting from the investment are:

Year Sales units Sales price ($)

1 10,000 50

2 12,000 55

3 15,000 60

Calculate the NPV of the project (to the nearest $000).

The discount factors for a 7% discount rate are:
Year Discount factor

0 1.000

1 0.935

2 0.873

3 0.816

Activity 2: NPV
A company is considering starting a new project. The project would begin immediately and last
for three years. The following information is about the project:
The start-up cost is $100,000 and includes machinery that will have no resale value. It will cost
$20,000 to dispose of the machinery. Initial research costing $2,500 has provided information
about the expected costs and revenue of the project: annual cash sales will be $60,000, and
yearly costs will be 30% of the sales revenue. The company has a cost of capital of 6%.
Calculate the NPV of the project
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The discount factors for a 6% discount rate are:

Year Discount factor

0 1.000

1 0.943

2 0.890

3 0.840

3.5 Advantages and Disadvantages

3.5.1. Advantages
• The NPV method considers the time value of money.
• NPV is an absolute measure of return, presented in monetary terms and not as a percentage.
• The NPV method uses cash flows (which are real) rather than profit (which is more
subjective as it can be manipulated).
• The NPV method considers the whole life of the investment or project.
3.5.2. Disadvantages
• The NPV method is complicated for non-financial managers to understand.
• NPV relies on judgment regarding the discount rate used.
18.4.1 Internal Rate of Return (IRR)

4.1 Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount rate at which the NPV of an investment is zero.
It is the internal rate of return generated from an investment.
4.1.1. Decision Rule
The IRR is compared to the cost of capital.
• If IRR > cost of capital, the project returns higher than the cost of capital and should be
accepted.
• If IRR < cost of capital, the project returns lower than the cost of capital and should be
rejected.
4.1.3. Estimating IRR with the Interpolation Method
The NPV of two discount rates, one higher and one lower, is calculated, and the IRR is estimated
between them.
Ideally, a positive and negative NPV should be calculated, and they should not be too distant
from zero.
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is:

Ra = lower discount rate chosen

Rb = higher discount rate chosen
Na = NPV at ra
Nb = NPV at rb
Graphically, the method looks like this:
Activity 4: IRR
T-Shirt Co is considering investing in a new piece of machinery. The investment would start
immediately and last for six years.
The following information about the investment is available:

Year Net cash flow ($)

0 (520,000)

1 115,000

2 115,000

3 127,000

4 127,000

5 131,000

6 211,000

What is the IRR of the potential investment?

Activity 5: IRR
A company is considering starting a new project. The project would begin immediately and last
for three years.
The following information about the cash flows of the project is available:
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Year Net cash flow

0 (150,000)

1 40,000

2 60,000

3 80,000

What is the IRR of the project?

4.2 Advantages and Disadvantages

4.2.1. Advantages
• The IRR method considers the time value of money
• IRR uses cash flows (which are real) rather than profit (which can be manipulated)
• The IRR method is easy for non-financial managers to compare against a target %
4.2.2. Disadvantages
• IRR ignores the size of projects when appraising investments (if two projects have the same
IRR, the larger project will increase investor wealth more).
• An investment decision based on IRR may conflict with NPV. In this case, it is always NPV
that is the superior appraisal method.
• For non-conventional investments (where multiple investments are needed throughout the
project’s life), There may be more than one solution for IRR.

5.1 Simple Payback

Simple payback is a method of investment appraisal that measures the time it will take for cash
inflows to equal initial cash outflows.
5.1.1. Decision Rule
An organisation may limit how long an investment project should take to break even.
If the payback period for a project is shorter than the set limit, the project will be selected.
If two or more projects are being considered, the project with the shortest payback period may be
selected.
There is a risk that the decision recommended by payback is not consistent with NPV; the most
lucrative investment may be rejected by payback for not generating returns fast enough.
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5.1.2. Calculation
The calculation of payback requires knowing the following:
• The value of the cash flows
• The timing of the cash flows.
It is usually assumed that cash flows accrue evenly over the year.
The template to calculate simple payback is:

Year Cash flow ($) Cumulative cash flow ($)

0 (XXX) (XXX)

1 XXX (XXX)

2 XXX (XXX)

3 A B

4 XX XXX

Activity 6: Simple Payback

A project has the following cash flows.

Year Net Cash flow

0 (250,000)

1 160,000

2 180,000

3 140,000

What is the payback period?

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5.2 Discounted Payback

Simple payback does not consider the time value of money, which means its payback period is
understated.
Discounted payback considers the time value of money and adjusts cash flows to their present
value. The calculated payback period is the time taken for cumulative PV to break even (equals
zero).
5.2.1. Calculation
The discounted payback template is as follows:

Year Cash flow ($) Discount factor PV ($) Cumulative PV ($)

0 (XXX) XXX (XXX) (XXX)

1 XXX XXX XXX (XXX)

2 XXX XXX XXX (XXX)

3 XXX XXX A B

4 XXX XXX XXX XXX

5.3 Advantages and Disadvantages

5.3.1. Advantages
• The payback method is simple to calculate
• outcome is easy to understand for non-financial managers
• helps organisations with cash flow problems identify which projects will return the
investment early
5.3.2. Disadvantages
• Simple payback does not consider the time value of money
• Payback does not consider the cash flows that take place after the payback period; it may
underestimate the value of the project
• The payback method does not work well if there are costs later in the project.
• The payback method encourages decisions to be made on short-term factors rather than the
long-term benefit to the organisation
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Summary and Quit

• Cash flow and profit are different because, in financial accounting, revenue and costs are
recorded on an accruals (when the transaction occurs) basis. They might not reflect the
organisation's cash flows during the same period.
• For investment appraisals which evaluate the long-term value of a potential investment by an
organisation, relevant cash flows are used, rather than profit, to assess the future value of the
investment.
• For investment appraisal, future cash flows (future value) must be discounted to an
equivalent immediate cash flow (present value). The discount rate reflects the various factors
that affect the valuation of future cash flows (such as risk, inflation, and cost of capital).
• The NPV is the sum of the present values of an investment’s relevant cash flows.
• The cost of capital is usually the discount rate used in NPV analysis to appraise potential
investments.
• The internal rate of return (IRR) is the discount rate at which the NPV of an investment is
zero. It is the internal rate of return generated from an investment.
• Simple payback is a method of investment appraisal that measures the time it will take for
cash inflows to equal initial cash outflows.
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CHAPTER 19: Visual Overview

1.1 What is Cash?
In accounting, cash refers to cash and cash equivalents. Cash equivalents are assets that can be
converted to currency quickly, with insignificant risk to changes in value.
For accounting purposes, cash includes:
• Physical cash (banknotes and coins)
• Bank current account balances
• Investments readily convertible into cash (such as money market instruments).

1.3 Working Capital

Working capital (trading assets) is the current assets needed for a business to sustain operations.
It consists of the following:
• Inventory (finished goods, work-in-progress, and raw materials)
• Trade receivables (sums owing from customers for credit sales)
• Trade payables. (sums owed to suppliers for credit purchases)
The level of working capital maintained by a company is calculated as follows:

Working capital $ = Inventory $ + Trade receivables $ - Trade Payables $

1.3.1. The Working Capital Cycle

The working capital cycle measures the amount of time for cash used for working capital to be
converted back into cash.
It means that cash has been used in working capital for this period and would be unavailable.
It can be calculated as:
Days Description
Inventory holding The period inventory is retained (as raw materials, work-in-
period X progress, and finished goods)

+ Receivables The period from the sale of goods/services to receipt of

collection period X payment

- Payables payment The period from the purchase of goods/services to payment

period made
(X)
Working capital cycle
X
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2.1 Cash Inflows and Outflows

Classification Description Cash Inflows Cash Outflows

Associated with the • Cash earned from sales

Operating operations of the entity • Cash earned from non-current • Payment of expenses (wages,
assets (rent, royalties, etc.) rent, utilities, taxes, etc.)

Associated with non-

Investing current assets of the entity • Cash earned from the disposal • Payment for purchase of non-
of assets current assets

• Cash received from a loan

taken
• Cash received from the issue • Drawings by owners
Associated with the of shares • Dividends paid to
Financing entity’s financing • Cash received from capital shareholders
introduced by owners • Payments to service loans
Activity 1: Classification of Cash Flows
Classify the cash flows as operating, investing, or financing.
Cash flow Classification

Dividends paid to shareholders

Issue of company shares to investors

Cash received from long-term loan

Purchase of raw materials

Purchase of machine for long-term use

Payment of electricity bills

Receipts from trade receivables

Bonuses paid to staff

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2.1.1. Regular and Exceptional Cash Flows

• Regular cash flows occur in the ordinary course of business, so they are usual and can be
frequent or infrequent.
• Exceptional cash flows are unusual and rare.
An exceptional event (which would give rise to extraordinary receipts and payments) happens
outside the ordinary course of business and is not expected to happen again soon.
Most cashflows would be classified as regular unless they are unusual for the organisation.
Activity 2: Classification of Cash Flows
Classify the cash flows as regular or exceptional.
Cash flow Classification

Costs related to the closure of a division

Costs related to an earthquake in Europe

Costs related to the bankruptcy of a trade receivable

Purchase of factory for production

Costs related to seasonal storm damage

Payment for a large order of goods

Government grant received for research

Cash received on sale of a non-current asset

4.1 Cash versus Accruals

The difference between cash and accruals accounting is the timing of the transaction recognition.
• In cash flow accounting, items are recognised at the time of the payment or receipt
• In accruals accounting, items are recognised in the period in which the transaction occurred,
regardless of when the payment or receipt occurs.
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Example 4: Cash versus Accruals Accounting

T-Shirt Co buys a piece of machinery it will use for three years. The machine costs $300,000 and generates an
income of $150,000 yearly.
Calculate the profit earned from the machine by T-Shirt Co, in total and for each of the three years, usin
1. cash accounting; and
2. accruals accounting
Solution:
1. Cash accounting:
The costs and
Year Cash outflow ($) Cash inflow ($) Net Cash flow ($)
1 (300,000) 150,000 (150,000)
2 0 150,000 150,000
3 0 150,000 150,000
Total Cash Flow 150,000
After three years, a net cash flow (profit) of $150,000 will be earned.
2. Accruals accounting:
• When the machine is purchased, it is recognised as a non-current asset (capital expenditure), so no loss is
incurred.
• The use of the machine is charged each year as a depreciation expense and matched to its income.
Year Costs ($) Income ($) Profit ($)
1 (100,000) 150,000 50,000
2 (100,000) 150,000 50,000
3 (100,000) 150,000 50,000
Total Profit 150,000
The total profit after three years is also $150,000. However, the timing of the profit recognition in those years is
different from cash accounting.

5.1 Liquidity
An asset described as being liquid means it is easily convertible to cash.
For example, the illustration below shows the relative liquidity of some asset classes:
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5.2 Cash Flow Management

• A cash surplus occurs when cash inflows exceed cash outflows. The surplus funds may be
retained or invested.
• A cash deficit occurs when cash outflows exceed cash inflows. The organisation would need
access to funding to cover the deficit or manage its operations to reduce it.

5.2.1. Managing Working Capital Cycle

The working capital cycle may be managed to reduce or eliminate cash deficits.

Working capital
element Management actions

• Keeping inventory to a minimum to reduce the payments to trade suppliers.

• Only paying suppliers when invoices are due.
Trade payables • Negotiating favourable credit terms (the amount of time allowed before payment
is due) with suppliers.

• Ensuring customers pay on time.

• Ensuring customers keep to their credit limits.
Trade receivables • Setting reasonable, but not too long, credit terms.
• Providing incentives to encourage early settlement.

• Efficient turnaround of raw materials into finished goods

• Producing finished goods only when customers require them (low inventory of
Inventory finished goods).
• Good relationship with suppliers to reduce lead time when ordering goods.

5.2.2. Financing a cash deficit

In addition to managing the working capital cycle, additional cash to cover a cash deficit may be
financed by:
• Equity (issue of shares, capital injection by owners)
• Long-term loans
• Short-term loans (i.e. overdraft)
• Sale of investments and assets.
Each financing method has its cost and risk implications, which managers must consider.
For example, over-reliance on short-term loans may incur high interest charges, reducing
profitability.
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Summary and Quiz

• In accounting, cash refers to cash and cash equivalents. Cash equivalents are assets that can
be converted to currency quickly, with insignificant risk to changes in value.
• A business must have enough cash to meet its financing obligations. If it does not, it would
be susceptible to bankruptcy.
• Cash is also needed to maintain working capital and take advantage of opportunities
• Working capital is the current assets needed for a business to sustain operations.
• The working capital cycle measures the amount of time for cash used for working capital to
be converted back into cash.
• Regular cash flows occur in the ordinary course of business, so they are usual and can be
frequent or infrequent, whereas exceptional cash flows are unusual and rare.
• Cash flows may be classified by operating, investing, or financing activities.
• Different organisations will have different combinations of receipts and payments. The cash
flow pattern of an organisation will depend on what is typical for the industry.
• The difference between cash and accruals accounting is the timing of the transaction
recognition.
• An asset described as being liquid means it is easily convertible to cash.
• A cash surplus occurs when cash inflows exceed cash outflows. The surplus funds may be
retained or invested.
• A cash deficit occurs when cash outflows exceed cash inflows. The organisation would need
access to funding to cover the deficit or manage its operations to reduce it.
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CHAPTER 20: Visual Overview

1.1 Treasury
The treasury function manages the money and financial risks of an organisation.
Some of the activities of the treasury function are:
• Ensuring the organisation has enough cash to meet operating requirements and financing
obligations.
• Identifies and executes opportunities to invest excess cash.
• Identifies and manages risks involved in the cash flow and funding of the organisation.
• forecasting cash flow positions, related borrowing needs and funds available for investment.
• Manages the organisation’s banking requirements.
• Advises on long-term strategic funding requirements and investments.
• Manages pension obligations and insurance requirements.
• Manages foreign exchange exposure and risks, such as ensuring sufficient foreign exchange
for import/export requirements and minimising the negative impact of forex movements.
1.1.1. Cash Management
Cash management is a vital activity of the treasury function. It ensures the organisation always
has enough cash to meet expenses, seeks funding for deficits, and invests surplus.
2.1 Economic Cycles
The economic trend is the general long-term direction in which the economy moves. It represents
the fluctuations in activity that the economy experiences over time.
Fluctuations are part of the business cycle. They are often described as boom and bust, recovery
and recession. These terms are used to describe the different stages of the business cycle.
Organisations will have different cash management priorities and strategies depending on the
economy's stage.
2.1.1. Stages of an Economic Cycle

Generally, the economy’s performance is measured as the growth % of gross domestic product
(GDP).
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GDP is the net output of an economy. It is the total monetary value of all the goods and services
produced by the examined economy and is usually net of exports and imports.

Organisations are more willing to take risks during a boom than during a recession. They may
operate with lower cash balances, expecting easy access to funds if necessary. They may expand
their production volumes to capitalise on the higher product demand.
Some of the economic issues that entities may need to consider are:
• Inflation rates
• Interest rates
• Foreign exchange rates
• Industry consumption trends

3.1 Differences in Private and Public Sector Investment

The private sector refers to entities privately owned by individuals and organisations that invest
capital to maximise owner wealth.
The public sector refers to entities created by the constitution and laws of a country to govern its
citizens. Its investments aim to provide public goods and services to its constituents.

Investment Entity Private Public

Source of funds • Debt (Loans) • Taxes

• Equity (Owners; shareholders) • Debt (public borrowings)

Purpose Obtain a return on capital. Provide a public service

Risk appetite higher Low

Accountable to Owners/shareholders Citizens

The risk that public sectors need to reduce is not only in investment appraisal but also in the
retention of cash and cash equivalents..

3.1.1. Guidance on Public Sector Treasury Management

Public authorities must prioritise loss minimisation and liquidity above return when evaluating
potential investments and holdings (deposits).
To do this, they should ensure that their appraisal and risk teams have the appropriate skills and
experience to reduce these risks.
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4.1 Cash Handling Procedures

Due to their highly liquid nature, cash equivalents (i.e. cheques and deposits) are susceptible to
misappropriation (theft) and loss.

4.1.1. Physical Cash

Cash handling procedures must be implemented to protect against these risks:

Risks

Receive cash in the post

Date-stamp post and keep in a secure room

Ensure two responsible people open the post

Record cash receipts immediately

Ensure segregation of duties

Ensure prompt banking

Reconcile cash book to banking records

Investigate any differences between cash and banking records

Arrange random checks

Ensure documentation of each step

4.1.2. Electronic Payments and Receipts

Electronic cash payments and receipts usually involve a current account and some means of
transfer (such as direct debit or credit or EFTPOS).
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Summary and Quiz

• The treasury function manages the money and financial risks of an organisation.
• Cash management is a vital activity of the treasury function. It ensures the organisation
always has enough cash to meet expenses, seeks funding for deficits, and invests surpluses.
• The economic trend is the general long-term direction in which the economy moves. It
represents the fluctuations in activity that the economy experiences over time.
• To stay competitive and survive an economic downtrend, businesses need to rethink their
operations, manage costs and risks, and build for the future.
• The public sector refers to entities created by the constitution and laws of a country to govern
its citizens. Its investments aim to provide public goods and services to its constituents.
• Due to their highly liquid nature, cash equivalents (i.e. cheques and deposits) are susceptible
to misappropriation (theft) and loss. Cash handling procedures must be implemented to
protect against these risks.
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CHAPTER 21: Visual Overview

1.1 Introduction and Purpose

Definition

Cash budgets are financial plans that show an organisation’s planned cash inflows and outflows over a
period.

1.1.1. Purpose
Cash budgets help managers forecast periods of cash deficit (cash inflow < cash outflow).
Examined together with cash reserves, they indicate when the organisation will need more cash.
This minimises bankruptcy risk.
1.1.2. Cash Deficit
A cash deficit occurs with cash inflows are less than cash outflows. The shortfall will need to be
funded either from cash reserves or additional funding (i.e. loans, trade payables, or overdrafts).
1.1.3. Cash Surplus
A cash surplus occurs when cash inflows exceed cash outflows. This surplus may be held to
spend when opportunities arise, invested to generate a return, or returned to owners as drawings
or dividends.

1.2.3. Differences with Cash Budget

• Cash budgets are different because the cash flows are recorded when cash receipts and payments
occur.
Transaction Operational budget (accruals basis) Cash budget

Sales are recognised when

Sales Sales are recognised when the sale is made. payment is received.

The cost of sales figure is included when incurred

Purchases (cost of (including adjustments for opening inventory, plus Supplier costs are recognised
sales) purchases, less closing inventory). when paid.

Expenses are recognised when

Expenses Expenses are recognised when incurred. paid.
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No expense is recognised on the purchase of a non-current

asset, as cash (asset) is converted into a non-current asset
(asset)
Purchase of non- Use of the asset is recognised as depreciation charged to The cost of a non-current asset
current assets profit and loss. is recognised when paid.

Gain or loss on disposal (disposal value versus book value) Disposal of non-current assets
Disposal of non- of non-current assets is recognised in the statement of recognised when payment is
current assets profit or loss. received.

1.3 Assumptions
1.3.1. Achievability of Budget
Different budgets may be prepared reflecting expected cash flows in various economic
conditions:
• A target budget: based on what the organisation wants to want to happen
• An optimistic budget: based on higher-than-expected sales
• A pessimistic budget: based on lower-than-expected sales.

2.1 Preparing a Cash Budget

2.1.1. Procedure to Prepare Cash Budget
1. Forecast the cash receipts and payments
2. Calculate net cash flow per period
3. Calculate cumulative cash flow
4.
Example 1: Cash Inflows

T-Shirt Co has the following information for a product line of logo t-shirts for staff working in a restaurant.
• The selling price of a t-shirt is $25, and sales are made on credit and invoiced on the last day of the month
• The sales manager has forecasted the following volumes:
Month Jan Feb Mar Apr May Jun

Sales quantity 100 200 500 600 500 700

• The customer is expected to pay 40% of the invoice one month after the sale and the remaining 60% after tw
months.
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Example 1: Cash Inflows

• The variable costs to produce each t-shirt are as follows:

$

Materials 10

Labour 3

Overheads 2

Total 15

• T-Shirt Co makes the t-shirts one month before they are sold, and the trade payables for materials are paid t
months after production.
• Variable overheads are paid in the month following production.
• Wages are paid in the month of production.
T-Shirt Co has a cash balance of $1,900 at the beginning of January
What are the monthly cash flows for T-Shirt Co from January to June?

Solution:
Month Jan Feb Mar Apr May Jun

Sales quantity 100 200 500 600 500 700

Sales revenue ($) 2,500 5,000 12,500 15,000 12,500 17,500

Cash inflows: $ $ $ $ $ $

Cash receipts 1,000 2,000 5,000 6,000 5,000

(40% after 1 month)

Cash receipts 1,500 3,000 7,500 9,000

(60% after 2 months)

Total cash inflow 1,000 3,500 8,000 13,500 14,000

Cash outflows: $ $ $ $ $ $

Materials costs 1,000 2,000 5,000 6,000 5,000

(2 months after production)

Wages 600 1,500 1,800 1,500 2,100 0

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Example 1: Cash Inflows

(in the month of production)

Variable overheads 200 400 1,000 1,200 1,000 1,400

(1 month after production)

Total cash outflow 800 2,900 4,800 7,700 9,100 6,400

Net cash flow (800) (1,900) (1,300) 300 4,400 7,600

Opening cash balance 1,900 1,100 (800) (2,100) (1,800) 2,600

Closing cash balance 1,100 (800) (2,100) (1,800) 2,600 10,200

T-shirt Co is forecast to be in a cash deficit from February to April.

3.1 Inflation

Definition

Inflation is an increase in the prices of goods and services over time.

3.1.1. Impact of Inflation

A low and steady price increase is usually deemed healthy as it reflects economic growth.
Governments usually have a target inflation rate to support a healthy economy.
3.1.2. Deflation
The opposite of inflation is deflation, where prices fall over time. This may happen during a
recession.
Deflation can damage an economy because people may avoid spending money if they expect
prices to fall. This can cause economic activity to fall and lead to a recession.
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3.2 Calculating Inflation Using an Index

An index is a statistical measure of the relative changes between data points. It is usually
expressed as a percentage of change.
The figure that data points are compared to is usually assigned a value of 100 (representing
100%).
In the context of inflation, an index can measure the changes in the prices of goods and services.
A price index would be calculated as follows:

Current year index = (Pricecurrent year / Pricebase year) × 100base year

Change % = Current year index / 100base year
The consumer price index measures the change in prices on a representative group (basket) of
goods and services and is often how governments measure inflation.

Example 2: Consumer price index

Prices in the current year are compared to the base year and expressed over the base figure of 100.
For example, if the price of a good in the base year was $80 and is $94 in the current year:
Current year index = (Pricecurrent year / Pricebase year) × 100base year
Current year index = (94 / 80) × 100
Current year index = 117.5
Change % = Current year index / 100base year
Change % = 117.5 / 100
Change % = 17.5%
The inflation rate between the base and the current year is 17.5%

Example 3: Using a Price Index

The following index is available for T-shirt Co:

Year Revenue ($000) Index

20X1 10,000 100

20X2 ? 110

20X3 ? 115

1. Which year has been selected as the base year?

2. What is T-Shirt Co’s revenue in the years 20X2 and 20X3?
Solution:
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Example 3: Using a Price Index

1. As 20X1 has been assigned the index value of 100, it is the base year.
2. Current year index = (Pricecurrent year / Pricebase year) × 100base year
Re-arranged:
Pricecurrent year = Pricebase year × (Current year index / 100base year)
Revenue20x2 = 10,000 × (110 / 100)
Revenue20x2 = 10,000 × 1.1
Revenue20x2 = 11,000
T-Shirt Co’s revenue in 20X2 is $11m
Revenue20x3 = 10,000 × (115 / 100)
Revenue20x3 = 10,000 × 1.15
Revenue20x3 = 11,500
T-Shirt Co’s revenue in 20X3 is $11.5m

Activity 1: Using a Price Index

The following index is available for T-shirt Co:

Year Revenue ($000) Index

20X1 50.00 100

20X2 ? 95

20X3 ? 115

20X4 ? 100

20X5 ? 120

20X6 57.50 ?

1. What is T-Shirt Co’s expected revenue for 20X2 to 20X5?

2. What is the index for the year 20X6?
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4.1 Time Series

It may be helpful to identify past sales and cost patterns to predict future trends.
The assumption is that these patterns will continue in the future and may be used to calculate
budget values.
A time series is a sequence of data points recorded at intervals.
4.2 Time Series Analysis
There are usually four components in time series analysis:

Component Description

Trend The underlying long-term movement in values over time.

Seasonal short-term fluctuations in value, resulting from differing circumstances affecting results at
variation different times of the day, week, month, year, etc.

Cyclical medium-term changes in values resulting from factors that repeat in cycles. Cyclical
variation variations are longer-term than seasonal variations.

Random
variation Fluctuations that are not part of a pattern and are difficult to predict

4.2.1. Identifying Variations from a Graph

• The data line is the plotted time series data on a graph.

Time series data can be plotted onto a graph to identify patterns.
• The trend is the data line's general direction, showing the data values' long-term movement.
In this graph, the trend appears to be increasing.
• Seasonal variations are short-term fluctuations around the trend line. They are the gaps
between the trend and the data line on a graph that regularly recur.
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4.3 Predicting Future Values

Time series analysis can be expressed as either an additive or multiplicative model:

Y = T + S + C+ R
Or
Y=T×S×C×R
Y = Data point
T = Trend
S = Seasonal variation
C = Cyclical variation
R = Random variation

For short-term forecasting, cyclical and random variations are ignored as they are difficult to
predict. The model may be simplified to:

Y=T+S
Or
Y=T×S

5.1 Moving Average Method

The trend is the smoothed-out time series line. In other words, the trend line indicates the general
direction of the data line with minimal fluctuations.
One method to find the trend in a time series is to use a moving average.

Example 4: Moving Average (Odd-Numbered Set & Even-Numbered Set)

The following revenue data is available:

Year Revenue

$’000

20X1 50

20X2 54
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Example 4: Moving Average (Odd-Numbered Set & Even-Numbered Set)

20X3 55

20X4 59

20X5 60

20X6 64

20X7 68

20X8 72

1. Calculate a three-point moving average from the data and plot it on a graph.
2. Calculate a two-point moving average from the data.
Solution:

1.
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Example 4: Moving Average (Odd-Numbered Set & Even-Numbered Set)

For the sake of presentation, the axis does not start from the origin (zero).
2. Table
3. The observed trend is increasing.

Activity 2: Moving Average Method

The following revenue data is available:

Quarter Revenue ($)

1 24,000

2 33,000

3 48,000

4 15,000

1. Calculate a three-point moving average from the data.

2. Calculate a two-point moving average from the data.

5.2 Average Periodic Increase

The average period increase of the trend can be calculated by taking the difference between the
earliest and latest values and dividing them by the number of periods.
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This assumes the trend is consistent.

The formula is:

Average periodic increase = (Trendlatest value − Trendearliest value) / Number of periods

Example 5: Average Periodic Increase

This is the 3-point moving average calculated from Example 4:

Year Revenue Sum of three years Moving average

$000 $000 $000

20X1 50

20X2 54 159 53.00

20X3 55 168 56.00

20X4 59 174 58.00

20X5 60 183 61.00

20X6 64 192 64.00

20X7 68 204 68.00

20X8 72

Calculate the average periodic increase for the given trend and forecast the trend’s expected value for 20
and 20X0.
Solution:
Average periodic increase = (Trendlatest value − Trendearliest value) / Number of periods
Average periodic increase = (68 − 53) / 5 [20X2 to 20X7 is 5 periods]
Average periodic increase = 15 / 5
Average periodic increase = 3
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Example 5: Average Periodic Increase

The average yearly increase in trend is $3,000.

The expected values for 20X9 and 20X0 are:

Last trend point Periods after the last trend point Trend Expected
Year (20X7) (20X7) increase value
$000 $000 $000

6
20X9 68 2 74
(3 × 2)

9
20X0 68 3 77
(3 × 3)

6.1 Seasonal Variation

Seasonal variations are regularly recurring fluctuations on the trend line for a time series. They
are caused by the pattern of demand for a product or service and can occur annually, monthly,
weekly or daily.
The seasonal variation in a time series can be calculated and used in conjunction with the trend
to predict future cash flows.
As a reminder, the formula for calculating a time series is:

Y = T + S (Additive model)
Or
Y = T × S (Multiplicative model)
The seasonal variation may be determined as follows:

S = Y − T (Additive model)
Or
S = Y / T (Multiplicative model)

Example: Calculating Seasonal Variation (Additive Model)

The following data is available for sales:

Year Quarter Revenue ($000)

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Example: Calculating Seasonal Variation (Additive Model)

Q1 60

Q2 55
20X1
Q3 25

Q4 70

Q1 61

Q2 57
20X2
Q3 27

Q4 74

Q1 63

Q2 56
20X3
Q3 29

Q4 77
There is a clear indication of seasonality for each quarter.
1. Using the additive model, calculate the quarterly seasonal variation. (use a three−point moving avera
calculating the trend)
2. Using the additive model, forecast the quarterly sales for 20X4.
Solution:
1. Calculate the trend (moving average method):
Revenue Moving average
Year Quarter ($000, Y) Sum of three years ($000; T)

20X1 Q1 60

Q2 55 140 46.67

Q3 25 150 50.00

Q4 70 156 52.00

20X2 Q1 61 188 62.67

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Example: Calculating Seasonal Variation (Additive Model)

Q2 57 145 48.33

Q3 27 158 52.67

Q4 74 164 54.67

20X3 Q1 63 193 64.33

Q2 56 148 49.33

Q3 29 162 54.00

Q4 77
Average periodic increase = (54.00 - 46.67) ÷ 9 periods = 0.81
Calculate the variation for each season (quarter):
Forecast the future data value by using the time series formula Y = T + S:
Revenue Moving average Seasonal variation
Year Quarter ($000; Y) ($000; T) (Y − T)

20X1 Q1 60

Q2 55 46.67 8.33

Q3 25 50.00 (25.00)

Q4 70 52.00 18.00

20X2 Q1 61 62.67 (1.67)

Q2 57 48.33 8.67

Q3 27 52.67 (25.67)

Q4 74 54.67 19.33

20X3 Q1 63 64.33 (1.33)

Q2 56 49.33 6.67

Q3 29 54.00 (25.00)

Q4 77
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Example: Calculating Seasonal Variation (Additive Model)

Average the variation for each season (quarter), and normalise to zero (this step is to ensure any trend effects a
removed)
Quarter Q1 Q2 Q3 Q4 Total
20X1 8.33 (25.00) 18.00
20X2 (1.67) 8.67 (25.67) 19.33
20X3 (1.33) 6.67 (25.00)
Total (3.00) 23.67 (75.67) 37.33
÷ Number of periods (quarters) 2 3 3 2
Average seasonal variation (1.50) 7.89 (25.22) 18.67 (0.16)
Normalisation adjustment 0.04 0.04 0.04 0.04 0.16
Seasonal variation ($000; S) (1.46) 7.93 (25.18) 18.71 0.00
Minor rounding errors are ignored.
2. Forecast the future data value by using the time series formula Y = T + S:
+ =
Trend Seasonal variation Expected revenue
Year Quarter ($000; T) (S) ($000, Y)

Q1 55.62 (1.46) 54.16

Q2 56.43 7.93 64.36

Q3 57.24 (25.18) 32.06

20X4 Q4 58.05 18.71 76.76

Example: Calculating Seasonal Variation (Multiplicative Model)

Using the data from the earlier example,

1. Using the multiplicative model, calculate the quarterly seasonal variation. (use a three−point moving
average for calculating the trend)
2. Using the multiplicative model, forecast the quarterly sales for 20X4.
Solution:
1. Calculate the trend (moving average method, from Example 5):
Revenue Moving average
Year Quarter ($000, Y) ($000; T)

20X1 Q1 60

Q2 55 46.67
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Example: Calculating Seasonal Variation (Multiplicative Model)

Q3 25 50.00

Q4 70 52.00

20X2 Q1 61 62.67

Q2 57 48.33

Q3 27 52.67

Q4 74 54.67

20X3 Q1 63 64.33

Q2 56 49.33

Q3 29 54.00

Q4 77
Average periodic increase = (54.00 - 46.67) / 9 periods = 0.81
Calculate the variation for each season (quarter):
Revenue Moving average Seasonal variation
Year Quarter ($000; Y) ($000; T) (Y / T)

20X1 Q1 60

Q2 55 46.67 1.18

Q3 25 50.00 0.50

Q4 70 52.00 1.35

20X2 Q1 61 62.67 0.97

Q2 57 48.33 1.18

Q3 27 52.67 0.51

Q4 74 54.67 1.35

20X3 Q1 63 64.33 0.98

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Example: Calculating Seasonal Variation (Multiplicative Model)

Q2 56 49.33 1.14

Q3 29 54.00 0.54

Q4 77

6.2 Differences between the Additive and Multiplicative Model

The main difference between the additive and multiplicative models of time series analysis is the
relationship between the seasonal variation and the trend.

Model Variation Forecast seasonal variation Forecast seasonal varia

(upward trend) (downward trend)

Absolute
Additive (no relationship to trend) Constant Constant

Relative
Multiplicative (changes according to trend) Increases Decreases

Usually, the multiplicative model will produce more accurate future values, as the absolute
forecast seasonal variation is proportional to the trend.

8. Monitoring and Investigating Variances

8.2.1. Variances
A variance is a difference between an expected and actual outcome.
Regarding cash management, variances occur when cash flows differ from cash
budgets/forecasts.
Variances should be investigated to identify the reasons for the variance, enable corrective
action, and improve the budgeting/forecasting process.
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Some examples of cash flow variances are:

Variance Possible reasons

• Sales volumes lower than expected (i.e. due to obsolete products,

etc.)
• Sales prices are lower than expected. (i.e. due to new competitors
in the market, etc.)
• Customers taking longer to pay than expected (i.e. due to poor
credit control, etc.)
• Clearing of funds taking longer than expected. (i.e. due to delays
in the banking process, etc.)
Actual cash inflows < expected • Disposal of non-current assets for a lower price than expected.
cash inflows • Investment returns lower than expected (i.e. due to poor
economic conditions, etc.)

• Tax payments higher than expected (i.e., increased tax rates, etc.)
• Penalties incurred for late payment of suppliers
• Wages paid higher than expected (i.e. due to union negotiation,
etc.)
Actual cash outflows > expected • Increased regulatory compliance costs.
cash inflows • Unexpected inflation (i.e. due to global events that affected
supply chains, etc.)

8.3 Taking Corrective Action

If forecasts indicate a significant variance between budgeted and expected performance,
managers must take corrective action to improve the organisation’s performance.

8.4 Financing Options

An organisation with a cash deficit may require extra finance in the short term to manage a
temporary cash shortage (deficit).
If cash deficits consistently occur, the organisation should consider longer-term financing.
8.4.1. Short-Term Financing
• Contingency funds - many organisations will keep some cash in a contingency fund in case
of unexpected problems.
• Overdraft facilities (borrowing on a current bank account)
• Short-term loans (provided by banks and building societies)
• Selling investments
• Postponing capital expenditure
• Reducing the working capital cycles by leading and lagging or reducing inventory levels.
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8.4.2. Long-Term Financing

• Leasing rather than buying non-current assets
• Selling non-current assets
• Not reinvesting long-term deposits when they mature.
• Obtaining a long-term loan from a bank or building society
• Issuing shares
• Reducing operations (in other words, reducing production or service provision to reduce
costs)
• Reducing dividend payments to shareholders.

Summary and Quiz

• Cash budgets are financial plans that show an organisation’s planned cash inflows and
outflows over a period.
• Managers build cash budgets using the operational and asset budgets as a starting point.
• Inflation is an increase in the prices of goods and services over time.
• An index is a statistical measure of the relative changes between data points. It is usually
expressed as a percentage of change.
• A time series is a sequence of data points recorded at intervals.
• Time series analysis identifies patterns in the data. It implements a statistical model to
determine this pattern, which may then be used to forecast future values.
• There are four components in time series analysis: trend and seasonal, cyclical, and random
variation.
• Time series analysis can be expressed as either an additive or multiplicative model.
• The trend is the smoothed-out time series line. In other words, the trend line indicates the
general direction of the data line with minimal fluctuations.
• Seasonal variations are regularly recurring fluctuations on the trend line for a time series.
They are caused by the pattern of demand for a product or service and can occur annually,
monthly, weekly or daily.
• A variance is a difference between an expected and actual outcome.
• If forecasts indicate a significant variance between budgeted and expected performance,
managers must take corrective action to improve the organisation’s performance.
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CHAPTER 22: Visual Overview

1.1 Cash Surpluses
A cash surplus arises when cash inflows are higher than cash outflows.
1.1.1. Stakeholders
Different stakeholders will have different opinions on what a company should do with excess
cash:
• Shareholder: If the business has a surplus, it should pay it out in a dividend, as shareholders
are invested in it to earn a return.
• Treasurer: Surpluses can be invested to earn more money for the business in the long term.
• Finance manager: Surplus should be set aside as contingency funds for unexpected
problems.
• Production manager: Surplus should be spent to upgrade non-current assets so that the
entity can continue to operate and manufacture products efficiently.
• Managing director: Surplus should be used to grow the business by expanding into new
markets overseas or developing new product lines.

2.1 Short-Term Investments and Risks

2.1.1. Terms
Investment means purchasing something to earn a future financial gain (return).
Short-term investments are expected to be held up to a year. They would usually be recognised
as current assets.
Risk is the probability and impact of an adverse event.
There is usually a positive relationship between risk and the expected return. The higher the risk,
the higher the expected return.
Usually, short-term investments are of lower risk than more extended term due to the short
timeframe and their high liquidity.
2.1.2. Bank Deposits
Bank deposits are accessible, highly liquid, and of relatively low risk. Cash deposited at a bank
in a current or savings account is considered a cash equivalent (as liquid as cash).
They include:
• Current accounts, which are highly liquid but earn little or no interest;
• Savings accounts, which earn higher interest but may restrict accessing funds.
2.1.3. Money Market Deposits
Financial instruments (securities) are contracts that can be purchased and sold. A good
example is a share (a certificate of ownership of a company) and bonds (a loan sold by
companies to raise cash).
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Most financial instruments have a maturity date, the date it will be redeemed by the issuer,
which repays the principal and any interest accrued.
Money market instruments are financial instruments that are highly liquid (easily tradeable on
an exchange).
They are usually a contract by the issuer that promises to pay cash at a specific time. They often
offer higher returns than bank deposits, and their risk exposure varies depending on the issuer
and the nature of the instrument.
• Certificates of Deposit (CDs)
• Short-Term Government Bonds
• Short-Term Local Authority Bonds
2.1.4. Choosing Short-Term Investments
Businesses must consider several factors when choosing a short-term investment:
• Return
• Liquidity
• Risk
The general rule is that the lower the liquidity and higher the risk of an investment, the higher the
expected return.

3.1 Financing Cash Deficits

A cash deficit arises when the cash outflows of an organisation exceed its cash inflows. This
shortfall in cash must be financed for the organisation to continue operating.
Financing means acquiring funds. The need to obtain funds may be for the short-term, to cover a
cash deficit, or long-term to fund projects with longer timeframes.
Usually, entities would want to match the tenure (timeframe) of finance with the length of the
investment.

3.1.1. Banks
Banks are a common and vital source of finance.
The finance products banks offer usually differ by their tenure:
• Short-term finance is for funding working capital – a short-term gap in cash flow
• Medium-term finance is for investment in medium-term projects or assets, such as launching
a minor new product line or buying vehicles
• Long-term finance is for long-term projects such as buying a building or building a factory.
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Product Description Features

• Flexible.
• Interest is charged only if
Bank allows a business to spend up to a specified used.
Bank overdraft amount above its bank balance. • Repayable on demand.
• High interest rate.

Like a bank overdraft, except the bank cannot

Revolving facility demand immediate repayment.
• Same features of overdraft

A loan with scheduled repayments; the loan term

may be for two years to much more extended
Term loans periods. • Repayment must be made
according to schedule.

Banker’s The bank pays the supplier on the business’s behalf, • Guarantees supplier will be
acceptance facility which will be later repaid with interest. paid.
• Useful for import activities

Banks may request security for the financing products; this means a charge is placed on the
business’s assets, which the bank may possess if the loan is not repaid promptly.
Providing security may result in a lower interest rate, but the business takes the risk that the bank
could possess its assets.
Unsecured financing (overdraft, credit cards) may be significantly more expensive than secured
financing.
3.1.2. Financing Costs
Costs of financing are the interest payments, fees, and other charges the borrower must pay for
the funds received.
The following factors are considered by banks when pricing loans:
• Availability of security for the loan
• Creditworthiness of the borrower
• Size of the borrower (net assets, turnover, profits, etc.)
• Presence of existing loan obligations
• Reputation of the borrower
• Reason for borrowing
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Summary and Quiz

• A cash surplus arises when cash inflows are higher than cash outflows.
• Cash management is concerned with optimising the amount of cash available to the company
and maximising the interest on any spare funds not required immediately.
• Investment means purchasing something to earn a future financial gain (return).
• Usually, short-term investments are of lower risk than more extended term due to the short
timeframe and their high liquidity.
• Bank deposits are accessible, highly liquid, and relatively low risk. Cash deposited at a bank
in a current or savings account is considered a cash equivalent (as liquid as cash).
• Money market instruments are financial instruments that are highly liquid (easily tradeable
on an exchange).
• A cash deficit arises when the cash outflows of an organisation exceed its cash inflows. This
shortfall in cash must be financed for the organisation to continue operating.
• Financing means acquiring funds. The need to obtain funds may be for the short-term, to
cover a cash deficit, or long-term to fund projects with longer timeframes.