ILM Level 5

1. ILM Level 5 Making a Financial Case Presenter name

2. Two financial units to the level 5 programme • Making a Financial Case • Understanding Financial Management

3. Your personal objectives...

4. Areas to be covered Over the unit we will be considering how to: Day 1: • Differentiate between the direct and indirect costs of the business • Identify the fixed and variable costs of the business • Use break-even and contribution analysis • Understand the principles of three costing systems • Consider some simple strategies for profit improvement Day 2: • Understand and apply the main investment methods used in business • Discuss the strengths and weaknesses of each method • Understand the importance of risk and the need for sensitivity analysis • Identify a structure for controlling and reviewing capital projects

5. Day 1

6. Understanding Costs

7. Direct Costs Direct Labour Direct Materials Direct Expenses Front Line Service

8. Direct Costs

10. Indirect ‘Overhead’ Costs

11. Direct and Indirect Costs Activity:Now consider your own operational area and see if you can divide it up into the front line service and support service and, consequently, make a brief list of the direct and indirect costs.

12. Fixed and Variable Costs Fixed Costs: in the short-term stay the same each month Variable Costs:vary with changes in activity Activity: workbook p.9 - For the focus of this activity, let’s use the example of the Olympic swimming pool. Working with a partner consider which of the following costs should be treated as fixed or variable by ticking the appropriate column.

13. Fixed and Variable Costs Activity: Consider your own operational are – what are your fixed and variable costs?

14. Break Even Analysis Break-even analysis helps the business to: • calculate the total costs of providing a service • forecast the revenue that needs to be generated in order to cover costs and start making a profit • The break-even point occurs where total costs equals total revenue • Any revenue below the break-even point is at a financial loss to the organisation for that particular product/service. Once revenue has exceeded the break-even point, then the organisation will be operating at a profit.

15. Activity: Constructing a Break Even Table To illustrate the break even concept, you can construct a break-even table. For this example we will use the University Sports Centre Activity: The centre has fixed costs of £10,000 per month  • It charges an entry fee to the centre of £1.50  • It incurs variable costs per customer, eg electricity to power fitness machines, use of shower etc, of £0.50 per customer. • The monthly break-even point can be calculated by completing the table below.

16. Demand no. of customers Fixed Costs £10,000 Variable Costs (£0.50 per customer) multiply by demand (customers) Total Costs (Fixed Costs + Variable Costs) Sales Revenue (£1.50 per customer) multiply by demand (customers) 0 10,000 0 10,000 0 2,000 10,000 1,000 11,000 3,000 4,000 6,000 8,000 10,000 12,000 Break-Even Analysis

17. Demandno. of customers Fixed Costs £10,000 Variable Costs (£0.50 per customer) multiply by demand (customers) Total Costs (Fixed Costs + Variable Costs) Sales Revenue (£1.50 per customer) multiply by demand (customers) 0 10,000 0 10,000 0 2,000 10,000 1,000 11,000 3,000 4,000 10,000 2,000 12,000 6,000 6,000 10,000 3,000 13,000 9,000 8,000 10,000 4,000 14,000 12,000 10,000 10,000 5,000 15,000 15,000 12,000 10,000 6,000 16,000 18,000 Break-Even Analysis

19. The Contribution Method Need to know: • Fixed cost allocation • Variable costs per unit (customer) • Sales price per unit (revenue per customer) Contribution = selling price less variable costs Contribution means the ‘contribution’ of each unit sale to: • Payment of fixed costs • The generation of a profit Example: £ Price 1.50 (Less) Variable cost 0.50 Contribution 1.00 Break-Even Point (BEP) = Fixed costs / contribution per unit Therefore the BEP = 10,000 / 1 = 10,000 customers (customers)

20. Activity • Using the contribution method, calculate the following break even points (BEPs). Complete the table in your workbook on p. 14. • (The original figures may change for each subsequent calculation where stated. You should always use the most recent figure. The BEP should be expressed in units of demand. Use the table below, to enter your calculations.) • The first BEP has been calculated for you. Follow exactly the same approach to calculate the BEPs for scenarios 2 to 6. • Scenario: The Sports Centre has expanded and it is now including some premium extra value added services in the price charged to the customer, hence the increased entry price. This decision is taken in a bid to compete with two new private leisure centres which have opened locally.

21. Selling Price (less) Variable Costs = Contribution Fixed costs / Contribution per customer Break-Even Point (no. of customers) 1. 9.00 6.50 2.50 2. 3. 4. 5. 6. 15,000/2.50 6,000

22. Selling Price (less) Variable Costs = Contribution Fixed costs / Contribution per customer Break-Even Point (no. of customers) 1. 9.00 6.50 2.50 15,000/2.50 6,000 2. 7.00 6.50 0.50 15,000/0.50 30,000 3. 11.00 6.50 4.50 15,000/4.50 3,333 4. 11.00 8.50 2.50 15,000/2.50 6,000 5. 9.00 8.50 0.50 15,000/0.50 30,000 6. 9.00 8.50 0.50 9,000/0.50 18,000

23. Costing Methods

24. Costing Methods The aim of a costing system is to ensure that all the costs of a business are recovered by being charged to that part of the business making the money, which is normally the front line operation. • Absorption costing • Marginal costing • Activity-based costing

25. Marginal Costing Vs Absorption Costing

26. Absorption Costing The sports centre allows admission only through a one year membership scheme. It has 2 key income earning facilities: its gym and sports hall. It allocates the direct costs for each facility accordingly Direct Costs eg. £30,000 for the year based on 100 members Gym Direct Costs eg. £25,000 for the year based on 100 members Sports Hall

27. Absorption Costing If each of the above sports centre facilities accounted for 50% of sales, the decision could be made to allocate 50% of the centre’s indirect (overhead) costs to both the gym and the sports hall respectively Direct Costs + 50% of Indirect ‘Overhead’ Costs = Total Cost Gym

28. I Absorption Costing • If total indirect (overhead) costs for the sports centre over the period are forecast to be £20,000, then: • 50% of £20,000 = £10,000 = the total indirect costs to be allocated to the gym for the period Total Costs for running the Gym for a year (based on 100 members) Direct Costs (£30,000) + 50% of Indirect ‘Overhead’ Costs (£10,000) = Total Cost (£40,000)

29. Calculating the Total Cost to be allocated to each Membership Fee Scenario 1: • Based on 100 paying members • Direct costs for running the gym for the year = £30,000 • Indirect costs allocated to the gym = £10,000 • Direct costs to be allocated to each annual membership fee: £30,000 direct costs / 100 customers = £300 • Indirect costs to be allocated to each annual membershipfee: £10,000 indirect costs allocated / 100 customers = £100 • Total costs per member: £300 direct costs + £100 indirect cost = £400 • The membership card fee for the gym is, therefore, £400 plus the profit margin Pairs Activity: complete the financial calculations in scenario 2 on p.18 of the workbook

30. Marginal Costing Vs Absorption Costing When is it appropriate to use each technique? • Absorption Costing - when forecasting demand for the year ahead – because at this stage of planning, we need to ensure that all costs will be absorbed into the forecast demand for the period.  • Marginal Costing - when taking on a non-forecast job – assuming that forecast demand is on target, the indirect overhead costs will have already been accounted for; we have, therefore, the opportunity to cost the job only taking into consideration an increase in the variable costs (the marginal cost). • Activity: To compare both costing techniques in action let’s look at the following mini case study on pps. 19/20 of the workbook

32. Existing Production: 100 bikes @ £100 per bike Existing Production: 100 bikes @ £100 per bike Plus  Option A: 50 bikes @ £60 each Existing Production: 100 bikes @ £100 per bike  Plus  Option B: 100 bikes @ £40 each Sales Revenue per month: £ £ £ 100 bikes @ £100 each 10,000 10,000 10,000 50 bikes @ £60 each 3,000 100 bikes @ £40 each 4,000 Total Sales Revenue 10,000 13,000 14,000 Less Production Costs: Direct Materials (£20 per unit) 2,000 3,000 4,000 Direct Labour (£25 per unit) 2,500 3,750 5,000 Fixed Factory Overheads 3,500 3,500 3,500 Total Production Costs 8,000 10,250 12,500 Gross Profit (Total Sales Revenue less Total Production Costs) 2,000 2,750 1,500

33. Marginal Pricing • A contribution to fixed costs can be attractive • Useful to gain market entry or increase market share • Be careful, this is a short-term tactic • Don’t let the marginal price become the market price • Don’t undermine full paying customers

34. ABC Costing Process: • identify each necessary supporting activity in the production process and collect costs into a separate pool for each identified activity • develop a measure for each activity, eg. a measure for the engineering department may be hours, whereas the measure for the maintenance department may be square metres • use activity measures as cost drivers to allocate costs to products

35. ABC in Action Product A 200 hours engineering time 91% engineering cost allocated Product B 20 hours engineering time 9% engineering cost allocated

36. Profit Improvement

37. Activity In what ways can the profitability of an organisation be improved?

38. Increase Profits? • Increase Sales Volume • Improve Selling Price • Re-negotiate Supplier Prices • Reduce Waste & Cut Bureaucracy! • Improve Quality (right first time) • Reduce COS & Overheads

39. PRICE VARIABLE COSTS CLIENTS FIXED COSTS

40. Price increase of 1% = Profit increase of 11% 10.1 101 PROFIT 9.1 PRICE 66.4 VARIABLE COST 24.5 FIXED COST

41. Cost Efficiency Activity: using the post-it notes and flip chart pens provided in the workshop, identify opportunities for greater cost efficiency within your operational area or other areas in the University that you have observed. Note the outcome of this exercise below.

42. Day 2

43. Investment Decisions

44. Today’s Objectives • Understand and apply the main investment methods used in business • Discuss the strengths and weaknesses of each method • Understand the importance of risk and the need for sensitivity analysis • Identify a structure for controlling and reviewing capital projects

45. Investment Projects

46. Investment Appraisal Objectives • Expected benefits • Choice between competing alternatives • If there is a shortage of funds available, which proposals should be chosen

47. Project Evaluation • Does the project fit within overall objectives of the business? • How will it be funded? • What other resources will be required and timescales? • How long will the project last and what are its key stages? • What is the expected pattern of cash flows? • What are the ‘key sensitivities’ and what if… scenarios? • How does the investment compare with other opportunities available? The opportunity cost!

48. Investment Appraisal Methods • Payback period (PP) • Accounting rate of return (ARR) • Net present value (NPV) • Internal rate of return (IRR)

49. Payback Period (PP)

50. Payback Scenario 1 • Activity: Let’s assume that the University’s Sports Centre has 3 projects in mind for developing the business, for example, different sports hall layouts combining different activities. Each project is forecast to generate different cash inflows but cost roughly the same at £10,000 per project. The business can only choose to go ahead with of the three projects and, therefore, constructs a table below to make a comparison in order to help the decision. See the following slide. • If you were advising the Sports Centre management, which of the 3 projects would you recommend from a financial perspective? Explain your choice and reasons below.