CAIIB-FM-Module D topics • Marginal Costing • Capital Budgeting • Cash Budget • Working Capital
COSTING • Cost accounting system provides information about cost • Aim : best use of resources and maximization of returns • cost = amount of expenditure incurred( actual+ notional) • Purposes +profit from each job/product, division, segment+pricingdecision+control+profit planning +inter firm comparison
Marginal costing • Marginal costing distinguishes between fixed cost and variable cost • Marginal cost is nothing but variable cost of additional unit • Marginal cost= variable cost • MC= Direct Material + Direct Labour +Direct expenses
Marginal costing problems • Sales (-) variable cost (=) contribution • Contribution(/ divided by) sales (=) C.S. Ratio • Contribution=Fixed cost (=)Break even point • Fixed Cost (/ divided by) contribution per unit = break even units
Marginal costing problems • SP = Rs.10, VC =Rs.6 Fixed Cost Rs.60000 Find • Break even point (in Rs. & in units) • C/S ratio • Sales to get profit of Rs.20000
Marginal costing problems • Sales Rs.100000 • Fixed Cost Rs.20000 • B.E.Point Rs.80000 • What is the profit ?
Management decisions- assessing profitability CONTRIBUTION/SALES=C.S.RATIO
DECISIONS • Make or buy decisions • Close department • Accept or reject order • Conversion cost pricing
Marginal costing • cost‑volume‑profit analysis is reliant upon a classification of costs in which fixed and variable costs are separated from one another. Fixed costs are those which are generally time related and are not influenced by the level of activity. • Variable cost on the other hand are directly related to the level of activity; if activity increases, variable costs will increase and vice‑versa if activity decreases.
Marginal costing • USES OF COST‑VOLUME‑PROFIT ANALYSIS • The ability to analyse and use cost‑volume‑profit relationship is an important management tool. The knowledge of patterns of cost behaviour offers insights valuable in planning and controlling short and long‑run operations. The example of increasing capacity is a good illustrations of the power of the technique in planning. • The implications of changes in the level of activity can be measured by flexing a budget using knowledge of cost behaviour, thereby permitting comparison to be made of actual and budgeted performance for any level of activity.
Marginal costing • LIMITATIONS OF COST‑VOLUME-PROFIT ANALYSIS • A major limitation of conventional CVP analysis that we have already identified is the assumption and use of linear relationships. Yet another limitation relates to the difficulty of dividing fixed costs among many products and/or services. Whilst variable costs can usually be identified with production services, most fixed cost usually can only be divided by allocation and apportionment methods reliant upon a good deal of judgement. However, perhaps the major limitation of the technique relates to the initial separation of fixed and variable costs.
Marginal costing • ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING • ADVANTAGES • 1. More efficient pricing decisions can be made, since their impact on the contribution margin can be measured. • 2. Marginal costing can be adapted to all costing system. • 3. Profit varies in accordance with sales, and is not distorted by changes in stock level. • 4. It eliminates the confusion and misunderstanding that may occur by the presence of over‑or‑under‑absorbed overhead costs in the profit and loss account.
Marginal costing • 5. The reports based on direct costing are far more effective for management control than those based on absorption costing. First of all, the reports are more directly related to the profit objective or budget for the period. Deviations from standards are more readily apparent and can be corrected more quickly. The variable cost of sales changes in direct proportion with volume. The distorting effect of production on profit is avoided, especially in month following high production when substantial amount of fixed costs are carried in inventory over to next month. A substantial increase in sales in the month after high production under absorption costing will have a significant negative impact on the net operating profit as inventories are liquidated.
Marginal costing • 6. Marginal costing can help to pinpoint responsibility according to organisational lines: individual performance can be evaluated on reliable and appropriate data based on current period activity. Operating reports can be prepared for all segments of the company, with costs separated into fixed and variable and the nature of any variance clearly shown. The responsibility for costs and variances can then be more readily attributed to specific individuals and functions, from top management to down management
Marginal costing • DISADVANTAGES OF MARGINAL COSTING • 1. Difficulty may be experienced in trying to segregate the fixed and variable elements of overhead costs for the purpose of marginal costing. • 2. The misuse of marginal costing approaches to pricing decisions may result in setting selling prices that do not allow the full recovery of overhead costs. • 3. Since production cannot be achieved without incurring fixed costs, such costs are related to production, and total absorprtion costing attempts to make an allowance for this relationship. This avoids the danger inherent in marginal costing of creating the illusion that fixed costs have nothing to do with production.
It involves current outlay of funds in the expectation of a stream of benefits extending far into the future CAPITAL BUDGETING
CAPITAL BUDGETING • A capital budgeting decision is one that involves the allocation of funds to projects that will have a life of atleast one year and usually much longer. • Examples would include the development of a major new product, a plant site location, or an equipment replacement decision. • Capital budgeting decision must be approached with great care because of the following reasons: • Long time period: consequences of capital expenditure extends into the future and will have to be endured for a longer period whether the decision is good or bad.
CAPITAL BUDGETING • . Substantial expenditure: it involves large sums of money and necessitates a careful planning and evaluation. • Irreversibility: the decisions are quite often irreversible, because there is little or no second hand market for may types of capital goods. • Over and under capacity: an erroneous forecast of asset requirements can result in serious consequences. First the equipment must be modern and secondly it has to be of adequate capacity
CAPITAL BUDGETING • Difficulties • There are three basic reasons why capital expenditure decisions pose difficulties for the decision maker. These are: • Uncertainty: the future business success is today’s investment decision. The future in the real world is never known with certainty. • Difficult to measure in quantitative terms: Even if benefits are certain, some might be difficult to measure in quantitative terms. • Time Element: the problem of phasing properly the availability of capital assets in order to have them come “on stream” at the correct time.
CAPITAL BUDGETING • Methods of classifying investments • Independent • Dependent • Mutually exclusive • Economically independent and statistically dependent • Investment may fall into two basic categories, profit-maintaining and profit-adding when viewed from the perspective of a business, or service maintaining and service-adding when viewed from the perspective of a government or agency.
CAPITAL BUDGETING • Expansion and new product investment • Expansion of current production to meet increased demand • Expansion of production into fields closely related to current operation – horizontal integration and vertical integration. • Expansion of production into new fields not associated with the current operations. • Research and development of new products.
CAPITAL BUDGETING • Reasons for using cash flows • Economic value of a proposed investment can be ascertained by use of cash flows. • Use of cash flows avoids accounting ambiguities • Cash flows approach takes into account the time value of money • For any investment project generating either expanded revenues or cost savings for the firm, the appropriate cash flows used in evaluating the project must be incremental cash flow. • The computation of incremental cash flow should follow the “with and without” principle rather than the “before and after” principle
Types of capital investments • New unit • Expansion • Diversification • Replacement • Research & Development
Significance of capital budgeting • Huge outlay • Long term effects • Irreversibility • Problems in measuring future cash flows
Facets of project analysis • Market analysis • Technical analysis • Financial analysis • Economic analysis • Managerial analysis • Ecological analysis
Financial analysis • Cost of project • Means of finance • Cost of capital • Projected profitability • Cash flows of the projects • Project appraisal
Decision process INVESTMENT OPPORTUNITIES PROPOSALS PLANNING PHASE REJECTED OPPORTUNITIES Improvement in planning & Evaluation procedure Improvement in planning & Evaluation procedure PROPOSALS NEW INVESTMENT OPPORTUNITIES EVALUATION PHASE Rejected Proposals PROJECTS SELECTION PHASE Rejected projects ACCEPTED PROJECTS IMPLEMENTATION PHASE ONLINE PROJECTS CONTROL PHASE PROJECT TERMINATION AUDITING PHASE
Methods of capital investment appraisal • Solution IRR NAV • Project A 20% 309 • Project B 15% 1441 • These project are mutually exclusive • The IRR ranks project A higher, whereas the NPV ranks project B first. • The conflict arises because B is ten times the size of A. This gives a higher NPV but in relative terms it is less profitable with a lower percentage return. Naturally, B is preferable because it gives the greatest increase in shareholder’s wealth.
Methods of capital investment appraisal • The advantages of IRR over NPV are: • 1. It gives a percentage return which is easy to understanding at all levels of management. • 2. The discount rate/required rate of return does not have to be known to calculate IRR. It does have to be decided upon at sometime because IRR must be compared with something. The discussion as to what is an acceptable rate of return can however be left until much later stage. In a NPV calculation the discount rate must be specified prior to any calculation being performed.
Methods of capital investment appraisal • The advantages of NPV over IRR are: • 1. NPV gives an absolute measure of profitability and hence immediately shows the increase in shareholder’s wealth due to an investment decision. • 2. NPV gives a clear answer in an accept/reject decision. IRR gives multiple answers. • 3. NPV always gives the correct ranking for mutually exclusive project while IRR may not. • 4. NPVs of projects are additive while IRRs are not. • 5. Any changes in discount rates over the life of a project can more easily be incorporated into the NPV calculation. • The NPV approach provides as absolute measure that fully represents in value of the company if a particular project is undertaken. The IRR by contrast, provides a percentage figure from which the size of the benefits in terms of wealth creation cannot always be grasped.
Future value • Assume that an investor has $1000 and wishes to know its worth after four years if it grows at 10 percent per year. At the end of the first year, he will have $1000 X 1.10 or 1,100. By the end of the year two, the $1,100 will have grown to $1,210 ($1,100 X 1.10). The four-year pattern is indicated below.
BUDGET • Quantitative expression of management objective • Budgets and standards • Budgetary control • Cash budget
PROFIT PLANNING • Budget & budgetary control • Marginal costing • CVP and break even point • Comparative cost analysis • ROCE
PRICING DECISIONS • Full cost pricing • Conversion cost pricing • Marginal cost pricing • Market based pricing
PRICING DECISIONS • PRICING AND ITS OBJECTIVES • The objective of pricing in practice will probably be one of the following: • (a) To ‘skim’ the market (in the case of new products) by the use of high prices; • (b) To penetrate deeply into the market (again with new products) at an early stage, before competition produces similar goods; • (c) To earn a particular rate of return on the funds invested via the generating of revenue; and • (d) To make a profit on the product range as a whole, which may involve using certain items in the range as loss leaders, and so forth.
PRICING DECISIONS • Full cost pricing • The object is to recover all costs incurred plus a percentage of profit. It is a method best used where the product is clearly differentiated and not in immediate, direct competition. It would not lend itself to situation where price tended to be determined by the market,
PRICING DECISIONS • Conversion cost pricing • Conversion cost consists of direct labour cost and factory overhead, ignoring the cost of the raw material on the grounds that profit should be made within the factory and not upon materials bought from suppliers.
PRICING DECISIONS • Marginal cost pricing • Briefly it is that cost which would not be incurred if the production of the product were discontinued. An important advantage of differential cost of pricing is the flexibility it gives to meet special short‑term circumstances, while accepting that full costs must be recovered in the long term. This is by no means always desirable in the short term. For example, there may be surplus productive capacity in a factory, in which case any opportunity to accept an order which covers differential cost and makes a contribution to fixed cost and profit should be accepted. Any contribution is better than none.
PRICING DECISIONS • Market based pricing • This can be based on the value to a customer of goods or services and involves variable pricing. It also takes account of the price he is able and willing to pay for the goods or services. Businesses using this approach develop special products or services which command premium prices. • The other market‑based approach is to price on the basis of what competitors are charging.
Operating leverageFinancial leverage • OL= amount of fixed cost in a cost structure. Relationship between sales and op. profit • FL= effect of financing decisions on return to owners. Relationship between operating profit and earning available to equity holders (owners)