Operational P1

Section A Managing short-term finance

Chapter 1: Working capital and the operating cycle

Working capital cycle

The Working Capital Cycle (otherwise known as the Cash Operating Cycle) is the length of time
between payment for raw materials and cash receipt from the sale of finished goods. It indicates
the number of days for which finance is required. It is given by
Raw materials days
WIP days
Finished goods days
Receivables days

RM / RM purchases (or Usage) for the year x 365

WIP / Cost of production (or Sales) x 365
FG / Cost of sales x 365
Receivables / Credit sales (or Revenue) x 365

Less (Payables days)

Payables / Credit purchases (or Cost of sales) x 365

The numerators refer to the year-end amounts (or a particular time), while the denominators
refer to a 12 month period
The Receivables Days can be otherwise known as the Average Debt Collection Period
In the absence of WIP, Raw Materials or Finished Goods, use Inventory Days = Inventory / Cost
of sales x 365
Sometimes starting balances will be given, alongside information to get the closing balances,
always work out and use the latter
When starting balances and closing balances are given use the average figures
Receipts refer to the income of cash

Risks of not monitoring working capital

Every company intends on reducing its Working Capital Cycle so that money isnt tied up. If it is not
monitored, the following can occur:
Overtrading where even if a business is operating at a profit, there is a shortage of cash to pay
due debts
Overcapitalization where there is excessive working capital

Influencing the cycle

The Working Capital Cycle can be sped up by (but also has consequences of):
1.
2.
3.
4.
5.

Hold less raw materials to reduce RM days but may result in stock outs
Speed up production to reduce WIP days but it will cost more (overtime)
Produce when required to reduce FG days but loss of customer goodwill if they have to wait
Reduce credit period to reduce receivables days but loss of customer goodwill
Take longer to pay to increase payables days but may incur financial penalties

The aforementioned are also short term methods of increasing cash.

Adjusting working capital

The impact of changing the inventory, receivables and payables days is threefold:
Customer relationships reduction in receivables days may deter customers to suppliers who offer
more liberal payment terms
Supplier relationships reduction in payables days may result in foregone discounts, increase in
prices from suppliers and lost goodwill
Stock out reducing inventory days requires strong relationships with suppliers, but they will be
unwilling to offer this service

Liquidity ratios
The Working Capital Cycle and the below Liquidity ratios are only useful when comparing against
industry averages, prior period figures or expectations. If a liquidity ratio falls, the risk of

bankruptcy increases, these are given by:

Working capital = Current assets Current liabilities
Current ratio = Current assets / Current liabilities
Quick ratio = (Current assets not including inventory) / Current liabilities
Some quick operational changes can create the following effects:
1. Halving the credit terms will half the trade receivables, which is offset by an increase in cash by
the same amount
2. Paying off an overdraft will reduce cash and liabilities
3. Purchases of inventories on credit will increase assets and liabilities by the same amount.

Business policy
A business divides its assets into:
1. Permanent current assets the core levels of cash and inventory that is maintained
2. Fluctuating current assets that vary depending on activity
Businesses that accept a greater level of risk will hold fewer permanent assets i.e. holding less
inventory reduces holding costs but increases risk of not being able to respond to demand. The
aforementioned are funded by the following policies:
Conservative All permanent and some fluctuating assets are financed by long-term funding
Aggressive All the fluctuating and some permanent assets are financed by short-term funding
Moderate Fluctuating assets are financed by short-term funding and permanent assets by longterm funding

Chapter 2: Cash flow forecasts

A cash budget is a detailed forecast of expected cash receipts, payments and cash balances over a
planning period. A broad guideline to the preparation of a cash budget is:
Step 1: Identify the starting cash position
Step 2: Determine the period in which receivables and payables impacts the cash
Step 3: Set out the cash budget month-by-month.
Jan

Feb

Mar

X
X
X
X

X
X
X
X

X
X
X
X

Cash outflows
Purchases
30 days
60 days
90 days
Overheads
Wages

(X)
(X)
(X)
(X)
(X)

(X)
(X)
(X)
(X)
(X)

(X)
(X)
(X)
(X)
(X)

Net cash flow

Cash b/f
Cash c/f

X
X
X

X
X
X

X
X
X

Cash inflows
From Sales
30 days
60 days
90 days
Other cash receipts

Gains are not included within the Cash Budget as only cash elements are
Unless otherwise stated, credit terms start from the beginning of the month after which it is
purchased. So, a 30 day credit term means that if X is purchased in May, it is required to pay for
the item at the end of June, so is included in Junes budget
If a probability of cash flow is given, then use the expected value to include in the Cash Budget.
It is important noting that the expected balance is pointless in being used for planning as their
will only be two outcomes (X or Y), which make up the EV, but the outcome will never actually
be EV

Chapter 3: Cash management

Short-term finance
Some of the actions that an organisation can take to generate short-term
1. Increasing the Overdraft facility
2. Taking out a Short-Term Loan
3. Spreading CAPEX over installments rather than paying for it all immediately, or leasing CAPEX
rather than purchasing it outright
4. Decreasing credit terms (all the way to asking for payment in advance)
5. Delaying supplier payments

Overdraft vs. Bank loan

The advantages of borrowing through an overdraft are:
Interest is not paid on the full facility
Compared with other types of loans it is quick and easy to set-up
The disadvantages of borrowing through an overdraft are:
Overdrafts carry greater financial risk as they are repayable on demand
Term loans can be negotiated over a timescale relating to the companys forecast
A lower interest rate than an overdraft can be attained

Export finance
An entity selling abroad will experience a longer Working Capital Cycle as a result of payments not
being received in time. The options for medium-term finance include:
Bill of exchange A supplier draws up a bill of exchange and the customer signs it to acknowledge
the debt. The supplier can hold the bill until the due date or discount the bill with a bank or transfer
the bill to its own supplier to settle its debts with them
Forfaiting The customer makes a small payment and a promissory note to cover the balance
during a sale. An avalising bank guarantees the payment of the note. The supplier sells the notes to
a forfaiting bank at a discount to obtain finance
Letter of credit A document issued by a bank on behalf of a customer authorizing them to draw
money to a specified amount
The benefits of all of the above include:
1.
2.
3.
4.

Immediate access to cash

Exporter carries no liability to bank
Exporter transfers all risks
Allows transactions to be entered into which may not otherwise be possible

Debt factoring
Where the sale of debts is made to a third party in return for prompt cash. It can be with recourse
(debts passed back to entity) or without recourse (factor bearing all risks). The drawbacks of such a
system include:
Customer relationship a debt factor places a barrier between supplier and customer
Reputation debt factoring is perceived as a sign of financial difficulty
Internal debt-collection team indicator they are not doing there job properly
When ultimately deciding on whether to use a debt-factoring service compare benefits and costs
Benefits Admin savings, Bad debt recovery, Receivables given in advance
Costs Annual fee, Extra interest = (Interest payable to debt factoring company interest rate
from bank) x advanced receivables

Managing cash surpluses and investment options

When considering the method of investing cash surpluses, consider the Risk, Liquidity and Return in
decreasing levels of importance
Treasury bills Short-term, risk-free government debt that repays greater than its purchase price on
redemption (rather than interest)
Local authority stocks Similar to Treasury bills but not valued quite as high
Certificate of deposit Fixed-term risk-free bank deposits, which can be liquidated at any time but
at the cost of a lower yield
Bonds Long-term, risky debt instrument that offers a fixed-rate of interest over a fixed period of
time with a redemption value

Lower interest rates normally follow lower risk

Price risk refers to interest changes impacting the tradable value of an investment (if interest
rates depreciate to 1%, while the bond offers 2.5%, the bond will be worth more)
Short-term cash surpluses are invested in liquid options (Bank Deposits) and not risky options
(Bonds)
Yield on investments
The Yield on an investment is the rate of return and is given by
Interest yield = Gross interest / Market value x 100%
The Yield-to-Maturity is the overall return a security holder achieves over the period of holding the
security. It is the combination of interest received on a security and repayment at maturity, and is
calculated using the internal rate of return (IRR). The Coupon Rate of a security is the actual
amount of interest that is paid on the security based upon its face value.

Chapter 4 Receivables and payables

Reasons to offer credit

Offering credit terms has benefits and costs
Benefits: Additional sales volume generated, Profitability of the extra sales
Costs: Extra length of the average debt collection period, Required rate of return
Compare additional profit against cost when determining the impact of credit terms. The cost is the
increase in working capital, given by:
Additional receivables: sales revenue per annum x credit term period
Additional inventories
(Additional payables):
Net increase in working capital x interest rate

Cost of offering settlement discounts

Discounts are offered to incentivize early payments.
Cost of Early Settlement Discount = (100 / 100 discount)360 / Days early 1
Where, Days early = Credit term length Discount length
The Cost of Early Settlement Discount is the Required Rate of Return for the buyer. If the Cost is
greater than the Required Rate of Return then reject the discount.

The credit cycle

The Credit Control function occupies a number of stages which together makes up the credit cycle.

Order Cycle Customer places order, Establishes credit status, Checks credit limit, Issues delivery
note, Delivers goods, Raise invoices
Collection Cycle Customer receives invoice, Sends statement, Sends remainder letter, Calls
customer, Receives cash

Finance requirements
The annual financing requirements of an organisation are:
Total inventories + Total receivables (Total payables x Cost of capital)

Age analysis
An aged analysis on the outstanding balance normally dictates 3 consecutive 30-day periods, with
the outstanding receivables placed in each category depending on when the invoice was raised. It
highlights the overdue amounts that the credit controller needs to chase up. It also highlights
particular customers who may have a large outstanding balance, and to whom no further goods
should be delivered until the account is settled.

Methods of payment
Different transactions have more suitable methods of payment
Cash Convenient but Needs to be kept secure, Difficult to control, Bad for record keeping
Cheques Convenient, Widely used but Security problems with theft, Slow method of payment

Chapter 5 Managing inventory

Reasons and costs for holding inventory

Inventory is held in order to Prevent stock-outs, Hedge against price increases and Secure quantity
purchase discounts
The costs associated with holding inventory include:
Order costs = (annual demand / quantity) x cost per order; Admin, Delivery
Holding costs = (quantity / 2) x holding cost per unit; Opportunity cost, Warehousing, Insurance and
obsolescence
Purchase costs = annual demand x price after discount; Amount paid for order

Economic Order Quantity (EOQ)

The model finds the Order Quantity that minimizes annual inventory costs, it is calculated by:

2 CoD
Ch

D = Annual demand in units, Co = Order cost per order, Ch = Holding cost per unit of inventory

The EOQ is dependent on the assumptions that

1. Demand is constant and certain (no stock-out costs)
2. Delivery is instantaneous
3. Purchase costs are constant (no discounts for bulk purchases)
If the supplier does offer a discount, calculate the EOQ as normal, and then recalculate the EOQ
with the discount if it falls within a discount bad. Moreover, calculate the EOQ at the lower
boundary of each discount bound. Select the order quantity that minimizes costs

If the question is stated with two different elements, reword the information into a common
element before working out, i.e. Co being given in trolleys whereas Ch given in wheels reword
Co into wheels and use this in the EOQ

Section B Cost accounting systems

Chapter 6 Fundamentals of absorption and marginal costing

Absorption costing
The premise of Absorption Costing is to included Fixed Production Costs into the Cost per unit card.
Its element of the Cost per unit card is given as:
OAR = Fixed Production Overheads / Expected activity level, this can be in terms of units, labour
hours or kg
The income statement under absorption costing principles is structured around the split between
production and non-production costs
Year 1

Year 2

Sales
Cost of sales:
Opening inventory
Production:
Variable costs
Absorbed production fixed
costs
Closing inventory
(Over)/under absorption
GROSS PROFIT
Variable selling and distribution
Fixed selling & distribution
NET PROFIT

42, 000

40, 000

1, 600

26, 400
8, 800
35, 200
(1, 600)
(300)

22, 800
7, 600
32, 000
900

(33, 300)
8, 700
(4, 200)
(2, 000)
2, 500

(32, 900)
7, 100
(4, 000)
(2, 000)
1, 100

Closing inventory is given as Opening Inventory + Purchases Sales, valued at full cost (All
Variable Costs + OAR)
The over/under absorption relates to the difference between Absorbed Production Overheads
and Actual Production Overheads Over/under absorption = (Budgeted OAR x Actual Units)
Actual Overheads

Marginal costing
Marginal costing is based on a principle that Variable Production Costs are charged to cost units and
Fixed Costs attributed to relevant periods. This means that Inventory is valued at Variable
Production Costs only
The income statement under marginal costing principles is structured around the split between
Fixed and Variable Costs

Sales
Variable costs:
Opening inventory
Production costs (Labour, Materials):
Less: Closing inventory
Less: Variable costs of sales (Selling, Distribution and
Administration costs)
CONTRIBUTION
Less: Total Fixed costs (Production & selling, administration)
PROFIT

X
X
(X)
(X)
(X)
X
(X)
X

Absorption costing vs marginal costing

The arguments for the use of traditional absorption costing rather than marginal costing for profit
reporting and inventory valuation include:
1. Faire share it is fair to charge all output with a share of fixed production costs
2. IAS 2 requirements follows the requirements of international accounting standard on inventory
valuation
3. Matching concept consistent with the accruals concept
4. Recoverable profit charging fixed overheads to a product allows the organisation to determine
the price and sales to break evene ar
The argument against it is that it allows profit to be manipulated.

Reconciling absorption and marginal costing proforma

There are steps taken to reconcile these forms of costing, if moving from Absorption to Marginal

costing, follow these steps:

1. Set up a cost card:
Direct materials and labor per unit (direct materials and labor / production units)
Variable overheads per unit
Fixed overheads per unit
Total cost per unit
2. Separate Variable Overheads
A line for Overheads will contain Variable and Fixed elements within it. Use the high-low
method across two years to separate these costs, using Actual Overheads (Overheads +
(over)/under absorption) and Production Units. This will give Variable Overheads per Unit,
multiply this by Production units to get the Variable Overheads.
3. Separate Fixed Production Costs
Divide Overheads (without adjustment for (over)/under absorption) by Production Units to get
the Total Overhead Cost per Unit. Remove the Variable Overheads per Unit from this to get the
Fixed Overheads per Unit.
4. Adjust inventory
Divide Inventory by Total Overhead Cost per Unit and then multiply by Variable Overheads per
Unit to get the new Marginal Costing Opening and Closing Inventories
5. Selling, distribution and admin
Use the above method to separate any Non-Production Overheads that have a mixture of Fixed
and Variable Costs, however multiply by Sales Units in the calculation this time

The High-Low Method is calculated by Variable Cost per Unit = (y2 y1) / (x2 x1), where y
refers to Cost and x refers to Production
The above method can be used to separate Fixed and Variable costs in Overheads for budgets
as well

Reconciling absorption and marginal costing profits

The size of each profit is dependent on the amount of inventory left at the end of the year:
Sales = production, AC profit = MC profit
Sales > production, AC profit < MC profit
Sales < production, AC profit > MC profit
Absorption Costing increases the value of Inventory (as it adds OAR in comparison to Marginal
Costing). As Cost of Sales is removed from Revenue, which is given as (Opening Inventory +
Expenses Closing Inventory), it means that Inventory increases over the course of the year
(through Production being greater then Sales), less is taken off Reenue as Closing Inventory
increases, making profit larger.
To reconcile AC and MC simply add the OAR x inventory which is also (all variable costs + OAR
variable production costs) x inventory

AC Profit
add: fixed overhead in opening inventory (OAR x opening
inventory)
less: fixed overhead in closing inventory (OAR x closing
inventory)
MC profit
Reconciling profits over time

Year 1
2, 500
400
2, 100

Profits under absorption costing principles can be reconciled by

Profit in X1
Increase/Decrease in Sales Volume (Profit per Unit x
Sales)
Difference in overhead recovery
Increase/Decreases in Distribution Costs

X
X/(X)
balancing figure
X/(X)
X

Year 2
1, 100
400
2, 100

Profit in X1

Breakeven point
The break-even point is given as:
Breakeven point = Total Fixed Overheads / Contribution per Unit

Where Contribution = Total Sales less Variable Costs; and,

Contribution per Unit = Selling Price per Unit Variable Cost per Unit
Chapter 7 Standard costing and variance analysis

Standard cost
A standard cost is a benchmark measurement of resource cost and usage. It can be determined
through pricing discussions with suppliers, purchase contracts already signed and forecasted
movements of price.
Internal benchmarking likely to be more useful than external benchmarking as it is easier to source
and business practices can be transferred more easily. Moreover, external benchmarking may be
useless if the company is unable to understand how the external organisation achieved the
performance

Setting standards
The setting of standards raises the problem of how demanding the standard should be, there are
four types of standard:
1. Ideal standard Attainable under near-perfect conditions, causes unfavorable motivational
impact as Variances are always adverse
2. Current standard Attainable under current operation standard, do not attempt to improve
current levels of efficiency
3. Basic standard Unaltered standard over a lengthy period of time, may become out of date
4. Attainable standard Attainable under efficient conditions with allowances made for waste, will
provide a positive psychological incentive by giving employees a realistic but challenging target

Similarity of budgets and standards

A Budget and a Standard are both predetermined quantities targets, both of which look to the
future and are used for control purposes. They are also different as Standards are limited to
situations where Output can be measured, while Budgets can only be in monetary terms.

Limitations of standard costing

The three limitations and criticisms of standard costing include:
1. Dynamic business environment Standards can become out of date in a modern business
environment as technology and customer demand changes rapidly, it would be timeconsuming and expensive to revise so often
2. Labour focus Standard costing was created for labour-intensive operations, but as
processes have become more automated, the cost of labour has become a small proportion
of total costs, thus making its variances of little value
3. Cost control focus Standard costing tends to focus on controlling costs, whereas the
modern business environment should focus on quality and continuous improvement

Variances
Material Variances
Price
Should have cost (Actual purchases kg x
Budgeted price)
Did cost (Actual purchases kg x Actual price)
Variance = Difference

Usage
Should have used (Actual units x Budgeted
kg/unit)
Did use (Actual units x Actual kg/unit)
Variance = Difference x Standard cost/kg

Variable Overhead Variances

Expenditure
Should have cost (Actual used purchases x
Budgeted price)
Did cost (Actual used purchases x Actual price)
Variance = Difference

Efficiency
Should have used (Actual units x Budgeted
kg/unit)
Did use (Actual units x Actual kg/unit)
Variance = Difference x Standard cost/kg

Labour Variances
Rate
Should have cost (Actual hours worked x
Budgeted price)
Did cost (Actual hours worked x Actual price)
Variance = Difference

Efficiency
Should have used (Actual units x Budgeted
hours/unit)
Did use (Actual units x Actual hours/unit)
Variance = Difference x Standard cost/hour
Idle Time
Hours worked
Hours paid
Variance = Difference x Standard cost/hour

Fixed Overhead Variances

Expenditure
Budgeted expenditure
Actual expenditure
Variance = Difference

Volume Variance (only exists for Absorption

Costing)
Budgeted units
Actual units
Variance = Difference x OAR per Unit

Sales Variances
Price
X Units should have sold for (Budgeted price x
X)
X Units sold for (Actual price x X)
Variance = Difference

Volume Profit/Contribution
Budgeted sales units
Actual sales units
Variance = Difference x Standard
Contribution/unit (Profit per unit for absorption
costing)

Mix/Quantity contribution/profit used instead of Volume Profit/Contribution when there is more

than one output
Onions
Tomatoes

Actual Std Mix

750
750
1, 500

Actual/Budget
Mix
600
900
1, 500

Difference
150 (F)
150 (A)

X std
x4
x2

Variance
600 (F)
300 (A)
300 (F)

Variance = Difference x Standard Contribution/unit (Profit per unit for absorption costing)
Actual Standard Mix is Actuals in budget proportion. Use Actual Output Mix for Mix and Unflexed
Budget Output Mix for Quantity.

Mix tells us how contribution changes when proportion of products sold are different to
those in the budget, while Quantity tells us difference in contribution as a result of
difference in sales volumes
It highlights the fact that maximizing sales volume may not be as advantageous as creating
the most profitable mix of products

Planning variances
Labour Rate/Materials Price
Actual units x Original hours/unit x Original
standard X per hour
Actual units x Original hours/unit x Revised

Labor Efficiency/Material Usage

X units should original take L hours
X units should revised take M hours
Variance = Difference x Original Standard

standard Y per hour

Variance = Difference

X/hours

Operational variances
Price
Actual kg/hours x Revised standard Y per hour
Actual kg/hours x Actual standard X per hour
Variance = Difference

Labor Efficiency/Material Usage

Revised A units should take L hours
Actual A units did take M hours
Variance = Difference x Revised Standard
X/hours

Materials mix variances

Represents the financial impact of using a different proportion of raw materials to the standard
Onions
Tomatoes

Actual Std Mix

750
750
1, 500

Actual Mix
600
900
1, 500

Difference
150 (F)
150 (A)

X std
x4
x2

Variance
600 (F)
300 (A)
300 (F)

The Actual Standard Mix is obtained by dividing the Total Actual Mix by the original Standard Mix
proportions
Yield variances
Represents the financial impact of the input yielding a different level of output to the standard
Actual inputs should yield
Actual inputs did yield
Variance = Difference x Standard X/hours

Original standard is the same as budgeted standard

Advantages of planning and operational variances

A standard costing system that identifies planning and operational variances have three
advantages of
1. Controllable vs uncontrollable The analysis highlights the variances that are controllable and
uncontrollable, allowing management to focus on those variances that can be impacted
2. Motivation Managers will not be held responsible for poor planning and faulty standard setting
3. Improved standard setting Observant models will ensure the planning and standard setting
process should improve

Flexible budgeting
A Flexed Budget is calculated for all Costs and Revenue, using the original Price per Unit but for the
Actual Units. The advantages of flexible budgeting include:
1. Pinpoints problem areas Flexible budgets are more likely to pinpoint actual problem areas on
which control may be exercised.
2. Removes volume effect Relying on a fixed budget will create large variances as forecast
volume is unlikely to be matched
3. Helps monitor efficiency of operations Flexible budgets gives a better indication of
performance since it shows what costs or revenues should have been at the actual activity level
Flexed budget additional costs = Additional units x variable costs

Reconciling profit
A budget can be reconciled to actuals using variances
(F)
Budgeted sales
(Opening Inventory Closing Inventory)
Budgeted variable overheads

(A)

Budgeted fixed overheads

Flexed budget additional costs
Budgeted profit
Sales volume profit variance
Sales price variance
Labour rate variance
Labour efficiency variance
Materials price variance
Materials usage variance
Materials mix variance
Materials yield variance
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure variance
Fixed overhead volume variance
Actual profit

X
X

Budgeted and standard are synonymous

If reconciling Total Cost use the same method but remove Budgeted Sales, Sales Volume and
Sales Price Variance
If there are more than two outputs Sales Volume Profit Variance splits into Sales Mix Profit and
Sales Quantity Profit Variance
Materials mix and yield are only included if there are more than two types of materials
Planning and operational variance are only included if there has been a price change, it
replaces the Price Variance in this case
Fixed overhead volume variance does not exist for Marginal costing so this is removed
If reconciling Materials Cost only, use Materials Price Variance for each input, and Materials Mix
and Yield. If there is a price change in any of the Materials, replace the Materials Price Variance
with Materials Planning Price and Material Operational price Variance

Investigating variances
The three factors that should be considered before deciding to investigate a variance are:
Materially obtaining explanations for variances is time-consuming and so small variations are not
worthwhile
Cost the cost of the variance needs to be weighed against the cost to the organisation of allowing
variance to continue in future periods.
Controllability whether the variance can be influenced anyway

McDonalisation

This has been facilitated through the idea of Standard Costing as every meal is identical in terms of
the way it looks, the materials used in its process and the amount of materials used in each item.
This has been achieved by reducing human influence by substituting machines for humans, and
has ensured that each meal has a measurable standard cost unit. These standard costs has
enabled the organisation to
Chapter 8 The modern business environment

Traditional production methods focused on high volume, low cost output. In todays environment
the emphasis has shifted towards quality and being flexible to customers requirements. This is
embodied in the philosophy of world class manufacturing which has the following features:

Quality improvement
Get it right, first time so that cost of preventing mistakes is less than the cost of correcting them if
they occur; this means having prevention and appraisal costs that are less than external and
internal failure costs.
There is also a focus on continuous improvement, which is measured using a number of different
metrics.
Problems with implementing this is that it can be demotivating to constantly strive for better, not
everyone can be involved and it relies heavily on the quality of suppliers.

Optimsed production technology a technique whre the primary goal is to amximise throughput
hile simualtnously maintain or decreasing inventory and operating costs

Just-in-time
A system whose objective is to produce or procure products or compoennts as they are required by
a customer or for use, rather than fro iventory
JIT is a system which produces or buys units when they are required rather than for inventory. It has
zero inventories, buys raw materials when needed and uses raw materials as soon as they are
delivered. It aims for low cost, high quality, on-time production by minimizing inventory levels
between processes and minimizing idle equipment, facilities and workers.
Benefits
1. Reduction in inventory holding costs
2. Reduced manufacturing lead times

Limitations
Not always appropriate (hospital)
Large up-front costs of a full study on
production methods
Access to sizeable funds is required to
run a JIT purchasing system

Backflush accounting
Backflush accounting is a method of accoutnting that is used with JIT production systems. It saves
consideratbale amount of time as it avoids having to make a number ofa ccountting entries that
are required by a traditional system. In Backflush account, costs are caclualted and charged when
the product is sold or when it si transferred to the finished goods store.
There are three accounts of
Conversion account = Conversion x unit
Sales account = Price x unit
Cost of Sales account = (Standard cost) x unit + excess conversion costs
What goes into sales account is cost

Computer-integrated manufacturing (CIM) brings together advanced manufacturing technologyand

modern quality ontrol into a single comptuerised coherent system
Flexible manufacturing systems (FMS) is an integrated, computer-controlled production system
which is capable of producing any of a range of parts, and of switching quickly and economically
between them
Electronic data interchange (EDI) facilitates communication between an organisation an dits
customer and suppliers by the electronic transfer of infromation

Chapter 10 Modern costing techniques

Throughput accounting (TA) is an accounting system based on constraints, which identifies material
costs as the only variable cost in the short run (even labour is treated as fixed). Profit is determined
by the throughput generated how quickly raw materials can be turned into sales to generate
cash.
The throughput of a factory is reflected in the TA ratio
a) Throughput return per unit = Sales price Materials cost
b) Throughput return per hour = Throughput return per unit x Output per hour (in units)
c) Throughput cost per hour = Total factory costs per period / Total bottleneck hours per period
d) TA = Throughput return per hour / Throughput cost per hour
Products are ranked by the TA ratio the ratio should be greater than 1 if a product is to be viable.

Identifying the bottle neck

The bottleneck process is the one that has the highest machine utilization rate. Start by calculating
the maximum units of demand for each machine and then divide this by the capacity of the
machine to get the fraction.
Machine utilization rate = Hours required to meet maximum demand / Hours available

Back flush accounting is a simplified standard costing system, which works backwards to attribute
costs to inventory and sales. The two trigger points that determine when entries are made are
purchase of materials and sale of goods. When a sale is made, the following is recorded at standard
cost
DR Cost of Sales
CR Materials
CR Conversion costs
The credits are split according to the weight of pricing, while purchases and conversion costs are
added to the T accounts from the information.

Back flush accounting is most suitable in a JIT environment so that the bulk of manufacturing costs
are in costs of sale.
Advantages
a) Fewer entries so saves time
and cost of operating a
complex accounting system

Disadvantages
b) It doesnt operate well when
inventory levels are significant
c) Absence of financial information may
make management control more
difficult

Chapter 11 Modern costing techniques

Traditional absorption costing uses a single basis for absorbing all overheads into cost units for a
particular production cost center. Activity based costing (ABC) is an extension to this, usually for
when more than one product is produced and specifically considering the cause of each type of
overhead the process is:
Step 1: Group fixed overheads into activities or cost pools according to how they are driven
i.e. Machining, Packaging, Distributing, Quality control
Step 2: Identify the cost drivers for each activity
i.e. Machining No. of machine hours, Quality control
No. of customer orders

No. of production runs, Packing

Step 3: Calculate a cost per unit for cost drivers

Cost per unit = Full activity cost / Required time for activity, i.e. 3000 / 5000 machine hours
Step 4: Absorb activity costs into production based on usage of cost drivers: Cost per unit x activity
The total the absorbed costs will be the fixed overheads and this divided by the number of units
being produced will give the cost per unit
Fixed overheads cost per unit = Cost per unit x activity

Activity based costing should be used when production overheads are high relative to prime costs
or where consumption of resources is not driven by volume.
The use of ABC allows for better cost control and information by allowing for efficient management
of cost drivers as well as information to assist pricing decisions.
However, it is time consuming and expensive and which has a reduced benefit if only one product
is being produced.

Chapter 12 Environmental costing

There are many benefits of having a clear understanding of the environment-related costs of
business activities and these include:
1. Ethical issues businesses should be aware of how their production affects the environment
2. Brand image green ways of doing business can be a selling point
3. Once identified, environmental costs can be controlled and reduced
4. Associating environmental costs with individual products leads to more accurate pricing

Environmental costs are categorized as either:

Internalized environmental costs: The company pays the full cost as the impact is contained within
the company i.e. emissions permit, waste disposal costs, training, environmental taxes
Externalized environmental costs: Wider society has to pay at least an element of these costs i.e.
carbon emissions, pollution, energy control
Internal failure costs: The costs of putting things right while they are still under the control of the
organisation and hve yet to impact the external environment
External failure costs: The costs incurred when an organisations activities has an adverse impact on
the external environment

The standard Total Quality Management (TQM) principles of get it right the first time and
continuous improvement can be applied to environmental management. The objective would be to
minimize externalized costs

Chapter 13 Budgeting

A budget is a financial and/or quantitative plan of operations for a forthcoming period. They allow
for planning, integration between departments, employee motivation and evaluation against
actuals.

There are a number of different types of budgets

Incremental budgeting
Based on previous years
results plus extra for
growth.
Zero-based budgeting
Starting from zero every
process, activity and
expenditure must be
justified before it is included
in the budget.
Rolling budgets
These are prepared every
month and running for 12
months each time.

Advantages: Easy to prepare

Disadvantages: Rigid
Advantages: Removes inefficient operations,
Disadvantages: Emphasizes short-term over long
term and requires time and effort
Advances: Regular assessment means planning and
control will be based on a more recent plan
Disadvantages: Demotivating to managers if they
cannot see benefits and effort and expense required

An operating budget often requires sales quantities and materials purchases for inventories to be
adjusted. The closing inventory is always the opening inventory for the next period for both finished
goods and materials.
Production
Sales
Add: Closing inventory
Less: Opening inventory
Materials usage
Materials usage
Add: Closing inventory
Less: Opening inventory
Total

Chapter 14 Preparing forecasts

January
X
(X)
X
X
(X)
X

The four main components of a time series are:

1. Trend: the underlying increase or decrease in demand
2. Seasonal variations: short-term repeated fluctuations from the trend
3. Cyclical variations: long-term repeated fluctuations from trend
4. Random variations: seen in past data but cant be included in future estimates

When forecasting use the trend and then adjust for seasonal variation
The trend within data can be found by using the Hi-Lo method, which is:
y = a + bx, where b = y2 y1 / x2 x1 where 1 and 2 indicates the highest and lowest levels of
activity respectively
Seasonal variations are either fixed amounts (additive) TS = T + SV or constant proportions of
trend (multiplicative) T = T x SV.

Advantages of time series forecasts are that it reflects the underlying pattern and is a simple and
cheap method of forecasting. However, it is disadvantageous as it assumes all changes are time
related, equal weight are given to all figures and extrapolation is inherently risky.

Chapter 15 Investment decision-making

The payback period of an investment at the point where the cumulative cash flow reaches a
positive
T
0
1
2
3

Cash inflow
(500)
150
220
310

Cumulative cash inflow

(500)
(350)
(130)
180

As capital expenditure involves the outlay of large sums of money and benefits may take a while to
accrue, it is critical that investment decisions are subject to appraisal and control. These steps
involve:
1. Origination of proposals i.e. environmental scanning, internal innovation
2. Project screening high level criteria must be met before financial analysis
3. Analysis and acceptance a financial analysis is undertaken with a yes/no decision
4. Monitoring and review

The accounting rate of return is given by:

ARR = Average annual profit from investment / Initial investment or Average investment x 100
where, Average annual profit = (Profit inflow after depreciation) / number of years
Average investment = (Initial outlay + Scrap value) / 2
The advantages of using ARR to determine investment is that profit is easy to understand while it
suffers from the fact that no account is taken of time value of money.

Post-completion audits cant reverse decisions but ensures lessons are learned, managers are
rewarded, cost overruns do not occur and failing projects are identified and abandoned. However,
they often are expensive and time-consuming as well as creating a risk-averse attitude.

Chapter 16 DCF techniques of investment appraisal

DCF techniques take into account the time value of money. This is critical when cash flows are
going to be spread across several years. The process of adjusting a projects cash flows to reflect
the return that the investor could get elsewhere is known as discounting the cash flows.

Only the cash flows affected by the decision to invest should be considered when appraising
investments, these are called relevant cash flows. Relevant cash flows also include opportunity cost
and avoidable costs (costs avoided if activity did not exist). Non-relevant cash flows include
Depreciation, Allocated Overheads, Sunk costs (market research, surveyor fees)
A scrap value on materials reduces the cost so reduces cash outflow.

The sum of cash in and outflows for a particular period multiplied by the discount factor generates
a present value the sum of present values is the net present value (NPV) and a positive NPV
means that the project is always accepted
The discount factor is given by
cash flow

1+r n where r=discount/interest rate and n=time period of

The discounted payback (DPP) is the time it will take before a projects cumulative NPV turns from
being negative to being positive. It is when the project has paid back its initial costs.

The internal rate of return is calculated by:

IRR=a+

NP V a
(ba)
NP V aNP V b

Where a = the first discount rate giving NPVa and b = the second discount rate giving NPVb when
using the same cash flows
a and b have to give a positive and negative cash flow
The rule is then to accept all projects that has an IRR that is greater than the cost of capital
Advantages of the IRR is that it takes into account the time value of money, can provide a
breakeven point and considers all cash flows, however it may conflict with the NPV decision and
assumed cash s reinvested at IRR.

There are occasions where the results from an NPV and IRR calculation provide conflicting
information (i.e. NPV is greater in one but IRR is greater in the other), in this case accept the NPV
result as the IRR doesnt take into account the relative size of the projects. Choosing projects based
on NPV will ensure wealth maximization.

Chapter 17 Taking account of taxation and inflation

The NPV proforma is laid out as

Sales
Cost (variable and
fixed)
Operating cash flow
Taxation
Capital Expenditure
Scrap value
Tax benefits of capital
allowance
Working capital
Net cash flows
Discount factors @
post-tax cost of capital
Present value

1
X
(X)
X

2
X
(X)
X

3
X
(X)
X

4
X
(X)
X

(X)

(X)

(X)

(X)

(X)

X
X

(X)
X

(X)
X

(X)
X

(X)
X

X
X

.
X

(X)

(X)

(X)

In year 0, is where the investment is made which indicates why there are no costs or sales but just
a large capex spend. In year 4, the investment is sold at its scrap value

Some pointers when given a cash flow proforma include:

1. Only include overheads that are relevant to the project and none that are reallocated
(sometimes this might be mean taking a percentage of initial overheads)
2. Sunk costs such as research and surveying costs are not included
3. Only revenue cash flow pertaining to an as a result of the investment should be included on the
proforma

Corporate tax on profits can be either

1. Tax payments all in the year of the cash flow

2. Tax payments in the year after the cash flow

3. Half in the year of the cash flow and half the following year
For the last option the tax is based on the operating cash flow, but because this tax is split over two
years use a the following workings

Year 1
Year 2
Year 3

Operatin
g CF
(30)
340
740

Tax @
30%
9
(102)
(22)

Payabl
e

4.5

4.5
(51)

4.5

Total
tax

(46.5)

(51)
(111)
(162)

(11)
(111)

A business can claim tax allowances, called capital allowances, on certain purchases or
investments, which should also be included and shown as a separate cash flow. This cash flow is an
inflow as the purpose of the capital allowances is to reduce the tax liability of the company.
The capital expenditure that qualifies for allowances will be indicated into the question by stating
that it is tax depreciable at a particular rate. The cash timing of the allowance will be the same as
the corporation tax timing if corporation tax is paid in two installments so will the allowance.
So if a 750 capital expenditure qualified for tax depreciation at a rate of 20%, which is resold in
year 4 for 200, this will be calculated as:
Year
1
20% WDA
2
20% WDA
3
20% WDA
4
Proceeds
Balancing
allowance

Asset
balance
750
(150)
600
(120)
480
(96)
384
(200)
184

Tax
saved
45

23

22
18

36
29
55
165

23

40

18
15

14

33

28
42

27
27

Major projects will require an injection of funds to finance the level of working capital required.
Questions will only show the total amount of working capital required at that point. So if the
working capital requirements over four years is 250, 300, 375 and 350
Year
1
2
3
4

Annual working
capital
requirement
250
300
375
350

Increment
(250)
(5)
(75)
25

In the year that it is sold, the sum of the working capital increments are released and shown on the
proforma

An investor will require a higher return on their investment in the presence of inflation. If there is a
single rate of inflation, it is easier to use real cash flows and an inflated (real) discount rate, which
is given by:
( 1+r ) (1+i )=(1+m) where r=real cost of capital , i=inflation rate, m=inflated (money) cost of
capital or discount rate
From here, the NPV is calculated by discounting using the real cost of capital

If there is more than one rate of inflation affecting cash flows, inflation will impact profit and
therefore needs to be including in the NPV. In this case, the cash flows must be inflated and
inflation must also be incorporated into the discount rate. Working capital is a function of sales and

purchases; it then follows that if sales and purchases are to be inflated, then any figures resulting
from them (receivables, payables, inventories) should also be inflated.
Chapter 18 Further aspects of investment decision-making

Sensitivity analysis measures how sensitive the success or failure of a project is to changes in one
of the factors influencing the project. This is calculated using:
Sensitivity = NPV of project / NPV of variable x 100%
Where the NPV of the variable is the risk variable and the sensitivity gives the percentage change
in the risk variable to reach an NPV of zero. The variable will often be revenues or total costs.
Questions will require the disclaimer of costs will have to increase by X% for the project to fail,
assuming all other variables are in line with expectations.

Asset replacement analysis measure the optimal replacement cycle. When cash flows do not
inflate, this is determined by calculating the equivalent annual cost which gives an equivalent
money payable each year of the assets life
EAC = NPV of one cycle of replacement / Cumulative discount factor for this cycle length
Where CDF is simply the addition of all discount factors for this cycle (i.e. 2 years = 2 DFs). The
target is to have the cycle of replacement which has the lowest EAC

When cash flows inflate, the EAC cannot be used, as an annuity cannot exist. To calculate the
optimal replacement cycle now, the lowest common multiple is needed. So if the option of
replacement is either 2 years or 3 years, draw up a proforma for 6 (2 x 3) years for both:

Machine purchase
Running costs
Resale
Net cash flow
DF
PV
NPV

0
(X)
(X)

(X)
%
X
X

(X)
%
X

(X)

2
(X)
(X)
X
(X)
%
X

3
(X)
(X)
%
X

4
(X)
(X)
X
(X)
%
X

(X)

(X)
X
(X)
%
X

(X)
%
X

Calculate the NPV for both and choose the one that has the highest NPV (if negative, the lowest
absolute NPV)

Capital rationing arises when there is insufficient capital to invest in all available projects, which
have a positive NPV. The objective is maximize total NPV from available investment capital, the first
step to achieving this is ranking all projects by their profitability index
Profitability index = NPV / Capital Invested
If projects can be subdivided then it will all the projects from the top to bottom until all capital
invested (the last chosen project will normally have to be subdivided so that all capital is used).
If projects cannot be subdivided then the steps to take are:
1. Starting from the top, add each successive project until no more projects can be added
2. If a project had to be skipped as a result of it insufficient funds and a project further down the
list is added, then check other combination by completing the process again but this time
starting from the second highest ranked project and going down
Choose the combination that yields the highest total NPV

The rate of return on investments is called the yield the yield on debentures, loan sstock and
bonds is measured either with:
Interest yield = Gross interest / Market value x 100%
or using yield to maturity, which recognises that investments can be purchased at one price and
redeemed at a different price, often a premium. It is calculated using the internal rate of return
(IRR).
The coupon rate is not the discount factor it is cash flow revenue which is the percentage of the

redeemable value that is returned each period, this amount will have to be discounted

If you are discounting over a number of years where the return is constant i.e. 10 is received every
year, the net present value of these cash flows can be easily calculated by
10 x CDF
where CDF is the cumulative discount factors and is simply the sum of all discount factors across
the periods

Chapter 19 Risk and uncertainty in decision-making

Risk exists where a decision-maker has knowledge that several different future outcomes are
possible. Past experience enables a decision-maker to estimate the probability of the likely
occurrence of each potential future outcome
Uncertainty exists when the future is unknown and the decision-maker has no past experience on
which to base predictions.

When there is a risk, a range of possible future outcomes can be quantified and probabilities
assigned to them and an expected value (weighted average) of these calculated

EV = px

where x is the value ( profitcost ) p is probability of it occurring

p
0.2
0.6
0.2
EV

X
0.2 x 4, 200
0.6 x 4, 200
0.2 x 4, 200
4, 200

Y
0.2 x 4, 100
0.6 x 4, 600
0.2 x 4, 600
4, 500

Z
0.2 x 3, 500
0.6 x 4, 000
0.2 x 5, 000
4, 100

Although Y has the highest EV

X is risk free, and guarantees 4, 200
Z is chosen by risk seeker as it could generate the highest 5, 000
Z is avoided by risk averse as it could generate the lowest 3, 500

The limitations of EV are that it ignores risk risk can be defined as a variability of return, or the
range of possible outcomes. Risk can be measured through standard deviation of the expected
value, which compares all actual outcomes with the expected value and calculates how far on
average the actual outcomes deviate from the mean

xEV
p
=

The coefficient of variation measures the standard deviation as a percentage of the mean (
/ EV ) and the higher the percentage, the higher the dispersion
For the above example, the standard deviation of Y can be calculated as
x
4, 100
4, 600

x - EV
(400)
100

(x EV)2
160, 000
10, 000

p
0.2
0.8 (0.6 + 0.2)

p(x EV)2
32, 000
8, 000
40, 000

Standard deviation = 40, 000

Coefficient of variation = 200 / 500 = 4.4%
these metrics are only useful when they are compared against each other, but on their own hold no
value.

A maximin decision is taken by risk-averse decision-makers and they choose the option that
maximizes the minimum return (in the above example this would be X i.e. 4, 200). A maximax
decision is taken by the risk-seeking decision-makers and they choose the option that maximizes
the maximum return (in the above example this would be Z i.e. 5, 000)

A minimax regret is calculated from opportunity cost, where decisions are taken to minimize the
maximum opportunity cost from making the wrong decision. The process is to find the maximum
return for each probability and then find the opportunity cost of not receiving this

p
0.2
0.6
0.2

X
400
800

Y
100
400

Z
700
600
-

Max regret
Minimum regret
Choose Y

800

400
400

700

The value of perfect information is calculated as the difference between the EV (with perfect
information) and EV (without perfect information). With perfect information we know all the
outcomes so for each probability we simply choose the option that provides the greatest return (or
lowest cost)
p
0.2
0.6
0.2

Option
X
Y
Z

Value
4, 200
4, 600
5, 000

EV (px)
840
2, 760
1, 000
4, 600

The EV this time is 4, 600 and as the EV last time was 4, 500 we can say tha the value of perfect
information is 100

If instead of one, two variables are uncertain or risk, it will require a joint probability table that
records the range of possible outcomes. These tables do not permit a decision to be taken but do
allow the risks to be assessed.
A two way table for profit essentially determines the profit at a combination of outcomes, while the
joint probability table determines the probability of the joint outcome

X
Y
Z

A
290
260
230

B
280
250
220

C
270
240
219

X 0.2
Y 0.35
Z 0.45

A
0.4
0.08
0.14
0.18

B
0.5
0.1
0.175
0.225

C
0.1
0.02
0.035
0.045

If the corresponding cells on both tables are then multiplied it is possible to get the expected value
of profit table

X
Y
Z

A
23.2
36.4
41.4

B
28
43.75
49.5

C
5.4
8.4
9,45

To then determine the probability of the company making a profit of at least 230, all you then need
to do is sum the joint probabilities that provides a profit of above 230

X
Y
Z

A
290
260
230

B
280
250

C
270
240

X 0.2
Y 0.35
Z 0.45

A
0.4
0.08
0.14
0.18

B
0.5
0.1
0.175

C
0.1
0.02
0.035

Probability = 73%

A decision tree is a probability tree, which shows the sequence of interrelated decisions and their
expected outcomes. They will incorporate both the probabilities of, and value of expected
outcomes, and are used in decision-making. They are most useful when there are several decisions

and ranges of outcome

The steps involved with creating one are:
Plan the tree diagram and tick off all the information in the question as you use it in the plan
Draw the tree from left to right, using a ruler, giving yourself as much space as possible
Show a key in the answer detailing the symbols for decisions and outcomes