budgeting and evaluating financial performance

Question 1

what are relevant costs?

Answer 1

those which will be affected by the decision being taken. all relevant costs should be considered in mgment decision making. if a cost will remain unaltered, not relevant

Question 2

what are the 5 types of non-relevant cost?

Answer 2

sunk/past - already spent and non-recoverable

absorbed fixed overheads - overheads that don’t inc/dec as result of decision. amount absorbed may alter but not relevant.

historical cost depreciation - doesn’t result in any future cash flows.

committed costs - will be incurred because of past decisions. cannot be changed.

notional costs - notional rent and interest. only relevant if they represent an identified lost opportunity to use premises/finance. they become opp. costs then.

Question 3

what are opportunity costs?

Answer 3

value of benefit forgone as result of choosing one thing over another. forgone potential benefit from the best rejected course of action.

Question 4

what are notional vs opportunity costs?

Answer 4

very similar, especially notional rent. could be the rental that company is forgoing by occupying premises itself, however only true opp cost if can identify a forgone opportunity.

Question 5

what is an avoidable cost?

Answer 5

specific costs of an activity/sector of a business which would be avoided if it didn’t exist. e.g. savings from shutting down a department.

Question 6

what are differential vs incremental costs?

Answer 6

differential -
difference in total costs between alternatives. can be useful to highlight consequences. still only use relevant costs in calculation.

incremental -
difference in revenues. incremental gain/loss = incremental revenues - incremental costs

Question 7

what two points are important when considering relevant costs?

Answer 7

remember relevant costs are NOT incremental

labour is only -ve for idle workers if you were going to fire them, otherwise it’s 0

Question 8

what is the minimum price a company should quote for special orders?

Answer 8

relevant cost of special order = minimum price company should charge to break even. this should likely be increased rather than offered. does give starting point for pricing decisions

Question 9

what are the main groups of accounting ratios? what do they help to do?

Answer 9

three main groups - profitability, solvency, business efficiency

Understanding the reasons for movements in the level and structure of revenue may explain why performance has improved or worsened in the past and give us insights as to what might happen in the future.

Question 10

what are the profitability ratios?

Answer 10

ROCE

Gross profit percentage

Net profit percentage

Question 11

what is ROCE?

Answer 11

return on capital employed (ROCE)

- most important profitability ratio
- complicated by measurement of capital employed, can be a few methods here
- debatable whether profit should be taken before or after tax. might be argued that each org is affected by tax in different ways. can argue it’s part of mgment’s responsibility to minimise the tax charge so after tax more appropriate.
- always want a high ROCE, but can be hard to decide if it’s high enough.

Question 12

what are the two main formulae for ROCE?

Answer 12

1- if measuring overall effectiveness of mgment:

net profit before tax and interest / (share capital + reserves + long term debt)

can be used to compare profitability of orgs that use debt and equity in different proportions. to be consistent, figure for return must show total amount generated on behalf of investors, which means including interest.

2 - if measuring profitability from POV of individual shareholders:

net profit before tax / (share capital + reserves)

sometimes return on equity, restricts definition to investment made by shareholders

Question 13

what is gross profit percentage?

Answer 13

orgs ability to trade effectively. markups vary between industries. can be difficult to analyse differences even within industries in practice. can be used to pinpoint areas that need further investigation.

Question 14

what conclusions can be drawn from high gross profit percentage?

Answer 14

• It is better at extracting higher prices from its customers.
• It is better at negotiating lower prices from its suppliers.
• It is overcharging for its products — and could be losing business as a result.

Question 15

what is the gross profit % formula?

Answer 15

gross profit / sales

Question 16

what is net profit percentage?

Answer 16

• net profit / sales * 100%
• when interpreting, should link back to gross percentage. if gross profit fell expect net profit to as well, but good cost control can limit this.
• arguably equally valuable to compare net profit with fixed asset, number of employees, factory footage etc.
• unlikely to be any point in comparing these percentages. may not be comparable due to accounting policies, even if they can be reconciled there may be operating/financing policies too. can sometimes be useful for monitoring overheads over time.

Question 17

what are the liquidity ratios?

Answer 17

current ratio

quick assets ratio

Question 18

what is the current ratio?

Answer 18

current ratio = current assets / current liabilities

usually a ratio not a percentage. important, can go out of business if you’re illiquid even if turning a profit. sometimes suggested that ideal is 2:1, more usually regarded as excessive and could mean investing too much in unproductive current assets. this is industry dependent, perishable goods ratios can be much lower as the stock will go.

main thing is looking at last year. if you’re managing to survive consistently at 1.7:1 then probably not a worry.

Question 19

what is the quick assets ratio?

Answer 19

more stringent than current ratio:

quick assets = (current assets - inventory) / current liabilities

AKA acid test ratio. concentrates on assets immediately available to pay creditors as they fall due. optimal quick asset ratio seen as 1:1. again industry dependent.

Question 20

what is operational gearing?

Answer 20

Operational gearing (also known as operating leverage) is based on the mix of fixed and variable costs. It can be determined in different ways, but the simplest method is to consider the contribution‑to‑sales ratio (C/S ratio). A low C/S ratio signifies that a company has a low proportion of fixed costs and a high C/S ratio signifies that it has a high proportion of fixed costs.

Question 21

how can a high C/S ratios affect profits around break even?

Answer 21

there will be higher losses when sales are below the break even point, but higher profit when above it. therefore more risky, and higher rewards

Question 22

how can operational gearing influence the overall risk profile of a company?

Answer 22

For example, managers of highly financially geared companies operating in risky industries may seek to reduce risk by adopting a lower level of operational gearing. Equally, companies with low levels of business and financial risks may take on higher levels of operational gearing to improve potential returns when sales are high.

Question 23

what are the efficiency ratios and their formulas?

Answer 23

asset turnover
= revenue / capital employed

inventory turnover
days = (inv held / cost of sales)*365
OR
*12 for months, 52 for wks

receivables turnover
days = receivables balance / sales * 365

payables turnover
days = payables balance / purchases * 365

Question 24

what is asset turnover?

Answer 24

impression of efficiency with which capital is being used. contributes to overall performance as measured by ROCE, since operating profit margin * asset turnover = ROCE. if AT can be raised, ROCE will rise.

changes will be linked to movements in revenue, assets or both.

Question 25

what is inventory turnover?

Answer 25

dividing by rate of consumption. desirable to be short as possible. can be too short though, easy to reduce the figure produced by allowing inventories to run down. this can lead to stoppages in production because of inadequate inventory or materials/components. holding low inventory can also cost trade and goodwill if you can’t meet demand.

Question 26

what are receivables and payables turnover?

Answer 26

again want this to be short. better for cash flow if people are paying quickly. difficult to purposefully lower as can damage relationships. try to collect cash asap, and delay making payments to suppliers. effectively this is equivalent to taking out an interest free loan which can be used to finance working capital. make sure you aren’t seen as a slow player, this can damage chances of getting credit. if measuring an external org you won’t have purchases balance, but can approximate it by using cost of sales

Question 27

what is another term for the DuPont model?

Answer 27

triangulation - operating profit margin * asset turnover = ROCE capital employed = equity + long term finance

Question 28

what is an important part of financial analysis?

Answer 28

understanding the business!! Financial analysis requires an understanding of the products, services and operating characteristics of the business. The business operates within an industry consisting of businesses with similar operating characteristics. If the analysis invites comparison of the business with the industry norms, it is important to identify the key characteristics of the industry and so establish benchmarks. However, should exercise care in evaluating performance on basis of comparison with industry 'benchmarks'. No two businesses are the same and can never be sure that one is comparing like for like. For one thing, ROCE and related metrics tend to move with the plant replacement cycle. A business with old, heavily depreciated equipment is likely to report a higher ROCE than one with new equipment. But this does not imply that the former is performing better than the latter in a strictly economic sense.

Question 29

what is a fixed budget?

Answer 29

fixed — unchanged regardless of actual activity levels. predominantly used in planning stage of budget prep and often referred to as original budget. set at beginning of period based on estimated production.

Question 30

what is a flexed budget and why is it used?

Answer 30

flexed budget - actual results compared to relevant section of flexible budget, that which corresponds to the actual level of activity. this is the flexed budget. when mgrs are comparing actuals with budget, important to ensure the comparison is valid. flex budgets can help w that. in situations where activity likely to change and significant variable costs difficult to control expenditure satisfactorily with fixed budget. flex budget can help make valid comparisons. comparing flexed with actual expenditure/revenue makes it possible to distinguish genuine efficiencies. original budget can also be flexed to show costs and revenues for actual.

Question 31

how is a flexible budget prepared?

Answer 31

first identify costs that are fixed and variable. allowed expenditure on var costs changes with activity. Then, based on a certain period, calculate the variable cost per unit of each cost. even fixed costs may have some element, e.g. production overheads are fixed at 18000, but in a period where you produced and sold 1200 units you incurred 24000 in prod overheads. So, variable cost per unit = 5. now you’re aware of fixed costs and variable cost per unit, can flex the og budget to product a budget cost allowance for 1000 units produced and sold. cost allowance per line item = budgeted fixed cost + (number of units produced and sold * var cost per unit)

Question 32

are flexible budgets useful for planning?

Answer 32

useful for control but not great for planning. og budget must contain single target level of activity so mgrs can plan factors like resource requirements and product pricing policy. wouldn’t be possible if they were faced with a range of possible activity levels. budget can be designed so fixed costs are distinguished from variable, this will allow prep of budget cost allowance for control at end of each period when actuals are known.

Question 33

how are budgetary control and responsibility accounting linked?

Answer 33

important to ensure each mgr has well defined responsibility area and also that there are no grey areas with uncertain responsibilities. each centre will have own budget with mgr receiving control info relevant.

Question 34

what are the three main approaches to reporting a performance evaluation?

Answer 34

trend analysis - horizontal analysis over several years. horizontal analysis - line by line comparison of one set of data with another. identifying % movements can reveal indicators but more importantly prompt further enquiry. vertical analysis - expressing data as % of a critical component of financial statements. SOFP usually has critical component of total assets. income statement usually % of total sales. can give clues as to financial condition and operations of business.

Question 35

how can you ensure meaningful reporting of a performance evaluation?

Answer 35

can be carried out for a whole business of individual segments. in this context your attention is drawn to discussion of budget and responsibility centres. budgets assembled and results reported in manner consistent with org structure. key thing to be aware of is consideration of a given figure/metric may tell you little when considered in isolation, and becomes more meaningful in context - previous year, industry average, as a % of sales, against the budget etc.

Question 36

what is benchmarking?

Answer 36

Benchmarking is the establishment, through data gathering, of targets and comparators, that permit relative levels of performance (and particularly areas of underperformance) to be identified. Adoption of identified best practices should improve performance. standard cost of a product/activity is a form of benchmark. however, it is all internal and generally a wider view is better

Question 37

how does data gathering for benchmarking work?

Answer 37

not necessarily easy - especially in non-financial areas. can be obtained by reverse engineering, e.g. buying the product and dismantling to see content and configuration, product literature, press comments etc. effective benchmarking requires understanding of processes that make up the product from multiple businesses. this info is hard to obtain.

Question 38

what are the 7 types of benchmarking?

Answer 38

- internal - within the org; possible if org is large and divided into similar regional divisions. widely used within gov. in UK, public sector benchmarking service maintains database of performance measures. - competitive - most successful used as benchmark. competitors unlikely to provide willingly any information for comparison but might be possible to observe competitor performance, e.g. through reverse engineering. - functional - comparisons with similar functions (selling, order handling, despatch) in other orgs that aren’t direct competitors. e.g., fast food vs restaurant. - strategic - form of competitive, aimed at reaching decisions for strategic action and organisational change. companies in same industry may agree to join collaborative benchmarking process. averages are provided for group as a whole, used to assess individual companies’ performance. - customer - perf vs that expected by customers. - intra-group - groups of orgs in same industry agree that similar units within cooperating org will pool data on processes. then benchmarked against each other and at an operational level improvement task forces are established to identify and transfer best practice. - inter-industry - non-competing orgs with similar processes identified and asked to participate in benchmarking. e.g. distributor of personal computers may approach distributor of hi-fi tech to establish benchmarking relationship. two are not in direct competition but many similarities in characteristics of supply/distribution and customers. benefits both to participate

Question 39

how does public sector benchmarking work?

Answer 39

local authorities may exchange data on wide variety of subjects. non-local may also be useful, e.g. an insurance company for costs per sq mtr of office space maintained could be used to benchmark performance of office functions. can be one off or continuous. adverse discrepancies obviously show areas for improvement, but again very contextual. degree of sensitivity required in manner in which benchmarks are selected and manner in which comparisons are interpreted.

Question 40

what is the motivation for collaborating with other orgs for benchmarking?

Answer 40

it enables an organisation to improve its performance by learning from the experience of others. Obviously, there is a danger in intra-group benchmarking that competitors may gain more from the process than one's own organisation and this is an issue that will be of concern to management. However, this concern may be tempered by the knowledge that other competitors are outside the system. Nevertheless, the attraction of inter-industry benchmarking in providing less of a direct commercial threat is obvious.

Question 41

how can you ensure a benchmark is meaningful?

Answer 41

benchmark should relate to a ‘key performance indicator’, that is something within the business process that has a major influence on results. Establishing benchmarks is a necessary part of benchmarking but of itself does not provide an understanding of best practices nor does knowledge of the benchmarks lead necessarily to improvement.

Question 42

what three distinct approaches to benchmarking have been identified?

Answer 42

1. Metric benchmarking: The practice of comparing appropriate metrics to identify possible areas for improvement 2. Process benchmarking: The practice of comparing processes with a partner as part of an improvement process 3. Diagnostic benchmarking: The practice of reviewing the processes of a business to identify those which indicate a problem and offer a potential for improvement.

Question 43

why is benchmarking becoming more popular?

Answer 43

The general thrust behind this idea is that standard costing belongs in the era when goods were produced in long continuous production runs and a high proportion of costs were ‘product specific’. In the new economy, goods tend to be highly customised, contain a significant service element and are produced in short discontinuous production runs on a JIT basis. A large proportion of product costs are determined at the design stage or are ‘customer specific’, that is, they relate to the manner in which the goods are provided to the customer. Efficiency is therefore very much a function of product engineering, the flexibility of the production operation and customer relationship management. It is argued that the traditional budgetary control report based on standard costing simply does not address these issues.