1. Making a Financial Case Presenter name
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. Learning Objectives There are two key learning outcomes to this unit:
To understand the financial concepts used to inform management decisions
Be able to make a financial case to inform a management decision

5. 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

6. Assessments Work based assignment - M5.02 and M5.03:
Title: Improvement Report
Purpose: to assess own and organisation’s ability to manage quality, and design and implement an improvement plan(s) to meet, and if possible exceed, customer requirements
2 parts:
Understand the effectiveness of the organisation and won ability to manage and improve quality to meet customer requirements
Be able to plan and implement projects to meet, and if possible exceed, customer requirements
Suggested word count: 2,500 to 3,000

7. Day 1

8. Understanding Costs

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

10. Direct Costs Cost Code Cost Category Description Direct Costs:
These costs are normally directly attributable to the manufacture of the product, or the provision of the front line service. A
Direct Labour
The people who directly make the product, or provide the front line service B
Direct Materials
Any materials consumed in the manufacturing process /provision of the front line service C
Direct Expenses
Associated directly with the manufacture of the product/ provision of the service, eg. hire of specialised equipment, any royalties payable as commission

12. Indirect ‘Overhead’ Costs
Indirect Costs:
These costs are commonly known as ‘overheads’. They comprise those factors that are not directly attributable to the manufacture of the product, or provision of the front line service, eg. D
Indirect
labour
Managers, supervisors, maintenance and cleaning staff E
General administration
General office staff and office materials F
Reception
Staff G
Marketing and distribution
Advertising, selling, promotions, transport costs, marketing and distribution staff H
Buildings occupancy
Rent/rates, property taxes, insurance, heating, lighting, water rates, electricity, repairs and maintenance

13. 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.
Direct Costs
Indirect Costs

14. 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.

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

16. 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.

17. 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.

18. multiply by demand (customers)
Break-Even Analysis
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)
10,000
2,000
1,000
11,000
3,000
4,000
6,000
8,000
12,000

19. multiply by demand (customers)
Break-Even Analysis
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)
10,000
2,000
1,000
11,000
3,000
4,000
12,000
6,000
13,000
9,000
8,000
14,000
5,000
15,000
16,000
18,000

21. 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)

22. 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.

23. Contribution per customer
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

24. Contribution per customer
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
0.50
15,000/0.50
30,000 3.
11.00
4.50
15,000/4.50
3,333 4.
8.50 5. 6.
9,000/0.50
18,000

25. Costing Methods

26. Costing Methods Absorption costing Marginal costing
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

27. Marginal Costing Vs Absorption Costing
A technique for dealing with variable costs
Producing one extra unit will incur an increase in variable costs (direct labour, materials and expenses) = marginal cost
Absorbs all costs (the direct costs and a proportion of the indirect [overhead] costs) into each unit of sale

28. Absorption Costing Gym Sports Hall
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

29. 50% of Indirect ‘Overhead’ Costs
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

30. 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)

31. 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 membership fee:
£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

32. 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

33. Sales Revenue per month: £ 100 bikes @ £100 each 50 bikes @ £60 each
Existing
Production:
100 £100 per bike
Plus
Option A: 50
£60 each
Option B:
100
£40 each
Sales Revenue per month:
100 £100 each
50 £60 each
100 £40 each
Total Sales Revenue
Less Production Costs:
Direct Materials (£20 per unit)
Direct Labour (£25 per unit)
Fixed Factory Overheads
Total Production Costs
Gross Profit
(Total Sales Revenue less Total Production Costs)

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

35. 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

36. 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

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

38. Profit Improvement

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

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

41. PRICE
VARIABLE
COSTS
CLIENTS
FIXED
COSTS

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

43. 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.

44. Day 2

45. Investment Decisions

46. 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

47. Investment Projects

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

49. 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!

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

51. Payback Period (PP)

52. 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.

53. Payback Period Project A B C Initial Capital Outlay £10,000
Cash Inflows:
Year
Cost less
Cash inflows
cash inflows 1
1,000
(9,000)
7,000
(3,000) 2
(8,000)
2,000
(1,000)
8,000 3
(7,000) 4 5
10,000
Total
20,000
11,000
Payback Period
4 years
2.5 years

54. Payback Scenario 2
Activity: Let’s assume that another opportunity for business expansion has been identified by the Sports Centre. Calculate the payback periods for each of the three projects below. We will be using exactly the same figures below throughout the rest of this section, to evaluate the 3 projects using the other financial appraisal methods. See p.28 of the workbook.
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.

55. Payback Period Answer Project A B C Initial Capita Outlay £240,000
Year
Cash Inflows:
Cost less
Cash inflows
cash inflows 1
60,000
(180,000)
40,000
(200,000)
140,000
(100,000) 2
100,000
(80,000)
(160,000)
100,000/120,000
= 1.83 years
20,000 3
80,000/100,000
= 2.8 years
(120,000)
48,000
68,000 4
80,000
120,000/140,000
= 3.86 years
108,000 5
160,000
128,000
Total
400,000
368,000
Payback
Period
2.8 years
3.86 years
1.83 years

56. Accounting Rate of Return (ARR)

57. Accounting Rate of Return
PP measures time not profitability
ARR method actually measures profitability.
An organisation will set a required rate of return on its investment.
See example on following slide

58. ARR: Project A
Project A: initial capital outlay - £240,000
Year
Cashflow (less)
Depreciation =
Net Profit
£000 1 60 48 12 2
100 52 3 4 80 32 5
Total Net Profit
160
Evaluation
Average Annual Profit
32 (160/5 years)
Rate of Return:
Average Net Profit/
Capital Expenditure x 100
32/240 x 100 = 13.33%
Activity: now calculate the ARRs for projects B and C on p.31 of the workbook

59. ARR: Project B Project B: initial capital outlay - £240,000 Year
Cashflow (less)
Depreciation =
Net Profit
£000 1 40 48
(8) 2 3 4
140 92 5
Total Net Profit
160
Evaluation
Average Annual Profit
160/5 years = 32
Rate of Return:
Average Net Profit/
Capital Expenditure x 100
32/240 x 100 = 13.33%

60. ARR: Project C Project C: initial capital outlay - £240,000 Year
Cashflow (less)
Depreciation =
Net Profit
£000 1
140 48 92 2
120 72 3 4 40
(8) 5 20
(28)
Total Net Profit
128
Evaluation
Average Annual Profit
128/5 = 25.6
Rate of Return:
Average Net Profit/
Capital Expenditure x 100
25.6/240 x 100 = 10.67%

61. Discounted Cash Flow Methods: NPV

62. Net Present Value
The Net Present Value (NPV) measures the value of the money received at the end of the project, eg. in 5 years’ time.
NPV takes into account all of the costs (except depreciation) and benefits of a project as well as addressing the issue of timing of cash flows.

64. NPV: Project A Project A: initial capital outlay £240,000 Year
Cashflow (X)
Discount Factor (=)
Present
10%
-240,000 - 1
60,000
.909
+54,540 2
100,000
.826
+82,600 3
.751
+75,100 4
80,000
.683
+54,640 5
.621
+37,260
Net Present Value
+64,140
Activity: now calculate the NPVs for projects B and C on p.35 of the workbook

65. NPV: Project B Project B: initial capital outlay £240,000 Year
Cashflow (X)
Discount Factor (=)
Present
10%
-240,000 - 1 40
.909
+36,030 2
.826
+33,040 3
.751
+30,040 4
140
.683
+95,620 5
.621
+86,940
Net Present Value
+42,000

66. NPV: Project C Project C: initial capital outlay £240,000 Year
Cashflow (X)
Discount Factor (=)
Present
10%
-240,000 - 1
140
.909
+127,260 2
120
.826
+99,120 3 48
.751
+36,048 4 40
.683
+27,320 5 20
.621
+12,420
Net Present Value
+62,168

67. Discounted Cash Flow Methods: IRR

68. Internal Rate of Return
If the discount rate is increased sufficiently, eventually a rate will be identified which will cause the NPV to exactly equal zero at the end of the project life = the IRR
Where there are competing projects, the one with the highest IRR should be preferred
See example on following slide

69. IRR: Project A
Project A
Year
Cashflow (x)
Discount Factor (=)
Present
20%
-240,000 - 1
60,000
.833
+ 49,980 2
100,000
.694
+ 69,400 3
.579
+ 57,900 4
80,000
.482
+ 38,560 5
.402
+ 24,120
Net Present Value
+ 40
Activity: now fill in the table on p.38 of the workbook with the summary of all the PPs, ARRs, NPVs and IRRs

70. Final Investment Evaluation
Project A
Project B
Project C PP
2.8
3.86
1.83
ARR
13.33%
10.67%
NPV
+£64,140
+£42,000
+£62,168
IRR
20%
15%
24%

71. Investment Appraisal Summary
The choice of project will depend on the relative importance to the business of:
Liquidity
Profitability
Cost of capital investment

72. Risk in Appraisal Investment
Cash Inflows
Sales Prices and Margins
Project Life
Project Investment
Operational Costs
Interest Costs

73. Risk Analysis and Contingency Planning
What is risk?
the chance of exposure to the adverse consequences of future events …

74. Risk Assessment

75. Response
What this means
Examples
Avoidance
Taking the risk out of the project altogether
Generally used on RED status risks
Reduce the scope of the project to remove the risky task from it
Buy in specialists to eliminate a skills gap
Supplement a team to eliminate a capacity issue
Cancel the project!
Transference
Transfer the risk to a 3rd party outside the organisation
Could apply to any High Impact Risk regardless of RAG status
Insure against the risk, we do this without thinking on our premises burning down!
Use fixed price or shared risk contracts with 3rd parties where risk of overspend is identified (which in turn leads to other risks)
Mitigation
Do something to reduce the probability or impact of the risk
Good for reducing Red to Amber or Amber to Green
Introduce QA and Testing procedures to deal with product quality risks (Reduces probability)
Develop change management processes to reduce risk of resistance to the project (Reduces probability)
Bring tasks that could cause delay forward in the project schedule (Reduces Impact)
Acceptance
Accept the risk could happen and either ignore it or put a contingency plan in place for when it occurs
“Ignore” should only be used for Green status risks
“Contingency” best for Green status risks but can be acceptable for Amber. Most common use is low probability, high impact risks.
Invest in backup and recovery solutions as a contingency for an IT system failure

76. Risk Log Risk Description Probability Impact Response
Amount allowed for in business plan is insufficient to purchase and implement the chosen tool
Medium
High
Reduce amount of licences to essential number of users rather than optimum level
Procurement process delays project delivery
Low
Accept risk as delay would not be significant and project benefits would still be realised
Project not delivered to programme

77. Performing a Risk Analysis
Activity: Within your group, select a potential capital investment programme.
Identify the potential risks
Assess the risk using the probability/impact matrix
Assess how you are going to respond to each risk by selecting one of the responses in the table on p.42 of the workbook
Complete the risk assessment template on p.43 of the workbook
Flip chart and feedback

78. Screening Other Criteria

79. The Criteria Matrix
Another method for screening decisions is the criteria matrix. An example of this is presented on the next slide. In this scenario, the purchasing department of an organisation has decided to renew its fleet of 4 wheel drive vehicles. It has shortlisted 4 vehicles from the original list of ten:
Honda CR –V
Nissan X-Trail
Toyota Rava
Land Rove Freelander

80. Criterion
Weighting (W)
Honda CR – V
Rating (R)
Out of 4
Score (W x R)
Nissan X-Trail
Toyota Rava
Land Rover Freelander
Price 10
£20,150
£19,800
£19,600
£22,000
MPG (Urban) 8 35 32 29 28
Cost per mile 7
45.7p
44.4p
46.0p
43.8p
Service Intervals 5
12,500
12,000
10,000
15,000
0 to 60 Mph 3
10.5 secs.
12.4 secs.
12.6 secs.
15.2 secs.
TOTAL SCORES

82. Criteria Matrix Answer
Criterion
Weighting (W)
Honda CR – V
Rating (R)
Out of 4
Score (W x R)
Nissan X-Trail
Toyota Rava
Land Rover Freelander
Price 10
£20,150 2 20
£19,800 3 30
£19,600 4 40
£22,000 1
MPG (Urban) 8 35 32 24 29 16 28
Cost per mile 7
45.7p 14
44.4p 21
46.0p
43.8p
Service Intervals 5
12,500 15
12,000
10,000
15,000
0 to 60 Mph
10.5 secs. 12
12.4 secs. 9
12.6 secs. 6
15.2 secs.
TOTAL SCORES 93 94 74 69

83. Management and Control of Projects

84. Case Study

85. Module Learning Objectives Review
By the end of this unit, you will be able 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