4Learning Objectives There are two key learning outcomes to this unit: To understand the financial concepts used to inform management decisionsBe able to make a financial case to inform a management decision
5Areas to be covered Over the unit we will be considering how to: Day 1:Differentiate between the direct and indirect costs of the businessIdentify the fixed and variable costs of the businessUse break-even and contribution analysisUnderstand the principles of three costing systemsConsider some simple strategies for profit improvementDay 2:Understand and apply the main investment methods used in businessDiscuss the strengths and weaknesses of each methodUnderstand the importance of risk and the need for sensitivity analysisIdentify a structure for controlling and reviewing capital projects
6Assessments Work based assignment - M5.02 and M5.03: Title: Improvement ReportPurpose: 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 requirements2 parts:Understand the effectiveness of the organisation and won ability to manage and improve quality to meet customer requirementsBe able to plan and implement projects to meet, and if possible exceed, customer requirementsSuggested word count: 2,500 to 3,000
9Direct Costs Direct Labour Direct Materials Direct Expenses Front Line Service
10Direct 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.ADirect LabourThe people who directly make the product, or provide the front line serviceBDirect MaterialsAny materials consumed in the manufacturing process /provision of the front line serviceCDirect ExpensesAssociated directly with the manufacture of the product/ provision of the service, eg. hire of specialised equipment, any royalties payable as commission
12Indirect ‘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.DIndirectlabourManagers, supervisors, maintenance and cleaning staffEGeneral administrationGeneral office staff and office materialsFReceptionStaffGMarketing and distributionAdvertising, selling, promotions, transport costs, marketing and distribution staffHBuildings occupancyRent/rates, property taxes, insurance, heating, lighting, water rates, electricity, repairs and maintenance
13Direct 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 CostsIndirect Costs
14Fixed and Variable Costs Fixed Costs: in the short-term stay the same each monthVariable Costs: vary with changes in activityActivity: 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.
15Fixed and Variable Costs Activity: Consider your own operational are – what are your fixed and variable costs?Fixed CostsVariable Costs
16Break Even Analysis Break-even analysis helps the business to: calculate the total costs of providing a serviceforecast the revenue that needs to be generated in order to cover costs and start making a profitThe break-even point occurs where total costs equals total revenueAny 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.
17Activity: 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 CentreActivity: 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.
18multiply by demand (customers) Break-Even AnalysisDemand no. of customersFixed Costs£10,000Variable Costs(£0.50 per customer)multiply by demand (customers)Total Costs(Fixed Costs +Variable Costs)Sales Revenue(£1.50 per customer)10,0002,0001,00011,0003,0004,0006,0008,00012,000
19multiply by demand (customers) Break-Even AnalysisDemand no. of customersFixed Costs£10,000Variable Costs(£0.50 per customer)multiply by demand (customers)Total Costs(Fixed Costs +Variable Costs)Sales Revenue(£1.50 per customer)10,0002,0001,00011,0003,0004,00012,0006,00013,0009,0008,00014,0005,00015,00016,00018,000
21The Contribution Method Need to know:Fixed cost allocationVariable costs per unit (customer)Sales price per unit (revenue per customer)Contribution = selling price less variable costsContribution means the ‘contribution’ of each unit sale to:Payment of fixed costsThe generation of a profitExample: £ Price 1.50(Less) Variable cost 0.50Contribution 1.00Break-Even Point (BEP) = Fixed costs / contribution per unitTherefore the BEP = 10,000 / 1 = 10,000 customers (customers)
22ActivityUsing 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.
23Contribution per customer Selling Price (less)Variable Costs =ContributionFixed costs /Contribution per customerBreak-Even Point(no. of customers)1.9.006.502.502.3.4.5.6.15,000/2.506,000
24Contribution per customer Selling Price (less)Variable Costs =ContributionFixed costs /Contribution per customerBreak-Even Point(no. of customers)1.9.006.502.5015,000/2.506,0002.7.000.5015,000/0.5030,0003.11.004.5015,000/4.503,3334.8.505.6.9,000/0.5018,000
26Costing 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 costingMarginal costingActivity-based costing
27Marginal Costing Vs Absorption Costing A technique for dealing with variable costsProducing one extra unit will incur an increase in variable costs (direct labour, materials and expenses) = marginal costAbsorbs all costs (the direct costs and a proportion of the indirect [overhead] costs) into each unit of sale
28Absorption 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 accordinglyDirect Costseg. £30,000 for the yearbased on 100 membersGymDirect Costseg. £25,000 for the yearbased on 100 membersSports Hall
2950% of Indirect ‘Overhead’ Costs Absorption CostingIf 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 respectivelyDirect Costs +50% of Indirect ‘Overhead’ Costs= Total CostGym
30IAbsorption CostingIf 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 periodTotal 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)
31Calculating the Total Cost to be allocated to each Membership Fee Scenario 1:Based on 100 paying membersDirect costs for running the gym for the year = £30,000Indirect costs allocated to the gym = £10,000Direct costs to be allocated to each annual membership fee:£30,000 direct costs / 100 customers = £300Indirect costs to be allocated to each annual membership fee:£10,000 indirect costs allocated / 100 customers = £100Total costs per member:£300 direct costs + £100 indirect cost = £400The membership card fee for the gym is, therefore, £400 plus the profit marginPairs Activity: complete the financial calculations in scenario 2 on p.18 of the workbook
32Marginal 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
33Sales Revenue per month: £ 100 bikes @ £100 each 50 bikes @ £60 each ExistingProduction:100 £100 per bikePlusOption A:50£60 eachOption B:100£40 eachSales Revenue per month:100 £100 each50 £60 each100 £40 eachTotal Sales RevenueLess Production Costs:Direct Materials (£20 per unit)Direct Labour (£25 per unit)Fixed Factory OverheadsTotal Production CostsGross Profit(Total Sales Revenue less Total Production Costs)
34Total Production Costs ExistingProduction:100 £100 per bike Plus Option A:50£60 each Option B:100£40 eachSales Revenue per month:100 £100 each10,00050 £60 each3,000100 £40 each4,000Total Sales Revenue13,00014,000Less Production Costs:Direct Materials (£20 per unit)2,000Direct Labour (£25 per unit)2,5003,7505,000Fixed Factory Overheads3,500Total Production Costs8,00010,25012,500Gross Profit(Total Sales Revenue less Total Production Costs)2,7501,500
35Marginal Pricing A contribution to fixed costs can be attractive Useful to gain market entry or increase market shareBe careful, this is a short-term tacticDon’t let the marginal price become the market priceDon’t undermine full paying customers
36ABC CostingProcess:identify each necessary supporting activity in the production process and collect costs into a separate pool for each identified activitydevelop 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 metresuse activity measures as cost drivers to allocate costs to products
37ABC in Action Product A 200 hours engineering time 91% engineering cost allocatedProduct B20 hours engineering time9% engineering cost allocated
42Price increase of 1% = Profit increase of 11% 10.1101PROFIT9.1PRICE66.4VARIABLECOST24.5FIXEDCOST
43Cost EfficiencyActivity: 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.
46Today’s ObjectivesUnderstand and apply the main investment methods used in businessDiscuss the strengths and weaknesses of each methodUnderstand the importance of risk and the need for sensitivity analysisIdentify a structure for controlling and reviewing capital projects
48Investment Appraisal Objectives Expected benefitsChoice between competing alternativesIf there is a shortage of funds available, which proposals should be chosen
49Project EvaluationDoes 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!
50Investment Appraisal Methods Payback period (PP)Accounting rate of return (ARR)Net present value (NPV)Internal rate of return (IRR)
52Payback Scenario 1Activity: 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.
53Payback Period Project A B C Initial Capital Outlay £10,000 Cash Inflows:YearCost lessCash inflowscash inflows11,000(9,000)7,000(3,000)2(8,000)2,000(1,000)8,0003(7,000)4510,000Total20,00011,000Payback Period4 years2.5 years
54Payback Scenario 2Activity: 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.
55Payback Period Answer Project A B C Initial Capita Outlay £240,000 YearCash Inflows:Cost lessCash inflowscash inflows160,000(180,000)40,000(200,000)140,000(100,000)2100,000(80,000)(160,000)100,000/120,000= 1.83 years20,000380,000/100,000= 2.8 years(120,000)48,00068,000480,000120,000/140,000= 3.86 years108,0005160,000128,000Total400,000368,000PaybackPeriod2.8 years3.86 years1.83 years
57Accounting Rate of Return PP measures time not profitabilityARR method actually measures profitability.An organisation will set a required rate of return on its investment.See example on following slide
58ARR: Project AProject A: initial capital outlay - £240,000YearCashflow (less)Depreciation =Net Profit£00016048122100523480325Total Net Profit160EvaluationAverage Annual Profit32 (160/5 years)Rate of Return:Average Net Profit/Capital Expenditure x 10032/240 x 100 = 13.33%Activity: now calculate the ARRs for projects B and C on p.31 of the workbook
59ARR: Project B Project B: initial capital outlay - £240,000 Year Cashflow (less)Depreciation =Net Profit£00014048(8)234140925Total Net Profit160EvaluationAverage Annual Profit160/5 years = 32Rate of Return:Average Net Profit/Capital Expenditure x 10032/240 x 100 = 13.33%
60ARR: Project C Project C: initial capital outlay - £240,000 Year Cashflow (less)Depreciation =Net Profit£000114048922120723440(8)520(28)Total Net Profit128EvaluationAverage Annual Profit128/5 = 25.6Rate of Return:Average Net Profit/Capital Expenditure x 10025.6/240 x 100 = 10.67%
62Net Present ValueThe 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.
64NPV: Project A Project A: initial capital outlay £240,000 Year Cashflow (X)Discount Factor (=)Present10%-240,000-160,000.909+54,5402100,000.826+82,6003.751+75,100480,000.683+54,6405.621+37,260Net Present Value+64,140Activity: now calculate the NPVs for projects B and C on p.35 of the workbook
65NPV: Project B Project B: initial capital outlay £240,000 Year Cashflow (X)Discount Factor (=)Present10%-240,000-140.909+36,0302.826+33,0403.751+30,0404140.683+95,6205.621+86,940Net Present Value+42,000
66NPV: Project C Project C: initial capital outlay £240,000 Year Cashflow (X)Discount Factor (=)Present10%-240,000-1140.909+127,2602120.826+99,120348.751+36,048440.683+27,320520.621+12,420Net Present Value+62,168
68Internal 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 IRRWhere there are competing projects, the one with the highest IRR should be preferredSee example on following slide
69IRR: Project AProject AYearCashflow (x)Discount Factor (=)Present20%-240,000-160,000.833+ 49,9802100,000.694+ 69,4003.579+ 57,900480,000.482+ 38,5605.402+ 24,120Net Present Value+ 40Activity: now fill in the table on p.38 of the workbook with the summary of all the PPs, ARRs, NPVs and IRRs
75ResponseWhat this meansExamplesAvoidanceTaking the risk out of the project altogetherGenerally used on RED status risksReduce the scope of the project to remove the risky task from itBuy in specialists to eliminate a skills gapSupplement a team to eliminate a capacity issueCancel the project!TransferenceTransfer the risk to a 3rd party outside the organisationCould apply to any High Impact Risk regardless of RAG statusInsure 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)MitigationDo something to reduce the probability or impact of the riskGood for reducing Red to Amber or Amber to GreenIntroduce 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)AcceptanceAccept 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
76Risk Log Risk Description Probability Impact Response Amount allowed for in business plan is insufficient to purchase and implement the chosen toolMediumHighReduce amount of licences to essential number of users rather than optimum levelProcurement process delays project deliveryLowAccept risk as delay would not be significant and project benefits would still be realisedProject not delivered to programme
77Performing a Risk Analysis Activity: Within your group, select a potential capital investment programme.Identify the potential risksAssess the risk using the probability/impact matrixAssess how you are going to respond to each risk by selecting one of the responses in the table on p.42 of the workbookComplete the risk assessment template on p.43 of the workbookFlip chart and feedback
79The Criteria MatrixAnother 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 –VNissan X-TrailToyota RavaLand Rove Freelander
80CriterionWeighting (W)Honda CR – VRating (R)Out of 4Score (W x R)Nissan X-TrailToyota RavaLand Rover FreelanderPrice10£20,150£19,800£19,600£22,000MPG (Urban)835322928Cost per mile745.7p44.4p46.0p43.8pService Intervals512,50012,00010,00015,0000 to 60 Mph310.5 secs.12.4 secs.12.6 secs.15.2 secs.TOTAL SCORES
85Module 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 businessIdentify the fixed and variable costs of the businessUse break-even and contribution analysisUnderstand the principles of three costing systemsConsider some simple strategies for profit improvementDay 2:Understand and apply the main investment methods used in businessDiscuss the strengths and weaknesses of each methodUnderstand the importance of risk and the need for sensitivity analysisIdentify a structure for controlling and reviewing capital projects