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ILM Level 5 Making a Financial Case Presenter name.

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1 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 2

3 Your personal objectives... 3

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 4

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 5

6 Assessments 1.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: 1.Understand the effectiveness of the organisation and won ability to manage and improve quality to meet customer requirements 2.Be able to plan and implement projects to meet, and if possible exceed, customer requirements  Suggested word count: 2,500 to 3,000 6

7 Day 1 7

8 Understanding Costs

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

10 Direct Costs CostCodeCost CategoryDescription 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 service BDirect MaterialsAny materials consumed in the manufacturing process /provision of the front line service CDirect ExpensesAssociated directly with the manufacture of the product/ provision of the service, eg. hire of specialised equipment, any royalties payable as commission

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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. DIndirect labour Managers, supervisors, maintenance and cleaning staff EGeneral administration General office staff and office materials FReceptionStaff GMarketing and distribution Advertising, selling, promotions, transport costs, marketing and distribution staff HBuildings occupancy Rent/rates, property taxes, insurance, heating, lighting, water rates, electricity, repairs and maintenance

13 Direct and Indirect Costs 13 Direct CostsIndirect 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.

14 Fixed Costs: in the short-term stay the same each month Variable Costs: vary with changes in activity Fixed and Variable Costs 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 15 Fixed CostsVariable Costs Activity: Consider your own operational are – what are your fixed and variable costs?

16 Break Even Analysis Break-even analysis helps the business to: 1.calculate the total costs of providing a service 2.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 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) multiply by demand (customers) 010, ,00010,0001,00011,0003,000 4,000 6,000 8,000 10,000 12,000

19 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) multiply by demand (customers) 010, ,00010,0001,00011,0003,000 4,00010,0002,00012,0006,000 10,0003,00013,0009,000 8,00010,0004,00014,00012,000 10,000 5,00015,000 12,00010,0006,00016,00018,000

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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. 22

23 Selling Price (less) Variable Costs = Contribution Fixed costs / Contribution per customer Break-Even Point (no. of customers) ,000/2.506,000

24 Selling Price (less) Variable Costs = Contribution Fixed costs / Contribution per customer Break-Even Point (no. of customers) ,000/2.506, ,000/0.5030, ,000/4.503, ,000/2.506, ,000/0.5030, ,000/0.5018,000

25 Costing Methods

26 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 27

28 Absorption Costing 28 Direct Costs eg. £30,000 for the year based on 100 members 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 Direct Costs eg. £25,000 for the year based on 100 members 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

29 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 Direct Costs + 50% of Indirect ‘Overhead’ Costs = Total Cost Gym

30 30 Total Costs for running the Gym for a year (based on 100 members) 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) Direct Costs (£30,000) + 50% of Indirect ‘Overhead’ Costs (£10,000) = Total Cost (£40,000) 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 I Absorption Costing

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 32

33 33 Existing Production: 100 £100 per bike Existing Production: 100 £100 per bike Plus Option A: 50 £60 each Existing Production: 100 £100 per bike Plus 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 Existing Production: 100 £100 per bike Existing Production: 100 £100 per bike Plus Option A: 50 £60 each Existing Production: 100 £100 per bike Plus Option B: 100 £40 each Sales Revenue per month:£££ 100 £100 each10, £60 each 3, £40 each 4,000 Total Sales Revenue 10,00013,00014,000 Less Production Costs: Direct Materials (£20 per unit) 2,000 3,000 4,000 Direct Labour (£25 per unit) 2,500 3,750 5,000 Fixed Factory Overheads 3,500 Total Production Costs 8,00010,25012,500 Gross Profit (Total Sales Revenue less Total Production Costs) 2,000 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 91% engineering cost allocated 9% engineering cost allocated 20 hours engineering time 200 hours engineering time Product A Product B

38 Profit Improvement

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

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 FIXED COSTS VARIABLE COSTS CLIENTS

42 PRICE FIXED COST VARIABLE COST PROFIT Price increase of 1% = Profit increase of 11%

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. 43

44 Day 2 44

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. 52

53 Payback Period ProjectABC Initial Capital Outlay£10,000 Cash Inflows: Year Cost less Cash inflows Cost less cash inflows Cost less cash inflows 11,000(9,000)7,000(3,000)1,000(9,000) 21,000(8,000)2,000(1,000)8,000(1,000) 31,000(7,000)2,0001,0002,0001,000 47, , Total20,00010,00011,0001,00011,0001,000 Payback Period4 years2.5 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. 54

55 ProjectABC Initial Capita Outlay £240,000 YearCash Inflows:Cost less Cash inflows Cash Inflows:Cost less cash inflows Cash Inflows:Cost less cash inflows 160,000(180,000)40,000(200,000)140,000(100,000) 2100,000(80,000)40,000(160,000)100,000/120,000 = 1.83 years 20, ,000/100,000 = 2.8 years 20,00040,000(120,000)48,00068, ,000100,000120,000/140,000 = 3.86 years 20,00040,000108, ,000160,000140,000160,00020,000128,000 Total400,000160,000400,000160,000368,000128,000 Payback Period 2.8 years3.86 years1.83 years Payback Period Answer

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 57

58 ARR: Project A Project A: initial capital outlay - £240,000 YearCashflow (less)Depreciation =Net Profit £ Total Net Profit160 Evaluation Total Net Profit160Average Annual Profit 32 (160/5 years) Rate of Return: Average Net Profit/ Capital Expenditure x /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 YearCashflow (less)Depreciation =Net Profit £ (8) 24048(8) 34048(8) Total Net Profit160 Evaluation Total Net Profit160Average Annual Profit 160/5 years = 32 Rate of Return: Average Net Profit/ Capital Expenditure x /240 x 100 = 13.33%

60 ARR: Project C Project C: initial capital outlay - £240,000 YearCashflow (less)Depreciation =Net Profit £ (8) 52048(28) Total Net Profit128 Evaluation Total Net Profit128Average Annual Profit 128/5 = 25.6 Rate of Return: Average Net Profit/ Capital Expenditure x /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.

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64 NPV: Project A Project A: initial capital outlay £240,000 YearCashflow (X)Discount Factor (=) Present £10%£ 0-240, , , , , , , , , , ,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 YearCashflow (X)Discount Factor (=) Present £10%£ 0-240, , , , , ,940 Net Present Value +42,000

66 NPV: Project C Project C: initial capital outlay £240,000 YearCashflow (X)Discount Factor (=) Present £10%£ 0-240, , , , , ,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 YearCashflow (x)Discount Factor (=)Present £20%£ 0-240, , , , , , , , , , ,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 AProject BProject C PP ARR13.33% 10.67% NPV+£64,140+£42,000+£62,168 IRR20%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 71

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

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

74 Risk Assessment

75 ResponseWhat this meansExamples 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 3 rd 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 3 rd 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 DescriptionProbabilityImpactResponse Amount allowed for in business plan is insufficient to purchase and implement the chosen tool MediumHighReduce amount of licences to essential number of users rather than optimum level Procurement process delays project delivery LowMediumAccept risk as delay would not be significant and project benefits would still be realised Project not delivered to programme Medium Accept risk as delay would not be significant and project benefits would still be realised

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 77

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 79

80 80 Criterion Weighting (W) Honda CR – V Rating (R) Out of 4 Score (W x R) Nissan X-Trail Rating (R) Out of 4 Score (W x R) Toyota Rava Rating (R) Out of 4 Score (W x R) Land Rover Freelander Rating (R) Out of 4 Score (W x R) Price10£20,150£19,800£19,600£22,000 MPG (Urban) Cost per mile 745.7p44.4p46.0p43.8p Service Intervals 512,50012,00010,00015,000 0 to 60 Mph secs secs secs secs. TOTAL SCORES

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82 Criterion Weighting (W)Honda CR – VRating (R)Out of 4Score (W x R)Nissan X-TrailRating (R)Out of 4Score (W x R)Toyota RavaRating (R)Out of 4Score (W x R)Land RoverFreelanderRating (R)Out of 4Score (W x R) Price10£20,150220£19,800330£19,600440£22, MPG (Urban) Cost per mile 745.7p p p1743.8p428 Service Intervals 512, , , , to 60 Mph secs secs secs secs. 13 TOTAL SCORES Criteria Matrix Answer

83 Management and Control of Projects

84 Case Study 84

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 85


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