Documentos de Académico
Documentos de Profesional
Documentos de Cultura
SCHOOL OF BUSINESS
DEPARTMENT OF POSTGRADUATE STUDIES
Table of contents
1.0
2.0
Introduction to Accounting----------------------------------------------------------------------------
Page
3
4.0
Financial Statements------------------------------------------------------------------------------------ 37
6.0
Costs--------------------------------------------------------------------------------------------------------- 64
7.0
Budgeting-------------------------------------------------------------------------------------------------- 81
8.0
Budgetary Control---------------------------------------------------------------------------------------- 86
9.0
INTRODUCTION TO ACCOUNTING
1.1
What is accounting
Accounting is defined as the process of collecting, recording, summarizing, and communicating financial information
to owners and other interested parties. Alternatively it can be defined as a method of accumulating financial
information using an organized/ systematic approach involving recording transactions in the books of account (journals
and ledgers), analyzing these transactions, summarizing them and reporting them to various users including owners by
way of financial statements. Financial information is an output of the accounting system.
Recording transactions in the books of account constitutes BOOKKEEPING. Keeping accounts and generating
financial reports and information from these accounts for various purposes is ACCOUNTING. In other words
accounting is broader than bookkeeping.
Accounting takes place in an organizational context. It is carried out in all sorts of organizations. They can be
businesses or non-businesses. Although the growth of accounting information is closely associated with economic
progress it is not exclusively found in business contexts.
1.2
Purpose of accounting
The purpose of the accounting is to provide information to users to enable them to make decisions. That is the
information provided enables the users to answer a number of questions such the following:
What does the entity own at a particular time?
What does the entity owe other parties ?
How is the entity financed?
How has the entity performed over a specified/given period?
What is owed to the entity by other parties?
Accounting information is required for a variety of reasons such to fulfill legal requirements and to assist managers to
plan, control and make decisions.
Accounting information is of interest not only to the entity but also to other users such those specified below.
1.3
1.4
Directors and
Managers
Employees
Lenders
Customers
Suppliers
Governments
Tax authorities
Unions
Competitors
Local
Communities
Analysts and
Advisors
Regulatory
Agencies
The general
public
1.5
Regulatory Framework
The maintenance of accounts and production of financial reports from those accounts has to be done according to
accounting rules (also called accounting principles) and financial reporting standards established by the Accountancy
Profession.
The standards are enforced by Professional bodies such as the Zambia Institute of Chartered Accountants (ZICA) in
Zambia, the Association of Certified Chartered Accountants (ACCA), Chartered Institute of Management Accountants
(CIMA), Institute of Chartered Accountants in England and Wales (ICAEW) AND OTHERS in the United Kingdom
(UK). With effect from 01/01/2005 the International Accounting Standards Board is responsible for the issuance of the
International Financial Reporting Standards (IFRSs). Accountants are required to observe these standards in the
preparation and presentation of the financial reports.
In Zambia accounts produced by companies and /or corporate bodies are required by the Company Law or by Statutes
establishing those corporations. Such companies or corporations have to observe the legal requirements and the
requirements of the Accountancy profession when preparing the accounts and the financial reports.
Financial Information for Managers
Managers are one of the users of accounting information. They are responsible for managing organizations. They plan,
organize, direct, coordinate, communicate, staff and control. In short managers plan, control and make decisions. They
are responsible for achieving organizational objectives. Managers need information to do their job. The information
needed for planning, control and decision making is financial and non financial. Financial information is derived from
the accounting or financial system of the organization. It comes from accounts that are maintained in the organization
or the accounts provide the data which when analysed will be financial information. The accounting information is
about assets, liabilities, capital, reserves, revenues and expenses. It is about cash flows of the organization.
Questions
1. State 10 users of accounting information. and indicate the type of information they need.
2.
Explain what measures have been instituted to ensure that accounting information is truthful or valid.
Accounting Principles
2.1.1
Introduction
The preparation of financial reports is based on accounting principles or conventions. There are accounting
standards as well which must be observed in the preparation, presentation and disclosure of financial
information in the financial reports. The financial information reported to the various parties must be objective
relevant, understandable, reliable and comparable.
Some of the attributes of the accounting / financial information are explained below.
2.1.2
Relevance
Accounts must be up to date and current and actually used by the reader.
2.1.3
Reliability
The reader must have faith in the information in the accounts and the information must be free from material
error.
It must represent faithfully what it is supposed to represent.
2.1.4
Comparability
Consistency is really the consistency concept, comparable from period to period and within like items in the
same period.
2.1.5
Understandability
Financial reports must be understandable to the user.
Users of accounting information include the following:
Owners (i.e. shareholders)
Creditors
Lenders
Managers
Government including Tax Authorities
Financial Analysts
Investors
Employees
The public
2.2
10
2.2.2
11
2.2.3
2.2.4
Monetary Principle
Money is the basic yardstick or measuring unit for financial reporting.
denominator in which accounting measures are made and reported.
The Kwacha represents a unit of value i.e. it reflects ability to command goods and services.
The Kwacha is a stable unit of value just as a kilometer is a stable unit of measure of distance.
Accountants combine dollar measures of economic transactions occurring at various times during the
life of a firm. They combine K10, 000 cost of furniture purchased in 1968 and the K21, 000 cost of
furniture purchased in 1978 and report the total K21, 000 investment in furniture.
BUT the Kwacha is not a stable unit of value. The prices of goods and services in our economy change
over time.
When the general price level increases the value of money decreases.
general price level rises.
12
Despite the steady erosion in the purchasing power of the Kwacha, Accountants continue to prepare
financial statements in which the value of the Kwacha is assumed to be stable.
Hence financial statements are misleading to the extent that the Kwacha is assumed to be stable when it
is unstable. That is why there are calls for change to replacement costs or current costs as bases for
valuation instead of historical costs.
2.2.5
Objectivity
To attain reliability, there must be objectivity. Measurements that are unbiased and subject to
verification by independent experts e.g. a price established in an arms length transaction are an
objective measure of an exchange value at the time of the transaction.
Not surprising, exchange prices established in business transactions contribute much of the raw material
from which accounting information is generated.
Despite the goal of objectivity, opinions and personal judgment are quite common, e.g. in computing
depreciation expense.
2.2.6
13
2.2.7
Realization Principle
(when to consider that revenue is earned and expenses incurred)
When should an entity recognize that revenue has been earned? Under the accrual concept, revenue is
recognized when it is earned. The earning of revenue is an economic process. It does not actually take
place at a single point in time.
The earning process relates to economic activity. In such a case, accountants do not recognize revenue
until the revenue has been realized. Revenue is realized as follows:
(i)
(ii)
(iii)
When cash is received cash basis of accounting (realized revenue is cash that is received). But
to wait until cash is received to recognize that revenue is earned may be too late.
(iv)
14
Long-Term Contracts
For companies that carry out long term projects revenue is the contract priceThe revenue (contract price) is
known when the construction job is begun. As the job/contact progresses the revenue earned is estimated by
reference to the contract and the portion of the project completed during the financial year. Revenue earned is
determined on the basis of work that is completed in the financial.
Actual Cost
Incomes
1
2
3
600 000
2 000 000
1 452 000
4 052 000
Actual costs as
a % of
estimated total
cost
15
50
*
Portion of
contract price
realized
75 000
2 500 000
1 750 000 bal
5 000 000
Profit
considered
realized
150 000
500 000
298 000
948 000
2.2.8
15
Revenue (the gross increase in net assets resulting from the production or sale of goods and services) is
offset by expenses incurred in bringing the firms output to the point of sale or in earning the revenue.
Therefore, match
Cost of goods sold
The expiration of asset services and
Out of pocket expenditures for operating costs
to the revenue earned in the year or period.
The measurement of expenses occurs in two stages:
i)
Measuring the cost of goods and services that are consumed or expire in generating the revenue.
ii)
Determining when the goods and services acquired have contributed to revenue and their cost
thus becomes an expense.
16
ii)
cost paid to a real estate salesperson by a real estate brokerage office is an expense directly
related to the revenue generated by the salesperson.
Cannot be related to a
specific transaction. They
are overheads for the
period (they are period
costs)
17
2.2.9
Consistency Principle
A particular accounting method once adopted should not be changed from period to period.
It enables users of financial statements to interpret intelligently the changes in financial position and the amount
of net income/loss.
But management can change an accounting method if a different method would better serve the needs of users
of the financial statements.
The auditor will have to report the changes and the Kwacha effect of the change.
Consistency applies to a single accounting entity and increases the comparability of financial statements from
period to period.
18
What is material for one business unit may not be material for another.
2.2.12 Conservatism/Prudence
19
The excessive use of conservatism or failure to apply conservatism may produce misleading information and
result in losses to creditors and stockholders (bondholders/debenture holders).
Examples
Lower cost or market in the valuation of inventories.
Another way of knowing accounting principles is to consider:
Basic concepts
Accounting Conventions
Accounting Procedures
Assets
Liabilities
Capital
Revenue
Expenses
Profit
Transactions
Entity
Recording transactions
Money Measurement
Classifying transactions
Going Concern
Summarizing transactions
Cost
Reporting transactions
Realization
Interpreting reports
Accrual
Matching
Periodically
The Accounting Model Consistency
Consists of traditions, conventions Prudence
and laws that must be followed in accounting. See the diagram beow.
Judgment
Judgment
Conventions
1. Separate entity
2. Money terms
3. Double entry
4. Historic Cost
Traditions
5. Realization
1. Terminology 6. Matching Laws
2. Presentation
1. Disclosure
3. Conservation
2. Security
4. Accounting
3. Consistency
Progression
Judgment
20
Accounting processes involve recording transactions in the accounts as shown in the diagram below:Transactions
(must be
authorized and
approved)
Are captured on
business
documents e.g.
receipts,
invoices, credit
notes,
debit
notes, bank, pay
in slips etc.
Journals, books
of prime entry
e.g. cash book
journal proper, or
general journal,
sales day book,
purchases day
book, returns
inwards book,
returns outwards
book.
Ledger
(Collection of
accounts)
accounts of
assets, liabilities,
capital income
expenses
Internal
Financial reports
For use by
management e.g.
budgets, variance
analysis and
operating
statements (see
costing below).
External
Financial
reports
To fulfill the
stewardship
function of
management
Income
Statements
Balance Sheet
21
Records in accounts are made using the double entry bookkeeping system. Very
simply the double entry bookkeeping system involves debiting and crediting
accounts for every transaction.
Posting
LEDGER
ORIGINAL
INFORMATION
(TRANSACTIONS)
(Journalizing)
CASH BOOK
Collection of
accounts
FINAL ACCOUNTS OR
FINANCIAL
STATEMENTS
(Financial Reports)
LEDGERS
CASH BOOK
SALES LEDGER
BALANCE
SHEET
PURCHASES LEDGER
EQUITY ACCOUNT
22
Date
Transaction
1/1/2003
2/1/2003
3/1/2003
8/1/2003
17/1/2003
18/1/2003
28/1/2003
31/1/2003
Amount in
KMillion
100
5
0.5
4.5
7.8
1.7
10
6.3
3.1
100
5
2.6
14
11.3
3.5
.05
13
0.8
2.3
0.625
0.625
0.4
Solution
Taking each transaction at a time we must identify what account is debited
and what account is credited. This is because the double entry
23
3.4
Date
2003
1/1
2/1
3/1
8/1
17/1
18/1
28/1
31/1
Account Debited
Account Credited
Bank
Cash
Furniture and Fittings
Office equipment
Office supplies
Motor vehicles
Purchases
Cash
Insurance
Bank
Cash
John
Purchases
Bank
Peter
Rent
Purchases
Electricity
Salaries and wages
Salaries and wages
Interest
Loan
Water
Share capital
Bank
Bank
Bank
Bank
Bank
Bank
Sales
Bank
Loan
Sales
Sales
Apollo Mart
Cash
Sales
Bank
Mukuni Wholesalers
Bank
Cash
Wages payable
Loan
Bank
Cash
Amount Km
100
5
4.5
7.8
1.7
35
10
6.3
3.1
100
5
2.6
14.0
11.3
3.5
0.5
13
0.8
2.3
0.7
0.625
0.625
0.4
24
3.5
Bank
100
Bank
1/1
17/1
18/1
Capital
Loan
Cash
100
100
11.3
2/1
3/1
8/1
28/1
31/1
Cash
F&F
OE
OS
MV
Purchases
Insurance
Rent
Bank
Electricity
Balance c/d
211.3
142.275
5
4.5
7.8
1.7
35
10
3.1
0.5
0.625
0.8
142.275
211.3
Cash
2/1
8/1
Bank
Sales
5.0
6.3
18/1
Sales
5.0
16.3
Balance b/d
18/1
31/1
Bank
S&W
Water
Balance c/d
2.3
11.3
2.3
0.4
2.3
16.3
211.3
95.0
Bank
4.5
25
Office equipment
3/1
Bank
7.8
Motor vehicles
3/1
Bank
35
Office supplies
3/1
Bank
1.7
Purchases
3/1
18/1
28/1
Bank
Apollo Mart
Mukuni
10
14
13
37
Insurance
8/1
Bank
3.1
Loan
3/1
Bank
Balance c/d
0.1625
100
100.625
17/1
31/1
Bank
Interest
100
0.625
100.625
Balance b/d
100
John
18/1
Sales
2.6
Sales
8/1
18/1
28/1
Cash
Cash
John
Peter
6.3
5
2.6
3.5
17.4
26
Rent
28/1
Bank
0.5
Apollo Mart
18/1
Purchases
14
Electricity
31/1
Bank
0.8
Cash
2.3
Mukuni Wholesalers
28/1
Purchases
13
Interest
31/1
Loan
0.625
Peter
28/1
Sales
3.5
Water
31/1
Cash
0.4
27
3.6
Balancing an account
To balance an account involves adding debit entries for that account and
also adding credit entries for the same account. The difference between the
bigger sum and the smaller sum is found. and added to the smaller side so
that the smaller side equals the bigger sum. If the debit is bigger than the
credit the difference is added to the credit and vice versa. The totals are
written and underlined. The account balance is described by the side
which is larger. Eg If the debit side of an account is larger than the credit
side of the same account then such an account has a debit balance. The
list of account balances as at a particular time is called a trial balance as at
that date.
Dr
Km
Capital
Bank
Cash
F&F
OE
Motor Vehicles
OS
Purchases
Insurance
John
Loan
Sales
Rent
Apollo Mart
Electricity
Salaries & Wages
Mukuni Wholesalers
Interest
Peter
Water
Cr
Km
100
142.275
2.3
4.5
7.8
35
1.7
37
3.1
2.6
100
17.4
0.5
14
0.8
3
0.625
3.5
0.4
245.1
0.7
13
245.1
28
3.4
Periodic Adjustments
3.4.1 Introduction
The accounting process consists of a series of activities/tasks the
performance of which ensures that transactions are recorded in the
accounts using the double entry bookkeeping system. These transactions
consist of cash and credit transactions as well as correction of errors and
periodic adjustments.
3.4.2
3.4.3
The Adjustments
Various adjustments have to be made to assets, liabilities, income and
expenses in order to provide true and fair information based on the
accounts. The commonest adjustments are:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
Closing stock
Prepaid expenses
Provision for doubtful debts
Unearned income
Depreciation of fixed assets
Accrued expenses
Accrued income
Correction of errors
29
PURCHASES AT COST
ENTITY
SALES AT COST + %
Purchases are goods recorded in the purchases account at the cost incurred
to acquire those goods. Similarly sales are recorded in the sales account at
the selling price.
Recording purchases at cost:
However, it may happen that some of the goods purchased or available for
sale remain unsold. Then there is need to calculate the cost of the stock of
goods which are unsold. This will facilitate the determination of the COST
OF GOODS SOLD. Closing stock can be calculated by either keeping a
perpetual inventory system or physically counting the unsold goods and
calculating their cost.
A perpetual inventory system can be used to determine the cost of goods
unsold. However, it is quite expensive to keep a perpetual inventory
system. That is why it should be done only for very expensive goods.
Alternatively, a physical count of the unsold goods can be carried out.
This is the most common method in our environments.
Some
organizations do stock taking at the end of every month. It is quite
common to come across notices on doors to the effect that a
shop/store/organization is closed for stock taking.
The closing stock is important in the determination of the profit/surplus.
30
31
debtors. When some debtors actually fail to pay then they are written off
as bad debts.
The adjustment is to:
Debit the Profit and Loss Account (or Income and Expenditure
Account)
Credit the Provision for Doubtful Debts (with the amount of
provision)
32
33
XXX
XXX
XXX
Accrued Expenses
Some expenses may accrue during an accounting period. Such expenses are
actually incurred but are not yet recorded in the accounts. The required
adjustment is to bring such expenses in the accounts by:
Examples of accrued expenses are interest on loan, wages that have been
incurred but not yet paid, etc.
Accrued Income
Just as expenses can be incurred but be unrecorded in the accounts it is
possible to earn income which is not yet reflected in the accounts. The
adjustment is to record the income in the accounts by the following entry:
34
Adjust for insurance part of which is prepaid for the next period:
1
Calculate
of the expense appearing in the accounts. K3.1 million *
12
1/12=
K0.26 million.
The journal entry is as follows.
Dr Prepaid Insurance 2.84 million
Cr Insurance
2.84 million
2.
10% of cost
25 % of cost
20% of cost
The physical count of stock revealed that closing stock is K25.7 million.
A journal entry has to be passed as follows.
Dr Stock
K25.7 million
Cr. Trading account K25.7 million
4.
Other income in January 2003 arose from the sale of sundry goods on
credit to various customers K5.8 million.
A journal entry is passed as follows.
Dr. Debtors
Cr. Other income
5.
K5.8 million
K5.8 million
35
The accounts affected by the above adjustments are adjusted as appropriate. See below.
Insurance
Balance
Balance b/d
3.1
31/1
Prepaid Insurance
Balance c/d
3.1
0.26
2.84
0.26
3.1
Prepaid Insurance
31/3
Insurance
2.84
Depreciation F & F
31/1
Depreciation F & F
0.0375
Depreciation OE
31/3
0.1625
Depreciation
31/3 Provision for depreciation
Depreciation
0.1625
Motor Vehicles
0.583
36
0.583
Stock Account
31/1
Trading
5.7
Trading
31/1
Stock
5.7
2.3
0.7
3.0
3.0
0.7
Km
2.6
3.5
5.8
11.9
Creditors schedule
Apollo Mart
Mukuni Wholesalers
Shown in the balance Sheet
Km
14
13
27
37
ASSIGNMENT
Why are adjustments made in the accounts?
Give five examples of the adjustments made in the accounts of a company.
4.2.1
38
Production costs
39
PERIOD
Income Statement
Income
Expenses
Surplus/ (deficit)
500
(570)
(10)
1980
(1700)
280
2590
3000
(410)
3240
2700
5600
4780
4370
3960
540
820
410
Balance Sheet
Assets
Liabilities
Owners Equity (or capital)
550 10 = 540
Loss for
The period
The easiest way to comprehend this is to say the retained profit is equal to
the opening net profit or loss plus/(minus) the net profit or loss for the
40
current period in order to end up with the closing net profit or loss which
is added to or subtracted from capital.
Alternatively, liabilities and capital can be on the left hand side and assets
on the right hand side. Presenting it either way does not violate any
accounting principle because the Balance Sheet is not an Account.
However, the format in one period must be followed consistently in other
periods to facilitate comparison between periods. Balance Sheets are
prepared conventionally by categorizing assets and liabilities into current
(or short term) and long-term categories. Thus for assets, we have:
Current Assets and Fixed Assets. Current Assets are short-term
possessions of the company, which form part of working capital i.e. pool
of resources used to meet short term obligations.
To emphasize an asset is a possession, which has value to the company.
When that possession is of a short term nature, it constitutes a current
asset. Thus our figures for assets, cash in hand and at bank, debtors, office
supplies, prepaid insurance are current assets. These assets will change
their present form within one year or less. For instance, cash/bank
balances will be used to purchase stocks/inventories, which in turn will be
used up and change their form. Thus motor vehicles, furniture and office
equipment will be used up in company operations. The debtors will pay
cash to the company and cash will increase. The bank balances will
ultimately be reduced as cash is drawn from the bank. Office supplies will
be consumed when writing letters. New assets will be purchased and
become current assets. Cash and bank balances also fluctuate as they are
used to pay for assets, expenses and liabilities.
Current Assets circulate in the course of the year. Hence they are also
called CIRCULATING ASSETS. As a group, current assets are part of
working capital money which keeps the company operating.
NON CURRENT OR FIXED ASSETS
Assets classified as fixed are retained for use in the company. They have
an economic life during which they are useful to the company. They are
used by the company for a number of years.
The distinguishing characteristic of fixed assets is that they wear out or are
subject to wear and tear as they are employed. Depreciation represents the
systematic spreading out of the cost of fixed assets over their useful lives.
It is important to note that depreciation is an expense (cost of resources)
like any other expense. The only difference with other expenses is that
depreciation does not involve an outflow of cash. It is a non-cash
expense.
41
From our balance sheet the following are fixed assets: motor vehicles,
furniture and office machinery. Depreciation already written off from a
fixed asset is reflected in a separate account called provision for
depreciation e.g. any depreciation written off from vehicles account will
be credited to the provision for depreciation for motor vehicles. Each time
depreciation is written off, the debit goes to a depreciation expense
account, which will then be shown in the Income Statement/Profit and
Loss Account.
So there will be a provision for depreciation account for each fixed asset.
When presenting fixed assets on the balance sheet the credit balances in
the provision for depreciation accounts for the fixed assets are deducted
from the (gross) figure of the asset to which they related to give the net
book value of each fixed asset. See the balance sheet above.
CURRENT LIABILITIES
Liabilities are obligations on the part of the company to pay other
entities/parties such as people, other companies, government, ZRA or any
other organization. When that obligation has to be settled in the short term
(i.e. within a period of up to one year) that obligation is called current
liability. To settle the obligation current assets in the form of cash or bank
balances are used. Thus the following obligations are current:
Apollo Mart
Mukuni Wholesalers
Accrued wages
K14 million
K13 million
K0.7 million
42
Some liabilities are payable after more than one year e.g. 2 5 years or
more. Such liabilities are distinguished from current liabilities. They are
called long term liabilities. Such obligations usually carry interest charges
to compensate the lenders for parting with their money for an extended
period of time.
OWNERS EQUITY
The difference between assets and liabilities is called owners equity or
capital. This quantity represents what the owners put in the company
originally or what the owners have left in the company after offsetting
liabilities from assets. The capital originally contributed as well as
additional investments plus any profit not distributed to shareholders as
dividends or less any loss will be shown as capital or owners equity.
Assets = Capital + Liabilities or Assets Liabilities = Capital.
This is the accounting equation.
4.2.3
The Cash Flow Statement should include all reporting entitys inflows
and outflows of cash and exclude any other transactions from the cash
flows.
43
An entitys cash flows should incorporate a list of cash flows for the
period classified under the following standard headings:
Taxation
Financing
Definitions
i.
Cash
Includes:
Cash in hand and deposits repayable on demand with any
qualifying financial institution eg a commercial bank, less
overdrafts from any qualifying financial institution eg a
commercial bank repayable on demand. Deposits are repayable
on demand if they can be withdrawn at any time without notice to
the bank and without penalty or if a maturity or period of not more
than 24 hours or one working day has been agreed.
Cash includes cash in hand and deposits denominated in foreign
currency.
ii.
Cash Flow
An increase or decrease in an amount of cash.
iii.
Equity Dividend
Dividends relating to equity shares (i.e. shares other than nonequity shares.
iv.
Liquid Resources
44
(b)
(i)
(ii)
v.
Net Debt
The borrowings of the reporting entity together with related
derivatives and obligations under finance leases less cash and
liquid resources.
Where cash and liquid resources exceed the borrowings of the
entity reference should be to net funds rather than net debt.
vi.
Overdraft
A borrowing facility repayable on demand that is used by drawing
on a current account with a qualifying financial institution.
vii.
viii.
Operating Activities
The principal revenue producing activities of the entity /
enterprise and other activities that are not investing or financing
activities.
ix.
Financing Activities
Activities that result in changes in the size and composition of the
equity capital and borrowings of the entity/enterprise.
x.
Investing Activities
45
Interest received
Dividends received
Cash outflows include:
Interest paid
Cash flows treated as finance costs (e.g. issue costs)
46
Taxation
Cash flows to/from taxation authorities in respect of the reporting entitys revenue and
capital profits.
Other taxes exclude from here e.g. VAT, other sales taxes, property taxes and others.
Taxation cash inflows rebates, claims or returns of overpayments.
Taxation cash outflows cash payments to tax authorities of tax, including payments of
Advance Corporation Tax.
Cash Inflows
Include receipts from sales/disposals of property, plant or equipment and receipts from
repayment of the reporting entitys loans to other entities or sales of debt instruments of
other entities other than receipts from part of an acquisition/disposal or a movement in
liquid resources.
Cash outflows include:
Payments to acquire property, plant or equipment and loans made by reporting entity and
payments to acquire debt instruments of other entities other than payments forming part
of an acquisition or disposal or a movement in liquid resources.
Cash Outflows:
Financing
Financing cash flows comprise receipts or payments of principal from or to external
providers of finance.
Cash flows in this section can be shown in a single section with those under right of
liquid resources provided that separate subtotals for each are given.
48
(b)
Receipts from issuing debentures, loan, notes and bonds and from other short
term borrowings (other than overdrafts).
(b)
(c)
(d)
xxx
xxx
xxx
xxx
xxx
Cash flow from operations can be calculated by the direct method or the indirect
method.
49
Appendix
There are two methods of calculating cash flow from operations
Direct Method
Cash received from customers
Cash paid to suppliers and employers
Cash generated from operations
x
x
x
x
Indirect Method
Net profit before taxation and extra ordinary item (s)
Adjustments for
Depreciation
Foreign exchange loss
Investment income
Interest expense
Operating II before working capital changes
Increase in trade and other receivables
Decrease in inventories
Decrease in trade creditors
Cash generated from operations
x
x
x
(x)
x
x
x
x
(x)
x
The cash from operations can then be adjusted for other items to get cash flow from
operating activities.
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
x
x
x
x
50
5.
51
We shall explain and discuss all the ratios but compute those for which
data are available
Ratios
Liquidity ratios (solvency
ratios)
Profitability ratios
Efficiency ratios
Leverage ratios
Invesment Ratios
Purpose Served
Show projects/organizations ability to
meet short-term obligations.
Gauge projects/organizations profitability
based on sales (or turnover) and investment
in assets.
How efficient operations have been and
how well assets have been used to generate
sales.
Show the extent of debt in financing the
project/organization/company
Show the performance of investment in
shares
To compute the various ratios we are going to use figures from the
financial statements of GMK Limited, which are attached.
Current Ratio
Current Ratio =
K 712 884
Current Assets
=
= 4.0
Current Liabilites K178 200
52
Using liquid assets or quick assets are defined as current assets less
stock the quick ratio or acid test can be calculated. This is a
further indicator of ability to pay it excludes stock which might
take long to sell and get cash.
Current assets less stock are called quick assets. The ratio of quick
assets to current liabilities is called the quick ratio. For GMK this
was:
(b)
K 435 584
K 178 200
= 2.4
Quick assets exceed current liabilities more than 2 times. Once more it is
noticed that current liabilities are more than adequately covered.
Current assets differ in their liquidity, some current assets are more liquid
than others. Stock is excluded from other current assets in order to show
that it is the least liquid of the current assets. It requires time to convert it
into cash and may also lose value. The problem is that by excluding stock
it is implied that stock is worthless. This is not true.
It is a fact that stock takes time to convert into cash or to liquidate it. But
it can never be wholly worthless. Other current assets such as debtors and
cash are more liquid than stock. The ability to pay short-term obligations
is enhanced by how fast debtors pay their debts and the speed of payment
to suppliers.
Therefore, for GMK we can conclude that current assets are adequate to
pay current liabilities even when stock is excluded. However, GMK has
unnecessarily huge amounts of cash. Cash is not an earning asset. Cash
does not earn a return unless it is invested. Therefore, keeping huge
amounts of cash in hand and at bank is not productive. GMK should
consider investing excess cash in short-term investments to earn some
return.
53
(c)
Other ratios Debtors, stock and creditors turnover are also helpful in
the evaluation of the liquidity of an entity.
Ratio
Debtors Turnover
Stock Turnover
Creditors Turnover
Meaning
How fast they pay
How fast stock is bought and sold
How fast they are paid
It is beneficial if debtors pay faster than the entity pays creditors. See
below for computation of these ratios.
(a)
Gross Profit
Gross Profit =
In GMK:
Gross Profit =
K 246 900
100
K 597 800
= 41%
The company earns a gross profit of K41.3 on sales of K100. This means cost of
goods sold as a percentage of sales is 58.7%. It would appear that the level of
trading expenses is higher than gross profit. Since it is out of gross profit that
operating expenses are met and a profit is earned, the gross profit is not adequate.
Trading operations are not profitable.
Therefore, trading operations should be revamped so as to make them more
profitable by generating more gross profit.
54
(b)
Net profit before tax to Sales Ratio. This is obtained by finding the net profit
before tax divided by (net) sales.
Hence:
Net profit before tax to sales =
K115 144
19 %
K 597 800
(Net) sales
= 100%
=
=
58.7%
22.0%
100.0
K 597 800
K 926 384
= 0.65
This shows that K1 of the assets is generating only K0.65 of sales. This is less
than satisfactory. However, if we consider fixed assets only and compute their
turnover, we see that the Fixed Assets turnover is 2.8 as follows:
(Gross) Fixed Assets Turnover
Sales
Fixed Assets
K 597 800
K 213 500
= 2.8
55
K1 of Fixed Assets is able to generate K2.8 of sales. This is much better than
total assets turnover. Since total assets are equal to current assets plus fixed
assets, it would appear that there is excessive investment in current assets in
relation to the level of sales, hence the dismal total assets turnover of K0.65 only.
It is important to look at the ratio of Net Profit before tax in relation to capital
employed which in this case is total assets. This ratio shows the profitability of
the investment in the entity i.e. GMK in this case. This is the PRIMARY RATIO
for an investor.
Earning Power or Return on Investment
K115 144
100
K 926 384
= 12.4%
A return of 12.4 is not satisfactory. Therefore, we can conclude that both the
operations of GMK and the profitability of the investment in it are low. This is a
weak area. Something should be done in future periods to improve this area. The
improvement needs to be planned so that when implemented in the future it will
improve the operation of GMK.
Further analysis can be done by relating the various expenses to sales. When such
relationships between expenses and sales are made over a period of time, a project will be
able to see the trends of expenses over time. Such an insight will be helpful in future
financial planning.
56
(i)
1.3 times
Stock turnover indicates how fast goods are bought and sold. The higher the
turnover, the better because it is only when goods are sold that profit is generated.
It is not good for stocks to take a long time to be sold. The longer goods stay on
the shelf, the more likely they are to deteriorate an fail to be sold. Goods, which
are unsold, represent money tied in stocks. Thus the longer goods take to be sold,
the higher the cost of funds tied in those stocks.
A low stock turnover may be a sign of weakness in stock management.
Another way of looking at the stock turnover is to calculate how long it takes for
stocks to be bought and sold. This is done by the following:
K 277 300
365 days
K 350 900
Average Stock
365 days.
=
Cost of goods sold
= K288 days
Stocks take 288 days or about 10 months to be converted into sales. This is an
extremely long time. Stocks need to move faster than suggested by these figures.
Please note that a very high turnover may also not be good.
(ii)
Debtors Turnover
The speed with which debtors pay their accounts is crucial for cash flow
management in the organization.
Credit Sales
Debtors turnover ratio
=
Debtors
=
K160 900
K 75 000
2.1 times
57
Debtors buy goods on credit and pay for them later. Using figures in the given
financial statements it is clear that debtors take time to pay their accounts.
When debtors pay fast, the debtors turnover is high. What is shown above is that
the debtors are taking a long time to pay because the turnover is low at 2 times.
This can best be understood by calculating how long (i.e. the number of days) the
debtors take to settle their accounts. This is calculated below:
Debtors
Time in days debtors take to pay (the collection period) =
Credit Sales
365 days
=
75 000
365 days
160 900
160 900
365
= 170 days
The level of debtors in relation to credit sales suggests that debtors take as long as 6
months to pay their accounts. As the organizations money is tied up in debtors it has to
borrow money for its operations. Therefore, the management of debtors is inefficient.
Trade creditors ratio =
Trade Creditors
178 200
365 days =
100
Credit Purchases
524 200
= 124 days
This ratio shows the number of days credit is taken from suppliers.
Debtors take 170 days to pay their account but creditors are paid in 124 days. The
desirable situation is to pay creditors later than debtors pay the company. Therefore, the
above situation shows weakness in the management of working capital.
Therefore, the operations of GMK Limited are not efficient. With the same resources,
GMK Limited could earn more revenue and increase the returns on investment.
Net Working Capital Turnover
This turnover measures the efficiency in the management of working capital. An
organization invests in both fixed and working capital. Fixed capital is represented by
fixed assets. On the other hand, working capital represents a short term investment.
Working capital turnover is calculated by:
58
Sales
Sales
=
Current Assets Current Liabilities
Net Working Capital
K 597 800
K 534 684
= 1.1
The higher the Working Capital Turnover, the greater the efficiency in the management
of working capital and the larger the rate of profit generation. However, very high rates
may show a shortage of working capital i.e. there may be overtrading which is not
DESIRABLE to the entity. Too high or too low working capital turnover should be
avoided. Therefore, it is appropriate to establish the right turnover rate, not too low and
not too high.
In the above case, the turnover of 1 is very low which means there is an excessive
investment in working capital. The stocks, debtors and cash i.e. current assets less
current liabilities are excessive. This is not ultimately good for GMK because both stock
and debtors mean a lot of money is tied up in these items. Cash does not earn any return.
Hence very high levels of working capital is injurious to the financial health of the entity.
We have already seen the Fixed Assets turnover. We have seen that it is not satisfactory
either.
It can therefore be concluded that GMK is not efficiently managed. That is why
profitability is low although liquidity and solvency are good. There is need to plan for
the improvement of profitability and efficiency.
59
FIXED ASSETS + NET WORKING CAPITAL = LONG TERM LIABILITIES + OWNERS EQUITY
(INVESTMENT)
(FINANCING)
Leverage ratios are concerned with the extent to which an entity is financed by debt.
Relevant ratios calculated are:
DEBT TO EQUITY RATIO
This shows long-term debt in relation to the funds from owners.
e.g. in GMK: 400 000 : 528 984 = 0.76
Alternatively, DEBT can be related to the TOTAL LONG TERM financing i.e.
DEBT/DEBT + EQUITY
In GMK:
400 000
100 = 43%
928 984
Long-term lenders finance 43% of the long-term funds of GMK Limited. Interest has to
be paid on this debt. This interest is deductible from operating profit (or earnings) in
arriving at the income chargeable to tax. This is an advantage of debt finance compared
to equity. But debt must be used judiciously as excessive debt is risky or potentially
harmful. It (Debt) can lead to an entity winding up its operations as a result of failing to
pay interest or to service its debt.
The ability to pay debt is measured by the number of times profit before interest and tax
is available to pay interest charges. The profit before interest and tax for GMK is K131
800. The interest charges are K20 000. Therefore, the number of times profit before
K 131 800
interest and tax covers interest charges is
= 6.59 or 7 times.
K 20 000
This means that profit before interest and tax can fall 7 times before GMK Limited fails
to pay interest on the loan. GMK is therefore able to service its debt.
Debt in the long term financing of a project/organization/company shows the extent of
financial risk. Excessive debt shows high financial risk. That is interest charges become
burdensome and the company might fail to pay back the debt.
These figures are rough guides. The cover is based on earnings as reported in the profit
and loss account. However, it may be appropriate to assess the firms ability to repay
interest charges on the basis of the firms expected cash flows instead of on reported
operating profits.
There is a view that it is not only the payment of periodic interest but also the periodic
repayment of the principal is important. Hence it is important to calculate the cover
60
taking into account both interest and the annual repayment of the principal by the
following:
Interest and annual repayment ratio =
1
where t = corporation tax rate. The
adjusts the annual repayment to the before tax
i t
basis. This adjustment is made because repayments are out of after tax profits. This
cover shows how many times interest charges and annual repayments of principal are
covered by current earnings before interest and taxes.
For GMK the above cover = 2.6 times assuming an annual repayment of K20 000 per
year for 20 years and a tax rate of 35%.
Dividend yield =
(2)
Earnings yield =
Profit after tax is what is available to shareholders who are existing investors in
the companys shares. Preference shareholders receive their dividends prior to the
ordinary shareholders. Hence the preference dividend is deducted and what is left
is what is available to ordinary shareholders. Even if not all profits made are paid
to the shareholders, profit after tax belongs to shareholders. This yield can be
61
compared with the return obtained by the company i.e. Net Profit after tax divided
by capital employed.
(3)
P/E ratio when the earnings yield is turned upside down (i.e. invested) it gives the
price/earnings (P/E) ratio.
A high P/E ratio indicates that the market expectation is that the companys
profits will rise in the future, and a low P/E ratio shows the opposite. But a
companys share price may fluctuate for reasons other than change in profit
expectations e.g. market expectations of a takeover bid may increase the market
price of shares of a company.
(4)
(5)
Dividend Cover
This is obtained by the following calculation:
Earnings after tax and preference dividend
100
Ordinary dividend
It shows the number of times a dividend goes into the after tax earnings available
to ordinary shareholders.
Once again note that it is not possible to calculate these investment ratios based
on the GMK Limited data/figures. There are no data to use n the calculation of
these investment ratios. These ratios have been explained to make you aware that
investment ratios can also be calculated. In fact, there are newspapers and
magazines, which publish stock market ratios on a daily basis. Where such ratios
exist one should determine what they mean to learn how companies are doing.
62
5.3 CONCLUSION
The overall evaluation of the performance of GMK is that the company is not efficiently
managed although it is liquid and solvent (i.e. it is able to pay its short term debts). It is
not enough to only be able to pay debts.
Profitability requires to be improved. Primarily it would appear that the generation of
sales have to be revamped and the profitability of these sales need to be enhanced.
Management of GMK should focus on improving working capital management.
GMK has substantial debts, but debt is NOT EXCESSIVE. However, the company needs
to improve the use of resources at its disposal.
Finally, it is important to point out that the data we have used in the analysis is over a
very short period, a period of one year. Accordingly some of the conclusions may be
invalid on account of data not being typical of GMK. However, ratios point to something
to be looked into. There is need to consider other information to arrive at more valid
conclusions.
63
UNIT 6 COST S
6.2
Cost Elements
The expenditure making a cost of a product, or a service can be respect
of:
(a)
(b)
(c)
Materials
Labour
Expenses
64
Direct Materials
Raw materials
Components
Consumables
Direct Labour
Wages and other remuneration to all employees who directly contribute to
the conversion of direct materials into saleable products/services. All
associated expenditure paid by the company in employing people
including NAPSA contributions and overtime premium constitute direct
labour costs.
Are expenses other than direct materials and direct labour, which is
directly, incurred in the conversion/transformation process e.g. hire
purchase charges for special equipment used in manufacturing a product.
65
CLASSIFICATION OF COSTS
Materials Used
Wages
Direct
Materials
General Administration
Marketing (Selling &
Distribution) and
Research and
Development
Indirect
Wages
Expenses
Costs related to
other functions
(Non-Production)
Expenses
Materials
Wages
Expenses
Production
Overhead
Prime Cost
Production
Cost
Total Cost
66
Indirect Costs
All those expenditures, which are not direct. They are incurred outside the
production function but enable production to take place e.g. general
administration.
BEHAVIOUR OF COSTS
This is defined as the way in which costs of output are affected by fluctuations in the
level of activity. Costs behave differently when there are changes in the level of
activity.
Variable Costs
These are costs, which vary (i.e. increase or decrease) in proportion with changes in the
level of activity. Variable costs increase when the level of activity increases and
decrease. Variable costs are fixed per unit of product or service. Variable costs are
always presumed to be linear. This may not be strictly true.
K
Variable Costs
Variable
cost per
unit
Fixed Costs
Fixed costs are fixed no matter what happens to level of activity within the relevant
range. Beyond such a range they vary. Fixed costs per unit decrease as output increases.
Fixed costs
Fixed costs
per unit
67
Semi-Variable Costs
These costs comprise both fixed and variable elements. Semi-variable costs increase as
activity increases but not in direct proportion to the increase in activity.
Importance of Classification
The classification of costs into variable and fixed is very useful in break-even analysis.
COST ASCERTAINMENT
Having looked at the elements, characteristics and behaviour of costs, we need to
examine cost ascertainment, that is, to look at some methods used to arrive at the costs of
jobs, products, processes and services.
There are various methods of cost ascertainment. The same method cannot be used to
determine the cost of a new hospital, a computer, a packet of biscuits or a flight between
Lusaka and Dar-es-salaam. The cost unit differs for each of the above products. The cost
unit is important in determining which method of ascertainment will produce desired
result. Due to diversity of production in organization, it may be necessary to have more
than one method of cost determination.
The Need for Cost Ascertainment
Cost ascertainment is known as historical costing because it is concerned with recording
actual costs.
Excessive time-lag between incurring the cost and ascertaining it is usually due to poor
organisation. A well-managed cost ascertainment system produces historical cost that is
very close to the event that effective action for the future can be taken. Cost is
ascertained for a number of reasons. First, cost control. For this to happen, there must
be accurate cost reporting.
Secondly, cost ascertainment is to determine selling price. Having known costs and
having used the cost to help to determine selling price, there is need to measure profit and
profitability. Profit is the difference between revenue and cost. Profitability is the
relationship between profit and sales or capital employed. Lastly, cost ascertainment will
enable an enterprise to decide whether what is happening (as shown by costs) is normal
(i.e. what is expected) and controllable (i.e. something can be done to about it).
Therefore, because of the above reasons, it is crucial to ascertain costs.
68
Costing Methods
INFORMATION
DATABASE
(COST DATA)
SERVICE/FUNCTION
COSTING
JOB ORDER
COSTING
CONTRACT
COSTING
JOB
COSTING
BATCH
COSTING
CONTINUOUS
OPERATION/
PROCESS COSTING
PRODUCT COSTING
69
Job Costing
Job order costing is used where the cost units are relatively small e.g. plumbing jobs in
households by enterprise crew.
The method involves the following:
(a)
(b)
Each Job
(i)
(ii)
Direct Costs
(i)
(ii)
(c)
Absorption rate
K10, 000,000.00
K2, 160, 000.00
K1, 296, 000.00
K13, 456, 000.00
Budgeted overhead
If actual overheads came to K1, 500, 000, there is under absorption of:
70
BATCH COSTING
Batch costing is the application of the principles of cost ascertainment where a batch of
identical units is treated as singe identifiable job cost unit.
Cost per unit =
Materials ordered are specifically for the contracts. They will be charged direct
from the suppliers invoices.
(b)
All labour will be direct including night watchmen and site clerks.
(c)
(d)
Nearly all overheads are head office costs, e.g. tender preparation costs, material
procurement and labour administration. They will be a small proportion of the
total costs.
(e)
Plant and machinery costs may be charged either on hourly rate or with the full
plant value and credited with depreciated value.
Architects certificates are prepared periodically after inspection of the work. The details
of the work completed show the value of the work completed at contract price (not at cost
price).
The contractor submits invoices to his customer/client claiming these amounts as
progress payments, enclosing the architects certificate as evidence of work done. The
customer withholds a proportion of the contract value (e.g. 10%) for a specified period
after the end of the contract. The retained money is held back to ensure that the
contractor remedies rectifies defects that are detected afterwards.
A separate contract account should be opened for each contract. Debit this account with
contact costs (materials, labour and overheads, plant and head office overheads). Credit
it with the contract price and many materials, plant and other items transferred from the
contract.
71
Example
CONTRACT 158 (CLIENT KITWE CITY COUNCIL)
K 000
Materials purchased
Materials ex-store
Site wages
Site direct expenses
Plant sent to site
Architects fees
Subcontract work
Head office overheads
Accruals c/d
4421
374
1440
195
480
200
680
180
37
8007
K 000
Materials returned
Plant returned
Prepayment c/d
Stock at site c/d
Plant at site c/d
Cost of work certified c/d
Work in progress c/d
86
130
11
124
205
7080
371
8007
72
L
E
Materials
M
Loss
(Normal)
N
T
Labour
S
O F C OST
Loss
Overhead
(Abnormal)
PROCESS
Work in Process
Scrap
By-product
Joint products
73
PROCESS COSTING
Process costing is where identical/homogeneous cost units are produced e.g. beer, juices, chemicals and fuel.
PROCESS ACCOUNT
Previous process
Materials:
A
B
Labour
Direct expenses
Overheads
Litres
30 000
K 000
15 000
Litres
Next Process 35, 000
K 000
34 500
20 000
10 000
10 000
10 000
20 000
600
3 000
586 000
Losses:
Normal
18 000
Abnormal
4 000
Closing stock 3 000
12 000
11 290
810
60 000
58 600
60 000
74
BUSINESS
Brewing
Brick making
Coal mining
Electricity
Engineering
Water
Gas
Paper
Petroleum
Sand and gravel
Steel
Timber
Transport (Railway)
Airline
Hotel and Catering
Professional Service (accountants,
architects, lawyers, surveyors)
Education
Healthcare (Hospitals)
Activity:
Building service
Credit control
Materials storage/handling
Personal Administration Selling
Telephone service
COST UNIT
Barrel/Hectolitre
1 000 bricks
Ton/tonne
KWH
Contract, job
Cubic metre
Therm
Ream
Barrel, tonne, litre
Tonne/ton/sheet (a) Rolled
(b) Cast
(c) Extracted
100ft/standard/store kilometer/ton
Available tonne km
Room/cover
Chargeable hour
(a) Enrolled student
(b) Successful student
(a) Bed-occupied
(b) Out-patient
Square metre account maintained
(a) Requisition
(b) Unit issued/received
(c) Value issued/received
Employee
(a) K of turnover
(b) Call made
75
6.3
ABSORPTION COSTING
The view is taken that a fair share of overhead costs should be added to
the cost of units produced. This fair share will include a portion of all
production overhead expenditure and possibly administration and
marketing overhead too.
2.
3.
4.
5.
6.
7.
76
Example
At the start of period 1, no stocks
Period 1
Sales
1200 units
Production
1500 units
V C of production
K4 per unit
Sales price per unit
K6 per unit
FC of which K1500 are fixed K2000
production cost
Period 2
1800 units
1500 units
K4 per unit
K6 per unit
K2000
Sales
Opening stock
Production (F+V)
Less Closing
PERIOD 1
PERIOD 1
PERIOD 2
PERIOD 2
K
7200
K
10 800
-07 500
7 500
(1 500)
1 500
7 500
9 000
(6 000)
1 200
(500)
700
Gross Profit
Less FC
Net Profit
TOTAL
K
18 000
1 500
15 000
16 000
(1 500)
(9 000)
1 800
(500)
1 300
(15 000)
3 000
(1 000)
2 000
1 500
K1 per unit
1 500 units
Definition
A marginal cost is the variable cost of one unit of a product or a service
i.e. a cost which would be avoided if the unit was not produced or
provided.
2.
77
3.
Administration
Sales
Distribution
Marginal Cost of Sales
4.
Marginal Costing
5.
ii)
iii)
iv)
v)
Contribution/Sales Ratio
78
Since contribution per unit is the same at all sales volumes, given
no change in the unit sales price, there n=must be a consistent
relationship between contribution and sales i.e. Profit per volume
or P/V ratio or contribution margin ratio.
MARGINAL COSTING P & L
Sales
Opening stock
Variable
Production Costs
Less Closing stock
Contribution
FC (Prod + Sales)
PERIOD 1
PERIOD 1
PERIOD 2
PERIOD 2
K
7200
K
10 800
-06 000
6 000
(1 200)
1 200
6 000
7 200
(4 800)
2 400
(2 000)
400
TOTAL
K
18 000
1 200
12 000
13 200
(1 200)
(7 200)
3 600
(2,000)
1 600
(12 000)
6 000
(4 000)
2 000
Identify VC
C
FC
VC
FPC
FC
C
MC
=
=
=
=
=
Absorption
Costing
At full production cost
including a share of
FPC
Cost of sales include
some FC incurred in
the previous period and
will exclude some FC
incurred in the current
period
No need to distinguish
MC from FC
VARIABLE cost
Fixed Production Cost
Fixed Cost
Contribution
Marginal Cost
79
K
TR
Profit
Income and costs
TC
FC
FC
P VC
Where:
Q
FC
VC
P
=
=
=
=
FC
Contribution Ratio
80
Where
Q = Break-even point in Kwacha
Contribution ratio =
Contribution M arg in
100
Selling Pr ice
UNIT 7 BUDGETING
Definition of budget and budgeting
A budget is a financial plan for a future period. It is prepared taking into
account objectives to be achieved, and resources to be employed to
achieve those objectives.
A budget is useful in all organizations. The degree of sophisication of the
budget differs as between organizations. Its use is similar in all
organizations. It is a planning and control tool for managers.
81
82
Budget Manual
The budget manual sets formal procedures for the preparation of budgets
and use of budgets.
Stages in the Budgeting Process
The first stage in the budgeting process is to communicate policy guidelines for
the budget period and identify the limiting factor.
Sales Budget
Having communicated the policy guidelines including the limiting factor, the
sales budget will be prepared by specifying the products and quantities budgeted
to be sold and the respective selling prices. The sum of the budgeted sales
revenue for all products will sum up to the budgeted sales revenue for the whole
firm.
83
84
OPERATING BUDGET
Sales Budget
Production Budget
RMB
LB
C G S Budget
S&DEB
MB
Budgeted B S
85
METHODS OF BUDGETING
Budgets can be prepared using a number of methods.These are
INCREMENTAL BUDGETING
ZERO BASE BUDGETING and
ACTIVITY BASED BUDGETING
ACTIVITY BASED COSTING
Activity based costing provides for a means of associating resource consumption with
products, which is made more rigorous and sophisticated than the conventional approach
(i.e. the traditional budgeting system). It highlights not only the res inputs (costs) but
also the outputs in terms of the cost drivers. Usually the cost drivers are expressed in
non-financial terms, such as the volume of purchase. Order or the level of service
provided.
Activity Based Budgeting links the proposed res inputs and the expected outputs for the
forthcoming period. Activity Based Budgeting also recognizes that (non-volume-related)
some resources will be required for activity sustaining (non-volume related) as distinct
from activity variable resources (activity variable resources are driven directly by the
level of output of that particular activity).
An activity based approach means that resource inputs must be justified in relation
to each activity e.g. if an activity has been identified as non-value added, but it has
proved impossible to eliminate this activity in the short term, there would be no
question of increasing the resources.
Plan
Evaluate
Implement
Monitor
Budget
Actual Results
Corrective action
(where appropriate)
Variances
Reasons for
variances
86
IDEAL STANDARDS
Too difficult targets result in adverse V when compared with actual. Managers and employees will not try to achieve too
difficult targets because they can never achieve them. Hence the difference between budget and actual expenditure will always
be adverse. Too difficult targets do demotivate.
LOW STANDARDS
These are standards that can be easily achieved so that comparing actual results with
budgeted will always result in favourable variances.Low standards do demotivate
employees.
ATTAINABLE STANDARDS
Attainable standards are difficult to achieve but they can be achieved.They motivate.
Easily achievable targets do not motivate either. They demotivate. Such targets do not
call for extra/additional effort to achieve them. They do not challenge. Therefore, when
interpreting /investigating Varinces, one should always bear in mind:
87
(i)
(ii)
The level at which standards or targets are set affects motivation. Both too easily
attainable targets and too difficult to achieve targets demonstrate.
Budget costing is applicable to both the private and the public sector. It may/may
not be linked to standard costing. When linked to standard costing and attainable
standards, are used the budget will then tell you what the costs should be.
BUDGET REPORTING
In budget costing system feedback reports consists of provision of information with actual results or actual performance and
the computation of variances. Such information should be relevant to the recipients or the responsible managers. It should be
timely and be reliable, at appropriate level of detail and cost effective.
Relevant
Timely
Reliable
Cost effective
At appropriate level of detail detailed at low level of management; summarized at higher levels.
Engineered costs
Discretionary costs
Committed costs
Efficiency
Effectiveness
Economy
88
Managers are responsible for the activities over which they exercise control.
Managers should strive to achieve goals and objectives that have been established
for their responsible centres.
Managers participate in establishing the goals and objectives against which their
performance will be measured.
Goals and objectives are attainable with efficient and effective performance.
89
Flexible Budgets
Production (units)
K
DM
DL
Maintenance
Depreciation
Rent & Rates
Other costs
Total
Budget
2000
K
6 000
4 000
1 000
2 000
1 500
3 600
18 100
Actual
3000
K
8 500
4 500
1 400
2 200
1 600
5 000
23 200
Variance
1000
K
2 500 U
500 U
400 U
200 U
200 U
1 400 U
5 400 U
(a)
2 000
K
6 000
4 000
1 000
Flexed
Budget
(b)
3000
K
9 000
6 000
1 500
Actual
Results
(c)
3 000
K
8 500
4 500
1 400
Variance
(b c )
K
3 600
4 600
5 000
400 U
2 000
1 500
2 000
1 500
2 200
1 600
200 U
18 100
24 600
23 200
Fixed
Budget
Production (units)
Variable costs
DM
DL
Maintenance
K
500 F
1 500 F
100 F
Semi-Variable Costs
Other costs
Fixed Costs
Depreciation
Rent & Rates
100 U
1 400 F
90
UNIT 9.
Cash
Payments
Collections
Creditors
Debtors
Purchases
Raw materials
Sales
Finished goods
Completion of production
Production
Work-in-progress
Current liabilities and part of long term liabilities becoming current have to be settled
using liquid resources (i.e. cash and bank balance).
This whole process of ensuring that there are adequate liquid resources to settle short
term obligations adequate stocks, giving credit to credit worthy customers, using short
term resources profitably requires to be managed. Working capital management entails
managing current assets and current liabilities.
Sound financial management requires that short term assets be financed by short term
funds whilst fixed assets are financed with long term funds.
91
Short term funds tend to be cheaper than long term funds but carry renewal risk. They
may not be renewed by the bank. Eg overdraft. When a company uses overdraft to fund
its assets or operations the bank can demand immediate settlement of the overdraft.
Alternatively the overdraft may be withdrawn by the bank at short notice.
Long term funds are more secure but more expensive. They are not available to the
lender for a long time whilst they are being used by the borrower.
The financing policy for working capital is normally revealed by a firms current and
quick ratio. The current and quick ratios indicate a firms ability to pay short term
obligations or current liabilities. Generally if a firm is unable to pay its short-term
liabilities suppliers might force it to be wound up.
The higher the current ratio e.g. more than 2 to 1 the more conservative (or less
aggressive) the company is with its working capital policy or in its working capital. A
high current ratio means that the firm has more current assets for every kwacha of current
liabilities. A lower ratio shows an aggressive working capital policy.
Methods of managing (controlling) the components of working capital are discussed
below.
Management of Stock
A firms stock includes raw materials, work in progress and/or finished goods.
Stock of raw materials, work-in-progress and finished goods are necessary to enable a
firm to continue its operations. Raw materials are required for input into production.
Work-in-progress has to be completed into finished goods. The latter is available for sale
to customers who wish to buy them. Stocks are therefore required for sustaining
operations of the company- production operations as well as sales operations.
Managing stock involves ensuring that the money tied in stocks is not excessive and
addressing problems relating to stocks.
Advantages of holding stock
Discounts for bulk buying can be obtained from suppliers / be given to customers
Reduction in total annual order costs (order costs are fixed)
Continuity of supply/of production (avoidance of stock outs and hence avoidance
of loss of goodwill of customers and to ensure continued production).
Investment value in stocks ensure that the investment in stocks is optimized
which means that not too much/not too little money is tied in stocks.
Disadvantages of holdings stock
92
To optimise the investment in stock a firm should buy stocks in economic lots i.e.
purchase stocks utilising the basic EOQ model (see below).
Example.
Demand for one of X plcs products averages 1000 units per month. It costs K60 000
each time a delivery of goods is received/to order the product from a supplier and K4 000
per unit per year to store a unit.
How many units should the company order at a time to minimize total cost?
Solution:
EOQ
2 DC
h
Where,
D =
C =
h =
D =
C =
h =
Annual demand
Ordering costs
Cost of holding one unit per year using the above information
12000 units (1000 x 12 months)
K60,000
K4000
the EOQ is
EOQ
2 1000 12 60000
4000
= 600 units
Derivation of the EOQ Formula
The formula for the EOQ can be derived as follows:
93
Let h be holding costs. h(I,e, cost of holding 1 unit stock for 1 year (often includes an
element of cost of capital.)).
Let c be ordering costs; (Costs incurred for placing an order for units of the item to be
stocked).
Let q be the Economic Order Quantity (EOQ)
Let d be the annual demand (in units)
Total holding costs are : Q h
2
Total Ordering costs are
DC
Q
Q h + DC
2
Q
The objective of controlling stock is to minimise total costs consisting of costs of keeping
the stock in the firm and ordering it when more is required.
Total costs are minimised when the change in total cost as quantity orders.
dTC = 0 (The change in TC as Q changes is equal to 0)
dQ
dTC = h DC
dQ
2 Q2
Set h - DC = 0
2
Q2
Multiply by 2 throughout
h 2DC = 0
Q2
Multiply by Q2 throughout
Q2h 2DC = 0
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2 DC
h
Q
2
h = Qh
2
Recorder level (ROL and Buffer Stocks)
1.
If there is constant demand and zero lead time, the Recorder Level is zero.
i.e. ROL = Zero
2.
3.
95
Assess credit worthiness of new customers (make use of credit rating agencies
which exist).
96
Institute a debt collection policy inducing the use of Debt Collection Agencies.
Use a Factor
A factor is an outsider who offers a service at a cost.
Services offered by a factor: include:
1.
2.
3.
4.
97
Examples
1. Debtors
800,000
800.000
000
25
70
Discount 8m x 60% x 2%
(96)
Debtors
Current
Proposed
800 000
8000000 x 20.6
41.819
40.819
======
451.507
98
365
Proposed
Current
8000
8 000 000 x 365
=36.5 days
60% x 10 days
= 6.0
Example 2
Effect of policy change on current ratio
Liquidity ratio
Employing a factor
Vs
Offering a discount
= Current Assets
Current Liabilities
99
CASH MANAGEMENT
Cash Float Refers to money tied up between the time when a payment is
initiated by a debtor and the time when the funds become available for use in the
recipients effect from the bank account.
Reasons for cash float (i.e a cash float arises from):
1.
Transmission delay
2.
Lodgement delay
3.
Clearance delay
Measures to reduce the float
The cash float can be reduced by:1.
Depositing cheques for collection on the day of receipt
2.
Arranging for collection of cheques from customers
3.
Including a bank credit slip on the bottom of invoice so that the debtors banks
the payment
4.
Using bankers Automated Clearing Services Ltd (BACs) whereby you can
transfer funds between banks, (e.g. for salary payments).
5.
Using clearing House Automated Payment (CHAPS). Same day settlements,
minimum payment 10,000.
USING THE INVENTORY MODEL IN CASH MANAGEMENT
Cash Management Models can be used to indicate the optimum amount of cash that a
company should hold at any one time so as to be able to meet obligations as they arise.
Drawbacks
The Baumol Model has some drawbacks
1.
2.
3.
Q
Where
i
Q
=
=
of
100
Upper
Limit
---------------------------------------------------------------------------------Return Point
Sells securities
------------------------------------------------------------------------------- Lower Limit
Time
Setting of upper limit, lower limit and return points is dependent on:
i)
ii)
iii)
101
The objective of using Cash Models is to indicate minimum and maximum levels of cash
holding in order to minimize the cost of holding idle cash balances and maximize interest
earned on surplus funds.
Spread
Tax There may be interest on delayed tax payments provided it is lower than
interest on bank loans
2.
3.
102
4.
Debtors
-
Creditors
-
Stock
-
Constant rate?
Order Stock according to demand?
5.
6.
7.
)
)
Sources of finance
8.
Adopt cost control & cost reduction. Cost reduction is better than cost
control
9.
103
Appraisal
Appraising a project is evaluating/ determining the worth of the investment. It is
calculating the cash inflows and comparing them to cash outflows so as to find
out whether the project is viable.
Evaluating whether an investment is worthwhile is determining whether the
investment is viable? Does it generate more cash inflows than cash outflows.
Companies have to look for investment opportunities and invest in viable ones so
as to generate wealth for shareholders. Companies should invest shareholders
money in those projects which are viable so as to make money for them. Project
appraisal is necessary because investment decisions involve a lot of money which
is tied for a number of years. Such decision once made and money invested are
irreversible.
8.1
104
The average
It ignores the time value of money (TVM) like the accounting rate
of return.
It ignores all cash flows arising after the payback period.
105
FV
FV (1 i ) n
n
(1 i )
FV
1
can be re-written as FV
.
n
(1 i ) n
(1 i )
There are tables for present values or present value factors expressed as
(1 i ) n . The tables have the following structure:
i
%
n
1
2
3
4
5
6
7
.
.
.
n
1
2
3
4
5
6
.
n
106
The expression
1
is the present value factor.
(1 i) n
Year Investment
KMillion
Cashflows
KMillion
Present Value
Factors @ 10%
25
1.000
0.909
(100)
22.725
30
0.826
24.78
40
0.751
30.04
65
0.683
44.395
0.621
0.564
0.513
43
0.467
0
1
(100)
Present value
KMillion
The sum of positive present values minus the investment will give the net present value
(NPV). If the NPV is positive the investment is viable it should be undertaken. If it is
negative the project should be rejected.
107
IRR= Ra +
NPV
IRR
Ra
Rb
108