«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
What are the questions you would want to ask the trainee accountant in order to satisfy yourself that the budget was realistic and achievable? Can you identify any errors that have been made in the budget or cash forecast? If so, make any corrections that you think are necessary and comment on any problems you have identiﬁed.
This question particularly relates to an understanding of Chapter 14.
Case study 8: White Cold Equipment PLC
White Cold Equipment (WCE) makes refrigeration equipment for the domestic market. It sells all its production wholesale to a large retail chain. WCE’s budget versus actual report for a recent month was as in Table A3.10.
Management was concerned about the signiﬁcant shortfall in proﬁts of £8,550 and asked the ﬁnance director for more information. The ﬁnance director produced a revised report (Table A3.11) based on a ﬂexible budget.
CASE STUDIES 455
The above report showed that by adjusting the budget to the actual volume of production/sales, the proﬁt was £2,950 higher than expected. The ﬁnance director also produced a variance analysis (Table A3.12).
This showed that the gross margin was lower than expected for the 1,000 units actually produced by £3,550, but that selling and administration expenses were below budget by £6,500. Therefore, proﬁts were higher than expected for the 1,000 units actually produced.
On receipt of the ﬁnance director’s report, comments were sought from the operational executives.
This question particularly relates to an understanding of Chapter 15.
Appendix 4 Solutions to Case Studies Case study 1: Paramount Services PLC It is important to remember that ratio analysis is really only useful to identify trends and comparisons. Trends require more than two years’ data, while comparisons require either budget data or industry/competitor results that can be used as a performance benchmark.
Nevertheless, although the two years’ data is limited, some conclusions can be drawn from the ratios.
Sales growth is high (17.2%) but expense growth is greater (26.9%), suggesting the need to control expenses. Consequently, proﬁt growth (9.4%) has not been maintained at the same level as sales growth. Interest cost has increased due to higher long-term borrowings and consequently the interest cover has fallen, a slightly more risky situation for lenders.
All proﬁtability measures (PBIT/Sales, ROCE and ROI) have fallen, as a result of the above-mentioned reasons. However, dividend payout has increased in total (and consequently per share for a constant number of shares) while the yield has increased, predominantly a result of the fall in the share price. For the same reason (a reduced share price) the price/earnings ratio has fallen.
Asset efﬁciency is constant at 1.2, although Paramount does appear to have a very high level of investment in ﬁxed assets in relation to its income from services.
Days’ sales outstanding have increased signiﬁcantly from 60 days to 76 days, a reﬂection of a credit control problem. Although creditors have also increased, the working capital ratio has increased and is adequate at 1.7. Gearing has increased, but the level of long-term debt is quite low in comparison to the ﬁxed asset investment, an indication that a substantial part of the capital and reserves has been invested in ﬁxed assets, possibly real estate.
Perhaps the major area of concern is whether the large ﬁxed asset investment can be justiﬁed in terms of the business services that the company carries out.
Case study 2: Swift Airlines By separating the controllable and non-controllable costs for the route, which the route manager has not done, we can see the true position (Table A4.1).
ACCOUNTING FOR MANAGERSTable A4.1 Swift Airlines
Contrary to the route manager’s belief, the loss is £480, not £1,305. This is because she did not take account of the per passenger variable cost of £25. This reduces the costs by £825 per ﬂight (120 − 87 = 33 @ £25).
While the additional revenue of £600 would help, the route manager has also overlooked the additional per passenger variable cost of £25. Each passenger would therefore contribute £15 to proﬁts (£40 − £25), a total of £225, although this is only half the loss.
It is important to identify the relevant costs. On a per passenger basis, the relevant cost is £25 as that is the only extra cost to cover the additional fuel, insurance, baggage handling etc. The relevant costs for the Nice destination are the ﬂight costs of £7,500 (£15,000 for the outbound and inbound legs) and £4,000 for the costs that support each route. If the route were discontinued, Swift would save £11,500, particularly as it could reassign the aircraft and crew costs to another route. The £3,000 allocation of business overhead (£6,000 for the return ﬂight) are not relevant costs as those costs would not be saved, but would have to be reallocated to other routes.
Importantly, the route still makes a positive contribution to the recovery of head ofﬁce overheads, which are allocated over each route. The route manager still needs to address the capacity utilization problem and the average price needed to generate a proﬁt on each ﬂight. The average price based on Swift Airlines’ model is £175 (£21,000/120). The average price being achieved on the outbound route is £163.16 (£14,195/87). There is a likely trade-off between price and volume (of passengers).
The breakeven per ﬂight can be calculated based on ﬁxed costs of £12,500 (£7,500 + £2,000 + £3,000) and variable costs of £25 per passenger. A range of breakeven prices can be calculated.
The breakeven price for 120 passengers is:
Using a range of volume/price scenarios, the route manager should be able to present a report to head ofﬁce asking for additional time to reduce the losses, emphasizing the small size of the loss, the positive contribution to head ofﬁce costs being made, and how ﬂexibility in pricing and capacity utilization could overcome the current problem.
Case study 3: Holly Road Farm Produce Ltd
The high cost of redundancy and retraining of skilled employees erode the cost savings. Given the salary differential between agricultural specialists and unskilled labourers (£15,000 compared to £9,000), it would make more sense to make the unskilled labourers redundant and to use the agricultural specialists to do all the work necessary to convert the farm to organic crops. As unskilled labourers have lower salaries the redundancy payments would be less, and as all the agricultural specialists are retained there would be no retraining costs.
Table A4.2 shows the potential cost savings if this strategy were adopted.
This would of course require the agricultural specialists to undertake labouring work,
but in the absence of unionization, their interest in retaining their jobs and on-thejob learning about crop changeover could have a motivational effect, which will also beneﬁt the business. The cost savings of £467,500 exceed the across-the-board redundancy savings by £222,500. Some of this could be paid to the agricultural specialists as a bonus to cover their changed working conditions for the next 12 months.
Case study 4: Call Centre Services PLC The stafﬁng level in the call centre provides a capacity of 60,000 calls (10 staff @ 6,000), but 70,000 calls have been taken. The telemarketing division has subsidized the operations of the call centre.
In the short term, all costs in CCS are ﬁxed costs. The standard cost of a call is £250,000/60,000 calls = £4.17. The standard cost for 70,000 calls is £291,900.
It could therefore be argued that a more accurate presentation of the divisional performance is as in Table A4.3.
Note: Telemarketing expenses have been calculated as total expenses (£440,000) less standard cost for 70,000 calls in the call centre (£291,900).
Table A4.3 Call Centre Services
This shows quite a different picture. However, the telemarketing manager is likely to point out that his staff are paid considerably more than call centre staff (£22,000 compared to £15,000) and that the standard cost is based on a salary of £15,000.
The appropriate stafﬁng for the call centre to handle 70,000 calls is 12 staff (70,000/6,000 = 11.7). Given the recruitment freeze, two of the telemarketing staff costs should be transferred to the call centre. Rental costs are adjusted accordingly.
It is arguable as to whether the lease costs should be allocated 50/50, but in the absence of more information this is left unchanged. The revised proﬁtability is as in Table A4.4.
Whether based on standard costs or a reallocation of expenses between the divisions, the originally reported proﬁt of £100,000 to the call centre and £60,000 to telemarketing is distorted. As the standard cost and reallocation calculations demonstrate, the call centre is making a much smaller proﬁt and telemarketing a much larger proﬁt than originally reported.
Case study 5: Cryogene Corp.
Table A3.6(a) reveals the contribution margins for each product.
These are as in Table A4.5.
Yogen, which has little more than a quarter of total sales, has the highest contribution, followed by Cryod and Genet.
Table A3.6(b) shows the gross proﬁt after allocating the manufacturing overhead of £3,500,000 (which is very high at 83% of the contribution) based on labour hours.
This suggests that Yogen is the only proﬁtable product, with Cryod making a gross loss and Genet almost breaking even. Table A3.6(b) also shows the gross proﬁt after allocating manufacturing overhead based on machine hours. This suggests that both Yogen and Genet are proﬁtable, but that Cryod is making a large loss.
Looking at the information on the right-hand side of Table A3.6(b), we can see that Cryod has the highest number of labour and machine hours, which is why the overhead allocation results in that product appearing to be unproﬁtable. If the high level of manufacturing overhead is a consequence of high labour and/or machine hours, then that result is acceptable. However, if there are other drivers of overheads, such a reported result may be misleading.
Table A3.6(c) shows the allocation of overhead based on activity costing principles, using four cost drivers: purchase orders, batches (set-ups), work orders
(scheduling) and deliveries. Contrary to the position in Table A3.6(b), Table A3.6(c) shows that Cryod makes the highest gross proﬁt, followed by Yogen, whereas Genet makes a gross loss. Looking at the information in Table A3.6(c), we can see that most of the overhead is allocated to the Cryod because, on a cost driver basis, that product is consuming more of the four cost pools of overhead. The activity-based approach provides a more accurate allocation of overheads to products because it looks at the causes of costs rather than allocating overheads on an arbitrary basis, such as labour or machine hours.
Table A3.6(d) adopts a throughput accounting perspective, which treats materials as the only variable cost and identiﬁes the ‘value added’ per unit of the capacity that limits the volume of production.
Assuming that machine hours are the capacity limitation, throughput accounting suggests that the maximum contribution can be achieved from the Yogen, followed by the Genet and the Cryod. It is important to remember that while this information is useful, it does not take into account the overheads that are needed to support each product. Throughput accounting is a valuable tool in making optimum use of capacity, but is not a substitute for the other methods, unless overheads are either relatively insigniﬁcant or difﬁcult to allocate accurately to individual products.
Table A3.6(d) also shows the proﬁtability using a target pricing approach.
Target pricing takes into consideration the capital investment needed to support each product and the cost of capital of the business. Table A3.6(d) shows that the main investments are in the Yogen and the Cryod, which are expected to generate the highest return.
Each presentation of information provides different information. Assuming that activity-based costing provides the most meaningful allocation of overhead costs, then we should maximize sales of Cryods and Yogens. Genets consume more overheads than they contribute. This requires investigation: either the selling price is too low, or costs are too high to support that product. Continued sales of the Genet are likely to reduce the overall proﬁtability of the business. This is despite the low capital investment in the Genet.
The maximum throughput contribution comes from the Yogen and the least from the Cryod. This suggests a need to look at the manufacturing methods for the Cryod to see if productivity can be improved to reduce the number of machine hours needed to make this product.
In terms of target pricing, the gross proﬁt made by the Cryod is almost twice the required return of £300 (10% of £3,000), while the Yogen is a little below target. However, in neither case have non-manufacturing overheads been taken into consideration. This leads to the overall conclusion that overhead costs are very high in the business, resulting in an overall contribution of 45.3% being reduced to a net proﬁt of 1.2% of sales (£110/£9,300). Overhead cost control should be the over-riding consideration of Cryogene Corp. Subject to this and to the above comment about the high number of hours required to produce the Cryod, Cryogene needs seriously to consider dropping the Genet if costs cannot be restructured and increase its sales of the Cryod and the Yogen. It is important to note that if Cryogene used labour hours or machine hours to allocate
SOLUTIONS TO CASE STUDIES 463overhead as the principal measure of proﬁtability, it would be likely to discontinue the Cryod!
Case study 6: Serendipity PLC The ﬁrst comment to be made is in relation to the accuracy of the expected additional cash inﬂows and outﬂows, which are notoriously difﬁcult to assess. The proposer of the capital investment will need to have some information to support the revenue growth projections and expected cost increases.
The ROI calculations are important, although as is common with ‘cap ex’ proposals, the higher ROIs are in later years. A fuller picture may be seen by looking at the average ROI over the life of the investment. Average proﬁts are £560,000 (total proﬁts/5) and average investment is £2.5 million (£5 million/2).
The average ROI is therefore 22.4% (560/2,500).
Given a cost of capital of 8% used in the NPV calculation (which needs to be veriﬁed as the weighted average cost of capital for Serendipity), a residual income approach may also present a fuller picture (Table A4.6).
The total RI over the project is £2 million.
The NPV produces a positive £1.225 million at a cost of capital of 8%. Again, to present a fuller picture, an internal rate of return calculation shows the discount rate that equates to a nil NPV. The IRR is 16.8%, which is double the cost of capital, a more meaningful ﬁgure than the NPV residual value.
Finally, a payback calculation shows that on a cash ﬂow basis the investment is paid back after three years and two months (Table A4.7).
Provided that payback, ROI, RI, NPV and IRR meet any board criteria, the investment proposal appears to be sound, but inclusion of the additional information should assist in obtaining board approval.
Case study 7: Carsons Stores Ltd The ﬁrst set of questions to be asked is how the level of sales was arrived at.
In particular, have the sales been broken down by department/product? Have managers been consulted to see if the budget sales ﬁgures are achievable? Is the seasonal increase over the four quarters consistent with past trends, consumer spending patterns and market share? Does it reﬂect changing prices and competitive trends?
The second set of questions is in relation to the rate of gross proﬁt (264/440 = 60%). In particular, is this broken down by product or supplier? Is the cost of sales consistent with previous trading? Does it reﬂect current negotiations with suppliers? Does it reﬂect changing prices?
The third set of questions is in relation to expenses. Is the salary budget consistent with the headcount and approved salary levels for each grade of staff? Has an allowance for across-the-board (i.e. inﬂation-adjusted) salaries been built in? Have all the oncosts been included? Is the rental ﬁgure consistent with the property lease? How has depreciation been calculated (e.g. the asset value and expected life)? Promotional expenses appear to be 10% of sales – is this consistent with past experience and/or with marketing strategy? Are administration expenses consistent with past experience and any changes that have been introduced in the administration department?
The fourth set of questions is in relation to the cash ﬂow. Are all sales for cash (because there is no assumption about delayed receipts for sales on credit)?
Cost of sales appear to be on 30-day terms, but there is no payment showing for Quarter 1 – the payments for purchases made in Quarter 4 of the previous year have not been included. It also appears from the pattern of payments for purchases that there is no increase or decrease in stock – is this correct given the trend of increasing sales over the year? All expenses have been treated as cash expenses, i.e. no allowance has been made for creditors – is this correct? The inclusion of depreciation expense as a cash ﬂow is incorrect. Have the assumptions as to the timing and amount of capital expenditure, income tax and dividends been checked with the appropriate departments?
An adjusted cash forecast, taking into account the missing purchases ﬁgure (assume £40,000) and removing depreciation as a cash outﬂow, would be as in Table A4.8.
The previous cash ﬂow of £8,000 has been increased by the non-cash depreciation expense of £20,000 and reduced by the omission of the estimated Quarter 1 purchases of £40,000. This results in a negative cash ﬂow of £12,000. Importantly, this raises the question as to whether Carsons has an adequate overdraft facility to cover the negative cash ﬂows in the third and fourth quarters. Due to the errors, this was not disclosed by the trainee accountant’s cash forecast.
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Case study 8: White Cold Equipment PLC While the ﬂexible budget provides a better tool for evaluating manufacturing performance, the business cannot ignore the difference between the budgeted level of sales (1,050 units) and the actual level of sales (1,000 units). The loss of margin is shown in Table A4.9.
The full variance reconciliation is as in Table A4.10. This comes back to the variance in the original actual versus budget report for the month.
In explaining the variances, it must be remembered that WCE can sell all its output and that it has failed to produce (and therefore sell) 50 units. This may be the result of a productivity or a quality problem.
Although 9% fewer materials have been used (90/1,000), this has been at an additional 8% cost (£20/£250). The overall favourable materials variance may be a result of less wastage or a greater productivity of materials used in the manufacture
of the ﬁnal product. However, the adverse labour and overhead variances cannot be ignored.
Labour cost 3.3% less (£5/£150), which may be the result of lower-paid employees or less overtime. However, 5% more labour units than expected have been used (50/1,000). This may be linked to the lower materials usage, which may have caused quality problems. The overhead rate is 2.85% higher (£2/£70) and, as usage follows labour usage, this is also 5% higher (50/1,000).
Consequently, if the change in materials has caused excess labour to be worked, then the favourable materials variance of £4,300 may be more than offset by the adverse labour usage (£7,500) and adverse overhead usage (£3,500), resulting in an overall adverse variance of £6,700. This is offset by the favourable rate variance on labour (£5,250) less the adverse rate variance on overhead (£2,100). The danger is that the adverse usage variances persist while the rate variances are eliminated.
These issues are particularly important if the effect of the variances has been to reduce the actual production volume from 1,050 to 1,000 units! The most important questions are therefore what usage and rates will persist in the future? And is there a quality problem caused by materials that is inﬂuencing labour productivity?
Of course, the actual production situation may be something different to what has been described here. In a real business situation, managers would undertake an investigation into the causes of the material, labour and overhead rate and usage variances. In the absence of such an investigation, the above comments may be reasonable conclusions to draw from the variance analysis.
Author Index The author index contains a list of the ﬁrst-named author only.