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MBA Intensive Seminars 2004. FMA Revision notes. Definition. Accounting is the process of identifying, measuring and communicating financial information about an entity to permit informed judgments and decisions by users of the information. . The Accounting Equation.

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mba intensive seminars 2004

MBA Intensive Seminars 2004

FMA

Revision notes

MBA INTENSIVE SEMINARS 2004

definition
Definition

Accounting is the process of

  • identifying,
  • measuring
  • and communicating
  • financial information about an entity
  • to permit informed judgments and decisions
  • by users of the information.

MBA INTENSIVE SEMINARS 2004

the accounting equation
The Accounting Equation

Assets minus Liabilities equals Equity

A - L = E

Assets equals Liabilities plus Equity

A = L + E

Equity

Capital

Ownership claim

Shareholders’ funds

MBA INTENSIVE SEMINARS 2004

power of accounting
Power of Accounting

“Accounting provides a very selective but powerful representation of the corporate identity..”

“The detailed language of assets, liabilities, costs, profits provide a range of corporate imagery and vocabulary …….”

“Accounting provides the categories through which organisational participants perceive both themselves and the organisation.”

Mike Powers

MBA INTENSIVE SEMINARS 2004

creative accounting
Creative Accounting?

“Things may exist independently of our accounts, but they have no human existence until they become accountable. They may not exist, but they take on human significance by becoming accountable..”

“Accounts define reality and at the same time they are that reality….”

“Accounts do not more or less accurately describe things. Instead they establish what is accountable in the setting in which they occur”

“Whether they are ACCURATE OR INACCURATE by some other standards, accounts define reality for a situation in the sense that people act on the basis of what is accountable in the situation of their action.”

Ruth Hines

MBA INTENSIVE SEMINARS 2004

you will discover
You will discover

That accounting is subjective, partial and potentially misleading

Accountants use language / numbers in a highly technical way

Accounts are a highly stylised story, representation, description of organisational events

Differences between the ‘Accounting World’ and the ‘Organisational World’

Problematic nature of accounting numbers

MBA INTENSIVE SEMINARS 2004

and there s more
And there’s more….

The tribe of accountants takes many forms and lives within all organisations

No such thing as a correct ‘cost’, ‘value’, ‘profit’..it all depends on context

The value of accounting in managing organisations

MBA INTENSIVE SEMINARS 2004

roles of accounting
Roles of Accounting

Improve problem solving / decision making

Manage risks

Trust, Assurance

Educational - learn about organisations

Language of business

Construct, define, measure success/failure

MBA INTENSIVE SEMINARS 2004

roles of accountants
Roles of Accountants

Assisting the internal management of organisations

Complying with external financial reporting, controls and with taxation regulations

Expert consultants on financial and organisational performance

MBA INTENSIVE SEMINARS 2004

financial accounting
Financial Accounting

Accounting concepts

Profit and Cash distinction

Financial statements

Organisational impact

MBA INTENSIVE SEMINARS 2004

hierarchy of accounting qualities
Hierarchy of Accounting Qualities

Decision Makers and their characteristics

Benefits > Costs

Understandability

Decision-Usefulness

Relevance

Reliability

Predictive value

Timeliness

Verifiability

Representational Faithfulness

Comparability & consistency

Feedback Value

Neutrality

Materiality

MBA INTENSIVE SEMINARS 2004

slide12

Transactions

Buy materials on credit from suppliers

Sell goods or services on credit to customers

Pay suppliers

Receive cash

MBA INTENSIVE SEMINARS 2004

slide13

When is profit reported?

When goods or services are sold

NOT

when cash is paid or received

MBA INTENSIVE SEMINARS 2004

slide14

Example: Antiques dealer

Buy 10 chairs for cash $200 each

Sell 6 chairs on credit $300 each

Profit 6 x $100 each = $600

Cash flow = minus $2,000

MBA INTENSIVE SEMINARS 2004

profit not cash
Profit, not cash

Matching Concept – match revenues received with the costs incurred to generate them

Goods received but not paid for –Creditors (Payables)

Goods or services supplied but no cash yet - Debtors (Receivables)

Prudence concept – providing for known / probable losses – e.g. Doubtful debts, Depreciation of fixed assets

MBA INTENSIVE SEMINARS 2004

slide16

Profit, not cashcontd

Customers pay in advance for services extending beyond the accounting period

Company agrees with supplier to buy materials at fixed price for 5 years

Home currency euros, borrow in dollars

Increase in valuation of fixed assets

MBA INTENSIVE SEMINARS 2004

slide17

Change over a period

start

Assets - Liabilities = Equity

During the period

Profit/loss

end

Assets - Liabilities = Equity

MBA INTENSIVE SEMINARS 2004

slide18

Contents of annual report

Financial highlights

Company overview

Chairman’s statement

Chief Executive’s review

Audit report

Financial statements

Notes to the accounts

MBA INTENSIVE SEMINARS 2004

the main financial statements
The main financial statements

Balance

Sheet 1

AS AT

Balance Sheet 2

AS AT

Balance Sheet 3

AS AT

31 Dec Year 1

31 Dec Year 2

31 Dec Year 3

Profit and Loss Account

For period

Profit and Loss Account

For period

Cash Flow Report

Cash Flow Report

MBA INTENSIVE SEMINARS 2004

balance sheet horizontal
Fixed assets

Current assets

Liabilities

Shareholders’ funds

Balance sheet horizontal

MBA INTENSIVE SEMINARS 2004

balance sheet vertical
Balance sheet vertical

MBA INTENSIVE SEMINARS 2004

profit and loss account
Profit and loss account

MBA INTENSIVE SEMINARS 2004

cash flow statement
Cash flow statement

Operating cash flows

plus

Investing cash flows

plus

Financing cash flows

Equals change in cash and bank loans

MBA INTENSIVE SEMINARS 2004

slide24

Creative accounting

What do we want to create?

Less profit?

More profit?

Fewer assets?

More assets?

More liabilities?

Fewer liabilities?

MBA INTENSIVE SEMINARS 2004

creative accounting practices
Creative Accounting Practices

Income smoothing – move profit from one year to another

Changing accounting policies, particularly depreciation, asset valuations

Overstating costs, particularly in regulated industries

Making expenses into Assets - ‘capitalisation’

MBA INTENSIVE SEMINARS 2004

slide26

Off-balance sheet financing , e.g leasing, Sale and buyback, special purpose vehicles

Recognising profits that aren’t really there – foreign exchange rates affecting values of assets and loans

Corporate takeovers – ACCOUNTING MINEFIELD adjusting policies, fair values, goodwill, brands, reorganisation costs……...

MBA INTENSIVE SEMINARS 2004

corporate crime fraud
Corporate crime / fraud

Directors are responsible for preventing crime and fraud

They are required to have a system of internal controls

Who controls executive directors for honesty/? Audit committees, Non-executive Directors, Supervisory Board

MBA INTENSIVE SEMINARS 2004

slide28

Corporate crime/ fraudcontd.

Creating fictitious contracts

Fictitious Assets, inaccurate valuations

Omitting Liabilities, misleading valuations

Raid the employees’ pension fund

MBA INTENSIVE SEMINARS 2004

first steps bc before calculation
First Steps BC (before calculation)
  • Why are you analysing accounts?
  • Who are you interpreting for?
  • When are you interpreting?
  • What are you intending to interpret?
  • Limitations of Financial Accounts

MBA INTENSIVE SEMINARS 2004

always bear in mind
Always bear in mind
  • Preparers of accounts know how people will interpret their accounts
  • Be cynical – assume the accounts are the best possible picture
  • Analysis only as good as original data –
  • Never just use accounts – check from many different sources
  • Accounting terms are different from general understandings

MBA INTENSIVE SEMINARS 2004

however
However….
  • Accounts are main source of systematically produced regulated information
  • Good as it gets
  • Usually reliable – 3rd party verified
  • Follow the same basic rules
  • Most of the information is there (in the small print)
  • You can never eliminate the risk of fraud / criminal misrepresentation

MBA INTENSIVE SEMINARS 2004

analyse accounts to determine
Analyse Accounts to determine

Is the company:

  • Growing?
  • Profitable?
  • Managing its assets effectively?
  • Sufficiently liquid?
  • Financed properly?
  • Able to meet its financial obligations?
  • Viewed favourably by financial markets?

MBA INTENSIVE SEMINARS 2004

financial ratios
Financial ratios
  • Quick and simple check on financial health
  • Small number of ratios gives a picture of the business. Easy to calculate, harder to interpret.
  • Provide a starting point for further investigation.

MBA INTENSIVE SEMINARS 2004

key areas for analysis
Key areas for analysis
  • Profitability
  • Liquidity
  • Asset management
  • Debt management (financial structure)
  • Market value

MBA INTENSIVE SEMINARS 2004

success in making profit
Success in making profit

Return on capital employed

profit sales Profit

_____ x _______ = __________

sales total assets total assets

profitability x efficiency = ROCE

MBA INTENSIVE SEMINARS 2004

managing liquidity
Managing liquidity
  • Can we pay the bills as they fall due?
  • Can we pay the wages of employees?
  • Buy stock (inventory) on credit
  • Sell on credit = accounts receivable
  • Pay suppliers = accounts payable
  • Ideally, match cash flows in and out

MBA INTENSIVE SEMINARS 2004

asset management
Asset management
  • Use fixed assets to earn sales revenue
  • Manage working capital
  • stocks (inventory)
  • debtors (accounts receivable)
  • creditors (accounts payable)
  • working capital cycle

MBA INTENSIVE SEMINARS 2004

financial structure
Financial structure
  • Is it a good idea to borrow?
  • Creates greater risk - interest payments and capital repayments
  • Benefits to shareholders when profits are rising
  • Risks to shareholders when profits are falling

MBA INTENSIVE SEMINARS 2004

advantages of ratios
Advantages of ratios
  • Comparisons are relative to other figures
  • Compare businesses of different size
  • Gives picture of company strategy
  • Financial and trading performance
  • Compare with industry averages
  • Simple summary of complex information

MBA INTENSIVE SEMINARS 2004

reasons for using ratios
Reasons for using ratios
  • Gives summary statistics
  • Helps identify industry benchmarks
  • Input to formal decision model
  • Standardise for size

MBA INTENSIVE SEMINARS 2004

applications of analysis
Applications of analysis
  • Predictions of corporate earnings
  • Construct projected financial statements
  • Predict corporate failure
  • Indicators of financial distress

e.g. Altman’s models, combination of ratios

MBA INTENSIVE SEMINARS 2004

problems with ratio analysis
Problems with ratio analysis
  • No agreement on definitions or specific set of ratios
  • Accounting estimation
  • Data not available
  • Timing of data does not match
  • Differing accounting policies
  • Negative numbers and small divisors

MBA INTENSIVE SEMINARS 2004

limitations of ratio analysis
Limitations of ratio analysis
  • Diverts attention from the underlying information
  • May not give sufficient attention to the notes to the accounts
  • Accounting policies may affect comparison
  • Industry differences

MBA INTENSIVE SEMINARS 2004

creative accounting45
Creative accounting

Could involve:

  • Inflating reported profits and EPS
  • Accounting for losses via balance sheet reserves and all profits through P & L
  • Reporting profits without generating equivalent cash
  • Reporting lower borrowings

MBA INTENSIVE SEMINARS 2004

survival tips for accounting jungle
Survival Tips for Accounting Jungle
  • Read the accounts backwards
  • Read the accounting policies and compare
  • Screen accounts using filters – e.g. high profit low tax, changing depreciation policies
  • Cash is King (or Queen)
  • Assess risk: If in doubt, keep out (or get out)

MBA INTENSIVE SEMINARS 2004

return on capital employed
Return on Capital Employed

Profit before interest and taxation x 100

Shareholders’ funds plus long term debt

  • Often called ‘Operating profit’

Assets minus Liabilities = Equity

  • Total assets minus current liabilities equals

Shareholders’ funds plus long term loans

MBA INTENSIVE SEMINARS 2004

return on capital employed48
Return on Capital Employed

Top line questions

  • What increases/ decreases profit?
  • Sales? Operating Costs?

Bottom line questions

  • Recent increases in assets may not yet have created profit
  • Is there any debt ‘off balance sheet’?

MBA INTENSIVE SEMINARS 2004

return on shareholders funds
Return on Shareholders Funds

(also called Return on Equity)

Net profit after taxes x 100

Shareholders’ funds

MBA INTENSIVE SEMINARS 2004

return on shareholders funds50
Return on Shareholders Funds

Top line questions

  • What increases/ decreases profit?
  • Sales? Operating Costs?
  • Interest charges? Taxes?

Bottom line questions

  • Is the company high/ low geared?

MBA INTENSIVE SEMINARS 2004

net profit percentage
Net Profit Percentage

Net profit after taxes x 100

Sales

  • Often shown as ‘Profit attributable to ordinary shareholders’
  • Sales also called ‘turnover’

MBA INTENSIVE SEMINARS 2004

net profit percentage52
Net Profit Percentage

Top line questions

  • Is gross profit high or low?
  • What are the admin and selling costs?
  • What are the effects of interest and taxation?

Bottom line questions

  • Is the measurement of sales explained?

MBA INTENSIVE SEMINARS 2004

gross profit percentage
Gross Profit Percentage

Gross profit x 100

Sales

Gross profit = Sales minus cost of sales

Cost of sales = making ready for sale

MBA INTENSIVE SEMINARS 2004

gross profit percentage54
Gross Profit Percentage

Top line questions

  • Have sales volumes or prices changed?
  • Have costs of sales changed?
  • Are costs of sales mainly variable or fixed?

Bottom line questions

  • Is the measurement of sales explained?

MBA INTENSIVE SEMINARS 2004

current ratio
Current Ratio

Current Assets

Current Liabilities

Solvency = Ability to meet obligations as they fall due

Working capital = CA minus CL

MBA INTENSIVE SEMINARS 2004

current ratio56
Current Ratio

Top line questions

  • What affects levels of stocks, debtors, cash

Bottom line questions

  • What affects levels of bank borrowing, trade creditors, other short term creditors

Overall - How does the company manage its working capital?

MBA INTENSIVE SEMINARS 2004

quick ratio acid test
Quick Ratio (Acid Test)

Current Assets less Stock

Current Liabilities

Solvency = Ability to meet obligations as they fall due

Cash flow: How does the company manage inflows and outflows of cash?

MBA INTENSIVE SEMINARS 2004

quick ratio acid test58
Quick Ratio (Acid Test)

Top line questions

  • How is the company managing debtors and cash?

Bottom line questions

  • How is the company managing trade creditors and bank overdraft?

MBA INTENSIVE SEMINARS 2004

stock holding period days
Stock Holding Period (days)

Stock x 365

Cost of Sales

  • Change 365 to 12 for a calculation in months.
  • Sales minus cost of sales equals gross profit

MBA INTENSIVE SEMINARS 2004

stock holding period days60
Stock Holding Period (days)

Top line questions

  • Year-end stock or average stock? Use year-end for ease of calculation but check there are no significant changes from start.

Bottom line questions

  • May have to make some approximations to get cost of sales

MBA INTENSIVE SEMINARS 2004

debtor payment period days
Debtor Payment Period (days)

Trade Debtors x 365

Sales

  • Debtors = Accounts receivable (customers who buy on credit terms)
  • Use notes to the accounts to find trade debtors.

MBA INTENSIVE SEMINARS 2004

debtor payment period days62
Debtor Payment Period (days)

Top line questions

  • Average or year-end? Year-end is less trouble but check there are no major changes.

Bottom line questions

  • Are all sales made for credit?Think about the nature of the business.

MBA INTENSIVE SEMINARS 2004

creditor payment period days
Creditor Payment Period (days)

Trade Creditors x 365

Purchases or cost of sales

  • Trade creditors = Accounts payable

(suppliers who provide goods on credit terms)

  • Use notes to the accounts for detail.

MBA INTENSIVE SEMINARS 2004

creditor payment period days64
Creditor Payment Period (days)

Top line questions

  • Average or year-end?

Bottom line questions

  • Opening stock + purchases - closing stock = Cost of goods sold.
  • Should be Purchases but Cost of goods sold is Ok if stocks are constant.

MBA INTENSIVE SEMINARS 2004

gearing
Gearing

Long Term Debt

Long Term Debt plus Equity

  • Look carefully at balance sheet and use notes to accounts.
  • Add Preference shares to Debt
  • Omit Provisions

MBA INTENSIVE SEMINARS 2004

gearing66
Gearing

Top line question

  • What are the sources of finance that create fixed commitments to pay interest and repay capital?

Bottom line question

  • What is the total long-term financing of the business, based on borrowings and equity?

MBA INTENSIVE SEMINARS 2004

interest cover
Interest Cover

Profit before interest and tax

Interest expense

  • EBIT = Earnings Before Interest and Taxation
  • Interest expense: either in profit and loss account or in detailed notes.

MBA INTENSIVE SEMINARS 2004

interest cover68
Interest Cover

Top line questions

  • What is the amount of profit available to ‘cover’ interest payments?
  • Is the company generating sufficient wealth to meet interest payments?

Bottom line questions

  • What is the cost of servicing borrowings?

MBA INTENSIVE SEMINARS 2004

concepts cost and costing

Concepts, Cost and Costing

MBA INTENSIVE SEMINARS 2004

management accounting
Management accounting
  • Integral part of management
  • identify, present and interpret information
  • for strategy, planning and control,
  • for decision taking and use of resources
  • for disclosure to employees
  • to safeguard assets

MBA INTENSIVE SEMINARS 2004

management accounting contd
Management accounting (contd)
  • Internal use within organisation
  • No regulation by law
  • Projections for future
  • Analysis of past
  • Directing attention, planning and control
  • Solving problems

MBA INTENSIVE SEMINARS 2004

slide72

Measuring and analysing performance

Implementing

plans

Examining future

environment

Action plans and budgets

Developing objectives

Operating plans

Formulating strategy

MBA INTENSIVE SEMINARS 2004

importance of costing
Importance of costing
  • Many organisational decisions rely on costings
  • Costing is complex but essential
  • “An accountant knows the cost of everything but the value of nothing” Oscar Wilde

MBA INTENSIVE SEMINARS 2004

describing costs
Describing costs
  • Direct (identified with a saleable unit)
  • Indirect (spread across saleable units)
  • Indirect costs = Overheads
  • How to find a fair way of spreading the overheads?

MBA INTENSIVE SEMINARS 2004

confusing terminology
Confusing terminology
  • Allocate = give all cost to one unit or centre
  • Apportion = share across units or centres
  • Absorb (Absorption) Soak up into the units of output

See page 142 of text book

MBA INTENSIVE SEMINARS 2004

terminology contd
Terminology (contd)
  • What are the direct costs? Allocate these to units of output
  • What are the indirect costs? Allocate to cost centres if we know where they belong.
  • Otherwise Apportion (share) across cost centres.
  • Absorb costs from production centres into products.

MBA INTENSIVE SEMINARS 2004

absorption bases
Absorption bases

Absorb as

  • cost per unit
  • cost per labour hour
  • cost per £ of labour
  • cost per kilo of material
  • cost per machine hour

Different bases give different answers

MBA INTENSIVE SEMINARS 2004

cost behaviour
Cost behaviour

Pairs of classifications

  • Direct or indirect?
  • Fixed or variable?
  • Period or product?

Case: Bus company sends buses to 10 schools for taking children home each day. How does the company describe the costs?

MBA INTENSIVE SEMINARS 2004

direct or indirect
Direct or indirect?

Direct for each school:

Driver’s working time, fuel for bus, bridge tolls

Indirect to spread across all journeys:

Insurance, repairs, maintenance, licences, depreciation, driver’s idle time, holiday pay

MBA INTENSIVE SEMINARS 2004

fixed or variable
Fixed or variable?

Variable change with activity level

Fuel, repairs, bridge tolls

Fixed regardless of activity level

Drivers’ wages, Insurance, Licences,

Maintenance checks, Depreciation

MBA INTENSIVE SEMINARS 2004

period or product
Period or product?

What is the product?

A person-mile.

Product costs

Driver’s time, fuel, bridge tolls

Period costs

Insurance, Licences, routine maintenance, depreciation

MBA INTENSIVE SEMINARS 2004

examples of decisions
Examples of decisions
  • Price setting, tendering for contracts
  • Product profitability analysis
  • Product design modifications
  • R & D management
  • Value Engineering
  • General Cost Management
  • Contracting out / Buying in
  • Plant / Department Closure

MBA INTENSIVE SEMINARS 2004

short term decisions
Short-term decisions

In the short term business can continue if the selling price covers variable costs and makes a contribution to fixed costs.

Contribution = Selling price - variable cost

MBA INTENSIVE SEMINARS 2004

contribution analysis
Contribution analysis

Break even point =

Fixed costs

Contribution per unit

Pay £1,000 rent for market stall. Buy toys for £6 each, sell for £8 each. What is breakeven volume?

£1,000/£2 = 500 toys

MBA INTENSIVE SEMINARS 2004

contribution analysis contd
Contribution analysis (contd)

Sell 500 at £8 = £4,000.

Variable cost 500 x £6 = £3,000

Add fixed costs £1,000

Neither profit nor loss

How many toys to sell for profit of £4,000?

£(1,000 + 4,000)/£2 = 2,500 toys

MBA INTENSIVE SEMINARS 2004

scarce resources
Scarce resources

Sell gardening services and house cleaning.

Contribution per job £10 and £8.

Gardening needs 2 hours per job, House cleaning needs 1 hour per job.

Shortage of labour. Which has priority?

House cleaning £8 per hour, Gardening £4 per hour.

Contribution per unit of limiting factor

MBA INTENSIVE SEMINARS 2004

short term decisions87
Short term decisions
  • Make internally or buy externally
  • Hire own staff or pay agency for outsourcing
  • Keep a business activity going
  • Take on a special order at lower price

MBA INTENSIVE SEMINARS 2004

other factors in decisions
Other factors in decisions

Not just an accounting matter. Consider

  • organisation’s objectives
  • relationship with employees
  • marketing
  • corporate goodwill/ image
  • customer reactions
  • government policies

MBA INTENSIVE SEMINARS 2004

get the costs wrong and
Get the costs wrong and...
  • Set prices too high - lose sales;
  • too low - sell products at loss
  • Lose potentially profitable contracts, win loss making contracts
  • Don’t know where we are making / losing money
  • Continue with loss making products, cut profit making products, sub-optimal product mix

MBA INTENSIVE SEMINARS 2004

get the costs wrong and90
Get the costs wrong and...
  • R & D to create ‘better’ product when none needed
  • Product Design Modifications not done when needed
  • Contracting out production that costs more than internal production
  • Making products that could be cheaper to buy in
  • Close profit-making Plant / Keep open loss making plant

MBA INTENSIVE SEMINARS 2004

different costs for different purposes
Different Costs for Different Purposes

Not a single, universal ‘true’ cost.

Appropriate cost is governed by:

Needs of management

Specific organisational situations

Specific problem to be solved

Available information - pragmatics

MBA INTENSIVE SEMINARS 2004

different costs for different purposes92
Different Costs for Different Purposes

MBA INTENSIVE SEMINARS 2004

costing problem
Costing Problem
  • In contemporary organisations the fixed/variable classification is not relevant
  • Logical impossibility of attributing all costs to products
  • Wrong approach to the problem
  • ‘Solution’ based in the ‘accounting world’ not the ‘organisational world’

MBA INTENSIVE SEMINARS 2004

activity solution
Activity ‘Solution’

Costs don’t drive activities, activities cause costs

Organisations do things that consume resources and (should) create value

Costing should start with what the firm does - activities in organisational world

MBA INTENSIVE SEMINARS 2004

activity based costing
Activity Based Costing
  • What are the activities of the organisation?
  • What resources are used by each activity?
  • How much does each resource cost?
  • Collect cost in ‘cost pools’
  • How does each product or service make use of each activity?
  • Share cost from the cost pools.

MBA INTENSIVE SEMINARS 2004

slide96

Money

cost

Resources

consume

Non-financial

Performance

Analysis

Collect Data

Activities

produce

Outputs

creates

Value

MBA INTENSIVE SEMINARS 2004

benefits of abc
Benefits of ABC
  • Makes visible the activities that drive the costs
  • Prevents misallocation of costs
  • Links costs more closely to responsibility for causing costs

BUT does not save money or generate profit. It only gives more accurate information

MBA INTENSIVE SEMINARS 2004

activity costing is
Activity costing is...
  • Not based on accounting coding structures
  • Not based on accounting time frames
  • Not based on techniques designed to make the accountants life easier
  • Not based on producing Financial Statements

MBA INTENSIVE SEMINARS 2004

short term planning

Short term planning

Budgets and

Budgetary Control

MBA INTENSIVE SEMINARS 2004

what is a budget
What is a budget?
  • Quantified format
  • management plans and strategies
  • for decision making
  • communication medium

MBA INTENSIVE SEMINARS 2004

slide101

Mission/ goals

Financial plans

Corporate objectives

Assumptions

on critical

factors

Assessed market

opportunities/

organisational

capability

Long term

strategy

Long term plans

MBA INTENSIVE SEMINARS 2004

slide102

Long term strategy

Long term planning

Market

opportunities

Organisational

capability

Forecasting

assumptions

Short term strategy

Budget/ short term

planning

Modify

assumptions

MBA INTENSIVE SEMINARS 2004

budget process
Budget process
  • Formalises planning and control
  • Defines goals
  • Goal congruence - brings goals together
  • Authority and responsibility are clear
  • Framework to judge performance

MBA INTENSIVE SEMINARS 2004

slide104

financial

operating

Master budget

Sales budget

Capital budget

+

Cost of goods sold budget

+

Cash budget

Development /design budget

+

Marketing budget

+

Budgeted

balance sheet

Distribution budget

+

Administration budget

Budgeted statement

of cash flow

Budgeted profit and loss

account

MBA INTENSIVE SEMINARS 2004

budget preparation
Budget preparation
  • Start with sales budget (demand driven)
  • Then match with cost of sales
  • Is this a production organisation?

Plan:

inventories of raw materials, finished goods

purchases to cover sales and inventories

MBA INTENSIVE SEMINARS 2004

budget preparation contd
Budget preparation (contd)
  • Is this a service organisation?

Plan service programme, labour needs, materials needed

  • Plan all other operating expenses
  • Plan capital expenditure
  • Bring together in cash budget, budgeted profit and loss account, balance sheet.

MBA INTENSIVE SEMINARS 2004

cash budget
Cash budget
  • Most important part of budget cycle
  • Monthly, quarterly?
  • Cash receipts from operations
  • Cash payments for operations
  • Other cash receipts (new finance, sale of fixed assets)
  • Other cash payments (tax, dividends, interest)

MBA INTENSIVE SEMINARS 2004

fixed and flexible budgets
Fixed and flexible budgets
  • Fixed means that budget is not adjusted later if volumes start to vary
  • Flexible budgets means that budget is adjusted to take account of change in volumes of activity over the period

MBA INTENSIVE SEMINARS 2004

fixed and flexible contd
Fixed and flexible (contd)

Budget variable costs of £200,000 for 5,000 units of output

Actual variable costs are £195,000 for 4,500 units of output

How has manager performed against budget?

MBA INTENSIVE SEMINARS 2004

fixed and flexible contd110
Fixed and flexible (contd)

Appears to have saved £5,000

But budgeted cost = £4 per unit

So flexible budget for 4,500 is £180,000

Performance is £15,000 worse than flexible budget.

MBA INTENSIVE SEMINARS 2004

alternative approaches
Alternative approaches

Easy approach = Last year plus inflation

Zero-based budgeting

  • Start with a clean sheet
  • Justify every item
  • Focus on goals and objectives

MBA INTENSIVE SEMINARS 2004

alternative approaches contd
Alternative approaches (contd)

Activity based budgeting

  • Extension of activity based costing
  • Focus on cost of each activity

Kaizen budgeting

  • continuous improvement
  • budget is achieved if improvements are met

MBA INTENSIVE SEMINARS 2004

not for profit organisations
Not-for-profit organisations
  • Goals and objectives measured differently
  • Need to be cost effective

Planning programming budget system

  • Focus on outputs rather than inputs
  • ‘joined-up’ government

MBA INTENSIVE SEMINARS 2004

behavioural aspects
Behavioural aspects

Budgets can motivate employees to achieve goals of the organisation. What helps?

  • degree of difficulty
  • top management participation
  • perceived fairness
  • feeling of ownership
  • avoid discontent about preparation

MBA INTENSIVE SEMINARS 2004

not foolproof
Not foolproof

Why might budgets fail?

  • Fail to understand changing environment
  • using unsuitable existing structures
  • fail to understand business systems
  • lack of senior management support
  • fail to understand central role of budgeting

MBA INTENSIVE SEMINARS 2004

are budgets necessary
Are budgets necessary?

What matters is PLANNING

This does not have to use budgets. Essential:

  • Set targets: to maximise long term value
  • Strategy: Make development continous
  • Growth and improvement: challenge staff
  • Resource management: wealth creation

MBA INTENSIVE SEMINARS 2004

are budgets necessary117
Are budgets necessary?
  • Co-ordination: manage cause and effect
  • Cost management: challenge all costs
  • Forecasting: use rolling forecasts
  • Measurement and control: key indicators
  • Rewards: unit rewards not individuals
  • Delegation: give managers freedom to act

MBA INTENSIVE SEMINARS 2004

performance measurement

Performance Measurement

MBA INTENSIVE SEMINARS 2004

strategic planning
Strategic planning

Five year plan, rolling forward.

  • Profitability
  • Growth of sales, profit
  • Market share
  • Customer satisfaction
  • Rate of innovation

How to measure achievement of strategy?

MBA INTENSIVE SEMINARS 2004

accounting based performance measures
Accounting-based performance measures

Profit?

  • Could compare actual profit against budget, but companies don’t give information
  • An absolute measure, needs ratios for comparison.
  • Affected by choice of accounting policies
  • Measured differently in different countries

MBA INTENSIVE SEMINARS 2004

accounting based performance measures contd
Accounting-based performance measures (contd)

Profitability

  • A relative measure, better for comparison.
  • Calculate for subdivisions of an organisation.

Methods

  • Return on capital employed
  • Residual income
  • Economic value added

MBA INTENSIVE SEMINARS 2004

return on capital employed122
Return on capital employed

Profit before interest and taxes

Fixed assets plus current assets less current liabilities

Can be used for divisions of a company if assets and liabilities can be allocated.

MBA INTENSIVE SEMINARS 2004

return on shareholders funds123
Return on shareholders’ funds

Net profit after interest and taxation

Shareholders’ funds

Can only be calculated for the company as a whole, not subdivided for divisions of organisation.

MBA INTENSIVE SEMINARS 2004

residual income
Residual income

Ask: What is the income (profit) remaining after deducting a notional interest charge for the use of capital?

X Z £000’s

Operating profit (EBIT) 18 1,500

Capital employed 100 10,000

ROCE 18% 15%

MBA INTENSIVE SEMINARS 2004

residual income contd
Residual income (contd)

Suppose cost of capital is 10% for both.

X Z £000’s

Operating profit (EBIT) 18 1,500

Less interest charge (10)(1,000)

Residual income 8 500

Company Z gives higher income to shareholders

MBA INTENSIVE SEMINARS 2004

economic value added eva
Economic Value Added (EVA)

Companies should deliver value that exceeds the cost of capital.

X Z

Profit after tax (before interest) 13 1,050

Interest charge (net of tax) (7)(700)

EVA 6350

Z gives higher EVA than does X

MBA INTENSIVE SEMINARS 2004

performance of a division
Performance of a division

Divisions are created by decentralisation

  • Gives greater responsiveness
  • Allows faster decisions
  • Motivates managers
  • Uses specialist experience of managers

But needs a measure of performance

MBA INTENSIVE SEMINARS 2004

performance of a division contd
Performance of a division (contd)

Problems of decentralisation

  • Focus on division, not on total organisation

(Called ‘dysfunctional decision making)

  • More information is needed, cost involved
  • Duplication of activities

MBA INTENSIVE SEMINARS 2004

performance of a division contd129
Performance of a division (contd)

Cost centre

  • Manager is responsible for costs

Discretionary cost centre

  • Manager has some choices in cost budget

Revenue centre

  • Manager is responsible for generating planned sales

MBA INTENSIVE SEMINARS 2004

performance of a division contd130
Performance of a division (contd)

Profit centre

  • Manager is responsible for revenues and costs
  • Target profit is set

Investment centre

  • Manager is responsible for resources and profit, target return to be achieved

MBA INTENSIVE SEMINARS 2004

transfer pricing
Transfer pricing

What price is charged for transfers between divisions within an organisation?

  • Variable cost?
  • Variable cost plus a profit margin?
  • Variable cost plus portion of fixed cost?
  • Variable + fixed + profit margin?
  • Negotiated price? Reflect market?

MBA INTENSIVE SEMINARS 2004

financial performance measurement
Financial Performance Measurement
  • Success / Failure often determined by accounting numbers
  • Growth in profit, ROCE, Sales
  • Reduction in costs, headcount, errors, stock
  • Financial Ratio Analysis

MBA INTENSIVE SEMINARS 2004

financial performance measurement contd
Financial Performance Measurement (contd)
  • Achieving outcome at or under budget
  • Adverse / Favourable variance analysis
  • Project NPV – cost overruns
  • OBJECTIVE APPROACH TO Performance measurement

MBA INTENSIVE SEMINARS 2004

problem with financial measures
Problem with financial measures

A Simple Scenario.

Division in large company enjoyed major growth in profitability over two years ..manager promoted.

New manager ….drop in profits.

WHY ?

MBA INTENSIVE SEMINARS 2004

financial measures contd
Financial measures (contd)

Top line answer

  • Division’s market share dropped
  • Costs were reduced by reducing maintenance of cutting machine, reducing staff training
  • build up of stocks (inventory) of unsold goods

Bottom line answer

  • Reduced investment in new technology

Financial System did not pick up the BAD Events

MBA INTENSIVE SEMINARS 2004

problems with financial information
Problems with financial information
  • Complexity /mystery and the method of calculation
  • Arbitrary treatment of some cost items
  • Time lag between event and the financial ledger
  • No direct observable relationship between activities and reported costs
  • Irrelevant to managers

MBA INTENSIVE SEMINARS 2004

problems with financial information contd
Problems with financial information (contd)
  • Managers need to convert data into meaningful information.
  • Implied assumption that control costs will control activities.
  • Focus on cost minimisation, not on effectiveness or value-adding. Could be valid reasons for costs increasing.
  • Simplification of organisational activities, by reducing everything into a single £ value.

MBA INTENSIVE SEMINARS 2004

value of financial performance measurement
Value of Financial Performance Measurement
  • Managers accept importance of financial outcome of their function (especially if linked to pay / prospects).
  • Managers will try to increase their profitability.
  • Managers often devise their own budget 'systems’.

MBA INTENSIVE SEMINARS 2004

value of financial performance measurement contd
Value of Financial Performance Measurement (contd)
  • Need information on relationships between activities they control and financial outcome
  • Ignore formal budget reports / spend time and effort proving official budget is wrong
  • Do not assume that managers can "translate" £s into actual activities

MBA INTENSIVE SEMINARS 2004

information managers use
Information Managers Use

US study concluded information used for daily operating control did not come from the budgeting system.

Managers' information needs are affected by:

  • the resources most significant to their process, in terms of cost, quality, availability
  • the time frame in which this information is needed

MBA INTENSIVE SEMINARS 2004

indicators for managers
Indicators for managers
  • level of finished goods
  • level of orders (demand)
  • key production limiting factors
  • simple counts of output per hour / shift / day,
  • physical quantities of materials / labour used,
  • down-time

MBA INTENSIVE SEMINARS 2004

indicators for managers contd
Indicators for managers (contd)
  • scrap quantities,
  • rework rates.
  • capacity utilisation
  • physical production requirements (long - medium and short-term)

MBA INTENSIVE SEMINARS 2004

non financial measures
Non-Financial Measures

Non-financial is any information not valued in £s. It has the following advantages:

  • Expressed in terms/language understandable to managers (non-accountants)
  • Requires very little "translation" by managers

MBA INTENSIVE SEMINARS 2004

non financial measures contd
Non-Financial Measures (contd)
  • Potentially quicker, relevant
  • Relates to events, activities, actual observable performance
  • Can be used to make sense of financial budgets
  • Better reflects the "reality" of the situation, not confused by strange accounting rules/conventions

MBA INTENSIVE SEMINARS 2004

integrating non and measures
Integrating Non-£ and £ measures
  • Activity Based Accounting
  • Benchmarking
  • Performance Scoring
  • Balanced Scorecard
  • Strategic Management Accounting
  • Many other – multiple criterion decision making, data envelopment analysis, etc…

MBA INTENSIVE SEMINARS 2004

balanced scorecard

Financial Perspective

Customer Perspective

Internal Business Perspective

Vision and Strategy

Learning & Growth Perspective

Balanced Scorecard

MBA INTENSIVE SEMINARS 2004

balanced scorecard147
Balanced Scorecard
  • systematic attempt to design performance measurement system that integrates
    • organisational objectives,
    • co-ordination of individual decision making
    • need for organisational learning.
  • create an environment that facilitates continual improvement

MBA INTENSIVE SEMINARS 2004

balanced scorecard contd
Balanced Scorecard (contd)
  • reflect the organisation’s understanding of the causes of successful performance.
  • monitoring performance and what managers believe are drivers of good performance
  • performance measure system should measure the most critical aspects of organisational performance.

MBA INTENSIVE SEMINARS 2004

balanced scorecard contd149
Balanced Scorecard (contd)

BS performance measures should

  • be clearly understood by all employees
  • link manufacturing performance and financial performance
  • be linked to ensure constancy of purpose.

MBA INTENSIVE SEMINARS 2004

balanced scorecard contd150
Balanced Scorecard (contd)

BS performance measures should

  • be able to identify cause-effect relations to enable employees to deal with poor performance and continue good practices.
  • be based on critical success factors
  • identify trends and rate of change

MBA INTENSIVE SEMINARS 2004

not for profit organisations151
Not-for-profit organisations
  • Economy

Cost at which resources are acquired

  • Efficiency

Compare inputs and outputs

  • Effectiveness

How resources are used

Value for Money

MBA INTENSIVE SEMINARS 2004