Table of Contents

Table of Contents
Table of Contents
.............................................................................................................
2
Business: The big picture .................................................................................................. 4
‘The model’ ............................................................................................................................ 4
Writing the exam............................................................................................................. 6
The syllabus ........................................................................................................................... 6
Exam technique and style of testing ..................................................................................... 8
Examiners’ comments from the SAICA ITC............................................................................ 9
The Objective of the ITC .................................................................................................... 9
Specific comments............................................................................................................. 9
Study Programme and Suggested Approach .................................................................... 13
Suggested approach to revision .......................................................................................... 13
Tutorial Schedule ................................................................................................................. 14
Study Plan ............................................................................................................................ 18
Course Notes.................................................................................................................
19
Management decision making and control ..................................................................... 20
1. Cost classifications ........................................................................................................... 20
Cost behaviour................................................................................................................. 21
Decision making............................................................................................................... 24
Management control....................................................................................................... 24
Tips and examination technique ..................................................................................... 25
2. Inventory costing ............................................................................................................. 25
Job costing ....................................................................................................................... 26
Process costing ................................................................................................................ 31
Joint and by-product costing ........................................................................................... 34
3. Activity-based costing and management ........................................................................ 36
4. Cost volume profit analysis ............................................................................................. 44
Break-Even Analysis ......................................................................................................... 45
Cost behaviour within relevant range ............................................................................. 47
Multiple product scenarios.............................................................................................. 48
Sensitivity Analysis........................................................................................................... 50
5. Budgeting......................................................................................................................... 52
6. Standard costing .............................................................................................................. 55
Setting standards ............................................................................................................. 56
Variance analysis ............................................................................................................. 56
Treatment of variances ................................................................................................... 61
Sales variances................................................................................................................. 68
Reconciliation of budget to actual profit......................................................................... 71
7. Transfer pricing and decentralisation of control ............................................................. 74
Goals of transfer pricing .................................................................................................. 75
Transfer pricing systems .................................................................................................. 76

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 Price elasticity and transfer pricing ................................................................................. 80
8. Performance evaluation .................................................................................................. 85
Goals of Performance Evaluation .................................................................................... 85
Performance measures ................................................................................................... 86
9. Relevant costs and the decision process ......................................................................... 95
Special Orders.................................................................................................................. 96
Make or buy................................................................................................................... 108
Closing a branch or division ........................................................................................... 112
Sell now or process further ........................................................................................... 113
Qualitative factors and pricing decisions ...................................................................... 113
Pricing decisions ............................................................................................................ 114
10. Strategic management accounting.............................................................................. 117
JIT (Just-in-Time) and ERP (Economic-Resource-Planning) ........................................... 117
Quality control ............................................................................................................... 119
Balanced Scorecard ....................................................................................................... 121
Financial management ................................................................................................. 122
11. Working capital and treasury ...................................................................................... 122
12. Capital budgeting......................................................................................................... 125
Basic principle ................................................................................................................ 125
Methods ........................................................................................................................ 125
Types of projects ........................................................................................................... 126
Factors to consider with Net Present Value .................................................................. 126
13. Leasing ......................................................................................................................... 133
14. The financing decision ................................................................................................. 138
Risk and risk management ............................................................................................ 138
Sources of finance ......................................................................................................... 140
15. Cost of capital .............................................................................................................. 148
Optimal capital structure............................................................................................... 148
Weighted Average Cost of Capital................................................................................. 148
16. Valuations .................................................................................................................... 151
The market approach (applying price multiples) .......................................................... 151
Dividend discount model............................................................................................... 157
DCF valuation (Free Cash Flow method) ....................................................................... 158
Valuations for mergers and acquisition purposes ......................................................... 163
17. Specialised topics in finance ........................................................................................ 166
Dividend policy .............................................................................................................. 166
Derivatives ..................................................................................................................... 167
Foreign exchange management .................................................................................... 169
Asset-backed securitisation (ABS) ................................................................................. 170

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Business: The big picture
Individuals are unique. Generally speaking, organisations are similarly unique – they are, of
course, made up of a group of individuals!

However, there is a basic “model” that underpins all organisations – it matters not whether
they are companies seeking profits, non-profit organisations seeking to provide aid, or
government organisations seeking to provide services to communities. The main goal of any
organisation should be to create value– it is simply what you define as value that differs.
How they create value is also similar, but the emphasis may be different.

‘The model’
1. Any organisation is formed through the raising of finance, both Equity and Long
Term Debt; what you may generically call making financing decisions
.

2. Finance obtained is used to invest in Fixed Assets and Net Working Capital. This
action would be generically referred to as making investing decisions. The various
types of assets in which an organisation invests will depend on the strategy of the
organisation, but most organisations need some form of assets to create productive
capacity.

3. Using this productive capacity requires operating decisionmaking. It requires that

we establish a value chain; which results in incurring/generating:

a) Fixed Costs (costs that do not vary with productive output) to support/create
capacity;
b) Variable Costs incurred in producing the goods or services (costs that do vary
with productive output);
c) Revenue through the sale of goods or services at some price (i.e. revenue should
have both a volume and price aspect); and
d) Net Cash Flow through the collection of the revenue and payment for the costs
incurred – i.e. can we turn the profit into cash.

4. The cash generated from operations can either be paid out to our original investors
through a dividend decision, or returned back into the business to support the
purchase of further assets.

This model merely describes a slightly modified version of the basic accounting equation,
something with which we should all be familiar. Every section covered in Management
Accounting and Financial Management covers some aspect of this basic business model with
the view of assisting the business in creating value. If you have not yet done so, we urge you
to go back to each of the “sections” you have covered and ask yourself the following
questions:

1. Where does this topic fit into the basic business model?

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 2. What is the point of this topic? How does this assist us in creating value for the
business?
3. How does this topic relate to other topics?

By doing this, you should be able to draw a more detailed diagram similar to the one
presented on the following page:

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Writing the exam
This portion of the notes deals with the following information, which is vital to you when
preparing for and while you are writing the ITC:

x The syllabus;
x Exam technique and style of testing; and
x Examiners’ comments from the SAICA ITC.

The syllabus
There is no official syllabus list for Management Accounting and Finance. Unlike the other
three disciplines, there are no examinable pronouncements, as the principles of
Management Accounting and Financial Management are not codified. The best place for us
to look for some guidance of the topics to be examined in the ITC is to look at the SAICA
Competency Framework Detailed Guidance for Academic Programmes 2014. This document
identifies the specific competencies required in the areas of “Financial Management” and
“Management Decision Making and Control”. These two areas of competence also have
strong links to the area of “Strategy, Risk Management and Governance”.

We recommend you make an effort to become familiar with this document, especially from
a Management Accounting and Financial Management perspective, as this should inform
your studies of the various topics included in this note pack. If we examine how the topics
within Management Accounting and Financial Management relate to one another, we can
group the topics together in three distinct “pillars” for each discipline.

Management Decision Making and Control consists of:

x A costing aspect;

x A planning and control aspect; and

x A decision-making aspect (refer to diagram below).

Management of an organisation will create value by making good decisions and maintaining
control over the operations. Without accurate costing, you will not be able to exercise
adequate control or make good decisions. Each of the topics covered in university should
have taught you an aspect within each of these three pillars.

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Similarly, the basic principles of risk, return and the time value of money underpin the
Financing and Investing Decisions that Financial Managers should make on a daily basis –
again with the view of creating value. Again, we can view the topics of Financial
Management in three pillars, as is shown in the diagram below.

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Examtechnique and style of testing
Succeeding in Managerial Accounting and Financial Management requires two basic skillsets:

1. Managerial Accounting and Financial Management require unstructured problem

solving. All of the principles to which you have been exposed in your university
career have been developed in response to a problem experienced in business.
Given that businesses are largely unique, the problems to which they are exposed
are largely unique. Having said this, there is a generic manner in which all
organisations operate – refer to the “big picture of business”. There are actually
relatively few principles in Management Accounting and Financial Management;
however, these principles can be (and often need to be) applied differently in
different scenarios.

This is the first important skill: Can you understand the context in which a business
operates (i.e. the scenario presented to you in a tutorial or examination question)
and then use your understanding of the basic principles of Management Accounting
and Financial Management to solve the unique business problems flowing from the
business context. Often, students have failed to fully understand the basic
Management Accounting and Financial Management principles because they have
attempted to learn the topics in a procedural fashion – “if I (aka. The student) get
asked to do X (e.g. an ABC calculation), I need to do it in this order…”. In practising
your tutorials, focus on understandingwhat each of the tools is trying to achieve and
how this relates to the business context.

2. The more generic skillset required to pass any ITC question is an ability to read large
volumes of information, make sense of this information in your mind, clarify the
problems presented and respond to these problems using your technical
understanding, all under time pressure. This skillset we will refer to as exam
technique.

Responding to problems under time pressure requires practice. However, this

practice should only be performed once you have spent time practising the first
skillset above – i.e. understanding a business in context and using your problem
solving skills and understanding of the basic Management Accounting and Financial
Management tools.

Exam technique is often the major failing point of candidates in the ITC. However, it
is difficult to practise good exam technique when you are struggling with the basic
concepts/principles underpinning Management Accounting and Financial
Management. Therefore, we recommend you practi se firstly without time
pressure, practising the problem solving skillset, and then practi sing under time
pressure, focussingon good exam technique .

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Examiners’comments from the SAICA ITC
Following the writing of the Initial Test of Competence (previously Part 1 of the Qualifying
Examinations (QE)), a document is drafted containing the comments of the various
examiners and umpires involved in the marking process. These documents are available on
the SAICA website for the use of candidates, both first time writers as well as previously
unsuccessful candidates. This commentary highlights key areas of concern that surfaced
during the marking process. For ease of reference, the following note provides a summary of
the key points that candidates should bear in mind while doing the Cape Town Board Course
in preparation to write the SAICA ITC 2014. These comments contain some general
information as well as information specific to Management Decision Making, Control,
Financial Management, Strategy, Risk Management and Governance.

The Objective of the ITC

As per the SAICA issued report of examiner and umpire comments, the “primary objective of
the Initial Test of Competence is to test the integrated application of technical competence,
candidates are tested on their ability to –

x Apply the knowledge specified in the subject areas set out in the prescribed syllabus;
x Identify, define and rank problems and issues;
x Analyse information;
x Address problems in an integrative manner;
x Exercise professional judgement;
x Evaluate alternatives and propose practical solutions that respond to the users’
needs; and
x Communicate clearly and effectively.”

Specific comments
From the annual review of candidates’ answers to the SAICA ITC examination questions, a
number of general deficiencies (as set out below) have been identified. These problems
affect the overall performance of candidates, and it is a matter of concern that candidates
make the same mistakes year after year. Although these aspects seem like common sense,
candidates who pay attention to them are likely to obtain better marks, and it may even
turn a low mark into a pass.

Application of knowledge
“A serious problem experienced throughout the examination was that candidates were
unable to apply their knowledge to the scenarios described in the questions. Many
responses by candidates were a ‘shopping list’ of items – this being a pure regurgitation of
what candidates may have learnt about the theory at university, but of no real relevance to
the question in hand. Candidates also do not appear to be able to identify the correct issues
in the scenario provided.

This is a major concern, because by the time candidates qualify for entry to these
examinations, one would expect them to have assimilated the knowledge, at least to the
extent of being able to apply it to simplified facts as set out in an examination question.

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Obviously, candidates who are unable to identify the correct issues did not do well in the
examination.”

#KEYCONCEPT
Application of knowledge is particularly pertinent to the topics of Management Decision
Making, Control and Financial Management. Most scenarios for these topics include
qualitative information that a candidate is expected to

a) Identify key qualitative info; and

b) Use this info to demonstrate their understanding of the underlying theory.

Workings
“It is essential that candidates show their workings and supply detailed computations to
support the figures in their answers. Marks are reserved for methodolo gy, but can only be
awarded for what is shown. Workings should, like the rest of the paper, be donein blue or
black inkto ensure legibility. In many instances workings were performed by candidates but
not cross-referenced to the final solution. Once again, markers could not award marks as
they were unable to follow which working related to which part of the final solution.
Candidates must ensure they show their workings and that these are properly and neatly
cross-referenced to the final solution.”

#KEYCO NCEPT
Marks can only be awarded for what is written on the page! Get in the habit of writing your
thought process down in solutions. But, be mindful of good exam technique – don’t waste
time writing unnecessary detail.

Communication
“Candidates fared better in questions requiring calculations than in discursive questions. It is
important that candidates bear in mind that written answers are a large component of the
ITC, because written communication is a key competency required in the workplace.
Candidates should learn to answer discursive questions properly. This can be done by
practising exam-type answers under exam conditions in preparation for the examination.

In addition, markers found that candidates used their own abbreviations (SMS messaging
style) in their answers. Marks could not be awarded here, as it is not up to the markers to
interpret abbreviations that are not commonly used. The increased use of an SMS style of
writing in a professional examination it is a major concern. Candidates should pay specific
attention to the way in which they write their answers, and bear in mind that this is a
professional examination for which presentation marks are awarded.”

#KEYCONCEPT
Practise doing discussion questions – that does not mean jotting down the key words! When
you practise doing discussion, you need to write full sentences, as you would in the exam.
You cannot become good at discussion without practice and the more you practise, the
better you will become at writing concisely and to the point. When you practise, you need to
go back and interrogate your own sentences (does what I have written express what I meant

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to say?) as well as the suggested solution (what is the point of their sentence?). Just because
you used a particular WORD, does not make your discussion right!

Time management
“Candidates are advised to use their time wisely and budget time for each question. The
marks allocated to each question are an indication of the relevant importance the examiners
attach to that question and thus the time that should be spent on it. Candidates should
beware of the tendency to spend too much time on the first question attempted and too
little time on the last. They should never overrun on time on any question, but rather return
to it after attempting all other questions.”

#KEYCONCEPT
PLAN your answer! You need to have a strategy when answering examination questions to
ensure you do not waste the time allocated in the exam and to avoid panic. That means you
need to:

a) Know how long you should spend reading a question (or reviewing it);

b) Know how long you should spend answering a specific required based on the mark
allocation;

c) Know how many areas you need to cover in answering a required (often one part of a
required may as you for multiple things – e.g. Calculate the financial impact of accepting a
project and make a recommendation to management regarding the project’s acceptance);
and

d) Plan how many issues you need to address (especially in discussion questions) and how
many marks (and time) you should dedicate to each issue.

Layout and presentation

“Candidates should allocate time to planning the layout and presentation of their answers
before committing thought to paper. Very often, candidates start to write without having
read the question properly, which invariably leads to, for example, parts of the same
question being answered in several places or restatement of facts in different parts. Marks
are awarded for appropriate presentation and candidates should answer questions in the
required format, that is, in the form of a letter, memorandum or a report, if this is what is
required.

The quality of handwriting is also an on-going problem and was of particular concern in this
year’s examination. The onus is on the candidate to produce legible answers .

Separate books are used to answer each question of the ITC. Each book is clearly marked
and colour coded. Candidates are given explicit instructions to write the correct answer in
the correct book. Despite this, some candidates did not write the correct answer in the
correct book. The secretariat did ensure that candidates who wrote answers in the incorrect
book were marked by the correct mark team.”

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#KEYCONCEPT
Planning! Make sure you read all parts of the required prior to answering anything. You
want to avoid repeating answers in multiple parts of the required. For example, if part 1 asks
for a financial analysis and part 4 asks for an evaluation of the working capital practices, you
should not be spending time analysing working capital in part 1, save it for part 4! But, you
will only know what is coming if you read all parts to the required.

Irrelevancy
“Marks are awarded for quality, not quantity. Verbosity is no substitute for clear, concise,
logical thinking and good presentation. Candidates should bear in mind that a display of
irrelevant knowledge, however sound, will gain no marks.”

Recommendations / interpretations
“Responses to these requirements are generally poor, either because candidates are unable
to explain principles that they can apply numerically or because they are reluctant to
commit themselves to one course of action. It is essential to make a recommendation when
a question calls for it, and to support it with reasons. Not only the direction of the
recommendation (i.e. to do or not to do something) is important, but also particularly the
quality of the arguments – in other words, whether they are relevant to the actual case and
whether the final recommendation is consistent with those arguments. Unnecessary time is
wasted by stating all the alternatives.”

#KEYCONCEPT
Making a recommendation generally requires that a candidate considers all angles. If you
recommend that a project should be accepted, you need to provide reasons why acceptance
will be preferable, but, to be a balanced recommendation, you should also identify why it
may not be preferable to accept. Examiners are looking for your ability to evaluate both pros
and cons and provide a professional opinion based on your considerations.

Examination technique
“Examination technique remains the key distinguishing feature between candidates who
pass and those that fail. Many candidates did not address what was required by the
questions and, for example, provided a discussion where calculations were required or
presented financial statements where a discussion of the appropriate disclosure was
required.”

#KEYCONCEPT
Read the required IN FULL – never assume that you know what the required is asking and
start writing without having read the required in detail. The quickest way to waste time is to
start to answer a question and realising half way that you have misunderstood what the
question requires.

Also refer to #KEYCONCEPT on planning your answer.

Refer to the Markers’ and Umpires’ Comments to the SAICA ITC and Qualifying Examinations
available on the SAICA website for more details.

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Study Programme and Suggested Appr
oach
Suggested approach to revision
The syllabi for Management Decision Making and Control, Financial Management as well as
Strategy, Risk Management and Governance have been allocated a combined six study days.
Each day of study tests a wide range of topics in the MAF syllabus, this is done intentionally
due to the highly integrated nature of the ITC exam.

The approach has been to have approximately 200 marks per study day. However, this
hasn’t always been possible. There are roughly 1 200 marks available the six days of study.

We recommend you approach your revision as follows:

1. It is not recommendedthat you do any reading prior to attempting the tutorials,

unless you are certain that you have weaknesses in specific areas. Remember, by
doing the tutorials properly, you should be revising the basic concepts of the
sections mentioned in the notes.

2. As you complete a tutorial, it is recommended that you draw up a little summary of

the sections tested in that tutorial.

a) Ask yourself if you are comfortable with all of the concepts tested.

b) Also ask yourself what other concepts were not tested in that question – for
example, if a question included a decision relating to a special order, it probably
did not include a make/buy decision or a decision to close down an operation.

c) If there were concepts about which you did not feel comfortable, visit the notes
for clarification.

3. Remember to use some of the tutorials, especially in the initial study days, for
practicing your problem solving skills (refer to “Writing the Exam” above). The
integrated study days are perfect for testing your skills of writing under time
pressure and becoming “exam fit”.

See the following page for an index of tutorials, the source from whence they originated and
suggested readings within the notes, if required. When analysing the ranking, A indicates
tutorials that are relatively easy while B’s are more challenging and C’s most challenging.

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 Tutorial Schedule
Tutorial Name (Source) Topics Covered Skills Examined Rank
Number
MAF 1 Ubex CVP,Standard Calculating: B
#* (SAICA 2016
) Costing, Capital x NPV/IRR
Budgeting,Risks x Break even
x Net profit per unit
Discussion:
x Variances
x Business Risks
MAF 2 Crushtide Inventory Costing Calculations:
^ (SAICA 2014J P4Q2) Transfer Pricing x Costing of joint B/C
products
x Gross profit unit
/
Discussion:
x Transfer pricing
x Joint Cost
allocation
MAF 3 Amandla Costing, cost Variance analysis, C
#* (SAICA 2009 P2 Q3) classification, commentary on financial
financial analysis, performance
pricing
MAF 4 Applewood Electronics Activity Based Calculations: A/B
^ (UCT 2008) Costing x Profitability of
products
x Discussion:
Usefulness and
imitations of ABC
MAF5 Signs for Africa Standard Costing Calculations: C
(SAICA 2008 P1Q3) CVP x Variances
x Break even
Discussion:
x Profitability
MAF 6 Outdoor Holdings Financial Analysis Calculations:
* (UCT 2014) Break-even x Relevant costing
Relevant costing (minimum price,
Balanced scorecard constraints,
nested decisions)
x Variances
Discussion:
x Theory of standard
costing
MAF7 IGL Financial Analysis Calculations: B/C
(UCT 2007) Cost Allocation x NPV (including
assessed loss)

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MAF 8 Eficaz Inventory Costing, Calculations: B
* (SAICA 2013J P4Q2) Relevant Costing, x NPV
Pricing, Risks x Break even
Discussion:
x Theory of leasing
x Pricingmodel
considerations
MAF 9 Electribolt Valuations Calculations: B
* (SAICA 2010 P2 Q3) Capital Budgeting x DCF valuation
Sources of x Options
financing x Financing cash
flows
Discussion:
x Due Diligence
MAF10 Zomat Valuations Calculations:
#^ (SAICA 2007 P1Q2) Financial Analysis x Lease or buy
Working Capital
(integration with
corporate
governance issues)
B/C
MAF 11 VPharm CVP Calculations: C
# (SAICA 2006 P1Q4) Capital Budgeting x Lease or buy
Risks x Effect of changing
Pricing assumptions
Discussion:
x Effect of changing
assumptions on
decision
MAF 12 OPM Conflicts of interest Calculations: C
^ (SAICA 2014) Valuations x Cost of two loans
x Estimating WACC
Discussion:
x Estimation of
WACC
x Fixed or floating
rate debt
x Asset backed
securitization
MAF13 Aspen Valuations Calculations: C
(UCT 2009) Specialised Topics x Estimating WACC
in finance Discussion:
x Type of debt
x Estimating WACC
x Asset backed
securitization

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MAF14 Silky Mills (UCT 2003) Leasing Calculations:
x Sustainable
growth rate A/B
Discussion:
x Sustainable
growth rate
MAF 15 Cloth Cost of capital Discussion: A/B
# (SAICA 2009 P1Q2) Sources of finance x Risk and response
Specialised topics to risk of
in finance outsourcing
x (substantive
procedures)
MAF16 Umhlanga Holdings Capital Budgeting Discussion: C
* (SAICA 2015) SRMG x Identification of
key risks and
mitigation
MAF17 Electrograpp Cost allocation Calculations: C
# (SAICA 2014) CVP x Variance analysis
Relevant Costing x Break even
Pricing Discussion:
SRMG x Analysis
x Hedging
x Riskidentification
x Governance
MAF18 Rexelor Financial analysis Calculations: B
(SAICA 2015) Forecasting cash x Return of
flows investment
Overhead analysis x IRR and NPV
x Forecasting
Discussion:
x Performance
evaluation
Strategic considerations
MAF19 SouthAfrican Rail Relevant Costing Calculations: C
Holdings Limited Qualitative factors x Profitability
(UCT 2013) Balanced Scorecard analysis
Pricing x Working capital
management
x Forecats cash
flows
Discussion:
x Qualitative factors
x Hedging
MAF20 Aquazania Cost allocation Calculations: C
(SAICA2015) Incremental cash x Gross margins
flows x Incremental cash

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 Sources of finance flows
Risk Discussion:
x Financial analysis
x Sources of finance
x Business risk
MAF21 Aero Africa Budgeting Calculations: C
(SAICA 2013) CVP x Variance analysis
Financial analysis x Break even
Hedging Discussion:
SRMG x Analysis
x Hedging
x Risk identification
x Governance
MAF22 TT Transport Performance Calculations: B
(SAICA 2013) evaluation x Return of
Capital Budgeting investment
Specialised topics x IRR and NPV
in finance x Forecasting
SRMG Discussion:
x Performance
evaluation
x Strategic
considerations
MAF23 Ithemba Engineering Profitability analysis Calculations: C
^ (SAICA 2013) Working capital x Profitability
management analysis
Hedging x Working capital
Forecast cash flows management
Relevant costing x Forecast cash
Settlement flows
discount Discussion:
x Qualitative factors
x Hedging

Key: A: Introductory level, B: Intermediate difficulty, C: Advanced/Integrated

* Annotated solution
# General tutorial commentary included
^Interdisciplinary integration

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Study Plan
Below is our proposed study plan for each of the six study days for Management Accounting,
Financial Management and Strategy, Risk Management and Governance. Given that you are
likely to see a mixture of Management Accounting, Financial Management and Strategy, Risk
Management or Governance in a single question, each day of study is highly integrated with
the intention that Management Accounting, Financial Management and SRMG are all tested
to some extent on a single day. It has been determined that this is the approach that will
most accurately simulate the structure of the ITC exam, which is essential to get used to
before the big day.

If you find yourself struggling with any of the basics, please refer to our suite of free Learn
Accounting videos to be found at http://learnaccounting.uct.ac.za/

Recommended Study Timetable Mark Allocation

Study Day 1 MAF 1, MAF 7, MAF 9, MAF 18 195
Study Day 2 MAF 2, MAF 10, MAF 16, MAF 22 205
Study Day 3 MAF 3, MAF 13, MAF 14, MAF 21 195
Study Day 4 MAF 4, MAF 8, MAF 11, MAF 23 196
Study Day 5 MAF 6, MAF 17, MAF 20 199
Study Day 6 MAF 5, MAF 12, MAF 15, MAF 19 205

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Course Notes

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 Management decision making and control
1. Cost classifications
Costs and cost behaviour underpins a lot of the theory of management accounting. The
classification of a cost will determine how it is treated in different situations. In the business
world, understanding the costs of the company and how they behave allows management to
respond appropriately to control these cost, ensure that revenue is sufficient to cover these
costs and make effective decisions .

Summary
For the purpose of the ITC, you should be fully conversant with the following summary of
cost terminology:

OBJECTIVE CLASSIFICATION NOTES

Cost behaviour Variable costs Costs that vary with the production
Semi-variable costs (mixed) Costs that have a fixed and variable
component.
Fixed costs Costs that do not vary with production
Step-fixed costs Costs that remain constant within certain
ranges of production

Product costing and Direct costs Can be directly traced to a particular unit
accounting basis
Indirect costs Cannot be directly traced to a particular unit
(these are overhead costs)
Manufacturing costs Incurred during the manufacturing process
Non-manufacturing costs Incurred in another (perhaps administrative)
area of the business i.e. not manufacturing
Full (absorption) cost (Unit) cost including fixed manufacturing
overheads
Direct (variable) cost (Unit) cost excluding fixed manufacturing
overheads

Decision making Sunk costs Costs that have already been incurred or
irrevocably committed to
Relevant costs Cash flows that differ between alternatives
Opportunity costs Cash flows foregone by choosing a specific
alternative

Management control Discretionary costs Costs that do not have a relationship with

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 production
Engineered costs Costs that have a relationship with production
(not necessarily a linear relationship)
Committed costs Costs that are incurred upfront at the
beginning of the project

Note: The classifications are not always mutually exclusive. For example: Indirect costs (i.e.
overheads) can be either variable or fixed or both, depending on the situation.

Costbehaviour
Costs can be classified by their behaviour when activity changes, i.e. fixed, semi-variable,
variable costs or step-fixed costs.

The High-low method can be used to calculate the fixed and variable components of a semi-
variable cost.

Don’t forget to use the highest and lowest activity to select the two points for the
calculation.

For example:

Cost Units
70 000 20 000
85 000 23 000
80 000 25 000

Variable costs = R80 000 - R70 000 = R2/unit

25 000-20 000

Fixed costs = 70 000 - (20 000 x 2) = R30 000.

Note: There could be possible changes in fixed or variable costs at different levels of
production.

For example, step-fixed costs have the following cost behaviour profile:

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 Step-fixed costs are commonly found in:

x Relevant costing questions

o For example, if a special order requires 30 units and the units are cast in a
mould with a useful life of 25 units, the relevant cost of the moulds for the
order will be the cost of two moulds.

x CVP questions

o See the CVP section for the treatment of step fixed costs in break-even
analysis.

Note: The nature, and hence the classification of a cost, can differ depending on the
perspective from which the cost is considered.

Consider the following example:

Skyflyer Pty (Ltd) is an established, low-cost airline operating within the borders of South
Africa.

Flight information:

The average distance Skyflyer travels per one-way flight is 997 Kilometres. Skyflyer offers
only one type of meal to passengers and these are ordered according to the number of
passengers booked per flight. Each meal costs Skyflyer R35.

Fleet size (number of planes) 10

Maximum passengers per flight 120

Load factor (Avg. passengers travelling per flight / maximum) 70%

Litres of fuel per passenger travelling per 100km’s 4.1

Staffing requirements:

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Each flight requires a pilot and co-pilot who are paid a combined rate of R8 400 per flight.
Skyflyer requires at least one flight attendant per 30 passengers and each flight attendant is
paid R3 000 per flight. Skyflyer also employs five customer service personnel who are
employed full-time at a monthly rate of R8 000 each.

Lease costs:

Skyflyer leases all of its aircraft. Lease costs amount to R500 000 per month per plane.

Fuel costs:

Skyflyer has noticed that a certain amount of fuel is burned on both landing and take-off
regardless of distance to be travelled.

Route Fuel consumption per plane

LONGEST ROUTE (1,254 Km’s) 4,100 Litres

SHORTEST ROUTE (497 Km’s) 1,829 Litres

PER FLIGHT (AVERAGE NUMBER OF KM PER FLIGHT)

FIXED: VARIABLE:

Step cost air hostess (Although the

amount that each air hostess is paid is
Annual customer service
fixed, the number of air hostesses varies
with the number of flights)

Pilot cost (the amount paid depends on

Leasing cost
the number of flights)

Fuel cost per flight (using the average

distance and number of customers i.e. 4.1
x 70% x 120 x 997/100 x ZAR/litre)

PER KM (NUMBER OF FLIGHTS FIXED)

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 FIXED VARIABLE

Step cost air hostess (the average Fuel cost per litre (there is a relationship
number of passengers per flight will between the length of the flight and the
determine the number of air hostesses)km travelled)

Take-off / landing fuel (No matter how

long the flight is, a fixed amount must
be incurred to take off and land) Note: The high-lo method must be
used to separate the fuel cost per
Pilot cost (No matter how long the flight km from the fixed cost incurred to
is, the pilots are paid R8
400) take off and land.

Annual customer service cost

Leasing cost

Decisionmaking
Costs can be classified by reference to their role in short
-term decision making . Only costs
which will differ between the alternativesbeing considered will be relevant for decision
making. For example a sunk cost is irrelevant as it has
already been incurred or irrevocably
as it could be avoided in one of the alternatives.
committed while a variable cost is relevant

Managementcontrol
the three
Costs can be classified by the type of system that is required to control them,
categories being:

1. Engineered costs:Costs that have a direct relationship to the production output.

Best controlled by flexible budgeting linked to a standard costing system.

2. Committed costs:Costs that are incurred up-front and early in the life cycle of the
project. Best controlled through capital budgeting and post implementation review.

3. Discretionary costs:Costs that can be incurred throughout the life of a project,

which have no direct relationship to output. For example, research and
development or marketing. These costs are best controlled by a negotiated static
budget.

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Tips and examination technique
1. This cost behaviour section is important as cost analysis forms the foundation for
decision-making, which is frequently examined in the ITC. Note that semi-variable
costs and the high-low method are frequently tested. Look out for scenarios where
there are a number of costs given for different levels of output or where two costs
at two different levels of activity are given, but the cost per unit is not the same at
each level. Either of these cases could indicate that the high-low method should be
used to separate the fixed and variable components of the cost. See also section 6
on “Relevant costs and the decision process”.

2. The High-low method can be summarised as follows:

Costat Costat
highest - lowest
Variable activity activity
=
cost/u
highest lowest
-
activity activity

Fixed Cost = Cost at highest (lowest) activity - highest (lowest) activity x variable cost/u

2. Inventory costing
There are two major objectives of cost accumulation:

1. To identify costs of responsibility centres for planning and control purposes; and

2. To identify costs of products for inventory valuation and income determination

purposes.

Types of product-costing systems include:

x Job-order costing:for production of goods and services that are readily identified
by individual units or batches called jobs.

x Process costing:for mass production of uniform units that usually flow

continuously through a series of standard production steps called processes.

For example: A business that produces high-end yachts might use a job-order costing
system, as they are likely to produce yachts as they are ordered. Whereas a business that
produces ball point pens to sell to wholesaler and/or retailers is likely to use a process
costing system, as the units will be produced continuously and not to order.

A key distinctionbetween these two costing systems:

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 x Job order costingallocates costs to individual jobs and hence each job will have a
unique cost. Costs included will generally be the actual cost of direct materials and
direct labour and an allocation of overheads based on the amount of allocation base
(e.g. machine hours) used by that particular job.

x Process costingallocates the same cost to the uniform items produced in each
period.

Job costing
Main forms and records for job-order costing:

x Job-cost-record: Accumulates product costs by identifiable lots or batches. The job-

cost records for uncompleted jobs serve as a perpetual book inventory and a
subsidiary ledger for Work-in-Process Control account.

x Stores record: A perpetual book inventory of costs and quantities of materials on

hand and a subsidiary ledger for Stores Control account.

x -cards: A perpetual book inventory of costs and quantities of

Finished stock
completed goods held for sale. A subsidiary ledger for Finished Goods Control.

x Factory department-overhead cost records: Accumulate detailed manufacturing

overhead costs incurred. A subsidiary ledger for Factory Department Overhead
account.

x Stores requisitions, work tickets and clock cards: Source documents for charging
costs to jobs and overhead departments. To aid in fixing responsibility for control
and usage of materials and labour.

Absorption vs. variable costing

Absorption (full) costing and variable (direct) costing determine how fixed manufacturing
overheadcostsare treated.

Direct costing treats fixed manufacturing overhead as a period cost, which means that all
fixed over heads are expensed in the year that they are incurred.

Absorption costing treats fixed manufacturing overheads as an inventory cost, which means
that fixed overhead costs are capitalised to the cost of inventory. This effectively defers the
expense until the inventory is sold at which point the fixed overheads are expensed as part
of cost of sales. IFRS requires full absorption costing to be used (see IAS 2: 13). Thus, while
variable costing may be used for internal reporting, it is not acceptable for financial
statements drawn up for external reporting.

The method used will arrive at different profits if there is a difference between the units
produced and the units sold, i.e. the opening and closing balances of inventory have
changed:

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 x If the level of inventory is increasing(i.e. opening balance < closing balance),
absorption costing will lead to higher profits than if variable costing were used. This
is because increasing inventory levels implies that units produced exceed the units
sold, hence, if absorption costing is used there are production costs that are being
deferred in the cost of units not yet sold, while the same costs would be completely
expensed on the variable costing method.

x If the level of inventory is decreasing(i.e. opening balance > closing balance)

variable costing will lead to a higher profit, because in this case units sold exceed
units produced. Thus, if using the variable costing method the only expense is the
current year fixed overhead, but if absorption costing is used, all the current year
overheads are expensed as part of the units produced and sold in the current year
and in addition, some fixed over heads from the previous year are expensed as part
of the cost of the inventory produced in the prior year but only sold in the current
year.

Where production and salesare equal, the two methods will result in the same level of
profit, provided that was no opening balance or closing balance. If there is opening
inventory, the units will be the same as the closing stock and provided the fixed overhead
rate has not changed, the level of profit will be the same. MAF06 highlights how
performance can be distorted by the use of absorption costing.

Most factory-overhead costs are indirect costs and thus cannot be identified with specific
jobs. Therefore, the amount of factory-overhead cost applicable to specific jobs must be
estimated by using rates based upon total direct-labour cost, total direct-labour hours, total
machine hours, or some other base. Accurateoverhead cost rates for a given period could
be calculated at the end of each period by using actual overhead costs and actual overhead
allocation bases, but the resulting cost information would usually not be available on a
timely basisfor several important purposes:

a) Making interim cost measurements for inventory valuation and income

determination and relating factory-overhead costs to products for planning and
control.

b) Manufacturing cost is an important factor in setting selling prices of finished

products.

Therefore, instead of using the more accurate actual or historical rates for applying
overhead costs to production, most companies use the less accurate but more timely
budgeted rates (also known as a pre-determined overhead rate) based upon budgeted
amounts of factory-overhead costs and the budgeted overhead rate base (such as total
direct-labour costs or hours).

These budgeted rates are typically used on an annualised basis, i.e. the POH rate is
calculated once at the beginning of the year, rather than a monthly basis for two important
reasons:

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 a) To overcome the volatility in computed unit costs caused by changes in the level of
activity volume (the denominator reason) and:

b) To avoid the volatility in computed unit costs caused by seasonal variations in total
factory-overhead costs (the numerator reason).

As mentioned before, the unit cost is important in determining the selling price. Costs that
vary month to month could result in undesirable price fluctuations.

Accounting for factory-overhead costs involves actual overhead, applied overhead, and the
difference between these two amounts.

Actual overhead costis the amount of overhead cost incurred on the accrual accounting
basis.

Applied overhead costis found by multiplying the budgeted (pre-determined) overhead

rate by the actual (historical) amount of the overhead rate base (such as total direct-labour
costs or hours). Applied overhead cost is debited to Work-in-Process Control and its
subsidiary ledger, the individual job-cost records. The offsetting credit is made to Factory
Overhead Applied, a contra or offset account to Factory Department Overhead Control.

The difference between applied and actual overhead is called either:

x if the rand amount applied is greater than

Over applied (over absorbed) overhead
the actual amount incurred; or

x if the rand amount applied is less than

Under applied (under absorbed) overhead
the actual amount incurred.

Over or under applied overheads can be as a result of production volumes not being what
was expected or the actual overhead costs being more or less than expected.

At the end of the year, there is typically only a small amount of under- or over applied
overhead cost, and it is usually closed out by a debit or credit, respectively, to cost of goods
sold, in contrast to the more accurate method of prorating the amount over the cost of
sales, finished goods and work in process accounts.

The amount of overhead closed off to each account is calculated as follows:

Balance of COS/FG/WIP before prorating

Over/under applied overhead X

Sum of COS, FG and WIP before prorating

Treatment of overheads in terms of IAS 2:13

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 x Allocation of fixed manufacturing overheads must be based on normal capacity,
which is the production expected to be achieved on average over a number of years.

x Where actual capacity achieved is less than normal, the resulting unallocated
overheads are expensed.

x Where actual capacity achieved exceeds normal capacity, the overheads must be
applied using normal capacity. The principal is the inventory must be at the lower of
cost and net realisable value. The process of prorating effectively achieves this, by
reversing the over applied overheads.

This can be illustrated in the following example:

Budgeted Machine Hours 50 000

Budgeted Factory Cost R 100 000

a) Actual Machine Hours 55 000

b) Actual Machine Hours 45 000

The POHR (R100 000/50 000) R2

a) Applied overhead (55 000 x R2/Mhr) R 110 000 Factory Overhead Control Account
Work in
Depreciation 70 000 110 000
Over Appliedoverhead (R110 000-R100 000) R 10 000 Process

This will be a credit to Rental 30 000

inventory or COS
which may be Over Applied
10 000
overstated as R10 000 Overhead
of the cost applied did
not actually occur 110 000 110 000

b) Applied overhead (45 000 x R2/Mhr) R 90 000 Factory Overhead Control Account
Work in
Depreciation 70 000 90 000
Under Appliedoverhead R -10 000 Process
Under
Rental 30 000 Applied 10 000
This will be a debit to Overhead
COS as per IAS 2

100
000 100 000

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If, in scenario a) above, the following amounts were shown in the trial balance:

Cost of sales R25 000

Work in process R10 000
Finished goods R5 000

The over applied overhead of R10 000 would be prorated as follows:

Balance before Amount Balance after

Proportion of
prorating prorated prorating
total balance
Dr/(Cr) Dr/(Cr) Dr/(Cr)
62.5% (R6 250)
Cost of sales R25 000 R18 750
(25 000/40 000) 62.5% x R10 000
Work in 25% (R2 500)
R10 000 R7 500
progress (10 000/40 000) (25% x R10 000)
(R1 250)
12.5%
Finished goods R5 000 (12.5%x R3 750
(5 000/40 000)
R10 000)
R40 000 (R10000) R30 000

The journal entry would be as follows:

Dr Factory Overhead control account 10 000

Cr Finished goods 1 250
Cr Work in process 2 500
Cr Cost of sales 6 250

The procedures described above for factory overhead illustrate the difference between two
basic costing approaches for manufacturing companies: normal absorption costinguses
budgeted overhead ratesfor applying factory overhead to production while actual
absorption costinguses the actual factory overheadcosts for products manufactured. Both
of these approaches use the actual costs of direct materials and direct labour for products
manufactured. The normal system measures more realistic costs of individual products at
the time they are manufactured.

Note: The principles of inventory costing and prorating illustrated above also apply to
standard costing and variances.

For short-term decisions, absorption costing will be misleading (refer to Section 6). The
inclusion of fixed manufacturing overhead as a product cost can result in it being considered
variable when making decisions. This situation often causes for controversy in short-term
decision making e.g. transfer pricing or special sales to utilise spare capacity. However, for
long-term decisions, absorption costing is appropriate, as ultimately, all overheads must be
recovered.

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Process costing
The key to the process costing system is equivalent units. An equivalent unit essentially
measures how many complete units could have been produced with the amount of
resources that have been applied or used on the production line.

For example, if the conversion costs have been fully applied to 300 units completed in a
process but only 40% applied to the ending inventory of 100 units partially completed, the
equivalent units would be 300 + 40% (100) = 300 + 40 = 340 units. Essentially, this means
that the resources that have been used on the 400 items are enough to produce 340
complete units.

Total costs are divided by the number of equivalent units to arrive at unit costs. Unit costs
are then used to allocate total costs between completed production and the ending
inventory of work in process.

It is also important to note the following:

x When are the materials and conversion costs added to the products?

For example, Product R has two materials, X and Y. material X is added at the beginning of
the process and material Y is added 75% of the way through the process. Labour and
overheads are incurred evenly throughout the process. The following production took place
during the year:

Units Started 100

Opening Work in Progress (30% complete) 30
Closing Work in Progress (60% complete) 60

Transfers to finished goods 70

The opening work in progress balance represents 30 EU in respect of material X, and 0 EU in

terms of material Y because it has not yet reached the stage in the production process
where material Y is added. The closing work in progress balance represents 60 EU in respect
of both material X and Y because the 75% mark has been reached.

The opening balance of WIP represents (30 x 30%) 9 EU in respect of conversion costs thus
only 21 equivalent units of conversion costs are required to complete the inventory in the
current period. Similarly, the closing balance represents 36 EU in respect of conversion costs
incurred in the current year.

Spoilage
Spoilage refers to units that do not meet the production standards. These units are removed
from the production line and discarded. Be aware of when in the process inspections
happen (e.g. 60% of the way through) as this will be the point at which material and/or
conversion costs stop being added to the units as well as how much materials and/or
conversion costs have already been added to the units.

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There are two types of spoilage;

1. Normal spoilage; this is the amount of spoilage that is expected under normal
circumstances. For example, a company that bottles drink in glass bottles could
expect 5% of bottles transferred to the production line to break. The cost of this
spoilage is added to the cost of units that pass the inspection point in the current
year. Units that passed the inspection point in the prior year are not allocated any
cost of normal spoilage.

2. Abnormal spoilage; this is wastage over and above what is normally expected. The
cost of this spoilage is recognised as an expense.

Weighted Average vs.FIFO

x The weighted average method: WIP is assumed to have merged with the goods
produced during the current year, and can no longer be identified separately.

x The first in, first out method: WIP is assumed to only be the group of products that
are processed and completed during the current year. The opening stock is
therefore assigned separately to completed production and the cost per unit is
based only on the current costs of that year. The closing stock is assumed to come
from the new units produced that year.

The following is a summary of the steps to follow when approaching a process costing
question:

1. Determine the flow of units

2. Determine the equivalent number of units produced

3. Determine the total cost per production process

4. Determine the cost per unit

Consider the example below:

Company CAN (Pty) Ltd produces ballpoint pens. All materials are added at the beginning of
the process and conversion costs are incurred evenly throughout the process. A visual
quality inspection is conducted 40% of the way through production at which point 5% of all
units started are usually found to be defective. The company uses a FIFO costing system.
During the year 1420 units were found to be defective.

The following relates to the current year:

Direct labour worked 2000 hours at R15/hr and other overheads are applied at R17.238 per
direct labour hour.

Opening Raw Materials R20 000

Purchased Raw Materials R150 000

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Closing Raw Materials R54 500

Opening Work in Progress 0

Closing Work in Progress (55% complete) 1680

Units Started 23 100

Units Completed 20 000

Step 1: Determine the flow of units

Opening inventory completed 0

Units Started 23 100
This is a breakdown of
23 100
all of the units that
Units Completed and Transferred to finished goods 20 000 were worked on to any
Normal Spoilage (23 100 x 5%) 1 155 extent during the year.
Abnormal Spoilage (1 420 - 1 155) 265
Closing Work In Progress 1680
23 100

Step 2: Determine the equivalent units produced

Equivalent Units
%
% Complete units Complete units
opening inventory
completed 0
units started 23100
23100

Completed and
transferred 20000 100% 20000 100% 20000
Normal Spoilage 1155 100% 1155 40% 462
Abnormal Spoilage 265 100% 265 40% 106
Closing units 1680 100% 1680 55% 924
23100 23100 21492
Step 3: Determine the total cost per production process

x Raw materials = 20 000 + 150 000 – 54 500 = R115 500

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 x Direct Labour = 2 000 x R15 = R30 000
Total conversion costs: R34 476 + R30 000 = R64 476
x Overheads = 2000 x R17.238 = R34 476

Step 4: Determine the cost per equivalent unit

Materials Conversion
Current year production costs 115500 64476
Equivalent Units 23100 21492

Cost Per EU R5 R3

The current yearcosts are then allocated as follows:

Materials Conversion Costs

Closing WIP 8 848 2 879
8 400 2 772
Good Units
(1680 x 5) (924 x 3)
448 107
Normal Spoilage (1155 x 5 x (462 x 3 x 1
1 680/21 680) 680/21 680)
Costs Transferred to
105 327 61 279
Finished Goods
Started and Completed 100 000 60 000
Units (20 000 x 5) (20 000 x 3)
5 327 1 279
Normal Spoilage (1155 x 5 x (462 x 3 x
20 000/21 680) 20 000/21 680)
Abnormal Loss 1 325 318
(Expensed) (265 x 5) (106 x 3)
Total Cost Allocated 115 500 64 476

Notice: the total cost allocated must match the costs calculated in step four.

In the following year, when the closing work in progress is finished, 45% x 1680 = 756 EU of
conversion costs will be added to the balance to arrive at the cost of the completed units.
No more normal spoilage will be allocated to those units as have already had the cost of
normal spoilage allocated to them in the current year.

Joint and by-product costing

Distinguishing between joint products and by-products:

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Both emerge from a joint production process and are not separately identifiable until a
certain point in the production process (the split-off point). Joint products have relatively
high sales value as compared to that of the by-products.

For example, coal is processed to produce gas, benzyl and tar. There are costs that are
incurred while the coal is not yet anything besides coal, these are joint costs. The point in
time where the coal stops being just coal i.e. it there is gas, benzyl and tar also present, is
called the split off point.

Below is a figure representing the joint and by-product process:

Cost allocation of joint products:

If some products are left unsold at the end of the period, cost allocation is necessary
because not all of the joint costs should be expensed yet. However, because joint products
are not separately identifiable until the split off point, joint costscan only be estimated for
allocation purposes (costs after the split off point can be traced directly to the joint
product).

Common methods of allocating costs up to the split off point are:

x By dividing by physical measures (weight, volume produced etc.) of the joint

products at the split off point or

x By allocating costs relative to the market/sales values (or net realisable values) of
the joint products at the split off point i.e. before any further processing occurs.

Sales Value Allocation

For example, if the joint costs of processing the coal where R 120 000, and the sales values
of the gas, benzyl and tar produced were R150 000, 250 000 and R100 000: the allocation
based on sales value would be as follows:

Total sales value = R200 000 + R150 000 + R250 000= R600 000

Gas: R200 000/ R600 000 x R120 000 =R40 000

Benzyl: R150 000/R600 000 x R120 000 = R30 000

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Tar: R250 000/ R600 000 x R120 000 = R50 000

Physical units allocation

Say the joint costs yielded 500kg, 750 kg and 1 250kg of gas, benzyl and tar respectively at
the split off point. The joint costs would be allocated as follows:

Total physical yield at split off point = 500kg + 750kg + 1 250 = 2 500kg

Gas: 500kg/2 500kg x R120 00 = R24 000

Benzyl: 750kg/ 2 500kg x R120 000 = R36 000

Tar: 1 250kg/2 500kg = R60 000

The two methods yield different results and therefore the following should be considered:

x Selling prices do not influence costs and thus allocation of costs based on selling
price could be misleading

x The allocation method must produce a realistic result i.e. the cost in relation to the
price

The 2014 June ITC featured joint cost allocation (See tutorial MAF02)

Accounting for the by-products:

Because these products are only incidentalto the business, it is appropriate that no costs are
allocated to the by-products. This differs to joint products which are purposefully produced
by the company. The correct treatment of the by-products would be to deduct the net
revenue earned from the cost of producing the joint or main products. This is consistent
with the requirements of IFRS.

Tips and Examination Technique

1. Job costing and process costing are unlikely to be examined in any detail.

2. For the ITC you should be aware of the environments and activities where job order
and process costing can be used for management planning and control purposes.

3. The treatment of fixed manufacturing overheads in terms of IAS 2 has been

examined frequently in the past.

3. Activity-based costing and management

Activity-based costing (ABC) is a specific type of costing system refinement that focuses on
activities (also called activity areas) as the fundamental cost object. In a manufacturing
context, ABC assigns the cost of activities to jobs, products, or customers.

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The traditional approach tends to allocate indirect manufacturing costs too heavily to high-
volume products and too lightly to low-volume products. The inherent assumption is that
indirect manufacturing overheads are highly correlated with the number of units produced.

When such allocations occur, high-volume products are overcosted and low -volume
products are undercosted . This overcosting/undercosting phenomenon is called product-
cost cross-subsidisation.

To understand this phenomenon better, consider a batch level cost. For example setting up
a machine will generally take up the same amount of time and resources whether the batch
has one item or one thousand items in it. If total set up costs are R1000/set up, the
traditional method would allocate, say, R3/unit based on some arbitrary allocation basis, but
ABC will allocate R1000/set up. Hence the high volume units will carry a cost of R1/unit in
respect of set up costs as opposed to R3/unit on the traditional method and the low volume
units will carry R10/unit as opposed to R3/unit on the traditional method.

Although ABC provides more accurate product costs, some companies believe its most
important benefit is providing information for cost management, referred to as Activity
Based Management ABM, (that is, reducing the usage of cost drivers can help control costs).
If the allocation bases really cause the indirect costs (that is, they really are the cost drivers),
using less of them can ultimately reduce costs – such as when products are designed with
fewer parts or less soldering. Stating the same point differently: managers cannot control
costs per se, but they can control the variables (drivers) that cause costs.

ABCshould be used only if it passes the cost

-benefit test.

x The costs include clerical and computer time, the cost of tracing cost to the cost
driver, as well as user education.

x The benefits are the expected improvements in collective operating decisions in an

organisation. These decisions include, elimination of non-value adding cost drivers
and final product pricing.

ABC most likely would be beneficial to companieswhere:

1. A traditional costing method would give rise to product cost distortion. Thiswould occur
in the following situations:

x A large proportion of overheads are non volume related. If a large proportion of

overheads a related to volume then the activities identified using ABC will also be
volume related, hence the allocation will be similar to a traditional system.

x High product diversity in terms of:

a. Products that use different amounts of resources;

b. Products that don’t consume resources homogenously; and

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 c. Production processes and batch sizes that are different.

2. The industry is a highly competitive environment where knowledge of costs and cost
control are critical. This is because inaccurate cost information can quickly translate into
decreasing margins due to:

x Inappropriate pricing decisions;

x Inappropriate product emphasis; and

x Ineffective cost control.

3. There is access to accounting and information systems expertise to implement and

maintain refined costing systems.

Exam technique for ABC

The most effective way to approach an ABC question is to use a table. Work on double pages
as opposed to using one page in landscape view. An illustration is provided below.

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From the table above, the following points should be considered and are useful for discussion questions:

x Why use practical capacity?

Allocating fixed indirect costs highlights the cost of spare capacity

. The total cost incurred is what the
company pays to make full capacity available. If the company does not use all of this capacity some of the
cost is essentially wasted.

The question that follows on from this is, what should be done with spare capacity? A number of options are
available:

1. Get rid of it. If this is possible, there could be significant cost savings. However, the
disadvantage of this option is that the company loses its ability to be flexible and respond
quickly to increases in demand.

2. Use it. Opportunities for special orders or leasing should be considered.

x Which indirect costs are allocated to the product?

All indirect costs (including non-manufacturing costs) are allocated, except for facility sustainingcosts.

A facility sustaining cost is a cost that is incurred to support the whole organisation and there would have to
be an extremely dramatic change for these costs to change.

x The reliability of ABC depends on:

x Correct identification of cost drivers. Cost drivers can be transaction, intensity or duration
cost drivers. For example, the telephone bill of the ordering department is not only
influenced by the number of transaction but also by the duration of each phone call. An
electricity bill of a bakery is influenced by the number of items produced (transaction) as
well as the time (duration) in the oven and the temperature of the oven (intensity); and

x The nature of the decision being made. ABC can create a false impression of relevance of
overheads. Fixed overheads are included in the cost of the product but for short-term
decision making it is not appropriate to consider these costs as relevant.

Note: Despite the advantages of ABC, you should also be aware of and prepared to discuss the limitations of
ABC. This might be in a purely theoretical context or you may be required to discuss how a company could
improve the way that ABC is already being applied (See tutorial MAF04).

Example

XYZ Ltd manufactures four products, namely A, B, C and D, using the same plant and processes. The
following information relates to a production period:

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Product Volume Material cost Direct labour Machine time Labour cost per
per unit per unit per unit unit
A 500 R5 1/2 hour 1/4 hour R3
B 5000 R5 1/2 hour 1/4 hour R3
C 600 R16 2 hours 1 hour R12
D 7000 R17 1 1/2 hours 1 1/2 hours R9

Total production overhead recorded by the cost accounting system is analysed under the following headings:

x Factory overhead applicable to machine-oriented activity is R37 425

Total overheads = R59 880,
x Set up costs are R4 355 of which 37.5% are not
related to machine hours.
x The cost of ordering materials is R1 920 This is an indication that
ABC could be beneficial.
x Handling materials - R7 580

x Administration for spare parts - R8 600

These overhead costs are absorbed by products on a machine hour rate of R4.80 per hour, giving an
overhead cost per product of:

A = R1.20 B = R1.20 C = R4.80 D = R7.20

However, investigation into the production overhead activities for the period reveals the following totals:

Product Number of set-ups Number Number of times Number of spare

of material orders material was parts
handled
A 1 1 2 2
B 6 4 10 5
C 2 1 3 1
D 8 4 12 4

YOU ARE REQUIRED:

(i) To compute an overhead cost per product using activity based costing, tracing overheads to
production units by means of cost drivers; and

(ii) To comment briefly on the differences disclosed between overheads traced by the present system
and those traced by activity based costing.

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Example discussion and suggested solution

Workings

(W1) Total machine hrs = 125 + 1250 + 600 + 10500 = 12475 mhrs
(W2) Total set ups = 1+6+2+8= 17 set ups In all questions, make
sure your workings are
(W3) Total Material orders = 1+4+1+4= 10 orders well referenced and
(W4) Total Materials handling operations = 2+10+3+12= 27 operations legible.

(W5) Total Spare Parts administered =2+5+1+4=12 parts administered

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Unit Overhead Cost Structure

Product Machine Set- Material Material Spares Total Old DIFF

Overhead ups ordering handling System
A 0.75 0.51 0.38 1.12 2.87 5.63 1.20 +4.43
B 0.75 0.31 0.15 0.56 0.72 2.49 1.20 +1.29
C 3.00 0.85 0.32 1.40 1.19 6.76 4.80 +1.96
D 4.50 0.29 0.11 0.48 0.41 5.79 7.20 -1.41

The traditional system makes the false assumption that all overheads are related to volume
and machine time. A and C are under-costed, by the traditional system because it mis-
allocates costs for small volume products. The activity-based system recognises the
differences of relative input consumption between products, and traces the appropriate
amount of input to each cost unit. Product B previously avoided its full share of overheads
because of its low machine time, and may still do so if part of the R37 425 of machine-
oriented overhead should be apportioned on some other basis.

Product D is over-costed because the traditional system loaded it with overheads

attributable to activities concerned with A, B, and C, as a result of using a volume-based and
machine-oriented rate, which failed to pay proper attention to activity costing.

Traditional management accounting has also used labour or machine hour costs as a
measure of resource consuming activity and thus the greater the labour or machine hour
cost, the greater the assumed activity and consumption of indirect resources. In fact, cost
headings have been viewed as a substitute for activity. Complex modern production systems
require costs expressed in terms of activity to reveal the causes of costs. Activity-based
information may be non-financial, but concerns activities across the entire chain of value
adding processes, and focuses the attention of managers on activities that cause costs
rather than the costs themselves. These activities are known as "cost drivers". Many
processes within a business add cost to the product, directly or indirectly, but not all add
value to the product. The differentiation between value adding and non-value adding
activities is significant, since it identifies costs, which can be cut without deterioration of the
product. For example, the cost of holding inventory does not add value to the product, and
is therefore a promising activity for cost reduction.

A further example of cost drivers concerns the allocation of overheads to production units.
Products manufactured in short runs generate more support department cost per unit than
products made in long runs, but if such overheads are allocated to products per unit based
on total volume, (direct labour hours or machine hours), all production units will receive the
same charge. This under-costs short run products and overcharges long run products. Cost
tracing based on arbitrary allocation rules, (e.g. cost drivers such as direct labour hours and
machine hours) can lead to distortion because there is no real cause and effect relationship
in a complex modern manufacturing system between the apportionment base and the cost
to be apportioned.

Production with a series of short run products creates manufacturing overhead derived from
set-up time and switching from one product to another. If such costs are allocated to

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production units on the basis of non-related activities, distortion will result. Cost drivers for
activity-based cost allocation should be selected because they relate to the scope and
diversity of production rather than volume alone. Cost tracing based on activity recognises
differences in the consumption of indirect input costs that are ignored by a volume-based
system.

Tips and Examination Technique

1. Activity-based budgeting/management has been examined infrequently in the ITC.
However the general acceptance of ABC/ABM by the profession and industry give
rise to a chance of ABC/ABM being included in the coming ITC.

2. Activity-based costing questions are unique with clearly defined activities and clearly
defined cost pools. Once each cost pool has been matched to an activity, the cost for
each activity can be determined and these traced through to the cost objective.

3. Do not confuse an activity

-based costing question with an ordinary cost allocation
or decision-making question.It should be quite clear from either the body of the
question, or the required section, that you are required to apply activity based
costing.

4. Cost volume profit analysis

The overriding concept in cost volume profit relationships is contribution margin, which is
simply the excess of sales revenues over all variable expenses. This idea is the essence of a
powerful management planning control technique known as break-even analysis.

The break-even point is the point of activity (level of sales volume) where total revenues
. At this point there is neither profit nor loss.
equal total expenses

There are a number of assumptions implicit in cost volume profit analysis:

x The relationships between total sales and total expenses apply only to the relevant
range.

x The band of expected activity volume for the planning period.

x That total costs and revenues are linear.

x That all costs must be divisible into strictly fixed and variable elements.

Unit selling prices, unit variable costs and total fixed costs are assumed constant at different
activity levels. A further assumption is that no changes in efficiency or productivity occur at
different volume levels. In essence, we are assuming that activity volume is the only relevant
factor affecting costs.

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Break-Even Analysi
s
The break-even point is the point of activity (level of sales volume) where total revenue
equals total expenses. At this point there is neither profit nor loss.

NOTES
Contribution Margin Sales Revenue - It is important to use all variable cost and not just
Variable Costs the manufacturing costs i.e. selling costs such as
commission or royalties must be included.
It might be necessary to use the High-lo method
to separate a semi variable cost into the fixed and
variable component.
Contribution margins are also used in the
relevant costing section when deciding how to
allocate limited resources. The idea is to
emphasize the product that will contribute to
covering fixed costs the most.
CM ratio CM/Sales Revenue Contribution margin can be expressed as a
percentage of revenue. This is especially useful
for calculating the break-even sales level .
Break-Even (Units) Fixed Cost/Unit This is the number of units that the company
Contribution must sell in order to just cover fixed costs. This
can also be used for a service company if there is
sufficient information about variable costs per
transaction.
Break-Even (Units) [FC+(ATP/(1-t))] The units here are not “break-even” units as
Unit Contribution defined, because at break-even, profit is R Nil.
This is the number of units to reach a target profit
[After Tax Profit (ATP)].
The reason that ATP must first be grossed up for
tax (by dividing by 1-t) is because sales revenue is
before tax, thus a few extra units must be sold in
order to compensate for the tax that is still to be
paid.
Break-Even (Rands) Fixed Costs/CM ratio Expressing the break-even level in rands can be
useful where insufficient information about the
variable costs per unit/transaction. In this case
total revenue and variable costs will be known,
thus the contribution margin ratio can be found.
Break-Even (Rands) [FC+(ATP/(1-t))]/CM See comment above on grossing up ATP.
ratio

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Some questions might ask for different types of break-even, such as break-even exchange
rate or break-even selling price. What is important to remember is that at break-even FC =
CM. There will only be one unknown for you to calculate.

For example, when calculating a unit selling price to achieve a certain level of ATP with a
given number of sales units, the following formula can be used:

Number of units = [FC+(ATP/(1-t))]

Unit Contribution Margin

The “unknown” is the unit contribution margin. Once that is found, simply add back the
variable costs to arrive at the before tax selling price.

This type of calculation might arise in a situation where the demand for a product or the
capacity of the company is limited and thus the company is not in a position to rely on
increasing volumes to increase profit. This logic also applies where competition in a market
is very high, and therefore the company has limited demand and can’t increase prices above
a certain level. The formula above can be used to adopt a target costing approach i.e. the
company must aim to achieve a low level of variable costs per unit in order to increase the
contribution margin.

The graphic approachis often useful in visualising the concept of break-even analysis.

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Think about how a company could fail to achieve break-even volumes and yet still make a
profit.

Break-even analysis will not always be explicitly asked for, but keep in mind that it is useful
and can help provide insightful comments in a number of situations. For example,
commenting on whether a new product should be launched or a special order accepted. If
for example the break-even level is at or above capacity, the project might not be feasible.

Cost behaviour within elevant

r range
Stepped Fixed Costs and CVP (Also refer to the cost classification section)

When answering CVP questions that involve a step-fixed cost, it is important to show the
examiner that you are aware of the step fixed cost. This is done by leaving evidence on your
script that you have checked that the break even units arrived at is on the same “step” as
the level of fixed costs used in the calculation.

These principles are illustrated below:

Fixed Cost
Units of Production A
0-199 R 30 000
200-399 R 50 000 As a general rule, in CVP
400- R 70 000 questions, round up the
break-even units to the
nearest whole number.
Other fixed costs R 50 000
Presumably it is not
possible to sell 290.9
CM/u R 275 units.

Initially pick any level of production. It’s usually easiest to start at the bottom.

Break-even = (R50000 + R30 ììì•lîóñAîõìXõìCîõíµv]š•

This implies that if the company invests in capacity that costs R30 000, 291 units must be
sold to break even, however, a R30 000 investment only gives enough capacity to produce a
maximum of 199 units. Hence, a larger investment in capacity must be made, which will in
turn increase the total fixed costs.

Revised break-even = (R50 000 + R50 000)/275 = 363.6 Cïòðµv]š•

Thus, if the company invests R50 000 in capacity, 364 units must be sold. This is feasible as a
maximum of 399 units can be produced at the new level of investment.

This can be illustrated graphically as follows:

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In this example, it is apparent that there is more than one break-even volume. If the
company increased its investment in capacity to R70 000, 434 units would have to be sold in
order to break even. This could be risky if the company is not confident that it can achieve
that level of sales and thus they may choose to make the smaller investment in capacity.

Think about what types of investments could give rise to such a situation. Perhaps, the
company leases its production machines and theses are available in varying sizes and the
rental for each size is different. The fixed cost would be the annual rental and the
production units would be the maximum amount that the machine can produce.

Multiple product scenarios

The main issue with multiple product scenarios is: which contribution margin to use? This is
because the fixed costs are incurred for the whole business, i.e. they can’t be traced to
individual products. Hence, in order to do one break-even calculation, one contribution
margin is required.

The following two methods can be used:

1. Weighted-averagecontribution margin and;

2. Batchcontribution margin

In both cases the sales mix (i.e. the ratios in which the products are sold) is assumed to be
constant.

Weighted average contribution margin

This involves taking the contribution margins of all the products in the sales mixand
calculating an average. The proportion of each product in the sales mix is used to weight the
contribution margins.

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 Batch contribution margin
This is where the sales are assumed to take place in batches with a constant sales mix. In the
example below one batch consists of 4 units i.e. 1 unit of product A and 3 units of product B.

The following example illustrates the weighted-average and the batch method:

Weighting: Product Units CM/u

A 1 R 50 Batch CM:
A: 1/4 = 25%; B: 3/4 = 75% B 3 R 25
(R50 x 1) +
CM = (R50 x 25%) + (R25 x 75%) (R25 x 3)
Total fixed costs R 62 500

a) Weighted average CM R 31.25 b) Batch CM R125

Break even Units Break even Batches
(62 500/31.25) 2000 (62 500/12 500) 500

2000 Units 5 Batches

Product Total
Product A Product B Total Units Product A B Units
500
1500 500 1500 2000
(2000 x 2000
(2000 x 75%) (1 x 500) (3 x 500) (4 x 500)
25%)

Note that the final result is the same

, regardless of the method used.
A and B are the
The two methods shown above can be summarised as follows: number of units of
each product in a
batch

A% and B% is
the weighting of
each product in
the sales mix

After the final multiplication, the result is the break-even units of each product.

Tutorial MAF05 and MAF06 illustrate how a CVP in a multi product scenario can be
examined.

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Sensitivity Analysis
Costs, volume and profits are interrelated and thus a change in any factor could affect the
break-even point and net income.

To cope with uncertainty, it is useful to construct a model to deal with sensitivity analysis.

Margin of Safety Expected Units – Break even

Degree of Operating Leverage CM/Net Profit

Margin of safety: The result of this calculation is the number of units by which sales can fall
before the company starts to make losses.

Margin of safety can also be expressed as a percentage:

Margin of safety ratio = Margin of safety (units)/Expected units

Margin of safety is very useful when used in conjunction with other information in the
scenario to provide insightful commentary. For example, if the scenario is about a new
product launch, the margin of safety is important because it is an indication of how risky the
venture is since the sales units used to calculate the break-even units are all estimates. A
small margin of safety means there is very little room for error in the estimates of sales.

Margin of safety can also be used in relevant costing discussions, as this is one of the factors
management will have to consider when deciding to, say, introduce a limited edition
product to use up spare capacity.

Degree of operating leverage: This is a multiple to estimate the percentage increase or

decrease in profit for a given increase in sales from a given level.

The degree of operating leverage is driven by fixed costs. The formula shown above can be
broken down as follows: DOL = CM/(CM-Fixed costs) i.e. the only difference between the
numerator and the denominator is the fixed costs. As the fixed costs increase the multiplier
also increases. The larger the multiplier is, the more sensitive profit is to a change in sales.

If the business in question is doing well, a high DOL could be a good thing because a small
increase in sales will result in a relatively larger increase in profit. However, the effect of a
small decrease in sales will result in a relatively larger decrease in profit. Thus, it can be said
that fixed costs introduce risk into the business.

The level of fixed operating costs tends to be inherent in the nature of the business. For
example, a manufacturing company will tend to have higher fixed costs than, say, a retailer.
The effect of the resulting high DOL can be offset by reducing the degree of financial
leverage(FL).

FL = EBIT/(EBIT-I)

Where I is interest expense

.

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Degree of operating leverage x Degree of financial leverage is the Total leverage of the
business. Thus a business, with a high degree of operating leverage can manage its level of
total risk by controlling its level of debt.

'What if' questions can be used to establish the volatility of the break-even volume. When
using what if questions only change one variable at a time in order to isolate the cause of
the change in the break-even.

For example, increase fixed costs by 10% and then recalculate the break-even level. Then
reduce variable costs by 10% and recalculate the break-even level. Compare each new
break-even level to the original break even in order to establish to which variable the break-
even level is more sensitive. This is illustrated below:

Product A
SP R 100
VC R 80
CM R 20

Fixed Cost R 20 000

Break 1 000
Even Units

If Variable costs decrease by 10% If Fixed Costs decrease by 10%

CM R 28 CM R 20
Fixed Costs R 20 000 Fixed Costs R 18 000
New Break-
Even 715 Units New Break-Even 900 Units
% Change 29% % Change 10%

The break-even is more sensitive to changes in variable costs. If the margin of safety is less
than 29% there is very little room for poor cost control (if product A is already in
production), or inaccurate estimates (if Product A is a proposed new product).

In practice this is often done on a spreadsheet using a personal computer. Sensitivity

analysis allows one to make different predictions and assumptions for various critical factors
in a given case. The model will then reflect the effects of these changes and this analysis will
help managers focus on the most sensitive aspects of a particular plan of action, before
making a potentially costly commitment.

Contribution margin helps to identify products that should be emphasised and also those
that should be de-emphasised. The products that should be emphasised are the ones that
contribute the most to covering the fixed costs of the business. Emphasising a product or
discontinuing a product based on the profit per unit can be misleading as the allocated fixed

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costs will not be saved by selling less of the product, they will only be allocated to another
product. The principal of ranking products by contribution margin is also used in transfer
pricing to assess the optimal strategyfor the company.

Further the contribution margin assists decisions concerning selling price changes and
special price promotions.

No decision on how to use machines, materials and other resources profitably can be made
without a contribution margin (see relevant costing notes on constraints).

Tips and Examination Technique

1. There is a high chance of CVP and break-even being included in the exam.

2. Elements of cost volume profit and break-even analysis have been examined along
with other issues in decision-making questions. It is an area where candidates score
marks easily and you should pay attention to the basics.

3. A common problem in this area is the incorrect classification of costs. Make sure you
are able to discern which costs are variable and which costs are fixed in relation to
production output. These concepts have also been examined in the context of
activity based budgeting/management, where typically costs are semi-fixed at each
activity level.

5. Budgeting
A budget is the device used in management planning and control systems to co-ordinate a
set of detailed operating forecasts for all parts of an organisation.

Consider the following behavioural arguments for and against involving those members of
management who are responsible and accountable for the implementation of the budget in
the process of setting annual budgets.

Advantages that have been claimed to result from a participative budgeting process are:

x Participation increases the aspiration levels and motivation, and increases the
probability that the budget will be accepted as a legitimate target for which to aim.

x Participation may lead to an increased level of efficiency.

x Participation improves communication between the employees and their superiors.

The disadvantages of participative budgeting include:

x It may lead to creation of budget slack. Where managers are able to influence their
budget standard, there is a possibility that they will bias the information in order to
gain the greatest possible benefit. This will apply particularly where the reward
system places great stress on achieving the budget.

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 x The personality traits of the employees may limit the benefits of participation.
Individuals with certain personality traits may perform better when a higher
authority imposes budgets.

x Participation may encourage managers to adopt a departmental self-centred

approach and concentrate solely on maximising the benefits of their own
departments at the expense of the benefits of the organization as a whole.

Some of the disadvantages which result from imposed budgets include:

x Non-acceptance of the budget as a target may result in the employees not

attempting to achieve the target set. This could be because the budget is too tight.

x The budget is likely to be viewed as a punitive device which management uses in a

recriminatory manner to evaluate subordinates. There is a danger that this might
create hostility towards the budget system and a failure to use the system as a
planning and control device.

x Pressure to achieve an imposed budget might result in the falsification of data or

under-performance in order to influence the setting of future budget targets so that
they are set at easily attainable levels.

Problems are likely to apply, regardless of which approach is used.

The most commonly used static budget is the zero-based budget. This is where the budget is
completely re-drafted from zero every year, as opposed to simply adjusting the prior year
budget. This way, management must motive why they need as certain budget and what they
intend to do with it.

The advantage of zero-based budgeting over incremental budgeting, is that the prior year
appropriation is not used as the starting point. With zero-based budgeting, activities are
identified and decision packages presented for alternative levels of fulfilment. Thus,
priorities are easily identified and funded accordingly, i.e. resources are more efficiently
allocated.

However, zero-based budgeting can be time consuming.

Budgets show in quantitative terms the action plans of organisations, whether profit-seeking
or non-profit. Budgets should:

x Compel managers to face planning tasks;

x Express plans in numbers for evaluating performance;

x Communication and co-ordinate plans; and

x Assist managers in making decisions both operating and financing.

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Budgets can be both short and long term. A short-term budget would cover one year
divided into months or quarters and be continuously updated (rolling). A long-term budget
would cover 10 years or more and would consider changes in products, facilities and
operations.

Normally a budget would include a set of pro-forma financial statements. The operating
budget would consist of an income statement including sales, production and expenses. The
financial budget would consist of a balance sheet, a cash budget, capital budgets and
changes in any financial position.

The steps that need to be taken in preparing a budget are:

x Forecast sales in product units and in turnover.

x Prepare production budget including target inventory levels.
x Construct support schedules of material, labour and overhead costs.
x Generate the cost of goods sold.
x Prepare expense budgets.
x Draw up the budgeting income statement.
x Draw up a cash budget.
x Draw up a pro-forma balance sheet.

The forecast of sales volume is central to the entire budget. There are many factors that
need to be considered, such as: past sales volume, general economic and industry
conditions, market research studies, pricing policies, advertising, competition and other
factors.

In forecasting sales, salesmen and sales managers combine their predictions after
considering previous sales volumes, economic indicators and competitive conditions.

You should use the factors described above to help you answer a question that asks you to
comment on a cash flow forecast or a budget. In addition, the following issues should also
be considered when commenting on a forecast/budget:

x Is it reasonable in terms of:

o Inflation or has inflation been included?

o Expected growth of the market?
o Prior year performance?
o How does the growth rate used compare to the sustainable growth rate of
the company?

x Are the statement of profit and loss and comprehensive income estimates
reasonable? Think about what drives each line item:

o Operating expenses are probably (but not always) driven by revenue and
therefore would change in a similar way to revenue. What are the reasons
for forecast cost efficiencies? Are they achievable? Increasing margins are
not sustainable forever.

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 o Depreciation is driven by capex (is the capital expenditure of the company
smooth or lumpy).
o Interest expense and income are driven by debt and investment
respectively.

x Are the statement of financial position estimates reasonable?

o Working capital is generally forecast as a percentage of revenue.

o Are accounts payable, accounts receivable and inventory days achievable? Is
the operating cash sufficient?
o Is the forecast PPE and capex sufficient to support the forecast growth or, at
the very least, maintain operations? Consider if asset efficiency ratios look
stable?

Master budgets often form a basis for the construction of computer based simulation
models. These master budgets are normally drawn up using a spreadsheet on a personal
computer and they define the relationship among the company's activities and identify
related factors, both internal and external. Such a spreadsheet can then be used not only
for preparing and revising budgets but also for comparing the effects of various decision
alternatives (sensitivity analysis).

Management by objective (MBO) is a system for measuring and evaluating performance.

The process works by a manager and superior jointly specifying budget goals and plans for
attaining them. Ultimately the superior evaluates the performance accordingly and thus the
joint participants tend to view MBO favourably.

Tips and examination technique

1. Questions on budgeting (other than capital budgeting) have not been asked for
many years. As a result it is felt that it is an unlikely topic for inclusion in the ITC.
2. Do not concern yourself with the various techniques used to forecast sales.
3. In the event of a budgeting question remember:

a) Any potential budgeting question will require an analysis based on the

information contained in the particular question.
b) Generally, there is little that you can do to prepare yourself other than to be
aware of the basic principles of budgeting.
c) READ THE QUESTION CAREFULLY MAKING NOTES/HIGHLIGHTS AS YOU
PROCEED.

6. Standard costing
Standard costing is an inventory costing method. Pre-determined standards are established
with respect to the various aspects of the cost of the product. For example, the standard
price of raw materials, the standard quantity of raw materials that should be used per unit
and the standard amount of direct labour time that should be spent producing each unit.
These costs are then accumulated in a standard cost card, which shows the total final

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standard cost per unit. Inventory is initially costed assuming that the standards were
adhered to.

Standard costs are predetermined, currently attainable, costs based on targets set. They
assist management in improving performance as they allow comparison between standards
and actual, enhancing both planning and controlling functions.

Setting standards
x Standards should be tough, but attainable. This is to encourage good performance,
without making it too difficult which would most likely demotivate management.

x Currently attainable standards should be set and these are the costs that should be
incurred in short-term, efficient operating conditions. These standards allow for
normal idle time, normal spoilage, etc. and because they are difficult to achieve,
tend to result in a slightly unfavourable bias.

x Standards should not be imposed. The managers who will be held accountable for
the variance should be involved in setting standards. Responsibility for variances
depends on the organisational structure and the amount of managers' autonomy.
For example, the buying manager will normally be held responsible for a material
price variance unless the variance arose from a rush order demanded by production.

The points mentioned above are very similar to issues raised in the budgeting section, as
setting standards is essentially a form of budgeting.

Varianceanalysis
However, standards are not always adhered to perfectly. The difference between actual
costs and standard costs (predetermined measures of what costs should be under specified
conditions) are called variances. The analysis of these variances can aid managers in judging
and improving performance. Variance analysis is a tool used to analyse differences between
actual performance and budgeted operations.

Of paramount importance to variance analysis where a standard costing system is used is

the flexible/flexed budget, which is the master/static budget adjusted to the actual level of
activity volume.

The comparison of actual results with a static budget is meaningless because the static
budget shows costs at only one level of activity. If this budget is compared with actual
results when there is a change in volume level it will lead to misleading variances because it
is not unusual for costs incurred to increase when production volumes increase.

A flexible/flexed budget (variable budget) adjusts the static budget for changes in the
volume level and so overcomes the problems associated with static budget s. It essentially
calculates what the expected rand amount is for a particular cost or input at the actual
production levels if all other standards had been adhered to.

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Note: The flexed budget is not only useful in standard costing questions. Whenever you
must compare actual results to budgeted/expected results, it is important to remove the
impact of different production/sales volumes. This is illustrated in tutorial MAF03.

A flexible/flexed budget varianceindicates the difference between the flexible budget and
actual results. Flexible budget variances can be further subdivided into price and quantity
variances.

When asked to calculate and comment on the variances in a standard costing situation,
consider the following variances.

A flexible budget varianceis:

x (Total actual cost) - (Total standard cost)

Where the flexible budget total (Total standard cost) is:

x (Good output) x (Input per unit of output) x (Standard price of input)

A price or rate varianceis:

x (Difference in input unit price) x (Actual input)

An efficiency or usage variance

is:

x (Difference in quantity of input units) x (Standard price)

Normally price variances should be isolated as soon as possible as the current control of
purchasing is important. Purchases are recorded at standard prices and therefore the
variance is recorded simultaneously (because the debit to inventory will not match the
credit to bank/accounts payable). Thus the materials price variance is based on quantities
actually purchased while the usage variances are based on quantities issued to production.

Manufacturing processes often involve different mixes of materials to make a specific

product. As a result it is possible to further analyse the usage variance
into a mix variance
and a yield variance.

The material yield variance is the difference between the actual units of input and the
standard units of input, multiplied by the standard average price per unit of input.

The material mix variance is the difference between the actual mix standard average price
per unit of input and the standard mix standard average price per unit multiplied by the
standard units of input.

The most important thing to remember when calculating a mix and yield variance is that it is
only relevant when the materials are interchangeable. This is because of what the mix and
yield variance shows.

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 x The mix variance shows how much was saved or how much more was spent because
a more or less of a cheaper input was used instead of a more expensive input. For
example using more margarine in a cake instead of butter, which is more expensive.

x The yield variance shows how efficient the new mix was. It analysed whether more
or less material in total was used to produce a given level of out put. For example, if
cheap vanilla essence is used in a recipe instead of pure vanilla extract, the total
amount that must be used to bake the same number of cupcakes is more than if
more of the better quality ingredient is used.

With variable overheads , the variance analysis and accounting treatment are very similar to
that of variable labour cost. However, variable overhead consists of numerous different
types of costs, such as indirect labour or material, repairs, power and idle time; and these
costs need to be analysed separately. The variable-overhead rateis calculated by dividing
the total variable factory overhead at a given level of activity by the standard level of activity
at that level which is often expressed in terms of direct-labour hours allowed. This is the
same concept as calculating a pre-determined overhead rate.

The variable overhead efficiency variance is:

x {(Actual hours) - (Standard hours)} x (Standard hourly rate)

The variable overhead spending variance is:

x {(Actual Var O/H - (Flexible Budget Var O/H)} - (Efficiency variance)

Fixed factory overheads do not change in total over a wide range of activity. However, unit
costs, of course, do change. This causes a problem in identifying the standard fixed overhead
per unit as it is dependent on the level of activity

The fixed factory overhead volume variance is:

x {(Actual activity) - (Capacity used as allocation base)} x {Standard allocation rate}

This variance is of little use for control as it merely indicates the extent of either over or
under allocated fixed overheads. If a variable costing system is used, there will be no volume
variance.

The fixed factory overhead spending variance is:

x (Actual fixed overhead) - (Budgeted fixed overhead)

The information above is summarised below:

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 Where estimates change, it is normal to reflect the change in estimate as planning variances
while the operating variance is calculated using the revised estimate. Therefore, the
difference between the flexible budget and the revised flexible budget will indicate the total
planning variance. The difference between the revised flexible budget and actual will
indicate the total operating variance.

For example: The standard wage rate for direct labour is R60/hour, but after unexpected
strike action and wage negotiations this increased by 3% at the beginning of the year. The
actual rate paid to staff was R62/hour. The standard hours for the output produced is 31 500
but the actual hours worked were 32 150. The following variances can be calculated:

Actual at
RFB FB standard Actual
R194 670 R189 000 R198 687 R199 330
61.80 x 3 150 60 x 3 150 61.80 x 3215 62 x 3215

Planning Operating
Rate Rate
Variance Variance
R5 670 U R643 U

Efficiency
Variance
R4 017U

If the planning portion of the rate variance is not separated, it would appear that the rate
variance is (62 -60) x 3215 = R6 310. However, this is misleading because R5 670 was not
within management’s control. Management should only be held accountable for issues
within their control.

A technique to calculate the basic variances which is used in the following working example,
is to calculate for each input:

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 x The flexible/flexed budget;

x The actual input at standard price; and

x The actual input at actual price.

The difference between the flexible budget and the actual input at standard price is the
efficiency/usage variance.

The difference between the actual input at standard price and the actual input at actual
price is the price/rate variance.

This technique has two advantages. Firstly, it is less prone to error as the approach requires
the construction of a flexible budget for all inputs followed by the construction of the actual
input at standard price, likewise for inputs. The actual input at actual price (actual
consumption) is given in the question. Secondly, it saves time as candidates are focused on
specific aspects of the question rather than jumping about.

A table, similar to the summary shown above, can be used to keep track of the flexed
budget, actual input at standard price and actual input at actual price for each item. You
should be comfortable calculating all of the variances shown including the sales variances
(see sales variance section). Tutorial MAF05 is an example of why you should be aware of all
the possible variances and when it is appropriate to calculate them, as the required gave no
guidance as to which variances should be calculated. You should also be able to calculate
specific variances that are asked for as is required in tutorial MAF21.

Treatment of variances
If there are variances in the ledger accounts at the end of the year they will need to be
disposed of by either:

x Writing them off in the income statement to cost of goods sold if the variances are
insignificant.

x Prorating them between the income statement and inventory when the variances
are material.

However, the account to which the variance is prorated depends on the nature of the
variance. For example, by year-end a favourable material price variance will have caused
cost of sales, raw materials, work in progress, finished goods and the material usage
varianceto be over-stated.

This is because of the way journal entries are processed in a standard costing system. The
principal is that when a debit is made to an inventory account, the standard should be used.

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For example:

Dr Raw Materials AQ x SP
Cr Price Variance (F) balance
Cr Bank AQ x AP
Dr Work in Progress SQI*x AQoutput x SP The Usage Variance is found using the
Dr Usage Variance (U) balance standard price but this is higher than
Cr Raw Materials AQused x SP the actual price.

Hence the following journal entry will be required:

Dr Materials Price Variance xxx

Cr Cost of sales xxx
Cr Raw Materials xxx
Cr Work in Process xxx
Cr Finished Goods xxx
Cr Materials usage variance xxx

Note that the usage variance could also have been favourable. As a result, the journal entry
above would increase the usage variance. The larger usage variance would then be prorated
as appropriate.

Material usage, labour and overhead variances will only be prorated to the cost of sales,
finished goods and work in progress accounts.

For example, consider the following variances and account balances:

Direct Labour Rate Variance R 100 F

Direct Labour Efficiency Variance R 50 U

Raw Materials Price Variance R 100 U

Raw Materials Usage Variance R 80 F

Raw Materials Balance R 120

Work In Progress R 100
Finished Goods R 200
Cost of Sales R 500

It is also known that 40% of the work in progress, finished goods and cost of sales consist of
raw materials.

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 If the overhead variances had been given, they would be
prorated in the same proportions as the labour variances.

The following table illustrates the workings for prorating the variances:

RM Usage WIP FG COS Total

Balance R 120 000 R 220 000 R 100 000 R 200 000 R 500 000 R 800 000
% Content of raw materials 100% 100% 40% 40% 40%
Base to allocate RM variances over
(Balance x %) R 120 000 R 220 000 R 40 000 R 80 000 R 200 000 R 660 000
% content conversion costs 0% 60% 60% 60% 60%
Base to allocate RM variances over
(Balance x %) n/a n/a R 60 000 R 120 000 R 300 000 R 480 000

RM Price (Base/ R520 000) x R100 000 (R 18 182) (R 33 333) (R 6 061) (R 12 121) (R 30 303) R 100 000
RM Usage (Base/R320 000) x R186 667 R0 (R 186 667) R 23 333 R 46 667 R 116 667 R0

DL Rate (Base/480 000) x 100 000 R 12 500 R 25 000 R 62 500 R 100 000
DL Efficiency Variance (Base/480 000) x 50
000 (R 6 250) (R 12 500) (R 31 250) (R 50 000)

Total (Dr)/Cr (R 18 182) (R 220 000) R 23 523 R 47 046 R 117 614

The total Dr required is R220 000 but R33 000 has already been debited
against the price variance. Only the remaining R186 667 must be debited
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The composite journal entry required is:

Dr Cr
RM Price 100 000
RM Usage 220 000
DL Rate 100 000
DL Efficiency 50 000
Raw Materials 18 182
WIP 23 523
Finished Goods 47 046
Cost of Sales 117 614
338 182 338 183

This is made up of the following:

RM Price variance

Dr Cr
Raw Materials 18 182
RM Usage 33 333
WIP 6 061
FG 12 121
COS 30 303
RM Price 100 000
100 000 R 100 000

RM usage variance

Dr Cr

RM Usage 186 667

WIP 23 333
FG R 46 667
COS R 116 667

186 667 R 186 667

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DL rate variance:

Dr Cr

DL rate 100 000

WIP 12 500
FG 25 000
COS 62 500

100 000 R 100 000

DL efficiency:

Dr Cr

DL efficiency 50 000
WIP 6 250
FG R 12 500
COS R 31 250

50 000 R 50 000

Inventory must be valued at the lower of cost and NRV.

x Variances (except the fixed overhead volume variance) should be prorated unless they represent
abnormal wastage, which cannot be included in the cost of inventory.

x A favourable fixed overhead volume variance must be prorated to avoid inventory being valued
above cost (IAS2).

x An unfavourable fixed overhead volume variance represents unallocated overheads, which must be
written off as an expense in the period in which they were incurred (IAS2).

Example

Mingus Ltd produces granoids. It revises its cost standards annually in September for the year commencing
1st December.

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At a normal annual volume of output of 40,000 granoids its standard costs, including overheads, for the year
to 30th November 2014 are:

Cost Standard Per Unit Total

R R000s
Direct materials 5kg at R10 per kg 50 2 000
Direct labour 2 hrs at R5 per hr 10 400
Variable overheads R1 per kg of variable material 5 200
Fixed overheads R5 per hr of variable labour 10 400
75 3 000

The actual expenditure incurred in that year to produce an actual output of 50,000 granoids was:

Cost Total Expenditure Further Details

Direct materials 2 880 320,000 kgs at R9 per kg
Direct labour 540 90 000 hrs at R6 per hr
Variable overheads 280
Fixed overheads 380
4 080

Due to an industrial dispute in 2013 there was no stockholding of materials, work in progress, or completed
granoids at 1 December 2013. At 30th November 2014 there was an inventory of 10,000 completed
granoids, but no work in progress, and no raw materials inventory.

YOU ARE REQUIRED TO:

a) Calculate the detailed variances under both absorption and variable costing indicating how the
variances would be prorated at the year-end.

b) Calculate, in each case, the balance that would remain in the finished goods inventory account if
each of the following six costing systems were used:

(i) Actual absorption costing

(ii) Standard absorption costing with variances written off

(iii) Standard absorption costing with variances prorated between cost of sales and inventory

(iv) Actual variable costing

(v) Standard variable costing with variances written off

(vi) Standard variable costing with variances prorated between cost of sales and inventory

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 c) Comment briefly, in general terms, on the main effects of applying to inventory valuation the various
costing systems set out above, referring to your calculations in part (a) and (b), if you wish.

d) Discuss the use of overhead cost absorption procedure for both:

(i) Pricing; and

(ii) Control of costs.

Example discussion and suggested solution

(a) Variances assuming absorption costing in R000s.

Flex Bud Act input Actual Total Price Eff Vol

@ std pr 1
Direct materials R2, 500 R3, 200 R2, 880 380u 320f 700u
Direct labour R 500 R 450 R 540 40u 90u 50f
Variable Overhead R 250 R 320 R 280 30u 40f 70u
Fixed Overhead R 500 R 400 R 380 120f 20f - 100f
R3 750 R4, 370 R4, 080 330u 290f 720u 100f

* R1 x 320 000kg(f)
** (250 000kg – 320 000kg) x R10

Prorated to:

Cost of sales (40 000/50 000) x 330(u) R264

Finished goods (10 000/50 000) x 330(u) R 66

Variances assuming variable costing in R000s

Flex Bud AI@SP Actual Total Price Eff

Direct materials R2, 500 R3, 200 R2, 880 380u 320f 700u
Direct labour R 500 R 450 R 540 40u 90u 50f
Variable Overhead R 250 R 320 R 280 30u 40f 70u
Fixed Overhead R 400 R 400 R 380 20f 20f -
R3, 650 R4, 370 R4, 080 430u 290f 720u
Prorated to:

1
This column reflects the actual input at standard prices. The difference between the first two columns is the
efficiency/usage variance while the difference between column 2 and 3 is the price/rate variance.

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Cost of sales {(40 000/50 000) x 450(u)} + 20(f) R340
Finished goods (10 000/50 000) x 450(u) R 90

Note: because fixed overhead is not treated as a product cost when using variable costing, a fixed overhead
expenditure variance will ALWAYS be prorated to cost of sales in full when variable costing is being used.

(b) (R000s) Workings

(i) R816 (20% x R4 080 000)

(ii) R750 (10 000 x R75)

(iii) R816 (10 000 x R75) + R66 000

(iv) R740 (20% x R3 700 000)

(v) R650 (10 000 x R65)

(vi) R740 (10 000 x R65) + R90 000

(c) With absorption costing the fixed overhead is treated not as being a period cost but rather as being
a stock cost. This has the effect of increasing the closing stock values, which will result in higher
profits where the closing stocks are greater than the opening stocks. If the variances are not
prorated and the variances are unfavourable, then the closing stock value will be less than it would
have been had the variances been prorated. Of course, the converse will hold where the variances
are favourable. If the variances are prorated, then the value of stock will be the same as if actual
absorption costing had been applied.

With variable costing, the fixed overhead is treated as being a period cost and, as a result, is written
off in the period that it arises. Therefore closing stock does not include any element of fixed
overhead. When the variances are written off, if the variances are unfavourable the profits will be
lower and the converse will again hold for favourable variances. With variable costing, only the
variable expense variances will be prorated and the fixed overhead will be written off in full to the
cost of sales.

(d) For long term planning, companies need to be able to establish the full costs of the products they
produce so as to establish suitable margins when setting their pricing strategy. While fixed costs
normally do not affect short term decision making, it is important to identify that they are relevant
in the longer term when a strategy can be formulated to modify these fixed costs.

Fixed costs, like any other costs, need to be controlled. To control costs and to establish a viable
strategy, businesses, for example, need to be able to calculate break-even points. This in turn helps
the organisation establish the relevance of fixed costs within the profit structure.

Salesvariances
The purpose of these variances is to analyse the deviation of the actual sales from the budgeted sales.

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This deviation is driven by two factors:

x Changes in selling price; and

x Changes in sales volume

The following variances are relevant:

x Sales Price Variance = AQsales x (SP – AP)

The sales price variance indicates the change in contribution or profit arising from the difference between
actual and budgeted selling prices.

x Sales Volume Variance

o Variable costing system: BCM x (BQsales – AQsales)

o Absorption costing system: BGPx (BQsales – AQsales)

(Where BCM, BGP and BQ represent budgetedcontribution margin, gross profit and quantity respectively.)

The sales volume variance

indicates the change in contribution or profit arising from a change in the level of
activity.

Where there are a number of products sold, the sales volume variance can be further analysed in two
different ways as illustrated below:

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 Sales Volume Variance

Mix and Yield Market size and share

AQsales at Market
AQsales at standard Market
standard Size
market share Share
mix Variance
BQsales Yield Mix AQsales BQsales Variance AQsales

Product R x A xx A' xxx

Product M y B yy B' yyy C D

z zz zz Total actual sales in

Total budgeted sales in
the market x
the market x standard
standard market
market share
share

Mix Variance = (A' x BGPM) + (B' x BGPR) Market size Variance = C x BGP
Yield Variance = (A x BGPR) + (B x BGPR) Market share Variance = D x BGP

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Note: The summary above assumes an absorption costing system is used.

As with the production mix and yield variances, the sales mix and yield should add up to the
sales volume variance because the mix and yield is only a further analysis of the sale volume
variance.

Reconciliation of budget to actual profit

Up to this point, the variances we have looked at analyse the difference in the flexed budget
and actual cost for individual inputs or costs. The reconciliation of budgeted profit to actual
profit brings all the variances together into one place to determine to overall effect on
profit. In reconciling budgeted profit to actual profit it is necessary to identify the sales
variances.

Notes
Budgeted Sales
Budgeted Cost of Sales
This is the actual balance as the actual closing
Opening Balance balance from the prior year would have been used
to draw up the budget
Production units are costed using the standard
Production
prices and quantities
Less: Closing Balance

Take note of whether an absorption or variable

costing is used as this will influence whether or not
Budgeted GP/CM
fixed overheads are included in the cost of
inventory
Fixed manufacturing overheads will only be
Budgeted Fixed
expensed (in full) as part of the budget if a variable
manufacturing overheads
costing system is used
± Sales volume variance
± Budgeted Selling and
Administrative expenses

Budgeted Gross Profit/ The inclusion of the sales volume variance

CM for actual level of effectively flexes the budget for the level of sales
sales activity

± Materials variances
± Labour variances

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 ± Fixed Manufacturing
Overhead Spending
variance
± Fixed Manufacturing
This variance will only be included if an absorption
Overhead Volume
costing system is used
Variance
± Selling and
Administrative spending
variance
± Sales Price variance

Actual Profit

Tips and examination technique

1. Standard Costing was examined in 2008 after being absent for many years, and
more recently in January 2013. Standard costing is widely used in the manufacturing
sector and so it remains relevant. As a result, there is a chance of it being examined
in the coming ITC.

2. Concentrate on getting the basic variances correct. This is where the majority of the
marks are. Calendar, idle time and other specialised variances are unlikely to be
required.

3. An area that seems to always cause confusion in examination questions is the

different level of activity. Frequently, questions have a budgeted activity, a sales
activity and a production activity, which are all different. The production activity
must be used to draw up the flexible budget to analyse production costs. The sales
activity must be used to analyse the sales variances only. The only significance of the
original budgeted activity is that it used to calculate the budgeted profit.

4. Do not bother to calculate a material mix and yield variance where there is little
likelihood that substitution can take place between the various material inputs.

5. Before calculating your manufacturing overhead variances, identify whether the

company is using a variable costing or absorption costing system. If absorption
costing is being used, a fixed manufacturing overhead volume variance must be
calculated. If the volume variance is favourable, the book value of closing inventory
must be written down to actual cost.

6. When analysing variances, consider the following:

x Inter relationships between variances;

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 o A favourable price variance could mean cheaper materials were purchased
resulting in more wasted, which could therefore explain an unfavourable
usage variance.

o Similarly, cheaper, inexperienced labour could result in a favourable rate

variance, but an unfavourable efficiency variance.

x Other business reasons for the variance:

o An unfavourable market size variance could indicate a general downturn in

the economy or perhaps that the product is going out of fashion.

o Unfavourable labour rate variances could be as a result of wage hikes after

negotiations.

x Who should be held responsible for the variance? For example, the sales manger
should answer for the sales variances. This is illustrated very well in tutorial MAF05.

At this point it is also useful to consider how the company incentivises or remunerates its
employees. For example, a manger who is offered a bonus for increasing sales volumes or
market share, will not hesitate to dramatically cut prices in order to achieve this. This could
be evidenced by an unfavourable selling price variance.

For more practice on discussing the qualitative issues around variances, see MAF01.

As mentioned above, standard costing was examined in the 2008 ITC. The following is an
extract from the examiners comments,

“This section required of candidates to discuss the key reasons for the lower than
expected profitability of the company and to provide feedback on the performance
of the manufacturing, procurement and sales divisions. This section was generally
poorly answered. In many cases candidates were merelyre-stating the calculated
variance calculations in words . This did not earn marks as the question specifically
required comments on the performance of the divisions.

Very few candidates were able to give comments at a general level as required in
section (b)(i) as they focused on the detail in the calculated variances. It is important
to develop the skill to identify the most significant reasonsand provide that in a
summary format (3 marks) – similar to providing high-level information to senior
management of an organisation. Some candidates were unable to link the calculated
variances to performance (i.e. did not seem to understand that a favourable price
variance actually means that material was acquired at a cost lower than budget!).”

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7. Transfer pricing and decent
ralisation of control
As organisations grow, they tend to develop more segments such as departments, cost
centres, profit centres, and divisions. The freedom to make decisions may be distributed
more widely among managers (decentralisation).

Decentralised operations often involve exchanges of goods and services among the sub-
units of an organisation. Transfer prices are the monetary values assigned to these
exchanges. Ideally, transfer prices should motivate managers to make decisions that
. However, there is rarely a single type
maximise the profits of the organisation as a whole
of transfer price that will accomplish this goal.

The decentralisation of an organisation's management is a matter of degree. The essence of

decentralisation is the freedom of managers to make decisions.

The advantages of decentralisation are:

x Decisions are better and timelierbecause of the manager's proximity to local

conditions;

x Top managers have more time for strategic planning; and

x Managers' motivation increasesbecause they have more control over results.

The disadvantages of decentralisation are:

x Loss of control of sub-units/divisions;

x Duplication of costs; and

x The largest cost of decentralisation is probably dysfunctional decision making

,
which produces a net negative benefit to the sub-units affected (and to the
organisation as a whole). This can be caused by:

o Lack of goal congruence (which means that the goals of the sub-units are not
aligned with those of the organisation as a whole);

o Insufficient information; or

o Increased costs of obtaining sufficient information.

Dysfunctional decision-making is most likely when there is a high degree of

interdependenceamong sub-units.

The points above should be applied specifically to the scenario at hand and not simply listed
when answering discussion questions.

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A profit centre is a sub-unit of an organisation that is assigned both revenues and expenses.
The profit centre is normally the major organisational device used to maximise
decentralisation.

Goals of rtansfer pricing

The backbone of any transfer pricing discussion question is the following three points:

1. Goal congruence

o This is the harmonising of managers' goals with organisation goals. The goal is to
maximise the profit of the company as a whole by making decisions that
maximise the contribution margin of the company. The only way for this to
happen is for the best decision for the manager to also be the best decision for
the company. This leads on to the second point.

2. Performance evaluation

o The transfer pricing system should be fair. Consider whether it allows for some
profit at a divisional/sub-unit level. If not, the system could be demoralising for
staff and not give a fair reflection of their efforts.

o The transfer pricing system should be economicallyrealistic. The results of the

division should be comparable to similar stand-alone companies in order to
assess the performance of management properly.

o Finally, the transfer pricing system should encourage cost control . A transfer
pricing system that guarantees that costs will be covered by allowing the
division to add a mark-up to actual costs does not achieve this. Inefficiencies will
be passed from one division to another and will cause the results of subsequent
divisions to appear poorer than they are.

3. Preserving autonomy

o This is the freedom of managersto operate their sub-units as decentralised

entities without undue influence from top executives. This is to help ensure that
managers are only evaluated based on what they can control.

Transfer pricing necessarily results from interactions among decentralised sub-units,

typically a profit centre supplying a product or service to another profit centre.

x The transfer price will affect not only the reported profit of each centre, but will also
affect the allocation of an organisation's resources.

x The basic purpose of transfer pricing is to induce optimal decision-making.

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 Transfer pricing systems
1. Marginal/Variable cost
The transfer price could be set equal to the supplying division’s variable cost of production.
This is the theoretically correct minimum. The variable cost of the supplying division is the
same as the variable cost to the company. Thus the receiving division is correctly motivated.
This is because the receiving division will make decisions that maximise its own contribution
margin, which will use the transfer price as one of the variable costs. If the transfer price is
the same as the company’s variable cost, the receiving division will arrive at the same
contribution margin as that calculated from a company perspective. This results in goal
congruence. The problem of premature cut-off is also avoided (see note on cost plus
pricing).

However, this method has a short-term focus, as the fixed costs of the supplying division are
not considered. A marginal cost transfer price also fails to provide any profit to the supplying
division, which can result in demoralisation as the supplying division is essentially being
forced to make sales at a loss. Opportunity costs are also ignored if this method is used.

2. Full cost
This method includes variable and fixed costs in the transfer price. Although there is more of
a long-term focus, the supplying division is still not motivated due to the lack of profit. This
method can also result in premature cut-off. Premature cut-off is a situation where the
receiving division stops buying from the supplying division and hence stops selling the final
product before it is optimal to do so for the company. Consider the following:

Supplying Receiving
Division Division
VC 10 10
Transfer
Price 17
Allocated
FC 7 3
Full cost 17 30

Product A (Receiving division perspective) Product A (Company perspective)

Selling Price R 25 Selling price R 25
Variable
Costs -R 10 Variable costs -R 22
Net Marginal Revenue R 15 Receiving division R 12
Transfer Price -R 17 Supplying division R 10
Contribution Margin -R 2 Contribution margin R3

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From the perspective of the company, Product A should still be produced and sold as it
produces a positive contribution to fixed costs. However, from the perspective of the
receivingdivision, this product is not helping to cover fixed costs at all.

3. Cost plus pricing

This is where the transfer price is the full cost to the supplying division plus a mark-up. This
has the advantage of allowing the supplying division to make a profit. However, the issue of
premature cut-off is not resolved. Further, short-term decision making is not supported due
to the inclusion of fixed costs. Finally, financial reporting is made more difficult due to the
existence of unrealised profit in inventory balances.

It is important to consider whether actual or standard costis to be used in the preceding

three transfer prices. The use of actual prices will not encourage cost control, as the
supplying division will always be able to pass on inefficiencies to the receiving division.
Similarly, any good cost control will be passed on the receiving division. This does not
support performance evaluation in the receiving division.

4. Market prices
In some cases, market prices are the most appropriate transfer prices because they help
solve goal congruence, performance evaluation, and autonomy; the three major problems.
Favourable conditions for using market prices include:

x Minimal interdependences of units

;

x Existence of a competitive market for the intermediate product, with dependable

market-price quotations;

x The selling sub-unit should have the option of not selling internally and an
arbitration procedure should be available for settling disputes amongst sub-unit
managers; and

x Generally, the outside market price would be a ceiling not to be exceeded by the
internal transfer price. Otherwise, a false sense of profitability could be created in
the selling division, because the transfer price is not economicallyrealistic.

The main difficulty with the use of market prices for transfer prices is the frequent lack of a
market that is perfectly competitive because one of the assumptions of a perfect market is
that transaction cost are R Nil.

Where there is market imperfection, it must be limited and measurable. For example, if
there are selling costs that would normally be incurred and the selling division does not
incur these on internal transfers, the transfer price must be adjusted accordingly, i.e. the
transfer price must be the market price less the selling costs. If this adjustment is not made,
the selling division will appear more profitable than a stand-alone company in a similar
position.

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Although cost plus pricing and market-based transfer prices allow the supplying division to
make a profit, the profit is unrealised from a financial reporting perspective and must be
eliminated.

5. Dual transfer prices

This is where two separate transfer prices are used, one for the supplying division and one
for the receiving division.

This can be used for the purpose of motivating the manager of the receiving division to
make the optimal economic decisions . The transfer price would be based on variable cost.
For the purpose of fairly evaluating performanceof the supplying division, the transfer price
would be a market price allowing for a normal profit margin to the supplying division.

This can achieve goal congruence in the short term, but it is not a long-term solution. Dual
transfer prices protect the divisions from competition by:

x Making it so that the supplying division is always the cheapest for the receiving
division; and

x Making it so that the price offered by the receiving division is always the highest for
the supplying division.

Thus, a false sense of profitability can be created.

6. Variable cost per unit plus a fixed lumpsum

With this system, individual transfers will be at variable cost to the supplying division and
the lumpsum charged will be for the period. The lumpsum is to compensate the supplying
division for the capacity that it has dedicated to the receiving division. Therefore, this
method is ideal when a large amount of capacity and therefore fixed costs are dedicated to
supplying the receiving division.

The lumpsum can be based on:

x Capacity in the supplying division used to supply the receiving division:

Units transferred
to Receiving
Fixed Costs in Division
x
Supplying Division Total units
produced in
Supplying Division

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 x Required return on capital:

Required Divisional Profit Actual Divisional Profit

_
(ROI x Net investment) (before the lumpsum)

7. Negotiated transfer prices

Managers can negotiate a single transfer price so that the overall contribution to corporate
profit from a given internal transfer would be shared between the buying and selling
divisions on some mutually agreeable basis. Although this supports goal congruence, the
process could be lengthy and hindered by unequal bargaining power between the managers.

8. The “golden rule”

This is a general rule that serves as a helpful first step in reaching an optimal economic
decision in a particular situation. This rule is expressed below:

Minimum Maximum
Transfer Price
Transfer Price G G Transfer Price

Variable Cost + Net Marginal

Transfer Price
Opportunity Cost G G Revenue

The minimum transfer price is set by the supplying division, while the maximum price is the
most that the receiving division will pay.

The variable costs exclude any costs not incurred on internal transfers.

Whether or not there is an opportunity cost depends on the spare capacityin the supplying
division. Spare capacity is found after considering all other sales that the supplying division
would otherwise make (including special orders) i.e. positive contribution margin.

If there is spare capacity

, the opportunity cost for the units that use up this capacity is R Nil.

If there is no spare capacity, the opportunity cost is the contribution margin that the
supplying division loses out on, i.e. selling price that would have been achieved less variable
costs that would have been incurred.

This means that there could be more than one minimumtransfer price if the required sales
to the receiving division exceed the spare capacity.

Different kinds of transfer prices (for example, market prices and cost prices) may be
assigned to different classes of transactions.

The theory of the different transfer pricing methods discussed above may be tested by
requiring the candidate to evaluate a transfer pricing system that is already in place or by
requiring the candidate to compare two or more of the different methods (see MAF 02).

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Optimal strategy for the company

Make sure you are comfortable calculating the impact on the company’s profit of using a
particular transfer pricei.e. cost to the company of a particular transfer price. This is the
difference between the optimal contribution margin and the contribution margin currently
achieved.This is sometimes referred to as transfer pricing dysfunction.

Optimal contribution margin requires ranking of products. When ranking products, take note
of the following:

x The product with the highest contribution margin to the company will have the
highest ranking.

x Only variable costs paid to external parties are considered.

x Be aware of demand and capacity limitations for the products. There may be
capacity to keep producing the highest ranked product, but if there is not enough
demand the next ranked product will be produced.

Priceelasticity and transfer pricing

In a situation where the price of the final product depends on supply, for example, as
volumes in the market increase the price that can be charged decreases, the goal is to
charge the price that maximises the contribution margin of the company.

Since the final price is charged by the receiving division, the transfer price must encourage
the receiving division to purchase the amount of intermediate product that will allow for the
optimal volume and price of the final product. This usually involves an increase in volume
and a decrease in price.

The receiving division must therefore be indifferent between the optimal contribution
margin for itself and the optimal contribution margin for the company:

Optimal CM for Receiving Contribution Margin if Receiving Division does what is

Division = optimal for the company

(SP1-VC-TPnew) x VOL1 = (SP2-VC-TPnew) x VOL2

SP1 and VOL1 represent the price and volume that the receiving division would currently
choose in order to make the most of the current transfer price.

SP2 and VOL2 are the selling price and the volume that are optimal for the company. Hence it
is important to first calculate the optimal strategy for the company.

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Example

Mechanics (Pty) Ltd is a large company with fully autonomous subsidiaries throughout South
Africa. A dispute has arisen between two or its subsidiaries in the Transvaal over the transfer
price of product A, which is manufactured by Uniproduct (Pty) Ltd and supplied to Britten
(Pty) Ltd.

Uniproduct (Pty) Ltd manufactures a standard product A and sells 20 000 units per annum in
the open market at a price of R50 each and 10 000 units per annum to Britten (Pty) Ltd at a
transfer price of R48 each. The reduction in selling price of R2 is possible as no selling
expenses are incurred. Uniproduct (Pty) Ltd has a total production capacity of 40 000 units
of product A per annum.

Britten (Pty) Ltd uses product A as a component in the manufacture of an advanced product
called CA1, which is sold on the open market at a price of R200 per unit.

The following table gives details of the selling price and cost for each product:

Product A Product CA1

Total unit production/sales 30 000 10 000
Established selling price per unit R50 R200

Variable costs R R
Direct material 8 55
Direct labour 5 35
Variable manufacturing overheads 3 20
Selling and packaging expenses 2 2
Transfer from Uniproduct (Pty) Ltd - 48
Fixed costs
Manufacturing overheads 7 20
Total cost 25 180
Profit 25 20

A recent market survey commissioned by Mechanics (Pty) Ltd revealed the following open
market demand at different selling prices:

Product A
Selling price per unit R35 R50 R65
Demand 30 000 20 000 10 000
Product CA1
Selling price per unit R180 R200 R220
Demand 15 000 10 000 5 000

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The manager of Britten (Pty) Ltd argues that the transfer price should be variable cost plus a
reasonable mark-up of say 20% as Uniproduct (Pty) Ltd cannot sell all its output at R50. He
believes that a 20% mark-up on variable cost will allow both subsidiaries to make a
reasonable profit as well as improving overall group profits.

The manager is Uniproduct (Pty) Ltd, on the other hand, believes that it is unreasonable to
squeeze the price down to variable cost plus 20%. He believes that there is room for a
transfer price negotiation but a drop to variable cost plus 20% is unacceptable.

YOU ARE REQUIRED TO:

Prepare a report for presentation at the next management meeting of Mechanics (Pty) Ltd
detailing, with comments relating to:

(a) The profit which would be made by Uniproduct (Pty) Ltd and Britten (Pty) Ltd if
current sales levels are maintained and product A is transferred at R48;

(b) The minimum price at which product A could be transferred without Uniproduct
(Pty) Ltd incurring a loss on each unit transferred as well as the profits of Uniproduct
(Pty) Ltd and Britten (Pty) Ltd at the various potential sales levels, if this transfer
price is used; and

(c) The upper limit transfer price which would maximise group profits and, at the same
time, have the minimum adverse effect on Uniproduct (Pty) Ltd. Calculate the profit
that each subsidiary would make at this transfer price.

Example discussion and suggested solution

:

Report to the management of Mechanics Limited.

The transfer price of R48 is above the market prices at a sales level of 30 000 units. In
general the market price of R35 should be regarded as a ceiling. The current profit is as
follows:

(a) Uniproduct profit

30 000 units @ R25 profit per unit R750 000

Britten profit

10 000 units @ R20 profit per unit R200 000

R950 000

(b) Minimum transfer price for A = variable cost of R16.

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Workings:

A A A
Selling price per unit R35.00 R50.00 R65.00
External demand 30 000 20 000 10 000
Variable cost per unit R18.00 R18.00 R18.00
Contribution per unit R17.00 R32.00 R47.00
Total contribution R510 000 R640 000 R470 000
Less: Fixed overheads R210 000 R210 000 R210 000
R300 000 R430 000 R260 000

The optimal sales level is 20 000 units at R50.

CA1 CA1 CA1

Selling price per unit R180.00 R200.00 R220.00
External demand 15 000 10 000 5 000
Variable cost per unit R128.00 R128.00 R128.00
Contribution per unit R52.00 R72.00 R92.00
Total contribution R780 000 R720 000 R460 000
Less: Fixed overheads R200 000 R200 000 R200 000
R580 000 R520 000 R260 000

Using true variable costs Britten should sell 15 000 units at R180 as this will increase
contribution by R60 000. However, at the current transfer price of R48 Britten will be worse
off if the selling price is reduced to R180 to achieve sales of 15 000 units.

(c) At a selling price of R180, Britten will increase group profits by R60 000 and hence
the transfer price should only increase to below the point where Britten opts for a
selling price of R200 and sells only 10 000 units, reducing group profit by R60 000. If
X is the increase in variable cost then the following equation will hold:

15 000 * (52 - X) = 10 000 * (72 - X)

780 000 - 15 000X = 720 000 - 10 000X
5 000X = 60 000
X = 12

Thus the transfer price could go up to R28 (R16+R12).

Alternatively, the total transfer price is equal to the net marginal revenue of Britten before
allowing for the transfer price.

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Increased sales R700 000

Increased costs (5 000 x R112) 560 000

Net marginal revenue 140 000

This gives a transfer price of R28 per unit (R140 000/5 000)

Using this transfer price the profits will be as follows:

A CA1 Total
Selling price per unit R50.00 R180.00
External demand 20 000 15 000
Variable cost per unit R18.00 R140.00
Contribution per unit R32.00 R40.00
External contribution R640 000 R600 000
Internal contribution R180 000 -
Less: Fixed overheads R210 000 R200 000
R610 000 R400 000 R1 010 000

Tips and examination technique

1. This topic has not been examined frequently. However as the analysis is often based
on opportunity costs, there is some chance of the topic being included in the ITC.

2. With a transfer-pricing question, the first thing you should identify is whether there
is spare capacity or not.

3. In arriving at a suggested transfer price, you should also bear in mind the general
rule that states the transfer price is equal to the variable cost plus opportunity cost.
Where there is spare capacity this is likely to mean that the opportunity cost is equal
to zero and the transfer price would be the variable cost. Where there is no spare
capacity, the opportunity cost is likely to be the difference between the normal
market price and the variable cost i.e. the contribution foregone. In such an
instance, the transfer price will approximate the normal market price.

4. While most solutions to transfer pricing questions come up with a specific transfer
price, it must be borne in mind that a range of transfer prices could be equally
acceptable.

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8. Performance evaluation
In the transfer pricing section we highlighted the advantages and disadvantages of
decentralisation. Decentralisation highlights the problems of goal congruence, managerial
effort, and sub-unit autonomy. Thus we need to consider the measurement of segment
performance in developing management motivation toward the achievement of
organisational goals. Performance evaluation is closely linked to the incentives and rewards
offered to management, thus it is important to select a performance evaluation system that
does not encourage mischievous behaviour.

Goals of Performance Evaluation

x Encourage cost control;

x Fairness in terms of only holding managers accountable for results within their
control;

x Encourage goal congruence;

x Hold managers accountable for resources/assets under their control; and

x Penalise mangers for actions that are not in the best interest of the company.

Large business organisations may have at least three kinds of sub-units or segments:

1. A cost centre, typically a department, is the smallest segment of activity or area of

responsibility for which costs are accumulated.

2. A profit centre, often called a division, is a segment responsible for both revenues
and expenses.

3. An investment centre is a segment responsible for its invested capital and the
related income.

Basic matters to be considered by control system designers include making some critical
choices concerning performance measures.

1. Measures of accomplishment that reflects top-management goals.

2. Definitions of key terms such as “income” and “investment”.

3. Bases for measuring various items: historical cost, replacement cost, realisable
value.

4. Standards of performance to be required.

5. Timing of feedback of performance.

6. The types of incentives to be provided to management.

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 Performancemeasures
The calculation of the most common performance measures are summarised below:

Notes
ROI Profit Profit is usually NOPAT + i x (1-t)
Net Investment If NPBT is given, the adjustment for interest is (NPBT + i) x 72%
When evaluating an individual, allocated costs, such as head
office costs are excluded from profit, as these are not
controllable by the manager. They can be included for the
evaluation of a division as they are costs that would be incurred
had the division been a stand-alone company.

Net Investment = Total Assets - Current Liabilities or

Profit - WACC x Net Net Investment = Equity + Long Term Liabilities.
RI Investment

Only permanent sources of finance must be used when

calculating the net investment, i.e. the current portion of a long term
liability is excluded from current liabilities.

Whether or not a source of finance is permanent depends on the

(Profit ± adjustments) – nature of the business. For example, in a large retailer, trade
EVA WACC x (Net investment ± payables could be a permanent source of finance if they always
adjustments) make all purchases on credit, compared to a smaller business
where trade payables might just be bridging form of finance.

The assets that are included in net investment are those that are
controllable by the manager/division. Assets managed centrally
are not included. Take note of whether the division is a profit or
investment centre.

Net book value is often used to reflect the investment although this
is often conceptually incorrect. It is preferable to ascertain the
assets present value or replacement cost less depreciation.

Return on investment (ROI)

1. ROI is the ratio of net income to invested capital
.

2. ROI can also be computed by multiplying capital turnover by the net income percentage
of sales:

x (Sales/Invested Capital) x (Net Income/Sales) = Net Income/Invested Capital = ROI

3. Management can further analyse performance by using the Du Pontmodel.

4. The advantages of using ROI are:

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 a. As it is a percentage, comparisons with other divisions, companies and
available investments are possible;

b. It reveals information about cost control and asset management; and

c. It is easily understood by managers.

5. The disadvantages are as follows:

a. It encourages management to either not replace assetsor inappropriately

sell assets. This decreases the denominator and increases ROI;

b. ROI does not support goal congruence. The acceptable return on a new
project for the company, as a whole, is WACC. If WACC< Project A < ROI ,
such a project will not be accepted as it will reduce the ROI of the division,
but it would have created value for the company. If Project A is an existing
project, a manager might discontinue it in order to boost ROI resulting in
shrinkageof the business;

c. ROI can result in acceptance of value destroyingprojects. If ROI < Project A<
WACC, Project A will be accepted, as it will boost the ROI of the division, but
since the return is less than WACC, value is being destroyed; and

d. ROI encourages management to target percentage returnsand not to

maximise returns in absolute terms i.e. they will rather accept a R5m
investment that returns 30% (R1.5m) rather than a R10m investment that
returns 20% (R2m). As long as WACC is less than 20% the second investment
should be accepted.

Residual income RI
1. Another measure of performance, which reflects the net income over the imputed
interest on the invested capital used, i.e. WACC.

2. The advantagesof RI are:

a. This approach is conceptually superior to ROIas it encourages expansion

where return rates exceed the charge for invested capital i.e. WACC. Any
project that returns more than WACC will cause RI to increase. Thus goal
congruence is encouraged;

b. RI is more flexible, since different costs of capital can be used to assess

divisions with different risk profiles; and

c. RI is a better indication of value creationor destruction.

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3. The disadvantagesof RI are:

a. It is an absolute measure and therefore comparisons are difficult; and

b. It encourages cutting of discretionary expenditure that could have long-term

benefit, for example training costs.

Economic value added (EVA)

1. EVA is based on the residual income concept. EVA is designed to measure the value
added to shareholder wealth and to motivate managers to maximise hareholder
s value.

2. Managers can increase shareholders value by:

a. Increasing the return on existing assets;

b. Investing in new assets which generate a return which is higher than the WACC; and

c. Selling assets where the return on capital is below the WACC. This happens when
the present value of the future economic cash flows (economic value) is less than
the disposal value.

3. Certain accounting adjustments are typically made:

a. Expenditure that has the potential for enduring benefit. For example, the costs of a
major marketing campaign would be expensed in the year incurred, but from an EVA
perspective, these costs would be capitalised and impaired over the period that the
benefits were expected to accrue.

b. Operating leasesare capitalised and expensed over the life of the asset. This is
because the asset base would otherwise be understated. The opening balance of the
leases that is included is the present value of the lease commitments. The pre-tax
cost of debt is used as the discount rate. The net profit is adjusted by adding back
the lease expense and replacing this with the depreciation of the capitalised lease.

c. The profit must be adjusted from the absorption costing to variable costing
basis.

Disadvantages of using accounting based mea

sures and a company wide WACC
include:

x Managers are encouraged to reduce potentially beneficial discretionary

expenditure;

x Accounting figures can be manipulated;

x Accounting measures do not represent free cash flow; and

x The company WACC might not be representative of the risk of the division being
evaluated, which could make results look artificially poor or impressive.

Ways of over-coming the disadvantages

include:

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 x More than one measure should be used;

x Some non financial measures should also be used to evaluate performance (consider
the use of a balanced score card);

x Accounting figures can be adjusted in a similar manner to calculating EVA;

x WACC can be risk adjusted as appropriate for each division; and

x A bonus bank can be used. For example, bonuses could be linked to EVA with a
portion of the bonus being retained in a bonus bank. In bad times when the EVA is
negative, managers would lose portions of their accrued bonuses.

Example

Schreuder Ltd is a manufacturer of children's clothing, which has its head office in
Johannesburg. It also has two autonomous divisions; one in Cape Town and the second in
Durban.

Both divisional managers are responsible for all aspects of the operations of the divisions,
including revenue, expenditure, the financing and acquisition of assets and general cash
management. Head office charges the divisions with overhead costs as it deems necessary.

The financial results of the two divisions for the three years, 20x6 to 20x8, are as follows:

Durban division Cape Towndivision

20x6 20x7 20x8 20x6 20x7 20x8
R'000 R'000
Estimated regional sales
value:
Potential market 60 000 68 000 83 000 20 000 32 000 40 000
Division sales 6 300 7 000 7 150 2 100 3 650 7 900
Direct costs 2 580 2 980 3 170 725 1076 2 070
Depreciation:
Plant and equipment 15 14 18 125 180 250
Equipment leases 55 75 102
Factory rent 40 45 45
Maintenance and repairs 262 301 320 58 63 81
Indirect production costs 2 678 2 730 2 452 847 1 406 3 062
Head office allocated 630 680 750 210 615 1 535
costs
Total costs 6 205 6 750 6 755 2 020 3 415 7 100
Net income 95 250 395 80 235 800

BALANCE SHEET

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 Durban division Cape Town division
20x6 20x7 20x8 20x6 20x7 20x8
R'000 R'000
Assets employed
Plant and equipment (net 265 238 250 2 585 3 200 4 000
book value)
Factory - - - 800 800 800
Net current assets 900 910 750 1 050 945 1 405
Current assets 1 260 1 490 1 655 1 350 1 405 2 185
Current liabilities 360 580 905 300 460 780
Notes

1. The performance of divisions and of divisional managers is measured on the basis of

their return on investments before taxation.
2. The Durban division was established in 19x0 and rents factory premises. The factory
has the same production capacity as the Cape Town division.
3. The Cape Town division was established in 19x6 and constructed a factory, as no
suitable premises were available.
4. Both divisions have a required rate of return of 16%.
5. The Durban division is more labour intensive than the more modern Cape Town
factory.
Head office is concerned that the current return on investment is not the most
appropriate performance measure and has asked you to use other measures,
including the residual income method, to evaluate the performance of the divisions.
YOU ARE REQUIRED TO:

(a) Set out the advantages and disadvantages of the return on investment and residual
income measures of performance evaluation with reference to the two divisions.

(b) Calculate the following for each of the two divisions:

x Return on investment;
x Residual income;
x Market share;
x Sales growth; and
x Net profit percentage.
(c) State which division has, in your view, achieved the better performance based on
your calculations in (b).

Suggested solution:

(a)

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Return on Investment

The return on investment as a measure of establishing a branch or company's efficiency is

normally calculated on the basis of profit before interest (in order to exclude the effects of
gearing) expressed as a percentage of total assets.

1. Advantages

1.1 Ease of calculation and comparison

The key elements in this performance evaluation are the amount of money that has been
invested and the return being generated from that investment. It is thus relatively easy to
compare the percentage return that the total assets generate with whatever alternatives are
available, either in the money market or through an investment in equities on the stock
exchange or in a private company.

1.2 Reveals quality of asset management

This method of performance evaluation automatically brings into account the efficiency of
asset management. If a company has over- extended its stockholding this would reduce the
return. Similarly if debtor collections lag the accepted norms for the industry, the ratio
would be lower. An investment in plant or machinery that is not productive, would also
have an negative impact on the ratio. A low turnover ratio (turnover divided by assets)
would also reduce the return.

1.3 Reveals cost control

Turning to the income statement, a reducing gross profit percentage over time would
impact on the percentage return. Similarly, increases in expenditure (such as wages) which
are out of proportion to the increase in sales, would also have a negative impact on the
percentage return on investment.

2. Disadvantages

2.1 ROI will increase as the investment base decreases (net of depreciation) rather than
due to an increase in profits. This might encourage managers not to replace old
assets.

2.2 Problems of inconsistency can arise in profit measurement and asset valuation. For
example the Cape Town division has relatively new assets as compared to the
Durban Division. It also leases assets which Durban does not. The Durban division
rents factory premises while Cape Town does not. The Durban division is labour
intensive while Cape Town is not.

2.3 ROI encourages managers to invest only in projects with ROI's higher than a
division's existing ROI. Consequently a divisional manager with a high existing ROI
say 40% will reject investments that will reduce the ROI, even if the return is in
excess of the cost of capital. The converse is true where a divisional manager will

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 accept projects with a return lower than the cost of capital but higher than the
existing ROI.

2.4 ROI encourages managers to maximise a percentage return rather than maximising
profits in absolute terms. A manager would for example accept a project costing R5
million and yielding a return of say 30% rather than one costing R10 million and
yielding a 25% return.

Residual Income

1. Advantages

1.1 As long as the return exceeds the cost of capital, managers will accept the
investment.
1.2 It measures the branch's contribution to the overall group.

2. Disadvantages

2.1 Although this method gives the residual income, it does not give this in relation to
the capital tied-up in each of the branches.
2.2 Where the average cost of capital applied is unrealistically low in comparison to
what is available in the market, the results will be distorted.

b) Calculations

Durban division Cape Town division

20x6 20x7 20x8 20x6 20x7 20x8
R'000 R'000
Fixed Assets 265 238 250 3 385 4 000 4 800
Net current assets 900 910 750 1 050 945 1 405
Net assets 1 165 1 148 1 000 4 435 4 945 6 205
Net profit 95 250 395 80 235 800
Head Office costs 630 680 750 210 615 1 535
725 930 1 145 290 850 2 335
Interest (note 1) (186) (184) (160) (710) (791) (993)
Residual Income 539 746 985 (420) 59 1 342

NOTE 1.

Notional interest is calculated as required rate of return x net assets. Preferably the
replacement cost of the assets rather than net book values should be used to calculate the
interest charge.

DURBAN CAPE TOWN

1 165 x 16% = 186.4 4 435 x 16% = 709.6

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 1 148 x 16% = 183.7 4 945 x 16% = 791.2

1 000 x 16% = 160 6 205 x 16% = 992.8

(i) Return of Investment (Excluding Head Office Costs)

Durban division Cape Town division

20x6 20x7 20x8 20x6 20x7 20x8
R'000 R'000
Net current assets 725 930 1 145 290 850 2 335
Net assets 1 165 1 148 1 000 4 435 4 945 6 205

Head Office costs = 62.2% = 81% = 114.5% = 6.5% = 17.2% = 37.6%

(ii) Residual Income

Durban division Cape Town division

20x6 20x7 20x8 20x6 20x7 20x8
R'000 R'000
Residual Income 539 746 985 (420) 59 1 342

(iii) Market Share

DURBAN CAPE TOWN

20x6 20x7 20x8 20x6 20x7 20x8

6 300 7 000 7 150 2 100 3 650 7 900

60 000 68 000 83 000 20 000 32 000 40 000

= 10.5% = 10.3% = 8.6% = 10.5% = 11.4% = 19.8%

(iv) Annual Sales Growth

DURBAN CAPE TOWN

20x6-20x7 20x7-20x8 20x6-20x7 20x7-20x8

700 150 1 550 4 250

6 300 7 000 2 100 3 650

= 11% = 2% = 74% = 116%

(v) Net Profit Percentage (based on profit before head office costs)

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 DURBAN CAPE TOWN

20x6 20x7 20x8 20x6 20x7 20x8

725 930 1 145 290 850 2 335

6 300 7 000 7 150 2 100 3 650 7 900

= 11.5% = 13.3% = 16% = 13.8% = 23.3% = 29.6%

(c) Comparison of Performance

1) It seems that the Cape Town division has achieved the better performance.

JUSTIFICATION

We do not know ultimate capacity of plants or unit sales, but assuming that:

a) Neither plant is at full capacity; and

b) Sales prices are similar per unit.

Cape has built up a 20% market holding inside 4 years, whilst Durban (admittedly in a slower
growing market) has lost share (10,5% to 8,5%).

2) Whilst cost comparisons are difficult because of the very different fixed asset
structures, Cape Town is keeping its margin higher than Durban – both are improving
margins (Cape Town is helped by its trade growth).

3) The equipment leases in Cape Town and the growth in plant investment indicate a
willingness on the part of the division to invest – Durban appears to be standing still and
making no investments in plant.

There is a strong possibility that the ROI measure has discouraged Durban from making
investment, which would lower the 80-100% returns they enjoy (have a real need to
consider RI).

4) In many respects the build-up of the Cape Town business renders the trends
incomparable, but the levels of RI and ROI achieved by Cape Town indicate sound
performance.

5) An area where Durban beats Cape Town, again driven by ROI, is in working capital
management – especially in the utilisation of current liabilities and on the actual 20x8 (not
average) figures for current assets.

6) Due to its plant acquisitions and increasing working capital, Cape Town produces a
slightly lower cash flow to the group.

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Tips and examination technique
1. Performance evaluation has been examined infrequently in the ITC. However, you
should be aware of the behavioural implications of performance evaluation systems.

2. It is important to identify that the appropriate type of responsibility centre will

depend on the degree of autonomy given to the manager. Managers cannot be held
responsiblefor issues beyond their control.

3. With investment centres there are two generally accepted measurement

techniques, Return on Investment and Residual Income. While these two
performance measurement methods are very similar, the residual income is
regarded as being conceptually superior as it sets managers the correct hurdle rate
for decision-making.

9. Relevant costs and the decision process

The objective of this section is to understand and to be able to apply the main concepts of
relevant information; expected future costs and revenues that will differ among alternative
actions in order to make financially sound decisions.

Relevant costing is a short-term decision-making tool. In the short term, capacity cannot be
altered and management must therefore make the most of what is available.

When tackling relevant costing questions always keep in mind the definition of a relevant
cost:

A relevant costis defined as: A future cashflow that will differ among alternatives.

From the above definition, the following points must be kept in mind:

x In order to meet the “future” criteria, the cost in question must not be sunk. A sunk
cost is a cost that has already been incurred (or irrevocably committed to, regardless
of the company’s future actions).
x When considering cash flow, keep in mind that some accounting expenses, such as
depreciation, are not cash flows. Also remember the cash flow can be an inflow or
an outflow.
x The cash flow must not be one that will be incurred regardless of the choice i.e. it
must differ. It is possible that there will be a cash flow for the same income or
expense in both alternatives but the rand amount could differ. In this case, it is only
the incremental amount that is relevant.

In previous sections (inventory costing, ABC and transfer pricing) it has been mentioned that
the inclusion of fixed overhead costs in the cost of a product is misleading for short-term
decisions. This is because relevant costing is a short term decision-making tool, fixed costs a
related to making capacity available, but in the short term capacity cannot be changed.
Hence, the portion of fixed costs allocated to inventory is not relevant, as the fixed cost as a
whole will be incurred in the short term, regardless of the decision made.

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Determining which information is relevant to the choice of the best action to take in order to
maximise the benefit to the company, requires a clear understanding of the role of historical
costs in the decision process. Historical costs are useful in predicting the future turn of
events.

Special Orders
Idle capacity often permits special, reduced price sales orders that would not affect regular
sales. In such cases, average overall unit costs do not normally serve as a proper base for
evaluating such orders. The only costs that would usually be relevant to these situations are
the variable costs that would be affected by accepting the special sales orders; because fixed
costs would usually not be affected by the decision, and would therefore be irrelevant.
However, if the decision would affect certain fixed costs immediately or in the future, they
of course should be given appropriate consideration.

On the basis of relevant cost approach, it is possible that some special orders should be
accepted at selling prices below the average unit costs that include variable costs, as well as
a portion of fixed costs. This is because the special order could still provide a positive
contribution margin and thus contribute towards covering fixed costs.

The important point is that such decisions should depend primarily on the revenues and cost
expected to be different among alternatives. This is true whether or not the financial reports
to management also include any revenues and costs expected to be the same among
alternatives.

Consider the following example:

SJ (Pty) Ltd has budgeted output of 100 000 units. Cost estimates are as follows:

Direct Labour R 600 000 R6/ Unit

Direct Materials R 200 000 R2/ Unit
Variable Overheads R 200 000 R2/ Unit
Fixed Overheads R 400 000
Total Costs R1400 000

The company has confirmed orders for 80 000 units at a selling price of R18/u. Should a
special order for 20 000 units at R12/u be accepted?

Thus the special order should only be accepted if the incremental revenue is at least equal to
the incremental costs.

Workings Exam technique tip: If there is a

cost mentioned in the scenario,
that is not relevant, you must
write it down and justify why it
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the cost and you know that it is
not relevant.
 Incremental revenue
Sales R12 x 20 000 R 240 000

Incremental costs R -200 000

Direct materials R6 x 20 000 R 120 000
Direct labour R2 x 20 000 R 40 000
Variable Overheads R2 x 20 000 R 40 000
Fixed Overheads Not differential R0

Incremental cash flow R 40 000

The special order should be accepted as it provides a positive incremental cash flow to the
business.

The example above is very simple because SJ (Pty) Ltd has spare capacity of 20 000 units. But
what happens if the special order received is for 30 000units? SJ (Pty) Ltd now has a shortfall
in capacity of 10 000 units and the decision will have to consider the opportunity cost of the
10 000 units of normal sales that would have to be sacrificed in order to make the entire
special order.

x An opportunity cost is the next bestalternative forgone.

In the simple example above, the opportunity cost is simply the sales revenue lost. This is
because the variable costs for the 10 000 unites are simply being transferred from units for
normal sales to units for the special order, i.e. they will be incurred regardless of the
decision made.

In most cases, the opportunity cost of lost sales will be the contribution margin forgone. I.e.
the revenue is lost but the variable costs are saved.

x Calculating opportunity costs can be made more complicated by nested decisions

.

A nested decision is a decision within a decision.

For example, SJ (Pty) Ltd has material A on hand, which is no longer used in normal
production. A special order has been received that would require the use of material A. If
material A is not used in the special order, SJ could sell the material for R20 000 (selling costs
of R4 000). SJ could also convert material A into an equal quantity of material B, which
would normally cost R35 000, however the costs of this conversion would amount to
R17 000. Material B is currently being used on a limited edition product and the amount that
could be produced is exactly enough to finish off the units being produced. If the special
order is accepted, revenue of R64 000 would be generated and other variable costs of
R30 500 would be incurred. Should the special order be accepted?

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The information above is illustrated below:

Material A Notes

Special Order Don't do the special order

This is the nested decision.

Before a decision can be
made on the special order,
Incremental R 64 the opportunity cost must be
revenue 000 Sell Modify determined. This requires
-R 30 Incremental analysing what the company
Other variable costs 500 revenue R 20 000 Cost saved R 35 000 would have done with
-R 18 Modification material A if there had been
Opportunity cost 000 Selling Costs -R 4 000 Costs -R 17 000 no special order.
R 15 Net savings on
Net Benefit 500 Net Benefit R 16 000 material B R 18 000

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Notice that, before the opportunity cost is considered, the net benefit of the special order is
R33 500 (64000 – 30500), which appears to be better than what could be achieved on either
of the alternatives if the special order is not accepted. However, in accepting the order,
R18000 is forgone, because this is the next best alternative, i.e. in the absence of the special
order the company would have chosen to modify material A. The net benefit of the
opportunity cost is therefore only R15 500, and therefore the special order should not be
accepted.

If the other variable costs were, say, R27 000, the net benefit of the special order would be
R19 000 and the special order should be accepted.

As a final consideration, what would happen if, all else equal, SJ had double the quantity of
material A on hand? What would the opportunity cost of doing the special order be in this
case? SJ would do the special order with half of the material and with the other half, modify
it to produce material B and finish off the limited edition range. SJ is therefore forgoing
R16000, which is the net benefit of selling the other half of material A, because in the
absence of the special order, the company would have modified half and sold half. The net
benefit of the special order is now R17500 (R64 000- 30 500-16 00). Therefore, the special
order should be accepted.

Nested decisions can also present themselves in capital budgeting questions, where the
company has a choice to make at the end of the life of the asset.

The example above considers the use of materials on a special order in the context of
opportunity costs. The following is an illustration of the thought process that should be
followed when deciding what the relevant cost of materials is:

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When the current purchase price of materials is a batch levelcost i.e. the materials can only
be purchased in whole batches, consider the following:

x The material is regularly used in production

If the material is used in normal operations, the relevant cost is the cost of the incremental
batches. For example, material R is used in normal production and is purchased in batches
of 75kg at R1000 per batch. Normal operations will require 240kg of material R and a special
order will require 180kg. What is the relevant cost?

Workings

3.6
Normal production 240kg Batches
75kg

With special order 180kg + 240kg 5.6

75kg Batches
Incremental
Batches 2 Batches

Only an additional 2 batches must be purchased, thus the relevant cost is R 2000. The
temptation is to calculate the number of whole batches that would be need for the special
}ŒŒ]v]•}oš]}v]XXíôìlóñAîXðCïšZ•XdZ]•]•v}š}ŒŒšµ•v}Œu al production
Œ‹µ]Œ• îðìlóñAïXò C ð šZ• š} ‰µŒZ•U Z}ÁÀŒU ìXð }( šZ ]• o(š unused.
This 0.4 of a batch is added to the 2 batches purchased to arrive at the total of 2.4 batches
required.

If no information had been given about the number of kilograms required for normal
operations, the relevant cost would be R1000/75 = R13.33/kg x 180kg = R2 400. It is not
physically possible to buy 2.4 batches, and 3 batches will be purchased, only the cost of 2.4
batches is differential because the assumption is that the remaining 0.6 will be used in
normal production and hence, it would have been purchased as part of another batch at
some point in the future.

x The material is not regularly used in production

If, in the example above, material R is not used in production and any extra material can be
sold for scrap at R3/kg. What is the relevant cost?

Batches to be 180/75 = 2.4 C ï Æ Z íR 3 000

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 purchased 000
Sales of extra material (3-2.4) x 75kg x R3/kg -R 135
Relevant cost R 2 865

Historical costs will have an impact on the relevant cost when the material required for the
special order is a limited factor and the opportunity cost is production and sale of another
product. Consider the following: SJ (Pty) Ltd receives a special order for 100 units of product
Y. This order will require 500kg of material R, which is very difficult to obtain, as there is a
serious shortage in the market. Material R is used to produce another product, X. Product X
uses 20kg/unit and there a currently orders for 25 units of X. There is only 600kg of material
R on hand. The cost structure of product X is as follows:

Selling Price R 1 500

Variable costs -R 1 100
Material R R 150
Other direct materials R 700
Variable overheads R 250
Fixed overheads -R 100
Net Profit R 300
What is the relevant cost of using material R on the special order?

The first step is to analyse the constrained resource:

Workings Notes
Material R The layout of the analysis of the constrained material
On hand 600 shown here can be adapted to apply to all constraints.
Normal production 25 x 20 -500 The best way to handle multiple constraints is to analyse
Available 100 them all together. To do this, simply add additional
Special Order -500 columns to the right of the material R column. The reason
Short fall -400 it is helpful to do this is that cutting 20 units of product X
frees up not only material R but all the other resources
Sourced from used in the production of X as well. Had there been
400/20 = 20 multiple constraints only what was not freed up from
Product X units 400 cutting product X would have to be sourced form
Short fall 0 elsewhere.

The next step is to calculate the cost of forgoing production and sales of 20 units of product
X:

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 Workings Notes
Lost sales R1 500 x 20 R 30 000
The cost of material R is sunk because it has
Variable costs
already been purchased and thus the cost of the
saved -R 19 000
material will not be saved. This is a situation in
Other direct
which the contribution margin of R8 000 is not
materials R700 x 20 R 14 000
the relevant cost. The sunk cost of R 3 000 (R150
Material R Sunk Cost R0
x 20) must be added back.
Variable overheads R250 x 20 R 5 000
Fixed overheads Not differential R0
Opportunity cost R 11 000

Therefore the relevant cost of material R is R11000.

Materials are not the only resources that could be constrained. Labour and machine time
can also be constrained, i.e. there is not enough to fulfil normal production requirements
and the special order. The most important principle to remember is that management will
always strive to make the most economical choice i.e. obtaining the resource from the
.
cheapest source first

Therefore when attempting a question that has constrained resources (limited factors),
consider all of the alternatives of freeing up the resource. These could include:

x Cutting production (which will probably free up more than one resource);

x Using overtime if labour is the constrained resource;

x Outsourcing normal production to make resources available for the special order; or

x Using a less skilled form of labour (in this case an adjustment for inefficiency is
required).

Where there is more than one constrained resource that can only be obtained from cutting
production of other products, and there are multiple products to choose from, consider the
following:

x The cheapest place to obtain the resource is the product that generates the least
contribution margin per unit of limited factor, thus ranking of the products is
required.

x Where there is a conflict in rankingi.e. it is cheaper to get resource X from product

A and resource Y from product B, the most limited factor must be identified.

x The most limited factor is the resource that would require the greatest amount of
production units to be cutfrom all the products in order to free up enough of the
resource.

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 x Only products that will free up all of the constrained resources should be
considered.

Consider the following example: CAN (Pty) Ltd has received a special order for product D
which is not normally manufactured. However, the company is almost operating at full
capacity and therefore there are not enough resources to fill the order and carry on with
normal operations. The special order will require 600 direct labour hours (Lhrs) and 450
machine hours (Mhrs). The company currently has total capacity of 10 000 Lhrs and 15000
Mhrs. Labour is unskilled and paid hourly and there is no overtime. The company produces
two other products, X and Y, which are currently utilising 9 900 Lhrs and 14 800 Mhrs and
have the following cost and revenue structures:

Notes
X Y
Selling Price R 1 500 2000
Variable costs -R 1 090 -R 1 400
Direct Material R 700 R 1 075
Direct Labour R 300 R 250 Direct Labour costs R50/Lhr
Variable overheads R 90 R 75 Variable overheads are applied at R15/Lhr
Contribution Margin R 410 R 600
Fixed overheads -R 250 -R 300 Fixed overheads are applied at R20/Mhr

Net Profit R 160 R 300

How should labour and overheads be sourced?

As mentioned earlier, it is best to analyse all the constraints together.

Workings Lhr Mhr Notes

Capacity 10 000 15 000 If there was a still a shortfall of Mhr after
Normal production -9900 -14800 enough labour was freed up, product X
Available 100 200 would be cut as that is the cheapest source

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 of Mhr.
Special Order -600 -450
Short fall -500 -250
The surplus of machine hours does not
Sourced from: represent a cost saving as the company
Product X 0 0 would most likely have to decrease its
investment in fixed capacity in order to
Product Y (100 units [W2] x 15) 500 1 500 remove the surplus. This is a long-term
decision. If, however, a surplus of labour
hours that are paid hourly (i.e. not fixed
salaried employees) is created or an existing
surplus is increased, the incremental surplus
will represent a cost saving if those hours
(Short fall)/surplus 0 1 250 will not be used for anything else.

The first step is to determine, how much of each resource is required.

The next step is to determine which product is the cheapest source of Lhr and Mhr:

(W1)
Workings X Y Notes
(410/(300/50)),
There is a conflict in rankingas product
CM/Lhr (600/(250/50)) 68.33 12
X is the cheapest source of Mhr but
CM/Mhr (410/(250/20), (600/(300/20) 32.8 40
product Y is the cheapest source of Lhr

(W2)
Workings Lhr Mhr Notes
mount required 500 250 Labour hours are the most limited
factor because for both products,
Units of production to be cut: labour requires the most production
Prodcut X (500/6),(250/5) 84 50 to be cut. Therefore, the cheapest
Product Y (500/5), (250/15) 100 17 source of labour must be found first.
Next, assess what the most limited factor is:

From the calculations above, the relevant cost with respect to Lhr and Mhr is the
opportunity cost of 100 units of product X.

At this point it is worthwhile to note that the in a situation similar to the one given above, it
is absolutely vital that you do not double count costs/opportunity costs. Make a choice at
the beginning of the question to use the total or the incremental approach and be
consistent through out the question. This is illustrated below:

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Total Approach Notes

Workings
Opportunity cost -60 000 The total approach treats all of the
Product Y Sales forgone 100 x 2000 -200 000 variable costs associated with product
Materials saved 100 x 1075 107 500 Y as being saved and then included that
Direct labour saved 100 x 250 25 000 total cost of the variable costs to
Variable overheads saved 100 x 75 7 500 produce D. However, the labour is not
actually saved since 500 hours are
Production of Product D simply being shifted from product Y to
Direct Labour 600 x 50 -30 000 product D. Similarly, not all 600 of the
Variable overheads hours incurred on product D are
incurred 600 x 15 -9000 incremental; however the net effect is
that only 100 hours are actually treated
-99 000 as a cost.

Incremental Approach

Workings
Opportunity cost -92 500 The incremental approach is
Product Y Sales forgone 100 x 2000 -200 000 conceptually correct, but it can be
Materials saved 100 x 1075 107 500 tricky. This method treats only the cost
of the incremental hours, i.e. the 100
hours that were spare capacity, as
Direct labour saved 0 relevant.
Variable overheads saved 0

Production of Product D The financial impact will be the same,

Incremental Direct Labour 100 x 50 -5 000 regardless of the method used.
Incremental Variable
overheads incurred 100 x 15 -1500
-99 000

MAF 06 illustrates the use of the total approach. Notice how the full cost of the labour hours
for the order is included as a cost.

CONTRIBUTION PER LIMITING FACTOR AND LINEAR PROGRAMMING

Uses

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 x Optimum solution for short-run problems where a resource is in limited supply.
Maximising the contribution per limiting factor will optimise profitability.
x When there is a conflict between products in the contribution per limiting factor.
(Only a conflict between two products can be resolved using a graph.)

Technique

x Establish the objective function – usually maximising contribution from the two
products with conflicting priority for manufacture based on contribution per limiting
factor.
x Formulate the constraints in the form of inequalities.
x Calculate the slope of the objective function (iso-profit line) and the various
constraints. (Fast but risky method.)
x Alternatively – draw a graph using fairly accurate scales in order to identify the
feasible region and production plan corners. (Slow but safe method.)
x The constraints with slopes closest to the slope of the objective function – one
steeper and the other flatter – will be relevant and the intercept between these
constraints will determine the optimal production combination.
x If graphical - use the iso-profit line to identify the optimal corner.
x Solve the simultaneous equation for the intersecting lines at the optimal corner in
order to establish the quantities of each product.

Testing for sensitivity

x The optimal production plan can be tested for sensitivity to changes in the
contribution (increase/decrease in selling price or costs). Only the points on either
side of the optimal point are relevant for initial sensitivity testing.

x Sensitivity is indicated by the extent of the increase or decrease in contribution. The

change in contribution which will make the slope of the objective function equal to
the slope of the line on which the optimal point and the point being tested lie, is the
sensitivity. Example: Objective function 5 X + 3 Y has a slope of -5/3. The constraint
on which optimal point lies and being tested may have a slope of -750/900. The
contribution of X can then decline to where X/3 = 750/900 i.e. R2.50. So if the
contribution of X drops from R5 to R2.50, then both production plans will yield the
same contribution. If it drops further, a change in production plan will be optimal.

x Shadow prices indicate the premium that could be paid if an additional unit of a
scarce resource could be obtained. The shadow price is also the opportunity cost of
not having one extra unit of that scarce resource. The shadow price is determined by
solving the simultaneous equation after adding one unit to the scarce resource that
is constraining further production. The difference between the contribution without
the extra unit and the contribution with the extra unit is the shadow price of that
constraining factor.

A quick way to calculate the shadow price is to reformulate the equations to reflect the
contribution per unit of scarce resources. For example:

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 Objective function is to maximise R8.50X + R5.00Y

Labour constraint is 2X + 4Y < 2000

Material constraint is 4X + 2Y < 2000

Then the following equations would evolve:

2L + 4M > R8.50

4L + 2M > R5.00

Solving these equations simultaneously, we get:

Shadow prices are:

M (material) = R2.00 and L (labour) = R0.25.

Make or buy
When manufacturers are confronted with the question of whether to make or buy (i.e.
outsource) a product, the decision may be based on qualitative factors such as the quality of
the product or long run business relationships. However, an important factor is the
quantitative measurement of the difference in future costs among alternatives, especially
where idle productive facilities are involved. At this point, it is important to make a
distinction between a short-term make or buy decision (perhaps due to limited capacity) and
a long-term make or buy decision.

In arriving at make or buy decisions, managers and accountants should be aware of several
pitfalls. Distorted unit costs could be produced by allocations of fixed costs that would not
be affected by the decision. The comparisons of unit costs not computed on the same basis
could lead to the wrong decision. This error can best be avoided by comparing total costs for
alternatives.

Consider the following example: A component T has the following costs of production:

Direct Labour 100

Direct Materials 300
Variable OH 50
Fixed OH 200
Total Costs 650

An outside supplier has offered to supply 100 units of T for R500 per component. Should this
offer be accepted?

Purchase price -R 500

Materials saved R 300

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 Variable OH saved R 50
Fixed Costs saved R0
Net (cost)/saving per unit -R 150

In the short term, even though the purchase price of R500 is less than the total cost, the
fixed costs are not relevant, as they will not be saved in the short term. As a result, the
relevant cost saving is only R350. The offer should not be accepted.

In the example above, the assumption was that the outsourcer will provide the materials. In
some cases only the assembly of the component is outsourced (maybe to free up labour
time internally); in that case the cost of the materials are not a cost saving as they will be
purchased either to make the component in-house or to provide to the outsourcer.

In some scenarios outsourcing will be an option available to free up capacity to fulfil a

special order. For example, SJ (Pty) Ltd has a special order for component D that will require
1000 machine hours, but only 800 hours are available. Component T takes 2 machine hours
per unit to manufacture and is sold for R690 per unit. What is the relevant cost of the special
order with respect to machine hours?

Workings Notes
Machine
The cheapest source of machine
Hours
hours must be used first.
On hand xxx
Normal
production xxx
Available 800 (W1)
Special Order -1000 Outsourcing R 150
Short fall -200 Purchase price -R 500
Materials saved R 300
Sourced from VOH saved R 50
Outsourcing
(W1) 100 x 2 200
Short fall 0 Cost per hour 150/2 R 75

Cut Production -R 340

Selling price forgone -R 690
Materials saved R 300
VOH saved R 50

Cost per hour 340/2 R 170

Outsourcing is the cheaper option and should be exhausted before cutting production of
component T. The relevant cost is therefore, R75 x 100 units = R7 500.

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The essence of a long term make or buy decision is how best to utilise available facilities
after considering such alternatives as:

1. Leaving facilities idle.

2. Buying products and renting out unused facilities.

3. Buying products and using facilities for other products.

This requires a determination of when outsourcing becomes more expensive than in-house
production. Before making a long term decision to outsource, it is important for
management to assess:

x How many units could be outsourced before the decision to outsource becomes
more expensive, and;

x How much the cost of the outsourced unitscan increase by before outsourcing
becomes more expensive than in house production.

Say a long term decisionis being made to stop manufacturing component T and the fixed
costs directly related to component T are R1 500 000, the fixed cost saving must be
considered as it is relevant in the long term.

How many units can be outsourced?

The graph below illustrates that the cost of outsourcing will exceed the total cost of
production after 10 000 units. This is calculated as follows:

d}šo}•š}(Kµš•}µŒ]vPHd}šo}•š}(Dvµ(šµŒ]vP

WµŒZ•‰Œ]Æš}šoµv]š•H&]Æ}•š•=sŒ]o}•šÆš}šoµv]š•

ZñììyHZí 500 ììì=ZïñìyYyHíìììì

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In a discussion question, consider the number of units currently being used in production, if
SJ (Pty) Ltd is currently using 9 900 units of component T, the outsourcing arrangement will
limit the company’s ability to respond to increases in volume without negatively affecting
profit because only another 100 units can be outsourced cost effectively.

By how much can the outsourcer increase prices?

Say, at the current production levels, 5 000 units of T are required, the price by which the
outsourced units can increase is:

Total Cosš}(Kµš•}µŒ]vPHd}šo}•š}(Dvµ(šµŒ]vP

WµŒZ•‰Œ]Æš}šoµv]š•H&]Æ}•š•=sŒ]o}•šÆš}šoµv]š•

WµŒZ•‰Œ]H &]Æ}•š•=sŒ]o}•š•Æš}šoµv]š•

Total units

WµŒZ•‰Œ]HR1 500 000 + (350 x 5 000) YZòñì

5 000

Thus, at production levels requiring 5 000 units of T, cost per unit of the outsourced units
can increase by R150. Note, that this also means that if the company can reduce ti s variable
manufacturing costsby R150 outsourcing 5000 or fewer units will be more expensive than
in house production. Depending on the product and the outsourcer R150 may or may not
represent a sufficient buffer against the negative impact of price increases.

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 Closing a branch or division
In coming to a decision as to whether an unprofitable branch or division should be closed,
care must be taken to analyse the impact of the closure on fixed overheads. Some fixed
overheads will be specific to the branch or division and these overheads will normally be
saved on closure. However, other general fixed overheads, which are incurred by head
office and merely allocated to the branch or division, are unlikely to change and so are not
relevant to the decision on closure.

The analysis should focus on whether there is a positive contribution (after specific fixed
overheads) to general overheads. If there is a positive contribution, the branch or division
will be kept operating. If there is a negative contribution, the branch or division should be
closed.

For example; Division A, is part of SJ (Pty) Ltd, and has the following costs and revenues:

Revenue R 900 000

Variable Costs -R 598 000
Contribution Margin R 302 000
Fixed Costs -R 358 000
Loss R 56 000
Should Division A be closed?

In order to answer this question, the fixed costs must be analysed further. Say the fixed
costs are as follows:

Rental of Division A building R 98 000

Employee salaries R 105 000
Depreciation R 80 000
Allocated Head office costs R 75 000
Total fixed costs R 358 000
The impact of closing Division A is as follows:

Notes
Contribution Margin Lost -R 302 000 The rental is specific to Division A and will be saved.
The assumption is that all the staff will be retrenched.
Fixed Costs Saved R 283 000 However, if an indication had been given that some staff will
Rental of Division A be relocated to other divisions of the company, the salaries
relating to those employees would not be saved.
building R 98 000
Employee Salaries R 105 000 Although depreciation is not a cash flow, it is included here as
a proxy for future capital expenditure that would have been
Depreciation R 80 000 incurred in Division A.
Allocated costs R0 The head office costs will not be saved; they will simply be
Financial Impact -R 19 000 reallocated to another division.

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Therefore, Division A should not be closed as it is making a positive contribution to the fixed
costs of the company.

Sell now or process further

In some cases a company will produce an intermediate product that can be sold on its own.
Or else the intermediate product can be processed further to produce the final product.

For example: CAZ (Pty) Ltd produces products B and C using raw material A. Usually B is
processed further and sold as product D. C is sold without further processing.

JRM (Pty) has approached CAZ (Pty) Ltd to supply a special order of 120 000kg of product E
which is product C after further processing.

Specialised transport and vats costing a total of R200 000 will have to be acquired if the
order is accepted.

The selling price of C is R5/kg and the transport costs of 120 000kg of C to the customer are
R74 000. JRM will purchase E for R9.50/kg.

Processing C further will cost R3/kg of C processed and will result in no volume loss (i.e. 1kg
of C will yield 1kg of E).

CAZ (Pty) Ltd does not have the capacity to produce E and its normal volume of C.

Should the special order be accepted?

Workings
Incremental Revenue 120 000 x (9.50 - 5) R 540 000
Additional processing
costs 120 000 x 3 -R 360 000
Transport Costs Saved R 74 000
Specialised Transport -R 200 000
Financial Impact R 54 000

Therefore, it would be beneficial from a purely financial perspective to accept the order.
However, there may be qualitative factors to consider.

Qualitative factors and pricing decisions

Note: * indicates areas in which calculations can be incorporated into your discussion where
enough information is provided. Note that broad requireds do not explicitly state all
calculations that are required. When answering any discussion question, consideration
should always be given to sensible supporting calculations that provide additional insight
(see MAF 4).

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Most relevant costing questions will have a second part that asks for the qualitative factors
that should be considered before the decision in question is made.

The best way to answer these questions is to use the scenario as a springboard for your
answer. Each risk mentioned must be specificto the scenario given; very few (probably zero)
marks are given for generic answers.

That being said a few issues that should be kept in mind are:

x Issues surrounding estimates of costs and revenues. Are the estimates reasonable
and reliable? Have all of the costs and revenues been considered? Where there is
uncertainty, what is the percentage *chance of a loss? Watch out for opportunity
costs that have not been included.

x Project risk of the decision. Does the decision make sense strategically? For
example, a decision to take a special order to use up spare capacity might delay a
more sensible decision to get rid of the spare capacity.

x Operational factors.

o How will the reputation of the company be impacted if the quality of the
product is poor? This is especially of concern where the company has no
expertise in making the product.

o Timing is also of importance. For example, if a special order has a tight

deadline, *penalties on the contract could be incurred if the deadline is
missed. Consider the facts that could delay fulfilment of the project
(importing components, heavy reliance on one supplier, employees who are
unfamiliar with the product, machine downtime, etc.)

x The opportunities created by the decision. For example, access to new markets and
customers.

x Pricing. How does the *gross profit margin compare to other products? Will it result
in possible cannibalism if it is too low? In the case of a special order, existing
customers could be unhappy if the price is lower than what they are currently
paying. The next section provides a more extensive discussion on pricing.

Pricing decisions
When pricing products, a number of factors must be considered:

1. The price must alwaysexceed the cost of producing the product.

However, the way “cost” is defined, depends on the nature of the decision being made:

x Short term decisions , for example, a once off special order, require the price to
exceed the variable incremental costs. This only applies when:

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 o There is spare capacity i.e. any positive contribution margin will help cover
fixed costs of idle capacity. If there is no spare capacity, the *opportunity
cost must be considered.

o The price will not impact future prices that the company can charge, i.e. no
expectation of low prices for an indefinite period should be created.

o The spare capacity used, can be freed up quickly in order to take advantage
of better opportunities that come along.

x Long term decisions, for example introducing a new product, require a price that
will allow the business to cover its total costs, i.e. fixed and variable costs. A
business cannot sustain losses for an indefinite period of time, thus when pricing a
product with a long-term focus, consideration must be given to macro-economic
factors that could affect input prices. For example, inflation, exchange rate
fluctuations and electricity prices.

2. The type of product will influence the price that can be charged.

A customised or niche product can be sold for more than a standard product. This links to
the idea of perceived customer value; i.e. the customer will not pay more than what they
think the product is worth and at the same time, the price could influence how the product
is perceived. Some customers are weary of cheap versions of certain products, as the low
price is perceived to indicate poor quality.

3. Competition and the company’s position in the market must be considered.

In a highly competitive market, it is difficult to increase prices, as customers will simply go

elsewhere.

A company that is a price-setter (i.e. has a monopoly) should be concerned about the
legality and ethical issues surrounding the price.

When there is an oligopoly in the market (i.e. a few large companies), legal and ethical issues
must also be considered and the company should be weary of finding itself in a cartel.

Most companies are price-takers and will be focused on minimising costs and will therefore
adopt a target costing approach.

4. Demand and Elasticity.

Consideration should be given to the sensitivity of demand to chances in price. This includes
how the current economic conditions are affecting customers. In tough economic times
when disposable income is low, customers are more sensitive to changes in prices of goods.

5. Cost plus pricing.

This is where the price charged is based on the cost of the product and a mark-up is added.
The cost that is used influences the mark-up. For example, if full cost is used, a lower mark-

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up is needed than if variable cost is used. The use of a standard cost (as opposed to actual
cost) is beneficial for the following reasons:

x It is more timely; and

x Avoids undesirable fluctuations in price due to changes in actual cost.

Cost plus pricing has the following advantages:

x It is simple and easy to use, especially when there are a lot of products; and

x Price stability can be achieved, especially if standard costs are used.

However, there are some disadvantages:

x Cost control is not encouraged (if actual costs are used) because they will always be
covered by the mark-up; and

x The company could make losses if the estimate of demand is incorrect. This is
because the mark-up is intended to at least cover fixed costs and is calculated with
certain volumes being anticipated. If these volumes are not met, the total mark-up
might fall short of even covering fixed costs.

6. The *break-even position of the company must be considered

The price directly influences the contribution margin and therefore the number of units that
must be sold to break even. If the price results in a break-even volume that the company
cannot realistically achieved (whether due to demand or capacity constraints) a new price
may have to be considered.

The margin of safety at the price being considered is important in order to reduce the risk to
the company. If the margin of safety is too low, there is a high risk of losses being incurred.

7. The type of pricing policy should be appropriate for the circumstances.

The stage in the product life cycle will influence the price of the product as follows:

Early/Initial stage:

x Price skimming is introducing a new product at a high price to take advantage of the
high initial interest in the product (novelty appeal). Price skimming is most
appropriate where the company has a constraint and cannot produce large volumes
and there are no or not many substitute products on the market.

x Penetration pricing is introducing a new product at a low price in order to gain

market share. This can be used where capacity is not an issue and the low margins
can be made up for with high volumes. If the market is already competitive
penetration pricing can help gain market share and establish brand loyalty.

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Growth phase:

x All factors discussed above should be considered and the policy should help ensure
the long-term survival of the product.

Decline:

x When the product is dying, any policy that maximises profit in the short term should
be adopted. However, care must be taken not to damage the reputation of the
company as a whole.

The points above are useful for discussing the factors that must be considered when pricing
a product but you should also be able to comment on an existing/suggested pricing policy,
giving both the positives and negatives.

Tips and examination technique

1. This section has often formed the core of the management accounting question
historically. Further, as relevant costs and decision making integrate readily with
other sections such as transfer pricing, there is a very strong likelihood of this topic
being examined in the future. Note that linear programming has not been examined
previously and while it is in the syllabus, there is little chance of a linear
programming question. However, some questions have included a scenario that
includes scarce resources, which could be solved by using a contribution per limiting
factor approach.

2. The major problems seem to stem from candidates not being able to identify all the
opportunity costs. In handling a relevant cost question, it is important to first
identify exactly what the alternatives are. Once all the alternatives have been
clearly identified the differential cash flows of each alternative should be
considered. Where the alternative is mutually exclusive to an existing activity, it is
important to identify the opportunity cost of foregoing the existing activity.

3. Maximising the contribution per limiting factor will identify the optimal production
mix.

4. You should pay particular attention to the determination of the contribution for
each product produced. This information is required to determine either the
objective function or the contribution per limiting factor. Remember to include
variable selling costs in calculating the contribution per unit.

10. Strategic management accounting

JIT (Just
-in-Time) and ERP (Economic
-Resource-Planning)
There is growing interest in just-in-time purchasing systems.

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Just-in-time (JIT) purchasing:The purchase of goods or materials such that delivery
immediately precedes demand or use; in the extreme case, a retailer or manufacturer would
hold no inventories.

Economic Order Quantity (EOQ) is reduced by various combinations of two changes:

1. Decreases in ordering costs of each purchase order; and

2. Increases in carrying costs of inventory.

. This is due to two reasons:

JIT & EOQ are unlikely to be consistent

1. Because the model assumes a constant order quantity, but fluctuating demand
would require differing order quantities; and

2. Because the model does not consider three of the five categories of costs pertaining
to inventory – purchasing costs, stockout costs, and quality costs.

Changes that result from moving toward JIT purchasing include smaller and more frequent
purchase orders , fewer suppliers for each item, long-term contracts with suppliers, less
inspection of ordersreceived, and less paperwork. These changes substantially reduce the
ordering costs per purchase order.

Two basic types of systems used to manage materials inventories in manufacturing

companies are economic resource planning (ERP) and JIT production.

ERP: Asystem that considers first the amount and timing of finished goods demand, and
then determines the derived demand for resources including materials, components, and
subassemblies at each stage of production.

ERP is carried out on a centralised "pull-through" basis that emphasises demand forecasts.
Management accounting can play an important role in ERP by supplying accurate and timely
information on all inventories and by providing estimates of set-up costs, downtime costs,
and carrying costs of inventories. (Note that set-up costs in production situations are
analogous to ordering costs in purchasing situations.)

JIT production: A system in which each component on a production line is produced

immediately as needed by the next step on the production line.

Three features of JIT production are:

x The production line is run on a decentralised "demand-pull" basis that responds to

actual customer demand; this feature is often implemented by a Kanban system.

x Emphasis is placed on minimising the set-up time and the manufacturing lead-time
for each unit.

x The production line is stopped if parts are absent or defective work is discovered;
such action creates an urgency about correcting these problems.

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The underlying philosophy of JIT is simplifying the production process so that only essential
activities that add value to the product are conducted. Some JIT adopters have extended this
simplification to their internal accounting system. JIT adopters make heavy use of
nonfinancial performance measures in the day-to-day control of operations at the plant
level.

Quality control
Quality and time are two key success factors that are part of the newly evolving
management approach. Companies increasingly emphasise manufacturing or delivering
high-quality products or services. Why? Because quality impro
vement programs can result
in sizeable cost savings and higher sales revenue.

Quality: the conformance of a product or service with a preannounced or prespecified

standard. The costs of quality are significant, ranging from 15% to 20% of sales in many
companies. Two basic aspects of quality are quality of design and conformance quality.

Quality of design:measures how closely the characteristics of products (or services) match
the needs and wants of customers.

Conformance quality: is making the product according to design, engineering, and

manufacturing specifications.

Costs of quality (COQ):encompass costs incurred to prevent poor quality from occurring
and costs incurred because poor quality has occurred. Four COQ classifications are often
distinguished:

1. Prevention costs:costs incurred in preventing the production that do not conform

to specifications.

2. Appraisal costs:costs incurred in detecting which of the individual units of product

do not conform to specifications.

3. Internal failure costs: costs incurred when a nonconforming product is detected

before being shipped to customers.

4. External failure costs:costs incurred when a nonconforming product is detected

after being shipped to customers.

COQ are incurred across the entire value chain. Most prevention costs are incurred in R&D
and design. Appraisal and internal failure costs are incurred in manufacturing. External
failure costs are incurred in marketing, distribution, and customer service.

In a situation where competitors are improving quality, a company that does not invest in
quality improvement will likely suffer a decline in sales.

Two trends occur in successful quality programs:

1. COQ as a percentage of sales decreases over time; and

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 2. The sum of internal and external failure costs as a percentage of the total COQ
decreases over time.

Customer satisfaction is an important element in quality programs. Producing a defect-free,

high-quality product is profitable only if it satisfies customers. Most organisations use both
financial and nonfinancial measures of customer satisfaction.

x Financial measuresinclude warranty repair costs and forgone contribution margin

on lost sales.

x Non-financial measuresinclude number of customer complaints and customer-

response time. Examples of non-financial measures of internal quality are:

o Defect rate;

o Process yield; and

o Manufacturing lead time.

Some organisations include both financial and non-financial measures of quality

performance in a single report, often called a balanced scoreboard.This approach helps top
management evaluate whether lower-level managers have improved one performance
aspect (such as net income) at the expense of others (such as time
on-delivery).

Companies increasingly view time as a key variable in competition. Several measures of time
are used.

x New product development time:the amount of time from when the initial concept
for a new product is improved by management to its market introduction.

x Break-even time (BET):the amount of time from when the initial concept for a new
product is approved by management until the time when the cumulative present
value of net cash inflows from the project equals the cumulative present value of
net investment outflows.

x Customer-response time: the amount of time from when a customer places an

order to when delivery occurs.

x Manufacturing lead time (also called manufacturing cycle time): the amount of
time from when an order is ready to start on the production line (ready to be set up)
to when it is finished.

x On-time performancerefers to situations in which the product or service is actually

delivered to the customer on schedule. There can be a trade-off between customer-
response time and on-time performance; on-time performance can be improved
simply by promising longer customer-response times.

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Balanced Scorecard
While a Balanced Scorecard is often referred to in performance evaluation, we cannot
ignore the fact that any Balanced Scorecard is rooted in company strategy. A Balanced
Scorecard is often thought of as a method of communicating the broader strategy of the
company to employees in a way that they understand how they (the employees) contribute
to the overall company strategy.

The Balanced Scorecard has a collection of four areas of performance including both
financial and non-financial measures. This ensures that a company and its employees to not
neglect certain core areas of importance – after all, the financial performance of a company
will only remain strong if the operational integrity of the company remains equally strong.
For each of the four core areas of performance listed below, strategic/performance
objectives are set and some objective measure selected to allow the monitoring of
performance against those objectives.

1. Financial Perspective:

The ultimate aim of a for-profit enterprise is to maximise shareholder wealth.

Typical measures that could be used to reflect this are RI, ROI, and Net Profit. In
addition to a high level target, other more specific financial measures are also
specified. These other measures would relate to key variables affecting the high
level objective/measure, and would relate directly to objectives detailed in the
customer perspective.

2. Customer perspective:

Objectives in this category focus on maintaining and growing a profitable customer

base. Typical measures in this category would thus be market share, number of
customer complaints, lost customers, customer enquiries new customers, customer
turnover, etc. A balance between internal/external and intermediate/final measures
is important.

3. Internal business perspective:

This perspective focuses on the activities that the company must excel at. Quality
and service-related measures are usually found in this category.

4. Learning and Growth perspective:

Measures focusing on employee training, innovation, research and development

would be appropriate here.

Tips and examination technique

1. You are advised to skim through this section, as there is a low likelihood of it being
examined in the ITC. It is, however, recommended that candidates familiarise
themselves with the content of a Balanced Scorecard and understand how such

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 principles may be tested in ITC (especially given the integration with Strategy, Risk
Management and Governance.

2. These notes are given to candidates to provide them with some background and to
allow them to become familiar with the terminology that is evolving around modern
manufacturing technologies. It would be inappropriate to spend a lot of time
studying this section.

3. Just-in-time and materials requirement planning are manufacturing techniques that

have gained increasing popularity in recent years. They are production techniques as
against management accounting systems, yet they do have significant implications
for management accounting systems. For this reason it is important for candidates
to have an overall understanding of the implications of JIT and ERP on management
accounting systems.

Financial management
11. Working capital and treasury
Some definitions:

x Working capitalrefers to current assets.

x Net working capitalrefers to net current assets (current assets less current liabilities). In
most cases, this refers to operating working capital assets and liabilities such as
inventory, accounts receivable, operating cash, and trade payables.
x Working capital policy refers to basic policy decisions regarding optimal levels for each
category of current asset and to the financing of these assets.
x Working capital managementinvolves the day-to-day administration ensuring that the
aforementioned policy is upheld.

Working capital is required so that a firm can fund upcoming operational expenses as well as
repay maturing short-term debt as it becomes due. Working capital involves managing
inventories, accounts receivable and payable, and cash.

If there is insufficient working capital, profits will fall as a result of for example, production
disruptions, lost sales and liquidity problems caused by insufficient inventory, excessively
tight credit control or inadequate cash reserves. If there is excessive working capital, return
on investment drops as profit, beyond the optimal level of investment, remains constant
against an increased investment level.

The level of investment in working capital that yields the highest return on investment is
considered optimal.

The method of matching financing terms to working capital payback periods will also have
an impact on profits. Short-term finance is generally less costly than long-term finance but
creates greater financial risk for the firm. Conservative financing would result in all

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permanent current assets and most non-permanent current assets being financed long-
term. An aggressive policy would see some permanent and all non-permanent current assets
financed short-term. The optimal situation would be somewhere between these extremes
probably reflecting long-term financing for permanent current assets and short-term
financing for temporary current assets. Such a policy would not have the lowest cost but
would reflect the highest acceptable level of risk. Risk is highest when the financing terms do
not match the useful life of the assets they finance. For example, if you finance an asset that
will provide incomes for 3 years with a 5 year loan. It is clear that there will be a risk you do
not set aside enough of your profits earned in years 1-3 to finance the repayment of the
debt in years 4 and 5.

Working capital requirements can often be estimated using the percentage of sales method.
This method assumes a direct relationship between the level of sales and net working capital
and measures spontaneous finance. Often in exam scenarios you will be required to
calculate the working capital ratios. These on their own will not attract a large amount of
marks, but their interpretation may do so. It is important to apply the information given in
the scenario to the ratios calculated in order to identify any trends.

The credit policy, which refers to the credit terms provided to customers on sales made,
involves making decisions regarding:

x The length of the credit period;

x Levels of credit worthiness – this will include screening customers who apply for
credit;

x The collection policy; and

x Cash discounts – this will tie in well with the Financial Reporting Section, in
particular IAS 16 – Revenue.

Changes in credit policy will affect one or more of the following factors:

x Sales – by issuing clients with credit you are granting them the ability to make
purchases that they cannot currently afford; think Edgars and Lewis Stores;

x Production costs;

x Bad debt losses – by providing credit to customers who cannot afford to repay in
line with the terms provided; hence the importance of screening – see above. Also
see Ellerines for a real life example of where things did not go so well;

x Cash discounts – by providing discounts for all cash purchases;

x Investment in accounts receivable;

x Credit administration costs; and

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 x Collection expenses – these can run into the millions for large firms if they have
granted credit too liberally and are forced to chase after their returns.

There are a number of short-term sources of finance, including:

x Accruals; and

x Trade credit – where a business allows its customers to pay in delay, receiving goods
today and making payment in the future.

The effective cost of trade creditor finance is:

Discount No of days in the year

{Amount - discount} x No of days by which credit
is extended
x Factoring – where a business sells its debtors book to raise funds and the purchaser
takes on the responsibility of retrieving any outstanding debt. The sale usually takes
place at a discount, for example a firm may sell the debtors book for 30 cents in the
Rand, meaning they receive 30 cents for every Rand of debt they have on their
books. In Poland there is a relatively well know firm, Kruk Group, which buys the bad
books of a bank. They are known for taking up to 10 years to retrieve the debts but
have become so successful that they have moved out of Poland and into the rest of
Europe.

The effective cost of factoring can only be estimated after allowing for:

x Service facility costs;

x Finance facility costs;

x Retention rebates;

x Credit administration cost savings;

x Bank overdrafts;

x Term loans; and

x Bankers’ acceptances – a short-term debt instrument issued by a firm that is

guaranteed by a commercial bank, similar to a T-Bill.

Tips and examination technique

1. Working capital may be examined on its own, but it is often examined in
combination with other topics such as capital budgeting or valuations, as is the case
in MAF 10. Familiarise yourself with how to calculate working capital ratio’s.

2. Consider how working capital differs from industry sector to industry sector. For
example, the management of inventory lines is critical for the major retailers
including food and apparel retailers. Yet net working capital for the major food

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 retailers is expected to be negative (as sales revenue increases, working capital
generates positive cash flow). Why? Food retailers mainly sell for cash and so the
investment in accounts receivable is immaterial whilst inventory is funded by
accounts payable. Companies such as MTN and service companies such as hospital
and hotel groups will have little investment in inventory and so the net investment
in working capital may be very low. The investment in working capital will be high
for manufacturers such as Tiger Brands. Therefore evaluate the industry sector.
Operationally, the management of inventory for the food retailers is critical, as this
will affect sales. Further, the management of perishables is more complex than
other types of inventory. For apparel retailers, the use of IT is critical to ensure
control, to determine demand patterns as well as to determine which lines to order.
For apparel retailers, such as Truworths, the management of inventory is critical, but
Truworths also has to carefully manage their debtors book.

3. How do we determine the investment in working capital for companies such as

Truworths or Foschini, when interest becomes payable on outstanding balances?
The answer here is that we need to include accounts receivable as working capital
until the point it becomes interest bearing. Once accounts receivable become
interest bearing, then these accounts receivable balances become financial assets.
Value financial assets separately to working capital.

4. Remember that working capital adjustments in valuations and capital budgeting may
be either direct cash flows or in most cases may represent adjustments to forecast
earnings which need to be converted to cash flows.

5. Check your working capital ratios over time or at least for the last year to ensure you
have not made an error.

6. Remember that excess cash is not part of working capital. (See the Valuation
section.)

12. Capital budgeting

Basicprinciple
x Only differential cash flows are considered. However, in calculating the taxation
cash outflow, consideration must be given to taxable income, which is based on the
accrual accounting system.

Methods
x Payback: The length of time taken to recover the initial investment. Where cash
flows are not consistent, they must be accumulated on an annual basis. Discounted
payback takes time value of money into account.

x Internal rate of return: The rate that causes the net present value to equal zero. In
other words, where the inflows equal the outflows. IRR can only be calculated using
Excel, a financial calculator or approximated by trial and error.

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 x Net present value: Cash flows, including tax shields if there is taxable income, are
discounted at the firm’s cost of capital; see relevant revenues and costs for cash
flows to be included in the calculation. In exam situations an assumption may be
made that the project risk equals the overall company risk. If project risk differs,
adjustment may be made to the rate. (Refer also to adjusted present values.)

Types of projects
x Mutually exclusive: Select project A or B or C; in other words you cannot select
more than one project.

x Independent: Select all projects that satisfy the selection criterion, such as payback
period or positive net present value, subject to capital rationing. (Capital rationing
makes projects dependent.)

x Divisible: In cases of capital rationing, divisibility of projects is a factor in selecting

the combination of projects which makes the best use of available capital by
maximising the net present value.

Factors to consider with Net Present Value

Types of cash flows
x Acquisition outflows;

x Working capital outflows – See working capital section for classification of working
capital;

x Net annual operating inflows;

x Disinvestment inflows – note working capital recovery; and

x Taxation shield flows. The capital allowance on new machinery used in the process
of manufacture is 40:20:20:20 (s12C) and thus the write off is over four years.
Recoupment or scrapping is based on the difference between tax value and amount
realised (any recoupment is up to the original cost only). Any amount realised above
cost is generally subject to capital gains tax (CGT).

Relevant revenues and cost

Only incremental cash flows need to be discounted. The following are examples of relevant
and irrelevant cash flows:

x Sunk costs can be ignored, as they are not relevant. (The tax deduction relating to
sunk costs may be relevant if there is a ring-fencing of tax allowances to the project.)

x Opportunity costs are relevant. For example, a new project might use existing space
and so the factory rental is considered irrelevant. However, if the project is not
taken, the under-utilised space could be sub-let. The rental foregone by taking on

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 the project is an opportunity cost and is relevant for the analysis. We look at the
highest opportunity cost forgone when making our decision.

x Effect of new product on the demand for existing products is relevant, as the
existing revenue forgone will be an opportunity cost. There may be complimentary
effects as well. Therefore, by investing in a new product line, this may result in
higher demand for existing products.

x Allocated costs are irrelevant, as they will be incurred irrespective of whether the
project is undertaken or not. The key concept to take away here is that we look at
the financial impact of a decision from the perspective of the entity as a whole.
Therefore, as an example, allocated head office costs will still be incurred, regardless
of a division closing. There are exceptions to this rule if the head office costs in fact
will be reduced by the decision made by a division.

x A change in working capital is relevant; an increase being a cash outflow and a

decrease being a cash inflow. If we increase our credit terms to our customers it will
result in a reduced amount of cash inflow in the current year, hence a cash outflow.
Note these cash flows have no impact on taxation.

Note: MAF 11 and MAF 16 provide good illustrations of how to use relevant costing
principals to identify and deal with relevant and irrelevant cash flow s in a capital budgeting
question.

Some other general rules are:

x Ensure that you have identified all the possible alternatives. For example, the option
to do nothing is often ignored. One always has the option to do nothing. This is
relevant when you are asked to compare investing in either Machine X or Y as a
replacement to Machine A. Yet it may be best not to replace at all.

x Ignore depreciation, as it is not a cash flow. However, ensure that you include the
tax saving of any depreciation allowances. Capital expenditure should not be
ignored.

x Ignore financing costs such as interest paid. The cost of debt is included in the WACC
and will result in double counting if included as a cash flow too. In MAF 16, a
negative markwas awarded if finance costs were included in the capital budget.

Discount rate
x Use the WEIGHTED AVERAGE COST OF CAPITAL to discount project cash flows.
Assumption: Risk of Project = Risk of Firm. If the risk of the project is higher than the
firm, then use a higher discount rate. If the investment is in a different sector, then
best to use comparable firm data such as betas to determine a separate cost of
capital for the project.

When calculating the WACC we multiply the cost of the various financing streams by their
respective weights. You should be familiar with the denotations used in this section:

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 ke: Cost of equity

kd: Cost of debt

kp: Cost of preference shares

See the Cost of Capital section where this will be dealt with in more depth.

A capital budgeting question could require you to draw up the capital budget for a project or
ask you to analyse a capital budget that has already been drawn up (see MAF 10 and 16).
Keep in mind that it is not only the principles that are described in this section that are
relevant; the principles of drafting a normal budget will also apply especially when there is
some estimation involved (see section 5).

Projects with unequal lives

x Use Lowest Common Multiple Time period – e.g. if one project has a life of 2 and
another 3 years, then you would use a 6 year time span (project one being renewed
3 times and project 2 twice).

x Assumption: The projects can be repeated.

x Use annuity equivalent:

NPV

PVFA

Where: NPV is the project NPV

PVFA is the present value annuity factor for the length of the project at the discount rate
(WACC).

x A financial calculator can be used to calculate the annuity factor.

o FV = 1

o PV = 0

o Int rate = the applicable interest rate

o N = Number of payments

o Pmt = annuity factor

x The project with the highest annuity equivalent will maximise shareholders wealth.

Different cash outlay projects(Profitability Index)

We use the PI where we have financing for future capex, however we do not have enough to
finance all the positive future projects. In other words, we have a number of projects that

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we are willing to accept in respect to their ability to provide a positive future NPV, however,
we do not have sufficient financing to do so. Therefore we use the PI to determine which
projects we accept, as we want to maximise the future NPV earned in relation to the
financing we have at our disposal. See Capital rationing.

PI = PV of Project Cash Flow/Cost

The highest profitability index will maximise shareholders wealth.

Capital rationing
x Determine the combination of projects that maximises the combined NPV without
exceeding the capital ceiling (use PI as starting point).

Inflation as a consideration
x Cost of Capital (nominal rate of return) INCLUDES inflationary expectation.

x Two options:

o Use NOMINAL rate and NOMINAL (Future Rand) cash flows; or

o Use REAL rate and REAL (Present Rand Value) cash flows.

x Not all cash flows will increase by inflation e.g. Tax allowances.

x Inflation reduces the real value of tax shields resulting in lower project returns and
greater project risk.

Revisionexample

Brix Lighting Ltd is considering opening a new store and the following financial information is
relevant for evaluating the investment.

Information
Fixtures, fittings & demo lights 18,000,000
Working capital (inventory) 6,000,000
Project life (years) 5
End of life of the project recovery:
Fixtures, fittings & demo lights 3,000,000
Working capital (inventory) 6,000,000

Annual operations:
Unit sales 60,000
Unit selling price 300
Unit variable costs 100

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 Annual fixed costs (excl. depreciation) 1,000,000

Tax rate 28%

WACC 14%
Yr 1 Yr 2-5
Depreciation 20% 20%

Required:

a) Determine the project's net present value.

b) Calculate the minimum contribution per unit required to break even.

c) Determine the minimum yearly sales (number of units) required to provide a 14% return
on initial investment.

d) If the unit selling price is reduced to R150, how many units must be sold each year to
earn a 14% rate of return?

IGNORE VAT

Suggested Solution

(a)

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In part (d) we have separated the cash flows that will stay constant and will not change. We
determine the present value or net present cost (NPC) of the investment after tax. NPC in
this case will include the cost of fixtures, working capital, fixed costs, tax effects of the
depreciation deductions and recoupment as well as the residual value.

(Number of units x contribution per unit)(1-tax rate) PVFA = NPC

Rearranging the equation: Number of units = NPC / Contribution per unit x (1-tax rate)PVFA

This means that we can work out the break-even number of units as follows:

The example above illustrates how capital budgeting and CVP can be integrated. The main
principle to remember is that in order to break even, the NPV must be R NIL. This is also
illustrated in MAF 11.

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Tips and examination technique
1. Capital budgeting and project evaluation will often be examined and it is important
to understand the key principles of basing an investment decision on incremental
cash flows.

2. Understand the tax consequences and cash flows, and effects of depreciation
deductions, recoupments and scrapping allowances, as well as CGT. These are easy
marks. Practise good exam technique when calculating tax cash flows. From the
revision example above and the tutorials provided, you will notice that the tax cash
flows are usually calculated in a separate schedule. It is especially important to have
clear workings for tax when the calculation is slightly more complicated. For
example when there are assessed losses involved.

3. Remember that working capital is often a key issue, but you need to understand that
any cash flow savings from a more effective working capital policy will generally
have no tax consequences. If a project (new manufacturing technology) results in
the company being required to hold lower inventory, say from R200m to R120m,
then the cash flow saving will be R80m. Remember, however, that you are receiving
R80m today but you would have received this R80m at the end of the current
project life anyway.

4. It often is a good idea to set out your solution in a spreadsheet format with each
year represented by a column. Leave enough rows to complete potential entries.
Then, once you have put the number in the right space, ensure that you set out the
workings in a separate section to explain how you got to the number. Do it like you
would in Excel, as this enables you to better plan and organise your solution.

5. Identify the cash flows carefully and make sure that your analysis is clear to the
examiner. Often candidates use financial calculators to arrive at a net present value
with little detail of workings being given. In addition to identifying the cash flows
correctly, the timing of the cash flows must also be accounted for correctly. MAF 16
requires you to pay careful attention to the timing of the various costs that occur.

6. Always use the weighted average cost of capital as the discount rate for an
investment decision unless the question indicates that this investment is of a higher
risk than the firm’s other projects. Do not use the cost of equity.

7. You will always be asked to comment on whatever calculations you perform so don’t
forget qualitative factors that need to be considered.

13. Leasing
Leasing an asset is an alternative to borrowing and purchasing an asset, as the lessee obtains
the full use of the asset either way. Leasing is a very important way of financing assets and
total leasing amounts to about R7.5 trillion worldwide. Leasing is an alternative form of
financing a project and must be treated as such.

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The decision to finance the asset via either borrowing to purchase or leasing comes only
after the NPV of the project is looked at. The financing decision is looked at in isolation of
the investing decision in most part, unless the financing is asset-specific. This is also the only
time you would consider accepting a decision despite the NPV being negative, as the benefit
of the asset-specific financing is added to the negative NPV to determine the attractiveness
of the project.

The value of the asset-specific financing is calculated as the cost of financing the asset
through normal means less the cost of financing the asset through the asset-specific
financing.

The types of lease are as follows:

x Direct lease

x Sales and lease-back (this has been dealt with in the Financial Reporting section).

x Leveraged lease – some of the funding required to purchase the asset is obtained
from a third party.

The advantages of leasing are:

x Changing technology;

x Tax advantages;

x Operating flexibility; and

x Obtaining 100% finance.

In finance, all leases are finance leases, whilst in accounting we differentiate between
operating and finance leases. However, in terms of proposed changes to lease accounting in
terms of IFRS, leases will be classified into Type A and Type B (property) leases. All leases will
be capitalised and the right of use asset and the associated lease liability will be reflected in
the Statement of Financial Position. The income statement effects will differ between Type A
and Type B leases.

The proposed changes to lease accounting is expected to increase EBITDA and the
Debt/Equity ratios, and affect other ratios such as ROE quite significantly, particularly for
sectors such as logistics, transport, food and drug retailers, hotel and hospital groups, the
travel and leisure sector and other retailers.

To evaluate the leasing decision,the differential cash flows between leasing and
borrowing and purchasing need to be identified and discounted at the after tax cost of
debt.

Where the lease finance is linked to a particular asset (asset

-specific)the net advantage of
leasing can be combined with the net present value of the project to ascertain the total
increase in shareholders' wealth.

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The discount rate applicable is that related to the cost if debt, NOT the WACC. Remember
the cost of debt must be after tax.

Tip: The taxation applied to leasing (the entire lease payment) and borrowings (only the
interest portion) only results in a deduction at year-end.

Also, to calculate the annual loan repayment and interest portion, it is often necessary to
prepare an amortisation table, setting out the opening balance of the loan as well as the
capital and interest repayments per annum. Only the interest repayments result in a
taxation deduction, whereas the whole amount is a cash outflow. The interest rate to apply
in the table is the rate specific to the loan, NOT the firm wide cost of debt. It is not necessary
to prepare an amortisation table where the cost of debt equals the loan specific interest rate
and a shortcut method can be used were you deduct the entire loan amount in year 0 for
your cashflow analysis. However this only applies where the two rates are identical.

Below is a graphical representation of the borrowing to purchase vs. leasing decision.

When there is asset-specific finance, consider whether or not this could change the investment
decision? In MAF 14, investment decision was positive without considering the asset-specific finance
that was available. Because asset specific finance only serves to lower the discount rate, a positive
decision will stay positive, while a negative decision could go from positive to negative.

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The advantages of leasing include:

Revision Example:

Blue Sky Airlines, a domestic airline, is considering expanding its air routes into Africa by
offering its passengers a direct route to Luanda from Johannesburg. The company is
considering an A320 plane at a cost of R300m. There are a number of international plane
leasing companies competing for business and the company has been offered a 5-year lease,
which will require annual payments in advance of R50m. Its current bank has also offered to
lend the company R300m, which is repayable at the end of 5 years. The current tax rate is
28%. The cost of capital is 12%. The before-tax cost of debt is 9.7222%. The lease option will
include maintenance which is expected to cost R5m per year whilst if Blue Sky uses loan
financing, then the company will be required to pay for maintenance. Maintenance is
payable at the end of each year and is expected to escalate at 5% per year after the first
year. The company is able to depreciate the plane over 5 years at 20% per year straight-line.

The tax effects relating to the lease payments are realised one year after the cashflows
occur. Other deductions, such as the maintenance and depreciation, will occur in the same
year as the cashflow or deduction. The tax effects of the residual payment or value will occur
in Year 5. The airline leasing company has agreed to a purchase option at the end of the
lease, which will require Blue Sky to make a residual payment of R50m to obtain ownership
of the plane when the market value is expected to be R90m.

Required:

What is the net advantage of leasing the plane?

Suggested solut
ion

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We can set out the borrow and purchase and lease options separately and determine the
net present cost of each alternative (NPC). The net advantage of leasing is the difference
between the NPCs of these financing alternatives.

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Tips and examination technique
1. Leasing is considered as an alternative to borrowing to purchase and, as a result, the
cashflows must be discounted at the after-tax cost of debt.

2. Always keep the leasing decision separate from the investment decision, unless
there is asset-specific finance and the terms and cost of the lease financing is
dependent on the investment decision.

Firms may use the terms of lease financing to effectively reduce the cost of the
operating asset. For example, if Company A purchases equipment from
Manufacturer B, then the cost may be R100m, but Manufacturer B will also offer a
lease at an interest rate of prime overdraft rate less 5%. The financing is dependent
on Company A acquiring the asset from Manufacturer B, and so we need to include
the benefit of the special financing arrangement in making the investment decision
as the financing arrangement is dependent on the investment decision. If there is no
asset-specific finance, the decision to invest is not influenced by how the investment
is made.

3. This is an area that integrates well with other disciplines like Financial Reporting and
Tax, and therefore it is considered an important area for the APC exam.

4. Often it is also easy to integrate a leasing question with a capital budgeting question.

5. Note that leasing financing is often used in specific industry sectors (see above) and
you should consider the terms of leases, which include risks and opportunities
relating to residual values and end-of-lease purchase options. For retailers, leases
are often a critical part of their operations and you need to consider the term of
current leases, escalation clauses, and renewal clauses of leases.

14. The financing decision

Risk and isk
r management
The capital structure decision involves the choice between risk and expected return.
Additional debt increases the riskiness of the firm, but added leverage can result in higher
returns. The optimal capital structure balances risk and return to maximise shareholders’
wealth.

A firm has a certain amount of operating risk, even when there are no borrowings, and this
is often referred to as business risk. It is dependent on the following factors:

x Sales volatility;

x Ratio of fixed costs to variable costs (operating leverage);

x Variability of selling prices;

x Variability of costs; and

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 x How competitive the environment is.

When a firm uses debt or preference share finance, additional risk is placed on the common
shareholders. This is called financial risk. Financial leverage refers to the impact on
shareholders' returns – if assets generate a higher return than the cost of borrowing, there is
positive financial leverage as the shareholders' returns have been levered up. The converse
will hold where assets generate a return that is less than the cost of borrowing (negative
financial leverage). In general, financial leverage will increase the shareholders' return but at
the same time increase the variability (risk) of these returns. As financial leverage increases,
the cost of debt is also likely to increase as there is an increased chance of financial distress.

Changes in the capital structure will affect EPS and share prices. As interest is tax-deductible,
debt in the capital structure will enhance the income attributable to shareholders. This in
turn will increase the share price and shareholders wealth.

On the other hand, higher debt ratios lead to an increased chance of financial distress. The
increased chance of financial distress and the costs involved will cause the price of the share
to fall.

A firm will thus increase debt until the marginal tax shield value is equal to the marginal cost
of financial distress. This point is the optimal capital structure, which will maximise
shareholders’ wealth and minimise the cost of capital.

To summarise, adding debt up to the optimal point will result in a decrease in your WACC,
and therefore an increase in your firm’s wealth, as the interest tax shield benefit outweighs
the cost of financial distress. Once you pass this point, adding debt will decrease the firm’s
wealth.

The following factors will have some influence on the firm's choice of a target capital
structure:

x Sales stability;

x Types of asset and asset structure;

x Operating leverage;

x Growth rate;

x Profitability;

x Taxes;

x Shareholders control;

x Management attitudes;

x Credit ratings;

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 x Attitudes of institutions;

x Market conditions; and

x Firm's internal condition.

Sources of finance
Financial markets consist broadly of money markets and capital markets. The money market
is mainly for short-term borrowers and lenders while the capital market caters for long-term
borrowers and lenders. Financial markets can also be categorised as either primary or
secondary markets. A primary market is the market for new issues of finance while a
secondary market is for trading in previously issued financially instruments. Primary and
secondary markets apply to both money and capital markets. The JSE is the major market in
South Africa. The futures market, SAFEX, is a division of the JSE and this sector has shown
strong growth.

The main types of financial institutions operating in South Africa are:

x Banks

o Commercial banking
o Investment banking

x Investment institutions and insurance firms

x Private equity and venture capital entities

x Special institutions

o Industrial Development Corporation (IDC)

o Public Investment Corporation (PIC)
o Business Partners
o National Empowerment Fund and Khula Enterprise Finance
o Development Bank of Southern Africa
o Land and Agricultural Development Bank

x Financial instruments can be divided into equity or debt related instruments.

o Equity related
o Ordinary shares
o Preference shares

x Debt related

o Preference shares

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 o Debentures/bonds
o Mortgage bonds
o Loans
o Leases
o Short-term debt
o Off-shore finance

Note: Preference shares have the qualities of both equity and debt related instruments
depending on the terms and conditions of redemption or convertibility.

Example:

You are an independent financial advisor to FRA Ltd, a manufacturer of packaging products
for sale to food and beverage manufacturers. FRA Ltd obtained a US $3,5 million loan from
Case Bank, New York, on 1 January 20x1. The directors of FRA Ltd were of the opinion that
the cost of the US dollar loan would be cheaper than raising finance in the South African
market. The Loan was raised to finance the expansion of a factory of FRA Ltd based in
Roodepoort.

The salient terms of the loan from Case Bank are as follows:

x The loan bears interest at 11% per annum, payable half yearly in arrears. The
interest rate is fixed for the duration of the loan and interest is calculated and paid
on the outstanding balance at the end of each six month period;

x The loan is to be repaid in four equal annual instalments which repayments

commenced on 1 January 20x3; and

x The loan is secured by a cession of FRA Ltd’s debtors book.

The financial director of FRA Ltd is concerned about the loan exposure of the company to
Case Bank, given the devaluation of the rand against the US dollar. FRA Ltd has historically
been prepared to accept a moderate degree of risk in financial transactions. The financial
director is also concerned about the low level of exports achieved by FRA Ltd. Currently,
exports represent 5% of total turnover. FRA Ltd has not covered the foreign loan exposure
through the use of forward exchange contracts or through any other derivative instruments.

The following selected financial information has been extracted from the annual reports of
FRA Ltd:

Years ended 31 December

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 20x2 20x1
BALANCE SHEET R’000 R’000

Ordinary shareholders’ interest 20 067 18 455

Interest bearing liabilities
Long-term liabilities 15 750 17 150
Current portion of long-term liabilities 5 250
Bank and cash resources 3 514 2 784

INCOME STATEMENT

Revenue 61 765 51 470

Gross profit 16 429 13 691
Operating profit 4 304 5 920
Net interest paid 1 824 1 371
Profit after taxation 1 612 2 957

Additional information

1. Exchange rate (SA rand to one USA $) R R

Beginning of the year 4,90 4,60

Middle of the year 6,30 4,55

End of the year 6,00 4,90

2. Proposed loan from BE Bank

BE Bank, a leading South African Bank, has offered FRA Ltd a loan facility to replace the
existing loan of the company from Case Bank. The terms of the proposed loan from BE Bank
are as follows:

x R15 million is to be advanced on 1 June 20x3;

x The loan is to bear interest at 1% below the prime overdraft rate (currently 24%);

x Interest is to be paid quarterly in arrears calculated on the capital balance

outstanding at the end of each quarter; and

x The loan is to be repaid in ten equal quarterly instalments, which will commence on
1 October 20x3.

YOU ARE REQUIRED: TO

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(a) Calculate the effective, all inclusive, annual borrowing cost (as a percentage) in rand
terms of the loan from Case Bank for the financial years ended 31 December 20x1
and 20x2; (8)

(b) Draft a report to the financial director of FRA Ltd in which you document your
assessment of the exposure of FRA Ltd to interest rate risk, currency risk and
liquidity risk. Your report should detail the following:

x Definitions of interest rate risk, currency risk and liquidity risk; (6)

x Your assessment, with reasons, of whether the exposure of FRA Ltd to the
aforementioned risks is low, moderate or high; and (11)

x Any suggestions you may have regarding how FRA Ltd can minimise its exposure to
these risks; and (8)

(c) Discuss whether FRA Ltd should replace the loan from Case Bank with the proposed
loan from BE Bank. (7)

QE (adapted)

Example discussion and suggested solution

(a) Effective interest rates

20x1

Period CF

0 Initial loan amount R(16 100 000)

1 Interest for first six months ($3.5m x 11% x 4.55 x .5) 875 875

2 Interest for second six months 943 250

2 Capital return 17 150 000

^]u‰o]všŒ•š]•‚~íóíñìììì=ôóñôóñ=õðïîñì•líòíìììììƒ –1

= 17,82%

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20x2

Period CF

0 Initial loan amount R(17 150 000)

1 Interest for first six months 1 212 750

2 Interest for second six months 1 155 000

2 Capital return 21 000 000

^]u‰o]všŒ•š]•‚~îíìììììì=íîíîóñì=ííññììì•líóíñììììƒ –1

= 36,26%

(b) Definition of risks

x Interest rate risk is the risk that the value of a financial instrument will fluctuate due to
the changes in market interest rates.

x Currency risk is the risk that the value of a financial instrument will fluctuate due to
changes in foreign exchange rates.

x Liquidity risk is the risk that the company cannot meet its financial obligations when
they fall due.

Assessment of exposure

Assessment of FRA Ltd's exposure to interest rate risk.

x The loan from Case Bank is fixed for the duration of the loan hence there is no
exposure to interest rate risk.

x In addition, the company has no other interest bearing debt.

Assessment of exposure to currency risk.

x FRA Ltd is highly exposed to currency risk evidenced by the loss on translation of the
Case loan.

20x1 - R1,05 million loss

20x2 - R3,85 million loss

x The Rand depreciated against the US$ by 6,1% in 20x1 and 18,3% in 20x2.

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The effect of future adverse currency movements can be illustrated as follows:

Devaluation of Rand against $ Loss incurred by FRA

in 20x3 (R'000)

10% 1,575

20% 3,150

30% 4.725

FRA Ltd's exposure to currency risk is high particularly given 20x2 profit before interest of
R4,3 million, It follows that FRA Ltd may incur losses in 20x3 given the interest burden (R1,7
million) and potential foreign currency translation losses.

Assessment of exposure to liquidity risk.

Gearing levels (debt to equity ratios)

20x1 78%

20x2 87%

Interest cover ratios

20x1 4,3 times

20x2 2,4 times

FRA Ltd's ability to repay foreign loan is dependent on the company generating sufficient
cash flow and/or raising further debt/equity. Net borrowings of R17,5 million needs to be
repaid over the next 3 years.

Given the 20x2 financial results:

Increase in cash resources of R0,7 million. Profit after tax of R1,6 million; and the nature of
FRA Ltd's business i.e. manufacturing (not usually cash generative if high capital
expenditure), it would appear unlikely that FRA Ltd will generate sufficient cash to repay the
Case loan.

FRA Ltd's exposure to liquidity risk is assessed to be high for these reasons. FRA Ltd has
however, used long-term finance to fund expansion which would reduce the risk.

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Suggestions to minimise risks

Suggestions to minimise currency risk

x Obtain forward cover on interest payments and loan repayments;

x Attempt to increase export turnover;

x Consider replacing foreign debt with local loans;

x Repay part of foreign loan utilising current cash resources of R3,5 million; and

x Consider swapping Case loan with South African corporate which has a significant
export business.

Suggestions to minimise liquidity risk

x Consider recapitalising the business through an equity injection or selling off surplus
assets;

x Consider replacing Case loan with local debt; and

x Examine asset base i.e. consider sale and leaseback of land and buildings (longer
term finance).

(c) Replacement of foreign loan

Given FRA Ltd's limited export business (R3,1 million in 20x2 – R0,8 million in gross profit) it
is advisable to limit currency risk.

The interest cost of the Case loan was higher than local borrowings in 20x2, another reason
to convert to local borrowings.

It may be argued that the Rand has strengthened against the $ in the last 6 months and
hence retain the foreign loan.

Recommendation is to replace the Case loan with a loan from BE Bank given FRA Ltd's stated
policy of accepting a moderate risk profile.

Tips and examination technique

1. It is important that you have an overall knowledge of the types of long, medium and
short-term finance that are available both locally and off-shore. Further, you should
be able to identify the appropriate circumstances for each type of finance.
Remember, the financing decision is not merely a choice between debt and equity.
There are different types of debt and different types of equity. MAF 09 and MAF 15
illustrate the quantitative comparison of two types of debt; MAF 15 also provides a
qualitative assessment.

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 2. The examination of sources of finance may be interlinked with an investment
decision; this was the case in MAF 09. Understand that firms in transportation,
logistics and distribution, and retail will have a increased ability to borrow/lease
against assets, whilst other firms investing in new products or intangibles may be
required to use equity financing. Also, consider capital structure theory and the
impact of any financing option on the company’s capital structure.

3. Consider the tax effects of financing structures. See the leasing section for clarity on
the tax effects on leasing and borrowing to purchase as an example.

4. The use of derivatives is becoming increasingly important, and for financing

decisions, consider the use of interest rate swaps in making decisions regarding fixed
rate and variable rate debt. Also, consider the use of caps, floors and collars when
you select a debt alternative. For example, you may select a variable rate loan with
an interest rate cap so that you are assured that you will never be required to pay an
interest rate higher than say 11% (you have purchased a call option on the interest
rate).

5. BBBEE transactions will often require vendor financing structures or guarantees to

ensure that such leveraged financing structures are viable and therefore you may be
asked to suggest an appropriate financing structure or comment on a proposed
financing structure.

6. Consider the loan covenants of loan financing structures as this may be very
important in times of financial distress (when a firm is defaulting on debt and
breaching its loan covenants, it is usually experiencing a tough economic period, and
it is in these times they require the debt facility the most) and may affect operating
decisions. Understand the commons loan covenants that a lender may place on a
firm. In terms of a loan decision, a firm may be required to maintain a certain
minimum current ratio. Let’s say that the firm does not comply due to a difficult
trading period, this will then enable the bank to call the loan (so a long-term loan
becomes a short-term loan) and interest rates may be increased significantly. Watch
those loan covenants.

7. For larger companies, obtaining a favourable credit rating from a rating agency is
important in order to raise loan financing at a competitive interest rate.

8. Increasingly, firms are issuing hybrid instruments such as convertible debentures.

Remember that the conversion right represents a call option for the holders (right to
convert debentures into shares at a fixed price). Understand the advantages and
disadvantages of convertible debentures.

9. It is a good idea to consider financing alternatives by referring to the chapter in the

book on Risk Management and Derivatives.

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15. Cost of capital
Definition: The rate of return required by a company on its assets in order to reward the
providers of different classes of capital for the time value of money, inflation and risk
undertaken. It thus does not include wealth or value creation or growth.

Optimal capital structure

All companies have a theoretical optimal capital structure. It is the correct mixture of
financial instruments funding the total assets (notably debt and equity). The optimal capital
structure is in force when, all other factors remaining constant, the share price is expected
to fall if the structure is changed. An increase in the relative proportion of equity would
cause the share price to fall as a result of losing some benefit, which could be obtained
through gearing. A decrease in the relative proportion of equity causes the share price to fall
as a result of higher financial risk resulting from fixed annual interest costs.

Why use a Weighted Average Cost of Capital?

The required rate of return for individual projects is not measured by the specific cost of
funding to be used for that project. A particular source of funding is only tapped at a
particular point in time in order to maintain the optimal capital structure.

Example: Return on project A at time 1 = 12%

Fund with debt at time 1. Cost = 10%

Return on project B at time 2 = 13%

Fund with equity at time 2 Cost = 14%

To accept project A would be incorrect, causing more profitable project B to be rejected.

Weighted Average Cost of Capital

The only relevant rate for investment decisions is the WACC, that is the weighted average
cost of the next R1 of finance to be raised. The weighting is based on the target capital
structure or market value optimal capital structure (book value in the absence of other
information). The costs for each type of capital instrument must also be known or
calculated.

Cost of Debt = Interest rate (1- tax rate)

The cost of debt is typically based on the interest rate that is paid on interest bearing debt.
Thus for the weighting, only interest bearing debt should be included (both long and short
term interest bearing debt of a permanent nature).

The cost of debt can either be given to you in the information or can be calculated as the
interest expense (or interest paid) divided by the average of the long-term liabilities (be sure
to include the current portion of the liabilities).

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Cost of Equity (CAPM) = Rf =t~Zu -Rf)

Rf is the risk free rate and is normally based on the long-term RSA bond yield. If two rates
are given, use the longer term.

Either the company beta co-efficient or the sector beta co-efficient will be given. If the
sector beta is given, this beta will have to be unlevered and re-levered to reflect the beta
applicable to the company. The beta shows the sensitivity of the relevant share to the
market.

thAt>l‚í +(1-t)D/E}

t>AthÆ‚í=~í -t)D/E}

(Rm-Rf) is the market risk premium. The CAPM may be written as:

Cost of equity = Risk-free rate + Beta(Market risk premium)

The cost of preference shares may be the dividend rate at time of issue. However, you may
have to determine the yield to maturity of preference shares to determine the cost of
preference shares. This may also apply to debentures/bonds (see example below).

Firms can also determine the cost of equity by using the Dividend Growth Model:

Cost of equity = Dividend (1+growth rate)/Price + growth rate

However, this method is hardly ever used in practice. It has become standard practice to
determine a firm’s WACC by using CAPM. In practice, firms can also employ hurdle rates. For
example, Grindrod determines its WACC and then uses a hurdle rate of 1.3 x WACC to
evaluate projects.

The weightings to be used should be based on market values where possible.

x For equity this would be the market capitalisation, based on the share price and
number of shares in issue. In your paper, if you are not supplied with the share price
and means of calculating the market capitalisation of the firm then you would use
the book value of equity.

x For debt it is the present value of future loan repayments. If the loan is variable rate
then the balance sheet loan figure can be used to approximate the market value,
this is not the case for a fixed loan where you will be required to calculate the
market value.

Key principles
x Use marginal costs – ignore the historical cost of debt financing or equity financing

x Include the effects of corporate tax

x Use nominal rates (unless you are discounting real cash flows)

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 x Use market values or a target capital structure

When answering a question that requires the estimation of WACC, or cost of equity, be sure
to explain each variable you have used to come up with the answer (see MAF 15). This is
especially important if there is more than one option in the scenario (see MAF 16).

Breaks in the WACC

x When a specific debt instrument is exhausted, a higher cost may have to be incurred
for further issues. The new cost will result in a higher WACC. The point at which such
breaks occur is found by dividing the total supply of funds from a specific financing
instrument by its weighting.

Tips and examination technique

1. This topic can be combined with valuation and capital budgeting questions. Its
continued relevance to financial managers is likely to ensure that it has a reasonable
chance of being examined in the future.

2. Areas where candidates have had problems in the past include deferred taxation
and non-controlling interest. Generally deferred taxation is considered to be part of
equity unless the liability is likely to arise in the short-term. Where equity is being
valued at market value, no adjustment is required for deferred tax (the market price
includes this value already). The non-controlling interest has to be valued separately
from the normal market capitalisation of the holding company.

3. In order to determine the cost of debt, it may be necessary to determine the yield to
maturity (YTM) of a current bond/debenture issue. Therefore it is important to
revise the valuation of debentures/bonds and how to determine the YTM (same as
IRR) of a bond issue if you are given information on the current price of bonds and
the coupon payments and repayment of the principal amount.

For example, Company A currently has bonds in issue with a face value of R100,
which will be redeemed in 4 years time. The coupon payment is R8 per bond per
year. The bonds are currently trading at R90 per bond. Determine the current cost of
debt.

Solution:

The after-tax cost of debt is simply YTM (1- tax rate). In this case, it would be 8.1%.

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16. Valuations
Valuations is one of the most important topics in financial management and this topic has
often been examined in prior ITC or QE examinations set by SAICA. It is expected that
valuations will continue to be an important component of future scenarios/case studies for
APC. Valuations will often be required for merger and acquisitions, shareholder transactions,
determining fair value for IFRS purposes, valuing share options and making private equity
and other investing decisions.

Candidates are required to be able to value a company or equity using four approaches:

1. Projected earnings discounted at a fair earning yield or price earnings ratio.

2. The dividend growth model.

3. The discounted cash flow or free cash flow model.

4. Net asset value.

Increasingly Valuations are divided into the following categories:

x The Market Approach; and

x The Income Approach.

The Market Approach includes applying price multiples such as using comparable price-
earnings ratios and price-book ratios.

The income approach includes DCF valuations – either by discounting free cash flows to the
firm at WACC or discounting the equity cash flows at the cost of equity or discounting future
dividends at the cost of equity.

You should be aware that there are guidelines issued by the IPEV and IFRS has issued its own
set of guidelines in relation to fair value.

The market approach(applying price multiples)

The price-earnings (P/E) multiple
Steps to follow when using the P/E valuation technique:

1. Calculate a stable / maintainable earnings figure that is expected for the future.

2. Select and justify a P/E ratio or EY (earnings yield).

3. Calculate the value of equity.

4. Test the above value for reasonability and attempt to explain any discrepancies.

STEP 1- Calculating a sustainable / maintainable earnings figure

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Past profits provide an indication of stability and/or earnings potential within a business.
However, investors will only benefit from FUTURE profits and it is these that they are
interested in valuing. Past earnings must be converted into a figure which will likely reflect
future earnings. Thus, we calculate maintainable earnings.

The usual starting point is normally the past profit figures that have been provided. This
information usually comes in the form of an income statement with comparatives for
several years. A number of general adjustments must be made before further analysis i.e. in
order to establish maintainable earnings.

General adjustments:

x Non-recurring items are not a fair indicationof what is likely to happen in future.
They do not form part of maintainable earnings. These items should be removed
from profit (don’t forget the tax thereon). Possible examples include; extraordinary
items, profit or loss from sale of PPE, impairments or an inventory write-down to
NRV. Further, if margins (e.g. gross profit % etc.) are expected to change due to a
change in the industry (e.g. increased competition) you will need to adjust for this
too i.e. change the current profit figure for the new GP%. However, there are gains
or losses that occur infrequently but are expected to occur in the future. For
example, the gains/losses of closing and opening branches may be infrequent but
are expected to occur. The best to do here is to make an adjustment. So, if the cost
of closing a branch is R12m and this is expected to occur every 3 years, then we
should perhaps include an expense of R4m as an annual cost for this item.

x Notional or inadequate amounts must be adjusted for by using an amount reflective

of the market. We value a company in a manner that best reflects normal business
practice. This gives a truer reflection of value. Be particularly aware of potential
issues in an owner-managed company. For example, management salaries in an
owner-managed company are likely to be over or under stated and personal
expenses may be included with company expenses. Likewise; rental payments to a
connected person may be excessive. A further example could be an interest free
loan. If a fair salary is R1.5m per year for the CEO and he/she is being paid R3.5m,
then we would need to increase before-tax earnings by R2m per year in order to
value the company.

x As we are trying to value the equity attributable to the ordinary shareholders of the
company, preference dividends should be excluded in the determination of earnings
but this is obvious as we are using the price per ordinary share and will need to
relate this to earnings attributable to ordinary shareholders.

What historic earnings figure should be used as a valuation base i.e. what earnings figure
should we be making these adjustments to? The most recent earnings figure? A weighted
average?

1. If there is a clearly defined upward trend in past profits then the last available profit
figure is often used to estimate future profitability. We are saying that future profits
will be at least equal to this amount. One may even increase this amount to better

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 reflect future earnings expectations. It is important to justify your assumptions
about future earnings. This does not require an essay explaining your assumptions;
rather a concise reason for why you did something and ensure this is well
referenced.

2. If, however, past profits have no noticeable trend i.e. are erratic; a weighted average
amount may be calculated. Greater weight can be given to more recent periods

It is important to note that this relates to profit before interest and tax. We need to
reduce the profit by the forecast interest expense and then further reduce the profit
after interest by the expected tax charge.

3. Alternatively, if specific information is available for the future, and it is possible to

predict the future earnings figure for the forthcoming year and future years with a
reasonable amount of certainty, then this should rather be used. If you are
undertaking the valuation and have access to management’s views and internal
budgets, then this will be useful to determine future earnings.

4. It is also important to note what is happening within the industry sector. For
example, if you are valuing a pharmaceutical company, you would consider the fact
that patents and brands are becoming increasingly difficult to protect
internationally, that generic manufacturers have become significant competitors
and that the costs of R&D have grown significantly and are expected to remain high
in the future. Also, you need to determine the remaining term of existing patents
and new drugs in the pipeline. Is there a possibility of a recall of an existing drug?
Specific information will be set out in the question but we would expect a more
difficult trading environment and lower margins than experienced in the past –
although the ability to distribute new biotech drugs may provide impetus to future
earnings. Check out the information in each scenario.

5. It is important to compare accounting and operating policies of the comparable

company to the company being valued. For example, the comparable company
leases its assets whilst the company being valued borrows and purchases its
operating assets. This will result in differences in operating and net income.
Financing structures may differ with one company using a greater level of debt to
finance its operations. The companies may have varying depreciation policies that
also impact on relative incomes. One company may have excess cash balances which
will tend to increase the P/E ratio.

Once the above has been done, we now have sustainable/maintainable earnings.

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STEP 2- Selecting and justifying a P/E ratio or EY

The higher the P/E and thus, the lower the earnings yield, the greater the value of equity (if
all else holds constant). It is important to keep this in mind when making adjustments to
either of these as the adjustments will then make sense.

As mentioned above, if the P/E for the company you are valuing is readily available then use
this P/E after adjusting for any future changes clearly evident. If a P/E is not readily available,
use the P/E of a similar company and adjust this for differences. In most cases you will be
valuing an unlisted company and you will be required to value the company by using the P/E
ratios of comparable companies. In most cases you will be required to make adjustments to
comparable P/E ratios.

Some questions will give you a P/E ratio to work with (see MAF 12) while others will require
you to choose a comparable company from a number of options (see MAF 10). Just
remember that none of the companies will be a “perfect fit”, just make it clear to the
examiner what factors you have considered in order to come to your decision.

A few examples of factors affecting the P/E ratio: (The effect on the P/E ratio is given. The
effect on the EY is the inverse of this i.e. if the P/E increases the EY decreases.)

x Future growth prospects.

The higher the future growth prospects, the higher the P/E ratio i.e. due to good future
growth prospects the value of equity is greater.

x The marketability of the security

The less marketable the security (e.g. unlisted versus listed), the lower the P/E ratio i.e. the
security is less liquid and thus more risky than comparable shares. The value of that
shareholding will decrease. For private companies, there may be restrictions on
transferability and this will also reduce the value of an entity.

x Sovereign (country specific) risk

The greater the sovereign risk, the lower the P/E i.e. the economic and operating
environment in the UK is likely to be less risky than in South Africa. The P/E’s in the UK will,
on average, be higher than in South Africa. However, note that although emerging markets
imply higher risks, they also imply higher future growth rates.

x Capital structure

Capital structure will have an effect i.e. the more debt financing the greater the risk and the
lower the P/E will be.

x Operating activities

For example, the extent of foreign trading and thus exposure to foreign currency risk will
affect the P/E or, the P/E will be lower for a company trading in industries that experience

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great volatility, than that of a company in a less volatile sector, with less volatile earnings. It
is also important to note that a company with extensive domestic and international
operations may be diversified to a greater extent, which may result in lower levels of
volatility. Resource companies will be subject to a greater degree of volatility. Also, note that
companies such as Anglo-American and BHP Billiton a few years ago (around 2012) were
trading at very low P/E ratios. Why? Investors perceived that current earnings were not
sustainable and would fall, or that growth rates would fall.

x Size

The size of the entity being valued could affect the P/E; e.g. an investment in a smaller firm
is more risky than an investment in a similar large established firm. The P/E of the smaller
firm would thus be expected to be lower than that of the larger firm, as the smaller firm has
a smaller capital base. However, remember that although small firms involve higher risks,
often they also reflect higher growth prospects.

x Extent of shareholding being valued

If valuing a majority shareholding, a premium should be added; i.e. control of the company
is being gained and should be paid for. The P/E should increase. However, it is relevant to
consider why this should be the case. If one is using a comparable P/E ratio of a listed
company, then it is important to note that this represents a minority valuation. If one
obtains control of an entity this will enable you to make changes to operations and make
investing and financing decisions. This should increase the value. Therefore, if we are using a
comparable P/E ratio to value the company, then we should add a control premium. In most
cases, when a take-over is proposed for a listed company, the share price increases often by
20-30%. If the take-over does not happen, then often the share price will fall.

x Depth of management

The quality, skill and stability of management are all attributes of management that are
highly valued by the market. The P/E should be increased to reflect this additional value if
the depth of management is considered to be greater than that of the comparable company.
Sometimes the success of a company is driven by a very able CEO – so check out the depth
of the management team. Otherwise – succession issues may in fact reduce the price and
the rating of the company – particularly if the CEO is closer to the age of 70 than to 50.

It is important to consider whether the comparable P/E ratios do not already include some
of these factors. For example, a company may be expected to reflect high growth in the
future. However, if this also true for the industry sector, then a comparable P/E ratio will
already include the higher growth rate in the current price of the comparable company. By
making a further adjustment, then we are double-counting for this growth.

Remember that the current P/E ratio may already include a recovery/growth in earnings.
Assume that a company’s share price is R20 per share and current earnings per share is R2
so the company is trading at a P/E ratio of 10. Assume that the market expects the
company’s earnings to double to R4 per share (say due to a fall in the exchange rate and the
company is an exporter). The price may immediately double one day later. What you see
now is a P/E ratio of 20 (40/2). This is what you see as the comparable P/E ratio. Let’s

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assume that the unlisted company you are valuing is expected to grow its EPS from R5 per
share to R10 per share (similar to the industry). If you decide that maintainable earnings is
R10 per share and then multiply this by 20 (the comparable P/E ratio), then you will have
overstated the value of the company. Rather, use a comparable P/E that is based on the
forward EPS and not based on historic EPS. The correct value is 10 (R40/R4) x R10 = R100.

Step 3 -Calculate the value of equity

Once maintainable earnings and a suitable adjusted P/E have been calculated and justified,
the value of equity is simply maintainable earnings multiplied by the P/E or maintainable
earnings divided by the EY.

Step 4 -Test the above for reasonability and explain any discrepancies

A reasonability check for a P/E valuation (and indeed, all other valuations as well) is to
compare the calculated equity value of the business in question with the NAV of that
business. The net asset value is simply the book value of the company at year-end.

Possible explanations for any differences are recommended e.g. mention any relevant
assumptions that you have made in the P/E valuation and highlight the fact that NAV is
largely an accounting number and not truly representative of value. In general, we would
expect that although NAV may not be highly relevant, it really depends on the industry
sector. Then at least compare the Price to NAV (price to book) ratio of comparable
companies. Is our value to book ratio reasonable? For certain sectors such as banking – due
to the fact that there are monetary assets and monetary liabilities, we would expect that
price to book ratios should be in the range of 1-2. For pharmaceuticals and software
companies with strong brands & patents, we would expect to see a high price to book ratio.

Enterprise value
Increasingly valuations will relate to determining the value of the firm or Enterprise Value
rather than the value of ordinary equity. This is often applied in private equity and merger
transactions. The IPEV valuation guidelines refer to using a multiple to determine Enterprise
Value. Once we determine Enterprise Value, we can get to the value of equity by deducting
the value of debt. If we are valuing the operations, then we need to add surplus and non-
operating assets – such as excess cash balances.

We follow the same process as in using P/E ratios. What are the EBIT (operating income) or
EBITDA multiples for comparable listed companies? Make appropriate adjustments and do
not include any interest income, interest expense or income from non-operating assets.
EBITDA multiples may be useful if the companies have varying depreciation policies. If we
are valuing a controlling interest, then we may have to increase the EBIT or EBITDA multiple
in order to add a control premium. We may need to deduct a discount for the lack of
marketability and may need to make other adjustments (see adjustments for the P/E
method).

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Dividend discount model
The model merely looks at the income to be generated in the first year of the perpetuity
divided by the capitalisation rate, which is the difference between the required rate of
return and the growth factor. Thus we have the formula:

Value = D0 (1+g)/(k-g)

D0 = current dividend

g = growth rate in dividends

k = cost of equity

The dividend cash flow, the cost of equity and the anticipated growth rate drive the use of
this model. The growth rate is estimated using either the sustainable growth rate (ensure
you practise this, for example, if you are calculating the SGR between 2000 and 2005 you
would take your 2005 figure and divide it by the 2000 figure and take it to the power of 1/5)
or it is based on an extrapolation of historic growth. An alternative formula does exist to
estimate the SGR – refer to Correia et al. The required rate of return would be the cost of
equity. The model assumes a constant growth rate and should not be applied where this
assumption is not valid. Further, the model is not valid where the expected growth is higher
than the cost of equity.

You may be required to estimate future dividends for the next few years and thereafter use
the constant dividend growth model to determine the terminal value (continuing value) at
the end of the explicit period.

Example:

Tru Ltd paid a dividend in the current year (20x3) of R3.26 per share. Management has
indicated that it expects to achieve a growth in dividends of 14% per year for the next 5
years. Thereafter, dividends are expected to grow by 6% per year indefinitely. The cost of
equity is 12%.

The value per share will be R80.12.

The terminal value is R110.89 at the end of 20x8 [R6.28(1+0.06)/(0.12-0.06)].

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DCFvaluation (Free Cash Flow method)
In the same way that we value projects using discounted cash flows, we can also value a
business entity. To do this, we need to be able to project future cash flows and discount
them at the required rate of return.

There are two approaches to valuing the ordinary equity of a firm. We can discount the
operating cash flows at the weighted average cost of capital to determine the value of the
firm (enterprise value) and then we deduct the value of debt and other liabilities (that do
not form part of operating working capital) and add the value of excess cash and non-
operating assets to arrive at the value of equity. We can also determine the value of equity
directly by discounting the cash flows to equity at the cost of equity. Movements in debt
balances, excess cash, interest income and expense are included to determine the cash
flows to equity.

Operating Cash Flow Equity Cash Flow

Discount rate: WACC Ke
Cash Flows are: Before interest After interest
Before dividends Before dividends
After tax After tax
Value of: Total assets less debt = Equity
equity

In most cases, you will be required to undertake a valuation of the firm by discounting
operating cash flows. We use the free cash flow to equity mostly to value leveraged buyouts
and financial institutions.

The free cash flow to the firm model calculates the value based on free operating cash
flows. The free operating cash flow is available to repay debt, reinvest on behalf of
shareholders, repurchase shares or to pay cash dividends.

The appropriate discount rate is the Weighted Average Cost of Capital (WACC)
, and the
calculation of this rate is discussed in the previous section.

The cash flows are divided into two components:

x The specific cash flows that are expected for a specified number of years (the
explicit period); and

x The cash flow thereafter, which is expected to be stable with a constant growth in
perpetuity (the terminal valueat the end of the explicit period).

The valuation of specific cash flows is achieved as follows:

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1. The period for which annual cash flows can be forecast with accuracy is determined
– normally this is a five to ten year time-span (questions will normally be limited up
to 5 years).

2. The expected cash flows are determined for each year under review. The estimation
is often based on projected income statements and statements of financial position.
Focus on operating income. Items not requiring the outflow of cash are added back
to operating income i.e. depreciation as well as interest as it is a financing cost. The
estimated taxation of operating income is deducted from operating income. Future
investments in fixed assets and working capital are reflected as cash outflows. See
the example for the best layout for calculating these.

3. The terminal value is generally based on what is expected to happen when the firm
achieves a stable return on assets and stable asset turnover and the firm is expected
to grow at a sustainable growth rate after the explicit period. Normally in valuations,
firms will either use the expected inflation rate or the inflation rate plus the real
growth rate expected within the economy. Often this will be set at a conservative
rate. The terminal value is then discounted to the present and firms will often
analyse the value of the terminal value in relation to the total value of the firm to
indicate whether the value is reasonable or whether too much of the value is based
on the terminal value as this can increase the risk of such valuations.

Example:

RAPS is a major group which distributes to independent supermarkets in South Africa who
operate under the name of RAPS Stores. The forecast financial statements for the group are
set out below and you have been asked to value the ordinary equity using the DCF valuation
approach (free cash flow to the firm method). The group’s weighted average cost of capital
is 12% and the corporate tax rate is 28%. The sustainable growth rate after 20x9 is expected
to be 6% per year. The deferred tax asset and the operating lease liability relate to the
straightlining of leases. The forecast financial statements are presented below and you are
required to value the firm by deriving and discounting the free cash flows and determining
the value of the ordinary equity.

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Cash equivalents represents excess cash balances. The investments in associates can be
valued at a price-earnings ratio of 9. The investment in the associate (at book value)
amounts to R40m and is included in “Other investments”. The loans and receivables are not
part of operations and are valued at book value. Post-retirement benefit assets and liabilities
are to be included separately in the valuation of the firm and other liabilitiesneed to be
deducted from the value of the firm. RAPS has 185.566 million shares in issue on a fully
diluted basis.

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Suggested solution

We start by setting out the future operating income (EBIT) numbers per year. The tax is
estimated to be EBIT multiplied by the corporate tax rate. As the straightlining of leases does
not represent cash flows, we reverse this out as well as the associated deferred tax effects.
We add back depreciation and amortisation and then deduct future capital expenditure,
which is determined as the difference in carrying values and adding depreciation (which has
reduced the carrying value within the year so that we can get back to capital expenditure –
often laying out a T- account for one year will help you understand this concept). Changes in
working capital balances are included but the change in net working capital is not material in
this case. Notice how we bring in tax owing here, you do NOT need to make an adjustment
for tax owing when you calculate your tax figure above using EBIT figures, as it will be double
counting.

The value of operations for the explicit period amounts to R4462m and the present value of
the terminal value amounts to R15483m. So most of our value derives from the terminal
value but this is because we are only using an explicit period of 5 years. The group has no

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borrowings and few liabilities and we add to the value of operations, the value of its excess
cash balances, loan receivables, the investment in the associate and other investments to
get to a value for the ordinary equity of R20946m.

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Workings:

An important point to remember is that a DCF valuation uses the free cash flow from
operations. The sum of cash flows from financing activities are called financing cash flows
and must be equal and opposite (i.e. inflow or outflow) to the free cash flow from
operations. This is illustrated in MAF 13.

Valuations for mergers and acquisition

purposes
x Establishing a merger price is an important and difficult task and requires the use of
valuation techniques as well as consideration of financing structures and the terms
of the merger.

x Whilst most corporate growth occurs through internal expansion, the most dramatic
growth is often obtained through merger or acquisition activities, the primary
objective being to maximise shareholders wealth. See Aspen as a good example of
growth through acquisition.

x Synergy is said to exist whenever the value of the combined firms is greater than the
value of the two firms taken separately. Synergistic effects arise from economies of
scale in production or distribution or financial economies such as a lower cost of
debt, use of liquidity or the avoidance of taxation. Reduced competition can also
result in increased power. Synergies are most commonly found in horizontal and
also in vertical mergers. Conglomerates often do not result in an increase in value
due to the absence of synergies. However, there are exceptions such as Bidvest in
South Africa and Berkshire Hathaway (Warren Buffett) in the USA.

x In mergers and acquistions, effective due diligence is critical to ensure that a merger
is successful. In an annexure to Chapter 17 of Financial Management, we set out the
due diligence activities that an acquiring firm should perform prior to proceeding
with a merger or acquisition. Due diligence questions are not particularly difficult
provided you are aware of the general procedures that should be followed. MAF 13
has an example of how due diligence can be integrated into a question.

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 x If a merger is financed with the issue of shares in the acquiring company, then the
determination of an appropriate exchange ratio is important. If an exchange ratio is
based on respective share prices and the share price of A Ltd is R30 and the share
price of B Ltd is R45 then an appropriate exchange ratio would be 1.5 (B/A) so that if
the total number of shares in issue for B Ltd is 10m shares, then A Ltd would be
required to issue 15m shares to finance the transaction. However, synergy from the
merger may enable A Ltd to be able to offer a higher exchange ratio and B Ltd to
receive a lower exchange ratio if the objective is to maintain the value of current
holdings.

Tips and examination technique

1. Valuations are important and candidates should ensure that they are well prepared
in this area.

2. If the question requires the valuation to be done on a particular basis (i.e. earnings,
DCF, etc.), do not waste time by justifying the approach taken. If it is open-ended
however, you will perhaps need to look at a few methods of valuation and you will
need to justify the method selected (a past exam required students to perform a
DCF, NAV and PE valuation and use them to determine a range of values for a firm).
This is a difficult area also due to the inherent role of judgement and difficulties of
forecasting future cash flows. Analyse the facts in the question or scenario. If not
specific, does the question enable you to perform a DCF valuation or based on the
information is it only possible to perform a valuation based on price multiples such
as the P/E ratio?

3. Use the weighted average cost of capital as the discount rate and do NOT adjust it
for any further risk factors - the WACC is already company specific. If the company is
however investing in a new sector than you may need to determine a WACC
appropriate to that sector by determining mainly an appropriate beta (refer to cost
of capital section).

4. Remember to compare the valuation calculation to the net asset value as a

reasonability check. Is the price to book ratio reasonable?

5. A DCF valuation is similar to calculating the Present Value of a project – remember

to exclude any items that do not result in a cash flow and exclude financing costs.
You will deduct the value of borrowings later to determine the value of equity.

6. Questions and scenarios can take a number of formats. The question may set out a
valuation and you may be required to set out the errors in such a valuation. For
example, the financing flows may be included in a DCF valuation of the firm. The
cost of equity may have been used rather than WACC. Interest income may be
included or depreciation may not have been added back. These are some of the
errors that you need to identify. Remember that you are reviewing, rather than
undertaking a valuation.

7. The scenario/question will often include relevant information that you need to use
to determine future cash flows. Questions will not always set out forecast annual

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 financial statements and you may need to estimate these cash flows directly from
information in the question. These questions are then similar to capital budgeting
questions but often there will be a terminal value.

8. You may be asked to comment on the assumptions set out in the valuation
question/scenario. This may require that you have some knowledge of macro-
economic factors and some specific industry factors. For example, if the question
assumes an inflation rate of 9%, then you should know that inflation for South Africa
is expected to be in the range of 3-6%. The growth rate in earnings and cash flows
for a firm is unlikely to continue at higher rates than the general economy over the
longer term. Be aware of topical developments. The cost of mining has increased
significantly so that the break-even price for such sectors as platinum and gold has
been pushed so high that mining faces an uncertain future in these sectors. Labour
issues have come to the fore in the sector. Understand the consequences. So stay up
to date with developments in the South African economy. Remember the Board
paper is written in advance. Therefore you need to have a high overview of the SA
economy from a few months pre Board, not just the final few weeks before you
write.

9. Valuations can integrate topics in finance such as cost of capital, mergers, financial
analysis and derivatives. Understand how employee share options will reduce the
value of ordinary equity. The question/scenario may require you to value bonds or
debentures so it is important to know how to value debentures as you need to
deduct the value of debentures or bonds from the value of the firm to determine
the value of ordinary equity. Remember that although there may be issues regarding
spreads, in general if a company has variable rate financing, the value of such
borrowings will be the values set out in the Statement of Financial Position.

10. In valuations, sustainability is important. Are current margins sustainable? Is

competition likely? For example, for mobile operators such as MTN and Vodacom,
margins are increasingly expected to come under pressure and the mix of revenue
will shift increasingly to data as compared to prior years. Bidvest for example earns
low margins but is highly effective. Understand the sector.

11. It would be wise to have a list of items that are included in your explicit period, such
as EBIT, Working Capital investment and capex, and items you would subtract/add
from/to your Enterprise Value, such as borrowings, excess cash and investment in
associate.

Remember cash and cash equivalents is split into two parts;

a) Cash used in operations which is included in working capital; and

b) Excess cash which is added onto the enterprise value at the end of your valuation
calculation.

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17. Specialised topics in finance
Dividend policy
The residual theory of dividends is based on the concept that shareholders prefer to have a
firm retain its income for re-investment, so long as the return on the reinvestment is at least
comparable with that of alternative investments of similar risk. The application of this theory
requires the following steps:

1. Determine the optimal capital structure;

2. Determine the amount of equity that is required to finance the optimal capital
structure;

3. To the extent possible, use retained earnings to supply equity to avoid flotation
costs; and

4. Pay dividends if income is greater than the retained income required to support the
optimal capital structure.

Miller and Modigliani argue that dividend policy is irrelevant, as it has no effect on share
prices or cost of capital. Gordon and Lintner argue that dividend policy is relevant and they
maintain that shareholders prefer dividends to capital gains (bird in the hand theory). It
should be noted that the MM approach is more consistent with the residual theory of
dividends.

The following factors influence the dividend decision and should be discussed when asked
should a firm pay a dividend:

Constraintson payment: Loan covenants

Liquidity

Taxation

Investment opportunities: Location of Investment Opportunity Set

Accelerated projects

Alternative sources of Flotation costs

capital Management control

Capital structure

sensitivity

Effect on cost of equity Shareholder preference

DWT & Taxation of shareholders

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 Risk of dividends vs. capital gains

Informational content of dividends

Types of dividend policy:

x Stable dividend

x Stable payout ratio

x Stable dividend plus bonus

Each one of the above can be linked to a dividend reinvestment scheme where shareholders
have the choice of receiving cash or additional equity. To minimise the liability for DWT,
companies may declare a script dividend, and to comply with JSE requirements; allow
shareholders to elect cash dividends in lieu of script.

Companies can also repurchase their own shares. Thus, if management feel that the shares
are under-valued, the company can repurchase the issued shares and reduce issued share
capital. As a subsidiary can hold up to 10% of the holding company’s share capital, a number
of companies have elected to go this route. These shares remain issued and, on
consolidation, are treated as treasury stock. The ability to repurchase shares has the
advantage of making markets more efficient, as inside information is impounded in the
share price.

Derivatives
A derivative is a generic term for a range of traded financial instruments, which have
developed mainly from securities and currency trading. In general, it means that the
instruments have been “derived” from underlying securities and currencies. Examples are
futures and options in widely-traded currencies.

There are two ways of using derivatives:

1. As a hedge against risk; or

2. By speculating to make a profit.

An example of a hedge would be to buy US dollars forward if we know we are required to

pay US dollars in say, three months time (the exchange rate fluctuations will be dealt with in
the Financial Reporting section). There is a transaction cost, but this is relatively small in
relation to the total amount involved. However, the exchange rate is “locked in” and the
company knows exactly how much it will have to pay for the dollars. There is, however, a
type of risk involved. This is the opportunity cost of lost profit, should the movement in the
exchange rate mean that the company would have been better off not hedging the risk. Not
hedging is an option, and may not be profitable, but involves risks that might be
unacceptable to shareholders.

The second use of derivatives is in speculation or taking a position. For example, we might
buy US dollars forward if we believe that the rand will weaken against the dollar. If we are

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right, we will be able to buy dollars at the agreed forward rate and then sell on the spot
market to make a profit. However, this is taking substantial risks, as the rand might
strengthen against the dollar in the short-term. Up until recently, companies were only
allowed to enter into forward contracts if there was an underlying transaction. Firms will
often indicate as part of their risk management strategy that forward contracts are not
entered into for speculative purposes and are only used for hedging purposes. For example,
Shoprite states the following in its 2013 Integrated Report:

“The treasury department hedges the Group’s net position in each foreign currency
by using call deposits in foreign currencies and derivative financial instruments in
the form of forward foreign exchange rate contracts for all cumulative foreign
commitments of three months or more. Forward foreign exchange rate contracts
are not used for speculative purpose.”

Derivatives tend to be used to hedge risks where there are extensive international interests
and where financial risks need to be minimised.

Options
Options represent rights to either buy or sell at an exercise price at a specified time in the
future. You have the right but not the obligation. We can use a call option (the right to buy)
to hedge the price of an input. If the price in the future is above the exercise price, we then
use the option to limit the cost of the input to the exercise price. If the price falls, we let the
option lapse and take advantage of lower prices in the market.

A gold mining company may, for example, buy a put option (the right to sell) at, say, $1200
per oz. If the gold price falls, then the company will sell the gold at the exercise price. If the
gold price goes above this price, then the company lets the option lapse and such an option
will have no value at expiry, as the company will prefer to sell at a higher price in the market.

Option pricing models include the Black-Scholes model and the Binomial model. It is
important to understand how the following factors impact on option values (for equities):

x The share price

x The exercise price

x Volatility

x Interest rate

x Term to expiry

x Dividends

For example, an increase in volatility will increase the value of options as it becomes more
likely that you will be in the money at expiry date.

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Interest rate swapsand Forward Rate Agreements
(FRAs)
A swap is an exchange of one stream of cash flows, in this case interest payments, for
another stream of future cash flows with different characteristics, for example, with regard
to timing or currency of payment. Interest rate swaps are normally used to effectively switch
from variable rate borrowings to fixed rate borrowings and vice versa. Forward rate
agreements (FRAs) are agreements where an organisation locks into an interest rate today
for a period of time starting in the future. On the future date, the two counterparties settle
their account and, depending on the way rates have moved, one will pay the other,
depending on the FRA and the actual rate. Interest-rate futures are standardised traded
forms of FRAs. FRAs are usually arranged by banks and are tailored for a company. Futures
are exchange-traded and each contract is for a pre-specified amount on a pre-specified date.
Futures are not likely to be used except for commodities such as maize futures.

Interest rate swaps are used where:

x Companies have different credit ratings in different markets; and

x There is a need to restructure the nature of interest commitments.

Foreign exchange management

The impact of the Rand on SA business can be significant and this is an area that students
should understand.

The foreign exchange market consists mainly of:

x The spot market; and

x The forward market

Currencies can be quoted on a direct basis (Rx = 1FC) or indirect basis (R1 = xFC). Note that
one is the inverse of the other. The rand is quoted on a direct basis against the US$ and
other currencies.

In order to hedge currency risk, a company can enter into a forward exchange contract
whereby the exchange rate is fixed today but the payment or receipt of foreign currency will
be affected at a future specified date.

In a money market hedge, a firm will enter into an offsetting loan agreement in foreign or
local currency to cover the foreign currency transaction. Therefore an exporter awaiting 1
million in US$ in six months time, would enter into an offsetting loan of 1 million (inclusive
of interest payable) in US$, buy spot Rands and use the export proceeds to repay the loan
with interest in six months time. Shoprite uses foreign currency deposits to hedge some of
its foreign currency risks (see prior section).

As a result of arbitrage transactions and the banks covering their own forward foreign
currency positions in the spot market, the cost of forward cover should approximate the
interest differentials between the two countries. This is called interest parity and is reflected
by:

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Management
Decision Making,
Control and
Financial
Management