Answers to Textbook Questions

A2 Accounting for AQA Answers to textbook questions Note: these are the answers to the texbook chapter questions which do not have an asterisk. The answers to the asterisked questions are in the back of the texbook. The page numbers below relate to the answers set out in this document.

A2 Unit 3 Further Aspects of Financial Accounting 1

Sources of finance

1

2

Incomplete records

2

3

Partnership final accounts

8

4

Changes in partnerships

15

5

Published accounts of limited companies

21

6

Cash flow statements

26

7

Accounting standards

30

8

Stock valuation

34

A2 Unit 4 Further aspects of Management Accounting 9

Manufacturing accounts

40

10

Costs and contribution

44

11

Break-even analysis

47

12

Absorption and activity based costing

52

13

Overheads and overhead absorption

57

14

Costing in decision-making

62

15

Standard costing and variance analysis

70

16

Capital investment appraisal

73

17

Further aspects of budgeting

79

18

Decision-making and social accounting

85

1

CHAPTER 1 Sources of finance 1.2

(a) Sajit will need a bank overdraft. Its features are: • borrowing on a current account up to a set limit • interest is only charged when the business borrows • variable interest rate • reviewed every year advantages: • flexibility – the borrowing can be repaid as and when funds are available • economical – interest only charged when the business borrows disadvantages: • interest rates for bank overdrafts can be higher than bank loan rates • repayable on demand • security normally required – danger of loss of property if business fails (b) Rachel will need a bank loan for the equipment for her business. Its features are: • a fixed amount over a fixed period • interest at a fixed or variable rate • a regular repayment schedule advantages: • easy to budget for, as the timing of repayments is known • the possibility of negotiating the timing of repayments (‘holiday’ may be possible) • interest rates may be lower than overdraft rates disadvantages: • a long-term financial commitment which has to be met • security normally required – which could include Rachel’s property (c) Basil will need a commercial mortgage. Its features are: • a long-term loan secured on business premises (ie the hotel) • finance available normally up to 70% of property value (Basil’s deposit of £150,000 will be sufficient) • interest at a fixed or variable rate • a regular repayment schedule advantages: • easy to budget for, as the timing of repayments is known • interest rates may be lower than overdraft rates disadvantages: • a long-term financial commitment which has to be met • the property will be required as security • if the business fails and the bank calls in the loan, Basil will lose his hotel

1.5

Tariq has two distinct financial needs: £80,000 for fixed assets and £70,000 for working capital. There is no ‘right or wrong’ answer to this question. In an exam situation the examiner will be looking for knowledge of the different forms of financing and a reasoned conclusion based on a discussion of the relevant advantages and disadvantages of each form. (a) asset finance The first consideration is likely to be whether the finance can be met from internal sources. The question states that Tariq is already putting in a capital contribution, so further internal financing could be met from a loan from the family – this has the advantage of being cheap and flexible, but the possible downside is the family wanting a say in the way the business is run. The other internal source of finance would be funding from cash generated from profits, but as the business is not yet trading this is not a viable option. The other options are financing from external sources: •

Bank loan – repayable over the long term, repayments can be budgeted for, repayment schedule may be negotiated to include ‘holiday’, interest fixed or variable rate; but . . . security will be required, Tariq may lose his house if the business fails. This is, on balance, probably the favoured option for asset finance.

•

Bank mortgage – not applicable as the office will be rented and not available as security.

•

Business angel – the finance may be available, but the angel will want a stake in the business and a say in how it is run – this may be an advantage or a disadvantage depending on Tariq’s expertise and ambitions for ‘going it alone’. The biggest downside will be the loss of total control, an issue which is often important for the entrepreneur.

1

•

Incorporation of the business as a limited company in order to attract external equity finance from a private equity firm – this is very unlikely in view of the small amount involved. It will also involve a partial loss of control of the business.

(b) working capital finance The requirement could be met from internal sources, but the same considerations in (a) apply, ie Tariq does not have more funds himself; also, involving the family could cause problems and financing from profits is not possible in a business start-up situation. The only other option is an external source of finance – the bank overdraft, which involves borrowing on a current account up to a set limit. The advantages are that it is flexible (the borrowing can be repaid as and when funds are available) and is economical (interest is only charged when the business borrows). The disadvantages are: an overdraft is repayable on demand (this would happen if the bank wanted to cancel the overdraft) and security will be required (the danger of the possible sale of Tariq’s house if the business fails).

CHAPTER 2 Incomplete records 2.2

£77,000

2.5 TALIB ZABBAR CALCULATION OF STOCK LOSS FOR THE YEAR ENDED 30 SEPTEMBER 20-7 £ Opening stock Purchases Cost of stock available for sale Sales 160,000 Less Normal gross profit margin (40%) 64,000 Cost of sales Estimated closing stock Less Actual closing stock Value of stock loss

2.7

•

£ 30,500 89,500 120,000

96,000 24,000 21,500 2,500

Calculating cost of sales, gross profit and sales: £ 890 46,753 47,643 950 46,693 46,693 93,386

Opening stock at 1 January 2004 Purchases Less Closing stock at 31 December 2004 Cost of sales Gross profit at mark-up of 100% ∴ Sales

Tutorial note: mark-up is applied to cost of sales, not to purchases.

•

Using a sales ledger control account:

Dr

Sales Ledger Control Account

2004 1 Jan

£ Balance b/d Sales

2004 31 Dec

96,172 2005 Balance b/d

Balance c/d

93,532 2,640 96,172

2005 1 Jan

£ Bank (missing figure)

2,786 93,386

Cr

2,640

2

•

Calculating the cash loss: £ 93,532 93,322 210

Cash expected to be banked (from control account) Cash actually banked ∴ Cash loss

2.8

(a) Dr

Summarised Cash Account

2003/04 1 Jan

£ Balance b/d Cash sales

Cr

2003/04

229

£ Bank

219,941

165,640

Expenses

49,600

29 May

Amount of cash stolen (missing figure)

31 May

Balance c/d

220,170

2.10

160 220,170

2004/05 1 Jun

4,770

2004/05 Balance b/d

160

(b)

Measures to prevent such a loss occurring in the future; any two from: • Record cash transactions as they occur, eg by using tills that issue receipts. • Collect cash from tills regularly, and place the cash in a safe in the office. • Bank cash regularly, so that there is a low level of cash on the premises at any time. • Pay bills by cheque rather than in cash, so avoiding the need to carry cash when paying creditors. • Divide duties within the business, ensuring that no one person is responsible for all cash handling. • Carry out cash checks at regular intervals, eg to ensure that the cash in tills balances against receipts. • Improve security, eg use of a safe in the office for cash to be banked, keep the office door locked when the office is empty, use of security cameras. • Set authorisation limits for employees who pay bills, to ensure that large amounts cannot be paid out without authority.

(c)

Advice to maintain accurate records of cash transactions; any two from: • Keep a detailed cash book. • Keep a copy of all receipts issued. • Use a numbering system for all receipts and invoices. • Prepare bank reconciliation statements each time a bank statement is received. • Use margin and mark-up to compare expected sales with actual sales figures.

(a) • • • • •

receipts from trade debtors less trade debtors at beginning of year add bad debts written off during year add trade debtors at end of year sales for year

£ 121,000 36,000 550 35,000 120,550

(b)

• • • •

payments to trade creditors less trade creditors at beginning of year add trade creditors at end of year purchases for year

62,500 32,500 30,000 60,000

(c)

• • • •

payments for expenses less accrual at beginning of year add accrual at end of year expenses for year

30,000 500 700 30,200

3

(d)

COLIN SMITH TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 20-5 £ £ Sales 120,550 Opening stock 25,000 Purchases 60,000 85,000 Less Closing stock 27,500 Cost of sales 57,500 Gross profit 63,050 Less expenses: Expenses 30,200 Provision for depreciation: fixtures and fittings 5,000 Bad debts written off 550 35,750 Net profit 27,300

(e)

COLIN SMITH BALANCE SHEET AS AT 30 JUNE 20-5

Fixed Assets Fixtures and fittings

£

£

£

Cost

Provision for depreciation

Net book value

50,000

15,000

35,000

Current Assets Stock

27,500

Trade debtors

35,000

Bank

1,210 63,710

Less Current Liabilities Trade creditors

30,000

Accrual: expenses

700 30,700

Net Current Assets

33,010

NET ASSETS

68,010

FINANCED BY Capital Opening capital*

69,500

Add Net profit

27,300 96,800

Less drawings

28,790 68,010

* Opening capital:

£

• assets at 1 July 20-4

102,500

• less liabilities at 1 July 20-4

33,000

• capital at 1 July 20-4

69,500

4

2.11

SANDRINE TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006 £ £ Sales (working 1) 228,295 Opening stock 4,987 Purchases (working 2) 62,794 67,781 Less Closing stock 5,038 Cost of sales 62,743 Gross profit 165,552 Less expenses: Wages (working 3) 56,404 Motor expenses 7,920 General expenses 7,963 Loan interest (working 4) 3,000 Provision for depreciation: equipment (working 5) 1,500 vehicles (working 6) 12,000 Loss on sale of equipment (working 7) 3,800 92,587 Net profit 72,965 WORKINGS £ 163,729 3,746 2,988 65,324 228,295

1

• • • • •

receipts from trade debtors less trade debtors at beginning of year add trade debtors at end of year add cash sales sales for year

2

• • • •

payments to trade creditors (720 + 61,700) less trade creditors at beginning of year add trade creditors at end of year purchases for year

62,420 1,822 2,196 62,794

3

• • •

payments for wages less wages owing at beginning of year wages for year

57,200 796 56,404

4

• • •

payments for loan interest add loan interest paid in advance at beginning of year loan interest for year

5

• •

net book value of equipment at beginning of year less net book value of equipment sold during year

• •

less net book value of equipment at end of year provision for depreciation of equipment for year

• •

net book value of vehicles at beginning of year cost of vehicle purchased during the year

26,000 22,000 48,000

•

provision for depreciation of vehicles for year (£48,000 x 25%)

12,000

• • •

net book value of equipment sold during the year sale proceeds of equipment during the year loss on sale of equipment for year

6

7

5

2,500 500 3,000 20,000 5,000 15,000 13,500 1,500

5,000 1,200 3,800

2.13 (a)

CINDY TOFE Bank Reconciliation Statement as at 31 December 2005 £ (668) (291) (959) 1,084 125

Balance at bank as per bank statement Unpresented cheque Outstanding lodgement Balance at bank as per cash book

Tutorial note: the topic of bank reconciliation statements is covered in AQA AS Accounting; the statement starts with the bank balance, which is overdrawn. (b)

Dr

Bank Account

2005 1 Jan

£ Balance b/d Receipts for year

Cr

2005

1,726

£ Payments for year Drawings (missing figure)

201,784 31 Dec

Balance c/d

17,320 125

203,510

203,510

2006 1 Jan

186,065

2006 Balance b/d

125

(c) Stock at 31 December 2005 – sales at cost price – sales to F Fearless at cost price + sales returns at cost price + purchases – purchases returns Stock valuation at 8 January 2006

£ ? 1,800 780 360 1,036 140 2,986

2,520 ÷ 1.4 858 ÷ 1.1 504 ÷ 1.4

By working up the calculation (adding the minuses and deducting the pluses), the stock valuation at 31 December 2005 is found to be £4,310.

(d)

Dr

Disposals Account

2005

£ Vehicle (book value)

Cr

2005

12,000

£ Vehicle (part exchange value)

(missing figure)

11,500

Profit and loss account (loss on sale) 12,000

500 12,000

6

(e)

CINDY TOFE TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005 £ £ Sales (working 1) 198,506 Opening stock 2,998 Purchases (working 2) 143,102 146,100 Less Closing stock 4,310 Cost of sales 141,790 Gross profit 56,716 Less expenses: General expenses 1,604 + 5,162 6,766 Wages (working 3) 23,041 Rent (working 4) 4,680 Motor expenses 3,040 Provision for depreciation: equipment 4,000 vehicles (working 5) 17,000 Loss on sale of vehicle 500 59,027 Net loss 2,311

WORKINGS 1

Dr

Cash Account

2005 1 Jan

£ Balance b/d Receipts (missing figure)

Cr

2005

142

£ Expenses

197,833

Bank 31 Dec

Balance c/d

197,975

169

Sales Ledger Control Account

2005

£ Balance b/d Sales (missing figure)

2005

6,546 198,506

31 Dec

Balance c/d

197,833 7,219 205,052

2006

2

Cr £

Receipts

205,052

1 Jan

169

2006 Balance b/d

Dr 1 Jan

186,784 197,975

2006 1 Jan

11,022

2006 Balance b/d

Dr

7,219

Purchases Ledger Control Account

2005 Bank 31 Dec Balance c/d

£

2005

142,911

1 Jan

£ Balance b/d Purchases (missing figure)

5,433

Cr

148,344

5,982 142,362 148,344

2006

2006 1 Jan

Balance b/d

Purchases for year: £142,362 (above) + £740 (cash purchases) = £143,102

7

5,433

3

Dr

Wages Account

2005 Bank 31 Dec Balance c/d

£

2005

23,110

1 Jan

762

Cr £ Balance b/d Profit and loss account

(missing figure) 23,872 2006 1 Jan

Dr

Balance b/d

Rent Account

2005 1 Jan

£ Balance b/d Bank

160

£ Profit and loss account

(missing figure)

4,940

Balance c/d

5,100

420

Vehicles Account

2005

£

Cr

2005

£

Balance b/d

60,000

Disposals

Bank

13,500

Profit and loss account

Part exchange

11,500

(missing figure) Balance c/d

31 Dec 85,000 2006 Balance b/d

12,000 17,000 56,000 85,000

2006 1 Jan

420

2006 Balance b/d

Dr 1 Jan

4,680 5,100

2006

5

762

Cr

2005

31 Dec

1 Jan

23,041 23,872

2006

4

831

56,000

CHAPTER 3 Partnership final accounts

3.3

£10,800

(£32,800 – £1,800 – £10,000 + £600) ÷ 2

3.4

£580 Cr

(£550) + £900 + £10,000 – £14,000 + £4,230

8

3.6 Dr

Partners' Capital Accounts Mike £ 30,000

20-4 31 Dec Balances c/d

Bernie £ 20,000

20-5

Dr

20-4 1 Jan Balances b/d

Bernie £ 20,000

20-5 1 Jan Balances b/d

30,000

20,000

Partners' Current Accounts

20-4 1 Jan Balance b/d 31 Dec Drawings 31 Dec Balances c/d

Mike £ – 21,750 1,510

Bernie £ 420 17,350 830

23,260

18,600

20-5

3.9

Cr Mike £ 30,000

20-4 1 Jan 31 Dec 31 Dec 31 Dec

Cr

Balance b/d Salary Interest on capital Share of profits

20-5 1 Jan Balances b/d

Mike £ 1,560 – 1,500 20,200 23,260

Bernie £ – 7,500 1,000 10,100 18,600

1,510

830

(a) DANIEL AND FREDA, IN PARTNERSHIP STATEMENT OF AFFAIRS AS AT 31 DECEMBER 2005 £

£

Assets Premises

40,000

Vehicle

3,750

Office equipment

6,000

Stock

2,400

Debtors

150

Cash at bank

10,950 63,250

Less Liabilities Creditors

3,250

Capital at 31 December 2005

60,000

Capital at 1 January 2005

50,000

Capital at 31 December 2005 (see above)

60,000

Profit retained for the year

10,000

Add drawings: Daniel

17,000

Freda

23,000 40,000

Profit for the year ended 31 December 2005

50,000

9

(b)

Although there is no legal requirement for Daniel and Freda to keep their financial records using a double-entry system, such a system will: •

provide more accounting information to assist with management decisions

•

enable tax liabilities – income tax and Value Added Tax – to be calculated easily

•

allow better control of the business, eg debtor control

•

allow the partners to see their own financial position with the business better, eg capital accounts and current accounts

•

provide more information to a lender – such as a bank – should the partnership require a bank loan or overdraft

A double-entry system will involve more work than a single-entry system. Thus single-entry is cheaper, easier to maintain, and requires no special training; however, a double-entry system may reduce or eliminate the fees of an external accountant and is a more complete system.

3.11

(a) Dr 20-5 31 Mar Balances c/d

Partners' Capital Accounts Sara £ 10,000

Simon £ 6,000

20-5

Dr 20-5 31 Mar Drawings 31 Mar Balance c/d

20-5 1 Apr Balance b/d

Cr

20-4 1 Apr Balances b/d

Sara £ 10,000

Simon £ 6,000

20-5 1 Apr Balances b/d

10,000

6,000

Partners' Current Accounts Sara £ 12,700 1,550

Simon £ 7,400 –

14,250

7,400

–

1,060

20-4 1 Apr 20-5 31 Mar 31 Mar 31 Mar 31 Mar

Balances b/d Salary Interest on capital Share of profits Balance c/d

20-5 1 Apr Balance b/d

10

Cr Sara £ 560

Simon £ 1,050

8,000 1,000 4,690 – 14,250

– 600 4,690 1,060 7,400

1,550

–

3.11

(b)

SARA AND SIMON PENNY, TRADING AS ‘CLASS CATERERS’ TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 MARCH 20-5 £ Sales

£ 44,080

Opening stock

2,850

Purchases

11,300 14,150

Less Closing stock

3,460

Cost of sales

10,690

Gross profit

33,390

Less expenses: Wages

8,020

Rent and rates

4,090

Sundry expenses

1,500

Provision for depreciation: office equipment

800 14,410

Net profit

18,980

Less appropriation of profit: Salary: Sara

8,000

Interest allowed on partners’ capitals: Sara Simon

1,000 600 1,600 9,380

Share of remaining profit: Sara

4,690

Simon

4,690 9,380

BALANCE SHEET AS AT 31 MARCH 20-5 Fixed Assets Equipment

£ Cost 8,000

Current Assets Stock Trade debtors Bank Less Current Liabilities Trade creditors Accrual of expenses

£ Provision for depreciation 800

£ Net book value 7,200

3,460 4,500 8,640 16,600 7,200 110 7,310

Net Current Assets NET ASSETS

9,290 16,490

FINANCED BY Capital Accounts Sara Simon

10,000 6,000 16,000

Current Accounts Sara Simon

1,550 (1,060) 490 16,490

11

3.12

(a) Dr

Partners' Capital Accounts

20-5 30 Jun Balances c/d

A Adams £ 30,000

J Beeson £ 20,000

20-5

Dr

20-4 1 Jul

Balances b/d

20-5 1 Jul

Balances b/d

30,000

20,000

Partners' Current Accounts

20-5 30 Jun Drawings 30 Jun Balances c/d

A Adams £ 16,000 1,209

17,209

J Beeson £ 10,000 1,349

Cr A Adams J Beeson £ £ 780 920

20-4 1 Jul Balances b/d 2005 30 Jun Salary 30 Jun Share of profits

11,349

20-5

(b)

Cr A Adams J Beeson £ £ 30,000 20,000

20-5 1 Jul

Balances b/d

6,000 10,429 17,209

– 10,429 11,349

1,209

1,349

ANNE ADAMS AND JENNY BEESON, TRADING AS ‘A & B ELECTRICS’ TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 20-5 £

£

Sales

£ 250,140

Less Sales returns

1,360

Net sales

248,780

Opening stock

26,550

Purchases

175,290

Less Purchases returns

850 174,440 200,990

Less Closing stock

27,750

Cost of sales

173,240

Gross profit

75,540

Add income: Decrease in provision for doubtful debts

13 75,553

Less expenses: Rent and rates

8,170

Wages

29,020

Vehicle expenses

2,470

General expenses

6,210

Bad debts written off

175

Provision for depreciation: vehicle

2,250

fixtures and fittings

400 48,695

Net profit

26,858

Less appropriation of profit: Salary: A Adams

6,000 20,858

Share of remaining profit: A Adams

10,429

J Beeson

10,429 20,858

12

3.12

(b)

continued

BALANCE SHEET AS AT 30 JUNE 20-5 £ Cost 12,000 4,000 16,000

Fixed Assets Vehicle Fixtures and fittings

Current Assets Stock Trade debtors Less provision for doubtful debts

£ Provision for depreciation 5,250 1,200 6,450

27,750 6,850 137 6,713 250 22,009 1,376 58,098

Prepayment of expenses Bank Cash

Less Current Liabilities Trade creditors Accrual of expenses

£ Net book value 6,750 2,800 9,550

14,770 320 15,090

Net Current Assets NET ASSETS

43,008 52,558

FINANCED BY Capital Accounts A Adams J Beeson

30,000 20,000 50,000

Current Accounts A Adams J Beeson

1,209 1,349 2,558 52,558

3.14

(a) Dr 2006 1 Jan

2007 1 Jan

Total Debtors Account* Balance b/d Sales (missing figure)

£ 317 43,915 44,232

Cr

2006 31 Dec

Cash received from debtors Balance c/d

£ 44,049 183 44,232

2007 Balance b/d

183 * also known as sales ledger control account

(b) Dr 2006 Payments to creditors 31 Dec Balance c/d

Total Creditors Account** £ 195,911 5,163 201,074

2007

2006 1 Jan

2007 1 Jan

Balance b/d Purchases (missing figure)

Balance b/d

** also known as purchases ledger control account

13

Cr £ 4,872 196,202 201,074

5,163

3.14

(c)

MARTIN AND NASSER, IN PARTNERSHIP TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006 £ Sales – cash

£ 332,467

– credit

43,915 376,382

Opening stock

14,003

Purchases

196,202 210,205

Less Closing stock

13,471

Cost of sales

196,734

Gross profit

179,648

Add income: Rent received (working 1)

6,000 185,648

Less expenses: Wages (working 2)

63,482

General expenses

56,676

Provision for depreciation: vehicle (working 3)

8,000

machinery (working 4)

10,000

Loss on sale of machinery (working 5)

800 138,958

Net profit

46,690

Workings: 1. Rent received: £7,000 – £500 owing at 1 Jan – £500 paid in advance at 31 Dec = £6,000 2. Wages: £63,156 – £612 accrued at 1 Jan + £938 accrued at 31 Dec = £63,482 3. Vehicle depreciation: £16,000 valuation at 1 Jan – £8,000 valuation at 31 Dec = £8,000 depreciation for year 4. Machinery depreciation: £147,000 valuation at 1 Jan + £12,000 cost of new machine – £4,000* book value of old machine now sold – £145,000 valuation at 31 December = £10,000 depreciation for year * £10,000 cost – £6,000 depreciation

5. Loss on sale of machinery: cost £10,000 – £3,200 part exchange value – £6,000 depreciation = £800 loss on sale

(d)

MARTIN AND NASSER, IN PARTNERSHIP PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006 £ £ Net profit

46,690

Add interest charged on partners’ drawings: Martin

230

Nasser

100 330 47,020

Less appropriation of profit: Salary: Nasser

3,000

Interest allowed on partners’ capitals: Martin

£100,000 x 6%

6,000

Nasser

£70,000 x 6%

4,200 10,200 33,820

Share of remaining profit: Martin (60%)

20,292

Nasser (40%)

13,528 33,820

14

3.14

(e) Dr

Partners' Current Accounts

Martin 2006 £ 31 Dec Drawings 35,660 31 Dec Interest on drawings 230

Nasser £ 26,480 100

35,890

26,580

6,388

4,548

2007 1 Jan

(f)

2006 1 Jan Balances b/d Salary 31 Dec Interest on capital 31 Dec Share of profit 31 Dec Balances c/d

Cr Martin £ 3,210 – 6,000 20,292 6,388 35,890

Nasser £ 1,304 3,000 4,200 13,528 4,548 26,580

2007 Balances b/d

The benefits of maintaining separate capital and current accounts are: •

the capital amount remains fixed except for capital introduced or withdrawn

•

the current account is a working account dealing with all aspects of the distribution and drawings of profits

•

the distinction between the two accounts shows whether or not partners are maintaining their permanent capital in the business, while the fluctuating current account shows whether or not partners have withdrawn more profit from the business than they are earning

•

the fixed capital account makes interest on capital – where permitted by the partnership agreement – easy to calculate

However, it should be pointed out that separate capital and current accounts require more work and are, therefore, more time-consuming for the book-keeper than using the partners’ capital accounts for all transactions. As to which is used will depend on the size and complexity of the partnership business.

CHAPTER 4 Changes in partnerships

4.1

(a)

(b)

•

Goodwill can be defined as the difference between the value of a business as a whole, and the net value of its separate assets and liabilities.

•

Goodwill is used when changes are made to partnerships, eg the admission of a new partner or retirement of an existing partner.

•

The principle is that the agreed value of goodwill is shared amongst those partners who created the goodwill, and is then charged to new partners as a premium for joining an established business.

•

It is normal practice not to record goodwill on a partnership balance sheet – this follows the concept of prudence.

Using figures of your own choice: •

agree a valuation for goodwill

•

old partners

•

–

debit goodwill account with the amount of goodwill

–

credit partners' capital accounts (in their old profit-sharing ratio) with the amount of goodwill

old partners + new partner –

debit partners' capital accounts (in their new profit-sharing ratio) with the amount of goodwill

–

credit goodwill account with the amount of goodwill

The effect of this is to charge the new partner with a premium for goodwill.

15

4.5

(a) Dr

Revaluation Account

20-4 31 Aug Capital accounts: Reena (4/8) Sam (2/8) Tamara (2/8)

£

20-4 31 Aug

Cr £ 24,000

Fixed assets (£74,000 – £50,000)

12,000 6,000 6,000 24,000

Dr

24,000

Goodwill Account

20-4 31 Aug Capital accounts: Reena (4/8) Sam (2/8) Tamara (2/8)

£

20-4 31 Aug

8,000 4,000 4,000 16,000

Dr

Cr £ Capital accounts: Reena (1/2) Tamara (1/2)

8,000 8,000 16,000

Partners' Capital Accounts Reena

20-4 31 Aug Goodwill w/off

Sam

Tamara

£

£

£

8,000

–

8,000

31 Aug Bank

22,000

31 Aug Balances c/d

45,000

–

32,000

53,000

22,000

40,000

Cr Reena

20-4

Sam

£

£

£

31 Aug Balances b/d

33,000

12,000

30,000

31 Aug Revaluation

12,000

6,000

6,000

31 Aug Goodwill created

1 Sep

Balances b/d

8,000

4,000

4,000

53,000

22,000

40,000

45,000

–

32,000

(b) BALANCE SHEET OF REENA AND TAMARA AS AT 1 SEPTEMBER 20-4 £ Fixed Assets (£50,000 + £24,000)

74,000

Current Assets

10,000

Bank (£25,000 – £22,000)

3,000 87,000

Trade creditors

(10,000) 77,000

Capital Accounts Reena

45,000

Tamara

32,000 77,000

16

Tamara

4.7

(a) Dr

Revaluation Account

2007 28 Feb Fixed assets (£123,000 – £120,000)

£ 3,000

2007 28 Feb

Cr £ Capital accounts: Ibrahim (3/6) Joan (2/6) Kelly (1/6)

1,500 1,000 500 3,000

3,000

Dr

Goodwill Account

2007 28 Feb Capital accounts: Ibrahim (3/6) Joan (2/6) Kelly (1/6)

£ 37,500 25,000 12,500 75,000

Dr 2007 28 Feb Revaluation

Ibrahim

Joan

Kelly

£

£

£

1,500

1,000

500

1,532 45,000

28 Feb Bank 28 Feb Balances c/d

£ Capital accounts: Ibrahim (3/5) Kelly (2/5)

45,000 30,000 75,000

Partners' Capital Accounts

28 Feb Current account 28 Feb Goodwill w/off

2007 28 Feb

Cr

–

Cr Ibrahim

Joan

Kelly

£

£

£

28 Feb Balances b/d

45,000

30,000

35,000

28 Feb Goodwill created

37,500

25,000

12,500

82,500

55,000

47,500

36,000

–

17,000

2007

30,000

52,468 36,000

–

17,000

82,500

55,000

47,500 1 Mar

Balances b/d

(b) Dr 2007 28 Feb Balance c/d

Bank Account £ 72,058

Cr

2007 28 Feb 28 Feb 28 Feb

Balance b/d Joan: loan account Joan: capital account

£ 4,590 15,000 52,468 72,058

1 Mar

Balance b/d

72,058

72,058

17

4.9

(a) JEAN AND DAVID, IN PARTNERSHIP PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 20-4 6 months to 30 June Net profit

6 months to 31 December

Total for year

£

£

£

16,350

16,350

32,700

Less appropriation of profit: Salaries: Jean

6,000

6,000

12,000

David

5,000

5,000

10,000

250

250

500

Interest allowed on partners' capitals: Jean David

300

300

600

4,800

4,800

9,600

Jean

(2/3) 3,200

(1/2) 2,400

5,600

David

(1/3) 1,600

(1/2) 2,400

4,000

4,800

4,800

9,600

Share of remaining profit:

(b) Dr

Partners' Current Accounts

20-4 1 Jan

Balance b/d

31 Dec

Drawings

31 Dec

Balance c/d

Jean

David

£

£

20-4

–

1,250

1 Jan

18,600

14,200

31 Dec

Salaries

1,900

–

31 Dec

Interest on capital

31 Dec

Share of profit

31 Dec

Balance c/d

20,500

15,450

–

850

20-5 1 Jan

4.10

Balance b/d

Cr Jean

David

£

£

2,400

–

12,000

10,000

500

600

5,600

4,000

–

850

20,500

15,450

1,900

–

20-5 Balance b/d

1 Jan

Balance b/d

Tutorial notes: • Parts (a) and (b) of this question have been seen already as question 3.9. • As David and Freda do not have a partnership agreement, the Partnership Act 1890 applies, ie they each have an equal share in the activities of the partnership. (c) Dr 2006 30 Jun 30 Jun 30 Jun

Revaluation Account Stock (£3,200 – £2,600) Debtors (£1,985 – £1,410) Capital accounts: Daniel (1/2) Freda (1/2)

£ 600 575 25,000 25,000 51,175

18

2006 30 Jun

Cr Fixed assets (£100,000 – £48,825)

£ 51,175

51,175

Dr

Goodwill Account

2006 30 Jun

£ Capital accounts: Daniel (1/2) Freda (1/2)

Cr

2006 1 Jul

£ Capital accounts: Daniel (1/2) Freda (1/3) Helen (1/6)

30,000 30,000

30,000 20,000 10,000 60,000

60,000

Dr

Partners' Capital Accounts Daniel

2006

Freda

Cr

Helen

Daniel 2006

Freda

Helen

£

£

£

£

£

£

1 Jul

Goodwill w/off

30,000

20,000

10,000

30 Jun Balances b/d

25,000

28,000

–

1 Jul

Balances c/d

50,000

63,000

40,000

30 Jun Revaluation

25,000

25,000

–

30 Jun Goodwill created

30,000

30,000

–

–

–

50,000

80,000

83,000

50,000

50,000

63,000

40,000

1 Jul Bank 80,000

83,000

50,000 1 Jul Balances b/d

(d) DANIEL, FREDA AND HELEN, IN PARTNERSHIP PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006 6 months to 30 June Net profit

6 months to 31 December

Total for year

£

£

£

45,000

45,000

90,000

250

250

Add interest charged on partners’ drawings: Daniel Freda

80

80

Helen

160

160

45,490

90,490

2,500

2,500

Daniel (£50,000 x 6% x 6 months)

1,500

1,500

Freda (£63,000 x 6% x 6 months)

1,890

1,890

45,000 Less appropriation of profit: Salaries:

Helen (£5,000 x 6 months)

Interest allowed on partners' capitals:

Helen (£40,000 x 6% x 6 months)

1,200

1,200

45,000

38,400

83,400

Daniel

(1/2) 22,500

(1/2) 19,200

41,700

Freda

(1/2) 22,500

(1/3) 12,800

35,300

Helen

–

Share of remaining profit:

45,000

19

(1/6)

6,400

6,400

38,400

83,400

4.10

(e) Dr

Partners' Current Accounts Daniel

Freda

Helen

£

£

£

41,000

35,000

12,000

250

80

160

1,950

2,110

–

2006 31 Dec Drawings 31 Dec Interest on drawings 31 Dec Balances c/d

Cr

2006 31 Dec Salary

37,190

12,160

2007

£

£

£

–

2,500

1,890

1,200

41,700

35,300

6,400

–

–

2,060

43,200

37,190

12,160

1,950

2,110

–

2007

1 Jan Balance b/d

(f)

Helen

–

31 Dec Balance c/d 43,200

Freda

1,500

31 Dec Interest on capital 31 Dec Share of profit

Daniel

–

–

2,060

1 Jan Balances b/d

The benefits of maintaining separate capital and current accounts are: •

the capital amount remains fixed except for capital introduced or withdrawn, and any subsequent capital transactions such as revaluations and adjustments for goodwill

•

the current account is a working account dealing with all aspects of the distribution and drawings of profits

•

the distinction between the two accounts shows whether or not partners are maintaining their permanent capital in the business, while the fluctuating current account shows whether or not partners have withdrawn more profit from the business than they are earning

•

the fixed capital account makes interest on capital – where permitted by the partnership agreement – easy to calculate

However, it should be pointed out that separate capital and current accounts require more work and are, therefore, more time-consuming for the book-keeper than using the partners’ capital accounts for all transactions. The decision to keep separate capital and current accounts is justified in this partnership in view of the complexity of partners’ transactions.

4.14

(a) ALI, BAMBI AND CHARLIE: PROFIT OR LOSS ON DISSOLUTION £ Net book value of assets (excluding bank)

82,020

Less liabilities

23,420

Business sold to Daphne

40,000

Loss on dissolution

18,600

58,600

Capital accounts: Ali (3/6)

9,300

Bambi (2/6)

6,200

Charlie (1/6)

3,100 18,600

20

4.14

(b) Dr

Partners' Capital Accounts

2006

Ali

Bambi

Charlie

£

£

£

9,300

6,200

31 Dec Current account 31 Dec Share of loss 31 Dec Bambi 31 Dec Bank

4,700 720

–

180

31,680

–

9,020

41,700

10,900

12,300

Bambi

Charlie

£

£

£

40,000

10,000

10,000

1,700

–

2,300

2006 31 Dec Balances b/d

3,100

Cr Ali

31 Dec Current accounts 31 Dec Ali

720

31 Dec Charlie

180 41,700

10,900

12,300

Tutorial notes: •

Upon dissolution the capital account of Bambi has a deficit of £900.

•

As Bambi is unable to meet this liability, the rule in Garner v Murray applies, and the amount must be paid by Ali and Charlie in the ratio of their last agreed capital balances, ie Ali £40,000 and Charlie £10,000.

•

Thus Ali will pay £720 and Charlie £180.

•

The amounts paid to Ali and Charlie from the bank are £31,680 + £9,020 = £40,700; this is the £40,000 paid by Daphne plus £700 bank balance from the partnership balance sheet.

CHAPTER 5 Published accounts of limited companies 5.1

5.3

The report and accounts – or corporate report – of a public limited company is available to every shareholder and contains the main elements of financial statements: •

income statement (also known as a ‘statement of comprehensive income’)

•

balance sheet (also known as a ‘statement of financial position’)

•

cash flow statement

•

statement of changes in equity

•

notes to the financial statements, including a statement of the company’s accounting policies

•

directors’ report

•

auditors’ report

•

The directors are responsible for ensuring that the provisions of the Companies Acts 1985 and 2006 which relate to accounting records and statements are followed.

•

In particular the company’s accounting records must:

•

–

show and explain the company’s transactions

–

disclose with reasonable accuracy at any time the financial position of the company

–

enable the directors to ensure that the company’s income statement and balance sheet give a true and fair view of the company’s financial position

A company’s accounting records must contain: –

day-to-day entries of money received and paid, together with details of the transactions

–

a record of the company’s assets and liabilities

–

details of inventories held at the end of the year

•

A company’s financial statements must be prepared in accordance with the Companies Acts and with either UK accounting standards or international accounting standards.

•

The directors must report annually to the shareholders on the way that they have run the company on behalf of the shareholders.

•

Every company director has a responsibility to ensure that the statutory accounts are produced and filed with the Registrar of Companies.

•

The annual accounts must be approved by the company’s board of directors and the copy of the balance sheet filed with the Registrar of Companies must be signed by one of the directors on behalf of the board.

21

5.6

•

The directors must prepare a directors report – this must be approved by the board (and the copy to be filed with the Registrar of Companies signed on behalf of the board by a director, or the company secretary).

•

The statutory accounts must be laid before the company at the annual general meeting (and they must be circulated beforehand to shareholders, debenture holders and any other persons entitled to attend the meeting).

(a)

The published income statement of a limited company does not have to detail every single overhead or expense incurred. However, IAS 1, Presentation of Financial Statements, requires that certain items must be detailed on the face of the income statement, including: •

revenue

•

finance costs

•

tax expense

IAS 1 states that further detail may be needed to give information relevant to an understanding of financial performance. The income statement concludes by showing the profit or loss for the period attributable to equity holders.

(b)

For the income statement, expenses must be analysed either: •

by nature (raw materials, employee costs, depreciation, etc), or

•

by function (cost of sales, distribution expenses, sales and marketing expenses, administrative expenses, etc)

The analysis selected will depend on which provides the more reliable and relevant information – the analysis by nature is often appropriate for manufacturing companies, while the analysis by function is commonly used by trading companies. As Presingold plc is a trading company, the analysis by function would seem to be more appropriate.

5.7

This Question is principally concerned with:

initial reading in order to get an overview of the company’s accounts and an understanding of the industry • horizontal analysis in order to compare certain figures from the financial statements with the figures from the previous accounting period The Question can be developed to look at various aspects of: • the company’s structure and its own industry • the stage of its development • both internal and external influences on the company •

5.9

(a)

Share premium account This occurs where an established company issues shares to the public at a higher amount that the nominal value – the amount above nominal value is the share premium. For example, if shares with a nominal value of £1 are issued at £1.50 each, then 50p per share is credited to share premium account. Revaluation reserve This occurs when a non-current asset – most probably freehold land and buildings – is revalued upwards in the balance sheet. The amount of the revaluation is placed in a revaluation reserve where it increases the value of the shareholders’ investment in the company. For example, if freehold land and buildings had originally cost £250,000 and are now revalued at £450,000, then £200,000 is the amount credited to revaluation reserve.

(b)

Retained earnings are profits that have been retained in the company. They belong to the shareholders, but are represented by assets in the balance sheet and are not a cash balance at the bank available to build a new warehouse for the company.

(c)

Equity is the stake of the ordinary shareholders in the company. It comprises ordinary share capital, plus capital and revenue reserves. Non-current liabilities are those liabilities that are due to be repaid more than twelve months from the date of the balance sheet. Examples include loans and debentures.

22

5.10

This answer may be set out either vertically or horizontally. Non-current Assets

£000

Property, plant and equipment Net book value at start of year

4,217

Additions at cost

930

Disposals during year (£1,634 – £920)

(714)

Depreciation for year (missing figure)

(132)

Net book value at end of year

4,301

Net book

Additions

Disposals

Depreciation

Net book

value at start

at cost

during year

for year

value at end

£000

£000

£000

£000

£000

4,217

930

(714)

(132)

4,301

Non-current Assets

Property, plant and equipment

5.12

This answer may be set out either vertically or horizontally. Non-current Assets

£000

Property, plant and equipment Net book value at start of year

8,074

Additions at cost

1,175

Disposals during year (£2,168 – £970)

(1,198)

Depreciation for year (missing figure)

(404)

Net book value at end of year

7,647

Net book

Additions

Disposals

Depreciation

Net book

value at start

at cost

during year

for year

value at end

£000

£000

£000

£000

£000

8,074

1,175

(1,198)

(404)

7,647

Non-current Assets

Property, plant and equipment

23

5.14

(a)

Shareholders They will almost certainly get a dividend; profits are up which is better for dividends and for ploughing back to yield future dividends; plans for growth will save the company from stagnating.

(b)

Loan stock holders The profits indicate that they will be paid their interest; also the profits mean the company should not fail, so they will be repaid their loans when they are due.

(c)

Employees The profits mean they are put into a better bargaining position for a pay rise. Employees may also be in a company share scheme, so a prosperous company will make their shares worth more. The future growth of the company should mean that their jobs are safe.

5.16 MITHIAN PLC INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-2 £ Revenue

£ 2,640,300

Opening inventories

318,500

Purchases

2,089,600 2,408,100

Less Closing inventories

340,600

Cost of sales

(2,067,500)

Gross profit

572,800

Overheads: Distribution expenses

(216,320)

Administrative expenses (note 1)

(229,080) (445,400)

Profit/(loss) from operations

127,400

Finance costs

(20,000)

Profit/(loss) before tax

107,400

Tax

(30,000)

Profit/(loss) for the year attributable to equity holders

77,400

STATEMENT OF CHANGES IN EQUITY (EXTRACT)

Retained earnings Balance at 1 January 20-2

63,250

Profit for the year

77,400 140,650

Dividends paid

(20,000)

Balance at 31 December 20-2

120,650

24

MITHIAN PLC BALANCE SHEET AS AT 31 DECEMBER 20-2 Non-current Assets

Valuation

Cost

Net

£

Aggregate Depreciation £

£

110,060

48,200

61,860

235,000

55,000

180,000

345,060

103,200

241,860

£

Property, plant and equipment Office equipment Vehicles – Current Assets Inventories

340,600

Trade receivables

415,800

Cash and cash equivalents

20,640 777,040

Total assets

1,018,900

Current Liabilities Trade payables

(428,250)

Tax liabilities

(30,000) (458,250)

Net Current Assets

318,790 *560,650

Non-current Liabilities 10% loan stock

(200,000)

Total liabilities

658,250

Net Assets

360,650

EQUITY Issued Share Capital Ordinary shares of £1 each

200,000

Capital Reserves Share premium account

40,000

Revenue Reserve Retained earnings

120,650

TOTAL EQUITY

360,650

* fixed assets + net current assets Working note 1 Administrative expenses

£ 220,180

Bad debts

8,900 229,080

25

CHAPTER 6 Cash flow statements 6.2

Depreciation is added back to profit from operations because depreciation is a non-cash expense, ie no money is paid out by the business in respect of depreciation charged to the income statement. Thus profit added back to depreciation gives the amount of cash generated by the trading activities of business: this, together with the changes in net current asset items (except for cash/bank) and adjustments for any profits/losses on sales of non-current assets, forms the operating activities section of the cash flow statement.

6.3

Raven Limited: £ Profit from operations

30,000

Depreciation for year

10,000

Increase in inventories

(5,000)

Decrease in trade receivables Increase in trade payables Cash from operations

6.4

4,000 6,000 45,000

Meadow Limited: £ Loss from operations

6.5

6.7

(10,000)

Depreciation for year

8,000

Decrease in inventories

4,000

Increase in trade receivables

(5,000)

Decrease in trade payables

(3,000)

Cash from operations

(6,000)

Points when assessing the cash flow statement of a company include: •

reasonable cash flow from operating activities

•

link changes in net current asset items of inventories, trade receivables and trade payables to changes in profit from operations – is there a strain on the liquidity of the company?

•

link purchase/sale of non-current assets to context of company – expanding or declining?

•

where finance has been raised through increases in loans/shares, look to see how the cash has been used – to finance new non-current assets, or to finance inventories and trade receivables, or other purposes?

•

look at change in cash/bank in relation to profit/loss from operations – is the company generating cash?

(a)

(i)

cash generated from operations amount of cash generated by the trading activities of the company, taking into account non-cash items – such as depreciation – and changes in the net current asset items of inventories, trade receivables and trade payables

(ii)

net cash from operating activities cash generated from operations, less interest paid and taxes paid

(iii)

net cash used in investing activities amount of net cash the company receives from buying and selling non-current assets, from interest received and dividends received

26

(b)

(i)

(ii)

(iii)

6.10

managers •

a cash flow statement highlights information not available from the income statement and balance sheet

•

it shows clearly sources and uses of cash over the year

•

it shows cash available at the year end for future developments

•

it aids decision-making and development of the company

shareholders •

a cash flow statement demonstrates the ability of the company to generate cash from operating activities

•

it shows the liquidity of the business

•

it shows clearly the sources and uses of cash over the year

•

it shows the investment of the company in capital expenditure

•

it shows the amount of dividends paid to shareholders

debenture holders •

a cash flow statement shows the cash available at the year end which demonstrates to debenture holders the security of their loan

•

it shows additional loans raised or repaid, in the financing activities section

•

it shows interest paid to lenders, in the operating activities section

(a) ADAGIO PLC RECONCILIATION OF PROFIT FROM OPERATIONS TO NET CASH FLOW FROM OPERATING ACTIVITIES £000 Profit/(loss) from operations

(2,127)

Adjustments for: Depreciation for year

3,490

Loss on disposal of non-current assets

58

Decrease in inventories

48

Decrease in trade receivables

986

Decrease in trade payables

(1,787)

Cash from operations

668

Interest paid

(–)

Income taxes paid

(278)

Net cash (used in)/from operating activities

390

(b)

ADAGIO PLC DRAFT CASH FLOW STATEMENT FOR THE YEAR ENDED 30 APRIL 2004 £000 Net cash from operating activities

£000 390

Cash flows from investing activities Purchase of non-current assets

(1,795)

Proceeds from sale of non-current assets

818 (977)

Cash flows from financing activities Dividends paid

(299)

Net decrease in cash and cash equivalents

(886)

27

(c)

Using a cash flow statement to judge the financial performance of a company •

The cash flow statement focuses on cash inflows and cash outflows. It concentrates on the liquidity of the business – it is often a lack of cash that causes most businesses to fail.

•

Cash is often described as the ‘life blood’ of a business.

•

The cash flow statement uses the money measurement concept – only items which can be recorded in money terms can be included. This makes it difficult to manipulate, and cash can be seen as an accurate measure of business success or failure. This contrasts with the income statement where judgement has to be made about items such as:

•

6.11

–

recognition of sales/revenue

–

the distinction between capital and revenue expenditure

–

depreciation methods and policies

The cash flow statement shows: –

the cash from operations after interest and tax have been paid

–

the investing activities of the business, eg the purchase of non-current assets

–

the financing activities of the business, eg an increase/decrease in loans/share capital

•

The cash flow statement links profit with changes in cash. Both of these are important: without profit, the company cannot generate cash (unless it sells non-current assets), and without cash it cannot pay bills as they fall due.

•

The cash flow statement is important in judging financial performance because of its emphasis on: –

liquidity and solvency

–

investment in assets

–

financing methods

(a) HALLS-KROSBY PLC RECONCILIATION OF PROFIT FROM OPERATIONS TO NET CASH FLOW FROM OPERATING ACTIVITIES £000 Profit from operations

573

Adjustments for: Depreciation for year

206

Loss on sale of non-current assets (machinery) Increase in inventory

(b)

18 (230)

Increase in trade receivables

(62)

Decrease in trade payables

(46)

Cash from operations

459

Interest paid

(–)

Income taxes paid

(–)

Net cash (used in)/from operating activities

459

Changes made to original reconciliation statement (question asks for an explanation of three of the changes): •

Depreciation is non-cash and is added back to profit from operations in the cash flow statement.

•

Loss on sale of machinery is non-cash and is also added back to profit from operations.

•

Receipts from sale of machinery is shown as a receipt in the investing activities section of the cash flow statement.

•

Dividends paid – both ordinary and preference – are shown as payments in the financing activities section of the cash flow statement.

•

Share premium receipts are included with the proceeds of the ordinary share issue in the financing activities section of the cash flow statement.

28

6.15

(a) KALSI PLC RECONCILIATION OF PROFIT FROM OPERATIONS TO NET CASH FLOW FROM OPERATING ACTIVITIES £000 Profit from operations

237

Adjustments for: Depreciation for year

275

Gain on sale of non-current assets

(2)

Increase in inventories (210–200)

(10)

Increase in trade receivables (390–250)

(140)

Decrease in trade payables (150–160)

(10)

Cash generated from operations

350

Interest paid

(20)

Income taxes paid

(21)

Net cash (used in)/from operating activities

309

(b) KALSI PLC CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 20-5 £000 Net cash (used in)/from operating activities

£000 309

Cash flows from investing activities Purchase of non-current assets

(110)

Proceeds from sale of non-current assets1

7

Net cash (used in)/from investing activities

(103)

Cash flows from financing activities Proceeds from issue of share capital (40–25) Proceeds from long-term borrowings (200-100) Repayment of debentures

15 100 (500)

Dividends paid

(30)

Net cash (used in)/from financing activities

(415)

Net increase/(decrease) in cash and cash equivalents

(209)

Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

10 (199)

Working note 1

Proceeds from sale of non-current assets

Non-current assets (cost) Gain on sale

Non-current Assets £ 10,000 Accumulated depreciation 2,000 Proceeds (bal fig) 12,000

29

£ 5,000 7,000 12,000

(c)

From the point of view of the company’s shareholders, the following points are highlighted by the cash flow statement of Kalsi plc for the year ended 31 March 20-5: •

an excellent cash flow has been generated from operations, £350,000, which is well above the amounts paid for tax, £21,000, and dividends, £30,000

•

There have been increases in inventories and trade receivables – the increase of £140,000 in the latter seems very large and might indicate that the company is having to offer extended terms to its customers in order to maintain sales; there has been a small decrease in trade payables

•

new non-current assets of £110,000 have been bought – an indication that the company is re-equipping for the future

•

debentures of £500,000 have been repaid – financed mainly from profits and an increased long-term loan of £100,000; the company’s gearing has reduced and it seems that this is a short/medium-term aim of the company

•

the reduction in borrowed funds will reduce the amount of interest to be paid in future years

•

a small share issue has taken place during the year

•

the bank balance – cash and cash equivalents – has fallen during the year from a credit balance of £10,000 to an overdraft of £199,000

Conclusion: The cash flow statement shows that Kalsi plc is a highly profitable company which generates a good cash flow from operations. There has been an expansion of net current assets but shareholders may be concerned to note the increase of £140,000 in trade receivables. The debentures have been repaid – partly from profits which explains the significant fall in cash and cash equivalents. New non-current assets of £110,000 have been purchased. Overall, it seems that the company is reorganising its financing so as to reduce its reliance on borrowed funds, while at the same time seeking to develop in the future. For shareholders, they should hold their existing shares and should consider increasing their holdings as profits and dividends seem likely to increase in the future.

CHAPTER 7 Accounting standards 7.2

Accounting principles are the broad concepts that are applied in the preparation of financial statements. Examples: going concern, accruals, consistency.

Accounting bases are the methods used for applying accounting principles to financial statements, and are intended to reduce subjectivity by identifying the acceptable methods. Example: the use of historic cost or revaluation to value assets. Accounting policies are the specific principles, bases, conventions, rules and practices applied in the preparation and presentation of financial statements. Examples: the use of straight-line or diminishing (reducing) balance method of depreciation for non-current assets.

7.3

(a)

IAS 16, Property, Plant and Equipment, defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life. (Depreciable amount is the cost or valuation of the asset, less any residual value.)

(b)

•

IAS 16 states that, initially, PPE are to be measured (recorded) at cost in the balance sheet.

•

After acquisition of PPE a company must choose either the cost model or the revaluation model as its accounting policy – which is then applied to an entire class of PPE.

•

Using the cost model, assets are shown in the balance sheet at cost less accumulated depreciation and impairment losses.

•

Using the revaluation model, assets are shown at a revalued amount, being fair value less subsequent depreciation and impairment losses; revaluations are to be made regularly to ensure that the revalued amounts do not differ materially from fair values at the balance sheet date.

•

Depreciation is to be charged on all non-current assets – with the exception of freehold land, which is shown at cost.

•

Depreciation methods include the straight-line and the diminishing (reducing) balance methods.

30

7.6

(a)

•

A company chooses the depreciation method which best reflects the way in which the asset’s economic benefits are consumed.

•

The depreciation method should be reviewed at least annually in order to consider if the method used is still the most appropriate one.

An impairment review is carried out in three steps: STEP 1

The asset’s carrying amount is ascertained

STEP 2

The asset’s recoverable amount is ascertained

STEP 3

If an asset’s carrying amount is greater than its recoverable amount, then the asset is impaired and should be written down to its recoverable amount.

Terms used:

Carrying amount is the amount at which an asset is recognised after deducting any accumulated depreciation/amortisation and accumulated impairment losses. Recoverable amount is the higher of the asset’s •

fair value, less any costs that would be incurred were it to be sold

•

its value in use.

Fair value, less costs to sell is the amount at which an asset could be sold for, less any selling costs. Value in use is the present value of the future cash flows from an asset’s continued use, including cash from its final sale.

7.7

(b)

When an asset is impaired it should be written down to its recoverable amount in the balance sheet. The amount of the impairment loss is shown as an expense in the income statement.

(c)

The fork lift truck is impaired: its carrying amount is £20,000 but its recoverable amount is £19,000 (the higher of fair value less costs to sell of £18,000, and value in use of £19,000). Accordingly, an impairment loss of £1,000 should be shown as an expense in the income statement.

The overriding principle of inventory valuation is that inventories should be valued at ‘the lower of cost and net realisable value’. Thus two different inventory values are compared: •

cost, which means the purchase price, plus any other costs incurred to bring the product (or service) to its present location and condition

•

net realisable value, which is the estimated selling price less the estimated costs to get the product into a condition necessary to complete the sale

The lower of these two values is taken, and different items or groups of inventory are compared separately.

7.8

Using the lower of cost and net realisable value: £ Vauxhall Corsa Landrover Discovery

2,800 cost 10,000 cost

Nissan Primera

2,600 net realisable value

Ford Focus

6,000 cost

Volkswagen Polo TOTAL

500 net realisable value 21,900

31

7.12

7.14

(a)

Although the selling of the inventory (stock) is an event which happened after the year end, under IAS 10, Events after the Reporting Period, this is an example of an adjusting event. Such events provide evidence of conditions that existed at the end of the reporting period; if the amount involved is material, then the amount shown in the financial statements should be changed. The sale of inventory provides evidence as to the net realisable value of the inventory reported in the financial statements for the year under review. Under IAS 2, Inventories, inventories are to be valued at the lower of cost and net realisable value.

(b)

A dividend declared or proposed on ordinary shares after the balance sheet date is, under IAS 10, an example of a non-adjusting event. Such events are conditions that arose after the reporting period; no adjustment is made to the financial statements – if such events are material, then they are disclosed by way of notes to the accounts. The notes would explain the nature of the event and, if possible, give the likely financial consequences of the event. The proposed ordinary dividend cannot be recorded as a liability at 30 September 20-6 as it was not a present obligation of the company at the financial year end. The details of the proposed dividend will be given in the notes to the financial statements, including the amount of £75,000.

(c)

Under IAS 10, this is an example of a non-adjusting event after the reporting period. Although the employee was working for Gernroder Limited at the financial year end, the legal proceedings do not relate to conditions that existed at the end of the reporting period. Instead, the legal proceedings are conditions that arose after the reporting period and no adjustment is to be made to the financial statements. The amount of £20,000, if material, is to be disclosed by way of a note which explains the nature of the event and the likely financial consequences of the event.

1

IAS 38, Intangible Assets As this is internally generated goodwill, it cannot be recognised as an asset and recorded in the financial statements.

2

IAS 2, Inventories Cost is £100,000; net realisable value is £160,000. Inventories (stocks) are to be valued at ‘the lower of cost and net realisable value’. Therefore this stock should be recognised as an asset at £100,000 and recorded in the financial statements.

3

IAS 16, Property, Plant and Equipment The valuation of £205,000 is acceptable as the overhaul ensures that future economic benefits will flow to the business, and the cost of the overhaul can be measured reliably. The depreciable amount for the machine is now £205,000.

7.15

(a)

IAS 2 states that inventories must be valued at the lower of cost and net realisable value. Cost means the purchase price plus any other costs incurred to bring the product (or service) to its present location and condition. Net realisable value is the estimated selling price less the estimated costs to get the product into a condition necessary to complete the sale. The lower of these two values is taken, and different items or groups of inventory are compared separately.

(b)

1

2

This situation – where a customer, who owes money at the balance sheet date, subsequently goes into liquidation – is covered by IAS 10, Events after the Reporting Period. Adjusting events provide evidence of conditions that existed at the end of the reporting period. If the amount is material, then the amount shown in the financial statements should be changed. In this case, the amount of £30,000 needs to be written off as a bad debt. The book-keeping entries are: DEBIT

Bad debts written off

CREDIT

Trade receivables

£30,000 £30,000

The situation described here is covered by IAS 37, Provisions, Contingent Liabilities and Contingent Assets. A contingent asset is a possible asset arising from past events whose existence will be confirmed only by uncertain future events not wholly within the control of the company. It follows from the above definition that the probable inflow of £25,000 from the legal suit is a contingent asset. IAS 37 states that if a contingent asset is probable, it should be disclosed by way of a note in the financial statements. It cannot be recognised in the financial statements because it would not be prudent to recognise income that may never be realised.

32

7.16

(a)

(b)

1

IAS 38, Intangible Assets

2

IAS 38, Intangible Assets

3

IAS 16, Property, Plant and Equipment

4

IAS 18, Provisions, Contingent Liabilities and Contingent Assets

5

IAS 2, Inventories

Retained earnings and other reserves: £ Balance at start

780,000

Item 1

(40,000) amortisation of intangible asset, £200,000 ÷ 5 years

Item 2

– internally generated goodwill, so cannot be recognised as an asset

Item 3

(50,000) depreciation at 2% on £250,000

Item 4

(480) provision for bad debts, 3% on £16,000

Item 5

(25) cost 10 x £20 = £200; net realisable value 10 x £30 = £300 – £125 repairs = £175; nrv to be used

Corrected balance

689,495

(c)

GROGLIN PLC BALANCE SHEET AT 31 DECEMBER 2008 £ Assets Non-current assets Intangible asset

160,000

Property, plant and equipment

2,450,000

200,000 – 40,000 2,000,000 + 500,000 reval’n – 50,000

2,610,000 Current assets Inventories

119,975

120,000 – 25

Trade receivables

15,520

16,000 – 480

Cash and cash equivalents

28,000 163,495

TOTAL ASSETS

2,773,495

Liabilities Current liabilities Trade payables

(84,000)

NET ASSETS

2,689,495

Shareholders’ equity Called up share capital

1,500,000

Retained earnings and other reserves

1,189,495

TOTAL EQUITY

2,689,495

33

689,495 + 500,000 revaluation

(d)

Although accounting standards are not laws – ie they are non-statutory – any limited company that fails to apply them would cast serious doubts on the reliability of its financial statements. It is one of the duties of directors to ensure that a company’s financial statements are prepared in accordance with the Companies Acts and with accounting standards. At the same time, the auditors’ report must state whether or not the financial statements have been prepared in accordance with company law and accounting standards: if they have not, the auditors’ report will be qualified. The reasons for using international accounting standards are: •

to provide a framework for preparing and presenting financial statements – the ‘rules’ of accounting

•

to ensure that accountants follow the same set of rules

•

to reduce the number of different accounting treatments and so make ‘window dressing’ more difficult

•

to meet with the duty of the directors to ensure that financial statements comply with accounting standards

•

to meet with the auditors’ report requirement to state that the financial statements have been prepared in accordance with accounting standards

The benefits of international accounting standards are: •

to standardise financial statements internationally – thus a company operating in several countries knows that the same accounting rules have been applied to all parts of its business

•

to reduce the variations of accounting treatments used in financial statements – thus making ‘window dressing’ the accounts more difficult

•

to allow users of financial statements to make inter-firm comparisons in the knowledge that all the financial statements have been prepared using the same standards.

CHAPTER 8 Stock valuation 8.3

Date 20-4

Description

FIFO £

AVCO £

21 June

Total issue value*

5,150

5,250

30 June

Total closing stock value†

1,150

1,050

* FIFO:

AVCO:

2,000 units at £2.00 per unit 500 units at £2.30 per unit 2,500

= =

£4,000 £1,150 £5,150

2,000 units at £2.00 per unit 1,000 units at £2.30 per unit 3,000 units at £2.10 per unit

= = =

£4,000 £2,300 £6,300

=

£5,250

500 units at £2.30 per unit

=

£1,150

500 units at £2.10 per unit

=

£1,050

∴ 2,500 units issued at £2.10 per unit

† FIFO:

AVCO:

34

8.4

(a) FIFO

Date 20-4

STORES LEDGER RECORD: Wye

Quantity

Receipts Cost £

Total Cost £

Quantity

Issues Cost £

Total Cost £

1 Aug Balance

10 Aug

2,000

5.25

10,500

Quantity

Balance Cost £

Total Cost £

5,000

5.00

25,000

5,000

5.00

25,000

2,000

5.25

10,500

7,000

18 Aug

3,000

5.50

16,500

35,500

5,000

5.00

25,000

2,000

5.25

10,500

3,000

5.50

16,500

10,000

23 Aug

AVCO

Date 20-4

5.00

25,000

2,000

5.25

10,500

1,000

5.50

5,500

Receipts Cost £

1 Aug

Balance

6 Aug

5,000

4.30

7,500

4.40

Total Cost £

Quantity

Issues Cost £

Total Cost £

21,500

33,000

24 Aug

12,000

(b)

2,000

5.50

11,000

STORES LEDGER RECORD: Zed

Quantity

19 Aug

5,000

52,000

4.20

50,400

Quantity

10,000

£ 4.00

Total Cost £ 40,000

10,000

4.00

40,000

5,000

4.30

21,500

15,000

4.10

61,500

15,000

4.10

61,500

7,500

4.40

33,000

22,500

4.20

94,500

10,500

4.20

44,100

Valuation at 31 August 20-4: £ Wye

10,000

(net realisable value)

Zed

44,100

(cost price)

54,100

35

Balance Cost

8.5

(a) FIFO

Date

20-7

STORES LEDGER RECORD: product Alpha

Receipts

Quantity

Issues

Cost

Total Cost

£

£

Quantity

Balance

Cost

Total Cost

£

£

Quantity

Cost

Total Cost

£

£

Jan

20

3.00

60.00

20

3.00

60.00

Feb

10

3.60

36.00

20

3.00

60.00

10

3.60

36.00

30 Mar

8

3.00

24.00

96.00

12

3.00

36.00

10

3.60

36.00

22 Apr

10

4.00

40.00

72.00

12

3.00

36.00

10

3.60

36.00

10

4.00

40.00

32 May

12

3.00

36.00

4

3.60

14.40

112.00

6

3.60

21.60

10

4.00

40.00

16

61.60

(b)

AVCO Date 20-7

STORES LEDGER RECORD: product Alpha Receipts

Quantity

Issues

Cost

Total Cost

£

£

Quantity

Balance

Cost

Total Cost

£

£

Quantity

Cost

Total Cost

£

£

Jan

20

3.00

60.00

20

3.00

60.00

Feb

10

3.60

36.00

20

3.00

60.00

10

3.60

36.00

30

3.20

96.00

22

3.20

70.40

22

3.20

70.40

10

4.00

40.00

32

3.45

110.40

16

3.45

55.20

Mar Apr

May

8 10

4.00

3.20

25.60

40.00

16

3.45

36

55.20

8.6

(a) FIFO

Date

20-7

STORES LEDGER RECORD: product Jay Receipts

Quantity

Jan

100

Issues

Cost

Total Cost

£

£

4.00

400.00

Feb

Quantity

80

Mar

120

4.21

Balance

Cost

Total Cost

£

£

4.00

320.00

505.20

Quantity

Cost

Total Cost

£

£

100

4.00

400.00

20

4.00

80.00

20

4.00

80.00

120

4.21

505.20

140 Apr

70

3.94

275.80

585.20

20

4.00

80.00

120

4.21

505.20

70

3.94

275.80

210 May

Jun

105

4.30

20

4.00

80.00

120

4.21

505.20

451.50

861.00

70

3.94

275.80

70

3.94

275.80

105

4.30

451.50

175

AVCO

STORES LEDGER RECORD: product Jay

Date 20-7

Jan

Receipts Quantity

100

Issues

Cost

Total Cost

£

£

4.00

400.00

Feb Mar

Apr

Quantity

80 120

70

4.21

3.94

4.30

Cost

Total Cost

£

£

4.00

320.00

275.80

140 105

Balance

505.20

May Jun

727.30

4.10

451.50

37

574.00

Quantity

Cost

Total Cost

£

£

100

4.00

400.00

20

4.00

80.00

20

4.00

80.00

120

4.21

505.20

140

4.18

585.20

140

4.18

585.20

70

3.94

275.80

210

4.10

861.00

70

4.10

287.00

70

4.10

287.00

105

4.30

451.50

175

4.22

738.50

(b) FIFO

LEDGER RECORD: product Kay

Date 20-7

Receipts Quantity

Cost

£

£

Jan

200

10.00

Feb

100

9.55

Issues Total Cost

Quantity

Cost

£

£

Balance Total Cost

Quantity

Cost

£

£

2,000.00

200

10.00

2,000.00

955.00

200

10.00

2,000.00

100

9.55

955.00

300 Mar

Apr

90

10.50

200

10.00

2,000.00

40

9.55

382.00

945.00

2,955.00

60

9.55

573.00

60

9.55

573.00

90

10.50

945.00

150 May

150

10.00

1,500.00

1,518.00

60

9.55

573.00

90

10.50

945.00

150

10.00

1,500.00

300 Jun

60

9.55

573.00

40

10.50

420.00

3,018.00

50

10.50

525.00

150

10.00

1,500.00

200

AVCO

Receipts Quantity

Cost

£

£

Jan

200

10.00

Feb

100

9.55

Issues Total Cost

May

Jun

Quantity

Cost

£

£

Cost

£

£

2,000.00

200

10.00

2,000.00

955.00

200

10.00

2,000.00

100

9.55

955.00

300

9.85

2,955.00

60

9.85

591.00

60

9.85

591.00

90

10.50

945.00

150

10.24

1,536.00

150

10.24

1,536.00

150

10.00

1,500.00

300

10.12

3,036.00

200

10.12

2,024.00

240 90

150

10.50

10.00

Balance Quantity

Mar Apr

2,025.00

STORES LEDGER RECORD: product Kay

Date 20-7

Total Cost

9.85

Total Cost

2,364.00

945.00

1,500.00

100

10.12

38

1,012.00

Total Cost

Valuation at 30 June 20-7: £ Product Jay

727.30 (cost price, using FIFO)

Product Kay

1,950.00 (net realisable value) 2,677.30

8.10

(a)

Tutorial note: This part of the question requires a calculation of the value of closing stock at 30 April 2007. For clarity, the answer below is set out in the form of a stores ledger record; however, it can be answered instead by means of a calculation.

AVCO

STORES LEDGER RECORD: Caravans

Date

Receipts

2007

Quantity

Cost

£

£

Issues Total Cost

Quantity

Cost

£

£

Balance Total Cost

Quantity

Cost

£

£

1

17,700

17,700

3

17,900

53,700

1

17,900

17,900

4

18,275

73,100

2

18,275

36,550

1 Apr Balance

10 Apr

2

18,000

36,000

18 Apr

2

26 Apr

3

18,400

30 Apr

(b)

17,900

35,800

55,200

2

18,275

36,550

Total Cost

•

FIFO will give him a closing stock valuation of £36,800 (2 x £18,400). This higher closing stock under FIFO will give him a higher profit of £250. This could be an advantage if he is thinking of selling the business in the near future; the disadvantage is that he will pay more tax.

•

However, any change in profit will be only temporary as, over the life of his business, total profits will be the same under both methods, and there will be no effect on the cash generated by the business.

•

The FIFO method is logical and relatively easy to calculate; however, for the low number of items that Tom has in stock, AVCO is not difficult to calculate.

•

To meet the accounting concept of consistency, if he changes to FIFO he will need to adjust his financial statements to show comparability.

•

Both FIFO and AVCO are acceptable for tax purposes and under IAS 2.

Conclusion Tom is currently using AVCO which, for the low number of items that he has in stock, is relatively easy to calculate. Although his profits will be higher under FIFO when prices are rising, there will be no effect on the cash generated by the business. All-in-all, there do not appear to be compelling reasons to make the change.

39

8.12

(a)

A stock-take is carried out regularly to check that the quantity of stock held is the same as that recorded in the stock records. This is done by counting the physical stock on hand against the balance shown by the records, and to identify any theft or deterioration. A stock-take is carried out on either a periodic basis or continuously.

(b)

(c)

Stock reconciliation is the process of comparing the stock-take and the stock record. This process is important because: –

an accurate stock figure can then be used to value the stock

–

it will highlight any discrepancies which can then be investigated

Stock number 146: as the discrepancy here is a small shortfall in the physical stock compared with the stock record, ie £2 x 2 units = £4, the likely action to be taken by the company accountant will be to authorise the discrepancy for write-off. Stock number 523: this is a larger discrepancy, ie £200 x 10 units = £2,000 and needs to be investigated to see if it has been caused by: –

an error on the stock record

–

theft of stock

–

damaged stock being disposed of without any record having been made

CHAPTER 9 Manufacturing accounts 9.4

(a)

JACQUI KING PLC MANUFACTURING ACCOUNT FOR THE YEAR ENDED 30 NOVEMBER 2001 £

Opening stock of raw materials Add Purchases of raw materials Less Closing stock of raw materials COST OF RAW MATERIALS USED Direct labour 959,400 x 2/3 Royalties PRIME COST Add Factory overheads: Indirect labour 959,400 x 1/3 Depreciation of factory machinery Overheads

319,800 48,000 548,000 915,800 2,067,100 23,000 2,090,100 24,100 2,066,000

Add Opening stock of work-in-progress Less Closing stock of work-in-progress PRODUCTION COST OF GOODS COMPLETED

(b) 9.6

£ 47,600 498,000 545,600 50,900 494,700 639,600 17,000 1,151,300

Payment/receipts for use of patented/copyrighted process.

(a) (i) 31 December 2007: £4,000, ie £20,000 x 25/125 (ii) 31 December 2008: £4,800, ie £24,000 x 25/125

40

(b)

MALCOLM PLC PROFIT AND LOSS ACCOUNT EXTRACT FOR THE YEAR ENDED 31 DECEMBER 2008 £ 170,000 800 169,200

Factory gross profit Less Increase in provision for unrealised profit 4,000 – 4,800 Adjusted factory gross profit

MALCOLM PLC BALANCE SHEET EXTRACT AS AT 31 DECEMBER 2008 £ Current asset Stock of finished goods Less Provision for unrealised profit Adjusted stock of finished goods

9.7

(a)

24,000 4,800 19,200

DEWRAY PLC SUMMARISED MANUFACTURING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2002 £000 1,207 915 15 2,137 34 2,171 36 2,135 427 2,562

Prime cost Factory overheads Depreciation of machinery Add Opening stock of work-in-progress Less Closing stock of work-in-progress Factory profit of 20% PRODUCTION COST OF GOODS COMPLETED (transfer price)

(b)

TRADING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2002 £000 Sales Less Cost of goods sold Opening stock of finished goods Production cost of goods completed

156 2,562 2,718 192

Less Closing stock of finished goods

2,526 934

Gross profit

(c)

£000 3,460

The amount of the adjustment to the provision for unrealised profit to be shown in the profit and loss account is £6,000.

Workings: 192 x 20/120 = 32 156 x 20/120 = 26

(d)

The amount of the adjustment is shown as a deduction from factory profit shown in the profit and loss account.

41

(e)

BALANCE SHEET EXTRACT AS AT 31 DECEMBER 2002 £000 Current Assets Stock – raw materials – work-in-progress – finished goods – less provision for unrealised profit adjusted stock of finished goods

9.8

£000 75 36

192 32 160 271

(a)

CATHY YOW MANUFACTURING ACCOUNT EXTRACT FOR THE YEAR ENDED 31 DECEMBER 2001 £ Opening stock of raw materials 9,000 Add Purchases of raw materials 63,600 72,600 Less Closing stocks of raw materials 9,400 COST OF RAW MATERIALS USED 63,200 Direct labour (146,800 + 3,450) 150,250 Royalties 8,140 PRIME COST 221,590

(b)

The adjustment is £100 Workings: £1,750 – £1,850* * £9,250 x 25/125

(c)

Provision for unrealised profit is made to reduce the closing stock value of finished goods to cost price. This enables the balance sheet valuation to comply with IAS 2, Inventories, and the concept of prudence.

9.10 (a)

CATHERINE DONOVAN MANUFACTURING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006 £ 9,840 126,430 136,270 10,211

Opening stock of raw materials Add Purchases of raw materials Less Closing stock of raw materials COST OF RAW MATERIALS USED Direct wages Manufacturing royalties

£

126,059 274,700 55,000 329,700 455,759

PRIME COST Add Production (factory) overheads: Factory supervisors’ wages Rates – factory Indirect expenses – factory Factory machinery depreciation

63,150 *4,500 337,171 **40,000

Less increase in work-in-progress PRODUCTION COST Factory profit of 25% PRODUCTION COST OF GOODS COMPLETED (transfer price)

444,821 900,580 580 900,000 225,000 1,125,000

* Rates: £6,400 – £400 prepaid = £6,000, apportioned three-quarters to factory, £4,500, and one-quarter to office, £1,500 ** Factory machinery depreciation: £400,000 x 10%

42

(b)

Closing stock at 31 December 2006: £ £25,600

x

25 100 + 25

=

5,120

Less provision for unrealised profit

4,700

Increase in provision for unrealised profit

420

(c)

£ Gross profit on trading

£ 312,400

Factory profit

225,000

Less increase in provision for unrealised profit

420 224,580

Total gross profit

(d)

9.12

(a)

536,980

Reasons for making a provision for unrealised profit: •

A provision is always required when production is increased with the addition of a factory profit, ie the transfer price to trading account is higher than production cost.

•

As a result of the transfer price, the valuation of finished goods stocks is higher than cost price.

•

Following the prudence concept, the profit element needs to be removed from the valuation of finished goods stocks.

•

IAS 2, Inventories, requires that stock is valued at the lower of cost and net realisable value.

•

In final accounts provision for unrealised profit is dealt with as follows: –

in the profit and loss account, an increase is deducted from the factory profit (and a decrease added) in order to remove the profit element from stock so that profit is not overstated

–

In the balance sheet, the total amount of the provision is deducted from the stock of finished goods in order that the valuation is not overstated and that the balance sheet gives a true and fair view of the business

Finished goods stock at 31 December 2005: £ £31,776

x

20 100 + 20

=

5,296

Finished goods stock at 1 January 2005: £27,804

x

20 100 + 20

=

4,634

Increase in provision for unrealised profit

(b)

662

AMANDEEP PAWAR TRADING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005 £ Sales Opening stock of finished goods Production cost of goods completed (transfer price) Less Closing stock of finished goods COST OF SALES Gross profit

£ 1,430,972

27,804 *864,000 891,804 31,776 860,028 570,944

* £720,000 x (100 + 20)%

43

(c)

SUMMARISED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005 £ £ Gross profit 570,944 Less Administrative expenses 478,221 Profit from trading 92,723 Factory profit **144,000 Less increase in provision for unrealised profit 662 143,338 Net profit 236,061 ** £720,000 x 20%

9.13

(a) (i) Closing stock at 31 March 2008: £31,906

x

40 100 + 40

(ii)

=

£9,116 provision for unrealised profit

S H MATT BALANCE SHEET EXTRACT AS AT 31 MARCH 2008 £ Current Assets Stock – raw materials – work-in-progress – finished goods less provision for unrealised profit adjusted stock of finished goods

£ 10,980 9,946

31,906 9,116 22,790 43,716

(b)

£ 9,116 8,536 580

Provision for unrealised profit at 31 March 2008 Provision for unrealised profit at 31 March 2007 Increase in provision for unrealised profit

In profit and loss account the increase is deducted from the factory profit in order to remove the profit element from stock so that profit is not overstated. (c)

Any two reasons for transferring goods to the trading account at cost plus a profit: •

Enables the factory to make a notional profit which is added into net profit at a later stage.

•

Gives the unit cost of goods manufactured a more realistic value which can be compared with the cost of buying in completed goods from an outside source.

•

By showing a factory profit, the profit from trading activities can be identified separately.

•

The factory and the warehouse become separate profit centres which show the contribution of each to the overall profitability of the business.

CHAPTER 10 Costs and contribution 10.4

(a)

fixed

(b)

variable

(c)

semi-variable

(d)

fixed

(e)

variable

(f)

fixed

(g)

variable

(h)

variable

44

10.5

The following are example figures; each student’s solution will be different. (a) Fixed costs: Advertising Room hire Speakers

Lunch Course materials

(b)

Variable costs:

£15 £10 £25

(c)

If price charged per delegate is £80, then contribution will be £80 – £25 = £55 per delegate

(d)

less equals less equals

10.7

£200 £150 £350 £700

(a)

(b)

£ 2,400 750 1,650 700 950

course fees £80 x 30 people variable costs £25 x 30 people total contribution fixed costs profit for event

Marginal cost per pair of trainers variable costs: direct materials (per pair) direct labour (per pair) marginal cost (per pair)

15 12 27

Contribution per pair of trainers selling price (per pair) less variable costs (per pair) equals contribution (per pair)

£ 40 27 13

(c)

£

John Walker Limited Marginal costing statement: 25,000 pairs of trainers £ sales (25,000 x £40) less variable costs direct materials (25,000 x £15) direct labour (25,000 x £12)

equals less equals

10.8

375,000 300,000 675,000 325,000 245,000 80,000

total contribution fixed costs (overheads) profit on sales of 25,000 pairs

(a)

Contribution is selling price minus variable cost. Total contribution is used to cover, firstly, fixed costs and then profit.

(b)

(i)

Contribution per unit before the proposed purchase of the machinery:

less equals

£ 1,000,000

£ 44 34 10

selling price (per parachute) variable costs £10 + £16 + £8 contribution (per parachute)

45

(ii)

Contribution after the proposed purchase of the machinery: materials labour £9 per hour x 1.5 hours other variable costs variable costs per parachute

less equals

(c)

selling price per parachute variable costs contribution per parachute

£ 10.00 13.50 8.00 31.50 44.00 31.50 12.50

Profitability before purchase of new machinery: sales £44 x 22,000 parachutes less variable costs £34 x 22,000 parachutes equals total contribution less fixed costs equals profit for the year

£

£ 968,000 748,000 220,000 134,000 86,000

Profitability after purchase of new machinery: sales £44 x 22,000 parachutes less variable costs £31.50 x 22,000 parachutes equals total contribution less fixed costs retraining costs

£

£ 968,000 693,000 275,000

equals

134,000 32,000 166,000 109,000

profit for the year

Tutorial note: The increase in profits of £23,000 (£109,000 – £86,000) can also be calculated by reference to the increase in contribution, as follows: £ increase in contribution £2.50* x 22,000 parachutes 55,000 less retraining costs 32,000 equals increased profits 23,000 * £34.00 – £31.50 = £2.50

Notes:

10.10 (a)

(b)

•

If the new machinery is purchased, profitability in the first year increases from £86,000 to £109,000, an increase of £23,000. As the retraining costs are a ‘one-off’, profits in subsequent years will be £32,000 higher.

•

Depreciation on the new machinery will increase fixed costs, so reducing profit.

•

On the information available, the company should purchase the new machinery.

•

Direct costs can be identified directly with each unit of output.

•

Indirect costs (overheads) cannot be identified directly with specific units of output.

Marginal cost of one compass Variable costs per unit:

£

direct labour (£23,000 ÷ 5,000)

4.60

direct materials (£35,000 ÷ 5,000)

7.00

other direct costs (£9,000* ÷ 5,000)

1.80

marginal cost of one compass

13.40

* £21,000 – £12,000 fixed costs

46

(c)

Marginal costing statement

£

sales £20 x 5,000 compasses

less

£ 100,000

variable costs: direct labour

23,000

direct materials

35,000

other direct costs

9,000 67,000

(d)

equals total contribution

33,000

less

fixed costs

12,000

equals profit for the period

21,000

Advantages of producing a marginal costing statement One from: •

contribution, ie selling price less variable cost, is clearly identified

•

identifying the marginal cost of output enables the managers of a business to focus on the contribution provided by the output

•

the effect on costs of changes in sales turnover can be calculated

•

helps with decision-making in the forms of –

costing a project

–

make or buy

–

acceptance of additional work

–

price setting

–

optimum use of scarce resources

CHAPTER 11 Break-even analysis

11.1

units of

fixed costs

variable costs

total cost

output

sales

profit/(loss)*

revenue

£

£

£

£

£

0

7,500

0

7,500

0

(7,500)

500

7,500

2,500

10,000

5,000

(5,000)

1,000

7,500

5,000

12,500

10,000

(2,500)

1,500

7,500

7,500

15,000

15,000

nil

2,000

7,500

10,000

17,500

20,000

2,500

2,500

7,500

12,500

20,000

25,000

5,000

3,000

7,500

15,000

22,500

30,000

7,500

* brackets indicate a loss

47

11.4

(a) •

contribution sales ratio contribution (£)

=

selling price (£)

£15*

= 0.6 or 60%

£25

* selling price £25 – variable cost £10 •

break-even point in units fixed costs (£)

=

£300,000

contribution per unit (£) •

= 20,000 units

£15

break-even point in sales revenue fixed costs (£)

=

£300,000

CS ratio

= £500,000

0.6

check: 20,000 units x selling price £25 per unit = £500,000 •

margin of safety at output of 30,000 units current output – break-even output

= 30,000 – 20,000 30,000

current output

x 100 1

= 33.3%, or 10,000 units, or £250,000 of sales revenue •

number of units to generate a target profit of £100,000 fixed costs (£) + target profit (£)

= £300,000 + £100,000 = 26,667 units £15

contribution per unit (£)

(b)

(c) •

forecast output (30,000 units)

maximum output (40,000 units)

£

£

sales revenue (at £25 each)

750,000

1,000,000

less

variable costs (at £10 each)

300,000

400,000

equals

contribution (to fixed costs and profit)

450,000

600,000

less

monthly fixed costs

300,000

300,000

equals

forecast profit for month

150,000

300,000

contribution sales ratio £10*

=

0.5 or 50%

£20 * selling price £20 – variable cost £10 •

break-even point in units £300,000

=

30,000 units

£10 •

break-even point in sales revenue £300,000

=

£600,000

0.5 check: 30,000 units x selling price £20 per unit = £600,000 •

margin of safety at maximum output of 40,000 units 40,000 – 30,000 40,000

x

100 = 25%, or 10,000 units, or £200,000 of sales revenue 1

48

•

forecast profit at maximum output of 40,000 units £

less equals less equals

sales revenue (at £20 each)

800,000

variable costs (at £10 each)

400,000

contribution (to fixed costs and profit)

400,000

monthly fixed costs

300,000

forecast profit for month

100,000

EMAIL To:

General Manager

From: A2 Student Date: Today

Proposal to reduce selling price Introduction •

This report considers the suggestion from one of the managers that the selling price for our product should be reduced from £25 per unit to £20.

•

The manager has suggested that the effect of this reduction would be to increase output from the forecast of 30,000 units per month to our maximum output of 40,000 units per month.

Report •

•

As can be seen from the workings at current levels of output of 30,000 units per month: –

contribution sales ratio is 60%

–

break-even point is 20,000 units

–

margin of safety is 33.3%

–

forecast profit is £150,000 per month

If the manager’s suggestion is adopted sales will increase to our maximum output of 40,000 units per month; this will give us: –

contribution sales ratio of 50%

–

break-even point of 30,000 units

–

margin of safety of 25%

–

forecast profit of £100,000 per month

Conclusion •

From the data summarised above it can be seen that the manager’s suggestion would reduce our contribution sales ratio, increase the break-even point, and reduce the margin of safety. All of these are all movements in the wrong direction.

•

The main point to note is that forecast profit will fall by £50,000 per month to £100,000 per month, and the volume of output will need to be higher.

•

Although the firm would be working at maximum output if the suggestion is adopted, this does mean that there is no scope to increase output and sales in the future without major changes to our cost structure. We would not be able to meet requests for additional sales from our existing customers, and this could cause them to seek all of their supplies from our competitors.

•

For these reasons, it is recommended that the manager’s suggestion is not undertaken.

49

11.5

(a) Fixed costs

Variable costs per

£

unit in pence

Wages

20

Raw materials

30

Salespeople’s wages

10

Administration costs

42,000

Business rates

20,400

Total

(b)

(c)

(a)

60p

(i)

Contribution per unit = selling price per unit – variable costs per unit

(ii)

Contribution per unit = £1.00 – £0.60 = £0.40

(iii)

Contribution goes, firstly, towards fixed costs and, when they have been covered, secondly, contributes to profit

(i)

Break-even point (units) =

11.8

£62,400

£62,400 £0.40

=

fixed costs (£) contribution per unit (£)

=

156,000 bookmarks

(ii)

Total revenue = 156,000 bookmarks x £1 = £156,000

(iii)

Sales of 150,000 bookmarks are 6,000 below break-even point. There will be a loss of 6,000 x £0.40 contribution = £2,400

A = margin of safety, between 3,500 and 6,000 carpets, ie 2,500 carpets B = area of loss C = profit at maximum capacity of 6,000 carpets D = sales value and total costs, £25,000, at break-even point

(b)

11.9

Disadvantage of using a break-even graph to identify the break-even point, one from: •

the assumption is made that all output is sold

•

the presumption is made that there is only one product

•

all costs and revenues are expressed in straight lines

•

it is not possible to extrapolate the graph

•

the profit or loss shown by the graph is probably only true for figures close to current output levels

•

external factors are not considered

(a)

Marginal cost is the cost of producing one extra unit of output.

(b)

Marginal cost per unit:

£

materials (3 metres at £5 per metre)

£15.00

labour (15 minutes at £12 per hour)

3.00

variable manufacturing overheads

3.00

marginal cost per unit

(c)

21.00

Marginal cost x 1.2 = £21.00 x 1.2 = £25.20 selling price per unit

50

(d)

Break-even in units: fixed costs (£) contribution per unit (£)

=

£52,500 £25.20 – £21.00

= 12,500 units

Break-even revenue: break-even units x selling price per unit = 12,500 units x £25.20 = £315,000

(e)

Usefulness of break-even analysis in decision-making: •

Break-even is the point at which neither a profit nor a loss is made and tells a business the sales (in both units and revenue) that have to be made to meet costs.

•

It provides: –

the profit or loss at any level of output/sales within the range of the analysis

–

the margin of safety, ie the amount by which sales exceed the break-even point

•

It helps a new business to determine selling prices and can be used to support an application for finance.

•

It can be adapted to take note of changes in costs and selling price.

•

However, break-even analysis: –

assumes that all output is sold

–

presumes that there is only one product

–

all costs and revenues are expressed in straight lines

–

cannot be extrapolated

–

the indicated profit or loss is probably only true for figures close to current output levels

–

does not take into account external factors

Conclusion: break-even analysis is useful for giving guidance to a business about individual products, but it does have a number of limitations.

11.11 (a)

fixed costs (£) contribution* per unit (£)

=

break-even point (in units)

* selling price per unit – variable costs per unit

(b)

(i)

Year ended 30 November 2003: £42,250

=

1,625 portraits

£38 – £12

(ii)

Year ended 30 November 2004: £52,000

=

2,000 portraits

£38 – £12

(c)

(d)

•

Increase in fixed costs: £52,000 – £42,250 = £9,750

•

£9,750 ÷ 1,625 portraits at 2003 break-even = £6 extra per portrait

•

Therefore the price of each portrait will need to increase by £6 to £44

•

The price change to £44 is a 16% increase

•

As a result of the increase the demand for portraits may fall to below break-even point

•

The prices charged by competitors may be below that charged by Tracey

•

Tracey should investigate reducing her variable costs and/or see if the increase in fixed overheads can be reduced in any way.

51

CHAPTER 12 Absorption and activity based costing 12.1

(a) (b)

12.2

•

cost units – units of output to which costs can be charged

•

cost centres – sections of a business to which costs can be charged

Suggestions to include: COST UNIT client hour

COST CENTRE partner in firm tax department administration

parcel delivery company

per parcel per kg per mile/kilometre per kg mile (or kilometre)

vehicle depot head office

•

college of further education

student hour

teaching department learning resources administrative office

•

mixed farm

kg of wheat head of cattle

field cattle shed

•

firm of accountants

•

Suggestions to include: 1.

Sections of a theatre which could be used as cost centres: Productions Bar Confectionery Printing and advertising (or marketing) Box office, stewarding and programme sales Administration Maintenance and cleaning of buildings

2.

Sections of a garage which could be used as cost centres: New car sales Used car sales Repairs and servicing Valeting Management and administration

12.4

•

•

Marginal cost per barbecue

£

Direct materials

30.00

Direct labour

25.00

MARGINAL COST

55.00

Absorption cost per barbecue

£

Direct materials

30.00

Direct labour

25.00

PRIME COST

55.00

Overheads (fixed) 150,000 ÷ 10,000 barbecues

15.00

TOTAL COST

70.00

52

•

COOK-IT LIMITED PROFIT STATEMENT: 10,000 BARBECUES £

£

Sales (10,000 x £90)

12.6

900,000

Direct materials (10,000 x £30)

300,000

Direct labour (10,000 x £25)

250,000

PRIME COST

550,000

Overheads (fixed)

150,000

TOTAL COST

700,000

PROFIT

200,000

(a) ACTIVTOYS LIMITED PROFIT STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-1 MARGINAL COSTING £ £ Sales at £125 each

ABSORPTION COSTING £ £

162,500

162,500

Variable costs Direct materials at £25 each

37,500

37,500

Direct labour at £30 each

45,000

45,000

82,500 Less Closing stock (marginal cost*) 200 frames at £55 each

11,000 71,500

CONTRIBUTION

91,000

Fixed production overheads

82,500

82,500 165,000

Less Closing stock (absorption cost*) 200 frames at £110 each

22,000

Less Cost of goods sold

143,000

PROFIT

8,500

19,500

* Closing stock is calculated on the basis of this year’s costs:

marginal costing, variable costs only, ie £25 + £30 = £55 per frame x 200 frames = £11,000 absorption costing, variable and fixed costs, ie £165,000 ÷ 1,500 frames = £110 per frame x 200 frames = £22,000

(b)

Reasons for different profit figures: •

The difference in the profit figures is caused by the closing stock figures: £11,000 under marginal costing and £22,000 under absorption costing – the same costs have been used, but fixed production overheads have been treated differently.

•

Only fixed production overheads are dealt with differently using the techniques of marginal and absorption costing – both methods charge non-production overheads in full to the profit statement in the year to which they relate.

•

With marginal costing, the full amount of the fixed production overheads has been charged in this year’s profit statement; by contrast, with absorption costing, part of the fixed production overheads (here, £11,000) has been carried forward to next year in the stock valuation.

Comment on the directors’ statement: •

A higher profit does not mean more money in the bank.

•

The two costing methods simply treat fixed production overheads differently and, in a year when there is no closing stock, total profits to date are exactly the same – but they occur differently over the years.

53

12.7

(a) DURNING LIMITED PROFIT STATEMENT FOR THE MONTH ENDED 30 APRIL 20-4 MARGINAL COSTING £ £ Sales 8,000 units at £4 each

ABSORPTION COSTING £ £

32,000

32,000

Variable costs Direct materials at £0.80 each Direct labour at £1.60 each

8,000

8,000

16,000

16,000

24,000 Less Closing stock (marginal cost) 2,000 units at £2.40 each

4,800 19,200

CONTRIBUTION

12,800

Fixed production overheads

10,000

10,000 34,000

Less Closing stock (absorption cost) 2,000 units at £3.40 each

6,800

Less Cost of goods sold

27,200

PROFIT

2,800

4,800

Working notes: Closing stock is calculated on the basis of this year’s costs:

marginal costing, variable costs only, ie £0.80 + £1.60 = £2.40 per unit x 2,000 units = £4,800 absorption costing, variable and fixed costs, ie £34,000 ÷ 10,000 units = £3.40 per unit x 2,000 units = £6,800

(b)

The difference in the profit figures is caused only by the closing stock figures: £4,800 under marginal costing, and £6,800 under absorption costing. With marginal costing, the full amount of the fixed production overheads has been charged in this year’s profit statement; by contrast, under absorption costing, part of the fixed production overheads (here £10,000 x 20%* = £2,000) has been carried forward in the stock valuation. * 2,000 units in stock out of 10,000 units manufactured

12.9

(a)

(i)

Fixed production costs ÷ 12,000 units = £90,000 ÷ 12,000 = £7.50 absorption rate per unit

(ii)

Absorption costing: variable production costs per unit + absorption cost per unit = £70.00 + £7.50 = £77.50 production cost per unit

(b)

Budgeted profit for June

£

sales 10,000 units @ £90

900,000

opening stock 500 units @ £77.50

add

£

38,750

production costs 12,000 units @ £77.50

930,000 968,750

less

closing stock 2,500 units @ £77.50

193,750

cost of sales

775,000

gross profit

125,000

less

non-production costs

50,000

equals

budgeted net profit for June

75,000

54

(c)

12.11 (a)

•

Using absorption costing, budgeted net profit for June is £75,000 which is £15,000 higher than the £60,000 profit using marginal costing.

•

With marginal costing, the full amount of fixed production costs of £930,000 has been charged in this month’s profit statement; by contrast, with absorption costing, part of the fixed production costs (here, £7.50 x 2,000 units = £15,000) has been carried forward to next month in the stock valuation.

•

Profit will always be higher under absorption costing in accounting periods of increasing stock levels.

•

However, a higher profit does not mean more money in the bank and, over the longer term, profit is the same under both methods.

•

Under IAS 2, Inventories, Jayne Bonde plc must use absorption costing for its stock valuation, based on the costs of direct materials, direct labour, direct expenses (if any), and production overheads. Note that nonproduction overheads are charged in full to the profit statement to which they relate.

•

It seems unlikely that there will be any effect on the shareholders as marginal costing cannot be used for stock valuation purposes in published accounts.

Activity based costing is a costing method which charges overheads to output on the basis of activities. The cost per unit of a product can be calculated based on its use of activities. The steps to applying activity based costing are:

(b)

12.13 (a)

1.

The overhead costs which are incurred by the same activity are grouped together in cost pools, eg the costs of purchasing goods to be used in production.

2.

The cost driver – the factor which influences the costs – is then identified, and the rate for each cost is calculated, eg the cost of placing a purchase order for goods to be used in production.

3.

The rate for each cost is charged to production, based on the use of the activity, eg if a product requires two purchase orders to be placed, it will be charged with the cost of two activities.

•

Today’s capital intensive, low-labour industries are very different from older industries which are labour intensive, or where production requires the use of heavy machinery. Traditionally, older industries have charged overheads to output on the basis of direct labour hours, or machine hours. Such methods are not appropriate for modern, complex methods of production.

•

In capital-intensive industries, overheads often form a high proportion of total costs and are complex in nature. They need to be accounted for in a more sophisticated way than would be the case under absorption costing, eg absorbing overhead costs under one basis – such as direct labour hours – does not acknowledge the complex nature of the overheads and production processes.

•

Often modern flexible manufacturing methods require short production runs, with the ability to switch from one product to another at short notice. This is in contrast to older industries where the same product is produced over a long production run. These differing production methods impact on costs such as setting up equipment, which will be much larger per unit of output for small production runs than for large ones. Activity based costing is able to charge the cost of overheads to output on the basis of activities – something which absorption costing would not do.

calculation of weekly overheads for set ups and quality inspections £ set ups:

product Aye

5 x £250

1,250

product Bee

50 x £250

12,500

product Aye

5 x £150

750

product Bee

50 x £150

7,500

£

13,750 quality inspection:

8,250 TOTAL

22,000

At present the weekly overheads are charged on the basis of labour hours: £ product Aye (500 hours)

11,000

product Bee (500 hours)

11,000

TOTAL

22,000

55

(b)

activity based costing: £ product Aye 5 set ups at £250 5 quality inspections £150

£

1,250 750 2,000

product Bee 50 set ups at £250 50 quality inspections £150

12,500 7,500 20,000 22,000

TOTAL

(c)

•

By using activity based costing, there is a more accurate reflection of the cost of the activities of set up and quality inspection.

•

The cost of 50,000 units of product Aye is reduced by £9,000 (ie £11,000 – £2,000), while the cost of 50,000 units of product Bee is increased by £9,000 (ie from £11,000 to £20,000).

•

This may well have implications for the viability of product Bee, and for the selling prices of both products.

12.14 Marginal costing

less

equals less equals

• •

sales variable costs: direct materials direct labour

Product Exe £ £ 200,000 60,000 20,000

Product Wye £ £ 160,000 40,000 20,000

80,000 120,000

contribution fixed production costs profit for the week

Total £

60,000 100,000

220,000 36,000 184,000

With marginal costing, the focus is on the contribution – both by product and in total. Fixed production costs are treated as a period cost – ie cost of time (such as a week, as here) rather than being product related.

Absorption costing Product Exe £

less

equals

sales direct materials direct labour PRIME COST fixed production costs TOTAL COST profit for the week

Product Wye

£ 200,000

60,000 20,000 80,000 *18,000

£

£ 160,000

Total £

40,000 20,000 60,000 *18,000 98,000 102,000

78,000 82,000

184,000

* 2,000 direct labour hours for each product per week, so fixed production costs are £36,000 ÷ 2 = £18,000 per product. • •

With absorption costing, the focus is on profit – both by product and in total. Overhead costs are absorbed by production before profit is calculated.

Activity based costing Fixed production costs: product Exe product Wye

• •

set ups number 2 10

set ups: £24,000 ÷ 12 = £2,000 per set up inspections: £12,000 ÷ 12 = £1,000 per inspection

56

£ 4,000 20,000 24,000

inspections number £ 2 2,000 10 10,000 12,000

Product Exe £ sales less

Product Wye £

£

200,000

Total £

£

160,000

direct materials

60,000

40,000

direct labour

20,000

20,000

PRIME COST

80,000

60,000

fixed production costs set ups

4,000

20,000

inspections

2,000

10,000

TOTAL COST equals

profit for the week

86,000

90,000

114,000

70,000

184,000

• With activity based costing, which is a development of absorption costing, the focus is on identifying the overhead costs for a particular activity. • It gives more accurate costing information and shows that smaller batches (as here with product Wye) cost more to produce.

CHAPTER 13 Overheads and overhead absorption 13.3

(a)

Budgeted total overheads (£) Budgeted lecturer hours Budgeted overhead absorption rate (£)

OVERHEAD ANALYSIS SHEET for January 20-8 Accountancy Department 22,143 1,525 14.52

Management Department 17,251 1,300 13.27

OVERHEAD ANALYSIS SHEET Course: Finance for Managers Accountancy Department 45 14.52 653.40

Management Department 20 13.27 265.40

(b)

Lecturer hours Budgeted overhead absorption rate (£) Overhead absorbed by course (£)

13.5

(a) and (b) cost

basis of apportionment

Rent and rates Buildings insurance Machinery insurance Lighting and heating Depn of machinery Supervisory salaries Maintenance dept salary Factory cleaning

Floor area Floor area Value of machinery Floor area Value of machinery No. of employees

Re-apportionment of maintenance dept

total

machining

finishing

maintenance

£ 5,520 1,320 1,650 3,720 11,000 30,000

£ 2,760 660 1,200 1,860 8,000 18,000

£ 1,840 440 450 1,240 3,000 9,000

£ 920 220 – 620 – 3,000

Allocation Floor area

16,000 4,800 74,010

– 2,400 34,880

– 1,600 17,570

16,000 800 21,560

Value of machinery

– 74,010

15,680 50,560

5,880 23,450

(21,560) –

57

(c)

35 hours x 47 weeks = 1,645 direct labour hours per employee Machining Dept: 6 employees = 9,870 hours = £5.12 per direct labour hour Finishing Dept: 3 employees = 4,935 hours = £4.75 per direct labour hour

(d)

Depending on the method and type of production, the company is most likely to use overhead absorption rates based on: • direct labour hours, or • machine hours The OAR selected may vary from one department to another, depending on whether departments are labour-intensive or machine-intensive. The labour hour rate is a popular method because overheads are absorbed on a time basis. However, the machine hour is particularly appropriate where expensive machinery is used in a department.

13.8

(a)

Direct labour hour: (3 hours x 80 seats) + (3.5 hours x 40 seats) = 380 direct labour hours per month = £2.63 per hour. Machine hour: (1 hour x 80 seats) + (2.5 hours x 40 seats) = 180 machine hours per month = £5.56 per hour. Alternative methods could be based on a percentage of certain costs, eg direct labour.

(b)

Direct labour hour 'Standard'

£36.50 + £7.89

=

£44.39

'De Luxe'

£55.00 + £9.21

=

£64.21

'Standard'

£36.50 + £5.56

=

£42.06

'De Luxe'

£55.00 + £13.89

=

£68.89

Machine hour

Note: some figures have been rounded to the nearest penny

(c)

See text. The machine hour rate charges most to 'de luxe' model. On balance, direct labour hours may be the best method to use because the products are more labour-intensive than machine-intensive.

13.10 total

Overheads Administration Operating theatre

£ 112,195 –

day care ward £ 28,750 1,650

surgical ward £ 42,110 4,125

– 112,195

20,320 50,720

15,240 61,475

total £ 25,000 –

tables £ 12,000 1,500

chairs £ 8,000 1,200

– 25,000

1,380 14,880

920 10,120

operating theatre £ 32,260 3,300 35,560 (35,560) –

administration

stores £ 3,000 (3,000) – – –

maintenance £ 2,000 300 2,300 (2,300) –

£ 9,075 (9,075) – – –

13.11

Overheads Stores Maintenance

58

59

Net book value Floor space Floor space Allocated Allocated

Depreciation of fixed assets

Rent

Other property overheads

Staff costs

Administration overheads

(b)

62,055

21,580

2,600

16,900

3,900

13,000

23,575

6,500

17,075

6,850

450

1,000

–

(13,000)

13,000

18,980

9,975

900

2,000

840

£

Administration

62,055

7,390

1,350

3,000

4,200

£

Servicing

3,860

11,080

1,800

4,000

1,260

£

Used Car Sales

3,860

35,295

4,500

10,000

2,100

£

£ 8,400

New Car Sales

Total

Budgeted fixed overhead absorption rate for the servicing centre: £23,575 ÷ 1,025 hours = £23.00 per direct labour hour

Administration

Basis

(a)

Fixed overheads for four weeks ended 28 April 20-4

13.12

13.13 (a)

Labour hour method Expected number of labour hours, 26,000 units x 3 labour hours per unit = 78,000 hours

total cost centre overheads

=

total labour hours

(b)

£39,000

=

£0.50 per labour hour

78,000 hours

Selling price per unit, using cost-plus pricing £ direct materials

40 metres at £2.50 per metre

direct labour

3 hours at £16 per hour

fixed overheads

3 hours at £0.50 per hour

total cost

plus equals

(c)

100.00 48.00 1.50 149.50

mark-up of 20%

29.90

selling price per unit

179.40

Advantages of using absorption costing to set selling price •

As absorption costing calculates a total cost – variable costs and fixed costs – all overheads are recovered in the selling price.

•

Overhead absorption rates are often based on either machine hours or labour hours – whilst these may not be entirely accurate, they provide a good estimate of overhead costs.

•

The percentage cost-plus mark-up can be varied to suit market conditions but, provided the business sets selling price above total cost, a profit will be made.

Advantages of using marginal costing to set selling price •

As marginal costing focuses on variable costs and contribution it can be a more flexible way of setting selling prices.

•

Variable costs represent the starting point for setting selling prices but Dario Uno must recover the fixed overheads from total sales – even if different prices are charged to different customers – in order to make a profit.

Tutorial note •

In order to set the same selling price under absorption costing and marginal costing, the cost-plus mark-up will be different – it will be lower for absorption costing (being a mark-up on total cost), and higher for marginal costing (being a mark-up on variable cost).

60

61

machine net book value machine hours

Factory machinery depreciation

Machine maintenance

44,860

102,400

57,540

5,040

900

51,600

16,000

8,000

9,600

18,000

£

Assembly

–

(6,300)

300

6,000

–

–

–

6,000

£

Maintenance

Tutorial note: canteen costs are re-apportioned before maintenance because it does not receive any services from the maintenance department.

1,260

–

Maintenance

1,800

41,800

102,400 –

24,000

4,000

4,800

40,000

12,000

14,400

9,000

£

£ 36,000

Machining

Total

Canteen

number of set-ups

number of employees

Factory canteen expenses

Machine set-up costs

Basis

(c)

Fixed overheads for 2006

13.14

–

–

(3,000)

3,000

–

–

–

3,000

£

Canteen

(d)

Machining department The method to be used in this department is labour hour, because the department is more labour-intensive than machineintensive. total machining department overheads

=

total labour hours

£44,860

=

approx £1.12 per labour hour

40,000 hours

Assembly department The method to be used in this department is machine hour, because the department is more machine-intensive than labourintensive. total assembly department overheads total machine hours (e)

=

£57,540

=

approx £0.96 per machine hour

60,000 hours

Cost drivers are activities which cause costs to be incurred. Activity based costing uses cost drivers linked to the way in which the business is conducted in order to charge costs – through cost pools – to activities.

(f)

•

for factory canteen expenses the cost driver will be the number of employees

•

for factory machine maintenance the cost driver will be the number of machine hours

•

for factory machine set-up costs the cost driver will be the number of machine set-ups

CHAPTER 14 Costing in decision-making

14.1

There are a wide range of marginal costing applications in the service businesses mentioned. For example: •

•

•

•

hotel – ‘bargain break’ weekends to make use of rooms occupied by business people during the week – last minute bookings, which are discounted from the normal tariff transport – season tickets – weekend fares – cheaper fares after the morning rush – discounts for categories of people in slack travel months cinema or theatre – standing or cheap tickets released only on the day of the performance – ‘half-price’ ticket booths on day of performance – special cheap ticket deals with transport companies – family tickets holiday companies – discounts for last minute bookings to fill empty places on planes and at hotels – discounts for early bookings, which help with planning the travel companies’ operations – special deals with transport companies – off-peak prices Consider also the benefits and restrictions/problems for both the customer and the supplier. Often only a limited number of products are available at special prices, or there are restrictions on the time that they are available. The major disadvantage for the supplier is that those customers who have paid the full price will be disgruntled when they learn the lower price paid by others.

62

14.2

In-house manufacture Marginal cost of manufacture per pump motor:

£

direct materials

40.00

direct labour

25.00

variable overheads

20.00

marginal cost

85.00

The marginal cost of making 3,500 pump motors per year: 3,500 units at £85

plus

£ = 297,500

contribution which will be lost from ‘olde worlds’ handpumps: 750 units at £250 – £150

=

75,000

= 372,500

Buying in cost from outside supplier 3,500 units at £95

= 332,500

Therefore, by buying in pump motors from an outside supplier, the company has the potential to increase profits by £40,000 (£372,500 – £332,500).

14.5

(a)

Absorption cost per seat (based on sixty seats sold) £ direct materials

£12.50 x 60

direct labour

£10.00 x 60

600.00

£2.50 x 60

150.00

direct expenses fixed overheads

3,500.00

TOTAL COST

5,000.00

The absorption cost per seat is £5,000 ÷ 60 (b)

(c)

750.00

=

Marginal cost per seat direct materials direct labour direct expenses MARGINAL COST (per seat)

£83.33

£ 12.50 10.00 2.50 25.00

Profit or loss if no further tickets sold revenue 60 seats at £100 each less total cost (see above) PROFIT

£ 6,000.00 5,000.00 1,000.00

63

(d) MERCIA AIRWAYS profit statement for flight MA 005 60 seats sold £

60 seats + 30 sold to travel firm £

60 seats + 40 sold to newspaper £

6,000

6,000

6,000

30 seats at £45 each

–

1,350

–

40 units at £35 each

–

–

1,400

6,000

7,350

7,400

Direct materials (£12.50 per passenger)

750

1,125

1,250

Direct labour (£10 per passenger)

600

900

1,000

Sales revenue for flight: 60 seats at £100 each

Less costs:

Direct expenses (£2.50 per passenger)

150

225

250

Fixed overheads

3,500

3,500

3,500

PROFIT

1,000

1,600

1,400

Flight MA 005 to Rome •

•

Two proposals for the 40 unsold seats on next week’s flight: –

to sell approximately 30 seats at £45 each to the travel firm

–

to sell all 40 seats to the local newspaper at £35 each

The profit statement shows –

if no further seats are sold the profit will be £1,000

–

if sold to the travel firm, the contribution (selling price – marginal cost) is 30 seats x (£45 – £25) = £600, which gives a profit figure of £1,600

–

if sold to the newspaper, the contribution is 40 seats x (£35 – £25) = £400, which gives a profit figure of £1,400

Conclusion

14.6

(a)

•

The offer from the travel firm should be taken up, while the newspaper offer should not be considered on this occasion.

•

With contributions of £20 per seat from the travel firm and £10 from the newspaper, provided that the flight firm can sell more than 20 seats, the contribution will be greater than that from the newspaper.

Absorption cost

£

direct materials (per pair)

20.00

direct labour (per pair)

18.00

fixed overheads

16.00

(£200,000 ÷ 12,500 pairs)

ABSORPTION COST (per pair)

54.00

Marginal cost

£

direct materials (per pair)

20.00

direct labour (per pair)

18.00

MARGINAL COST (per pair)

38.00

Profit or loss at existing production of 12,500 pairs of boots, see below.

64

(b) THE LAST COMPANY LTD profit statements Existing production 12,500 pairs of boots £

Existing production + 2,500 pairs @ £45 each £

Existing production + 5,000 pairs @ £37 each £

12,500 pairs at £60 each

750,000

750,000

750,000

2,500 pairs at £45 each

–

112,500

–

5,000 pairs at £37 each

–

–

185,000

750,000

862,500

935,000

250,000

300,000

350,000

Sales revenue (per week):

Less production costs: Direct materials (£20 per pair) Direct labour (£18 per pair)

225,000

270,000

315,000

Fixed overheads

200,000

200,000

200,000

75,000

92,500

70,000

PROFIT

Offer from Zambesi Limited •

•

Two contracts offered by Zambesi Limited for the ‘Snowdon’ range: –

either 2,500 pairs at £45 per pair

–

or 5,000 pairs at £37 per pair

The profit statement for planned sales, together with the two offers shows: –

if either offer is not taken up, profits next year are expected to be £75,000

–

if 2,500 pairs sold to Zambesi at £45 per pair, the contribution (selling price – marginal cost) is 2,500 x (£45 – £38) = £17,500; thus profits increase by £17,500 to £92,500

–

if 5,000 pairs sold to Zambesi at £37 per pair, the contribution is 5,000 (£37 – £38) = (£5,000); this price of £37 is below our marginal cost of £38; thus profits fall by £5,000 to £70,000

Conclusion •

The offer of 2,500 pairs at £45 per pair should be taken up, while the offer of 5,000 pairs at £37 should be rejected. This follows the principle that, once the fixed overheads have been recovered from normal sales, provided that additional units can be sold at a price above marginal cost, then profits will increase.

14.10 (a)

Product

‘People’ £

Selling price per unit

60

‘Animals’ £

27.50

‘Birds’ £

17.50

Less: Unit variable costs Direct materials

5

3

2

Direct labour

15

5

3.33

Variable overheads

10

4.50

2.96

Contribution per unit

30

65

15

9.21

(b)

Break-even point for the ‘People’ range is: fixed costs (£) contribution per unit (£)

= £45,400 £30

= 1,514 units

(c)

Product

(d)

‘People’

‘Animals’

‘Birds’

Contribution per unit

£30

£15

£9.21

Labour hours per unit

1.5

0.5

0.333

Contribution per labour hour

£20

£30

£27.66

•

Labour hours are the scarce resource here, with 2,800 hours available.

•

To maximise profits, the company should maximise the contribution from each labour hour.

•

The preferred order is ‘Animals’ (at £30 contribution per labour hour), ‘Birds’ (at £27.66), and ‘People’ (at £20).

•

Optimum production plan:

less

Total hours available per month

2,800

‘Animals’, 2,000 units x 0.5 hours per unit

1,000 1,800

less

‘Birds’, 2,700 units x 0.333 hours per unit

900

equals

hours remaining to produce units of ‘People’

900

Therefore production of ‘People’ at 1.5 hours per unit will be 600 units per month. This production plan does not allow for full production of the ‘People’ range.

14.12 (a)

(i)

sales revenue – variable costs = contribution

(ii)

sales revenue – variable costs = contribution per unit number of units £

(b)

(i)

Ink pen £8.00 – £6.20 = £1.80 contribution x 4,200 units

=

7,560

Novelty ruler £2.50 – £0.60 = £1.90 contribution x 8,400 units

=

15,960

Total contribution (ii)

23,520

Ink pens £1.80 contribution x 3,000 units

=

5,400

Novelty rulers £1.90 contribution x 6,000 units

=

11,400

Bought in: ink pens £8.00 – (£3.10 + £4.00) = £0.90 contribution x 1,200 units

=

1,080

novelty rulers £2.50 – (£0.40 + £1.10) = £1.00 contribution x 2,400 units

=

2,400

Total contribution

(c)

20,280

•

The bought-in goods give a positive contribution of £0.90 for the pen and £1.00 for the ruler; these amounts will contribute to fixed costs and profit.

•

By buying-in goods Drew Armstrong is able to satisfy the demand from customers who will not seek out an alternative supplier.

•

Drew must be sure of the quality of the bought-in goods, the timing of deliveries, and the reliability of the supplier.

66

(d)

14.13 (a)

(b)

See also chapter 18: •

The current staff may be resistant to retraining on the new machine.

•

The staff will be demotivated until they know who is to be made redundant and who is to be retrained; some staff may seek work elsewhere.

•

The staff to be retrained may seek a pay rise on account of their increased skills.

•

Once retrained, staff will have transferable skills useful to other employers who may seek to recruit them.

•

Staff may see increased production as a positive sign that their jobs are safe. They may be concerned about the effect of the loan interest and repayments for the machine on the financial viability of the business.

•

Fixed costs remain fixed over a range of output levels and vary with time rather than activity levels, eg rent, insurance.

•

Semi-variable costs include both a fixed and a variable element, eg utility bills such as telephone, fuel.

•

Variable costs vary directly with output, eg direct materials, royalties, direct labour.

Sales revenue – variable costs = contribution. £

(c)

less

selling price £40 per unit x 12,000 units

480,000

variable costs £12 per unit x 12,000 units

144,000

variable overheads £1.50 per unit x 12,000 units

equals

(d)

total contribution for year to 31 May 2007

fixed costs (£) contribution per unit (£)

=

£256,500 – £18,000 variable costs £318,000 ÷ 12,000 units

£238,500 £26.50

=

9,000 units to break-even

(e)

18,000 318,000

Profit statements for each new order for the year ended 31 May 2008 Order JJH 6,000 units £ Sales JJH £180,000/6,000 = £30 per unit; JHB £256,000/8,000 = £32 per unit

180,000

256,000

Variable costs £14 x 6,000 (JJH) or 8,000 (JHB) units

(84,000)

(112,000)

Variable overheads £1.50 x 6,000 (JJH) or 8,000 (JHB) units

(9,000)

(12,000)

Delivery charges JJH 2% of £180,000; JHB 2.5% of £256,000

(3,600)

(6,400)

Machinery modification

(19,000)

–

Staff retraining

(8,000)

–

Overseas agent

(14,000)

(14,000)

Temporary staff

–

(28,000)

42,400

83,600

PROFIT FROM EACH NEW ORDER

(f)

Order JHB 8,000 units £

Note that the factory is currently operating at 60 per cent of capacity: current production is 12,000 units, so maximum capacity is 20,000 units, ie an increase of 8,000 units.

Order JJH •

Although profit on this order is lower than for JHB, future orders “are almost guaranteed”.

•

In the year to 31 May 2008, one-off costs of machinery modification and staff retraining are £27,000. Provided no further such costs are incurred, the profit of subsequent years will be £42,400 + £27,000 = £69,400 from this order.

•

Staff retraining will motivate the staff but will also give them transferable skills useful to other employers who may seek to recruit them.

•

Staff may seek a pay rise once they have been retrained.

•

Staff may see increased production as a positive sign that their jobs are safe.

67

•

With a selling price of £30 per unit, this order gives a positive contribution, £30 – £15.50 (£14 + £1.50) = £14.50 to delivery charges and fixed costs.

•

It utilises spare capacity, but leaves 2,000 further units of spare capacity.

•

Although the selling price is £30 instead of the normal selling price of £40, the company is already past the break-even point with its normal sales.

Order JHB •

This is a ‘one-off’ order which utilises the full capacity of the factory, and so prevents future growth of the business for the year to 31 May 2008.

•

With a selling price of £32 per unit, this order gives a positive contribution, £32 – £15.50 (£14 + £1.50) = £16.50 to delivery charges and fixed costs.

•

Profit is higher than for JJH but is likely to be for one year only.

•

Temporary staff will need to be employed, helping the local economy, in the short-term.

•

For this order, the product will need to be modified – management needs to ensure that the modifications are within the capabilities of the staff.

Conclusion The order from JJH is to be preferred provided that there is the likelihood of future orders. This will safeguard the jobs of current employees and may enable the company to expand in the future. Although profit will be lower than JHB in the first year, this will be more than made up by the second year order.

14.14 (a)

less

PRODUCT

Caz

Jaz

Selling price per unit

£42

£45

Unit variable costs per unit Caz, materials £18, direct labour £16

£34

Jaz, materials £12, direct labour £24

equals

£36

Contribution per unit Direct labour hours per unit

£8

£9

2 hours

3 hours

£4

£3

Contribution per direct labour hour

(b)

•

Labour hours are the scarce resource, with 42,000 hours available.

•

To maximise profits, the company should maximise the contribution from each labour hour.

•

The preferred order is Caz (at £4 contribution per labour hour) and Jaz (at £3).

•

Optimum production plan: Total hours available per year

42,000

less

Caz, 12,000 units x 2 hours per unit

24,000

equals

hours remaining to produce units of Jaz

18,000

Therefore production of Jaz at 3 hours per unit will be 6,000 units. In summary:

Production plan Caz

12,000 units

Jaz

6,000 units

68

(c)

The shortfall in Jaz is 2,000 units (8,000 – 6,000): £ Selling price per unit

less

45.00

Buying-in price per unit £38 + *£5.70 delivery charge

equals

Contribution per unit

43.70 1.30

* £38 x 15% This contribution will increase profit by £2,600 (£1.30 x 2,000 units) and will be worthwhile –

to maintain market share

–

to retain customers

provided that –

quality can be assured

–

delivery dates can be relied upon

14.16 (a)

PRODUCT Selling price per unit

less

JHB1

JJH2

£50

£50

Unit variable costs per unit JHB1, labour £32, materials £8

£40

JJH2, labour £16, materials £16

equals

Contribution per unit Direct labour hours per unit Contribution per labour hour

£32 £10

£18

4 hours

2 hours

£2.50

£9

2

1

Ranking

•

Labour hours are the scarce resource, with 80,000 hours available.

•

Optimum production plan: Total hours available per year

80,000

less

JJH2, 20,000 units x 2 hours per unit

40,000

equals

hours remaining to produce units of JHB1

40,000

Therefore production of JHB1 at 4 hours per unit will be 10,000 units. (b)

Shortfall in JHB1 is 5,000 units (15,000 – 10,000): £ Selling price per unit

50

less

Buying-in price per unit

45

equals

Contribution per unit

5

This contribution will increase profit by £25,000 (£5 x 5,000 units) and will be worthwhile –

to maintain market share

–

to retain customers

provided that –

quality can be assured

–

delivery dates can be relied upon

69

(c)

Contribution: JHB1 JJH2

£ 10,000 units @ £10 per unit

100,000

5,000 units @ £5 per unit

25,000

20,000 units @ £18 per unit

360,000 485,000

less

Fixed costs

equals

Profit

420,000 65,000

CHAPTER 15 Standard costing and variance analysis

15.1

(a)

Standard costing sets a pre-determined/budgeted cost for materials, labour and overheads in advance of production. Many businesses establish a standard or budgeted cost for their output in advance of production. Standard costs can then be compared with actual costs and variances calculated.

(b)

The main advantages of standard costing are that it can be used: •

to help with decision-making – for example, with price setting

•

to assist in planning – for example, to plan the quantity and cost of resources needed for production

•

as a means of controlling costs – standard costs are compared with actual costs and variances calculated so that action can be taken by the responsible manager or department when appropriate

15.4

Material A

Material B

£ p

£ p

Material C £ p

Material D £ p

material price variance

120.00 FAV

200.00 ADV

500.00 FAV

250.00 ADV

material usage variance

100.00 ADV

400.00 FAV

1,000.00 FAV

100.00 FAV

20.00 FAV

200.00 FAV

1,500.00 FAV

150.00 ADV

materials variance

15.5

Product 1

labour rate variance labour efficiency variance labour variance

15.6

(a)

Product 2

Product 3

£ p

£ p

7.00 ADV

4.00 ADV

15.00 FAV

15.00 ADV

10.00 FAV

9.00 ADV

72.00 ADV

48.00 ADV

3.00 FAV

13.00 ADV

57.00 ADV

63.00 ADV

Material price variance 800 kg x (75p – 80p)

=

£40 ADVERSE

75p per kg x (900 kg – 800 kg)

=

£75 FAVOURABLE

TOTAL MATERIALS VARIANCE

=

£35 FAVOURABLE

Material usage variance

Labour rate variance 140 hours x (£10 – £11)

=

£140 ADVERSE

£10 per hour x (150 hours – 140 hours)

=

£100 FAVOURABLE

TOTAL LABOUR VARIANCE

=

Labour efficiency variance

£40 ADVERSE

70

£ p

Product 4 £ p

(b)

15.8

(a)

•

the managers responsible for each section of the business will be asked to explain the reason for any significant variances of their section

•

the buying department should explain the 5p per kilo adverse variance in the cost of materials – perhaps better quality materials have been purchased, or there has been a price increase, or there has been an adverse exchange rate fluctuation

•

the production department should explain the favourable variance in materials usage – perhaps better quality materials have been used with less wastage, or the workforce is better trained in using the materials

•

the human resources department will need to explain the £1.00 per hour higher labour rate – perhaps there has been a pay rise; alternatively, overtime rates may have had to be paid, which the production department will be asked to explain

•

the production department should be asked to explain the favourable variance in labour efficiency – perhaps more use has been made of machines, or the workforce is better trained, or better quality materials have been used

•

it may be that variances are linked, eg more expensive materials have less wastage; skilled employees (on higher pay rates) work more efficiently

•

corrective action may need to be taken in some areas despite the overall favourable variance in total cost

(i)

Material price variance: actual quantity x (standard price – actual price) 60,000 metres x (£8.00 – *£9.75)

=

£105,000 ADVERSE

* £585,000 ÷ 60,000 metres

Material usage variance: standard price x (standard quantity – actual quantity) £8.00 x (*66,000 metres – 60,000 metres)

=

£48,000 FAVOURABLE

=

£0 NO VARIANCE

* 12,000 units produced x 5.5 metres per unit

(ii)

Labour rate variance: actual labour hours x (standard rate – actual rate) 60,000 hours x (£6 – *£6) * £360,000 ÷ 60,000 hours

Labour efficiency variance: standard rate x (standard hours – actual hours) £6 per hour x (*52,000 hours – 60,000 hours)

=

£48,000 ADVERSE

* 12,000 units produced x 4 hours 20 minutes (note 20 minutes = 1/3rd of an hour) = 48,000 hours + 4,000 hours = 52,000 hours

(b)

JAYNE BONDE PLC VARIABLE PRODUCTION COSTS RECONCILIATION STATEMENT FOR MAY £

£

ADV

FAV

£

Materials: 5.5 metres x £8 per metre x 12,000 units produced

528,000

Labour: 4 hours 20 minutes x £6 per hour x 12,000 units produced

312,000

Budgeted variable production costs

840,000

Material price variance

105,000

Material usage variance

48,000

Labour efficiency variance

48,000 153,000

Actual variable production costs

48,000

105,000 945,000

Remember: because we are dealing with costs, adverse variances are added and favourable variances are deducted.

71

(c)

15.10 (a)

•

As the material price variance is adverse this could indicate that the material is of better quality which has led to a favourable material usage variance because there is less wastage.

•

However, the labour efficiency variance is adverse which may have been caused by the workforce spending longer and taking more care with the product; alternatively a lower grade of labour may have been used which does not have sufficient skills.

Material price variance: actual quantity x (standard price – actual price) 80,000 kg x (£18 – *£15)

=

£240,000 FAVOURABLE

* £1,200,000 ÷ 80,000 kg

Material usage variance: standard price x (standard quantity – actual quantity) £18 x (*76,200 kg – 80,000 kg)

=

£68,400 ADVERSE

=

£30,000 FAVOURABLE

=

£58,080 ADVERSE

* 15,240 units produced x 5 kg per unit

(b)

Labour rate variance: actual labour hours x (standard rate – actual rate) 15,000 hours x (£12 – *£10) * £150,000 ÷ 15,000 hours

Labour efficiency variance: standard rate x (standard hours – actual hours) £12 per hour x (*10,160 hours – 15,000 hours)

* 15,240 units produced x 40 minutes (2/3rd of an hour) per unit

(c)

A J DAN PLC: COSTS RECONCILIATION STATEMENT FOR APRIL 2008 £

£

ADV

FAV

Materials: 5 kg x £18 per kg x 15,240 units

£

1,371,600

Labour: 40 minutes x £12 per hour x 15,240 units

121,920

Budgeted total cost

1,493,520

Material price variance

240,000

Material usage variance

68,400

Labour rate variance

30,000

Labour efficiency variance

58,080 126,480

Actual total cost

270,000

(143,520) *1,350,000

* Materials £1,200,000 + labour £150,000

Remember: because we are dealing with costs, adverse variances are added and favourable variances are deducted.

(d)

The costs reconciliation statement is used to: –

link the budgeted total cost with the actual total cost

–

identify whether the actual total cost of output is greater or less than the standard cost of the output

–

show the effect of variances on the total budgeted costs

–

list the amounts of the variances – and whether they are adverse or favourable – and bring them to the attention of management so that they can take appropriate action

72

15.13 (a)

Sales price variance: actual quantity x (standard price – actual price) 18,000 units x (£5 – *£6)

=

£18,000 FAVOURABLE

=

£10,000 ADVERSE

* £108,000 ÷ 18,000 units

(b)

Sales volume variance: standard price x (standard quantity – actual quantity) £5 x (20,000 – 18,000)

(c)

ZELAH LTD SALES RECONCILIATION STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-9 £ Forecast sales (20,000 units at £5 per unit)

(d)

100,000

add

Sales volume variance

less

Sales price variance

(10,000)

Actual sales (18,000 units at £6 per unit)

108,000

18,000

Sales price variance: –

higher selling price than expected

–

less competition, or

–

smaller discounts offered to customers

Sales volume variance: –

fewer sold than expected

–

either higher price has been charged than competitors

–

or competitors are seeking to gain market share by reducing their selling prices

CHAPTER 16 Capital investment appraisal

16.4

(a)

payback period

PROJECT ESS Year

Cash Flow

PROJECT TEE Cash Flow

£

Cumulative Cash Flow £

£

Cumulative Cash Flow £

0

(100,000)

(100,000)

(115,000)

(115,000)

1

40,000

(60,000)

50,000

(65,000)

2

60,000

–

35,000

(30,000)

3

20,000

20,000

30,000

–

4

20,000

40,000

30,000

30,000

5

*15,000

55,000

*37,500

67,500

* includes scrap value

73

net present value

PROJECT ESS Year

PROJECT TEE

Discount Factor

Cash Flow £

Discounted Cash Flow £

Cash Flow £

Discounted Cash Flow £

0

1.000

(100,000)

(100,000)

(115,000)

(115,000)

1

0.909

40,000

36,360

50,000

45,450

2

0.826

60,000

49.560

35,000

28,910

3

0.751

20,000

15,020

30,000

22,530

4

0.683

20,000

13,660

30,000

20,490

5

0.621

15,000

9,310

37,500

23,290

Net Present Value

23,910

25,670

(b) REPORT To:

Managing Director

From:

A2 Accounting Student

Date:

Today

Capital investment projects: Ess and Tee This report carries out an appraisal of these two projects, based on the information provided. Two techniques are used: • payback • net present value The first of these, payback, sees how long it takes for the initial outlay of the project to be repaid by the net cash flow coming in. For Project Ess, the payback period is two years; for Project Tee, it is three years. Using this technique, Project Ess is more favourable. Payback is an easy technique both to calculate and understand. However, it does have the disadvantage of ignoring all cash flows after the payback period. With these two projects, Tee has strong cash inflows in years 4 and 5, after the payback period (however, these could be a disadvantage if the project is likely to go out-ofdate soon). The net present value technique relies on discounting relevant cash flows at an appropriate rate of return, which is 10 per cent for these projects. Net present value is a more sophisticated technique than payback in that it uses all cash flows and takes the timing of cash flows into account. However, the meaning of NPV is not always clear, and the rate of return required on the projects may vary over their life. Project Tee has a higher net present value (but also a higher initial cost) at £25,670, when compared with Ess at £23,910. The fact that both figures are positive means that either project will be worthwhile. However, Project Ess is to be preferred because: –

it has the faster payback

–

the initial capital outlay is smaller

–

it has strong cash flows in the early years, which are likely to be more accurate than the amounts for later years

74

16.5

(a)

THE CHESTER CARPET COMPANY Working paper for the financial appraisal of a new machine for the production department DISCOUNTED CASH FLOW

Year

Cash Flow

Discount Factor at 10%

Discounted Cash Flow

£

£

0

(65,000)

1.000

(65,000)

1

17,000

0.909

15,453

2

25,000

0.826

20,650

3

31,000

0.751

23,281

4

*28,000

0.683

19,124

Net Present Value

13,508

* £24,000 + £4,000 scrap value

PAYBACK PERIOD

Year

Cash Flow

Cumulative Cash Flow

£

£

0

(65,000)

(65,000)

1

17,000

(48,000)

2

25,000

(23,000)

3

31,000

8,000

4

28,000

36,000

£23,000* required

* £31,000 – £8,000

Payback period = 2 years + (£23,000/£31,000) = 2 years and 8.9 months/2 years and 38.6 weeks/2 years and 270.8 days

(b)

REPORT To:

General Manager

From:

A2 Accounting Student

Date:

Today

Purchase of a new machine for the production department This report carries out an appraisal of the above project. The proposal to purchase the new machine is acceptable from a financial viewpoint because it returns a positive net present value of £13,508 at a discount rate of 10%. This calculation assumes that all cash flows occur at the end of each year. The payback period is during year 3. Assuming even cash flows during the year, the payback period is 2 years and 8.9 months/2 years and 38.6 weeks/2 years and 270.8 days. This is acceptable since it is shorter than the company requirement of three years, although there is not a great deal of room for error in the cash flow calculations.

75

16.6

(a)

The net cash flows are: £ year 0

(110,000)

year 1

20,000

year 2

60,000

year 3

80,000

year 4

80,000

year 5

85,000

payback period

Year

Cash Flow £

Cumulative Cash Flow £

0

(110,000)

(110,000)

1

20,000

(90,000)

2

60,000

(30,000)

3

80,000

50,000

4

80,000

135,000

5

85,000

220,000

∴ £30,000 required

The development costs are recovered in the first half of year 3: £20,000 + £60,000 + (£30,000/£80,000). Thus the payback period is 2 years and 4.5 months/2 years and 19.5 weeks/2 years and 136.9 days. Note that these assume even cash flows during the year.

net present value

Year

Cash Flow

Discount Factor

£

Discounted Cash Flow £

0

(110,000)

x

1.000

(110,000)

1

20,000

x

0.909

18,180

2

60,000

x

0.826

49,560

3

80,000

x

0.751

60,080

4

80,000

x

0.683

54,640

5

85,000

x

0.621

52,785

Net Present Value

76

125,245

(b)

REPORT To:

Managing Director

From:

A2 Accounting Student

Date:

Today

Development of new product: ‘Zelahcold’ This report carries out an appraisal of the project, based on the information provided. It would be relevant to know: 1.

whether there are any additional cash flows beyond year 5

2.

whether the introduction of ‘Zelahcold’ will affect sales of our existing products

The net present value technique relies on discounting relevant cash flows at an appropriate rate of return – 10 per cent for this project. The proposal to develop the new product is acceptable from a financial viewpoint because it returns a positive net present value of £125,245 at a discount rate of 10 per cent. This calculation assumes that all cash flows occur at the end of each year. The payback period is 2 years and 4.5 months/19.5weeks/136.9 days. These calculations assume even cash flows during the year. Both project appraisal methods show that the project meets with the company’s criteria of: •

a positive net present value at a discount rate of 10 per cent, and

•

a maximum payback period of three years

These show that, from a financial viewpoint, the project should be carried out.

16.7

(a)

Net cash inflow per month: £

less

14,000 units at £90 each

1,260,000

total costs

1,130,000

cash inflow per month

130,000

∴ cash inflow per year £130,000 x 12

1,560,000

Payback period: cost of machinery cash flow per year

= £2,400,000 x 365 days = £1,560,000

561.54 days = 1 year, 196.5 days Tutorial note: the examiner will also accept the answer given in weeks, 1 year and 28 weeks, and months, 1 year and 6 months.

(b)

Any two limitations of payback: •

all cash flows after the payback period are ignored

•

within the payback period the timing of receipts and payments is not considered

•

the effects of inflation are ignored

•

the time value of money is ignored

•

the life of the asset is not considered

77

16.9

(a) Net present value of new machine

Year

Cash Flow

Discount Factor

Discounted Cash Flow

£

£

0

(350,000)

x

1.000

=

(350,000)

1

144,000

x

0.877

=

126,288

2

144,000

x

0.769

=

110,736

3

144,000

x

0.675

=

97,200

4

144,000

x

0.592

=

85,248

=

69,472

Net Present Value

current production (units) per year x 120% x 6,000 units per year

(b)

profit per unit

= cash flow per year

x 120% x £20 profit (£80 – £60)

= £144,000 per year

On the basis of net present value, the new machine should be purchased.

Advantages: –

There is a positive net present value over the four years for which information is given.

–

There is a further six years when, subject to economic conditions, cash flow should continue to be generated.

–

Payback is 2 years and 157 days, leaving a further 7.5 (approx) years to generate cash flow.

Disadvantages:

16.12 (a)

–

Can purchase of the new machine be justified when the old machine has four years’ economic life remaining?

–

Will the quality of the output from the new machine be as good as/better than from the old machine?

–

Will Roberta be able to sell the increased output of 1,200 units per year? If not, and output/sales continue at 6,000 units per year, cash flow will be £120,000 per year. This gives a payback of 2 years and 335 days, and a negative net present value of £440 at the end of year 4.

–

Will the market continue for the product over the next ten years?

–

The new machine will need financing – is this available?

–

Will there be any proceeds from the sale of the old machine?

–

The cost of capital is high at 14% – is lower cost finance available?

–

Borrowing will increase the gearing of the business and may make it less attractive to investors.

–

The estimates of cash flows may be inaccurate.

–

Staff may need to be retrained.

Year

Machine A

Machine B

£

£

0

(30,000)

(80,000)

1

*18,000

†30,000

2

*18,000

†30,000

3

–

†30,000

6,000

10,000

Expected total net cash flow * 12,000 cakes x (£3.00 – £1.50)

= £18,000

† 15,000 cakes x (£3.00 – £1.00) = £30,000

78

(b)

Net present value Year

(c)

Cash Flow

Discount Factor

Discounted Cash Flow

Machine A

Machine B

Machine A

Machine B

£

£

£

£

0

(30,000)

(80,000)

x

1.000

=

(30,000)

(80,000)

1

18,000

30,000

x

0.909

=

16,362

27,270

2

18,000

30,000

x

0.826

=

14,868

24,780

3

–

30,000

x

0.751

=

–

22,530

Net Present Value

=

1,230

(5,420)

On the basis of net present value, Machine A should be purchased and Machine B should be rejected because of its negative net present value.

Reason: Machine A has a positive net present value and the initial cost is much less than Machine B. However, –

the net present value is not large and the estimates of revenues and costs may be inaccurate.

–

if the cost of capital increases, the positive net present value could disappear.

–

will there be any proceeds from the sale of the old machine?

–

if Beard Bakeries Ltd needs to borrow to finance the machine, the company’s gearing will increase and may make the company less attractive to investors.

CHAPTER 17 Further aspects of budgeting 17.1

(a)

Benefits of budgetary control • planning – using a formal framework of budgets to predict future activities and potential problems • co-ordination – individual budgets are integrated into the master budget • control – comparison of actual results against the budget • communication – between the owner and staff to achieve the objectives of the business • motivation – of staff to ensure that budgets are met • evaluation of performance – to see where improvements can be made • decision-making – about production, sales and costs

(b)

Any three budgets • sales budget • production budget • purchases budget • debtor budget • creditor budget • cash budget The most likely three budgets for a small business such as AggieSurf would be cash, sales and production

(c)

Relevant factors when implementing budgetary control • costs and benefits – benefits must exceed the cost of budgetary control • accuracy – of information used • demotivation – of staff may occur if they have not been involved in planning the budget and/or where budgets are set at too high a level • disfunctional management – ensure that the budgets co-ordinate • set too easy – ensure that budgets are set at realistic levels to enable the business to use its resources to best advantage • may restrict activities – budgets may be inflexible so that staff are unable to take advantage of opportunities

79

17.3

(a) purchases budget April

June

August and

October and

December

February

and May

and July

September

November

and January

and March

£000

£000

£000

£000

£000

£000

40.0

35.0

30.0

20.0

10.0

10.0

Sales

(b)

Margin

10.0

8.75

7.5

5.0

2.5

2.5

Purchases

30.0

26.25

22.5

15.0

7.5

7.5

(i)

Debtor collection period Formula:

Debtors Credit sales

x 365 days (or 52 weeks or 12 months)

Year ended 31 March 2003: £12,000 £150,000

x 365 days

= 29.2 days

Year ended 31 March 2004: £14,000 £145,000*

x 365 days = 35.2 days

* (£20,000 x 3 months) + (£15,000 x 4 months) + (£5,000 x 5 months)

(ii)

Creditor payment period Formula:

Creditors Credit purchases

x 365 days (or 52 weeks or 12 months)

Year ended 31 March 2003: £11,000 £110,000

x 365 days = 36.5 days

Year ended 31 March 2004: £10,000 £108,750*

x 365 days

= 33.6 days

* see purchases budget

(c)

Debtor collection period: •

debtor days have increased by six days

•

this means that customers are taking longer to pay

Creditor payment period: •

creditor days have reduced by almost three days

•

this means that suppliers are being paid earlier

Recommendation: •

encourage debtors to pay quicker

•

delay payments to creditors

80

17.4

(a) ROBERT ADAMS Production budget for periods 1 – 3 Period 1

Period 2

Period 3

units

units

units

Sales

13,600

12,400

12,000

Opening stock

(3,400)

(3,100)

(3,000)

3,100

3,000

2,700

13,300

12,300

11,700

Closing stock Production

Tutorial note: the closing stock for each period is one-quarter of the next period’s expected sales.

(b)

Budgeted closing stock at end of period 3

2,700 units

Actual closing stock at end of period 3

2,500 units

Stock lost during periods 1 – 3

(c)

(d)

200 units

Any two limitations of budgetary control: •

costs and benefits – the benefit must exceed the cost of budgetary control

•

accuracy – some information used in the budget may be inaccurate and may distort the budget

•

demotivation – of staff who have not been involved in planning the budget, or who are set too high a level to achieve

•

dysfunctional management – where different sections of the business are not co-ordinated there may be departmental rivalry

•

set too easy – where budgets are set at too low a level they will not enable the business to use its resources to best advantage

•

may restrict activities

Debtor collection period

=

Debtors

x 365 days (or 52 weeks or 12 months)

Credit sales Total sales for periods 1–3 at £1 per football

£38,000

14% of sales is ∴ Debtor collection period

£5,320 =

£5,320

x 365 days

= 51.1 days

£38,000

(e)

•

A longer period of credit can be offered to customers.

•

The amount of cash discount for prompt payment can be reduced so that customers have less incentive to pay quickly.

•

Both of the above will delay receipt of payment by customers.

•

As a result, the bank balance will be reduced or an overdraft will be increased.

81

17.6

(a) SU LING LTD Labour budget for months 1 – 3 Month 1

Month 2

Month 3

2,100

2,400

3,000

Labour hours at 6 hours per unit

12,600

14,400

18,000

Labour hours available

15,000

15,000

15,000

2,400

600

(3,000)

Production in units

Surplus/(shortfall) of labour hours

(b)

•

Total cost without using part-time labour: (12,600 hours + 14,400 hours + 15,000 hours) x £8 per hour = 42,000 hours x £8

•

= £336,000

Total cost with the use of part-time labour: £336,000 + 3,000 part-time hours at £14 per hour = £336,000 + £42,000

= £378,000

∴ percentage increase in total cost: £378,000

x 100

= 112.5%

= 12.5% increase

£336,000 (c)

17.7

•

The surplus of labour hours in months 1 and 2 could be used to manufacture stock in advance of month 3.

•

This additional stock would need to be stored until month 3.

•

The costs of manufacturing the stock earlier will have to be paid.

•

The management of Su Ling Ltd need to consider whether it is cheaper to manufacture earlier, with its attendant costs, or whether to pay the higher rate for part-time labour in month 3.

•

The main limitation of using the labour budget in this way is that much depends on the accuracy of future sales forecasts, as this will affect the production budget. If the sales forecasts are over-stated, goods will be manufactured needlessly and may remain unsold, thus incurring extra storage costs, or have to be scrapped if the goods have a limited life (eg perishable goods).

(a) debtor budget Jan

Feb

Mar

Apr

May

Jun

Total

£

£

£

£

£

£

£

Opening debtors

65,500

60,550

61,050

65,600

69,500

73,200

65,500

Credit sales

38,300

39,500

42,400

45,000

47,400

44,700

257,300

(42,400)

(38,100)

(37,400)

(40,600)

(43,200)

(45,800)

(247,500)

Discount allowed

(350)

(400)

(450)

(500)

(500)

(400)

(2,600)

Bad debts written off

(500)

(500)

–

–

–

–

(1,000)

60,550

61,050

65,600

69,500

73,200

71,700

71,700

Receipts

Closing debtors

(b) creditor budget Jan

Feb

Mar

Apr

May

Jun

Total

£

£

£

£

£

£

£

Opening creditors

42,400

39,130

40,730

41,410

42,830

40,870

42,400

Credit purchases

19,500

22,300

22,500

24,000

22,600

23,400

134,300

(22,600)

(20,500)

(21,600)

(22,300)

(24,300)

(23,200)

(134,500)

(170)

(200)

(220)

(280)

(260)

(270)

(1,400)

39,130

40,730

41,410

42,830

40,870

40,800

40,800

Payments Discount received Closing creditors

82

17.10 (a)

(b)

Difference between cash and profit: •

cash is the actual amount of money held in the bank or as physical cash (eg in a cash till)

•

profit is a calculated figure which shows the surplus of income over expenditure for the period; it takes note of adjustments for accruals and prepayments and non-cash items such as depreciation and provision for doubtful debts; it does not include capital expenditure (ie the purchase of fixed assets), or owner’s drawings/dividends

Possible reasons for a bank overdraft when profits are being made: •

capital expenditure – the purchase of fixed assets reduces cash, but profit is affected only by the amount of depreciation on the asset

•

increase in debtors – with more goods sold, profits will increase but, until debtors pay, there is no benefit to the bank balance

•

decrease in creditors – if creditors have been paid earlier there will be no effect on profit, but a bank overdraft will increase

•

increase in stock – with more stock purchased there will be an increase in profit as it is sold, but paying for the stock will increase the bank overdraft

•

prepayment of expenses made at the year end – no effect on profit as the prepayment is an expense for next year, but the bank overdraft will increase

•

repayment of a loan – no effect on profits (although loan interest may be reduced), but the bank overdraft will increase

•

drawings/dividends – no effect on profit, but the bank overdraft will increase

(c) SALES BUDGET

Parts (units) Revenue (£)

March

April

May

June

July

200

200

260

260

260

£4,800

£4,800

£6,240

£6,760

£6,760

(d) PRODUCTION BUDGET IN PARTS (UNITS) March

April

May

June

July

Sales

200

200

260

260

260

Opening stock

(20)

(20)

(26)

(39)

(39)

20

26

39

39

39

200

206

273

260

260

Closing stock Production

(e)

Other budgets:

• purchases budget

•

(f)

Tutorial note: see also Chapter 18 • No pay rise – workforce will be demotivated – may understand that it is needed for job security – some may seek alternative employment • An increase in the working day – workforce will become tired at the end of the day – workforce will be demotivated and stressed – quality of output may suffer – health and safety issues, particularly when working with machinery – some may seek alternative employment • A reduction in overtime rates – workforce will not work overtime – output is likely to be reduced, leading to reduced sales and profit – job security may be at risk if overtime not worked

83

debtor budget

• creditor budget

17.13 (a)

production budget (units/surfboards) March

April

May

June

July

16

16

28

40

40

Opening stock

–

(24)

(48)

(60)

(44)

Closing stock

24

48

60

44

28

Production

40

40

40

24

24

March £

April £

May £

June £

July £

Sales

2,560

2,560

4,480

7,600

7,600

Variable costs

3,400

3,400

3,400

2,040

2,040

Brother’s wages

800

800

800

–

–

Fixed overheads

500

500

500

500

500

4,700

4,700

4,700

2,540

2,540

(2,140)

(2,140)

(220)

5,060

5,060

3,200

1,000

(1,140)

(1,360)

1,000

(60)

–

–

(2,700)

(5,060)

1,000

(1,140)

(1,360)

1,000

1,000

Sales

(b)

cash budget

Net cash flow Add opening balance Less drawings Closing balance

Tutorial notes: •

The selling price of each board increases to £190 from 1 June

•

Net cash flow is receipts from sales less payments for expenses

•

Drawings have been shown in the bank summary, but could be included amongst the payments

•

Other layouts of the cash budget are acceptable in the examination

17.14 (a)

Potter and Son Ltd Forecast trading and profit and loss account for the year ending 31 March 2004 £ Sales (312,500 units at £13.60 each)

£ 4,250,000

Opening stock (20,000 units)

200,000

Purchases (317,500 units at £9.00 each)

2,857,500 3,057,500

Less Closing stock (25,000 units)

225,000

Cost of sales

2,832,500

Gross profit

1,417,500

Less expenses: Overheads (£1,080,000 x 106.25%)

1,147,500

Net profit

270,000

Tutorial notes: •

Units of closing stock are 8% of sales: at 31.03.2004 312,500 units x 8% = 25,000 units.

•

Closing stock at 31.03.2003 had cost £10 per unit (£200,000 ÷ 20,000 units), so purchases for the year ended 31.03.2004 will be £10 x 90% = £9 per unit.

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(b)

•

The forecast profit – both gross and net – can be calculated and compared with the actual profit of the previous year.

•

The forecast profit shows the effect of changes in the selling price, volume of units sold, the buying price, and in overhead expenses. Here the forecast profit is reduced by £190,000 from the actual profit of the previous year.

•

Management can take action by reviewing their selling and buying prices, and overhead expenses.

•

Corrective action can be taken in advance if the forecast operating statements show a loss.

•

The actual gross and net profits for the year can be compared with the forecast profits, and any differences can be investigated.

CHAPTER 18 Decision-making and social accounting

18.2

(a)

Increase in total contribution resulting from the change in paint supplier Original contribution = (£190 – £140) x 12,000 sheds = £600,000 New paint = (£190 – £118*) x 12,000 sheds = £864,000 * £140 – £22 saving Increase in total contribution = £264,000

(b)

Points raised in the discussion might include: •

an increased contribution which, once fixed costs have been paid off, becomes profit

•

the increase in contribution could be used to reduce the selling price to stimulate sales

•

increased funds generated could be used to invest in the business

•

the break-even point will be reduced

•

the margin of safety will be increased

The possible downsides are:

18.4

•

the need to investigate the fact that the paint is only ‘rumoured’ to be harmful to wildlife – this has to be substantiated

•

possible bad publicity from environmental activists and loss of customers if product is then seen to be environmentally unfriendly

•

extra costs incurred in dealing with potentially harmful paint (safety procedures)

The suggested answer from the textbook is shown below. The question, however, requires the students to explain this term in their own words. ‘Social accounting’ is the term used to describe the way in which businesses are accountable and responsible to society as a whole. Social accounting requires that businesses should not be driven just by the profit motive but should also consider the wider implications of their decisions. The issues which involve social accounting can be internal, eg the demands of the workforce, or they can be external. External factors can be economic (providing local employment), ethical (not selling high nicotine cigarettes to developing countries), political (not selling goods to oppressive governments), legal (employment law) or environmental (using renewable resources or not polluting the atmosphere).

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