Management Advisory Services

MANAGEMENT ADVISORY SERVICES Crash Course for NOTRE DAME OF JOLO COLLEGE MODULE 1: COST-VOLUME-PROFIT ANALYSIS Nature of CVP Analysis Cost-Volume-Profit (CVP) Analysis – a systematic examination of the relationships among costs, cost driver/activity level /volume, and profit. It is a powerful tool used by the management in order to help them understand the interrelationship among cost, volume and profit in an organization by focusing on interactions between five CVP elements. The Elements of CVP Analysis 1. Sales price of a product 2. Volume or level of activity (within a relevant range) 3. Variable cost per unit 4. Total fixed cost 5. Sales mix Application of CVP Analysis CVP Analysis may be applied to the planning and decision-making function of the management, which may involve choosing the 1. type of product to produce and sell; 2. pricing policy to follow; 3. marketing strategy to use; and 4. type of productive facilities to acquire. Simplifying Assumptions of CVP Analysis 1. All costs are classifiable as either variable or fixed (components of mixed costs are already segregated). 2. Cost and revenue relationships are predictable and linear over a relevant range of activity and a specified period of time. 3. Variable costs per unit and total fixed costs remain constant over the relevant range. 4. Unit sales price and market conditions remain unchanged. 5. Changes in costs in revenue are brought about by changes in volume alone. 6. There is no significant change in the level of inventory (Production = Sales). 7. Sales mix remains constant (for a company that sells multiple products). 8. Technology, as well as productive efficiency, is constant. 9. Time value of money concept is ignored. Break-Even Analysis and Target Profit Analysis in a Single-Product Company Definition of Break-Even Point Break-Even Point – the sales volume (in pesos or in units) where total revenues equal total costs (TR = TC). Thus, at this point, the entity experiences neither profit nor loss (TR – TC = 0). Methods of Computing Break-Even Point Break-even sales can be computed using any of the following methods: 1. Graphic Approach 2. Equation Method or Algebraic Approach 3. Formula or Contribution Margin Approach Graphic Approach CVP Graph – also called break-even chart, it depicts the relationship of cost, volume, and profit in a graphical form. In this graph, the point where the total cost line intersects with the total revenue/sales line represents the break-even point. Steps in preparing the break-even chart: 1. Draw a line parallel to the volume axis to represent total fixed expense.

2. Choose some volume of unit sales and plot the point representing total expense (fixed and variable) at the sales volume you have selected. After the point has been plotted, draw a line through it back to the point where the fixed expense line intersects the dollars axis. 3. Again choose some sales volume and plot the point representing total sales dollars at the activity level you have selected. Draw a line through this point back to the origin. Pesos

Equation Method or Algebraic Approach This method uses the profit equation and applies algebraic techniques in computing the break-even point. Profit Equation: NI = TR – TC where: NI = profit/net income TR = total revenue (sales) TC = total cost TR = SP/u X Salesu where: SP/u = sales price per unit Salesu = units sold TC = TVC + TFxC where: TVC = total variable costs TFxC = total fixed costs TVC = VC/u X Salesu where: VC/u = variable cost per unit Salesu = units sold Thus, expanding the Profit Equation: NI = (SP/u X Salesu) – [(VC/u X Salesu) + TFxC] NI = [(SP/u X Salesu) – (VC/u X Salesu)] – TFxC NI = [(SP/u – VC/u) X Salesu] – TFxC NI = (Unit CM X Sales) – TFxC Contribution Margin Method or Formula Approach This method uses directly the formula in finding Break-even point (in units or in pesos). Break-Even Point in Pesos (BEPP)

Total Fixed Cost (TFxC) Contribution Margin Ratio (CMR) When the BEP in units is already known, the BEPP can be computed as BEPP = BEPu X Sales Price per Unit (SP/u) BEPP =

Break-Even Point in Units (BEPu)

BEPu =

Total Fixed Cost (TFxC) Contribution Margin per Unit (CM/u)

Target Profit Analysis At certain instances, entities need to determine the volume of sales (in pesos or in units) that they need in order to achieve a specified amount of desired/targeted profit. In determining the targeted sales for a desired profit, the formula in finding for the BEP will still be used, substituting the zero-value for profit with the amount of the desired profit. Thus, In Pesos In Units TFxC + Desired Profit (DP) TFxC + Desired Profit (DP) TSP = TSu = CMR CM/u where: TS = Targeted sales DP = Desired profit before tax

After-tax Desired Profit When the amount of the desired is expressed in an after-tax amount, said amount would have to be grossedup/converted into its before-tax equivalent before added to the amount of the total fixed cost. To compute for the before-tax profit, the formula is: After-Tax Profit DP = 1 - Tax Rate Desired Profit as a Percentage of Sales When the desired profit is expressed not as an amount, but as a percentage of sales, the formula to compute for the required sales can be derived based on the formula above, substituting the DP with the expression Profit Ratio (PR) multiplied by TS; thus, TSP

TFxC + (PR X TSP) CMR = TFxC + (PR X TSP) =

(Eq. 1)

(CMR X TSP) (CMR X TSP) - (PR X TSP) = (CMR - PR) X TSP =

(Eq. 2)

TSP

TFxC TFxC TFxC CMR - PR

=

(Eq. 3)

TFxC + (P/u* X TSu) CM/u = TFxC + (PR X TSu)

TSu

=

(CMR X TSu) (CM/u X TSu) - (P/u X TSu) =

(Eq. 4)

(CM/u - P/u) X TSu

=

TSu

=

TFxC TFxC TFxC CM/u - P/u

*P/u = SP/u X PR Break-Even Analysis and Target Profit Analysis in a Multiple Product Company Multi-Product BEP – the total volume of sales (in pesos or in units) that a company that produces and/or sells multiple products generates where the company experiences neither loss nor profit. Product BEP – the share of an individual product in the total BEP of a multiple product company based on the predetermined sales mix of the company’s products. Sales Mix – the relative proportion in which a company’s products are sold. Break-Even Analysis for a Multiple Product Company In a multiple product company, determining the break-even point may involve additional computations due to the following considerations: 1. Fixed costs incurred by a company cannot be usually identified with the specific products that the company produces and/or sell. 2. Each product may differ in terms of its contribution to the profit of the company due to the difference in selling price, variable costs, and sales volume of each product, thus differently contributes to the recovery of the total fixed costs incurred by the entity. In order to compute for the BEP for multiple product company, instead of using a single CMR or CM/u, it is required that the same shall be expressed in terms of their weighted average values (WaCMR and WaUCM) using the sales mix of each product as basis for weight assignment.

BEPP

TFxC WaCMR

=

BEPu

TFxC WaUCM

=

The WaCMR and WAUCM can be computed using the following formulae: WaCMR = Σ (CMRj X SMPj) WaUCM = Σ (CM/uj X SMuj)

or WaCMR =

Total CM Total Sales

or WaUCM =

Total CM Total Units

Sales mix ratios (SM) in pesos and in units for each product may be computed as follows: Salesj Units Soldj SMPj = SMuj = Total Sales Total Units Sold The BEP shall then be distributed to the different products using the following formule: Product BEPP = BEPP X SMPj Product BEPu = BEPu X SMuj

Target Profit Analysis Target sales determination in a multiple product company is basically similar to that of a single product company. TFxC + DP TFxC + DP TSP = TSu = WaCMR WaUCM Margin of Safety Margin of Safety – the excess of budgeted (or actual) sales over the creak-even volume. It is the amount or units of sales by which actual or budgeted sales may be dropped/decreased without resulting into a loss. MSP = SP - BEPP MSu = Su - BEPu

MSR

=

MSu

OR

Su

MSR

=

MSP SP

Where: MSP = Margin of sales in pesos MSu = Margin of sales in units SP = Sales in pesos Su = Sales in units Operating Leverage Operating Leverage – a measure of how sensitive net operating income is to a given percentage change in sales. It is also considered as the extent to which a company uses fixed costs in its cost structure. Degree of Operating Leverage (DOL) – also called as Operating Leverage Factor (OLF), this serves as multiplier in measuring the extent of the change in profit before tax resulting from the change in sales. CM DOL = PBT Where: PBT = Profit before tax To compute for the percentage change in profit: %Δ in P =

%Δ in S X DOL

Sample Problems: 1. Hellopo Company manufactures and sells a telephone answering machine. The company’s contribution format income statement for the most recent year is given below: Total Per Unit Percent of Sales Sales (20,000 units) Less variable expenses Contribution margin Less fixed expenses Net income

P

900,000 675,000 P 225,000 180,000 P 45,000

P45.00 33.75 P11.25

100% ?% ?%

Management is anxious to improve the company's profit performance and has asked for several items of information. REQUIRED: 1. Compute the company's CM ratio and variable expense ratio. 2. Compute the company's break-even point in both units and sales pesos. 3. Assume that sales increase by P300,000 next year. If cost behavior patterns remain unchanged, by how much would the company's net income increase? Use the CM ratio to determine your answer. 4. Refer to original data. a. Assume that next year, management wants the company to earn a minimum profit of P67,500, How many units will have to be sold to meet this target profit figure?

b. How much should peso sales be to earn profit after tax of P42,000? Assume that the

company pays income tax at the rate of 30%. c. Compute the peso sales volume required to earn profit of 10% of such sales volume. d. How many units must be sold to earn profit of P2.25 per unit? 5. Refer to the original data. Compute the company's margin of safety in units, pesos, and percentage form. 6. Answer the following questions: a. Compute the company's degree of operating leverage at the present level of sales. b. Assume that through a more intense effort by the sales staff, the company's sales increase by 10% next year. By what percentage would you expect net income to increase? Use the operating leverage concept to obtain your answer. c. Verify your answer to (b) by preparing a new income statement showing an 10% increase in sales. 2. Samsonette sells one of its products, a piece of soft-sided luggage, for P6,000. Variable cost per unit is P3,400, and monthly fixed costs are P6 million. A combination of changes in the way Samsonette produces and sells this product could reduce variable cost per unit to P2,800 but increase monthly fixed cost by P4.4 million. REQUIRED: 1. Determine the monthly break-even points under the two available alternatives. 2. Determine the indifference point of the two alternatives 3. Allen Cosmetics makes two facial creams, Allergy-free and Cleansaway. Data are as follows: Allergy-free Cleansaway Price per jar P18 P24 Variable cost per jar 9 6 Monthly fixed costs are P180,000 REQUIRED: 1. If the sales mix in pesos is 60%-for Allergy-free and 40% for Cleansaway, what is the weighted contribution margin percentage? What peso sales are needed to earn a profit of P60,000 per month? At that level, how many units of each product, and total units will the company sell? 2. If the sales mix is 50% for each product in units, what is the weighted average unit contribution margin? What units sales are needed to earn P60,000 per month? Why is this number of units different from the answer you found in requirement 1? What are the total peso sales and why is this figure different from your answer to requirement 1? 3. Suppose that the company is operating at the level of sales that you calculated in requirement 1, earning a P60,000 monthly profit The sales manager believes that it is possible to persuade customers to switch to Cleansaway from Allergy-free by increasing advertising expenses. He thinks that P8,000 additional monthly advertising would change the mix to 40% for Allergy-free and 60% for Cleansaway. Total peso sales will not change, only the mix. What effect would the campaign have on profit? 4. Relax Company and Recline Company both make rocking chairs'. They have the same production capacity, but Relax is more automated than Recline. At an output of 1,000 chairs per year, the two companies have the following costs: Relax Recline Fixed costs P400,000 P200,000 Variable costs at P100 per chair 100,000 Variable costs at P300 per chair 300,000 Total cost P500,000 P500,000 REQUIRED: Assuming that both companies sell chairs for P700 each and that there are no other costs or expenses for the two firms, a. Which company will lose the least money if production and sales fall to 500 chairs per year? b. How much would each company lose at production and sales level of 500 chairs per year? c. How much would each company make at production and sales levels of 2,000 chairs per year?

MODULE 2: VARIANCE ANALYSIS Basic Standard Costing Concepts Standards and Standard Costs Standard – a measure of acceptable performance established by management as a guide in making economic decision. It serves as a “benchmark” or “norm” for measuring performance. In management accounting, standards are set for the quantity and cost of inputs used in manufacturing goods or providing services. Quantity Standards – indicate the quantity of materials and labor time required to produce a unit of product or provide a service. Cost Standards – specify the amount of payment that should be made for each unit of input. Standard Costs – pre-determined cost of manufacturing a unit of product during a specified period of time. These are determined by multiplying the quantity standards and cost standards. Types of Standards 1. Ideal Standards – also called Theoretical Standards, these are measure of optimum performance. These standards are established based on a perfect working condition – no delays, breakdowns, wastages, materials and manpower shortages, work stoppage, or any error of any sort. 2. Practical Standards – these are measure of tight but attainable performance. These standards are established for a normal level of operation and efficiency, allowing for certain expected or normal production problems. Users of Standard Costs 1. Manufacturing firms 2. Service firms 3. Non-profit organizations Purposes of Standard Costs 1. Cost control 2. Pricing decisions 3. Motivation and performance appraisal 4. Cost awareness and cost reduction 5. Preparation of budgets 6. Costing of inventories Cost Elements Actual Costing Direct Materials Actual Direct Labor Actual Factory Overhead Actual 7. Preparation of cost reports 8. Management by objective

Normal Costing Actual Actual Applied

Standard Costing Standard Standard Standard

Standard Costing Control Loop 1. Establish standards 2. Measure actual performance 3. Compare actual performance with standard 4. Analyze the variances 5. Investigate the variances that must be investigated 6. Take corrective action when needed. This may include revision of standards. Variance Analysis Definition and General Model for Variance Analysis Variance – also called as error or planning gap, is the variation in the amount of the actual cost incurred by an entity compared to the standard cost that would have been incurred at a given level of actual activity.

Variance Computation:

Actual Cost Standard Cost Total Cost Variance

P

XXX XXX XXX

P

In analyzing variance, analysts may decompose it into two elements: the price element and the quantity element. Price Variance – the difference between the actual amount paid for an input and the standard amount that should have been paid, multiplied by the actual input. Quantity Variance – the difference between how much of an input was actually used and how much should have been used and is stated in dollars term using the standard price of the input. Price and quantity elements in the variance analysis can be used for all production costs elements. Terms may vary depending on the element analyzed. Production Cost Element Price Element Variance Quantity Element Variance Direct materials Price Variance Quantity Variance Direct labor Rate Variance Efficiency Variance Variable factory overhead Spending/Budget Variance Efficiency Variance Fixed factory overhead Spending/Budget Variance Capacity/Volume Variance General model of the analysis: Actual Cost Standard Cost Total Cost Variance

-

P P

XXX XXX XXX

Price Variance

P

XXX

Quantity Variance Total Cost Variance

P

XXX XXX

Actual Cost Budgeted Cost Price Variance

P

Budgeted Cost Standard Cost Quantity Variance

P

P

P

XXX XXX XXX XXX XXX XXX

A variance is FAVORABLE when the actual cost incurred is lower than the standard cost. A variance is UNFAVORABLE when the standard cost is lower than the actual cost incurred.

DIRECT MATERIALS VARIANCE Total direct materials variance can be computed as follows: Actual Materials Cost Standard Materials Cost Materials Cost Variance

P P

XXX XXX XXX

DM Variance can be analyzed through the two elements of the variance cost: DM Price Variance

Actual Materials Cost (AP X AQP) Budgeted Materials Cost (SP X AQP) DM Price Variance or

P P

XXX XXX XXX

DM Price Variance = (AP - SP) X AQP Note that the direct materials price variance are computed using quantity of materials purchased rather than the quantity used for the purposes of simplifying bookkeeping and timely determination of variances. DM Quantity Variance

Budgeted Materials Cost

(SP X AQU)

P

XXX

Standard Materials Cost (SP X SQU) XXX DM Quantity Variance P XXX or DM Quantity Variance = (AQU - SQU) X SP

In case the production process involves combination or mixture of two or more materials in varying proportions, the Quantity Variance can be analyzed further into two elements, the materials input (MIX) and the product output (YIELD). DM Quantity Mix Variance Mix Variance – the difference between the actual combination or mixture of materials to produce certain quantity of output and the standard mixture at a given actual total input of materials. Total Actual Input at SP Σ(SP X AQU) P XXX

Total Actual Input at ASIC (ASIC* X TAI**) XXX DM Quantity Mix Variance P XXX or DM Quantity Mix Variance = Σ(AMAI***- SMAI****) X SP *ASIC = Average Standard Input Cost. The average of the standard cost per input of materials in a standard mixture. Computed as: Total Standard Cost/Total Standard Input Quantity **TAI = Total Actual Input. ***AMAI = Actual Mix based on total actual input. ****SMAI = Standard Mix based on total actual input.

DM Quantity Yield Variance Yield Variance – the difference between the actual unit of output produced based on the actual inputs placed into the production and the standard output that should have been produced. Total Actual Input at ASIC (ASIC X TAI) P XXX Total Actual Input at ASOC (ASOC* X TAI) XXX DM Quantity Yield Variance P XXX or DM Quantity Yield Variance = (AO** - SO***) X ASOC *ASOC = Average Standard Output Cost. The average of the standard cost per quantity of standard output. Computed as: Total Standard Cost/Total Standard Output **AO = Actual quantity of output produced. ***SO = Standard quantity of output that should have been produced based on the actual quantity of input used. Computed as: TAI X Yield %**** ****Yield % = The percentage of expected output over the standard input. Computed as: Total Standard Output Quantity/Total Standard Input Quantity

DIRECT LABOR VARIANCE Total direct labor variance can be computed as follows: Actual Labor Cost Standard Labor Cost Labor Cost Variance

P P

XXX XXX XXX

DL Variance can be analyzed into two factors: DL Rate Variance

Actual Labor Cost Budgeted Labor Cost DL Rate Variance

(AR X AH) (SR X AH)

P P

XXX XXX XXX

or DL Rate Variance = (AR - SR) X AH DL Efficiency Variance

Budgeted Labor Cost Standard Labor Cost DL Efficiency Variance

(SR X AH) (SP X SH)

P P

or DL Efficiency Variance = (AH - SH) X SR

XXX XXX XXX

In case the production process involves combination or mixture of two or more types of labor in varying efficiency proportions, the Efficiency Variance can be analyzed further into two elements, the labor input (MIX) and the product output (YIELD). DL Efficiency Mix Variance Mix Variance – the difference between the actual combination of labor to produce certain quantity of output and the standard mixture at a given actual total hours worked. Total Actual Input at SP Σ(SP X AH) P XXX Total Actual Input at ASIC (ASIC* X TAI**) XXX DL Efficiency Mix Variance P XXX or DL Efficiency Mix Variance = Σ(AMAI***- SMAI****) X SP *ASIC = Average Standard Input Cost. The average of the standard cost per input of materials in a standard mixture. Computed as: Total Standard Cost/Total Standard Input Quantity **TAI = Total Actual Input. ***AMAI = Actual Mix based on total actual input hours. ****SMAI = Standard Mix based on total actual input hours.

DL Efficiency Yield Variance Yield Variance – the difference between the actual unit of output produced based on the actual input hours placed into the production and the standard output that should have been produced. Total Actual Input at ASIC (ASIC X TAI) P XXX Total Actual Input at ASOC (ASOC* X TAI) XXX DL Efficiency Yield Variance P XXX or DL Efficiency Yield Variance = (AO** - SO***) X ASOC *ASOC = Average Standard Output Cost. The average of the standard cost per quantity of standard output. Computed as: Total Standard Cost/Total Standard Output **AO = Actual quantity of output produced. ***SO = Standard quantity of output that should have been produced based on the actual input hours. Computed as: TAI X Yield %**** ****Yield % = The percentage of expected output over the standard input. Computed as: Total Standard Output Quantity/Total Standard Input Hours FACTORY OVERHEAD VARIANCE Total direct labor variance can be computed as follows: Actual Overhead Cost Standard Overhead Cost Overhead Cost Variance

P P

XXX XXX XXX

The analysis on factory overhead is quite unique. Instead of using the traditional two-way variance breakdown (rate and efficiency) for the entire overhead cost, the overhead must first be broken into variable and fixed overhead costs before the analysis on budget and efficiency/capacity variances can be made. In addition, variances on overhead costs can be analyzed using two-way, three-way or four-way breakdown of costs. Two-way Variance Analysis In two-way analysis, the costs are broken down into two overhead cost control classification: Controllable and Capacity/Volume-related costs.

CONTROLLABLE VARIANCE Actual Overhead Cost (AFOH) Actual Variable Overhead Cost Actual Fixed Overhead Cost Budget Allowed at Standard Hours (BASH) Standard Variable Overhead Cost Budgeted Fixed Overhead Cost CAPACITY/VOLUME VARIANCE Budget Allowed at Standard Hours (BASH) Standard Variable Overhead Cost Budgeted Fixed Overhead Cost Standard Overhead Cost (SFOH) Standard Variable Overhead Cost Standard Fixed Overhead Cost

P

XXX XXX P

(SVFOHR X SH) P

(SVFOHR X SH) P

(SVFOHR X SH) P (SFxFOHR X SH)

Alternative computations for Capacity/Volume Variance: CAPACITY/VOLUME VARIANCE Budgeted Fixed Overhead Cost Standard Fixed Overhead Cost

XXX XXX

XXX XXX

XXX

XXX

P

XXX XXX

P

XXX

P

XXX XXX

XXX

XXX

(SFxFOHR X DH*) P (SFxFOHR X SH) P

XXX XXX XXX

*DH= Denominator level hours. The amount of hours used in determining the standard or pre-determined factory overhead cost per unit. Usually the Normal Capacity.

Or Capacity/Volume Variance = (DH - SH) X SFxFOHR

Three-way Variance Analysis In the three-way analysis, the controllable variance is simply split into two variance: the Spending/Budget Variance and Efficiency Variance SPENDING/BUDGET VARIANCE Actual Overhead Cost (AFOH) Actual Variable Overhead Cost Actual Fixed Overhead Cost Budget Allowed at Actual Hours (BAAH) Standard Variable Overhead Cost at AH Budgeted Fixed Overhead Cost EFFICIENCY VARIANCE Budget Allowed at Actual Hours (BAAH) Standard Variable Overhead Cost at AH Budgeted Fixed Overhead Cost Budget Allowed at Standard Hours (BASH) Standard Variable Overhead Cost at SH Budgeted Fixed Overhead Cost CAPACITY/VOLUME VARIANCE Budget Allowed at Standard Hours (BASH) Standard Variable Overhead Cost Budgeted Fixed Overhead Cost Standard Overhead Cost (SFOH) Standard Variable Overhead Cost Standard Fixed Overhead Cost

P

(SVFOHR X AH) P

(SVFOHR X AH) P

(SVFOHR X SH) P

(SVFOHR X SH) P

(SVFOHR X SH) P (SFxFOHR X SH)

XXX XXX

P

XXX XXX

XXX XXX

XXX

P

XXX XXX

XXX XXX XXX XXX

XXX

XXX

P

XXX

P

XXX XXX

XXX

XXX

P

P

XXX

XXX

Alternative computations for Efficiency Variance: EFFICIENCY VARIANCE Standard Variable Overhead Cost at AH Standard Variable Overhead Cost at SH

(SVFOHR X AH) P (SVFOHR X SH) P

XXX XXX XXX

Or Efficiency Variance = (AH - SH) X SVFOHR Four-way Variance Analysis The four-way variance analysis reflects the complete analysis of the spending/budget and efficiency or volume/capacity elements of the variable and fixed portion of the overhead cost. Thus, from the three-way analysis, the spending/budget variance is split into variable and fixed components. VARIABLE SPENDING/BUDGET VARIANCE Actual Overhead Cost (AFOH) Actual Variable Overhead Cost - Variable P XXX Budget Allowed at Actual Hours (BAAH) Standard Variable Overhead Cost at AH (SVFOHR X AH) XXX P XXX FIXED SPENDING/BUDGET VARIANCE Actual Overhead Cost (AFOH) Actual Variable Overhead Cost - Variable Budget Allowed at Actual Hours (BAAH) Budgeted Fixed Overhead Cost EFFICIENCY VARIANCE Budget Allowed at Actual Hours (BAAH) Standard Variable Overhead Cost at AH Budgeted Fixed Overhead Cost Budget Allowed at Standard Hours (BASH) Standard Variable Overhead Cost at SH Budgeted Fixed Overhead Cost CAPACITY/VOLUME VARIANCE Budget Allowed at Standard Hours (BASH) Standard Variable Overhead Cost Budgeted Fixed Overhead Cost Standard Overhead Cost (SFOH) Standard Variable Overhead Cost Standard Fixed Overhead Cost

P

XXX XXX

(SVFOHR X AH) P

(SVFOHR X SH) P

(SVFOHR X SH) P

(SVFOHR X SH) P (SFxFOHR X SH)

XXX XXX

P

XXX XXX

XXX XXX XXX XXX

XXX

XXX

P

XXX

P

XXX

P

XXX XXX

XXX

XXX

Alternative computations for Variable Spending/Budget Variance: Variable Spending/Budget Variance = (AVFOHR - SVFOHR) X AH Sample Problems: PROBLEM 1. Universal Company operates with a standard cost accounting system and uses cost variances as a means of detecting costs that my require more control. A standard cost sheet for a component that is manufactured exclusively in one plant is as follows: Direct materials (5 units @ P8) P 40.00 Direct labor (0.5 hours @ P40) 20.00 Variable overhead (0.5 direct labor hour @ P6) 3.00 Fixed overhead (0.5 direct labor hour @ P10) 5.00 Standard unit cost P 68.00 Data from the past year as follows: a. Purchased 1,550,000 units of materials at a cost of P12,430,000.

b. c. d. e. f. g. h.

Manufactured 295,000 units of product and sold 275,000 units. Budgeted P1,500,000 for fixed overhead for the year. Used 1,480,000 units of materials in production. Used 150,000 direct labor hours. Spent P5,960,000 for direct labor. Spent P910,000 for variable overhead. Spent P1,525,000 for fixed overhead.

REQUIRED: Using standard costing system, determine the following variances: a. Materials price variance b. Materials usage (efficiency) variance c. Labor rate variance d. Labor efficiency variance e. Variable overhead spending variance f. Variable overhead efficiency variance g. Fixed overhead spending variance h. Fixed overhead volume variance PROBLEM 2. PMY Company makes Collesterite, a new health food. For a 50-kilo batch, the standard costs for materials and labor are as follows: Materials Inputs Quantity Unit Price TOTAL Lard 25 kilos P 0.20 per kilo P 5.00 Sugar 25 kilos 0.10 per kilo 2.50 Egg yolk 10 kilos 0.05 per kilo 0.50 60 kilos P 8.00 Labor Inputs Skilled labor Unskilled labor

Quantity 0.80 hour 0.20 hour

Unit Price P12.00 per hour 8.00 per hour

TOTAL P 9.60 1.60

During June, the following materials and labor were used in producing 600 batches of Collesterite: Lard 18,000 kilos at P0.22 per kilo P 3,960 Sugar 14,000 kilos at P0.11 per kilo 1,540 Egg yolk 10,000 kilos at P0.04 per kilo 400 Skilled labor 400 hours at P12.25 per hour 4,900 Unskilled labor 260 hours at P8.00 per hour 2,080 REQUIRED: 1. Calculate the materials price, quantity, mix, and yield variances. 2. Calculate the labor efficiency, mix and yield variances. PROBLEM 3. Pulbosapaa Co. manufactures foot powder. The company uses a standard costing system. Following are data pertaining to the company’s operations for 2016: Production for the year 170,000 units Sales for the year (sales price per unit, P1.20) 175,000 units Beginning 2016 inventory 10,000 units STANDARD COST TO PRODUCE 1 UNIT Direct materials Direct labor Variable overhead Fixed overhead SELLING AND ADMINISTRATIVE COST Variable (per unit) Fixed (per year)

P

0.15 0.10 0.05 0.20

P 0.14 80,000.00

Fixed manufacturing overhead is assigned to units of production based on a predetermined rate using a normal production capacity of 200,000 units per year. The actual fixed overhead cost incurred was equal to the budgeted amount during the year. Actual variable manufacturing costs incurred during the year amounted to P48,000. All variances are closed to cost of goods sold. REQUIRED: Determine the net income of Pulbosapaa under (1) Absorption costing, and (2) Variable Costing.

MODULE 3. CAPITAL BUDGETING Definition of Capital Budgeting Capital Budgeting - mainly involves decisions as to setting up of new plant, expansion of existing facilities, make or buy decisions etc. It includes a financial analysis of various proposals regarding capital expenditure, mainly analysing the benefits arising from the project and choosing the best alternative. The capital budgeting decisions involve extensive use of various capital budgeting techniques. Characteristics of Capital Investment Decisions 1. 2. 3. 4.

Capital investment decisions usually require large commitments of resources. Most capital investment decisions involve long-term commitments. Capital investment decisions are more difficult to reverse than short-term decisions. Capital investment decisions involve so much risk and uncertainty

Stages in the Capital Budgeting Process 1. Identification and definition 2. Search for potential investment projects 3. Information gathering – both quantitative and qualitative information 4. Selection – choosing the investment projects after evaluating their projected costs and benefits. 5. Financing 6. Implementation and monitoring Types of Capital Investment Projects 1. Replacement of assets 2. Improvement of assets 3. Expansion projects Capital Investment Factors NET INVESTMENT Net Investment - the cost of cash outflows less cash inflows or savings incidental to the acquisition of the investment projects. Costs or cash outflows include: 1. The initial cash outlay covering all expenditures on the project up to the time when it is ready for use or operation 2. Working capital requirement to operate the project at the desired level. 3. Market value of an existing, currently idle asset, which will be transferred to or utilized in the operations of the proposed capital investment project. Savings or cash inflows include: 1. Trade-in value of old asset (in case of replacement) 2. After-tax proceeds from sale of old asset to be disposed due to the acquisition of the new project 3. Avoidable cost of immediate repairs on old asset to be replaced, net of tax. COST OF CAPITAL Cost of Capital – the firm’s cost of financing and is the minimum rate of return that a project must earn to increase firm value. It is also called hurdle rate and required rate of return. Weighted Average Cost of Capital – reflects the average future cost of capital over the long run, found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure. Sources of long-term capital 1. Long-term debt – includes bonds and long-term bank loans 2. Equity securities – issuance of new equity shares (preferred and common stock) 3. Retained earnings

NET RETURNS Net returns – the net cash operating inflows of the firm or the accounting net profit, whichever is most appropriately used. Methods and techniques of capital budgeting The capital budgeting techniques are bifurcated between 2 broad approaches – a. Traditional (non-discounted) techniques– 1. Payback period method 2. Accounting rate of returns method b. Discounted cash flow techniques – 1. Net present value method 2. Profitability index; and 3. Internal rate of return (IRR) method Payback period This method is used to simply calculate the period within which the cost of the project will be completely recovered. The calculation is done based on cash flows. The period of payback is the period within which the total cost of the project is recovered. Cash inflow is nothing but profit after tax but before depreciation. Payback Period =

Net cost of initial investment Annual net cash flows

Advantages of the payback period method 1. The method is very simple to understand and apply. 2. The method aims at selecting projects generating liquidity in earlier years, this is important for decision making when cash availability is a constraint and / or cost of capital is very high. 3. The payback period method is also used to analyse the risk associated with the project; the lesser the payback period, the lesser will be the risk and vice versa. Disadvantages of the payback period method 1. The payback period method totally ignores profitability aspect and talks only about the capital recovery. 2. It is not necessary that every businessman is interested in choosing a project with lesser payback period and he may be interested in choosing a project with higher profitability. 3. The method does not take into consideration the time value of money and the opportunity cost, which is considered under the net present value method. Accounting rate of return method (ARR) Accounting or average rate of return means the average annual yield on the project. The average rate of return is Profit after tax as a percentage of the total amount invested. ARR =

Average annual net income Investment

Advantages of the accounting rate of return method – 1. This method is easy to understand and apply 2. It covers the major aspect of profitability and helps the investor in knowing his rate of return. Disadvantages of the accounting rate of return method – 1. It ignores the time value of money 2. It does not take into consideration the uneven flow of cash and does not calculate the returns on year to year basis 3. It is not a good comparing technique i.e. project chosen by using this method can be less profitable than the project rejected by using this technique.

Net present value (NPV) This is the most popular method for evaluation of a capital project. This method is designed to take into account the time value of money. Net present value of a project is nothing but the present value of all the cash flows spread over a period of time. Present value of net cash inflows Cost of investment Net present value

P XXX . (XXX) P XXX .

Advantages of the Net present value method 1. NPV method considers the time value of money 2. NPV is nothing but the value of money as on today, when it is received at a later date. This eliminates the drawbacks of ARR method as it considers timing of cash flow as well as uneven cash flows. 3. The whole stream of cash flows is considered 4. It is the best way to analyse a project when the company has multiple choices as it is a very effective comparative analysis 5. It gives due weight-age to timing of cash flow, due to discounting the cash flows at a later date gets reduced more than the cash flows at earlier dates. Disadvantages of the Net present value method 1. It requires predetermination of the cost of capital or the discount rate to be used. 2. The net present values of different competing projects may not be comparable because of differences in magnitudes or sizes of the projects. Profitability index method (PI) This is a part of discounted cash flow technique and it explains the cost benefit relations between the inflows and the outflows of a proposal. The PI shows that how much inflows are expected for every one peso of outflows. PI =

Net Present Value Investment

or

Present value of cash inflows Present value of cash outflows

Internal rate of return (IRR) Internal rate of return is the rate at which the discounted cash inflows are equal to discounted cash outflows. The internal rate of return of a project is the discount rate at which the net present value of a project is nil. The IRR is compared with the minimum rate of return expected by the firm for its investment. The advantages of IRR method can be summarised as follows – 1. Its takes into account the time value of money 2. It gives the exact amount of returns which the project is offering, unlike NPV method where positive NPV only denotes that the returns are more than the minimum desired returns and it never outlines the exact amount of returns 3. This method is independent of that of NPV method and may give different results from the NPV method. Disadvantages of the IRR method – 1. The calculation process is difficult and tedious 2. As it may give different results from that of NPV method, it is difficult to form a decision just on the basis of IRR method. Sample Problem: Problem 1. Best Co. plans to replace a piece of machine that was acquired 5 years ago. It has now a net book value of P120,000 and a resale value of P50,000. New equipment can be acquired by paying P600,000, including an installation cost of P20,000. This new equipment has an estimated useful life of 8 years with a terminal salvage value of 60,000. The company is under the 40 percent tax bracket. Required: Compute the amount of investment. Problem 2. National Company is considering the purchase of a P800,000 machine, which will be depreciated on the straight-line method over an 8-year period with no salvage value for both book and tax purposes. The machine is expected to generate an annual before-tax cash inflow of P220,000. The income tax rate is 40%.

REQUIRED: 1. Determine the payback period. 2. Compute the accounting rate of return on: a) original investment; b) average investment. Problem 3. Albania Company expects to sell 100,000 units annually for the next four years at P9 each, with variable costs of P5 per unit, and annual cash fixed costs of P250,000. The product requires machinery costing P320,000 with a four-year life and no salvage value. The company will depreciate the machinery using straight-line depreciation. Additionally, working capital (in form of receivables and inventory) will increase by P150,000. This additional working capital will be returned in full at the end of the four years. The tax rate is 40% and cost of capital is 12%. REQUIRED: 1. Compute the expected net present value for this investment. 2. Compute the profitability index for this investment.