Often times, employees are confronted with situations which might be unpleasant for them, but are compelled to act against their instincts. That is, one finds himself or herself having to take decisions, which ethically he or she is not comfortable with. For professional bodies, it is clear what you need to do. As a start, you have to discuss with colleagues your discomfort. If that does not bear fruit then refer upwards, and if that still does not work you must refuse. And, obviously if it gets to this point you might start considering resigning from your employment.
So, issues about one getting bullied into doing something unethical should not arise- professionals are supposed to know how to deal with unethical behaviour. But, often times, most people consider their careers and what will happen to them if they were to resign. Studies in ethics are clear that you should always think about the consequences of your actions. Some may think that acting within the law is adequate to address ethics, but it is not since the law provides the floor upon which to lay the foundation for a good set of moral principles, which ought to guide good behaviour.
There
are several methods which can be used to absorb overheads. The most
common methods of calculating overhead absorption rates are: Rate per
unit produced; Direct labour hour rate; Machine hour rate; Percentage
of direct wages cost; Percentage of direct materials cost; Percentage
of prime cost
A
major factor in selecting the absorption rate to be used is a
consideration of the practical applicability of the rate. This will
depend on the ease of collecting the data required to use the selected
rate. Generally, a time-based method should be used.
Overhead absorption rates are usually predetermined, that is, they are
calculated in advance of the period over which they will be used. When
the actual overhead incurred per hour is different from the
predetermined rate per hour, the overhead is either under- or
over-absorbed.
Historically, the most common method of absorbing production overhead
has been based on direct labour hours. The mechanisation of the modern
methods of production has, however, resulted in the use of machine
hours as an absorption base.
Modern management accounting systems have developed a technique called
activity-based costing. This technique analyses all activities to
identify the factors that cause the costs to increase. These factors
are called cost drivers.
Marginal costing values all inventory items at their variable or
marginal costs only. Fixed costs are treated as period costs and are
written off in full against the contribution for the period.And, under
this method fixed production overheads are not absorbed. Basically, in
marginal costing the variable costs are matched against the sales value
for the period to highlight an important performance measure:
contribution.
Contribution = Sales value - Variable costs
Marginal costing and absorption costing methods produce different
profit figures which need to be reconciled. Similarly, it is necessary
to reconcile the profits for different periods.
There is no absolutely correct
answer as to when marginal costing or absorption costing is preferable.
Supporters of absorption costing argue that fixed production overheads
are a necessary cost of production and they should therefore be
included in the unit cost used for inventory valuation. Supporters of
marginal costing argue that management attention is concentrated on the
more controllable measure of contribution.
Relevant
costs are the type of costs which are influenced by the decisions made.
That is, they are decision specific. As such, all relevant costs should
be considered in management decision-making. And, a cost that remains
unaltered regardless of the decision being taken, is regarded as being
a non-relevant cost.
Different types of non-relevant costs are:
Sunk or past costs: These are costs, which have already been incurred and hence no matter what happens they cannot be altered.
Absorbed fixed overheads: These are fixed costs which are
allocated or apportioned on an arbitrary basis by using, for instance:
labour hours, machine hours etc as the basis for absorption.
Committed costs: These are the type of costs an entity becomes committed to due to contracts or past behaviour.
Historical cost depreciation: Depreciation is not relevant as it
does not represent the transfer of economic assets. It is just an
accounting cost, which does not represent an outflow of cash.
Notional costs: These are just theoretical costs e.g. notional rent, notional cost at split-off point.
Three types of relevant costs are: Opportunity costs; Avoidable costs; Differential/incremental costs
Opportunity costs identify the value of any benefit forgone as the
result of choosing one course of action in preference to another.
Avoidable costs are defined as 'the specific costs of an activity or
sector of a business which would be avoided if that activity or sector
did not exist'.
Differential/incremental costs
can be useful if the cost accountant wishes to highlight the
consequences of taking sequential steps in a decision. Incremental
revenues are the differences in revenues between the alternatives.
Matching the incremental costs against the incremental revenues
produces a figure for the incremental gain or loss between the
alternatives.
Total Shareholder Return (TSR) is based on the rise in the price of shares plus dividends received over a set period of time.
There are some important considerations when using TSR, such as: Risk.
When using TSR to compare the performance of two or more companies it
is important to allow for relative risk. TSR assumes efficient share
pricing at the beginning and end of the period examined. The time period of examination:
A TSR over a five-year period can look very different from a TSR
measured over a one-year or ten-year period when examined alongside the
TSR of a peer group. Please note that, using TSRs for bonuses may not
always align managerial interests with shareholders. And, TSR is
useless in the case of companies not quoted on a stock market.
The
wealth added index (WAI) takes as its starting point the factors in
TSR, i.e. capital gain or loss on shares plus dividends over a period
of time, but also takes into account the time value of money by
deducting the ‘cost of equity’.
WAI is measured in terms of absolute money amounts.
To calculate WAI: First, calculate the rise in market capitalisation over the period. Second,
deduct the portion of that market capitalisation rise due to the firm
raising more equity capital, e.g. through a rights issue. Third, add back any cash paid out to shareholders, e.g. dividends, share buy-backs. Fourth, deduct the required return on equity committed by shareholders at the start.
Considerations when using wealth added index:
Doubts about the capital asset pricing model -Assumes that the stock
market prices shares correctly at the beginning and end dates; There
can be long periods of poor performances; Big companies appear to do
best. Market Value Added (MVA) compares the market value of the firm
(debt plus equity) with the total capital contributions to date (debt
plus equity).
MVA is measured in terms of absolute money amounts.
If
the market value of debt is assumed to be the same as the book value,
then MVA will compare the market value of the equity with the total
equity contributions to date (including the economic value of retained
profits).
And,
the following are considerations when using market value added: Doubts
about the validity of the ‘capital invested figure’; When was value
created? Distorted by size; Does not state if the rate of return is
high enough
Excess return (ER) tries to solve two of the problems present in MVA calculations: First, it allows for the required rate of return for the period of time that the firm has held shareholders’ money. Second, it includes the dividends received by shareholders over the years since the firm’s foundation.
Excess
return expressed in present value terms equals Actual wealth expressed
in present value terms minus Expected wealth expressed in present value
terms
Expected
wealth is the current value that one should expect shareholders to have
in the business given the amount of capital they put in (and retained
in the business) and given the required rate of return since they put
it in.
Actual
wealth is the accumulated present value of the cash flows received by
shareholders over the years of their investment plus the current market
value of the shares.
ER is measured in terms of absolute money amounts.
The
drawbacks of excess return include: The difficulty of identifying the
amount of equity capital put into a business that has traded for many
decades; The assumption of market pricing efficiency in ‘correctly’
pricing the company’s shares at the present time; It is difficult to
state with precision what the required rate of return should be, and;
Large companies dominate a ‘league table’ of ER because it is measured
in absolute money amounts.
Market to book ratio, MBR = Market value divided by capital invested.
Because MBR is so similar to MVA it has similar advantages and disadvantages.
Limitations of whole-firm value metrics:
They require a market valuation and thus they are useful only for the
minority of corporations with a quotation and they cannot be employed
to analyse a sub-section of a company (such as a strategic business
unit or product line).
Shareholder
value is driven by the following four factors: The amount of capital
invested; The actual rate of return on capital invested; The required
rate of return on capital invested; The length of time over which the
performance spread (see below) will persist to create value. And,
essentially, the actual return must be more than the required return
for value to be created. That is, there must be a positive performance
spread.
The
performance spread is the percentage spread of the actual return above
or below the required rate of return, given the finance provider’s
opportunity cost of capital. To measure annual value created (or
projected value yet to be created), multiply the quantity of capital
invested by the performance spread.
Annual value creation = Investment x (actual return – required return) = I (r - k)
The point in the future where the required and the actual rates of return become the same is the ‘planning horizon’.
Corporate value = Present value of cash flows within planning horizon + Present value of cash flows after planning horizon
After
the planning horizon even if investment levels are increased
significantly corporate value will remain constant. This is because the
discounted cash inflows (to time zero) associated with that investment
exactly equal the discounted cash outflows (to time zero). In other
words, after the planning horizon it is not possible to make returns
greater than those required by investors.
Good
growth and bad growth: Good growth occurs when a business unit or an
entire corporation obtains a positive performance spread on new
investment capital. Bad growth occurs when investment is made in
strategies that produce negative performance spreads.
There
are five key actions firms can take in order to increase shareholder
value: Increase the return on existing capital; Raise investment in
positive spread units; Divest assets from negative spread units to
release capital; Extend the planning horizon; and, Lower the required
rate of return.
Shareholder
value can be defined as the value of the return that a shareholder is
able to obtain from their investment in a company. This is made up of
capital gains, dividend payments, proceeds from buyback programs and
any other payouts that a firm might make to a shareholder.
Managers
should examine a business , or parts of their business, in terms of the
following questions: How much money has been (or will be) placed in
this business by investors? What rate of return is being (or will be)
generated for those investors? Is this sufficient given the opportunity
cost of capital? These three questions can be used to examine past
performance, or future plans.
Value-based
management is a managerial approach in which the primary purpose is
long-run shareholder wealth maximisation. The objective of the firm,
its systems, strategy, processes, analytical techniques, performance
measurements and culture, all have as their guiding objective
shareholder wealth maximisation.
Identifying
value destructive and value generating activities within a business can
lead to realignment of management priorities: -Plans for the business
are considered by focusing on the extent to which their current or
planned business operations will create value for shareholders. That
is, business operations should generate discounted cash inflows greater
than the cash devoted to the investment by the finance providers.
-Managers are rewarded according to the achievement of shareholder
value over the long term. Large changes to incentive systems in most
firms can be the result. -Often the discounted cash inflows in a part
of the business amount to less than the amount that could be generated
by closing down the activity or selling it. -If a subsidiary is sold,
managers then need to consider whether the cash released should be
invested in other activities or be given back to shareholders to invest
elsewhere in the stock market?
Once
an organisation becomes value based a wide range of questions becomes
informed by value principles, e.g. Mergers, Strategic analysis, Capital
structure and Dividend payouts
Frequently,
a shift in culture, in systems and procedures as well as a major
teaching and learning effort is required to create a value-based
corporation.
The
three steps to creating shareholder value are: Communicate the
importance of shareholder value and then encourage a genuine commitment
to shareholder wealth-enhancement throughout the organisation; Use good
measurement techniques to evaluate whether value is being created at
various organisational levels; and then manage actively to ensure that
every aspect of management is suffused with the shareholder value
objective.
Activity Based Costing is a development on traditional absorption costing methods. Several developments in manufacturing have made it imperative to have a method that could more accurately deal with the problem of overheads. In the modern business environment, overheads have become a significant proportion of total production cost. This has, therefore, necessitated the need to find a method of accounting that could provide accuracy in product costing.
In the past, production was mostly manual and as such labour was a significant part of total cost of production. And, because most of the operations were labour based, material costs were also significant because of human error. That is, when work is not automated it is very likely that there would be a lot of errors and wastage during production. so, in the past overheads were an insignificant part of total production costs.
So, ABC is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.
Traditional cost accounting involves attributing indirect costs to individual products on the basis of an overhead absorption base related to some proxy. The proxy could be related to the usage of labour hours, machine hours, materials cost, labour cost etc. This approach provides ambiguous results in modern circumstances.
Transactions that give rise to overhead costs include: Logistical transactions; Balancing transactions; Quality transactions and Change transactions
The conditions under which ABC system analysis differs from traditional system analysis are:
When production overheads are high relative to direct costs, particularly direct labour. This, therefore, makes it important to use ABC in order to more accurately deal with overheads.
Where there is great diversity in the product range. When there is diversity it is likely that the amount of support given for the production of goods or provision of services would be high. When this is high, it implies that overheads would in turn be high.
Where there is considerable diversity of overhead resource input to products. Same as above.
When consumption of overhead resources is not driven primarily by volume. When overheads are driven by other factors other than the volume of output, it becomes imperative to use ABC. ABC would, in this case, find an appropriate driver for such overheads.
The different steps to a basic ABC process are:
Step 1: Identify the main production-related activities of the organisation.
Step 2: Identify the cost (cost pool) of each of the activities identified in Step 1.
Step 3: Determine the cost driver for each activity identified in Step 1.
Step 3a: Select the activity cost pools and cost drivers that will be used within the system.
Step 4: Calculate a cost driver rate for each activity cost pool in the same way as an overhead rate is calculated in a traditional system.
Step 5: Apply the activity cost driver rates to products (cost units) to arrive at an activity-based product cost.
The hierarchy of cost comprises the following activities: Unit-level; Batch-level; Product-level; Facility-level
Marginal
Costing and Absorption Costing are methods which are often used to
prepare profit statements, value inventory and assist in pricing
decisions. The methods have some notable differences, which can be
reconciled though.
Absorption
Costing absorbs all manufacturing/production costs into inventory
valuation. These costs include direct material, direct labour, direct
expenses,variable production overheads, as well as fixed production
overheads. On the contrary, Marginal Costing absorbs only variable
manufacturing/production costs into inventory.
The method chosen to cost inventory or prepare the profit statement has
the potential to: affect the pattern of calculated profits; influence
employee behaviour, and provide management with relevant and useful
information for planning and control purposes. And, the following could
be considered to be advantages of each method.
Advantages of absorption costing:
Gives attention to both fixed and variable costs; that is, all
production costs are considered regardless of whether they are variable
or fixed. And, this is very important when it comes to pricing
decisions since the manufacturer can have a clear picture of the profit
margin to be made on each sale, as all costs would have been
incorporated into the product cost.
Provides realistic periodic profits if company has a natural
business cycle; profits are realistic in the sense that all production
costs are matched to sales volume, rather than production volume as
under Marginal Costing.
It is consistent with external reporting requirements; in fact,
International Accounting Standard Board recommends the use of
absorption costing method over marginal costing, which is considered
more useful for internal reporting.
Advantages of marginal costing:
Distinguishes between fixed and variable costs therefore
providing relevant information about costs for decision making
purposes. When fixed and variable costs are split, it becomes easier to
manage costs as it gets clearer to management on how costs behave. So,
by altering the activity level, for instance, management can choose an
optimal production level.
Removes the effect of inventory changes on profit and reduces
the danger of dysfunctional behaviour in employees. Dysfunctional
behaviour may occur in the case of absorption costing by encouraging
managers to produce more inventory than can be sold. Producing for
stock has the effect of absorbing more fixed production overheads,
hence reducing the cost of sale. The reduced cost of sale has the
effect of improving the level of reported profits. However, it is
possible for such stock to tie up capital and even become obsolete.
This is dysfunctional.
Avoids capitalisation of fixed overheads in unsaleable stocks.
Under marginal costing, all fixed costs are treated as period costs,
meaning that they are all written off in the accounting period to which
they relate. So, there is no question of using inventory to defer fixed
cost expenses, as might be the case with Absorption Costing.
The difference in approach by the 2 methods has implications for
reported profits, especially when the inventory level is changing. The
fact that absorption costing can defer fixed costs until a sale is made
means that when stock level is rising it reports a higher profit than
marginal costing. On the other hand, when the stock level is reducing
marginal costing reports a higher profit than absorption costing. These
differences in the reported profits can be reconciled by taking into
account the fixed overhead absorption rate and the extent of the change
in inventory.
There is, however, no clear advantage in using either absorption or
marginal costing. Both have their uses and the fact that the results
from both systems can be reconciled indicates that there are strong
links between the two.
The appraisal of projects is a complicated area, especially if investments take place in countries other than the domestic country. It is common to confront additional challenges, eg: Which perspective to take? Is it the project's cash flows in the host country or, those cash flows expected to be repatriated to the head office?. The receipt of net cash flow in the domestic currency is usually exposed to foreign exchange risk; What is the systematic risk on an international project? and Political/country risk.
There are 2 approaches in discounting overseas project cash flows: Discount the overseas cash flows at the overseas discount rate to create a overseas NPV. Then convert this NPV at the current spot exchange rate to give the NPV in home currency; Convert each of the estimated future overseas cash flows into home currency. Then discount these to generate a home currency NPV. Problem: Difficult to hedge project cash flows against currency risk.
Overall, however, overseas projects should be evaluated from the parent point of view. That is, after allowing for restrictions on cash repatriation. By diversifying internationally the variance (standard deviation) of the investor's or the firm's portfolio is generally reduced and therefore the equity risk premium can be reduced.
Shareholders with an internationally diversified portfolio will theoretically measure the systematic risk of an individual share in terms of a worldwide portfolio and global betas. Many investors are not fully diversified internationally and firms can lower risk for shareholders through international diversification
International diversification of operations can lower the fluctuations in shareholder returns back home, which is a force that lowers the cost of capital. However, many institutional investors are diversified internationally (among developed economies) and so required returns are determined by these international diversified investors.
In many parts of the world the financial markets are illiquid and function poorly, and the cost of capital is relatively high - global accessibility of finance outside of the home base has led to greater availability of finance at lower cost.
There are factors raising the cost of capital when sourced abroad. These include foreign exchange risk, asymmetric information and political/economic risk. There is thus a trade-off between the benefits and additional costs of raising funds overseas.
The cost of debt for a MNC is higher in some countries than in others due to: - The risk free rate of return being higher. - The risk premium being higher.
The cost of debt for large firms can generally be estimated using publicly available information such as the bond yields incurred by other firms in that country carrying the same risk as the proposed project.
If a firm diversifies its portfolio of projects internationally there is an argument that it will have less cash flow variability and therefore the risk, as perceived by lenders would be lower, resulting in a lower cost of debt. However, this is frequently more than offset by the agency costs of debt, political risks, foreign exchange risks and asymmetric information costs.
The cost of
equity capital is the return that needs to be offered to investors to
induce them to buy and hold the equity shares in a company. This return
is determined by the returns available on similar securities of the
same risk class.
The
capital asset pricing model gives a required rate of return for any
asset if it is possible to obtain its beta (measure of its systematic
or non-diversifiable risk) and the equity risk premium demanded by
investors above the risk free rate of return for accepting the risk
associated with investing in shares, generally.
Some
risks are unique to the particular share. The impact of these variables
is known as diversifiable risk (also referred to as firm, unique or
unsystematic risk).
Some
risk variables will affect all shares, to a greater or lesser extent.
The impact of these variables is known as non-diversifiable risk (also
referred to as market or systematic risk).
The
reduction in standard deviation of the returns on the portfolio comes
about because security returns generally do not vary with perfect
positive correlation.
Because
most shares are held by highly diversified institutions, market returns
are dominated by the actions of fully diversified investors. These
investors ensure that the market does not reward investors for bearing
some unsystematic risk.
A
share‟s sensitivity to general market movements is its beta value. A
beta of 1.0 indicates that the share tends to produce returns that move
broadly in line with the market index. A beta greater than 1.0
indicates that the share displays amplified movements relative to the
market.
Beta can measure the systematic risk of any asset – so shares, debt instruments, and indeed any asset can have a beta.
The required return from any risky investment is described by the Capital Asset Pricing Model – the CAPM.
For share j, under the CAPM, the required return is: rj = rf + Beta(rm – rf)
Since the required return for equity is the same as the cost to the firm kE, kE = rf + Beta(rm – rf) This is the CAPM formula.
The
CAPM formula can be shown on a graph as the Security Market Line ,
which shows the rise in expected returns as beta increases.
Market
(equity) risk premium (rm – rf) or RP, is the extra return demanded by
investors in equities generally above the risk free rate. Historical
data on equity and government bond returns reveal the equity risk
premia above the risk free rate are generally in the range of between
3% and 6% per annum.
Any
measure of the equity risk premium will be sensitive to: - the period
covered by the study. - the proxy for the risk-free rate (short-dated
or long-dated government securities?); - the analyst‟s view of the
riskiness of the average share relative to rf. - the market and
currency.
To
obtain the risk-free rate we ideally need to satisfy two conditions: -
There is a zero default risk. - When intermediate cash flows are earned
on a multi-year investment there is no uncertainty about reinvestment
rates. In practice, finance directors and analysts use a long-term
government rate on all the cash flows of a project that has a long-term
horizon. Also, the bond used is one with coupons.
The
slope of the characteristic line is the beta for the share. This
relationship between rj and rm can be expressed thus for a generic
share j: - Betaj = Covariance of security with the market / Variance of
the market; or- Betaj = Correlation of security with the market x
(Standard Deviation of security / Standard Deviation of the market)
Criticisms
of CAPM: - It relies on the identification of a market portfolio to
calculate both the equity (or market) risk premium and beta. In theory,
this consists of a representative sample of all possible assets on
which a return can be generated by an investor - identifying such a
portfolio is almost impossible. - What data should be used to measure
beta? Changing the time period the periodicity or the market proxy will
change the measured beta. - Can the past be used to predict the future?
Betas change, sometimes considerably, over time. - CAPM is a one period
model – it assumes the variables (rf, beta, rm – rf ) will be stable
for the period of the cash flows to be valued.
Assumptions
that were used to derive the CAPM: -investors are rational and risk
averse; -all investors have identical investment horizons; -all
investors have identical perceptions regarding the expected returns,
volatilities and correlations of available risky investments;
-information has no cost and there are no barriers to information:
investors come to identical conclusions regarding expected risks and
returns given identical information; -there are no transaction costs or
taxes; -investors can borrow and lend at the risk-free rate; -there is
no dominant player in the market; and -no one transaction will move the
market price of an asset.
Early
(1970s) measurements of the Securities Market Line suggest that it is
flatter than is predicted by the theory - beta risk requires some
compensation, but not as much as suggested by the model. Also at a zero
beta, investors seem to receive more than the rf. Studies in the 1990s
concluded that a rise in beta does not lead to a higher return - many
academics and practitioners have drawn the conclusion that beta is
„dead‟ as relevant factor in adjusting required returns.
Arbitrage
pricing theory (APT) uses a number of factors (each with betas and each
with risk premiums), which relate to unexpected changes in economic
quantities.
Beta
is used for: -Assessing the risk of a portfolio; -Identifying whether a
fund manager‟s performance is the result of good management or
excessive risk taking; -Identifying „mispriced‟ shares, and; -To
evaluate investment projects as well as to value shares. The Gordon
growth model method for estimating the cost of equity capital is kE =
d1/P + g
Investors
in a company's debt are interested in getting a rate of return that is
in line with the return offered on other interest-bearing instruments,
which carry the same risk. This is called the cost of debt.
It
is also essential to note the following: That is, the yield to
redemption, or market yield, is the average pre-tax marginal rate of
interest (kd) on a firm‟s debt, reflecting its current credit rating.
For irredeemable debt this is determined as: kd = I/P0. For redeemable
debt, the yield to redemption will be the internal rate of return of
debt using the current market value of the debt and future cash flows.
The
relationship between the price of redeemable bonds, the coupon rate and
the yield to redemption: P = PVcoupon flows + PVface = {C/r x
[1-1/(1+r)n]} + {F/(1+r)n}
Also
note that: the longer the maturity of a bond, the greater the
sensitivity of the bond to changes in interest rates; and, therefore
the greater the change in price corresponding to a particular change in
yield.
The
average cost of debt can be calculated on the basis of the cost of each
of the different elements, with appropriate value weighting. Short-term
debt should be included as part of the overall debt burden of the firm.
However, cash and securities which can be sold easily may be deducted
to derive the net short-term debt burden. And, the capitalised value
of lease commitments may be added to the overall debt.
Required
Rate of Return can also be referred to as the opportunity cost of
capital. This represents the rate which should adequately compensate
investors for their investments in a company.
The
cost of capital is important for several reasons, because: Investors
expect a return on their investment sufficient to compensate them for
their risk; Value creation is evidenced by a residual positive net
present value (NPV) after discounting cash flows at the cost of
capital; and many management compensation packages are based on metrics
using cost of capital numbers.
The
cost of capital can also be described as the rate of return that a firm
has to offer finance providers to induce them to buy and hold a
financial security. This rate is determined by the returns offered on
alternative securities with the same risk.
Investing
in government bonds is, usually, considered the safest form of
investment available. Government bonds are, normally, associated with
the “risk-free” rate of return, and given the symbol rf.
The cost of debt capital: kd = rf + RP
If
a company is financed by both debt and equity, then the required return
on projects, etc. (of the same risk as the existing set of projects in
the firm) is a weighted average of the required returns on each form of
finance. In the absence of corporation tax, this gives:
WACC
= kd x (proportion of debt) + kE x (proportion of equity), where the
proportions of equity and debt are evaluated at market value.
Modigliani
and Miller presented a case that in a perfect capital market the
increase in kE due to the additional financial risk as gearing rises is
only just sufficient to offset the benefit from the increase in the
debt proportion. Thus the WACC is constant as the debt weight alters.
By
being able to lower the tax burden through financing through debt the
effective cost of debt is reduced (the „tax shield effect‟). However,
in practice, companies do not use excessive amounts of gearing. One of
the reasons firms generally do not select very high financial gearing
levels to take advantage of the tax shield benefits is that firms with
high borrowing are vulnerable to financial distress.
Bringing
it together, when firms are calculating their WACC they should use the
target gearing ratio and not a gearing ratio they happen to have at the
time of calculation. Calculating the WACC when there are three or more
sources of finance: WACC = kd1 x (1-Tc) x (proportion of debt type 1) +
kd2 x (1-Tc) x (proportion of debt type 2) + kE x (proportion of
equity).
The
proportions should: always be based on the market values of debt and
equity, not their book values; and reflect the target proportions of
debt and equity financing (market values), i.e. based on optimum
capital structure estimates; and, finally, always add to one.
As
you consider investing in a project it is necessary to think about the
possibility of failure. So, therefore, this chance that you might fail
needs to be captured in the appraisal model.
Raising the discount rate
is one way of dealing with project risk. There are 2 difficulties with
this approach: A high degree of subjectivity in categorising projects
into risk categories, and the difficulty of choosing an appropriate
risk premium.
Sensitivity analysis:
A method of allowing for risk (and one used by over 80% of large
companies) which builds up a picture of possible outcomes by
recalculating the NPV when one or more of the variables at a time is
changed by a certain percentage or round amount. With sensitivity
analysis managers can pay special attention to the potential for
deviations from estimated mostly likely value for the variables. They
may also pre-plan to control cash flows in that area.
We can also use the break-even model.
Break-even represents the point at which no profits or losses are made.
And, this occurs when total costs equals total revenue or when total
contribution equals total fixed costs. In break-even analysiswe try to establish the point at which the NPV becomes zero as one variable deviates from the most likely outcome.
In
both sensitivity analysis and break even analysis we can look into how
changing two variables may affect the NPV, especially when those
variables might be related, such as volume and sales price.
Scenario analysis: managers consider more drastic events occurring or looking at best and worse cases in a project and review the consequent NPV.
Probability analysis:
calculate the expected return and the standard deviation of the project
given estimated probabilities for a range of possible outturns.
Probability analysis is conducted by about one-third of large companies.
Expected NPV: weight each of the outcomes by the probability of occurrence and sum the result
Standard deviation:
Standard deviation is a statistical measure of the dispersion around
the expected value. Standard deviation is the square root of the
variance.
To
rank projects we generally assume that investors (and managers) are
risk averse. That is, Project X will be preferred to project Y if at
least one of the following applies: The expected return (NPV) of X is
at least equal to the expected return of Y, and the variance is less
than that of Y: or the expected return of X exceeds that of Y and the
variance is equal to or less than that of Y.
Profitability index, PI is present value of all cash flows except the initial investment (GPV) divided by initial investment. Projects with a PI > 1 are acceptable; they generate shareholder value. If there is a rationing of capital, so that not all positive NPV projects can be financed, then the rule is to select those projects with the highest PI first, going down the PI ranking until the capital investment limit is reached.
In capital rationing, sometimes, we have to deal with divisible and indivisible projects. Divisible projects are those whereby a fraction can be undertaken, and a proportionate cost and NPV is produced. On the other hand, an indivisible project is where fractions of the project cannot be implemented.
Other important considerations in project appraisal are hard capital rationing, and soft capital rationing. Hard capital rationing: capital from outside the firm (e.g. from lenders or shareholders) is limited, even though managers have identified positive NPV projects. It is a form of externally imposed risk management. Soft capital rationing: internal management-imposed limits on investment cash outflows. This may be to control divisional expenditure, to prevent the firm from over-stretching itself, to avoid breaching key financial ratio levels, or because a controlling shareholder/manager may also be unwilling to provide more finance but also unwilling to allow the sale of new shares to other shareholders. It is also a form of risk management.
It is essential that tax be considered in project appraisal, since it is the after tax returns that will be available to shareholders. So, deduct tax payments to arrive at the cash flows generated for the finance providers.
There are 2 rules to follow in allowing for tax in NPV calculations: Include incremental tax effects; and Include the tax outflow at the right time
Depreciation is not allowable as a deductible expense in the calculation of taxable profits in many jurisdictions. However, a writing down allowance (WDA) is usually permitted.
Inflation should also be factored in the project appraisal model. It is important to note that there are 2 types of inflation: Specific inflation, which refers to price changes of an individual good or service, and General inflation, which is associated with the reduced purchasing power of money, measured by an overall price index.
The rate of inflation does affect the rate of the required return, hence we can start talking about the Real Rate of Return and the Money/Nominal Rate of Return. Real rate of return is the rate of return required in the absence of inflation. And, the Money (or Nominal) rate of return includes a return to compensate for inflation.
The relationship between real and money rates of return is: (1 + money rate of return) = (1 + real rate of return) x (1 + anticipated inflation).
To allow for inflation either of these approaches may be used: Forecast the future cash flows in money terms and use a money discount rate, or Forecast the future cash flows in real terms and use a real discount rate.
The following two methods are incorrect: Using a real discount rate with money cash flows, and using a money discount rate to discount real cash flows.
Aside from the quantitative aspects, project appraisal should be subjected to qualitative scrutiny. The following is a suggested process towards investment.
Idea generation: the creation of a culture and system that encourages people within the organisation to come forward with ideas for future projects or improvements to existing ones. An atmosphere that allows investment ideas to surface and to evolve can be a significant competitive advantage for a firm.
Sponsorship of a project might involve: - presenting the idea to others who have specialist expertise helping to test the idea and shed light on the project’s viability - considering how the investment fits with the strategic direction of the business - evaluating the project using the discounted cash flow techniques as well as more traditional techniques such as payback - applying for authorisation and funding - taking a leading role in the project implementation; and - helping to assess the project as it is being undertaken to see if it lives up to its promise, to learn from mistakes and to control a run-away cash outflow.
Develop proposals and classify: ideas need to be examined in more critical detail as the data collected increases and estimates of future cash flows are refined. Major capital expenditures are treated differently in the evaluation process from more routine investments as it would be very expensive to apply sophisticated analysis to all projects.
A suggested classification of projects: New products; Expansion or improvement of existing products; Equipment replacement; Cost reduction; Statutory and welfare
Screening, strategy and budget: Proposals need to be screened to filter out those that will not go forward to detailed project appraisal, so as not to over-burden managers with numerous evaluations. Many will not taken further because they do not fit the strategic direction of the firm or because of some other limitation. To some extent (especially in the long-run) the budget can expand or contract depending on the availability of positive NPV projects.
Appraisal: detailed cash flow forecasts needed for the appraisal of projects using NPV or IRR.
Report and authorisation: NPV, IRR, payback and ARR are often presented, together with a description of the project in qualitative terms and a risk analysis in ‘capital appropriation request forms’.
Capital expenditure controls: While the investment phase of a project is underway managers track it to ensure that if there are delays or costs different from the plan they can take corrective action quickly.
Post-completion audit: monitor and evaluate the progress on the project by comparing forecast cash flows with actual cash flows over many years. Reasons for post-completion audits can be summarised as: To control the progress of the particular project under consideration; The knowledge gained from regular reviews of previous projects helps future capital investment decision-making; Psychological impact on managers.
It is always important that before undertaking an expensive capital project, a company evaluate it to determine whether it has the potential to increase shareholders' wealth; rather than destroy it. To this end, several appraisal techniques are used. These techniques include the Net Present Value (NPV); the Internal Rate of Return (IRR) and others.
Generally, NPV is viewed to be a much superior capital budgeting method than others. Despite this, IRR is still a popular choice among managers.
The Association of Corporate Treasurers (ACT) report indicated that companies have increased their use of discounted cash flow techniques over the last thirty years. Also, large firms are more likely to use net present value (NPV) than small firms and small firms use payback as much as the discounted cash flow (DCF) methods. Companies do not tend to select one of the techniques to the exclusion of all the others, many use three or four.
Explanations advanced for the continued use of methods other than net present value include the fact that: Practitioners take time to catch up with state of the art techniques; Each method has something positive to offer, e.g. allows easier communication of project viability or that the metric more closely relates to managerial incentives;‘True’ NPV is rarely known with any great certainty therefore it helps the decision-makers select projects if a portfolio of approaches is used to estimate project viability; Managers are not solely focused on returns to shareholders;Managers use more than one technique and switch between them so that they then can choose the method that shows the current project they are sponsoring and promoting to the rest of the organisation in the best light
Why is IRR still so popular? The following are possible explanations: Managers prefer to discuss project viability using a measure that is expressed as a percentage; Senior managers often like to separate the discount rate hurdle they are trying to achieve from the discounted cash flow calculation.
All businesses should be able to fully understand their costs of production. Failure to do so is likely to lead to business failure, since there might be a possibility of operating at suboptimal levels.
In economics, by costs of production we refer to the prices paid for the factors of production and the opportunity cost attributable to factors already owned. It is important to note that we also factor in our costs formula the opportunity cost. In accounting, opportunity cost is often ignored.
Costs of production are divided into two categories: Fixed costs,these do not change with the level of production or activity; Variable costs, these costs vary with the level of activity or production.
It is important that we get ourselves familiar with some of the terms such as the the short run and the long run. The short run, in economics, is defined as a period of time in which at least one factor of production is fixed. On the contrary, in the long run, all factors are considered to be variable. However, it is assumed that the quality of the factors stays constant.
To understand the optimum level of output, we should operate at a point where the marginal cost of production equals the average production cost. The average cost is calculated by dividing the total costs by output, whereas the Marginal cost refers to the extra cost of increasing output by one unit.
The relationship of AC to MC in the short run is depicted in the following graph:
In the short run, the law of diminishing returns to a fixed factor ensures that the average cost curve (AC) is U shaped and the marginal cost curve (MC) cuts the AC curve from below at the lowest point of the AC curve. The level of output where average costs are minimised is the optimum output. If fixed costs and variable costs are added, they give the total cost of production at different levels of output.
The theory of diminishing marginal returns explains why, eventually, in the short-run average cost starts to rise. The production in the short run is characterised by diminishing returns and rising average costs, eventually. This gives rise to U-shaped cost curves.
U-shaped cost curves are shown in the following figure:
In the long run, because all factors of production are variable, an organisation can change its scale of production significantly. And, since there are no fixed factors in the long run, there are no long-run fixed costs.
The three possible shapes of the long-run average cost curve (LRAC) are shown in the following figure:
The long-run average cost curve for most businesses will be saucer-shaped.
The advantages of producing on a large scale are known as economies of scale. The economies of scale fall into two categories: Internal economies of scale whereby the organisation's average cost of production is reduced as the organisation itself becomes bigger. There exist four types of main internal economies: Technical economies; Financial economies; Trading economies; Managerial economies
External economies of scale whereby the organisation's average cost of production is reduced as the industry in which the organisation operates becomes bigger, even if the organisation itself does not. Where the benefits of large scale production can accrue to all organisations in an expanding industry irrespective of the size and growth of the individual organisation, they are classed as external economies of scale. It is also possible to have diseconomies of scale. These occur when the average cost of production rises with increased scale of production. Managerial diseconomies are probably the most important source of diseconomies of scale. Since the middle of the 20th century, most large organisations have responded to this problem by adopting a divisional structure.
Finally, note that in the short run, fixed costs are the same whether or not the organisation undertakes production. Variable costs are, however, avoidable if the organisation chooses not to start production. An organisation will undertake production in the short run provided the price it can obtain for its product is at least equal to the average variable cost of production.
The price, or exchange value, of a good or service usually indicates the resources which are brought together to produce or provide it.
Production is, usually, not adequate to meet all of needs. The fact that our needs are unlimited and yet resources are causes scarcity. Scarce resources, usually, command a high price. It is also worthwhile to note that, sometimes, there are competing ends for which resources could be used. If these ends are many and varied in importance and the means of achieving them are limited, then there is an economic problem and someone has to decide which end will be satisfied through production.
We sometimes talk about Relative scarcity of resources, which means that a choice has to be made. When a choice arises, an alternative has to be given up. The sacrifice, when a choice is made, is termed the opportunity cost because it is the next best alternative foregone. Usually, the opportunity cost has a monetary value.
In production, we need to make decisions in consideration of the fact that there is scarcity; the economic problem. The production decisions that need to be made when allocating scarce resources include the following: For whom to produce? What to produce? How to produce?How to distribute?
To tackle the economic problem, we obviously need resources. These resources are called the factors of production. These factors include the following: Land, whose reward is rent; Labour, which is rewarded through wages. Enterprise or entrepreneurship-The reward of risk-taking, organising and decision making earned by the entrepreneurs is termed profit and Capital, which is rewarded through interest.
The way in which scarce factors of production are employed and organised depends on the nature of the economic system which operates in a country. And, there are 3 possible economic systems, which are: Market economy; Mixed economy; Command economy
In practice we do not have a purely Market or Command economy, but rather a mix of the 2 systems. This is called the mixed economy. The main features of mixed economies are: Most economic activity is conducted by private sector, profit-seeking organisations; The price system plays an important role in resource allocation as it acts as a set of signals and incentives for both producers and consumers; Governments play an active role in the economy.
Also, note that the aims and activities of organisations are constrained, in practice, by certain factors such as the law, the nature of the business and human nature. And, in order to be able to calculate the profit maximising position for an organisation, it is first necessary to define certain concepts. These include: Total revenue (TR) = Volume of sales or Output x Sale price; Average revenue (AR) = Total revenue/Sales volume; Average revenue and sale price refer to the same thing; Marginal revenue (MR) = The change in total revenue when sales are increased by one unit; Total cost (TC) = The cost of all the resources employed in producing a given level of output including normal profit; Average cost (AC or ATC) = Total cost/Volume of output; Marginal cost (MC) = The change in total cost when output is increased by one unit.
Profit maximisation is where the difference between total revenue and total cost is greatest. This is always where marginal cost (MC) is equal to marginal revenue (MR). This is the equilibrium level of output for the organisation since it will wish to stay at this profit maximising level of output.
Please note that in Economics Total Cost includes an element for normal profit or opportunity cost. And, also Breakeven for an organisation occurs where average revenue equals average cost and total revenue equals total cost.
The amount of profit obtained and whether it is normal or abnormal depends upon: the market structure within which an organisation operates; the time period involved.
Although the not-for-profit organisations are not profit-orientated, as with most business organisations they have some characteristics in common with them. These include: Use of resources (factors of production) in order to produce some good or service; Flow of expenditure to finance those resources and other operating costs; Flow of income to finance the expenditure; Sales of services or goods to its customers, clients or members to obtain a flow of income
Overall, there are important economic constraints on organisations. These business organisations need to: avoid making a financial loss; be efficiently managed to ensure that the organisation achieves its objectives and ensures financial stability; choose investment projects carefully so that they contribute to the achievement of the objectives of the business in an efficient manner.
Finally, much of the management activity in not-for-profit organisations is similar to that which occurs in profit-seeking businesses. Similar decisions have to be made concerning the: types of product and service to be produced; markets to focus on; level of output to be produced; prices to be charged for the product or services; choice of production methods and technologies; investment decisions; sources of finance.
The consolidated statement of financial position is a statement of financial position that reflects the financial position of a parent and all its subsidiaries, as if they were one single entity. That is, it reflects the performance of the entire group.
In consolidating the results of a parent company and its subsidiaries, full consolidation method is used. Full consolidation entails aggregating the net assets of all the group entities on a line-by-line basis. In consolidating the results of the group, it is often necessary to deal with goodwill. Goodwill, specifically goodwill on acquisition arises when the cost of investment does not equal the net assets at the date of acquisition. And, this goodwill on acquisition is carried as an asset in the consolidated statement of financial position.
Pre-acquisition retained earnings, and any other reserves existing at the acquisition date are just some of the other items that have to be dealt with. These are part of the net assets at acquisition, and will help in the calculation of goodwill. Post-acquisition profits, on the other hand, are earned by the group and are included in the consolidated reserves.
Please note that a parent can control a subsidiary without owning all of its equity shares. The interests of other shareholders in the subsidiary entities are referred to as non-controlling interests. The basic aggregation is not affected where subsidiaries are not wholly owned. The net assets of the parent and 100% of the net assets of the subsidiary are added together. Where the subsidiary is not wholly owned, then the goodwill calculation is calculated as the cost of the investment plus the non-controlling interest in the investment (either held at fair value or at its proportionate share of the fair value of the net assets acquired) less the net assets of the subsidiary at the date of acquisition.
Where a group exists, it is inevitable that there would be intra-group transactions. Intra-group balances need to be eliminated in preparing the consolidated statement of financial position. This is because the consolidated statement of financial position is of the group as a combined entity, and balances that are wholly internal will not be receivables or payables of the whole entity. From a group perspective, this profit cannot be recognised until the goods are sold outside the group.
Furthermore, a parent entity is free to hold debt of its subsidiary, but is not required to do so. Investing in loan stock, debentures, etc. of the subsidiary does not give any control as it is an investment in debt and not equity. Investment in the debt of a subsidiary is eliminated on consolidation as it is an internal balance of the group.
And, lastly, where the parent entity invests in the non-equity of an existing subsidiary, goodwill on acquisition will be calculated in a similar way to the goodwill on acquisition of the equity shares.
A group is a cohesive economic unit. And, a cohesive economic unit is one that is subject to control from a common source. We can look at a group of companies as being made up of a number of separate legal entities that are subject to common control and therefore can be said to be a single economic entity for financial reporting purposes.
Within a group there is a parent company. It is the parent company, which usually exercises common control. The exercise of common control means that the parent entity controls the operating and financial policies of the other entities of the group, which are known as the subsidiary entities.
A subsidiary is an entity that is controlled by another entity. In financial management, control is known as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. And, the most common way for one entity to control another is by obtaining a sufficient number of equity shares to control more than 50% of the votes at shareholders' meetings.
The obligations of a parent company are that it should prepare consolidated statements, in addition to its own separate accounts (according to IAS 27, Consolidated and Separate Financial Statements). The following are the consolidated statements a parent company is expected to prepare: A consolidated statement of financial position dealing with the state of affairs of the parent and all of its subsidiary entities; A consolidated income statement dealing with the profit or loss of the parent and all of its subsidiary entities; A consolidated statement of cash flows dealing with the cash flows of the parent and all of its subsidiary entities.
In addition, there are further guidelines on when a parent company could prepare consolidate financial statements, such as the following: The parent entity's debt or equity instruments are traded on a public market; The parent is engaged in filing statements in preparation for trading in a public market.
However, a parent entity is not required to prepare and present consolidated financial statements if: It is specifically exempted by the IAS from doing so. The parent entity has itself an ultimate or immediate parent that prepares and presents consolidated financial statements for public use; Where a subsidiary has been acquired and is held exclusively with a view to its subsequent disposal (within 12 months of the year end), it does not require consolidation. It is treated as an asset 'held for sale' (as per IFRS 5).
Associate companies are dealt with through IAS28. This standard defines an associate as an entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture. According to IAS 28, significant influence is the power to participate in the financial and operating policy decisions of the entity but is not control over those policies.
The existence of significant influence by an investor is usually evidenced in one or more of the following ways: Representation on the board of directors; Participation in policy-making processes; Material transactions between the investor and the entity; Interchange of managerial personnel; Provision of essential technical information; A holding of at least 20% creates a presumption that the investor exercises significant influence, unless it can be demonstrated that this is not the case.
The
International Accounting Standard Committee (IASC) foundation was
established in 1973 as a way of bringing about convergence in
accounting policies and practices around the world. It has evolved
since its foundation but, currently, the duties of its trustees are as
follows:
The
IASC foundation serves, through its trustees, the purpose of appointing
members of the International Accounting Standard Board (IASB); the
International Financial Reporting Interpretation Committee (IFRIC) and
the Standards Advisory Council (SAC). It also evaluates and reviews the
effectiveness of the IASB, on an annual basis. And, also to finance the
activities of the IASB. It makes an assessment on the financial budget
submitted by the IASB and stipulate the basis for funding. It also
reviews broad strategic issues affecting accounting standards and to
promote the work of the IASB, as well as promoting the objective of
rigorous application of the IASB's standards.
On
the other hand, the SAC gives advice to the IASB on agenda decisions
and priorities in the IASB's work. It also informs the IASB board of
the views of its member organisations and individuals about
standard-setting projects, as well as giving other advice to the board
or trustee.
The IASB's objectives, however, can be summarised as being:
To
develop, in the public interest, a single set of high-quality,
understandable and enforceable global accounting standards that require
high-quality, transparent and comparable information in financial
statements and other financial reporting to help participants in the
world's capital markets and other users make economic decisions. It
also promotes the use and rigorous application of those standards;
bring about convergence of national accounting standards and
international accounting standards to high-quality solutions
The
IFRIC's mainl duties can be described as being to consider, on a timely
basis, accounting issues that are likely to receive divergent or
unacceptable treatment in the absence of authoritative guidance. And,
to publish draft interpretations for public comment; to report to the
IASB and obtain approval for final interpretations.
The
IASC framework is built upon the fundamental understanding that
harmonisation can best be pursued by focusing on financial statements
that are prepared for the purpose of providing information that is
useful in making economic decisions. Its principal purposes are to
assist the board of the IASC in the development of international
accounting standard; in promoting harmonisation of regulations,
accounting standards and procedures relating to the presentation of
financial statements by providing a basis for reducing the number of
alternative treatments permitted by international standards
The
IASC framework contains the following principal sections: Objective of
financial statements; Underlying assumptions; Qualitative
characteristics of financial statements; Elements of financial
statements; Recognition of the elements of financial statements;
Measurement of the elements of financial statements; Concepts of
capital and capital maintenance
The IASC framework notes that financial statements principally convey
the financial effects of past events with regard to performance,
position and changes in financial position so that the information is
useful to a wide range of users in making economic decisions.
The IASC framework also defines the 4 principal qualitative
characteristics of financial statements as understandability,
relevance, reliability and comparability. It also notes that the most
commonly adopted basis of measurement in financial statements is
historical cost, but it does not prohibit the adoption of other bases
of measurement. The framework highlights that the elements of financial
statements related to the measurement of financial position are income
and expenses.
Recognition in the statement of financial position or income statement
of the elements depends upon the criteria that: It is probable that any
future economic benefit associated with the item will flow to or from
the entity; the item has a cost or value that can be measured reliably.
The fundamental requirement for the presentation of financial
statements is that the financial statements should present fairly the
financial position, performance and cash flows of an entity. IAS 1 Presentation of Financial Statements
prescribes that a complete set of financial statements should include
the following: A statement of financial position ; A statement of
comprehensive income or an income statement; A statement of changes in
equity; A statement of cash flows; Accounting policies and explanatory
notes
IAS 1 prescribes minimum
disclosure requirements for the content of the statement of financial
position, income statement, statement of changes in equity and provides
details of what should be disclosed in the supporting notes to the
accounts. That is, notes should present information about the bases of
preparation of the financial statements, the accounting policies
selected and applied, information required by international standards
which is not presented elsewhere and any other information required for
a fair presentation.
A standard has been defined as a benchmark measurement of resource usage set under defined conditions. The conditions under which a standard may be set could vary. For instance we could have an ideal standard, attainable standard, current standard and a basic or historical standard.
An ideal standard is one that is set at a very higher level, such that it does not entertain a normal level of loss. That is, no human error is factored into the standard when it is set. Often times, an ideal standard leads to adverse variances, which may be demotivating to employees.
An attainable standard, on the other hand, allows for normal levels of inefficiency. And, unlike the ideal standard it can be motivating for employees.
A current standard is set by looking at the current operating conditions. That is, whatever level of performance is achieved helps in providing a benchmark for the standard.
And, then the basic or historical standard is the type that does not get adjusted. It has no useful control purposes, but may provide valuable comparative data over time.
When using a standard for variance analysis it becomes pertinent that we split up the standard to show the quantitative and monetary components separately. This type of analysis then helps us in preparing a detailed operating statement for reconciliation of budgeted performance against actual.
There are 2 major traditional methods, which could be used to prepare accounts. These are absorption costing and marginal costing methods. The major difference in the 2 methods depends on how stock is valued ,under each of the methods.
With marginal costing, stock is valued at only variable costs of production. These costs of production include direct material, direct labour, direct expenses and variable production overheads. So, you must note that only variable production costs are used in stock or inventory valuation when marginal or variable costing is used.
Absorption costing on the other hand, in addition to the variable production costs, includes a fixed production overhead absorption rate. This fixed production absorption rate is measured by dividing budgeted fixed overheads by the budgeted or normal level of activity. Because budgeted values have been used in developing a fixed overhead absorption rate; also known as a predetermined rate, a possibility for over or under absorbing arises. It should be noted though that the under or over absorption arises only when absorption costing method is used.
There are other distinctions between the 2 methods, for instance marginal costing uses a contribution approach.(which is the difference between revenue and variable costs) In other words, when preparing accounts, under marginal costing, you will have to calculate cotal ontribution. And, then deal with fixed costs afterwards to determine the net profit for the period. Absorption costing method, on the contrary, makes use of gross profit. That is you need to find the difference between revenue and all production cost; and this is what is called gross profit. After this, you then less all non production costs to derive a net profit for the period.
The difference in approach may cause differences in the reported net profit. This happens when the amount of inventory is changing; that is, when stock is increasing or decreasing. You will know that inventory is changing when the opening and closing stocks are different or when production amounts differ from the sales volume. The difference in profit is, therefore, attributed to 2 factors; the change in stock and the amount of the fixed overhead absorption rate.
And, effectively when stock is increasing absorption costing will report a higher profit than marginal costing. When stock is decreasing it is marginal costing, which will report a higher profit. This happens because under marginal costing all fixed costs are treated as period expenses and written off in the period they are incurred. With absorption costing, however, fixed production costs are absorbed and will be transferred to future accounting period if there is a lot of closing inventory. This means less overheads are charged to the statement of comprehensive income when the amount of closing inventory is significant, hence profits will be maximised. When the stock level is reducing it means that more sales volume is registered than the amount of production, and as such a higher amount of overheads, brought forward in stock from previous accounting periods, would be released. When this happens, less profits would be reported under absorption costing.
For us to understand costs incurred by our businesses we should be able to classify them, otherwise it would be difficult to control them to within a reasonable level. There are, actually, several ways in which costs could be classified. For instance, we could classify costs according to their elements, behaviour or function.
In terms of elements, costs could be looked at in terms of whether they are material, labour or expenses. However, this classification does not end here. We need to go further and ascertain whether these are direct (prime costs) or indirect (overheads). If we are in manufacturing or service industries, it is relatively easier to deal with the direct costs since we can trace them to the product or service we have provided, otherwise known as cost units.
The overheads on the contrary, are hard to deal with. This is because overheads can not be directly linked with any cost unit. Under traditional costing systems, the solution to the overheads problem is to: Firstly, allocate or apportion them to cost centres e.g. production department, purchasing department, engineering department etc. After this initial allocation and apportionment, we then re-apportion all overheads to those cost centres, which we can categorise as production cost centres. The reason being that if there was no production then other departments would not have incurred any overheads.
When this re-apportionment is over, we then need to find a suitable basis for absorption. This basis could be labour hours, machine hours, a proportion of material costs, a proportion of labour costs, a proportion of prime costs etc. The choice depends on which basis management feels would provide more accuracy in costing products. After this, we would then come up with an absorption rate, for overheads recovery.
The other classification of costs could be based on behaviour. This is because costs have been found to be either variable, semi-variable or fixed; that is, if we try to be simplistic. This type of classification has several uses in Cost or Management Accounting. For example, we could do a Cost-Volume-Profit (CVP) analysis only if we know the behaviour of costs. The CVP analysis, by the way, is a technique we use to try to figure out how profit would change, say, if we change costs by a certain proportion etc.
And, we could also classify costs on the basis of whether they are production, marketing, purchasing, distribution, financial etc. This type of classification, by function, is most common when we prepare Financial Accounts.
I remember back in the days, whilst an MBA student at the University of Botswana writing an essay based on the work of a reknown marketer, C.K.Prahalad. The essay was entitled: The Market/ Wealth at Bottom of the Pyramid. This is a very accurate observation, especially in the context of developing countries.
If you take a country like Botswana, it's only a few who can be characterised as rich. The fallacy for a long time has been that it's only the rich who can afford to buy significant amount of merchandise; hence companies, usually, in doing their market surveys tend to concentrate on potential disposable incomes. But, you see there are very few rich people in developing countries, as earlier pointed out. On aggregate, therefore, consumption by the rich is negligible. Besides, we also learn in economics that rich people have a low marginal propensity to consume.
In a nutshell, to succeed in a developing country like Botswana, location is very important. Specifically, you ought to locate your business nearer to the lower income groups. These are many, and their marginal propensity for consumption is higher. Look at companies like Choppies Stores. I remember in 2004 there were a small outlet situated next to the Botswana Meat Commission in Lobatse. And, they had been trading on that location for several years before then. In fact, I bet, most of their revenues might have been coming from selling basic food items mealie-meal, sugar and samp to the BMC kitchen. But, once they moved out and started operating from underpriviledged sections of the community, their growth became phenomenal.
We can learn a lot from Choppies. First, is that the poor can bring a lot of business, because of numbers. Reciprocally, and secondly, the poor do not need aid. Aid tends to create dependency and, in fact, does not lead to economic growth. What is needed are opportunities. And, still on the Choppies story, I am sure the store does employ a lot of people from the communities in which it is operating.
It's that time of the year when most young city dwellers are frantically organising to go to their masimo and meraka. For most, they would have been busy working in the city (the whole year) with little opportunity to visit their parents and relatives back in the rural areas. So, come christmas the city of Gaborone becomes almost deserted. You can literally stand in the middle of what used to be a traffic jammed highway for 5 minutes without seeing any vehicle coming your way.
So, business can sometimes be bad in Gaborone, this time of the year. On the contrary, this time usually brings a lot of joy for farmers in the rural areas. It is time for celebration, and goats and chickens get slaughtered, as most Batswana relish goat meat and Tswana chicken. For the aspiring young farmers, it is not a bad idea to venture into farming. Agriculture is basically one industry one cannot regret by going into; the returns are enormous. In fact the Botswana Development Corporation, a parastatal organisation, has put up proposals for interested investors to come forward and establish joint ventures with it for the production of dairy products.
It seems the responses are going to be positive, from the look of things. I don't have the numbers, but not so long ago I had one Chartered Institute of Management Accountants (CIMA) student approaching me for ideas on how to put up a business proposal. That is, after realising I have some training in Animal Health and Production. Who says Batswana are not entrepreneurial? This is a common fallacy; and I cannot understand why people perpetuate this negative stereotyping. This is a great country with good people. Stop pulling yourself down; I mean if Batswana were not entrepreneurial or hardworking, this country would not be where it is. Of course more can be done, but compared to the rest of the world we are doing well.
It seems that everyone is catching a fever on these bailouts. As, I recall the US government came up with a stimulus package to shore up American companies, mostly banks. The reason was to make credit easily available, so that companies could have access to financing and, therefore, produce.
You see, if government injects money into an economy, production goes up and jobs are created. The increase in employment tends to lead to an increase in aggregate demand, which in turn leads to further increases in production, consumption and more jobs. As more and more people are employed, there is more money available to households, which can, potentially, be used for more consumption. This is called the multiplier effect; and it gets repeated over and over. In the US, there are signs that it is beginning to work.
I am yet to be educated on whether we had a credit crunch here in Botswana. I know a lot of our financial institutions are multinational, and their parent companies would have been afffected. But, seriously, have our local banks stopped lending? The fact is that most of our locally produced goods e.g. beef, garmets, diamonds, copper, nickel are consummed outside. Would our government's bail out encourage consumption of our products in the US, Europe etc. Note that most of these countries do not accept government subdidised imports. The problem is that as economic conditions deteriorated in the West, families began to save and became more concerned with value for money. The market, therefore, shrunk. So, at this juncture its hard to keep supplyng the same quantities at the same price. Cut down on costs. Cutting down on costs, doesn't mean you should retrench. Labour costs are mostly direct, except for senior management(which represent overheads). If you cut down on production employees, then you forfeit the opportunity to earn revenue.
So, what is the solution. No currency devaluation; rather companies should look at target costing. It's mostly about studying the market, and determining what share of that market you want to capture given the market price or the price you are comfortable with. Determine your desired profit margin, and lo you have the target cost. Invest in reengineering your processes to get the target cost of production if it differs, significantly, from the actual cost.
I have noted that in most occassions, companies in Botswana invest a lot in Financial Accounting; but not much in Cost Accounting or Management Accounting.
I can not recall any time before where a private company has suspended production because food containers have expired. This is something to be hailed. I mean, upon realising that some of the bottles have passed their expiry dates, the company decided to suspend production until suitable ones were acquired. I remember in the past some private companies used to temper with labels on food items to change expiry dates.
However, I must commend public corporations for setting an example. Take the Botswana Meat Commission, for example. They deal in meat products for export; and every time there is any possibility of foot and mouth outbreak they shut their production facilities, until there are certain the disease has been eradicated.
I can't help but wonder as I shopped with my younger daughter at The Game City Mall. It was clear that business is strong and a lot of people can't get enough of what is available. No wonder the Game City Mall is expanding. Actually, the same type of activity can be witnessed at the River Walk Mall and Molapo Crossing.
Could this be proving the pundits wrong. I remember a few year ago, +/- 5 years, some of the pundits were expressing concern that so many investors seemed to be putting a lot of their investments in building shopping complexes. Their concerns were whether there would be sufficient business generated to cover the costs of such investments.
This sort of remind me of the not uncommon errors we keep on making. That is, we tend to think small, when the rest of the world has a bigger picture. Investments by the way are not costs, but represent future value creation. If we always think in terms of costs, we are likely to make dysfunctional decisions and focus on short term gains.
This is a thought provoking heading; but as world leaders converge in Copenhagen to consider how to deal with global warming it is, probably, worthwhile to take a pause; and consider whether we are being environmentally friendly.
The talk is more about carbon, because it has been found that the rise in the amount of carbon gases released into the atmosphere increases world temperatures. Consider that with the fact that we cut a lot of trees! That's a recipe for disaster. Trees, by the way, use carbon dioxide for photosynthesis. So, next time you cut trees, have this in mind.
On a related note, one of the ways Botswana can contribute to this green campaign is to improve our public transport system. That way, most of us would use public transport rather than our cars. Have you noticed that most of the times, you will find only one occupant in a car, whilst we experience terrible traffic jams in the morning.
What about having a mono-rail system? I mean Botswana's first underground railyway system. This will take passengers in an almost circular flow(around Gaborone) and drop them off at strategic points of the city. They can then connect to other modes of transport, to reach their workplaces.
I am sitting around thinking about my next move. That is, where am I taking The Learning Village? I have already registered the company and it is incorporated. I am yet to open a bank account, and register for both the income tax and the value added tax. After that what? I would likely have to wait and do a lot of marketing for the company. I may be sounding pessimistic, but it doesn't appear as if the future is that bleak, though.
I am very hopeful that the next year would bring a lot of business opportunities. The economy is growing; and looking around it doesn't appear as though the world economic crisis has hit Botswana that much. A lot of construction activities are taking place, and the new CBD is taking shape.
In finance, we know that the more you take on risk, the more rewards are likely to come your way. There is that positive correlation that all finance people would tell you about. By the way, these were my reflections for the day, as I sat around and read an article on Economics and Knowledge by F.A.von Hayek
