1 More Standard Costing & Variance Analysis Week 10

2 Fixed Overhead Variances With Fixed Overheads we use BUDGETED fixed overheads Fixed Overheads are absorbed into units of output Total variance : Difference between actual fixed oh and absorbed fixed oh (ie under- or over- absorbed fixed oh) Expenditure variance : difference between budgeted fixed oh and actual fixed oh Volume variance : difference between budgeted production volume and actual production volume X std absorption rate per UNIT

3 Fixed Overhead Variances Scenario Product X Budgeted output = 1,000 Std time to produce a unit = 2 hours Budgeted fixed oh (FO) = £20,000 Therefore: fixed oh absorption rate (FOAR) per unit = 20,000 = £20 1,000

4 Fixed Overhead Variances Scenario Actual Data Fixed Overhead = £20,450 Actual Output = 1,100 units Actual hours worked = 2,300

5 Total Variance Actual fixed oh = 20,450 Absorbed fixed oh (1,100 units X FOAR £20) =22,000 Variance 1,550 (F) (ie £1,550 of fixed oh OVERabsorbed)

6 Expenditure Variance (this is the easy one) Budgeted fixed oh = 20,000 Actual fixed oh =20,450 Variance 450 (A)

7 Volume Variance (Budgeted output – Act output) X FOAR (1,000 – 1,100) X 20 = 2,000 (F) Summary Expenditure 450 (A) Volume2,000 (F) Total1,550 (F) BUT……..

8 Fixed Overhead Volume Variance – Sub Variances Volume Variance can be split into Efficiency variance Capacity variance We have FOAR per UNIT, need to calculate FOAR per HOUR FOAR per hour = Budgeted Fixed OH Budgeted hours (1,000 X2) = 20,000/2,000 = £10

9 Fixed Overhead Volume Variance – Sub Variances Efficiency (Std hrs – Act hrs) X FOAR per hr = (2,200 – 2,300) X 10 = 1,000 (A) Capacity (Budgeted hrs – Actual hrs) X FOAR = (2,000 – 2,300) X 10 = 3,000 (F) Volume 2,000 (F)

10 Fixed Overhead Volume Variance – Sub Variances NOTES Notes 1 Std hrs : Std time per unit = 2 hrs 1,100 units actually made Therefore Std hrs = 2 X 1,100 = 2,200 Notes 2 Budgeted hours = capacity Here 2,000 hrs were budgeted for but actual hours exceeded that so effectively exceeded capacity

11 Back to Acme Blocks Fixed & Variable overheads Budgeted production = 1,000 units (blocks) Budgeted fixed oheads = £0.30 per unit Budgeted variable oheads = £0.10 per unit Budgeted fixed oh absorption rate (hourly) 50 £6.00 per hour = 300 Budgeted variable oh absorption rate (hourly) 50 £2.00 per hour = 100

12 Acme Blocks – Actual Data Fixed overheads 68 £6.20 = £ Variable overheads 68 £1.80 = £ Note 10 hours idle

13 Acme Block - Analysis Total Variance 1,200 units should cost (1,200 X 10p) = Actual cost = Variance 2.40 (A)

14 Sub Variances Expenditure variance Productive hours (68-10) = hrs should incur (58 X 2) = Actual overheads = Variance 6.40 (A) Efficiency Variance (Std hrs – Productive hrs) X VOAR If 1,000 units budgeted to take 50 hrs, Then 1,200 units should take 60 hrs (60 – 58) X 2 = 4.00 (F) Summary 6.40 (A) (F) = 2.40 (A)

15 Capital Investment Appraisal If a company is going to invest in a project it need to ensure The project will be financially viable It will be successful Risk levels will be minimised

16 Discount or not? We will consider 4 methods of decision making for capital projects Each method can be used to Make comparisons between projects competing for scarce resources Make comparisons between a project and a company benchmark 2 methods employ discounting 2 do not

17 Company scenario Verminous Ltd (cost of capital 10%) Verminous Ltd are contemplating the purchase of a new machine. They have a choice of either the "Weasel" or the "Stoat". The company has made some estimates of costs and expected cash inflows and this is rovided below: WeaselStoat £,000£,000 Cost of Machine Cash inflows Year Year Year Year Year Year 6 60 Profit160240

18 Payback Period (PP) The payback period Is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow This method computes the amount of time required to recover the initial investment The acceptance criterion is dependent upon the maximum cutoff period established by management for projects of a similar type

19 Pros and Cons of PP Advantages Easy to use and understand Can be used as a measure of liquidity Easier to forecast short term than long term cashflows Disadvantages Does not account for time value of money*** Does not consider cashflows beyond the payback period The cutoff period is subjective

20 Weasel & Stoat cumulative cumulative Year Year Year Year Year Year 660 Weasel = 4yrs 1/6 th (4 yrs 2 months) Stoat = 3 yrs 7/8 th (3 yrs 10.5 months)

21 A PP conundrum M1M2M3 Cost of machine Yr 1 cashflow Yr 2 cashflow Yr 3 cashflow Yr 4 cashflow Yr 5 cashflow What is PP? PP = 3 years for each

22 Accounting Rate of Return (ARR) This technique is similar to ROCE ratio you are familiar with Remember, ROCE can be used as a measure of management efficiency How effectively can management make profit (return) from capital in the business (capital employed)

23 Accounting Rate of Return (ARR) All other appraisal techniques are concerned with NET cashflows ie cash generated less cash costs ARR considers Accounting Profit as the measurement Accounting Profit = Income less all costs incurred in generating that income, therefore includes depreciation

24 Accounting Rate of Return (ARR) ARR = Average annual profit X 100 Average Investment Average annual profit = total profit for project / number of years Average Investment = (Capital cost + residual value) / 2

25 So, applying it to Weasel & Stoat WeaselStoat Total dep'n Year Year Year Year Year Year 6 60 Total profit

26 Which means.. There is no residual value, so full cost is depreciated. Average Annual Profit = (Total Net cashflows – Full cost of asset) / years of project Again, as no RV average investment = Cost/2 Weasel(160/6)/200*100 =13% Stoat(240/5)/300*100 =16%

27 ARR and ROCE Assume Verminous Ltds ROCE is 14% If Weasel were chosen it would reduce (if only marginally) the companys ROCE If Stoat were chosen it would, of course, increase ROCE In this case higher ARR = project with higher profit But what is most important Profits or ROCE? Assume Verminous has ROCE of 12%...

28 ARR a conundrum WeaselStoat Total depreciation Year Year Year Year Year Year 6 60 Total profit ARR Av profit(160/6) 27 (170/5)3413% (W) Av Investment % (S)

29 Pros & Cons of ARR Advantages generally accepted provides index of performance encourages managers to improve ARR can be used to gauge performance & make comparisons Disadvantages lack of consensus on definitions of capital or profit can be manipulated can distort overall allocation of resources noncash items included ignores the timing of cash flows

30 Discounting methods Both PP and ARR assume absolute values in cashflows The value of a cashflow today = the same as its value in 5 or 6 years time There is no consideration of risk involved (cashflows are estimates!) They assume the capital used is costless Apart from the projects they assume there is no alternative use for the capital (ie invest it)

31 A question.. Let us suppose you were given the choice of receiving £10,000 today or £10,000 in 3 years time. Which would you choose?

32 Discounting cashflows The value of that £10,000 today can be measured as £10,000 plus the potential value of interest earned. If you were to receive your cash in 3 years time, then, you would expect to receive not just £10,000 but an additional sum for the interest receivable over that time period. Conversely the value today of that £10,000 plus interest received in 3 years, would simply be £10,000.

33 Graphically represented

34 The use of PV tables To discount cashflows use PV tables Example (Also found in textbook)

35 Net Present Value The essence of a business is to maximise shareholder wealth If raw cashflows are considered it is possible that an apparent increase in wealth could actually result in a diminution

36 Application to Weasel & Stoat WeaselStoat 10% PV Year Year Year Year Year Year NPV =4.97NPV = 5.63

37 Comparison of results The 2 machines both have POSITIVE NPVs But only just… It is up to management to decide if the factors incorporated in the Discount Rate are sufficient to accept the project with the higher NPV

38 Internal Rate of Return (IRR) The application of Present Values to the cashflows shows that the actual rate of return must be >10% In some instances management would want to know the exact rate of return We can find this by formula

39 Internal Rate of Return (IRR) Ideal Scenario By trial & error calculate Negative NPV As 10% gives Positive NPV Choose a higher Discount Rate In this case 11% should do Apply DF to cashflows & determine NPV Then apply formula

40 IRR Formula IRR = A + C (B – A) C – D Where: A = discount rate of low trial B = discount rate of high trial C = NPV of low trial cashflow D = NPV of high trial cashflow

41 Weasel & Stoat WeaselStoat 11% Year Year Year Year Year Year NPV = -6.71NPV =-12.37

42 Weasel & Stoat Outcomes Weasel IRR = 10 + [4.97/( )]* = 10.43% Stoat IRR = 10 + [5.63/( )]* = 10.31%