Be Able to Make Financial Decisions Based on Financial Information - Assignment Example

Be Able to Make Financial Decisions Based on Financial Information Table of Contents SL.No. Contents Page No Outline of Budgetary Control Cycle 2 2 Analysis, Recommendations and suggestions of revenue budget for the year Jan-Dec 2011 2-4 3 Calculation of unit costs and making pricing decisions 4-6 4 Calculation of Accounting Rate of Return 6-7 5 Calculation of Payback period 7-8 6 Calculation of Net Present Value 8-9 7 Calculation of Profitability Index 9 8 Calculation of Internal Rate of Return 9-11 9 Advantages and disadvantages of Accounting Rate of Return 11 10 Advantages and disadvantages of Payback period 11-12 11 Advantages and disadvantages of Net Present Value 12 12 Advantages and disadvantages of Profitability Index 12 13 Conclusion 12 14 Reference 13 PART A: AC 3.1 Analyze budgets and make appropriate decisions Outline of Budgetary Control Cycle: Review the variance analysis of Yuri’s budget. Suggest reasons for the results. Units sold: An adverse variance in the units sold is due to the difference in actual number of units sold (75,000); it was lower than the budgeted units sold (100000). The variance in the units sold may result in the variance in the sales volume. The budgeted number of units sold is the resultant of the sales and marketing managers. It is based on the estimation of Yuri concerning how the product’s features, price, market share, anticipated marketing actions, allocation channels, and the sales in new areas will impact future sales. These variances may be mainly as a result of the tight competition in the market. Competitors may have offered new products having more superior quality that attract more number of customers. Another reason may be that the company might have changed the product price that may, in turn, result in a variance in the unit sales volume. Material price variance: The direct material price variance (£7,500) is the variation between actual material cost (£22,500) and budgeted material cost (£ 15,000). Here, the material price variance shows an unfavorable trend, as the actual cost is higher than the material. The main reasons for the material price variances are: 1. There may possibly be current variations in the purchase price of materials. 2. Price variation may be due to the substitution of raw materials, unlike from the original material arrangement. The other reason for the price variance may be due to the non accessibility of cash discounts that are actually expected at the time of deciding the price standards and also may be due to changes in transportation costs, careless purchasing and changes in the material standard. Direct labor variance: The total direct labor variance is found by evaluating actual cost of direct labor to the budgeted direct labor cost. If the actual cost is in excess of the budgeted cost, the resultant variances become unfavorable. This may be due to the usage of more labor hours as there is shortage of adequate experienced labors in the concerned cutlery manufacturing. The other reasons are the higher payment of labor rate per hour. The sum of unfavorable direct labor variance (1,875) is the combination of adverse direct labor efficiency variance of (5,625) + adverse direct labor rate variance of 3,750. Material and labor (Price/rate variance and Usage/efficiency variance) The adverse variance in the material usage amounting (£ 3,000) are due to the imperfect material, unnecessary waste of material, and stricter quality control. The labor rate variance has shown an adverse trend. This unfavorable variance is due to the increase in the wage rate of laborers. The labor efficiency rate is also showing an unfavorable trend of (£ 5,625). This is mainly due to the usage of poor quality material. The company lacks the supply of steel material of adequate quality. The other reason may be the lost of time over and above the standard agreed, as well as production lesser than the standard set as a result of the purposeful constraint. PART B: AC 3.2 Explain the calculation of unit costs and make pricing decisions using relevant information Solution: 1. Total cost for the job and the cost per leaflet. Direct Costs = (204*3) + (2*9) = £630 Direct Labor = (2*15) = £30 Production Overheads = (2*55) = £110 Selling, Distribution and Administration Overheads = (2*20) = £40 Total Cost for the Job = 630+30+110+40 = £810 Cost per Leaflet = Total Cost for the Job / Total Leaflets = 810 / 100000 = £ 0.0081 2. Total Production Cost = Direct Material + Direct Labor + Production Overheads = 630+30+110 = £770 3 Calculate the price that the company must quote for the job Price that the company must quote for the job = Direct Costs+ Direct Labor+ Production Overheads+ Selling, Distribution and Administration Overheads (including 10% mark up) = £630+£30+£110+ (£40+40*10/100) =770+44 =£814 4 Re-estimate the price that the company must quote if i. The budgeted number of hour that the job requires is readjusted to 2.5 hours Re-estimation of price that the company must quote for the job = Direct Costs+ Direct Labor+ Production Overheads+ Selling, Distribution and Administration Overheads (including 10% mark up) =£630+£30+ (2.5*£55) + (£40+40*10/100) =660+137.5+44 =£841.5 ii. The budgeted number of hour that the job requires is readjusted to 1.5 hours Re-estimation of price that the company must quote for the job= Direct Costs+ Direct Labor+ Production Overheads+ Selling, Distribution and Administration Overheads (including 10% mark up) =£630+£30+ (1.5*£55) + (£40+40*10/100) =660+82.5+44 =£786.5   PART C: AC 3.3 Assess the viability of a project using investment appraisal techniques  Solution: 1) i.         Calculation of Accounting Rate of Return (ARR): ARR = (Average Net Income / Average Investment) * 100 Where Average Net Income = Total Net Income /Number of Years Project A = (35000+30000+25000+30000) / 4 = £30000 Project B = (20000+20000+24000+46000) / 4 = £27500 Average Investment = Initial Investment/2 = 50000/2 = £25000 ARR = Project A = (30000/25000) *100 = 120% Project B = (27500/25000) *100 = 110% A project with higher ARR is to be accepted. Therefore, Project A is to be selected with higher ARR. ii.       Calculation of Payback Period: Payback = 1+2/3 As per the formula mentioned above, 1 is the end period having negative cumulative cash flow; 2 is the total value of the cumulative cash flow at the end period of 1; 3 is the real Cash Flow for the period following 1. Note: At the end of Year 4, there is a resale value of £10,000 for each project and this shows incremental cash inflows. Therefore, it is to be added with the cash inflows of Year 4 for both projects. Year Project A Project A Project B Project B Cash Inflows Cumulative Cash Inflows Cash Inflows Cumulative Cash Inflows 1 35000 35000 20000 20000 2 30000 65000 20000 40000 3 25000 90000 24000 64000 4 30000 120000 46000 110000 Project A: The above table shows that within one year, the project recovers £35000. So, £15000 is left out of the initial investment. In the 2nd year, the cash inflow is £30000. This means that the pay-back period is between the 1st and 2nd years, determined as follows: Pay-back period = 1 year + £15,000 / £30,000 = 1.5 years Project B: The above table shows that in 2 years, the project recovers £40000. So, £10000 is left out of the initial investment. In the 3rd year, the cash inflow is £24000. This means that the pay-back period is between the 2nd and 3rd years, calculated as follows: Pay-back period = 2 year + £10,000 / £24,000 = 2.4 years Hence, invested parties can invest in Project A because according to pay-back period, it will return the profit within 1.5 years before Project B. iii.    Calculation of Net Present Value (NPV): NPV = Present Value of Cash Inflows – Present Value of Cash Outflows Year Project A Project B Discount factor 10% Project A Present Value of Cash Inflows Project B Present Value of Cash Inflows Cash Inflows Cash Inflows 1 35000 20000 0.9091 31818.5 18182 2 30000 20000 0.8264 24792 16528 3 25000 24000 0.7513 18782.5 18031.2 4 30000 46000 0.6830 20490 31418 Total Present value of cash inflows £95883 £84159.2 Project A: NPV = Present Value of Cash Inflows – Present Value of Cash Outflows NPV = 95883-50000 = £45883 Project B NPV = Present Value of Cash Inflows – Present Value of Cash Outflows NPV = 84159.2-50000 NPV = £34159.2 Project A with higher NPV is to be selected for investment. iv. Calculation of Profitability Index: Profitability Index = Present Value of all Cash Flows / Initial Cash Investment Project A = 95883 / 50000 = 1.91766 Project B = 84159.2 / 50000 = 1.683184 Both the Projects A and B are to be accepted as both have a profitability index greater than 1. But Project A has a higher profitability index. 2) Calculation of Internal Rate of Return: Internal rate of return is a rate of return applied in capital budgeting to evaluate the profitability of investments. The internal rate of return (IRR) is defined as “the rate of return promised by an investment project over its useful life. The internal rate of return is computed by finding the discount rate that equates the present value of a projects cash out flow with the present value of its cash inflow” (Internal Rate of Return (IRR) Method in Capital Budgeting Decisions 2012). IRR = Lower rate + NPV at lower rate- Initial investment * (higher-lower rate) NPV at lower rate – NPV at higher rate Project A: Year Cash Inflows P.V factor @ 13% Discounted Cash Inflows P.V factor @ 50% Discounted Cash Inflows 1 35000 0.8850 30975 0.6667 23334.5 2 30000 0.7831 23493 0.4444 13332 3 25000 0.6931 17327.5 0.2963 7407.5 4 30000 0.6133 18399 0.1975 5925 90194.5 49999 Workings: Present Value Factor = Investment / Average Cash Inflows Average cash inflows = 35000+30000+25000+30000= 120000/4 = 30000 4 Present Value Factor = 50000/30000 = 1.66 The factor 1.66 is to be located in the present value annuity table at 13% discount factor. At 13%, the present value of cash inflow is 90194.5, which is more than the cost of project 50000. To attain a value less than the cost of project, the discount factor must be increased. IRR = 13 + 90194.5-50000 *(50-13) 90194.5-49999 = 13 + (40194.5/40195.5)37 = 13+0.999*37 = 13+36.999 = 49.999% Project B: Year Cash Inflows P.V factor @ 7% Discounted Cash inflows P.V factor @ 35% Discounted Cash inflows 1 20000 0.9346 18692 0.7407 14814 2 20000 0.8734 17468 0.5487 10974 3 24000 0.8163 19591.2 0.4064 9753.6 4 46000 0.7629 35093.4 0.3011 13850.6 90844.6 49392.2 Present Value Factor = Investment / Average Cash Inflows Average Cash Inflows = 20000+20000+24000+46000= 110000/4 = 27500 4 Present Value Factor = 50000/27500 = 1.81 The factor 1.81 is to be located in the present value annuity table at 7% discount factor. At 7%, the present value of cash inflow is 90844.6, which is more than the cost of project 50000. To obtain value less than the cost of project, the discount factor must be increased. IRR = 7 + 90844.6-50000 *(35-7) 90844.6-49392.2 = 7 + (40844.6 / 41452.4) 28 = 7 + 0.9853 * 28 = 7 + 27.589 = 34.589% Project A with higher internal rate is to be selected. 3) Advantages and disadvantages of the four methods of evaluation ARR: Advantages: Simple to compute and understand. Focuses on the accounting information and does not require any additional data. Evaluates the profitability of investment. Disadvantages: Ignores the time value of money. Ignores the cash flow from investment. Payback Period: Advantages: Simple to apply and helps to determine how long it will take to recover an investment. Helps to make quick evaluation of project with small investment. Disadvantages: Does not take into account the reality that future returns might be less important. Ignores qualitative aspects of the assessment. Net Present Value: Advantages: Gives importance to interest rates. Focuses on the profitability of the project. Disadvantages: Ignores qualitative aspects of the assessment. Profitability Index: Advantages: Take into account the time value of money. Considers study of all cash flows of entire life. Determines the accurate rate of return of the project. Disadvantages: It is a complex process to determine the interest rate. Difficult to calculate profitability index if two projects have different useful life. 4) Conclusion: Investment appraisal techniques are applied to ascertain whether a project’s long term investments are worth pursuing. Through the various investment appraisal techniques, project A and B are compared to determine their investment value. Since the Accounting rate of return, Payback period, Net present value, Profitability index and internal rate of Project A is higher as compared to Project B, the former is to be recommended for acceptance. References List Anthony et al. (2007). Accounting Text and Cases. 12th Edition Accounting- Text & Cases. The McGraw- Hill Companies. [Online] Available at http://books.google.co.in/books?id=jP7QwrqcAdAC&pg=PA652&lpg=PA652&dq=variances+between+actual+net+income+and+budgeted&source=bl&ots=rD24czgdW&sig=XQE41nturQ69_0wzMk3pI462tRw&hl=en&sa=X&ei=oJRdUIvkGs7yrQeG34CwBQ&ved=0CDMQ6AEwAg#v=onepage&q=variances%20between%20actual%20net%20income%20and%20budgeted&f=false [Accessed on 23 September 2012]. Internal Rate of Return (IRR) Method in Capital Budgeting Decisions. (2012). Accounting for Management. [Online] Available at http://www.accounting4management.com/use_of_internal_rate_of_return_m.htm [Accessed on 27 September 2012]. Read More