Business Insight and Performance

accounting rate

Total Fixed Cost

Fixed Costs per unit DECREASE as Production Levels Increase

• Total fixed cost remains the same at differing production levels

• Therefore Fixed Cost per unit reduces as output increases

Correct sequence for budget preparation (For company without production resource limitations)

Sales budget, Finished goods inventory budget, Production budget, Materials usage budget

Sales would be the principal budget factor (as there are no production resource limitations) and so this is the first budget to be prepared.

Inventory adjustments in the finished goods inventory budget indicate the production requirements for the production budget. Once the level of production is known, the materials usage budget can be prepared.

The correct answer is: B. Sales budget, Finished goods inventory budget, Production budget, then Materials usage budget

Finding Production Units when Closing Inventory is an increase?

Step 1: Find Closing Inventory
Opening Inventory × (1 + Increase %) = Closing Inventory
(e.g., 270 × 1.10 = 297 units)

Step 2: The Production Formula
Sales + Closing Inventory - Opening Inventory = Units to Produce

The Logic:

• Sell it: How much is going out to customers?

• Store it: How much extra do we want left in the warehouse at the end?

• Have it: What did we start the year with? (Subtract this because you don't need to make these again).

Quick Check:
If you want to increase inventory over the year, you must produce more than you sell.
In this case: 3,600 (Sales) + 297 (Closing) - 270 (Opening) = 3,627 units.

Standard Rate Formul

Rate Variance = (Standard Rate - Actual Rate) x Hours Paid

Rate Variance = (Standard Rate x Hours Paid) - (Actual Rate x Hours Paid)

Positive result: Favourable (paid less than standard)

Negative result: Adverse (paid more than standard)

Rate Variance (favourable?) = (Standard Rate x Hours Paid) - Actual Cost

C/S Ratio (Contribution to Sales Ratio)

C/S Ratio = Contribution per unit / Sales Price per unit

• Measure of how much contribution is earned from each £1 of sales revenue

Ch 11 Breakeven analysis and Limiting Factor Analysis

Breakeven Point = Fixed Costs / Contribution per unit

Breakeven Revenue = Fixed costs / C/S Ratio

C/S Ratio = Contribution per unit / Sales Price per unit

Margin of Safety (%) = (Budgeted Sales units - Breakeven Sales units) / Budgeted Sales units

Units Sold to achieve Target Profit = (Fixed costs + Target Profit) / Contribution per unit

Revenue Required for Target Profit = (Fixed costs + Target Profit / C/S Ratio

Contribution vs Profit

Total Contribution = Total Sales Revenue - Total Variable Costs

Contribution Per Unit = Selling Price per Unit - Variable Cost per Unit

Net Profit = Total Contribution - Total Fixed Costs

Net Profit = (Total Sales Revenue - Total Variable Costs) - Total Fixed Costs

Limiting Factor Analysis

Step 1: Identify the Limiting Factor

• Calculate material/labour required to produce enough units to reach maximum sales demand

• Compare to maximum available material/labour

Step 2: Calculate Contribution per unit of limiting factor

• Rank in terms of highest contribution per limiting factor (prioritise)

Scrap Value: ARR vs. NPV/Payback

• Accounting Profit (ARR):

  • Rule: Don't add scrap value as "income."

  • Role: It only reduces total depreciation (Cost - Scrap).

  • Why: Including it as income would "double-count" the benefit already captured by lower depreciation.

• Cash Flow (NPV/Payback):

  • Rule: Do include it as a cash inflow.

  • Role: Add it to the final year’s operating cash flow.

  • Why: It is actual "green cash" entering your bank account when you sell the asset.

• The "Add-Back" Formula:

  • To get Cash Flow from Profit:

  • Annual Cash Flow = Accounting Profit + Depreciation

  • (Then add Scrap Value separately in the final year).

The 4 Investment Appraisal Techniques

1. The Payback Period

2. The Accounting Rate of Return (ARR)

3. Net Present Value (NPV)

4. Internal Rate of Return (IRR)

OAR (Overhead Absorption Rate)

OAR = Budgeted Overhead cost / Budgeted Hours

Over/Under Absorption = (Actual Activity Level x OAR) - Actual Overhead

Overhead Apportionment

Overhead Apportioned to Cost Centre = Total Overhead Cost x (Apportionment base value for that centre / Total Apportionment Base value)

Reapportionment of Overheads

Cost Centres:

• Production Centres: Goods pass through these departments: Apportionment

• Service Centres: Goods don’t pass through: Reapportionment needed

After indirect costs apportioned to Service Centres, need to Reapportion (I.e. Clear the costs in these departments and apportion them to production departments):

• First Reapportionment: Service Centre with Largest Costs: Shared between all other cost centres (including other service centres)

• Reapportioned based on a fair basis e.g. based on no. of employees

• Second Service Centre: Now includes some of first service centre’s costs: Reapportioned between rest of cost centres on fair basis

Absorption Costing Steps

1. Allocation of Overheads

• Allocation = Whole cost items charged in full to single cost centres e.g. mixing department supervisor salary allocated to mixing department (only related to that department)

• Direct Costs always allocated (Indirect costs sometimes)

2. Apportionment of Overheads

• Apportionment = Splitting overhead cost across several different cost centres on a fair basis

• Overhead Apportioned to cost centre = Total Overhead Cost x (Apportionment Base value for that centre / Total Apportionment Base Value)

3. Reapportionment of overheads

• After indirect costs apportioned to Service Centres, need to Reapportion (I.e. Clear the costs in these departments and apportion them to production departments):

4. Calculate Predetermined OARs for each production cost centre

• Ensures each product/service unit is charged a fair share of each production centre’s overheads (Overhead absorption)

• OAR = Total Budgeted Production Overhead Cost / Total Budgeted Activity Level

OAR Activity Level:

• No. of units = When all products made in cost centre are identical

• Labour Hours = When work in cost centre is mostly manual

• Machine Hours = When work in cost centre is mostly automated

• Total Direct costs = Labour/Machine hour data not available, but cost data is

5. Over/Under Absorption Adjustment

• Over/Under Absorption = (Actual Activity Level x OAR) - Actual Overhead Costs

• IF NEGATIVE: Overheads underabsorbed: Record Additional Cost (lower profit)

• IF POSITIVE: Overheads Overabsorbed: Reduce Cost (higher profit)

Absorption Profit Calculations

Revenue X

Cost of Sales (X)

Production Cost

Add: Opening inventory

Less: Closing inventory

Fixed Overhead Over/Under absorption X/(X)

Variable non-production costs (X)

Fixed non-production costs (X)

Profit for the quarter

Shortcut for Cost of Sales:

COS = Actual units sold x full production cost/unit

Marginal Costing

Marginal Costing:

• Only variable production costs (material/labour/overheads) included in valuation of cost units

• Fixed costs treated as period costs charged to income statement for the period

• Alternative to absorption costing

• Uses Contribution = Sales Price - Variable (marginal) cost

Indirect Labour costs

• Idle Time: When a direct worker is idle due to management or supply issues (like delays in raw materials), the cost of that time is treated as an indirect production overhead.

• Unless overtime is specifically requested by a customer for a specific job, the "premium" portion (the extra amount paid above the basic rate) is treated as an indirect cost.

Overheads

Overheads: Indirect running costs of a business that CANNOT be directly traced to a specific product or service

Marginal Costing vs Absorption Costing

Marginal Costing: Fixed costs treated as period costs and expensed immediately

• fixed overheads do not change regardless of how many units produced

• Focuses on Contribution = Sales Revenue - Total Variable Costs (Prod+Selling)

Absorption Costing: Fixed production overheads absorbed into product cost

• Focuses on Gross Profit = Sales Revenue - Full Production Cost of Sales (Adj. for over/under absorption)

Variable Non Production Costs (Marginal costing)

Variable Non Production costs (i.e selling/dist costs) = Variable non prod cost per unit x No. units SOLD

Variable Non Production Costs

1. Absorption Costing

• Production Cost per Unit: Variable Production + Fixed Production (OAR). (No selling costs allowed).

• Inventory is valued at: This Full Production Cost.

• At the bottom: You deduct Total Variable Selling Costs to get Net Profit.

2. Marginal Costing

• Production Cost per Unit: Variable Production ONLY. (No selling costs allowed here either).

• Inventory is valued at: This Variable Production Cost only.

• Where the selling cost goes: You deduct Variable Selling Costs after Cost of Sales to get your Contribution.

Why does rise in inventory levels result in higher profit for absorption costing than marginal costing

• Under Absorption Costing: Closing inventory acts like a sponge. When it grows, it absorbs a portion of your fixed overheads out of the current month and parks them on the balance sheet. This drops your current expenses and inflates your profit.

• Under Marginal Costing: Closing inventory ignores fixed costs completely. No matter how much inventory you pile up in the warehouse, the full fixed overhead expense hits your profit statement today. Profit is completely unaffected by production levels and changes strictly based on what you actually sell.

When given Marginal Profit and need to calculate Absorption Profit (or vice versa)

Use Master Profit Reconciliation Formula:

Absorption Profit = Marginal Profit +- (Change in Inventory Units x OAR)

Accounting Rate of Return

Estimates ARR a project should yield: If project exceeds target ARR: Acceptable

• Only Appraisal method that uses accounting profits instead of cash flow

ARR = (Average Annual Accounting Profit / Initial OR Average Investment) x 100

Average Investment = ½ x (Initial investment + final or scrap value)

Net Present Value (NPV)

£1 today worth more than future £1

Compounding: Converting present value intro future value through interest

• Assume interest compounds annually

• Future Value = £10,000 × 1.05^8 = £14,775

Discounting: Converting future value into present value

• Multiply future value by discount factor i.e. 1/(1+r)^n

• Present Value = £14,775 × 1/(1.05)^8 = £10,000

Cost of Capital = Interest Rate

NPV: Finds present value of cash inflows minus the present value of cash outflows, by discounting future cash flows

• Positive NPV: Cash inflows from project > Cost of Capital: Undertake project

• Negative NPV: Cash inflows from project < Cost of Capital: Don’t undertake project

• NPV = 0 : Cash inflows from project = Cost of Capital

Net Terminal Value (NTV)

NTV = Opposite of NPV: Cash surplus remaining at end of project: Compounded to future value

NTV discounted at cost of capital will give NPV:

NPV = NTV x 1/(1+r)^n and NTV = NPV x (1+r)^n

NPV with changing discount rates

Calculating NPV if Cost of capital is 10% for first year and 20% for second year:

NPV = C0 + C1/(1+r1) + C2/(1+r1)(1+r2)
= C0 + C1/1.1 + C2/(1.1)(1.2)

Internal Rate of Return (IRR)

IRR: Discount rate (r) at which NPV =0

If IRR GREATER than Cost of Capital (r): Project adds value: Accept Project

If IRR LESS than Cost of Capital (r): Project destroys value: Reject Project

Cost Behaviour

Behaviour of Total Cost as activity level INCREASES:

• Variable Costs: Increases

• Fixed Costs: Remains constant

• Semi Variable Costs: Increases

Behaviour of Cost Per Unit as activity level INCREASES:

• Variable Costs: Remains Constant

• Fixed Costs: Reduces

• Semi Variable Costs: Reduces

Total Material Variance

Total Material Variance = Material Usage Variance + Material Price Variance

Material Usage Variance = (Standard Quantity - Actual Quantity) x Standard Price

Material Price Variance = (Standard Price - Actual Price) x Actual Quantity Used

Total Labour Variance

Total Labour Variance = Labour Efficiency Variance + Labour Rate Variance

= (Actual units produced x standard labour cost per unit) - Actual total labour cost

Labour Efficiency Variance = (Standard Hours for Actual Output - Actual Hours Worked) x Standard Rate

Labour Rate Variance = (Standard Rate - Actual Rate) x Actual Hours Worked

Breakeven Point

At Breakeven Point:

• Total Contribution = Fixed Costs

• No of Units Sold x Contribution per unit = Fixed Costs

Breakeven point = Fixed Costs / Contribution per unit

• i.e. No. of sales units needed to “breakeven”

Therefore Profit = 0

Profit = Contribution - Fixed Costs

Breakeven Revenue

Breakeven Revenue = Breakeven point x Sales Price

OR
Breakeven Revenue = Fixed Costs / C/S Ratio

C/S Ratio = Contribution per unit / Sales price per unit

• aka Contribution to Sales Ratio OR Profit/Volume Ratio

Margin Of Safety

Margin of Safety = (Budgeted Sales Units - Breakeven Sales Units) / Budgeted Sales units

or (Budgeted Revenue - Breakeven Revenue) / Budgeted Revenue

Target Profit

Added onto BEP formulas to calculate no. of sales units to reach target profit

Units sold to achieve Target Profit = (Fixed costs + Target Profit) / Contribution per unit

Revenue required to achieve Target Profit = (Fixed Costs + Target Profit) / C/S Ratio

Limiting Factor Analysis

Prioritises products based on Contribution per Unit (kg) of Limiting Factor

Extra Supply of a Limiting Factor

Maximum Premium (in addition to usual purchase price) a business is willing to pay to acquire extra units of a limited resource is the additional contribution earned by using those additional units