Making a Financial Case

ILM Level 5 Certificate in Management

Making a Financial Case

Making a Financial Case

Contents / Page No.
Module introduction / 3
Understanding costs and costing systems
Direct and indirect costs / 4
Fixed and variable costs / 8
Break even analysis / 10
The contribution method / 13
Costing systems: marginal and absorption costing / 15
Absorption costing / 16
Activity-based costing / 21
Profit improvement / 22
Investment decisions / 25
Investment appraisal methods / 26
The payback period method / 27
The accounting rate of return method / 30
Discounted cash flow methods: NPV and IRR / 32
Net present value / 34
Internal rate of return / 37
Risk in investment appraisal / 39
Risk analysis / 40
The criteria matrix / 44
Management and control of investment projects / 47
Summary / 48

Unit Introduction

Welcome to the ‘Making a Financial Case’ unit. There are two key learning outcomes to this unit:

• To understand the financial concepts used to inform management decisions
• Be able to make a financial case to inform a management decision

In the first part of the unit, you will be introduced to a number of key principles in terms of understanding costs and costing systems. The second part of the unit is concerned with exploring a range of capital investment appraisal methods. The key focus for the assessment of this unit is an Improvement Report, not to be completed until you have attended “Managing Improvement”.

The specific areas to be covered are as follows:

• Differentiate between the direct and indirect costs of the business
• Identify the fixed and variable costs of the business
• Use break-even and contribution analysis
• Understand the principles of three costing systems
• Consider some simple strategies for profit improvement
• Understand and apply the main investment methods used in business
• Discuss the strengths and weaknesses of each method
• Understand the importance of risk and the need for sensitivity analysis
• Identify a structure for controlling and reviewing capital projects

Understanding Costs and Costing Systems

Cost control and management is a key basis for competitive advantage. An understanding of how to categorise costs and how certain costs behave is, therefore, going to be of great value to you in your decision making role, and will be of significant value to your organisation. This is a key area covered in this section.

If you are going to survive and prosper as an organisation, you must ensure that all the business costs are covered by the fees that you charge for your service. This includes the direct costs of the product/service and the organisation’s overheads – but how do we deal with the overheads? In this section, you will look at three different costing methods, each of which has a specific purpose, and will serve to provide you with answers to this question.

The knowledge of how much the business needs to sell in order to cover the costs of operating and start making a profit would be of great value, providing a clear business target. In this section, you will see how ‘break-even analysis’ and ‘contribution analysis’ can be used to provide this information.

Within this section of the unit we will be covering the following topics:

• Direct and indirect costs
• Fixed and variable costs
• Break even analysis
• Contribution analysis
• Marginal and absorption costing
• Activity-based costing
• Profit improvement

Direct and Indirect Costs

In order to charge an appropriate fee for the product/service provided and for the organisation to make a genuine profit/surplus, we need to be able to identify both the costs directly associated with providing that specific product/service (the direct costs) and those overhead costs which are incurred as a result of generally running the business (the indirect costs). If we assume that the key front line service of the University are the lectures, we could identify the direct costs as follows:

• The direct labour would be the lecturers
• The direct materials would include a number of items but perhaps, most obviously, the handouts provided to students during a lecture
• Whilst we may not always allocate direct expenses to the service, this could include any specific equipment or service that we have had to buy in; in this example it is a web host provider – Fasthosts.

Now we need to consider the indirect (overhead) costs which could be as follows:

• The property rates for the University
• Heating and lighting
• ... and, of course, administration and management support represented by the typical manager above

These represent just some of the potentially huge indirect costs that are incurred in order to run the operation. The table below presents a general breakdown of these costs.

Cost / Code / Cost Category / Description
Direct Costs:
These costs are directly attributable to the provision of the front line service. / A / Direct Labour / The people who directly make the product, or provide the front line service
B / Direct Materials / Any materials consumed in the process /provision of the front line service
C / Direct Expenses / Associated directly with the provision of the service, eg. hire of specialised equipment, any royalties payable as commission
Indirect Costs:
These costs are commonly known as ‘overheads’. They comprise those factors that are not directly attributable to the provision of the front line service, eg. / D / Indirect
labour / Managers, supervisors, maintenance and cleaning staff
E / General administration / General office staff and office materials
F / Reception / Staff
G / Marketing and distribution / Advertising, selling, promotions, transport costs, marketing and distribution staff
H / Buildings occupancy / Rent/rates, property taxes, insurance, heating, lighting, water rates, electricity, repairs and maintenance

It is entirely up the business as to how it decides to categorise costs. There are no accounting standards to which the business should conform.

Activity: Now consider your own operational area and see if you can divide it up into the front line service and support service and, consequently, make a brief list of the potential direct and indirect costs.

Direct Costs / Indirect Costs

Fixed and Variable Costs

The ability to monitor and control costs requires an understanding of the nature of costs, ie how certain costs behave. The difference between fixed and variable costs is a case in point.

• Fixed Costs are those costs which do not alter with changes in organisational activity, eg. the property rates will remain the same each month regardless of how well or how badly the organisation is doing.

• Variable Costs are those costs which will vary directly with changes in organisational activity, eg. if the volume of work increases beyond the capacity of full time staff, then there may be a need for either overtime working, temporary staff, or casual staff etc. You may already have found that some costs have a fixed element and a variable element, eg. a phone bill may have a standing charge for the line rental, and a variable charge for the amount of phone useage; these cost are known as semi-variable.

Activity:For the focus of this activity, let’s use the example of the Olympic swimming pool. Working with a partner consider which of the following costs should be treated as fixed or variable by ticking the appropriate column.

Cost Area / Question / Fixed / Variable
Direct Materials: / Direct materials
Direct Labour: / Swimming pool attendant’s wages
Swimming pool attendant’s overtime
Overheads: / Promotional literature
Lighting
Business rates
Salesperson’s commission
Advertising

Activity: Consider your own operational are – what are your fixed and variable costs?

Fixed Costs / Variable Costs

Break-Even Analysis

Clearly, if the organisation is going to be profitable, then both its fixed and variable costs need to be covered by sufficient revenue generation. Break-even analysis is a tooldesigned to help calculate how much revenue needs to be generated in order to cover both these costs. Essentially, it helps to:

• calculate the total costs of producing a product/providing a service

• forecast the revenue that needs to be generated in order to cover costs and start making a profit

The break-even point occurs where total costs equals total revenue

Any revenue below the break-even point is at a financial loss to the organisation for that particular product/service. Once revenue has exceeded the break-even point, then the organisation will be operating at a profit.

To illustrate this concept, you can construct a break-even table. For this exercise, let’s use the example of the University’s sports centre

Activity:

• The centre has fixed costs of £10,000 per month

• It charges an entry fee to the centre of £1.50

• It incurs variable costs per customer, eg electricity to power fitness machines, use of shower etc, of £0.50 per customer.

The monthly break-even point can be calculated by completing the table below.

Demand
(no. of customers) / Fixed Costs
£10,000 /

Variable Costs

(£0.50 per customer)
multiply by demand
(no. of customers) / Total Costs
(Fixed Costs +
Variable Costs) /

Sales Revenue

(£1.50 per customer)
multiply by demand
(no. of customers)
0 / 10,000 / 0 / 10,000 / 0
2,000
4,000
6,000
8,000
10,000
12,000

The break-even point (BEP)= customers.

The Contribution Method

There is a more simple way of performing the same analysis. However, you still need to know the following:

• Fixed costs

• Variable costs per customer (unit)

• Price per customer (unit)

The difference between the price and variable cost per unit is a kind of profit figure known as the contribution, because it is the amount that each sale contributes towards:

• The payment of fixed costs

• The generation of a surplus (profit)

Example:£

Price 1.50

(Less)Variable cost0.50

Contribution1.00

Break-Even Point (BEP)=Fixed costs / contribution per unit

Therefore the BEP =10,000 / 1=10,000 units of demand

Activity

Using the contribution method, calculate the following break even points (BEPs).

(The original figures may change for each subsequent calculation where stated. You should always use the most recent figure. The BEP should be expressed in units of demand. Use the table below, to enter your calculations.)

The first BEP has been calculated for you. Follow exactly the same approach to calculate the BEPs for scenarios 2 to 6.

Scenario: The sports centre has expanded and it is now including some premium extra value added services in the price charged to the customer, hence the increased entry price. This decision is taken in a bid to compete with two new private leisure centres which have opened locally.

1.Fixed costs:£15,000

Variable costs per customer:£6.50

Price per customer: £9

2.Falling customer demand: a reduction in the price to £7 per customer entry fee.

3.Increase in demand after Christmas: increase in the selling price to £11 per customer entry fee.

4.Increase in energy costs. Variable costs are increased by £2 per customer to £8.50 per customer entry fee.

5.Recession: selling price reduced to £9 per unit, variable costs remain at £8.50 per unit

6.Selling price remains at £9 per unit during recession. Efficiency savings reduce fixed costs to £9,000.

Selling Price (less)
Variable Costs =
Contribution / Fixed costs /
Contribution per unit / Break-Even Point
(in no. of units)
1 / 9.00
6.50
2.50 / 15,000/2.50 / 6,000 units
2
3
4
5
6

As you can see, changes in the input variable costs, eg.increase in material, labour, energy costs, can have a significant effect on profit margins. The decision has to be taken as whether the business should absorb these increases thus shielding the customer, or increase the selling price, thus passing the costs onto the customer. This will depend upon a number of factors, including competitor activity, economic conditions, and the anticipated effect that pricing decisions will have on demand.

Costing Systems

The aim of a costing system is to ensure that all the costs of an organisation are recovered by being charged to that part of the organisation making the money.

The following are 3 different techniques used in cost accounting as an aid to management decision-making:

• Marginal costing
• Absorption costing
• Activity-based costing

Marginal Costing

Marginal costing is a technique for dealing with variable costs. It recognises that fixed costs vary with time rather than activity and attempts to identify the cost of producing one extra unit, eg:

In theory, providing for one extra unit will incur an increase in the variable costs (direct materials, direct labour and, probably, direct expenses) – this increase is the marginal cost.

Absorption Costing

This method:

• Absorbs all costs (both direct and a proportion of the indirect ‘overhead’ costs) into each unit

• Remember – direct costs are directly attributable to the product/service being provided, eg. staff labour time

Absorption Costing

Absorbs all costs (both direct and a proportion of the indirect costs) into each unit made and sold

Remember – direct costs are normally directly attributable to the front line service, eg. labour time

Example:the sports centre allows admission only through a one year membership scheme. It has 2 key income earning facilities: its gym and sports hall. It allocates the direct costs for each facility accordingly. Remember, these would comprise the direct labour (gym and sports hall staff), direct materials, and any direct expenses. In some cases, the direct expenses may include the power to run the machines. As there are no strict guidelines, the decision is down to the sports centre as to how it categorises and allocates costs. However, the direct costs are really straightforward to allocate:

But what about the indirect ‘overhead’ costs, eg. business rates?

Let’s look at this in simple terms. If each of the above sports centre facilities accounted for 50% of sales, the decision could be made to allocate 50% of the centre’s indirect (overhead) costs to both the gym and the sports hall respectively. This would determine the total cost of providing the facility for the year, eg.

Based on the volume of forecast sales, it is now possible to calculate the total cost of providing a service for either the gym or the sports hall, eg.

• If total indirect (overhead) costs for the sports centre over the period are forecast to be £20,000, then:

• 50% of £20,000

=£10,000

=the total indirect costs to be allocated to the gym for the period

I

Calculating the Total Cost to be allocated to each Membership Fee

Scenario 1:

• Based on 100 paying members
• Direct costs for running the gym for the year = £30,000
• Indirect costs allocated to the gym = £10,000

1. Direct costs to be allocated to each annual membership fee:

• £30,000 direct costs / 100 customers = £300

1. Indirect costs to be allocated to each annual membershipfee:

• £10,000 indirect costs allocated / 100 customers = £100

1. Total costs per member:

• £300 direct costs + £100 indirect cost = £400

1. The membership card fee for the gym is, therefore, £400 plus the profit margin

Scenario 2:

• Based on 500 paying members
• Direct costs for running the gym for the year = £50,000

(these have now increased owing to the increase in the number of members from 100 to 500)

• Indirect costs allocated to the gym = £10,000

Key Point:The lower the sales, the greater the proportion of indirect costs that each membership card (unit sold) will incur.

When is it appropriate to use each technique?

Absorption Costing - when forecasting demand for the year ahead – because at this stage of planning, we need to ensure that all costs will be absorbed into the forecast demand for the period.

Marginal Costing - when taking on a non-forecast job – assuming that forecast demand is on target, the indirect overhead costs will have already been accounted for; we have, therefore, the opportunity to cost the job only taking into consideration an increase in the variable costs (the marginal cost).

To compare both costing techniques in action let’s look at the following mini case study

Mini-Case: Promobikes

Promobikes’ manufacturing costs for producing 100 fitness bicycles in one month are:

£

Direct Materials(£20 per bike)2000

Direct Labour(£25 per bike)2500

4500

Factory Overheads3500

Total Cost of producing 100 bikes8000

The selling price is £100 per bike.

Activity

1.What is the cost of producing one bikeunder:

The marginal costing technique (remember we’re only concerned with the variable costs)?

The absorption costing technique?

2.A major retail store offers to buy:

EitherA.50 bikes each month at a price of £60 each

OrB.100 bikes each month at a price of £40 each

What decision would you make on options a and b above? (It is assumed that these sales will be produced in addition to existing production of 100 bikes per month.)

To do this, complete the summary profit statements table below:

Existing
Production:
100 bikes @ £100 per bike / Existing
Production:
100 bikes @ £100 per bike
Plus
Option A:
50 bikes @
£60 each / Existing
Production:
100 bikes @ £100 per bike
Plus
Option B:
100 bikes @
£40 each
Sales Revenue per month: / £ / £ / £
100 bikes @ £100 each
50 bikes @ £60 each
100 bikes @ £40 each

Total Sales Revenue

Less Production Costs:
Direct Materials (£20 per unit)
Direct Labour (£25 per unit)
Fixed Factory Overheads
Total Production Costs

Gross Profit

(Total Sales Revenue less Total Production Costs)

Only enter figures in the blank white spaces. The shaded areas are deliberately intended to be left blank.

Activity-based Costing (ABC)

Manufacturing accountants have developed an array of methods for allocating indirect overhead costs, ABC being the latest method. This method conforms to the following process: