London Conference - David Palmer - AUA Finance presentation

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London Conference - David Palmer - AUA Finance presentation

  1. 1. FINANCIAL MANAGEMENT DEVELOPMENT THE AUA LONDON CONFERENCE DECEMBER 2011 Changing Times in Higher Education FINANCE - A Blessing not a Curse An overview of Financial and Management Accounting £ 1 £££ 333 ££££££ 35753 FINANCIAL MANAGEMENT DEVELOPMENTRev. David A Palmer BA FCA CTA MCIPD20 Brooke Road, KenilworthWarwickshire, CV8 2BD01926 511720E-mail: dap@FinancialManagementDevelopment.comWebsite: www.FinancialManagementDevelopment.comThis is one of a series of documents produced by David A Palmer as a guide for managers onspecific financial topics to assist informed discussion. Readers should take appropriate advicebefore acting upon any of the issues raised. Other documents are freely available on thewebsite: www.FinancialManagementDevelopment.com
  2. 2. University Finance - A Blessing not a Curse Page 2 of 20As with all human endeavour Let us start with the question Why?WHY KEEP FINANCIAL ACCOUNTS?If you had invested money in a company you would want to know what the managers of thecompany had spent your money on and whether they had spent it wisely. As a sophisticatedinvestor you would recognise that some spending is by way of an investment for the future asopposed to an expense. Because some transactions do not involve paying cash, you wouldwant a record of commitments as well as cashflow. Financial accounting in its current formwas designed several centuries ago to meet these needs. It provides the basis for theproduction of the Published Report and Accounts. Used properly it protects investors (in thecase of Universities the Government) from the enthusiasm and excesses of management towhom they have entrusted a vital national task - the education of students. It provides a recordof past performance and therefore may give no guidance regarding the future.WHY HAVE MANAGEMENT ACCOUNTS?The short answer is because managers want to. There is no duty to keep managementaccounts. Provided the financial records are sufficient to satisfy statutory obligations, there isno need to add to costs and waste valuable management time preparing and reviewing extramanagement data. In many organisations, management information is produced on a routinebasis, in a format which is production rather than customer led. In too many instances theyfollow the format and content of Financial Accounts which have a different role and arefrequently unsuitable as an aid to management decisions. Such documents are then the causeof considerable time wastage because people wish to find a use for them.The only reason to have management accounts is to help managers manage by providinginformation that enables better decisions to be made. FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING RECORDS THE PAST HELPS IMPROVE THE FUTURE HAS RIGID DEFINITIONS CHANGES TO SUIT NEED PROTECTS THE SHAREHOLDER HELPS THE MANAGER IS CONTROL ORIENTATED HAS MULTIPLE USES IS FOR EXTERNAL REPORTING IS FOR INTERNAL REFERENCE IS A LEGAL REQUIREMENT IS SELF INFLICTED MERELY KEEPS THE SCORE ADDS VALUE TO DECISIONS BOTH RELY ON ACCURATE RELIABLE TIMELY DATAThis document covers some of the principles underlying the two of the three key reportingdocuments in the Financial Report and Accounts, some comments on key performanceindicators and some illustrations of the use to which good costing information can be put tomake ad hoc management decisions. It is in four sections:Pages 2 - 5 The Income and Expenditure AccountPages 6 - 8 The Balance SheetPages 9 - 12 Key Performance IndicatorsPages 13 - 19 CostingFor further information - particularly regarding Budgets and their use to plan and controlactivities please see the website. www.FinancialManagementDevelopment.comwww.FinancialManagementDevelopment.com © David A Palmer 2011
  3. 3. University Finance - A Blessing not a Curse Page 3 of 20 THE INCOME & EXPENDITURE ACCOUNT (UNIVERSITIES)OBJECTIVEThe objective of the Income and Expenditure Account is to match earnings from activitieswith the costs of providing goods and services for a given period of time. It says nothingabout the assets involved in generating surpluses (or deficits) nor does it necessarily indicatewhether cash is being generated. It is a key document in assisting measurement and thereforeimprovement of Business Performance, which ultimately determines the sustainability of theorganisation. A surplus arises when Income exceeds attributable Cost. All incomes and allrevenue costs (i.e. not the cost of assets purchased - which are capital costs) should appear inthe Income and Expenditure Account. Note that it is not the cash received or paid which isshown but the amounts earned or incurred. (The Accruals concept of Accounting).INCOMEIncome represents amounts earned from activities during the period. It will normally be theinvoiced value of goods and services provided to customers. It may therefore bear littlerelation to cash received. To the extent that income is generated without receiving cash thefigure for debtors in the Balance Sheet will change. For a University the recognition ofincome can be problematic - not least because the income does not necessarily come from thecustomers. The key sources of income with some notes as to how income might be recognisedare shown below:Grants from Funding Councils - Normally received for an academic year on the basis ofstudent numbers, grant income can therefore be recognised fairly easily as having been fullyearned by the end of the year. If the grant has been based (and received) on expected studentnumbers and these turn out to have been lower than anticipated then there will need to be aprovision for clawback i.e. the income will eventually be recognised on the actual number ofstudents and the excess will have to be repaid. Recognition of extra income earned, to bereceived next year may be required - if actual numbers were higher than expected and thefunding body allows such additional amounts to be claimed. The recognition of incomeearned from grants during the academic year is fraught with problems (e.g. how much isearned in August?). Many institutions sensibly adopt a high level approach - releasing incomebased on proven student numbers on a monthly basis - thus spreading annual income in linewith costs incurred.Tuition Fees - For annual courses these are similar to Grants. For short courses the income isnormally recognised at the completion of the course, or apportioned on the basis of dayscompleted compared to total days if courses run over a month end. This latter approach is alsoused for longer courses which run over the year end.Research Grants - Income is recognised on the basis of the percentage completed, oftencalculated by reference to costs incurred/total costs anticipated at completion.www.FinancialManagementDevelopment.com © David A Palmer 2011
  4. 4. University Finance - A Blessing not a Curse Page 4 of 20Other Income - Most other income e.g. rents, catering, interest etc. are recognised whenreceived, only allowing for accruals and prepayments if material. Donations are normallyrecognised when received, but can be accrued for if future receipt is certain e.g. a legacy isnotified, or the tax on gift aid is claimed but not received.ExpenditureIn Retailing and Manufacturing organisations it is normal to calculate the Direct Costs ofGoods sold to enable a comparison of the Gross Margin (Sales less Direct Costs) for differentproducts. In the University sector this is often difficult as: 1. A major part of costs are staff costs (or directly related to staff time) and without a vast expenditure of effort in keeping detailed records it is not possible to allocate staff time to different "products" i.e. courses. 2. Cost allocation methods of the "overheads" premises, administration, human resources, student records, finance etc have, of necessity, to be based on relatively arbitrary bases rather than detailed usage records, yet they often form part of the direct costs of delivering the service. 3. The increasing popularity of modular courses and the practice of allowing students to change courses mid year adds a considerable degree of complexity.Thus many institutions have a summary Income and Expenditure Account with costs shown asstaff and non-staff (analysed as appropriate) plus some form of resource allocation model,which is used for management purposes to help allocate summary totals of budgets and actualdata across the academic departments or campuses.In any event the basis for the recognition of costs is, or should be, the same as for income.Costs are recognised as incurred. Thus the cost is shown in the period when the goods and/orservices are used - not when they are ordered nor when they are paid for. An example of theproblems this can cause is in the provision for pay rises. In some institutions the Septemberpayroll costs are shown as the amount paid. In December an annual pay rise is agreed andthen backdated. Thus unless a central accrual is made for the pay rise in September theaccounts may be seriously wrong. It is easy to say that agreeing the pay rise in July for thefollowing year would solve the problem - but until student numbers are reasonably certain, theaffordability of the pay rise may not be known. However, in accounting it is generally agreedthat: It is better to be approximately right than to be precisely wrong. It is better to havean approximate accrual than to ignore the problem and just let December be a horrible month.The breakdown in communications between Accountants and Actuaries on the true cost ofPension provisions during the last Century which resulted in the belated recognition of somebillions of pounds worth of costs appearing in company and University accounts in thisCentury, is an example of what happens when you fail to account properly.Classification of OverheadsOverhead analysis should always be determined by the business need. Having one accountcode avoids the possibility of miscoding but does not help informed analysis. Too manycodes or headings causes inefficiency and destroys the value of the analyses; which aredesigned to help, not hinder informed management decision making.www.FinancialManagementDevelopment.com © David A Palmer 2011
  5. 5. University Finance - A Blessing not a Curse Page 5 of 20Revenue not Capital ExpenditureThe costs which appear in the Income and Expenditure Account are those for resourcesconsumed. Where money is spent on substantial items which last for more than oneaccounting period e.g. buildings or equipment, the cost of this is effectively spread over theiruseful lives by "Capitalising" them i.e. putting the cost on the Balance Sheet and reducing itover the useful life by making a book entry charging for "Depreciation." Thus the purchase ofan asset costing £10,000 with a five year life will result in an annual charge of £2,000. The£10,000 does not appear in the Income and Expenditure Account - but it will appear in therecord of cashflows. Something similar occurs when large stocks of items e.g. stationery, arebought in one period but not used until future periods. If material these may be shown asassets on the Balance Sheet until they are used.Bad DebtsA University may recognise income e.g. for Tuition fees or rent, but subsequently find that itcannot obtain the money. The charge for writing off these amounts will be shown separately -normally as a cost rather than as a reduction of Income.Provisions and ContingenciesIt is reasonable and indeed highly desirable, to make a provision for known future costs e.g.provision for bad debts, provision for redundancy costs, provision for pension liabilities.However these should only be for realistic items. It is not acceptable to make a contingencyprovision to smooth out the surplus for one year so that it can be released later to avoid afuture deficit. If known future eventualities are to be provided for, this is best done bydesignating part of the reserves for that specific purpose.InterestIf the University has borrowings, one of the costs will be the interest on these. To some extentthis cost may be reduced by any interest earned on bank deposits which may be shown asincome - in internal accounts these two amounts may be shown netted off.TaxationMost Universities are Charities and thus do not pay tax on their surpluses, nor reclaim tax ondeficits! If they have substantial "Trading activity" which might be taxable, this is normallycarried out through a subsidiary company which then donates its profits to the University - sono tax is suffered.If a University has to charge Value Added Tax on some activities it shows the income fromthose without addition of the VAT, which it has collected from customers on behalf of theGovernment, it may then be able to recover some of the VAT it has suffered on related costs.Otherwise the costs in the Income and Expenditure Account will include any VAT charged bysuppliers, since the main activity of education provision precludes recovery of VAT.Surplus or (Deficit)This is the amount of the difference between Income and Expenditure. For a University it isreasonable that over the long term it should generate modest surpluses. Any large orexceptional items may be worthy of separate identification. A Surplus will add to theUniversitys Reserves in the Balance Sheet. A Deficit will reduce them.www.FinancialManagementDevelopment.com © David A Palmer 2011
  6. 6. University Finance - A Blessing not a Curse Page 6 of 20 THE BALANCE SHEET (UNIVERSITIES)OBJECTIVEThe Balance Sheet, as its name implies, balances. It sets out items owned (assets) and itemsowed (liabilities) by an organisation. If there are Net Assets these will have been funded byeither capital which has been paid in (share capital, or some other form of equity) or by theretention of surpluses or profits from the past - called Reserves.The objective of the Balance Sheet is to identify the constituent parts of the Net Assets inorder to show the owners where their money has been invested. It is not a statement of thevalue of the business. The layout and headings are defined for businesses by the CompaniesActs, and for Universities by the provisions of SORP (Statement of Recommended Practice onAccounting and Reporting by Charities). The Board of Governors are responsible for theUniversity even though they are not its "owners". (NOTE - For all practical purposes ignorecolumns in published accounts headed "University". Always look at the "Consolidated"figures. For those who want to know why - see Acquisition Accounting on the website.)ASSETSFixed AssetsFixed Assets are items purchased by the business (or transferred to it) which are for use ratherthan for resale. The main categories are:1. Intangibles - Goodwill, Brand Names, Patent Rights etc. These are normally only shown when purchased.2. Land and Buildings - Some organisations separate the Land from the Buildings. This also includes the value of any premiums paid for leasehold properties.3. Equipment - Any asset live or dead used to assist the trade. There are rules about what is equipment and what is not. A few organisations e.g. Football Clubs, treat people as assets by showing the cash paid for them (transfer fees).4. Vehicles - Lorries, cars etc.5. Investments - Long term investments e.g. shares in associated companies.It is normal to write off (charge as an expense) the cost of a fixed asset by depreciating it. Theannual depreciation charge is merely the cost less any expected value on disposal spread overthe assets useful life. For intangibles the charge is called amortisation - effectively this is thesame as depreciation.For many Universities land and buildings were inherited when they were founded or created asseparate institutions. A value will normally have been placed on these as at the date ofincorporation. Land is not normally depreciated and some organisations recognise anyincrease in land value by showing the revalued amount in the Balance Sheet together with abalancing increase in the Equity (a Revaluation Reserve - see below).www.FinancialManagementDevelopment.com © David A Palmer 2011
  7. 7. University Finance - A Blessing not a Curse Page 7 of 20Stocks and Work in ProgressStocks are normally shown at cost. This includes the cost of any work done on them e.g.delivery or packing costs. If the value of the stock has declined then the reduction should bemade to reduce the value together with an equivalent charge against profits. Universities tendto show low figures for stock - most items being written off when purchased.PrepaymentsWhere cash has been paid in advance of receiving a service, it is held as an asset and onlycharged against profit as it is used up or the service is received.DebtorsThe amounts owed by customers who have not yet paid are shown as assets. This will includeany associated VAT i.e. the amount is the true cash owing. If there is any doubt about gainingpayment then it is normal to make a provision against the debt. (i.e. reduce its value in theBalance Sheet and charge the reduction as a cost). The main debtors for a University will beGrant Funds and Tuition Fees owing. There may also be accrued income e.g. work doneunder a research grant which has yet to be received.CashThis is the cashbook cash figure and will therefore need to be reconciled to the bank statementto allow for unpresented cheques or lodgements in transit.LIABILITIESOverdraftsNormally overdrafts are shown separately from cash balances. Again it is the cashbook figurewhich is shown.CreditorsCreditors are the amounts owed to third parties for goods or services received but not yet paidfor. Normally this is the total of unpaid invoices including VAT. VAT is not recoverable byUniversities since their "output" - education - is exempt from VAT. Although if they providesome VATable services e.g. catering or exports (even if these are zero rated for VAT) theymay be able to recover some proportion of the VAT on inputs. There may be a separatecreditor for VAT charged but not yet paid to the Government, just as there will commonly be acreditor for PAYE and NI deducted from salaries, but not yet paid over.AccrualsAccruals are amounts owed for which no invoice has been received. It is normal to haveaccruals for items such as electricity, phone etc. where bills are received in arrears as well asfor bank interest, audit and professional fees.Deferred IncomeSometimes income has been received in advance of it being earned - e.g. research grants, orpayments in advance for courses. These are held on the Balance Sheet as an amount owingand only released as income when the work is done.www.FinancialManagementDevelopment.com © David A Palmer 2011
  8. 8. University Finance - A Blessing not a Curse Page 8 of 20ProvisionsIn addition to creditors and accruals most Universities have provisions for future liabilities e.g.pension liabilities.LoansLoans, whether from a bank or elsewhere are liabilities and therefore will be shown at theamount owing. Normally any related interest owing is shown under accruals.EQUITY (or the way in which the net assets have been funded)In Companies this is called Shareholders Funds, in Universities it may be called Reserves orFunds. It includes:Deferred Capital GrantsAmounts received to fund the acquisition of assets, which are released to the Income andExpenditure account as the assets are depreciated.EndowmentsSpecific monies received to fund future activities e.g. to provide scholarship funds. Some arepermanent i.e. only investment income can be spent, the capital must be retained. Some areExpendable i.e. can be spent at the Governors discretion (within the terms of the endowment).Revaluation ReservesA recognition of the increase in values of assets - commonly the increase in value of land andbuildings since acquisition, or incorporation. (It is silly to show the value of a building at itsoriginal cost of 32 Shillings and a Groat, but if you show its proper value the Balance Sheetdoes not balance so the difference is shown as a Revaluation Reserve.) Where assets have"inestimable value" eg The Book of Kells at Trinity College Dublin, the normal treatment is tomention them in a note but not attempt to value them.Balance on the Income and Expenditure AccountThis consists of the Surpluses, less Deficits since the University was Founded or Incorporated.In some cases a part of the Reserves may be designated as being set aside for a specific use eg.to pay future pensions. It is beyond the scope of this paper to point out that pensionobligations are a real liability - showing them separately does not make them disappear.Minority InterestsThese arise when a University decides to share the risk of ownership of specific assets oractivities e.g. an overseas campus, student accommodation or buses. The University sets up asubsidiary company and sells (say) 30% of the shares to another party (a local overseas entity,landlord or bus company). Since the University owns 70%, it controls the whole company,but it has only paid for 70%. The way the books are balanced is to bring in 100% of the assetsand liabilities, but to show the value of the remaining 30% as a deduction - thus indicating it isnot owned by the University. This is called the Minority Interest.www.FinancialManagementDevelopment.com © David A Palmer 2011
  9. 9. University Finance - A Blessing not a Curse Page 9 of 20KEY PERFORMANCE INDICATORSWHY USE KEY PERFORMANCE INDICATORSThe use of Key Performance Indicators and Ratio Analysis is a common managementtechnique. It assists management by exception and enables the reviewer to compare andcontrast different business units easily. This paper sets out some of the main financial and nonfinancial indicators and ratios used to analyse performance. There are many financial and nonfinancial indicators. Each organisation should produce its own relevant ratios to suit its uniqueneeds; and review these regularly to ensure they remain fit for purpose.Ratios provide an insight into how results compare on a like for like basis with another set ofresults. They help comparisons over time, against budget, against other organisations, withinan organisation between departments, products etc.They rarely answer questions but they help the reviewer identify the right questions toask, by highlighting anomalies and trends.In many cases, perfecting the calculation of the components of an indicator is less importantthan consistency of approach.FINANCIAL PERFORMANCE INDICATORSThere are many different types of users of financial data. For Universities these include 1. Managers who want to examine operational performance 2. Creditors who wish to establish future stability 3. Government as funder, taxation authority, etc.MANAGEMENT OPERATIONAL RATIOSThe key management ratio in commercial business is Return on Capital Employed (ROCE). Itis also known Return on Net Assets (RONA). It has many different definitions and mostorganisations have their own version.It is normally defined as OPERATING PROFIT SHAREHOLDERS FUNDS PLUS BORROWINGSAs a measure this is similar to the return on an investment, where profit is seen as the returnand the value of the funds employed in the business are seen as the amount invested. In aUniversity this would be "Surplus/(Deficit)" divided by Reserves. However, care would needto be taken regarding the valuation of assets - particularly property, in the Balance Sheet, sincethis impacts on the value shown for Reserves.The profit normally used for this purpose is Profit before Interest and Tax (if applicable) asinterest is affected by Gearing (see below) and tax is frequently seen as outside operationalmanagement control. Most Universities use Operating Surplus as the denominator.www.FinancialManagementDevelopment.com © David A Palmer 2011
  10. 10. University Finance - A Blessing not a Curse Page 10 of 20Because Capital Employed must equal Net Assets, ROCE should be the same as Return onNet Assets (RONA) and it is RONA which is used as a basis to split the return down into itscomponent parts as shown in the Hierarchy of Ratios. The first step is to introduce Sales(Income) into the equation. PROFIT = PROFIT x SALES NET ASSETS SALES NET ASSETSor ROCE = MARGIN x ASSET TURNOVERThis forms the basis for a number of ratios as followsMARGINAll costs can be expressed as a % of sales. Profit can be taken at Gross Profit level to revealGross Profit Margin (Sales less Variable or Direct Costs) as a %. This is particularly useful atbudget time to see which costs are moving with sales and identify any anomalies. It is alsocommon in interfirm and inter departmental analyses. The level of specific overheads as apercentage of income is frequently cited in interfirm comparisons.In Universities the Contribution from Faculties, Modules, Courses, etc. is often calculatedusing some form of Resource Allocation Model. Care needs to be taken with this data assometimes fixed costs can be treated as variable costs by being allocated on usage.ASSET TURNOVERROCE can be improved by reducing asset levels or by increasing sales. Analysing the NetAssets into their constituent parts will prove a useful indicator over time.BEWARE1. One way of improving ROCE is to increase the Fixed Asset Turnover. This is good if done through efficiency but dangerous if it is done by failing to buy new fixed assets and allowing the ratio to improve through the action of Depreciation. New Capital Expenditure should exceed the Depreciation charges. If not, the assets are being run down.2. Many assets are not recorded on the Balance Sheet e.g. Employees, Customers, Patents, Knowledge, Brand Image and Supplier relationships. There is a danger in ignoring these as over time their value needs to be maintained if the business is to continue.FIXED ASSET TURNOVERA useful measure in capital intensive industries. SALES FIXED ASSETSFor universities care needs to be taken that the values placed on fixed assets, especiallyproperty, are reasonable. A ratio based on utilisation rather than values may be better.www.FinancialManagementDevelopment.com © David A Palmer 2011
  11. 11. University Finance - A Blessing not a Curse Page 11 of 20DEBTOR DAYSThe comparison between Sales and Debtors is normally expressed as a number of days sales. DEBTORS x 365 = Days Sales Outstanding SALES FOR A YEARThere are norms in each industry for the appropriate level. An aircraft manufacturer may have180 days, a Retailer zero. In some countries it is wise to allow for Sales Taxes which will be inthe Debtors figure but not in the sales figure. As Universities become more reliant on non-governmental sources of income the risk of non payment will grow and this may become amore important measure.STOCK DAYSThe comparison between Sales and Stock is also expressed as a number of days sales. STOCK x 365 = Stock Days SALES FOR A YEARThere are norms in each industry for the appropriate level. A builder may have 180 days, afood retailer 2 days, and a dairy 2 hours! The figure does not represent the number of days ofsales in stock, because the stock is at cost price while sales are at sales price. For mostUniversities stock levels are trivial for the organisation as a whole, but they may be significantin specific trading areas or subsidiaries.CREDITOR DAYSThe ratio between Sales and Creditors is also expressed as a number of days sales. CREDITORS x 365 = Creditor Days SALES FOR A YEARAgain there are norms in each industry for the appropriate level. Like the Stock Days, thefigure does not represent the number of days of sales financed by creditors, because they arealso at cost price while sales are at sales price. However it provides a useful basis when thedata is extracted from consecutive published accounts. In internal accounts it can be andshould be related to the purchases figure, although there may again be a need to adjust forSales Taxes.CREDITORS RATIOSCreditors, both Trade Creditors for goods supplied and Loan Creditors who have lent money,are mainly interested in whether they will be repaid. They are thus interested in short termliquidity and in levels of risk. They will look at:THE CURRENT RATIO Defined as Current Assets Current LiabilitiesThe higher the ratio, the safer the company for creditors. However a high figure will mean alower ROCE which suggests inefficiency on the use of working capital.www.FinancialManagementDevelopment.com © David A Palmer 2011
  12. 12. University Finance - A Blessing not a Curse Page 12 of 20INTEREST COVER is a Banking concept. It is defined as OPERATING PROFIT INTEREST PAYABLEIt merely calculates that there is sufficient scope for profits to fall before interest payments areat risk. Loan agreements may include covenants based on interest cover or on gearing levels.GEARING, sometimes called the Debt to Equity Ratio or Leverage, is a measure of therelative risk of a companys capital structure. A high GEARING is relatively risky. ForUniversities funding bodies or lenders may set a limit on the ratio of borrowings to reserves(or free reserves i.e. excluding designated or restricted funds). It is normally calculated asBorrowings -net of any cash, as a percentage of Reserves.NON FINANCIAL RATIOSNon financial ratios are almost exclusively used by Management, since for outsiders the scopefor different definitions makes comparison between organisations difficult. The keyapproaches are based on Employees, Operational activities, Assets, Customers or Suppliers.They take many forms. In commercial organisations they include:EMPLOYEES - Output per Hour, Employee cost per hour, Employee cost per unit, StaffRetention (or Turnover), Employee Satisfaction Survey StatisticsOPERATIONAL - Units per Day, Rejects per ‘000, Waiting time (or order fulfilment time),Cost per Hour, Cost per UnitASSETS - Machine Utilisation (or idle time), Cost per unit, Downtime, Repair statisticsCUSTOMER - Customer Satisfaction, Order fulfilment, Complaint levels, Returns, RepeatOrdersSUPPLIER - Order fulfilment, Complaint levels, ReturnsIN UNIVERSITIES THE MOST COMMON FINANCIAL RATIOS USED ARE:Margin, Contribution, Unit cost (after allocations), Gearing, Interest cover, Current ratio,Level of free cash, Reserves as a percentage (or number of days) of recurrent costs.AND SOME COMMON NON FINANCIAL INDICATORS ARE:Employee - Staff Costs as a percentage of Income (or income as a multiple of staff costs),average salary, Staff/student Ratio, Academic Staff/Non Academic StaffSpace - Utilisation statistics, Investment/DepreciationSustainability - Government/non Government income, Research Income/Total Income,Other - International Students/Total Students, New Project Income/Total IncomeIn addition to satisfaction surveys etc, etc.KEY PERFORMANCE INDICATORS ARE A MANAGEMENT TOOL. WHAT ISIMPORTANT IS THAT THE DECISION MAKING IS IMPROVED. KPIS SHOULDBE REGULARLY REVIEWED TO ENSURE RELEVANCE. DATA COLLECTIONAND REPORTING IS NOT AN END IN ITSELF.www.FinancialManagementDevelopment.com © David A Palmer 2011
  13. 13. University Finance - A Blessing not a Curse Page 13 of 20 COSTING IN UNIVERSITIESTHE NATURE OF COSTSMuch of Management Accounting involves consideration of costs. There are many differenttypes of cost. However it is vital to realise that no one cost is appropriate for all decisions.True cost analysis and its use in decision making involves considering the future, not justrelying on the past. The most commonly used cost is the amount spent on an item to get it toits current state or the amount of an expense. This is the Historic Cost. It is the keystone ofFinancial accounting and is used to calculate profit by deducting it from sales value. Othercategories of cost are:Variable costs Costs which directly vary with the volume sold or produced. Examples include materials or overtime.Fixed costs Costs which are not related to volume. E.g. rent or heating costs.Direct Costs Costs which can be identified with particular courses, processes or parts of an organisation. E.g. the materials on a technology course or the depreciation cost of equipment used on a course.Indirect Costs Costs which are not directly connected with that particular course, process or part of the organisation and which therefore may have to be allocated or apportioned on some arbitrary basis. An example is the rent of a campus which is apportioned to the various faculties on the basis of floorspace occupied.Marginal Cost The cost of one more unit. This may be a little or a lot depending on the state of capacity. It will change with circumstances. If a campus is working at half capacity then there may be no marginal cost of performing an extra task. If it is already at full capacity then the cost of accepting one more unit might be the cost of setting up a new campus.Sunk Cost A past cost irrelevant for future decisions. e.g. the cost of a machine which is obsolete, the original cost is of no assistance in any management decision for the future. An example is original cost of the Channel Tunnel. Who cares what it cost, we will not build another.Opportunity cost The cost of the next best alternative which would be foregone if a particular course of action were taken. e.g. The cost of your time on a training course is not your salary but the loss of the value you would have added to your organisation if you had done something else.FIXED AND VARIABLE COSTS FOR RISK ASSESSMENTIn the short term all costs are fixed, in the long term all costs are variable. It depends ontimescale and the level of the review. However the split between fixed and variable costs isvital to assess the impact of changes in the level of demand. Consider two companies. One hasmainly variable costs and one has mainly fixed costs.www.FinancialManagementDevelopment.com © David A Palmer 2011
  14. 14. University Finance - A Blessing not a Curse Page 14 of 20TWO COMPANIES - SAME SALES, SAME COSTS DIFFERENT STRUCTURESCOMPANY A £ COMPANY B £SALES 10,000 SALES 10,000VARIABLE COSTS 8,000 VARIABLE COSTS 1,000 ______ ______CONTRIBUTION 2,000 CONTRIBUTION 9,000FIXED COSTS 1,000 FIXED COSTS 8,000 ______ ______PROFIT 1,000 PROFIT 1,000 ===== =====Both companies have the same profit but which company would you rather work for?Hopefully those who are sales orientated would opt for company B, while those who are riskaverse would opt for company A. The answer depends upon your view of the future.To illustrate this, recalculate profits under two different scenarios. In the first, sales areexpected to rise by 20%. In the second, sales are expected to fall by 20%. Notice thatcontribution is defined as sales less variable costs, and that variable costs vary directly withsales whereas fixed costs do not. SALES SALES UP 20% DOWN 20%COMPANY A £ £ £SALES 10,000 12,000 8,000VARIABLE COSTS 8,000 9,600 6,400 ______ ______ ______CONTRIBUTION 2,000 2,400 1,600FIXED COSTS 1,000 1,000 1,000 ______ ______ ______PROFIT 1,000 1,400 600 ===== ====== =====When Sales are good the contribution rises and since fixed costs do not change the profit isautomatically improved. When sales fall by 20% profits are reduced. However, because themajority of costs are variable the company is protected when times are hard. The price it paysfor the low risk is the lower reward when sales are good. Examples of such companies aresupermarkets, staff agencies and training companies.COMPANY B £ £ £SALES 10,000 12,000 8,000VARIABLE COSTS 1,000 1,200 800 ______ ______ ______CONTRIBUTION 9,000 10,800 7,200FIXED COSTS 8,000 8,000 8,000 ______ ______ ______PROFIT 1,000 2,800 (800) ===== ===== =====www.FinancialManagementDevelopment.com © David A Palmer 2011
  15. 15. University Finance - A Blessing not a Curse Page 15 of 20Because company B has low variable costs it does well when times are good and badly whensales fall. Such companies have cyclical profits and tend to hit the headlines in both good andbad times. Examples are the car industry, merchant banks, estate agents etc. Such companiesneed to concentrate all their efforts on making sales and because of their cost structure arefrequently found to be dumping surplus capacity at marginal cost.Employers try to alter the cost structure, by making fixed costs variable to reduce the risk of adown turn in demand. Outsourcing and subcontracting are one approach. More common isredundancy for some, with those retained being asked to work overtime. Employees are avariable cost for companies but a fixed cost for the nation!Are the costs at your University mainly fixed or variable? (are you fixed or variable?)What does this mean for strategy? Should you focus on income generation or cost reduction?FIXED AND VARIABLE COSTS FOR PRODUCT RISK APPRAISALThe split between fixed and variable costs is vital to assess the break-even point for sales whenevaluating a new product or when considering delisting an existing product. For a Universitythis could be a new Course or a new Campus.The break-even point is defined as being the level of sales when profit is zero. At this pointsales less variable costs less fixed costs equals zero.IF SALES - VARIABLE COSTS - FIXED COSTS = 0THEN SALES - VARIABLE COSTS = FIXED COSTSOR CONTRIBUTION = FIXED COSTSConsider the data above as being for two new potential products:Product A has a contribution ratio of 20%. That is the ratio of contribution to sales value is20% (2,000/10,000). Thus for every £1 of sales the contribution and therefore the profit forproduct A increases by 20p.How many sales of 20p contribution are needed to cover the fixed costs of £1,000?5,000 or £5,000 worth because 20p x 5,000 = 1,000The same calculation can be carried out for product BProduct B has a contribution ratio of 90% (9,000/10,000). Thus each £1 of product B sold willadd 90p contribution and therefore 90p profit.For product B, fixed costs are £8,000. How many 90ps are required to cover £8,000?8,889 or £8,889 worth because 90p x 8,889 =8,000Thus if the sales forecast for each product is 10,000, the manager of product A can afford ashortfall of 50% before he makes a loss, while the manager of product B can only afford ashortfall of 11%. If these were two competing potential new products then the prudentaccountant would accept product A before product B, because it is less risky.www.FinancialManagementDevelopment.com © David A Palmer 2011
  16. 16. University Finance - A Blessing not a Curse Page 16 of 20Break-even analysis can be a useful mechanism for quantifying risk and identifying the actionto take to mitigate it. For example if firm orders of 9,000 can be proved for B then there is norisk of it making a loss. Using spreadsheets different levels of demand, prices and costs can beused to establish the best course of action if a reasonable estimate is made of the fixed andvariable costs. Estimates are fine in management accounting. It is better to be approximatelyright than precisely wrong.FIXED AND VARIABLE COSTS FOR RESOURCE ALLOCATIONWhen considering whether to take a particular course of action it is vital to consider only thosecosts which will vary and ignore those which are fixed. Assume a new salesperson is to berecruited and they can sell £10,000 worth of either product A or product B. Which productshould they be asked to sell?If they sell £10,000 of product A the extra profit generated will be £2,000, because each extra£1 brings in an extra 20p. If they sell £10,000 of product B the extra profit generated will be£9,000, because each extra £1 brings in an extra 90p.It does not take a degree in finance to appreciate that the sales person should sell product B,the product with the higher contribution ratio. However, many organisations have no clearpicture of the contribution ratios of the various products in their portfolio and thus do notknow which products to promote. In Universities are those involved in promoting coursesaware which are high contributors and which are not?DIRECT AND INDIRECT COSTS - THE DANGERS OF COST ALLOCATIONThe direct and indirect definition varies with level. All a Universitys costs are direct for theUniversity as a unit but some will be indirect for the departments within it. It is right to usecosts to guide to decisions on pricing, but external pricing needs consideration of direct costs,uncorrupted by allocations which can lead to misleading conclusions.Assume a campus costs £100,000 per month to run. It expects to teach 1,000 students permonth and therefore when budgeting, each student is costed at £100. During the year demandis poor and volume falls to 500 students. There are too many examples of costing systemswhich would suggest to management that the cost of each student is now £200 and thattherefore the price charged should be doubled! This will not improve income.In cost conscious organisations "Cost per unit" is often a key measure of efficiency. Bewareimprovements in cost per unit that result from purchasing more than is required for currentneeds. Since the units will stay in stock, profit looks fine. Management frequently onlydiscover the problem when they run out of storage space, or worse, cash.Direct costing is an approach when considering new activities. True cost increases should beidentified or estimated, rather than arbitrary allocations of overheads based on existing ratios.It is true that all costs have to be covered, but that does not mean that lower priced businessshould be turned away. It merely means that due consideration needs to be given to the coststructure and the market place in both the short and long term.www.FinancialManagementDevelopment.com © David A Palmer 2011
  17. 17. University Finance - A Blessing not a Curse Page 17 of 20MARGINAL COSTSMarginal cost is the cost of the next unit. It embodies the consideration of both theFixed/Variable analysis and the Direct/Indirect analysis. As a concept it can be very valuablein assisting pricing decisions but it can be very dangerous unless used carefully. Marginalcosting of activities is fine, marginal pricing can be disastrous. Here are some examples:1. Costing and Pricing (Standard) You have established the following data for a three day course: Tutor £500 per day Room £300 per day Materials £30 per delegate Admin Support £50 per delegate Overhead and IT costs £400 per courseHow many students are required to break even at a price of (a) £375 each, (b) £400? £ Fixed Costs: Tutor 3 x 500 1,500 Room 3 x 300 900 Overheads 400 2,800 Income per Student 375 or 400 Variable Cost Materials (30) (30) Variable Cost Admin Support (50) (50) Contribution per Student 295 320(a) At £375 10 students covers the fixed costs and yields a surplus of £150.(b) At £400 9 students covers the fixed costs and yields a surplus of £80.What is the "profit" if there are 12 students paying £375 (12 x 295) - 2,800 = £740What is the "profit" if there are 10 students paying £400 (10 x 320) - 2,800 = £4002. Costing and Pricing (Marginal)Assume you have 10 students booked at £375 and another student rings up and asks tojoin the course; what is the minimum price you should charge?The variable costs are £80 so the minimum charge is £80. BUT The assumptions include: The other students will not want a similar deal. The room can take another person. The materials are available. The materials are extra (if there is a spare set then there is no extra cost). The Admin Support is truly variable. You are certain that the late booking will not mean that they will not book a future course at £375.www.FinancialManagementDevelopment.com © David A Palmer 2011
  18. 18. University Finance - A Blessing not a Curse Page 18 of 203. Costing and Pricing (Sunk)(a) You discover that the course had a development cost last year of £2,000. Doesthis change your earlier answers?No. What has been spent is spent; it cannot affect decisions for the future.(b) You calculate that updating the course material will cost £150. Does this changeyour earlier answers?The breakeven remains at 10 students, profits will fall by £150. The answer to 2. isunaffected.(c) You have four training rooms empty. Heating etc. costs are trivial - What is the minimum you should charge for their use; what is the maximum?Zero is the minimum. The maximum is much as you can without losing the business but bearin mind the alternative uses.(d) You have four tutors with no courses to run. Why is the answer to (c) less applicable to people.Tutors not running courses can be usefully employed: Developing material Generating new business - advertising the University name Doing Research for which grants or funding may be available Pastoral care of Students (to reduce likelihood of leaving) Chasing payments etc. In fact anything to increase income or reduce costs!!!!! (if you ask nicely)Starting new courses, ceasing to run old courses, scheduling, decisions on short term hire orpurchase, overtime or recruitment should all be driven by consideration of marginal andaverage cost and demand forecasts. Because demand is difficult to forecast, it may be better toaccept fixed contracts at below normal price in order to avoid or reduce risk.OPPORTUNITY COSTSOpportunity costs are difficult but it can be dangerous to ignore them. The opportunity cost isthe lost profit or benefit from using a scarce resource in one activity in preference to the nextbest alternative. The "cost" is the benefit foregone from the alternative.An employee could walk home or drive home each day. To walk home takes one hour morethan driving home. If he stayed at work he could earn an extra £10 in overtime. Theopportunity cost of walking is the loss of £10 earnings. (If he would merely go to the pubinstead and spend £5 before driving home then the opportunity gain from walking is £5 whichis cash saved). Some individuals would say that quality of life is relevant - Accountantswould agree and then try to put a value on it by asking how much would you require tocompensate for a lower quality of life.Beware of fictitious opportunities "I could hire a Rolls Royce to go home in for £1,000" solook how much I have saved! The earlier example on fixed and variable costs can be used toillustrate the concept of opportunity cost. The benefit from the new sales person will be£9,000, if they sell product B. The opportunity cost of using them to sell product B is thecontribution from the sales of A which will now not be made i.e. the £2,000.www.FinancialManagementDevelopment.com © David A Palmer 2011
  19. 19. University Finance - A Blessing not a Curse Page 19 of 20COST ALLOCATIONSIn most large organisations costs are allocated to products because Direct Costs are only partof the total cost. In order to arrive at full cost, various methods of cost absorption/allocationhave been used to simulate the fact that costs have been incurred over the product range.Activity Based Costing is merely an application basis which is a more refined approach thanfloorspace, headcount etc. The important factor is that whatever allocation is used it should berelevant. The most common bases are:Basis Used For (for example)Employee Headcount Personnel Dept. Non-productive space costs.Floorspace Occupied Heat/Light/Insurance/RentStudents Administration Costs Finance Costs Purchasing Department CostsHours Worked/Taught Management CostsBy definition the results will be approximate. The objective is to ensure all costs are includedwhen considering strategic decisions. The allocation methods may be misleading if used fortactical decisions or performance measurement. In particular, managers who have cost targetswhich include allocated costs may seek to play games to reduce the costs e.g. if allocated onemployee headcount - take on expensive agency staff rather than employees; if allocated onfloorspace - rope off areas as "not being mine so you cant charge me". In addition, allocatedcosts may cause external suppliers to appear cheaper. e.g. food for internal meetings is boughtfrom outside suppliers rather than in-house because the in house catering cost includesallocated premises costs. Unintended consequences of cost allocation must be avoided.Cost Estimation is an art not a science. It involves consideration of the future, theopportunities and the past. It involves consideration of risk and common sense.If costing is an Art, Pricing is even more so!SUMMARYIt is vital for the health of an organisation that managers realise that different information isneeded for different decisions. The management information required on a routine basis is notnecessarily appropriate for all purposes.The exact format of the management accounts will be unique to each organisation. In additionit is perfectly reasonable to change the format to highlight particular areas of informationneed. Management reports should be subject, like every other activity, to cost/benefit analysis.They should be produced to aid specific decisions and then stopped. Too many organisationssuffer from excess management information because no-one has the courage to say that theyno longer wish to look at data which the purpose of which is lost in the past.The acid test for all management information is "Does it produce a noticeably betterdecision which demonstrably added value?" Has reading this caused you to dosomething differently which will result in more money? If not why have you read it?www.FinancialManagementDevelopment.com © David A Palmer 2011
  20. 20. University Finance - A Blessing not a Curse Page 20 of 20Rev. DAVID A. PALMER BA (Financial Control) FCA CTA MCIPDAn experienced financial professional who has devoted his skills to management training inpractical understanding and utilisation of financial information. Having graduated fromLancaster University, he qualified as a Chartered Accountant and as a member of the Instituteof Taxation while with Price Waterhouse. In 1993 through his training expertise, he wasaccepted as a member of the Chartered Institute of Personnel and Development.He has worked as a Financial Controller and Company Secretary in the Finance Industry andas a Director of Finance and Administration in the Computer Services industry. Since 1990 hehas run management programmes for over thirty major organisations including Arla Foods,BP, CSC, Conoco, Department of Social Security, Lloyds Bowmaker, Royal Mail, Unileverand Zeneca. International training experience includes work in Denmark, Kenya and theCzech Republic for Unilever, in Holland and the US for Zeneca, and in Bahrain and SaudiArabia for Cable & Wireless. He also runs a variety of financial management developmentprogrammes for the management teams at a number of Universities – including CentralLancashire, Coventry, Hertfordshire, Middlesex, and Trinity College Dublin– as well as forthe Leadership Foundation.He specialises in programmes in financial management for both tactical and strategic decisionmaking. He has run courses in acquisition evaluation (The Economist, Eversheds, BlueCircle) and in post-acquisition management (Unilever). All training is specifically tailored tothe needs of the organisation with the emphasis on practical applications to enhanceprofitability and cashflow. He has developed material for delivery by in-house personnel(Royal Mail, Lloyds Bowmaker and Conoco), computer based training packages (The PostOffice, Unilever and BP), and post course reinforcement self-study workbooks (CSC andZeneca). He has also produced a training video on Cashflow Management.A prolific writer of case studies, role plays and course material, he has published articles onthe financial justification of training, financial evaluation of IT investment, commercialrealities for consultants, financial considerations for retailers, activity based costing, centralservice function charging mechanisms, customer profitability analysis, stakeholder value andthe need for taxation awareness training for general managers. Many of his genericdocuments are freely available on his website: FinancialManagementDevelopment.comincluding papers on Charity Management.He is married with one daughter and three granddaughters. He is a Deacon in the CatholicChurch. He is a member of The Court of the University of Bedfordshire and a Trustee of theTen Ten Theatre. He has formerly held voluntary positions as Hospice Trustee (treasurer),Governor of Luton University, Governor of Dunstable College, school Governor, Trustee forvarious charities and was a member of the Catholic Alpha Training Team (Promoting theAlpha course on Basic Christianity).This series of papers is designed to help managers by providing a basic understanding ofkey financial concepts to assist them in their work. It is provided at no cost since thisknowledge is a Gift from God and thus to be shared (Matthew 10:8).www.FinancialManagementDevelopment.com © David A Palmer 2011

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