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Accounting34
This document provides an overview of accounting and financial statement analysis. It defines accounting and describes the accounting equation and key financial statements. It discusses how accounting provides a representation of a company and can be creative. The roles and uses of accounting are outlined. The document then covers analyzing and interpreting financial statements, including calculating and using ratios to assess a company's profitability, liquidity, asset management, financial structure, and market value. Limitations of ratio analysis are also noted.
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Accounting34
- 1. MBA Intensive Seminars2004 FMA Revision notes MBA INTENSIVE Page 1
- 2. Definition Accounting is theprocess of •identifying, •measuring •and communicating •financial information about an entity •to permit informed judgments and decisions •by users of the information. MBA INTENSIVE Page 2
- 3. The Accounting Equation Assetsminus Liabilities equals Equity A L = E Assets equals Liabilities plus Equity A = L + E Equity Capital Ownership claim Shareholders’ funds MBA INTENSIVE Page 3
- 4. Power of Accounting “Accountingprovides a very selective but powerful representation of the corporate identity..” “The detailed language of assets, liabilities, costs, profits provide a range of corporate imagery and vocabulary …….” “Accounting provides the categories through which organisational participants perceive both themselves and the organisation.” Mike Powers MBA INTENSIVE Page 4
- 5. Creative Accounting? “Things mayexist independently of our accounts, but they have no human existence until they become accountable. They may not exist, but they take on human significance by becoming accountable..” “Accounts define reality and at the same time they are that reality….” “Accounts do not more or less accurately describe things. Instead they establish what is accountable in the setting in which they occur” “Whether they are ACCURATE OR INACCURATE by some other standards, accounts define reality for a situation in the sense that people act on the basis of what is accountable in the situation of their action.” Ruth Hines MBA INTENSIVE Page 5
- 6. You will discover Thataccounting is subjective, partial and potentially misleading Accountants use language / numbers in a highly technical way Accounts are a highly stylised story, representation, description of organisational events Differences between the ‘Accounting World’ and the ‘Organisational World’ Problematic nature of accounting numbers MBA INTENSIVE Page 6
- 7. And there’s more…. Thetribe of accountants takes many forms and lives within all organisations No such thing as a correct ‘cost’, ‘value’, ‘profit’..it all depends on context The value of accounting in managing organisations MBA INTENSIVE Page 7
- 8. Roles of Accounting Improveproblem solving / decision making Manage risks Trust, Assurance Educational - learn about organisations Language of business Construct, define, measure success/failure MBA INTENSIVE Page 8
- 9. Roles of Accountants Assistingthe internal management of organisations Complying with external financial reporting, controls and with taxation regulations Expert consultants on financial and organisational performance MBA INTENSIVE Page 9
- 10. Financial Accounting Accounting concepts Profitand Cash distinction Financial statements Organisational impact MBA INTENSIVE Page 10
- 11. Hierarchy of AccountingQualities Decision Makers and their characteristics Benefits > Costs Understandability Decision-Usefulness Relevance Predictive value Reliability Timeliness Feedback Value Verifiability Comparability & consistency Representational Faithfulness Neutrality Materiality MBA INTENSIVE Page 11
- 12. Transactions Buy materials oncredit from suppliers Sell goods or services on credit to customers Pay suppliers Receive cash MBA INTENSIVE Page 12
- 13. When is profitreported? When goods or services are sold NOT when cash is paid or received MBA INTENSIVE Page 13
- 14. Example: Antiques dealer Buy10 chairs for cash $200 each Sell 6 chairs on credit $300 each Profit 6 x $100 each = $600 Cash flow = minus $2,000 MBA INTENSIVE Page 14
- 15. Profit, not cash MatchingConcept – match revenues received with the costs incurred to generate them Goods received but not paid for –Creditors (Payables) Goods or services supplied but no cash yet - Debtors (Receivables) Prudence concept – providing for known / probable losses – e.g. Doubtful debts, Depreciation of fixed assets MBA INTENSIVE Page 15
- 16. Profit, not cashcontd Customers pay in advance for services extending beyond the accounting period Company agrees with supplier to buy materials at fixed price for 5 years Home currency euros, borrow in dollars Increase in valuation of fixed assets MBA INTENSIVE Page 16
- 17. Change over aperiod start Assets - Liabilities = Equity During the period end Profit/loss Assets - Liabilities = Equity MBA INTENSIVE Page 17
- 18. Contents of annualreport Financial highlights Company overview Chairman’s statement Chief Executive’s review Audit report Financial statements Notes to the accounts MBA INTENSIVE Page 18
- 19. The main financialstatements Balance Sheet 1 AS AT Balance Sheet 2 AS AT 31 Dec Year 1 Profit and Loss Account For period Cash Flow Report Balance Sheet 3 AS AT 31 Dec Year 2 31 Dec Year 3 Profit and Loss Account For period Cash Flow Report MBA INTENSIVE Page 19
- 20. Balance sheet horizontal •Fixed assets • Liabilities • Current assets • Shareholders’ funds MBA INTENSIVE Page 20
- 21. Balance sheet vertical Fixedassets Current assets Less Current liabilities Less long term liabilities Equals Shareholders’ funds MBA INTENSIVE Page 21
- 22. Profit and lossaccount Revenue (sales) Less Expenses (costs) Equals Profit MBA INTENSIVE Page 22
- 23. Cash flow statement Operatingcash flows plus Investing cash flows plus Financing cash flows Equals change in cash and bank loans MBA INTENSIVE Page 23
- 24. Creative accounting What dowe want to create? Less profit? More profit? More assets? More liabilities? Fewer assets? Fewer liabilities? MBA INTENSIVE Page 24
- 25. Creative Accounting Practices Incomesmoothing – move profit from one year to another Changing accounting policies, particularly depreciation, asset valuations Overstating costs, particularly in regulated industries Making expenses into Assets - ‘capitalisation’ MBA INTENSIVE Page 25
- 26. Off-balance sheet financing, e.g leasing, Sale and buyback, special purpose vehicles Recognising profits that aren’t really there – foreign exchange rates affecting values of assets and loans Corporate takeovers – ACCOUNTING MINEFIELD adjusting policies, fair values, goodwill, brands, reorganisation costs……... MBA INTENSIVE Page 26
- 27. Corporate crime /fraud Directors are responsible for preventing crime and fraud They are required to have a system of internal controls Who controls executive directors for honesty/? Audit committees, Non-executive Directors, Supervisory Board MBA INTENSIVE Page 27
- 28. Corporate crime/ fraudcontd. Creating fictitious contracts Fictitious Assets, inaccurate valuations Omitting Liabilities, misleading valuations Raid the employees’ pension fund MBA INTENSIVE Page 28
- 29. Analysis and Interpretation of FinancialStatements MBA INTENSIVE Page 29
- 30. First Steps BC (beforecalculation) • • • • • Why are you analysing accounts? Who are you interpreting for? When are you interpreting? What are you intending to interpret? Limitations of Financial Accounts MBA INTENSIVE Page 30
- 31. Always bear inmind • Preparers of accounts know how people will interpret their accounts • Be cynical – assume the accounts are the best possible picture • Analysis only as good as original data – • Never just use accounts – check from many different sources • Accounting terms are different from general understandings MBA INTENSIVE Page 31
- 32. However…. • Accounts aremain source of systematically produced regulated information • Good as it gets • Usually reliable – 3rd party verified • Follow the same basic rules • Most of the information is there (in the small print) • You can never eliminate the risk of fraud / criminal misrepresentation MBA INTENSIVE Page 32
- 33. Analyse Accounts todetermine Is the company: •Growing? •Profitable? •Managing its assets effectively? •Sufficiently liquid? •Financed properly? •Able to meet its financial obligations? •Viewed favourably by financial markets? MBA INTENSIVE Page 33
- 34. Financial ratios • Quickand simple check on financial health • Small number of ratios gives a picture of the business. Easy to calculate, harder to interpret. • Provide a starting point for further investigation. MBA INTENSIVE Page 34
- 35. Key areas foranalysis • • • • • Profitability Liquidity Asset management Debt management (financial structure) Market value MBA INTENSIVE Page 35
- 36. Success in makingprofit Return on capital employed profit sales Profit _____ x _______ = __________ sales total assets total assets profitability x efficiency = MBA INTENSIVE ROCE Page 36
- 37. Managing liquidity • • • • • • Can wepay the bills as they fall due? Can we pay the wages of employees? Buy stock (inventory) on credit Sell on credit = accounts receivable Pay suppliers = accounts payable Ideally, match cash flows in and out MBA INTENSIVE Page 37
- 38. Asset management • • • • • • Use fixedassets to earn sales revenue Manage working capital stocks (inventory) debtors (accounts receivable) creditors (accounts payable) working capital cycle MBA INTENSIVE Page 38
- 39. Financial structure • Isit a good idea to borrow? • Creates greater risk - interest payments and capital repayments • Benefits to shareholders when profits are rising • Risks to shareholders when profits are falling MBA INTENSIVE Page 39
- 40. Advantages of ratios • • • • • • Comparisonsare relative to other figures Compare businesses of different size Gives picture of company strategy Financial and trading performance Compare with industry averages Simple summary of complex information MBA INTENSIVE Page 40
- 41. Reasons for usingratios • • • • Gives summary statistics Helps identify industry benchmarks Input to formal decision model Standardise for size MBA INTENSIVE Page 41
- 42. Applications of analysis • • • • Predictionsof corporate earnings Construct projected financial statements Predict corporate failure Indicators of financial distress e.g. Altman’s models, combination of ratios MBA INTENSIVE Page 42
- 43. Problems with ratioanalysis • No agreement on definitions or specific set of ratios • Accounting estimation • Data not available • Timing of data does not match • Differing accounting policies • Negative numbers and small divisors MBA INTENSIVE Page 43
- 44. Limitations of ratioanalysis • Diverts attention from the underlying information • May not give sufficient attention to the notes to the accounts • Accounting policies may affect comparison • Industry differences MBA INTENSIVE Page 44
- 45. Creative accounting Could involve: •Inflating reported profits and EPS • Accounting for losses via balance sheet reserves and all profits through P & L • Reporting profits without generating equivalent cash • Reporting lower borrowings MBA INTENSIVE Page 45
- 46. Survival Tips forAccounting Jungle • Read the accounts backwards • Read the accounting policies and compare • Screen accounts using filters – e.g. high profit low tax, changing depreciation policies • Cash is King (or Queen) • Assess risk: If in doubt, keep out (or get out) MBA INTENSIVE Page 46
- 47. Return on CapitalEmployed Profit before interest and taxation x 100 Shareholders’ funds plus long term debt • Often called ‘Operating profit’ Assets minus Liabilities = Equity • Total assets minus current liabilities equals Shareholders’ funds plus long term loans MBA INTENSIVE Page 47
- 48. Return on CapitalEmployed Top line questions • What increases/ decreases profit? • Sales? Operating Costs? Bottom line questions • Recent increases in assets may not yet have created profit • Is there any debt ‘off balance sheet’? MBA INTENSIVE Page 48
- 49. Return on ShareholdersFunds (also called Return on Equity) Net profit after taxes x 100 Shareholders’ funds MBA INTENSIVE Page 49
- 50. Return on ShareholdersFunds Top line questions • What increases/ decreases profit? • Sales? Operating Costs? • Interest charges? Taxes? Bottom line questions • Is the company high/ low geared? MBA INTENSIVE Page 50
- 51. Net Profit Percentage Netprofit after taxes x 100 Sales • Often shown as ‘Profit attributable to ordinary shareholders’ • Sales also called ‘turnover’ MBA INTENSIVE Page 51
- 52. Net Profit Percentage Topline questions • Is gross profit high or low? • What are the admin and selling costs? • What are the effects of interest and taxation? Bottom line questions • Is the measurement of sales explained? MBA INTENSIVE Page 52
- 53. Gross Profit Percentage Grossprofit x 100 Sales Gross profit = Sales minus cost of sales Cost of sales = making ready for sale MBA INTENSIVE Page 53
- 54. Gross Profit Percentage Topline questions • Have sales volumes or prices changed? • Have costs of sales changed? • Are costs of sales mainly variable or fixed? Bottom line questions • Is the measurement of sales explained? MBA INTENSIVE Page 54
- 55. Current Ratio Current Assets CurrentLiabilities Solvency = Ability to meet obligations as they fall due Working capital = CA minus CL MBA INTENSIVE Page 55
- 56. Current Ratio Top linequestions • What affects levels of stocks, debtors, cash Bottom line questions • What affects levels of bank borrowing, trade creditors, other short term creditors Overall - How does the company manage its working capital? MBA INTENSIVE Page 56
- 57. Quick Ratio (AcidTest) Current Assets less Stock Current Liabilities Solvency = Ability to meet obligations as they fall due Cash flow: How does the company manage inflows and outflows of cash? MBA INTENSIVE Page 57
- 58. Quick Ratio (AcidTest) Top line questions • How is the company managing debtors and cash? Bottom line questions • How is the company managing trade creditors and bank overdraft? MBA INTENSIVE Page 58
- 59. Stock Holding Period(days) Stock x 365 Cost of Sales • Change 365 to 12 for a calculation in months. • Sales minus cost of sales equals gross profit MBA INTENSIVE Page 59
- 60. Stock Holding Period(days) Top line questions • Year-end stock or average stock? Use year-end for ease of calculation but check there are no significant changes from start. Bottom line questions • May have to make some approximations to get cost of sales MBA INTENSIVE Page 60
- 61. Debtor Payment Period(days) Trade Debtors x 365 Sales • Debtors = Accounts receivable (customers who buy on credit terms) •Use notes to the accounts to find trade debtors. MBA INTENSIVE Page 61
- 62. Debtor Payment Period(days) Top line questions • Average or year-end? Year-end is less trouble but check there are no major changes. Bottom line questions • Are all sales made for credit? Think about the nature of the business. MBA INTENSIVE Page 62
- 63. Creditor Payment Period(days) Trade Creditors x 365 Purchases or cost of sales •Trade creditors = Accounts payable (suppliers who provide goods on credit terms) • Use notes to the accounts for detail. • MBA INTENSIVE Page 63
- 64. Creditor Payment Period(days) Top line questions • Average or year-end? Bottom line questions • Opening stock + purchases - closing stock = Cost of goods sold. • Should be Purchases but Cost of goods sold is Ok if stocks are constant. MBA INTENSIVE Page 64
- 65. Gearing Long Term Debt LongTerm Debt plus Equity • Look carefully at balance sheet and use notes to accounts. •Add Preference shares to Debt •Omit Provisions MBA INTENSIVE Page 65
- 66. Gearing Top line question •What are the sources of finance that create fixed commitments to pay interest and repay capital? Bottom line question • What is the total long-term financing of the business, based on borrowings and equity? MBA INTENSIVE Page 66
- 67. Interest Cover Profit beforeinterest and tax Interest expense • EBIT = Earnings Before Interest and Taxation • Interest expense: either in profit and loss account or in detailed notes. MBA INTENSIVE Page 67
- 68. Interest Cover Top linequestions • What is the amount of profit available to ‘cover’ interest payments? • Is the company generating sufficient wealth to meet interest payments? Bottom line questions • What is the cost of servicing borrowings? MBA INTENSIVE Page 68
- 69. Concepts, Cost andCosting MBA INTENSIVE Page 69
- 70. Management accounting • • • • • • Integral partof management identify, present and interpret information for strategy, planning and control, for decision taking and use of resources for disclosure to employees to safeguard assets MBA INTENSIVE Page 70
- 71. Management accounting (contd) • • • • • • Internaluse within organisation No regulation by law Projections for future Analysis of past Directing attention, planning and control Solving problems MBA INTENSIVE Page 71
- 72. Measuring and analysing performance Implementing plans Examining future environment Actionplans and budgets Operating plans Developing objectives Formulating strategy MBA INTENSIVE Page 72
- 73. Importance of costing •Many organisational decisions rely on costings • Costing is complex but essential • “An accountant knows the cost of everything but the value of nothing” Oscar Wilde MBA INTENSIVE Page 73
- 74. Describing costs • Direct(identified with a saleable unit) • Indirect (spread across saleable units) • Indirect costs = Overheads • How to find a fair way of spreading the overheads? MBA INTENSIVE Page 74
- 75. Confusing terminology • Allocate= give all cost to one unit or centre • Apportion = share across units or centres • Absorb (Absorption) Soak up into the units of output See page 142 of text book MBA INTENSIVE Page 75
- 76. Terminology (contd) • Whatare the direct costs? Allocate these to units of output • What are the indirect costs? Allocate to cost centres if we know where they belong. • Otherwise Apportion (share) across cost centres. • Absorb costs from production centres into products. MBA INTENSIVE Page 76
- 77. Absorption bases Absorb as •cost per unit • cost per labour hour • cost per £ of labour • cost per kilo of material • cost per machine hour Different bases give different answers MBA INTENSIVE Page 77
- 78. Cost behaviour Pairs ofclassifications • Direct or indirect? • Fixed or variable? • Period or product? Case: Bus company sends buses to 10 schools for taking children home each day. How does the company describe the costs? MBA INTENSIVE Page 78
- 79. Direct or indirect? Directfor each school: Driver’s working time, fuel for bus, bridge tolls Indirect to spread across all journeys: Insurance, repairs, maintenance, licences, depreciation, driver’s idle time, holiday pay MBA INTENSIVE Page 79
- 80. Fixed or variable? Variablechange with activity level Fuel, repairs, bridge tolls Fixed regardless of activity level Drivers’ wages, Insurance, Licences, Maintenance checks, Depreciation MBA INTENSIVE Page 80
- 81. Period or product? Whatis the product? A person-mile. Product costs Driver’s time, fuel, bridge tolls Period costs Insurance, Licences, routine maintenance, depreciation MBA INTENSIVE Page 81
- 82. Examples of decisions • • • • • • • • Pricesetting, tendering for contracts Product profitability analysis Product design modifications R & D management Value Engineering General Cost Management Contracting out / Buying in Plant / Department Closure MBA INTENSIVE Page 82
- 83. Short-term decisions In theshort term business can continue if the selling price covers variable costs and makes a contribution to fixed costs. Contribution = Selling price - variable cost MBA INTENSIVE Page 83
- 84. Contribution analysis Break evenpoint = Fixed costs Contribution per unit Pay £1,000 rent for market stall. Buy toys for £6 each, sell for £8 each. What is breakeven volume? £1,000/£2 = 500 toys MBA INTENSIVE Page 84
- 85. Contribution analysis (contd) Sell500 at £8 = £4,000. Variable cost 500 x £6 = £3,000 Add fixed costs £1,000 Neither profit nor loss How many toys to sell for profit of £4,000? £(1,000 + 4,000)/£2 = 2,500 toys MBA INTENSIVE Page 85
- 86. Scarce resources Sell gardeningservices and house cleaning. Contribution per job £10 and £8. Gardening needs 2 hours per job, House cleaning needs 1 hour per job. Shortage of labour. Which has priority? House cleaning £8 per hour, Gardening £4 per hour. Contribution per unit of limiting factor MBA INTENSIVE Page 86
- 87. Short term decisions • • • • Makeinternally or buy externally Hire own staff or pay agency for outsourcing Keep a business activity going Take on a special order at lower price MBA INTENSIVE Page 87
- 88. Other factors indecisions Not just an accounting matter. Consider • organisation’s objectives • relationship with employees • marketing • corporate goodwill/ image • customer reactions • government policies MBA INTENSIVE Page 88
- 89. Get the costswrong and... •Set prices too high - lose sales; too low - sell products at loss •Lose potentially profitable contracts, win loss making contracts •Don’t know where we are making / losing money •Continue with loss making products, cut profit making products, sub-optimal product mix MBA INTENSIVE Page 89
- 90. Get the costswrong and... •R & D to create ‘better’ product when none needed •Product Design Modifications not done when needed •Contracting out production that costs more than internal production •Making products that could be cheaper to buy in •Close profit-making Plant / Keep open loss making plant MBA INTENSIVE Page 90
- 91. Different Costs forDifferent Purposes Not a single, universal ‘true’ cost. Appropriate cost is governed by: Needs of management Specific organisational situations Specific problem to be solved Available information - pragmatics MBA INTENSIVE Page 91
- 92. Different Costs forDifferent Purposes Activity Based Cost Average Cost Avoidable Cost Budgeted Cost Controllable Cost Current Cost Direct Cost Environmental Cost Engineered Cost Fixed Cost Failure Cost Planned Cost Full Cost Historic Cost Incremental Cost Indirect Cost Product Cost Quality Cost Relevant Cost Joint Cost Marginal Cost Opportunity Cost Overhead Cost Period Cost Sunk Cost Standard Cost Total Cost MBA INTENSIVE Step Cost Transfer Cost Variable Cost Page 92
- 93. Costing Problem •In contemporaryorganisations the fixed/variable classification is not relevant •Logical impossibility of attributing all costs to products •Wrong approach to the problem •‘Solution’ based in the ‘accounting world’ not the ‘organisational world’ MBA INTENSIVE Page 93
- 94. Activity ‘Solution’ Costs don’tdrive activities, activities cause costs Organisations do things that consume resources and (should) create value Costing should start with what the firm does activities in organisational world MBA INTENSIVE Page 94
- 95. Activity Based Costing • • • • • Whatare the activities of the organisation? What resources are used by each activity? How much does each resource cost? Collect cost in ‘cost pools’ How does each product or service make use of each activity? • Share cost from the cost pools. MBA INTENSIVE Page 95
- 96.
- 97. Benefits of ABC •Makes visible the activities that drive the costs • Prevents misallocation of costs • Links costs more closely to responsibility for causing costs BUT does not save money or generate profit. It only gives more accurate information MBA INTENSIVE Page 97
- 98. Activity costing is... •Notbased on accounting coding structures •Not based on accounting time frames •Not based on techniques designed to make the accountants life easier •Not based on producing Financial Statements MBA INTENSIVE Page 98
- 99. Short term planning Budgetsand Budgetary Control MBA INTENSIVE Page 99
- 100. What is abudget? • • • • Quantified format management plans and strategies for decision making communication medium MBA INTENSIVE Page 100
- 101. Mission/ goals Financial plans Assessedmarket opportunities/ organisational capability Corporate objectives Long term strategy Assumptions on critical factors Long term plans MBA INTENSIVE Page 101
- 102. Long term strategy Market opportunities Longterm planning Short term strategy Organisational capability Budget/ short term planning MBA INTENSIVE Forecasting assumptions Modify assumptions Page 102
- 103. Budget process • • • • • Formalises planningand control Defines goals Goal congruence - brings goals together Authority and responsibility are clear Framework to judge performance MBA INTENSIVE Page 103
- 104. operating Master budget Sales budget financial Capitalbudget + Cost of goods sold budget + Development /design budget Cash budget + Marketing budget + Distribution budget + Administration budget Budgeted profit and loss account MBA INTENSIVE Budgeted balance sheet Budgeted statement of cash flow Page 104
- 105. Budget preparation •Start withsales budget (demand driven) •Then match with cost of sales •Is this a production organisation? Plan: inventories of raw materials, finished goods purchases to cover sales and inventories MBA INTENSIVE Page 105
- 106. Budget preparation (contd) •Is this a service organisation? Plan service programme, labour needs, materials needed • Plan all other operating expenses • Plan capital expenditure • Bring together in cash budget, budgeted profit and loss account, balance sheet. MBA INTENSIVE Page 106
- 107. Cash budget • • • • • Most importantpart of budget cycle Monthly, quarterly? Cash receipts from operations Cash payments for operations Other cash receipts (new finance, sale of fixed assets) • Other cash payments (tax, dividends, interest) MBA INTENSIVE Page 107
- 108. Fixed and flexiblebudgets • Fixed means that budget is not adjusted later if volumes start to vary • Flexible budgets means that budget is adjusted to take account of change in volumes of activity over the period MBA INTENSIVE Page 108
- 109. Fixed and flexible(contd) Budget variable costs of £200,000 for 5,000 units of output Actual variable costs are £195,000 for 4,500 units of output How has manager performed against budget? MBA INTENSIVE Page 109
- 110. Fixed and flexible(contd) Appears to have saved £5,000 But budgeted cost = £4 per unit So flexible budget for 4,500 is £180,000 Performance is £15,000 worse than flexible budget. MBA INTENSIVE Page 110
- 111. Alternative approaches Easy approach= Last year plus inflation Zero-based budgeting • Start with a clean sheet • Justify every item • Focus on goals and objectives MBA INTENSIVE Page 111
- 112. Alternative approaches (contd) Activitybased budgeting • Extension of activity based costing • Focus on cost of each activity Kaizen budgeting • continuous improvement • budget is achieved if improvements are met MBA INTENSIVE Page 112
- 113. Not-for-profit organisations • Goalsand objectives measured differently • Need to be cost effective Planning programming budget system • Focus on outputs rather than inputs • ‘joined-up’ government MBA INTENSIVE Page 113
- 114. Behavioural aspects Budgets canmotivate employees to achieve goals of the organisation. What helps? • degree of difficulty • top management participation • perceived fairness • feeling of ownership • avoid discontent about preparation MBA INTENSIVE Page 114
- 115. Not foolproof Why mightbudgets fail? • Fail to understand changing environment • using unsuitable existing structures • fail to understand business systems • lack of senior management support • fail to understand central role of budgeting MBA INTENSIVE Page 115
- 116. Are budgets necessary? Whatmatters is PLANNING This does not have to use budgets. Essential: • Set targets: to maximise long term value • Strategy: Make development continous • Growth and improvement: challenge staff • Resource management: wealth creation MBA INTENSIVE Page 116
- 117. Are budgets necessary? • • • • • • Co-ordination:manage cause and effect Cost management: challenge all costs Forecasting: use rolling forecasts Measurement and control: key indicators Rewards: unit rewards not individuals Delegation: give managers freedom to act MBA INTENSIVE Page 117
- 118.
- 119. Strategic planning Five yearplan, rolling forward. • Profitability • Growth of sales, profit • Market share • Customer satisfaction • Rate of innovation How to measure achievement of strategy? MBA INTENSIVE Page 119
- 120. Accounting-based performance measures Profit? • Couldcompare actual profit against budget, but companies don’t give information • An absolute measure, needs ratios for comparison. • Affected by choice of accounting policies • Measured differently in different countries MBA INTENSIVE Page 120
- 121. Accounting-based performance measures (contd) Profitability •A relative measure, better for comparison. • Calculate for subdivisions of an organisation. Methods • Return on capital employed • Residual income • Economic value added MBA INTENSIVE Page 121
- 122. Return on capitalemployed Profit before interest and taxes Fixed assets plus current assets less current liabilities Can be used for divisions of a company if assets and liabilities can be allocated. MBA INTENSIVE Page 122
- 123. Return on shareholders’funds Net profit after interest and taxation Shareholders’ funds Can only be calculated for the company as a whole, not subdivided for divisions of organisation. MBA INTENSIVE Page 123
- 124. Residual income Ask: Whatis the income (profit) remaining after deducting a notional interest charge for the use of capital? X Z £000’s Operating profit (EBIT) 18 1,500 Capital employed 100 10,000 ROCE 18% 15% MBA INTENSIVE Page 124
- 125. Residual income (contd) Supposecost of capital is 10% for both. X Z £000’s Operating profit (EBIT) 18 1,500 Less interest charge (10) (1,000) Residual income 8 500 Company Z gives higher income to shareholders MBA INTENSIVE Page 125
- 126. Economic Value Added(EVA) Companies should deliver value that exceeds the cost of capital. X Z Profit after tax (before interest) 13 1,050 Interest charge (net of tax) (7) (700) EVA 6 350 Z gives higher EVA than does X MBA INTENSIVE Page 126
- 127. Performance of adivision Divisions are created by decentralisation • Gives greater responsiveness • Allows faster decisions • Motivates managers • Uses specialist experience of managers But needs a measure of performance MBA INTENSIVE Page 127
- 128. Performance of adivision (contd) Problems of decentralisation • Focus on division, not on total organisation (Called ‘dysfunctional decision making) • More information is needed, cost involved • Duplication of activities MBA INTENSIVE Page 128
- 129. Performance of adivision (contd) Cost centre • Manager is responsible for costs Discretionary cost centre • Manager has some choices in cost budget Revenue centre • Manager is responsible for generating planned sales MBA INTENSIVE Page 129
- 130. Performance of adivision (contd) Profit centre • Manager is responsible for revenues and costs • Target profit is set Investment centre • Manager is responsible for resources and profit, target return to be achieved MBA INTENSIVE Page 130
- 131. Transfer pricing What priceis charged for transfers between divisions within an organisation? • Variable cost? • Variable cost plus a profit margin? • Variable cost plus portion of fixed cost? • Variable + fixed + profit margin? • Negotiated price? Reflect market? MBA INTENSIVE Page 131
- 132. Financial Performance Measurement • Success/ Failure often determined by accounting numbers • Growth in profit, ROCE, Sales • Reduction in costs, headcount, errors, stock • Financial Ratio Analysis MBA INTENSIVE Page 132
- 133. Financial Performance Measurement (contd) • • • • Achievingoutcome at or under budget Adverse / Favourable variance analysis Project NPV – cost overruns OBJECTIVE APPROACH TO Performance measurement MBA INTENSIVE Page 133
- 134. Problem with financialmeasures A Simple Scenario. Division in large company enjoyed major growth in profitability over two years ..manager promoted. New manager ….drop in profits. WHY ? MBA INTENSIVE Page 134
- 135. Financial measures (contd) Topline answer • Division’s market share dropped • Costs were reduced by reducing maintenance of cutting machine, reducing staff training •build up of stocks (inventory) of unsold goods Bottom line answer • Reduced investment in new technology Financial System did not pick up the BAD Events MBA INTENSIVE Page 135
- 136. Problems with financialinformation • Complexity /mystery and the method of calculation • Arbitrary treatment of some cost items • Time lag between event and the financial ledger • No direct observable relationship between activities and reported costs • Irrelevant to managers MBA INTENSIVE Page 136
- 137. Problems with financialinformation (contd) • Managers need to convert data into meaningful information. • Implied assumption that control costs will control activities. • Focus on cost minimisation, not on effectiveness or valueadding. Could be valid reasons for costs increasing. • Simplification of organisational activities, by reducing everything into a single £ value. MBA INTENSIVE Page 137
- 138. Value of FinancialPerformance Measurement • Managers accept importance of financial outcome of their function (especially if linked to pay / prospects). • Managers will try to increase their profitability. • Managers often devise their own budget 'systems’. MBA INTENSIVE Page 138
- 139. Value of FinancialPerformance Measurement (contd) • Need information on relationships between activities they control and financial outcome • Ignore formal budget reports / spend time and effort proving official budget is wrong • Do not assume that managers can "translate" £s into actual activities MBA INTENSIVE Page 139
- 140. Information Managers Use USstudy concluded information used for daily operating control did not come from the budgeting system. Managers' information needs are affected by: •the resources most significant to their process, in terms of cost, quality, availability •the time frame in which this information is needed MBA INTENSIVE Page 140
- 141. Indicators for managers level of finished goods level of orders (demand) key production limiting factors simple counts of output per hour / shift / day, physical quantities of materials / labour used, down-time MBA INTENSIVE Page 141
- 142. Indicators for managers(contd) scrap quantities, rework rates. capacity utilisation physical production requirements (long - medium and short-term) MBA INTENSIVE Page 142
- 143. Non-Financial Measures Non-financial isany information not valued in £s. It has the following advantages: • Expressed in terms/language understandable to managers (non-accountants) • Requires very little "translation" by managers MBA INTENSIVE Page 143
- 144. Non-Financial Measures (contd) •Potentially quicker, relevant • Relates to events, activities, actual observable performance • Can be used to make sense of financial budgets • Better reflects the "reality" of the situation, not confused by strange accounting rules/conventions MBA INTENSIVE Page 144
- 145. Integrating Non-£ and£ measures • • • • • • Activity Based Accounting Benchmarking Performance Scoring Balanced Scorecard Strategic Management Accounting Many other – multiple criterion decision making, data envelopment analysis, etc… MBA INTENSIVE Page 145
- 146. Balanced Scorecard Financial Perspective CustomerPerspective Vision and Strategy Internal Business Perspective Learning & Growth Perspective MBA INTENSIVE Page 146
- 147. Balanced Scorecard • systematicattempt to design performance measurement system that integrates – organisational objectives, – co-ordination of individual decision making – need for organisational learning. • create an environment that facilitates continual improvement MBA INTENSIVE Page 147
- 148. Balanced Scorecard (contd) •reflect the organisation’s understanding of the causes of successful performance. • monitoring performance and what managers believe are drivers of good performance • performance measure system should measure the most critical aspects of organisational performance. MBA INTENSIVE Page 148
- 149. Balanced Scorecard (contd) BSperformance measures should • be clearly understood by all employees • link manufacturing performance and financial performance • be linked to ensure constancy of purpose. MBA INTENSIVE Page 149
- 150. Balanced Scorecard (contd) BSperformance measures should • be able to identify cause-effect relations to enable employees to deal with poor performance and continue good practices. • be based on critical success factors • identify trends and rate of change MBA INTENSIVE Page 150
- 151. Not-for-profit organisations • Economy Costat which resources are acquired • Efficiency Compare inputs and outputs • Effectiveness How resources are used Value for Money MBA INTENSIVE Page 151