answers to textbook questions

1

A2 Accounting for AQA

Answers to textbook questions

A2 Unit 3Further Aspects of Financial Accounting

1 Sources of finance 1

2 Incomplete records 2

3 Partnership final accounts 8

4 Changes in partnerships 15

5 Published accounts of limited companies 21

6 Cash flow statements 26

7 Accounting standards 30

8 Stock valuation 34

A2 Unit 4Further aspects of Management Accounting

9 Manufacturing accounts 40

10 Costs and contribution 44

11 Break-even analysis 47

12 Absorption and activity based costing 52

13 Overheads and overhead absorption 57

14 Costing in decision-making 62

15 Standard costing and variance analysis 70

16 Capital investment appraisal 73

17 Further aspects of budgeting 79

18 Decision-making and social accounting 85

Note: these are the answers to the texbook chapter questions which do not have an asterisk. The answers to the asteriskedquestions are in the back of the texbook.

The page numbers below relate to the answers set out in this document.

1

1.2 (a) Sajit will need a bank overdraft. Its features are:• borrowing on a current account up to a set limit• interest is only charged when the business borrows • variable interest rate• reviewed every yearadvantages:• flexibility – the borrowing can be repaid as and when funds are available• economical – interest only charged when the business borrowsdisadvantages:• interest rates for bank overdrafts can be higher than bank loan rates• repayable on demand• security normally required – danger of loss of property if business fails

(b) Rachel will need a bank loan for the equipment for her business.Its features are:• a fixed amount over a fixed period• interest at a fixed or variable rate• a regular repayment scheduleadvantages:• easy to budget for, as the timing of repayments is known• the possibility of negotiating the timing of repayments (‘holiday’ may be possible)• interest rates may be lower than overdraft ratesdisadvantages:• a long-term financial commitment which has to be met• security normally required – which could include Rachel’s property

(c) Basil will need a commercial mortgage. Its features are:• a long-term loan secured on business premises (ie the hotel)• finance available normally up to 70% of property value (Basil’s deposit of £150,000 will be sufficient)• interest at a fixed or variable rate• a regular repayment scheduleadvantages:• easy to budget for, as the timing of repayments is known• interest rates may be lower than overdraft ratesdisadvantages:• a long-term financial commitment which has to be met• the property will be required as security• if the business fails and the bank calls in the loan, Basil will lose his hotel

1.5 Tariq has two distinct financial needs: £80,000 for fixed assets and £70,000 for working capital.

There is no ‘right or wrong’ answer to this question. In an exam situation the examiner will be looking for knowledge of thedifferent forms of financing and a reasoned conclusion based on a discussion of the relevant advantages and disadvantages ofeach form.

(a) asset finance

The first consideration is likely to be whether the finance can be met from internal sources. The question states that Tariq isalready putting in a capital contribution, so further internal financing could be met from a loan from the family – this has theadvantage of being cheap and flexible, but the possible downside is the family wanting a say in the way the business is run. Theother internal source of finance would be funding from cash generated from profits, but as the business is not yet trading this isnot a viable option.

The other options are financing from external sources:

• Bank loan – repayable over the long term, repayments can be budgeted for, repayment schedule may be negotiated toinclude ‘holiday’, interest fixed or variable rate; but . . . security will be required, Tariq may lose his house if the business fails.This is, on balance, probably the favoured option for asset finance.

• Bank mortgage – not applicable as the office will be rented and not available as security.

• Business angel – the finance may be available, but the angel will want a stake in the business and a say in how it is run –this may be an advantage or a disadvantage depending on Tariq’s expertise and ambitions for ‘going it alone’. The biggestdownside will be the loss of total control, an issue which is often important for the entrepreneur.

CHAPTER 1 Sources of finance

2.2 £77,000

2.5TALIB ZABBAR

CALCULATION OF STOCK LOSS FOR THE YEAR ENDED 30 SEPTEMBER 20-7£ £

Opening stock 30,500Purchases 89,500Cost of stock available for sale 120,000Sales 160,000Less Normal gross profit margin (40%) 64,000Cost of sales 96,000Estimated closing stock 24,000Less Actual closing stock 21,500Value of stock loss 2,500

2.7 • Calculating cost of sales, gross profit and sales:£

Opening stock at 1 January 2004 890Purchases 46,753

47,643Less Closing stock at 31 December 2004 950Cost of sales 46,693Gross profit at mark-up of 100% 46,693∴ Sales 93,386

Tutorial note: mark-up is applied to cost of sales, not to purchases.

• Using a sales ledger control account:

Dr Sales Ledger Control Account Cr

2004 £ 2004 £

1 Jan Balance b/d 2,786 Bank (missing figure) 93,532

Sales 93,386 31 Dec Balance c/d 2,640

96,172 96,172

2005 2005

1 Jan Balance b/d 2,640

2

CHAPTER 2 Incomplete records

• Incorporation of the business as a limited company in order to attract external equity finance from a private equity firm – thisis very unlikely in view of the small amount involved. It will also involve a partial loss of control of the business.

(b) working capital finance

The requirement could be met from internal sources, but the same considerations in (a) apply, ie Tariq does not have morefunds himself; also, involving the family could cause problems and financing from profits is not possible in a business start-upsituation.

The only other option is an external source of finance – the bank overdraft, which involves borrowing on a current account upto a set limit.The advantages are that it is flexible (the borrowing can be repaid as and when funds are available) and is economical (interestis only charged when the business borrows). The disadvantages are: an overdraft is repayable on demand (this would happenif the bank wanted to cancel the overdraft) and security will be required (the danger of the possible sale of Tariq’s house if thebusiness fails).

• Calculating the cash loss:£

Cash expected to be banked (from control account) 93,532Cash actually banked 93,322∴ Cash loss 210

2.8 (a)

Dr Summarised Cash Account Cr

2003/04 £ 2003/04 £

1 Jan Balance b/d 229 Bank 165,640

Cash sales 219,941 Expenses 49,600

29 May Amount of cash stolen (missing figure) 4,770

31 May Balance c/d 160

220,170 220,170

2004/05 2004/05

1 Jun Balance b/d 160

(b) Measures to prevent such a loss occurring in the future; any two from:• Record cash transactions as they occur, eg by using tills that issue receipts.• Collect cash from tills regularly, and place the cash in a safe in the office.• Bank cash regularly, so that there is a low level of cash on the premises at any time.• Pay bills by cheque rather than in cash, so avoiding the need to carry cash when paying creditors.• Divide duties within the business, ensuring that no one person is responsible for all cash handling.• Carry out cash checks at regular intervals, eg to ensure that the cash in tills balances against receipts.• Improve security, eg use of a safe in the office for cash to be banked, keep the office door locked when the

office is empty, use of security cameras.• Set authorisation limits for employees who pay bills, to ensure that large amounts cannot be paid out without

authority.

(c) Advice to maintain accurate records of cash transactions; any two from:• Keep a detailed cash book.• Keep a copy of all receipts issued.• Use a numbering system for all receipts and invoices.• Prepare bank reconciliation statements each time a bank statement is received.• Use margin and mark-up to compare expected sales with actual sales figures.

2.10 (a) £• receipts from trade debtors 121,000• less trade debtors at beginning of year 36,000• add bad debts written off during year 550• add trade debtors at end of year 35,000• sales for year 120,550

(b) • payments to trade creditors 62,500• less trade creditors at beginning of year 32,500• add trade creditors at end of year 30,000• purchases for year 60,000

(c) • payments for expenses 30,000• less accrual at beginning of year 500• add accrual at end of year 700• expenses for year 30,200

3

(d) COLIN SMITHTRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 20-5

£ £Sales 120,550Opening stock 25,000Purchases 60,000

85,000Less Closing stock 27,500Cost of sales 57,500Gross profit 63,050Less expenses:

Expenses 30,200Provision for depreciation: fixtures and fittings 5,000Bad debts written off 550

35,750Net profit 27,300

(e) COLIN SMITHBALANCE SHEET AS AT 30 JUNE 20-5

£ £ £

Fixed Assets Cost Provision for Netdepreciation book value

Fixtures and fittings 50,000 15,000 35,000

Current Assets

Stock 27,500

Trade debtors 35,000

Bank 1,210

63,710

Less Current Liabilities

Trade creditors 30,000

Accrual: expenses 700

30,700

Net Current Assets 33,010

NET ASSETS 68,010

FINANCED BY

Capital

Opening capital* 69,500

Add Net profit 27,300

96,800

Less drawings 28,790

68,010

* Opening capital: £

• assets at 1 July 20-4 102,500

• less liabilities at 1 July 20-4 33,000

• capital at 1 July 20-4 69,500

4

2.11 SANDRINETRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006

£ £Sales (working 1) 228,295Opening stock 4,987Purchases (working 2) 62,794


Wages (working 3) 56,404Motor expenses 7,920General expenses 7,963Loan interest (working 4) 3,000Provision for depreciation: equipment (working 5) 1,500

vehicles (working 6) 12,000Loss on sale of equipment (working 7) 3,800

92,587Net profit 72,965

WORKINGS£

1 • receipts from trade debtors 163,729• less trade debtors at beginning of year 3,746• add trade debtors at end of year 2,988• add cash sales 65,324• sales for year 228,295

2 • payments to trade creditors (720 + 61,700) 62,420• less trade creditors at beginning of year 1,822• add trade creditors at end of year 2,196• purchases for year 62,794

3 • payments for wages 57,200• less wages owing at beginning of year 796• wages for year 56,404

4 • payments for loan interest 2,500• add loan interest paid in advance at beginning of year 500• loan interest for year 3,000

5 • net book value of equipment at beginning of year 20,000• less net book value of equipment sold during year 5,000

15,000• less net book value of equipment at end of year 13,500• provision for depreciation of equipment for year 1,500

6 • net book value of vehicles at beginning of year 26,000• cost of vehicle purchased during the year 22,000

48,000

• provision for depreciation of vehicles for year (£48,000 x 25%) 12,000

7 • net book value of equipment sold during the year 5,000• sale proceeds of equipment during the year 1,200• loss on sale of equipment for year 3,800

5

2.13 (a) CINDY TOFEBank Reconciliation Statement as at 31 December 2005

£Balance at bank as per bank statement (668)Unpresented cheque (291)

(959)Outstanding lodgement 1,084Balance at bank as per cash book 125

Tutorial note: the topic of bank reconciliation statements is covered in AQA AS Accounting; the statement starts withthe bank balance, which is overdrawn.

(b)

Dr Bank Account Cr

2005 £ 2005 £

1 Jan Balance b/d 1,726 Payments for year 186,065

Receipts for year 201,784 Drawings (missing figure) 17,320

31 Dec Balance c/d 125

203,510 203,510

2006 2006

1 Jan Balance b/d 125

(c) £Stock at 31 December 2005 ?

– sales at cost price 2,520 ÷ 1.4 1,800– sales to F Fearless at cost price 858 ÷ 1.1 780+ sales returns at cost price 504 ÷ 1.4 360+ purchases 1,036– purchases returns 140

Stock valuation at 8 January 2006 2,986

By working up the calculation (adding the minuses and deducting the pluses), the stock valuation at 31 December2005 is found to be £4,310.

(d)

Dr Disposals Account Cr

2005 £ 2005 £

Vehicle (book value) 12,000 Vehicle (part exchange value)

(missing figure) 11,500

Profit and loss account

(loss on sale) 500

12,000 12,000

6

(e) CINDY TOFETRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005

£ £Sales (working 1) 198,506Opening stock 2,998Purchases (working 2) 143,102


General expenses 1,604 + 5,162 6,766Wages (working 3) 23,041Rent (working 4) 4,680Motor expenses 3,040Provision for depreciation: equipment 4,000

vehicles (working 5) 17,000Loss on sale of vehicle 500

59,027Net loss 2,311

WORKINGS

1 Dr Cash Account Cr

2005 £ 2005 £

1 Jan Balance b/d 142 Expenses 11,022

Receipts (missing figure) 197,833 Bank 186,784


197,975 197,975

2006 2006


Dr Sales Ledger Control Account Cr

2005 £ 2005 £

1 Jan Balance b/d 6,546 Receipts 197,833

Sales (missing figure) 198,506 31 Dec Balance c/d 7,219

205,052 205,052

2006 2006


2 Dr Purchases Ledger Control Account Cr

2005 £ 2005 £

Bank 142,911 1 Jan Balance b/d 5,982

31 Dec Balance c/d 5,433 Purchases (missing figure) 142,362

148,344 148,344

2006 2006


Purchases for year: £142,362 (above) + £740 (cash purchases) = £143,102

7

3 Dr Wages Account Cr

2005 £ 2005 £

Bank 23,110 1 Jan Balance b/d 831

31 Dec Balance c/d 762 Profit and loss account

(missing figure) 23,041

23,872 23,872

2006 2006


4 Dr Rent Account Cr

2005 £ 2005 £

1 Jan Balance b/d 160 Profit and loss account

Bank 4,940 (missing figure) 4,680


5,100 5,100

2006 2006


5 Dr Vehicles Account Cr

2005 £ 2005 £

1 Jan Balance b/d 60,000 Disposals 12,000

Bank 13,500 Profit and loss account

Part exchange 11,500 (missing figure) 17,000

31 Dec Balance c/d 56,000

85,000 85,000

2006 2006


3.3 £10,800 (£32,800 – £1,800 – £10,000 + £600) ÷ 2

3.4 £580 Cr (£550) + £900 + £10,000 – £14,000 + £4,230

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CHAPTER 3 Partnership final accounts

3.6Dr Partners' Capital Accounts Cr

Mike Bernie Mike Bernie20-4 £ £ 20-4 £ £ 31 Dec Balances c/d 30,000 20,000 1 Jan Balances b/d 30,000 20,000

20-5 20-51 Jan Balances b/d 30,000 20,000

Dr Partners' Current Accounts Cr

Mike Bernie Mike Bernie20-4 £ £ 20-4 £ £

1 Jan Balance b/d – 420 1 Jan Balance b/d 1,560 – 31 Dec Drawings 21,750 17,350 31 Dec Salary – 7,50031 Dec Balances c/d 1,510 830 31 Dec Interest on capital 1,500 1,000

31 Dec Share of profits 20,200 10,10023,260 18,600 23,260 18,600

20-5 20-51 Jan Balances b/d 1,510 830

3.9 (a)DANIEL AND FREDA, IN PARTNERSHIP

STATEMENT OF AFFAIRS AS AT 31 DECEMBER 2005£ £

Assets

Premises 40,000

Vehicle 3,750

Office equipment 6,000

Stock 2,400

Debtors 150

Cash at bank 10,950

63,250

Less Liabilities

Creditors 3,250

Capital at 31 December 2005 60,000

Capital at 1 January 2005 50,000

Capital at 31 December 2005 (see above) 60,000

Profit retained for the year 10,000

Add drawings:

Daniel 17,000

Freda 23,000

40,000

Profit for the year ended 31 December 2005 50,000

9

(b) Although there is no legal requirement for Daniel and Freda to keep their financial records using a double-entrysystem, such a system will:

• provide more accounting information to assist with management decisions

• enable tax liabilities – income tax and Value Added Tax – to be calculated easily

• allow better control of the business, eg debtor control

• allow the partners to see their own financial position with the business better, eg capital accounts and currentaccounts

• provide more information to a lender – such as a bank – should the partnership require a bank loan or overdraft

A double-entry system will involve more work than a single-entry system. Thus single-entry is cheaper, easier tomaintain, and requires no special training; however, a double-entry system may reduce or eliminate the fees of anexternal accountant and is a more complete system.

3.11 (a)

Dr Partners' Capital Accounts Cr

Sara Simon Sara Simon20-5 £ £ 20-4 £ £ 31 Mar Balances c/d 10,000 6,000 1 Apr Balances b/d 10,000 6,000

20-5 20-51 Apr Balances b/d 10,000 6,000


Sara Simon Sara Simon20-5 £ £ 20-4 £ £ 31 Mar Drawings 12,700 7,400 1 Apr Balances b/d 560 1,05031 Mar Balance c/d 1,550 – 20-5

31 Mar Salary 8,000 –31 Mar Interest on capital 1,000 60031 Mar Share of profits 4,690 4,69031 Mar Balance c/d – 1,060

14,250 7,400 14,250 7,400

20-5 20-51 Apr Balance b/d – 1,060 1 Apr Balance b/d 1,550 –

1 0

3.11 (b)

1 1

SARA AND SIMON PENNY, TRADING AS ‘CLASS CATERERS’

TRADING AND PROFIT AND LOSS ACCOUNTFOR THE YEAR ENDED 31 MARCH 20-5

£ £

Sales 44,080

Opening stock 2,850

Purchases 11,300

14,150

Less Closing stock 3,460

Cost of sales 10,690

Gross profit 33,390

Less expenses:

Wages 8,020

Rent and rates 4,090

Sundry expenses 1,500

Provision for depreciation: office equipment 800

14,410

Net profit 18,980

Less appropriation of profit:

Salary: Sara 8,000

Interest allowed on partners’ capitals: Sara 1,000

Simon 600

1,600

9,380

Share of remaining profit:

Sara 4,690

Simon 4,690

9,380

BALANCE SHEET AS AT 31 MARCH 20-5

£ £ £Fixed Assets Cost Provision for depreciation Net book valueEquipment 8,000 800 7,200

Current AssetsStock 3,460Trade debtors 4,500Bank 8,640

16,600Less Current LiabilitiesTrade creditors 7,200Accrual of expenses 110

7,310Net Current Assets 9,290NET ASSETS 16,490

FINANCED BYCapital Accounts

Sara 10,000Simon 6,000

16,000Current Accounts

Sara 1,550Simon (1,060)

49016,490

3.12 (a)Dr Partners' Capital Accounts Cr

A Adams J Beeson A Adams J Beeson20-5 £ £ 20-4 £ £ 30 Jun Balances c/d 30,000 20,000 1 Jul Balances b/d 30,000 20,000

20-5 20-51 Jul Balances b/d 30,000 20,000


A Adams J Beeson A Adams J Beeson20-5 £ £ 20-4 £ £ 30 Jun Drawings 16,000 10,000 1 Jul Balances b/d 780 92030 Jun Balances c/d 1,209 1,349 2005

30 Jun Salary 6,000 –30 Jun Share of profits 10,429 10,429

17,209 11,349 17,209 11,349

20-5 20-51 Jul Balances b/d 1,209 1,349

(b)

1 2

ANNE ADAMS AND JENNY BEESON, TRADING AS ‘A & B ELECTRICS’TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 20-5

£ £ £

Sales 250,140

Less Sales returns 1,360

Net sales 248,780

Opening stock 26,550

Purchases 175,290

Less Purchases returns 850

174,440

200,990



Gross profit 75,540

Add income:

Decrease in provision for doubtful debts 13

75,553

Less expenses:

Rent and rates 8,170

Wages 29,020

Vehicle expenses 2,470

General expenses 6,210

Bad debts written off 175

Provision for depreciation: vehicle 2,250

fixtures and fittings 400

48,695

Net profit 26,858


Salary: A Adams 6,000

20,858


A Adams 10,429

J Beeson 10,429

20,858

3.12 (b) continued

3.14 (a)

Dr Total Debtors Account* Cr

2006 £ 2006 £ 1 Jan Balance b/d 317 Cash received from debtors 44,049

Sales (missing figure) 43,915 31 Dec Balance c/d 18344,232 44,232

2007 20071 Jan Balance b/d 183

* also known as sales ledger control account

(b)

Dr Total Creditors Account** Cr

2006 £ 2006 £ Payments to creditors 195,911 1 Jan Balance b/d 4,872

31 Dec Balance c/d 5,163 Purchases (missing figure) 196,202201,074 201,074

2007 20071 Jan Balance b/d 5,163

** also known as purchases ledger control account

1 3

BALANCE SHEET AS AT 30 JUNE 20-5

£ £ £Fixed Assets Cost Provision for depreciation Net book valueVehicle 12,000 5,250 6,750Fixtures and fittings 4,000 1,200 2,800

16,000 6,450 9,550

Current AssetsStock 27,750Trade debtors 6,850Less provision for doubtful debts 137

6,713Prepayment of expenses 250Bank 22,009Cash 1,376

58,098

Less Current LiabilitiesTrade creditors 14,770Accrual of expenses 320

15,090Net Current Assets 43,008NET ASSETS 52,558

FINANCED BYCapital Accounts

A Adams 30,000J Beeson 20,000

50,000Current Accounts

A Adams 1,209J Beeson 1,349

2,55852,558

3.14 (c) MARTIN AND NASSER, IN PARTNERSHIPTRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006

£ £

Sales – cash 332,467

– credit 43,915

376,382

Opening stock 14,003

Purchases 196,202

210,205



Gross profit 179,648

Add income: Rent received (working 1) 6,000

185,648

Less expenses:

Wages (working 2) 63,482

General expenses 56,676

Provision for depreciation:

vehicle (working 3) 8,000

machinery (working 4) 10,000

Loss on sale of machinery (working 5) 800

138,958

Net profit 46,690

Workings:

1. Rent received: £7,000 – £500 owing at 1 Jan – £500 paid in advance at 31 Dec = £6,000

2. Wages: £63,156 – £612 accrued at 1 Jan + £938 accrued at 31 Dec = £63,482

3. Vehicle depreciation: £16,000 valuation at 1 Jan – £8,000 valuation at 31 Dec = £8,000 depreciation for year

4. Machinery depreciation: £147,000 valuation at 1 Jan + £12,000 cost of new machine – £4,000* book value of oldmachine now sold – £145,000 valuation at 31 December = £10,000 depreciation for year

* £10,000 cost – £6,000 depreciation

5. Loss on sale of machinery: cost £10,000 – £3,200 part exchange value – £6,000 depreciation = £800 loss on sale

(d) MARTIN AND NASSER, IN PARTNERSHIPPROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006

£ £

Net profit 46,690

Add interest charged on partners’ drawings:

Martin 230

Nasser 100

330

47,020


Salary: Nasser 3,000

Interest allowed on partners’ capitals:

Martin £100,000 x 6% 6,000

Nasser £70,000 x 6% 4,200

10,200

33,820


Martin (60%) 20,292

Nasser (40%) 13,528

33,820

1 4

3.14 (e)Dr Partners' Current Accounts Cr

Martin Nasser Martin Nasser2006 £ £ 2006 £ £ 31 Dec Drawings 35,660 26,480 1 Jan Balances b/d 3,210 1,30431 Dec Interest on drawings 230 100 Salary – 3,000

31 Dec Interest on capital 6,000 4,20031 Dec Share of profit 20,292 13,52831 Dec Balances c/d 6,388 4,548

35,890 26,580 35,890 26,580

2007 20071 Jan Balances b/d 6,388 4,548

(f) The benefits of maintaining separate capital and current accounts are:

• the capital amount remains fixed except for capital introduced or withdrawn

• the current account is a working account dealing with all aspects of the distribution and drawings of profits

• the distinction between the two accounts shows whether or not partners are maintaining their permanent capitalin the business, while the fluctuating current account shows whether or not partners have withdrawn more profitfrom the business than they are earning

• the fixed capital account makes interest on capital – where permitted by the partnership agreement – easy tocalculate

However, it should be pointed out that separate capital and current accounts require more work and are, therefore,more time-consuming for the book-keeper than using the partners’ capital accounts for all transactions. As to whichis used will depend on the size and complexity of the partnership business.

4.1 (a) • Goodwill can be defined as the difference between the value of a business as a whole, and the net value of itsseparate assets and liabilities.

• Goodwill is used when changes are made to partnerships, eg the admission of a new partner or retirement of anexisting partner.

• The principle is that the agreed value of goodwill is shared amongst those partners who created the goodwill, andis then charged to new partners as a premium for joining an established business.

• It is normal practice not to record goodwill on a partnership balance sheet – this follows the concept of prudence.

(b) Using figures of your own choice:

• agree a valuation for goodwill

• old partners

– debit goodwill account with the amount of goodwill

– credit partners' capital accounts (in their old profit-sharing ratio) with the amount of goodwill

• old partners + new partner

– debit partners' capital accounts (in their new profit-sharing ratio) with the amount of goodwill

– credit goodwill account with the amount of goodwill

The effect of this is to charge the new partner with a premium for goodwill.

1 5

CHAPTER 4 Changes in partnerships

4.5 (a)

Dr Revaluation Account Cr

20-4 £ 20-4 £ 31 Aug Capital accounts: 31 Aug Fixed assets (£74,000 – £50,000) 24,000

Reena (4/8) 12,000Sam (2/8) 6,000Tamara (2/8) 6,000

24,000 24,000

Dr Goodwill Account Cr

20-4 £ 20-4 £ 31 Aug Capital accounts: 31 Aug Capital accounts:

Reena (4/8) 8,000 Reena (1/2) 8,000Sam (2/8) 4,000 Tamara (1/2) 8,000Tamara (2/8) 4,000

16,000 16,000


Reena Sam Tamara Reena Sam Tamara

20-4 £ £ £ 20-4 £ £ £

31 Aug Goodwill w/off 8,000 – 8,000 31 Aug Balances b/d 33,000 12,000 30,000

31 Aug Bank 22,000 31 Aug Revaluation 12,000 6,000 6,000

31 Aug Balances c/d 45,000 – 32,000 31 Aug Goodwill created 8,000 4,000 4,000

53,000 22,000 40,000 53,000 22,000 40,000

1 Sep Balances b/d 45,000 – 32,000

(b)BALANCE SHEET OF REENA AND TAMARA AS AT 1 SEPTEMBER 20-4

£

Fixed Assets (£50,000 + £24,000) 74,000

Current Assets 10,000

Bank (£25,000 – £22,000) 3,000

87,000

Trade creditors (10,000)

77,000

Capital Accounts

Reena 45,000

Tamara 32,000

77,000

1 6

4.7 (a)


2007 £ 2007 £ 28 Feb Fixed assets (£123,000 – £120,000) 3,000 28 Feb Capital accounts:

Ibrahim (3/6) 1,500Joan (2/6) 1,000Kelly (1/6) 500

3,000 3,000


2007 £ 2007 £ 28 Feb Capital accounts: 28 Feb Capital accounts:

Ibrahim (3/6) 37,500 Ibrahim (3/5) 45,000Joan (2/6) 25,000 Kelly (2/5) 30,000Kelly (1/6) 12,500

75,000 75,000


Ibrahim Joan Kelly Ibrahim Joan Kelly

2007 £ £ £ 2007 £ £ £

28 Feb Revaluation 1,500 1,000 500 28 Feb Balances b/d 45,000 30,000 35,000

28 Feb Current account 1,532 28 Feb Goodwill created 37,500 25,000 12,500

28 Feb Goodwill w/off 45,000 – 30,000

28 Feb Bank 52,468

28 Feb Balances c/d 36,000 – 17,000

82,500 55,000 47,500 82,500 55,000 47,500

1 Mar Balances b/d 36,000 – 17,000

(b)

Dr Bank Account Cr

2007 £ 2007 £ 28 Feb Balance c/d 72,058 28 Feb Balance b/d 4,590

28 Feb Joan: loan account 15,00028 Feb Joan: capital account 52,468

72,058 72,058

1 Mar Balance b/d 72,058

1 7

4.9 (a)JEAN AND DAVID, IN PARTNERSHIP

PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 20-4

6 months to 6 months to Total30 June 31 December for year

£ £ £

Net profit 16,350 16,350 32,700


Salaries:

Jean 6,000 6,000 12,000

David 5,000 5,000 10,000

Interest allowed on partners' capitals:

Jean 250 250 500

David 300 300 600

4,800 4,800 9,600


Jean (2/3) 3,200 (1/2) 2,400 5,600

David (1/3) 1,600 (1/2) 2,400 4,000

4,800 4,800 9,600

(b)


Jean David Jean David

20-4 £ £ 20-4 £ £

1 Jan Balance b/d – 1,250 1 Jan Balance b/d 2,400 –

31 Dec Drawings 18,600 14,200 31 Dec Salaries 12,000 10,000

31 Dec Balance c/d 1,900 – 31 Dec Interest on capital 500 600

31 Dec Share of profit 5,600 4,000

31 Dec Balance c/d – 850

20,500 15,450 20,500 15,450

20-5 20-5

1 Jan Balance b/d – 850 1 Jan Balance b/d 1,900 –

4.10 Tutorial notes:

• Parts (a) and (b) of this question have been seen already as question 3.9.

• As David and Freda do not have a partnership agreement, the Partnership Act 1890 applies, ie they each have anequal share in the activities of the partnership.

(c)


2006 £ 2006 £ 30 Jun Stock (£3,200 – £2,600) 600 30 Jun Fixed assets (£100,000 – £48,825) 51,17530 Jun Debtors (£1,985 – £1,410) 57530 Jun Capital accounts:

Daniel (1/2) 25,000Freda (1/2) 25,000

51,175 51,175

1 8


2006 £ 2006 £ 30 Jun Capital accounts: 1 Jul Capital accounts:

Daniel (1/2) 30,000 Daniel (1/2) 30,000Freda (1/2) 30,000 Freda (1/3) 20,000

Helen (1/6) 10,00060,000 60,000


Daniel Freda Helen Daniel Freda Helen

2006 £ £ £ 2006 £ £ £

1 Jul Goodwill w/off 30,000 20,000 10,000 30 Jun Balances b/d 25,000 28,000 –

1 Jul Balances c/d 50,000 63,000 40,000 30 Jun Revaluation 25,000 25,000 –

30 Jun Goodwill created 30,000 30,000 –

1 Jul Bank – – 50,000

80,000 83,000 50,000 80,000 83,000 50,000

1 Jul Balances b/d 50,000 63,000 40,000

(d)DANIEL, FREDA AND HELEN, IN PARTNERSHIP

PROFIT AND LOSS APPROPRIATION ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006

6 months to 6 months to Total30 June 31 December for year

£ £ £

Net profit 45,000 45,000 90,000

Add interest charged on partners’ drawings:

Daniel 250 250

Freda 80 80

Helen 160 160

45,000 45,490 90,490


Salaries: Helen (£5,000 x 6 months) 2,500 2,500

Interest allowed on partners' capitals:

Daniel (£50,000 x 6% x 6 months) 1,500 1,500

Freda (£63,000 x 6% x 6 months) 1,890 1,890

Helen (£40,000 x 6% x 6 months) 1,200 1,200

45,000 38,400 83,400


Daniel (1/2) 22,500 (1/2) 19,200 41,700

Freda (1/2) 22,500 (1/3) 12,800 35,300

Helen – (1/6) 6,400 6,400

45,000 38,400 83,400

1 9

4.10 (e)


Daniel Freda Helen Daniel Freda Helen

2006 £ £ £ 2006 £ £ £

31 Dec Drawings 41,000 35,000 12,000 31 Dec Salary – – 2,500

31 Dec Interest on drawings 250 80 160 31 Dec Interest on capital 1,500 1,890 1,200

31 Dec Balances c/d 1,950 2,110 – 31 Dec Share of profit 41,700 35,300 6,400

31 Dec Balance c/d – – 2,060

43,200 37,190 12,160 43,200 37,190 12,160

2007 2007

1 Jan Balance b/d – – 2,060 1 Jan Balances b/d 1,950 2,110 –

(f) The benefits of maintaining separate capital and current accounts are:

• the capital amount remains fixed except for capital introduced or withdrawn, and any subsequent capitaltransactions such as revaluations and adjustments for goodwill

• the current account is a working account dealing with all aspects of the distribution and drawings of profits

• the distinction between the two accounts shows whether or not partners are maintaining their permanent capitalin the business, while the fluctuating current account shows whether or not partners have withdrawn more profitfrom the business than they are earning

• the fixed capital account makes interest on capital – where permitted by the partnership agreement – easy tocalculate

However, it should be pointed out that separate capital and current accounts require more work and are, therefore,more time-consuming for the book-keeper than using the partners’ capital accounts for all transactions.

The decision to keep separate capital and current accounts is justified in this partnership in view of the complexity ofpartners’ transactions.

4.14 (a)ALI, BAMBI AND CHARLIE: PROFIT OR LOSS ON DISSOLUTION

£

Net book value of assets (excluding bank) 82,020

Less liabilities 23,420

58,600

Business sold to Daphne 40,000

Loss on dissolution 18,600

Capital accounts:

Ali (3/6) 9,300

Bambi (2/6) 6,200

Charlie (1/6) 3,100

18,600

2 0

4.14 (b)


Ali Bambi Charlie Ali Bambi Charlie

2006 £ £ £ 2006 £ £ £

31 Dec Current account 4,700 31 Dec Balances b/d 40,000 10,000 10,000

31 Dec Share of loss 9,300 6,200 3,100 31 Dec Current accounts 1,700 – 2,300

31 Dec Bambi 720 – 180 31 Dec Ali 720

31 Dec Bank 31,680 – 9,020 31 Dec Charlie 180

41,700 10,900 12,300 41,700 10,900 12,300

Tutorial notes:

• Upon dissolution the capital account of Bambi has a deficit of £900.

• As Bambi is unable to meet this liability, the rule in Garner v Murray applies, and the amount must be paid by Ali andCharlie in the ratio of their last agreed capital balances, ie Ali £40,000 and Charlie £10,000.

• Thus Ali will pay £720 and Charlie £180.

• The amounts paid to Ali and Charlie from the bank are £31,680 + £9,020 = £40,700; this is the £40,000 paid byDaphne plus £700 bank balance from the partnership balance sheet.

5.1 The report and accounts – or corporate report – of a public limited company is available to every shareholder and containsthe main elements of financial statements:

• income statement (also known as a ‘statement of comprehensive income’)

• balance sheet (also known as a ‘statement of financial position’)

• cash flow statement

• statement of changes in equity

• notes to the financial statements, including a statement of the company’s accounting policies

• directors’ report

• auditors’ report

5.3 • The directors are responsible for ensuring that the provisions of the Companies Acts 1985 and 2006 which relate toaccounting records and statements are followed.

• In particular the company’s accounting records must:

– show and explain the company’s transactions

– disclose with reasonable accuracy at any time the financial position of the company

– enable the directors to ensure that the company’s income statement and balance sheet give a true and fairview of the company’s financial position

• A company’s accounting records must contain:

– day-to-day entries of money received and paid, together with details of the transactions

– a record of the company’s assets and liabilities

– details of inventories held at the end of the year

• A company’s financial statements must be prepared in accordance with the Companies Acts and with either UKaccounting standards or international accounting standards.

• The directors must report annually to the shareholders on the way that they have run the company on behalf of theshareholders.

• Every company director has a responsibility to ensure that the statutory accounts are produced and filed with theRegistrar of Companies.

• The annual accounts must be approved by the company’s board of directors and the copy of the balance sheet filedwith the Registrar of Companies must be signed by one of the directors on behalf of the board.

2 1

CHAPTER 5 Published accounts of limited companies

• The directors must prepare a directors report – this must be approved by the board (and the copy to be filed with theRegistrar of Companies signed on behalf of the board by a director, or the company secretary).

• The statutory accounts must be laid before the company at the annual general meeting (and they must be circulatedbeforehand to shareholders, debenture holders and any other persons entitled to attend the meeting).

5.6 (a) The published income statement of a limited company does not have to detail every single overhead or expenseincurred. However, IAS 1, Presentation of Financial Statements, requires that certain items must be detailed on theface of the income statement, including:

• revenue

• finance costs

• tax expense

IAS 1 states that further detail may be needed to give information relevant to an understanding of financialperformance.

The income statement concludes by showing the profit or loss for the period attributable to equity holders.

(b) For the income statement, expenses must be analysed either:

• by nature (raw materials, employee costs, depreciation, etc), or

• by function (cost of sales, distribution expenses, sales and marketing expenses, administrative expenses, etc)

The analysis selected will depend on which provides the more reliable and relevant information – the analysis bynature is often appropriate for manufacturing companies, while the analysis by function is commonly used by tradingcompanies.

As Presingold plc is a trading company, the analysis by function would seem to be more appropriate.

5.7 This Question is principally concerned with:

• initial reading in order to get an overview of the company’s accounts and an understanding of the industry

• horizontal analysis in order to compare certain figures from the financial statements with the figures from the previousaccounting period

The Question can be developed to look at various aspects of:

• the company’s structure and its own industry

• the stage of its development

• both internal and external influences on the company

5.9 (a) Share premium account

This occurs where an established company issues shares to the public at a higher amount that the nominal value –the amount above nominal value is the share premium. For example, if shares with a nominal value of £1 are issuedat £1.50 each, then 50p per share is credited to share premium account.

Revaluation reserve

This occurs when a non-current asset – most probably freehold land and buildings – is revalued upwards in thebalance sheet. The amount of the revaluation is placed in a revaluation reserve where it increases the value of theshareholders’ investment in the company. For example, if freehold land and buildings had originally cost £250,000 andare now revalued at £450,000, then £200,000 is the amount credited to revaluation reserve.

(b) Retained earnings are profits that have been retained in the company. They belong to the shareholders, but arerepresented by assets in the balance sheet and are not a cash balance at the bank available to build a new warehousefor the company.

(c) Equity is the stake of the ordinary shareholders in the company. It comprises ordinary share capital, plus capital andrevenue reserves.

Non-current liabilities are those liabilities that are due to be repaid more than twelve months from the date of thebalance sheet. Examples include loans and debentures.

2 2

5.10 This answer may be set out either vertically or horizontally.

Non-current Assets £000

Property, plant and equipment

Net book value at start of year 4,217

Additions at cost 930

Disposals during year (£1,634 – £920) (714)

Depreciation for year (missing figure) (132)

Net book value at end of year 4,301

Net book Additions Disposals Depreciation Net book

value at start at cost during year for year value at end

£000 £000 £000 £000 £000

Non-current Assets

Property, plant and equipment 4,217 930 (714) (132) 4,301

5.12 This answer may be set out either vertically or horizontally.

Non-current Assets £000


Net book value at start of year 8,074

Additions at cost 1,175

Disposals during year (£2,168 – £970) (1,198)

Depreciation for year (missing figure) (404)

Net book value at end of year 7,647

Net book Additions Disposals Depreciation Net book

value at start at cost during year for year value at end

£000 £000 £000 £000 £000

Non-current Assets

Property, plant and equipment 8,074 1,175 (1,198) (404) 7,647

2 3

5.14 (a) Shareholders

They will almost certainly get a dividend; profits are up which is better for dividends and for ploughing back to yieldfuture dividends; plans for growth will save the company from stagnating.

(b) Loan stock holders

The profits indicate that they will be paid their interest; also the profits mean the company should not fail, so they willbe repaid their loans when they are due.

(c) Employees

The profits mean they are put into a better bargaining position for a pay rise. Employees may also be in a companyshare scheme, so a prosperous company will make their shares worth more. The future growth of the company shouldmean that their jobs are safe.

5.16

2 4

MITHIAN PLC

INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-2

£ £

Revenue 2,640,300

Opening inventories 318,500

Purchases 2,089,600

2,408,100

Less Closing inventories 340,600

Cost of sales (2,067,500)


Overheads:

Distribution expenses (216,320)

Administrative expenses (note 1) (229,080)

(445,400)

Profit/(loss) from operations 127,400

Finance costs (20,000)

Profit/(loss) before tax 107,400

Tax (30,000)

Profit/(loss) for the year attributable to equity holders 77,400

STATEMENT OF CHANGES IN EQUITY (EXTRACT)

Retained earnings

Balance at 1 January 20-2 63,250

Profit for the year 77,400

140,650

Dividends paid (20,000)

Balance at 31 December 20-2 120,650

2 5

MITHIAN PLC

BALANCE SHEET AS AT 31 DECEMBER 20-2

Non-current Assets Valuation Cost Aggregate NetDepreciation

£ £ £ £


Office equipment 110,060 48,200 61,860

Vehicles 235,000 55,000 180,000

– 345,060 103,200 241,860

Current Assets

Inventories 340,600

Trade receivables 415,800

Cash and cash equivalents 20,640

777,040

Total assets 1,018,900

Current Liabilities

Trade payables (428,250)

Tax liabilities (30,000)

(458,250)

Net Current Assets 318,790

*560,650

Non-current Liabilities

10% loan stock (200,000)

Total liabilities 658,250

Net Assets 360,650

EQUITY

Issued Share Capital

Ordinary shares of £1 each 200,000

Capital Reserves

Share premium account 40,000

Revenue Reserve

Retained earnings 120,650

TOTAL EQUITY 360,650

* fixed assets + net current assets

Working note 1 £

Administrative expenses 220,180

Bad debts 8,900

229,080

6.2 Depreciation is added back to profit from operations because depreciation is a non-cash expense, ie no money is paid outby the business in respect of depreciation charged to the income statement. Thus profit added back to depreciation gives theamount of cash generated by the trading activities of business: this, together with the changes in net current asset items(except for cash/bank) and adjustments for any profits/losses on sales of non-current assets, forms the operating activitiessection of the cash flow statement.

6.3 Raven Limited:

£

Profit from operations 30,000

Depreciation for year 10,000

Increase in inventories (5,000)

Decrease in trade receivables 4,000

Increase in trade payables 6,000

Cash from operations 45,000

6.4 Meadow Limited:

£

Loss from operations (10,000)


Decrease in inventories 4,000

Increase in trade receivables (5,000)

Decrease in trade payables (3,000)

Cash from operations (6,000)

6.5 Points when assessing the cash flow statement of a company include:

• reasonable cash flow from operating activities

• link changes in net current asset items of inventories, trade receivables and trade payables to changes in profit fromoperations – is there a strain on the liquidity of the company?

• link purchase/sale of non-current assets to context of company – expanding or declining?

• where finance has been raised through increases in loans/shares, look to see how the cash has been used – tofinance new non-current assets, or to finance inventories and trade receivables, or other purposes?

• look at change in cash/bank in relation to profit/loss from operations – is the company generating cash?

6.7 (a) (i) cash generated from operations

amount of cash generated by the trading activities of the company, taking into account non-cash items – suchas depreciation – and changes in the net current asset items of inventories, trade receivables and tradepayables

(ii) net cash from operating activities

cash generated from operations, less interest paid and taxes paid

(iii) net cash used in investing activities

amount of net cash the company receives from buying and selling non-current assets, from interest receivedand dividends received

2 6

CHAPTER 6 Cash flow statements

(b) (i) managers

• a cash flow statement highlights information not available from the income statement and balance sheet

• it shows clearly sources and uses of cash over the year

• it shows cash available at the year end for future developments

• it aids decision-making and development of the company

(ii) shareholders

• a cash flow statement demonstrates the ability of the company to generate cash from operating activities

• it shows the liquidity of the business

• it shows clearly the sources and uses of cash over the year

• it shows the investment of the company in capital expenditure

• it shows the amount of dividends paid to shareholders

(iii) debenture holders

• a cash flow statement shows the cash available at the year end which demonstrates to debenture holdersthe security of their loan

• it shows additional loans raised or repaid, in the financing activities section

• it shows interest paid to lenders, in the operating activities section

6.10 (a)

ADAGIO PLC

RECONCILIATION OF PROFIT FROM OPERATIONS TO NET CASH FLOW FROM OPERATING ACTIVITIES

£000

Profit/(loss) from operations (2,127)

Adjustments for:


Loss on disposal of non-current assets 58

Decrease in inventories 48

Decrease in trade receivables 986

Decrease in trade payables (1,787)

Cash from operations 668

Interest paid ( – )

Income taxes paid (278)

Net cash (used in)/from operating activities 390

(b)

ADAGIO PLC

DRAFT CASH FLOW STATEMENT FOR THE YEAR ENDED 30 APRIL 2004

£000 £000

Net cash from operating activities 390

Cash flows from investing activities

Purchase of non-current assets (1,795)

Proceeds from sale of non-current assets 818

(977)

Cash flows from financing activities

Dividends paid (299)

Net decrease in cash and cash equivalents (886)

2 7

(c) Using a cash flow statement to judge the financial performance of a company

• The cash flow statement focuses on cash inflows and cash outflows. It concentrates on the liquidity of thebusiness – it is often a lack of cash that causes most businesses to fail.

• Cash is often described as the ‘life blood’ of a business.

• The cash flow statement uses the money measurement concept – only items which can be recorded in moneyterms can be included. This makes it difficult to manipulate, and cash can be seen as an accurate measure ofbusiness success or failure.

This contrasts with the income statement where judgement has to be made about items such as:

– recognition of sales/revenue

– the distinction between capital and revenue expenditure

– depreciation methods and policies

• The cash flow statement shows:

– the cash from operations after interest and tax have been paid

– the investing activities of the business, eg the purchase of non-current assets

– the financing activities of the business, eg an increase/decrease in loans/share capital

• The cash flow statement links profit with changes in cash. Both of these are important: without profit, thecompany cannot generate cash (unless it sells non-current assets), and without cash it cannot pay bills as theyfall due.

• The cash flow statement is important in judging financial performance because of its emphasis on:

– liquidity and solvency

– investment in assets

– financing methods

6.11 (a)

HALLS-KROSBY PLC


£000

Profit from operations 573

Adjustments for:

Depreciation for year 206

Loss on sale of non-current assets (machinery) 18

Increase in inventory (230)

Increase in trade receivables (62)

Decrease in trade payables (46)

Cash from operations 459

Interest paid ( – )

Income taxes paid ( – )


(b) Changes made to original reconciliation statement (question asks for an explanation of three of the changes):

• Depreciation is non-cash and is added back to profit from operations in the cash flow statement.

• Loss on sale of machinery is non-cash and is also added back to profit from operations.

• Receipts from sale of machinery is shown as a receipt in the investing activities section of the cash flowstatement.

• Dividends paid – both ordinary and preference – are shown as payments in the financing activities section ofthe cash flow statement.

• Share premium receipts are included with the proceeds of the ordinary share issue in the financing activitiessection of the cash flow statement.

2 8

6.15 (a)

KALSI PLC


£000

Profit from operations 237

Adjustments for:

Depreciation for year 275

Gain on sale of non-current assets (2)

Increase in inventories (210–200) (10)

Increase in trade receivables (390–250) (140)

Decrease in trade payables (150–160) (10)

Cash generated from operations 350

Interest paid (20)

Income taxes paid (21)


(b)

KALSI PLC

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 20-5

£000 £000


Cash flows from investing activities

Purchase of non-current assets (110)

Proceeds from sale of non-current assets1 7

Net cash (used in)/from investing activities (103)

Cash flows from financing activities

Proceeds from issue of share capital (40–25) 15

Proceeds from long-term borrowings (200-100) 100

Repayment of debentures (500)

Dividends paid (30)

Net cash (used in)/from financing activities (415)

Net increase/(decrease) in cash and cash equivalents (209)

Cash and cash equivalents at beginning of year 10

Cash and cash equivalents at end of year (199)

Working note

1 Proceeds from sale of non-current assets

Non-current Assets£ £

Non-current assets (cost) 10,000 Accumulated depreciation 5,000Gain on sale 2,000 Proceeds (bal fig) 7,000

12,000 12,000

2 9

(c) From the point of view of the company’s shareholders, the following points are highlighted by the cash flow statementof Kalsi plc for the year ended 31 March 20-5:

• an excellent cash flow has been generated from operations, £350,000, which is well above the amounts paidfor tax, £21,000, and dividends, £30,000

• There have been increases in inventories and trade receivables – the increase of £140,000 in the latter seemsvery large and might indicate that the company is having to offer extended terms to its customers in order tomaintain sales; there has been a small decrease in trade payables

• new non-current assets of £110,000 have been bought – an indication that the company is re-equipping for thefuture

• debentures of £500,000 have been repaid – financed mainly from profits and an increased long-term loan of£100,000; the company’s gearing has reduced and it seems that this is a short/medium-term aim of thecompany

• the reduction in borrowed funds will reduce the amount of interest to be paid in future years

• a small share issue has taken place during the year

• the bank balance – cash and cash equivalents – has fallen during the year from a credit balance of £10,000to an overdraft of £199,000

Conclusion:

The cash flow statement shows that Kalsi plc is a highly profitable company which generates a good cash flow fromoperations. There has been an expansion of net current assets but shareholders may be concerned to note theincrease of £140,000 in trade receivables. The debentures have been repaid – partly from profits which explains thesignificant fall in cash and cash equivalents. New non-current assets of £110,000 have been purchased. Overall, itseems that the company is reorganising its financing so as to reduce its reliance on borrowed funds, while at the sametime seeking to develop in the future.

For shareholders, they should hold their existing shares and should consider increasing their holdings as profits anddividends seem likely to increase in the future.

7.2 Accounting principles are the broad concepts that are applied in the preparation of financial statements.

Examples: going concern, accruals, consistency.

Accounting bases are the methods used for applying accounting principles to financial statements, and are intended toreduce subjectivity by identifying the acceptable methods.

Example: the use of historic cost or revaluation to value assets.

Accounting policies are the specific principles, bases, conventions, rules and practices applied in the preparation andpresentation of financial statements.

Examples: the use of straight-line or diminishing (reducing) balance method of depreciation for non-current assets.

7.3 (a) IAS 16, Property, Plant and Equipment, defines depreciation as the systematic allocation of the depreciable amountof an asset over its useful life. (Depreciable amount is the cost or valuation of the asset, less any residual value.)

(b) • IAS 16 states that, initially, PPE are to be measured (recorded) at cost in the balance sheet.

• After acquisition of PPE a company must choose either the cost model or the revaluation model as itsaccounting policy – which is then applied to an entire class of PPE.

• Using the cost model, assets are shown in the balance sheet at cost less accumulated depreciation andimpairment losses.

• Using the revaluation model, assets are shown at a revalued amount, being fair value less subsequentdepreciation and impairment losses; revaluations are to be made regularly to ensure that the revalued amountsdo not differ materially from fair values at the balance sheet date.

• Depreciation is to be charged on all non-current assets – with the exception of freehold land, which is shownat cost.

• Depreciation methods include the straight-line and the diminishing (reducing) balance methods.

3 0

CHAPTER 7 Accounting standards

• A company chooses the depreciation method which best reflects the way in which the asset’s economicbenefits are consumed.

• The depreciation method should be reviewed at least annually in order to consider if the method used is stillthe most appropriate one.

7.6 (a) An impairment review is carried out in three steps:

STEP 1 The asset’s carrying amount is ascertained

STEP 2 The asset’s recoverable amount is ascertained

STEP 3 If an asset’s carrying amount is greater than its recoverable amount, then the asset is impaired andshould be written down to its recoverable amount.

Terms used:

Carrying amount is the amount at which an asset is recognised after deducting any accumulateddepreciation/amortisation and accumulated impairment losses.

Recoverable amount is the higher of the asset’s

• fair value, less any costs that would be incurred were it to be sold

• its value in use.

Fair value, less costs to sell is the amount at which an asset could be sold for, less any selling costs.

Value in use is the present value of the future cash flows from an asset’s continued use, including cash from its finalsale.

(b) When an asset is impaired it should be written down to its recoverable amount in the balance sheet. The amount ofthe impairment loss is shown as an expense in the income statement.

(c) The fork lift truck is impaired: its carrying amount is £20,000 but its recoverable amount is £19,000 (the higher of fairvalue less costs to sell of £18,000, and value in use of £19,000). Accordingly, an impairment loss of £1,000 should beshown as an expense in the income statement.

7.7 The overriding principle of inventory valuation is that inventories should be valued at ‘the lower of cost and net realisablevalue’.

Thus two different inventory values are compared:

• cost, which means the purchase price, plus any other costs incurred to bring the product (or service) to its present locationand condition

• net realisable value, which is the estimated selling price less the estimated costs to get the product into a conditionnecessary to complete the sale

The lower of these two values is taken, and different items or groups of inventory are compared separately.

7.8 Using the lower of cost and net realisable value:

£

Vauxhall Corsa 2,800 cost

Landrover Discovery 10,000 cost

Nissan Primera 2,600 net realisable value

Ford Focus 6,000 cost

Volkswagen Polo 500 net realisable value

TOTAL 21,900

3 1

7.12 (a) Although the selling of the inventory (stock) is an event which happened after the year end, under IAS 10, Events afterthe Reporting Period, this is an example of an adjusting event. Such events provide evidence of conditions thatexisted at the end of the reporting period; if the amount involved is material, then the amount shown in the financialstatements should be changed. The sale of inventory provides evidence as to the net realisable value of the inventoryreported in the financial statements for the year under review. Under IAS 2, Inventories, inventories are to be valuedat the lower of cost and net realisable value.

(b) A dividend declared or proposed on ordinary shares after the balance sheet date is, under IAS 10, an example of anon-adjusting event. Such events are conditions that arose after the reporting period; no adjustment is made to thefinancial statements – if such events are material, then they are disclosed by way of notes to the accounts. The noteswould explain the nature of the event and, if possible, give the likely financial consequences of the event. Theproposed ordinary dividend cannot be recorded as a liability at 30 September 20-6 as it was not a present obligationof the company at the financial year end. The details of the proposed dividend will be given in the notes to the financialstatements, including the amount of £75,000.

(c) Under IAS 10, this is an example of a non-adjusting event after the reporting period. Although the employee wasworking for Gernroder Limited at the financial year end, the legal proceedings do not relate to conditions that existedat the end of the reporting period. Instead, the legal proceedings are conditions that arose after the reporting periodand no adjustment is to be made to the financial statements. The amount of £20,000, if material, is to be disclosed byway of a note which explains the nature of the event and the likely financial consequences of the event.

7.14 1 IAS 38, Intangible Assets

As this is internally generated goodwill, it cannot be recognised as an asset and recorded in the financial statements.

2 IAS 2, Inventories

Cost is £100,000; net realisable value is £160,000.

Inventories (stocks) are to be valued at ‘the lower of cost and net realisable value’. Therefore this stock should berecognised as an asset at £100,000 and recorded in the financial statements.

3 IAS 16, Property, Plant and Equipment

The valuation of £205,000 is acceptable as the overhaul ensures that future economic benefits will flow to thebusiness, and the cost of the overhaul can be measured reliably. The depreciable amount for the machine is now£205,000.

7.15 (a) IAS 2 states that inventories must be valued at the lower of cost and net realisable value.

Cost means the purchase price plus any other costs incurred to bring the product (or service) to its present locationand condition.

Net realisable value is the estimated selling price less the estimated costs to get the product into a conditionnecessary to complete the sale.

The lower of these two values is taken, and different items or groups of inventory are compared separately.

(b) 1 This situation – where a customer, who owes money at the balance sheet date, subsequently goes intoliquidation – is covered by IAS 10, Events after the Reporting Period. Adjusting events provide evidence ofconditions that existed at the end of the reporting period. If the amount is material, then the amount shown inthe financial statements should be changed. In this case, the amount of £30,000 needs to be written off as abad debt. The book-keeping entries are:

DEBIT Bad debts written off £30,000

CREDIT Trade receivables £30,000

2 The situation described here is covered by IAS 37, Provisions, Contingent Liabilities and Contingent Assets.A contingent asset is a possible asset arising from past events whose existence will be confirmed only byuncertain future events not wholly within the control of the company.

It follows from the above definition that the probable inflow of £25,000 from the legal suit is a contingent asset.IAS 37 states that if a contingent asset is probable, it should be disclosed by way of a note in the financialstatements. It cannot be recognised in the financial statements because it would not be prudent to recogniseincome that may never be realised.

3 2

7.16 (a) 1 IAS 38, Intangible Assets

2 IAS 38, Intangible Assets

3 IAS 16, Property, Plant and Equipment

4 IAS 18, Provisions, Contingent Liabilities and Contingent Assets

5 IAS 2, Inventories

(b) Retained earnings and other reserves:

£

Balance at start 780,000

Item 1 (40,000) amortisation of intangible asset, £200,000 ÷ 5 years

Item 2 – internally generated goodwill, so cannot be recognised as an asset

Item 3 (50,000) depreciation at 2% on £250,000

Item 4 (480) provision for bad debts, 3% on £16,000

Item 5 (25) cost 10 x £20 = £200; net realisable value 10 x £30 = £300 – £125 repairs = £175; nrv to be used

Corrected balance 689,495

(c) GROGLIN PLC

BALANCE SHEET AT 31 DECEMBER 2008

£

Assets

Non-current assets

Intangible asset 160,000 200,000 – 40,000

Property, plant and equipment 2,450,000 2,000,000 + 500,000 reval’n – 50,000

2,610,000

Current assets

Inventories 119,975 120,000 – 25

Trade receivables 15,520 16,000 – 480

Cash and cash equivalents 28,000

163,495

TOTAL ASSETS 2,773,495

Liabilities

Current liabilities

Trade payables (84,000)

NET ASSETS 2,689,495

Shareholders’ equity

Called up share capital 1,500,000

Retained earnings and other reserves 1,189,495 689,495 + 500,000 revaluation

TOTAL EQUITY 2,689,495

3 3

(d) Although accounting standards are not laws – ie they are non-statutory – any limited company that fails to apply themwould cast serious doubts on the reliability of its financial statements. It is one of the duties of directors to ensure thata company’s financial statements are prepared in accordance with the Companies Acts and with accountingstandards. At the same time, the auditors’ report must state whether or not the financial statements have beenprepared in accordance with company law and accounting standards: if they have not, the auditors’ report will bequalified.

The reasons for using international accounting standards are:

• to provide a framework for preparing and presenting financial statements – the ‘rules’ of accounting

• to ensure that accountants follow the same set of rules

• to reduce the number of different accounting treatments and so make ‘window dressing’ more difficult

• to meet with the duty of the directors to ensure that financial statements comply with accounting standards

• to meet with the auditors’ report requirement to state that the financial statements have been prepared inaccordance with accounting standards

The benefits of international accounting standards are:

• to standardise financial statements internationally – thus a company operating in several countries knows thatthe same accounting rules have been applied to all parts of its business

• to reduce the variations of accounting treatments used in financial statements – thus making ‘window dressing’the accounts more difficult

• to allow users of financial statements to make inter-firm comparisons in the knowledge that all the financialstatements have been prepared using the same standards.

8.3

Date Description FIFO AVCO20-4 £ £

21 June Total issue value* 5,150 5,250

30 June Total closing stock value† 1,150 1,050

* FIFO: 2,000 units at £2.00 per unit = £4,000500 units at £2.30 per unit = £1,150

2,500 £5,150

AVCO: 2,000 units at £2.00 per unit = £4,0001,000 units at £2.30 per unit = £2,3003,000 units at £2.10 per unit = £6,300

∴ 2,500 units issued at £2.10 per unit = £5,250

† FIFO: 500 units at £2.30 per unit = £1,150

AVCO: 500 units at £2.10 per unit = £1,050

3 4

CHAPTER 8 Stock valuation

8.4 (a)

FIFO STORES LEDGER RECORD: Wye

Date Receipts Issues Balance 20-4 Quantity Cost Total Quantity Cost Total Quantity Cost Total

Cost Cost Cost£ £ £ £ £ £

1 Aug Balance 5,000 5.00 25,000

10 Aug 2,000 5.25 10,500 5,000 5.00 25,000

2,000 5.25 10,500

7,000 35,500

18 Aug 3,000 5.50 16,500 5,000 5.00 25,000

2,000 5.25 10,500

3,000 5.50 16,500

10,000 52,000

23 Aug 5,000 5.00 25,000

2,000 5.25 10,500

1,000 5.50 5,500 2,000 5.50 11,000

AVCO STORES LEDGER RECORD: Zed

Date Receipts Issues Balance 20-4 Quantity Cost Total Quantity Cost Total Quantity Cost Total

Cost Cost Cost£ £ £ £ £ £

1 Aug Balance 10,000 4.00 40,000

6 Aug 5,000 4.30 21,500 10,000 4.00 40,000

5,000 4.30 21,500

15,000 4.10 61,500

19 Aug 7,500 4.40 33,000 15,000 4.10 61,500

7,500 4.40 33,000

22,500 4.20 94,500

24 Aug 12,000 4.20 50,400 10,500 4.20 44,100

(b) Valuation at 31 August 20-4:

£

Wye 10,000 (net realisable value)

Zed 44,100 (cost price)

54,100

3 5

8.5 (a)

FIFO STORES LEDGER RECORD: product Alpha

Date Receipts Issues Balance

20-7 Quantity Cost Total Quantity Cost Total Quantity Cost TotalCost Cost Cost

£ £ £ £ £ £

Jan 20 3.00 60.00 20 3.00 60.00

Feb 10 3.60 36.00 20 3.00 60.00

10 3.60 36.00

30 96.00

Mar 8 3.00 24.00 12 3.00 36.00

10 3.60 36.00

22 72.00

Apr 10 4.00 40.00 12 3.00 36.00

10 3.60 36.00

10 4.00 40.00

32 112.00

May 12 3.00 36.00

4 3.60 14.40 6 3.60 21.60

10 4.00 40.00

16 61.60

(b)

AVCO STORES LEDGER RECORD: product Alpha



£ £ £ £ £ £

Jan 20 3.00 60.00 20 3.00 60.00

Feb 10 3.60 36.00 20 3.00 60.00

10 3.60 36.00

30 3.20 96.00

Mar 8 3.20 25.60 22 3.20 70.40

Apr 10 4.00 40.00 22 3.20 70.40

10 4.00 40.00

32 3.45 110.40

May 16 3.45 55.20 16 3.45 55.20

3 6

8.6 (a)

FIFO STORES LEDGER RECORD: product Jay



£ £ £ £ £ £

Jan 100 4.00 400.00 100 4.00 400.00

Feb 80 4.00 320.00 20 4.00 80.00

Mar 120 4.21 505.20 20 4.00 80.00

120 4.21 505.20

140 585.20

Apr 70 3.94 275.80 20 4.00 80.00

120 4.21 505.20

70 3.94 275.80

210 861.00

May 20 4.00 80.00

120 4.21 505.20 70 3.94 275.80

Jun 105 4.30 451.50 70 3.94 275.80

105 4.30 451.50

175 727.30

AVCO STORES LEDGER RECORD: product Jay



£ £ £ £ £ £

Jan 100 4.00 400.00 100 4.00 400.00

Feb 80 4.00 320.00 20 4.00 80.00

Mar 120 4.21 505.20 20 4.00 80.00

120 4.21 505.20

140 4.18 585.20

Apr 70 3.94 275.80 140 4.18 585.20

70 3.94 275.80

210 4.10 861.00

May 140 4.10 574.00 70 4.10 287.00

Jun 105 4.30 451.50 70 4.10 287.00

105 4.30 451.50

175 4.22 738.50

3 7

(b)

FIFO LEDGER RECORD: product Kay



£ £ £ £ £ £

Jan 200 10.00 2,000.00 200 10.00 2,000.00

Feb 100 9.55 955.00 200 10.00 2,000.00

100 9.55 955.00

300 2,955.00

Mar 200 10.00 2,000.00

40 9.55 382.00 60 9.55 573.00

Apr 90 10.50 945.00 60 9.55 573.00

90 10.50 945.00

150 1,518.00

May 150 10.00 1,500.00 60 9.55 573.00

90 10.50 945.00

150 10.00 1,500.00

300 3,018.00

Jun 60 9.55 573.00

40 10.50 420.00 50 10.50 525.00

150 10.00 1,500.00

200 2,025.00

AVCO STORES LEDGER RECORD: product Kay



£ £ £ £ £ £

Jan 200 10.00 2,000.00 200 10.00 2,000.00

Feb 100 9.55 955.00 200 10.00 2,000.00

100 9.55 955.00

300 9.85 2,955.00

Mar 240 9.85 2,364.00 60 9.85 591.00

Apr 90 10.50 945.00 60 9.85 591.00

90 10.50 945.00

150 10.24 1,536.00

May 150 10.00 1,500.00 150 10.24 1,536.00

150 10.00 1,500.00

300 10.12 3,036.00

Jun 100 10.12 1,012.00 200 10.12 2,024.00

3 8

Valuation at 30 June 20-7:

£

Product Jay 727.30 (cost price, using FIFO)

Product Kay 1,950.00 (net realisable value)

2,677.30

8.10 (a) Tutorial note: This part of the question requires a calculation of the value of closing stock at 30 April 2007. For clarity,the answer below is set out in the form of a stores ledger record; however, it can be answered instead by means ofa calculation.

AVCO STORES LEDGER RECORD: Caravans


2007 Quantity Cost Total Quantity Cost Total Quantity Cost TotalCost Cost Cost

£ £ £ £ £ £

1 Apr Balance 1 17,700 17,700

10 Apr 2 18,000 36,000 3 17,900 53,700

18 Apr 2 17,900 35,800 1 17,900 17,900

26 Apr 3 18,400 55,200 4 18,275 73,100

30 Apr 2 18,275 36,550 2 18,275 36,550

(b) • FIFO will give him a closing stock valuation of £36,800 (2 x £18,400). This higher closing stock under FIFO willgive him a higher profit of £250. This could be an advantage if he is thinking of selling the business in the nearfuture; the disadvantage is that he will pay more tax.

• However, any change in profit will be only temporary as, over the life of his business, total profits will be thesame under both methods, and there will be no effect on the cash generated by the business.

• The FIFO method is logical and relatively easy to calculate; however, for the low number of items that Tom hasin stock, AVCO is not difficult to calculate.

• To meet the accounting concept of consistency, if he changes to FIFO he will need to adjust his financialstatements to show comparability.

• Both FIFO and AVCO are acceptable for tax purposes and under IAS 2.

Conclusion

Tom is currently using AVCO which, for the low number of items that he has in stock, is relatively easy to calculate.Although his profits will be higher under FIFO when prices are rising, there will be no effect on the cash generated bythe business. All-in-all, there do not appear to be compelling reasons to make the change.

3 9

8.12 (a) A stock-take is carried out regularly to check that the quantity of stock held is the same as that recorded in the stockrecords. This is done by counting the physical stock on hand against the balance shown by the records, and to identifyany theft or deterioration.

A stock-take is carried out on either a periodic basis or continuously.

(b) Stock reconciliation is the process of comparing the stock-take and the stock record. This process is importantbecause:

– an accurate stock figure can then be used to value the stock

– it will highlight any discrepancies which can then be investigated

(c) Stock number 146: as the discrepancy here is a small shortfall in the physical stock compared with the stock record,ie £2 x 2 units = £4, the likely action to be taken by the company accountant will be to authorise the discrepancy forwrite-off.

Stock number 523: this is a larger discrepancy, ie £200 x 10 units = £2,000 and needs to be investigated to see if ithas been caused by:

– an error on the stock record

– theft of stock

– damaged stock being disposed of without any record having been made

9.4 (a) JACQUI KING PLC

MANUFACTURING ACCOUNT FOR THE YEAR ENDED 30 NOVEMBER 2001

£ £

Opening stock of raw materials 47,600

Add Purchases of raw materials 498,000

545,600

Less Closing stock of raw materials 50,900

COST OF RAW MATERIALS USED 494,700

Direct labour 959,400 x 2/3 639,600

Royalties 17,000

PRIME COST 1,151,300

Add Factory overheads:

Indirect labour 959,400 x 1/3 319,800

Depreciation of factory machinery 48,000

Overheads 548,000

915,800

2,067,100

Add Opening stock of work-in-progress 23,000

2,090,100

Less Closing stock of work-in-progress 24,100

PRODUCTION COST OF GOODS COMPLETED 2,066,000

(b) Payment/receipts for use of patented/copyrighted process.

9.6 (a) (i) 31 December 2007:£4,000, ie £20,000 x 25/125

(ii) 31 December 2008:£4,800, ie £24,000 x 25/125

4 0

CHAPTER 9 Manufacturing accounts

(b) MALCOLM PLC

PROFIT AND LOSS ACCOUNT EXTRACT FOR THE YEAR ENDED 31 DECEMBER 2008

£Factory gross profit 170,000Less Increase in provision for unrealised profit 4,000 – 4,800 800Adjusted factory gross profit 169,200

MALCOLM PLC

BALANCE SHEET EXTRACT AS AT 31 DECEMBER 2008

£Current asset

Stock of finished goods 24,000Less Provision for unrealised profit 4,800Adjusted stock of finished goods 19,200

9.7 (a) DEWRAY PLC

SUMMARISED MANUFACTURING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2002

£000

Prime cost 1,207

Factory overheads 915

Depreciation of machinery 15

2,137

Add Opening stock of work-in-progress 34

2,171

Less Closing stock of work-in-progress 36

2,135

Factory profit of 20% 427

PRODUCTION COST OF GOODS COMPLETED (transfer price) 2,562

(b) TRADING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2002£000 £000

Sales 3,460

Less Cost of goods sold

Opening stock of finished goods 156

Production cost of goods completed 2,562

2,718

Less Closing stock of finished goods 192

2,526

Gross profit 934

(c) The amount of the adjustment to the provision for unrealised profit to be shown in the profit and loss account is £6,000.

Workings:

192 x 20/120 = 32

156 x 20/120 = 26

(d) The amount of the adjustment is shown as a deduction from factory profit shown in the profit and loss account.

4 1

(e) BALANCE SHEET EXTRACT AS AT 31 DECEMBER 2002£000 £000

Current AssetsStock – raw materials 75

– work-in-progress 36

– finished goods 192

– less provision for unrealised profit 32

adjusted stock of finished goods 160

271

9.8 (a) CATHY YOWMANUFACTURING ACCOUNT EXTRACT FOR THE YEAR ENDED 31 DECEMBER 2001

£



72,600

Less Closing stocks of raw materials 9,400


Direct labour (146,800 + 3,450) 150,250

Royalties 8,140

PRIME COST 221,590

(b) The adjustment is £100

Workings:£1,750 – £1,850*

* £9,250 x 25/125

(c) Provision for unrealised profit is made to reduce the closing stock value of finished goods to cost price. This enablesthe balance sheet valuation to comply with IAS 2, Inventories, and the concept of prudence.

9.10 (a) CATHERINE DONOVAN

MANUFACTURING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2006

£ £



136,270

Less Closing stock of raw materials 10,211


Direct wages 274,700

Manufacturing royalties 55,000

329,700

PRIME COST 455,759

Add Production (factory) overheads:

Factory supervisors’ wages 63,150

Rates – factory *4,500

Indirect expenses – factory 337,171

Factory machinery depreciation **40,000

444,821

900,580

Less increase in work-in-progress 580

PRODUCTION COST 900,000

Factory profit of 25% 225,000

PRODUCTION COST OF GOODS COMPLETED (transfer price) 1,125,000

* Rates: £6,400 – £400 prepaid = £6,000, apportioned three-quarters to factory, £4,500, and one-quarter to office, £1,500

** Factory machinery depreciation: £400,000 x 10%

4 2

(b) Closing stock at 31 December 2006:

£

£25,600 x 25 = 5,120100 + 25

Less provision for unrealised profit 4,700

Increase in provision for unrealised profit 420

(c) £ £

Gross profit on trading 312,400

Factory profit 225,000

Less increase in provision for unrealised profit 420

224,580

Total gross profit 536,980

(d) Reasons for making a provision for unrealised profit:

• A provision is always required when production is increased with the addition of a factory profit, ie the transfer priceto trading account is higher than production cost.

• As a result of the transfer price, the valuation of finished goods stocks is higher than cost price.

• Following the prudence concept, the profit element needs to be removed from the valuation of finished goodsstocks.

• IAS 2, Inventories, requires that stock is valued at the lower of cost and net realisable value.

• In final accounts provision for unrealised profit is dealt with as follows:

– in the profit and loss account, an increase is deducted from the factory profit (and a decrease added) in orderto remove the profit element from stock so that profit is not overstated

– In the balance sheet, the total amount of the provision is deducted from the stock of finished goods in orderthat the valuation is not overstated and that the balance sheet gives a true and fair view of the business

9.12 (a) Finished goods stock at 31 December 2005:

£

£31,776 x 20 = 5,296100 + 20

Finished goods stock at 1 January 2005:

£27,804 x 20 = 4,634100 + 20


(b) AMANDEEP PAWARTRADING ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005

£ £

Sales 1,430,972

Opening stock of finished goods 27,804

Production cost of goods completed (transfer price) *864,000

891,804

Less Closing stock of finished goods 31,776

COST OF SALES 860,028


* £720,000 x (100 + 20)%

4 3

4 4

(c) SUMMARISED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2005£ £


Less Administrative expenses 478,221

Profit from trading 92,723

Factory profit **144,000

Less increase in provision for unrealised profit 662

143,338

Net profit 236,061

** £720,000 x 20%

9.13 (a) (i) Closing stock at 31 March 2008:

£31,906 x 40 = £9,116 provision for unrealised profit100 + 40

(ii) S H MATT

BALANCE SHEET EXTRACT AS AT 31 MARCH 2008£ £

Current AssetsStock – raw materials 10,980

– work-in-progress 9,946

– finished goods 31,906

less provision for unrealised profit 9,116

adjusted stock of finished goods 22,790

43,716

(b) £

Provision for unrealised profit at 31 March 2008 9,116

Provision for unrealised profit at 31 March 2007 8,536


In profit and loss account the increase is deducted from the factory profit in order to remove the profit element fromstock so that profit is not overstated.

(c) Any two reasons for transferring goods to the trading account at cost plus a profit:

• Enables the factory to make a notional profit which is added into net profit at a later stage.

• Gives the unit cost of goods manufactured a more realistic value which can be compared with the cost of buyingin completed goods from an outside source.

• By showing a factory profit, the profit from trading activities can be identified separately.

• The factory and the warehouse become separate profit centres which show the contribution of each to the overallprofitability of the business.

10.4 (a) fixed

(b) variable

(c) semi-variable

(d) fixed

(e) variable

(f) fixed

(g) variable

(h) variable

CHAPTER 10 Costs and contribution

10.5 The following are example figures; each student’s solution will be different.

(a) Fixed costs: Advertising £200

Room hire £150

Speakers £350

£700

(b) Variable costs: Lunch £15

Course materials £10

£25

(c) If price charged per delegate is £80, then contribution will be £80 – £25 = £55 per delegate

(d) £

course fees £80 x 30 people 2,400

less variable costs £25 x 30 people 750

equals total contribution 1,650

less fixed costs 700

equals profit for event 950

10.7 (a) Marginal cost per pair of trainers £

variable costs:

direct materials (per pair) 15

direct labour (per pair) 12

marginal cost (per pair) 27

(b) Contribution per pair of trainers £

selling price (per pair) 40

less variable costs (per pair) 27

equals contribution (per pair) 13

(c) John Walker LimitedMarginal costing statement: 25,000 pairs of trainers

£ £

sales (25,000 x £40) 1,000,000

less variable costs

direct materials (25,000 x £15) 375,000

direct labour (25,000 x £12) 300,000

675,000


less fixed costs (overheads) 245,000

equals profit on sales of 25,000 pairs 80,000

10.8 (a) Contribution is selling price minus variable cost.

Total contribution is used to cover, firstly, fixed costs and then profit.

(b) (i) Contribution per unit before the proposed purchase of the machinery:

£

selling price (per parachute) 44

less variable costs £10 + £16 + £8 34

equals contribution (per parachute) 10

4 5

4 6

(ii) Contribution after the proposed purchase of the machinery: £

materials 10.00

labour £9 per hour x 1.5 hours 13.50

other variable costs 8.00

variable costs per parachute 31.50

selling price per parachute 44.00

less variable costs 31.50

equals contribution per parachute 12.50

(c) Profitability before purchase of new machinery: £ £

sales £44 x 22,000 parachutes 968,000

less variable costs £34 x 22,000 parachutes 748,000


less fixed costs 134,000

equals profit for the year 86,000

Profitability after purchase of new machinery: £ £

sales £44 x 22,000 parachutes 968,000

less variable costs £31.50 x 22,000 parachutes 693,000



retraining costs 32,000

166,000

equals profit for the year 109,000

Tutorial note:The increase in profits of £23,000 (£109,000 – £86,000) can also be calculated by reference to the increase incontribution, as follows:

£

increase in contribution £2.50* x 22,000 parachutes 55,000

less retraining costs 32,000

equals increased profits 23,000

* £34.00 – £31.50 = £2.50

Notes:

• If the new machinery is purchased, profitability in the first year increases from £86,000 to £109,000, an increaseof £23,000. As the retraining costs are a ‘one-off’, profits in subsequent years will be £32,000 higher.

• Depreciation on the new machinery will increase fixed costs, so reducing profit.

• On the information available, the company should purchase the new machinery.

10.10 (a) • Direct costs can be identified directly with each unit of output.

• Indirect costs (overheads) cannot be identified directly with specific units of output.

(b) Marginal cost of one compass

Variable costs per unit: £

direct labour (£23,000 ÷ 5,000) 4.60

direct materials (£35,000 ÷ 5,000) 7.00

other direct costs (£9,000* ÷ 5,000) 1.80

marginal cost of one compass 13.40

* £21,000 – £12,000 fixed costs

(c) Marginal costing statement £ £

sales £20 x 5,000 compasses 100,000

less variable costs:

direct labour 23,000

direct materials 35,000

other direct costs 9,000

67,000



equals profit for the period 21,000

(d) Advantages of producing a marginal costing statement

One from:

• contribution, ie selling price less variable cost, is clearly identified

• identifying the marginal cost of output enables the managers of a business to focus on the contribution providedby the output

• the effect on costs of changes in sales turnover can be calculated

• helps with decision-making in the forms of

– costing a project

– make or buy

– acceptance of additional work

– price setting

– optimum use of scarce resources

11.1

* brackets indicate a loss

4 7

CHAPTER 11 Break-even analysis

units of fixed costs variable costs total cost sales profit/(loss)*

output revenue

£ £ £ £ £

0 7,500 0 7,500 0 (7,500)

500 7,500 2,500 10,000 5,000 (5,000)

1,000 7,500 5,000 12,500 10,000 (2,500)

1,500 7,500 7,500 15,000 15,000 nil

2,000 7,500 10,000 17,500 20,000 2,500

2,500 7,500 12,500 20,000 25,000 5,000

3,000 7,500 15,000 22,500 30,000 7,500

11.4 (a) • contribution sales ratio

contribution (£) = £15* = 0.6 or 60%selling price (£) £25

* selling price £25 – variable cost £10

• break-even point in units

fixed costs (£) = £300,000 = 20,000 unitscontribution per unit (£) £15

• break-even point in sales revenue

fixed costs (£) = £300,000 = £500,000CS ratio 0.6

check: 20,000 units x selling price £25 per unit = £500,000

• margin of safety at output of 30,000 units

current output – break-even output = 30,000 – 20,000 x 100

current output 30,000 1

= 33.3%, or 10,000 units, or £250,000 of sales revenue

• number of units to generate a target profit of £100,000

fixed costs (£) + target profit (£) = £300,000 + £100,000 = 26,667 unitscontribution per unit (£) £15

(b) forecast output maximum output(30,000 units) (40,000 units)

£ £

sales revenue (at £25 each) 750,000 1,000,000

less variable costs (at £10 each) 300,000 400,000

equals contribution (to fixed costs and profit) 450,000 600,000

less monthly fixed costs 300,000 300,000

equals forecast profit for month 150,000 300,000

(c) • contribution sales ratio

£10* = 0.5 or 50%£20

* selling price £20 – variable cost £10

• break-even point in units

£300,000 = 30,000 units£10

• break-even point in sales revenue

£300,000 = £600,0000.5

check: 30,000 units x selling price £20 per unit = £600,000

• margin of safety at maximum output of 40,000 units

40,000 – 30,000 x 100 = 25%, or 10,000 units, or £200,000 of sales revenue40,000 1

4 8

• forecast profit at maximum output of 40,000 units

£

sales revenue (at £20 each) 800,000

less variable costs (at £10 each) 400,000

equals contribution (to fixed costs and profit) 400,000

less monthly fixed costs 300,000

equals forecast profit for month 100,000

EMAIL

To: General Manager

From: A2 Student

Date: Today

Proposal to reduce selling price

Introduction

• This report considers the suggestion from one of the managers that the selling price for ourproduct should be reduced from £25 per unit to £20.

• The manager has suggested that the effect of this reduction would be to increase output fromthe forecast of 30,000 units per month to our maximum output of 40,000 units per month.

Report

• As can be seen from the workings at current levels of output of 30,000 units per month:

– contribution sales ratio is 60%

– break-even point is 20,000 units

– margin of safety is 33.3%

– forecast profit is £150,000 per month

• If the manager’s suggestion is adopted sales will increase to our maximum output of 40,000units per month; this will give us:

– contribution sales ratio of 50%

– break-even point of 30,000 units

– margin of safety of 25%

– forecast profit of £100,000 per month

Conclusion

• From the data summarised above it can be seen that the manager’s suggestion wouldreduce our contribution sales ratio, increase the break-even point, and reduce the margin ofsafety. All of these are all movements in the wrong direction.

• The main point to note is that forecast profit will fall by £50,000 per month to £100,000 permonth, and the volume of output will need to be higher.

• Although the firm would be working at maximum output if the suggestion is adopted, thisdoes mean that there is no scope to increase output and sales in the future without majorchanges to our cost structure. We would not be able to meet requests for additional salesfrom our existing customers, and this could cause them to seek all of their supplies from ourcompetitors.

• For these reasons, it is recommended that the manager’s suggestion is not undertaken.

4 9

11.5 (a)

Fixed costs Variable costs per

£ unit in pence

Wages 20

Raw materials 30

Salespeople’s wages 10

Administration costs 42,000

Business rates 20,400

Total £62,400 60p

(b) (i) Contribution per unit = selling price per unit – variable costs per unit

(ii) Contribution per unit = £1.00 – £0.60 = £0.40

(iii) Contribution goes, firstly, towards fixed costs and, when they have been covered, secondly, contributes to profit

(c) (i) Break-even point (units) = fixed costs (£)contribution per unit (£)

= £62,400 = 156,000 bookmarks£0.40

(ii) Total revenue = 156,000 bookmarks x £1 = £156,000

(iii) Sales of 150,000 bookmarks are 6,000 below break-even point. There will be a loss of 6,000 x £0.40 contribution = £2,400

11.8 (a) A = margin of safety, between 3,500 and 6,000 carpets, ie 2,500 carpets

B = area of loss

C = profit at maximum capacity of 6,000 carpets

D = sales value and total costs, £25,000, at break-even point

(b) Disadvantage of using a break-even graph to identify the break-even point, one from:

• the assumption is made that all output is sold

• the presumption is made that there is only one product

• all costs and revenues are expressed in straight lines

• it is not possible to extrapolate the graph

• the profit or loss shown by the graph is probably only true for figures close to current output levels

• external factors are not considered

11.9 (a) Marginal cost is the cost of producing one extra unit of output.

(b) Marginal cost per unit: £

materials (3 metres at £5 per metre) £15.00

labour (15 minutes at £12 per hour) 3.00

variable manufacturing overheads 3.00

marginal cost per unit 21.00

(c) Marginal cost x 1.2 = £21.00 x 1.2 = £25.20 selling price per unit

5 0

(d) Break-even in units:

fixed costs (£) = £52,500 = 12,500 unitscontribution per unit (£) £25.20 – £21.00

Break-even revenue:

break-even units x selling price per unit = 12,500 units x £25.20 = £315,000

(e) Usefulness of break-even analysis in decision-making:

• Break-even is the point at which neither a profit nor a loss is made and tells a business the sales (in both unitsand revenue) that have to be made to meet costs.

• It provides:

– the profit or loss at any level of output/sales within the range of the analysis

– the margin of safety, ie the amount by which sales exceed the break-even point

• It helps a new business to determine selling prices and can be used to support an application for finance.

• It can be adapted to take note of changes in costs and selling price.

• However, break-even analysis:

– assumes that all output is sold

– presumes that there is only one product

– all costs and revenues are expressed in straight lines

– cannot be extrapolated

– the indicated profit or loss is probably only true for figures close to current output levels

– does not take into account external factors

Conclusion: break-even analysis is useful for giving guidance to a business about individual products, but it does havea number of limitations.

11.11 (a) fixed costs (£) = break-even point (in units)contribution* per unit (£)

* selling price per unit – variable costs per unit

(b) (i) Year ended 30 November 2003:

£42,250 = 1,625 portraits£38 – £12

(ii) Year ended 30 November 2004:

£52,000 = 2,000 portraits£38 – £12

(c) • Increase in fixed costs: £52,000 – £42,250 = £9,750

• £9,750 ÷ 1,625 portraits at 2003 break-even = £6 extra per portrait

• Therefore the price of each portrait will need to increase by £6 to £44

(d) • The price change to £44 is a 16% increase

• As a result of the increase the demand for portraits may fall to below break-even point

• The prices charged by competitors may be below that charged by Tracey

• Tracey should investigate reducing her variable costs and/or see if the increase in fixed overheads can bereduced in any way.

5 1

12.1 (a) • cost units – units of output to which costs can be charged

• cost centres – sections of a business to which costs can be charged

(b) Suggestions to include:COST UNIT COST CENTRE

• firm of accountants client hour partner in firmtax departmentadministration

• parcel delivery company per parcel vehicleper kg depotper mile/kilometre head officeper kg mile (orkilometre)

• college of further education student hour teaching departmentlearning resourcesadministrative office

• mixed farm kg of wheat fieldhead of cattle cattle shed

12.2 Suggestions to include:

1. Sections of a theatre which could be used as cost centres:

Productions

Bar

Confectionery

Printing and advertising (or marketing)

Box office, stewarding and programme sales

Administration

Maintenance and cleaning of buildings

2. Sections of a garage which could be used as cost centres:

New car sales

Used car sales

Repairs and servicing

Valeting

Management and administration

12.4 • Marginal cost per barbecue £

Direct materials 30.00

Direct labour 25.00

MARGINAL COST 55.00

• Absorption cost per barbecue £

Direct materials 30.00

Direct labour 25.00

PRIME COST 55.00

Overheads (fixed) 150,000 ÷ 10,000 barbecues 15.00

TOTAL COST 70.00

5 2

CHAPTER 12 Absorption and activity based costing

• COOK-IT LIMITED

PROFIT STATEMENT: 10,000 BARBECUES

£ £

Sales (10,000 x £90) 900,000

Direct materials (10,000 x £30) 300,000

Direct labour (10,000 x £25) 250,000

PRIME COST 550,000

Overheads (fixed) 150,000

TOTAL COST 700,000

PROFIT 200,000

12.6 (a)

ACTIVTOYS LIMITED

PROFIT STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-1

MARGINAL COSTING ABSORPTION COSTING£ £ £ £

Sales at £125 each 162,500 162,500

Variable costs

Direct materials at £25 each 37,500 37,500

Direct labour at £30 each 45,000 45,000

82,500

Less Closing stock (marginal cost*)

200 frames at £55 each 11,000

71,500

CONTRIBUTION 91,000

Fixed production overheads 82,500 82,500

165,000

Less Closing stock (absorption cost*)

200 frames at £110 each 22,000

Less Cost of goods sold 143,000

PROFIT 8,500 19,500

* Closing stock is calculated on the basis of this year’s costs:

marginal costing, variable costs only, ie £25 + £30 = £55 per frame x 200 frames = £11,000

absorption costing, variable and fixed costs, ie £165,000 ÷ 1,500 frames = £110 per frame x 200 frames = £22,000

(b) Reasons for different profit figures:

• The difference in the profit figures is caused by the closing stock figures: £11,000 under marginal costing and£22,000 under absorption costing – the same costs have been used, but fixed production overheads havebeen treated differently.

• Only fixed production overheads are dealt with differently using the techniques of marginal and absorptioncosting – both methods charge non-production overheads in full to the profit statement in the year to whichthey relate.

• With marginal costing, the full amount of the fixed production overheads has been charged in this year’s profitstatement; by contrast, with absorption costing, part of the fixed production overheads (here, £11,000) hasbeen carried forward to next year in the stock valuation.

Comment on the directors’ statement:

• A higher profit does not mean more money in the bank.

• The two costing methods simply treat fixed production overheads differently and, in a year when there is noclosing stock, total profits to date are exactly the same – but they occur differently over the years.

5 3

12.7 (a)

DURNING LIMITED

PROFIT STATEMENT FOR THE MONTH ENDED 30 APRIL 20-4

MARGINAL COSTING ABSORPTION COSTING£ £ £ £

Sales 8,000 units at £4 each 32,000 32,000

Variable costs

Direct materials at £0.80 each 8,000 8,000

Direct labour at £1.60 each 16,000 16,000

24,000

Less Closing stock (marginal cost)

2,000 units at £2.40 each 4,800

19,200

CONTRIBUTION 12,800

Fixed production overheads 10,000 10,000

34,000

Less Closing stock (absorption cost)

2,000 units at £3.40 each 6,800

Less Cost of goods sold 27,200

PROFIT 2,800 4,800

Working notes:

Closing stock is calculated on the basis of this year’s costs:

marginal costing, variable costs only, ie £0.80 + £1.60 = £2.40 per unit x 2,000 units = £4,800

absorption costing, variable and fixed costs, ie £34,000 ÷ 10,000 units = £3.40 per unit x 2,000 units = £6,800

(b) The difference in the profit figures is caused only by the closing stock figures: £4,800 under marginal costing, and£6,800 under absorption costing. With marginal costing, the full amount of the fixed production overheads has beencharged in this year’s profit statement; by contrast, under absorption costing, part of the fixed production overheads(here £10,000 x 20%* = £2,000) has been carried forward in the stock valuation.

* 2,000 units in stock out of 10,000 units manufactured

12.9 (a) (i) Fixed production costs ÷ 12,000 units =

£90,000 ÷ 12,000 = £7.50 absorption rate per unit

(ii) Absorption costing:

variable production costs per unit + absorption cost per unit =

£70.00 + £7.50 = £77.50 production cost per unit

(b) Budgeted profit for June £ £

sales 10,000 units @ £90 900,000

opening stock 500 units @ £77.50 38,750

add production costs 12,000 units @ £77.50 930,000

968,750

less closing stock 2,500 units @ £77.50 193,750

cost of sales 775,000

gross profit 125,000

less non-production costs 50,000

equals budgeted net profit for June 75,000

5 4

(c) • Using absorption costing, budgeted net profit for June is £75,000 which is £15,000 higher than the £60,000profit using marginal costing.

• With marginal costing, the full amount of fixed production costs of £930,000 has been charged in this month’sprofit statement; by contrast, with absorption costing, part of the fixed production costs (here, £7.50 x 2,000units = £15,000) has been carried forward to next month in the stock valuation.

• Profit will always be higher under absorption costing in accounting periods of increasing stock levels.

• However, a higher profit does not mean more money in the bank and, over the longer term, profit is the sameunder both methods.

• Under IAS 2, Inventories, Jayne Bonde plc must use absorption costing for its stock valuation, based on thecosts of direct materials, direct labour, direct expenses (if any), and production overheads. Note that non-production overheads are charged in full to the profit statement to which they relate.

• It seems unlikely that there will be any effect on the shareholders as marginal costing cannot be used for stockvaluation purposes in published accounts.

12.11 (a) Activity based costing is a costing method which charges overheads to output on the basis of activities. The cost perunit of a product can be calculated based on its use of activities.

The steps to applying activity based costing are:

1. The overhead costs which are incurred by the same activity are grouped together in cost pools, eg the costsof purchasing goods to be used in production.

2. The cost driver – the factor which influences the costs – is then identified, and the rate for each cost iscalculated, eg the cost of placing a purchase order for goods to be used in production.

3. The rate for each cost is charged to production, based on the use of the activity, eg if a product requires twopurchase orders to be placed, it will be charged with the cost of two activities.

(b) • Today’s capital intensive, low-labour industries are very different from older industries which are labourintensive, or where production requires the use of heavy machinery. Traditionally, older industries havecharged overheads to output on the basis of direct labour hours, or machine hours. Such methods are notappropriate for modern, complex methods of production.

• In capital-intensive industries, overheads often form a high proportion of total costs and are complex in nature.They need to be accounted for in a more sophisticated way than would be the case under absorption costing,eg absorbing overhead costs under one basis – such as direct labour hours – does not acknowledge thecomplex nature of the overheads and production processes.

• Often modern flexible manufacturing methods require short production runs, with the ability to switch from oneproduct to another at short notice. This is in contrast to older industries where the same product is producedover a long production run. These differing production methods impact on costs such as setting up equipment,which will be much larger per unit of output for small production runs than for large ones. Activity based costingis able to charge the cost of overheads to output on the basis of activities – something which absorption costingwould not do.

12.13 (a) calculation of weekly overheads for set ups and quality inspections

£ £

set ups: product Aye 5 x £250 1,250

product Bee 50 x £250 12,500

13,750

quality inspection: product Aye 5 x £150 750

product Bee 50 x £150 7,500

8,250

TOTAL 22,000

At present the weekly overheads are charged on the basis of labour hours:

£

product Aye (500 hours) 11,000

product Bee (500 hours) 11,000

TOTAL 22,000

5 5

(b) activity based costing:£ £

product Aye5 set ups at £250 1,2505 quality inspections £150 750

2,000product Bee50 set ups at £250 12,50050 quality inspections £150 7,500

20,000TOTAL 22,000

(c) • By using activity based costing, there is a more accurate reflection of the cost of the activities of set up andquality inspection.

• The cost of 50,000 units of product Aye is reduced by £9,000 (ie £11,000 – £2,000), while the cost of 50,000units of product Bee is increased by £9,000 (ie from £11,000 to £20,000).

• This may well have implications for the viability of product Bee, and for the selling prices of both products.

12.14 Marginal costingProduct Exe Product Wye Total£ £ £ £ £

sales 200,000 160,000less variable costs:

direct materials 60,000 40,000direct labour 20,000 20,000

80,000 60,000equals contribution 120,000 100,000 220,000less fixed production costs 36,000equals profit for the week 184,000

• With marginal costing, the focus is on the contribution – both by product and in total.• Fixed production costs are treated as a period cost – ie cost of time (such as a week, as here) rather than being

product related.

Absorption costingProduct Exe Product Wye Total

£ £ £ £ £sales 200,000 160,000

less direct materials 60,000 40,000direct labour 20,000 20,000PRIME COST 80,000 60,000fixed production costs *18,000 *18,000TOTAL COST 98,000 78,000

equals profit for the week 102,000 82,000 184,000

* 2,000 direct labour hours for each product per week, so fixed production costs are £36,000 ÷ 2 = £18,000 per product.

• With absorption costing, the focus is on profit – both by product and in total.• Overhead costs are absorbed by production before profit is calculated.

Activity based costingFixed production costs: set ups inspections

number £ number £product Exe 2 4,000 2 2,000product Wye 10 20,000 10 10,000

24,000 12,000

• set ups: £24,000 ÷ 12 = £2,000 per set up• inspections: £12,000 ÷ 12 = £1,000 per inspection

5 6

Product Exe Product Wye Total

£ £ £ £ £

sales 200,000 160,000

less direct materials 60,000 40,000

direct labour 20,000 20,000

PRIME COST 80,000 60,000

fixed production costs

set ups 4,000 20,000

inspections 2,000 10,000

TOTAL COST 86,000 90,000

equals profit for the week 114,000 70,000 184,000

• With activity based costing, which is a development of absorption costing, the focus is on identifying the overhead costs fora particular activity.

• It gives more accurate costing information and shows that smaller batches (as here with product Wye) cost more to produce.

13.3 (a)

OVERHEAD ANALYSIS SHEETfor January 20-8

Accountancy Department Management DepartmentBudgeted total overheads (£) 22,143 17,251Budgeted lecturer hours 1,525 1,300Budgeted overhead absorption rate (£) 14.52 13.27

(b)

OVERHEAD ANALYSIS SHEETCourse: Finance for Managers

Accountancy Department Management DepartmentLecturer hours 45 20Budgeted overhead absorption rate (£) 14.52 13.27Overhead absorbed by course (£) 653.40 265.40

13.5 (a) and (b)

cost basis of total machining finishing maintenanceapportionment

£ £ £ £ Rent and rates Floor area 5,520 2,760 1,840 920 Buildings insurance Floor area 1,320 660 440 220 Machinery insurance Value of machinery 1,650 1,200 450 – Lighting and heating Floor area 3,720 1,860 1,240 620 Depn of machinery Value of machinery 11,000 8,000 3,000 – Supervisory salaries No. of employees 30,000 18,000 9,000 3,000 Maintenance deptsalary Allocation 16,000 – – 16,000 Factory cleaning Floor area 4,800 2,400 1,600 800

74,010 34,880 17,570 21,560 Re-apportionment ofmaintenance dept Value of machinery – 15,680 5,880 (21,560)

74,010 50,560 23,450 –

5 7

CHAPTER 13 Overheads and overhead absorption

(c) 35 hours x 47 weeks = 1,645 direct labour hours per employee

Machining Dept: 6 employees = 9,870 hours = £5.12 per direct labour hour

Finishing Dept: 3 employees = 4,935 hours = £4.75 per direct labour hour

(d) Depending on the method and type of production, the company is most likely to use overhead absorption rates basedon:

• direct labour hours, or

• machine hours

The OAR selected may vary from one department to another, depending on whether departments are labour-intensiveor machine-intensive. The labour hour rate is a popular method because overheads are absorbed on a time basis.However, the machine hour is particularly appropriate where expensive machinery is used in a department.

13.8 (a) Direct labour hour: (3 hours x 80 seats) + (3.5 hours x 40 seats)= 380 direct labour hours per month = £2.63 per hour.

Machine hour: (1 hour x 80 seats) + (2.5 hours x 40 seats)= 180 machine hours per month = £5.56 per hour.

Alternative methods could be based on a percentage of certain costs, eg direct labour.

(b) Direct labour hour

'Standard' £36.50 + £7.89 = £44.39

'De Luxe' £55.00 + £9.21 = £64.21

Machine hour

'Standard' £36.50 + £5.56 = £42.06

'De Luxe' £55.00 + £13.89 = £68.89

Note: some figures have been rounded to the nearest penny

(c) See text. The machine hour rate charges most to 'de luxe' model. On balance, direct labour hours may be the bestmethod to use because the products are more labour-intensive than machine-intensive.

13.10total day care surgical operating administration

ward ward theatre£ £ £ £ £

Overheads 112,195 28,750 42,110 32,260 9,075 Administration – 1,650 4,125 3,300 (9,075)

35,560 – Operating theatre – 20,320 15,240 (35,560) –

112,195 50,720 61,475 – –

13.11

total tables chairs stores maintenance£ £ £ £ £

Overheads 25,000 12,000 8,000 3,000 2,000 Stores – 1,500 1,200 (3,000) 300

– 2,300 Maintenance – 1,380 920 – (2,300)

25,000 14,880 10,120 – –

5 8

5 9

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total cost centre overheads = £39,000 = £0.50 per labour hour

total labour hours 78,000 hours

(b) Selling price per unit, using cost-plus pricing

£

direct materials 40 metres at £2.50 per metre 100.00

direct labour 3 hours at £16 per hour 48.00

fixed overheads 3 hours at £0.50 per hour 1.50

total cost 149.50

plus mark-up of 20% 29.90

equals selling price per unit 179.40

(c) Advantages of using absorption costing to set selling price

• As absorption costing calculates a total cost – variable costs and fixed costs – all overheads are recovered inthe selling price.

• Overhead absorption rates are often based on either machine hours or labour hours – whilst these may not beentirely accurate, they provide a good estimate of overhead costs.

• The percentage cost-plus mark-up can be varied to suit market conditions but, provided the business setsselling price above total cost, a profit will be made.

Advantages of using marginal costing to set selling price

• As marginal costing focuses on variable costs and contribution it can be a more flexible way of setting sellingprices.

• Variable costs represent the starting point for setting selling prices but Dario Uno must recover the fixedoverheads from total sales – even if different prices are charged to different customers – in order to make aprofit.

Tutorial note

• In order to set the same selling price under absorption costing and marginal costing, the cost-plus mark-up willbe different – it will be lower for absorption costing (being a mark-up on total cost), and higher for marginalcosting (being a mark-up on variable cost).

6 0

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The method to be used in this department is labour hour, because the department is more labour-intensive than machine-intensive.

total machining department overheads = £44,860 = approx £1.12 per labour hour

total labour hours 40,000 hours

Assembly department

The method to be used in this department is machine hour, because the department is more machine-intensive than labour-intensive.

total assembly department overheads = £57,540 = approx £0.96 per machine hour

total machine hours 60,000 hours

(e) Cost drivers are activities which cause costs to be incurred.

Activity based costing uses cost drivers linked to the way in which the business is conducted in order to charge costs –through cost pools – to activities.

(f) • for factory canteen expenses the cost driver will be the number of employees

• for factory machine maintenance the cost driver will be the number of machine hours

• for factory machine set-up costs the cost driver will be the number of machine set-ups

14.1 There are a wide range of marginal costing applications in the service businesses mentioned. For example:

• hotel

– ‘bargain break’ weekends to make use of rooms occupied by business people during the week

– last minute bookings, which are discounted from the normal tariff

• transport

– season tickets

– weekend fares

– cheaper fares after the morning rush

– discounts for categories of people in slack travel months

• cinema or theatre

– standing or cheap tickets released only on the day of the performance

– ‘half-price’ ticket booths on day of performance

– special cheap ticket deals with transport companies

– family tickets

• holiday companies

– discounts for last minute bookings to fill empty places on planes and at hotels

– discounts for early bookings, which help with planning the travel companies’ operations

– special deals with transport companies

– off-peak prices

Consider also the benefits and restrictions/problems for both the customer and the supplier. Often only a limitednumber of products are available at special prices, or there are restrictions on the time that they are available. Themajor disadvantage for the supplier is that those customers who have paid the full price will be disgruntled when theylearn the lower price paid by others.

6 2

CHAPTER 14 Costing in decision-making

14.2 In-house manufacture

Marginal cost of manufacture per pump motor: £

direct materials 40.00

direct labour 25.00

variable overheads 20.00

marginal cost 85.00

The marginal cost of making 3,500 pump motors per year: £

3,500 units at £85 = 297,500

plus contribution which will be lost from ‘olde worlds’ handpumps:

750 units at £250 – £150 = 75,000

= 372,500

Buying in cost from outside supplier

3,500 units at £95 = 332,500

Therefore, by buying in pump motors from an outside supplier, the company has the potential to increase profits by £40,000(£372,500 – £332,500).

14.5 (a) Absorption cost per seat (based on sixty seats sold)

£

direct materials £12.50 x 60 750.00

direct labour £10.00 x 60 600.00

direct expenses £2.50 x 60 150.00

fixed overheads 3,500.00

TOTAL COST 5,000.00

The absorption cost per seat is £5,000 ÷ 60 = £83.33

(b) Marginal cost per seat £

direct materials 12.50

direct labour 10.00

direct expenses 2.50

MARGINAL COST (per seat) 25.00

(c) Profit or loss if no further tickets sold £

revenue 60 seats at £100 each 6,000.00

less total cost (see above) 5,000.00

PROFIT 1,000.00

6 3

(d)

Flight MA 005 to Rome

• Two proposals for the 40 unsold seats on next week’s flight:

– to sell approximately 30 seats at £45 each to the travel firm

– to sell all 40 seats to the local newspaper at £35 each

• The profit statement shows

– if no further seats are sold the profit will be £1,000

– if sold to the travel firm, the contribution (selling price – marginal cost) is 30 seats x (£45 – £25) = £600,which gives a profit figure of £1,600

– if sold to the newspaper, the contribution is 40 seats x (£35 – £25) = £400, which gives a profit figureof £1,400

Conclusion

• The offer from the travel firm should be taken up, while the newspaper offer should not be considered on thisoccasion.

• With contributions of £20 per seat from the travel firm and £10 from the newspaper, provided that the flight firmcan sell more than 20 seats, the contribution will be greater than that from the newspaper.

14.6 (a) Absorption cost £

direct materials (per pair) 20.00

direct labour (per pair) 18.00

fixed overheads (£200,000 ÷ 12,500 pairs) 16.00

ABSORPTION COST (per pair) 54.00

Marginal cost £

direct materials (per pair) 20.00

direct labour (per pair) 18.00

MARGINAL COST (per pair) 38.00

Profit or loss at existing production of 12,500 pairs of boots, see below.

6 4

MERCIA AIRWAYS

profit statement for flight MA 005

60 seats 60 seats 60 seatssold + 30 sold + 40 sold

to travel firm to newspaper£ £ £

Sales revenue for flight:

60 seats at £100 each 6,000 6,000 6,000

30 seats at £45 each – 1,350 –

40 units at £35 each – – 1,400

6,000 7,350 7,400

Less costs:

Direct materials (£12.50 per passenger) 750 1,125 1,250

Direct labour (£10 per passenger) 600 900 1,000

Direct expenses (£2.50 per passenger) 150 225 250

Fixed overheads 3,500 3,500 3,500

PROFIT 1,000 1,600 1,400

(b)

Offer from Zambesi Limited

• Two contracts offered by Zambesi Limited for the ‘Snowdon’ range:

– either 2,500 pairs at £45 per pair

– or 5,000 pairs at £37 per pair

• The profit statement for planned sales, together with the two offers shows:

– if either offer is not taken up, profits next year are expected to be £75,000

– if 2,500 pairs sold to Zambesi at £45 per pair, the contribution (selling price – marginal cost) is 2,500 x(£45 – £38) = £17,500; thus profits increase by £17,500 to £92,500

– if 5,000 pairs sold to Zambesi at £37 per pair, the contribution is 5,000 (£37 – £38) = (£5,000); this priceof £37 is below our marginal cost of £38; thus profits fall by £5,000 to £70,000

Conclusion

• The offer of 2,500 pairs at £45 per pair should be taken up, while the offer of 5,000 pairs at £37 should berejected. This follows the principle that, once the fixed overheads have been recovered from normal sales,provided that additional units can be sold at a price above marginal cost, then profits will increase.

14.10 (a)

6 5

THE LAST COMPANY LTD

profit statements

Existing Existing Existingproduction production production

12,500 pairs + 2,500 pairs + 5,000 pairsof boots @ £45 each @ £37 each

£ £ £

Sales revenue (per week):

12,500 pairs at £60 each 750,000 750,000 750,000

2,500 pairs at £45 each – 112,500 –

5,000 pairs at £37 each – – 185,000

750,000 862,500 935,000

Less production costs:

Direct materials (£20 per pair) 250,000 300,000 350,000

Direct labour (£18 per pair) 225,000 270,000 315,000

Fixed overheads 200,000 200,000 200,000

PROFIT 75,000 92,500 70,000

Product ‘People’ ‘Animals’ ‘Birds’

£ £ £

Selling price per unit 60 27.50 17.50

Less: Unit variable costs

Direct materials 5 3 2

Direct labour 15 5 3.33

Variable overheads 10 4.50 2.96

Contribution per unit 30 15 9.21

(b) Break-even point for the ‘People’ range is:

fixed costs (£) = £45,400 = 1,514 unitscontribution per unit (£) £30

(c)

(d) • Labour hours are the scarce resource here, with 2,800 hours available.

• To maximise profits, the company should maximise the contribution from each labour hour.

• The preferred order is ‘Animals’ (at £30 contribution per labour hour), ‘Birds’ (at £27.66), and ‘People’ (at £20).

• Optimum production plan:

Total hours available per month 2,800

less ‘Animals’, 2,000 units x 0.5 hours per unit 1,000

1,800

less ‘Birds’, 2,700 units x 0.333 hours per unit 900

equals hours remaining to produce units of ‘People’ 900

Therefore production of ‘People’ at 1.5 hours per unit will be 600 units per month. This production plan doesnot allow for full production of the ‘People’ range.

14.12 (a) (i) sales revenue – variable costs = contribution

(ii) sales revenue – variable costs = contribution per unitnumber of units

£

(b) (i) Ink pen £8.00 – £6.20 = £1.80 contribution x 4,200 units = 7,560

Novelty ruler £2.50 – £0.60 = £1.90 contribution x 8,400 units = 15,960

Total contribution 23,520

(ii) Ink pens £1.80 contribution x 3,000 units = 5,400

Novelty rulers £1.90 contribution x 6,000 units = 11,400

Bought in:

ink pens £8.00 – (£3.10 + £4.00) = £0.90 contribution x 1,200 units = 1,080

novelty rulers £2.50 – (£0.40 + £1.10) = £1.00 contribution x 2,400 units = 2,400

Total contribution 20,280

(c) • The bought-in goods give a positive contribution of £0.90 for the pen and £1.00 for the ruler; these amountswill contribute to fixed costs and profit.

• By buying-in goods Drew Armstrong is able to satisfy the demand from customers who will not seek out analternative supplier.

• Drew must be sure of the quality of the bought-in goods, the timing of deliveries, and the reliability of thesupplier.

6 6

Product ‘People’ ‘Animals’ ‘Birds’

Contribution per unit £30 £15 £9.21

Labour hours per unit 1.5 0.5 0.333

Contribution per labour hour £20 £30 £27.66

(d) See also chapter 18:

• The current staff may be resistant to retraining on the new machine.

• The staff will be demotivated until they know who is to be made redundant and who is to be retrained; somestaff may seek work elsewhere.

• The staff to be retrained may seek a pay rise on account of their increased skills.

• Once retrained, staff will have transferable skills useful to other employers who may seek to recruit them.

• Staff may see increased production as a positive sign that their jobs are safe. They may be concerned aboutthe effect of the loan interest and repayments for the machine on the financial viability of the business.

14.13 (a) • Fixed costs remain fixed over a range of output levels and vary with time rather than activity levels, eg rent,insurance.

• Semi-variable costs include both a fixed and a variable element, eg utility bills such as telephone, fuel.

• Variable costs vary directly with output, eg direct materials, royalties, direct labour.

(b) Sales revenue – variable costs = contribution.

£

(c) selling price £40 per unit x 12,000 units 480,000

less variable costs £12 per unit x 12,000 units 144,000

variable overheads £1.50 per unit x 12,000 units 18,000

equals total contribution for year to 31 May 2007 318,000

(d) fixed costs (£) = £256,500 – £18,000 variable costscontribution per unit (£) £318,000 ÷ 12,000 units

£238,500 = 9,000 units to break-even£26.50

(e) Profit statements for each new order for the year ended 31 May 2008

Order JJH Order JHB6,000 units 8,000 units

£ £

Sales JJH £180,000/6,000 = £30 per unit; JHB £256,000/8,000 = £32 per unit 180,000 256,000

Variable costs £14 x 6,000 (JJH) or 8,000 (JHB) units (84,000) (112,000)

Variable overheads £1.50 x 6,000 (JJH) or 8,000 (JHB) units (9,000) (12,000)

Delivery charges JJH 2% of £180,000; JHB 2.5% of £256,000 (3,600) (6,400)

Machinery modification (19,000) –

Staff retraining (8,000) –

Overseas agent (14,000) (14,000)

Temporary staff – (28,000)

PROFIT FROM EACH NEW ORDER 42,400 83,600

(f) Note that the factory is currently operating at 60 per cent of capacity: current production is 12,000 units, so maximumcapacity is 20,000 units, ie an increase of 8,000 units.

Order JJH

• Although profit on this order is lower than for JHB, future orders “are almost guaranteed”.

• In the year to 31 May 2008, one-off costs of machinery modification and staff retraining are £27,000. Providedno further such costs are incurred, the profit of subsequent years will be £42,400 + £27,000 = £69,400 fromthis order.

• Staff retraining will motivate the staff but will also give them transferable skills useful to other employers whomay seek to recruit them.

• Staff may seek a pay rise once they have been retrained.

• Staff may see increased production as a positive sign that their jobs are safe.

6 7

• With a selling price of £30 per unit, this order gives a positive contribution, £30 – £15.50 (£14 + £1.50) = £14.50to delivery charges and fixed costs.

• It utilises spare capacity, but leaves 2,000 further units of spare capacity.

• Although the selling price is £30 instead of the normal selling price of £40, the company is already past thebreak-even point with its normal sales.

Order JHB

• This is a ‘one-off’ order which utilises the full capacity of the factory, and so prevents future growth of thebusiness for the year to 31 May 2008.

• With a selling price of £32 per unit, this order gives a positive contribution, £32 – £15.50 (£14 + £1.50) = £16.50to delivery charges and fixed costs.

• Profit is higher than for JJH but is likely to be for one year only.

• Temporary staff will need to be employed, helping the local economy, in the short-term.

• For this order, the product will need to be modified – management needs to ensure that the modifications arewithin the capabilities of the staff.

Conclusion

The order from JJH is to be preferred provided that there is the likelihood of future orders. This will safeguard the jobsof current employees and may enable the company to expand in the future. Although profit will be lower than JHB inthe first year, this will be more than made up by the second year order.

14.14 (a)

(b) • Labour hours are the scarce resource, with 42,000 hours available.

• To maximise profits, the company should maximise the contribution from each labour hour.

• The preferred order is Caz (at £4 contribution per labour hour) and Jaz (at £3).


Total hours available per year 42,000

less Caz, 12,000 units x 2 hours per unit 24,000

equals hours remaining to produce units of Jaz 18,000

Therefore production of Jaz at 3 hours per unit will be 6,000 units. In summary:

Production plan

Caz 12,000 units

Jaz 6,000 units

6 8

PRODUCT Caz Jaz

Selling price per unit £42 £45

less Unit variable costs per unit

Caz, materials £18, direct labour £16 £34

Jaz, materials £12, direct labour £24 £36

equals Contribution per unit £8 £9

Direct labour hours per unit 2 hours 3 hours

Contribution per direct labour hour £4 £3

(c) The shortfall in Jaz is 2,000 units (8,000 – 6,000):

This contribution will increase profit by £2,600 (£1.30 x 2,000 units) and will be worthwhile

– to maintain market share

– to retain customers

provided that

– quality can be assured

– delivery dates can be relied upon

14.16 (a)

• Labour hours are the scarce resource, with 80,000 hours available.


Total hours available per year 80,000

less JJH2, 20,000 units x 2 hours per unit 40,000

equals hours remaining to produce units of JHB1 40,000

Therefore production of JHB1 at 4 hours per unit will be 10,000 units.

(b) Shortfall in JHB1 is 5,000 units (15,000 – 10,000):

This contribution will increase profit by £25,000 (£5 x 5,000 units) and will be worthwhile

– to maintain market share

– to retain customers

provided that

– quality can be assured

– delivery dates can be relied upon

6 9

£

Selling price per unit 45.00

less Buying-in price per unit

£38 + *£5.70 delivery charge 43.70

equals Contribution per unit 1.30

* £38 x 15%

PRODUCT JHB1 JJH2

Selling price per unit £50 £50

less Unit variable costs per unit

JHB1, labour £32, materials £8 £40

JJH2, labour £16, materials £16 £32

equals Contribution per unit £10 £18

Direct labour hours per unit 4 hours 2 hours

Contribution per labour hour £2.50 £9

Ranking 2 1

£

Selling price per unit 50

less Buying-in price per unit 45

equals Contribution per unit 5

(c) Contribution: £

JHB1 10,000 units @ £10 per unit 100,000

5,000 units @ £5 per unit 25,000

JJH2 20,000 units @ £18 per unit 360,000

485,000

less Fixed costs 420,000

equals Profit 65,000

15.1 (a) Standard costing sets a pre-determined/budgeted cost for materials, labour and overheads in advance of production.

Many businesses establish a standard or budgeted cost for their output in advance of production. Standard costs canthen be compared with actual costs and variances calculated.

(b) The main advantages of standard costing are that it can be used:

• to help with decision-making – for example, with price setting

• to assist in planning – for example, to plan the quantity and cost of resources needed for production

• as a means of controlling costs – standard costs are compared with actual costs and variances calculated sothat action can be taken by the responsible manager or department when appropriate

15.4

Material A Material B Material C Material D

£ p £ p £ p £ p

material price variance 120.00 FAV 200.00 ADV 500.00 FAV 250.00 ADV

material usage variance 100.00 ADV 400.00 FAV 1,000.00 FAV 100.00 FAV

materials variance 20.00 FAV 200.00 FAV 1,500.00 FAV 150.00 ADV

15.5

Product 1 Product 2 Product 3 Product 4

£ p £ p £ p £ p

labour rate variance 7.00 ADV 4.00 ADV 15.00 FAV 15.00 ADV

labour efficiency variance 10.00 FAV 9.00 ADV 72.00 ADV 48.00 ADV

labour variance 3.00 FAV 13.00 ADV 57.00 ADV 63.00 ADV

15.6 (a) Material price variance

800 kg x (75p – 80p) = £40 ADVERSE

Material usage variance

75p per kg x (900 kg – 800 kg) = £75 FAVOURABLE

TOTAL MATERIALS VARIANCE = £35 FAVOURABLE

Labour rate variance

140 hours x (£10 – £11) = £140 ADVERSE

Labour efficiency variance

£10 per hour x (150 hours – 140 hours) = £100 FAVOURABLE

TOTAL LABOUR VARIANCE = £40 ADVERSE

7 0

CHAPTER 15 Standard costing and variance analysis

(b) • the managers responsible for each section of the business will be asked to explain the reason for anysignificant variances of their section

• the buying department should explain the 5p per kilo adverse variance in the cost of materials – perhaps betterquality materials have been purchased, or there has been a price increase, or there has been an adverseexchange rate fluctuation

• the production department should explain the favourable variance in materials usage – perhaps better qualitymaterials have been used with less wastage, or the workforce is better trained in using the materials

• the human resources department will need to explain the £1.00 per hour higher labour rate – perhaps therehas been a pay rise; alternatively, overtime rates may have had to be paid, which the production departmentwill be asked to explain

• the production department should be asked to explain the favourable variance in labour efficiency – perhapsmore use has been made of machines, or the workforce is better trained, or better quality materials have beenused

• it may be that variances are linked, eg more expensive materials have less wastage; skilled employees (onhigher pay rates) work more efficiently

• corrective action may need to be taken in some areas despite the overall favourable variance in total cost

15.8 (a) (i) Material price variance:

actual quantity x (standard price – actual price)

60,000 metres x (£8.00 – *£9.75) = £105,000 ADVERSE

* £585,000 ÷ 60,000 metres

Material usage variance:

standard price x (standard quantity – actual quantity)

£8.00 x (*66,000 metres – 60,000 metres) = £48,000 FAVOURABLE

* 12,000 units produced x 5.5 metres per unit

(ii) Labour rate variance:

actual labour hours x (standard rate – actual rate)

60,000 hours x (£6 – *£6) = £0 NO VARIANCE

* £360,000 ÷ 60,000 hours

Labour efficiency variance:

standard rate x (standard hours – actual hours)

£6 per hour x (*52,000 hours – 60,000 hours) = £48,000 ADVERSE

* 12,000 units produced x 4 hours 20 minutes (note 20 minutes = 1/3rd of an hour)

= 48,000 hours + 4,000 hours = 52,000 hours

(b) JAYNE BONDE PLC

VARIABLE PRODUCTION COSTS RECONCILIATION STATEMENT FOR MAY

£ £ £

ADV FAV

Materials: 5.5 metres x £8 per metre x 12,000 units produced 528,000

Labour: 4 hours 20 minutes x £6 per hour x 12,000 units produced 312,000

Budgeted variable production costs 840,000

Material price variance 105,000

Material usage variance 48,000

Labour efficiency variance 48,000

153,000 48,000 105,000

Actual variable production costs 945,000

Remember: because we are dealing with costs, adverse variances are added and favourable variances are deducted.

7 1

(c) • As the material price variance is adverse this could indicate that the material is of better quality which has ledto a favourable material usage variance because there is less wastage.

• However, the labour efficiency variance is adverse which may have been caused by the workforce spendinglonger and taking more care with the product; alternatively a lower grade of labour may have been used whichdoes not have sufficient skills.

15.10 (a) Material price variance:


80,000 kg x (£18 – *£15) = £240,000 FAVOURABLE

* £1,200,000 ÷ 80,000 kg

Material usage variance:


£18 x (*76,200 kg – 80,000 kg) = £68,400 ADVERSE

* 15,240 units produced x 5 kg per unit

(b) Labour rate variance:

actual labour hours x (standard rate – actual rate)

15,000 hours x (£12 – *£10) = £30,000 FAVOURABLE

* £150,000 ÷ 15,000 hours

Labour efficiency variance:

standard rate x (standard hours – actual hours)

£12 per hour x (*10,160 hours – 15,000 hours) = £58,080 ADVERSE

* 15,240 units produced x 40 minutes (2/3rd of an hour) per unit

(c) A J DAN PLC: COSTS RECONCILIATION STATEMENT FOR APRIL 2008

£ £ £

ADV FAV

Materials: 5 kg x £18 per kg x 15,240 units 1,371,600

Labour: 40 minutes x £12 per hour x 15,240 units 121,920

Budgeted total cost 1,493,520

Material price variance 240,000

Material usage variance 68,400

Labour rate variance 30,000

Labour efficiency variance 58,080

126,480 270,000 (143,520)

Actual total cost *1,350,000

* Materials £1,200,000 + labour £150,000

Remember: because we are dealing with costs, adverse variances are added and favourable variances are deducted.

(d) The costs reconciliation statement is used to:

– link the budgeted total cost with the actual total cost

– identify whether the actual total cost of output is greater or less than the standard cost of the output

– show the effect of variances on the total budgeted costs

– list the amounts of the variances – and whether they are adverse or favourable – and bring them to theattention of management so that they can take appropriate action

7 2

15.13 (a) Sales price variance:


18,000 units x (£5 – *£6) = £18,000 FAVOURABLE

* £108,000 ÷ 18,000 units

(b) Sales volume variance:


£5 x (20,000 – 18,000) = £10,000 ADVERSE

(c) ZELAH LTD

SALES RECONCILIATION STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-9

£

Forecast sales (20,000 units at £5 per unit) 100,000

add Sales volume variance 18,000

less Sales price variance (10,000)

Actual sales (18,000 units at £6 per unit) 108,000

(d) Sales price variance:

– higher selling price than expected

– less competition, or

– smaller discounts offered to customers

Sales volume variance:

– fewer sold than expected

– either higher price has been charged than competitors

– or competitors are seeking to gain market share by reducing their selling prices

16.4 (a) payback period

7 3

CHAPTER 16 Capital investment appraisal

PROJECT ESS PROJECT TEE

Year Cash Flow Cumulative Cash Flow CumulativeCash Flow Cash Flow

£ £ £ £

0 (100,000) (100,000) (115,000) (115,000)

1 40,000 (60,000) 50,000 (65,000)

2 60,000 – 35,000 (30,000)

3 20,000 20,000 30,000 –

4 20,000 40,000 30,000 30,000

5 *15,000 55,000 *37,500 67,500

* includes scrap value

net present value

(b)

REPORT

To: Managing Director

From: A2 Accounting Student

Date: Today

Capital investment projects: Ess and Tee

This report carries out an appraisal of these two projects, based on the information provided. Two techniquesare used:

• payback

• net present value

The first of these, payback, sees how long it takes for the initial outlay of the project to be repaid by the netcash flow coming in. For Project Ess, the payback period is two years; for Project Tee, it is three years. Usingthis technique, Project Ess is more favourable.

Payback is an easy technique both to calculate and understand. However, it does have the disadvantage ofignoring all cash flows after the payback period. With these two projects, Tee has strong cash inflows in years4 and 5, after the payback period (however, these could be a disadvantage if the project is likely to go out-of-date soon).

The net present value technique relies on discounting relevant cash flows at an appropriate rate of return,which is 10 per cent for these projects. Net present value is a more sophisticated technique than payback inthat it uses all cash flows and takes the timing of cash flows into account. However, the meaning of NPV is notalways clear, and the rate of return required on the projects may vary over their life.

Project Tee has a higher net present value (but also a higher initial cost) at £25,670, when compared with Essat £23,910. The fact that both figures are positive means that either project will be worthwhile. However, ProjectEss is to be preferred because:

– it has the faster payback

– the initial capital outlay is smaller

– it has strong cash flows in the early years, which are likely to be more accurate than the amounts for lateryears

7 4

PROJECT ESS PROJECT TEE

Year Discount Cash Discounted Cash DiscountedFactor Flow Cash Flow Flow Cash Flow

£ £ £ £

0 1.000 (100,000) (100,000) (115,000) (115,000)

1 0.909 40,000 36,360 50,000 45,450

2 0.826 60,000 49.560 35,000 28,910

3 0.751 20,000 15,020 30,000 22,530

4 0.683 20,000 13,660 30,000 20,490

5 0.621 15,000 9,310 37,500 23,290

Net Present Value 23,910 25,670

16.5 (a)

(b)

REPORT

To: General Manager


Date: Today

Purchase of a new machine for the production department

This report carries out an appraisal of the above project. The proposal to purchase the new machine isacceptable from a financial viewpoint because it returns a positive net present value of £13,508 at a discountrate of 10%. This calculation assumes that all cash flows occur at the end of each year.

The payback period is during year 3. Assuming even cash flows during the year, the payback period is 2 yearsand 8.9 months/2 years and 38.6 weeks/2 years and 270.8 days. This is acceptable since it is shorter than thecompany requirement of three years, although there is not a great deal of room for error in the cash flowcalculations.

7 5

THE CHESTER CARPET COMPANY

Working paper for the financial appraisal of a new machinefor the production department

DISCOUNTED CASH FLOW

Year Cash Flow Discount Factor Discountedat 10% Cash Flow

£ £

0 (65,000) 1.000 (65,000)

1 17,000 0.909 15,453

2 25,000 0.826 20,650

3 31,000 0.751 23,281

4 *28,000 0.683 19,124

Net Present Value 13,508

* £24,000 + £4,000 scrap value

PAYBACK PERIOD

Year Cash Flow CumulativeCash Flow

£ £

0 (65,000) (65,000)

1 17,000 (48,000)

2 25,000 (23,000)

3 31,000 8,000 £23,000* required

4 28,000 36,000

* £31,000 – £8,000

Payback period = 2 years + (£23,000/£31,000) = 2 years and 8.9 months/2 years and 38.6 weeks/2 years and 270.8 days

16.6 (a) The net cash flows are:

£

year 0 (110,000)

year 1 20,000

year 2 60,000

year 3 80,000

year 4 80,000

year 5 85,000

payback period

The development costs are recovered in the first half of year 3: £20,000 + £60,000 + (£30,000/£80,000). Thus thepayback period is 2 years and 4.5 months/2 years and 19.5 weeks/2 years and 136.9 days. Note that these assumeeven cash flows during the year.

net present value

7 6

Year Cash Flow CumulativeCash Flow

£ £

0 (110,000) (110,000)

1 20,000 (90,000)

2 60,000 (30,000)

3 80,000 50,000 ∴ £30,000 required

4 80,000 135,000

5 85,000 220,000

Year Cash Flow Discount Factor DiscountedCash Flow

£ £

0 (110,000) x 1.000 (110,000)

1 20,000 x 0.909 18,180

2 60,000 x 0.826 49,560

3 80,000 x 0.751 60,080

4 80,000 x 0.683 54,640

5 85,000 x 0.621 52,785

Net Present Value 125,245

(b)

REPORT

To: Managing Director


Date: Today

Development of new product: ‘Zelahcold’

This report carries out an appraisal of the project, based on the information provided.

It would be relevant to know:

1. whether there are any additional cash flows beyond year 5

2. whether the introduction of ‘Zelahcold’ will affect sales of our existing products

The net present value technique relies on discounting relevant cash flows at an appropriate rate of return –10 per cent for this project.

The proposal to develop the new product is acceptable from a financial viewpoint because it returns a positivenet present value of £125,245 at a discount rate of 10 per cent. This calculation assumes that all cash flowsoccur at the end of each year.

The payback period is 2 years and 4.5 months/19.5weeks/136.9 days. These calculations assume even cashflows during the year.

Both project appraisal methods show that the project meets with the company’s criteria of:

• a positive net present value at a discount rate of 10 per cent, and

• a maximum payback period of three years

These show that, from a financial viewpoint, the project should be carried out.

16.7 (a) Net cash inflow per month:

£

14,000 units at £90 each 1,260,000

less total costs 1,130,000

cash inflow per month 130,000

∴ cash inflow per year £130,000 x 12 1,560,000

Payback period:

cost of machinery = £2,400,000 x 365 days =

cash flow per year £1,560,000

561.54 days = 1 year, 196.5 days

Tutorial note: the examiner will also accept the answer given in weeks, 1 year and 28 weeks, and months, 1 year and6 months.

(b) Any two limitations of payback:

• all cash flows after the payback period are ignored

• within the payback period the timing of receipts and payments is not considered

• the effects of inflation are ignored

• the time value of money is ignored

• the life of the asset is not considered

7 7

16.9 (a)

current production (units) per year x 120% x profit per unit = cash flow per year

6,000 units per year x 120% x £20 profit (£80 – £60) = £144,000 per year

(b) On the basis of net present value, the new machine should be purchased.

Advantages:

– There is a positive net present value over the four years for which information is given.

– There is a further six years when, subject to economic conditions, cash flow should continue to be generated.

– Payback is 2 years and 157 days, leaving a further 7.5 (approx) years to generate cash flow.

Disadvantages:

– Can purchase of the new machine be justified when the old machine has four years’ economic life remaining?

– Will the quality of the output from the new machine be as good as/better than from the old machine?

– Will Roberta be able to sell the increased output of 1,200 units per year? If not, and output/sales continue at 6,000units per year, cash flow will be £120,000 per year. This gives a payback of 2 years and 335 days, and a negativenet present value of £440 at the end of year 4.

– Will the market continue for the product over the next ten years?

– The new machine will need financing – is this available?

– Will there be any proceeds from the sale of the old machine?

– The cost of capital is high at 14% – is lower cost finance available?

– Borrowing will increase the gearing of the business and may make it less attractive to investors.

– The estimates of cash flows may be inaccurate.

– Staff may need to be retrained.

16.12 (a) Year Machine A Machine B

£ £

0 (30,000) (80,000)

1 *18,000 †30,000

2 *18,000 †30,000

3 – †30,000

Expected total net cash flow 6,000 10,000

* 12,000 cakes x (£3.00 – £1.50) = £18,000

† 15,000 cakes x (£3.00 – £1.00) = £30,000

7 8

Net present value of new machine


£ £

0 (350,000) x 1.000 = (350,000)

1 144,000 x 0.877 = 126,288

2 144,000 x 0.769 = 110,736

3 144,000 x 0.675 = 97,200

4 144,000 x 0.592 = 85,248

Net Present Value = 69,472

(b) Net present value

(c) On the basis of net present value, Machine A should be purchased and Machine B should be rejected because of itsnegative net present value.

Reason:

Machine A has a positive net present value and the initial cost is much less than Machine B. However,

– the net present value is not large and the estimates of revenues and costs may be inaccurate.

– if the cost of capital increases, the positive net present value could disappear.

– will there be any proceeds from the sale of the old machine?

– if Beard Bakeries Ltd needs to borrow to finance the machine, the company’s gearing will increase and may makethe company less attractive to investors.

17.1 (a) Benefits of budgetary control• planning – using a formal framework of budgets to predict future activities and potential problems

• co-ordination – individual budgets are integrated into the master budget

• control – comparison of actual results against the budget

• communication – between the owner and staff to achieve the objectives of the business

• motivation – of staff to ensure that budgets are met

• evaluation of performance – to see where improvements can be made

• decision-making – about production, sales and costs

(b) Any three budgets

• sales budget

• production budget

• purchases budget

• debtor budget

• creditor budget

• cash budget

The most likely three budgets for a small business such as AggieSurf would be cash, sales and production

(c) Relevant factors when implementing budgetary control

• costs and benefits – benefits must exceed the cost of budgetary control

• accuracy – of information used

• demotivation – of staff may occur if they have not been involved in planning the budget and/or where budgetsare set at too high a level

• disfunctional management – ensure that the budgets co-ordinate

• set too easy – ensure that budgets are set at realistic levels to enable the business to use its resources to bestadvantage

• may restrict activities – budgets may be inflexible so that staff are unable to take advantage of opportunities

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CHAPTER 17 Further aspects of budgeting


Machine A Machine B Machine A Machine B

£ £ £ £

0 (30,000) (80,000) x 1.000 = (30,000) (80,000)

1 18,000 30,000 x 0.909 = 16,362 27,270

2 18,000 30,000 x 0.826 = 14,868 24,780

3 – 30,000 x 0.751 = – 22,530

Net Present Value = 1,230 (5,420)

17.3 (a)purchases budget

April June August and October and December February

and May and July September November and January and March

£000 £000 £000 £000 £000 £000

Sales 40.0 35.0 30.0 20.0 10.0 10.0

Margin 10.0 8.75 7.5 5.0 2.5 2.5

Purchases 30.0 26.25 22.5 15.0 7.5 7.5

(b) (i) Debtor collection period

Formula: Debtors x 365 days (or 52 weeks or 12 months)Credit sales

Year ended 31 March 2003:

£12,000 x 365 days = 29.2 days£150,000


£14,000 x 365 days = 35.2 days£145,000*

* (£20,000 x 3 months) + (£15,000 x 4 months) + (£5,000 x 5 months)

(ii) Creditor payment period

Formula: Creditors x 365 days (or 52 weeks or 12 months)Credit purchases


£11,000 x 365 days = 36.5 days£110,000


£10,000 x 365 days = 33.6 days£108,750*

* see purchases budget

(c) Debtor collection period:

• debtor days have increased by six days

• this means that customers are taking longer to pay

Creditor payment period:

• creditor days have reduced by almost three days

• this means that suppliers are being paid earlier

Recommendation:

• encourage debtors to pay quicker

• delay payments to creditors

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17.4 (a)

ROBERT ADAMS

Production budget for periods 1 – 3

Period 1 Period 2 Period 3

units units units

Sales 13,600 12,400 12,000

Opening stock (3,400) (3,100) (3,000)

Closing stock 3,100 3,000 2,700

Production 13,300 12,300 11,700

Tutorial note: the closing stock for each period is one-quarter of the next period’s expected sales.

(b) Budgeted closing stock at end of period 3 2,700 units

Actual closing stock at end of period 3 2,500 units

Stock lost during periods 1 – 3 200 units

(c) Any two limitations of budgetary control:

• costs and benefits – the benefit must exceed the cost of budgetary control

• accuracy – some information used in the budget may be inaccurate and may distort the budget

• demotivation – of staff who have not been involved in planning the budget, or who are set too high a level toachieve

• dysfunctional management – where different sections of the business are not co-ordinated there may bedepartmental rivalry

• set too easy – where budgets are set at too low a level they will not enable the business to use its resources tobest advantage

• may restrict activities

(d) Debtor collection period = Debtors x 365 days (or 52 weeks or 12 months)

Credit sales

Total sales for periods 1–3 at £1 per football £38,000

14% of sales is £5,320

∴ Debtor collection period = £5,320 x 365 days = 51.1 days

£38,000

(e) • A longer period of credit can be offered to customers.

• The amount of cash discount for prompt payment can be reduced so that customers have less incentive to payquickly.

• Both of the above will delay receipt of payment by customers.

• As a result, the bank balance will be reduced or an overdraft will be increased.

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17.6 (a)

SU LING LTD

Labour budget for months 1 – 3

Month 1 Month 2 Month 3

Production in units 2,100 2,400 3,000

Labour hours at 6 hours per unit 12,600 14,400 18,000

Labour hours available 15,000 15,000 15,000

Surplus/(shortfall) of labour hours 2,400 600 (3,000)

(b) • Total cost without using part-time labour:

(12,600 hours + 14,400 hours + 15,000 hours) x £8 per hour = 42,000 hours x £8 = £336,000

• Total cost with the use of part-time labour:

£336,000 + 3,000 part-time hours at £14 per hour = £336,000 + £42,000 = £378,000

∴ percentage increase in total cost:

£378,000 x 100 = 112.5% = 12.5% increase

£336,000

(c) • The surplus of labour hours in months 1 and 2 could be used to manufacture stock in advance of month 3.

• This additional stock would need to be stored until month 3.

• The costs of manufacturing the stock earlier will have to be paid.

• The management of Su Ling Ltd need to consider whether it is cheaper to manufacture earlier, with its attendantcosts, or whether to pay the higher rate for part-time labour in month 3.

• The main limitation of using the labour budget in this way is that much depends on the accuracy of future salesforecasts, as this will affect the production budget. If the sales forecasts are over-stated, goods will bemanufactured needlessly and may remain unsold, thus incurring extra storage costs, or have to be scrapped if thegoods have a limited life (eg perishable goods).

17.7 (a)

debtor budget

Jan Feb Mar Apr May Jun Total

£ £ £ £ £ £ £

Opening debtors 65,500 60,550 61,050 65,600 69,500 73,200 65,500

Credit sales 38,300 39,500 42,400 45,000 47,400 44,700 257,300

Receipts (42,400) (38,100) (37,400) (40,600) (43,200) (45,800) (247,500)

Discount allowed (350) (400) (450) (500) (500) (400) (2,600)

Bad debts written off (500) (500) – – – – (1,000)

Closing debtors 60,550 61,050 65,600 69,500 73,200 71,700 71,700

(b)

creditor budget

Jan Feb Mar Apr May Jun Total

£ £ £ £ £ £ £

Opening creditors 42,400 39,130 40,730 41,410 42,830 40,870 42,400

Credit purchases 19,500 22,300 22,500 24,000 22,600 23,400 134,300

Payments (22,600) (20,500) (21,600) (22,300) (24,300) (23,200) (134,500)

Discount received (170) (200) (220) (280) (260) (270) (1,400)

Closing creditors 39,130 40,730 41,410 42,830 40,870 40,800 40,800

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17.10 (a) Difference between cash and profit:

• cash is the actual amount of money held in the bank or as physical cash (eg in a cash till)

• profit is a calculated figure which shows the surplus of income over expenditure for the period; it takes note ofadjustments for accruals and prepayments and non-cash items such as depreciation and provision for doubtfuldebts; it does not include capital expenditure (ie the purchase of fixed assets), or owner’s drawings/dividends

(b) Possible reasons for a bank overdraft when profits are being made:

• capital expenditure – the purchase of fixed assets reduces cash, but profit is affected only by the amount ofdepreciation on the asset

• increase in debtors – with more goods sold, profits will increase but, until debtors pay, there is no benefit to thebank balance

• decrease in creditors – if creditors have been paid earlier there will be no effect on profit, but a bank overdraft willincrease

• increase in stock – with more stock purchased there will be an increase in profit as it is sold, but paying for thestock will increase the bank overdraft

• prepayment of expenses made at the year end – no effect on profit as the prepayment is an expense for next year,but the bank overdraft will increase

• repayment of a loan – no effect on profits (although loan interest may be reduced), but the bank overdraft willincrease

• drawings/dividends – no effect on profit, but the bank overdraft will increase

(c)

(d)

(e) Other budgets: • purchases budget • debtor budget • creditor budget

(f) Tutorial note: see also Chapter 18• No pay rise

– workforce will be demotivated– may understand that it is needed for job security– some may seek alternative employment

• An increase in the working day– workforce will become tired at the end of the day– workforce will be demotivated and stressed– quality of output may suffer– health and safety issues, particularly when working with machinery– some may seek alternative employment

• A reduction in overtime rates– workforce will not work overtime– output is likely to be reduced, leading to reduced sales and profit– job security may be at risk if overtime not worked

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SALES BUDGET

March April May June July

Parts (units) 200 200 260 260 260

Revenue (£) £4,800 £4,800 £6,240 £6,760 £6,760

PRODUCTION BUDGET IN PARTS (UNITS)


Sales 200 200 260 260 260

Opening stock (20) (20) (26) (39) (39)

Closing stock 20 26 39 39 39

Production 200 206 273 260 260

17.13 (a) production budget (units/surfboards)

(b) cash budget

Tutorial notes:

• The selling price of each board increases to £190 from 1 June

• Net cash flow is receipts from sales less payments for expenses

• Drawings have been shown in the bank summary, but could be included amongst the payments

• Other layouts of the cash budget are acceptable in the examination

17.14 (a) Potter and Son Ltd

Forecast trading and profit and loss account for the year ending 31 March 2004

£ £

Sales (312,500 units at £13.60 each) 4,250,000

Opening stock (20,000 units) 200,000

Purchases (317,500 units at £9.00 each) 2,857,500

3,057,500

Less Closing stock (25,000 units) 225,000

Cost of sales 2,832,500

Gross profit 1,417,500

Less expenses:

Overheads (£1,080,000 x 106.25%) 1,147,500

Net profit 270,000

Tutorial notes:

• Units of closing stock are 8% of sales: at 31.03.2004 312,500 units x 8% = 25,000 units.

• Closing stock at 31.03.2003 had cost £10 per unit (£200,000 ÷ 20,000 units), so purchases for the year ended31.03.2004 will be £10 x 90% = £9 per unit.

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Sales 16 16 28 40 40

Opening stock – (24) (48) (60) (44)

Closing stock 24 48 60 44 28

Production 40 40 40 24 24

March April May June July£ £ £ £ £

Sales 2,560 2,560 4,480 7,600 7,600

Variable costs 3,400 3,400 3,400 2,040 2,040

Brother’s wages 800 800 800 – –

Fixed overheads 500 500 500 500 500

4,700 4,700 4,700 2,540 2,540

Net cash flow (2,140) (2,140) (220) 5,060 5,060

Add opening balance 3,200 1,000 (1,140) (1,360) 1,000

Less drawings (60) – – (2,700) (5,060)

Closing balance 1,000 (1,140) (1,360) 1,000 1,000

(b) • The forecast profit – both gross and net – can be calculated and compared with the actual profit of the previousyear.

• The forecast profit shows the effect of changes in the selling price, volume of units sold, the buying price, and inoverhead expenses. Here the forecast profit is reduced by £190,000 from the actual profit of the previous year.

• Management can take action by reviewing their selling and buying prices, and overhead expenses.

• Corrective action can be taken in advance if the forecast operating statements show a loss.

• The actual gross and net profits for the year can be compared with the forecast profits, and any differences canbe investigated.

18.2 (a) Increase in total contribution resulting from the change in paint supplier

Original contribution = (£190 – £140) x 12,000 sheds = £600,000

New paint = (£190 – £118*) x 12,000 sheds = £864,000* £140 – £22 saving

Increase in total contribution = £264,000

(b) Points raised in the discussion might include:

• an increased contribution which, once fixed costs have been paid off, becomes profit

• the increase in contribution could be used to reduce the selling price to stimulate sales

• increased funds generated could be used to invest in the business

• the break-even point will be reduced

• the margin of safety will be increased

The possible downsides are:

• the need to investigate the fact that the paint is only ‘rumoured’ to be harmful to wildlife – this has to be substantiated

• possible bad publicity from environmental activists and loss of customers if product is then seen to be environmentally unfriendly

• extra costs incurred in dealing with potentially harmful paint (safety procedures)

18.4 The suggested answer from the textbook is shown below. The question, however, requires the students to explainthis term in their own words.

‘Social accounting’ is the term used to describe the way in which businesses are accountable and responsible tosociety as a whole. Social accounting requires that businesses should not be driven just by the profit motive butshould also consider the wider implications of their decisions. The issues which involve social accounting can beinternal, eg the demands of the workforce, or they can be external. External factors can be economic (providing localemployment), ethical (not selling high nicotine cigarettes to developing countries), political (not selling goods tooppressive governments), legal (employment law) or environmental (using renewable resources or not polluting theatmosphere).

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CHAPTER 18 Decision-making and social accounting

answers to textbook questions

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