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Accounting for Decision Making. Sect 1-4

Accounting for Decision Making. Sect 1-4. Business Activities Operating Investing Financing. Accounting Measuring Recording Reporting Analysing. Business Decisions. Identifying Economic information for decisions and

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Accounting for Decision Making. Sect 1-4

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  1. Accounting for Decision Making. Sect 1-4

  2. Business Activities Operating Investing Financing Accounting Measuring Recording Reporting Analysing Business Decisions Identifying Economic information for decisions and Measuring about an entity informed judgments Communicating Accounting is the process of: Topic 1: Accounting information & managerial decisions Accounting is the link between business activities and business decisions as illustrated in the diagram below. Ingram et al (2005:59)

  3. Accounting information Traditional Financial Accounting Information Non-financial Information • Financial Information • Balance sheet • Income statement • Cost of goods • Manufactured • Gross profit • Operating expenses • Other quantitative information • Percentage of defects • Number of customer complaints • Warranty claims • Units of inventory • Qualitative information • Customer satisfaction • Employee satisfaction • Product or service quality • Reputation Topic 1: Accounting information & managerial decisions Source: Jackson and Sawyers (2006: 5)

  4. Topic 1: Accounting information & managerial decisions The Decision-making Model Step 4: Select the best position Step 3: Identify and analyse available options Step 2: Identify objectives Step 1:Define the problem

  5. Topic 2: Financial Statements & Accounting concepts The flow from transactions to financial statements can be illustrated as follows: Transactions Financial statements Procedures for sorting, classifying, and presenting (bookkeeping) Selection of alternative methods of reflecting certain transactions (accounting) The financial statements and what they are intended to report on are as follows:

  6. Topic 2: Financial Statements & Accounting concepts

  7. Topic 2: Financial Statements & Accounting concepts

  8. Topic 2: Financial Statements & Accounting concepts

  9. Topic 2: Financial Statements & Accounting concepts

  10. Topic 2: Financial Statements & Accounting concepts

  11. Topic 2: Financial Statements & Accounting concepts Direct Method Shows the major classes of gross cash receipts and payments. This method starts with Revenues and Expenses while also including Current Assets as well as Current Liabilities. Indirect Method Shows the net profit or loss as a starting point and makes adjustments for all transactions of a non-cash items.

  12. Topic 3: Accounting & Presentation

  13. Topic 3: Accounting & Presentation

  14. Topic 3: Accounting & Presentation

  15. Periodic LIFO of Corner Shelf Bookstore:

  16. Perpetual LIFO of Corner Shelf Bookstore:

  17. Topic 4: Income statement & Cashflow The following table represents a framework of the main items that are reported in an Income Statement.

  18. Cost of goods sold in arriving at gross profit: Gross profit margin is simply the gross profit expressed as a percentage of sales. This ratio is determined as follows: Gross profit margin = = = 30%

  19. Indirect Method:

  20. Direct Method:

  21. Question. You are presented with the following information. IQUAD Ltd Trading and profit and loss statement for the year ended 31 December 2010

  22. IQUAD Ltd Balance sheet at 31 December 2010 Required: Prepare the cash flow statement for the year to 31 December 2010. (20)

  23. IQUAD Ltd Cash flow statement for the year ended 31 December 2010

  24. The following information applies to Trustworthy Enterprises for November 2010: 02 The owner of Trustworthy Enterprises commenced business by investing R65, 000 cash. 06 Purchased equipment for R15, 000 cash. 10 The owner obtained a long-term loan of R30, 000 from the bank. 14 Purchased merchandise on credit for R40, 000. 28 Sold merchandise that cost R15, 000 for R26, 000 on credit. 31 Paid salaries to the employees, R6000. Required: Prepare the Balance sheet of Trustworthy Enterprises as at end November 2010. Prepare the Cash Flow Statement for the month ended November 2010.

  25. a)

  26. (b)

  27. Good luck with your studies

  28. Accounting for Decision Making. Sect 5-8

  29. Sect 5: Cost-volume-profit relationships. • Using CVP analysis, managers would be able to get information to use in decision-making relating to: • How profits are affected by a change in costs. • What effect a change in sales volume will have on profit. • The profit that is expected from a certain sales volume. • How many units need to be sold to achieve a targeted profit. • At what output of production will the income and costs be the same. • Setting selling prices. • Selecting the mix of products to sell.

  30. Calculation of operating profit. Applying these figures in the model results in the following operating profit:

  31. Drop in selling price by R6 and increase in sales volume to 12000 units. The operating profit will be:

  32. Decrease in selling price by R6 accompanied by an increase in advertising expense of R6 000 and an expected increase in sales volume of 19 000 units. Operating profit is expected to be:

  33. Calculating the volume of sales required to achieve a target level of operating profit of R46 000. The required sales volume is 10 500 units (R126 000 / R12).

  34. Greystone CC manufactures one product. The following details relating to the product applies: Required: Calculate the break-even quantity and the break-even value. Calculate the margin of safety in terms of units and value.

  35. Break-even quantity = Fixed costs / Contribution margin per unit = R36 000 / R10 = 3 600 units Total revenue at break-even = Fixed costs / contribution margin ratio = R36 000 / 12,195% = R295 200 (or 3 600 x R82) Margin of safety = Sales units – Break-even sales units (in terms of units) = 6 000 – 3 600 = 2 400 units Margin of safety = Sales – Break-even sales (in terms of value) = R492 000 – R295 200 = R196 800

  36. Operating leverage is calculated as follows: Operating leverage = The formula for the margin of safety is: Margin of safety =

  37. Cost analysis for planning, control and decision-making. • Cost analysis for planning. • Planning is the management process of identifying and quantifying the goals of the organisation. • Strategic planning involves an identification of the long-term goals and drawing up plans to achieve them. • A budget is a plan in financial terms that extends for a period in the future. • Budgeting process. The first step in the budgeting process is to develop and communicate a set of broad assumptions about the economy, the industry and the entity’s strategy for the budget period. • The operating budget is a collection of related budgets comprising the sales forecast (or revenue budget), the purchase/production budget, the operating expense budget, the income statement budget, the cash budget, and the budgeted balance sheet. The operating budget is also called the master budget.

  38. Cost analysis for decision making. • Net Present Value • The difference between the market value of a project and its cost. • How much value is created from undertaking an investment? • The first step is to estimate the expected future cash flows. • The second step is to estimate the required return for projects of this risk level. • The third step is to find the present value of the cash flows and subtract the initial investment. This is to determine whether the project is viable. • Computing NPV for the Project • You are looking at a new project and you have estimated the following cash flows: • Year 0: CF = -165,000 (original investment) • Year 1: CF = 63,120 • Year 2: CF = 70,800 • Year 3: CF = 91,080 • Your required return for assets of this risk is 12%. • Using the formulas: NPV = –NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42

  39. Another way of determining NPV is as follows: • Decision rule. • If the NPV is positive, accept the project. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. • Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. • So, do we accept or reject the project? • NPV is positive at 12% - we can accept the investment!

  40. Internal Rate of Return • Internal rates of return (IRR). • This is the most important alternative to NPV. • It is often used in practice and is intuitively appealing. • It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere. • Definition: IRR is the return that makes the NPV = 0. • Another way of putting it is that the IRR is the discount rate that equates the PV of cash inflows with the initial investment associated with the project. • Decision Rule: Accept the project if the IRR is greater than the required return.

  41. Example: The management of Tiger Engineering are considering the following investment project. The following data is available: Cost of plant and equipment 60 000 Salvage value nil Expected profit/loss Yr 1 (15 000) Yr 2 10 000 Yr 3 35 000 Tiger Engineering uses the straight-line method of depreciation for all fixed assets. The estimated cost of capital is 10% p.a.

  42. Cash flows. ARR ARR = = x100 x 100 = 33.33% NPV

  43. IRR (Where do I get 1274 from? The diff between PV @ 17% and 18%.) IRR = 17.42%

  44. Quick example. • Suppose an investment will cost $90,000 initially and will generate the following cash flows: • Year 1: 132,000 • Year 2: 100,000 • Year 3: -150,000 • The required return is 15%. • Should we accept or reject the project? • Hurdle rate is 15%.

  45. EC Industrials manufactures a product, Brainagra that sells for R126 each. The cost of producing and selling 240 000 units are estimated as follows; Variable costs per unit: Direct materials R30 Direct labour R18 Factory overhead R12 Selling and administrative expenses R15 R75 Fixed costs: Factory overheads R3 200 000 Selling and administrative expenses R1 200 000 In the current year, to date 180 000 units were manufactured and sold. An additional 45 000 units are expected to be sold on the domestic market during the remainder of the year. EC Industrials received an offer from Namibia Wholesalers for 12 000 units of Brainagra at R84 each. Namibia Wholesalers will market the product in Namibia with its own name brand and no additional expenses will be incurred by EC Industrials. The sale to Namibia Wholesalers is not expected to affect domestic sales of the product and the additional units could be produced during the current year using excess capacity. As the Marketing Manager you are requested to make a decision to either accept or reject the above proposal and to motivate the decision you have made. (15)

  46. A comparison of the sales offer of R84 with the selling price of R126 indicates that the offer should be rejected. EC Industrials, however, has excess capacity and the focus should be on the relevant cost, which is the variable cost. The difference in the profit from accepting the offer is calculated as follows: Differential Revenue from accepting the offer: 12 000 units @ R84 R 1 008 000 Differential cost by accepting the offer: 12 000 units @ R60 (R30 + R18 + R12) (R 720 000) Differential profit from accepting the offer 288 000 The offer should therefore be accepted.

  47. The following information relates to two projects, Project A and Project B from which one must be chosen by Construction International. After-tax cash flows Year Project A Project B 1 0 36 000 2 18 500 36 000 3 36 200 36 000 4 123 000 36 000 Both projects require an initial investment of R117 700 As the project manager of Construction International you are required to: 3.1 Calculate the Net Present Value (NPV) for each project using a discount rate of 12%. Which project would you use choose? Why? 3.2 Calculate the Internal Rate of Return (IRR) for both projects. Which project should be chosen? Why (20)

  48. PROJECT A • YearCash InflowDiscount FactorPresent Value • 1 0 0.8929 0 • 2 18 500 0.7972 14 748 • 3 36 200 0.7118 25 767 • 123 000 0.6355 78 611 • Total Present Value 119 126 • Investment 117 700 • NPV (positive) 1 426 • PROJECT B • Net Inflow R 36 000 • Discount factor x 3.0373 • Total Present Value 109 342 • Investment 117 700 • NPV (negative) 8 358 • DECISION: • Project A should be chosen because the NPV is positive. Reject Project B because it has a negative NPV.

  49. PROJECT A • Choosing the discount factor: • Step 1 • Since we know the NPV is positive and above zero, although by a small margin, pick a higher discount rate e.g. 13% (Trial and error is used to obtain the higher rate). • Step 2 • Year Cash Discount Discount Present Present • Inflow Factor Factor Value Value • 12% 13% 12% 13% • 1 0 0.8929 0.8850 0 0 • 2 R 18 500 0.7972 0.7831 R14 748 R14 487 • 3 R 36 200 0.7118 0.6931 R25 767 R25 090 • 4 R123 000 0.6355 0.6133 R78 166R75 435 • Total PV R118 681 R115 012 • Investment (R117 700)(R117 700) • NPV R 981 (R2 688)

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