Business & Finance PDF

Cambridge International Diploma in Business
at Advanced Level
Business Finance
Business Finance
Advanced Version
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from Select Knowledge learning materials
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Select Knowledge Limited Page ii
Select Knowledge Limited
Contents
Introduction v
Section 1 1
Financial organisations and funding methods 3
Section 2 63
Keeping records 65
The accounting equation 87
The rules of accounting 95
The financial statements 109
The accounting cycle 136
Merchandising businesses 155
Section 3 191
The changing roles of finance directors 193
The financial information highway 209
Cost information 233
Analysing costs in detail 245
Controlling costs 275
Section 4 299
Preparing budgets 301
Using budgets 327
Budgetary control 351
Section 5 385
Financial statements 387
Interpreting profit and loss 417
Constructing a balance sheet 425
Analysing a balance sheet 431
The combined financial picture 439
Measuring financial performance 445
Making adjustments 455
Tracking planned and actual performance 469
Glossary 495
Contents Page iii
Select Knowledge Limited Page iv Contents
Select Knowledge Limited Introduction Page v
Introduction
The aim of this workbook is to take the student step by step through the assessment
objectives and competence criteria for this particular module.
The sections correspond to each of the assessment criteria wherever possible; however, in
some situations a number of competence criteria are dealt with in a logical manner linking
topics together to provide a broader understanding. The result of this is that some criteria
are not in the strict order provided by the syllabus. This may create the impression that
some of the competence criteria have been neglected. This is not the case and working
through the entire workbook will ensure that the entire range of competence criteria is
covered.
Students should work through the workbook in the order laid out, attempting all of the tasks
provided in order to test their understanding and knowledge.
There are major differences between the Standard and Advanced levels in terms of content
but, more importantly, the skills and knowledge required for the Advanced level are greater
and the depth of understanding for all of the competence criteria is far more demanding.
This workbook, whilst covering the competence criteria, should not be seen as the only
source of study for this module or the perfect text for this work. It provides a good source of
information which provides the opportunity to develop the skills and knowledge of the
individual in order to better attempt the assessment that follows at the end of the course.
Note that the figures in this workbook are nearly all expressed in dollars. While they may
not closely resemble prices in your country, they are based on real case studies and are
intended to show the processes involved in such contexts.
Select Knowledge Limited Page vi
Select Knowledge Business Finance Page 1
Section 1
Page 2 Business Finance Select Knowledge
Financial organisations
and funding methods
Introduction
We live in a complex society. For example, you have skills and experience in a particular
field and are likely to work for a particular organisation. But in your job you probably use
many kinds of materials, equipment, goods and expertise which are provided by other
people and other organisations. And outside of work you, like everyone else, buy food,
clothing, housing and so on from a variety of companies, individuals and public bodies.
In this section we will begin by looking at the main types of organisations in the United
Kingdom. Then well examine the different ways in which these organisations can be
funded.
Types of organisation
Imagine you have taken a job in Largetown, and have just bought a house a few miles
outside the town. You wake up one Saturday morning and decide to get a few jobs done.
During the course of the day, you come into contact with quite a few types of organisation.
First, you ring up a plumber, Plumbers and other tradespeople
because you want a new bath often operate as sole traders.
fitted. This simply means they are self-
employed, and are running their own
businesses.
You then decide to pop into Public libraries and other public
your local public library. services are run by local government
and are examples of public sector
bodies.
Next, you go to the station to Most trains in the UK are now
catch a train to Largetown. operated by limited companies.
Previously they were run by British Rail
which was a kind of public sector body
known as a nationalised industry.
When you arrive in Largetown, Solicitors frequently work in
you call in on the firm of partnerships.
solicitors which has been doing
the conveyancing on your
new house.
Then you decide to do some Many shops (and most businesses)
shopping. trade as limited companies either
private limited companies
(e.g. Jones and Co. Ltd) or public
limited companies (such as Marks
and Spencer plc).
You might also call in on your local
shop which could be run under a
special kind of business arrangement
called a cooperative.
Sole traders
The sole trader also called a sole proprietor or sole owner owns and controls his or
her own business. No one else has a share in it, no one else has a claim on the profits,
and no one else is responsible for any debts. If anything goes wrong and the business
gets into debt, then any or all of the sole traders possessions, including their house and
furniture, can be sold to pay off the debts. This means that the sole trader has unlimited
liability.
Many small businesses are run as sole trader organisations, for example small shops,
garages and hairdressers. You may know a number of tradespeople, such as electricians
and dressmakers, who work for themselves.
Partnerships
A partnership is legally very similar to a sole trader business, except that partners share
the responsibilities and the profits. Partnerships, like sole traders, have unlimited liability.
Many professional groups such as doctors, architects and accountants form partnerships.
People often form partnerships to share the costs, and because their individual areas of
expertise may complement those of their partners. One person, for instance, may be
skilled at administration, and another at selling.
But partnerships are not always successful, simply because the partners may disagree
from time to time. Partners usually have a contract, called a partnership agreement,
which sets out their obligations to one another, and defines what happens should one
partner want to leave.
Limited companies
Sole traders or partners are liable for all the debts of their business. A limited company,
on the other hand, exists separately from its owners, who arent liable for its debts. The
most common type of limited company is set up when its capital is divided into shares of
a certain value $1 each, say. To become a member or shareholder, a person must buy
one or more shares. Shareholders hope to share in the profits of the company by receiving
dividends, but they can lose no more than the amount of money they have invested (or
promised to invest) in the shares. Shares can usually be bought and sold at any time
without affecting the running of the company.
Look at the following case study.
If Tom has some shares, does this make him an owner of the Yes / No
company?
Could Gareth expect Tom, as a shareholder, to pay him the money Yes / No
he was owed?
However sorry Tom felt for Gareth, he was not liable for the companys debts just because
he owned shares in it. This limited liability is one of the advantages of being a member
of a limited company.
But unlike sole traders and partners, shareholders dont run the business. Instead, they
help to elect a board of directors to run the company for them.
By law, a limited company must produce annual accounts and these must be audited.
Shareholders can vote at the companys annual general meeting. The attendees of this
meeting will usually be asked to accept the accounts, approve the dividend payout (if
there is one), reappoint or elect new directors and reappoint the auditors.
There are two kinds of limited company: private and public.
Private limited companies
A private limited company has the word Limited (shortened to Ltd) after its name. Its
shares are sold privately, sometimes within a family or group of friends.
Public limited companies
A public limited company has plc after its name meaning public limited company.
Shares of a plc are on offer to the public, usually through the medium of a stock exchange,
which is a formalised market for share dealings. In the UK, shares must be stated in
terms of a fixed nominal amount, although they may change hands at a higher or lower
price than this. Plcs are required to have a share capital the nominal value of all the
shares of 50,000 or more. The risk for shareholders is limitied to the amount of their
investment in the company which, in the eyes of the law, is a separate legal entity.
Gareth Williams was a self-employed painter and decorator. He took on a job with Killy
and Co. Ltd, a building company, which lasted for several months. It meant that Gareth
had to supply his own tools and overalls, and live away from home at his own expense,
but he was glad of the work. The agreement was that Gareth would be paid at the end of
every month, but Killy and Co. Ltd got further and further behind with these payments.
Gareth went to see Tom Benthall, Killys site manager, who said he was sorry, but that the
company was short of cash. When Tom mentioned that, besides working for the company,
he also owned a few shares, Gareth said: If you have shares, you are one of the owners.
That means you owe me money.
CASE STUDY
Cooperatives
Cooperatives are businesses which are owned by the workers who produce the goods
or services (producer cooperatives) or by the customers who buy the goods (retail
cooperatives).
Producer cooperatives are usually small organisations owned by groups of people involved
in the same type of business (for example, printing, market gardening, and so on). Such
workers have all put some of their own money into the business and they are all involved
in making decisions about the business.
Retail cooperatives include the chain of Co-op shops which are found all over the UK.
They are owned by their customers who can buy shares in the business although the
everyday running of its business is conducted by a management committee chosen by
the shareholders.
Public sector bodies
There are two main types of public sector organisation: those controlled by central
government, including nationalised industries, and those run by local government.
Nationalised industries
The political parties in the UK have traditionally had opposing views on whether major
industries should be run by the state or as independent business organisations.
In the UK the post-war Labour government undertook a chain of nationalisation measures,
carrying through nine Acts of Parliament between 1946 and 1951. Among the institutions
and industries which were brought into public ownership at that time were:
the Bank of England civil aviation*
coal transport
electricity* gas
iron and steel * public corporations
Much of this nationalisation in the UK has now been reversed. From the beginning of the
1980s, it was Conservative government policy to privatise nationalised industries, turning
them into public limited companies operating as commercial enterprises.
Examples of companies in private ownership that were once in the public sector include:
British Airways
British Steel
British Gas
British Telecom (BT)
Powergen and National Power (formerly the Central Electricity Generating Board)
The Bank of England is the only one that remains in the hands of the state.
Many of the privatised companies are huge monopolies, because there is no effective
competition for them. However, they are still subject to public scrutiny through government
appointed watchdogs such as:
OFGAS, which keeps an eye on British Gas, and
OFTEL, which monitors BT
There has also been a trend towards introducing greater competition and commercial
accounting into public services in the UK, such as the National Health Service.
What type of organisation do you work for?
Who owns the organisation?
Who controls the organisation and makes the major decisions?
Who is this person or group of people answerable to?
Who receives the profits from the business?
Who is responsible for keeping your organisations financial records? Is it one person or a
department or section? Who else in the company contributes financial information?
ACTIVITY 1.1
Legal forms of business
Think about the legal forms of business that you could trade under. Review the potential
advantages and disadvantages of each form to arrive at a considered decision.
Sole trader
Advantages: Disadvantages:
Partnership
Limited company
Cooperative
ACTIVITY 1.2
My first thoughts on my trading status will be to trade as a:
for the following reasons:
1
2
3
4
5
Conduct this final review before committing yourself to a trading status.
Write a short response to the following questions:
1 What effect will your trading status have on:
your lenders?
your customers?
2 Is there anyone else to share the workload, the responsibility for actions, and the financial
risk?
3 Do you want or need to share it?
Give reasons for saying yes or no. This group of reasons either commits you to form a
partnership, or reflects that possibility.
4 From the above questions, can you detect any need to limit your liability in other
words to form a limited company? If not, you will probably simply become a sole trader.
Discuss your reasons briefly in the space below.
ACTIVITY 1.3
Further legal aspects of setting up
a business
Limited liability companies
If you are the owner of a limited liability company you will have responsibilities, as a
director, to ensure that the company is solvent and managed within the requirements of
the Companies Acts. This will require regular meetings to be kept and recorded, annual
reports to be made available to the Registrar of Companies, and records and accounts
to be maintained to the standards required. More details can be obtained from the Institute
of Directors or Companies House.
Financial and status considerations are not the only legal matters that an owner-manager
must consider. There are also other legal considerations to be taken into account as
follows.
National Insurance
If you intend to trade as a sole trader or partnership in the UK you will need to pay
National Insurance contributions as a self-employed person. If you intend to trade as a
limited company, you will be an employee of the company and pay National Insurance
contributions accordingly.
HMRC (Her Majestys Revenue and Customs)
In the UK you will need to notify the HMRC that you are starting up in business. As a self-
employed person your liability for tax will be based upon the profits of your business. You
will be required to submit a statement each year to the designated Inspector of Taxes
who will assess the tax due.
For a limited company in the UK, the company will be assessed for corporation tax on a
similar basis and will deduct tax from employees for the HMRC. You can appoint your
accountant to deal directly with the tax office, but it remains your responsibility.
Value Added Tax (VAT)/local taxes
If the goods or services you sell are subject to VAT or a local tax and your turnover
exceeds a stipulated level, you will be required to register with the tax agency and collect
the tax for them.
Health and safety
We are all affected by the health and safety at work legislation and if you have premises
or employ people, there will be particular responsibilities that you need to be aware of.
Some premises may also need fire certificates your local fire brigade will help.
Licences
Some businesses (e.g. restaurants) need licences to operate. These licences are issued
by regulating bodies (e.g. the local authority).
Consumer protection
Many countries have laws regarding consumer credit which require businesses offering
credit or hire purchase facilities to be licensed.
There are also laws in many countries regarding consumer protection which makes
providers of products for private use liable for injury or damage caused by defects. You
need to be aware of the potential implications to your business.
Data protection
If you intend to keep personal information about other people on your computer, you will
need to register with the Data Protection Register. People concerned also have a right of
access to check the accuracy of any information kept by you about them.
Employment law
If you employ people you will be required to have employee liability insurance and must
abide by the range of legislation concerning the employment of people (e.g. Contract of
Employment Act, etc.).
Describing products
In the UK the Trade Descriptions Act makes it illegal to apply a false description to a
product or service which is likely to mislead potential customers.
Contract law
The law here is complicated. Even if you are able to find a suitable contract for your own
business pursuits, say, with clients, upholding it in the courts is very difficult.
However, there are a number of areas you can and must protect, namely:
Copyright get a contract lawyer to make you a good contract, ensuring that the
work is really that of the author who sells it to you and that he or she passes his or
her copyright to you. This applies particularly in fields such as publishing and
marketing.
Inventions you will have to register your patent or invention if you create something
new. The Department of Trade and Industry will give you details.
Trademarks these have to be registered if you want to stop anyone else using
them.
The best advice for a business wanting contracts with customers is to jointly create a
relationship document. This will lay out each of your responsibilities in the relationship
and your commitment to each other.
It is essential that you have considered all the laws relating to your business idea and its
operation.
The list below covers a wide range of considerations and it is unlikely that everything will
relate to you. Include as evidence documents you have gathered from any source, and if
you dont think an issue is relevant to your situation, give a short note explaining why you
have rejected it.
1 Premises
If you are working from home, you probably need to show that your work is not likely to
interfere with neighbours, create environmental damage, or alter the structure and use of
your home in a way that is not acceptable to the building society or local council. Parking and
access is often a problem. If you think that you need external premises, give examples of
the sources of information for commercial premises. This is likely to include evidence of
discussions with estate agents, landlords or property developers.
Include here any correspondence with the:
building society
Environmental Services Officer at your borough or district council
Planning Department of the same authority
local council about by-laws
and any other documents such as professional indemnity.
ACTIVITY 1.4
(continued)
2 Insurance
You will certainly need to obtain insurances to protect the assets of your business from loss,
damage or theft.
In addition, if you employ any staff, you have a legal duty to buy insurance which will protect
them against injury or accident at work.
Almost inevitably people in business are in a situation where, in carrying out their work, they
may accidentally do something harmful to a member of the general public. This could lead
to expensive legal action so new business owners should examine the question of public
liability insurance.
In the course of setting up your business, consult an insurance broker and include the
documents that show the decisions you have made relating to:
public liability insurance
employers liability insurance
loss of profits insurance
insurance of assets and premises
3 The law as it applies to business
Show in your portfolio any documents that you have obtained (explaining their source) that
relate to the following, saying how each applies to your situation:
the Health and Safety at Work Act
laws relating to the rights of any employees
legislation specific to your industry
codes of practice specific to your industry
fire regulations
food hygiene legislation
trading standards
advertising standards
merchantable quality of goods (continued)
4 Record-keeping
To see how other organisations deal with their record-keeping, you will find it useful to
collect appropriate examples or illustrations of items such as:
terms of trading
purchase orders
delivery and advice notes
order acknowledgements
Legal requirements regulating the
employment of staff
All businesses need to be aware of employment legislation. You may wish to make a
policy statement on the various measures that apply and set up procedures to manage
them. In any case you must ensure that your procedures meet the minimum requirements
of the law.
Employment is an area where unfair discrimination has existed and still persists in some
respects today. Changes in social attitudes and the desire for equality of treatment led to
the introduction of statutory requirements that introduced a greater equality of opportunity
for people seeking, or remaining in, employment.
General employment provisions
The effects of employment laws have been to give to individuals and/or groups of people
statutory employment rights which can be legally enforced to penalise companies that
transgress, and to compensate individuals who suffer loss. The introduction of these
laws was for the intention of, and has been successful in, forcing companies to introduce
fairer and more professional procedures.
Amongst the main statutes giving legally enforceable employment rights in the UK are
the:
Race Relations Act 1976
Sex Discrimination Act 1975
Equal Pay Act 1970 and Equal Pay (Amendment) Regulations 1983
Disability Discrimination Act 1995
Employment Protection (Consolidation) Act 1978
Rehabilitation of Offenders Act 1974
Health and Safety at Work Act 1974
These Acts give certain statutory rights to individuals, some of which are immediately
available, with the others becoming available after a qualifying time period. Breaches of
these rights can be referred to an enforcing authority (usually by application to an industrial
tribunal) which has the power to remedy any transgression by an appropriate means
(which may include compensation or reinstatement). The compensation is usually paid
by the offending company, which serves as punishment.
Amongst the rights that individuals enjoy and that are legally enforceable in the UK are:
Equal pay for like or equivalent work.
Not to be discriminated against because of race, gender or sex.
Not to be unfairly dismissed (after a qualifying period, currently two years).
To receive maternity pay and return to the same or similar job after pregnancy
(qualifying period does apply).
Not to be refused employment because of trade union membership (or non-
membership).
To be allowed time off for trade union activities (for a recognised trade union).
Not to be dismissed or disciplined for trade union activity.
To be allowed time off to carry out public duties.
Not to be called upon to strike without a secret ballot.
Entitlement to a written reason for dismissal (after a qualifying period).
To receive minimum periods of notice.
To be paid if suspended for medical reasons.
To be guaranteed payment when work is not available.
To receive an itemised pay statement.
To work in a safe and healthy working environment.
To receive compensation if made redundant (after a qualifying period).
To be allowed reasonable time to look for alternative work or training (following notice
of redundancy).
Many of these rights are immediately applicable, but some (e.g. redundancy payment)
are only applicable after a qualifying period of employment.
In the UK the Equal Pay Act 1970 was introduced to eliminate discrimination in pay
primarily due to gender. It requires that workers should receive equal pay for equal
work, irrespective of gender. Equal work may be interpreted as:
Like work where the work is of a broadly similar nature but not necessarily exactly
so.
Equivalent work where the work has been measured or rated as equivalent.
Equal value where the demands placed upon the individual are seen to be of equal
value.
Health and a safe working environment
The Health and Safety at Work and its associated regulations places upon employers,
employees and others, general duties to maintain a safe and healthy environment and
working practices. In many countries regulations place duties on employers to:
Provide and maintain safe plant machines and safe systems of work.
Provide safe arrangements and systems for the use, handling/storage and transport
of hazardous articles and substances.
Provide necessary training, information, instruction and supervision.
Maintain a safe place of work.
Maintain safe access to and egress from the place of work.
Maintain a safe working environment.
Regulations often impose a duty on employees to work with the employer to maintain
these duties and not to do anything to hazard themselves or others.
Penalties for breach of duty (redress for
employees)
Statutory employee rights are usually protected by law and, in the event of a breach by
an employer, the employee can obtain redress by personal application to a civil court. In
many countries breaches of the health and safety regulations can be brought by a criminal
court.
Civil law
If the employee feels that they have been wronged and suffered loss they can apply to
the civil courts for redress.
Using the form below, produce a list of all the legislation which will apply to your business
operation and how you have fulfilled its requirements.
Legislation Does it affect me? How will it be fulfilled?
Insurances: compulsory
Insurances: voluntary
Sale of Goods Act 1970
Food safety
Prices
Trade descriptions
Unsolicited goods & services
Consumer credit
Consumer protection
Companies Acts
Partnership Act
Industry-specific legislation
Patents/copyright
Licences
Health & safety at work legislation
Planning regulations
Fire precaution regulations
HMRC (self-employment)
HMRC (employees)
Value Added Tax/local tax
Directors duties
Equal opportunities
Employment of others
Contracts
This list is not exhaustive and is intended merely to stimulate thought. You should add others
as they become known.
ACTIVITY 1.5
Raising funds
Imagine you want to set up a small, sole owner business, using your knowledge and
expertise to advise other people in your field of work. You decide to work from home but
you need about $2,000 to buy office equipment, have stationery printed, place
advertisements and so on. List three ways you might be able to raise the $2,000.
You probably first considered your savings and whether it would be wise to use these for
a business venture.
Next you may have pondered whether to sell something of value that you own, such as
your car, a valuable coin collection or that priceless heirloom that has been in the family
for generations.
You could also have looked into borrowing money from friends or relations, or from a
bank.
In short, you, or any would-be sole owner, could fund a business by:
using personal assets or
borrowing
Now imagine you run a small private limited company and it has been doing really well.
You need to buy more equipment to help you expand your business. You will need another
$10,000. How could you go about raising this sum? List as many ways as you can think
of.
The two main sources of funds for a company are:
its shareholders
its trade creditors and bankers
Both share capital and
retained profits belong
to the shareholders,
al though they are
shown separately in the
accounts.
The people to whom a
company normal l y
owes money are i ts
trade creditors and its
bankers. (However, as
you will see later, when
the term credi tor
appears i n accounts
statements, it usually
refers to shor t-term
creditors.)
The shareholders put in money when they buy shares.
This provides the share capital.
Once a year, the accounts are drawn up, the amount of profit
(if any) is ascertained and then checked and approved by
the auditors. The directors can then decide how much of this
profit should be paid to shareholders in the form of dividends,
and how much should be kept in the business, as retained
profits.
Funds borrowed and monies owed can be separated into
current liabilities and long-term liabilities.
Current liabilities must be paid back within the next year.
An example would be money owed to a supplier.
If money is raised by taking out a loan to be paid back over
a period longer than 12 months, it is a long-term liability.
To raise immediate funds for your private limited company, you may have thought of a
number of other options, for example:
Applying for government aid: the government has run various schemes over the
past few years, by which small businesses can obtain grants or loans directly from
public funds.
Selling some of your business assets: business assets include everything the business
owns, including equipment, buildings and stock.
Sometimes a business can raise money by selling assets it no longer needs. It could, for
instance, sell equipment it no longer uses, or it might sell or rent part of its business
premises.
Raising a loan
If a company borrows money from a bank or other institution, some guarantee is usually
required that the money will be repaid. The lender may ask for some form of security
something of value that can be sold if the loan is not repaid. It will also expect to be paid
extra money, above the sum loaned, in the form of interest.
The main lending bodies are:
commercial banks
merchant banks
venture capitalists
Commercial banks
Commercial (or high street) banks will lend money in the form of a bank loan, which is a
fixed amount lent for an agreed time and on specified terms.
This is not the same as a bank overdraft which is an arrangement by which the bank
agrees to allow, for a short period, more money to be drawn out of a clients account than
is put in. The interest charged on an overdraft is frequently higher than for a loan.
Merchant banks
Merchant banks originated from the diversifying activities of rich merchants, especially in
the eighteenth century, who found they could earn more by financing others than by
importing and exporting goods themselves.
Nowadays, besides lending money to large companies and governments, merchant banks
are able to offer a number of services, including advice and dealing. Some merchant
banks you may have heard of are Hambros, Kleinwort Benson, Lazard Brothers and J.
Henry Schroder Wagg.
Venture capitalists
Some investors, known as venture capitalists, are willing to risk putting money into
companies without the normal security. It is done most often when the investors perceive
that by putting funds into a company or project, there is a good chance that it will grow
and become very successful. They thus hope to obtain rich rewards at a later date. When
venture capitalists invest money in a business they normally expect a good deal of
involvement in its affairs.
Other forms of loans
Most businesses have to buy in goods or services from other companies. Could a business
obtain credit to buy these things without borrowing from a bank?
Trade credit
Creditors are a source of funds. There may be special arrangements between companies
to give credit, when it is to their mutual benefit. A printing firm, for instance, might allow a
book publisher to delay paying for the printing of a new book for three months, to give the
publisher time to sell it to book shops.
Read the following case study:
CASE STUDY
Bill owns a loft conversion business. His work is good and he has more customers than
he can handle. He employs four workers on a casual basis in his business and pays them
at the end of each day. He prides himself on always paying cash on the nail for his
building supplies. This month Bill has sent out invoices worth $23,000 for work on several
customers homes. His customers have the usual credit terms so payment isnt due until
30 days after the date of the invoice. So Bill does not have enough cash to keep the
business running until his clients pay.
Bill is giving credit to his clients but he is not trying to get the same arrangement for
himself. He needs to arrange with his workers to pay them once a week, or even once a
fortnight, if they will agree. He needs to arrange credit terms with his suppliers and to
change his suppliers if his present ones wont agree.
Hire purchase
Another way to obtain credit is by buying through hire purchase. For example, if an
engineering company needs an expensive piece of machinery but cannot afford to
purchase it outright, it might make a hire purchase agreement with a finance company.
Under such an agreement, regular payments are made over a specified period.
The engineering company will have use of the machinery, but it is only legally on hire to
them until the final payment is made, when it becomes their property. Of course, the total
amount of money paid through these instalments will exceed the original purchase price,
by an amount of interest.
Leasing
Certain equipment, such as computers, office machinery and cars, become out of date
very quickly and constantly need replacing. Instead of laying out a lot of money all at
once on these items, some companies prefer to lease them and then replace them when
they need updating.
Leasing differs from hire purchase in that the ownership of the property remains with the
lessor.
ACTIVITY 1.6
Talk to your manager, or someone in your accounts department, and try to find out the
following information.
1 Does your organisation lease any equipment or vehicles? Explain why it does (or does
not) lease.
2 How much credit (if any) is extended to its customers or clients?
3 How quickly does it pay its bills?
4 Does your organisation have a credit controller in the accounts department? If possible
talk to this person to find out what his or her main duties are, and describe them briefly
below.
Sources of funds for public sector
organisations
Public sector organisations are funded by public money and are accountable to the public
for how they spend it.
The government gets a good deal of its money from taxes, such as:
income tax
local tax/Value Added Tax (VAT)
duties on road fuel, alcohol and tobacco
corporation tax/profits tax
road vehicle tax
However, the government borrows money too. The amount borrowed is called the Public
Sector Borrowing Requirement (PSBR). There are differences of opinion between the
major political parties as to how much borrowing the government should do. The total
outstanding amount that is borrowed by the central government is called the National
Debt.
Another way the government can acquire funds is by selling off some of its assets.
Privatisation of public sector enterprises is one way of doing this.
At a local and regional level citizens are required to pay money directly to local government,
in return for the services provided.
Some local services are, of course, not provided entirely from public funds.
You should now be able to:
explain the difference between different types of organisation
describe some ways in which organisations are financed
describe the basic financial working of your own organisation
Complete Self-test A and read the Summary to review the work you have done.
Self-test A
1 Fill in the table for the different types of organisation.
Sole trader Partnership Limited
company
Is the liability limited
or unlimited?
Who owns the
organisation?
Who has control?
Who receives the
profits?
2 What type of business organisations do the following refer to?
a Its shares can be sold to the public.
b The profits are retained by one person.
c Every shareholder has an equal vote, no matter how many shares
they hold.
d A privately owned business, its shareholders having limited liability.
e It has two or more owners, who have unlimited liability.
3 List three ways of raising finance available to a sole trader.
4 List three types of lenders to large companies.
5 List three sources of government revenue.
6 Which of the following statements are true and which false?
Tick as appropriate.
True False
a To be self-employed, you have to become a limited
company.
b Public services like water and electricity are run by
the state.
c In a limited company, share capital and retained
profits belong to the owners.
d A bank overdraft is another term for a bank loan.
Turn to the end of this section to check your answers.
Funding
Fixed and working capital
As it has been said in the introduction, every business needs money and, although the
actual amounts may differ enormously, the uses to which they are put can easily be
generalised into two categories:
fixed assets
current assets
Fixed assets
These are the items that will be purchased for use by the business and kept for a relatively
long period (over a year). They could also be items like machines used to make the
product or service, buildings to use as offices and warehouses, vehicles to transport the
goods and travel in, etc. The money used to purchase these is locked up in the business
and is called fixed capital.
Current assets
These are the items that will be purchased for use in the business and will be consumed
by it in producing the goods or services for example, materials to make into products,
rent and rates for the buildings, petrol, oil and maintenance for the vehicles. This is called
working capital.
All these items will need financing but, whereas the effective life of the fixed assets is
more than a year, the current assets have an effective working life of less than a year
before they are consumed and turned into sales to generate income.
The total finance required by a business is the sum of the fixed assets and the working
capital employed in financing the goods or services.
Imagine that you are going to start up a small business selling computer games and have
acquired a licence and a market site from which to sell the games. What resources might
you have to obtain to start the business?
ACTIVITY 1.7
Feedback on Activity 1.7
The list you have may vary from what someone else might suggest, but you will
probably have identified:
the games that you hope to sell
the licence to operate
the cost of the site (pitch)
the stall which you purchase, complete with fittings/lighting
a van to drive the goods to the site
petrol/oil for the van
National Insurance
money for yourself (food, beverages, etc.)
Outline of the financial resources
required
It will be necessary for business planning and the Business Plan itself to identify the
amount of initial funding (capital) required for the business and how best it will be obtained.
The amount of initial funding will be the sum of the cost of purchasing the fixed assets,
plus any initial start-up costs, plus the working capital (obtained from the cash flow).
Care should be taken to ensure that items are not counted twice.
Finance required =
Finance required for start-up (one-off) costs =
Working capital required (from cash flow) =
Total capital required =
Less capital to be introduced by owner =
Initial funding required =
It is wise to consider adding a contingency factor of up to 10 per cent to allow for unforeseen
factors and a possible downturn in sales income.
From Activity 1.7 and the feedback on it, try to identify which of the resources are fixed
assets.
(continued)
ACTIVITY 1.8
Now try to put a cost on the items to work out how much money you will need to start up.
Fixed assets:
Working capital:
If you think it through you will find that, although it is easy to put a figure on the
fixed assets, it is not quite so easy with the working capital.
When purchasing fixed assets, payment is made before the business starts, and
this can be defined by obtaining quotes, etc.
With the working capital, however, it becomes a little more complex as timing
becomes important. If you obtained all your supplies on a months credit and your
customers paid cash, you might not need any working capital because, if you sold
all the games, you could pay your suppliers out of this. However, if all your suppliers
wanted cash and you gave your customers a months credit, this would be a different
story!
The amount of money and the timing (credit terms) will affect the amount of working
capital required. If the suppliers of the fixed assets could be persuaded to give
credit, could that be funded out of income?
The easy way to determine this is to plan and record the income and outgoings carefully
to work out the net result. This is done by means of a cash-flow forecast.
A similar situation will happen when a business seeks to expand because it is necessary
to invest in facilities and goods and services to produce the extra items or services for
sale.
Your business is going so well that you cannot keep pace with it, so you decide to expand
and open another stall (in the same market). What extras might you have to find?
ACTIVITY 1.9
It is likely that your list contains:
an extra stall
another van (possibly)
a person to look after the stall (wages)
extra stock to sell
another licence
pitch costs
increased insurance
This will result in an increase in the fixed assets and the working capital required. If
not planned correctly, this added demand for finance could cause problems to the
business to such an extent that it places added strain on the existing business. If
the money is borrowed, the interest/borrowing charges, together with the wages,
will increase the overhead costs of the business, which will require a higher level of
income and a correspondingly closer control of cash flow. Even for a seemingly
simple business or project, the need for planning exists.
Why do you think most businesses fail?
ACTIVITY 1.10
Research has shown that most businesses fail because of lack of money they
run out of cash. This is a very good reason to plan and control the finances of every
business. One bank quotes that most businesses collapse for the need of just an
extra $2,000!
Premises
By now your research should have identified whether you will work from home or find
suitable premises.
Premises must meet your needs, at the right price, to fit in with your financial plan.
There are so many options to consider. Remember that for some businesses the location
is the key element to consider, especially if you are a retailer. For others, image is important
for example, if you were running an advertising agency. Accessibility may be your
foremost consideration, especially if you are offering a service or goods for which people
would prefer to drive in.
CASE STUDY
CASE STUDY
George decided to go out on his own and start up his own dry cleaning business. He
found a small shop for rent next to a large supermarket with a big free car park. He found
that, in 6 months, he had achieved double the turnover compared to the shop he had
been working for in the High Street. However, this success presented other challenges!
If you decide to lease premises, consider what commitment you need to give to the
landlord. Many landlords are prepared to give short leases or licences during a recession.
New businesses may be able to negotiate a one-year lease or licence. Good premises
are more difficult to find in many areas. It is certainly worth waiting for the right one to
become available.
Kamaljit started out as a beautician and aromatherapist working from home. When she
split up with her husband, she almost lost her business too. She moved into shared,
rented accommodation and needed to find premises. Her budget was limited. She found
a small, run-down shop in a secondary shopping position. She discovered that the landlord
owned the shop next door but his second shop had been empty for two years. The landlord
was glad to find someone interested in his vacant shop, as it created a poor image for his
own business to have empty premises next door.
The landlord agreed to a six-month rent-free period if Kamaljit decorated the shop. Kamaljit
was fortunate in having good friends and family who rallied round her and decorated the
shop at a low cost using rag rolling and stencilling, creating a beautiful image.
She is still operating successfully from the shop and she looks after her landlords shop if
he goes out, and vice versa.
Why are fixed assets necessary?
Any business needs several important items before it can function. Most businesses
usually require:
premises a building (shop, office, workshop, etc.), although many small businesses
are run from home
fixtures and fittings for the building
equipment for the office such as a computer, fax machine, etc.
transport vehicles for use in the business
If these are purchased and owned by the business they become fixed assets because,
under normal circumstances, their anticipated life is more than a year and the money
invested in them is locked up or fixed.
Supposing we leased a vehicle instead of purchasing it. Would it still be considered a fixed
asset? What would we call the finance used to obtain it?
ACTIVITY 1.11
If we were to lease a vehicle it would not belong to our business, so is not a business
asset.
We would now have to pay regular, monthly leasing costs. These short-term, regular
costs are classed as revenue and will become part of the working capital
requirements.
By leasing equipment the business does not have an asset but a regular, contracted
payment instead. This has obvious implications for the amount of capital required
and the cash flow.
As such items have a financial value to the company they are assets, but as their
life is more than a year they are fixed assets.
Why is working capital necessary?
As well as fixed capital, the business will need money to fund the trading cycle illustrated
below. Most businesses buy in materials, goods or services which they then sell on to
customers. They need money from sales to purchase more materials, etc., to sell on. The
usual trading cycle can be represented in a diagram.
CASH FLOW
Production of business
goods/services
Sale of business
goods/services
Purchase of materials
and services for
business use
Customer pays for
goods/services
Cash
Taxes/equipment
etc.
Money paid in
There must be sufficient working capital to purchase all the goods and services used in
making the product or service, including stocking and selling costs, until the stock of cash
is replenished by the money coming in from debtors (customers who owe money).
The more goods sold, the more cash required. The longer the customers take to pay for
the goods, the more cash will be needed.
If the money (working capital) runs out, the business cannot pay its debts or buy goods
to produce more products/services. At this point the business is technically bankrupt (or
insolvent) and may have to close down if its creditors take action against it.
A larger business will also need fixed assets and will invest considerable sums in them. It
will also need working capital to fund its day-to-day operation of buying in goods/services,
selling them to customers, and getting money from them to buy more goods/services.
CASE STUDY
It is said that a well-known retailer started off by buying tea wholesale, on credit, and
selling it for cash. By selling quickly to generate funds, the working capital requirements
were minimised, allowing the business to grow quickly without the costs of borrowing.
Define which of the following are fixed assets and working capital by ticking the appropriate
column.
Fixed assets Working capital
Stock for sale in the shop
Cash register for the shop
Wages for the shop assistant
Advertisement in the local paper
Rent for the shop
Alterations to the shop
Insurance for the goods
Van to collect goods from the wholesaler
Water rates
Electricity charges
Petrol for the van
Heating and lighting charges
Postage
Telephone charges
Business rates
ACTIVITY 1.12
Fixed asset list
Now think about your business. What will you need? When should you buy it? What will it
cost? Try to complete the following table for your own business.
Asset When Estimated Already To be
required value/cost owned obtained Comments
Premises
purchase/
premium
Conversion/
renovation
Fixtures/
fittings
Professional
fees
Production
tools
Transport
car/van
Desks
Filing
cabinets
Telephone
system
Photocopier
Fax
Other
ACTIVITY 1.13
Action needed to break even
Now you need to consider the most important part of the action plan, by asking the
question How much do I need to sell?
This question involves a concept that we have touched on briefly before breakeven
analysis which at first sight looks like heavy mathematics, but is actually pretty
straightforward.
Consider two facts:
Firstly, just by being in business, you will incur some overheads or fixed costs. There
might be rent, extra phone costs, increased insurance bills, printing and stationery,
or many other ways in which your expenses rise. Its obvious that you must cover
these costs before you make any money for yourself.
Secondly, every time you do a job for a customer, you will make a gross profit which
is the difference between what the client pays you and what you have to spend on
materials. This will vary from business to business. A caterer might spend a third of
his or her income on food for clients, whereas a book-keeper has almost zero material
costs. Either way, getting an idea of your gross profit per transaction shouldnt be
difficult.
Obviously, you must first cover your overheads. Until youve done this you cant pay
yourself anything.
Eve was considering running a business making and selling sandwiches, going by van to
offices on industrial estates to deliver them.
She anticipates her overhead costs to be:
$60 weekly to run her van
$10 weekly for insurance
$18 weekly mobile phone costs
$4 weekly laundry bills
$100 personal survival budget
So, she will have fixed outgoings of $192 a week.
She will sell her sandwiches at an average cost of $1.20 each, and she reckons that
bread and fillings cost an average of 40c a sandwich. So, her gross profit will be 80c per
sandwich.
Shes got to sell enough sandwiches to cover her overheads of $92 before she can pay
herself the $100 she needs.
If she sells 115 sandwiches, and makes 80c gross from each one, this covers the $92
overhead costs. This is Eves breakeven point.
After shes sold the first 115 sandwiches, every extra one she sells makes 80c for herself,
so a further 125 sales meets her personal survival budget.
Therefore, 240 total sales cover all her needs.
Eve worked all this out before she started. She split her basic target of 240 into a daily
Monday to Friday target of 48 each day, and felt that this was easily within her grasp.
Eve now needs to consider the following aspects:
capital expenditure
one-off start-up costs
contingency factors
CASE STUDY
Calculate the following:
1 Your probable overheads per week or month.
2 Your likely selling price per transaction.
3 Your likely direct or material costs per transaction.
4 By deducting 3 from 2, your likely gross profit per transaction.
5 Dividing 1 by 4, form an estimate of the number of transactions per week or month you
need to break even.
ACTIVITY 1.14
Sources of funding
If the plan is to be successful, it is likely that financial support will have to be sought from
alternative sources, if they do not already exist.
Existing companies will tend to try to supply finances from their own resources, and
owners of new businesses from their own pockets or savings. In practice, most do not
have the finance available from their own resources and have to look outside for financial
support.
Can you identify the alternative sources of finance that may be available to:
a new business?
an existing business?
ACTIVITY 1.15
For new businesses, the search for finance is usually a vital concern and takes up
a great deal of time and energy. The areas explored are usually:
Friends or family some businesses are able to obtain finance from within
the family circle or from friends. This offers advantages and potentially serious
disadvantages. Any arrangements should be done formally and on a business
basis.
Banks the high street banks are still the most common place for new
businesses to raise finance. To do so successfully, the applicant will need to
understand the needs of the banks and present their case accordingly by
producing a Business Plan. Most banks have specialist business centre
branches.
Venture capital for the larger concern, the business idea may capture the
imagination and attract finance from the many venture capital organisations
that exist.
Loan guarantee scheme this is a government-supported scheme to help
finance new businesses by guaranteeing loans. It can be facilitated through
the banks or via some Enterprise Agencies.
Specialist organisations for new businesses there are often specialist funds
established to help particular groups of people. A good example in the UK is
the Princes Youth Business Trust which is available to people under the age of
29. It can supply not only funds but business advice too.
There are also other schemes and sources of funds set up to help
disadvantaged groups (usually on a small scale).
Existing businesses are usually limited to funding from banks or venture capital
organisations.
For new or existing businesses, the sources of finance will need to be researched
for their cost, availability, stability and flexibility Therefore, the terms of the loan will
substantially affect how the plan will be put into effect. It is obvious that these
factors will need to be established before any decisions are made by the lender.
Feasibility of plans
It is very unlikely that any Business Plan will be decided without advice, help and
discussions on the feasibility of its proposals. Most people producing plans are quite
capable, but lack the specialist information that professional advisers can give.
List some examples of professional advice that may be required to start up a new business.
ACTIVITY 1.16
Most new and existing businesses need advice on the implications of their plans,
particularly in the areas of:
Finance financial advice is usually obtained from accountants. They can
recommend sources of advice and their implications, and the best way of
financing equipment, etc.
Legal advice on the implications of contracts, leases, company law, trading
law, licences, etc., is usually provided by solicitors or lawyers.
Marketing market information and the implications of entering a market will
have to be discussed with marketing experts.
People when employing people, there are certain legal requirements.
Information must be obtained on employment law and taxation as well as
availability and recruitment costs.
Insurance information on the type, costs and conditions, and the implications
for the business, will have to be explored.
Production/design if premises are to be obtained and/or altered, then the
methods/cost/implications may require the expertise of an architect and/or a
surveyor.
Producing the plan very often the act of producing a Business Plan will
require help or advice.
In short, the person drawing up the plan will have to call upon the specific expertise
of many people. Although the final decision may be his or hers, whether individually
or collectively for a board decision, he or she will need to obtain advice and test the
feasibility of the proposal through discussion with other people.
In an existing company, the expertise is usually present within it (or perhaps should
be), although advice may still be sought through specialists or consultants. In these
cases the director(s) would test the viability of the proposal by discussions with
department managers, other directors and specialists before making a decision.
New business owners should go to professional service suppliers (e.g. accountants)
and business counsellors (Enterprise Agencies) or Business Links to test and refine
the viability of their proposals.
Raising finance
All firms have to raise finance.
This finance can come from three sources:
owners capital
retained profits
by borrowing from third parties
The ultimate aim is to finance your business from your own capital or by retained profits.
This is not always possible and firms may have to resort to borrowing money from other
sources. Banks should provide most of the finance required. Other sources are available,
and firms often arrange hire purchase facilities, for example. Where property is involved,
some building societies will lend for commercial purposes.
Borrowing costs and capital costs
Most firms should be able to arrange satisfactory finance from their banks.
Borrowing should be divided into two categories:
long-term loans
short-term loans or overdrafts
Long-term loans should be used to finance the purchase of fixed assets.
You should carefully consider what fixed assets you require. Make sure you will be getting
a return on the capital you propose investing. Then arrange a loan to make the purchase.
You should enter into a contract with the lender, clearly understanding what your
responsibilities are.
You need to know:
what interest charges are being made
the rate of interest being charged
the amount of each repayment
the total number of repayments
the amount of interest and capital repaid for each instalment
This way you know exactly what has to be repaid and when. You are protected by a legal
contract. Provided you conform to the terms, you will experience no problems. The contract
can be with a bank or finance house; just make sure you achieve the best terms that you
can.
These days leasing contracts, in various forms, are being offered. Leasing is a form of
renting. Ownership of the goods remains with the lender: you pay to use these goods.
Remember that the tax advantages under these schemes remain with the lender. You
may think that leasing is cheaper than hire purchase or a bank loan, but always check
the position after allowing for capital allowances. Your accountant will advise the cheapest
way to acquire these assets.
Short-term finance is often available to help you complete the trading cycle by providing,
say, bank overdraft facilities so that you can purchase stocks or pay for work in progress.
Overdrafts are normally approved for a short period of time, often only six months.
Generally no formal contract is drawn up. The lending source will agree to meet your
payments provided you do not exceed the agreed overdrawn limit. These funds are
designed to solve a temporary shortfall of funds. You should be able to sell the stock or
complete the work within six months, and therefore be able to repay the overdraft.
Overdraft facilities are not an excuse for failing to collect your debts.
Lending sources will normally want to satisfy themselves that you are a good risk. You will
need to prepare and present a good Business Plan, including an outline of why you
require the finance and just how you propose to use it. You have to convince the lender
that you can use its money wisely and profitably, and that you can repay it according to
the terms of the agreement. Very often lenders will require additional security from you.
They will require you to pledge some property to them so that, should you fail to repay
their money, they can sell or otherwise dispose of your property to recover their money.
You need to be very careful before you lodge security with a lender. Be assured that if
you default, lenders will act and secure your property. They will sell it and retain the
money. You will lose your asset.
Sole traders and partnerships
You will have to satisfy the lender that your plan shows that you can generate sufficient
profit to service the loan, to repay interest, and also to repay the loan out of taxed profits.
The lender will normally require security, usually in the form of a property pledge to
support the loan.
This property must be:
valued
lodged with the lender or legally charged to them
the charge must be legally enforceable
Examples of acceptable security are:
property
shares
pensions/life assurances
Limited companies
The lender might well require a debenture from the company. This is simply an
acknowledgement of a loan. It may contain a fixed charge, or a floating charge over all
the assets of the company.
The charges do not stop the company from using its assets in the normal course of
trade, but should the business find itself in financial trouble, i.e. should a Receiver be
appointed, then the company can no longer use its assets because they are then held by
the Receiver for the benefit of the lender.
Sometimes the lender will require the company to agree to additional requirements.
These could include:
restrictions on withdrawals from directors loan accounts
limits placed on directors emoluments
the signing over of life assurance policies
limits placed on the amount of capital expenditure
restructures of further capital raising ventures
management having to produce accounts each month for the lender
adequate insurance
restrictions on the type of business which can be undertaken using the facility
The terms are normally negotiable.
In some circumstances, a lender will ask for personal guarantees from the directors. This
is removing the protection of limited liability from the directors, as far as the lending
facility is concerned.
Sales forecasting
At this stage a company should be able to consider its position and, from the market
research knowledge of the market, competition and the marketing strategy, estimate the
effect the company will have on the market and thereby the likely sales.
The company may also be able to obtain information from people in a similar type of
business who are not in the area and do not see the company as a competitor.
Priti is a mobile hairdresser. She needs to take $7,000 a year out of her business as
drawings, and this will give her about $800 in tax and insurance bills as well.
Her car costs $2,000 a year to run, so she needs to create $9,800 in total.
Her average hair appointment is charged at $8.00, and she estimates that she spends
10% of this on sprays and lotions, so her gross profit is $7.20 and her gross profit margin
is 90%.
So, she needs to make a total of $9,800. Dividing this by her gross margin (90%), this
gives a sales target of $10,900, or about $900 a month.
Looking ahead, she thinks shell be able to start off her business at less than $900 a
month, but that it should build up well above this when she gets better known.
Also, she thinks she wont do terribly well in her quiet months which, like many businesses,
are February and August.
Using this knowledge, she writes the following target. By trying to stick to it, it becomes as
good as a forecast:
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
$800 $600 $800 $900 $900 $900 $1,000 $600 $1,000 $1,000 $1,100 $1,300
Total turnover is $10,900.
By setting manageable, monthly targets, Priti has increased her chances of achieving her
goal.
Actually, this true story led to some good business planning. Priti thought these sales
figures might be quite hard to achieve, especially in the second half of the year, at $8.00
a job. So, she decided that, while she was visiting clients for haircuts, shed sell them
tights and cosmetics as well in order to get her sales figures up and cover some of her
overheads. Planning and forecasting helped her to make good decisions before she started.
CASE STUDY
Estimating the capital costs associated with a
business
Capital items are those items which the business requires and which will be retained for
long periods usually over a year. They are different from consumable goods; that is,
items such as stock, components, materials and insurance which are consumed in the
course of making the product or service. Capital items are different in that they stay with
the business for several years and, in the case of machinery, perhaps decades.
The costs to the business of supplying and maintaining such items have to be recognised
and taken into account.
These costs can be identified in one of two ways:
If the item is leased, rented or hired, there will be a lease/rental or hire cost each
month which should be added to the costs (usually overhead costs) of the business.
If the item is purchased then the purchase price must be recognised and the source
of finance identified. If the finance is borrowed, then the cost of borrowing becomes
an overhead cost. In addition to this, the cost of the item itself must be recognised
and allocated to periods in which it is present. This process, called depreciation,
identifies the cost per annum to the business which is added to the overhead costs.
Its calculation requires the items service life to be determined.
Calculating depreciation of capital purchased items
There are several methods of calculating depreciation, but for simplicity the straightforward,
straight-line method is described.
Determine the purchase price of the item.
Identify how long the item is likely to give good service before it is replaced (service
life).
Estimate the value (resale price) of the item after its service life (residual value).
Put these figures in the following equation:
Depreciation cost = Purchase cost Residual value
(per annum) Service life
The depreciation cost will be the cost to the business of recouping the price of the item or
replacing it when worn out. This is added to the overhead costs.
Producing an asset register
An asset register is a list of all capital items owned by a business. In addition to recognising
these for management/control purposes, this list will help the accountant to claim tax
relief on such items, as well as assisting in security, insurance and valuation exercises.
Make a list of all the capital items you own and give them a unique reference number.
Where possible, mark them with it.
Make your list below:
Acquisition Disposal
Ref. Description Date Cash Ref. Date To Ref.
(item/make/ obtained disposed whom
model) of
The reference numbers will refer to the purchase/valuation information and the sales invoice/
disposal information.
In addition to this, your accountant may wish to keep individual records of the current value
of the items listed for tax purposes. This will be the basis for determining the written-down
value of the item for claiming tax relief. Your accountant will advise you on the precise form
these should take.
ACTIVITY 1.17
Examples of capital purchase items include:
buildings for business use
renovation/extension of buildings
fixtures and fittings
goodwill
machinery
computers
faxes
telephone systems
security systems
vehicles
desks
filing cabinets
Find out what grants are available to new businesses in your locality. For information, contact
your nearest reference library, local enterprise agency, Chamber of Commerce and local
government office.
ACTIVITY 1.18
Summary
The main types of financial organisation are:
sole owner/sole trader
partnership
limited company (private and public)
cooperative
public sector bodies
Limited companies and cooperatives are mainly financed by their shareholders and
creditors. Share capital and retained profit belong to the shareholders. Funds may
be raised through:
sale of assets
borrowings
issuing of shares
The public sector is financed mainly by:
taxes on incomes
national insurance contributions
local tax/VAT
local government taxes
duties on goods
Setting up and running a business involves many other legal considerations, including:
National Insurance (in the UK)
HM Revenue and Customs (in the UK)
VAT
health and safety
licences (if appropriate)
consumer protection
data protection
employment law
product description
Business funding may be used for:
purchase of fixed assets items for medium- to long-term use
current assets items which will be consumed in the process of producing goods
or services
Monitoring the resultant cash flow is important, enabling the identification of the
breakeven point.
Funds may be raised from a variety of sources:
main: commercial banks, merchant banks and venture capitalists
others: trade credit, hire purchase and leasing
Borrowing strategy will vary according to:
the business type
the amount of money needed
the purpose for which it is to be used
the timescale negotiated
the cost of borrowing
the security required
the depreciation of purchased items
Feedback on activities
Activity 1.12
Fixed assets Working capital
Stock for sale in the shop
Cash register for the shop
Wages for the shop assistant
Advertisement in the local paper
Rent for the shop
Alterations to the shop
Insurance for the goods
Van to collect goods from the wholesaler
Water rates
Electricity charges
Petrol for the van
Heating and lighting charges
Postage
Telephone charges
Business rates

Answers to self-test
Self-test A
1 The different types of organisation and their characteristics:
Sole trader Partnership Limited
company
Is the liability limited Unlimited Unlimited Limited
or unlimited?
Who owns the organisation? One person Partners Shareholders
Who has control? Owner Partners Managers
Who receives the profits? Owner Partners Shareholders
2 a Public limited company
b Sole trader
c Cooperative
d Private limited company
e Partnership
3 A sole trader might consider:
selling some/all of his/her assets
borrowing (by means of a bank loan or mortgage, or from personal contacts)
using trade credit
4 Large companies might consider:
borrowing from commercial banks
borrowing from merchant banks
borrowing from venture capitalists
approaching shareholders to make further investments
5 Sources of government revenue include:
taxes on income
taxes on profits
sales taxes
government borrowing
6 a To be self-employed, you have to become a limited company.
This is false. You can be a sole trader or a partner, although you may trade as a
limited company if you wish.
b Public services like water and electricity are run by the state.
This is false. Many of the industries once run as nationalised industries are now
public limited companies.
c In a limited company, share capital and retained profits belong to the owners.
This is true.
d A bank overdraft is another term for a bank loan.
This is false. An overdraft is an arrangement where a bank allows its customer
to go into debit on their account. A bank loan is a specified amount of money
lent by a bank, usually for a stated time and a set rate of interest, sometimes
with some form of security.
Section 2
Keeping records
Records are vital in a business. Without them, how would you know if you were keeping
within the law or making an adequate profit? They are also needed for tax purposes. In
many countries, the tax authorities require adequate records to assess your business for
tax. Without them, they may make their own assessment (possibly higher) of what you
owe.
Well-kept records also help your accountant to produce a set of accounts. Without
adequate records, the accountant has to do much more work and will charge you
accordingly. Information about your bank account is essential to see if payments can be
covered, or that you are keeping within your agreed overdraft.
Another reason to keep good records is to help avoid insolvency in short, the business
must have money available to pay its bills. In a large percentage of cases, insolvency
occurs because poor records were kept and danger signals ignored.
The basic system of recording is book-keeping.
The principal rules of book-keeping are to record every transaction (and keep these
records for as long as the law requires), and to keep evidence of every transaction
(receipts, etc.).
Keeping control of the money coming in and going out of your business involves accurate
book-keeping. This means keeping a record of expenditure and receipts that is, money
spent and money received by the business. Book-keeping systems can be complicated,
especially in large organisations with many customers and suppliers, a big payroll and
possibly foreign accounts. Systems like this will almost certainly be computerised. There
can also be very simple manual systems for small businesses.
The key records are held in the:
cash book
petty cash book
sales day book
paying-in book
cheque book
nominal ledger
For a small business, all this can be recorded in a simple cash analysis system.
The heart of any book-keeping system is the cash book. This records money coming in
and going out of the business. Receipts are entered on the left and payments on the
right. The pages of a cash book are divided into columns and each one has a separate
heading wages, rent and rates, heat, supplies, etc. This means that every transaction
can be entered in the appropriate column.
At the end of every week or month, the figures in the cash book are added up and the
total payments subtracted from the total receipts. This gives a balance for the period. The
figures can also be checked against the bank statement. This is called bank reconciliation,
and its a good way of checking the accuracy of the cash book (and the bank statement).
Large businesses, involved in many transactions, buying and selling on credit, may need
to keep ledgers and day books, but this is probably a level of complexity that need not
trouble the owner of a small business.
Double-entry accounting
Introduction
Most businesses record their accounting transactions using a system known as double-
entry. In this section, you will learn about the double-entry system and how to enter
financial transactions into the records of a business organisation. You will learn how to
make manual entries to the accounts of a business, though in practice most business
organisations today use a computerised system. It is, however, very useful to be able to
understand the process of double-entry which still forms the basis of computerised
accounting.
What is double-entry accounting?
The system is called double-entry accounting because for each transaction on an
account, there is an equal and opposite transaction on another account. We will
shortly be looking at the formal statement of this balance: it is called the accounting
equation and is usually expressed thus:
Assets = Liabilities + Owners equity.
Any change to one side of the equation has to be represented by a similar change on the
other side.
Example
George decides to start a business using money given to him by his uncle. He
pays $50,000 into a bank account for the business. The accounts will show that
the business has an asset of $50,000, and owners equity of $50,000. George
then buys some goods to sell. They cost $7,000 and the supplier allows him 30
days credit. This means George does not need to pay cash for the goods now,
but can pay the supplier in one months time. The debt is recorded as accounts
payable. Goods for resale are recorded as inventory.
What does the equation look like now?
Assets Liabilities Owners equity
Cash $50,000 Accounts payable Money introduced
Inventory $7,000 $7,000 $50,000
You can see that the two sides of the equation are still equal:
Assets (50,000 + 7,000) = Liabilities (7,000) + Owners equity (50,000)
Obviously, George wants to make money from his business and he will do this by selling
goods and services to customers. When he starts to operate his business, he will receive
revenues from customers and pay expenses to people who supply him with goods and
services. The difference between total revenue and total expenses represents a net
income or net loss which will cause a change to the owners equity.
George sells goods to a customer for $8,000. The customer pays cash. The goods sold
cost George $4,000. What has happened to the equation now?
Cash $58,000 Accounts payable Money introduced
Inventory $3,000 $7,000 $50,000
Net income $4,000
You can see that the equation still balances. The following is a summary of the changes:
Cash has increased by $8,000, which was paid by the customer for the goods.
Inventory (the value of goods still held by the business) has decreased by $4,000,
being the value of goods sold.
Net income of $4,000 has been included in owners equity. It is money due to the
owner of the business. The net income is calculated by deducting the cost of goods
sold from the revenue received from the customer: $8,000 $4,000 = $4,000. (Note
that a net loss occurs when the total expenses of a business are more than the total
revenues. Net losses reduce the owners equity.)
Assets (58,000 + 3,000) = Liabilities (7,000) + Owners equity (50,000 + 4,000)
Record the changes to assets, liabilities and owners equity that result from the following
transactions:
George pays the supplier $7,000.
He buys more goods on credit costing $9,000.
He pays rent for his premises of $2,000.
Every transaction of the business has an equal and opposite transaction. Double-entry
accounting reflects this. Each transaction is recorded in an account. The business will
have an account for each different business item.
ACTIVITY 2.1
The ledger accounts
There are three main categories of accounts which reflect elements of the accounting
equation assets, liabilities and owners equity. Under each category, there are items for
which the business needs to account. The following is a summary of the different items.
You will recognise some of them from the activities above. The collection of accounts that
a business uses to record its transactions is known as the ledger.
Assets
Assets are any items of value to the business now or in the future. The main asset
accounts that businesses use are detailed below.
Cash
Cash accounts detail the cash effects of business transactions. As well as paper currency
and coins, cash includes bank account balances.
Inventory
Inventory accounts record the value of goods held by the business for resale.
Accounts receivable
This account records the value of goods or services sold on account. Where customers
buy goods on the understanding that they will pay for them later, it is known as buying on
account or on credit.
Notes receivable
This account records the value of promissory notes that the business holds. Promissory
notes are written promises for payment of a fixed amount by a specified date. Businesses
may receive them from customers in exchange for goods and services. They are similar
to accounts receivable but offer more security because the terms of the specific
transaction are set out in writing.
Prepaid expenses
These accounts record expense items that the business has paid in advance. Prepaid
expenses are an asset to the business because they are amounts that the business will
not have to pay in the future. There will be a separate account in the ledger for each
prepaid expense. Items that might be prepaid include rent and insurance. They also
include office supplies which are purchased, then held in the business until they are used
for business activities.
Land and buildings
These asset accounts record the cost of land and buildings that the business owns and
uses for its business activities. (Note that if the business owns land and buildings that it
intends to resell, these would be recorded in a separate account as investments.)
Equipment, furniture and fixtures
These accounts record the cost of equipment, furniture and fixtures used in the business
operations. There will be separate accounts for different types of equipment, furniture
and fixture. For example, there might be accounts for office equipment, store equipment,
store fittings, office furniture, etc., depending on the type of business.
Investments
Businesses may hold investments which might be stocks and bonds in other companies,
or land and buildings for resale. Each investment will be recorded in a ledger account.
Liabilities
Liabilities are the debts of the business. A business will use the following accounts to
record these items.
Accounts payable
The accounts payable account records the value of credit purchases made by the business.
If the business buys goods or services on the understanding that they will be paid for at
a later date, the amounts are recorded as accounts payable.
Notes payable
The notes payable account records the value of promissory notes that the business has
issued in order to borrow money or purchase goods and services.
Accrued liabilities
These accounts record the amounts of expenses that have been incurred but not yet
paid. There will be a separate account for each accrued expense and these might include
items such as taxes payable, interest payable and salaries payable.
Owners equity
Owners equity is the claim of the owner or owners to the assets of the business. It is
recorded using the following accounts:
Capital
The capital account shows the amount of owners equity. It is made up of the owners
investment in the business, plus the net income of the business, less any net losses and
owner withdrawals. Net income is the income or revenue of the business less any
expenses.
Accountants like to keep a separate record of some of the capital account items to provide
more detailed information about the business. The accounts below are used to record
transactions during the accounting period. At the end of an accounting period, the net
totals (or balances) of these accounts are transferred to the capital account.
Withdrawals
When the business owners withdraw cash or other assets from the business for personal
use, this is initially recorded in a withdrawal or drawing account. At the end of the
accounting period, the balance of this account will be transferred to capital, and will
decrease the amount of owners equity. A separate record of withdrawals is kept so that
it is easy to see the total amount of owner withdrawals.
Revenues
Revenue accounts record income earned by providing goods and services to customers.
Many businesses will earn most of their revenue from one source such as supplying
goods to customers. Some may have additional revenue from rent on buildings they
own, or interest on money they have loaned to others. Each different type of revenue will
have its own ledger account.
Expenses
Expenses are costs incurred in the operation of the business. There will be a separate
account for each type of expense. Expenses will include items such as rent, salaries,
advertising and utilities.
Revenue and expense transactions are recorded in separate ledger accounts. At the
end of the accounting period the net income or loss is calculated and the resulting amount
is transferred to the capital account. (Revenue less expenses = net income/net loss.)
At the end of the accounting period the new capital account balance can be calculated
by:
Capital account balance (owners equity) = Beginning balance + capital introduced
withdrawals + revenues expenses.
Recording business transactions
Most businesses record transactions in the format of a T account. It is known as this
because it looks like a capital T. The vertical line divides the account into two halves in
which increases and decreases in the value of the item can be recorded. The cash account
from Georges business (used for the examples earlier) would look like this:
Cash
Beginning balance 0 Payments on account 7,000
Cash introduced 50,000 Rent 2,000
Revenue 8,000 Balance carried down 49,000
58,000 58,000
The beginning balance on the account is zero, because George had only just started his
business. The account shows the amounts paid into the business on the left side of the
account and the amounts paid out on the right. It is then possible to calculate the
balance of cash following these transactions by totalling each side and finding the
difference. This is the balance carried down on the account as the beginning balance for
the next accounting period.
Note that the currency units are left out to give more space for the other information.
Accountants apply a set of rules in recording account information so that the accounts
for all businesses are recorded in the same way. You will always see cash account
entries recorded in this way with receipts of cash (increases to the cash balance) recorded
on the left side of the account and payments (decreases to the cash balance) on the
right. In order to record entries in the accounts of a business, you need to learn the rules.
The rules of debit and credit
Accountants call the left side of the account the debit side; and the right side the credit
side. How increases and decreases are recorded in each account is determined by the
type of account. You will see that in the cash account above, increases are recorded as
debits (on the left side) and decreases as credits (the right side). The cash account is
an asset account and all asset accounts show increases as debits and decreases as
credits.
Entries in liability accounts are recorded the opposite way around. Decreases are recorded
as debits (on the left side of the account) and increases as credits (on the right side).
Look at Georges accounts payable T account:
(Debits) Accounts payable (Credits)
Payment on account 7,000 Beginning balance 0
Goods purchased on account 7,000
Balance carried down 9,000 Goods purchased on account 9,000
16,000 16,000
Looking at the capital account, you will see that entries are similar to those on liability
accounts. Decreases are recorded as debits and increases as credits. Georges capital
account is shown below:
Capital
Rent expense 2,000 Beginning balance 0
Cash introduced 50,000
Balance carried down 52,000 Net income from sale of goods 4,000
54,000 54,000
Note that here we have recorded all the entries that relate to owners equity in one capital
account. You will recall that revenues, expenses and withdrawals normally have their
own accounts from which the balances are transferred to the capital account at the end
of the accounting period. We will look at how this works in a later example.
We can summarise the rules of debit and credit thus:
For items that are included on the left side of the accounting equation (Asset accounts):
increases are recorded as debits (on the left) and decreases as credits (on the right).
For items on the right of the accounting equation (Liabilities and owners equity):
decreases are recorded as debits (on the left) and increases as credits (on the right).
The diagram below might help you to remember.
Source: Horngren, Harrison and Bamber (1999)
Note
You may have noticed that bank statements seem to be the opposite way around.
When you have money in your account, the bank tells you that you are in credit.
This is because the bank is looking at the account from their viewpoint and not
yours. The bank statement that you receive is simply a copy of their records and
as far as they are concerned, when you have money deposited in your account,
they owe you that amount. To the bank, your account is a liability.
Using T accounts, record the following transactions for Jenny Rodin. Jenny has just set up
as a tax accountant and these are her initial business transactions:
1 Cash introduced to start the business $35,000
2 Office supplies purchased on account $2,500
3 Office furniture purchased cash $4,000
4 Office equipment purchased cash $7,500
5 Payment to supplier re: office supplies $1,000
Include the number of each transaction as this will help you to cross-check entries later on.
Now we will introduce some revenues, expenses and withdrawals. Remember that,
although these affect the capital account, they are usually recorded in separate T accounts
during the accounting period. To decide whether entries should be debits or credits, just
think about the effect on owners equity.
ACTIVITY 2.2

Accounting
equation
Rules of debit
and credit
Assets
debit credit
Liabilities Owners'
equity
+
debit credit
+
debit credit
+
Remember:
Increases to owners equity are credits and decreases are debits.
Revenues increase owners equity.
Expenses decrease owners equity.
Withdrawals decrease owners equity.
Make entries in the accounts of Jenny Rodin for the following transactions. Note that
numbering for the transactions is continued from the previous activity. You will need some
new T accounts but if you wish some of the entries can be made in the T accounts you
prepared for the last activity.
6 Client work completed $1,500 on account
7 Client work completed $500 paid cash
8 Rent paid cash $2,000
9 Cash withdrawal by Jenny $2,500
10 Payment on account by client $750
Include the number of each transaction as this will help you to cross-check entries later on.
ACTIVITY 2.3
Balancing the accounts
It is possible to ascertain the balance on an account at any time by totalling each side of
the account and calculating the difference. If the debits total is higher, then the balance is
a debit balance. If the credits are higher, the account has a credit balance.
Look at Jennys cash account below. Each side of the account has been totalled and the
balance of the account calculated:
Cash
Beginning balance 0 [3] Furniture 4,000
[1] Capital 35,000 [4] Equipment 7,500
[7] Revenue 500 [5] Payment on account 1,000
[10] Payment on account 750 [8] Rent 2,000
[9] Withdrawal 2,500
17,000
Balance carried down 19,250
36,250 36,250
Balance brought down 19,250
The cash account has a debit balance of $19,250.
If you look at the balances, you will see that, in each case, the balance is on the side
where account increases are recorded. This is usually the case. The normal balance of
any account will be on the side on which increases are recorded. This means that for
asset accounts, the balance will normally be a debit balance; and for liability accounts,
the balance will normally be a credit balance. If the balance is the opposite to what you
would normally expect, it is probably due to an error.
You have seen that owners equity is made up of a number of accounts. In total, these
accounts will normally show a credit balance but individual accounts are different. Revenue
accounts will show a credit balance; expense and withdrawals accounts will normally
have a debit balance.
There are a few occasions when balances might be different from what would be expected.
For example, a cash account could have a credit balance, if the business overdraws on
its bank account. Similarly, an accounts payable account could have a debit balance if
the business overpaid its account. However, if the balance of an account is not as would
normally be expected, it is always wise to investigate.
Calculate the balances on the other accounts of Jenny Rodin.
Account Balance Debits/Credits
ACTIVITY 2.4
The trial balance
A trial balance lists all the accounts and their balances. It would normally be prepared at
the end of an accounting period. If all entries to the accounts have been made correctly,
then the total of credit balances should equal the total of debit balances. When accounts
were prepared manually, the trial balance was a valuable tool in identifying errors. If the
totals of credit and debit balances were not equal, something had been incorrectly posted.
In fact, most businesses now use computerised systems which will rarely show out-of-
balance transactions. The trial balance is still useful as a summary of account balances.
Trial balances usually list assets first, followed by liabilities, then owners equity accounts,
revenues and expenses. This is the same order in which they appear on the financial
statements.
Totals
Prepare a trial balance for Jenny Rodin.
Account Debits Credits
ACTIVITY 2.5
Resolving errors in the trial balance
If the trial balance doesnt balance, there are a few simple checks you can make in order
to locate the error:
Calculate the difference. You may be able to see immediately that you have failed to
include a particular account balance.
Check all account balances back to the accounts to see if you have missed any.
Look for a transaction that is equal to the amount of the difference.
Divide the difference by two. If you have included a debit balance as a credit or vice
versa, the amount of the error will be doubled. This also applies to transactions you
may have posted a transaction to the wrong side of an account.
Divide the difference by nine. If the amount is exactly divisible by nine, you may have
written one of the figures incorrectly. The error could be a transposition error for
example, writing $9,500 as $5,900 or a slide for example, writing $9,500 as
$950.
Most of these errors are avoided by using computerised systems because computerised
software packages are designed to make matching debit and credit entries, and will
highlight any discrepancies as postings are made. This does not mean computerised
accounts are error-free. They are only as accurate as the human input, and entries can
still be made to the wrong accounts or the wrong side of an account. These errors can be
more difficult to identify.
Summary
You have learned about the system that businesses use to record their financial
transactions:
The key points are:
The rules of double-entry accounting and how items are posted into T accounts
using debit and credit entries.
The position of entries shows which items are debits in the accounts and which are
credits.
The financial information that businesses record in the accounts forms the basis of
their financial statements.
There are methods of detecting and correcting errors at an early stage.
Self-test B
1 Which of the following accounts is an asset account?
a accounts payable
b withdrawals
c revenue
d accounts receivable
e capital
2 Which of the following T accounts shows the incorrect sides that would be
used to increase and decrease an account?
a b
Revenue Assets
Decrease Increase Increase Decrease
c d
Expenses Owners equity
Increase Decrease Increase Decrease
e
Liabilities
Decrease Increase
3 Which are the correct account entries for the following transaction? A customer
buys goods to the value of $3,500 and is allowed one months credit:
a debit accounts payable, credit cash
b debit revenue, credit accounts payable
c debit accounts receivable, credit revenue
d debit cash, credit accounts receivable
e debit cash, credit revenue
4 Which are the correct account entries for a transaction where the owner of a
business puts cash of $50,000 into the business?
a debit cash, credit capital
b debit capital, credit cash
c debit withdrawals, credit capital
d debit cash, credit withdrawals
e debit capital, credit revenue
5 Which of the following is the order of accounts as listed on the trial balance?
a capital, withdrawals, revenues, expenses, assets, liabilities
b revenues, expenses, assets, liabilities, capital, withdrawals
c revenues, expenses, capital, withdrawals, assets, liabilities
d assets, expenses, withdrawals, liabilities, revenues, capital
e assets, liabilities, capital, withdrawals, revenues, expenses
Turn to the Self-test answers at the end of this section.
Taxation
It is said that there are two things that cannot be avoided death and taxes. As a business
owner you will need to be aware of your responsibilities for tax and how they are likely to
affect your business. You can assign your accountant to deal directly with the tax authorities
on your behalf, but again it would be sensible to understand the basics.
Income tax
If an individual receives an income they may be liable for tax. This may mean being taxed
as a self-employed person (in arrears) or as an employee (limited company) under PAYE
(Pay As You Earn). As a director of a limited company there will also be duties to levy tax
from employees. In the UK advice may be obtained from the HMRC (Her Majestys
Revenue and Customs).
The simplest way to ensure that you are keeping within the law is to contact your local tax
office and tell them that you are thinking of setting up in business. They should explain
what taxes are applicable and when they should be paid. For business and income taxes
for the self-employed, these are often paid in lump-sum instalments.
In general, personal income taxes tend to work like this:
Taxable income equals income less personal allowances. Personal allowances make up
the part of our income that is not subject to tax. Every income earner is normally entitled
to these, although the amounts may vary with personal circumstances.
Taxable income is then taxed at an appropriate rate which may increase as income rises.
If so, the higher rate applies only to upper slices of income.
In the UK tax rates and personal allowances are reviewed annually.
Business taxes are usually levied on the net profit (operating profit) of the business. The
net profit is the business income less all allowable expenses. Allowable expenses are
those expenses which are wholly and exclusively reserved for the business. They may
include allowances on capital equipment.
For sole traders, such a profit is seen as their income, and taxable income would be this,
less their personal allowance. For example, a person who has an income of $20,000 and
a personal allowance of $5,160 will be taxed on the difference of $14,840.
Profits tax/corporation tax
A limited company will pay corporation tax on the profits of trading. Advice may be obtained
from the HMRC in the UK.
Sales tax/Value Added Tax
Many types of goods or services attract this tax based upon their sales value. If a business
sells taxable goods and its turnover exceeds a stipulated figure (revised annually), then
it will be required to register with HMRC and accept responsibility for the collection of tax
on sales. Advice may be obtained from HMRC. Many companies find it beneficial to
register voluntarily for VAT even if their turnover falls below the limit.
At present there are four rates of VAT in the UK:
exempt
zero-rated
8 per cent
17.5 per cent
This is the present situation but circumstances may well change. Rates can change and
new rates can be introduced at any budget point.
How the tax works
In the UK, businesses that are registered with HMRC collect sales tax/ VAT by adding it to
the price of their goods or services.
From the tax collected, the business is allowed to deduct the VAT that they have paid for
allowable expenses, with the balance being sent to HMRC at regular, arranged intervals.
Being able to reclaim the VAT element of expenses may be an advantage to the business.
Registering
Any businesses whose turnover (sales income) in taxable goods/services exceeds a
laid-down figure (revised annually) will have to register with HMRC and charge VAT on
the goods/services. They will be issued with a registration number which will appear on
all paperwork.
Businesses may also register voluntarily (when their turnover is below the threshold) if
they have commercial reasons for doing so. Some reasons for registering voluntarily are
that the customers require VAT invoices or that there are large investments on start-up.
Records
Registered businesses will need to keep good accounts and records will need to be kept
for at least seven years in the UK. If registered, you will receive a visit from the VAT
Inspector to ensure that your records are sufficient to support claims.
Further information
This can be obtained from your local HMRC office.
Import duties
Businesses that import goods may find that their purchases attract import tax if their
goods come from certain countries.
National Insurance
All individuals contribute towards National Insurance costs unless their income falls below
the national lower earnings level. You can obtain advice from the DSS (Department of
Social Security).
In the UK as soon as you start in business you must pay Class 2 National Insurance,
which every self-employed person must pay in order to secure an old age pension and to
ensure access to basic benefits like the National Health Service.
It isnt tax deductible you must pay it from your private account.
This charge may vary from year to year.
The accounting equation
The accounting equation is a basic tool of accounting. It shows how the resources of the
business are split between the different claims on those resources.
Assets = Liabilities + Owners equity
Assets are the resources of the business. These include anything that the business owns
or is owed, as well as any cash held by the business. It is anything that is of use or future
benefit to the business. For example, business equipment, merchandise for resale, and
amounts owed to the business by customers are all assets.
Liabilities are outside claims on the assets of the business. These are amounts owed by
the business to creditors. Owners equity is another claim on the assets of the business.
In fact, having taken account of any liabilities, any remaining assets represent the owners
stake in the business. You might like to think of the owners stake as money that the
business owes to the owners. You will sometimes see the accounting equation written as
follows:
Assets Liabilities = Owners equity
This shows how the owners stake in the business is represented by the net resources of
the business.
Later in this section, you will learn more about the assets and liabilities and how they are
valued. You will also look more closely at owners equity and at how the owners stake in
the business can be increased or decreased.
This equation can be used to calculate the different elements. For example, if the liabilities
of the business are $76,000 and the owners equity is $50,000, you can calculate that the
assets of the business are $126,000.
ACTIVITY 2.6
The assets of a busi ness are $132,000 and the l i abi l i ti es amount to $64,000.
What is the amount of owners equity?
The owners equi ty i n a busi ness i s $89,000 and the l i abi l i ti es are $56,000.
How much are the assets?
The financial statements
Financial statements are produced to report on the financial performance of the business.
They are formal reports that summarise the business activities in monetary terms. The
main financial statements are the income statement, the statement of owners equity, the
balance sheet and the statement of cash flows. Financial statements are prepared as at
a specified date and, where appropriate, should specify the period they cover. They
show what has happened to the business, in monetary terms, during the period or its
position at the end of the period.
Income statement a summary of the organisations revenues and expenses for a
specific period. The statement shows the net income or net loss for the period which
is calculated by deducting expenses from revenues. It is also known as the statement
of earnings or statement of operations. Statements are prepared on a periodic basis,
for example monthly, quarterly or annually.
Statement of owners equity owners equity represents the owners stake in the
business. The statement of owners equity shows any movements in value that have
occurred in the specific time period covered by the statement.
Balance sheet this shows the assets, liabilities and owners equity of the business
at a specific point in time. It might be prepared at the end of each month, each
quarter or each year. It is sometimes referred to as the statement of financial position.
Statement of cash flows this shows amounts of cash going in and out of the
business during the specified period. It shows the net increase or decrease in cash
during the period and the balance of cash remaining in the business at the end of
the period.
ACTIVITY 2.7
Corporations publish their financial statements, along with other information, as an annual
report. Annual reports are made available to the general public and often published on the
organisations website. Obtain a copy of the annual report of a corporation of your choice.
Identify the financial statements described above.
Making the rules GAAP
Business organisations keep accounting records and produce financial statements to
report on the financial position of the business. As in most technical and professional
areas, accounting has its own set of rules that control how financial information is identified,
processed and reported. These rules are generally very similar across the world.
Why do you think it is important for there to be rules governing the financial information that
businesses produce?
In the United States, the generally accepted accounting principles (GAAP) are most
influenced by the Financial Accounting Standards Board (FASB). The FASB is
supported financially by the professional accounting associations. It has seven members
supported by a large staff, and is independent of any government or professional bodies.
The FASB makes the rules by issuing Statements of Financial Accounting Standards
which explain how certain business transactions should be dealt with by a business.
These standards become part of GAAP which is generally accepted by the business
community as the right way to carry out financial accounting.
The Securities and Exchange Commission (SEC) is a government organisation that
regulates the trading of investments. The US Congress has also given SEC the
responsibility of making accounting rules that relate to businesses whose stocks are
traded. However, the SEC delegates much of this power to the FASB.
GAAP is made up of a variety of concepts and principles which give businesses the
guidelines they need to prepare and present accounting information.
Other countries produce similar rules for accounting and have their own standards boards
to regulate financial accounting. Most largely follow US GAAP, with perhaps the addition
of some locally relevant principles.
ACTIVITY 2.8
Summary
This unit has introduced you to some accounting terminology and looked at some of the
basic ideas behind accounting.
The key points from this unit are:
There are a number of different types of business ownership, the most common
being corporate ownership.
It is important that businesses keep financial records for decision-making purposes
and in order to report to third parties.
There are general accounting rules that are set by the Financial Accounting Standards
Board which should be applied in recording and reporting financial information.
The basic accounting equation (Assets = Liabilities + Owners Equity) explains the
relationship between the different financial elements of a business.
The main financial statements of a business are the income statement, the statement
of owners equity, the balance sheet and the statement of cash flows.
Self-test C
1 To which of the following groups is accounting information relevant?
business managers
government bodies
investors
creditors
a only business managers
b only government bodies
c investors and creditors
d business managers, government bodies and creditors
e all of the groups listed
2 Which of the following statements best describes the term limited liability in
respect of corporations?
a The liability of the business to its shareholders or stockholders is limited.
b The personal liability of shareholders or stockholders is limited to their
investment in the business.
c The personal liability of the owners is limited.
d The liability of the business to repay creditors is limited.
e The liability of shareholders or stockholders is limited to the amount of
their personal wealth.
3 A business has liabilities of $97,000 and assets of $176,000. What is the amount
of owners equity?
a $97,000
b $176,000
c $273,000
d $79,000
e $194,000
4 Which of the following summarises the earnings of the business and shows
the net income or loss for a specified financial period?
a the income statement
b the statement of owners equity
c the balance sheet
d the statement of cash flows
e the accounting equation
5 Which of the following is responsible for producing the Statements of Financial
Accounting Standards which form the rules of accounting in the US?
a US Congress
b FASB
c SEC
d the professional accounting bodies
e individual business organisations
The rules of accounting
Introduction
Previously you learned about the existence of generally accepted accounting
principles (GAAP). GAAP is the set of rules with which businesses comply when
measuring, processing and reporting financial information. This unit introduces the main
concepts and principles of GAAP.
What does GAAP attempt to do?
GAAP is primarily intended to guide businesses in providing appropriate financial
information for investors and lenders. Whilst other groups and individuals may use the
information, it is particularly important for investors and lenders because they rely on
this information to make judgements about businesses. If all accountants follow the rules
and guidelines set out by GAAP, then the financial statements produced by different
businesses will be broadly comparable. This allows investors and lenders to compare the
financial information of different businesses. The overriding principle of GAAP is to help
businesses to produce financial information that is relevant, reliable and comparable.
Concepts
There are a number of general assumptions which provide the starting point for financial
reporting. Unless otherwise stated, all financial statements should have been prepared
on the basis of these concepts.
Entity or separation concept
The assumption is that financial records and reports of an entity only contain transactions
relevant to that entity. An entity is an organisation or part of an organisation which is
considered to be a separate economic unit. In practice, this means that the financial
records of a business, and reports based on those records, do not include information
about the finances of the owners or other related individuals or other related businesses.
Example
If you started a business, you would account for your personal finances separately
from those of the business, even if you used the same bank account for both.
Imagine that you are running a small business. You have $1,300 in your bank
account. $500 of this was a gift from your parents. The remainder is net income
generated by the business. If you reported the whole $1,300 as income generated
by the business, you would be overstating the net income. This could have
implications in terms of decision-making for the business. Similarly, if you took
some money out of the account to buy groceries for yourself, you would not
include it as a business expense.
If you run more than one business, it makes sense to consider their finances separately
so you are able to see clearly which are more profitable. A loss by one business might be
hidden by the profits of another. Imagine you have two businesses. One makes a loss of
$6,000 in the accounting period, the other makes a profit of $8,000. If you accounted for
the businesses together, the overall profit would be $2,000. Looking at them separately,
however, you might decide to close the loss-making business and concentrate on the
profitable one. Many large organisations account for different divisions so they can identify
less profitable areas.
Why do you think it is important to investors and lenders that each entity is treated separately
for accounting purposes?
ACTIVITY 2.9
What does this concept mean if you are looking at a businesss financial information? You
can assume that the information does not contain anything that is not relevant to the
operations of the business entity and that the reported income has been generated by
the activities of the business. This is important to investors and lenders so that they can
assess the businesss ability to pay the required return or loan interest on a long-term
basis.
Going-concern concept
This is the assumption that the business will continue to operate in the foreseeable future.
The implications of this concept will become clearer when you look at some of the more
detailed principles relating to financial reporting. You need to be aware that the financial
statements of a business do not, and are not intended to, reflect the current market value
of the business. The statements are prepared on the assumption that the business will
continue its activities and continue to use the assets it owns in operating the business
and discharge any liabilities in the normal course of business.
The assets of a business include the equipment and supplies it uses to operate and any
goods it purchases for resale. In the normal course of business, the equipment such as
shop display units would remain in the business; supplies such as the paper rolls for
the cash register would be used; and the goods would be sold at a profit. Liabilities,
including loans and credit allowed by suppliers for goods, would be paid as required by
the terms of the agreement. Loans, for example, might be paid off over a period of
several years by a regular monthly payment that includes interest. Suppliers usually
specify the time period within which they expect payment of their accounts (commonly
30 days/one month).
Where a business ceases to operate, this will affect what happens to its assets and
liabilities. Goods may have to be sold at a loss to sell quickly; equipment sold as used
might not raise enough to cover any loan obtained to purchase it; supplies such as paper
will probably have no resale value. Liabilities will need to be paid in full. Loan interest will
probably be reduced for early payment; creditors might be prepared to wait a little longer
for payment until the business has collected all amounts due to it. You can see that
closing a business can affect the amounts and timing of payments and receipts.
You own a clothing store, but you have decided to close the business because it is no longer
profitable. There is too much competition from the larger department stores. You need to
sell all the assets and discharge liabilities. Consider the following questions, giving explanations
for your answers:
How will you dispose quickly of the items you have left in the store?
You have decided to sell the display units used in the store. They were purchased new six
months ago at a cost of $5,000. The bank loaned you the money to buy them. Do you think
you will raise enough from the sale to repay the loan?
ACTIVITY 2.10
can assume that the business will continue its normal business activities in order to
generate income and meet its liabilities as they fall due. This is important to investors and
lenders who want to continue to receive regular returns or payments.
Stable-monetary-unit concept
This is the name given to the assumption that the value of money remains constant over
time. In the US, for example, accountants record transactions in dollars (in the UK it is
pounds sterling). The value of a dollar can change over time. During times of inflation
when prices are generally rising a dollar is worth less in terms of the goods it will buy. If
you think of, for example, a loaf of bread in terms of its dollar value, when the price of
bread rises, a dollar buys less bread than before. In countries where inflation rates are
high, accountants make adjustments to express financial statements in terms of current
purchasing power. In the US, accountants assume that the dollar is relatively stable and
so ignore the effects of inflation.
can assume that no adjustments have been made to the monetary amounts to account
for general price rises. In times when there is no inflation, or rates are low, the statements
of different businesses will be comparable.
Time-period concept
This term summarises the idea that the financial information of a business is reported at
regular intervals. Businesses will produce annual financial reports. They may also produce
reports at shorter intervals such as monthly or quarterly. These interim reports are usually
internal reports.
can assume that up-to-date financial reports on the business will be available, which is
important for decision-making purposes.
Conservatism concept
The least favourable figures are reported in the financial statements. The goal is for
financial reporting to reflect a realistic position. For some items in the financial statements,
there may be doubt about valuation or timing. This is when the conservatism concept is
used. Items will be estimated at the least favourable figure. This means that assets and
income will be reported at the lowest possible figure; liabilities and expenses at the highest.
Example
If a business buys goods for resale (inventory) at $23,000, but knows that those
goods are now obsolete and have scrap value of around $6,000, they should be
recorded in the accounts at the lower amount. It may be that the business will be
able to sell the goods for more than this if the right buyer can be found, but the
worst-case scenario should be anticipated and allowed for.
ACTIVITY 2.11
The manager of the business in Activity 2.10 believes that he can sell the obsolete goods at
$10,000 and wants to include this figure in the accounts. The accountant insists that the
accounts should show $6,000.
Why is it important to the manager to report the higher figure?
Which figure do you think investors and lenders would want to see reported and why?
can assume that items in financial reports are included at their least favourable value.
Materiality concept
Material items must be reported strictly in accordance with proper accounting rules and
guidelines. Conversely, non-material items need not be reported strictly in accordance
with proper accounting rules. This concept frees accountants from the onerous task of
checking that every single item is reported in accordance with GAAP, whilst ensuring that
material items are properly reported. An item is material when it is significant enough to
affect the decisions made by users of the financial information. Actual values of material
items will vary according to the size of the business and the nature of the item.
Example
You have seen that the balance sheet of a business reports the assets and
liabilities of the business. Included in assets will be a value for equipment used in
the business. Mandeeps Restaurant reports a value for equipment of $500,000.
Mandeep has decided that small items of equipment such as kitchen knives and
utensils should not be included in the balance sheet as equipment, but charged
as an expense against income in the year of purchase. This year, the amount
spent on kitchen knives and equipment amounted to $300. Accountants would
probably accept this as being immaterial. In fact, it would probably cost more to
record them in strict accordance with GAAP than the value of the items. However,
if Mandeep decided to replace all the knives and forks for the restaurant, at a
cost of $25,000 and charged the amount to expenses, this could give a misleading
view of her net income for the year and the value of equipment used in the
business. Both these items would be shown as $25,000 less than their true
values. In this case, the item would probably be considered to be material and
accountants would insist on proper treatment in the financial statements.
can assume that reported figures are free from any material errors. This is important if
you are an investor or lender who needs to make a decision based on the financial
reports.
Principles
There are six general principles that should be applied in reporting financial information.
These form the framework for financial reporting.
Reliability or objectivity principle
Accounting records and statements should be based on the most reliable information
available. The most reliable information will be information that is verifiable. If you purchase
goods, supplies or equipment, you will have paid invoices in respect of the items. These
serve to verify the cost of the items. These items will normally be included in the financial
records and reports at their cost value.
What does this principle mean if you are looking at a businesss financial information?
The data used to prepare financial reports should be reliable and verifiable.
Cost principle
All items should be recorded at their historical cost. They will remain at historical cost in
the accounting records for as long as the business holds the item. Historical cost is the
actual cost of items. The principle links with the reliability principle explained above, in
that cost is a reliable measure of value.
ACTIVITY 2.12
A business purchases a building from which to operate at a cost of $130,000. Real estate
agents had valued the property at $150,000. The owner was keen to sell quickly so sold the
property at lower than market value. One year later, the business believes the property is
worth $160,000 as property values have improved.
What value for the property should be recorded in the accounting records?
What value should be recorded one year later, when the property seems to be worth more?
You can assume that all items reported have been included at their historical cost.
Revenue principle
Revenues are amounts earned by the business through its business activities. The revenue
principle states that revenues are to be recorded only when they have been earned and
at an amount equal to the cash value of the goods or services transferred to the customer.
Earned revenue will normally only include items where the goods or services have already
been delivered to the customer.
A company receives an order for goods worth $300. The company is waiting for the items to
arrive from the manufacturer. The customer pays for the goods and asks that the goods be
sent on as soon as they are available. The goods are delivered to the customer three weeks
later. The company gives the customer a refund of $20 because they have had to wait for
the goods.
When should the revenue be recorded?
What amount should be recorded?
ACTIVITY 2.13
You can assume that all reported revenues are certain and are recorded at actual amounts
earned.
Matching principle
Business expenses are recorded using the matching principle. Expenses are the costs of
operating a business. Under the matching principle, a business must identify and measure
all expenses incurred in the accounting period and match them against revenues earned
in the same accounting period. The aim is to measure net income for the period covered
by the financial reports. Any expense not relevant to the period covered by the reports
should be excluded.
The owner of a car lot pays his salespeople on a commission basis. They receive commission
for each sale made. Commission is paid in the month following that in which the sale was
made. Commission of $3,000 will be paid in May for sales made during April.
Rent for the car lot is $2,400 per quarter payable in advance. Rent for April, May and June
was paid at the end of March.
The historical cost of cars on the lot at the end of March was $123,000. The historical cost of
the cars sold in April amounts to $46,000. During April the owner purchased more cars for
resale at a cost of $22,000.
The owner prepares financial statements on a monthly basis. Using the matching principle,
identify the amounts recorded for April in respect of the following expenses:
commission
rent
cost of goods for resale
The matching principle ensures that net income for an accounting period is calculated
taking account of all items relevant to that period and is not overstated or understated.
Consistency principle
Businesses should use the same accounting methods and procedures from one
accounting period to the next. As you progress through this workbook, you will find that
there are different methods businesses can apply in determining certain amounts for the
financial statements. This is particularly the case in respect of inventory (goods purchased
for resale) and depreciation (an expense charged to reflect the use of an asset during
the period). The consistency principle will be explained further in the sessions dealing
with these items. The principle exists to ensure that the financial statements of a business
from different accounting periods are comparable. Businesses may change the methods
and procedures they use, but must disclose this in a note to the financial statements. The
note must also include an explanation of how the change has affected the statements in
monetary terms.
You can assume, unless there is a note to the contrary, that the financial statements of a
business from different accounting periods have been prepared on the same bases.
ACTIVITY 2.14
Disclosure principle
Businesses must report sufficient information for outsiders to make decisions about the
business. The information disclosed should be relevant, reliable and comparable. We
have already mentioned above the requirement to disclose information about changes
to accounting methods. Other standard disclosures include explanations of the methods
used to account for inventory and depreciation (also mentioned above). The disclosure
principle will be further explained as you continue through the workbook.
What does this principle mean if you are looking at a businesss financial information? As
an investor or lender, you can assume that the financial reports include all information
required for decision-making purposes.
Summary
In this unit, you have looked at the general concepts and principles that underlie the
reporting of financial information for businesses. You will continue to develop your
knowledge of these concepts and principles as you work through the remainder of the
unit.
GAAP is primarily intended to guide businesses in providing appropriate financial
information for investors and lenders.
There are a number of general assumptions that provide the starting point for financial
reporting. These are the concepts of:
the entity (or separation)
the going concern
the stable monetary unit
the time period
conservatism
materiality
Unless otherwise stated, all financial statements should have been prepared on the
basis of these concepts.
There are six general principles that form the framework in reporting financial
information. They are described as the principles of:
reliability or objectivity
cost
revenue
matching
consistency
disclosure
Self-test D
1 Which of the following is the accounting concept that emphasises the existence
of a business separate and apart from its owners?
a separation concept
b consistency concept
c going-concern concept
d materiality concept
e entity concept
2 Which of the following sets out the time-period concept?
a Expenses must be matched against revenues for an accounting period.
b Revenue should only be recorded in the period in which it was earned.
c Accounting information is reported at regular intervals.
d Businesses use the same accounting methods from one period to the
next.
e The accounting period covers one calendar year.
3 A toy company takes advance orders for Christmas delivery. An invoice is
issued to each customer on receipt of the order. Customers pay on receipt of
the goods. The company pays the supplier of the goods at the end of each
month. When should the revenue from the sales be recorded in the accounting
records?
a at the date of the order
b on issue of the invoice
c on delivery of the goods
d at the end of each month
e at Christmas
The financial statements
Introduction
You will now learn how to prepare the main financial statements. These are the income
statement, the statement of owners equity and the balance sheet. You will look at how
these statements differ for various types of business organisation. You will also look at
the relationship between these three statements.
Purpose of the financial statements
The financial statements are intended to summarise the business activities for an
accounting period and the balances at the end of that accounting period.
The income statement shows the net income or net loss arising from the business
activities over the accounting period. It is also known as the statement of earnings or
statement of operations. Reviewing and analysing the income statement can help people
assess the businesses success over the accounting period.
The statement of owners equity shows the changes to owners equity over the
accounting period. The statement shows how owners equity has increased by investment
and net income, and been reduced by withdrawals and net losses. It is a statement
showing the owners stake in the business.
The balance sheet is also known as the statement of financial position. It shows the
financial position of the business at the end of the financial period. It lists all the assets
and liabilities at the accounting period end date. Reviewing the balance sheet gives people
a view of the resources and commitments of the business as it begins the new accounting
period.
The statements are useful in making decisions about lending, investment and generally
about business activities. They will be used by owners, investors, lenders and managers.
The three financial statements are linked, as shown by the diagram below.
Income
statement
Net income
Statement of
owners' equity
Added to
capital balance
Total owners'
equity
Balance sheet
Total assets
are equal to
liabilities plus
owners' equity
Net income is calculated by deducting total expenses from total revenue on the income
statement. If expenses are higher than revenue, there will be a net loss. The net income
or loss is transferred to the statement of owners equity.
The statement of owners equity shows the owners stake in the business. Net income is
added to the capital balance from the start of the period together with any further
investment in the business by the owners during the accounting period. Any net losses
and withdrawals are deducted. This gives a capital balance at the end of the accounting
period. The balance of owners equity is used to balance the balance sheet!
The balance sheet represents the accounting equation. It shows all the assets, liabilities
and owners equity at the end of the accounting period.
Preparing the financial statements
Previously, you learned how to prepare an adjusted trial balance. The adjusted trial balance
provides the figures that you need to prepare the three financial statements described
here. A simple way to prepare the statements is to extend the adjusted trial balance.
The adjusted trial balance for Jenny Rodin is shown. We have numbered each account
to make it easier to reference in the notes to the adjusted trial balance. Note that currency
units are usually omitted to give more space for the figures.
Balances are transferred to the financial statements as follows:
Accounts 1 to 11 are transferred to the balance sheet and the statement of owners
equity. These include all assets, liabilities and owners equity accounts.
Accounts 12 to 17 are transferred to the income statement. These include all revenue
and expense accounts.
One simple way to draft the financial statements is to extend the adjusted trial balance.
On the next page, we have extended the adjusted trial balance to include columns for the
income statement and balance sheet.
Jenny Rodin Adjusted trial balance for the year ended 31 December
Trial balance Adjustments
Adjusted
trial balance
Account title Debits Credits Debits Credits Debits Credits
12,190
5,100
300
4,000
7,500
16,010
12,000
3,800
2,500
21,000
2,900
87,300
1 Cash
2 Accounts receivable
3 Office supplies
4 Office furniture
5 Accumulated
depreciation
6 Office equipment
7 Accumulated
depreciation
8 Accounts payable
9 Salary payable
10 Capital
11 Withdrawals
12 Revenue
13 Rent expense
14 Office supplies
expense
15 Depreciation
expense
16 Salary expense
17 Utilities expense
Totals
12,190
2,700
700
4,000
7,500
16,010
12,000
3,400
19,250
2,900
80,650
1,870
35,000
43,780
80,650
[4] 2,400
[5] 400
[1] 1,000
[2] 1,500
[3] 1,750
7,050
[5] 400
[1] 1,000
[2] 1,500
[3] 1,750
[4] 2,400
7,050
1,000
1,500
1,870
1,750
35,000
46,180
87,300
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On the extended trial balance worksheet, we have transferred all the account balances
to the appropriate financial statement. Owners equity accounts are included in the balance
sheet because, ultimately, they will appear on this statement anyway. The balances are
entered in the debit or credit column as appropriate.
The next stage is to total each column. When the income statement columns are totalled,
you will notice that there is a difference between debits and credits. This difference is
actually equal to the net income or net loss. We enter this difference in one of the columns
to make the two balance. A net income will be added to the debit column, a net loss to the
credit column. This provides a check that the calculations have been correctly carried
out.
The figure is also entered into one of the balance sheet columns. A net income is added
to the credit column, a net loss to the debit column. The balance sheet columns should
now be equal. If they are not, it is because of an error in calculation and you should check
all your figures.
On the next page is a worksheet for Terence Stott. The adjusted trial balance is reproduced
for you. Extend the adjusted trial balance to provide the figures for the income statement
and balance sheet. Calculate the net profit or loss and enter this in the appropriate columns.
ACTIVITY 2.15
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Presenting the financial statements
The final statements will obviously be presented in a different format from that on the
worksheet. However, once the worksheet is completed, preparing the statements is
relatively simple.
At the start of this section, you obtained a copy of a businesss annual report. If you look
back at it now, you should be able to identify the financial statements. The ones we will
prepare here are much simpler but use exactly the same principles.
Jenny Rodin Income statement for year ended 31 December
Revenue:
Service revenue 46,180
Expenses:
Rent expense 12,000
Salary expense 21,000
Office supplies expense 3,800
Utilities expense 2,900
Depreciation expense 2,500 42,200
Net income 3,980
Note that expenses are usually listed in descending order of amount, except where there
is a miscellaneous expense account. This is usually included at the end of the list.
You will also see that subtotals, instead of appearing at the foot of the column they relate
to, are placed to one side (thrown out) into the next column. This is so that when they
are involved in further calculations it is clear what figure is being used and that each
figure is only counted once in each process.
Jenny Rodin Statement of owners equity for year ended 31 December
Jenny Rodin, capital 1 January 35,000
Add: Net income 3,980
38,980
Less: Withdrawals 16,010
Jenny Rodin, capital December 31 22,970
Jenny Rodin Balance sheet at 31 December
Assets Liabilities
Current: Current:
Cash 12,190 Accounts payable 1,870
Accounts receivable 5,100 Salary payable 1,750
Supplies 300 Total liabilities 3,620
Plant:
Office furniture 4,000
Less: Accumulated
depreciation (1,000) 3,000
Office equipment 7,500 Owners Equity
Less: Accumulated
depreciation (1,500) 6,000 Jenny Rodin, capital 22,970
Total liabilities and
Total assets 26,590 owners equity 26,590
Assets and liabilities on the balance sheet are split into current and long-term. Current
assets are those that are held temporarily in the business and will change over the
accounting period (usually one year). These generally include cash, accounts receivable
and supplies. Longer-term assets or plant assets are those assets which are used in the
business on a long-term basis, such as buildings, furniture and equipment.
Current liabilities include accounts payable and any other items payable at the end of the
accounting period that are likely to be cleared quickly. Current liabilities are usually defined
as those that will be paid within one year. Any other loans or liabilities are known as long-
term liabilities.
This format of balance sheet is known as the account format. Many business
organisations use the report format which lists liabilities and owners equity below assets
rather than alongside.
The report format is shown below.
Jenny Rodin Balance sheet at 31 December
Assets
Current:
Cash 12,190
Accounts receivable 5,100
Supplies 300
Plant:
Less: Accumulated depreciation (1,000) 3,000
Office equipment 7,500
Less: Accumulated depreciation (1,500) 6,000
Total assets 26,590
Liabilities
Current:
Accounts payable 1,870
Salary payable 1,750
Total liabilities 3,620
Owners equity
Jenny Rodin, capital 22,970
Total liabilities and owners equity 26,590
Note that financial statements always show:
the name of the business
the date at which they were prepared
the period covered
ACTIVITY 2.16
From the worksheet of Terence Stott, prepare an income statement, statement of owners
equity and balance sheet.
(continued)
(continued)
Partnerships
For a partnership, the profits and losses of the business must be divided between the
partners. Ideally, there is a partnership agreement stating how the division is to be made.
If there is no agreement, then the profits are split equally among the partners. This may
not be a fair way to split the profits. In some partnerships one partner may contribute a
lot more capital and therefore require a bigger return. Alternatively, one partner may
work longer hours in the business than the others, so deserves more reward. There are
a variety of different bases for splitting the profits between partners. In fact, partners can
agree to split the profits and losses any way they wish. We will consider the following
commonly used methods:
using an agreed fraction
based on capital contribution
based on capital contribution and services to the business
based on salaries and interest
Note that, though the profits are split between the partners, much of the profit will remain
within the business. The amounts allocated to each partner are not actually paid out in
cash but represent an additional share in the business for each partner. The profits for
each partner are added to their capital, from which losses are deducted. Actual cash
from the business is taken in the form of salaries or withdrawals.
We will use the following example in this unit:
Anderson, Barker and Little are partners in business. Their capital contributions at the
start of the year are:
Anderson $80,000
Barker $100,000
Little $120,000
Total capital $300,000
Partnership profit for the year is $240,000
Sharing profits equally
If the profits were to be shared equally amongst the partners, they would each receive
$80,000. However, this method reflects neither the capital investment nor the contribution
to day-to-day business activities that each partner makes.
Using an agreed fraction
The partners could agree on a fraction to use in the division of profits. For example,
Anderson, Barker and Little might decide to split the profits as follows:
Anderson one-fifth
Barker two-fifths
Little two-fifths
This would mean the profits were allocated thus: Anderson $48,000; Barker and Little
$96,000 each. This is still not specifically related to amounts of capital or services
contributed, although the fraction does reflect the fact that Anderson has contributed
less capital. However, it is simple to calculate and, if the partners are satisfied with this
split, then it is perfectly acceptable.
Based on capital contribution
To calculate the split based on capital contributions, you need to calculate each partners
share of the total capital and give them a comparable share of the profits. To do this,
divide each partners capital by the total capital and multiply by the profit figure:
Anderson $80,000 300,000 x 240,000 = $64,000
Barker $100,000 300,000 x 240,000 = $80,000
Little $120,000 300,000 x 240,000 = $96,000
This method rewards partners in line with their investment in the business. If partners
contributions to everyday business activities are equal, this would be a good way to split
the profits and losses.
For the partnership of Raby, Charles and Mason, split the profits based on capital contribution:
Capital contributions are: Raby $40,000; Charles $40,000; Mason $60,000.
Net income for the year was $150,000.
ACTIVITY 2.17
:
:
:
Based on capital contribution and services to
the business
Services to the business might be longer hours, greater expertise or seniority based on
length of time in the partnership. The partners might decide to reflect any or all of these
in the profit share.
Suppose that Anderson worked the longest hours for the business, followed by Barker.
Little very much takes a back seat on day-to-day activities. The partners might decide to
use the following basis for profit share:
The first $120,000 is to be split on the basis of capital contribution.
The next $75,000 is to be used to reward Anderson and Barker for their work for the
business. It is to be split $45,000 to Anderson and $30,000 to Barker.
Any remaining profits are to be split equally among the partners.
This would give profit shares as follows:
Anderson Barker Little Total
Total net income $240,000
First $120,000 split
re capital contributions:
$32,000
$40,000
$48,000
Total allocated ($120,000)
Second $75,000 split to reflect services:
Anderson $45,000
Barker $30,000
Remainder to be split equally: ($45,000)
Anderson $15,000
Barker $15,000
Little $15,000
Totals $92,000 $85,000 $63,000 $240,000
This method reflects both the capital contributions and services to the business by
partners.
Based on salaries and interest
Another way in which partners can be rewarded for their capital contribution and their
work contribution is by the payment of salaries and interest.
For example, Anderson and Barker receive salaries as before of $45,000 and $30,000
respectively. Little receives a salary of $20,000. Then the partnership may decide to
allocate interest to partners at 25 per cent of their capital balance. The remainder of the
profit is to be divided equally. Profit allocation would be:
Salaries:
Anderson $45,000
Barker $30,000
Little $20,000
Interest on capital:
Anderson $80,000 x 25% $20,000
Barker $100,000 x 25% $25,000
Little $120,000 x 25% $30,000
Anderson $23,333
Barker $23,333
Little $23,334
Totals $88,333 $78,333 $73,334 $240,000
Remember that here salary and interest is not the same as a salary to an employee, or
interest to a creditor. Employees salaries and interest on loans are expenses to the
business. Partners salaries and interest on capital are simply a way of allocating profits
to the partners.
Now look at what happens if there is not enough money to pay all the salaries and
interest. Using the same example as above, assume that the partnership only had net
income of $150,000.
The allocation would be as follows:
Salaries:
Anderson $45,000
Barker $30,000
Little $20,000
Anderson $80,000 x 25% $20,000
Barker $100,000 x 25% $25,000
Little $120,000 x 25% $30,000
Anderson ($6,667)
Barker ($6,667)
Little ($6,666)
Totals $58,333 $48,333 $43,334 $150,000
After allocating salaries and interest, there is a negative figure which is allocated among
the partners.
Tracy Baxter and Jayshree Mistry are in partnership. They had originally decided to split all
profits and losses from the partnership equally because they both worked full time in the
business and had similar capital contributions. In the last year, Jayshree decided she wanted
to work less in the business. She also withdrew some of her capital. Tracy agreed to this, but
they cannot decide how they should now allocate the profits. You are given the following
information:
An average full-time salary for working in this type of business is $40,000.
The partners feel that a 15% return on capital is acceptable.
Capital balances following Jayshrees withdrawal of capital will be: Tracy $80,000;
Jayshree $50,000.
Jayshree will work half-time in the business.
The net income for the year is $70,000.
Calculate the profit allocation for the year using the salaries and interest basis. (Any remaining
profits should be divided equally.)
ACTIVITY 2.18
Sharing losses
Where a partnership has a net loss, this is divided in the same way. Unless otherwise
agreed, salaries and interest are still allocated to the partners before the loss is allocated.
(Some partnerships agree a different allocation for losses than for profits.)
Smythe and Motson are partners. They split profits and losses on the basis of capital
contribution:
Capital balances are: Smythe $70,000; Motson $35,000.
They made a net loss of $45,000 in the year.
Allocate the loss between the partners.
Imagine that Smythe and Motson split profits on a salary and interest basis, sharing any
remaining profits or losses equally:
Smythe receives a salary of $10,000; Motson receives $7,000.
Interest on capital is allocated at 6%.
Capital and losses are as before.
Calculate the loss allocated to each partner.
ACTIVITY 2.19
ACTIVITY 2.20
A note about withdrawals
Partners will withdraw cash during the year for living expenses. These withdrawals are
dealt with in the same way as for a proprietorship. They are deducted from the partners
capital account at the end of the accounting period. They do not depend on the profits or
losses of the partnership.
Balance sheet presentation
The balance sheet for a partnership will be slightly different from that of a proprietorship
as there will be more than one capital balance shown under owners equity. Each partners
capital balance will be included. Otherwise the income statement and balance sheet are
the same as those of a proprietorship.
Corporate capital
Ownership of corporations differs from that of proprietorships and partnerships, in that
there could be large numbers of investors of capital who hold shares of stock in the
business. This has an impact on the balance sheet.
The equity of a corporation, or capital stock as it is known, is divided into shares. Investors
may buy any number of shares and the corporation will issue a stock certificate to them.
There are different types of stock, but corporations will mainly be funded by common
stock which is the permanent capital of the business. (Note that even if investors want to
pull out, they will normally sell their stock to another investor.) Profits are paid to the
owners or stockholders, by means of dividends based on the amount of stock held by the
stockholder. Dividends are similar to the withdrawals made by proprietors or partners in
businesses. Not all profit will actually be paid out as dividends. Most will be retained in the
business to fund business activities. It is known as retained earnings.
State laws require that the balance sheets of corporations show the sources of capital.
The two main sources will be paid-in capital and retained earnings. The following is the
summarised balance sheet of Abbey Corporation, showing the presentation of
stockholders equity.
Abbey Corporation Balance sheet at 31 December
Assets Liabilities
Assets $1,197,500 Liabilities $121,000
Stockholders equity
Paid-in capital:
Common stock $200,000
Retained earnings $876,500
Total stockholders equity $1,076,500
Total assets $1,197,500 stockholders equity $1,197,500
Summary
You have learned how to prepare simple financial statements for proprietorships,
partnerships and corporations. You will develop your understanding of the statements
throughout the remainder of the section.
The key points are:
The income statement presents a summary of the business activities for the financial
period.
The balance sheet shows the financial position of the business at the end of the
financial period.
The statement of owners equity summarises the financial ownership of the business.
Partnership profits need to be allocated to the partners on some agreed basis.
Corporate capital is comprised of a number of different elements.
Self-test E
1 Which of the following amounts appears on the income statement of a
business?
a current assets
b accounts payable
c owner withdrawals
d prepaid rent
e revenues
2 Which of the following best describes the treatment of owner withdrawals in
the financial statements?
a included as a liability on the balance sheet
b included as an expense on the income statement
c deducted from revenues on the income statement
d deducted from capital on the statement of owners equity
e added to capital on the statement of owners equity
3 The following figures have been extracted from Mason Construction for the
year ended 31 July: revenue $98,700; accounts payable $35,000; accounts
receivable $65,000; total expenses $57,000; building supplies used in the year
$2,000. Which of the following figures is equal to Masons net income for the
year?
a $41,700
b $71,700
c $69,700
d $30,000
e $39,700
4 Graham and Jade are in partnership. They decide to split profits on the basis
of salary and interest capital. Graham is to receive a salary of $15,000. His
capital contribution stands at $90,000. Jade is to receive a salary of $20,000.
Her capital contribution is $78,000. They will split any remaining profit equally.
Interest is to be paid at 8%. Their net income for the year is $40,000. Which of
the following shows the correct profit allocation?
a Graham $20,000, Jade $20,000
b Graham $22,000, Jade $26,240
c Graham $26,120 Jade $30,360
d Graham $17,880, Jade $22,120
e Graham $30,360, Jade $26,120
5 For a corporation, which best describes the two main sources of capital?
a common stock and retained income
b cash and earned income
c cash and common stock
d revenues and dividends
e accounts receivable and revenues
The accounting cycle
Introduction
This part looks at how accounting is actually carried out by businesses. You have learned
about the basic accounting system used by most businesses to record financial information
and at how the financial statements are prepared. You will now look at the ledgers and
journals that businesses use, and at the accounting cycle which produces the financial
statements.
The accounting cycle fitting it all
together
The process by which a business produces its financial statements is a cycle. It starts
with the opening of the ledger accounts at the beginning of an accounting period; and
finishes with the production of financial statements and closing of ledger accounts at the
end of that financial period. The different stages of the cycle are summarised in the
following diagram.
The accounting cycle
Open ledgers with
account balances at
start of period
Journalise and post
closing entries to
ledger accounts
Prepare trial balance
worksheet
Calculate
adjusting
entries
Journalise adjusting
entries and post to
ledger accounts and
worksheet
Prepare adjusted
trial balance on
worksheet
Prepare financial
statements for
period
Calculate balance in
each account at end
of period
Journalise
transactions
Start of accounting
period
During accounting
period
At end of accounting period
Post to
ledger
accounts
You will see from the diagram that there are some stages of the cycle we have not yet
covered in any detail. In this unit we will work through the cycle, explaining each stage,
and look at the journals and ledgers that a business uses. Throughout the unit, we will
use the example of Deliver Quick, a fictional company that offers a fast delivery service.
Note that, though we are looking here at a manual system of accounting, this is to give
you some understanding of the process. In practice, many businesses will use a
computerised system and the detail of posting is carried out by the accounting software
program and hidden from the operator.
Opening the ledgers
We have seen that businesses may prepare financial statements on a monthly, quarterly
or annual basis. All businesses will prepare statements annually; many feel it is useful to
prepare interim statements in addition. The start of the accounting period is the day after
the date for which financial statements have been prepared. At the start of the accounting
period, the ending balance from the previous accounting period is brought forward on
each ledger account. (Note that in some of the following examples, currency units have
been omitted to give more space for the text.)
Deliver Quicks accounting period ends on 31 December. Below is an extract of their
ledger at 1 January:
Cash Office furniture and fittings
1/1 1/1
Beginning Beginning
balance $69,770 balance $50,000
Office furniture and fittings
accumulated depreciation Accounts payable
1/1 1/1
Beginning Beginning
balance $20,000 balance $96,000
Note that only asset and liability accounts and the capital account will have balances to
carry forward to the new accounting period. All revenue and expense accounts are closed
off at the end of the previous accounting period, and their balances transferred to the
capital account. We will look at this closing-off process later in this workbook.
Accounting for transactions during the
accounting period
From the diagram at the start, you can see that there are two processes that take place
during the accounting period:
journalising transactions
posting to ledger accounts
You have already seen how transactions are posted to accounts. Businesses actually
use journals to record transactions prior to posting them to the ledger accounts. A journal
simply lists the transactions and shows where in the ledger the debit and credit entries
will be made. Five different journals are used to record different types of transactions:
sales journal records all sales on account
purchases journal records all purchases on account
cash receipts journal records all receipts of cash
cash disbursements journal records all cash payments
general journal records all accounting entries that are not entered in one of the
other journals: adjusting entries and closing entries are always entered in the general
journal
The use of these journals simplifies the posting to the ledger accounts. The transactions
from journals are posted to accounts in the general ledger, and to two subsidiary ledgers:
the accounts receivable ledger
the accounts payable ledger
Sales journal
Many businesses sell goods on account to customers. The sales journal is used to record
the details of these credit sales. When work for a customer is completed, or goods have
been delivered, a sales invoice is issued for the value of the transaction and the details of
the invoice are entered into the journal.
Notes
You will see that dates are now abbreviated in US style; thus 5 January is written as
1/5, 12 September as 9/12, and so on.
Some column headings are shortened to Dr (to denote debtor, in other words
what we have until now referred to as debits) or Cr (for creditor or credits).
Look at the following example for Deliver Quick. Sales in the first week of January are as
follows:
May Leaf Cookies $450
Trans Sport $1,500
Jordans $987
Sales journal Page 5
Date Invoice no. Account debited Post Accounts
ref receivable Dr
Sales revenue Cr
1/4 4221 May Leaf Biscuits $450
1/6 4222 Trans Sport $1,500
1/7 4223 Jordans $987
Total $2,937
(Account references)
General ledger accounts will normally be given a reference number and the reference
for accounts receivable as sales revenue would be noted under the total to be posted.
The sales journal is normally totalled on a monthly basis and the totals debited to accounts
receivable and credited to revenue accounts in the general ledger. It is important for the
business to keep an individual record for each customer showing how much they owe.
These records are kept in the accounts receivable ledger. Below is the account for May
Leaf Cookies as it appears in the accounts receivable ledger.
Accounts receivable ledger May Leaf Cookies
Date Journal reference Debits Credits Balance
1/1 $640
1/4 S5 $450 $1,090
The invoice from the sales journal has been posted to the May Leaf Cookies account in
the accounts receivable ledger. It is referenced to the page in the sales journal, S5. When
this has been done, the journal is marked to show that the posting is complete. (Note that
the account shows a beginning balance of $640.)
The accounts receivable account in the general ledger records the following:
General ledger accounts receivable
1/1 $92,000
1/7 S5 $2,937 $94,937
The total of accounts receivable is posted to the general ledger. This would normally be
posted monthly.
Summary of postings: Totals are debited to accounts receivable and credited to revenue
in the general ledger. Separate invoices are posted to the debit of individual ledger
accounts in the accounts receivable ledger.
The posting of individual invoices looks like a one-sided posting. There does not appear
to be a credit entry. This is because the accounts receivable ledger is simply a note of
amounts owed by individual customers. It is known as a subsidiary ledger. If the balances
on each individual account are totalled, they equal the balance of the accounts receivable
account in the general ledger. In fact this is carried out periodically as a check that all
invoices have been posted. For this reason, you will sometimes see the accounts receivable
account in the general ledger called a control account. It controls the balances on the
subsidiary accounts receivable ledger.
Purchases journal
The purchases journal and accounts payable ledger operate very much in the same way
as the sales journal and accounts receivable ledger. The journal lists all purchase invoices
received by the business.
This will include any purchase of supplies or expenses made on account, and will probably
look like this:
Purchases journal Page 9
Debits Credits
Other accounts
Date Account Terms Post Accounts Office Package Account Post Amount
credited ref payable supplies supplies title ref
All amounts appear in the credit column. They are individually posted to the accounts
payable ledger, and the total is posted to the accounts payable account in the general
ledger on a monthly basis. There are separate debit columns for purchases of assets on
account. For Deliver Quick, these include office supplies and packaging supplies. A
merchandising business may also have an inventory column. We will look at merchandising
operations in a separate unit later in the workbook. The Other accounts column records
all other expenses on account.
Record the following invoices for Deliver Quick in the purchase journal:
5 January, office supplies of $1,200 from The Office Supply Company
7 January, Jays Motor Repairs $279 for repairs to a delivery van (to be posted to
vehicle repairs account in general ledger)
9 January, packaging supplies of $300 from Greens Packaging
The Office Supply Company and Jays allow 30 days credit; Greens allow 60 days.
Debits Credits
Other accounts
ACTIVITY 2.21
The following shows the account of The Office Supply Company in the accounts payable
ledger:
Accounts payable ledger The Office Supply Company
1/1 Balance 750
1/5 P9 1,200 1,950
The accounts payable account in the general ledger would show the following postings:
General ledger accounts payable
1/1 Balance 96,000
1/7 P9 1,779 97,779
The total from the office supplies column is posted to the office supplies account in the
general ledger:
General ledger office supplies
1/1 Balance 750
1/7 P9 1,200 1,950
Summary of postings: Totals are debited to appropriate asset and expense accounts
and credited to accounts payable in the general ledger. Separate invoices are posted to
the credit of individual ledger accounts in the accounts payable ledger.
The accounts payable ledger is a subsidiary ledger which provides a record of balances
owed to individual suppliers. In the same way as the accounts receivable ledger, individual
balances should total the balance of the accounts payable account in the general ledger.
Cash receipts journal
The cash receipts journal shows all receipts of cash. The main sources of cash will be
receipts on account and cash sales. Any other receipts would be recorded in the Other
accounts column. These might include any cash borrowed, amounts invested in the
business by the owner, rents on properties the business owns but leases to others,
proceeds from the sale of business assets and interest on money loaned to other
businesses or individuals.
Cash receipts journal Page 12
Debits Credits
Date Cash Sales Account Post Accounts Sales Other
discounts title ref receivable revenue accounts
1/7 630 10 May Leaf Cookies 640
1/9 1,300 Cash sales 1,300
1/10 972 15 Jordans 987
2,902 25 1,627 1,300
As with the other journals, the cash receipts journal is totalled periodically and the total of
each column is posted to the appropriate general ledger account (usually monthly). In
addition, all individual amounts in the accounts receivable column are posted to individual
customer accounts in the accounts receivable ledger. Sales discounts are sometimes
given by businesses for early payment of account. In our example, May Leaf Cookies
has been given a discount of $10. The total of sales discounts is posted to the sales
discount account in the general ledger. The account balance of May Leaf Cookies is
reduced by $640, being $630 cash and $10 discount.
Post all entries from the cash receipts journal to the ledger accounts of Deliver Quick. The
accounts for May Leaf Cookies and accounts receivable are copied here for you. Jordans
account has a balance of $987, being invoice number 4223 issued to them on 7 January.
The cash account has a beginning balance of $69,770. The sales revenue account has a
beginning balance of $2,937.
Accounts receivable ledger May Leaf Cookies
1/1 Balance 640
1/4 S5 450 1,090
General ledger accounts receivable
Date Journal reference Debits Credits Balance (debit)
1/1 Balance 92,000
1/7 S5 2,937 94,937
Date Journal reference Debit Credit Balance (debit)
(continued)
ACTIVITY 2.22
Summary of postings: Totals of cash and sales discounts are debited to their respective
general ledger accounts. Column totals for accounts receivable and sales revenue are
credited to their respective general ledger accounts. Separate amounts from Other
accounts column are credited to appropriate general ledger accounts. Separate amounts
from the accounts receivable column are credited to individual accounts in the accounts
receivable ledger.
Cash disbursements journal
The cash disbursements journal records all payments made by the business. Most business
payments will actually be made by cheque, and the cash account is actually a record of
the bank account. A business that makes frequent cash payments may show an extra
column in the journal for cash payments that will be posted to a separate cash account
showing the amount of cash in hand.
The totals of accounts payable and cash columns are posted to their accounts in the
general ledger. Any amounts paid on account are also posted to individual supplier
accounts in the accounts payable ledger. Amounts in the Other accounts column are
individually posted to the appropriate general ledger account.
Deliver Quick make the following payments on 15 January. Make entries into the cash
disbursements journal and appropriate ledger accounts. (Note that all amounts will be entered
in the cash column.) Balances for ledger accounts prior to payments made on 15 January
are given where appropriate.
Rent prepaid for February $1,050, cheque number 161 (balance $1,000)
Office Supply $400, cheque number 162 (balance $1,950)
Jays Motor Repairs, $465 on account, cheque number 163 (balance $744)
Greens Packaging, $125 on account, cheque number 164 (balance $425)
Cash account balance as at 14 January was $87,267; accounts payable balance was
$98,765
Cash disbursements journal Page 16
Debits Credits
Date Cheque Account debited Post Other Accounts Cash
number ref accounts payable
(continued)
ACTIVITY 2.23
Summary of postings: Total of accounts payable is debited to accounts payable in general
ledger. Cash total is credited to the cash account in the general ledger. Individual amounts
from other accounts column are debited to appropriate general ledger accounts. Individual
amounts from accounts payable column are debited to appropriate accounts payable
ledger accounts.
General journal
The general journal is used for any other entries that need to be made to the accounts.
These might include the following types of transactions:
Adjustments at the end of the accounting period.
Closing entries for the accounts entries to close accounts at the end of the
accounting period.
Sales returns when a customer returns merchandise, a credit memorandum is
issued to reduce the amount owed by the customer. These are normally recorded in
the general journal.
Purchase returns when a business returns merchandise to a supplier, this is entered
in the general ledger.
General journal Page 8
Date Account debited Post ref Debits Credits
1/14 Accounts payable The Office Supply Company
Purchase returns 50
Defective goods returned 50
1/31 Salary expense
Salary accrued at month end 2,000
The general ledger simply lists the transactions, showing which accounts are to be debited
and credited. Each entry is separately posted to the appropriate account. The journal is
only totalled for checking purposes debit entries should always equal credit entries.
The totals are not posted.
Deliver Quick prepares its annual financial statements at 31 December. Write general journal
entries for the end of year adjustments to Deliver Quicks accounts:
Deliver Quick used $2,000 of its office supplies during the year.
Deliver Quick paid rent in advance for January of $1,050.
Depreciation on fixed assets was: Office furniture and fittings $10,000; Delivery vehicles
$32,500.
Salary accrued at the year end amounted to $10,000.
Unearned revenue received amounted to $22,500, of which $16,000 of work had been
completed in the year.
ACTIVITY 2.24
Completing the cycle
At the end of the accounting period, the balance on each account is calculated and a trial
balance is prepared. The accounts are then adjusted to reflect the net income for the
period. We looked at these adjustments earlier. Adjustments are entered in the general
journal, and posted to the appropriate ledger accounts. They may also be entered on a
worksheet that provides the information for preparing the financial statements. As you
have seen, every balance on the adjusted trial balance appears either on the income
statement or the balance sheet:
The balance sheet shows balances on all asset and liability accounts.
The income statement shows the balances on all revenue and expense accounts.
Once the financial statements have been prepared, the ledger accounts can be closed
and balances carried forward to the next accounting period. All revenue and expense
accounts and the withdrawals account will have a zero balance at the end of the period.
Revenue and expense account balances are transferred to an income summary account.
The balance of this account is then transferred to the capital account. The balance of the
withdrawals account is also transferred to the capital account.
These are the closing entries in the accounts for Deliver Quick. The beginning balance
on each account is the year-end balance:
Income summary Capital account
Office supp 2,000 Revenue 189,710 Withdrawals 34,650 12/31 Balance 146,500
Packaging 1,000 (closing) 32,600
Rent 11,550 Balance Income
Insurance 800 fwd 144,450 (closing)
Vehicle reps 2,060 179,100 179,100
Utilities 1,200 1/1 Beginning
Depreciation 42,500 balance 144,450
Salaries 96,000
Close 32,600
189,710 189,710
Withdrawals Revenue
12/31 34,650 Close 34,650 12/31 189,710 Close 189,710
Balance Balance
Office supplies expense Packaging supplies expense
12/31 2,000 Close 2,000 12/31 1,000 Close 1,000
Balance Balance
Rent expense Insurance expense
12/31 11,550 Close 11,550 12/31 800 Close 800
Balance Balance
Vehicle repairs Utilities
12/31 2,060 Close 2,060 12/31 1,200 Close 1,200
Balance Balance
Depreciation Salary expense
12/31 42,500 Close 42,500 12/31 96,000 Close 96,000
Balance Balance
The balance on the capital account, together with those of all asset and liability accounts
is carried forward to the next accounting period.
You are given the adjusted balances for Terence Stott at 30 April. Show his accounts for
capital, withdrawals and income summary, based on these balances:
capital $50,000
withdrawals $12,000
revenue $24,880
rent expense $2,800
office supplies expense $480
depreciation expense $720
salary expense $7,180
utilities $2,370
ACTIVITY 2.25
Summary
In this unit, you have looked at the whole of the accounting cycle and learned about the
journals and ledgers that businesses actually use to record financial information.
The purpose of the accounting cycle is to produce the financial statements of a
business.
A business uses journals and ledgers to record financial information, which is then
used to prepare the financial statements.
At the end of an accounting period, the ledger accounts should be closed off and
opening entries on capital, asset and liability accounts carried forward to the next
accounting period.
Self-test F
1 At the start of the accounting period, balances will be brought forward on
which of the following?
a all ledger accounts
b asset accounts only
c capital, asset and liability accounts
d capital account only
e revenue and expense accounts
2 Trojan Cleaners make cash sales of $400. In which of the following journals
will they record the sale?
a cash disbursements journal
b cash receipts journal
c sales journal
d purchases journal
e general journal
3 Trojan Cleaners purchase cleaning materials on account from Speediclean.
Which of the following shows the correct ledger account entries?
a Debit accounts receivable, credit cleaning materials on general ledger.
b Debit accounts payable, credit cleaning materials on general ledger, credit
Speediclean account in accounts payable ledger.
c Debit Speediclean on accounts payable ledger, credit cleaning materials
on general ledger.
d Debit cleaning materials, credit accounts receivable in general ledger, credit
Speediclean in accounts receivable ledger.
e Debit cleaning materials, credit accounts payable in general ledger, credit
Speediclean in accounts payable ledger.
Merchandising businesses
The operations of a merchandising
business
Merchandising operations are any businesses that buy goods (or merchandise) for resale
to customers. In addition to the usual accounting records, such businesses need to keep
records of the amount of goods they have on hand and of what is sold to customers. You
will now learn how merchandising businesses keep records of inventory and how they
calculate earned income.
Earned income in a merchandising business arises from the sale of goods to customers.
The business buys goods from a supplier, and sells them to customers at a higher price
than it paid for them. The cash received from customers for goods is used to buy more
goods to sell. The difference between the buying and selling prices is the earned income
before expenses, which is known as gross margin (or gross profit).
Example
Murrays Store purchases 20 pairs of jeans at $12 per pair. It sells them to
customers at $20 per pair. Gross margin will be:
Revenue $400
Cost of goods sold $240
Gross margin $160
From an accounting point of view, this means the business needs to keep records
of the cost of merchandise in order to calculate earned income. The business
needs to keep records of goods purchased for resale, and of the cost of goods
sold to customers. In reality, it is unlikely that all the goods would be sold within
the accounting period. The cost of goods needs to be split between those goods
sold to the customer within the accounting period and those still held by the
business at the end of the period.
Inventory systems
There are two main types of inventory systems. The periodic inventory system is used
by businesses such as grocery stores. They do not want to record every loaf of bread or
can of beans sold, so they count the goods at the end of each accounting period. They
know what goods they have purchased during the period, so can calculate the cost of
goods sold. A perpetual inventory system maintains a record of every individual item
sold. Where manual records are used, the perpetual inventory system is only worthwhile
for expensive goods. For inexpensive, high-volume sales items the time invested in keeping
records would not be worthwhile. However, with the introduction of optical scanning cash
registers and computerised accounting systems, most businesses can keep a perpetual
record if they wish to do so. Note that, in the perpetual system, inventory is still counted
at least once a year as this provides a check on the system. We will explain postings in
the perpetual inventory system initially, then cover the period system.
Purchases
When goods are purchased from a supplier, the supplier will provide an invoice. Details
shown on the invoice include:
Name and address details of the seller.
Name and address details of the purchaser.
Delivery address if different from purchaser address.
Invoice reference number which uniquely identifies the invoice.
Any purchaser reference which identifies the purchaser in the sellers accounting
system.
The purchasers order reference to enable the purchaser to match the invoice to the
original order.
Details of the goods reference, quantities, descriptions, price per unit and total
price.
Shipping or handling charges where applicable.
Any sales tax payable.
Date of invoice.
Terms of payment. Most sellers will give one months credit to purchasers which runs
from the invoice date. Sometimes sellers offer a discount for prompt payment. This is
usually about 23 per cent and can be deducted if the purchaser pays within the
specified time.
Example
Bailey Jewelers, a jewellery store in the US, buys goods on credit from Readings
Jewelry Design for resale. The invoice is shown below.
They will enter the invoice in the purchase journal. Merchandising businesses will have a
separate column in their purchase journal for inventory. The total from this column will be
debited to the inventory account.
Bailey Jewelers purchases journal Page 13
Debits Credits
Date Account Terms Post Accounts Office Inventory Account Post Amount
credited ref payable supplies title ref
6/26 Readings 30 days $4,590 $4,590
For a perpetual inventory system, the total of the inventory column is posted to an inventory
account. Note that any freight costs in respect of inventory items are included in the cost
of inventory.
If any discounts are allowed for prompt payment, these are recorded in the cash
disbursements journal at the time of payment and then transferred to inventory. Any
cash purchases will also be recorded in the cash disbursements journal.
Example
Bailey pay their May account with Readings of $6,250 but are allowed a discount
of $125 for prompt payment. They purchase merchandise for cash costing $400.
Bailey Jewelers cash disbursements journal Page 16
Debits Credits
Date Cheque Account debited Post Other Accounts Inventory Cash
6/27 189 Readings 6,250 125 6,125
6/28 190 Inventory 400 400
The discount allowed is credited to the inventory account because it reduces the cost of
inventory. Cash purchases are debited to inventory. All other postings are the same as
usual: the accounts payable total is posted to the general ledger and individual amounts
to the accounts payable ledger. Other amounts are debited to their individual accounts in
the general ledger; the total of cash is credited to the cash account in the general ledger.
Sometimes a purchaser will need to return goods to the seller because they are damaged,
defective or unsuitable. The cost of returns is debited to accounts payable and credited
to the inventory account to reduce the cost of inventory and the amount owed to the
seller.
Inventory Accounts payable Readings
5/28 6,250 6/27 125 6/27 6,250 5/28 6,250
6/26 4,590 7/3 75 7/3 75 6/26 4,590
6/28 400
If goods are damaged or defective but the purchaser decides to keep them, the seller
may make an allowance to reduce the cost of the goods. This is posted in the same way
as a return.
Some businesses prefer to keep a separate record of freight costs and returns and
allowance. Separate accounts would be set up for these but the balances are still used to
determine the cost of inventory for the financial statements.
Enter the following transactions for Bailey into their journals and ledger accounts:
5 July, purchased $780 goods from Readings
9 July, purchased $976 goods for cash (cheque number 191)
17 July, returned goods to Readings, original cost $57
17 July, Readings gave an allowance on defective goods of $43
10 July, paid to Readings on account $4,425 (cheque 192); Readings allowed discount
of $90
Bailey Jewelers purchases journal Page 13
Debits Credits Other accounts
6/26 Readings 30 days 4,590 4,590
ACTIVITY 2.26
(continued)
Debits Credits
6/27 189 Readings 6,250 125 6,125
6/28 190 Inventory 400 400
5/28 6,250 6/27 125 6/27 6,250 5/28 6,250
6/26 4,590 7/3 75 7/3 75 6/26 4,590
6/28 400
Sales
Sales of merchandise may be for cash or on account. Cash sales would be entered in the
cash receipts journal. As well as accounting for the cash transaction, in a perpetual
inventory system, the business needs to record the cost of the goods sold. A separate
column in the journal is used to record this.
Suppose Bailey sells goods costing $500 for $750 cash, the entries in the journals and
ledgers would be:
Bailey Jewelers cash receipts journal Page 18
Debits Credits
Other Cost of
accounts goods sold
Dr
Date Cash Sales Accounts Sales Account title Post Amount Inventory
discount receivable revenue ref Cr
6/26 750 750 500
The cash sales are entered in the journal as usual and the amount is debited to the cash
account and credited to revenue. There is an additional column in the cash receipts
journal which records the cost of goods sold. The total of this column is debited to a cost
of goods sold account and credited to inventory.
For sales on account, an invoice is issued to the customer. This would be similar to the
invoice issued to Bailey for their purchases from Readings. The invoice is entered in the
sales journal and ledger accounts. Suppose Bailey sells goods on account to a Mr Morrison
at $1,450 (invoice number 768); original cost $920.
Bailey Jewelers sales journal Page 16
Date Invoice Account Post Accounts receivable Dr Cost of goods sold Dr
no. debited ref Sales revenue Cr Inventory Cr
6/29 768 Morrison 1,450 920
An extra column in the ledger records the adjustment to the inventory account. The total
is debited to cost of goods sold and credited to inventory.
Note that the seller would normally pay freight charges for delivery to the customer and
these are recorded in a delivery expense account.
Sales returns and allowances will reduce accounts receivable and sales revenue by the
price charged to the customer. Inventory will then need adjusting for the cost of the
returned goods: debit inventory and credit cost of sales with the cost of the goods. Suppose
Mr Morrison returns $200 of goods, original cost $130 on 10 July:
Inventory Accounts receivable Morrison
5/28 6,250 6/27 125 6/29 1,450 7/10 200
6/26 4,590 6/26 500
6/28 400 6/29 920
7/5 780 7/3 75
7/9 976
7/20 130
Cost of goods sold
6/26 500 7/10 130
6/29 920
Enter the following sales transactions in the journals and ledgers of Bailey Jewelers:
12 July, Mr Morrison buys further goods on account $350; original cost $220 (invoice
769)
16 July, Mr Morrison pays $1,200 on account and is given discount for prompt payment
of $50
18 July, cash sales $700; original cost $500
Debits Credits
Other accounts Cost of
goods sold
Dr
Date Cash Sales Accounts Sales Account title Post Amount Inventory
discount receivable revenue ref Cr
6/26 750 750 500
6/26 768 Morrison 1,450 920
ACTIVITY 2.27
The cost of goods sold account keeps a record of goods sold during the accounting
period. Baileys accounts show that the cost of goods sold at the end of the period amounts
to $2,010, and inventory amounts to $10,426. At the end of the accounting period, these
accounts provide the required information on goods sold and inventory for the financial
statements. Bailey would carry out a physical count of inventory to verify the amount on
the account.
Before we look at the financial statements, we will consider the periodic system of recording
inventory. In the periodic system, all purchases are recorded in a purchases account
during the accounting period. At the end of the period, a physical count of inventory is
carried out, and cost of goods sold is calculated. Cost of goods sold is equal to:
Beginning balance of inventory + purchases ending balance of inventory
Financial statements
The financial statements of a merchandising business always show the gross margin on
the income statement. The ending amount of inventory is included as a current asset on
the balance sheet.
Summarised income statement Bailey Jewelers year ended 31 January
Sales revenue 164,650
Less: Cost of goods sold 83,235
Gross margin 81,415
Total expenses 55,290
Net income 26,125
(We have summarised expenses here, normally they would be listed.)
Balance sheet Bailey Jewelers 31 January
Assets Liabilities
Current: Current:
Accounts receivable 18,550 Salary payable 1,850
Inventory 32,900 Interest payable 300
Supplies 675 Long term:
Prepaid rent 500 Note payable 17,500
Plant: Total liabilities 42,820
Fixtures and fittings 13,250
Owners equity
Accumulated
depreciation (11,925) Capital 13,965
Total assets 56,785 owners equity 56,785
You are given the adjusted trial balance of Smiths Grocery Store. Prepare the income
statement, statement of owners equity and balance sheet for the year ended 31 December
on the following pages. (Note: Smiths do not sell any goods on account. They use a periodic
inventory system. Inventory as counted at the end of the year was $25,550.)
Cash 27,500
Inventory (at 1 January) 20,860
Packaging supplies 500
Shop furniture and fixtures 12,500
Accumulated depreciation Office furniture and fixtures 7,500
Delivery vehicle 8,000
Accumulated depreciation Delivery vehicle 4,000
Salary payable 250
Capital 20,765
Withdrawals 10,000
Purchases 44,055
Packaging supplies expense 750
Rent 6,000
Utilities 1,200
Insurance 400
Depreciation 4,500
Miscellaneous 500
Totals 136,765 136,765
ACTIVITY 2.28
Smiths Grocery Store
Income statement
Year ended 31 December
Statement of owners equity
Year ended December 31 2000
Balance sheet
Summary
You have learned how merchandising businesses keep their accounting records and
present their financial statements.
Merchandising businesses are involved in the purchase and resale of goods, and
their financial statements need to reflect this.
They need to keep records of these purchases and sales.
There are two systems of inventory: the perpetual inventory system and the periodic
inventory system.
The perpetual system relies on an ongoing record of purchases and sales and is
more suitable for high-value and unique items.
The periodic system relies on checks at regular intervals and is suitable for low-
value, mass-produced merchandise.
Self-test G
1 By which of the following is gross margin calculated?
a Deducting cost of inventory from sales revenues.
b Deducting inventory plus purchases from sales revenues.
c Deducting cost of goods sold plus expenses from sales revenues.
d Deducting cost of goods sold from sales revenues.
e Deducting expenses from sales revenues.
2 Which of the following best describes the main difference between perpetual
and periodic inventory systems?
a For a periodic system, a physical count of inventory is carried out.
b A perpetual system keeps a continuous record of inventory and cost of
goods sold.
c In a perpetual system, the cost of goods sold is calculated at the end of
the year.
d A perpetual system is only used for low-value merchandise.
e A periodic system is only suitable for high-value items.
3 Which of the following reflects the correct account entries for purchase returns
in a perpetual inventory system?
a debit inventory, credit accounts payable
b debit inventory, credit accounts receivable
c debit accounts payable, credit inventory
d debit accounts receivable, credit inventory
e debit inventory, credit cost of goods sold
4 Kandi Shoes has a beginning inventory value of $23,000, purchases during
the year of $42,000 and ending inventory $26,780. Which of the following figures
gives cost of goods sold?
a $45,780
b $38,220
c $42,000
d $49,780
e $65,000
5 Which of the following best indicates where ending value of inventory is
recorded on the financial statements?
a on the balance sheet under current liabilities
b on the income statement as cost of goods sold
c on the balance sheet under current assets
d on the statement of owners equity as capital introduced
e on the balance sheet under plant assets
Activity 2.1
You should find that the accounting equation still balances (Assets = Liabilities +
Owners equity). The following changes will have taken place:
Cash is reduced by $9,000 ($7,000 paid to supplier and $2,000 rent).
Inventory is increased by $9,000, being the new goods George has purchased.
Accounts payable are reduced by $7,000 (because George pays this amount),
but increased by $9,000 (because he buys further goods on credit).
Owners equity is reduced by $2,000 which reflects the rent expense paid.
(Note that there are no revenues so this is, in effect, a net loss.)
Cash $49,000 Money introduced $50,000
Inventory $12,000 Accounts payable $9,000 Net income $ 4,000
Expense ($ 2,000)
Assets (49,000 + 12,000) = Liabilities (9,000) + Owners equity (50,000 + 4,000 2,000)
Activity 2.2
Your accounts should look like the following. We have numbered the entries to
correspond with the numbered transactions listed in the activity so that you can
see how the entries have been made. Check that debits appear on the left side,
credits on the right.
Cash Capital
Beginning bal 0 [3] Furniture 4,000 Beginning bal 0
[1] Capital 35,000 [4] Equipment7,500 [1] Cash 35,000
[5] Payment
on account 1,000
Office supplies Accounts payable
Beginning bal 0 [5] Cash 1,000 Beginning bal 0
[2] Purchased [2] Office
on account 2,500 supplies 2,500
Office furniture Office equipment
Beginning bal 0 Beginning bal 0
[3] Cash [4] Cash
purchase 4,000 purchase 7,500
Activity 2.3
Your accounts should look like the following. Again, we have numbered the entries
to correspond with the numbered transactions listed in the activity. The cash account
is continued from the last activity.
Cash Revenue
Beginning bal 0 [3] Furniture 4,000 Beginning bal 0
[1] Capital 35,000 [4] Equipment 7,500 [6] Accounts
receivable 1,500
7] Revenue 500 [5] Payment
on account 1,000 [7] Cash 500
[10] Payment
on account 750 [8] Rent 2,000
[9] Withdrawal 2,500
Accounts receivable Rent expense
Beginning bal 0 [10] Cash 750 Beginning bal 0
[6] Revenue 1,500 [8] Cash 2,000
Withdrawal
Beginning bal 0
[9] Cash 2,500
Activity 2.4
You should have calculated the following balances:
Account Balance Debits/Credits
Capital 35,000 Credit
Office supplies 2,500 Debit
Accounts payable 1,500 Credit
Office furniture 4,000 Debit
Office equipment 7,500 Debit
Revenue 2,000 Credit
Accounts receivable 750 Debit
Rent 2,000 Debit
Withdrawal 2,500 Debit
Activity 2.5
Your trial balance for Jenny Rodin should look like this:
Cash 19,250
Office supplies 2,500
Accounts receivable 750
Capital 35,000
Withdrawal 2,500
Revenue 2,000
Rent 2,000
Totals 38,500 38,500
Activity 2.6
Using the accounting equation, you should have calculated that the owners equity
in the first question amounts to $68,000, and the assets in the second question
amount to $145,000.
Activity 2.8
The rules are important because they help to ensure that each business reports a
complete and accurate picture of its financial situation, and that different businesses
are using comparable principles.
Activity 2.9
If entities are not separated, it is not possible to see which businesses are profitable.
A highly profitable business could hide the losses of a failing one. Investors and
lenders want to know specifically about the business entity to which they are lending
money or in which they are investing.
Activity 2.11
Why is it important to the manager to report the higher figure?
The higher figure will increase the reported revenue received and thus increase
the profits or reduce the losses of the business. It will thus improve the businesss
financial statements.
Which figure do you think investors and lenders would want to see reported and
why?
Investors and lenders require an accurate account of the worth of the business.
The conservatism concept requires that the least favourable figures are reported
in the financial statements. The worst-case scenario should be anticipated and
allowed for.
Activity 2.12
The value of the property will be recorded as $130,000, which is the historical cost
of the property. The property will remain at this value one year later even though
the market value may be higher. This is also in line with the conservatism concept.
Activity 2.13
Applying the revenue principle, the revenue should not be recorded until it has
been earned and should be recorded at the cash value of the goods transferred to
the customer. The revenue from this transaction would be recorded as $280 ($300
less $20 refund) at the date goods were delivered to and accepted by the customer.
Activity 2.14
Using the matching principle, the commission of $3,000 should be included in the
financial statements for April. Though the amount will not be paid until May, it has
been incurred in respect of sales in April. It should be matched with the revenues
earned in April.
Rent for April should be included in the statements at $800. Renting the car lot for
the month of April allows the business to earn revenues in that month. Rent for
May and June, though already paid, cannot be matched against Aprils revenue
and will be carried forward to future accounting periods.
Only the cost of cars sold in April ($46,000) can be matched against revenues
earned in April. The cost of cars left on the lot at the end of April, including those
bought but not sold during the month, must be carried forward to future accounting
periods.
Activity 2.15
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Activity 2.16
You should have allocated profits as follows:
Terence Stott Income statement for year ended 30 April
Revenue:
Expenses:
Rent expense 2,800
Salary expense 7,180
Office supplies expense 480
Utilities expense 2,370
Depreciation expense 720
13,550
Net income: $11,330
Terence Stott Statement of owners equity for year ended 30 April
Terence Stott, capital 1 May 50,000
61,330
Terence Stott, capital 30 April $49,330
Terence Stott Balance sheet 31 December
Assets
Current:
Cash 12,780
Accounts receivable 12,330
Plant:
Less: Accumulated depreciation 12,000 10,900
Less: Accumulated depreciation 16,800 14,900
Total assets 52,510
Liabilities
Current:
Unearned income 1,380
Total liabilities 3,180
Owners equity
Terence Stott, capital 49,330
Total liabilities and owners equity 52,510
Activity 2.17
Raby $42,857
Charles $42,857
Mason $64,286
Activity 2.18
Your calculations should give the following profit allocations:
Tracy $47,250 (40,000 + 12,000 4,750)
Jayshree $22,750 (20,000 + 7,500 4,750)
Note that there is a negative amount left after allocation of salaries and interest,
which is allocated equally between the partners.
Activity 2.19
You should have allocated the loss as follows:
Smythe $30,000
Motson $15,000
Activity 2.20
Amounts allocated should be as follows:
Smythe Motson Total
Total net loss ($45,000)
Salaries:
Smythe $10,000
Motson $7,000
Smythe 70,000 x 6% $4,200
Motson 35,000 x 6% $2,100
Remainder to be split equally $68,300
Smythe ($34,150)
Motson ($34,150)
Totals ($19,950) ($25,050) ($45,000)
Note how the salaries and interest increase the negative amount to be allocated.
Activity 2.21
The entries should look like this:
Debits Credits
Other accounts
1/5 Office 30 1,200 1,200
Supply days
Co.
1/7 Jays 30
Motor days
Repairs 279 Repairs 279
1/9 Greens 60
Packaging days 300 300
1,779 1,200 300 279
Individual invoices are posted to the credit of individual accounts in the accounts
payable ledger. The total is credited to the accounts payable account in the general
ledger. Debit totals are posted to the appropriate accounts in the general ledger
(office supplies account, packaging supplies account, and repairs to motor vehicles
account).
Activity 2.22
You should have made the following account entries:
Debit cash $2,902, giving a debit balance of $72,672 (general ledger).
Debit sales discounts $25, giving a debit balance of $25 (general ledger).
Credit accounts receivable $1,627, giving a debit balance of $93,310 (general
ledger).
Credit sales revenue $1,300, giving a credit balance of $4,237 (general ledger).
Credit May Leaf Cookies $640, giving a debit balance of $450 (accounts
receivable ledger).
Credit Jordans $987, giving a balance of $0 (accounts receivable ledger).
Check: If you total the debit entries to the general ledger and compare them with
the total credit entries to the general ledger, they will be the same. If you total the
entries to the accounts receivable ledger, they should equal the amount posted to
the accounts receivable account in the general ledger.
Activity 2.23
Your cash disbursements journal should look like this:
Cash disbursements journal Page 16
Debits Credits
Date Cheque Account debited Post Other Accounts Cash
1/15 161 Prepaid rent 1,050 1,050
1/15 162 Office supplies 400 400
1/15 163 Jays Motor Repairs 465 465
1/15 164 Greens Packaging 125 125
1,450 590 2,040
The following entries should have been made to ledger accounts:
Debit prepaid rent $1,050, giving a debit balance of $2,050 (general ledger).
Debit office supplies $400, giving a debit balance of $2,350 (general ledger).
Debit accounts payable $590, giving a credit balance of $98,175 (general
ledger).
Debit Jays Motor Repairs $465, giving a credit balance of $279 (accounts
payable ledger).
Debit Greens Packaging $125, giving a credit balance of $300 (accounts payable
ledger).
Credit cash $2,040, giving a debit balance of $85,227 (general ledger).
Activity 2.24
Your entries should be:
12/31 [1] Office supplies expense 2,000
Office supplies used in year
12/31 [2] Prepaid rent 1,050
Rent expense 1,050
Rent paid in advance
12/31 [3] Depreciation expense 42,500
Acc. depreciation furniture & fittings 10,000
Acc. depreciation delivery vehicles 32,500
Depreciation for the year
12/31 [4] Salary expense 10,000
Salary accrued at year end
12/31 [5] Unearned revenue 16,000
Revenue 16,000
Being revenue earned in the year
Activity 2.25
Income summary Capital account
Rent 2,800 Revenue 24,880 Withdrawals 12,000 Capital 50,000
Office supp 480 Closing bal 49,330 Income 11,330
Depreciation 720 61,330 61,330
Salary 7,180
Utilities 2,370
Closing bal 11,330
24,880 24,880
Withdrawals
Withdrawals Transfer to
for year 12,000 capital 12,000
Activity 2.26
You should have made the following entries in the journals and ledgers:
Debits Credits
Other accounts
6/26 Readings 30 4,590 4,590
days
7/5 Readings 30 780 780
days
Debits Credits
6/27 189 Readings 6,250 125 6,125
6/28 190 Inventory 400 400
7/9 191 Inventory 976 976
7/20 192 Readings 4,515 90 4,425
5/28 6,250 6/27 125 6/27 6,250 5/28 6,250
6/26 4,590 7/3 75 7/3 75 6/26 4,590
6/28 400 7/17 57 7/5 780
7/5 780 7/17 43
7/9 976 7/20 4,515
Activity 2.27
Your entries should be:
Debits Credits
Other accounts Cost of
goods sold
Dr
Date Cash Sales Accounts Sales Account Post Amount Inventory
discount receivable revenue title ref Cr
6/26 750 750 500
7/16 1,200 50 1,250 Morrison
7/18 700 700 500
6/29 768 Morrison 1,450 920
7/12 769 Morrison 350 220
Inventory Accounts receivable Morrison
5/28 6,250 6/27 125 6/29 1,450 7/10 200
6/26 4,590 6/26 500 7/12 350 7/16 1,250
6/28 400 6/29 920
7/5 780 7/3 75
7/9 976 7/12 220
7/10 130 7/18 500
Cost of goods sold
6/26 500 7/10 130
6/29 920
7/12 220
7/18 500
Activity 2.28
Your answer should show the following:
cost of goods sold $39,365 (20,860 + 44,055 25,550)
gross margin $27,385
net income $14,035
total assets $62,550
total liabilities $37,750
owners equity $24,800 (20,765 10,000 + 14,035)
Income statement
Less: Cost of goods sold 39,365
Gross margin 27,385
Less: Total expenses 13,350
Net income 14,035
Statement of owners equity
Capital at 1 January 20,765
34,800
Capital at 31 December 24,800
Balance sheet
Assets Liabilities
Current: Current:
Inventory 25,550 Salary payable 250
Supplies 500 Total liabilities 37,750
Plant:
Accumulated depreciation (7,500) Owners equity
5,000 Capital 24,800
Delivery vehicle 8,000
Accumulated depreciation (4,000) 4,000
Total assets 62,550 Total liabilities and owners 62,550
equity
Answers to self-tests
Self-test B
1 d
2 d
3 c
4 a
5 e
Self-test C
1 e
2 b
3 d
4 a
5 b
Self-test D
1 e
2 c
3 c
Self-test E
1 d
2 d
3 c
4 a
5 e
Self-test F
1 d
2 a
3 d
Self-test G
1 e
2 d
3 e
4 d
5 a
Section 3
The changing roles of finance
directors
Introduction
The organisational world has always been in a state of flux but the pace of change has
never been as fast as it is at present. And as organisations change so do the jobs of the
people within them.
During the 1980s and 1990s many new management ideas and developments emerged.
Total quality management, bottom-up objective setting, continuous improvement and re-
engineering are all approaches affecting the running of organisations. In the UK there
was also an economic boom followed by a deep recession.
These changes created a period of organisational reflection and organisations have
become increasingly aware of new ways of structuring and managing themselves.
The last ten years have seen organisations embarking on a radical rethink of the financial
roles and skills needed not just by their finance departments but also by middle managers.
Put simply, the modern middle manager has to be financial all-rounder as well as a
manager of people.
In order to understand how and why your own role is changing it is helpful to look at the
broader picture. You may already recognise the changes that are taking place. Indeed
they may be the reason why you are studying now.
Consider what has happened to the role of finance director over recent years. If the
finance directors role has changed then there is a good chance that the changes will
have affected the whole finance department and the rest of the organisation.
Goodbye company accountant
Researcher Graeme Russell spent a good part of 1994 and the early months of 1995
talking to finance directors in organisations of varied size and operating in both the private
and public sectors in order to see what they thought about their changing roles. His
research aimed to give an up-to-the-minute insight into the way organisations are changing.
This is the picture Russell paints of the traditional finance directors role:
Traditionally, finance has often been seen in a negative light. The finance
department and director imposed constraints and limited the manager. The
manager then had to keep within budget. Money was fought for and won. The
head of finance in an organisation was the person who said no. From the finance
directors viewpoint their role was indeed to allocate budgets and to manage the
money.
This paints an interesting and probably familiar picture of the old role of the finance
department and finance director.
hello finance director
But how have things changed in the 1990s? Russell reports that while finance directors
are still allocating budgets and managing the money, there has been a definite change.
He reports one finance director as confirming that he still has the classic role but has
added to it by wearing general management, strategic and commercial hats as well as
his own financial expert hat.
And the big difference?
Finance directors increasingly facilitate the spread of financial information by
translating the complexities of financial management into simple messages for
their managers. My impression is that the finance director is becoming less the
secretive expert and more the internal consultant.The old days of financial
documents being marked top secret are long gone.
This move is happening in parallel to the more general shift which organisations
are making, towards becoming more open and communicative places to work.
This is interesting because it paints a picture of todays finance director as a facilitator
who is spending time opening up and empowering middle managers to understand what
is happening financially in the organisation. In this interpretation the finance director has
become much more of an internal consultant.
But what does this shift in emphasis mean for managers? For a start:
You may have found an increasing financial component in your job. The days of
consigning all the work on numbers to the finance department have long gone.
You may increasingly be responsible for disseminating and generating financial
information.
You will look in more detail later in the section at how the changes to the financial directors
role will affect, and indeed are affecting, managers at all levels in todays organisations
and businesses public and private, large and small.
Have you got a ticket to ride?
There have been some interesting knock-on effects of the changing role of the finance
director. Just take a look at some job advertisements and ask yourself what acts as a
passport to middle management appointments.
ACTIVITY 3.1
Dig out either your trade paper or a national newspaper and look at the basic requirements
asked for in job advertisements for your kind of job. Write down the three attributes that are
asked for most regularly.
The chances are that handling financial information is on your list.
This is what one manager found when she did this activity.
I am a middle manager for a housing association and I went through our
professional magazine, Inside Housing. A pattern emerged.
Front-line staff, namely housing officers, were expected to have a good sense
of humour, be organised and be able to handle stress. This reflects the fact that
these people are often out in the field dealing with our customers, often in trying
circumstances. Remember we deal with very disadvantaged people and
sometimes the going can get pretty tough.
However, when you start to look at whats required of middle managers the
picture is very different. Every single job for the middle manager required people
to have some kind of financial management skills. Clearly, without these skills
you dont have much chance of climbing the ladder from a front-line post into
middle management.
But look at the chief executive and deputy chief executive roles and there seems
to be very little mention of financial management skills. What you see is the
ability to take a strategic view and leadership ability.
These observations are particularly relevant as they reflect todays organisational reality.
They show that seni or managers have i ncreasi ngl y devol ved a l ot of the
day-to-day financial management to middle managers. Financial know-how has become
a modern-day ticket to ride.
But what has driven organisations to these changes?
Great minds think alike
It is important to understand this change in the organisational structure. Of course there
are a number of places where we can look for answers but one of the best places to start
is with some of the most influential thinkers and writers about management at the turn of
the twentieth to the twenty-first century.
On the one hand they have helped to drive the move towards flatter, more empowered
organisations. On the other hand they have reflected some of the great changes that
have taken place.
We will look at what the following writers have to say:
Sir John Harvey-Jones
Kenichi Ohmae
Tom Peters
Jan Carlzon
Each has a different view of the changing face of organisations but put together they
create a powerful picture of the way organisations are heading and, of course, the way
that you are heading within them.
Sir John Harvey-Jones stripping out dead
wood
Sir John Harvey-Jones came to prominence in the non-business world with his BBC
series Troubleshooter, filmed in 1989.
In it he visited a number of different organisations, spent some time with them and made
recommendations on how they could actually improve the way in which they worked. It
made compelling television as it was one of the first instances where we were able to see
a charismatic individual treating the business of management seriously.
The organisations he focused on have had mixed fortunes since his visits but a number
of very clear messages came through from the programmes:
In the main middle management was woefully unprepared for the challenges that
faced it. Sir John Harvey-Jones showed that senior managers were keeping too
much power to themselves probably not surprising given that many of the companies
he visited were family-owned.
That organisations needed to develop a much clearer customer focus.
That the business world was becoming increasingly competitive and that organisations
could no longer stand still.
That organisations should concentrate on what they are best at.
The following is typical of Sir John Harvey-Joness comments. In this instance he is talking
about the senior managers at Churchill Tableware:
They have wisely taken steps to strengthen their management but instead of
stepping back to play a more strategic role the brothers [the owners] are still
getting bogged down in the minutiae of management. They are not allowing
their new managers enough space to show what they are capable of. They arent
putting enough trust in them and they arent requiring enough of them.
This kind of comment occurred frequently during the series.
His one message seemed to be: devolve power and/or strip out the dead wood. His
ideas were influential and may have been at least in part responsible for the move towards
empowering middle managers, including empowering middle managers to handle
budgets.
Looking into the future
In a later book called Managing to Survive, Sir John Harvey-Jones assumes a clairvoyant
role and takes a gaze into the future. In this book, billed as a guide to management
through the 1990s, he looks at the way in which organisations will need to change in
order to respond to the challenges that face them. And he actually tackles the subject of
the finance function within organisations.
He argues that:
Organisations will have to be leaner and meaner, and use their human resources
much more effectively.
Because of the difficulty of raising finance, the actual financial knowledge within an
organisation needs to be much sharper and much more broadly shared.
In short he believes that senior and middle managers need to have a much clearer idea
of what makes their organisation profitable and that they need to take a real part in
compiling the required financial information.
His vision is of a far more integrated company, with finance not out on a limb or secret,
but part of the organisation and part of everyones job:
There must be a great deal of openness. Making financial information available
right down the line implies trust both in the sense of a possible misuse of the
information and the risk that harmful facts may flow out of the company to your
embarrassment and disadvantage.
He also believes in delegation, including that of financial day-to-day work to middle
management:
I believe in delegating even areas such as cash controls as far down the line as
possible. Everyone understands cash. In our private lives we all know only too
well that if we dont have it we cant spend it even when it comes to credit cards.
Delegating cash responsibility can obviate many of the corporate games that
are played to make the ratios or the control data look right.
Consider Sir John Harvey-Joness guide for the 1990s. Write down what you think about his
arguments and how far you think they are true of your own organisation in todays business
climate.
ACTIVITY 3.2
It is worth picking up once more on a central part of Sir John Harvey-Joness argument:
The vital thing is to learn to delegate and to develop greater trust and openness
towards those to whom you have delegated. A very effective way to maximise
the generation of cash is to push the responsibility right down the line, but this
only works if individuals, as well as having the responsibility, have the power to
do something about it.
Kenichi Ohmae The Mind of the Strategist
In this classic work Ohmae looks at the art of Japanese business. The book was published
at the beginning of the 1980s and in many ways helped to fuel the Wests interest in
Japanese business methods. The message of the book is deceptively simple. Ohmae
shows that in a classic and successful Japanese company the strategy role is not just
confined to senior managers. For Ohmae, Japanese business is more than just numbers
it is about people. Everyone has an ability and an obligation to put forward their ideas
and that includes ideas about financial objectives. He points out that:
There may be people with small brains and big muscles or vice versa but the
separation seldom occurs and the big companies stay lively and aggressive and
flexible.
In other words the Japanese organisation thrives on people being able to suggest
improvements and on everyone having a part. He also points out that in Japanese
companies middle managers have extensively devolved powers over their own budgets.
Tom Peters excellence as the key
Tom Peters was in many ways the quintessential 1980s management guru. He did and
still does give passionate and inspirational lectures, picking up on some of the very simple
points that organisations and managers tend to ignore. His view is very people-centred
but he also has much to say about the financial role of managers and other staff throughout
an organisation.
He is particularly scathing about organisations that have focused only on costs. His vision
of the modern and successful organisation is one in which managers focus on innovation
and entrepreneurial activity and not just on controlling their costs. This is a quote from his
book, A Passion for Excellence:
We have become cost freaks as a friend puts it Paper clip counting becomes
the most valued (and promotable) skill Service and quality invariably, albeit
unintentionally, suffer.
Tom Peterss message was clear. Managers within organisations, and organisations
themselves, need to concentrate on improving quality and focus on the customer, not
just the control of costs. He argued that it was important for middle managers to be given
the ability to innovate and to come up with new ideas, even if they cost a little bit more,
because in the long run they would make the organisation more customer-focused. The
organisation would provide a better service and would therefore be more profitable.
Jan Carlzon up, up and away
Jan Carlzons excellent and compact book, Moments of Truth, explains how he turned
Scandinavian Air Services (SAS) around. In some ways it can be seen as a classic 1980s
management book in that it paints a picture of the chief executive officer as hero.
In terms of budgeting, the most important idea Carlzon had was what he called flattening
the pyramid. For him, the original SAS had been set up wrongly. It was there simply to
service the staff rather than focus on customers. His vision was to turn the pyramid on its
head. What this meant was that middle managers had the primary role of supporting
front-line staff, who were themselves providing Carlzons famous moments of truth or, in
other words, those one-to-one interactions with customers that actually made customers
want to come back and use the service again.
Unsurprisingly, these ideas came as a bit of a shock to SAS but after some initial conflict
they were accepted. A key part of Carlzons experience was that it was important to
delegate financial responsibility. He saw middle managers role in this as providing
information about finance and costs for front-liners in order to allow them to make sensible
decisions.
This is what he said:
To motivate the front line and support their effort requires skilled and
knowledgeable middle managers who are proficient at coaching, informing,
criticising, praising, educating and so forth. Their authority applies to translating
the overall strategies into practical guidelines that the front line can follow and
then mobilising the necessary resources for the front line to achieve these
objectives. This requires hard-nosed business planning along with a healthy dose
of creativity and resourcefulness.
He argued that the creative and brave manager might be prepared to even exceed his or
her budget in the hope that this would produce better results coming by the time he or
she was held accountable. He was scathing of middle managers who looked just at the
issue of cost and were not prepared to be entrepreneurial and innovative with the finance
side of their work.
Putting it all together
Taken together, these four influential thinkers sum up many of the important areas in
which organisations have changed within the last ten years. They point to an increasing
democratisation, and an openness about the world of finance within organisations.
They also support the idea that middle managers should be the instruments of change
by providing, understanding and interpreting financial information and not just focusing
on the issue of costs. Their vision of middle managers is of empowered, financially literate
and motivated people.
But has their vision been put into practice?
How far has your organisation moved towards any of the ideas of these four management
writers? For each of the four, rate on a scale of 1 (low) to 10 (high) how effectively your
organisation has taken on any of their ideas.
Sir John Harvey-Jones
Kenichi Ohmae
Tom Peters
Jan Carlzon
Clearly, these writers are in many ways idealists and have chosen their examples very
carefully in order to support their own point of view. Indeed, Tom Peters has been criticised
because many of the organisations he has chosen to champion have subsequently had
financial problems or ceased to exist.
However, the ideas are important because they give a bigger picture of the way in which
organisations are changing and how the finance function is becoming more integrated.
Their view is that finance is no longer a secret walled garden defended by the finance
department.
ACTIVITY 3.3
The picture today
Apart from management thinkers and writers, what are the actual forces that have been
shaping organisations in the recent past?
We now look at a series of possible influences on organisations. Each of these has had
an effect not just on the way in which organisations treat customers but also on the way
in which middle managers and organisations treat finance.
The influences fall under three broad headings:
new management ideas
government initiatives
economic factors
New management ideas
A whole range of new management ideas have spread like wildfire through organisations.
Some of these ideas have been taken on and then dropped while others have stood the
test of time.
In the late 1980s and early 1990s many organisations toyed with the idea of total
quality management (TQM). TQM stressed the need to focus intently on what
customers needed and then provide it. Along the way it also stressed the need to
remove job demarcation and strip out unnecessary bureaucracy in order to allow
front-line staff to deliver a quality service.
A current buzzword is empowerment. The bookshelves are stuffed with books about
it. However, despite the rush of interest and the charge of possible faddism, it is
actually an interesting idea. The idea behind empowerment is simple and is built on
many of the ideas of the management thinkers of the 1980s. Empowerment stresses
that the front line knows best and that organisations should increasingly devolve
responsibility through the ranks. As part of this, middle managers are increasingly
likely to take on parts of the job that previously belonged to senior managers.
Organisations, especially those in the public sector, have increasingly looked to
decentralise their operations. This has been part of the process of getting closer to
the public.
Finding out what the customer wants. In the early 1980s it became obvious to
many organisations in the public and private sector that they had drifted away from
their customers and were not at all clear what customers were looking for. In response
to this, councils and other public sector organisations, for example, have opened
area and neighbourhood offices. They have sent out mobile information offices on
buses to get in contact with people and have opened one-stop shops. Some councils
have handed over budgetary responsibilities to tenants as part of tenant initiatives.
All this has increasingly democratised finance and budgeting. It is common now in
organisations to have many different budget holders. This has been a double-edged
sword. On the one hand it has opened up the finance function and made it more and
more part of individual council officers work. However, it has also opened up the possibility
of fraud and has led to an increased emphasis on auditing of accounts and procedures,
both internally and externally.
Government initiatives
The most striking UK government initiative with an impact on the financial responsibilities
of managers has occurred in the public sector. The move to internal markets and
compulsory competitive tendering (CCT) has reshaped both the health service and local
government.
Local authorities have had to put in tenders in competition with other businesses to run
services. Many of the early bids by local authorities were unsuccessful because they had
no idea how to calculate the costs of a business. Recently, local authorities have become
much more sophisticated. What CCT did was to focus local authorities and their staff on
costing the different aspects of a service or workforce.
The internal market in social services and the health service has created a whole new
army of budget-holding managers. For instance, in social services the job of care manager
has been created. Previously, social workers had very little control over budgets. But the
new care manager is in charge of purchasing packages of care for clients. This has led to
the need for financial and budget control skills for middle managers.
Economic factors
The recession of the late 1980s and early 1990s hit businesses hard. Many went under.
One of the ways in which organisations responded to the recession was by downsizing.
Downsizing meant that whole layers of management were cut out and organisations
shrank in order to concentrate on core businesses. The effect has been to give individual
staff more responsibilities.
In downsized organisations the finance department cannot take on all the day-to-day
financial running of the organisation. This has meant that financial control has been
devolved to lower levels of management, creating a whole new tier of more financially
sophisticated managers.
Which of the influences above have applied to your organisation or business? How has the
organisation responded to them? Note down your responses under the headings of:
new management ideas
government initiatives
economic factors
You will need to use a separate sheet of paper for this activity.
Middle managers and finance: the new reality
You have looked at the organisational picture, the views of theorists and writers, and at
some of the changes in society that have led to a review of the finance function in
organisations. But how has this affected new middle managers and their financial
responsibilities? Obviously it is difficult to get a complete picture as every organisation is
different. But there are a number of key characteristics that are shared by todays more
empowered middle manager. One of these is that middle managers are increasingly
taking responsibility for their own numbers.
ACTIVITY 3.4
Base your answer to this activity on your own experience or that of a colleague.
Consider the changes that we have outlined above. What new responsibilities and
roles do you think middle managers will need to take on in order to handle the new
financial responsibilities that have come, or are coming, their way?
ACTIVITY 3.5
Your response will be appropriate to your own situation. You may have suggested that it
has become more important to achieve results within budget, or to understand your
companys performance in relation to that of competitors. You may need a greater
understanding of financial statements and terminology.
Thoroughly modern middle managers
There are two broad areas in which middle managers are likely to need skills in finance.
They will need to be expert negotiators, and to be resourceful. If a budget cut looks
like heading their way, they will need to take avoiding action. The chances are that a
middle manager will increasingly be asked to take on a role in negotiating their
budget, rather than simply being handed down a budget to deal with. This means
that middle managers will need to be more political and more aware of a range of
negotiation and assertion techniques.
They will become financial information-givers and transmitters. Increasingly,
middle managers are being asked to produce financial information both for their
teams and for their managers. This means that the modern middle manager will
need to be adept at producing and presenting effective, concise and useful financial
information. This is likely to require a whole range of new techniques including use
of computer software and other methods to present financial information. It will almost
certainly involve middle managers brushing up presentation skills and understanding
the basics of financial information.
Looking at the Management Charter Initiative
The Management Charter Initiative, as the industry lead body, has drawn up a set of
standards for managers. These standards describe all the things a middle manager should
be doing in order to be seen as competent. They are measurable and reflect the reality of
a modern middle managers job. One part of the standards looks at the way in which
middle managers should manage finance. According to the standards, the competent
modern middle manager will have a number of areas of responsibility. Put briefly, these
are:
the ability to control costs and make suggestions for improvement
monitoring and controlling their work and the work of their department against budgets
justifying new proposals for expenditure on projects
negotiating and agreeing budgets
These are four of the crucial areas that middle managers will need to tackle in todays
organisations.
Summary
The changing role of finance directors is affecting the role of middle managers.
Senior managers are increasingly devolving much of the day-to-day financial
management to middle managers.
Middle managers are increasingly expected to have financial management skills.
Management thinkers and writers have been influential in the move towards flatter
organisations where financial responsibility is devolved as far down the line as possible
and managers take responsibility for their own numbers.
New management ideas, government initiatives such as compulsory competitive
tendering, and the recession of the late 1980s and early 1990s have all helped to
democratise the finance role and reshape the role of middle managers.
Increasingly, middle managers have to be expert financial negotiators and
information-givers.
The financial information highway
Introduction
In financial accounting, the aim of the company accountant is to look at historical
costs in an organisation and report to shareholders. Cost accounting is concerned with
establishing how much it costs to manufacture or supply something. Management
accounting helps organisations to plan effectively.
In this section you will look at the scope and purpose of management accounting. In
particular, you will see that it is a service to help you in your job and that, by developing
a partnership with your management accountants, you can improve your management
information service and hence your effectiveness as a manager.
Your part in the picture
In your work, you will come across financial information all the time. In fact, you can
probably identify five main information routes:
Financial information from your company accountant this may be in the form
of internal or external reports, prepared following legal requirements and accepted
practice. You may well provide some of the basic information from which reports and
financial statements are prepared.
Financial information as part of the management information system we will
examine the role of the management accountant and the principles of good
information in the first part of this section. The aim of this is to help you to become an
educated user of financial information so that you can work with your management
accountant to ensure that reports are tailored for your needs.
Financial information that you generate this may be in the form of reports,
capital expenditure proposals or budgets. In the second part of the section, you will
see principles of effective presentation of financial information and how you can use
these principles to win your arguments for expenditure.
Financial information that you interpret for others a major part of your role as
a middle manager is interpreting financial information for members of your team so
that they can understand and use it. In the third part of this section you will examine
the importance of this part of your job for the organisation, for the development of
your team and for your effectiveness as a manager.
Financial information that you report to senior management you are in a
unique position to suggest ideas for improvement from your team to senior
management. In the last part of this section you will look at communicating improvement
ideas.
Your management accountant
As a manager you need to get the best out of your management accountant. The first
stage is to be clear exactly what a management accountant does and how this differs
from the financial accounting role.
So, what is a management accountant?
Management accounting is about bespoke systems rather than off-the-shelf
systems.
Jake Claret, Chartered Institute of Management Accountants
The Chartered Institute of Management Accountants (CIMA) defines management
accounting as:
The application of professional knowledge and skills in the preparation and
presentation of accounting information in such a way as to assist management
in the formulation of policies and in planning and control of the undertaking.
You can see from the definition that the management accountants role is to provide an
information service to management. Financial accountants are more concerned to meet
the needs of external stakeholders in an organisation, such as shareholders, bankers
and the taxation authorities.
The table below shows the main areas with which financial accounting and management
accounting are concerned, but you should note that there is no absolute dividing point
between the two specialisms.
Financial accounting Management accounting
Past expenditure analysis Future budgeting
External users Internal users
Book-keeping Expenditure appraisal
Monitoring Planning
Analysis Controlling
Tax management
More about the differences
The responsibilities of financial accountants are mainly focused outside the organisation.
They include the statutory duties associated with record-keeping, and with preparing
and auditing the published accounts in accordance with company law and accounting
standards. They may also include tax management and managing external relationships
with the financial community (shareholders and bankers).
By contrast, the management accountants role is to provide an information service inside
the organisation to meet the needs of managers. Management accountants are therefore
not bound so tightly by legal constraints or standard accounting rules, but are free to
present the information in whatever form is most useful to management.
In particular, the management accounting service should help you in the areas of planning,
decision-making and control.
The management accountant in your
organisation
The next activity will help you to gain a clearer picture of the accounting function in your
organisation.
Some organisations have a specialist financial accountant and a specialist management
accountant. In others the roles are combined within the finance directors role.
ACTIVITY 3.6
Are the management accountant and financial accountant roles split in your organisation?
Yes No
What services does the management accountant provide for you? (If you work in an
organisation without a specialist management accountant, which services offered by the
finance director help you in your work?)
Your answer will depend on the kind of organisation you work for but a management
accountant might provide the kinds of services shown in the table below.
Planning Decision-making Control
Setting long- Fixed asset Performance
term objectives purchases appraisal
Budget Pricing decisions Variance
preparation analysis
Getting the best from the service
We have seen that management accounting is primarily an information service to assist
you as a manager across a wide range of business activities. Now we need to know what
criteria determine how effective the service is.
First think about the financial information that is provided to you in your organisation. In the
space below, write down the name of three familiar documents or reports that you use in
your job. Try to identify one document or report you use for planning purposes, one you use
for decision-making and one you use for control. For example, you may receive a monthly
report comparing actual expenditure in your department against budget (control), you may
receive information on planned or forecast levels of activity over the coming weeks or months
(planning), or you may receive financial information which helps you to make decisions.
Planning Decision-making Control
information information information
Document A Document B Document C
Good-quality management information evolves from an effective partnership between the
information providers and the information users. Below is a seven-point list of criteria for a
high-quality information service. The first letter of each point in sequence makes a useful
acronym: PARTNER. As you look through the list, rate the documents you have just selected
against each of the criteria in turn.
(continued)
ACTIVITY 3.7
Complete the boxes on the right, giving a score from 1 (low) to 5 (high) for each of your
chosen documents.
Points out of 5
Document Document Document
A B C
Precision
Information should be sufficiently precise to meet
the needs of its users. There is a need for balance
between being accurate enough to be useful without
being unduly delayed or excessively costly.
Adequacy
No matter how precise the information is, it will be
useful to you only if it is sufficiently complete and
contains enough detail to enable you to interpret
the data, and to use it as a basis for action. Vague
general information about how well the business is
doing may be interesting or even reassuring, but it
is unlikely to be useful.
Reliability
Managers will use information only if it is consistently
believable. The information systems of many
organisations are not always so trustworthy. Indeed,
information may be deliberately manipulated and
distorted to give the answer senior management want
to see. How reliable is the information you receive?
Timeliness
Information must reach users in time for it to be acted
upon. A frequent criticism of financial reports is that
they arrive too late to be of use. Monthly statements
are often received two or three weeks after the end
of the month.
Necessity
This is the complement of adequacy (see above).
Most of us receive too much rather than too little
information. How much of the paper that arrives in your
in-tray is really useful? Receiving too much information
can, in turn, lead managers to spend their time on
detail rather than policy, and to become involved
in day-to-day issues that would be better delegated.
(continued)
Points out of 5
Document Document Document
A B C
Economy
Information systems cost money and, just as with
any other business expense, it is important to ensure
that the benefits to the organisation outweigh the costs.
You may not know the cost of producing the three
documents you have chosen, but you probably have
an opinion as to whether they represent value for
money.
Readability
A frequent criticism of financial reports is that they are
difficult for the layperson to understand. The use of
obscure jargon is a professional trait not limited to
accountants. (This is an area where the computer
revolution can help: presentation software packages
able to produce graphs and charts almost literally at
the touch of a button are now widely available.)
Now add up the scores for each of your three documents, and enter the totals in the boxes
below (maximum score per document is 35).
Document A Document B Document C
out of 35 out of 35 out of 35
Score over 30
Any document with a total score of over 30 should be meeting your needs effectively,
and you could use this as a yardstick against which to measure other documents. But
look at where your winning document dropped points. Can you do anything to improve
it?
Score 2030
This document is not meeting your needs as well as it should. You will need to identify the
provider of the information and discuss ways in which the service can be improved
remember that you are the customer.
Score under 20
This document is clearly not adequate. The first question you should ask is whether you
really need it at all. If the answer is no, make a note to ensure that you are taken off the
circulation list and to explain your reasons to the information provider. If you need the
information, consider how you can ensure that the service is improved.
If any of your documents scored less than 30, list below the actions you could take to
improve the service you receive.
ACTIVITY 3.8
Financial information that you
generate
Your role in the information highway
In the last activity you considered how to assess the financial information you receive
from your management accountant. As a middle manager, though, you will not only receive
financial information, you will also generate and interpret it. Both duties require particular
skills against which, in part at least, your performance will be judged.
The middle manager as computer
As you saw earlier, budgeting, capital expenditure appraisal, credit control and product
costing are four of the functions of the management accountant. As a middle manager,
you may identify these as areas within your remit also.
In fact, you may see yourself as a prime mover in this area, generating a vast array of
financial appraisals and reports for use by your staff and your managers. How you present
this information is crucial to your own credibility and the credibility of the project you are
promoting.
That sounds straightforward. But what is the reality?
Example
John works for a local authority in the capital projects section. He is responsible
for the elderly in his area. He is a middle manager, second in command to his
departmental director. Each month, his departmental director meets with the
other directors to discuss policy and assess the risks on any housing schemes.
Last month, John had to cover for his director and present his own financial
appraisal. He did not find it easy; instead of the risk appraisal taking the usual
ten or so minutes, he was grilled by the other directors for over an hour.
When he asked his finance director, later in the day, why it had taken so long, his
finance director replied as follows:
We gave you a hard time because it was you. In the past, your appraisals have
been sloppy youve assumed the wrong interest rate or inserted the wrong
formula in the spreadsheet. We cant trust your figures and if the figures arent
right, why should we assume anything else is?
You dont get many chances to make a good impression, so you should make sure that
when you do, you seize the opportunity. In addition, there is another crucial reason for
making sure that your information is clear and well presented. Your organisation may be
relying on it to make a decision. Often your information may be the only information on
which your organisations decision-makers are relying, and you have a responsibility to
aid them as much as possible in this.
ACTIVITY 3.9
Can you identify at least four characteristics that good-quality financial information should
have?
Good-quality financial information has six main characteristics:
relevance
reliability
understandability
significance
sufficiency
practicality
Relevance
You must consider the needs of the user of the information. If it is full of jargon and
acronyms that are common to you but possibly bewildering to someone else, it will not
serve its purpose.
Who is the intended audience of the financial reports you produce?
ACTIVITY 3.10
Your response will be personal to you but one thing you may have noticed is that
you probably had more than one audience. This is how one manager responded.
I am responsible for a team in charge of our capital expenditure. My reports are
intended to persuade my chief executive and, most importantly, our Board to
back my proposals. I do not personally write all the reports. They are done by
members of my team.
The board members on the finance sub-committee have highly developed
financial skills. Of the seven members of the board all of whom are voluntary
members and not full-time officials of the organisation four are qualified
accountants, one is a building surveyor, one a chief executive of a similar
organisation and one an expert in our charitys field of operations.
I have worked with them for three years to perfect our capital expenditure
appraisal format. It is now in a format they understand immediately, and consists
of:
an income and expenditure account over the life of the project
a cashflow over the life of the project.
It incorporates a sophisticated net present value calculation and a sensitivity
analysis. They love it.
The only problem I have now is that my staff dont understand the layout. I have
since had to spend time training them in the basics of accountancy to make sure
that they are happy with it too.
A manager in a registered charity
This is an unusual reversal. Usually, the operators understand how to manipulate their
reports and the decision-makers are left to take a great deal on trust. Both situations are
unsatisfactory. You must be able to satisfy all your audiences with your financial information.
If you dont you may find that the capital project you have worked on for years is rejected
because your decision-makers are not convinced by, or indeed, cannot understand your
argument.
Reliability
Imagine you have decided to buy a new house from Cheap n Cheery House Builders
Ltd. The salesperson sits in front of you, working out the sale price: Labour, materials,
marketing costs and overheads thats 200,000. No, hang on, does that include VAT
on the consultants fees and white goods? Lets work it out again. Yes. Here we are,
237,000. Now, with your 10 per cent deposit, thats only 190,000 to pay. Ill just go and
get the contract prepared.
Five minutes later
Oh, I seem to have added this up wrongly. How about we settle for 250,000 cash?
You wouldnt be terribly impressed and might well decide to put your investment elsewhere.
In our earlier example, John found that his projects were particularly scrutinised because
of a previous reliability error.
This is of course oversimplifying the issue. Reliability of information is not just about
making sure that the figures add up correctly, though that is its starting point. Reliability
means being free of bias. This is one of the most difficult things to do when you favour
one particular outcome. But you must resist the temptation to stack the decks in your
favour or you will bear the consequences.
A cautionary tale
A very successful acquisitions director of a UK commercial property company
presented an appraisal to her board to buy land worth over 10m, on the basis
that the company would make a 3m profit. Her appraisal included an analysis
of the sensitivity of her proposal to rises in interest rates and increases in building
costs. In the worst imaginable case, she predicted a 2m profit.
However, this was in 1986 and the property world had just begun to discuss the
possibility of a slump to follow the years of excessive boom. The acquisitions
director, although aware of this, ignored it in her appraisal. Her enthusiasm for
the project was such that she could not put an obstacle in its way and admit to
herself, much less her board, that there was a cloud on the horizon.
The purchase was completed and within two months, the UK fell into the worst
property value slump this century. Her 3m profit turned into a 2m deficit
overnight.
She did not lose her job but a 20-year reputation for having good judgement
melted away immediately, severely affecting her self-confidence and the
confidence of the board in her.
Understandability
Understandability is linked to relevance. Your information must be understandable for
your decision-makers to feel comfortable with it. If you were unaware about something,
would you stake your reputation or possibly your shareholders dividend on it?
Take one of your financial reports. How might you make it more understandable for your
intended user?
ACTIVITY 3.11
There are a number of ways in which you can improve your reports. Here is how
one manager answered:
I run the credit control section of a large wholesale company. My job is to make
sure that debts are chased up and I have to report on progress every month to the
board.
For years, we have presented the figures in the same way:
Month 1 2 3 4
Sales 100,000 175,000 200,000 250,000
Debts 5,000 7,875 8,000 8,750
Debts as % of sales 5% 4.5% 4% 3.5%
The Board only ever seemed to focus on the cash amount of the debt and criticised
my section for failing to perform. It was only when I presented the information in a
graph that they could see that things were getting better and follow the downward
trend of debts against sales.
As well as graphical presentations, other managers present extracts or summary
information to allow the picture to be grasped immediately. One manager said that she
left nothing to chance in her presentation of financial information: she used the capabilities
of the computer graphics package to the full to box off the important figures or make
them bold. They wont always recognise the bottom line, she said, but if I box it off, make
it bold and write a by-line note to draw their attention to it, it tends to drive the message
home!
Significance
Significance relates to the effect the information will have on decision-makers; that is,
whether it will materially affect their decision or not. For example, if the acquisitions director
had admitted the possible property market slump, would it have influenced her board or
their decision? Some may have remembered the early 1970s property slump and for
them this would have been a highly significant fact. Others working in the area in the late
1970s and early 1980s would not have had this field of reference and, for them, it would
not have been so significant.
How you decide to play the significance card depends upon your judgement of the
dominant values of your decision-makers.
A question of risk
Sadiq argues that although his voluntary committee want to be entrepreneurs,
they are far too cautious and are frightened off by the word risk. He writes his
capital appraisal reports loosely. His assessment of his committees mindset is
that they are looking for him to convince them to do things. His reports therefore
stress the positive and present risk obliquely.
Mary thinks her committee is similar but she takes a different approach. She has
an up-front section on risks in each appraisal, has a further section on how
those risks can be minimised and puts forward recommendations that weigh up
the two factors. She feels that her committee respond far more positively to the
balanced position and, indeed, they give her far more latitude because they
trust her to have evaluated the options.
Unlike Sadiq, Mary gives the pros and cons equal significance. She believes in
strongly arguing a case but only if her decision-makers have the same facts to
draw upon.
Sufficiency
You have probably received reports that you think are all right, as far as they go, but what
about the things that they do not comment on?
If you present information that is not self-contained and that refers to other documents,
you stop your decision-makers reaching an informed conclusion. More than likely they
will defer a decision, by which time it may be too late for the organisation to take advantage
of the situation or close a deal.
Practicality
Herbert Simon, in his model of rational decision-making, came to the conclusion that
there was no such thing as a rational, perfect decision. He believed that the decision-
maker had two routes to find the sharpest needle in the haystack or to find a needle in
the haystack sharp enough to sew with.
In other words, in an ideal world, the decision-maker would have perfect information to
work from and he or she could make the perfect decision whatever the circumstances. In
the real world, the cost of obtaining perfect financial information may be prohibitive either
because of the time it takes to prepare it, causing the decision-maker to miss a key date,
or because of the resources required to prepare it.
The decision-maker therefore uses imperfect information to take a decision, in the
knowledge that he or she may be proved right or wrong but also in the knowledge that it
is the best decision that can be taken at the time. The practicalities of the situation have
been taken into account.
The middle manager as conduit
As a manager, you may often have felt that you were the meat in the sandwich, a member
of both your team and the management team but slightly different from both. Nowhere is
this more true than in an organisations approach to financial information-giving.
As a manager, you have a role as an interpreter of financial information for your team but
you also act as the organisations antennae, picking up good ideas from the front line.
The enabling role
Think of all the budgets that you have within your department. It is likely that you will not
be able to control each one personally. You have to rely on the actions of members of
your team to achieve your results.
Too often the problem in organisations is that front-line operatives do not understand the
budgeting process. They are excluded from it and consequently do not see the importance
of the decisions that have been made. Sir John Harvey-Jones, in Managing to Survive, is
clearly of this opinion. He believes that the responsibility for cash management should be
pushed down the hierarchy as far as possible:
I have seen factories operating in a manifestly inefficient manner, largely because
of the tightness of the unco-ordinated controls exerted on them from above,
which have made the achievement of the financial targets much more difficult.
This is the paradox of financial control systems. On the one hand, the temptation is to
make cash controls as tight as possible and to limit them to as few people as possible.
On the other, the people furthest away from the action often are not best placed to make
those decisions.
Provided that people on the front line are given the tools to do the job that is, they are
given enough information to make intelligent decisions they will use the cash to its best
advantage. This will help you achieve your budgetary targets.
So what would be your role in this new flattened structure? The manager quoted earlier
who described the development of her capital expenditure appraisal system is a case in
point. She had to coach and support the members of her team so that they could
understand the best way to present financial information.
In other areas, you may find you have the same role. You may have to sift the financial
information that you receive from your management accountant and put it into a more
manageable form for your team.
This is how one manager described the operation.
I work for a publishing house on the sales side. Im in charge of a team of sales
staff and as part of this years negotiations on the budget, I had to put forward
my estimation of what our sales would be for the year. In the past, previous sales
managers have looked at last years figures and added or deducted a bit and
put that forward as their target.
They often lived to regret it, and gave their team a very difficult task indeed to
achieve it. Before committing myself, I discussed it with my team to get their
realistic interpretation of the market. This gave us a pretty good idea of how
many books we could hope to sell and what sort of profit margins we could
achieve.
In March the agreed budget came down to me. It was 15 pages long and
contained a detailed budget for every section of the organisation. I made a copy
available for all the members of my team but realised that I had to do a little
unravelling to make it really stick.
Based on our earlier discussions, I was able to break down our overall sales
and profit target into individual sales patches. This meant I could give each
member of my team their own individual targets to meet.
Jan Carlzon, in Moments of Truth, which describes how he turned around Scandinavian
Air Services, also highlights the importance of the manager as interpreter and enabler.
The educating role
As a manager, you are much more likely than the members of your team to have the
financial and planning skills required in your organisation. That is not to say that you will
have all the answers but what you will have is an understanding of the way financial
information needs to be marshalled and presented in order to win a case.
Part of your role is to help your team develop those skills and to pass on elements of
good practice to your team. What you are trying to achieve is a move away from, say,
capital appraisals on the back of a beer mat to those that include sophisticated computer
spreadsheets, proper appraisals of risk and clear presentation of the facts.
It may be you who will initially design financial appraisal systems or reporting systems
but if you keep all the knowledge about how they work to yourself, your team will never
be able to use them properly. If they dont understand them they will find ways of ignoring
the system.
One manager found that by the incorrect use of a spreadsheet, one of her officers had
actually miscalculated the potential profit of a project by over 1,000,000. Fortunately,
the manager managed to spot this in time and correct it. However, you may not be so
lucky. You will not have time to check personally every single piece of financial information
that your team generates.
What you should be looking at is a team which is sufficiently financially literate to be able
to act as their own quality control function. In one organisation we know of, officers act as
their own tickers and checkers. Once one has finished a financial appraisal or budget
report, he or she passes it to a colleague who checks the arithmetic and the assumptions.
By the time the information reaches their manager, they are fairly sure that it is as accurate
and free of error as it can be.
Passing good ideas up the line
Although we said earlier that, as a manager, you may have greater skills than the members
of your team, this does not mean that you have a monopoly on good ideas. Your team
often do know best when it comes to front-line operations.
It is the job they do day in and day out.
Many organisations recognise this with their use of employee suggestion schemes. One
major car manufacturer, for example, has a suggestion scheme that allows front-line
operators to pass up suggestions about possible ways of improving efficiency. You may
remember such items on the news as Employee saves the company $2 million a year
with simple but revolutionary idea.
Your teams ideas may not be of that magnitude, but they may well have ideas that will
save the company both time and money.
Summary
Part of the role of the management accountant is to provide an information service
for managers. The information provided by the management accountant should help
you in the areas of planning, decision-making and control.
The information provided by the management accountant should meet the criteria
of:
precision
adequacy
reliability
timeliness
necessity
economy
readability
It is important to work with the management accountant in order to ensure that the
information you receive is tailored to your needs.
The information that you generate should be:
relevant
reliable
understandable
significant
sufficient
practical
Managers have an important role to play in interpreting financial information for the
members of their team and in educating them in financial skills. Managers also have
a crucial role to play in providing senior management with financial information and
suggestions from their team members.
Jot down here what you feel is the role of financial information in your organisation.
Now jot down what the following financial terms mean to you. If you do this now,
you will be able to check them later on to see how accurate you were.
profit
loss
budget
cost
balance sheet
ACTIVITY 3.12
Financial information for managers
Managers within organisations need to know how well they are doing for their own
sake, and also in the interests of employees or the tax authorities. The performance of
your organisation could probably be assessed in any one of a variety of ways: for example,
by the number of people you employ, or the quality of your product/service, or the amount
of cash deposited at the bank. In this section, you will examine the role that financial
information plays in enabling you to assess your organisations performance.
Organisations generate many kinds of financial information, of which only some will be
useful to managers and their departments. Managers need to be able to identify and use
the financial information that is relevant to them. Financial information can be defined as
knowledge about something expressed in terms of money.
You may already be aware of financial information that your organisation produces on an
annual basis. The annual report (which includes a balance sheet and a profit and loss
account for the year) will give a general picture of the financial position of the organisation.
This is known as financial accounting information. Its main users are those who have an
interest in the financial viability of the business, such as shareholders, loan creditors,
potential investors, employees and business contacts.
Answer the following in relation to financial information prepared by your own organisation.
What annual financial information is prepared? (It could be in the form of a published annual
report containing a balance sheet, profit and loss account, and directors report as well as
other information or simply a profit and loss account and balance sheet.)
Who prepares the information?
When was the information prepared and what period does it cover?
Who has access to the information?
Who uses the information and what is it used for?
ACTIVITY 3.13
As we have already noted, there are usually two main types of accounting which managers
come across in the day-to-day running of their organisation. These two types are:
financial accounting
management accounting
Financial accounting information is not usually detailed enough for day-to-day business
operations. You probably found that the information prepared was more for the benefit of
interested parties outside the organisation and was not really used by those involved in
day-to-day management. As a manager, you probably require more detailed information
about costs and resources to help you in planning and controlling finance, and in financial
decision-making. Management accounting can provide this detailed information.
You may also have noted that the information prepared is of a historical nature. It is
based on what happened in a past financial year. Managers need to be concerned about
the future of the organisation. Last years information will only tell you what happened
last year. It is only useful as an indication of what might happen next year, or for identifying
where things havent gone as planned to avoid making the same mistakes again.
Management accounting information helps managers make plans for the future.
You have decided that operational costs in your department could be reduced by purchasing
new equipment. This might be a machine used in production, a computer for storing and
processing data, or an item of office equipment.
Before making the decision to purchase the new equipment, what financial information
would you require?
ACTIVITY 3.14
Sources of information
You will find that you already collect and use management accounting information. As a
manager you will have a number of defined responsibilities within the organisation and
you will already collect or receive detailed financial information in relation to those
responsibilities. However, does the information you need match the information you
currently receive?
Financial information for managers can come from a variety of sources. Many
organisations employ management accountants to collect and interpret financial
information for management purposes. Some of the information you receive may be
provided by a management accountant.
You may also provide information from your department to help in the financial
management of the wider organisation. This information may have come from external
sources (for example, prices from suppliers); from other departments (for example, the
number of product units held in stock); or it may have been generated within your own
department (for example, the number of product units produced). It is useful to be aware
of these different sources so that you can obtain and use financial information more
efficiently.
You have now built up a picture of where your department fits into the management
accounting system of the organisation.
List your main responsibilities as a manager and the financial information you need in order
to fulfil those responsibilities.
Responsibilities Financial information
Look at the list of financial information you prepared and identify the source of the information.
Who do you supply the information to?
Financial information Source Supplied to:
ACTIVITY 3.15
Cost information
The importance of cost
Before looking at what is meant by the term cost, you will need to consider why cost is
important in an organisation. Manufacturing business can be taken as an example, but
similar principles apply to all organisations. Cost is relevant to the three management
activities of planning, controlling and decision-making.
Planning
Unless a manufacturing company knows the cost of making its products, it is not possible
to decide on a profitable selling price. If the market is very buoyant, the manufacturer
may be able to charge a very high price, but it is still important to ensure that this covers
the cost. If the market is very competitive, the manufacturer may wish to know how far
the selling price of the product can be reduced before a loss is made.
It would also be very difficult to determine the best way to plan production without knowing
the relevant costs. It is necessary to know the costs of all the items making up the
production process and the funds required to support them. Such costs are not confined
to materials and labour, but also include machinery, buildings, transport, administration,
maintenance and many other items.
Controlling
To maintain control, managers need to know the costs incurred and compare them with
the original plan. If costs are not known, the resources used by the organisation will be
employed inefficiently, leading to waste and, in the worst circumstances, the complete
failure of the organisation.
Decision-making
Managers are constantly making decisions. In order to make the correct decisions, they
need cost information. For example, it is impossible to decide whether it is worthwhile
investing in new manufacturing machinery without having information on costs.
Defining cost
Cost can be used as a verb to mean to calculate the cost of a specified thing or activity,
or as a noun to mean the amount of actual or notional expenditure incurred on, or
attributable to, a specified thing or activity.
Although it is important to know what the costs are, they are not always easy to identify.
Sometimes the cost of an item depends on your perspective. Buyers and sellers will look
at the cost of an item in different ways.
Look at a simple example:
You go to your local computer dealer one Friday and buy a pack of 10 computer
disks for $15. On Sunday, a friend asks you to sell him one for some urgent work
he is doing. You know that if you were to replace that disk on Monday it would
cost you $1.75.
What do you think is the cost of the disk?
$1.50
$1.75
neither or both of these figures
You may have answered this by taking the original cost of 10 disks and calculating
the cost of one at $1.50, or you may have decided that the cost is $1.75. One
difficulty is that the view of cost is determined by the different perspectives of, for
example, buyers and sellers, the context in which calculations are made and the
reasons for wanting this information. The cost used will always depend on the
perspective of the person calculating it.
Cost units
While it is useful to know the total costs in an organisation, it is essential to be able to
divide those costs across units of service or production. The term 'cost unit' describes the
units to which costs are attributed.
With a manufacturing company, the units are usually clearly identifiable, such as a television,
a pair of shoes or a packet of washing powder. In something like a brickworks, where
there are a large number of identical products, it is sometimes easier to have 1,000
bricks as one cost unit. This is because the cost of one brick is so small that there would
be difficulty in measuring it.
In a service industry, the costs may be of a more abstract nature. In a hospital, the cost
unit may be a patient bed occupiedand all the costs in respect of that unit will be recorded.
Where the organisation provides different products or services to individual customers
for example, a garage doing service and repair work then costs will be allocated to
individual jobs.
In some instances, and particularly with service companies, the output may not be so
easily identifiable. However, wherever the product or service is capable of being identified,
the output should be measured by devising some form of cost unit.
Can you suggest appropriate cost units for the following organisations?
a vehicle manufacturer
a paper bag manufacturer
a road haulage company
a plumber
a ball-point pen manufacturer
A paint manufacturer
ACTIVITY 3.16
Cost centres
As well as calculating costs for each cost unit, an organisation may also need to know the
costs for particular departments or units of the business. These are known as cost centres.
A cost centre may be a single factory, a department or unit, a single machine or group of
machines, an individual or a group of individuals. Look at the following example.
Consider how the following might be cost centres for a manufacturer of MP3 players or
a hotel:
assembly department
cost of drinks sold
stores department
reception area
sales team
laundry
specialised moulding machine
restaurant
clerical salaries
kitchen
You may not know anything about the manufacture of MP3 players, but the definition of
a cost centre given earlier should have helped you to identify the first four of these as
possible cost centres. Clerical salaries are an expense but not a cost centre. The specialised
moulding machine may be a cost centre if it is sufficiently important and complex to allow
a number of costs to be identified with that particular activity. This does not necessarily
mean that all radio manufacturers use the above cost centres, but they are all areas of
activity where managers may need to know the costs.
As far as the hotel is concerned, the cost of drinks sold is an item of expense, but all the
others are possible cost centres. However, some organisations may not formally identify
their cost centres and/or cost units.
Consult your organisations finance department (if you have one) and answer the following
questions. This will help you to identify the cost centres in your own organisation and determine
the extent of your responsibility for them.
What are the cost centres and cost units in your organisation?
Do you have direct responsibility for any of the cost centres or are you able to influence their
activities?
What financial information is generated in respect of the cost centres and cost units?
ACTIVITY 3.17
Classifying costs
Although it may be useful to know the total costs of an organisation for a financial period
or the cost of one cost unit, it is even more useful for planning, controlling and decision-
making if the costs are classified.
The way costs are classified depends on the purposes for which the information is required.
One way is to base the classification on the nature of the expenses incurred. The basic
classifications are materials, labour and expenses, although these are usually further
broken down or analysed in a way that provides useful information for example, into
different materials used.
Another way of classifying costs is to identify them as fixed or variable. Fixed costs are
those which do not usually change, no matter what the level of activity is. One example of
this might be an employees salary, if no overtime is paid. Variable costs are those which
usually vary in proportion to the amount of activity. For example, if the level of activity in
a factory increases, the amount of fuel being consumed by machinery will also increase
proportionately. This makes the cost of fuel a variable cost.
Look at the following example to see how different costs can be classified. The expenses
of a taxi business have been broken down in some detail. This can be used as the basis
for calculating further cost information.
The mileage by one taxi in one quarter is 15,000 miles and the costs analysed are as
follows:
Expense Total for quarter ($)
Drivers salary 2,670
Petrol and oil 1,050
Service repairs 450
Taxation and insurance 1,110
Depreciation 870
(Depreciation is an amount allowed to account for the fall in value of a business asset
due to time and usage. Here depreciation would relate to the vehicle.)
You will probably have realised that you can add up the costs so that you know that the
total costs for one vehicle for one quarter are $6,150. From this you can then calculate
the total cost per mile:
Total costs = $6,150 (= 41c per mile)
Total mileage = 15,000
You could also calculate the cost per mile for each of the expenses, as follows:
Expense Total for quarter Costs per mile
($) in cents
Drivers salary 2,670 17.8
Petrol and oil 1,050 7.0
Service repairs 450 3.0
Taxation and insurance 1,110 7.4
Depreciation 870 5.8
Total 6,150 41.0
The figures given here will remain the same provided that the average mileage for the
quarter remains at 15,000 miles. If this changes then some of the costs will change.
Imagine that you have been invited to submit a quotation for a special contract which will
involve an additional 500 miles per quarter. In this case, consider which of the costs
would change with the additional 500 miles and which costs would remain the same.
There is no additional salary for the driver incurred for the additional 500 miles as it
can be done in the drivers current time allowance. The driver's salary, in this example,
can be considered as a fixed cost. Certain other costs will not increase because of
the additional 500 miles per quarter.
Taking the costs in the order in which they are listed, the costs for petrol and oil will
obviously rise with the increased mileage, so they are variable costs. These are
costs which tend to change in direct proportion to changes in the level of activity.
With regard to servicing and repairs, some routine servicing will be carried out
regardless of the mileage and this is a fixed cost. Other servicing and repair costs
will depend on the mileage.
Road tax and insurance are fixed costs because they will remain the same regardless
of the mileage. In reality, depreciation could be expected to be influenced by the
amount of mileage done but would be difficult to calculate on this basis, so is normally
accounted for on a time basis and treated as a fixed cost.
Fixed costs are those which may change in some circumstances. In the example above,
the drivers salary would change if overtime had been paid. Also, variable costs may not
always vary directly in proportion to activity. For example, some suppliers give extra
discount on larger orders. You can generally assume, however, that the definitions given
above hold true.
The next activity will help you understand the differences between fixed and variable
costs. You may want to read the definitions above again before deciding on your answers.
ACTIVITY 3.18
1 Circle the correct answer in the following statements:
a If activity is increasing, the total fixed cost will increase/decrease/stay the same.
b If activity is increasing, the fixed cost per unit will increase/decrease/stay the same.
c If activity is decreasing, the total fixed cost will increase/decrease/stay the same.
d If activity is decreasing, the fixed cost per unit will increase/decrease/stay the same.
e If activity is increasing, the total variable cost will increase/decrease/stay the same.
f If activity is increasing, the variable cost per unit will increase/decrease/stay the
same.
g If activity is decreasing, the total variable cost will increase/decrease/stay the same.
h If activity is decreasing, the variable cost per unit will increase/decrease/stay the
same.
2 Make a list of the cost items in your department and identify those you consider are
fixed and those that are variable.
Direct and indirect costs
Costs may be classified in a number of other ways depending on the purpose for which
the information is required. One method is to classify costs into direct costs and indirect
costs.
Direct costs are those which can be identified with a specific product or saleable
service.
Indirect costs are those which cannot be identified with any particular product but
have to be shared over a number of products because they are common to or jointly
incurred by them.
Which of the following costs would normally be classified as direct and which would normally
be classified as indirect in a manufacturing organisation? Place a tick in the appropriate
box.
Direct costs Indirect costs
Materials used in the product
Rent of the factory
Royalties on product design
Supervisors salaries
Production workers wages
Accountants salaries
ACTIVITY 3.19
Cost of stock
All organisations need to purchase materials from time to time. For example, a firm of
solicitors needs a supply of stationery; hospitals need large amounts of drugs and other
medical supplies; restaurants and hotels require food and drinks. The cost of materials
does not in itself present a problem to the manager the items will be purchased from
the supplier at the suppliers price. However, most organisations keep stocks of materials
and it is the cost at which these are issued from stores that can be problematic. This is
more complex than it first appears. Stocks normally consist of various receipts made at
various dates, and perhaps at various purchase prices. It may be impossible to identify
each issue of materials to production, with the corresponding receipt into stores. Look at
the following example.
Example
A stores department has a record of the following receipts and issues of materials:
10 January, received 1,000 kg of materials at $2.00 per kg; 12 January received
1,000 kg of materials at $2.20 per kg; and 13 January issued 500 kg to Production.
If you needed to decide at what price per kg the 500 kg should be charged to
Production, you could have given any one of the following answers:
$2.00 per kg the price of the first delivery of materials for all issues of
materials until that particular consignment is exhausted. This method is known
as FIFO (First In, First Out).
$2.20 per kg the price of the last delivery of materials for all issues of
materials until that particular consignment is exhausted. This method is known
as LIFO (Last In, First Out).
$2.10 per kg the weighted average cost calculated by multiplying the prices
by the quantities for each receipt and then dividing the total value by the
quantities of stock held. This is known as the weighted average cost method.
The three different methods would, of course, mean different costs.
Using FIFO, 500 kg at $2.00 per kg is $1,000.
Using LIFO, 500 kg at $2.20 per kg is $1,100.
Using the weighted average method, 500 kilos at $2.10 per kilo is $1,050.
We will now look at a more detailed example of these three methods of stock valuation,
taking the calculations a stage further.
1 Data to be used in the calculation:
Date Received Unit price Price paid Issued to
production
units $ $ units
1 April 100 20 2,000 -
20 April 50 22 1,100 -
24 April - - - 60
28 April - - - 70
Total 150 42 3,100 130
2 Bases of calculation:
FIFO assume that the goods which arrived first are issued first.
LIFO assume that the goods which arrived last are issued first.
Average cost assume that all goods are issued at the average price of the stock
held.
3 Calculations:
Basis Date Quantity and Issued to Held in Total
unit price production stock
$ $ $
FIFO
24 April 60 units at $20 1,200
28 April 40 units at $20
30 units at $22 1,460
30 April 20 units at $22 440
Total 2,660 440 3,100
LIFO
24 April 50 units at $22
10 units at $20 1,300
28 April 70 units at $20 1,400
30 April 20 units at $20 400
Total 2,700 400 3,100
Average
24 April 60 units at $20.67 1,240
28 April 70 units at $20.67 1,447
30 April 20 units at $20.67 413
Total 2,687 413 3,100
FIFO, LIFO or average cost?
Look at the calculations and compare them with the original data. You will see from the
first table that the total amount spent on materials during the month was $3,100. You will
see from the second table of calculations that the total of the cost of goods issued to
production plus the cost of unsold goods is always $3,100, irrespective of which approach
is taken. All that differs is the allocation between goods used in production and goods
remaining unsold. Cost can never be gained or lost in total because of a particular
allocation process, provided the process is used consistently over time. The disadvantage
of the FIFO approach is that it matches outdated costs against current revenue. The
LIFO approach improves on FIFO by matching the most recent costs against revenue,
but at the expense of an inventory value which becomes increasingly out of date. The
average cost lies between the two and becomes more intricate to recalculate as more
items come into inventory.
ACTIVITY 3.20
Find out what method is used for pricing issues of materials from stores in your own
organisation. If the organisation is very small and does not have any system, you can work
out the effects of the three methods described by looking up the prices paid for stationery
items six months ago and comparing them with current prices. Note your observations here.
Analysing costs in detail
The importance of costing
Annual income twenty pounds, annual expenditure nineteen pounds 95 pence,
result happiness. Annual income twenty pounds, annual expenditure twenty
pounds and 5 pence, result misery.
Source: Mr Micawber in Charles Dickenss David Copperfield (decimalised)
Note down two unpleasant consequences that you think spending more than it
earns can have for an organisation and for its employees.
1
2
In an organisation where costs are not controlled, the ultimate consequence could be
failure. In the private sector, a company could go out of business or be taken over. In the
public sector, an organisation may have to be restructured or lay off staff.
Even the less drastic consequences are unpleasant: less money will be available for new
equipment, training, refurbishments, pay rises and the recruitment of new staff.
In addition, the organisation may be unable to afford to take advantage of new
opportunities that might have secured its future: investment dries up.
To control costs, you need to know what the current costs are as well as what they should
be.
Costing is straightforward, but some of the terms can be confusing because they depend
on what is being costed, so we will start by establishing the two main types of thing you
can cost.
Cost centres
One method of cost control is to work out a budget for each department, on the basis of
how much it costs to run.
Each department then becomes a cost centre with its own budget. This makes the
process of controlling each departments spending more straightforward.
Any part of an organisation can become a cost centre with responsibility for its own
costs; in other words, not just departments but teams, units and sections within
departments.
The purpose of setting up cost centres is to control costs, so for each one, there should
be an individual who can take on the responsibility for controlling costs in that cost centre.
Here are some examples of typical cost centres:
Marketing department
Personnel department
branch in a chain of stores
assembly line in a factory
school within an education authority
Any part of an organisation to which costs can be charged is a cost centre.
Bureaus is a small company which makes and installs office furniture.
Consider these remarks:
Joyce (customer services supervisor):
Gibsons have mislaid the brackets for our last delivery of desks get ten of
them off production, get down there and sort them out.
Sue (development supervisor):
The new executive desk has got to be ready for the trade exhibition tomorrow
get a couple of brackets off production and get it assembled.
Joyce and Sue are using their initiative to do their own jobs well. But what will
happen next?
Tom (production supervisor):
I cant work out why our wastage is so high we seem to keep running out of
brackets.
The production department of Bureaus seems to get through a lot of brackets.
Think of two advantages of making it a cost centre. Write them down below.
1
2
You may have suggested that by making a department into a cost centre you can:
accurately record the costs that the department incurs
increase individual awareness of the cost of resources
make someone responsible for controlling the use of resources
Cost centres are a way of identifying groups of costs, and who is responsible for
them.
Are you part of a cost centre in your organisation? Ask your line manager if you are not
sure.
Yes No
If so, write down the name of the cost centre, together with two others in your organisation,
and the name of the person responsible for each one. The accounts department may be
able to help.
Cost centre Person responsible for the centre
1
2
3
If not, try to find out why your section or department is not a cost centre, and note your
findings down here.
If your organisation does not operate cost centres, use the table above to note down your
suggestions for three new cost centres.
ACTIVITY 3.21
Cost units
Everything that a cost centre produces can be costed and is called a cost unit whether
that cost centre manufactures products or supplies a service.
All organisations will cost goods or services that they sell. Some organisations will also
want to cost the goods or services used internally, for example office stationery and
catering supplies.
Here are some other examples of cost units:
installing a car radio
handling a customer query
providing one hospital bed for one day
teaching a one-hour physics class
making a window frame measuring one square metre
These are all very different, but what they have in common is that they can all be priced.
Note that in order for them to be priced, they need to be precisely defined (not just
teaching a lesson or making a window frame).
A cost unit is a product or service (or part of a product or service) whose costs
can be calculated.
Note down one reason why an organisation should cost a product or service.
Consider this statement:
Sasha (sales manager):
Weve won the biggest order in the history of the company that extra 5%
discount just tipped the balance.
Is he a hero, or has he endangered the company? The organisation has to know how
much it costs to provide a product in order to:
give it a price, and
work out how much profit it will earn from its sale
Making a product or service a cost unit and pricing it accordingly helps an organisation to
manage its resources more effectively and maximise its profits. For example, if you know
the cost of printing a marketing brochure in-house, you can decide whether it would be
more or less cost-effective to send the work out to a printing firm.
Think of a product or service (or part of a product or service) that your department
is responsible for choose one that is, or could be defined as a cost unit. Find out
what it costs to produce (or supply).
Product or service Its overall cost
The actual product or service that you chose will depend on your own circumstances.
However, the cost unit you chose should be for a measurable amount such as a single
item of the product, or a day of service provision (otherwise you cannot calculate how
much it costs).
A cost unit is a measurable quantity of the thing being costed.
Which of the following are cost centres and which are cost units?
Cost centre Cost unit
a making a clock
b serving customers in a restaurant
c the X-ray department in a hospital
d the stock control section of a warehouse
e a companys accounts team
f taking a reservation for rail tickets
The giveaway is this: the cost centres relate to teams, sections or departments. The cost
units may have run up costs in each of a number of teams, sections or departments. So,
c, d and e are cost centres, and a, b and f are cost units.
List three cost units in your organisation. (Your accounts department may be able
to help.) If your organisation does not operate cost units, think of three that you
think would be suitable. Briefly explain why you think each one would be a suitable
cost unit.
ACTIVITY 3.22
Classifying and analysing costs
The principles of classifying, calculating and analysing costs are much the same for cost
units as for cost centres.
By analysing costs, we can assess whether products, services and the cost centres
responsible for them are cost-effective. The analysis involves finding out what the true
cost is of manufacturing the product, supplying the service or running the cost centre.
For example, when writing and sending a letter, is the true cost merely the cost of the
paper and the stamp, or are other costs involved?
Even simple tasks like writing and sending letters cannot be achieved without using many
of an organisations resources. For example:
the typewriter or word-processor
the desk to put it on
the typewriter ribbon or ink cartridge for the printer
the office space the desk takes up
the heat and light in the office
the authors time
the typists time
the envelope
the post room supervisors time
All of these contribute to the cost of the letter over and above the actual cost of the
paper and the stamp.
Everything that must be paid for in order for something to be produced, or a service
to be supplied, counts towards its cost.
Once you have established which costs should be included in the true cost of producing
a product, supplying a service or running a cost centre, you need to classify each of
these costs.
This is important, because knowing the total or true cost of a cost unit may not be enough
to help you to control the various costs involved. By classifying them, you can establish
where and how the money is being spent, and get a clearer picture of how any necessary
changes could be made.
We will look at three ways in which costs can be classified, using the example of writing
and sending a letter:
labour costs/material costs/expenses
direct costs/indirect costs (or overheads)
fixed costs/variable costs
Each of these methods of classifying costs can help us to make decisions about how to
control costs and set prices.
Labour costs/material costs/expenses
To classify costs in this way, you first need to identify which ones are related to the
payments for time spent on the production of a cost unit, or running of a cost centre.
These costs will come under the heading of labour costs.
Total costs can be looked at in three ways
I
n
d
i
r
e
c
t
D
i
r
e
c
t
(But whichever way you look, they still add up to the same total.)
Which of the following would be classified as labour costs?
a the typewriter or word-processor
b the desk to put it on
c the typewriter ribbon or ink cartridge for the printer
d the office space the desk takes up
e the heat and light in the office
f the authors time
g the typists time
h the paper
i the envelope
j the stamp
k the post room supervisors time
The labour cost involved here is the amount of money paid for each persons time spent
on the task of writing and sending the letter. So, you should have ticked f, g and k.
The money paid for the materials used wholly for the purpose of producing a cost unit or
running a cost centre will come under the heading of material costs. It is important not
to confuse these with expenses, which are payments for resources that are only partly
used for the purpose; for example, the electricity used to heat and light the whole office.
Expenses tend to be costs that are difficult to split into separate amounts for each cost
unit or cost centre.
Go back to the list above. Put an E against the items you think are expenses, and an
M against those you think are material costs.
The cost of the materials and the expenses involved in writing and sending a letter may
not be very high. For example, a piece of paper costs only a few pence, so we tend to
forget that if we waste paper, the cost can build up over a period of time. If you ensure
that your staff are aware of the cost of such materials and expenses in the long run, you
are likely to find that you can cut costs considerably.
In the exercise above, h, i and j would come under the heading of material costs and a,
b, c, d and e are all expenses.
Classifying costs in this way highlights the fact that in order to produce anything at all,
you need:
people to do the work
materials for them to work with
equipment for them to use
These are some of the costs involved in making one of Bureaus most popular lines the
executive desk.
Which type of cost does each of the following represent?
Labour Material Expenses
electricity
overtime payments
depreciation on machines
production supervisors salary
wood
steel
telephone
spare parts for machines
maintenance engineers salary
metal fittings
machine operators wages
Compare your answers with those given below.
electricity expense
overtime payments labour
depreciation on machines expense
production supervisors salary labour
wood material
steel material
telephone expense
spare parts for machines expense
maintenance engineers salary labour
metal fittings material
machine operators wages labour
So making office furniture, like writing and sending a letter, involves labour, materials and
expenses. It takes people, materials and plant and equipment.
To summarise:
Costs can be grouped under three headings:
labour
materials
expenses
This classification shows you how costs are made up, and helps you pinpoint areas for
cost reduction.
We can now go on to look at the second method of classification: direct and indirect
costs. This is linked to the one described above because, to use this method, it is useful
to group the costs you are analysing into labour, material costs and expenses. We will
continue to use the example of Bureaus, to show how this method is used in practice.
Direct costs/indirect costs (or overheads)
Labour costs, material costs and expenses can be divided into direct and indirect costs.
Direct costs are those which relate directly to whatever is being costed. Indirect costs
are those which only partly relate to whatever is being costed.
The following example shows how we can divide labour costs in this way.
In order to cost the production of a desk, you need to find out how much time
Bureaus employees spent on it. When you refer to the summary of the production
departments timesheets, this is what you find:
Worker Job Time (hours)
Machine operator Desks 100
Machine operator (overtime) Desks 20
Maintenance engineer Routine maintenance 20
Machine jam 6
Production supervisor Machine room
supervision 20
Requisitions 3
Training 10
Identify which of these labour costs are directly related to the production of a desk.
(The production department does not only make desks.)
Because the machines are used for making a number of different products, the cost of
their maintenance cannot be directly related to the desks. Because the production
supervisor is responsible for all the products being made, these costs cannot be related
to the desks either. In fact, only the hours actually booked by the machine operator for
desk production can be related directly to the desks.
So, the machine operators labour is a direct labour cost. It relates directly to the cost of
desk production.
The maintenance engineers time and the production supervisors time are indirect labour
costs. They relate to other jobs as well as the production of desks.
There are some costs that could be classified as direct costs but that are treated as
indirect costs. Take glue, for instance, used in the production of a desk. Even though it
would be possible to weigh the glue consumed in each job and calculate the direct cost,
it is not worth it. The cost of doing so would outweigh any possible benefit.
You would only need to collect information like the weight of glue used when:
The decisions you make, based on the information, earn more than the cost of
collecting the information (or save you from losing more than the cost of collecting
it).
The law requires you to do so.
So, to summarise:
A direct cost is one which relates directly to whatever is being costed.
An indirect cost is one which only partly relates to whatever is being costed.
Refer to the example of Bureaus. Is the production supervisors salary a direct or indirect
cost of the production department?
Direct cost Indirect cost
If the production department is a cost centre, then the production supervisors salary is a
direct cost of that department. It is, however, an indirect cost of the cost unit of making
desks, as the production supervisor may supervise several jobs at once.
This shows that the same item of cost may be a direct or indirect cost depending on what
is being costed.
You need to know which costs in your workplace are direct costs and which are indirect
costs, because as a first-line manager, you are likely to have more control over the direct
costs.
ACTIVITY 3.23
List three direct and three indirect costs in your department.
Direct Indirect
We will look at how indirect costs, also known as overheads, can be shared later in this
section. First, we look at how to classify costs using the fixed/variable method.
Fixed costs/variable costs
Another way of looking at costs is to consider whether they vary with the level of production
(or, in the case of service industries, the level of activity). Fixed costs are ones that are
much the same regardless of volume of activity, whereas variable costs alter in line with
quantity.
On the list of Bureaus costs below, which are variable and which are fixed costs?
Cost item Variable Fixed
wood
electricity
wages
overtime
rent and rates
Wood is certainly a variable cost the more you make, the more wood you need to make
it with.
Electricity is also a variable cost the more you make, the more electricity will be
consumed. But there is a fixed element, too for example, the electricity used for heating
and lighting the workshop.
Wages are fixed they are paid by the week or month, regardless of the work carried
out. However, if the workers are paid by the number of items they produce, then the
wages would be a variable cost.
Overtime is a variable cost the cost will depend on how much overtime is worked.
Rent and rates are fixed costs.
Identify five different costs in your own department, and indicate whether they are fixed or
variable costs.
ACTIVITY 3.24
Notice that no costs are completely fixed. For example, if output increases and you take
on more staff, the amount spent on wages will increase.
Naturally both fixed and variable costs also vary in line with inflation and other outside
factors. When we talk about a fixed cost in costing terms, we simply mean one that does
not vary with the level of output at least so long as the output level stays within bounds.
This highlights the fact that all costs can be variable at some level in the organisation.
For example, the Board can take on or fire staff and set up or close whole establishments.
You can also look at variable costs as the cost of producing extra. Once fixed costs are
being covered by selling the production you had planned, then the only expense of extra
production is the variable cost.
To summarise, costs can be grouped into:
variable costs that vary with the level of activity
fixed costs that stay the same regardless of activity
The distinction is useful in making pricing decisions.
And we have seen three ways of classifying costs:
labour costs/material costs/expenses
direct costs/indirect costs or overheads
fixed costs/variable costs
This classification gives you insight into how you are spending the organisations money,
and which costs you might be able to control.
Perhaps high labour costs show a need for more training, or investment in new machinery.
High material costs might mean that the buyers could be doing a better job. High expenses
might indicate that you could buy in some of the services that are presently provided in-
house (or the reverse).
By classifying costs as direct or indirect, you can concentrate on controlling the costs you
are responsible for.
This classification can help you to decide what volume of business must be done to
break even, how to get prices down to a desired level and whether to set quantity discounts.
It is particularly valuable in deciding whether to bid for new business or not. For instance,
if you are already covering your fixed costs, then you may be able to take additional
business that only covers the variable costs.
Sharing indirect costs or
overheads
Although indirect costs, or overheads, relate only partly to the thing being costed, they
still cost real money, and cannot be forgotten.
Suppose you are going shopping and a friend asks you to buy something a couple
of batteries, perhaps. When you return, bringing back purchases to the value of $4 in
all, your friend might be surprised to receive a bill like this:
Item Cost
$
Batteries 1.00
Bus fare ( of 80c) 0.20
Wear on shoes ( of 20c) 0.05
Cup of coffee and biscuit ( of $1.00) 0.25
1.50
1 What was the direct cost of the batteries?
a $1.50
b $0.50
c $1.00
d $4.00
2 What was the total value of shopping bought?
a $1.50
b $0.50
c $1.00
d $4.00
The direct cost of the batteries was $1.00, so your answer to the first question should
have been c. This is a quarter of the total value of shopping its direct cost was $4, so
your answer to question 2 should have been d.
In this example, the batteries accounted for a quarter of the value of purchases, so they
have been allocated a quarter of the indirect costs.
The allocation of indirect costs in proportion to value is one possible way of sharing
the indirect costs. Can you suggest two other ways in which they might have been
shared?
1
2
You may have suggested:
by number of individual purchases
by weight of goods purchased
by time spent on each purchase
by number of shops visited
It is important to remember that the method you choose will affect the person or people
incurring the cost, so you need to choose the method that encourages customers to
behave the way you want them to. So, if you would prefer your friends not to ask you to
look all over town for items that are hard to find, or visit lots of different shops and return
carrying a great weight of shopping, then any of the alternative methods is better than
sharing costs by value.
Another consideration in choosing your allocation method is that it must be in some
sense fair a quirky allocation method will cause unprofitable arguments, as well as
giving you biased costing information.
Before you presented your bill for the shopping, you had to go through the following
steps:
1 You decided what your cost unit (the thing you wanted to cost) was to be in this
case, the purchase of batteries.
2 You identified the direct cost the $1 you paid for the batteries.
3 You identified all the indirect costs the costs of the shopping trip not entirely
attributable to the battery purchase.
4 You decided on a method of sharing, or apportioning, the indirect costs between the
items that you bought.
5 You calculated the bill based on the costs you had identified and the method of
apportionment you had chosen.
Costing for work purposes involves the same steps and you have to make the same
choices when you decide how to share the indirect costs. Indirect costs such as electricity
or building rental can be difficult: the usual method is to share them between the cost
centres first.
Suggest how you might share the cost of renting a building between the cost centres
that occupy it.
The way most organisations would share the cost would be according to the floor area
that each cost centre occupied.
Other indirect costs might be shared differently.
Suggest how each of the following indirect costs might be shared between three or
four departments.
managing directors salary
electricity
telephones
cleaning
canteen
You could divide the costs in proportion to the number of staff in each department (canteen,
telephones, electricity, managing director), or by floor area occupied (cleaning). Or you
could devise more elaborate schemes to reflect, for example, productions heavy use of
electricity or the sales departments heavy use of telephones.
Remember that the organisations sales performance must pay for all these costs, no
matter where they fall within the organisation. Complex schemes are only worthwhile
when they yield information that helps the organisation improve its performance.
How many indirect costs are to be attributed to each cost unit? The rule is to distinguish
first between production cost centres (those that are concerned with making the
products or supplying the service to customers), and service cost centres (those, like
the canteen, that are not directly concerned with production).
First, you need to apportion the total costs (direct and indirect) of the service cost centres
between the production cost centres. All the costs then become indirect costs of the
production cost centres.
Then, in each production cost centre, you need to share the indirect costs between the
cost units.
This is how Polly, the Finance Director for Bureaus, allocated and apportioned costs.
First, she set out all the cost centres, with their costs, and noted which were production
cost centres and which service cost centres.
$
Production 900,000 production cost centre
Engineering 100,000 production cost centre
Sales 200,000 production cost centre
Accounts 50,000 service cost centre
Canteen 25,000 service cost centre
Total cost $1,275,000
She then allocated the costs of the service cost centres to the production cost centres:
Production Service cost Total production
cost $ allocation $ cost centre $
Production 900,000 10,000 accounts
10,000 canteen 920,000
Engineering 100,000 10,000 accounts
10,000 canteen 120,000
Sales 200,000 30,000 accounts
5,000 canteen 235,000
$1,275,000
Within each production cost centre, indirect costs (such as the account sections and
canteens costs) were then apportioned to different cost units. In production, the extra
$20,000 costs were apportioned equally over their four cost units:
executive desk
student desk
office desk
typists desk
Allocation is charging to a cost centre indirect costs that can be directly traced to that
cost centre that is, costs that are, from the point of view of the cost centre itself, direct
costs.
Apportionment is charging a share of an indirect cost to a cost centre.
Standard costing
You have looked at ways of analysing your actual costs. But there is one major problem
in practice that we have not considered so far, and that is this: costs actually vary all the
time, even on a daily basis.
Each box of metal fittings that Bureaus buys at a different price from the time before,
changes the cost of every product that those fittings go into. Their cost could vary upwards
simply because of the suppliers price rises, or because Bureaus is not always able to
take advantage of quantity discounts. The cost could fall for the opposite reasons.
Worse problems can arise where we do not know the cost of an item until after it has
been sold.
Example
Najma, a supervisor at Bureaus, is asked to arrange for a batch of 20 desks to
be produced. She knows that once the machinery is set up (which takes a long
time), the desks can be produced quite quickly so it is not economical for so
few to be made in one run. She actually asks for 30 to be produced, taking 30
hours. If it turns out that the extra 10 are sold, then each desk will have taken
one hour to make. Otherwise the 30 hours of labour will have produced only 20
saleable desks, so each will have taken 1 hours to make.
Whether the extra desks will be sold is not known when the batch of 20 desks
being costed leaves the Bureaus factory.
Another related question: It costs more to heat the factory in winter than in summer. Are
desks made in winter more costly than those made in summer? Should they be sold for
more?
These are tricky questions to answer, and yet decisions like these have to be taken on a
daily basis. Consider these remarks:
Sam (sales supervisor):
Mr Simpson has been offered desks at 5 per cent less than our price. Hell buy
from us if we can meet that price. Were making 50 per cent on desks lets get
that order.
Polly (finance director):
Our major customers are held up by the dock strike, and we shall have no cash
coming in next month we wont even be able to meet the wages bill. We should
get the Buyers Ltd order at any price, so long as it covers the materials and they
pay up front.
Tom (production supervisor):
I dont care if were making a mint, were still paying too much for metal fittings.
Veronica (managing director):
Dont bother me with the price of fittings, but tell me at once if our costs look like
getting really out of line.
These four statements reflect four important points:
1 You may have enough leeway in your costs that you do not have to worry about
small changes.
2 Cost may only be one consideration affecting a business decision.
3 It is a buyers job to buy as cheaply as possible and a salespersons job to get the
best price possible, regardless of how well the other is doing his or her job.
4 Detailed attention to costs takes management time, and is only worthwhile when
there is action to be taken as a result.
Each department needs a standard, a measure of what a product or service should cost.
You can use that standard:
For day-to-day decision-making (for example, should you take the order?).
To assign responsibility. It becomes the sales departments responsibility to sell above
the standard, the purchasing departments to buy below it.
For monitoring performance. Once the departments have a clear standard, they can
measure their performance against it.
To reduce the amount of management attention required. You only consult senior
management if you are going to miss the standard.
Such a standard is called a standard cost. You calculate the cost of each cost unit in
advance, based on your best estimates of the likely actual costs material costs, labour
costs, expenses, likely volumes of business, and so on and that becomes your standard
cost. In other words, it is the expected cost of an item calculated in advance. It is used to
assign responsibilities and monitor performance.
With standard costs, management are in a position to set targets for different departments:
The sales department will be held accountable for selling a certain volume and
achieving a certain notional profit, based on the standard cost. (For this purpose
profit = sales value minus the cost of the items sold at standard cost.)
The production department will be held accountable for making the necessary volume,
and will have a target to do so at some price below the standard cost.
Then senior management need only intervene when any of the targets is not met. This
intervention when something goes adrift is called variance analysis.
Should a standard cost be calculated as:
a the lowest cost you could theoretically achieve?
b the cost you actually expect?
c the highest cost you might have to pay?
Standard costs must be fair. For example, there would be no point in Bureaus setting a
standard cost for desks based on the lowest costs that could possibly be achieved. That
could have the following effects:
The production department would regularly miss its targets. A target that is impossible
to achieve is worse than no target at all: it can de-motivate staff.
Senior management would be deluged with exception reports from production.
The sales department would have such an easy life that they would have no real
incentive.
The company would be setting its selling prices too low (as they are based on standard
costs), and risking running into loss.
By basing standard costs on normal performance you can target each department to
exceed its norm, so you should have ticked b.
In a service industry, what do you think the standard time for a job is based on?
a how long the job usually takes?
b the maximum time it is likely to take?
c the minimum time it is likely to take?
The components of a standard cost, whether labour, materials or expenses, are calculated
based on how long the job usually takes, so you should have ticked a.
Note down one cost unit that you or your department are responsible for.
Cost unit:
Calculate your estimate for its standard cost including materials, labour and expenses as
best you can.
Estimated standard cost:
Note down any assumptions that you had to make in order to estimate the standard cost of
the cost unit you chose.
ACTIVITY 3.25
A difference between the standard cost and the actual cost is called a variance.
In order to benefit from standard costing, therefore, you need to take three steps:
1 Calculate standard costs from best estimates, taking into account past performance.
2 Calculate actual costs, including materials, labour and expenses.
3 Calculate variances, and investigate them.
It is rare for there to be no variance at all you do not have perfect foreknowledge of
your costs. However, substantial variances between standard cost and actual cost need
to be investigated.
Give two reasons why you should investigate the cause of a variance.
1
2
The reasons why it is important to investigate the cause of a variance include:
The variance can tell you whether you need to improve your work methods in order
to perform better in future.
If the actual cost was below the standard cost, then someone may have found a
quicker work method or a more efficient way of using materials this can then
become your standard.
If the actual cost was above the standard cost, then you know that something
went wrong. You can then try to find out what it was and take action.
You may find that your standard cost is unrealistic, and needs to be changed. In that
case you need to alert higher management, as other departments will be making
decisions based on your current standard cost.
If the actual cost is lower than standard, then other departments may be able to
profit from adopting the work methods that you and your department are using.
Bureaus has worked out that the standard cost for a batch of 100 desks is $2,500.
One particular batch has cost $2,707.96.
Give two possible reasons for this variance.
1
2
There is not much you can say about a variance unless you know how the costs are
made up, but you may have suggested that:
most of the work had to be done in overtime
the operatives worked slowly
the operatives were held up by machine stoppages
the wood was a difficult batch to work
the wood cost more than anticipated
You can only take action if you know where the extra costs were incurred. So standard
costing has to show how each cost is made up.
Again you are faced with a batch of desks that cost $2,707.96 instead of the standard
cost of $2,500. But this time you have this information:
Standard cost Actual cost
Units Cost Cost Units Cost Cost
each $ each $
Direct labour hours 150 10.00 1,500 170 10.00 1,700.00
Direct materials wood 100 4.00 400 103 3.87 398.61
metal 4,000 0.25 100 405 0.27 109.35
Indirect costs 500 500.00
Total 2,500 2,707.96
Be more precise about the reasons for the increase in costs this time and note
them down here.
Now you can see that only the hourly rate and the indirect costs have come out precisely
as expected.
Bureaus has used more materials than expected, the material cost of the batch was
$507.96 (wood: $398.61; metal fittings: $109.35) against a predicted $500.00.
However, the number of hours spent on production was 170 against 150 and that
clearly calls for investigation. The next step would be to find out why the extra labour was
used.
Did a machine go down and leave workers idle?
Is there a new operator who needs some help or training?
Was the wood inferior and difficult to work with?
Do the workers need more supervision and motivation?
Standard costing does not answer these questions, but it enables you to ask the right
ones.
If actual costs are more than standard, the variance is called an adverse variance.
If actual costs are less than standard, the variance is called a favourable variance.
Which are the more common in your department?
adverse variances or favourable variances
Given the principle that if something can go wrong it will certainly do so, you might think
that adverse variances would be more common than favourable ones and given the
human tendency to make optimistic forecasts, that may well be the case. But because
standard costs are based on best estimates there should in fact be about as many
favourable variances as adverse ones.
If this is not true in your department, you may not be operating standard costing correctly.
The consequences could be that other departments make critical decisions based on
unrealistic standard costs.
ACTIVITY 3.26
For the previous activity, you chose a particular cost unit and estimated a standard cost for
it.
Now, for the same cost unit, find out the actual cost of a recent unit. Your manager or the
accounts department may be able to help you.
Analyse the variances between the actual costs and your estimates. What conclusions can
you make?
You should be able to:
identify the components that make up a cost
calculate the cost of a product
understand, calculate and use standard costs
identify variances between planned and actual costs
Complete the Self-test and read the Summary to help you. Make a note of any points you
want to discuss with your manager.
Self-test H
1 Fill in the blanks in the following sentences with suitable words chosen from
the list below. (Note that not all the words are used.)
a Any part of an organisation to which costs can be charged is
a .
b A is a product or service whose costs
can be calculated.
c A is one which relates directly to what is being
costed.
d Charging a share of an indirect cost to a cost centre is
called .
cost unit / apportionment / allocation / cost centre / fixed cost /
direct cost
2 Briefly describe a standard cost.
3 Decide whether each of the following statements is true or false, and tick the
appropriate box:
True False
a Only adverse variances need to be investigated.
b Standard costs should be based on the lowest cost
you hope to achieve.
c First-line managers are likely to have more control
over direct costs than they have over indirect costs.
d Costs can be categorised into labour, materials
and expenses.
4 Here are the cost items incurred when making up bouquets of flowers.
Which of them are fixed and which are variable? Tick the appropriate box.
Flowers
Cellophane and ribbons for packaging
Wages
Rent/rates
Electricity/heating for the shop
5 What is another name for overheads?
Summary
Any part of an organisation to which costs can be charged is a cost centre.
A cost unit is a product or service (or part of a product or service) whose costs can be
calculated.
Everything needed to make a product or supply a service counts towards its costs.
Costs can be grouped under three headings:
labour
materials
expenses
A direct cost is one which relates directly to whatever is being costed.
An indirect cost is one that only partly relates to whatever is being costed.
Indirect costs, or overheads must be reflected in costs and prices
Variable costs are ones that vary with level of output.
Fixed costs are ones that remain constant regardless of the level of output.
The standard cost of a product or service should be based on how much it normally
costs to make the product or provide the service.
A difference between the standard cost and the actual cost is called a variance.
Standard costing enables variances to be detected and investigated.
Allocation is charging to a cost centre those costs which can be traced directly to that
cost centre.
Apportionment is sharing an indirect cost between cost centres.
Controlling costs
Cost control is about achieving the organisations objectives in the most cost-effective
way possible. That means making the best possible use of its resources labour, materials,
plant, equipment and services.
This can be done by:
analysing present costs (as you saw in the previous section)
setting targets for future costs (standard costs)
monitoring progress towards those targets
In this section we will look at how you might apply that analysis in practice in order to
reduce costs in your department.
A cost control exercise
We will look at Motorworks, a chain of car repair and maintenance workshops.
Jack is working as a supervisor in the Sheffield workshop. As Motorworks is opening
new workshops every six months, Jack has hopes of being given the job of
managing one that is due to open in Bradford.
Jack decides to analyse the costs in the Sheffield workshop. Depending on what
he finds, he will draw up lists of steps he can take to reduce costs, both in Sheffield
and in his own workshop if and when he gets it.
Jack begins by collecting details of the costs of one cost centre and one cost unit.
Suggest one cost centre that Jack might analyse, and one cost unit.
Cost centre:
Cost unit:
If you are unsure about the difference between a cost centre and cost unit look back at
your previous work.
The cost centre that Jack chooses to analyse is the workshop in Sheffield. He
chooses that one because, if he is appointed to the Bradford workshop, he will be
responsible for just such a cost centre himself.
The cost unit he chooses to analyse is Motorworks car cleaning and polishing
service.
Jack sets out to answer the following questions:
How are the costs made up? Where does all the money go? On labour, materials
or expenses?
Which costs can he control, and which are outside his area of responsibility? Which
are direct, and which are indirect?
Which costs depend on the volume of activity? What prices must be charged in
order to break even? Which costs are fixed, and which are variable?
Here again are the three ways you can look at total costs. (But whichever way you look,
they still add up to the same total).
I
n
d
i
r
e
c
t
D
i
r
e
c
t
The cube of expenses can be cut up into 12 separate categories:
Fixed/direct/labour Fixed/direct/materials
Variable/direct/labour Variable/direct/materials
Fixed/indirect/labour Fixed/indirect/materials
Variable/indirect/labour Variable/indirect/materials
Fixed/direct/expenses
Variable/direct/expenses
Fixed/indirect/expenses
Variable/indirect/expenses
Jack decides to begin by drawing up two tables, one for the workshop cost centre,
and one for the cleaning and polishing cost unit. He puts each cost into one of
these twelve categories.
Here are Jacks tables. He has not put all the costs in yet, only one cost in each category.
Cost centre: Motorworks workshop, Sheffield
Line Item Fixed Variable Direct Indirect Labour Materials Expenses
1 Salaries X X X
2 Overtime payments X X X
3 Head office salaries X X X
4 (Accounts overtime) X X X
5 Overalls X X X
6 Upholstery shampoo X X X
7 Head office stationery X X X
8 (Accounts stationery) X X X
9 Rent and rates X X X
10 Electricity X X X
11 Head office legal fees X X X
12 (Bank charges) X X X
Cost unit: Cleaning and polishing service at Motorworks, Sheffield
1 X X X
2 Overtime payments X X X
3 Salaries X X X
4 Cleaners wages X X X
5 X X X
6 Wax polish X X X
7 Overalls X X X
8 Upholstery shampoo X X X
9 X X X
10 Phone calls made
to customers X X X
11 Rent and rates X X X
12 Electricity X X X
Some of the same costs appear in both tables, but under different headings. For example,
when looking at the cleaning and polishing cost unit, rent and rates are indirect costs
(and will be shared across a number of different services that the workshop provides),
but when you look at the workshop cost centre, they are direct costs wholly attributable
to the Sheffield workshop.
In the cost unit table, lines 1, 5 and 9 are blank. Why do you think this is?
The blank lines are for costs (whether labour, material or expenses) that are both direct
(wholly attributable to this cost unit) and fixed (do not vary with volume). The cost unit
that Jack chose is in fact a unit of production. Therefore all the costs that are directly
attributable to it do rise with volume.
Choose one cost centre and one cost unit in your own organisation, and do as Jack did.
Fill in one cost item under each category.
Cost centre
1 X X X
2 X X X
3 X X X
4 X X X
5 X X X
6 X X X
7 X X X
8 X X X
9 X X X
10 X X X
11 X X X
12 X X X
1 X X X
2 X X X
3 X X X
4 X X X
5 X X X
6 X X X
7 X X X
8 X X X
9 X X X
10 X X X
11 X X X
12 X X X
ACTIVITY 3.27
Cost unit
Which costs can be controlled?
The cost centres (workshop) indirect costs are set by head office. The cost centre itself
cannot control them, so Jack does not spend time analysing them and concentrates on
the direct costs.
Similarly, Jack can disregard the cost units (cleaning and polishing services) indirect
costs and concentrate on its direct costs.
Where does the money go?
To see where the money is being spent, Jack analyses expenditure as labour, materials
or expenses.
Labour costs
Labour costs can be the most expensive resource in an organisation.
Fortunately, there are a number of steps you can take to make sure that people are
employed effectively.
The staff employed at Motorworks are generally busy, and cannot always offer the
services to customers within two days as they would like to. There is a shortage of
junior staff to do minor repair work and general fetching and carrying. However,
the mechanics are helpful and will turn their hand to most tasks.
Note down any similar situations in your workplace. You can then consider whether
you could make any improvements in this area, after working through this section
of the workbook.
Flexibility is good, and obviously it is desirable that staff should be prepared to help out
when necessary but Jack considers taking on a junior member of staff to handle the
minor repairs and other routine jobs.
This is because when Jack uses his highly skilled employees for minor or routine tasks,
he is paying more in wages than he needs to in order to get the job done. He may also be
wasting their skills by not letting them concentrate on some of the more complex tasks.
Before taking on a junior member of staff, he will need to ask himself these questions:
Will the extra turnover he could achieve through dealing with more cars pay in the
long run?
Is there some other resource, for example the amount of parking space available,
that would prevent him getting more cars serviced at the workshop?
How can he ensure that employees are suited to the type of work they do in terms of
their skills and qualifications?
A new steam-cleaning technique involves the use of special equipment and accurate
timing.
Motorworks customers prefer their cars upholstery to be cleaned in this way, but some
members of staff find it difficult. They take a long time over it, and are unhappy when
asked to do it.
Note down any similar situations in your workplace.
Jack does not waste time criticising the technique as the customers are happy with the
results it produces. The staff need to be taught how to use it properly so that they can
improve their speed and worry less about it.
You need to be able to identify when people need training. Leaving them to teach
themselves may not always be the best way for them to learn new skills. It may take
longer, incorrect methods may get passed on, and expensive mistakes are a possibility.
It is essential to provide or arrange proper training whenever possible.
Refer to the situations you wrote down above. Make a note of any action you would
like to take to increase the level of support and training offered in your workplace.
The staff responsible for cleaning and polishing the cars at Motorworks often have
to wait around for long periods of time while even minor repair work is being carried
out.
Skilled members of staff who spend a large part of their working day waiting around are
not being employed efficiently.
As a team leader or first-line manager, it is likely to be your responsibility to find the
reason for any delays, and do something about them. You may be able to put extra staff
on to the part of the job that is causing the delay, or you may be able to employ the staff
who are being kept waiting on other tasks. It is an essential skill of managing to reduce
the time that staff have to wait around.
Sometimes, it may be necessary for staff to work overtime, but if overtime rates are
higher, it means that the same job is costing more. If you are trying to achieve a standard
cost or are doing a job at a fixed price, you may find that unplanned overtime results in
you overspending on your budget. Avoid unnecessary overtime.
Refer to the situations you wrote down in relation to time-wasting in your workplace.
Make a note of any improvements you would like to make in this area. Also, note
down whether you could reduce the amount of overtime worked by your staff, and
if so, how.
Now that we have looked at how some of the labour costs can be reduced in the workplace,
we will go on to deal with material costs. We will continue to use the example of Motorworks
for this purpose.
Material costs
The reason for the delay in carrying out some of the minor repair work is that many of the
electrical tools are old and keep breaking down, so staff have to share some of the tools
between them.
Keep a regular check on machinery and equipment and ensure that staff have the
right equipment when they need it.
Faulty equipment can cause delays. In a factory, a machine that breaks down can stop a
whole assembly line and leave staff idle. Planned maintenance and proper work
procedures help to reduce this kind of delay considerably.
Whatever kind of place you work in, you can take some simple but effective measures to
prevent faulty equipment from wasting peoples time. For example:
Clean and maintain equipment regularly.
Ensure that your staff know how to operate equipment.
Report faults as soon as they are brought to your attention.
Keep up the pressure on maintenance staff until faults are fixed.
Note down any improvements you would like to make in relation to the machinery or
equipment in your department.
Also, be on the lookout for less expensive materials. Keep suppliers catalogues and
encourage their sales staff to send information. Always ask:
whether the price you are being offered is the best price
for a trade discount (especially when your organisation orders the material regularly
in large amounts)
for educational/government discounts, if those are your lines of business
for a settlement discount (for example 2 per cent off for cash payment within seven
days)
for a quantity discount if you are buying more than ten items
You may be surprised at what you can get just by asking. Ask for a discount whenever
possible, and shop around.
It is always possible that a lower price reflects lower quality. Balance what you could lose
by the product failing against the costs you could save.
At Motorworks, Jack decides to try a cheaper shampoo on the cars upholstery. He
knows that independent tests show that there is little to choose between shampoos
of widely varying price, so it is certainly worth trying a cheaper one. If it is less
good, his only loss will be that more of it will be needed to do the same job.
However, when Jack is offered a cheaper wax polish, he is very cautious.
Substandard polishes have been known to damage the bodywork of some cars,
which would be disastrous for trade.
It is important to use the right materials for the job and to monitor that usage.
Sarah and Ian at Motorworks are responsible for shampooing the cars upholstery.
Ian uses twice as much shampoo as Sarah.
Sarah and Ian cannot both be right. Maybe Sarah is cost-conscious, or perhaps Ian is
wasteful.
Prevent wasteful use of materials.
You need to prevent wasteful use of materials. Consider:
making sure that staff know that the materials they use are costly
insisting on more cost-effective working practices
laying down set procedures for the amounts of materials required for tasks
buying equipment to save materials; for example, Jack might decide to buy shampoo
dispensers.
Refer to the situations you wrote down above and make a note of any improvements
you would like to make in this area of your own organisation.
Guard against theft.
Motorworks has not stated that the cleaning and polishing products are available for staff
to use on their own cars. However, bottles of shampoo and similar low-value items have
been taken by staff for their own use as perks of the job.
Jack decides that this practice is no longer acceptable because it will cost Motorworks a
great deal of money in the long run and also makes accurate costing impossible. So he
makes the decision to:
institute a generous staff-purchase scheme, and
warns that staff could face dismissal if the practice continues
Keep a sensible stock of materials and look after and store them correctly.
There is always a temptation to over-order materials in order to get the benefit of a
quantity discount, or so as to be sure of not running out. Take care, however, because
materials:
can become obsolete before they are used
can be simply damaged or spoilt
occupy valuable storage space
represent cash that might have been spent elsewhere
The answer is to keep records so that you know what you have used in the past, and to
look ahead to avoid ordering something that is going to become obsolete.
Note down any improvements you would like to make in your workplace, in relation to the
ordering and storing of materials.
Expenses
Space
A well-designed layout enables equipment to be kept in an orderly and convenient way.
It helps staff work efficiently, and is a safer environment for them to work in.
Organise the work space.
Space costs money, and will be costed to your cost centre as an indirect cost. So, if you
can reduce your requirements, you can reduce your indirect costs in next years budget.
A practical layout and keeping your workplace tidy can help to improve efficiency. You
may have suggested improvements like:
Reorganising the layout to ensure that gangways are kept clear to allow for access
to equipment and filing cabinets.
Getting rid of any obsolete equipment or other unwanted items.
Electricity
Jack observes that some of the machines used in the workshop are left switched on
constantly.
How could Jack ensure that his staff use electricity more economically in future?
Make staff aware of costs and encourage them to take a responsible attitude.
The tried and tested methods include:
putting notices on light switches and equipment
using timer switches
installing meters
implementing plans to reduce usage by a certain amount over a certain period
stating facts; for example, a heating unit left on for one hour could use more electricity
than a light bulb left on for two days
Other expenses
Many people feel unduly intimidated by others in certain professions, for example by
lawyers, accountants and architects. Remember that they are there to provide us with a
service, so it is worth asking for discounts and shopping around for the best price as you
would for any other purchase your department makes.
Jack identifies many other expenses in running the workshop: telephones,
advertising, cleaning, insurance and legal costs. In each case, he asks: Do we
need to incur this cost? Can we use less of it? Can we buy it more cheaply? Then
he sets a goal: an amount by which this cost will be reduced, and a date by which
that saving will be made.
Set specific cost-saving goals, and review them regularly.
What is the effect of volume on costs?
Jack carries out the same analysis for the cost unit. The same general comments on cost
saving apply, but now he can compare the cost of the cleaning and polishing service at
the Sheffield workshop with the cost of the same item at other Motorworks workshops.
Note that Jack needs to apportion the fixed costs of the workshop across all the cost
units as indirect costs.
Jack at first planned to apportion the indirect costs equally across all the cars that
the workshop serviced. He then decided that the more expensive and time-
consuming servicing should carry a greater share of these indirect costs. Therefore
he divided these costs in proportion to the price of the cost units.
So, if Motorworks cleaned and polished 50 cars in one month, and this accounted
for 50 per cent of the months takings, then each cleaning and polishing service
brought in 1 per cent of the revenue and should bear 1 per cent of the indirect
costs.
Now Jack looks at the fixed and variable costs of this service. He finds that the
fixed costs amount to some 80 per cent of the total.
Jack realises that some car owners cannot afford to get their cars cleaned and
polished at Motorworks. So he considers offering a stand-by service at off-peak
periods to car owners who are on a low income or unemployed. He decides to offer
the service to them at $10 instead of $20, and makes the following calculation. Of
the $20:
the fixed costs come to $16 mainly rent and rates
the variable costs come to $2 labour and materials
the profit works out as $2
The profit margin on this item is 10 per cent. Because the fixed costs are already
met by the regular business, Jack allocates no indirect costs to the stand-by service.
So it only costs $2 (variable costs), and makes $8 (80 per cent) profit.
This reasoning is only valid if the stand-by service does not detract from regular business.
You might like to talk to your line manager about offering this kind of discount to your
customers, if it is relevant to the type of work you do.
You have looked at how to control costs, which costs to control and finally at what effect
volume has on costs.
Work through the Self-test and read the Summary to review what you have covered in
this part. Note down any points you would like to raise with your manager and then go on
to the Action Plan.
Self-test J
1 Decide whether the statements are true or false, and tick the appropriate box.
True False
a It is important to try to make sure that staff are
suited to the type of work they do in terms of
their skills and qualifications.
b Staff do not need to be concerned with costs.
c You need to use standard costing in order
to be able to tell whether resources are being
used inefficiently.
2 List three ways of using labour more efficiently:
3 List three ways of using space more efficiently:
4 Tick the resources below that team leaders or first-line managers normally
have control over. (You can select more than one.)
a time
b materials
c space
d overheads
5 List at least three possible reasons why a job could take longer than the expected
time:
Summary
Cost control is concerned with the efficient use of:
staff skills
materials
equipment
time
space
services
You can employ people more efficiently by:
ensuring that their skills are appropriate for the job they do
avoiding unnecessary overtime
providing training
reducing waiting time
You can use materials more efficiently by:
reducing wastage
keeping materials secure
ensuring that equipment is correctly used and maintained
You can use equipment more efficiently by making sure that:
it is cleaned and maintained regularly
staff have the right equipment
You can use space more efficiently by:
regularly reviewing your need for space
disposing of obsolete equipment and other unwanted items
organising an efficient layout
keeping the work environment tidy and clear from obstructions
You can make better use of services by:
ensuring that staff are aware of costs
using services efficiently yourself
Action Plan
Introduction
This Action Plan asks you to look at the cost centre and cost units you are responsible
for, calculate the standard and actual costs and analyse the variances. In the light of your
work here you should draw up a plan of action.
Time guide
Aim to spend a total of no more than four hours on the preparation and writing of this
Action Plan.
What your tutor will look for
If you are working with a tutor, you may be asked to present your completed Action Plan
for feedback and comments. Your tutor will expect you to show how you have met the
workbook objectives. To remind yourself of these objectives, look back to the workbook
introduction.
What you should do
This Action Plan consists of six steps:
1 Write down the cost centres that you are responsible for. If you work within a formal
cost centre and are not responsible for it, then list instead those costs that you do
personally control.
2 Write down the cost units that you are responsible for. (They may be actual products
or services that go to customers, or internal products or services such as the cleaning
of an office.)
3 Calculate and record standard costs for those cost units. You might like to ask your
manager or someone from the accounts department to help you do this.
4 Record the actual costs of your cost units.
5 Analyse the variances. Was your estimate accurate, but the actual costs out of line?
Or was your estimate unrealistic? If so, remember that it is only by practising estimation
and examining the results that you will get better at it.
6 Based on the variances you find, write down a suitable plan of action. Include dates
when you would like to carry out different aspects of your plan, as well as completion
dates for each step you will take.
Ensure that you continue to review your plan once it has been implemented. By
regularly reviewing and analysing its successes and limitations, you will be able to
improve and maintain efficiency in your part of the organisation.
Write up your answers to steps 1 and 2 in the form of lists and then draw tables to
complete steps 3 and 4. For step 5, write a short paragraph for each cost unit. Your plan
of action for step 6 could be in the form of a chart. Give your work on steps 1 to 6 to
your tutor or keep it with your work on this workbook.
Activity 3.14
You would certainly want to know the cost of the new equipment, but you would
also need to know what it currently costs to do the job. You would need to calculate
the cost savings in order to make the decision. This information is far more detailed
than would be found in the annual financial statements. You would need to examine
more detailed accounting records. Management accounting information will help
managers select and use this detailed information to plan for the future.
Activity 3.16
Some of these may have given you more trouble than others. These are some
possible answers:
A vehicle manufacturer
The obvious answer is that a vehicle is one cost unit. If the same organisation
manufactures the engine or gearbox, for example, separately, these may be
separate cost units.
A paper bag manufacturer
One bag would probably be too small, so a possibility is 1,000 bags.
A road haulage company
This is more difficult, but could be one tonne per mile or per kilometre.
A plumber
A plumber works on small jobs, so each job would have a cost and each job would
be a cost unit.
A ball-point pen manufacturer
Probably as the bag manufacturer, possibly 1,000 pens.
A paint manufacturer
Possibly 1,000 litres of paint, or as little as 1 litre for a specialist paint company.
Activity 3.18
In Question 1 you probably had little difficulty in deciding the answers as a and c.
These are drawn straight from the definition and in both cases the total fixed costs
stay the same regardless of changes in the level of activity. You may have found
the answers to questions b and d a little more difficult and some simple figures
may help.
Imagine a factory where the rent per annum is $9,000, a fixed cost. The output of
the factory each year is 1,000 units. The cost for rent per unit is therefore $9. If the
factory makes only 900 units one year, what is the rent per unit? The total rent cost
will stay the same at $9,000 so the cost per unit for rent will increase to $10.
Similarly, if activity increases, so the fixed cost per unit decreases.
Question 2 should have proved simpler after the earlier example. With alternatives
b and d the variable cost per unit will stay the same. When activity is increasing the
total variable cost increases and as activity decreases so the total variable cost
decreases.
Even if you do not have any experience of working in a manufacturing environment
you should have been able to classify these costs quite easily. Materials, royalties
and production workers wages can be identified with the product and are therefore
direct costs. Rent, supervisors salaries and accountants salaries cannot be identified
with any one particular product, but must be shared over a number of products.
They are therefore indirect costs.
Activity 3.19
Materials used in the product
Rent of the factory
Royalties on product design
Supervisors salaries
Production workers wages
Accountants salaries

Self-test H
1 a Any part of an organisation to which costs can be charged is a cost
centre.
b A cost unit is a product or service whose costs can be calculated.
c A direct cost is one which relates directly to what is being costed.
d Chargi ng a share of an i ndi rect cost to a cost centre i s cal l ed
apportionment.
2 The standard cost of a product or service is what you estimate the normal cost
of making the product or providing the service to be.
3 a Only adverse variances need to be investigated.
This is false. All serious variances, whether favourable or adverse,
should be investigated.
b Standard costs should be based on the lowest cost you hope to achieve.
This is false. They should be based on what you expect the cost to be.
c First-line managers are likely to have more control over direct costs
than they have over indirect costs.
This is true.
d Costs can be categorised into labour, materials and expenses.
This is true.
4 Flowers are a variable cost: the more bouquets being made the more flowers
are needed.
Cellophane and ribbons are a variable cost: the amount of packaging you
need will depend on the number of bouquets being prepared.
Wages are fixed they are paid by the week.
Rent and rates are fixed costs.
Electricity and heating for the shop are fixed costs.
5 Indirect costs are often called overheads.
Self-test J
1 a It is important to try to make sure that staff are suited to the type of
work they do in terms of their skills and qualifications.
This is true.
b Staff do not need to be concerned with costs.
This is false. If you want staff to be responsible about using equipment
and materials they need to be aware of the importance of costs.
c You need to use standard costing in order to be able to tell whether
resources are being used inefficiently.
This is false. Some inefficiencies may be obvious. But standard costing is
useful to monitor the use of resources.
2 Here are four ways of using labour more efficiently:
Make sure that employees skills are appropriate for the job they do.
Avoid unnecessary overtime.
Provide training.
Reduce waiting time.
3 Here are four ways of using space more efficiently:
Regularly review your need for space.
Dispose of obsolete equipment and other unwanted items.
Organise an efficient layout.
Keep the work environment tidy and clear of obstructions.
4 The resources that team leaders or first line-managers normally have control
over include:
a time
b materials
c space
5 Some possible reasons for a job taking longer than expected might be:
staff waiting (for equipment, materials, another part of the process)
lack of training
staff are not experienced
equipment malfunctioning or broken down
Section 4
Preparing budgets
Introduction
Every organisation, whether publicly or privately owned, and whether or not it aims to
make a profit, is concerned about money. This is because employees must be paid,
equipment and materials must be bought, and work premises have to be rented or
purchased. It follows that no organisation can continue to operate successfully unless its
managers have a firm control of its finances.
A budget is one of the simplest methods of planning for, and keeping control of, finances
and is therefore an important management tool.
In the work that follows, we will define what budgets are and what they are not. Then we
will go on to discuss the preparation of budgets. At the end of this topic we will be in a
position to list some of the advantages of budgets and budgeting.
What is a budget?
The mention of budgets in an organisation is frequently met with a groan. People often
perceive them as a kind of straitjacket, or as a means of hampering progress or stifling
initiative. In your work you may sometimes hear the groans after comments like this are
made:
It seems we cant have the training because it wasnt budgeted for.
Weve used up all our budget for this year, so theres no chance of that new
equipment you wanted.
Its all very well you talking about taking on extra staff, but I have my budget to
think of.
Yet budgets, properly used, are an extremely useful some would say essential method
of providing managers and supervisors with information, and of helping them in their
work.
Look at the following suggested definitions of a budget and tick the one which you think
is the most accurate. A budget is:
a a means of imposing financial restrictions by setting spending limits
b a way of deciding how a firm or a government will spend its money
c a plan, expressed in terms of money
d a statement of the accounts of an organisation, showing what money was spent,
and where it came from
Most of us take a keen interest in the governments budget because it affects us all.
When the budget statement is made every year, we all wonder whether income tax will
go up or down, whether the price of petrol will rise, and so on. The government runs the
finances of the country. It must decide how it is going to raise funds, and how the money
raised is to be spent.
Work organisations need to make the same kinds of decisions.
Of the suggested definitions on the previous page:
a a means of imposing This is a common but incorrect
financial restrictions by view of budgets. Budgets do have the
setting spending limits effect of setting spending limits, but
that is not their primary purpose.
b a way of deciding how a This definition is not wrong, but its
firm or a government only part of the story. For one thing,
will spend its money income, as well as expenditure, must
come into the equation.
c a plan, expressed in terms Now were getting more accurate.
of money We need to qualify this definition only
slightly, as youll see below.
d a statement of the accounts This is quite wrong. Budgets have
of an organisation, showing nothing to do with what happened in
what money was spent, and the past they are concerned
where it came from with predictions for the future. And
they arent statements of accounts
they are an expression of the
organisations plans.
The correct definition is as follows:
A budget is an expression, in financial terms, of the operational plans of an
organisation, for a forthcoming period of time.
Normally, budgets are prepared for the next financial year. In some industries there are
good reasons for budgeting for a shorter or longer period. A firm in the fashion industry,
for example, might prepare a budget for six months at a time, to coincide with the seasons
of fashion. A multinational car manufacturer, on the other hand, might set budgets for a
three- or five-year period.
You may agree that, although the finances of an organisation have a great effect on its
activities, not everything can be expressed in terms of money.
There are many intangible qualities which may feature in your plans (standards of service,
courtesy, team spirit, enthusiasm, and so on) which will be impossible to express in
financial terms. Indeed, they may be hard to define precisely in any terms.
In your job you may need to judge quality of work. This may be definable in terms of an
acceptable level of defects, or may be measurable by using instruments. Again, however,
it is not relevant or appropriate to express work quality as an amount of money. (Even so,
it is wise to remember that all work quality standards cost money to achieve and to
measure.)
So expressing all your plans in financial terms is not really practical. It will help us to have
a better understanding of budgets if we keep this fact in mind.
There are many aspects of work that cannot be measured or expressed in terms
of money.
That said, financial considerations can seldom be ignored, and may frequently take
precedence over other things. Supervisors may sometimes find their desire to achieve
something frustrated by financial constraints, as the following incident illustrates:
Jody Smith was to be in charge of Apsley Engineerings stand at a forthcoming
exhibition. She was talking to her boss, Mike Bradley.
I want our image to look right. Its important that our staff are in uniform outfits.
At shows like this, people judge you by your image.
That may be partly true, Jody, but the fact is we cant afford uniforms for the
sales people, just for one exhibition.
These kinds of decisions have to be made all the time: is a certain expense affordable or
not? Even if it is affordable, might it be better to spend the money on something else?
Jody thought uniforms were important, but perhaps Mike decided that other items were
more important. He would be guided in this decision by his budget for selling expenses.
In a similar way, each of us has to decide how we will spend our personal income. If we
buy that new pair of shoes, will we be able to pay the rent? We all make conscious
decisions about these things, and set ourselves limits on spending. People and
companies who dont, soon get into difficulties.
But to understand budgets more fully we need to think about objectives.
Budgets and objectives
The starting point for every organisation is its objectives: what it wants to achieve. A
company that is unclear about its objectives will find it difficult to make plans and, in the
long run, may not survive.
As an example, a company owning a chain of hotels might see its main long-term objective
as running the hotels as efficiently and profitably as possible. It may have other objectives,
such as the acquisition of sites to build new hotels. For a particular period, the directors
might set an objective of increasing its room bookings, to be achieved through a series of
special promotions.
It is the job of the owners or directors of an organisation to set overall objectives. For a
commercial company, one of the most important will be to maximise profit.
But even a non-profit organisation such as a charity must plan to ensure that expenditure
does not exceed income.
The task that the managers and supervisors of the organisation have is to use the available
resources to achieve those objectives.
The process can be summarised as follows:
Set objectives
Owner or
director level
Manager and
supervisor level
Make plans based on
objectives
Carry out actions to
implement plans
Compare results with
plans and modify
actions if necessary
Assess results
Objectives are set by the owners or directors.
The managers and supervisors make plans based on these objectives.
They then organise staff and other resources to carry out the plans.
The results must then be assessed and compared with plans.
If necessary, changes are made, to achieve the work results defined by the plans.
It is at the key planning stage where budgets come into the picture:
Set objectives
Owner or
director level
Manager and
supervisor level
Make plans based on
objectives
implement plans
plans and modify
Assess results
A budget is
an expression of an
organisation's plans. It serves
both as a guide and a
standard
We will look at this system a little more closely under the heading Using budgets. But
first we will look at the process of preparing budgets.
Preparing budgets
Lets consider a typical company. We will choose a manufacturing company to start with;
later on we can go on to look at other kinds of organisations.
This company is called Tiklox. Tiklox manufacture a range of wall clocks.Towards
the end of one financial year, the people in the company begin to make plans for
the next year. The company directors have set certain objectives, including a profit
target. They would like to know whether this profit can be achieved.
The Chief Accountant, Caroline Crisp, has the job of coordinating the budgeting
process, and its part of her job to calculate the forecast profit.
What kind of general information do you think Caroline will need in order to make
a forecast of profit for the coming year?
Presumably, Tikloxs main income is from the sale of clocks, so one key item of information
Caroline would need to have is the forecast sales figures: how many will they sell of each
type of clock, and at what prices?
For this information she turns to Jude Jarman, the Sales and Marketing Manager.
Jude knows his markets and he has a good idea of the sales trends. He does some
calculations and talks with his colleagues, and eventually comes up with a sales
budget. It includes forecasts of sales for the current range of products, and for two
new models which hes hoping to see go into production during the first half of the
year.
Next, Caroline goes to see Ron Redman, the Production Manager. The main functions
of Rons Production Department are to order the parts for the clocks, assemble
them, and put them into stock, ready for shipment to customers.
What kind of information do you think Caroline will expect Ron to provide?
Caroline talks to Ron and says:
If we are going to sell this number of clocks, how many clocks will you need to
produce, and how much will this cost?
Ron agrees to take great care in preparing his production budget for the coming
year.
Based on the sales forecast, he will need to:
look at the number of clocks budgeted to be sold
find out how many finished clocks he has in stock
calculate the number of clocks he will have to assemble to meet the sales, and
work out the type and quantity of parts needed
Ron will also have to calculate the number of production staff needed and the machinery
he wants. He must work out the expected costs of training, consumable items and the
many other things that go to make up the expenses of the department.
Caroline then calls on Patsy Prideaux in the Engineering Department, and reminds
her that its time once more to prepare her engineering budget. Patsys job as Head
of Engineering is to prepare new clock designs, according to specifications agreed
with other managers and with marketing staff.
Patsys costs include skilled staff, equipment, prototype models and so on. Her
budget will largely depend upon the number of new models the company plans to
introduce.
Meanwhile, Ron Redman gets his supervisors together and asks them to provide
budgeted expenditure information for each of their sections.
Patsy does the same thing in her department. Jude talks to his sales office supervisor
and his area sales managers, because he needs to know what they estimate their
selling costs will be during the coming year.
Eventually, when Caroline has all the departmental budgets, she compiles a master
budget, which draws together all the information, and enables her to calculate the
expected profit for the coming year.
This is the overall picture of the budget process at Tiklox. We can show the information
flow in the form of a diagram:
Simplified budget for a manufacturing company
Master budget
Budgeted
engineering
expenditure
Forecast sales
and budgeted
sales expenditure
Budgeted
production
expenditure
Production budget
Individual section budgets
Engineering budget Sales budget
As you can see from this simplified diagram, each part of an organisations budget must
interlock with the other parts. For instance, it wouldnt help Tiklox to meet its objective to
maximise profit if the Production budget assumed that they would be making 100 clocks
of one type, the Engineering budget assumed that they would develop six new clocks
and the Sales budget assumed that they would sell 300 clocks of all seven types.
Of course, if the figures first put forward are not approved (and they seldom are!), there
must be a further round of discussions and negotiations. Some planned expenses will
not be allowed, and perhaps sales targets must be increased. These discussions and
negotiations go on until the directors and senior executives are happy with the result.
The budget is then approved.
The budget for a service organisation (such as a firm of accountants) is no different in
principle from that for a manufacturing firm like Tiklox. Each organisation must work out
its budgeted costs based on its planned level of activity.
The limiting factor
In the Tiklox example we made an assumption that the profitability of the company
depended on the number and price of the clocks it could sell. In other words, we assumed
that sales were the limiting factor, and that the Production Departments budget, and the
master budget, depended on the sales forecasts.
The limiting factor is the factor upon which other budgets within an organisation
depend, because it holds the key to increasing the level of activity.
For a commercial company, sales are normally the limiting factor.
Can you think of circumstances in which the limiting factor for a companys budget
would not be sales, but something else?
We havent been given all the facts concerning Tiklox. It may be that it is a small company
which has grown quickly. Perhaps its production capacity is very small, and simply doesnt
have the space, or the people, to manufacture the number of clocks that the Sales and
Marketing Manager thinks his department can sell. In this case, the limiting factor would
be the companys production capability.
Another very real possibility for any organisation, and especially for a small or growing
one, is that it will be restricted by the amount of money it has available. Plans to take on
extra staff or to move to a larger building so that increased orders can be met will depend
on having the funds to achieve this. Later in the workbook we will take a look at cash
budgets, which are used to forecast cash income and outgoings.
In the case of a company making physically large products furniture or vehicles, for
example a limiting factor may be the amount of storage space available for the finished
products.
Your organisation almost certainly prepares budgets. As a first step in finding out more
about the system of budgeting at your place of work, look into the budgeting procedures,
and write down:
what the limiting or key factor is
a list of the main departments or sections which take part in the budgeting process
To do this you may need to talk to someone who is knowledgeable about the system used.
This may be your manager, or someone in the finance or accounting department. Record
your findings in the space below.
Limiting factor for the organisation:
The main departments or sections involved:
ACTIVITY 4.1
Lets now look at the sales departmental budgets at Tiklox, and consider the problems
they pose.
Planning production
In an ideal situation, Tiklox will manufacture just enough clocks to satisfy all their customers
requirements. Assuming that the sales forecasts are correct, the only thing the production
manager has to worry about is matching the quantities produced to the quantities to be
sold.
But there are inevitably other considerations. Two of these are as follows:
A buffer or safety stock of The company may decide to hold a minimum stock
each model must be kept. of (say) 50 of their Pan-Ceramic Kitchen Clock, as a
buffer against any unexpected demand, or possible
delays in production.
A smoth production flow is The production manager at Tiklox would far sooner
usually more efficient than keep the Pan-Ceramic production line flowing
an uneven one. evenly, than have to start it and stop it to keep
up with a fluctuating sales demand.
Suppose for example the forecast sales figures for the first six months were as follows:
Jan Feb Mar Apr May Jun
Sales 180 185 175 260 240 160
You can see that the average is 200 per month, but the monthly forecasts vary between
160 and 260.
Ron Redman, the Production Manager, might decide to vary production month by month
to match the sales figures.
Can you think of a disadvantage to varying production up or down like this every
month?
If you are familiar with production, you will be aware of the difficulties. If you arent, you
may have considered the resources that are needed by a production unit. We can show
these in a simplified diagram:
Production unit
Raw materials
IN
Finished products
OUT
People Machinery
Of these resources:
Raw materials requirements must be planned in advance of production. A good
deal of organising is needed so that they are available in the right quantities at the
right time and in the right place. Continually varying production makes this organising
more complex and more expensive.
People cannot easily be turned on and turned off. It is impractical to dismiss people
one month, only to re-employ them again the next. Yet there must be enough people
to meet the peak demands in production. This means that at other times they are
likely to be idle, which is inefficient and expensive.
Machinery can be turned on and off, but idle machinery is not an efficient use of
resources. As with labour, there must be enough machinery to cope with peak
demand.
So:
A manufacturer will usually aim to keep production flowing smoothly and evenly.
If sales are fluctuating, one answer is to ensure that the safety stock can cope
with the fluctuations.
Sales budgets
Because they are so often the limiting factor in an organisations budget, the accuracy
and usefulness of the master budget depends a great deal on the accuracy of sales
predictions. Suppose for instance that at Tiklox sales turned out to be an average of only
100 clocks per month, instead of the predicted 200, and production is 200 clocks per
month:
Opening stock 50 150 250 350 450 550
Production 200 200 200 200 200 200
250 350 450 550 650 750
less Sales 100 100 100 100 100 100
Closing stock 150 250 350 450 550 650
If sales turn out to
be only 100 per
month, and
production
continues at 200
per month, it wont
be long before
stocks build up to
unacceptable
levels.
Estimating sales
Imagine you are the Sales Manager of DigItAll Ltd, a manufacturer of garden tools. You
have five area sales representatives working for you, each selling to garden centres and
hardware stores in a different area of the country. Your export sales are handled by an
export manager, who deals through agents in a number of overseas countries.
How might you go about estimating sales for the next year? Write down any ideas
you have.
As you may have noted, a good starting point for many companies when forecasting
next years sales is actual sales for the past year and for previous years. You would want
to know how much variation there has been from year to year and, if possible, the reasons
for these variations. You would also want to take into account:
The overall economic climate: are people tending to spend more or less money than
they did in the past?
The activities of your competitors: is DigItAll increasing its share of the market in
garden tools or is its share declining?
The views of your sales representatives.
The views of your export manager, and of your overseas agents.
The expected impact of any new products you plan to introduce.
You might talk directly to some of your customers the garden centres and hardware
stores. You may even decide to carry out a survey among users of garden tools.
DigItAll sells thousands of tools and has thousands of customers. Suppose instead you
were a sales manager of a company which depended on negotiating large contracts with
just a few customers. Do you think it would be harder or easier to forecast sales?
Harder Easier It all depends
A well-established company which has spent a long time negotiating a contract with a
customer may feel fairly confident about getting it. But the sales manager of a firm that is
not yet well established, and is trying to break into a market, might not feel at all secure
about future orders. So perhaps the best answer to the question is that it all depends.
Of course, preparing a sales budget involves more than forecasting sales.
It should take into account the actions management is planning to take to influence
future events such as advertising, pricing, distribution and so on.
One final point, and perhaps the most important of all no matter how well informed the
sales staff, sales forecasts are seldom accurate.
This fact is often one of the hardest problems an organisation has to cope with, because
it makes budgets and plans less meaningful than managers would like them to be. One
way of trying to cope with the uncertainty is to make budgets flexible.
Zero-base budgeting
When budgeting costs, the easiest approach is to start with what was spent last year.
Adjustments to these figures can then be made based on any expected changes for next
year. As long as there are no major changes expected from one year to another, this can
be a quick and effective way of budgeting.
Can you think of a disadvantage of basing a budget on past costs?
However, it is easy to overlook the changes that may happen to a company over the
year. For example, an organisation may overlook the fact that:
Because of staff turnover, efficiency is not as high as it was when last years budget
was prepared.
Costs of labour or materials are rising.
Equipment will shortly need replacing, because it has been damaged, is worn out, or
just out of date.
There are fewer customers buying the goods.
But even if all the relevant factors are correctly taken into account, there is a more
fundamental drawback to basing future predictions on past experience: it prevents
managers taking a fresh approach.
Suppose a company (one like Tiklox perhaps) has been manufacturing products over a
period of years. During that time, the work has gradually become less and less labour-
intensive. In other words, fewer people and more machines are being used in production.
There may come a point when the premises used by the firm are no longer suitable,
because it needs less space. It may also be the case that its procedures and paperwork
systems are no longer appropriate.
Unless some basic questions are raised, it may be difficult for a company to recognise
the effects of cumulative changes.
Zero-base budgeting is a procedure which helps to overcome these problems. It requires
managers to justify costs as if they are beginning operations from scratch. Each department
and section must justify each and every cost in terms of the benefits it will bring to the
organisation. Nothing can be taken for granted.
Zero-base budgeting is very time-consuming. Nevertheless it frequently saves a great
deal of money.
Identify one type of expense in the area for which you are responsible. Some examples
might be: the overtime your team works; stationery expenses; heating expenses; the cost of
tools; the cost of consumable items. The list of expenses you can choose from will depend
on the work you do.
Now imagine you have been asked to participate in a budget for the next year, and that a
senior manager has suggested that this particular expense could be drastically reduced.
You perhaps do not agree, and will therefore need to justify the money you would like to
spend, in terms of the benefits to the organisation. Write three or four sentences that you
feel will justify your case.
You do not need to be specific about the amount of money involved. However, you will need
to argue as if you were organising your team and your section from scratch, rather than
simply stating your case for retaining the same level of expense as last year.
ACTIVITY 4.2
In practice, most organisations use a modified form of zero-based budgeting by
taking last years budget as a starting point and point of comparison, and then
rigorously examining key aspects of the budget, such as sales predictions, by
building them up from scratch.
Cash budgets
A limiting factor encountered in organisations of all kinds, but particularly in small and
developing businesses, is cash. By cash, we mean available money, including that kept
in a bank account.
Another example will help here.
Celena Tripp is an experienced beautician. In her spare time, she has been very
successful in selling a range of cosmetics, which she demonstrates to her clients
at their homes. She tells her friend Tina: Its fantastic, Tina. I buy these cosmetics
direct from the manufacturer and sell them for twice the amount I pay for them. Im
going to give up my regular job and do this instead. Tina asks her how much she
thinks she could make. Celena says: Im selling $500 worth of cosmetics a month
now. I reckon by doing it full time, I could increase that by $100 a month for the first
six months. That means if I start in March, by August Ill be selling $800 worth of
goods every month!
Lets look at Celenas predicted sales for the first six months:
Mar Apr May Jun Jul Aug
Sales of cosmetics $300 $400 $500 $600 $700 $800
Celena must of course buy the cosmetics, and decides to spend her savings in purchasing
some stock in advance. Thereafter, she intends to replace what she sells. She already
has a car and will use it to travel to her clients homes.
Can you think of any financial problems Celena might face during this period?
One possible difficulty you may have identified is that Celenas customers may not always
pay her for her goods straight away. Another factor is that Celena will have travel and
incur other expenses in her business. She must also pay her personal living expenses
the rent on her flat and so on.
Lets assume that:
Half of her customers pay straight away, and the rest pay a month late.
Celenas cosmetics supplier allows her to pay for goods one month after delivery.
Celena has $100 of business expenses and $175 of living expenses every month.
Now we can work out her cash budget. The first month works out as follows:
Celenas predicted sales of cosmetics are: $300
Celena has spent her savings on buying stock, so the cash she
has at the start of the first month is: 0
Half of her customers pay straight away, so she gets an income
in the first month of: $150
(In subsequent months, she will receive half of last months sales
plus half of this months.)
Each month she replenishes her stocks, but doesnt have to pay
until the following month. In the first month her expenditure on
purchases is therefore: $100
Her monthly business expenses are: $100
Celenas living expenses are: $175
To the cash she has at the start, we add her income. Then we
deduct her purchases and her two lots of expenses. For this month
Celenas incomings and outgoings are:
0 + 150 0 100 175 = ($125)
The result is in brackets because it is a negative amount
Celena has spent more than she has earned.
We can continue these calculations for the other months. Read the following table carefully
and make sure you understand how each figure is derived:
Celena Tripp
Cash budget for March to August
Mar Apr May Jun Jul Aug
$ $ $ $ $ $
Sales 300 400 500 600 700 800
Cash at start of month 0 (125) (200) (225) (200) (125)
Add income 150 350 450 550 650 750
Less outlay on purchases 0 150 200 250 300 350
Less business expenses 100 100 100 100 100 100
Less living expenses 175 175 175 175 175 175
Cash at end of month (125) (200) (225) (200) (125) 0
What conclusions would you draw from the calculations shown in this cash budget?
(Hint: look at the cash figure at the end of every month.)
It seems that, although Celenas income is steadily rising, she wont be able to carry on
her business unless she borrows some money to help her get through the first few months.
It isnt until the end of August that she breaks even.
Based on the figures shown, how much will Celena have to borrow?
At the end of May she will have spent $225 more than she has received so shell need a
loan of at least this amount. (Remembering what we said about the accuracy of sales
forecasts, Celena may find she has to borrow more than this amount.) Note that Celenas
business is still profitable she is selling the goods for twice the amount that she paid for
them but unless she is able to manage her cash properly, the business will go bust. A
lack of cash is one of the most common causes of business failure, so you can see why
this is so important.
You can see how a cash budget helps the planning process. By planning in advance like
this, its possible to foresee some of the problems that might arise, so that action can be
taken early to avoid these problems.
Cash budgets help an organisation predict possible cash deficiencies.
Now we are in a position to list some of the advantages of budgets.
Some benefits of budgets
Based on your reading of the workbook so far, list three benefits of budgets to an
organisation.
1
2
3
As we saw with both Tiklox and Celena Tripp, budgets proved very helpful in showing
managers the actions they needed to take for the future. The actual process of drawing
up a budget makes people think ahead and identify problems in advance.
Helen Tomkins, a supervisor in a food processing plant, had to take part in the
firms budgeting procedures for the first time last year. She was rather sceptical
about the value of budgets at first, but she admitted afterwards that in helping to
draw up a budget she had had to think long and hard about the kind of training her
team would need during the coming year. She said: I know that I wouldnt have
given training a second thought if I hadnt had to justify my expenses for next year.
But when I learned what new products we will be working on, and I was asked to
look into the implications for my section, it made me realise that most of my team
will need training.
This story illustrates another point: that budgets provide a structural framework upon
which detailed plans can be built. Furthermore, they encourage managers and
supervisors from different departments to coordinate, because a budget wont work
otherwise.
They can also help identify costs that already exist but arent necessarily recognised.
Norma Jacks was the office supervisor at a firm of civil engineers. She was
responsible for machines used to produce blueprints and photocopies of numerous
types of document. Norma allowed anyone in the company to use the machines.
Then Norma was asked to help produce a budget for her section. When she worked
out the costs, she realised how expensive these copying facilities were. She talked
to her manager about it and they decided to introduce a system of coded control
cards so that when other sections wanted to copy documents, the cost was
automatically charged to them.
So the benefits of budgeting weve identified so far include the following:
Budgets are helpful in showing managers the actions they need to take for the future.
The actual process of drawing up a budget makes people think ahead and identify
problems in advance.
Budgets provide a structural framework upon which detailed plans can be made.
They encourage managers and supervisors from different departments to coordinate,
because a budget wont work otherwise.
They can help identify costs that already exist but arent necessarily recognised.
These are just a few of the benefits of budgets and budgeting.
You have now worked through this topic and you should be able to:
describe what budgets are, and why they are prepared
explain how a budget is used to help an organisation meet its objectives
Self-test K
1 Fill in the blanks in the following definition by choosing appropriate words from
those listed.
A budget is an in
terms, of the operational of an organisation, for a
period of time.
identity / expression / expenditure / corporate / justifiable / financial /
expenses / plans / past / forthcoming / undefined
2 Whi ch of the fol l owi ng statements are true, and whi ch false?
Tick as appropriate.
True False
a Money is a primary concern in any organisation.
b Not all expenses can be expressed in terms of money.
c All companies need to set limits on spending.
d For a commercial company, one of the most important
objectives will be to maximise profit.
3 Complete the diagram with phrases chosen from the following list. (One phrase
listed is not used.)
Owner or director level
Manager and supervisor level
Make plans based on objectives
Prepare budgets, based on plans
Carry out actions to implement plans
Set objectives
Assess results
Compare results with plans and modify actions if necessary
4 Explain what a master budget is. (You dont have to write more than two
sentences.)
5 For organisations preparing budgets, decide what you would expect the limiting
factor to be in each of the following cases. Select your answer from the list
below.
a a company selling lawnmowers
b a charity
c a one-person business making garden ornaments, who has a full order
book
d a small company seeking to expand but already overdrawn on its bank
account
e a company involved in highly technical products, setting up a factory in a
new area
Cash
Availability of skilled labour
Income
Production capacity
Sales
6 Which of the following statements applies to sales budgets? Tick as appropriate.
a They are invariably inaccurate.
b They are easier to prepare if the staff know their products
and their markets well.
c They should take into account the actions management is
planning to take to influence future events, such as advertising,
pricing, distribution and so on.
d They are normally limited by production.
7 Which is the correct definition of zero-base budgeting?
a a budget system applied to the base line of the accounts
b a budget system which requires managers to justify each and
every expense in terms of the benefits to the organisation
c budgeting based on last years figures
d cutting expenses back to zero
Summary
Not all activities and objectives of an organisation can be expressed in terms of
money.
The starting point for every organisation is its objectives, i.e. what it is trying to achieve.
A simplified budget for a manufacturing company which exemplifies budgets of all
kinds, is as shown here:
Master budget
Budgeted
engineering
expenditure
Forecast sales
and budgeted
sales expenditure
Budgeted
production
expenditure
Production budget
Individual section budgets
Engineering budget Sales budget
The limiting factor is the factor upon which other budgets within an organisation
depend, because it holds the key to increasing the level of activity.
The budgeting process involves people from all sections of the organisation and
when the plans for each section are fitted together it helps to show how the organisation
will meet its objectives.
Sales forecasts are seldom accurate.
Zero-base budgeting is a procedure which requires managers to justify costs as if
they are beginning operations from scratch. Each department and section must justify
each and every cost in terms of the benefits it will bring to the organisation.
Cash budgets help an organisation predict possible cash deficiencies.
Using budgets
Introduction
So far, weve discussed and defined budgets and looked at some of the aspects of
preparing budgets.
We have already seen that a budget is more than simply a plan of action. This section will
illustrate this fact further by showing that a budget is also:
a means of providing managers and supervisors with information, and
a control medium
You will now learn about:
the importance of feedback and communication
the analysis of budgets
accountability
flexible budgets
We will list some more benefits of budgets, and take a look at the supervisors role in
budgeting.
The importance of feedback and
communication
You may recall the diagram below, which was shown previously, depicting the typical
process of management in an organisation:
Set objectives
Owner or
director level
Manager and
supervisor level
Make plans based on
objectives
implement plans
plans and modify
Assess results
The bottom half of the diagram forms a loop, called a feedback loop.
Set objectives
Owner or
director level
Manager and
supervisor level
Make plans based on
objectives
implement plans
plans and modify
Assess results
This is the feedback
loop
Its called a feedback loop because it is the point where information about the effects of
the actions are fed back to the people organising them the managers and supervisors.
They need to compare results with the plans. Its also where the re-thinking takes place,
so that modified actions are fed back into the system.
But this in itself implies that the results are available.
At the end of last year, Daryl Pointon had prepared a budget for his department.
This included a figure of $9,000 for hand-tools and protective clothing. In June of
this year Daryl got a call from Ketti Bharali, the firms management accountant. You
may like to know that your protective clothing and hand-tool costs are already over
$6,000 for the first five months, Daryl. Can you foresee any problems of keeping
within budget for the year on this item? Daryl confessed he hadnt realised so
much money had been spent.
If Daryl hadnt been reminded about this, he might have got into difficulties later in the
year. The information fed back to him made him think carefully about why so much money
was being spent on this item and what action he should take to keep a check on it.
Budgets and budgeting can only work well if there is good communication.
What kind of communication is needed? Which of the following pairs of groups need to
communicate about budgets? Tick whichever of the following you think are correct.
owners or directors and managers?
managers in one department and managers in another?
managers and supervisors in the same department?
supervisors and their team members?
For an organisation to produce a realistic budget, all its various departments and
sections need to be involved.
The degree of cooperation that must take place is in itself frequently beneficial, both for
individuals taking part, and for the organisation as a whole.
Good communication, as you perhaps agree, is necessary at and between all levels, and
in both directions, vertically and laterally.
Good budgeting depends on good communication.
But of course, the importance of good communication applies to all aspects of
management and supervision, not just to budgets.
Identify the actual procedures used in your own section or department to communicate the
information managers and supervisors need:
to prepare budgets, and
to assess how well performance is matching up to budgetary plans
Then answer the two points listed below.
(These procedures may be set out in documents (perhaps in a budget manual), or may
simply rely on people talking to one another.)
(If you arent currently involved in budgets, you will need to talk to someone who is.)
The information needed for budget preparation in my section/department is communicated
by means of:
Feedback on budgets is provided to managers and supervisors by:
ACTIVITY 4.3
Before going on to discuss the responsibilities managers and supervisors have for
budgets, lets look at some of the technical aspects of analysing budgets.
Analysing budgets
The difference between a budgeted figure and an actual figure is called a variance.
Terry Peelham is the manager of a shop selling a range of spares and accessories to
motorists. His budgeted and actual sales and costs for one trading year are as follows:
As you can see, if an actual cost is greater than a budgeted cost, it is called an adverse
variance. Adverse variances are usually shown in brackets.
If an actual cost is less than a budgeted cost, there is said to be a favourable variance.
Having identified a variance, the next step is to look into the reason for it. Why did costs
rise unexpectedly? Why were sales lower than expected?
In Terry Peelhams case, there may be no one to answer these questions but himself. For
a larger organisation, however, it is sensible that the variances be explained by the people
who made the predictions. This is part of the system of accountability, which we will look
at shortly.
For now, lets take a couple of areas of a business and try to analyse the variances.
In the first example, we will consider the possible reasons for a purchases variance.
In the second, we will look at a labour variance in which more than one factor is involved,
and use a technique to break the figure down so that it can be better understood.
Budget Actual Variance
Sales 500,000 470,000 (30,000) (Adverse)
Less costs:
Purchases 230,000 235,000 (5,000) (Adverse)
Wages 28,000 25,000 3,000 (Favourable)
Rent and local tax 45,000 45,000 0
Advertising 4,000 6,000 (2,000) (Adverse)
Lighting, heating
and telephone 2,300 2,100 200 (Favourable)
Total costs 309,300 313,100 (3,800) Adverse)
Profit 190,700 156,900 (33,800) (Adverse)
Purchases variance
Suppose the actual cost of materials purchased for a manufacturing company
turns out to be greater than the budgeted costs. Write down two possible reasons
for this.
1
2
An adverse variance in purchasing costs can occur because prices and/or quantities
bought were higher than predicted.
Some possible reasons are that:
production used more materials than they planned to
the purchasing department wasnt able to negotiate the expected discounts
supplies of some items became scarce, forcing the price up
failures or breakages caused the company to buy higher-grade materials
There are several other possible explanations. A full analysis would entail listing the
variance on each item.
Labour variance
Mackwitts Ltd manufacture shelving units. Last month there were variances in
production between the budgeted and actual labour costs as follows:
Budgeted costs Actual costs
Labour hours per unit 3.0 4.0
Wage rate per hour $5.60 $6.00
Number of finished units produced: 450
In this case, more than one factor is involved: both labour hours and wage rates have
increased. The reasons for these changes may be known, but to see the effect each has
on the overall costs, we need to analyse this labour variance further.
First we can calculate the total labour variance:
Actual labour cost =
4.0 hours per unit x 450 units produced x $6.00 per hour = $10,800
Budgeted labour cost =
3.0 hours per unit x 450 units produced x $5.60 per hour = $7,560
Total labour variance ($3,240)
This can be analysed further into the variance in the labour rate, and the variance in the
labour usage:
Labour rate variance:
Actual rate per hour $6.00
Budgeted rate per hour $5.60
Adverse variance ($0.40)
x actual hours per unit 4.0
= adverse variance per unit ($1.60)
x actual units 450
Adverse labour rate variance: ($720)
Labour usage variance:
Actual hours per unit produced 4.0
Budgeted hours per unit produced 3.0
Adverse variance (1.0)
x budgeted rate per hour $5.60
= adverse variance per unit ($5.60)
x actual units 450
Adverse labour usage variance: ($2,520)
Labour rate variance ($720)
Labour usage variance ($2,520)
So the total labour variance is: ($3,240
So it is important to know why variances occurred, where the variances occurred and be
able to communicate this to other managers so that the company can decide what to do
with this information.
Is this variance a good thing or a bad thing?
The answer to this is that we dont know, without further information. The labour rate may
have gone up because the company made a design change to its shelving units that
enabled the company to double the selling price: in this circumstance an increase of
labour costs of 40c per unit against an increase in sale price of $5.00 per unit is not a
problem to the company.
The figures at Mackwitts for a later period were as follows:
Budgeted costs Actual costs
Labour hours per unit 3.0 4.0
Wage rate per hour $5.60 $6.00
Actual units produced: 500
Using the previous example as a guide, analyse the labour rate variance and labour usage
variance.
Actual labour cost =
Budgeted labour cost =
Total labour variance
Actual rate per hour
Budgeted rate per hour
Adverse variance:
x actual hours per unit
= adverse variance per unit
x actual units
= adverse labour rate variance
Actual hours per unit produced
Budgeted hours per unit produced
Adverse variance
x Budgeted rate per hour
= adverse variance per unit
x actual units
Adverse labour usage variance
Labour rate variance
Labour usage variance
So the total labour variance is:
Turn to the end of this section to check your answers
ACTIVITY 4.4
Accountability
A key element of budgets is that they make managers and supervisors responsible for
budgets in their own area. This is sometimes called responsibility accounting.
So when variances occur the same managers and supervisors will be expected to account
for them. But does that mean they should take the blame for them?
Do you think that being responsible or
accountable for something necessarily means
taking the blame when things go wrong? Yes No
Explain your answer, briefly.
Many people do assume that carrying responsibility means taking the blame for errors or
discrepancies. But we have to be careful about the way we use these words. If you are
responsible for something, you are certainly liable to be called to account for the way you
handle it, and for the actions you have taken.
But blame is an expression of disapproval or reproach. Frequently, people have a very
negative reaction to being blamed or reprimanded. This is not the intention.
The aim of responsibility accounting is to encourage people to take ownership for a
budget. Managers and supervisors should then be able to do their jobs better, by being
better informed, and taking better decisions, in keeping with the company objectives.
To summarise;
A key element of budgets is that they make managers and supervisors responsible
for budgets in their own area.
Making managers and supervisors accountable for budgets does not necessarily
mean they should be blamed when things do not work out according to plan.
Controllable costs
When managers and supervisors are made accountable for budgets, decisions have to
be made about who is responsible for what costs. Look at this case.
Gerry Hart is a supervisor in charge of a production team making light fittings. Gerrys job
is to make the fittings to a defined standard, in the quantities required.
Which of the following costs do you think Gerry should be made accountable for?
a the cost of the materials
b the wages bill of his team, including overtime and bonus payments
c the maintenance costs of the machinery used
d the lighting and heating bill in his teams part of the factory
As a general principle, people should be held responsible for their budgeted costs, but
not for costs they cant control.
Looking at each of the above points in turn:
a The cost of the materials. As a production supervisor, Gerry has no control
over materials costs, so should not be asked to
account for them.
b The wages bill of his team, It is quite likely that Gerry can forecast wages
including overtime and costs accurately, and he ought to be able to
bonus payments. control the amount of overtime worked. However,
he can hardly be called to account if (for example)
the company unexpectedly increases wages for all
workers, or the union negotiates a new national
agreement.
c The maintenance costs of There is a case for making Gerry accountable for
the machinery used. maintenance costs of machines used entirely in
his section. However, Gerrys bosses would be
foolish to stop production by refusing to authorise
expensive repairs that had not been budgeted for.
d The lighting and heating Some firms apportion overheads like heating
bill in his teams part of and lighting, but unless each sections usage of
the factory. these facilities is measured, Gerry could not be
held accountable for them.
Flexible budgets
The budgets we have looked at so far in this workbook have been static budgets. That is
to say, they concern predictions for one specific level of activity; what happens if this level
is not reached is undefined. For instance, the sales predictions for Tiklox mentioned a
single total number of clocks; all other calculations were then based on that one prediction.
However, knowing that it is extremely difficult to be precise and accurate about sales,
some organisations base their budgets on a range of levels of activity by using flexible
budgets. According to the Chartered Institute of Management Accountants (CIMA):
A flexible budget is a budget that is designed to change in accordance with the level
of activity attained.
In effect, the flexible budget consists of a series of budgets, each being based on a
different activity level. If the managers at Tiklox were sure that sales, expected to be 200
per month, would not in any case fall below 170 per month, they might calculate budgets
for 170, 180, 190 and 200 per month.
Fixed and variable costs
Flexible budgeting entails the identification of fixed costs and variable costs. In any
business, there will be costs which always stay the same, and costs which vary according
to the level of sales or production.
Which of the following costs would you expect to stay the same, regardless of how much
business is done (fixed), and which would you expect to increase as more goods are
manufactured and sold (variable)? Tick the appropriate box in each case.
Fixed Variable
Materials costs
Factory lighting and heating
Packing materials costs
Building rents
Wages
Imagine a situation where a business has run out of orders, the staff are idle and the
machines are stopped. Some costs the cost of heating the buildings, paying the
employees, and so on will continue, even though no work is being done. But if business
picks up, these costs still remain the same: they are fixed costs. Other costs materials,
packing and so on rise as sales increase: these are variable costs.
The answers to the question above are therefore:
Fixed Variable
Materials costs
Factory lighting and heating
Packing materials costs
Building rents
Wages*
* You would be right to say that wages costs could go up if more staff were taken on to
deal with an increase in sales.
ACTIVITY 4.5
List as many costs as you are aware of that are incurred in the area for which you have
responsibility. Separate these expenses into fixed and variable costs. (You dont have to
work in production to do this: in most jobs, some costs will vary according to the level of
activity, while others remain the same.)
Cost Fixed Variable
Lets look at an example of a flexible budget for a manufacturing company: Henry Tillows
Ltd, makers of fine kitchen chairs. The sales predictions are that 20,000 units will be sold
during the coming year. However, all that can be said with reasonable certainty is that
half that number will be sold. The management at Henry Tillows decide therefore to
calculate costs on 10,000, 15,000 and 20,000 units.
Henry Tillows Ltd
Flexible budget for the year ended 31 December
Units expected to be 10,000 15,000 20,000
produced and sold:
$ $ $ $ $ $
Expected income at 50,000 75,000 100,000
$5 per unit
Variable expenses
expected:
Variable manufacturing 30,000 45,000 60,000
costs ($3 per unit)
Variable selling costs 5,000 7,500 10,000
($0.50 per unit)
Total variable expenses 35,000 52,500 70,000
Subtotal (income less 15,000 22,500 30,000
variable expenses)
Fixed expenses expected:
Fixed manufacturing cost 10,000 10,000 10,000
Fixed selling costs 2,000 2,000 2,000
Fixed general and 3,000 3,000 3,000
administrative costs
Total expected fixed costs 15,000 15,000 15,000
Net profit (loss)
expected before taxes $0 $7,500 $15,000
Note that where a subtotal needs a description (e.g. Total variable expenses), it is brought
down one line as well as being thrown out to the next column. This principle is also
applied to other financial documents.
Using the previous example as a guide, calculate the expected profit for Henry Tillows if
sales are 12,500, by filling in the figures in the table below:
Units expected to be produced and sold: 12,500
$ $
Expected income at $5 per unit
Variable expenses expected:
Variable manufacturing costs ($3 per unit)
Variable selling costs ($0.50 per unit)
Total variable expenses
Subtotal (income less variable expenses)
Fixed manufacturing cost
Fixed selling costs
Fixed general and administrative costs
Total expected fixed costs
Net profit (loss) expected before taxes:
The answer to this question is as follows:
Units expected to be produced and sold: 12,500
$ $
Expected income at $5 per unit 62,500
Variable expenses expected:
Variable manufacturing costs ($3 per unit) 37,500
Variable selling costs ($0.50 per unit) 6,250
Total variable expenses 43,750
Subtotal (income less variable expenses) 18,750
Fixed manufacturing cost 10,000
Fixed selling costs 2,000
Fixed general and administrative costs 3,000
Total expected fixed costs 15,000
Net profit (loss) expected before taxes 3,750
Another way of presenting this kind of information is in the form of a graph.
By plotting the fixed costs (the horizontal line in the following diagram) and variable
costs, using any of the predicted sales figures worked out in the table, it is then possible
to read off the total costs for any sales figure. The sloping line in the diagram represents
the total of fixed and variable costs.
The shaded area
represents the
range of sales we
are interested in
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At 14,000 units, costs
are $64,000
Total cost line
5,000 10,000 15,000
Sales in units
20,000 25,000
Fixed costs =
$15,000 per year
To find the total costs for 14,000 units:
find the point on the horizontal axis for 14,000
move your finger vertically until it reaches the sloping line
move along horizontally to the left until you reach the vertical axis
then read off the total costs (in this case $64,000)
Using the graph, estimate the total costs for sales of 16,000 units.
From the graph, you should be able to find that the total costs are $71,000:
The shaded area
represents the
range of sales we
are interested in
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Total cost line
5,000 10,000 15,000
Sales in units
20,000 25,000
Fixed costs =
$15,000 per year
Flexible budgets involve identifying fixed and variable costs. A graph can be used
to find the total costs for a particular activity level.
More benefits of budgets
Previously we were in a position to appreciate some of the benefits of budgets. Now we
can identify some further benefits.
Lets first list the advantages of budgets we discussed earlier:
Budgets are helpful in showing managers the actions they need to take for the future.
The actual process of drawing up a budget makes people think ahead and identify
problems in advance.
Budgets provide a structural framework, upon which detailed plans can be made.
They encourage managers and supervisors from different departments to coordinate,
because a budget wont work otherwise.
They can help identify costs that already exist but arent necessarily recognised.
From your work so far, try to identify three further advantages of budgets and
budgeting.
1
2
3
See how far you agree with the following suggestions:
Budgets help to prevent unauthorised overspending.
Because they are an expression of the operational plans of an organisation,
they are a means of communicating these plans to the managers and supervisors.
Budgets provide a standard or benchmark against which performance can be
measured, and so give an opportunity to take corrective action.
They can be used to assign responsibility and so make managers and supervisors
accountable for their financial performance.
They provide a chance for involvement at all levels.
They may be used to establish transfer prices for charging internal services
such as maintenance.
What are your views on the motivating aspects of budgets? Do you see budgets as
a means of motivating staff, or do you think that they can actually have the opposite
effect? Write down your opinions on this subject.
This seems to be another of those questions where it all depends is as good an answer
as any.
Ideally, budgets motivate people:
by setting challenging targets of performance
through the involvement of managers and supervisors in the objectives of the
organisation
by giving individuals responsibility for, and ownership of, the finances in their own
areas.
Of course we know that things dont always work out as we would like: budgets can
sometimes be a source of conflict; information about budgets and objectives does not
always get passed on to those who need it.
We began this section of the workbook by observing how often budgets are met with a
groan. Perhaps your reading of this workbook has helped you take a more positive view
of budgets, and made you realise that much of the criticism of budgets and budgeting
procedures stems from lack of understanding.
The supervisors role
Supervisors in many organisations are required to play a full part in budget procedures.
A supervisor may be asked to:
List the expected costs, and, if appropriate, the expected income, for his or her
section during budget preparation.
Justify those costs in terms of resulting benefit to the organisation.
Justify the cost of purchasing individual items, by describing the purpose and value
of the item, in a document to be presented to senior management for approval.
Keep actual costs incurred in line with budgeted costs.
Account for adverse variances.
The teams role
What of your team? What part do they play?
Try first to answer this question yourself by completing the following activity.
Describe your current budget responsibilities:
Explain how you involve your team in these responsibilities at present:
Even if you have no specific budget responsibilities, you will almost certainly be expected to
play your part in keeping costs down.
Do you believe that your team members should Yes No
be more involved in the budget process?
Do you think that your team should be involved Yes No
in keeping costs down?
Explain your reason for these answers:
(continued)
ACTIVITY 4.6
If you think the team should become more involved, describe ways in which you might do
this.
You have now worked through this topic and should be able to:
describe your role in preparing budgets for your own area of responsibility
participate in the preparation of budgets.
Before moving on, complete the Self-test and read the Summary to review the work you
have done. Note any points you would like to raise with your manager.
Self-test L
1 Tick each of the following statements below that you believe are correct.
a Budgets express operational plans.
b Budgets are used as a basis for management
to implement plans.
c Budgets are used to compare against results to
determine how good performance is.
d Budgets are feedback loops.
2 Fill in the blanks in the following sentences with suitable words.
a Good budgeting depends on good .
b A budget is a budget which is designed to change
in accordance with the level of activity attained.
c A key element of budgets is that of making managers and supervisors
d As a general principle, people should be held responsible for their budgeted
costs, but not for costs they cant .
3 Which two of the following statements are correct?
a An adverse variance occurs when a budgeted cost is
greater than an actual cost.
b An adverse variance occurs when an actual cost is
greater than a budgeted cost.
c A favourable variance occurs when actual sales are
greater than budgeted sales.
d A favourable variance occurs when budgeted sales
are greater than actual sales.
4 Explain the difference between a fixed cost and a variable cost.
5 In the following graph of costs against sales, assume fixed costs of $15,000.
Identify:
a the total cost line
b the fixed cost line
c the costs at zero sales
d the approximate total cost at sales of 20,000 units .
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Sales in units
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Summary
For an organisation to produce a realistic budget, all its various departments and
sections need to be involved.
Good budgeting depends on good communication.
A key element of budgets is that of making managers and supervisors responsible
Making managers and supervisors accountable for budgets does not necessarily
mean they should be blamed when things do not work out according to plan.
A flexible budget is a budget that is designed to change in accordance with the level
of activity attained.
Flexible budgets involve identifying fixed and variable costs. A graph can be used to
find the total costs for a particular activity level.
Supervisors and their teams frequently have a significant role to play in budgets and
budgeting.
Budgetary control
Objectives
When you have completed this topic, you should be able to:
Identify your own responsibilities in relation to the budgetary control system in your
organisation.
List the requirements for an effective system of budgetary control.
Identify the main features of the system of budgetary control in your organisation
and critically evaluate the system and your role in it.
Put forward suggestions to improve the system of budgetary control in your
organisation.
What is budgetary control?
Budgetary control is the setting of plans (budgets) which lay down policies for which
managers are responsible. A regular comparison is made between the plan and what is
actually achieved, so that individual managers can remedy any divergence from the plan
or revise the plan if necessary.
A budget is a plan expressed in monetary terms and shows the income and/or expenditure
needed during a financial period to achieve a given objective.
Budgets are drawn up for individual departments and functions for example, a sales
budget and a production budget as well as for capital expenditure, stock-holding and
cash flow. All the budgets are interrelated and incorporated into the master budget, which
includes a budgeted profit and loss account and balance sheet.
The interrelationships of various budgets
Sales budget
Cash
budget
Master budget
Production
budget
Selling overhead
budget
Administration
overhead budget
Research
budget
Plant
budget
Labour
budget
Overhead
budget
Draw up a diagram that shows the interrelationship of the various budgets in your own
organisation. Use the diagram above as a guide. If your organisation does not have a
budgetary control system, or if you cannot obtain the information, construct a diagram of
what you think the interrelationship should be.
ACTIVITY 4.7
Advantages and disadvantages of
a budgetary control system
A budgetary control system should improve planning and control within the organisation,
but let us look at all possible aspects.
Advantages
Budgeting systems provide a planning framework that obliges managers to think
ahead and identify their requirements for the next year.
Forecasting enables managers to identify in advance shortages of the resources
needed to achieve business objectives (skills, equipment, supplies, and so on).
By identifying problems in advance, there is time to take the necessary action (for
example, retraining or recruiting the required skilled people).
Budget preparation provides the base data to enable accountants to draw up
cash flow forecasts and arrange finance for an organisation.
Budget provides a yardstick for measuring performance. The information on actual
results against budget targets can be used to:
take action to correct adverse variances (control)
hold managers to account for the results of their activities (responsibility
accounting)
reward individual or group performance
Delegation having set detailed budgets for all managers and ensured that these
are consistent with the overall objectives of the organisation, senior managers can
leave middle and junior managers to manage their areas of responsibility. They need
only to become involved when help is needed on an exception basis.
Motivation it is often argued that budgeting motivates managers.
Disadvantages
Projected costs and revenues are unlikely to be entirely accurate.
Discrepancies between budget and actual may be outside a managers control.
Both these factors could lead to frustration and lack of motivation.
Suggest at least five ways in which a budgetary control system can help an organisation.
1
2
3
4
5
When you have completed this activity, check your answers against the list on the previous
page.
ACTIVITY 4.8
Purposes of a budgetary control
system
Although the main purpose of a system of budgetary control is to help managers in the
planning and control of resources, there are a number of other purposes. A budgetary
control system can help in the following areas. You are likely to have identified some of
these, as well as possibly others specific to your organisation.
Planning
A formal system of budgetary control enables an organisation to carry out its planning in
a systematic and logical manner.
Control
Control can only be effected by drawing up a plan of what is to be achieved in a specified
time period with managers regularly monitoring progress against the plan and taking
corrective action where necessary.
Coordination
By drawing up plans, the activities of the various functions and departments can be
coordinated. For example, the production manager can ensure that the correct quantity
is manufactured to meet the requirements of the sales team or the accountant can obtain
sufficient funding to make adequate resources available to carry out the organisations
activities, whether this is looking after children in care or running a railway network.
Communication
A system of budgetary control informs managers of the objectives of the organisation
and the constraints under which it is operating. Regular performance monitoring keeps
managers informed of the progress of the organisation towards its objectives.
Motivation
By communicating detailed targets to individual managers, motivation is improved. Without
a clear sense of direction, managers will lack motivation.
Responsibility
By drawing up separate plans for individual departments and functions, you are clear as
to what you are responsible for as a manager. This also allows you to make decisions, as
long as they are within your budget responsibilities, and avoids the need for every decision
to be made at the top level.
Identifying differences
The process of identifying the difference between planned and actual (budgeted)
performance is known as variance analysis. This will enable you to assess your managerial
performance and provide information you can use to determine where and how to take
corrective action. We will examine this topic in greater detail towards the end of this
section.
Decision-making
By predicting future events, managers are encouraged to collect all the information
relevant to a decision, analyse the information and make the decision in good time.
Consensus
An organisation is made up of a number of individuals with their own ambitions and
goals. The budgetary control process allows these individual goals to be modified and
integrated with the overall objectives of the organisation. Individuals can see how their
own personal aims fit into the overall context and how they might be achieved.
To what extent does your organisations budgetary control system achieve the purposes
listed below? If your organisation does not have a budgetary control system, can you identify
how these purposes are achieved?
Purpose Not achieved Partly Fully achieved How, if not
achieved through
budgetary
control system
Planning
Control
Coordination
Communication
Motivation
Responsibility
Identifying differences
Decision-making
Consensus
ACTIVITY 4.9
Unless you work in a perfectly run organisation, you will not have assessed every purpose
as being fully achieved. Because few of us work in perfect organisations, we need to look
at ways in which the budgetary control system can be improved.
The budgetary control process
One way of improving the process of budgetary control is to consider how a budgetary
control system should operate and thus identify where there are deficiencies. The process
of preparing budgets for each of the functions and other activities in an organisation and
drawing up a master budget can take a number of months. The budgets must be
communicated to managers before the start of the appropriate financial period, called
the budget period, so that they know what the plans are for their own departments and
can implement them. The actual budgets drawn up and the processes used vary
considerably from one organisation to another.
Some organisations adopt the top-down approach to budget-setting: the owners or
directors decide the individual plans for each department and function, and these plans
are given to the individual managers to implement.
Other organisations use the bottom-up approach to budget-setting: individual managers
construct their own budgets and these are given to the owners or directors who coordinate
the individual budgets into a master budget. These are the two extremes and most
organisations fall somewhere between the two.
On a continuum, between the top-down approach and the bottom-up approach:
Where do you think your organisations approach to budget-setting should be?
Where do you think your organisations approach to budget-setting actually is?
If you are fortunate, your two answers will be the same. If they are not, there may be a
discrepancy between what you would like to take place and what actually happens. You
may feel that you would like a totally bottom-up approach.
One difficulty is that individual managers may have different expectations of what the
organisation should achieve and the role of their own department. This can make it
almost impossible to integrate the plans of the individual managers and may lead to
disputes and acrimony.
If you believe that your organisation is too heavily biased towards the top-down approach,
you may feel that the plans drawn up for your department are unrealistic and not
achievable. The best approach is one that manages to achieve the purposes considered
earlier. It will help if the organisation has a clear procedure for setting budgets.You may
not be personally involved with this, but the procedure determines the drawing up of
plans under which you manage, so it is useful to understand how such procedures work.
Setting budgets
In many organisations, budgets are set by a committee made up of the functional or
departmental managers and chaired by the chief executive. The management accountant
usually occupies the role of committee secretary, coordinating and assisting in the
preparation of the budget data provided by each of the managers.
The budget committee reviews the budgets submitted by individual managers and ensures
that each budget:
conforms to the policies formulated by the owners or directors
shows how the objectives are going to be achieved and recognises any constraints
under which the organisation will be operating
is realistic
integrates with the other budgets
reflects the responsibilities of the manager concerned
If a budget does not display all these characteristics, it will need to be revised. This may
affect other budgets and there may need to be negotiations between the managers
concerned to introduce the necessary budget changes. When the budgets have been
approved by the budget committee, they are submitted to the directors for approval prior
to the commencement of the budget period. If the directors accept the budget, it is then
adopted by the organisation as a whole and becomes the working plan.
Describe the budget-setting procedure in your organisation and the part you play in it. If the
procedure is different from the one we have described, explain why.
ACTIVITY 4.10
Responsibility accounting
It is usual for decision-making to be delegated and the principle of responsibility
accounting is that financial control procedures should reflect this delegation of authority.
Responsibility accounting is based on the commonsense principle that managers should
be held accountable only for those activities, costs and revenues over which they have
control. This principle implies a management accounting system that charges costs (both
budget and actual) to the part of the organisation where they are controlled.
The organisation is divided into responsibility centres (i.e. budget centres) of which
there are five main types:
Cost centre
Budgeted and actual costs are recorded and compared. Accountants measure inputs as
costs and outputs as revenues. If your performance as a manager is measured on the
basis of your costs, and your objective is to provide services at the minimum cost, you
are managing a cost centre.
Revenue centre
Budgeted and actual revenues are recorded and compared. If the performance of your
part of the organisation is measured in terms of how much income it generates, then you
are the manager of a revenue centre. A typical revenue centre is a sales office.
Profit centre
Budgeted and actual costs, revenues and profit are recorded and compared. Profit centres
have a major advantage over the other two types of responsibility centres because they
allow managers to make trade-offs between cost and income in order to improve their
profit.
For example, if you are responsible for a factory that is a profit centre in the organisation,
you could decide to work extra overtime to meet a rush order. On the other hand, if your
factory is a cost centre, you might be more concerned to ensure that the overtime budget
is not exceeded. Such trade-offs also apply in the public sector performance is judged
on the quality of services, but the services have to be delivered with the budgeted sum of
money set. You can probably think of a number of public sector services where such
criteria apply.
A profit centre is similar to a cost centre in that it must relate to an area of managerial
responsibility, although the activity may be less homogeneous than that of a cost centre.
The profit centre, though, is likely to contain more than one cost centre.
Investment centre
Budgeted and actual costs, revenues and capital expenditure are recorded and compared.
Strategic business unit
This is effectively an investment centre which has the additional authority to determine
its own strategy.
An individual manager is delegated the authority and responsibility for running each
responsibility centre, for meeting and participating in setting that centres budget.
Responsibility accounting has two objectives: first, to enhance planning, control and
decision-making for a responsibility centre by delegating these functions to the manager
who best understands the centres functions and operations; second, by involving
managers in planning, control and decision-making, creating the possibility that those
managers will act in a manner that is inconsistent with the organisations overall objectives
should be greatly reduced.
ACTIVITY 4.11
Consider your own areas of responsibility.
1 What are the key measures used to assess your performance?
2 Are the measures consistent with each other?
3 Are the measures consistent with the overall objectives of the organisation?
How budgetary control can
influence your behaviour
When thinking about budgetary control it is important to bear in mind that a budgetary
control system is intended to assist managers it is not just a device dreamt up by
accountants. Because it is a system for planning and control, it influences individual
managers behaviour in a number of ways. It will be useful for you to consider how
budgetary control systems can influence your own behaviour as a manager.
Some managers are tempted to build in slack when setting their budgets. They try to
ensure that the budget that is approved for their own particular function is relatively easy
to achieve. This is an attempt to make life easier for themselves and to prevent any
discrepancies between the budget and actual performance which could lead to criticism.
At the time of setting budgets there is a tendency to take the previous periods budgets
and add a notional percentage to it to arrive at the budget for next year. This is known as
incremental budgeting.
The disadvantage of incremental budgeting is that adding a notional percentage to last
years budget perpetuates any past inefficiencies. This means that it is not a new budget,
relevant to the particular conditions that are forecast for the forthcoming financial period.
A budget must be forward-looking and should not merely repeat the past. When preparing
a budget you should consider any new factors or information that may affect the budget
and not simply look at last years figures.
Some organisations do not let managers participate in the setting of budgets. There are
a number of arguments put forward for not allowing managers to participate in the setting
of their own budgets.
The following are common arguments used as reasons for this non-participation:
Managers will build in budgetary slack.
Managers cannot spare the time needed to set budgets.
Confidential information is involved.
Managers do not have the necessary information or knowledge.
In those organisations that do not allow managers to participate, the managers may feel
that the targets set are not achievable, resulting in a lack of motivation. It is best if budgets
are set which are tight but achievable. This results in high levels of motivation.
Managers may be involved in the setting of budgets but not given the information on
actual achievement so that corrective action can be taken. Alternatively, the information
may not be given in the right amount of detail or the correct form for managers to be able
to use it. Even where the information is given, managers may not be able to take action
and may become frustrated.
For a good system of budgetary control, the organisation should make clear the extent
of a managers responsibilities.
ACTIVITY 4.12
Are the following statements true in respect of your own organisation?
Yes No
Budgets do not have slack built into them.
Managers participate in the setting of budgets.
Incremental budgeting is not used.
Targets are realistic and achievable.
Managers know the extent of their responsibilities.
Requirements for an effective
system
There is no model of a perfect budgetary control system, as each organisation needs a
budgetary control system that is tailored to its own needs. However, it is possible to list
the requirements for a system to operate effectively.
Below is a list of the requirements for an effective system of budgetary control. Is each of
these present in your own organisation? If not, consider what action you would suggest
for improving the situation.
A sound and clearly defined organisation with the responsibility of managers clearly
indicated.
Effective accounting records and procedures which are understood and applied in
each case.
Strong support and the commitment of top managers to the system of budgetary
control.
The education and training of managers in the development, interpretation and use
of budgets.
The revision of the original budgets where circumstances show that amendments
are required to make them appropriate and useful.
The recognition throughout the organisation that budgetary control is a management
activity and not an accounting exercise.
An information system that provides managers with data so that they can make
realistic predictions.
The correct integration of budgets and their effective communication to managers.
The setting of budgets that are reasonable and achievable.
The participation of managers in the budgetary control system.
Use this space to make an action plan which could be implemented to resolve any deficiencies
in the budgetary control system in your organisation. Discuss the plan with colleagues and/
or your line manager. Bear in mind that some of the suggestions may be outside your area
of responsibility, although constructive suggestions are usually welcomed in most
organisations.
ACTIVITY 4.13
Summary
For this topic you have looked at the purposes and characteristics of a budgetary
control system and the ways in which budgetary control can influence your behaviour.
Although there is no single model of a perfect system, you have analysed certain
aspects of your own organisation and identified where improvements might be made.
Constructing a cash-flow forecast
Once the budgets have been drawn up, a cash-flow forecast can be prepared. A cash-
flow forecast shows how much cash the organisation will need and when monies will be
paid and received, as the example below shows.
Jacksons Biscuits sales budget is as follows:
Biscuit sales ($)
4,000 4,000 5,000 5,500 4,500 5,000
Jacksons sell biscuits to wholesale customers and allow their customers one month to pay.
They normally receive half of the money from sales in the month of sale and half the following
month.
Therefore, the forecast of cash inflows looks like this:
Cash-flow forecast ($)
Cash inflows 2,000 4,000 4,500 5,250 5,000 4,750
At the end of June half of the cash for June sales is still outstanding.
A cash flow for costs is prepared in the same way by taking account of when the money will
actually be paid. Most suppliers give one months credit. Some costs may be paid on a
quarterly basis for example, electricity and telephone expenses.
Jacksons have budgeted costs ($) as follows:
Materials 500 500 625 688 562 625
Labour 2,000 2,000 2,500 2,750 2,250 2,500
Heat and light 100 100 100 100 100 100
Miscellaneous 300 300 300 300 300 300
Total 2 ,900 2,900 3,525 3,838 3,212 3,525
Jacksons are given one months credit by their suppliers. Labour and other expenses are
paid in the months to which they relate. Heat and light is paid quarterly in March and June.
1 Prepare a cash-flow forecast showing cash inflows and cash outflows for Jacksons
Biscuits.
Cash-flow forecast
Cash inflows:
Sales
Cash outflows:
Materials
Labour
Heat and light
Other expenses
Total
After completing this part of the activity, turn to the end of this section to check your answers.
2 You have already prepared a budget for your department in the previous activity.
This may be a revenue or an expenses budget depending upon the area in which you
work. You should now be able to prepare a cash flow using the budget as a basis.
Using your department budget as the basis, prepare a cash-flow forecast for your
department. You will need to identify appropriate headings for cash inflows and outflows.
ACTIVITY 4.14
Methods of budgeting
It is possible to build into the budget an allowance for uncertainty, using techniques such
as flexible budgeting and rolling budgets.
Flexible budgeting is a method of categorising costs according to how they behave in
response to a change in the level of activity, and building this flexibility into the budget.
Under a flexible budgeting system, the budget for variable costs is adjusted if the level of
activity is different from budget. Note that flexible budgeting should not be allowed to
obscure responsibility for the changed level of activity.
Rolling budgets build on the fact that most management decisions, particularly at junior
levels of an organisation, are not made 12 months ahead. As a result, most managers do
not need detailed budgets for a projected period (called a time horizon) as long as a full
year and instead prepare a budget for, say, three months and then each month prepare
a new three-month budget based on what they now know.
The greatest advantage of rolling budgets is their flexibility. They enable you to divert
resources from one part of the organisation to another in response to changing
circumstances, without the political and motivational problems of having to cut one
managers budget to give more resources to another. The main drawback with rolling
budgets, as you may have identified, is that they require more administrative effort. You
would need to be convinced that the benefits justified the extra cost.
There are two alternative approaches to budgeting which are often applied to overheads:
these are called incremental and zero-base. Read the definitions, then decide which
one is used more frequently in your organisation.
Incremental budgeting this years budget is based on last years actual results,
plus an allowance for inflation, or less a percentage to encourage cost reductions.
Zero-base budgeting the budget for each category is built up from scratch, by
first asking the question; Do we need to incur these costs at all? and then, if so,
What would be the most cost-effective way of providing the service we need?
Incremental budgeting is the traditional, and still the most widely used, method of
budgeting for overheads. Zero-base budgeting is a relatively recent technique.
Incremental budgets Zero-base budgets
Advantages:
Disadvantages:
From these brief definitions, list below what you think would be the main advantages and
disadvantages of each method. Try and think about how each method would apply to your
organisation, even if they are not currently used.
ACTIVITY 4.15
The end-uses of financial
information
Managers use financial information for business planning, controlling costs and resources,
and for making decisions.
Planning
Without plans and policies an organisation has no sense of direction or purpose. Financial
information allows plans and policies to be formulated and helps managers understand
the targets and standards that the organisation intends to achieve.
If the senior managers set targets in terms of a profit figure, then other managers can
plan their own strategies to achieve this. The sales manager can plan how many units
need to be sold to reach target income; the production manager can plan how many
units of a product need to be made to fill orders; and the accountant can ensure that
funds are available at the right time to make any purchases of materials or equipment
required. If this planning doesnt take place, the organisation is unlikely to reach its target.
You will also realise that coordination of separate department plans is important. If the
sales manager plans to sell 15,000 units of a product, then the production manager
needs to plan to produce 15,000, and the finance department needs to ensure sufficient
funds are available to buy materials as required for them. Where there is a lack of
coordination of the various activities, and managers follow their own ideas, this leads to
resources not being matched to the demands made on them, resulting in waste and
inefficiency. To prevent this chaos, business planning is required.
Controlling
If the organisation were to make detailed plans for the coming year and then lock them
away in a filing cabinet, the exercise would be interesting, but not very useful. The plans
must be translated into actions for individual managers to pursue.
However, even if detailed plans are made available to all managers so that activities are
coordinated, this does not mean control is achieved. Because the plans are based on
predictions, events will occur which mean that the plans cannot be achieved. Prices may
increase unexpectedly, new competitors may appear offering cheaper products, machines
may break down, suppliers may not be able to deliver materials on time. If an organisation
is going to achieve control, regular monitoring must take place so that what actually
happens can be compared with the original plan. In this way action can be taken whenever
circumstances dictate.
Most managers are concerned with translating the detailed plans into actual performance
and will be required to explain any differences between planned and actual performance.
Decision-making
In establishing plans, managers must decide which of the various courses of action they
should take. Managers need to know the financial implications of their action in order to
select the most appropriate plan. Earlier in the workbook, you saw how financial information
is required to help you make rational decisions in the workplace. Without information
about the costs of the various options, it would not be possible to decide the most cost-
effective one.
The activities of planning, controlling and decision-making are carried out at all levels of
an organisation. The owners or directors of an organisation will be more concerned with
these activities at a strategic level, looking at the long-term prospects of the organisation
and its overall profitability. As a department manager, your role is likely to be more
concerned with shorter-term financial planning, control of your departments costs and
resources, and decision-making in relation to changes in your department.
You should now be able to look at any financial information you currently receive as a
manager and decide whether it helps you in the activity of controlling, planning or
decision-making.
1 Classify the information you receive according to whether it helps you in controlling,
planning or decision-making. Write down each type of financial information you receive
and then tick the appropriate category. Sometimes the boundaries are blurred and you
may find that you use some information for more than one activity.
Type of financial information Used for:
Planning Controlling Decision making
2 List the benefits of management accounting to your own organisation. It may be helpful
to use the classifications of planning, controlling and decision-making.
ACTIVITY 4.16
Summary
You have looked at the importance of management accounting and how it helps you
as a manager.
You have identified your own role in the financial information process and the
advantages to an organisation of management accounting information.
Activity 4.4
Actual units produced: 500
Actual labour cost = 4.0 x 500 x 6.00 $12,000
Budgeted labour cost = 3.0 x 500 x 5.60 $8,400
Total labour variance ($3,600)
Actual rate per hour 6.00
Budgeted rate per hour 5.60
Adverse variance: (0.40)
x actual hours per unit 4.0
= adverse variance per unit (1.60)
x actual units 500
= adverse labour rate variance (800)
Actual hours per unit produced 4.0
Budgeted hours per unit produced 3.0
Adverse variance (1.0)
x budgeted rate per hour 5.60
= adverse variance per unit (5.60)
x actual units 500
Adverse labour usage variance (2,800)
Labour rate variance ($800)
Labour usage variance ($2,800)
So the total labour variance is ($3,600)
Activity 4.12
If your organisation has an effective system of budgetary control you should have
disagreed with all the statements for the following reasons:
Managers must be trusted. If top management believes that you or your
colleagues will build in slack or if the budgetary control system is so poor in its
operation that it encourages this form of behaviour, these problems should be
investigated.
Budgetary control is part of a managers responsibilities and time should be
available.
Data should not be so confidential that managers cannot obtain access to the
information necessary to carry out their responsibilities. If you are not informed,
you must be working in the dark.
Managers should have detailed knowledge and understanding of the work of
their own department and activities. Therefore, they should be ideally placed
to participate in setting budgets.
If the statements are true, your organisation appears to have the main ingredients
for a budgetary control system which managers will find effective. If they are not,
the system needs to be improved.
Activity 4.14
Your cash-flow forecast for Jacksons Biscuits should look like this:
Cash inflows:
Sales 2,000 4,000 4,500 5,250 5,000 4,750
Cash outflows:
Materials 0 500 500 625 688 562
Labour 2,000 2,000 2,500 2,750 2,250 2,500
Heat and light 0 0 300 0 0 300
Other expenses 300 300 300 300 300 300
Total (300) 1,200 900 1,575 1,762 1,088
Activity 4.15
Incremental budgeting
This has the advantage of being relatively simple and, therefore, cheap to
implement. It may also provide adequate results, particularly in more stable
businesses. However, it is unlikely to lead to the most efficient allocation of resources.
One criticism is that it tends to perpetuate inefficiencies certain parts of an
organisation always get larger budgets than they deserve. The infamous hockey-
stick effect can also result from incremental budgeting: a burst of spending occurs
at each year end as managers try to ensure that they spend up to budget, and
avoid a budget reduction next year.
Zero-base budgets
Zero-base budgeting, in contrast, asks much more fundamental, searching questions
when budgets are being prepared, and so can lead to major savings. The zero-
base approach is particularly powerful when used as part of the strategic analysis
of a business that focuses attention on activities and costs from the viewpoint of
the customer. By doing this, you identify the key activities that either provide or
could provide competitive advantage, and can focus the resources of a business
on these areas, while reducing or eliminating costs that do not add value for the
customer. The disadvantages of zero-base techniques are cost, and the practical
difficulties of implementing the system without creating more of the administrative
overheads the system is designed to reduce.
Activity 4.16
The benefits you have listed will depend on the type of organisation that you work
for, but you might have included examples like these:
Planning
The price you should put on a new product or service.
How many employees will be needed in the future and what should they be
paid?
How much of each product or service must you sell before you break even?
Controlling
Activities that your organisation carries out where the true cost is not known.
Areas where you might control costs more efficiently if you had the information.
Decision-making
Whether to make a particular component yourself or buy it from a supplier.
Whether it is financially worthwhile investing in new technology.
Which products your organisation should manufacture.
Self-test K
1 The correct statement is:
2 a Money is a primary concern in any organisation.
This is true: money is always a primary concern, even in non-profit-making
organisations which do not regard money-making as their main objective.
Without a means of balancing income against expenditure, no organisation
can hope to survive.
b Not all expenses can be expressed in terms of money.
This is false: not all factors affectingan organisation can be expressed in
terms of money, but expenses always are.
c All companies need to set limits on spending.
This is true.
d For a commercial company, one of the most important objectives will be
to maximise profit.
This is true.
3 The diagram should read as follows:
Set objectives
Owner or
director level
Manager and
supervisor level
Make plans based on
objectives
implement plans
plans and modify
Assess results
4 A master budget draws together all the information from individual departmental
budgets, and is used to calculate the overall effect of the predictions. (You may
have used different words.)
5 a a company selling Sales would be the most likely limiting
lawnmowers factor, as it is with most commercial
companies.
b a charity A charity depends on contributions,
and the amount of work it can do is
therefore limited by its income. (If
you said cash, this would be correct
also.)
c a one-person business The most likely limiting factor here
making garden ornaments, seems to be production capacity.
with a full order book
d a small company seeking Cash would seem to limit a company
to expand, but already in this position.
overdrawn on its bank
account
e a company involved in Lack of available skilled labour could
highly technical products, well be the limiting factor in this case.
setting up a factory in a
new area
6 When describing sales budgets the following statements should be ticked:
a They are invariably inaccurate.
b They are easier to prepare if the staff know their products and their
markets well.
c They should take into account the actions management is planning to
take to influence future events such as advertising, pricing, distribution
and so on.
d They are normally limited by production.
7 The correct definition of zero-base budgeting is:
b A budget system which requires managers to justify each and every
expense in terms of the benefits to the organisation.
Self-test L
1 Describing budgets, the following statements should be ticked:
a Budgets express operational plans.
b Budgets are used as a basis for management to implement plans.
c Budgets are used to compare against results to determine how good
performance is.
2 a Good budgeting depends on good communication.
b A flexible budget is a budget that is designed to change in accordance
with the level of activity attained.
c A key element of budgets is that of making managers and supervisors
responsible for budgets in their own area.
d As a general principle, people should be held responsible for their budgeted
costs, but not for costs they cant control.
3 Regarding variances, the following statements should be ticked:
b An adverse variance occurs when an actual cost is greater than a
budgeted cost.
c A favourable variance occurs when actual sales are greater than
budgeted sales.
4 A fixed cost is one which does not vary, whatever the level of activity of the
organisation. A variable cost is one which is related to the level of activity.
(You may have expressed this in a different way.)
5 The answers are shown in the following diagram:
100
90
80
70
60
50
40
30
20
10
C
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5,000 10,000 15,000
Sales in units
20,000 25,000
Fixed cost line
Total cost line a
c
b
d
Fixed (and total) costs at
zero sales = $15,000 per year
are $85,000
Section 5
Financial statements
Introduction
As you have already seen, the keeping of accounts can be said to have two branches.
The first is called book-keeping. It involves the recording of the day-to-day financial
events of a business, and processing this data in various ways.
The other branch is accountancy. This is concerned with summarising the information
in the financial records presenting this information to interested parties, and interpreting
it, in order to help make decisions about the organisation.
In this section we are going to look at these accountancy functions in more detail. We will
be mainly interested in two types of financial statements: the profit and loss account,
and the balance sheet.
For this activity you will need your copy of an annual report.
First, look through your annual report and find:
the profit and loss account, and
the balance sheet
Note that:
You will probably find that your annual report is more complicated than the examples in
this workbook and that you have to search through the details of the report to find the
relevant information.
You may also find that your annual report sometimes uses different wording from that
used in this workbook. Wherever possible we will include alternative terms for you to
look for.
You dont have to be able to interpret every detail of your annual report; you need only be
able to identify and understand the general principles discussed in this section.
You may find it will help you if you can discuss the report with someone knowledgeable,
such as a member of your accounts department. This person may also be able to help you
with any points you have difficulty with.
Turn to the end of this section for some additional comments.
ACTIVITY 5.1
Why are financial accounts kept?
Think about the different kinds of people who may be interested in the financial
health of an organisation. Make a list of the kind of financial information they might
want.
Once a limited company is formed, the organisation has a responsibility towards its
shareholders and is obliged to keep them informed of its activities. The law recognises
this responsibility by requiring limited companies to keep certain financial records, to
have them audited by an independent accountant and to make them available to
shareholders (and also to the general public in the case of public limited companies).
It would be impossible to run an efficient business without the information contained in
financial records. Even sole owner businesses keep some form of accounts.
Financial information is used to:
assess the present financial strength of a company
plan for future spending
investigate anything that needs to be done to make the organisation more efficient
find out how much money could be raised from the company if it should be needed
make sure a company has sufficient working capital
make sure a company is performing as planned and to predict any problems
compare an organisations performance over a number of years
calculate the amount of tax owed to the government
compare the financial performance of several companies
People outside the organisation, such as suppliers, customers and creditors, might also
use financial information to make sure the organisation can meet its obligations to them.
Do you think that employees of an organisation should take an interest in its
accounts? Give a reason for your answer.
Most employees dont bother to take an interest in the financial performance of their
employers, although there is no reason why they shouldnt.
If someone owed you money, you would probably be very interested in knowing whether
he or she is financially sound. Yet for most people, paid employment is their main source
of income. It certainly seems to make sense to take time and trouble to understand your
own organisations finances.
The methods used to present financial information apply to organisations of all kinds
sole traders, partnerships, limited companies and so on.
Lets first look at what is probably the most important concept in accounting: profit.
The need for profit
Any type of organisation has money coming in revenue, and money going out costs.
For a particular period of time, an excess of revenue over costs is called profit. If there
is an excess of costs over revenue, the organisation is making a loss.
Every organisation needs to make a profit or at least not make a loss if it is to be
viable. If costs continue to exceed revenue, sooner or later there will be no funds left to
run the organisation.
There are two kinds of profit: gross profit and net profit.
Gross profit is the excess of sales over the cost of goods sold in the period.
The gross profit is shown in the profit and loss account, as we will see.
Net profit is the gross profit minus all the other costs involved in running the
business.
Net profit is also shown in the profit and loss account which is one of the two types of
financial statements we will look at in detail.
Types of financial statements
There are two main statements which provide overall information about the performance
of an organisation over a period in the past:
the balance sheet, and
the profit and loss account
The balance sheet
A balance sheet is like a snapshot of the financial situation of a business at a particular
time. It shows the organisations assets and liabilities which must always balance.
In the balance sheet:
Assets = Capital + Liabilities
Lets look at assets first. They consist of two main types: fixed and current.
Fixed assets
Every business has some assets which it will hold on to for a relatively long time.
These are called fixed assets and include such things as:
machinery
buildings
equipment
vehicles
shop fittings
long-term investments
Some fixed assets are intangible things like copyright on a song or a patent on an
invention. It is often easier to put a value on tangible assets things you can touch.
1 Look at the balance sheet in your annual report.
2 Identify the figure for the fixed assets. What is the total amount recorded for fixed assets?
3 Does your report divide fixed assets into further categories? If so what are they?
4 What sort of items do you think are listed as fixed assets in your company?
Turn to the end of this section for further comments.
Current assets
Current assets are assets which are in the process of being turned into cash:
stocks of parts
stocks of finished goods
stocks of unfinished goods (called work-in-progress)
debts owed by customers
Cash and money in the bank are also both current assets.
ACTIVITY 5.2
Look again at the balance sheet in your annual report.
1 What is the total amount of current assets (i.e. the money and other items which the
organisation could easily turn into money)?
2 Does your report divide current assets into smaller categories? If so, what are they?
3 Does your annual report list stocks of raw materials or finished goods? If so, what items
do you think would be included under these headings?
Current liabilities
Current liabilities are debts which the organisation has to pay back to creditors within a
year. They include such things as:
bank overdrafts
short-term loans
unpaid invoices (bills)
If you recall, we discussed liabilities earlier in the workbook. We said that as well as
current liabilities there are long-term liabilities funds that have been borrowed from a
bank or other lender, to be paid back over a period longer than a year.
In addition, we must not forget about the investors in the organisation who have provided
the funds to purchase the organisations assets. In the case of limited companies these
are the shareholders.
ACTIVITY 5.3
Which funds in a limited company belong to the shareholders?
Shareholders funds consist of the share capital, plus any retained profits. Lets think a
little more about retained profits. These are sometimes known as capital reserves.
Retained profits
Retained profits can be thought of as a kind of long-term loan to the company. When an
investor buys shares in a company, he or she does so in the hope that:
dividends will be paid out on the profits of the company, and/or
the company will be successful, so that the shares are worth more than the
shareholder paid for them, should they be sold.
For a company to grow, it needs to invest in resources: buildings, machinery, people and
so on. If all the profits of the company are paid out in dividends to shareholders, growth
will be very difficult. So some or all of the profits are retained from year to year.
So liabilities consist of:
current liabilities
long-term liabilities
share capital
retained profits
1 What is the total amount of retained profits recorded in your annual report?
2 What dividends are recommended by the directors (if any)?
3 List any long-term loans shown in the report.
ACTIVITY 5.4
The completed balance sheet
The assets and liabilities have now all been identified, and we know that they must balance:
Current liabilities
+
Long-term liabilities
+
Share capital Current assets
+ +
Retained profits Fixed assets
Total liabilities = Total assets
In the past balance sheets were set up in this way to show clearly the relationship between
total liabilities and total assets. But now, though the principle is exactly the same,
accountants use a vertical format which makes the accounting equation:
Assets Liabilities = Capital
The balance sheet is then presented as follows:
Current assets
Current liabilities
Net current assets
+
Fixed assets
Total assets less current liabilities
Total net assets
Share capital
+
Retained profits (reserves)
Capital and reserves
Make sure you understand what all the figures in this balance sheet mean, and
then tackle the next activity.
Lets look at an example of a balance sheet:
Chica Boutica Ltd is a small limited company, under the day-to-day control of Doris
Huntley. The company runs a dress shop in Cardley High Road. Doris and her
boyfriend own all the shares. Longclaws Bank have granted the company a small
loan and is at present being very understanding about the companys overdraft.
From its balance sheet, you can see the overall state of Chica Bouticas affairs:
Chica Boutica Ltd
Balance sheet as at 31 March
Fixed assets $ $ $
Cash register 1,000
Vehicle 5,700
Computer equipment 2,200
11,900
Current assets
Stock 6,000
Debtors 1,200
Cash in hand 100
7,300
Current liabilities
Creditors (1,300)
Bank overdraft (3,000) (4,300)
Net current assets 3,000
Longclaws Bank (4,600)
10,300
Share capital 10,000
Retained profits 300
10,300
Clearvu Windows Ltd is a company which installs double glazing. Its assets, liabilities and
funding information as at 31 March were as follows:
$
Money owed to Clearvu on invoices 7,000
Finished goods stock 30,000
Tools and machinery 22,000
Retained profits 92,000
Money owed for short-term bank loan 13,000
Vehicles 35,000
Raw materials stock 63,000
Debtors 15,000
Long-term loan from Bradleys Bank 10,000
Cash in bank 7,500
Draw up a balance sheet for Clearvu Windows Ltd as at 31 March. You can use the balance
sheet for Chica Boutica above as a guide, but watch out for the items which are different!
The balance sheet gives an overall picture, but doesnt show how the profit figure
is derived. For that we must turn to the profit and loss account.
Profit and loss account
We know that the gross profit is the difference between the value of sales and the cost of
the sales. This is shown in the profit and loss account.
An example should help you get the idea.
ACTIVITY 5.5
Dominic Petrovsky has the sole agency to distribute the Dixxy box kite. Here is an
extract from his profit and loss account for the year ended 30 June:
$ $
Sales 6,550
Cost of sales
Opening stock 453
+ Purchases 3,275
= Value of disposable goods 3,728
Closing stock 1,274
= Cost of sales 2,454
Gross profit 4,096
(The +, and = signs would not be shown in an actual account, but we have
inserted them here to help you read it.
What was the value of the stock of box kites that Dominic had at the beginning of
the year?
How much did he spend on buying more kites during the year?
What do you think is meant by disposable goods?
The value of the kites Dominic had in stock at the start of the year was $453 (the opening
stock).
Dominic spent $3,275 on new kites during the year (his purchases). Disposable goods
are the total goods available for sale.
So this part of the profit and loss account is made up of:
sales cost of sales = gross profit
But this is only part of the story. Dominic, like all other businesses, had many incidental
expenses too. For example, he had a small office which he had to pay rent on, and which
required lighting and heating.
The other part of Dominics profit and loss account for the year ended 30 June was
as follows:
$ $
Gross profit 4,096
Lighting and heating 245
Rent for office 1,520
Advertising 353
Wages 1,300
Postage 123
Sundry expenses 50 3,591
Net profit 505
So the profit and loss account shows:
sales cost of sales = gross profit
gross profit indirect expenses = net profit
In the case we have just looked at, the only direct selling cost involved was the cost of
buying the goods.
Profit and loss account for a manufacturing
company
The diagram below shows a breakdown of costs for a manufacturing organisation:
Direct materials
plus
Direct labour Prime cost
plus
Factory overheads
plus
Direct expenses
Production cost
Total
cost
plus
Selling and
distribution expenses
plus
Administrative
expenses
This figure is the total
of the expenses
listed in the left-hand
column.
By direct we mean the materials, labour and expenses that can be traced to particular
goods that are made. So a lathe operator will be direct labour, whereas a supervisor or
manager, who is not directly involved with producing goods, would be classified as indirect
labour part of the factory overhead.
Lets look at an example of a manufacturing company during the year ended
31 December:
Doors and Drawers Ltd makes oak dressers, chests and cabinets. It employs a
supervisor, eight skilled workers and two apprentices. The company rents factory
and storage space for $32,000 per year. The supervisor earns $10,000, and the
total cost of wages for the rest of the factory staff during the year was $150,000.
Doors and Drawers Ltd also employs a secretary and a clerical assistant. Their
combined salaries are $21,000. During the year, materials needed to construct the
furniture were purchased at a cost of $160,000. The company spent a further
$15,000 on other manufacturing costs such as electricity. To meet a special order,
a machine was hired, at a cost of $29,000.
The company sells directly to large department stores. It contributes to the cost of
advertising its products and also employs a sales team who work on commission.
The advertising expenses last year were $92,000. Sales staff salaries came to
$35,000. Administration costs, for such things as stationery, postage, etc., amounted
to $12,000. Total sales for the year came to $720,000.
In the following table, list the various types of direct and indirect costs in this example.
Direct labour
Direct materials
Direct expenses
Factory overheads
Administrative expenses
Selling costs
Totals
The completed table is therefore:
Direct labour $150,000
Direct materials $160,000
Direct expenses* $29,000
Factory overheads $57,000
Administrative expenses $33,000
Selling costs $127,000
Totals $339,000 $217,000
(*The machine hired to meet a special order was classified as direct expenses because
it could be traced to particular goods that were made. On the other hand, electricity in the
factory is a cost which cannot be traced to particular goods, as it is used for many different
purposes.)
See how your answer compares with the one below:
Factory
overheads
Direct
labour costs
Administrative
expenses
Direct materials
Factory
overheads
Direct expenses
Selling
expenses
Selling
expenses
Administrative
expenses
Doors and Drawers Ltd make oak dressers, chests and cabinets. It
employs a supervisor, eight skilled workers and two apprentices. The
company rents factory and storage space for $32,000 per year. The
supervisor earns $10,000 and the total cost of wages for the rest of the
factory staff during the year was $150,000.
Doors and Drawers Ltd also employs a secretary and a clerical assistant.
Their combined salaries are $21,000. During the year, materials needed
to construct the furniture were purchases at a cost of $160,000. The
company spent a further $15,000 as other manufacturing costs such
as electricity. To meet a special order, a machine was hired, at a cost of
$29,000.
The company sells directly to large department stores. It contributes to
the cost of advertising its products and also employs a sales team who
work on commission. The advertising expenses last year were $92,000.
Sales staff salaries came to $35,000. Administration costs, for such
things as stationery, postage, etc., amounted to $12,000. Total sales
for the year came to $720,000.
Some more facts about Doors and Drawers in this year:
At the start of the year, Doors and Drawers had raw materials valued at $43,000.
At the end of the year, there were $39,000 of raw materials left.
At the start and end of the year there was, of course, some unfinished work; i.e.
work-in-progress. At January of the year under consideration, this was valued at
$23,000. At 31 December of the same year the work-in-progress was worth $32,000.
There were also some finished goods in stock. At the beginning of the year, these
were costed at $54,000. At the close of the year, there were $32,000 of finished
goods in stock.
For a manufacturing company, the production cost of goods completed is calculated in
the manufacturing account. This figure is then used in the first part of the profit and loss
account, which is concerned with finished goods.
Working through the next activity should help this become clearer.
Now you should be able to work out the gross profit and net profit in the profit and loss
account:
(continued)
Draw up a profit and loss account for Doors and Drawers Ltd by filling in the boxes in the
table below.
First, work out the cost of completed goods.
Doors and Drawers Ltd
Manufacturing account for the year ended 31 December
$ $
Stock of raw materials 1 January
Add Purchases
=
Less Stock of raw materials 31 December
= Cost of raw materials consumed
Add Direct expenses
Add Direct labour
= Prime cost
Add Factory overhead expenses:
General factory expenses
Rent
Add Indirect labour
=
Add Work-in-progress 1 January
=
Less Work-in-progress 31 December
Production cost of goods completed
(carried down)
ACTIVITY 5.6
Net profit
In the example weve looked at, we arrived at a net profit figure, after deducting direct
and indirect costs from the sales revenue.
Do you think that this net profit figure can all be put back into the business as
retained profit? Give a brief reason for your answer.
Compare your answer with the one given at the end of this section.
Profit and loss account for the year ended 31 December
$ $ $
Sales
Less Cost of goods sold:
Stock of finished goods 1 January
Add Production cost of goods
completed (brought down from above)
Less Stock of finished
goods 31 December
Gross profit
Administration expenses:
Administrative salaries
Stationery, postage, etc.
Selling expenses:
Sales staff salaries
Advertising
Net profit
There are two more items to consider. First, corporation tax must be paid. Then the
directors of Doors and Drawers Ltd have to decide what dividend to pay to the
shareholders, if any.
Now lets take an example from another company, and see how these figures may appear
in the profit and loss account and balance sheet.
Naardia Doorknobs Ltd
$ $
Sales 384,310
Stock of finished goods 1 January 58,500
Add Production cost of goods completed 108,720
167,220
Less Stock of finished goods 31 December 34,548 132,672
Gross profit 251,638
Selling and administrative overheads 105,000
Net profit before taxation 146,638
The next step is to determine the corporation tax, and hence calculate the net
profit after taxation:
$
Net profit before taxation 146,638
Corporation tax 60,000
Net profit after taxation 86,638
Then the directors decide what dividend to the shareholders it would be appropriate
to recommend:
$
Net profit after taxation 86,638
Proposed dividend 75,000
Retained profit for year 11,638
They can then issue the statement of retained profits/reserves:
$
Retained profit brought forward from previous year 173,288
Retained profit for the year 11,638
Retained profit carried forward 184,926
The retained profit carried forward is the figure taken into the balance sheet:
Balance sheet as at 31 December
$ $ $
Fixed assets
Plant 939,718
Current assets
Stock
Raw materials 37,000
Work-in-progress 56,160
Finished goods 34,548 127,708
Debtors 30,000
Cash 10,000
167,708
Current liabilities
Creditors (37,500)
Corporation tax (60,000)
Proposed dividend (75,000) (172,500)
Net current assets (liabilities) (4,792)
934,926
Retained profit 184,926
934,926
In this balance sheet, identify, by ringing the appropriate figures:
total fixed assets
total current assets
retained profits
total current liabilities
shareholders funds
As we noted earlier, subtotals needing extra description here, Net current assets
(liabilities) are dropped one line when they are taken across (thrown out) into the next
column.
See how your answers compare with those given below:
$ $ $
Fixed assets
Plant 939,718
Current assets
Stock
Work-in-progress 56,160
Debtors 30,000
Cash 10,000
167,708
Current liabilities
Creditors (37,500)
Corporation tax (60,000)
Proposed dividend (75,000) (172,500)
Net current assets (liabilities) (4,792)
934,926
934,926
Retained profit from
the profit and loss
account
Shareholders funds
Total
current
liabilities
Total current
assets
Total fixed
assets
Interpreting financial statements
Assuming that the information presented in an organisations financial statements is
correct, and is interpreted correctly, it can be used to judge the organisations past
performance and to help predict its future.
Performance over the past year is of interest to:
the organisation itself, which wants to know how well the company is using its resources
to shareholders who may expect to collect dividends on their investments
Investors, and potential investors, will use the information to compare the companys
performance with other companies. Management, customers, clients, potential investors
and employees can also use financial statements to see how well a company is performing
financially.
You will have already noticed that your annual report contains information for at least two
consecutive years so that such comparisons can be made.
The last example we looked at was for Naardia Doorknobs Ltd, for the year ended
31 December. Imagine you are employed by this company, and you want to know how
profitable the company is. It would be useful to have the previous years statements. So
that you can compare the performance over the two years, the profit and loss account
and balance sheet for the year just ended (Year 2) and the year before (Year 1) are
shown below.
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List three key figures on the two years financial statements which you think would
help you assess the companys performance.
One significant figure is the sales figure. Total sales is also called turnover. This figure will
give you an idea of the size of the organisation and whether business has increased or
decreased from one year to the next.
Others would be the profit figures and the dividend.
The profit before tax figure of $146,638 in Year 2 (compared with $132,139 in Year 1) is
probably the best measure of how well the business performed overall, as it shows whether
and by how much it has improved. (However, as you know, not all this profit is available to
be ploughed back into the business, since tax and dividends have to be paid out first.)
To get a true picture of performance, the profit figure for Naardia should be compared
with other companies in the same business.
It is also a good idea to look at profit in relation to turnover. You can do this by using the
formula:
Profit before tax x 100 = %
Sales
This formula is often referred to as the net profit margin.
Work out the net profit on sales as a percentage for Naardia for Year 1 and Year 2.
Did Naardia perform better, in terms of net profit margin, in Year 1 or Year 2?
For the two years, the figures are:
Year 1 Year 2
Profit before tax 132,139 146,638
Sales 327,536 384,310
Using our formula,
Profit before tax x 100 = %
Sales
we get:
Year 1 Year 2
Net profit margin 40.34% 38.16%
So the net profit margin has deteriorated slightly. So although Naardia Doorknobs Ltd
made more profit in Year 2 this was not in relation to sales.
Liquidity
If you were trying to find out whether Naardia Doorknobs Ltd was a company that was
likely to continue operating, you would not only be interested in sales and profit, but also
in its liquidity.
Liquidity is a measure of how well equipped an organisation is to meet its commitments
as they fall due. You may recall the case study described in Section 1 of Bill whose loft
conversion business was in trouble. Bill had plenty of business, but he did not have
enough cash to pay his workers or for supplies.
Think about which figures might be helpful in checking an organisations ability to
meet its immediate commitments. Note any ideas you have.
As you know, current assets are the assets which can be most quickly turned into cash,
as, by definition, they should become liquid within 12 months. The current liabilities show
the bills due for payment within the same period.
The most common ratio used to measure liquidity is the current ratio, (sometimes
described as the liquidity ratio) which is derived from the formula:
Current ratio = Current assets
Current liabilities
For Year 1, the current ratio for Naardia Doorknobs Ltd was
= 1.90
236,682
124,460
= 0.97
Work out the current ratio for Naardia for Year 2:
Is the current ratio better or worse than Year 1?
Looking back to the balance sheets, these show that for Year 2, Naardias current assets
were $167,708, and its current liabilities were $172,500. The current ratio is therefore:
167,708
172,500
So you can see that the liquidity of Naardia Doorknobs Ltd has fallen significantly in the
last year.
A company is considered to have the right amount of working capital if the current ratio is
about 1.5. If it is higher than 2 then the company would be better investing some of its
surplus in fixed assets. If it is lower than 1, the company may have problems paying
wages or buying materials or stock.
Total value of the organisation
Which figure do you think will give the total value of a company?
The total value is found by adding together fixed and net current assets. The balance
sheets show that in Year 1 Naardia was worth $923,288 and in Year 2 it was worth
$934,926. So it would appear that the company is growing. You would need to compare
these figures with the rate of growth for other similar businesses to find out whether this
is a normal rate of growth for this type of business during this period.
Return on capital employed
Another way to judge a limited companys success is to look at whether the business is a
good investment. This, of course, is of prime importance to any shareholders or prospective
shareholders.
Anyone who invests in a business by buying shares is running a greater risk than a
person putting money into a bank or building society. If the company is not doing well,
return on investment will be low, or even non-existent. And so, to make the risk worthwhile,
the investor expects to be able to make more money when the company is doing well
than if the money were just gaining interest in a bank.
You can work out what percentage return a company is earning on the money invested in
it (its return on capital employed or ROCE) by using this formula:
Net profit before tax
Fixed assets + Current assets
Look back to Naardias financial statements, and work out the ROCE for investors in
Naardia Doorknobs Ltd for Years 1 and 2. (Note that you need to find total current assets
and not net current assets.)
The applied formula for Year 1 was:
132,139
1,047,748
and for Year 2:
146,638
1,107,426
Its easy to see that profits and capital employed (fixed assets and current assets) have
both increased in Year 2. But the rise in ROCE (from 12.6% to 13.2%) means that the
extra capital used in Year 2 has been well used to generate a higher proportion of profits.
Bear in mind that there is no agreed definition of capital employed. Some organisations
use the capital and reserves figure, and others use fixed assets and current assets less
current liabilities. You may find it helpful to discover how your organisation calculates
ROCE.
Financial statements are used by people within and outside the organisation to
assess the organisations financial strength.
You have now worked through these topics and should be able to:
explain the purpose of profit and loss accounts and balance sheets and how they
are constructed
prepare a simple profit and loss account and balance sheet
interpret your own organisations financial accounts
Complete the Self-test and read the Summary to review the work you have done. Note
any points you would like to raise with your manager.
x 100 = % ROCE =
x 100 = 13.2%
x 100 = 12.6%
ROCE =
ROCE =
Self-test M
1 Tick the financial statement where you would find the following information:
Balance sheet Profit and loss account
current assets
gross profit
current liabilities
net profit
fixed assets
retained profit
2 Explain the difference between these terms:
a gross profit and net profit
b fixed assets and current assets
c net profit and retained profit
3 Fill in the blanks in the following definitions with the appropriate word
chosen from the list below:
a The total sales figure is the organisations .
b The ratio of the profit before tax to the turnover is called the .
c A measure of how well equipped an organisation is to meet its
commitments as they fall due is called its .
d The ratio of current assets to current liabilities is called the .
liquidity / turnover / net profit margin / current ratio
Summary
Profit is the excess of revenue over costs.
Gross profit is the excess of sales over the cost of goods sold in the period.
Net profit = gross profit minus all the other costs involved in running the business.
A balance sheet is like a snapshot of the financial situation of a business at a particular
time. It shows the organisations assets and liabilities, which must always balance.
Assets are classified into fixed assets and current assets.
Current liabilities are debts which the organisation has to pay back within a year.
The profit and loss account shows:
sales minus cost of sales = gross profit
gross profit minus indirect expenses = net profit
Financial statements are used by people within and outside the organisation to assess
the organisations financial strength.
Interpreting profit and loss
The uses of a profit and loss
account
As an example we will use a trading and profit and loss account for Morris Cloth
which looks like this:
Morris Cloth
Trading and profit and loss account
for the 3 months ending 31 March
$ $
Sales 1,920
Less cost of sales:
Purchases 1,400
Less closing stock 440
960
Gross profit 960
Less expenses:
Advertising 60
Telephone 50
Market stall 75
Miscellaneous 15
Depreciation of vehicle 75
275
Net profit 685
List the uses that you think this document might have for Morris Cloth or any other interested
parties.
ACTIVITY 5.7
Limitations of a profit and loss
account
It may have occurred to you when you were thinking about your answer to the previous
activity that a profit and loss account, although of considerable interest, may be limited in
what it reveals.
Here are some of the limitations which may have occurred to you:
Morris Cloths profit and loss account for January to March is concerned with the
past. It is a historical document. By the time it is prepared things may have improved
or deteriorated.
To some extent the profit and loss account is an estimate. You may be surprised by
this statement, but consider this. The amount entered for depreciation of the vehicle
is based on an estimate of the vehicles useful life; the amount entered for the
telephone bill may only include charges to the end of February and standing charges
for the period March to May. Even if the accountant has adjusted for this and included
only those costs which relate to the period January to March, he or she may be
guessing to a certain extent.
The account is for a limited period of time and should not be taken as typical of the
whole year. The management of Morris Cloth may be concerned by their results for
the three months, but it could be that the first quarter of the year is recognised by the
trade as a lean period.
Although the profit and loss account reveals how much profit (both gross and net)
has been made in monetary terms, it says nothing about whether the amount is high
or low (without further investigation) compared with:
the amount of money invested in the business
the budgeted level of profit
the amount required to support the necessary cash flow
others in the same line of trade
previous periods of trading
Can you think of any other limitations?
Interpreting a profit and loss
account
Fortunately something can be done about this. In this and the following pages you will
learn about some of the other financial documents and techniques which are used by
accountants to assess financial performance. Here the concern is only with the profit and
loss account and we are going to apply percentages to Morris Cloths figures for the
January to March profit and loss account. Before doing this, look at a simple example:
Jack buys a radio for $20 and sells it for $40. What percentage profit has he made?
To find out the answer, it is necessary to look more closely at the data.
Sales price $40
Cost of sales $20
Profit $20
Should you take the $20 profit as a percentage of the $40 sales price or the $20
cost of sales? Accountants usually do this:
Sales price $40 = 100%
Cost of sales $20 = 50%
Profit $20 = 50%
In other words, they treat the selling price as being 100 per cent and they then express
the costs and the profit as a percentage of that. Thus, they would say that Jack had made
a 50 per cent profit margin. On the other hand, Jack might say that he had bought the
radio for $20 and added 100 per cent on to the purchase price for profit. Accountants
usually refer to this adding on to the purchase price as mark-up.
So one answer to the question is that Jack made a profit of $20 which represented a
profit margin on his selling price of 50 per cent. To achieve this required a mark-up on his
purchase price of 100 per cent.
In view of the possible misunderstanding which can arise, you should always make it
clear what you mean when talking about percentages. Accountants who advise their
clients to aim for a percentage profit of 50 per cent could be misunderstood. If they
mean, as they probably do, 50 per cent of the selling price, but the clients think they
mean add 50 per cent to the purchase price, the clients may under-price their sales with
disastrous consequences. For example, Jack might have sold his radio for only $30.
What percentage profit would Jack make if he had sold his radio for only $30? The profit
margin would be 33.3 per cent, $10 as a percentage of $30. Now that we are clear about
percentages, we can add percentages to Morris Cloths profit and loss account.
Questions which might be asked regarding these percentages include the following:
Is the net profit margin of 36 per cent adequate?
How does it compare with our budget?
Is it better or worse than for others in the same line of trade?
Should we aim to improve it?
How can we do this?
Should we try to reduce expenses which are 14 per cent of sales?
Is the gross profit percentage of 50 per cent adequate?
How does it compare with the budget?
Is it better or worse than for others in the same line of trade?
If it is worse, are we buying our goods at the best price obtainable or should we
increase the selling price?
The important thing to note is that by themselves percentages say little, but they can
start a line of enquiry which may reveal past weaknesses and suggest future remedial
action.
Calculate Morris Cloths costs and profit percentages (expressed as a percentage of sales
and rounded to the nearest whole number) and enter them in the following table:
Morris Cloth
Trading and profit and loss account for the 3 months ending 31 March
$ $ %
Sales 1,920 100
Less cost of sales:
Purchases 1,400
960
Gross profit 960
Less expenses:
Advertising 60
Telephone 50
Market stall 75
Miscellaneous 15
275
Net profit 685
ACTIVITY 5.8
The profit and loss account in your
own organisation
Now that you have seen how the profit and loss account is prepared and how it can be
interpreted for Morris Cloth, you can apply the same principles to your own organisation.
Find out if a profit and loss account is prepared for your own organisation and if so:
Who prepares it?
How often is it prepared?
When was the last one prepared?
Who has access to it?
Is it prepared for private use (for example, for the owners only) or is it available for all
managers?
Is it used or simply filed away?
If it is used, who uses it? What benefits do they gain from it?
Is it a very detailed account? If so, who has access to the details and why is access
restricted?
Is a summarised version of the profit and loss account available to all employees?
For the next activity, you will need a copy of your organisations most recent profit and
loss account. If your organisation does not produce a profit and loss account, or if you
are unable to obtain a copy, find out if you can get one from another organisation. You will
find that major companies advertise their annual results in the financial press and you
can send for a copy of their annual report and accounts.
Look carefully at the items on the account, particularly at the various levels of profit (gross
or trading or operating profit, net profit before and after tax, dividends, etc.). There may be
some items and terms with which you are not yet familiar, but do not worry about this. Look
for the items that you can understand at this stage and ask the kinds of questions you asked
about Morris Cloth. In particular:
1 Work out percentages for major levels of profit (gross and net).
2 Look for trends, such as how this years figures compare with last years.
3 Ask whether the figures produced resulted in any kind of action; for example, did they
affect pricing policy or did they trigger some kind of investigation into costs?
ACTIVITY 5.9
Constructing a balance sheet
What is financial position?
You have been looking at profit and loss accounts which measure financial performance
over a period of time. In the case of Morris Cloth, this period was the first three months of
trading, ending 31 March. We are now going to look at the document called the balance
sheet which measures the financial position of an organisation at one particular moment
in time; in other words, what the organisation owns and what the organisation owes
at a particular date.
We will use the Morris Cloth example to illustrate the balance sheet and we will review
the information so far. The owners of Morris Cloth formed their business a short while
before the start of their first trading period. They decided to use some of their personal
savings to form a business selling cloth on a market stall. They knew they would need a
vehicle and found one costing $1,300. They decided not to put any more of their own
money into the business unless absolutely necessary.
Let us assume that on 28 December, before they started trading in January, they opened
a business account at their bank with $1,300 from their personal accounts. On 30
December, they paid for the vehicle, making out a cheque for $1,300 drawn on their
business account.
They decided to trade as Morris Cloth. The important thing to note here is that we should
treat the owners of Morris Cloth and the business of Morris Cloth as completely separate
entities. Previously, we have in fact been looking at the business and profit and loss
account of the owners themselves. This separation of the owners and their business is
particularly important when we look at balance sheets. The balance sheet shows us the
financial position of the business and not of the owners.
You will now create the first balance sheet of Morris Cloth as at midnight on 28 December,
after the owners have paid $1,300 into the business bank account. This balance sheet is
a financial snapshot of the business at that date. It will show all the resources the business
owns, such as land, premises, stock, cars, cash, etc. These are known as assets. It will
also show the money that the owners have invested in the business to finance it. This is
known as capital. The business may also obtain assets by borrowing funds from someone
else. The sources of these funds (that is, to whom the business owes money) are known
as liabilities. These are also shown on the balance sheet. The only asset that is owned
by the business on this date is the cash in the business account. It is financed by the
capital of $1,300 that the owners have invested in the business to start it up.
The completed balance sheet is as follows:
Morris Cloth
Assets: Cash at bank $1,300
Financed by: Capital $1,300
The accounting equation
This balance sheet illustrates what is known as the accounting equation, which can be
stated simply as:
Capital = Assets Other liabilities
Note that the date at which the balance sheet is drawn at is given at the top of the
statement. Assets are shown at the top of the balance sheet and liabilities at the bottom.
This has not always been the case: assets and liabilities used to be shown side by side in
a horizontal format. In theory a balance sheet can be prepared at any moment in time.
So we will move forward to 31 December (the day after Morris Cloth bought and paid for
the vehicle) and prepare the balance sheet of Morris Cloth as at that date.
The completed balance sheet is as follows:
Morris Cloth
Assets: Vehicle $1,300
Financed by: Capital $1,300
You will note that the asset of cash has been completely replaced by the vehicle, because
all the cash has gone on buying the vehicle.
Now we will move on to 3 January and we find that Morris Cloth has started trading by
buying 60 metres of cloth at $2 each on credit. You may remember that their supplier
allows them one months credit. Also remember that the organisation has $1,300 worth
of net assets that have been financed by the capital that the owners invested in the
business. Now complete Activity 5.10 using the information you already have.
Morris Cloth
Balance sheet as at 3 January
$
Assets:
Vehicle 1,300
Stock of cloth
Liabilities:
Trade creditors
Total net assets
Financed by:
Capital
It is traditional to sort assets into long-term and short-term and list them separately.
Long-term assets (for example buildings, plant and machinery, furniture and motor
vehicles), which facilitate manufacture or trade, are usually called fixed assets. Short-
term assets (for example stock, debtors and cash), which are part of the manufacturing
and trading cycle, are usually called current assets.
Similarly, liabilities are also separated into long-term and short-term. Short-term liabilities
include creditors, overdrafts and other debts which must be repaid within one year. Short-
term liabilities are called creditors: amounts due within one year, which is more specific
although rather long-winded. Long-term liabilities include items such as bank loans or
mortgages which are repaid over a longer period of time. In order to conform with these
conventions, we can redraft the last balance sheet.
Morris Cloth
$
Fixed assets:
Vehicle 1,300
Current assets:
Stock 120
Creditors: amounts due within one year
Trade creditors (120)
Total net assets 1,300
Financed by:
Capital 1,300
ACTIVITY 5.10
Enter the missing figures in the new balance sheet. Note that any profit Morris Cloth has
made is added to the capital as a source of finance to the business. At this early stage in
trading, ignore the fact that, strictly speaking, a proportion of expenses should be deducted
from the profit.
Morris Cloth
Fixed assets: $ $ $
Vehicle 1,300
Current assets:
Stock
Debtors
Cash in bank
Trade creditors
Working capital
Total net assets
Financed by:
Capital
Profit
Morris Cloths gross trading profit is:
Sales 120
Less cost of sales:
30 metres of cloth @ $2 60
Profit 60
The remaining stock is 60 less 30 sold = 30 metres of cloth @ $2 = $60.
The businesss debtors are the credit sales customers who now owe them for 20 metres of
cloth @ $4 = $80.
Now we will move on to 6 January and we find that Morris Cloth has sold some of its
stock.
Cash sales: 10 metres of cloth at $4 each = $40
Credit sales: 20 metres of cloth at $4 each = $80
ACTIVITY 5.11
Constructing a simple balance
sheet
We could continue to construct a whole series of balance sheets covering Morris Cloths
business on a day-to-day basis throughout January, February and March, but this would
be somewhat tedious. So we will move on to the end of March, and construct the balance
sheet for Morris Cloth as at 31 March. To do so we shall have to refer back to where we
prepared Morris Cloths profit and loss account.
Use the following information to complete the balance sheet in Activity 5.12.
The vehicle has depreciated by $75 over the three months.
Morris Cloths closing stock (at 31 March) was 220 metres of cloth @ $2 each =
$440.
The businesss credit sales customers had bought $1,500 worth of goods from them,
but had only paid $360 in respect of their January purchases. At the end of March
they still owed the business for their February and March purchases, because Morris
Cloth allows them two months credit.
Morris Cloths actual cash balance at the end of March was negative: an overdraft of
$220. Their net profit after allowing for depreciation of the vehicle was $685.
The business is owed $1,140 by people who have purchased goods but not paid for
them: such people are known as debtors.
ACTIVITY 5.12
Morris Cloth
$ $ $
Fixed assets:
Vehicle
Less depreciation
Current assets:
Stock
Debtors
Trade creditors
Bank overdraft
Working capital
Total net assets
Financed by:
Capital
Profit
Analysing a balance sheet
The uses of a balance sheet
As you saw in the previous pages, a balance sheet is a snapshot of the business at one
particular point in time. If you are to appreciate the possible users and uses of a balance
sheet, you must be familiar with its information content.
Here are some important facts about the balance sheet:
A balance sheet always states the date on which it is drawn up. It is essential that the
user of the balance sheet knows at what point in time the financial snapshot has
been taken.
The figure for stock shown on the balance sheet is the closing stock; that is, the
stock remaining at the balance sheet date.
Creditors shown on the balance sheet are people to whom money is owed and who
are therefore liabilities.
A bank overdraft is shown as a liability.
Capital is the amount invested in the business by the owner and appears at the
bottom of the balance sheet as financing the business.
Profit appears as part of capital. Any profit earned by the business belongs to the
owner. If the business has not paid it to the owner, then it still owes it.
The owner of the business needs to see the balance sheet to find out the financial position
of the business, its assets and its liabilities. But other people are also interested, such as
lenders of money.
1 Do you agree or disagree with the following statements?
a Only the figure for cash shown on the balance sheet is of use to lenders.
b All the information on the balance sheet is of use to lenders.
c Only the fixed assets information on the balance sheet is of use to lenders.
d Different lenders find some items of information more useful than others.
e Lenders are only interested in seeing whether there is a bank overdraft on the
balance sheet.
2 Explain the use of your organisations balance sheet to the following users:
a you, as a manager
b customers
c employees in general
ACTIVITY 5.13
Here are some of the assets of five different organisations engaged in five different kinds of
activity. They are relatively small organisations in their particular fields. All figures are $000.
Organisation A B C D E
Fixed assets:
Buildings 300 300 200 900 400
Plant and machinery 700 50 100 10 900
Office equipment 50 100 50 50 100
Vehicles 40 100 800 20 100
Current assets:
Stock 100 300 50 100 700
Debtors 300 5 5 200 500
The organisations represented above are:
a general engineering company
a motor car manufacturer
a bus company
a food store
a hotel
Match the activities against the organisations above. The kind of clue to look for is that
you might expect a bus company to have a heavy investment in vehicles compared with
office equipment, for example. Also cash businesses will have few or no debtors.
Organisation
A
B
C
D
E
ACTIVITY 5.14
Balance sheets in different
organisations
The balance sheets of organisations in different kinds of trade or industry vary widely in
the composition of their assets and liabilities. Of course, some organisations balance
sheets are not typical, but usually they do reflect the type of activity in which the
organisation is engaged. It is easy to understand that a shop will have quite a high stock
figure but a very low figure for debtors since most transactions are for cash. People
businesses, such as advertising and publishing, normally have very low figures for plant
and machinery, whereas this is much higher in manufacturing organisations.
Obtain copies of the balance sheets of three different kinds of organisation. If you own
shares, these will be readily available. You may be able to obtain them from a library and
sometimes they appear in newspapers or you can telephone or send off for them direct
from the company. Some companies now make a small charge for copies if you are not
a shareholder.
Find a balance sheet which may be headed group, rather than company. Group means
a consolidation of all the companies in the group, whereas Company means the balance
sheet of the holding company which holds the shares of the various subsidiary companies
in the group.
On a separate sheet draw up a list of the assets of the three companies in three columns
(as shown above for the previous activity). Compare the relative sizes of the assets and
try to put in writing the most significant differences; for example, Company XYZ has the
highest relative investment in plant and machinery because the industry is machine-
rather than labour-intensive.
The limitations of a balance sheet
A balance sheet can tell us many things, but there are limitations. As we have seen, a
balance sheet lists the assets and liabilities of an organisation at one moment in time, but
does it list all the assets and liabilities? An organisation will have many things that are
valuable and help the business but which cannot be valued in monetary terms, for
example, the enthusiasm of members of staff.
Which other valuable items are there in your organisation which may not be included in
a balance sheet? Your list may include the following:
goodwill which the organisation has built up with customers
expertise in manufacturing or trading
technical experience and development
skills and loyalty of staff
For example, if you consider a successful public relations company, its strengths are its
reputation in the industry, the standing it has with its clients and the flair and
professionalism of its employees.
Below is the balance sheet for Morris Cloth, as at 31 March.
Morris Cloth
$ $ $
Fixed assets:
Vehicle 1,300
Less depreciation (75)
1,225
Current assets:
Stock 440
Debtors 1,140
1,580
Creditors: amounts due within one year:
Trade creditors 600
Bank overdraft 220
(820)
Working capital: 760
Total net assets: 1,985
Financed by:
Capital 1,300
Profit 685
1,985
Consider whether any of the following figures show what the vehicle is worth at that date:
$1,300? $75? $1,225?
The problem is more difficult than it first appears to be. The figure of $1,300 is what the
vehicle originally cost and the figure of $75 is the amount of depreciation charged.
However, the balance remaining of $1,225 is not necessarily the value of the vehicle; it is
the result of deducting $75 from $1,300. What the van is worth depends on its condition
and market forces. If it is in excellent condition and there is high inflation, Morris Cloth
may even be able to sell it for more than they paid for it. However, if the van is in poor
condition and there is low demand, the amount it can be sold for may be a lot less than
$1,225. The figure for the vehicle in the balance sheet therefore does not tell us its value.
There are a number of items like this in a balance sheet. When we look at the amounts
for cash and debtors, we can be reasonably confident that these are actual amounts. We
may wish to be cautious about our debtors, however, in case they go out of business. But
with fixed assets we cannot be certain and the safest guide is to accept that a balance
sheet does not tell us the value of the organisation.
The final important limitation of a balance sheet is that it tells us about the financial
position on one particular date. This may not be typical of all the other days in the period
and therefore may not be a good basis for predicting the future. For example, on that
date the company may have a healthy cash balance, but may purchase a very expensive
fixed asset the next day. If you are the lender who is considering a loan of $0.5m to the
organisation for three years, you will be very aware of the limitation of the balance sheet.
Although these limitations are very important, they do not mean that the balance sheet is
of no use. However, you should bear them in mind when you use a balance sheet to
measure an organisations performance.
The balance sheet in your own
organisation
If you are able to obtain the balance sheet for your own organisation, you can use the
knowledge gained here to analyse it. If you are not able to obtain a balance sheet for
your own organisation, you can try to draw up your own. List all the items the organisation
owns at the top of the balance sheet and all the items it owes underneath. You will not
know the exact amounts, but you can make estimates to show which are the most
important items.
Extract from your organisations balance sheet, or the one you have drawn up, the amounts
for fixed assets and current assets. Compare them with the figures given for the five
hypothetical organisations earlier in this section, and then attempt the next activity.
Which of the five organisations do the fixed and current assets of your own organisation
most closely resemble and least resemble?
Most resemble
Least resemble
ACTIVITY 5.15
You should have found that the balance between fixed and current assets in your own
organisation reflects the type of industry you are in. If you found that some of the figures
are not what you expected, try to find out why.
One point made here is that a balance sheet does not include everything. The items
which are omitted include any goodwill the organisation has and the skills and talents of
the workforce. In many organisations, these items are extremely important. If you list all
the items which are of benefit to your organisation but which are not shown on the balance
sheet, it will probably be very long, and headed by the employees.
You may have included abstract information such as the firms reputation or a good
trading position. These are very important, but extremely difficult to value. You might
reflect on how successful your own organisation would be if it did not enjoy the benefits
of these items, even if they are not shown on the balance sheet.
The combined financial picture
The profit and loss account and
cash flow
For this topic, you are going to prepare all three documents for Morris Cloth for the six-
month period January to June. This will include the first three months of trading which we
have already looked at. This will not only help you to revise the ground covered so far,
but also allow you to gain an overall picture of the interrelationship of all three
documents. The following table shows the facts relating to the actual transactions of
Morris Cloth during the first six months of trading. Currency units are not shown because
of space.
Jan Feb Mar Apr May Jun Total
Cash sales 120 140 160 200 240 280 1,140
Credit sales 360 560 580 600 680 760 3,540
Purchases 400 400 600 400 400 400 2,600
Advertising 20 20 20 40 40 40 180
Telephone 50 80 130
Market stall 25 25 25 25 25 25 150
Miscellaneous 5 5 5 15 15 15 60
Depreciation 25 25 25 25 25 25 150
of vehicle
Morris Cloths supplier allows them one months credit. The sales from the market stall
represent 25 per cent of total sales and the customers pay cash. The remaining 75 per
cent of sales through mail order give customers two months credit. Telephone costs are
payable at the end of each quarter. The hire of the market stall is payable at the end of
each month. Miscellaneous expenses are payable in the month in which they occur.
Complete the following cash-flow forecast for Morris Cloth for the period January to June,
using the information on the previous page.
Morris Cloth
Cash-flow forecast January to June
Cash in:
Cash sales 120 140 160
Credit sales 0 0 360
Subtotal 120 140 520
Cash out:
Purchases 0 400 400
Advertising 20 20 20
Telephone 0 0 50
Market stall 25 25 25
Miscellaneous 5 5 5
Subtotal 50 450 500
Opening balance 0 70 (240)
Net cash flow 70 (310) 20
Closing balance 70 (240) (220)
ACTIVITY 5.16
1 You should now be able to complete the following trading and profit and loss account.
Morris Cloth
Trading and profit and loss account for the six months ending 30 June
$ $ $
Sales:
Cash sales
Credit sales
Less cost of sales:
Opening stock
Add purchases
Less closing stock
Gross (trading) profit
Less expenses:
Advertising
Telephone
Market stall
Miscellaneous
Depreciation of vehicle
Net profit
Before going on to the next stage, we are going to conduct a reconciliation between the
closing cash figure of $520 shown on the cash-flow forecast and the net profit of $1,670.
2 Show the reasons for the difference of $520 on the cash flow forecast and the figure of
$1,670 on the trading and profit and loss account for Morris Cloth for the six-month
period ending 30 June.
ACTIVITY 5.17
Complete the following balance sheet:
Morris Cloth
Balance sheet as at 30 June
$ $ $
Fixed assets:
Vehicle 1,300
Less depreciation
Current assets:
Stock
Debtors
Cash at bank
Trade creditors
Working capital
Total net assets
Financed by:
Capital 1,300
Profit
ACTIVITY 5.18
Bringing in the balance sheet
Now that we have the three completed documents, we can consider a what if question.
What would the position be if, from the start, Morris Cloth had only allowed their customers
one months credit instead of two?
Think about the effect on:
the cash-flow forecast
the profit and loss account
the balance sheet
The cash-flow forecast
Under cash in (credit sales), all the entries would move one month to the left. In June,
Mays credit sales of $680 would have been received, and the total cash in would also
have increased by $680. Hence the closing balance, which at present is $520, would
have increased by $680 to $1,200. If Morris Cloth had an overdraft it would have been
reduced by collecting in the cash more quickly.
The profit and loss account
This account would not have been affected at all. Strictly speaking, a higher balance at
the bank would have meant that interest could have been earned (or less interest paid
on an overdraft), which would have increased profits, but this complication can be ignored
at this stage. Remember that with the profit and loss account, the credit sales are included
in full, even if the cash has not been received.
Balance sheet
Debtors would have decreased by $680, but cash at the bank would have increased by
the same amount. Thus the current asset section of the balance sheet would have read:
$
Stock 260
Debtors 760
Cash at bank 1,200
2,200
The total of current assets is unchanged, but the composition of the current assets is
now more liquid. The change is quite dramatic.
Features of main financial
statements
So far you have looked at three important financial statements. You may find it helpful to
summarise their most important features.
Cash-flow forecast
This document, unlike the profit and loss account, concentrates on cash flows. The
document is usually prepared on a month-by-month or week-by-week basis, so that the
balance of cash in hand or overdrawn can be immediately identified. Cash budgets are
cash-flow forecasts for future planning. Preparing them identifies future troublespots,
enabling corrective action to be taken well in advance of problems. In addition, actual
(historical) cash-flow forecasts can be periodically compared with them, and variances
analysed so that the cash budget can be revised and updated.
Profit and loss account
This document measures financial performance over a defined period of time. Details of
gross and net profits are revealed, together with itemised expenses. Past performance
can be scrutinised, thus enabling corrective action to be taken and plans for improved
profit to be made.
Balance sheet
This document summarises the financial position of an organisation at one moment in
time. It is a financial snapshot which brings into focus the state of health of its subject.
Measuring financial performance
What is financial performance?
Imagine a business has just been set up and the management want to know how it is
doing. This is a list of questions you might ask a manager after their first six months in
business to find out if he or she thinks the business is a financial success.
Did you consider that your cash balance was satisfactory at the end of the first six
months?
Did you actually achieve what you hoped to achieve?
How much profit did you hope to achieve for the first six months?
How much profit did you actually make?
Were your planned and achieved cash surplus and profit adequate, considering the
money, time and effort you put into the business?
Were your achievements typical for your line of business?
Would you have been better off using your money, time and effort in some other
enterprise?
Have you built up a business which in itself is worth something, either in respect of
the assets it has acquired (cash, stock, etc.) or in potential?
This is a formidable list of questions and you may think that answering some of them will
be very difficult. However, preparing a financial statement, known as a profit and loss
account, can help managers to provide answers to these questions and measure financial
performance in an organisation.
The principles of a trading and
profit and loss account
It is important to remember the principle that profit is not cash. In other words, the figures
for sales and costs do not take into account whether the purchaser of an item has paid
for it, or whether the business has yet paid for expenses such as advertising. In a profit
and loss account we are concerned with matching sales with the cost of those sales.
Managers in trading organisations are interested not only in a single figure of profit but
also in more detailed information. It is therefore normal to show the profit the company
makes on buying and selling goods separately, that is, in trading. This is referred to as
the gross profit because not all the expenses of the business have been met. From the
gross profit are deducted all the other expenses of the business to arrive at a figure of
net profit. All of this information is shown on one account known as the trading and
profit and loss account.
We will now study the two sections of the trading and profit and loss account separately
and then combine them into the full account. Again, we are using the example of Morris
Cloth, a small business which buys cloth and then sells it from a market stall. Imagine
that the business buys some of its most popular cloth for $2 a metre and then sells it for
$4 a metre. In order to work out whether this business has made a profit for its first three
months since it started trading in January, it is necessary to forget the split of the figures
between the individual months since, for this activity, what is interesting is when the
transactions occurred rather than the timing of the cash movements.
It will help to look more closely at the sales and purchases of Morris Cloth for the first
three months:
Cash sales: 105 metres of cloth at $4 = $420
Credit sales: 375 metres of cloth at $4 = $1,500
Purchases: 700 metres of cloth at $2 = $1,400
In order to work out the closing stock, accountants would have used the following layout.
You will find this layout useful later on.
Opening stock at 1 January 0
Add purchases during the three months 700
Total available for sale 700
Less actual sold during the three months
Cash sales 105
Credit sales 375
480
Closing stock at 31 March 220 metres of cloth
Using the figures on the previous page, complete the following account for Morris Cloth. You
will see that it is entitled trading account and it ends with the words trading or gross profit.
The reason for this is that this account is the trading portion of the profit and loss account.
You will finish the profit and loss account soon by deducting other expenses from the trading
profit.
Morris Cloth
Trading account for the three months ending 31 March
Sales:
Cash sales metres of cloth at $ each =
Credit sales metres of cloth at $ each =
Total sales metres of cloth at $ each =
Less cost of sales:
Opening stock metres of cloth at $ each =
Add purchases metres of cloth at $ each =
Total available for sale metres of cloth at $ each =
Less closing stock metres of cloth at $ each =
Total cost of sales =
Trading or gross profit for the three months =
ACTIVITY 5.19
This trading account shows a trading or gross profit of $960 for the three months. Gross
simply means before something else is deducted. In this case, the something is the
other expenses that Morris Cloth have incurred in running the business during the same
three months. Note that under less cost of sales we are calculating how much the cloth
which has been sold cost the business. Sometimes this is called cost of goods sold.
As an example, the remainder of Morris Cloths profit and loss account might look
like this:
Sales $1,920
Less cost of sales:
Purchases $1,400
Less closing stock $440
$960
Gross profit $960
Less expenses:
Advertising $60
Telephone $50
Market stall $75
Miscellaneous $15
$200
Net profit $760
Note that the trading portion has been simplified. The degree of simplification depends
on what detail the managers and their accountant, if they have one, consider appropriate.
However, you would not show the actual quantities even in a small company. Obviously
in a large company, such as a national supermarket chain, it would be impossible.
Sometimes only the phrase cost of sales and the amount (in this case $960) would be
shown.
The profit and loss account and
cash flow compared
Imagine that Morris Cloths actual cash flow for the three months shows that their closing
balance of cash at the end of March was a negative balance of $220. If all their money
were banked, this negative balance would be an overdraft. How is it that Morris Cloth
made a net profit of $760 and yet the business is overdrawn by $220? There is an
apparent discrepancy of $760 plus $220 ($980).
The items that have caused the apparent discrepancy are the credit allowances that
the business allows its customers, compared to the amount of credit it is allowed by its
various suppliers.
Imagine Morris Cloth has allowed two months credit to their credit customers. Their
credit sales for the three months were $360 for the first month, $560 for the second and
$580 for the third. This makes $1,500, but they have only been paid for the first of these
three months ($360). So they are still owed $560 plus $580 ($1,140) at the end of March.
On the other hand, imagine Morris Cloth has taken one months credit from their suppliers.
At the end of March they owe their suppliers for their purchases for the month of March
which amounted to $600. (They paid for Januarys purchases in February and Februarys
in March.) They took no credit for expenses for advertising, telephone, market stall or
miscellaneous expenses, so there is now no discrepancy between profit and cash.
At 31 March, Morris Cloth has $440 worth of cloth in stock. These 220 metres of cloth
cost the business $2 each and this is how they have been valued in the profit and loss
account. (Whether they have been paid for or not is a separate issue.)
These items can be summarised as follows. They are listed under the headings of
Pluses and Minuses in order to make the position clear.
Minuses:
they are owed by customers $1,140
they had unsold stock which cost $440
$1,580
Pluses:
credit from suppliers $600
$980
Having deducted the Plus items from the Minus items, this leaves $980. This explains
the apparent discrepancy between Morris Cloths net profit of $760 and the actual overdraft
at 31 March of $220. Later on you will learn about the terms often used for some of the
items above; in the meantime you need to appreciate that profit is not the same as cash
and how profit and cash flow can be reconciled.
There are many important lessons, which might be used to run a business more efficiently,
that can be learnt from the principle that profit is not the same as cash.
Here are some examples:
Giving credit to customers may have the advantage of increasing sales (and,
potentially, profit) but results in a delay before the sales value is realised in the cash
flow. In extreme cases this means that an organisation can make a good profit, but
at the same time fail because of lack of cash.
Building up stock to an unnecessarily high level can have an adverse effect on cash
flow. Buyers who take advantage of bargains such as special discounts often forget
this, perhaps because they consider that cash flow is the concern of the accountant
and not of the organisation as a whole.
Taking credit from suppliers is one way of improving cash flow; after all, it is a form of
free finance. However, if an organisation takes more than its agreed credit, it runs
the danger of gaining a bad reputation. This may lead to difficulty in obtaining credit
in future, and even to the discontinuation of supplies.
Depreciation in the profit and loss
account
There is one more expense which must be considered. This is known as depreciation.
Morris Cloth owns a small vehicle which was bought by the business for $1,300 just
before they started trading in January. They use it to carry their stock to the market stall
and to make deliveries to their credit customers. The garage has told them that the
vehicle has about four years of useful life left, as it was not bought new. After this, they
will probably be able to sell it for scrap and get about $100.
The managers of Morris Cloth might wish to calculate how much depreciation on the
vehicle it would be reasonable to charge against their profits for the first three months of
trading. There are several ways they could calculate a figure, but here is a fairly simple
method which is in common practice. This method is known as the straight-line method
of depreciation which means that the cost is apportioned evenly over the useful life of
the asset.
1 Deduct the estimated scrap value from the cost:
$1,300 less $100 = $1,200
2 Divide the result by the expected life of the asset:
$1,200 divided by 4 years = $300 per annum
3 If you want the depreciation for part of a year, take the appropriate proportion
of the depreciation rate:
$300 x (3 out of 12 months) = $75
So you should deduct a further $75 as an expense from Morris Cloths gross profit
as follows:
Gross profit $960
Less expenses:
Advertising $60
Telephone $50
Market stall $75
Miscellaneous $15
Depreciation of vehicle $75
$275
Net profit $685
If you were asked for a brief description of what depreciation means, how would you define
it? Write down your answer here in the context of the $300 annual rate of depreciation for
Morris Cloths vehicle.
Remember that depreciation is not a cash flow. The cash flow occurred in December
when Morris Cloth bought and paid for the vehicle. That was why they started off with a
zero cash balance at the beginning of January. If you want to reconcile Morris Cloths
new (reduced) profit with their cash now, you will now have to include the $75 depreciation
in the reconciliation.
ACTIVITY 5.20
Profit and cash in an organisations
life
You will now appreciate that profit and cash are not one and the same thing. It is possible
for an organisation to make a very large profit and yet become bankrupt for lack of cash.
A new organisation needs cash to establish itself. It needs to buy long-term assets such
as buildings, furniture, equipment, machinery and motor vehicles. It needs to buy short-
term assets, such as raw materials, which it may then process in order to produce
goods for sale. When it sells the finished goods and thereby starts making a profit, it may
sell them all on credit.
All this expenditure on both long- and short-term assets means that a lot of cash has
been flowing out of the business and nothing has been coming in. Thus, in the early
years of its life, an organisation needs cash resources to cover these cash outflows.
Presumably the managers of Morris Cloth bought the vehicle from another source of,
maybe personal, income. By the end of February, they will also need to have arranged
an overdraft facility with the bank to cover the cash deficit of $220.
The good news is that eventually profit should turn itself into cash. Debtors (the customers
who have bought cloth from Morris Cloth on credit) will pay them cash, which will cover
their cost of sales, some of the expenses and any profit they may have made on the sale.
The bad news is that sometimes it is necessary to spend some of the profit on additional
assets, both long- and short-term, before the profit has had a chance to increase the
cash flow of the organisation.
Profit has the effect of strengthening the overall value of a business. However, this may
lie in an increase in the value of the businesss long- or short-term assets, or in a reduction
in its indebtedness to its trade creditors or to the bank if it has taken out loans. In spite of
the fact that Morris Cloth are overdrawn by $220, they were still able to make a profit,
during the first three months of trading, of $685.
Making adjustments
The measurement of business
income
Perhaps the most important piece of information about a business is whether or not it is
profitable. The profitability of a business is reported on its income statement for an
accounting period. The accounting period might be a month, a quarter or a year. All
businesses will produce an annual report, some may report more frequently.
The income statement shows the net income of the business for a specified accounting
period. This is calculated by taking total revenues and deducting total expenses for the
period. A business cannot simply take the balance from relevant revenue and expense
accounts because these will not necessarily be an accurate reflection of the net income
of the period. The accounts record all transactions that have occurred during the
accounting period. Some entries may not be relevant to the current accounting period,
but instead affect earlier or later periods. In most cases, some adjusting entries need to
be made to the accounts.
The basis by which accountants measure business income is guided by GAAP, the
generally accepted accounting principles. Earlier, you looked at the basic accounting
concepts and principles. In measuring income some of these concepts and principles
are applied.
Accrual-based and cash-based
accounting
There are two ways in which a business can record business transactions. Using the
cash-based accounting system, transactions are only recorded when cash is actually
received or paid. Cash receipts will be recorded as revenues and cash payments as
expenses at the date on which they were received or paid. We return to Jenny Rodin, the
newly established tax accountant we met in Section 2.
Record the following transactions for Jenny Rodin using cash-based accounting. You only
need record items which are relevant to her current accounting period which is the month of
September. You should record the date of each transaction in the accounts as well as the
amount:
15 August, Jenny completed work for a customer to the value of $1,700. The customer
paid Jenny for the work on 4 September.
7 September, Jenny purchased office supplies for $700. The supplier allows one month
credit. Jenny pays all accounts on the last day of each month.
10 September, Jenny completed and was paid for work to the value of $350.
23 September, Jenny was paid by a customer for work to be done in October, to the
value of $1,400.
27 September, Jenny pays rent in advance for October, November and December.
The beginning balance on Jennys cash account is $19,250.
In accrual-based accounting, the impact of each business transaction is recorded as it
occurs, whether or not the cash has been received or paid. Revenue is recorded as earned
when the goods have been delivered or the work has been carried out.
ACTIVITY 5.21
Record Jennys transactions for September using an accrual-based system. (Tip: use a
separate account for revenues and expenses paid in advance.)
ACTIVITY 5.22
GAAP require that businesses record their activities using the accrual basis. In Section 2,
you saw that GAAP require accountants to use the revenue principle and the matching
principle when preparing the financial statements of a business.
The revenue principle requires that revenues are only recorded when they are earned.
Under the accruals basis, Jennys accounts only show $350 revenue for September
because that was the only revenue actually earned in the month.
The matching principle requires that a business identifies all expenses incurred in the
accounting period and matches them against revenues for the period. Jenny pays $3,000
rent in September. Under the cash basis, she charges the amount to a rent expense
account during the period. Under the accruals method, she charges the amount to a
prepaid expense account. The amount is actually carried forward to the next accounting
period because it is not relevant for September. The rent payment is for October, November
and December.
Where a business uses the accruals basis to prepare its accounts, adjusting entries may
need to be made to some accounts at the end of the accounting period. We will look at
these adjustments below. In practice, many small businesses use a cash accounting
basis to avoid having to make any adjustments to the accounts and maintain detailed
ledgers. As these businesses are not preparing financial reports for public use, it does
not matter that they choose to use the cash method to record their activities.
Adjusting the accounts
In some cases adjusting entries need to be made to the accounts at the end of an
accounting period before the financial statements can be prepared. Taking Jenny Rodin
as an example, her accounts show an expense of $700 in September for office supplies.
Though Jenny has purchased $700 worth of office supplies during September, she does
not use all these supplies in September. It would be too time-consuming and is unnecessary
to record the value of supplies used on a daily basis but Jenny does need to make an
adjustment at the month end. The adjustment made is the value of supplies used during
the month. Jenny uses $200 worth of office supplies in September. This is charged as an
expense. The balance of office supplies carried forward to the next month is $500.
The purpose of the adjusting entries is to allocate revenues and expenses to the correct
accounting period. They also correct the balances to be carried forward on asset and
liability accounts. Adjusting entries arise when cash is received or paid in advance (before
the revenue or expense has been earned or incurred), and when cash is received or
paid in arrears (after the revenue or expense has been earned or incurred). We can
divide the adjustments into five categories:
prepaid expenses
depreciation of plant assets
accrued expenses
accrued revenues
unearned revenues
We will now look at each category.
Prepaid expenses
Prepaid expenses are payments that have been made in advance. There are a variety of
payments that businesses and individuals make in advance. The most common are rent
and insurance. Landlords and insurance companies usually require that their tenants/
customers pay in advance. Businesses have other prepaid expenses, many of which
depend upon the type of business. You saw that Jenny Rodin had office supplies. Many
businesses will buy packaging supplies in advance. At the end of the accounting period,
an adjustment needs to be made to account for the amount of the expense used up
during the accounting period. In effect, the balance on the asset account is being split
between the expense for the period and the asset value to be carried forward to the next
period.
Example
Jenny purchased office supplies in September for $700. She actually used $200
worth of supplies during September, which leaves $500 worth of supplies to be
carried forward to October. The $200 is transferred to an office supplies expense
account, leaving the correct balance of $500 in the office supplies asset account.
Office supplies Office supplies expense
9/7 9/30 9/30
Accounts 700 Office 200 Office 200 Balance 200
payable supplies supplies
Balance 500 200 200
700 700
You are given the following information about rent for Jenny Rodin. Calculate the rent expense
for the month of October and the balance to be carried forward to November. Make entries
as appropriate in the accounts.
On 27 September Jenny paid rent in advance of $3,000 for October, November and
December.
Prepaid rent Rent expense
10/1 Balance 3,000
ACTIVITY 5.23
Depreciation of plant assets
Plant assets are any long-term tangible assets held for use in the business. These include
items such as land, buildings, machinery, vehicles, equipment, furniture and fixtures.
Depreciation is an expense charged to the account for the use of plant assets. It reflects
the decline in value of the asset over time. It is charged for all assets except land which
is not held to decline in value. If you think about office supplies, you will remember that an
expense was charged in the accounts as the asset of office supplies was used up.
Depreciation works in a similar manner, though plant assets are charged over a number
of accounting periods.
When Jenny started her business, she purchased office furniture costing $4,000. She
believes this furniture will be used in the business for four years. At the end of that time it
will have no value. Jenny is preparing her accounts for the year ended 31 December.
She needs to calculate her depreciation expense for the year.
The depreciation expense for the year will be $4,000 4 = $1,000. (This is using the
method called the straight-line method of depreciation.) It is recorded in the accounts as
follows:
Office furniture Office furniture
accumulated depreciation
1/1 cash 4,000 12/31
Depreciation
expense 1,000
Depreciation expense
12/31
Office
furniture
acc. dep. 1,000
We transfer the $1,000 depreciation to a depreciation expense account. Normally, when
we make a charge for using up an asset, we would credit the asset account with the
amount. In the case of depreciation on plant assets, we always charge an accumulated
depreciation account. This is done so that the original cost of the asset remains in the
accounts. It is important to know the original cost of the asset for tax purposes and for
when the asset is sold.
The accumulated depreciation account is really the other half of the plant asset account.
There is an accumulated depreciation account for each of the different types of plant
assets. The accounts would always be shown together in order to give full information
about the business asset. Only one depreciation expense account is required for
depreciation charged on all plant assets.
The value of the furniture as recorded in the account, less the total of accumulated
depreciation is the value shown on the balance sheet. This value is known as the book
value or net book value of the asset. The book value of Jennys office furniture at 31
December is $3,000.
Note
A business may continue to use a plant asset when it has been fully depreciated
but cannot charge further depreciation to the accounts. Total accumulated
depreciation can never exceed the original cost of the asset.
Accrued expenses
Some expenses are incurred before the business pays for them. These include expenses
such as salary, interest on notes payable, and utilities. Jenny Rodin employs an assistant
at $1,750 per month. She pays this salary on the first Monday of the month, for the
previous month. At the end of September when Jenny is preparing her monthly accounts,
she needs to make an adjustment for Septembers salary which will not be paid until
October.
$1,750 is debited to the salary expense account and credited to salary payable account.
Salary payable is carried forward to the next accounting period as a liability.
Accrued revenues
In the same way as they accrue expenses, businesses will accrue revenues. These are
revenues that are earned but have not been received in cash. They are generally revenues
relating to work that is partially complete. Any completed work will normally have already
been accounted for in the accounts receivable account.
Carry out a similar exercise to calculate and record the depreciation for Jennys office
equipment in respect of the year ended 31 December. Also calculate the book value of the
equipment at that date. The office equipment was introduced to the business on 1 January
at a cost of $7,500. Jenny believes it will last for five years and have no scrap value at the
end of that time.
Office equipment
Office equipment accumulated depreciation
1/1 cash 7,500
Depreciation expense
12/31
Office furniture
depreciation 1,000
Book value
ACTIVITY 5.24
Example
At the end of the year, Jenny is part way through some contracted work for a
client. She has completed the first stage of the work worth $2,400. She will not
be paid for the work until she has completed the contract. Her accounts do not
currently reflect the work done. Jenny will debit the accounts receivable account
and credit the revenue account to reflect the accrued revenue.
Unearned revenues
These occur where customers pay in advance for work to be done or goods to be
delivered. It cannot be included in revenue for an accounting period until the work is
completed or the goods delivered. (Note: part of the revenue may be allocated to the
period for work done or goods delivered in the period.)
On 23 September, Jenny received $1,400 from a client for work to be carried out in
October. Jenny recorded the receipt as unearned revenue. In fact, she was able to start
the work in September. Work done in September amounted to $250. Jenny will charge
this to the revenue account for the period and carry the balance forward to October.
Revenues Unearned revenues
9/10 Cash 350 9/30 Revenue 250 9/23 Cash 1,400
9/30 9/30 Balance 1,150
Unearned 1,400 1,400
Balance revenue 250
600 600
$1,150 is carried forward to October as a liability. (Note: it is a liability because until Jenny
carries out the work, she owes the money back to the customer.)
Summary of adjustments
After calculating the amount of the adjustment, account entries will be as follows:
Prepaid expenses debit an expense account and credit the appropriate prepaid
expense (asset) account.
Depreciation of plant assets debit depreciation expense account and credit the
accumulated depreciation account for the plant asset.
Accrued expenses debit the expense account and credit the appropriate payable
(liability) account.
Accrued revenues debit the appropriate receivable account (asset) and credit the
revenue account.
Unearned revenues debit the unearned revenue account (liability) and credit the
revenue account for any amounts actually earned during the period.
Note that every adjustment affects an expense or revenue account and an asset or
liability account.
The adjusted trial balance
A trial balance summarises all the accounts of a business at the end of the accounting
period. Accountants often extend the trial balance to show the adjustments made and
the new trial balance after adjustments. This provides a useful worksheet which summarises
all adjustments and adjusted account balances.
This is Jennys adjusted trial balance for the year ended 31 December.
The adjustments shown are as follows:
1 Depreciation on office furniture 2 Depreciation on office equipment
3 Accrued salary at the year end 4 Accrued revenues at the year end
5 Office supplies used before the year end
Trial balance Adjustments Adjusted
trial balance
Cash 12,190 12,190
Accounts receivable 2,700 [4] 2,400 5,100
Office supplies 700 [5] 400 300
Office furniture 4,000 4,000
Accumulated depreciation [1] 1,000 1,000
Office equipment 7,500 7,500
Accumulated depreciation [2] 1,500 1,500
Accounts payable 1,870 1.870
Salary payable [3] 1,750 1,750
Capital 35,000 35,000
Withdrawals 16,010 16,010
Revenue 43,780 [4] 2,400 46,180
Rent expense 12,000 12,000
Office supplies expense 3,400 [5] 400 3,800
Depreciation expense [1] 1,000 2,500
[2] 1,500
Salary expense 19,250 [3] 1,750 21,000
Utilities expense 2,900 2,900
Totals 80,650 80,650 7,050 7,050 87,300 87,300
You are given the trial balance and adjusted trial balance of Terence Stott, management
consultant, for the year ended 30 April. Calculate the differences between the two trial
balances and enter the adjustments in the appropriate columns. Explain below what each
adjustment is likely to be and number them as in the Jenny Rodin example.
Terence Stott
Trial balances for year ended 30 April
trial balance
Cash 12,780 12,780
Accounts receivable 12,330 12,330
Office supplies 2,080 1,600
Accumulated depreciation 11,700 12,000
Accumulated depreciation 16,380 16,800
Unearned revenue 1,800 1,380
Capital 50,000 50,000
Revenue 24,460 24,880
Office supplies expense 480
Depreciation expense 720
Salary expense 5,380 7,180
Totals 104,340 104,340 106,860 106,860
ACTIVITY 5.25
Self-test N
1 Which accounting principles are specifically applied when using accrual-based
accounting?
a the consistency principle and the disclosure principle
b the cost principle and the objectivity principle
c the revenue principle and the matching principle
d the revenue principle and the cost principle
e the cost principle and the matching principle
2 Which entries are correct for the following transactions recorded using the
accruals basis of accounting?
Rent $3,000 prepaid; unearned revenue received $4,000; office supplies bought
on credit $670.
a
Cash Unearned revenue Office supplies
4,000 3,000 4,000 670
Accounts payable Prepaid rent
670 3,000
b
Cash Revenue Office supplies
4,000 3,000 4,000 670
Accounts payable
3,000
c
Cash Revenue Unearned revenue
3,000 4,000 4,000
Prepaid rent Office supplies Accounts payable
3,000 670 670
d
Revenue Unearned revenue Office supplies
4,000 4,000 670
Rent expense Prepaid rent Accounts payable
3,000 3,000 670
e
Cash Unearned revenue Office supplies
3,000 4,000 670
Prepaid rent Accounts payable Revenue
3,000 670 4,000
3 Which of the following describes payments made now for items that will be
due in the future?
a accrued expenses
b depreciation
c accrued revenues
d prepaid expenses
e unearned revenues
4 Which of the following best defines accrued revenues?
a income from business activities received before work has been completed
b items paid before they are due
c income from business activities recorded before it is due
d payments due for items received on account
e income earned from business activities but not yet paid
5 Which of the following best describes how the adjustment would be made for
depreciation on factory machinery?
a debit depreciation expense; credit factory machinery
b debit depreciation expense account; credit accumulated depreciation
factory machinery
c debit accumulated depreciation factory machinery; credit depreciation
expense
d debit factory machinery; credit depreciation expense
e debit factory machinery; credit accumulated depreciation factory machinery
Tracking planned and actual
performance
Variances
The process of identifying the difference between planned and actual (budgeted)
performance is known as variance analysis. We touched on how variances are classified
and calculated when looking at the budgeting process: we now look at them in more
detail.
There are many questions to ask when looking at a variance between planned and
actual performance. These might include:
Is it a significant variance? Minor variances are possibly not worth investigating.
Is it an adverse variance? That is, is it one that detrimentally affects the organisation?
Is it recent? If the reported variance has been identified too long after the event, the
manager responsible will have lost valuable time in which corrective action might
have been taken.
Has it been reported to the right people those who are responsible for taking
corrective action?
Imagine you are responsible for buying a raw material necessary for the manufacture of
your factorys product. A significant adverse variance has been reported within your area
of responsibility. You may feel that, in this case, you will be blamed for the variance.
However, just because an adverse variance has occurred within your area of responsibility,
this does not necessarily mean that you are at fault. For example, the price of the raw
material may have risen significantly and quite unexpectedly, or there may be some
other factor to be taken into account. While you will no doubt be asked to account for
what has gone wrong, it will not necessarily be something for which you can be held
responsible.
Investigating variances
Variances highlight the differences between planned and actual results. But identifying a
variance neither establishes its cause nor indicates the corrective action that must be
taken. Although an adverse variance is located within a managers area of responsibility,
it may not actually be that managers fault.
For example, the space occupied by a department may be decided at board level, so if
there is an increased cost shown on this it may be outside the control of the manager
concerned with setting the budget.
Another example could be in the cost of direct materials. If these are higher than budget,
it could be due to excessive wastage because poor-quality material has been used. This
may be the responsibility of the purchasing manager, but the adverse variance will appear
on the budget of the production manager. In other cases, the cause of the variance may
not be immediately obvious and work will need to be done to establish how it occurred.
However, such analysis can take time and therefore cost money. First it must be
established whether the variance is worth investigating.
ACTIVITY 5.26
Imagine you are responsible for a workforce of 10 people who between them produce
7,000 units of a product during the control period in question. There is a variance of 10
units, adding a cost of $70.
Can you think of some reasons why a decision might be made by senior management not
to investigate such a variance?
Standards
One of the methods by which performance is measured is by setting standards. Whereas
a budget is a financial plan for a period of time (for example one year), a standard is a
financial plan for one unit of input or output.
A product (or service) is therefore given a target cost, hourly rate, and so on, which is
taken as the standard when setting budgets. It is essential, of course, that these standards
represent reasonable targets, otherwise the workforce will feel that unrealistic demands
are being built into budgets and managers may begin to ignore variances in the
performance of their departments. Standards for such items as direct labour time (the
time taken to make one unit of output) can be established in trials, while those for materials
can be established by looking at current prices.
One reason for an adverse variance may therefore be that the standards on which the
budget has been based are out of date or badly set. If, during one or more control
periods, it emerges that the cause of variances is that unrealistic standards were adopted,
then senior management can revise the standards accordingly for future budgets.
Using the information in the previous activity, and assuming that the standards
have been correctly calculated, what would you consider to be a significant
variance, which ought to be investigated?
Whether or not you come up with an exact figure, you will realise that it is not enough for
managers to talk about significant or insignificant variances. A definition of significance
is required, such as greater than 5 per cent of the budgeted figure and this should be
established by senior management in advance of setting budgets. This tolerance level
should then be applied to all variance analysis unless and until it is considered necessary
to revise the definition.
Calculating variances
As we have seen, our actual performance is likely to depart from our planned performance
for a number of reasons and the difference between the budget and the actual performance
is known as the variance.
In the following activities we will consider the advertising revenue budget for High Life
magazine. You may not have any experience of publishing or you may not work in an
organisation which intends to make a profit. This does not matter for the purposes of
these activities; what is important is that you understand the principle of calculating the
differences and deciding whether the variance is adverse or favourable. This knowledge
can be applied to every organisation where budgetary control is used.
The budget for sales revenue for the month of January was:
$
Recruitment 14,000
Mono display 14,400
Colour display 24,000
Total revenue 52,400
At the end of January it will be possible to measure what has actually been
achieved and make a comparison between the budget for the month and the
actual.
In the following statement the actual figures have been given:
$ $ $
Recruitment 14,000 12,400 1,600
Mono display 14,400 15,000 600
Colour display 24,000 23,000 1,000
Total revenue 52,400 50,400
You probably found this relatively straightforward to work out. You will also have noticed
that for one of the calculations, for the mono display, the budgeted figure was lower than
the actual figure. In each of the other calculations the budgeted figures are higher than
actual.
Accountants treat variances as positive or negative depending on their impact on profit.
A negative variance is one that reduces profit. A positive variance is one that
increases profit.
In the previous example our planned revenue for recruitment advertising is $14,000. The
actual recruitment advertising revenue is $12,400. Assuming that no other figures change,
will our actual profit be:
$1,600 higher than the planned profit?
$1,600 lower than the planned profit?
Exactly the same as the planned profit?
The second answer is the correct one. Our actual profit will be $1,600 lower than planned,
because we sold less recruitment advertising than planned. This type of variance, which
has a negative effect, is known as an adverse or unfavourable variance. If we have sold
more than we planned our actual profit will be higher than planned. This is of benefit to
the organisation and the variance is known as a favourable variance. Look back at the
example and identify which variances are adverse and which are favourable. Put brackets
around any adverse variances. Your total should be $2,000.
To investigate the reasons for the fall in the total revenue, the advertisement department
manager will need to know details of the actual number of pages sold and the actual
price charged per page. Some organisations automatically provide this detailed information
to managers. In other organisations this may not be possible either because of the nature
of the activities or because the information is not generated by the system.
As you have seen, the process of investigating the reasons for the variances is known as
variance analysis and you will by now appreciate what an extremely important part of
management activity it is. If there is no variance, because the actual is the same as the
plan, then no action need be taken. Budgetary control therefore incorporates the principle
of management by exception. This means only where there is a difference need it be
investigated.
Until now you have only looked at revenue variances, but managers would also expect
actual costs to depart from their planned costs. In the following activity, the subject will be
the planned and actual costs in the magazines advertising budget.
When you have finished your statement you should ensure that the sum of the separate
cost variances agrees with the total cost variance. This is exactly the same procedure as
you used for the revenue variances. You should also check your profit variances. You
should get the same figure when you compare your planned and actual profit as when
you deduct your total cost variance from your total revenue variance.
Now the full statement is available, you can appreciate that managers can conduct a
number of enquiries. What questions would you ask if you received this statement?
Here are some possibilities:
Why have we overspent on salaries and expenses if our revenue is lower than
planned?
Are the savings in production and circulation costs due to the fact that we have sold
fewer pages, or for other reasons?
Are the standards unreasonable?
Has the market changed dramatically since the budget was set and does the budget
need revising?
Calculate the remaining variances and identify the adverse variances by putting brackets
around them.
Revenue and costs for January
$ $ $
Recruitment 14,000 12,400 (1,600)
Mono display 14,400 15,000 600
Colour display 24,000 23,000 (1,000)
Total revenue 52,400 50,400 (2,000)
Salaries 16,000 17,200
Expenses 8,500 12,000
Production costs 15,000 13,000
Circulation costs 11,500 8,000
Total costs 51,000 50,200
Profit 1,400 200
ACTIVITY 5.27
Activity 5.1
Once you have got hold of a company report, you may feel that its full of
information that you cant possibly understand. Dont worry try to find help.
There isnt enough room in this workbook to explain every aspect after all,
accountants spend years studying the subject! But if you can find someone
knowledgeable to discuss your report with, you should feel confident, by the
time you get to the end of the workbook, that you have a fair grasp of the
principles.
Activity 5.2
The fixed assets in your organisation depend on the kind of work you do.
Manufacturing companies will have machinery, a shop will list fixtures and
fittings, and a company doing research will probably have patent rights.
Activity 5.4
The answer to the first two questions will tell you a lot, because retained profits
and dividends are important clues to how well the organisation is performing.
You may like to compare retained profits and dividends with previous years.
Are they higher or lower? How could you learn more about the reasons for the
differences?
Question 3: Long-term loans are also important, because a large loan means
that a good deal of interest is being paid, which may be making life difficult for
the whole organisation.
Activity 5.5
Compare your answer with the one below. If yours differs in any way, make
sure you understand why. If you are not sure you understand this balance
sheet, talk to your tutor, or someone in your own organisation who can help
you.
Clearvu Windows Ltd
$ $ $
Fixed assets
Tools and machinery 22,000
Vehicles 35,000
57,000
Current assets
Stock
Debtors 15,000
Cash 7,500
115,500
Current liabilities
Bank loan (13,000)
Creditors (7,000) (20,000)
Net current assets 95,500
Bank loan (10,000)
142,500
142,500
Manufacturing account for the year ended 31 December
$ $
Stock of raw materials 1 January 43,000
Add Purchases 160,000
= 203,000
Less Stock of raw materials 31 December 39,000
= Cost of raw materials consumed 164,000
Add Direct expenses 29,000
Add Direct labour 150,000
= Prime cost 343,000
Add Factory overhead expenses:
General factory expenses 15,000
Rent 32,000
Add Indirect labour 10,000 57,000
= 400,000
Add Work-in-progress 1 January 23,000
= 423,000
Less Work-in-progress 31 December 32,000
Production cost of goods completed 391,000
(continued)
Activity 5.6
$ $ $
Sales 720,000
Stock of finished 54,000
goods 1 January
Add Production cost of 391,000
goods completed (brought
down from above) 445,000
Less Stock of finished
goods 31 December 32,000 413,000
Gross profit 307,000
Administration expenses:
Administrative salaries 21,000
Stationery, postage, etc. 12,000 33,000
Selling expenses:
Sales staff salaries 35,000
Advertising 92,000 127,000 160,000
Net profit 147,000
Activity 5.7
Some of the uses of a profit and loss account you may have listed are the following:
Management performance
The management of Morris Cloth can see how much gross and net profit they
have made and determine whether this is adequate.
Investment
People who may be interested in joining the managers in a partnership or other
form of business organisation, or who are lending them money, can assess whether
their levels of profit are adequate.
Competition
Competitors could compare their own levels of profit with that of Morris Cloth and,
if necessary, alter their pricing strategies if they had access to this document.
Taxation
HMRC will want to charge taxation and this will be based on Morris Cloths profits.
Activity 5.8
Your table should look like this:
Morris Cloth
Trading and profit and loss account for the three months ending 31 March
$ $ %
Sales 1,920 100
Less cost of sales:
Purchases 1,400
960 50
Gross profit 960 50
Less expenses:
Advertising 60
Telephone 50
Market stall 75
Miscellaneous 15
275 14
Net profit 685 36
Activity 5.10
Morris Cloth now has $1,420 worth of assets. However, their supplier (trade creditor)
is still owed $120 and so the net assets of the business remain the same at $1,300.
The net assets are financed by the capital that was originally invested into the
business. The completed balance sheet should be as follows:
Morris Cloth
$
Assets:
Vehicle 1,300
Stock of cloth 120
1,420
Liabilities:
Financed by:
Capital 1,300
Activity 5.11
Their cash at the bank (previously nil) is now increased by cash sales. So the new
balance sheet is as follows:
Morris Cloth
$ $ $
Fixed assets:
Vehicle 1,300
Current assets:
Stock 60
Debtors 80
Cash in bank 40
180
Working capital: 60
Financed by:
Capital 1,300
Profit 60
1,360
Notice the current assets less the current liabilities leaves $60 which is now labelled
working capital. This is the capital available for the business to conduct the day-
to-day operations.
Activity 5.12
Your completed balance sheet should look like this:
Morris Cloth
$ $ $
Fixed assets:
Vehicle 1,300
Less depreciation (75)
1,225
Current assets:
Stock 440
Debtors 1,140
1,580
Creditors: amounts due within one year:
Trade creditors 600
Bank overdraft 220
820
Working capital: 760
Financed by:
Capital 1,300
Profit 685
1,985
Although this is the most complex balance sheet you have used so far, you should
not have had too much difficulty. You may have had some trouble with the figure for
the vehicle at the year end which is $1,225 because Morris Cloth has used up $75
worth of the value of the vehicle.
Activity 5.13
1 You should have disagreed with statements a, c and e as they all suggest that
only one item of information on the balance sheet would be of use to lenders.
This is not true. It is impossible to understand one figure without seeing it in
the context of all the other figures on the balance sheet. Statements b and d
are therefore both correct. All the information on the balance sheet is of use,
but different lenders find some items of information more useful than other
items. Look at some of them now so that you can identify the uses to which
they can put the information contained in the balance sheet.
2 The main use to all three groups is that the balance sheet shows the financial
stability of the business. For employees it gives an indication of job security;
for customers it gives an indication of security of future supplies and services.
It will help you to understand the way that your organisation uses its resources
and will allow you to analyse the efficiency of the organisation in greater depth.
Activity 5.14
This may have caused you some problems if you are not familiar with the industries.
Organisation A is the general engineering company. The clue is the large amount
of plant and machinery representing the manufacturing facility.
Organisation B is the food store. You can see how much is held in stock: all the
goods on the shelves and in the warehouses. Notice also how low the figure for
debtors is. This is because most of the business is conducted by cash transactions.
Organisation C is the bus company. As already mentioned, the clue is the amount
tied up in vehicles. As with the food store chain, the figure for debtors is low because
most transactions are by cash.
Organisation D is the hotel. This organisation has a large amount invested in
buildings and relatively little invested in any other fixed assets.
Organisation E is the motor car manufacturer, which is not dissimilar in its
investment in fixed assets to the general engineering company. However,
organisation E has a large amount tied up in stock all the unsold cars awaiting
delivery.
Activity 5.16
Your completed cash-flow statement should be as follows:
Morris Cloth
Cash-flow statement January to June
Cash in:
Cash sales 120 140 160 200 240 280 1,140
Credit sales 0 0 360 560 580 600 2,100
Subtotal 120 140 520 760 820 880 3,240
Cash out:
Advertising 20 20 20 40 40 40 180
Telephone 0 0 50 0 0 80 130
Market stall 25 25 25 25 25 25 150
Miscellaneous 5 5 5 15 15 15 60
Subtotal 50 450 500 680 480 560 2,720
Opening balance 0 70 (240) (220) (140) 200 0
Net cash flow 70 (310) 20 80 340 320 520
Closing balance 70 (240) (220) (140) 200 520 520
Activity 5.17
1 Your completed trading and profit and loss account should be as follows:
Morris Cloth
Trading and profit and loss account for the six months ending 30 June
$ $ $
Sales:
Cash sales 1,140
Credit sales 3,540
4,680
Less cost of sales:
Opening stock 0
Add purchases 2,600
2,340
Gross (trading) profit 2,340
Less expenses:
Advertising 180
Telephone 130
Market stall 150
Miscellaneous 60
670
Net profit 1,670
This is quite a lengthy example and hopefully you will have successfully completed
it. Make sure you understand why any differences in your answer have arisen.
2 The answer looks like this: $
Figure shown on cash-flow forecast 520
Add cash still owed from credit sales 1,440
1,960
Less amount owed for purchases 400
1,560
Add value of closing stock 260
1,820
Less depreciation charged 150
Figure shown in profit and loss account 1,670
You may find that you have made your calculations in a different order or used a
different layout. However, that does not matter as long as you have understood the
adjustments that must be made to reconcile the two figures.
Activity 5.18
The completed balance sheet should look like this, except that we have added
numbers to help you relate the figures to the notes which follow.
Morris Cloth
Balance sheet as at 30 June
$ $
Fixed assets:
Vehicle 1,300
Less depreciation 1 150
1,150
Current assets:
Stock 2 260
Debtors 3 1,440
Cash at bank 4 520
2,220
Creditors: amounts due within
one year
Trade creditors 5 (440)
Working Capital 1,820
Financed by:
Capital 6 1,300
Profit 1,670
2,970
Notes
1 The depreciation on the van is now six months, half a year at $300 per annum.
Look at the earlier section if you are uncertain how this has been calculated.
2 Stock at 30 June is 130 metres of cloth at a cost of $2 each = $260.
3 Debtors owe for their May and June purchases from Morris Cloth: May $680
and June $760, totalling $1,440. If you check with the cash-flow forecast you
will see that at the end of June credit customers had only paid for the goods
received by them for the months of January to April inclusive. You will remember
that they are allowed two months credit.
4 Cash at bank is the amount shown in the cash-flow forecast which you calculated
earlier in this unit: $520 closing balance at the end of June.
5 The entry for creditors of $400 is Morris Cloths purchase of cloth for the month
of June. You will remember that they obtained one months credit from their
suppliers, and at the end of June Morris Cloth still owes this amount to them.
6 The capital figure of $1,300 is the original capital which the owners of Morris
Cloth put into the business in December. This has now increased by the net
profit which Morris Cloth now owes to them; that is, the net profit shown on the
profit and loss account of $1,670 for the six months.
Activity 5.19
Your completed trading account should look like this:
Morris Cloth
Trading account for the three months ending 31 March
Sales:
Cash sales 105 metres of cloth at $4 each = $420
Credit sales 375 metres of cloth at $4 each = $1,500
Total sales 480 metres of cloth at $4 each = $1,920
Less cost of sales:
Opening stock 0 metres of cloth at $2 each = $0
Add purchases 700 metres of cloth at $2 each = $1,400
Total available for sale 700 metres of cloth at $2 each = $1,400
Less closing stock 220 metres of cloth at $2 each = $440
Total cost of sales 480 metres of cloth at $2 each = $960
Trading or gross profit for the three months $960
Activity 5.20
There have been numerous attempts to describe depreciation in a comprehensible
way.
Here are some of them:
The benefit of using the vehicle has been spread over the four years.
Morris Cloth uses up the asset over the four years and this is an expense of
the business.
The $300 per annum is an attempt to spread the expenditure incurred in buying
the vehicle over the whole of its useful life.
The $300 per annum is a charge for the use of the vehicle.
The vehicle is wearing out and therefore decreasing in value over the four
years.
The $300 per annum is an inaccurate but expedient way of apportioning the
drop in value over the four years.
Activity 5.21
If Jenny accounts for transactions on a cash basis, her accounts would show the
following:
Cash Revenue
Beginning 9/27 Rent 3,000 9/4 Cash 1,700
balance 19,250
9/30 Office 9/10 Cash 350
9/4 Revenue 1,700 supplies 700
Balance 3,450 9/23 Cash 1,400
9/10 Revenue 350
3,450 3,450
9/23 Revenue 1,400 Balance 19,000
22,700 22,700
Activity 5.22
Using accrual-based accounting, Jennys accounts would record the transactions
as follows:
Cash Revenue
Beginning 9/27 Rent Balance 350 9/10 Cash 350
balance 19,250 paid in advance 3,000
9/4 Accounts
receivable 1,700 9/30 Accounts
payable 700
9/10 Revenue 350
9/23 Revenue
received in
advance 1,400 Balance 19,000
22,700 22,700
Accounts receivable Accounts payable
Beginning 9/4 Cash 9/30 9/7 Office
balance 1,700 Cash 1,700 Cash 700 Supplies 700
Office supplies Revenues received in advance
9/7 Accounts Balance 1,400 9/23 Cash 1,400
payable 700 Balance 700
Rent paid in advance
9/27 Cash 3,000 Balance 3,000
You will notice that the main difference here is that, instead of recording revenues
of $3,450 for the month, you have only recorded $350. This is a much more accurate
reflection of the business activities. Although Jenny received $3,450 cash for work
done, or planned, in September, the only work actually carried out in September
was to the value of $350. The remainder of the money received in respect of work
was $1,700 which was in respect of work carried out in August, and $1,400 paid in
advance by a client for work planned in October. To record the full amount received
as revenue for September gives a false view of the business activity for the month.
Office supplies Rent
9/30 Office 9/27 Cash 3,000 Balance 3,000
supplies 700 Balance 700
Activity 5.23
You should have calculated rent for October as $1,000. (Jenny paid $3,000 for
three months rent. One months rent = $3,000 3.) Entries to the accounts are:
Prepaid rent Rent expense
10/1 Balance 3,000 10/31 Rent 10/31 Prepaid
expense 1,000 rent
1,000 balance 1,000
balance 2,000
1,000 1,000
3,000 3,000
$1,000 is charged to the expense account for October. $2,000 is carried forward
as a balance on the asset account for November and December.
Activity 5.24
To calculate the depreciation expense using the straight-line method, divide the
cost of the asset by the number of years it will be useful to the business: here
$7,500 5. Depreciation for the year is $1,500 which is recorded in the accounts
as follows:
Office equipment
Office equipment accumulated depreciation
1/1 cash 7,500 12/31
Depreciation
expense 1,500
Depreciation
expense
12/31 Office
furniture
depreciation 1,000
12/31 Office
equipment
depreciation 1,500
The book value of office equipment is original cost less total of accumulated
depreciation. Book value at 31 December is $7,500 $1,500 = $6,000.
Activity 5.25
Your completed worksheet should look like this:
trial balance
Cash 12,780 12,780
Accounts receivable 12,330 12,330
Office supplies 2,080 [1] 480 1,600
Accumulated
depreciation 11,700 [2] 300 12,000
Accumulated
depreciation 16,380 [3] 420 16,800
Salary payable [4] 1,800 1,800
Unearned revenue 1,800 [5] 420 1,380
Capital 50,000 50,000
Revenue 24,460 [5] 420 24,880
Office supplies
expense [1] 480 480
Depreciation
expense [2] 300
[3] 420 720
Salary expense 5,380 [4] 1,800 7,180
Totals 104,340 104,340 3,420 3,420 106,860 106,860
Adjustments are due to the following:
1 office supplies used during the year
2 depreciation for the year on office furniture
3 depreciation for the year on office equipment
4 accrued salary at the year end
5 adjustment to unearned revenue for amounts earned in the year
Activity 5.26
The reasons for such a small variance might not be easy to determine. If investigation
procedures were put in place, they could be very time-consuming and therefore
expensive.
It could be damaging to the morale of the workforce to investigate what they see
as a trivial variance. Senior management might be seen as unreasonable or petty-
minded if they investigated every slight variance that occurs. In practice, small
variances between planned and actual performance are expected. Senior
management is not usually anxious to investigate what it considers to be insignificant
discrepancies.
Activity 5.27
Revenue and costs for January
$ $ $
Recruitment 14,000 12,400 (1,600)
Mono display 14,400 15,000 600
Colour display 24,000 23,000 (1,000)
Total revenue 52,400 50,400 (2,000)
Salaries 16,000 17,200 (1,200)
Expenses 8,500 12,000 (3,500)
Production costs 15,000 13,000 2,000
Circulation costs 11,500 8,000 3,500
Total costs 51,000 50,200 800
Profit 1,400 200 (1,200)
If you have run into problems it is probably because you have forgotten that it is
the impact on the planned profit that decides whether a variance is adverse or
favourable. Actual salaries, for example, are $1,200 higher than we planned. If our
actual costs are higher than we planned, the actual profit will be lower than the
planned profit.
Self-test M
1 Balance sheet Profit and loss account
current assets
gross profits
current liabilities
net profit
fixed assets
retained profits
2 a Gross profit shows the profit after direct costs of producing or buying the
goods or services is deducted. Net profit is the gross profit less indirect
business costs.
b Fixed assets are those things which an organisation owns, such as
buildings and machinery, which it intends to keep for a long time. Current
assets are cash, or those things which an organisation can turn into cash
very quickly, and which it will use to pay for the day-to-day running of the
organisation.
c Net profit is the profit after all direct and indirect costs involved in producing
the goods or services have been deducted. Retained profits are the profits
left after all other deductions for such things as tax and dividends have
been made.
3 a The total sales figure is the organisations turnover.
b The ratio of the profit before tax to the turnover is called the net profit
margin.
c A measure of how well equipped an organisation is to meet its
commitments as they fall due is called its liquidity.
d A ratio of current assets to current liabilities is called the current ratio.

Self-test N
1 c
2 d
3 d
4 e
5 e
Glossary
Assets Anything owned, whether in the possession of the
organisation or not.
Balance sheet A financial document that is like a snapshot of the financial
situation of a business at a particular time. It shows the
organisations assets and liabilities, which must always balance.
Bank overdraft A short-term facility by a bank to allow a customer to draw
more from his or her account than is put in.
Commercial Banks which offer a deposit and transfer service to the
banks public, both individuals and organisations. They are often
called the high street banks.
Cost The money going out of an organisation to pay for labour,
materials and all other requirements and demands.
Current assets The assets continually turned over in the course of business,
including debtors, stock, work-in-progress and cash.
Current liabilities Those monies owed, due to be paid back within the near
future, usually in the next 12 months.
Current ratio The ratio of current assets to current liabilities, used to
determine liquidity.
Dividends The share of a limited companys profit paid to
shareholders.
Factoring The purchase of debts for cash. Under a typical factoring
arrangement, the factor pays its client up to 90 per cent of
the value of invoices, and then proceeds to collect the full
value of the invoice from the debtors.
Fixed assets Those assets purchased for continuing use.
Gross profit The excess of sales over the cost of goods sold in the period.
Hire-purchase An agreement to hire goods for a specified period, in return
for regular payments. When the last payment is made, the
goods become the hirers property.
Intangible assets Unseen assets such as patents, trademarks and
copyrights.
Interest The amount paid by a borrower to a lender in return for a
loan.
Limited company A company whose owners have limited liability, and which
has an entity separate from the owners. (Companies can
also be limited by guarantee, a subject not covered in this
workbook.)
Limited liability The legal protection of the owners of limited companies,
which prevents any financial demands upon them beyond
the nominal value of their shares.
Liquidity A measure of how well equipped an organisation is to meet its
commitments as they fall due.
Loss An organisation is said to have made a loss when its revenue
is less than its costs (for a period or for a particular
transaction).
Merchant banks Banks whose customers are mainly large organisations and
governments, rather than the public.
National Debt The total indebtedness of the government to its citizens and
other parties.
Net profit The gross profit, minus all the other costs involved in
running the business.
Net profit margin The ratio of profit, before tax, to sales.
Partnership A business organisation under which two or more people
run a business together, under unlimited liability.
Partnership An agreement between par tners, whi ch i ncl udes
agreement arrangements for determining what happens in the event of a
break-up of the partnership.
Private limited A limited company whose shares are restricted to a private
company group of people.
Profit The excess of revenue over costs.
Profit and loss A financial statement showing the income and expenses
account not directly linked to trading, and from which is calculated
the net profit.
Public limited A limited company whi ch offers shares to the publ i c.
company
Public Sector The amount of money that the government needs to borrow
Borrowing to meet expendi ture not covered by taxati on.
Requirement (PSBR)
Return on capital This shows whether the capital employed has been well
employed (ROCE) used to generate profit.
Revenue Income money coming into an organisation.
Risk capital Capital invested in a (usually) new enterprise which is not
assets fully secured.
Share capital The total of shares issued, or authorised to be issued, by a
limited company.
Shareholder A holder of shares, and therefore one of the owners, of a
limited company.
Shares The ownership element in a limited company, usually
represented by transferable certificates.
Sole trader A person who runs his or her own business, under unlimited
liability.
Stock The central market for dealing in stocks, shares and
exchange securities.
Stockholders In the US, individuals, businesses or groups owning stocks in a
corporation. Comparable to shareholders in the UK.
Tangible assets Fixed assets which can be seen and touched.
Trading account A financial statement showing the turnover for a period, the
cost of sales and the gross profit.
Turnover The total sales revenue for a period.
Venture capital Same as risk capital.

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