BCOM - ACC Management Accounting and Finance 2

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REGENT Business School
All rights reserved, no part of this book may be reproduced in any form or by any means, including photocopying
machines, without the written permission of the publisher
BCOMACCT Management Accounting and Finance 2
General Objectives of this module:
In this module the student is introduced to the principles of Management Accounting and
finance.
The purpose of this module is:
 To give students a basic knowledge of cost classification, cost behaviour, cost analysis
and cost management accounting systems
 To enable students to understand and apply planning, budgeting and control techniques.
 To enable students to understand how financial and other data are analysed in order to
provide information for decision-making
 To give students a basic knowledge of financial management concepts, tools and
techniques
 To enable students to understand cost of capital, portfolio management and working
capital management.
The prescribed textbooks are as follows:
 Managerial Accounting, Fourth Edition, F Vigario, LexisNexis

 Managerial Finance, Fifth Edition, FO Skae and FAA Vigario, LexisNexis
It is essential to get the prescribed textbooks
REGENT Business School Page 1

TABLE OF CONTENTS
TITLE PAGE
1 Introduction to Management Accounting 3
Systems for recording and controlling product costs
2 8
3 Variable and Absorption costing 17
4 Cost-Volume-Profit Analysis 26
5 Budgeting and Budgetary control 34
6 Standard costing 41
7 Activity-based costing 48
8 Introduction to Financial Management 58
9 Present and future value of money 70
10 Capital Structure and the Cost of capital 94
11 Portfolio management and the Capital Asset Pricing Model 108
12 Financial and Business Analysis 113
Bibliography 129

CHAPTER 1
INTRODUCTION TO MANAGEMENT ACCOUNTING

Learning Outcomes:
 Understand the difference between financial and management accounting
 Understand terms used in management accounting
INTRODUCTION TO MANAGEMENT ACCOUNTING

What is accounting?
Accounting is a process consisting of three activities, viz.:
 Identifying those events that are evidence of transactions relevant to the particular
business or entity.
 Recording the monetary value of the transactions so as to provide a permanent history
of the financial activities of the business.
 The third activity entails the communication of the recorded information to interested
users. The information is communicated through the preparation of and distribution of
accounting reports, the most common of which are known as financial statements.
It exists to provide information for the end-user. It is possible to distinguish between two
branches of accounting.
1 Financial Accounting
The purpose of financial accounting is to report on the financial performance of the company.
It’s main focus is on external reporting to a number of groups viz.
Owners ( shareholders )
Loan creditors ( banks )
Trade creditors (suppliers )
Sundry creditors ( suppliers of services )
Government agencies ( tax authorities )
Employees ( trade unions )
A set of financial statements - a profit and loss account, a balance sheet and a cash flow
statement are prepared and published.

2 Management Accounting
The main purpose of management accounting is to provide information to the management
team at all levels within the organisation for the following purposes:
(a) formulating the policies - strategic planning
(b) planning the activities of the organisation - corporate planning
(c) controlling the activities of the organisation
(d) decision-making - long-term and tactical
(e) performance appraisal at strategic and operational level
Definition: Management accounting is the application of professional knowledge and skill 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 controlling the operations of the organisation.
Financial accounts indicate the results of a business over a period of time. They deal with
historic or past costs and are concerned with stewardship accounting.
A management accounting/ cost statement provides information to allow managers to plan,

control and organise the activities of the business. The purpose of a costing/management
accounting information system is:
1. to provide information about product costing to be used in financial statements.
2. to provide information for planning, controlling and organising.

Differences between Management Accounting and Financial Accounting:
Management Accounting Financial Accounting

User groups Internal users: Managers External: Owner/s; Lenders,
Creditors;
Nature of Reports tend to be specific Reports tend to be general-purpose

reports usually with a decision in mind. and are useful to a wide range of
users.
Legal Management accounting reports Financial reports are required by law

requirements are not required by law since they and are also regulated in terms of
are for internal use only. content and format.
GAAP/IFRS Management accounting reports Financial reports must conform to

are not subject to the principles of the practices and principles set by
GAAP (Generally Accepted GAAP/IFRS
Accounting Practice)
/International Financial Reporting
standards (IFRS)
Financial Accounting uses absorption costing, which means that all production costs, including
the value of work in progress, finished goods, and product and period costs (such as rent) are
incorporated in the closing stock valuation
It is important to note that Management Accounting does not concern itself with
absorption costing.
In Management accounting we will look into the variable costing model. This will result in what
we call contribution per unit, which is the selling price of a product less all variable costs. This
describes the concept of profitability as used by management accountants. It correctly
describes the increase or decrease in total profit as sales increase or decrease by 1 unit.

Example:
Company “A” purchases T-Shirts which it dyes and then sells for R70 each. The cost of the T-
Shirts is R40, while the cost of dying the T-Shirt is R10 each.
In this example the R40 material cost is a variable cost, as is the cost of converting the T-Shirt
into the saleable product.
We therefore have the following analysis:

R
Selling price 70
Material cost 40
Conversion cost – variable 10
Profit / Contribution 20
Every time the company sells a T-Shirt it will make a ‘profit’ or ‘contribution’ of R20. The word
‘contribution’ is the word used by management accountants to describe the incremental profit
that a company sells one more unit of production.
Types of costs:
The classification of costs into variable, fixed and semi-fixed is important in terms of decision-
making and cost control, activities that comprise the fundamentals of the management
accounting function.
Variable costs are those costs which increase/decrease with the level of production and sales.
In a manufacturing company the variable production costs change directly with the level of
production.
Fixed costs can be either committed fixed costs or discretionary fixed costs. Fixed costs are
termed fixed because they do not change in response to changes in the level of activity. It
should be noted that they are not fixed because they do not change because cost items like rent
is often subject to revision.
Semi-fixed/semi-variable costs are costs which move in the same direction but not at the
same rate as the level of activity. The semi-fixed/semi-variable cost contains a fixed and a
variable element. For example, the electricity bill contains a fixed or standing charge and the
variable aspect which depends on usage.

CHAPTER 2
SYSTEMS FOR RECORDING AND CONTROLLING PRODUCT

COSTS

SYSTEMS FOR RECORDING AND CONTROLLING PRODUCT COSTS
Learning outcomes:
 Explain the meaning of each of the terms listed in this chapter
 Differentiate between management accounting and financial accounting
 Identify and allocate costs for product costing under absorption costing
 Explain and apply the principle of pre-determined overhead recovery rate.
Companies analyse costs for stock valuation, product analysis, decision-making and planning.
Accounting profit vs contribution

Example:
Assuming a company sells a product for R12 each and they produce 1 000 units. Here is their
cost and profit structure
Production / Sales 1 000 units
Per unit
Sales R 12 000 R12
Material Costs R 4 000 R4
Variable labour R 2 000 R2
Fixed Costs R 4 000 R4
Profit R 2 000 R2
The cost per unit is R10. While the profit per unit is R2. We cannot say that we are making R2
profit per unit. That amount is only correct if the company manufactures and sells 1 000 units.
What happens if the company only manufactures and sell 500 units?
The fixed cost per unit is now R8, ie R4 000 divided by 500 units. The total costs is:
R8 + R4 + R2 = R14.
Therefore, if the selling price is R12, the company makes a loss of R2 per unit.

Contribution is the difference between the selling price and all variable costs. In the above
example, it would be
Selling price R12
Material R4
Labour R2
Contribution R6
Contribution is the term used by management accountants to define profit. It means that for
every unit sold, the company will make an increased profit of R6 per unit. This does not mean
that fixed costs can be ignored. It is very important that a company covers its fixed cost before
it starts to account for the profit. As management accountants looking at the above information,
we should first ask, “How many units do we have to sell to break even?”
Answer: R4 000 / R6 = 667 units
Now we can say that the company must sell 667 units to break even; thereafter it will make a
profit of R6 for each additional unit sold.
Key Costs Related to Managerial Accounting

In accounting, a cost measures how much you pay/sacrifice for something. Managerial
accounting must give managers accurate cost information relevant to their management
decisions. Here are several cost-related terms you encounter in managerial accounting:
 Direct cost: Cost that you can trace to a specific product
 Indirect cost: Cost that you can’t easily trace to a specific product
 Materials: Physical things you need to make products
 Labor: Work needed to make products
 Overhead: Indirect materials, indirect labor, and other miscellaneous costs needed to
make products
 Variable costs: Costs that change in direct proportion with activity level
 Fixed costs: Costs that don’t change with activity level
 Mixed costs: Combination of fixed and variable costs
 Contribution margin: Sales less variable costs
 Product costs: Costs needed to make goods; considered part of inventory until sold
 Period costs: Costs not needed to make goods; recorded as expenses when incurred

 Work-in-process cost: How much you paid for goods that are started but not yet
completed
 Finished goods cost: How much you paid for goods completed but not yet sold
 Cost of goods manufactured: The cost of the goods completed during a period
 Cost of goods sold: The cost of making goods that you sold
 Controllable costs: Costs that you can change
 Noncontrollable costs: Costs that you can’t change
 Conversion costs: Direct labor and overhead
 Incremental costs: Costs that change depending on which alternative you choose; also
known as relevant costs and marginal costs
 Irrelevant costs: Costs that don’t change depending on which alternative you choose
 Opportunity costs: Costs of income lost because you chose a different alternative
 Sunk costs: Costs you’ve already paid or committed to paying
 Historical cost: How much you originally paid for something
 Cost per unit: Cost of a single unit of product
 Expense: Costs deducted from revenues on the income statement
 Cost driver: Factor thought to affect costs
 Process cost: Cost of similar goods made in large quantities on an assembly line
 Job order cost: Cost of a batch of specially made goods
 Absorption cost: Cost that includes fixed and variable product costs
 Target cost: Cost goal set for engineers designing a product
Product valuation for financial accounting purposes – Absorption costing system

Financial accountants use absorption costing and as a basis for allocating fixed costs for
stock valuation purposes.

Cost allocation procedure

Step 1
Allocate relevant production overheads to the production and service departments.
Identify all overheads that are incurred by the company and allocate them to the departments
on an appropriate basis as follows:
Depreciation - Asset values in each department
Insurance - Asset values in each department
Rent - Area occupied
Salaries - Staff in each department
Water and electricity - Area occupied
Employee costs - Number of employees
Step 2
Reallocate service department costs to the production departments.
Service departments, such as maintenance, exist to support the manufacturing departments,
therefore we need to identify an appropriate basis to allocate the costs according to % of
usage by the production departments.
Some appropriate methods used are
 Direct cost allocation method
 Step cost allocation method
 Reciprocal allocation method
Step 3
Identify the activity most common to a specific production department and use that activity to
determine the cost recovery rate.
The Direct Method:

The direct method is the most widely-used method. This method allocates each service
department’s total costs directly to the production departments, and ignores the fact that service
departments may also provide services to other service departments.
Example: Machining and Assembly are the only production departments that used the services
of the Human Resources Department in March. Costs from Human Resources are allocated

based on the number of new hires. Machining hired seven employees in March and Assembly
hired three employees. Human Resources incurred total costs of R93 000 in March.
Allocation of H.R. Department costs to Machining: 70% of R93 000 = R65 100
Allocation of H.R. Department costs to Assembly: 30% of R93 000 = R27 900
The characteristic feature of the direct method is that no information is necessary about whether
any service departments utilized services of the Human Resources Department. It does not
matter whether no other service department hired anybody, or whether three other service
departments each hired five employees (implying that more than 50% of the hiring occurred in
the service departments). Under the direct method, service department to service department
services are ignored, and no costs are allocated from one service department to another.
Step Allocation
This method allocates the costs of some service departments to other service departments, but
once a service department’s costs have been allocated, no subsequent costs are allocated back
to it.
The choice of which department to start with is important. The sequence in which the service
departments are allocated usually affects the ultimate allocation of costs to the production
departments, in that some production departments gain and some lose when the sequence is
changed. Hence, production department managers usually have preferences over the
sequence. The most defensible sequence is to start with the service department that provides
the highest percentage of its total services to other service departments, or the service
department that provides services to the most number of service departments, or the service
department with the highest costs, or some similar criterion.
Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.)
provide services to the Machining and Assembly production departments, and in some cases,
the service departments also provide services to each other:

Total Service % of services provided by the service

Cost Dept department listed at left to:
H.R. D.P. R.M. Machining Assembly
R 80 000 H.R. -- 20% 10% 40% 30%
120 000 D.P. 8% -- 7% 30% 55%

40 000 R.M. -- -- -- 50% 50%
R240 000
The amounts in the far left column are the costs incurred by each service department. Any
services that a department provides to itself are ignored, so the intersection of the row and
column for each service department shows zero. The rows sum up to 100%, so that all services
provided by each service department are charged out.
The company decides to allocate the costs of Human Resources first, because it provides
services to two other service departments, and provides a greater percentage of its services to
other service departments. However, a case could be made to allocate Data Processing first,
because it has greater total costs than either of the other two service departments. In any case,
the company decides to allocate Data Processing second.
In the table below, the row for each service department allocates the total costs in that
department (the original costs incurred by the department plus any costs allocated to it from the
previous allocation of other service departments) to the production departments as well as to
any service departments that have not yet been allocated.
H.R. D.P. R.M. Machining Assembly

Costs prior to allocation R 80 000 R120 000 R40 000 -- --
Allocation of H.R. (R 80 000) 16 000 8 000 R32 000 R24 000
Allocation of D.P. (136 000) 10 348 44 348 81 304
Allocation of R.M. (58 348) 29 174 29 174
0 0 0 R105 522 R134 478
The Reciprocal Method:
The reciprocal method is the most accurate of the three methods for allocating service
department costs, because it recognizes reciprocal services among service departments. It is
also the most complicated method, because it requires solving a set of simultaneous linear
equations.

Example:
Assuming a company has two service departments and three production departments. The
overhead costs for each department after calculations arrives to be as follows:
Administration - R138 000
Maintenance - R98 000
Production A - R309 000
Production B - R210 000
Production C - R225 000
This method
Production
Service Dept Dept A Dept B Dept C Maint Admin
Maintenance 30% 25%
Administration 40% 10% -

Solution:
Using Linear Algebra Equations:
Let total allocated cost of administration =a
Let total allocated cost of maintenance =b
a = 138 000 + 0.05b
b = 98 000 + 0.10a
a = 138 000 + 0.005(98 000 + 0.1a)
a = 138 000 + 4 900 + 0.005a
a = 143 618
b = 112 362
Allocation A B C
Admin 143 618 28 724 57 447 43 085
Maint 112 362 33 709 44 945 28 090
62 433 102 392 71 175
Pre-determined overhead rates

Many companies need to allocate overhead costs to products and jobs before the product is
made or job undertaken. This is what is a pre-determined overhead rate.
It is calculated as Budgeted cost ÷ activity rate
An example of base rate is labour hours or machine hours.
In order to establish the amount of overheads per job one would have to take the pre-
determined recovery rate and multiply it by the activity such as labour hours and / or machine
hours which each job or product needs to pass through.

CHAPTER 3
VARIABLE AND ABSORPTION COSTING

VARIABLE AND ABSORPTION COSTING

Learning Outcomes:
 Explain the difference between variable and absorption costing
 Prepare an income statement using variable and absorption costing, and explain why
the profits are different.
 Reconcile an absorption costing income statement from one year to the next
 Explain the arguments for and against variable and absorption costing
 Account for under- and over- recovered overeheads
 Calculate the fixed cost for a period using the under or over- recovered overhead as a
reconciling figure.
Variable costing method:

 Only variable manufacturing costs, namely direct materials, direct labour and variable
manufacturing overheads, are taken into account when inventory is valued.
 Variable non-manufacturing costs, as well as ALL fixed costs, will be treated as period
costs
Absorption costing method:

 Includes both fixed variable and fixed manufacturing costs in the product costs.
 It excludes all non-manufacturing costs which are treated as period costs.
Arguments in support of variable costing

 It provides more useful incremental / relevant information for decision-making by
highlighting the separation of fixed and variable costs and facilitating the cost
estimation at different activity levels.
 It removes the effects on internally reported profits of frequent short term changes in
inventory levels, since variable costing profit is a function of sales volume.
 It is more suitable for frequent internal profit reports which are used for measuring
managerial performance as it prevents managers from increasing short term profits
artificially by ‘deferring’ fixed production overheads.
 It avoids misleading profit reports resulting from capitalising fixed overheads in
unsaleable / obsolete / surplus inventory.

Arguments in support of absorption costing

 It considers fixed production costs as essential for production and they should be
included in the cost of the products / inventory.
 It avoids the reporting of fictitious losses during out-of-season periods by
deferring/carrying forward an appropriate portion of fixed production overheads in
inventory when a planned inventory build-up strategy is being pursued.
 It is consistent with external reporting in terms of IAS 2 (Inventory) which are used by
financial markets to appraise an entity’s performance and influence its share price.
Reconciliation of absorption profit to variable profit

 The difference between the absorption and variable profit is ALWAYS the increase or
decrease in closing stock multiplied by the fixed manufacturing cost per unit.
Key Points of Absorption versus variable costing

1. The fundamental difference between absorption and variable costing is the treatment
of fixed production (manufacturing) overheads.
2. Absorption costing includes fixed production overheads as part of the product cost
(consistent with IAS2), whereas variable costing treats them as a period cost.
3. When production equals sales, this is not an issue, as the profit derived under each
method is identical. However, when sales and production are unequal, different profits
are derived. When production exceeds (in other words, closing inventory increases),
absorption costing derives a higher profit than variable costing. When sales exceed
production (in order words, some sales are drawn from inventory), the variable profit is
greater.
4. This arises as a result of absorption costing deferring the expensing of the fixed
production overhead until the product is sold, whereas variable costing expenses the
overheads when the cost is actually incurred (period cost).
5. Over the long term, the profits derived under each method will be equal, as production
must equate to sales. However, in the short term, distortions in profits can arise when
using absorption costing.
6. This is due to variable costing being a function of sales only. Whereas absorption
costing is a function of both sales and production.
7. Consequently, management accountants advocate that variable costing is superior to
absorption costing when assisting management with decision-making.

Variable costing example 1

A company manufactured 2 000 units and sold 1 000 units.
Per unit
Selling price R20
Production costs:
Material R4
Labour R4
Variable overheads R2
Total fixed overheads R 5 000
You are required to:

Produce an income statement showing the company profit using variable costing.
Solution
R R
Sales 1 000 units 20 000
Production 2 000 units
Raw materials (2000 units X R4) 8 000
Labour (2000 units X R4) 8 000
Variable overheads (2000 units X R2) 4 000
20 000
Closing stock (10 000)
Cost of sales 10 000 10 000
Contribution 10 000
Fixed overheads 5 000
Profit R 5 000

Absorption Costing example

(Information per example 1)
You are required to :

Produce an income statement showing the company profits using absorption costing.
R R
Sales 1 000 units 20 000
Production 2 000 units
Raw materials 8 000
Labour 8 000
Variable overheads 4 000
Fixed overheads 5 000
25 000
Closing stock (12 500)
Cost of sales 12 500 12 500
Profit 7 500
Illustrative example:
Statement of Comprehensive Income
XYZ Ltd manufacturers a single product. The particulars for February 20X1 are as follows:
Units manufactured 18 750
Units sold 15 000
Manufacturing cost:
-Variable R468 750
-Fixed R187 500
Selling and administrative cost:
-Variable selling cost(R5,00 per unit) R 93 750
-Fixed selling cost R 50 000
-Fixed administration cost R 12 500

Required:
Draft the statement of comprehensive income for the month ended 28 February 20X1
according to the:
i. Direct costing method
ii. Absorption costing method
Solution
i. Direct costing method
XYZ LTD
Contribution statement of comprehensive income for the month ended 28 February
20X1
R
Sales (15 000 x R100) 1 500 000
Less: Variable cost of sales 450 000
Opening inventory -
Variable manufacturing cost 468 750
Less: Closing inventory (3 750 x R25) 93 750
Variable selling cost (15 000 x R5) 75 000
Contribution 1 050 000

Less: Fixed costs 250 000
Manufacturing 187 500
Selling 50 000
Administration 12 500
Net profit before tax 800 000

ii. XYZ LTD

Statement of comprehensive income for the month ended 28 February 20X1
R
Sales (15 000 x R100 1 500 000
Less: Variable cost of sales 525 000
Opening inventory -
Fixed manufacturing cost 187 500
656 250
Less: Closing inventory (3750 X R35) 131 250
Gross Profit 975 000
Less: Selling and administration cost 137 500
Selling 50 000
Administration 12 500
Variable selling (15 000 x R5) 75 000
Net profit before tax 837 500
Revision Example
Sonic (Pty) Ltd is a multi-divisional company based in Cape Town. In September 2011, it
established an export division producing a single standardized product, and commenced
exporting to Europe. The organization has identified exports as its major source of growth.
A profit and loss account, using absorption costing, has been prepared for the export
division for the year 1 April 2013 to 31 March 2014, in two halves: 1 April to 30 September,
and 1 October to 31 March. The managing director of Quid (Pty) Ltd is anxiously reviewing
the financial performance of the export division and is most perplexed because it shows
that in the second half of the year, sales has increased, but profit has declined. ‘This is
crazy!’ he says the to financial director. ‘Can you please explain to me how this can
happen? Has it got something to do with the weakening of the rand, because I must
confess to being somewhat confused. We may have to review our emphasis on exports if
this carries on!’

The following data are relevant to Sonic (Pty) Ltd’s export division:
Export division: Budget forecast for the period 1 April 2013 to 31 March 2014
1 Apr – 30 Sep 1 Oct – 31 Mar
Opening inventory – Units 800 1 300
Sales – Units 3 500 3 900
Production – Units 4 000 3 100
Fixed Manufacturing overheads (R) 90 000 85 000

Administrative and selling expenses (R) 85 000 5 000
Export division: Actual for period from 1 April 2013 to 31 March 2014
1 Apr – 30 Sep 1 Oct – 31 Mar
Opening inventory – Units 800 2 700
Sales – Units 3 100 3 500
Production – Units 5 000 2 300
Fixed Manufacturing overheads (R) 85 000 80 000

Administrative and selling expenses (R) 80 000 95 000
The selling price and variable costs per unit remained constant over the period 1 January
2013 to 31 March 2014 as follows:
R
Selling price / Unit 180
Raw material cost / Unit 40
Direct labour / Unit 20
Variable manufacturing overheads/Unit 20
The fixed manufacturing overhead absorption rate at 31 March 2013 was R20 per unit.
Consequently, the value of opening inventory at 1 April 2013 was R80 000.

Required
a. Prepare profit statements for each of the two half years, using absorption costing. (7)
b. Prepare profit statements for each of the two half years, using variable costing. (7)
c. Reconcile the profits calculated in each of the respective costing methods . (3)
d. Explain how the apparently ‘perplexing’ situation arises when using
absorption costing. (5)
e. State the benefits of using variable costing as the basis of
management reporting. (2)
[24 marks]

CHAPTER 4
COST-VOLUME-PROFIT ANALYSIS

COST-VOLUME-PROFIT ANALYSIS
LEARNING OUTCOMES:
 Define what is meant by cost-volume-profit (CVP) analysis including break-even analysis
 Explain the difference between the economist’s and accountant’s cost-volume-profit
graph
 Calculate the break-even point to actual profit and discuss why CVP represents a
variable costing system
 Carry out multi-product break-even analysis and sensitivity analysis.
Introduction
CVP analysis is a powerful tool for decision making and helps us answer a number of questions
relating to the consequences of following certain courses of action, for example, “How many
units do we need to sell to breakeven?” “What would happen to profits if we sold more units?”
CVP analysis represents a systematic method of examining the relationship between changes
in activity and changes in total sales revenue, expenses and net profit. The primary objective of
CVP analysis is to predict what will happen to financial results if output volume fluctuates. It
enables management to identify one of the most critical output levels, namely, the level at which
the company will make neither a profit nor a loss, i.e. the breakeven point.
Contribution
One of the key elements in CVP analysis is the concept of contribution.
Contribution is the amount remaining after the deduction of all variable cost from sales. This
amount contributes towards covering the organisation’s fixed cost.
Contribution = sales – total variable costs

Contribution Ratio or Profit Volume (PV) Ratio

The ratio of the contribution to total sales is known as the contribution ratio.
The contribution ratio indicates the percentage of sales available to cover fixed costs. Once
ALL fixed costs are covered, each additional unit sold increases net profit by the amount of the
contribution per unit.
Contribtion Ratio = contribution / sales X 100%
Example:
Last month’s extracts from the financial records of Snack Time Ltd. is as follows:
Total Per unit Percent
R R %
Sales (1 500 units) 150 000 100 100
Less: Variable costs 90 000 60 60
Contribution 60 000 40 40
Less: Fixed costs 40 000
Net Profit 20 000
Required
a. Calculate the number of units sold.

b. Calculate the contribution ratio.
Solution
a. Contribution per unit = Total contribution / number of units sold

Number of units sold = R30 000 / R20 per unit
= 500 units
b. Contribution / sales x 100
R30 000 / R75 000 X 100
= 40%
The contribution ratio of 40% indicates that R0.40 of every R1 of sales is available to
cover fixed costs. Once all fixed costs are covered, R0.40 of every R1 of sales will
contribute to net profit.

Break-even analysis
The number of units needed to be sold in order to ‘break-even’ will be the total costs divided but
the contribution to break-even. This must be an amount which equals the fixed costs.
Breakeven point in units = total fixed costs / contribution per unit
This is the minimum number of units that has to be sold to ensure that the fixed costs are
covered and that a loss is not suffered. It is also known as the breakeven quantity or volume.
Breakeven Value
Breakeven value = breakeven units X selling price per unit
OR
Breakeven value = total fixed costs / contribution ratio
Example: Use the figures provided in the above example for Snack Time Ltd to calculate the
breakeven point in units and value.
Breakeven units = total fixed costs / contribution per unit
= R40 000 / R40
= 1 000 units
This means that when 1 000 units are produced and sold, sales and total costs (ie. Fixed and
variable costs) are equal.
Breakeven value = total fixed costs / contribution ratio
= R40 000 / 40%
= R100 000
The effects of price and cost changes on the breakeven point

The usefulness of CVP comes to the fore when the management of a business wants to predict
the effect on profitability of certain changes in selling price, variable costs or fixed costs

Example:
The following information relates to a manufacturer of bricks :
R R R
Sales (40 000 units at R10) 400 000
Less: Cost of sales Fixed Variable 280 000
Cost of direct materials 60 000
Cost of direct labour 80 000
Manufacturing overheads 100 000 40 000_____________
Gross profit 120 000
Less: Selling and admin costs 30 000 20 000 50 000
Net Profit 70 000
Required:
Determine the following:
a. The breakeven point (in units and value)

b. The effect on the breakeven units if there is an
i. Increase of 10 % in the selling price per unit
ii. Increase of 10% in the sales volume
iii. Increase of 10% in the variable costs per unit
iv. Increase of 10% in fixed costs.
Consider each scenario independently

a. The breakeven point (in units and value)

TOTAL PER UNIT
R R
Sales (40 000 units X 10) 400 000 10
Less: Variable costs (60 000 + 80 000 + 40 000+ 20 000) 200 000 5
Contribution 200 000 5
Breakeven units = total fixed costs / contribution per unit
= 130 000 / 5
= 26 000 units
Breakeven value = 26 000 X R10
= R 260 000
b. i. Increase in selling price unit = R1 + previous contribution per unit R5
= R6 per unit
Breakeven units = 130 000 / 6
= 21 667 units
There is a decrease from 26 000 to 21 667 in the breakeven units
ii . Fixed costs remain unchanged
Contribution per unit remains unchanged
Therefore: Breakeven units remain unchanged.
iii. Previous contribution per unit R5

Less : Increase in variable cost per unit of R0.50
Total R4.50
Breakeven units = R130 000 / R4.50
= 28 889 units
iv. Fixed costs increase by 10 % (R130 000 X 1.1) = R 143 000

Breakeven units = R 143 000 / R5
= 28 600
There is an increase from 26 000 to 28 600 in the breakeven units.

Margin of Safety
The margin of safety indicates by how much sales may decrease before a loss occurs.
Margin of safety = Total sales – breakeven sales
Margin of safety ratio = Sales – B/E Sales / Sales
The margin of safety ratio is useful to management because it indicates to what extent (by what
percentage) the value of sales can decline before the business starts to show a loss.
Target Profit Analysis
With the aid of CVP analysis, it is also possible to determine the sales value that will produce a
certain net profit.
Sales units = fixed costs + expected profit / contribution per unit
Sales value = fixed costs + expected profit / contribution ratio
Example:
Refer back to our example of Snack Time Ltd. Assume that the target profit is R15 000 per
month. How many units must it sell each month to reach this target ?
= fixed costs + expected profit / contribution per unit
= R40 000 + R15 000 / R40
= 1 375 units
End of chapter example:

Tea Time Ltd. Manufactures and sells a single product. The budgeted monthly information for
the next year is as follows:
Sales per month 70 000 units
Selling price per unit R5
Variable costs per unit R2
Fixed costs per month (annual / 12) R150 000
Initial investment R 2 000 000

Required:
a. Calculate the budgeted profit for the year by using CVP principles.
b. How many units must be sold per year if the company wishes to earn 10% net profit per
year on the initial investment?
c. What is the breakeven point in units and in value?
d. Using the figures for the year, assume that there is an increase of 10% in fixed costs and
an increase to R2.50 per unit in variable costs. Calculate the following:
i. The breakeven point in value and in units
ii. The margin of safety value and the margin of safety ratio

CHAPER 5
BUDGETING AND BUDGETARY CONTROL

Learning outcomes:
 Define budgeting and discuss its role in planning, control and decision-making.
 Describe the various stages of the budget process
 Prepare the master budget components, including the cash budget
 Discuss the need for flexible budgeting, and calculate the necessary income and
expenditure for specific flexed budgets.
 Describe zero-based budgeting
Reasons for Budgeting

 Planning annual operations
 Coordinating the activities of the various parts of the organization and ensuring that the
parts are in harmony with each other.
 Communicating plans to the various responsibility centre managers
 Motivating managers to strive to achieve the organizational goals
 Controlling activities
 Evaluating the performance of managers
Stages in the Budgeting Process

The important stages are as follows:
 Communicating details of budget policy and guidelines to those people responsible for
the preparation of budgets
 Determining the factor that restricts output
 Preparation of the sales budget
 Negotiation of budgets with superiors
 Coordination and review of budgets
 Final acceptance of budgets
 Ongoing review of budgets
The Master Budget

The Master Budget can also be called the main budget. This is the consolidated budget, which
is usually loaded on to the organisation’s main system. A master budget will consist of all
activities in the organization as a whole. Given that any organization includes a number of
functions, there are many sub budgets. These sub budgets make up the master budget.

Components of the Master Budget

Sales Budget
Here a forecast is required of the number of units sold. All the other budgets are based on the
sales budget. It is therefore important that sales forecasts are accurate.
Production Budget
After the sales budget has been developed, management knows how many units must be
manufactured. The function of the production budget is to ensure that sufficient inventory is
always available to meet expected sales and inventory is kept an optimal level.
Direct materials budget

This budget shows the estimated quantity and the cost of raw material required to manufacture
the budgeted finished goods.
Direct labour budget

A budget must be prepared to estimate labour requirements that will support the sales and
production budget.
Cash Budget
The cash budget provides an estimate of all payments and receipts for a given period and
determines an organisation’s cash and cash equivalent position.
The objective of the cash budget is to forecast the monthly and year-end cash position and
highlight the financial requirements for the forecast period.
The organisation’s objective will be jeopardized if it finds itself with a shortage of cash and no
plans for borrowing. A cash budget is vital to the management of an organisation’s cash. It
facilitates detection of both cash surpluses and cash shortages.
Flexible budgeting
A flexible budget is one that restates the position if a variation from the expected sales and
production volume occurs on which the fixed budget is based. In other words, a flexible budget
is a budget that calculates budgeted income and budgeted costs according to actual production
volume; it also recalculates the budgeted net profit or loss.

Zero-based budgeting (ZBB)

Zero based budgeting emerged as an attempt to overcome the limitations of incremental
budgets. Firstly, ZBB takes the view that the projected expenses start from zero, which means
that budgets are complied as though the organization had just only began its activities.
Secondly, budgets are complied on a line of line basis.
ZBB is the best tool to use when dealing with discretionary costs
Discretionary costs are costs over which management has some form of control. Examples
include marketing and human capital development.
ZBB has the following advantages when compared to with traditional budgeting:
 ZBB represents an allocation of resources based on need or profit, unlike traditional
budgeting that tends to use past data.
 ZBB focuses on output.
 ZBB requires managers to ask questions, like what is the reason for a budget for a
particular expense.
The disadvantages are that it is more costly and time-consuming than traditional budgeting.
End of chapter example

International Ltd manufacturers two products, Alpa and Beta. The results for the year just
ended are shown below.
Actual statement of comprehensive income for the year ended 31 December 2013
Alpa Beta Total
Production and sales – units 10 000 15 000
R’000 R’000 R’000
Sales 500 1 500 2 000
Cost of production and sales (350) (1 275) (1 625)
Direct materials 230 855
Direct labour (variable costs) 40 120
Production overheads 80 300
Normal gross profit 150 225 375
Fixed overhead (under- or over absorbed) (10) 20 10
Actual gross profit 140 245 385
Selling and administration costs (75) (150) (225)
Profit 65 95 160

The fixed production overheads are of a general nature and are absorbed at a predetermined
rate of 125 per cent of direct labour cost. Administration costs are all fixed while selling costs
are variable for both products. The selling costs incurred amounted to 5 per cent of selling price
for both Alpa and Beta.
The managing director has recently attended a management course at which the benefits of
using variable costing for internal reporting were emphasized. As a result he has asked you to
prepare a budgeted income statement for 2014 on a variable costing basis. You ascertain the
following information:
1. All variable costs per unit and total fixed costs incurred in 2013 are expected to be the
same in 2014.
2. Sales in 2014 are expected to be 11 000 units for Alpa and 16 500 units for Beta at the
2013 prices.
3. The machine and labour hour requirements per unit will be the same in 2014 as there
were in 2013 and are as follows:
Alpa Beta
Machine hours per unit 1 hour 0.75 hours
Direct labour hours per unit 0.5 hours 1 hour
The maximum hours available in 2014 are:
Machine time 25 000 hours
Direct labour 20 500 hours
Required:
(a) Prepare a sales budget for 2014 which will maximize company profits 17
(b) Based on yours sales budget in (a) above, prepare a detailed budgeted income
statement for each product and in total, in accordance with the managing director’s
wishes. 8
25

Cash Budget Question
You are provided with information of Fitz Supermarket; a business owned by Gerald Fitz. He is
worried about his poor cash flow situation at the end of September 2013. In order to rectify the
situation, Gerald plans to prepare a Cash Budget and to increase his mark up percentage.
Information:
1. Gerald currently uses a markup of approximately 52% on cost, but he plans to increase
this to 75% from 01 October 2013.
2. Extracts from the ledger for the past year ended 30 September 2013:
R
Sales (distributed evenly) 2 332 800
Cost of sales 1 536 000
Inventory 324 000
Loan from A1 Lenders
(Interest at 14% p.a.) 90 000
Bank overdraft 28 000
3. Cash sales comprise 20% of all sales. Johnny predicts total sales and cost of sales to be
the following:
October November
R R
Total sales 210 000 245 000
Cost of sales 120 000 140 000
Mark up % 75% 75%
4. Total sales in previous months are as follows:

July 180 000
August 240 000
September 150 000

5. Debtors are expected to settle their accounts as follows:

a) 50% in the month following the sales transaction month (that is, within 30 days).
These debtors are entitled to 5% cash discount for prompt settlement.
b) 44% in the second month following the sale transaction month (that is, within 60
days).
c) 6% will be written off as bad debt
6. Purchase of trading inventory

a) Inventory is kept at a constant level, purchase replace sales in the same month.
b) All purchases of merchandise are for cash.
7. Loan from A1 Lenders:

The short term loan was originally received on 30 September 2013. This is to be repaid
in equal instalments over 24 months on the last day of each month. Interest at 14% p.a.
is payable on the last day of each month.
8. On 01 November 2013, the salary of the shop manager will increase by 12%, while the
wages of the six shop assistants will increase by R120 each.
Required:
a. Prepare the Debtor’s Collection Schedule for October and November 2013. (All
calculations must round off to the nearest rand). (7)
b. Complete the Cash Budget for October and November 2013. (All calculations must
round off to the nearest rand). (18)

CHAPTER 6
STANDARD COSTING

Learning outcomes
 Discuss the need for a standard costing system and the different types of standards
 Understand the principle of reconciling the budget profit to actual profit
 Calculate material, labour, overhead and sales variances
 Identify and discuss the causes for variances and possible remedies
A Standard costing system is a tool used for control (financial and operational) and inventory
valuation purposes. This system enables deviations from the budget to be analysed in detail,
thus enabling costs to be controlled more effectively. Inventory can be valued at a standard.
Standards are predetermined targets; they are target inputs / variables that should be achieved
under efficient operating conditions.
The main aim of a standard costing system is to enable managers to draw comparisons
between what should have been achieved (as complied in the budget) and what exactly was
achieved.
Standard costing systems can improve cost control by:
 Establishing standards for each cost or income element
 Determining actual costs for each cost or element
 Comparing actual costs income with standard costs income and determining the
variances
 Analyzing the variances
 Facilitating measures to correct these variances, if necessary.
Variance Analysis
Material Variances
The cost of the materials used in a manufactured product are determined by two basic factors:
the price paid for the materials, and the quantity of materials used in production. This gives rise
to the possibility that the cost will differ from the standard cost because the actual quantity of
materials used will be different from the standard quantity and/or the actual price paid will be
difference from the standard price.
TOTAL MATERIAL VARIANCE (AC – SC)

The total material variance is calculated as the difference between the actual cost
(actual quantity of material consumed at the actual price) and the standard cost allowed

(standard quantity allowed for actual production at the standard price).

When:
AC > SC, the variance is negative or unfavourable.
AC < SC, the variance is positive or favourable.
The total material variance can thus be divided into two sub-variances:
● The material price variance
● The material quantity variance
MATERIAL PRICE VARIANCE (SP – AP) x AQ
The material purchase price variance is calculated as the difference between the actual
quantity purchased (or issued/consumed) at the actual purchase price and the actual
quantity purchased (or issued/consumed) at the standard price.
When:
AP > SP, the variance is unfavourable.
AP < SP, the variance is favourable.
MATERIAL QUANTITY VARIANCE (SQ – AQ) x SP
The material quantity or usage variance is calculated as the difference between the actual
quantity of material consumed at standard price and the standard quantity of material allowed
for actual production at standard price.
When:
AQ > SQ, the variance is unfavourable.
AQ < SQ, the variance is favourable.
Labour variances
As in the case of material, direct labour costs have two basic elements:
 the rate (or tariff) which is paid for each class of labour per hour
 the time (number of hours) required to manufacture the product

TOTAL LABOUR VARIANCE (AC – SC)

The total labour variance is the difference between the actual cost (actual hours worked at the
actual labour rate per hour) and the standard cost (standard number of hours allowed for actual
production at the standard labour rate per hour).
When:
AC < SC, the variance is positive or favourable
Labour rate/tariff variances
LABOUR RATE/TARIFF VARIANCE (SR – AR) x AH

The labour rate/tariff variance is calculated as the difference between the actual hours worked
at the actual rate/tariff and the actual hours worked at the standard rate/tariff.
When:
AR > SR, the variance is negative or unfavourable.
AR < SR, the variance is positive or favourable.
Labour efficiency variance
LABOUR EFFICIENCY VARIANCE (AH – SH) x SR

The labour efficiency variance is calculated as the difference between the actual time worked
(usually in hours) at the standard labour rate and the standard time (hours) allowed for actual
production at the standard labour rate.
When:
AH > SH, the variance is negative or unfavourable.
AH < SH, the variance is positive or favourable.
Variable overhead variances
TOTAL VARIABLE OVERHEAD VARIANCE (AC – SC)

The total variable manufacturing overheads variance is calculated as follows:
It is the difference between the actual variable manufacturing overheads incurred and the
standard hours allowed for actual production at the standard variable manufacturing overheads
rate per hour.

When:
AC < SC, the variance is positive or favourable.
VARIABLE OVERHEAD RATE VARIANCE (AR – SR) X AH

The variable manufacturing overheads rate variance is determined by measuring the difference
between the actual variable manufacturing overheads incurred and the actual hours worked at
the standard variable manufacturing overheads rate.
When:
“Actual rate” > SR, the variance is negative or unfavourable.
“Actual rate” < SR, the variance is positive or favourable.
VARIABLE OVERHEAD EFFICIENCY VARIANCE (AH – SH) X SR

The variable manufacturing overheads efficiency variance is calculated as follows:
It is the difference between the actual hours at the standard variable manufacturing overheads
rate and the standard hours allowed for actual production at the standard variable
manufacturing overhead rate.
When:
AH > SH, the variance is negative or unfavourable.
AH < SH, the variance is positive or favourable.
FIXED MANUFACTURING OVERHEAD EXPENDITURE VARIANCE

This is the difference between the actual fixed manufacturing expenditure and the standard or
budgeted fixed manufacturing overhead expenditure.
Variable sales and distribution cost variances

VARIABLE SALES AND DISTRIBUTION COST RATE VARIANCE
The variable sales and distribution cost rate (or expenditure/spending) variance is the difference
between the actual variable sales and distribution cost incurred and the standard variable sales
and distribution cost allowed for units actually sold.
When:
AR > SR, the variance is negative or unfavourable.
AR < SR, the variance is positive or favourable.

SELLING PRICE VARIANCE

The selling price variance is the difference between the actual selling price per unit and the
standard/budgeted selling price per unit for the actual volume sold.
When:
AP < SP, the variance is negative or unfavourable.
AP > SP, the variance is positive or favourable.
End of Chapter example
IJC Ltd manufacturers one type of product of car brakes. The Director has been presented with
the following report
Final Quarter Results

Budget Actual Variance
Sales 3 000 3 190 + 190
Production costs:
1 800 - 400
Direct materials 1 400
700 - 100
Direct Labour 600
Overhead costs: 650 - 50

Fixed 600 100 0
Variable 100 405 0
Add: Opening Inventory 405 (810) 405
Less Closing Inventory (405)
Cost of goods sold 2 700 2 845 -145
Profit 300 345 +45

The MD is confused by the results as he feels that though there was an increase in sales, all
other costs have increased out of proportion to the sales increase.
The following data are also relevant:
Budget Actual
Opening inventory – units 3 000 3 000
Production – units 20 000 25 000
Sales – units 20 000 22 000
Raw materials per unit 7 kg 8 kg
Labour hours per unit 5 hours 4 hours
Variable costs are incurred on the basis of units produced. There was no inventory of raw
materials or work-in-progress at the end of the period under review.
Required
a. Determine whether the organization uses a standard variable costing system or a

standard absorption costing system based on the budget information. In your answer
show the standard product cost for one unit (2)
b. Calculate the appropriate variances for sales, materials, labour and overheads in as
much detail as possible. (12)
c. Present a statement for the MD reconciling the budgeted profit with the actual profit. (3)
d. Suggest possible reasons for variances you have calculated in sales, direct materials
and direct labour. (4)
e. Comment on the usefulness of the existing reporting method for decision-making and
make some suggestions on how it could be improved. (4)

CHAPTER 7
ACTIVITY BASED COSTING

Learning outcomes
 Explain why using only unit-based cost drivers to assign overheads may produce
distorted costs
 Explain the advantages and disadvantages of activity-based costing (ABC)
 Explain why ABC is preferable to absorption costing but may be inappropriate for
decision-making purposes
 Compute product costs using activity-based costing
Activity based costing (ABC) originated in the late 1980s in response to the increase in
overhead costs, especially manufacturing support costs, this in itself was a result of the
increasingly complex manufacturing environment. Volume based measures of allocating
production overheads were deemed to be a crude way of allocating overheads owing to their
inadequate treatment of cause-effect relationships.
An activity based costing system is a sophisticated absorption costing system that provides
information that is more useful for decision making purposes. Cost drivers are used to allocate
indirect costs to products and product costs allocations are based on the level of usage of
drivers per product. ABC differs from traditional costing by having a greater number of cost
centers and a greater variety of cost drivers. This results in more accurate product cost
measurement.
Comparison of the two stage allocation process (between traditional and ABC)
Both methods use a two stage allocation process.
In the first stage, the traditional costing method allocates overheads to production and service
departments and then re-allocates service department costs to the production departments.
The ABC method pools overheads to each major activity.
The second stage of the two stage allocation process allocates costs from production
departments (traditional method) or cost pools (ABC) to products or other chosen cost objects.
The traditional costing method allocates overheads to products based on a small number of
second-stage allocation bases (ie units or hours, resulting in the overhead allocation rate. In
ABC, the term ‘cost driver rate’ is used rather than ‘overhead allocation rate’. A much wider
allocation base or drivers are used owing to technological development.

Differences between ABC and traditional Costing

With ABC:
 Non manufacturing, as well as manufacturing costs, may be assigned to products for
decision making purposes.(not of GAAP inventory valuation)
 A number of overhead activity cost pools are used, each of which is allocated to
products and other cost objects using ABC’s own unique measure of activity or driver.
 The allocation bases differ from those used in the traditional costing method.
 The activity rates may be based on the level of activity at normal capacity rather than on
the budgeted level of activity.
Advantages of ABC:
 Provides a more accurate method of product/service costing, leading to more accurate
pricing decisions.
 It increases understanding of overheads and cost drivers
 Makes costly and non-value adding activities more visible allowing managers to reduce
or eliminate them
 It also enables improved product and customer profitability analysis
 It supports performance management techniques as continuous improvement and
scorecards
Disadvantages of ABC:
 Difficult to identify the overall activities that influence costs.
 Not easy to select the most suitable cost driver
 Difficult to evaluate cost on the basis of activities
 Not suitable for small manufacturing concerns
 More time consuming to collect the data
 The benefits obtained from ABC may not justify the cost
 ABC can be more complex to explain to the stakeholders of the costing exercise.

Example:
Cats Ltd, manufactures two products namely “Snack” and “Hide”, using an automated
manufacturing process. The company manufactures 75 000 units of Snack and 525 000 units
of Hide per year.
Economic order quantity calculations determined that the most economical option would be
1 000 and 3 000 units per production run (batch) for Snack and Hide respectively. Set-ups are
done for every batch and each set-up takes 24 minutes for Snack and 15 minutes for Hide.
Total direct manufacturing costs for the coming financial year are as follows:
Direct Material
- Snack 1 988 000

- Hide 5 112 000
The budgeted manufacturing overheads for the coming financial year are as follows:
Material purchase and storage 520 000
Setting up of machines 3 705 000
Processing 2 125 000
Maintenance 150 000
Total 6 500 000
The products are manufactured by machines only. It takes three machine hours to manufacture
a batch of 1 000 Snack units and two machine hours for every batch of 3 000 Hide units. An
analysis of the manufacturing process revealed the following:

Activity Cost driver

Material purchase and storage Number of orders placed: 50 orders
Snack and 75 orders for Hide per
Year
Setting up of machines Setting up hours
Processing Machine hours
Maintenance (routine inspection of machines) Inspection hours (Inspection is done
After every 25 hours of machine time
and takes 36 minutes for Snack and
12 minutes of Hide
Cats Ltd. currently allocates all manufacturing overheads according to machine hours.
REQUIRED
a. Allocate the total overheads using the traditional costing method.

b. Set up an ABC system and allocate total overheads.
c. Calculate the product cost per unit for Snack and Hide by applying both methods and
then compare the results.
Solution
a. Allocating overheads using the traditional costing method
Total overhead cost / budgeted production hours
= R 6 500 000 / [(75 000 x 3/1000) + (525 000 x 2/3000)]
= R 11 304.35 / hour
(= 225 machine hours budgeted to manufacture Snack and 350 hours budgeted to for Hide)
Thus Snack overhead = R11 304.35 X 225 hours = R2 543 478
Thus Hide overhead = R11 304.35 X 350 hours = R3 956 522
Total overheads R6 500 000

b. Setting up an ABC system
Calc (1) Number of inspection hours
Snack Hide
Total machine hours 225 350
Inspections 25 25
Number of inspections 9 (225/25) 14 (350/25)
Inspection hours 5.4 (9 x 36/60) 2.8 (14 x 12/60)

ALLOCATION OF OVERHEADS
c. Calculating the product cost per unit for Snack and Hide using ABC

Mountain (Pty) Ltd makes two types of diaries – ‘Executive’ and ‘Standard’. The ‘Executive’ is
personalized, and has higher quality inking and a leather cover. The ‘Standard’ is generic, and
has a cardboard cover.
The diaries are manufactured in a two-stage production process, firstly printing, followed by
binding. Mountain (Pty) Ltd currently uses a departmental overhead recovery rate based on
machine hours for each production cost centre. Factory overheads, are allocated to the
products as they move through each production cost centre, and then a 100 per cent mark-up is
applied to the product cost to arrive at the final selling price.
The market for diaries has become very competitive, with price-cutting tactics a very
commonplace in the industry. Senior management recently appointed a team of external
management consultants to review their business, and one of the consultants’
recommendations was that Mountain (Pty) Ltd implement an Activiy-based costing (ABC)
System. They concluded their report by stating, ‘The benefits of ABC are enormous. One of its
key benefits is that it results in accurate product costing and from there, accurate profit
measurement of products.’
The financial director has asked you to review the consultants’ recommendations and undertake
a comparative analysis between the existing method and the proposed method using the
September 2014 figures to illustrate your analysis.
Key data for September 2014 were as follows:
1. During September, 50 000 Standards and 10 000 Executives were produced and
delivered to the customers.
2. The Standard and Executive diaries are manufactured in production runs of 1 000 and
500 units respectively. Actual machine hour utilization per production run during
September 2014 was:

Standard Printing run of 1 000 units: Time taken = 10 machine hours
Binding run of 1 000 units: Time taken = 20 machine hours
Executive Printing run of 500 units: Time taken = 15 machine hours
Binding run of 500 units: Time taken = 25 machine hours
3. Indirect costs allocated and apportioned to each production cost centre during
September were:
4. Direct costs incurred during September were:
Standard per 1 000 diaries Executive per 500 diaries
Materials 10 000 20 000

Labour 2 000 5 000
Expenses 4 000 10 000

5. The management consultants have recommended that Mountain (Pty) Ltd establish the
following five cost pools:
Activity Cost Driver
Purchasing Number of purchase orders
Production Number of machine set-ups
Maintenance Machine hours (printing and binding combined)
Inspection Number of units
Dispatch Number of deliveries
The printing and binding production cost centres would now be combined into one cost pool.
6. You establish that the following activity levels for the respective products and the total
overhead allocation for each cost pool during September 2014 would have been as
follows:
Required
(a) Derive a selling price per unit for each diary using the existing method (7)
(b) Derive a selling price per unit for each diary using the proposed ABC method.
You may assume that the 100 per cent mark-up still applies. (11)
(c) Draft a report to the financial director in which you:
(i) Give reasons for any changes in the selling price (if any).
(ii) State whether or not the organization should implement the ABC system. (4)

CHAPTER 8
THE MEANING OF FINANCIAL MANAGEMENT

Learning Outcomes:
 The fundamental concepts related to Managerial Finance

 The importance of a study of Managerial Finance
 The different career opportunities in Managerial Finance
 The function of Managerial Finance in the business world
 The goals of Managerial Finance
 The role of Managerial Finance in the market place
 The legal form of various businesses
 Understand Financial Institutions and Markets

The Field of Finance

The field of finance is broad and dynamic. It directly affects the lives of every person and every
organization. There are many disciplines and career opportunities in the field of finance. Basic
principles of finance, such as those you will learn in this guide, can be universally applied in
business organizations of different types. This extends from small businesses to SMME’s and
large corporations.
WHAT IS FINANCE?
Finance can be defined as the art and science of managing money. Finance is concerned with
the process, institutions, markets, and instruments involved in the transfer of money among
individuals, businesses, and governments.
MANAGERIAL FINANCE
Managerial Finance is concerned with the duties of the Financial Manager (FM) in the business.
FMs actively manage the financial affairs of a business entity and they are an important link in
the top management structure of a firm.
The Duties of the Financial Manager

Profit maximization: The FM tries to earn maximum profits for the company in the
short-term and the long-term. He cannot guarantee profits in the long term because of
business uncertainties. However, a company can earn maximum profits even in the
long-term, if:
a. The Finance manager takes proper financial decisions.
b. He/she uses the finance of the company properly.
Wealth maximization: Wealth maximization means to earn maximum wealth for the
shareholders. This may entail the FM giving a maximum dividend to shareholders
(shareholders are the owners of the company). He/she also tries to increase the market
value of the shares. The market value of the shares is directly related to the performance
of the company. Obviously the better the performance, the higher the market value of
shares and vice-versa.

Proper estimation of total financial requirements: The FM must find out how much
finance is required to start and run the company. He/she must find out the fixed capital
(to purchase fixed assets, like land and buildings, equipment and vehicles) and working
capital (to invest in inventory, accounts receivables and also accounts payable)
requirements of the company. His/her estimation must be correct. If not, there will be
shortage or surplus of finance. Estimating the financial requirements is a difficult task.
The financial manager must consider many factors, such as the type of technology used
by the company, the number of employees, scale of operations, legal requirements, etc.
Proper mobilisation: Mobilisation (collection) of finance is an important objective of

financial management. After estimating the financial requirements, the FM must decide
on the most appropriate source/s of finance. He can raise finance from many sources
such as shares, debentures, bank loans, etc. There must be a proper balance between
own finance and borrowed finance. The company must borrow money at a low rate of
interest.
Proper utilisation of finance: Proper utilisation of finance is an important objective of

financial management. The financial manager must make optimum use of finance.
She/he must not invest the company’s finance in unprofitable projects or block the
company’s finance in inventories.
Maintaining proper cash flow: Maintaining proper cash flow is a short-term objective of
financial management. The company must have a proper cash flow to pay the day-to-
day expenses such as the purchase of raw materials, payment of wages and salaries,
rent, electricity bills, etc. If the company has a good cash flow, it can take advantage of
many opportunities such as getting cash discounts on purchases, large-scale purchasing
and granting credit to customers, etc. A healthy cash flow improves the chances of
success of the company.
Creating reserves: One of the objectives of the FM is to create reserves. The company
must not distribute the full profit as a dividend to the shareholders. It must keep a part of
profits (called retained income/earnings) as reserves. Reserves can be used for future
growth and expansion.

Proper co-ordination: The FM must try to have proper co-ordination between the
finance department and other departments of the company.
Create goodwill: The FM must try to create goodwill for the company. It must improve
the image and reputation of the company. Goodwill helps the company to survive in the
short-term and succeed in the long-term. It also helps the company during difficult times.
Increase efficiency: The FM also tries to increase the efficiency of all the departments
of the company. Proper distribution of finance to all the departments will increase the
efficiency of the entire company.
Reduce the cost of capital: The FM must try to reduce the cost of capital. That is, it
tries to borrow money at the lowest possible rate of interest. The FM must plan the
capital structure in such a way that the cost of capital is minimised.
Reduce operating risks: Financial management also tries to reduce the operating risks.
There are many risks and uncertainties in a business. The finance manager must take
steps to reduce these risks. He/she must avoid high-risk projects. He/she must also take
proper insurance.
Prepare the capital structure: Financial management also prepares the capital
structure. It decides the ratio between owned finance and borrowed finance. It brings a
proper balance between the different sources of capital. This balance is necessary for
liquidity, economy, flexibility and stability.
Investment decisions: The business gets cash, mainly from sales. It also gets cash
from other sources. It gets long-term cash from equity shares, debentures, term loans
from financial institutions, etc. It gets short-term loans from banks, fixed deposits, dealer
deposits, etc. The FM must invest the cash properly. Long-term cash must be used for
purchasing fixed assets. Short-term cash must be used as a working capital.

Allocation of surplus: Surplus means profits earned by the company. When the
company has a surplus, it has three options:
It can pay the surplus as a dividend to shareholders.
It can save the surplus. This will form part of retained earnings.
It could also award a bonus to employees (although this is very rare).
Negotiating for additional finance: The finance manager has to negotiate for
additional finance. This means that he has to speak to many bank managers. He has to
persuade and convince them to give loans to his/she company. There are two types of
loans, namely, short-term loans and long-term loans. It is easy to get short-term loans from
banks. However, it is very difficult to get long-term loans.
Checking the financial performance: The finance manager has to check the financial
performance of the company. This is a very important finance function. It must be done
regularly. This will improve the financial performance of the company. Investors will invest
their money in the company only if the financial performance is good. The finance manager
must compare the financial performance of the company with the established standards. He
must find ways for improving the financial performance of the company.
Financial planning: The main responsibility of the chief financial officer in a large
concern is to forecast the needs and sources of finance and ensure the adequate supply of
cash at proper time for the smooth running of the business. He is to see that cash inflow
and outflow must be uninterrupted and continuous. For this purpose, financial planning is
necessary, i.e., he must decide the time when he needs money, the sources of supply of
money and the investments patterns so that the company may meet its obligations properly
and maintain its goodwill in the market. The financial manager must also ensure that there
is no surplus money in the business which earns nothing.
Responsibility to owners: Shareholders or stock-holders are the real owners of the

concern. Financial manger has the prime responsibility to for the risky capital provided to
those who have committed funds to the enterprise. He/she should not only maintain the
financial health of the enterprise, but should also help to produce a rate of earning that will
reward the owners adequately.

Legal obligations: Financial manager is also under an obligation to consider the

enterprise in the light of its legal obligations. A host of laws, taxes and rules and regulations
cover nearly every move and policy. Good financial management helps to develop a sound
legal framework.
Responsibilities of employees: The financial management must try to produce a

healthy going concern capable of maintaining regular employment at satisfactory rate of
pay under favourable working conditions.
Responsibilities to customers: In order to make the payments of its customers’ bill,

the effective financial management is necessary. Sound financial management ensures
he creditors continued supply of raw material.
FORMS OF OWNERSHIP
The 3 most common legal forms of business ownership in South Africa are the sole
proprietorship, the partnership, the company and close corporation. Other forms of business
organization also exist. The sole proprietorship is the most common. However, companies are
dominant with respect to their contribution of revenue and profits in a given economy.
Sole Proprietorships
A sole proprietorship is a business owned by one person who operates it for his or her own
benefit. The typical sole proprietorship is a small business, for example an electrician or a
general dealer. The sole proprietor has unlimited liability; his or her personal assets will be
attached to meet financial obligations if the business goes bankrupt. Continued existence of the
entity depends on one person, the owner. Growth is also limited due to the inability to raise
funds because individuals have limited funds and collateral available.
Partnerships
A partnership consists of 2 or more owners not exceeding 20 in number, doing business
together for profit. Partnerships account for 10% of all businesses. They are usually larger than
sole proprietorships but individual partner’s viewpoint is identical to single proprietors. Finance,
insurance and real estate firms are the most common types of partnership. Most partnerships
are established by a written contract. They have unlimited liability, and each partner is jointly
and severally liable for all the debts of the partnership. A major advantage of partnerships is the

pooling of resources (such as financial resources, technical skills and management expertise)
which each individual partner may be able to contribute.
Companies
A company is an artificial being created by law. Often called a “legal entity”, a company has the
same powers as an individual in that it can sue and be sued, make and be party to contracts,
and acquire property in its own name. The owners of companies are known as shareholders.
The ownership of a company is divided into a number of shares, each of equal size. Each
shareholder owns one or more shares in the company.
Private and public companies

Private company: According to the Companies Act, a private company exists when the
right to transfer shares is limited and the number of shareholders is limited to a maximum of 50.
Shares may not be offered to the general public.
Public company: A public company is an association of at least seven persons. There are
basically no limits to the number of shareholders. A public company can offer its shares for sale
to the general public.
Characteristics/key concepts related to companies

Perpetual life: When an owner (shareholder) of a company dies, that person’s shares pass
on to the beneficiary of their estate.
Limited liability: Shareholders can limit their losses to that which they have paid or agreed
to pay for the shares.
Management of companies: The shareholders elect directors to manage the company on a

day-to-day basis on behalf of those shareholders.
Shares and shareholders: When considering the (public) company, which enables
thousands of people to invest as joint owners, it is not practical for each owner to have his/her
own capital account in the books of the business. To overcome this problem, the company
divides its own capital into smaller portions, known as shares. Owners of these shares are
called shareholders. Ownership of these shares can easily be exchanged, especially if a
company’s shares are listed on a stock exchange.

Par value vs. market value
The SHARE CAPITAL of a company can be calculated as follows:
Number of issued shares x par value
The Par value of a share is the price at which the shares were first registered. The prices of
shares do not stay constant. They may change when shares are split. This is the reason why
share capital must be stipulated at the par-value cost of the shares. Remember: a
shareholder’s stake in a company is not determined by the amount of money contributed, but
by the number of shares owned (relative to the number of shares issued). If a company has
issued 500 000 shares, and one shareholder holds 100 000 thereof, he has 20% shares in the
company, irrespective of how much he paid for his shares.
As soon as the company reaches the second market (e.g. JSE), the price of shares will vary
according to changes in demand and supply, market sentiment, and other factors. The price, at
which the shares of a public company trade at a given point in time, is called the market
value(only public companies can be listed on a stock exchange). In the case of unlisted public
companies and private companies, the value of the shares will also change, but the price of the
shares will be determined by the directors of the company, and thus called directors value.
Authorised vs. issued share capital
The share capital that a company can acquire according to its memorandum of association is
called the authorised share capital. The authorised shares are seldom issued in full to the
potential shareholders. Those shares, which have actually been issued (sold), multiplied by the
par value per share equals issued share capital. The difference between the authorised and
issued share capital is called the “reserve capital”.
Share Premium
Assume that a company issues 10 000 shares at a price of R2 each. Given a par value of R1.50
per share, the amount over and above the par value is the premium. In the above example the
“premium” per share is 50c. Therefore, the amount that will be regarded as a premium for the
issue of 10 000 shares will be R5 000.

Classification of Shares
There are two basic types of shares, namely “preference shares” and “ordinary shares”
Preference Shares
Preference shares carry a fixed dividend, and provide a preference right to the holders thereof
with regards to dividends. Preference shareholders can only receive dividends if there’s a
sufficient profit after tax available for distribution.
Ordinary Shares
Ordinary shares are considered for dividends; only after the preference dividends have been
recommended. In contrast to preference shares capital, a fixed percentage is NOT paid out as
ordinary dividends. The amount paid out can vary from year to year. This will depend on
profits, and the decisions made by the directors of the company.
Reserves
Reserves are profits and gains, which, have been made by the company and which still form
part of the shareholders claims, because they have not been paid out to the shareholders.
These profits and gains are in a reserve, which represent a source of new finance for the
companies.
Equity
Equity is the value of ordinary shares and reserves of a company or the residual interest in the
assets after the deduction of all liabilities.
Close Corporation
A close corporation is a separate legal persona (like a company), i.e. it has perpetual
succession, can own assets apart from its members and its members enjoy limited liability.
Membership is restricted to between 1 and 10 persons. There is no share capital. Member’s

interest is merely shown as a percentage. Proportional interest in the business and owners are
not distinguished from management. Furthermore, the sale of members’ interest does not
terminate the existence of the business. The major advantage of a close corporation is the

absence of ‘jointly and severally liable’ provision which covers partnerships. A close corporation
does not have directors; members conduct the business.
Organisation of the Financial Function
The importance of the managerial finance function depends on the size of the firm. In small
firms, the finance function is generally performed by the accounting department. As a firm
grows, the finance function evolves into a separate department linked directly to the company
president or CEO through the chief financial officer (CFO).
The treasurer and the controller are required to report to the CFO. The treasurer (the chief
financial manager) is responsible for handling financial activities, such as financial planning and
fund raising, making capital expenditure decisions, managing cash, managing credit activities,
managing the pension fund, and managing foreign exchange. The controller (the chief
accountant) handles the accounting activities such as corporate accounting, tax management,
financial accounting and cost accounting. The treasurer’s focus tends to be more external, the
controller’s focus more internal.
A trained Financial Manager (FM) is able to monitor and manage the firm’s exposure to loss
from currency fluctuations of international sales and purchases.
Goals of the Managerial Finance Function
The owners of a company are distinct from its managers. Actions of the financial manager
should be in accordance with meeting the objectives of the firm’s owners; its shareholders.
Maximise Profits
Most FMs believe that maximising profit is the firm’s objective. To do this, the FM must take
certain actions that are expected to make a major contribution to the firm’s overall profits. For
each alternative considered, the FM would select the one that is expected to result in the
highest monetary return. A company measures profits in terms of its earnings per share (EPS).
Ethics
This involves the standards of conduct or moral judgement. The ethics of actions taken by
certain businesses have received major media attention. The business community and the
financial community are developing and enforcing ethical standards. The goal is to motivate
business and market participants to adhere to both the letter and the spirit of laws and

regulations concerned with professional practice. Businesses actually strengthen their

competitive positions by maintaining high ethical standards.
Social responsibility
A firm, in principle, has a responsibility towards the community and their employees. It should
be seen from the outside as an organ of society, which should serve the interests of society.
This means that the goal of the firm is to encourage and achieve the greatest possible socio-
economic wealth. This serves as a criterion for the evaluation of the actions of the firm. From
the perspective of social responsibility, the firm is a social entity within society which:
Should satisfy society’s needs for goods and services
Should provide job opportunities and job satisfaction
Should improve the welfare (material and other) of society by using entrepreneurship,
capital, human resources and raw materials economically.
Service to society is therefore a primary goal, while profitability still remains an important
consideration. A firm therefore also pursues social goals such as: a high standard of living,
economic progress and stability, personal and national security, improved living conditions on
both local and national levels, serve its community by maintaining a high standard of education,
participating in local government through town planning and the provision of recreational
facilities. Service to the community could also be expressed in a firm’s product range, quality
policy, research and product development programmes and employment policy.
Selecting optimal finance mix
A Financial Manager is constantly looking for investment opportunities but needs to raise funds
to finance these investments.
Main Sources of Funds:
 Capital Markets
 Money Markets
 Creditors
 Retained Income

CHAPTER 9
PRESENT AND FUTURE VALUE OF MONEY

Learning Outcomes
After working through this section you should be able to:
 Carry out calculations involving compound interest.

 Calculate nominal and effective rates.
 Use compound interest to calculate the present value and future value of an
investment.
 Calculate the future value of an ordinary annuity.
 Calculate the present value of an ordinary annuity.
 Calculate an amount of sinking fund payment.
 Calculate the amount of amortization payment

1. Compound interest
Compounded interest is interest charged on the original sum and un-paid interest. Compound
interest is applied a number of times during the term of a loan or investment. Compound interest
yields considerably higher interest than simple interest because it pays interest on a previously
earned interest. For compound interest, the interest earned for each period is reinvested or
added to the previous principal before the next calculation (Brechner, 2009).
Example 1
An investment of R500 in a bank for 3 years at interest of 6% compounded per year.
At the end of year 1 you have (1.06)  500 = R530.

At the end of year 2 you have (1.06)  530 = R561.80.
At the end of year 3 you have (1.06)  R56.80 = R595.51.
Note:
R595.51 = (1.06)  561.80
= (1.06) (1.06) 530
= (1.06) (1.06) (1.06) 500
= 500 (1.06)3
2. Concepts used in Compound Interest
This section uses a compound interest to explore various concepts including, the time value of
money, compound amount or future value (FV) and present amount or present value (PV).
2.1. Time value of money
Time value of the money refers to the idea that the money in the present, is more desirable than
the same amount of money in the future, because it can be invested and earn interest as time
goes by (Brechner, 2009). If the bank owed R12 000, you would prefer to have it now instead of
one year from now.

2.2. Compound amount (future value)
A future value is the total amount of principal and accumulated interest at the end of loan or
investment.
2.3. Present amount (present value)
A present value or a principal amount is an amount of money that must be deposited today, at
compound interest, to provide a specified lump sum of money in the future.
2.4. Compounding periods
The interest can be computed annually, semi-annually, quarterly, monthly, daily and
continuously. Various compounding options and the corresponding number of periods per year
are shown in Table 1.1.
Table1: The number of compounding periods
Interest compounded Compounding period per year
Annually Every year 1
Semi-annually Every 6 months 2
Quarterly Every 3 months 4
Monthly Every month 12
Daily Every day 365 or 360
Continuously Infinite
To find the number of compounding periods of an investment, multiply the number of years by
the number of periods per year.
Computing periods = Years x Periods per year

For example, a principal amount invested for 3years with interest rate compounded semi-
annually is calculated as follows:
Computing periods = 3 x 2 = 6 periods
2.5. Conversion of interest per period
The interest rate used per period is known as a periodic rate. This is the interest rate charged
(and subsequently compounded) for each period, divided by the amount of the principal. The
periodic rate is used primarily for calculations and is rarely used for comparison. The periodic is
different from the quoted annual rate known as nominal interest.
To find the periodic rate we divide the nominal interest by the number of periods per year.
PERIODIC RATE =
An example of converting an annual nominal interest of 12% into periodic rates is shown in
Table 1.2.
Table 2: Periodic rates
Nominal interest rate Periods per year Periodic rate Decimal
12% compounded annually 1 12% 0.12
12% compounded Semi-annually 2 6% 0.06
12% compounded quarterly 4 0.3 0.03
12% compounded monthly 12 1.5% 0.015

2.6. Effective interest rates
To put different rates and frequencies of conversion on a comparable basis, we determine the
effective rate. The effective rate is the rate converted annually that will produce the same
amount of interest rate per year as the nominal rate converted for periods per year. Effective
annual rate is the total accumulated interest that would be payable up to the end of one year,
divided by the principal. (Els 2010: 93)
Example 2
A nominal rate of 6% compounded annually, will also have the effective rate of 6%. However, if
the nominal rate 6% is compounded semi-annually, the amount of R1 at the end of one year will
be the accumulation factor for a rate per period of 3% and two periods. This is (1.03)2 =
R1.0609.
The interest on R1 for one year is then R1.069 - R1 = 0.0609. This is equivalent to an annual
rate of 6.09%. Thus, 6.09% compounded annually will result in the same amount of interest as
6% compounded semi-annually.
The formula for the effective interest rate is as follows:
Where: r = the effective rate, i = the nominal rate per period and m = the number of periods.
Applying this formula to our previous example, the effective rate is calculated as follows:
It is important to note that economists generally prefer to use effective annual rates to allow for
comparability. In finance and commerce, the nominal annual rate may however be the one
quoted instead. When quoted together with the compounding frequency, a loan/investment with
a given nominal annual rate is fully specified (the effect of interest for a given loan/investment
scenario can be precisely determined), but the nominal rate cannot be directly compared with
loans/investment that have a different compounding frequency.

3. Compound interest with present and future values
The compounding interest is used to calculate the future value of an investment when the
principal or present value is known. It is also used to calculate the present value to be deposited
now to earn a known future amount.
3.1 Future value and compound interest
Using the compounding interest rate the future value of the loan is calculated as follows:
= ( + )
Where: F = future value, P = principal or present value, i = periodic interest rate (in decimal
form) and n = number of compounding periods.
Example 3
Jock Stein invested R1200 at 8% interest compounded yearly for 5 years. Calculate:
3.1. His total investment at maturity and
3.2. The total amount of interest earned for the five year period?
Solution
3.1. Total investment at end of period:
= ( + ) = ( . ) = .
3.2. The total interest earned:
− = ( . ) −
= 1763.19 – 1200
= 563.19

Example 4
Use the compound interest rate formula to calculate the compound amount of R5000 invested,
at 10% interest compounded semi-annually, for 3 years.
Solution
Compounding periods (n) = 2 periods per year x 3 years = 6 periods
Periodic interest rate (i) = 10/2 = 5% = 0.05
= ( + ) = ( + . )
= ( . ) = .
3.2. Present value and compound interest
Using the compounding interest rate, the present value of an investment is calculated as
follows:
=( )
= ( + )
Where: P = principal or present value, F = future value, i = periodic interest rate (in decimal
form) and n = number of compounding periods.
Example 5
Ken Rosewall invested a certain amount of money at 8% interest compounded yearly for 5
years and earned a total interest of R1 763.19. Calculate the total amount of investment.
Solution
Since the interest rate is compounded annually, there is no adjustment for the compounding
period and periodic interest rate. =( )

= ( + )
.
= = = . ( + . ) =
( + . )

Example 6
Calculate the present value of R3 000 at interest rate of 16% compounded quarterly, for 6
years.
Solution
Compounding periods (n) = 4 periods per year x 6years = 24 periods
Periodic interest rate = 16/4 = 4% = 0.04
=( = . = ( . ) = .
. )
3.3 Summary of formulae for compound interest rate
These are the most basic formulae with compound interest rate:
1. The future value (FV) of an investment’s present value (PV) accruing at a fixed interest rate
(i) for n periods. = ( + )
2. The present value of an investment: =( )

= ( + )
3. The compound interest rate achieved: = −

( ) ( )
4. The number of periods required: = ( )
3.4. Using compound interest tables
First estimate the number of compounding periods and interest rate period. Determine whether
you are using a table for a future value or present value and follow the necessary steps. Tables
for future value and present vale are in Table 1.1 and 1.2 respectively.

Steps for using compound interest tables
Step 1: Scan across the top row of the table to find the interest rate per period.
Step 2: Look down that column to the row corresponding to the number of periods.
Step 3: The table factor at the intersection of the rate per period column and the number of
periods row is the future value or the present value of R1 at compound interest rate. Multiply the
table factor by the principal to determine the compound amount.
4. Types of Annuities
Business situations frequently involve a series of equal payments or receipts, rather than lump
sums. These equal payments or receipts are called annuities. An annuity is the payment or
receipt of equal amount of money per period for a specified amount of time (Brechner, 2009).
Common application of annuities include insurance and retirement plan premiums and payout,
loan payments and saving plan for the future events such as buying an expensive item or going
to university.
4.1. Annuities Certain and Contingent Annuities
Annuities may be divided into two major categories namely, annuities certain and contingent
annuities.
An Annuity Certain is one for which the payments begin and end at fixed times. This means
that such annuity has a specified number of time periods such as R4000 per month for 4 years.
A Contingent Annuity is one the date of the first or last payment, or both, depends on some
event. This annuity is based on an uncertain time period. Retirement plans, social security and
various life insurance policies are examples of contingent annuities.
4.2. Ordinary Annuities and Annuities Due
Based on the date of the annuity payment, annuities can be classified into ordinary annuities
and annuities due.
Ordinary Annuity: this is when the annuity is made at the end of each period. E.g. A salary
paid at the end of each month is an example of an ordinary annuity.

Annuity Due: this is when the payment is made at the beginning of each period. E.g. A rent
payment paid at the beginning of each month is an example of an annuity due.
5. Future Value of an Annuity

The future value of an annuity is the total amount of the annuity payments and the accumulated
(or compounded) interests on those payments. It is also called the amount of an annuity. In this
section, we will differentiate the calculation of the future value of an ordinary annuity from that of
an annuity due.
5.1. The future value of an ordinary annuity

Manual calculation of ordinary annuity
Calculate the future value of an ordinary annuity of R10 000 per year, for 3 years, at 6% interest
compounded annually.
Time Balance
Beginning of period 1 0
End of period 1 10 000 first annuity (P1)
Beginning period 2 10 000 from first period

+ 600 interest earned in period (P2)
+10 000 second annuity payment (P2)
End of period 2 20 600
Beginning period 3 20 600 (P1, P2, interest P2)
+ 1 236 interest (P3)
+ 10 000 third annuity
End period of three 31 836
Future value of the ordinary annuity is R 31 836

This is cumbersome to calculate. An annuity of 10 years, with payments made monthly, would
require 120 calculations. It is therefore easy to use formulae to solve for a future value of an
annuity.
Formula for future value of an ordinary annuity
( )
=
Where: FVA= future value of annuity, P= annuity payment, i= interest payment and n= number
of periods (years x periods per year).
Example 7
Suppose that you have won the lottery and will receive R5 000 at the end of every year for the
next 20 years. As soon as you receive the payments, you will invest them at your bank at an
interest rate of 12 percent per annum compounded annually. How much will be in your account
at the end of 20 years, assuming you do not make any withdrawals?
Solution
( )
Formula: =
Deposit made at the end of each period (R) = R5 000
Compounding: Annual and number of periods (n) = 20
Interest rate (i) = 12%
(1.12) − 1
= 5000 = 360 262.21
0.12

Example 8
Calculate the future value of an ordinary annuity of R1 000 per month, for 3 years, at 12%
interest compounded monthly.
Solution
( )
Formula: =
R = 1000 i = 12/12 = 1% n = 3 x 12 = 36periods
(1.01) − 1
= 1000 × = 1000 × 43.07688 = 43 076.88
0.01
5.2. The Future Value of an Annuity due
An annuity due is one in which payments are made at the beginning of the payment interval.
The formula for a future value of the annuity due is a modification of a formula for the future
value of an ordinary annuity. A future value of an ordinary annuity of n+1 payments is similar to
the amount of a corresponding annuity due.
Formula for future value of an annuity due
( + ) −
= × ( + )
Where: FVA= future value of annuity, P= annuity payment, i= interest payment and n= number
of periods (years x periods per year).
Thus, the annuity due = ordinary annuity x (1+ i)
Example 9
Calculate the future value of an annuity due of R1 000 per month, for 3 years, at 12% interest
compounded monthly.

Solution
( )
Formula: = × (1 + ) or FVA ordinary annuity x (1+i)
From Example 8, we know that FVA ordinary annuity = 43 076.88
FVA annuity due = 43 076.88 x (1.01) = R43 507.65
5.3 Present value of an annuity
Present value of an annuity is the sum of the present values of all payments or receipts of the
annuity. This is a lump sum amount of money that must be deposited now to provide a specified
series of equal payment (annuities) in the future. Similar to the future value, the calculation of
the present value of an ordinary annuity due is also different to that of an annuity due.
5.3.1 Present value of an ordinary annuity
The present value of an ordinary annuity is calculated as follows:
−( + )
= ×
Where: PV = present value (lump sum), P= annuity payment, i= periodic interest rate and n=
number of periods (years x periods per year)
Example 10
Calculate the present value of an ordinary annuity of R1 000 per month, for 4 years, at 12%
interest compounded monthly.

Solution
( )
Formula: = ×
P = 1 000
i = 12/12 = 1%
n = 12 x 4 =48 periods
( . )
PVA = 1000 × .
= 1000 x 37.97396 = R37 973.96
5.3.2 The present value of an annuity due
The present value of an annuity due is calculated as follows:
−( + )
= × ( + )
Thus, PVA annuity due x PVA ordinary annuity x (1 + i)
Example 10.1
Calculate the present value of an annuity due of R1 000 per month, for 4 years, at 12% interest
compounded monthly.
Solution
We can use the PVA of an ordinary annuity from the previous example multiplied by (1+i).
PVA annuity due = 37 973.96 x 1.01 = R38 353.70 OR
( . )
PVA annuity due = 1000 × (1.01) = R38. 353.70
.

6. Using annuity tables
Annuity tables may be used to calculate the future and present values of ordinary annuity and
annuity due.
Steps for calculating future value of an ordinary annuity
Step 1: Calculate periodic interest for the annuity (nominal rate / periods per year)
Step 2: Determine the number of periods of the annuity (years x periods per year)
Step 3: From Table 2.1, locate the present value table factor at the intersection of the periodic
rate column and the number of periods row.
Step 4: Calculate the present value of the ordinary annuity
Future value of an ordinary annuity = annuity table factor x annuity payment
Steps for calculating future value of an annuity due
Step 2: Calculate the number of periods of the annuity (years x periods per year) and add one
period from the total.
Step 3: Locate the table factor at the intersection of the periodic rate column and the number of
periods row.
Step 4: Subtract 1 from the ordinary annuity factor to get to the annuity due table factor.
Step 5: Calculate the present value of the annuity due.
Steps for calculating present value of an ordinary annuity
Step 2: Determine the number of periods of the annuity (years x periods per year)

Step 3: Locate the present value table factor at the intersection of the periodic rate column and
the number of period’s row.
Step 4: Calculate the present value of the ordinary annuity
Present value of an ordinary annuity = annuity table factor x annuity payment
For example, if the interest rate is 10 percent per year, the investment of R100 received in each
of the next 5 years is 3.791 x R100 = R379.1.
Steps for calculating present value of an annuity due
Step 2: Calculate the number of periods of the annuity (years x periods per year) and subtract
one period from the total.
Step 3: From Table 2.2, locate the table factor at the intersection of the periodic rate column
and the number of periods row.
Step 4: Add 1 to the ordinary annuity factor to get to the annuity due table factor.
Step 5: Calculate the present value of the annuity due.
For example, if the interest rate is 10 percent per year, the investment of R100 received at the
beginning of each of the next 5 years is (3.791 + 1) x R100 = R479.1.
7. Sinking funds and Amortisation
In the previous Sections, 2.2 and 2.3, the amount of the annuity payment was known and we
were calculating the future or present value (lump sum) of the annuity. In this section, we will be
calculating annuity payments when the future or present value is known. In this case we will
refer to sinking fund and amortisation.

7.1. Sinking funds
A sinking fund situation occurs when the future value of an annuity is known, and the periodic
payments required amounting to that future value is known. A sinking fund is an account used
to set aside equal amounts of money at the end of each period, at compound interest, for the
purpose of saving for future obligations.
The sinking fund payments may be calculated using the following formula:
Sinking fund payment = × ( )
Where: FV = amount needed in the future,
i = interest rate per period and
n = number of periods.
Example 11
El Loco needs R100 000 in 5 years to pay off a bond issue. What sinking fund payment is
required at the end of each month, at 12% interest compounded monthly, to meet this financial
obligation?
Solution
Formula: sinking fund payment = ×

( )
i = 12/12 = 1% n = 5 x 12 = 60 periods
.
Sinking fund payment = 100 000 ×
( . )
.
100 000 × = 100 000 × 0.0122444 = R1 224.44
.

7.1.1. Calculating the amount of an amortization payment by table
We can use the future value of annuity table (Table 2.1) to calculate an amount of the payment
as follows:
Sinking fund payment =
Example 12
What sinking fund payment is required at the end of each 6-month period, at 6% interest
compounded semiannually, to amount to R12 000 in 4years?
Solution
Sinking fund payment = = .

.
7.2. Amortisation
Amortization is the opposite of a sinking fund. Amortization is a financial arrangement whereby

a lump-sum obligation is incurred at compound interest now, such as a loan, and is paid off or
liquidated by a series of equal periodic payments for a specified amount of time (Brechner,
2009).
Amortization payments may be calculated, by using a formula, as follows:
Amortization payment = × ( )
Where: PV = amount of the loan or obligation,
i = periodic interest rate (nominal / periods per year) and
n=number of periods (years x periods per year)

Example 13
What amortization payment is required each month, at 18% interest, to pay off R5 000 in 3
years?
Solution
i = 18/12 = 1.5%
n = 3 x 12 = 36 periods
.
Amortization payment = × ( )
= × ( )
= R180.76
.
7.2.1. Calculating the amount of an amortization payment by table
We can use the present value of annuity table (Table 2.2) to calculate an amount of an
amortization as follows:
Amortization =
Example 14
What amortization payments are required each month, at 12% interest, to pay off a R10 000 in
loan 2 years?
Solution
Amortization = = R470.73
.

PRESENT VALUE OF SHARES
8. End of Chapter Questions

1. A finance company makes consumer loans at a nominal annual rate of 36% compounded
monthly. What are the nominal interest rate, the periodic interest rate and the number of
periods?
2. Find the effective interest rate equivalent to 8% compounded semi-annually.
3. An amount of R1 500 is deposited in a bank paying an annual interest rate of 4.3%,

compounded quarterly. Find the balance after 6 years.
4. Your goal is to accumulate R30 000 after 17 years from now. How much must you invest
now to have, at an interest rate of 8% compounded semi-annually?
5. If R500 accumulated to R700 in 5years with a certain interest compounded quarterly, what
is the rate of interest?
6. How many years will it take R175 to amount to R230 at interest rate of 4.4% compounded
annually.
7. An ordinary annuity starts on June 1, 2008, and ends on December 1, 2013. Payments are
made every 6 months. Find the number of periods (n).
8. Find the present value of an annuity of an annuity of R100 at the end of each month for 30
years at 6% compounded monthly.
9. An investment of R200 is made at the beginning of each year for 10 years. If interest is 6%
effective, how much will the investment be worth at the end of 10 years?
10. The premium on a life insurance policy is R60 a quarter, payable in advance. Find the cash
equivalent of a year’s premiums if the insurance company charges 6% compounded

quarterly for the privilege of paying a smaller amount every three months instead of all at
once for the year.
11. A family buys a R600 000 home and pays R100 000 down. They get a 25-year mortgage for
the balance. If the lender charges 12% converted monthly, what is the size of the monthly
payment?
12. A debt of R5000 is to be amortized by 5quarterly payments made at 3 month intervals. If

interest is charged at the rate of 12% convertible quarterly, find the period payment and
construct an amortization schedule. Round the payment up to the nearest cent.
Suggested Solutions
1. Nominal rate = 36%
Periodic interest rate 36/12 = 3%
The number of periods = 12
2. Periodic rate 8/2 = 4% = 0.04 Number of periods = 2

2
r = (1.04) – 1 = 0.0816 = 8.16%
3. F = P(1 + i)
P = 1500 r = 4.3/100 = 0.043 n = 4 x 6 = 24
0.043
= 1500 1 + = 1938.84
4
The balance after 6 years is approximately R1 938.84
4. F = 30 000I =8/2 = 4% n = 17 x 2 = 34
Present value = = R7 906.56
( . )
5. The formula for interest rate is: = − 1

700 .
= − 1 = (1.4) − 1 = 1.01697 − 1 = 0.01697
500
The quarterly interest rate is 0.01697 = 1.697%

The annual rate of interest is 1.697% x 4 = 6.788%
( ) ( )
6. Formula used: n = ( )
F=230 P = 175 i= 0.044

log(230) − log(175) 2.36173 − 2.24304
n= =
Log1.044 0.0187
= 6.347 years
7. Ordinary annuity is made at the end of each period

Year Month Day
2008 12 1
-2013 -6 -1
5years 6 months 0 days
Number of time periods = (5 x 2) 6/6 = 10 + 1 = 11
8. i =6/12 = 0.5% n = 12 x 30 = 360 periods
( )
= ×
( . )
= 100 = R16 679.16
.
9. P = 200 n = 10 i = 6%
( . )
Future value of annuity due = 200 × (1.06) = R279.33
.
( )
10. Present value of annuity due = = × ( + )
P = 60 n=4 i = 6/4 = 1.5%

( . )
Present value of annuity due = 60 × (1.015)= R234.73
11. Amortization payment = × ( )
PV = 600 000 -100 000 = R500 000 n = 25 x 12 = 300 i = 12/12 = 1%
.
Amortization payment = 500 000 × ( . )
= R5 266.12
12. Amortization payment = × ( )

.
= 5000 × ( . )
= R1 091.78
Amortization schedule
(1) (2) (3) (4) (5)
Payment Total Payment on Payment on Balance of the
number payment interest (0.3 x 5) principal (2) – (3) loan (5) – (4)
1 R 1 091.78 R150.00 R941.78 R5000.00
2 R 1 091.78 R12.75 R970.03 R4058.22
3 R 1 091.78 R92.65 R999.13 R3088.19
4 R 1 091.78 R62.67 R1029.11 R2089.06
5 R 1 091.78 R31.80 R1059.95 R1059.95
Total R5 458.87 R458.87 R5000.00 0

CHAPTER 10
CAPITAL STRUCTURE AND THE COST OF CAPITAL

Learning Outcomes
 Explain the advantages and disadvantages of debt finance in terms of financial risk and
increased return to shareholders.
 Explain the meaning of Weighted Average Cost of Capital
 Explain the different theories relating to capital structure
 Calculate the value and required return for equity and debt.
 Calculate the Weighted Average Cost of Capital
What do we mean by the cost of capital?

It represents the total cost of funds raised by a company.
It’s the return that different types of investors are paid to ensure that they place their
funds within the company and keep their funds in that company.
It’s the minimum return that a company must get on its projects to earn sufficient to pay
this expected return to investors.
This means that it is also the opportunity cost because, if investors don’t get the
required return, they will move their funds elsewhere.
Debt advantage
Reasons why equity is more expensive than debt
 The ordinary shareholders or the providers of equity carry the highest risk when
providing capital to a firm. Should the firm face insolvency, the ordinary shareholders
stand at the back of the queue in getting their money back.
 Ordinary shareholders require a higher level of return. They are the most demanding of
all when it comes to getting a return on their funds.
 There is tax benefits associated with debt finance.
Debt disadvantage
 Financial risk of the company increases as the company takes on debt finance.

Financial Gearing
Financial gearing describes the proportion of debt compared to the proportion of equity
financing. It is a measure of financial leverage, showing the degree to which a firm’s operations
are funded by debt as opposed to equity.
Traditional capital structure theory
The traditional capital structure assumes than an optimal capital structure does exist and
depends on the level of gearing. The company cannot maximize shareholders’ wealth unless
optimal WACC is achieved. In short, it assumes that the firm’s cost of capital is dependent on
its capital structure.
The Miller and Modigliani theory
Millar and Modigliani proposed that there is no optimal capital structure, because the advantage
of debt would be exactly counteracted by an increase in Ke, such that the WACC would have
always equal business risk. Millar and Modigliani, however made certain assumptions as
follows:
 Investors are rational
 All investors have the same expectation about the future
 Capital markets are perfect
 All relevant information is freely available
 There are no transaction costs
 There is no taxation, or no distinction between company and personal tax
 Firms can be grouped into business risk or operating
The Importance of Calculating the Cost of Capital
Benchmarking the firm’s return against similar firms in the industry.

Assessing the value creation potential of new projects as compared to the cost of capital.
It is an important calculation to make as it forms the basis of calculating the value of the
firms cost of capital.

The Elements of the Cost of Capital

The Risk-free Rate of Return
Here we are referring to investments with a risk-free yield, such as government bonds.
The Premium for Business Risk
This is an addition to the risk-free rate of return to allow for uncertainties connected with
the cash flows of a particular project, or the health of the company as a whole. The
higher the anticipated risk, the higher this additional percentage will be.
The Premium for Financial Risk
This is an addition that takes into account the gearing of the company: for example, if
this increases, then equity-holders will need a higher return to compensate them for the
increased amounts of interest which must be deducted from operating profit.
Weighted Average Cost of Capital (WACC)
Basic Assumptions
1. Dividends on ordinary shares are expected to remain at their current rate during the lives of
the project/s to be appraised.
2. Preference shares and debentures are irredeemable.
The cost of equity capital will, therefore, be based on the current rate of dividend but, as it is
extremely unlikely that equity and debt are in equal proportions, we shall need to calculate a
weighted average

The basic formula for the WACC is:
WACC = [Proportion of Equity X Cost of Equity] + [Proportion of Debt X Cost of Debt]

= [(E/V) X Re] + [(D/V) X Rd (I – Tc)]
Where:
E = Equity
V = Value of firm
D = Debt
Re = Return on Equity
Rd = Return on Debt/Cost of Debt
Weighted average cost of Debt - Rd
When estimating the cost of debt, we have to include the long term debt and short term debt, we
need to consider the historic (coupon rate) vs future (yield to maturity) costs. When looking at
debt (traded as well as untraded) we need to observe the cost of debt, risk ratings (from credit
rating agencies) and use the risk free yield curve (maturity) and add a premium for credit, and
liquidity risk. Lastly we need to consider whether the interest rate is floating or fixed. Interest
expenses are deductible for tax purposes and thus this also needs to be considered when
calculating WACC.
Weighted average cost of capital – Re
When estimating the cost of equity, two options are available:
The Dividend Growth (DG) Model Approach
– assume a constant growth in dividends

i.

ii. 
 

i. Advantages of the Dividend Growth Model

The dividend valuation model is simple to use.
It allows for the fact that future dividends should grow if profits are re-invested and that
shareholders are likely to value their shares according to their future dividends
expectations.
ii. Disadvantages of the Dividend Growth Model

The DG method also assumes that that the market value of the share is in equilibrium so
that the share price is correct.
although it allows for the fact that future dividends should grow if profits are reinvested,
and that shareholders are likely to value their shares according to their future dividend
expectations, it assumes that all shareholders behave in the same way – which is
improbable.
Where no growth in dividends is expected in the future, we use the formula:
Cost of equity Ke = (D1/P0) + g

Our calculation is based on the assumption that the market price of a share will be the
discounted future cash flows of revenues from that share, and on a constant growth rate in
dividends. It is sometimes called the ‘Gordon Growth model’ (DG Model).
So, for example, if we have a company with shares currently valued by the market at R800 000,
but with a nominal value of R500 000, last declared dividend 15% and an expected growth rate
of 5%, we would have for cost of equity:
Current dividend R500 000 x 15% = 75 000
So d1 will be 75,000 x 1.05 = 78,750
Ke = (78,750/800,000) + 0.05 = 0.1484375 or 14.84%
We do not simply relate the R78,750 back to the nominal value of the shares, as we are
trying to find the expected return based on what owners would have to invest now, i.e. the
market value.

Cost of Equity – the dividend valuation model
Example 1
Makhanya Ltd wishes to calculate its cost of equity, and

provides the following information.
Number of shares: 1,000,000

Nominal value of each share: R2
Market price of each share: R2.80
Last declared dividend: 12%
Expected growth rate: 6%
Calculate the cost of equity using the DG Model
Solution
Let’s calculate the current dividend:
Dividend = R2 X 0,12
= R0,24
However we need to calculate the value of D1. Hence, we project this dividend at a growth rate
of 6%.
D1= Do x (1+g)
D1= R 0.24 x 1.06
= R0.2544
Now let’s calculate the cost of Cost of equity

Ke= (D1/P0) + g
Ke= (0.2544/2.8) + 0.06
The formula
Re given by:
RE= Rf+ βE[RM -Rf]

Represented by:
P0= the current price of the share
D1= Dividend in Year 1
g = growth rate
Rf= the risk free rate
Β = the risk co-efficient (also known as beta)
RM = the market risk premium
i.The CAPM shows that the expected return is dependent on three variables:
1. The pure time value of money: this is measured by the risk free rate [Rf]. This is the
reward for merely waiting for your money without taking any risks. The best indicator of
the risk free rate is the yield on government bonds (also referred to as treasury bills).
2. The reward for bearing systematic risk: this is measured by the market risk premium,
which is denoted as follows: E(Rm) – Rf. This component is the reward the market offers
for bearing an average amount of systematic risk in addition to waiting.
3. The amount of systematic risk: as measured by β. This is the amount of systematic risk
that is present in a particular asset, relative to an average asset.
ii. The Beta Factor
The beta factor is ‘the measure of a share’s volatility in terms of market risk’. The beta factor
of the market as a whole is taken to be 1. This means that:
 results for individual shares which are greater than 1 imply a greater degree of
volatility.
 Results which are less than 1 imply a lower degree of volatility.
 It should then be possible to predict what will happen to the return on a share if there
is a change in the market return.
iii. Using CAPM

Previously, we looked at the use of the Capital Asset Pricing Model in assessing a project’s
systematic risk. We did not, however, attempt to calculate . We merely use  to obtain the
cost of a firm’s equity.

Example
Suppose that we have this information about the current market return and the risk-free return:
The market return is 12%, the risk free return is 8%, and the β is 1.4. Then:
Re = Rf+ βE[RM -Rf]
Re = 8% + 1.4[12% - 8%]
Re = 8% + (1.4 x 4%)
Re = 13,6%
How will this differ from using the dividend valuation model? If we assume that prices in the
stock market are in equilibrium, and that a firm’s dividends reflect systematic risk only, then the
two methods produce approximately the same result. However, in practice:
The dividends used in the dividend valuation model may include an allowance for
specific as well as systematic risk.
The current share values used in the model may not in fact be in equilibrium.
The CAPM assumes that there is equilibrium in the stock market, and considers
systematic risk only.
So far, we have presumed that we know what the beta factor for a share is. We can in
fact calculate it, although in practice it’s easier to look it up.
iv. Advantages of the CAPM

The CAPM allows for variations in share prices and returns as the result of market
risk. Therefore it can indicate whether the share at the moment is higher or lower
than it should be and what it should change to.
v. Disadvantages of the CAPM

It assumes the stock market is a perfect market with no dealing charges and with all
investors having the same perception of security.
It also assumes that there is a risk- free rate at which all investors may borrow
without limit.
It ignores taxes.

An example
Suppose La Roja Beperk has the following capital structure (ignore reserves):
Equity: 5 000 000 R1 ordinary shares, market price currently R1,70

Preference Shares: 2 000 000 @ R0.50 yielding 10%, market price currently R0.55
Debentures: R2 000 000, 15% debentures, issued at R1,00, market price currently
R1.08 (108c)
Bank loan: R1 000 000 12% bank loan
They have paid a dividend of 20c per share last year and they expect dividends to grow by 5%.
The corporate tax is 30%.
Calculate: Their cost of capital, using the DG Model as your basis for valuing equity.
Solution
First, we need to calculate the overall market value of these investments, by multiplying the
original values by the market price divided by the nominal value in each case, and totaling.
Ordinary Shares: 5 000 000 x 1.7 8 500 000

Preference Shares: 2 000 000 x 0.55 1 100 000
Debentures: 2 000 000 x108 2 160 000
Bank Loan: 1 000 000 1 000 000
Overall market value 12 760 000
Now let’s find the proportion of this total represented by each type of capital:
Equity: 8 500 000/12 760 000 = 0.6661
Preference: 1 100 000/12 760 000 = 0.0862
Debentures: 2 160 000/12 760 000 = 0.1693
Bank loan: 1 000 000/12 760 000 = 0.0784

1.0000

Let’s calculate the rate of return for each type of capital
Equity = (D1\ Po) + g Remember D1= D0 (1 + g)

= 0.20 (1 + 0.05) + 0.05 Workings [0,21/1,7) = 0,1235]
1,7
= 17,35%
Preference shares = D/P X 100 (note: dividends at present = 50c X 0,05 = 5C)
= 0.05/0.55 X 100
= 9.1%
Debentures = 15% x 100/108 X [1-Tc]
= 13.89% X 0.7
= 9.72%
Loans = [0.12 X (1 – Tc]
= 0.12 X 0.7
= 8.4%
Rate of Return Proportion Unit Cost

Equity: 17.35 X 0.6661 = 11.5568
Preference shares: 9.09 X 0.0862 = 0.7836
Debentures: 9.72 X 0.1693 = 1.6456
Loans 8.40 X 0.0784 = 0.6586
WACC =14.65%
This would be the minimum rate to apply for investment appraisal, assuming that all projects to
be evaluated bear the same risk, and that finance would be raised in the same proportions as
currently exist.

Key 1 2 1x2 3 4 3X4
Individual
Nominal Present Present Cost of
Equity Type Value Unit value total value Proportion ROI Capital
Ordinary Shares 5 000 000 1.7 8 500 000 0.6661 17.35 11.5576
Preference
Shares 2 000 000 0.55 1 100 000 0.0862 9.1 0.7845
Debentures 2 000 000 1.08 2 160 000 0.1693 9.72 1.6454
Loans 1 000 000 1 1 000 000 0.0784 8.4 0.6583
Total 10 000 000 12 760 000 1 14.6458
NB: The calculation for debentures and the loan interest is multiplied by 70 per cent, ie. [1 – Tc]
Debentures and interest on loan are tax deductible and as a result, do not bear tax.
The same cannot be said of dividends, as it is an after tax cost.
In order to equalise the tax effect, the debenture and bank-loan interest weighting is reduced by
multiplying it by 1 minus the given corporate tax rate (30 per cent).
Exercise 1
Tigerbrands Ltd has the following capital structure:
Equity 2 000 000 R2 ordinary shares, market price R2,50
Preference 1 000 000 12% R1 preference shares, market price R1,20
Reserves R1 500 000
Bank loan R500 000 15% bank loan
Debentures R1 750 000 16% debentures, market price R110 (issued at R100).
The current and expected future rate of ordinary share dividend is 20%.
What is the firm’s weighted average cost of capital?

Solution
Calculate overall market value Market Value Proportion
Ordinary shares 4,000,000 x R2.50/2 = 5,000,000 57.97
Preference shares 1,000,000 x 1.20/1 = 1,200,000 13.91
Bank loan = 500,000 5.80
Debentures 1,750,000 x 110/100 = 1,925,000 22.32
Total 8,625,000
Relevant returns: %
Ordinary shares 20 x 2/2.50 =16.00
Preference shares 12 x 1/1.20 =10.00
Debentures 16 x 100/110 =14.55
Weighted average cost of capital: %

Ordinary shares 57.97 x 16 = 9.28
Preference shares 13.91 x 10 =1.39
Bank loan 5.80 x 15 x 67/100 =0.58
Debentures 22.32 x 14.55 x 67/100 =2.18
WACC =13.43
Cost of Preference Share Capital

Because this is fixed dividend capital, i.e. amounts paid to shareholders will not fluctuate
(unless, of course, there are no profits from which to pay the obligation), we can consider the
cost of preference share capital to be similar to the cost of debt capital, ignoring taxation, which
is dealt with below.
KE = D/P0
D = Dividend. We do not consider a D1, as dividends on preference shares are constant.
P0 = the current value/price of the preference share.

End of Chapter Questions

1. Suppose AA Carriers has a beta of 1,3. The return on market is 12% and the risk free rate is
7%. AA’s last dividend was R2 per share and they expect a growth rate of 8%. The share is
currently trading at R20.
1.1 Using the CAPM approach, calculate the Return on equity.
1.2 What is their return on equity using the Dividend Growth (DG) Model?
1.3 Discuss 2 advantages of the CAPM approach.
2. Bassa Braziers Ltd, operate in the fabrication industry. They feel that some of their older gas
welding machines need to be replaced. They seek your help in order to calculate their cost
of capital. Their present capital structure is as follows:
 600 000 R2 ordinary shares now trading at R2,40 per share.
 200 000 preference shares trading at R2,50 per share (issued at R3 per share). 10 %
p.a. fixed rate of interest.
 A bank loan of R1 000 000 at 12 % p.a. (payable in 5 years time)
i. The company’s beta is 1,4. A return on market of 15% and a risk free rate of 6 %.
ii. Its current tax rate is 28 %.
iii. Its current dividend is 50c per share and they expect their dividends to grow by 7 % p.a.
1.4 Assuming that the company uses the CAPM to calculate their cost of equity,
calculate their weighted average cost of capital.
1.5 A further R500 000 is needed to finance the expansion which option should they use
(from ordinary shares, preference shares or loan financing) and why?

CHAPTER 11
PORTFOLIO MANAGEMENT AND THE CAPITAL ASSET

PRICING MODEL

Learning outcomes:
 Explain the difference between expected return and required return

 Calculate the Weighted Average Cost of Capital (WACC) using the Capital Asset Pricing
Model (CAPM)
 Discuss the limitations of CAPM for capital budgeting decisions

Introduction
Every entity in existence encounters and has to manage some type of risk. Because of the
uncertainty in the market, it is impossible to predict reliably what is going to happen in the future.
Defining risk
Risk can be defined as the probability of a disaster or the probability of things going wrong.
Business and financial risk
One way to classify risk is to distinguish between business risk and financial risk.
Business Risk
The possibility that a company will have lower than anticipated profits, or that it will experience a
loss rather than a profit. Business risk is influenced by numerous factors, including sales
volume, per-unit price, input costs, competition, overall economic climate and government
regulations. A company with a higher business risk should choose a capital structure that has a
lower debt ratio to ensure that it can meet its financial obligations at all times.
Financial Risk
The possibility that shareholders will lose money when they invest in a company that has debt, if
the company’s cash flow proves inadequate to meet its financial obligations. When a company
uses debt financing, its creditors will be repaid before its shareholders if the company becomes
insolvent.
Expected return
The expected return of an investment is the aggregate of all its estimated returns, weighted
according to the probability of the related events occurring.
Variance as a measure of risk
One way of calculating the risk of a share, investment, entity or decision is the calculate the
extent to which the related returns or outcomes fluctuate or vary from the expected average
return or most probable outcome. The greater the possible fluctuation between actual return or
outcome and average expected return or outcome, the greater the uncertainty about the cash

flows and the greater the risk. The variance is one measure of this possible difference between
actual outcome and expected outcome
Standard deviation as a measure of risk
Standard deviation is simply the square root of the variance. The standard deviation and
variance measure the same thing.
Coefficient of Variation
Measures the average risk expected for every unit of expected return.
Coefficient of variation = Standard deviation / Expected return
Portfolio management
A ‘portfolio’ is a collection of investments with different risk and return patterns. The
combination of a set of investments will produce a portfolio with a given value of return and risk
characteristics. Where every share in the economy is vulnerable to uncertainty, a shareholder
will reduce his/her risk by diversification.
Diversification spreads the investor’s risk across many investments and therefore reduces the
investor’s potential loss (and potential gain for that matter).
Portfolio return
The return of a portfolio of investments (portfolio return) is a function of the expected return of
each investment in the portfolio and the percentage holding of each investment in the portfolio.
Limiting an investor’s risk depends not only on the particular share investments, but also on the
correlation between the returns of those particular shares.
When investors are faced with investment decisions such as the selection of shares, they need
to select shares that will limit their risk of making a total loss. It is not possible to eliminate risk,
but it is possible to limit risk. However risk can also limit an investor’s potential upside.

The best way to limit risk is to invest in different shares where the returns of the shares have an
inverse relationship: when the returns of one share increase, the returns of the other share
decrease.
Investors can measure how the returns of different shares move in relation to each other using
the principle of covariance.
A positive covariance means that the returns of the two shares move in the same direction and
a negative covariance means that these returns move in an opposite direction.
The results of the covariance calculation can be interpreted by the investor as follows:
 When the covariance is positive, the returns of the different shares move in the same
direction
 When the covariance is negative, the returns of the different shares move in the opposite
direction
 When the covariance is equal to zero, the different shares are independent and there is
no relationship between their returns.
Cabar Ltd has just been listed on the JSE and has no return record. An investor has thus predicted
the following conditional returns:
State of economy Probability Return
Boom 5% 35%
Good 15% 20%
Normal 60% 12%
Bad 15% 1%
Recession 5% –15%
(a) What is his expected return in the next period?
(b) What is the variance and standard deviation of this return?
(c) What is the probability that Cabar’s return will be below 7%?

CHAPTER 12
FINANCIAL AND BUSINESS ANALYSIS

Learning outcomes
 Describe the difference between business and financial risk in the context of financial
statement analysis
 Analyse the cash-flow statement
 Calculate financial risk ratios and explain how a company is performing in the light of
such ratios
 Analyse the financial statements of a company and carry out an in-depth analysis of
business and financial risk

Business risk vs. Financial risk
Business Risk
Business risk is the risk that relates to the daily running of the operating activities of a
company. Business risk is affected or measured by:
 The nature of the business activities of a company

 The operating leverage of the company
 The physical state of the fixed assets
 Political considerations
 Product substitutes available
 Competition
 Management
 Future prospects for the business by product and volume
 Future prospects of the industry in general
It is important to assess all the business risk factors faced by a company when attempting to
form an opinion on the viability of a company, its current market value and its future prospects.
Financial Risk
Financial risk is the risk that relates to the borrowing of long- and short-term debt. Financing a
part of the company’s assets by borrowing money makes the company liable for:
 Monthly interest payments

 Capital repayments
The objective of using financial gearing is to increase the return to the shareholders, as it is
hoped that the cost of debt is lower than the returns offered by the assets that have been
purchased with the borrowed funds. The company therefore takes the risk that funds will be
available to repay both the interest and the capital liability. It is also faced with default risk,
which could be avoided if it chose to use equity finance only.

Limitations of financial accounting data
 Inflation – Any ratio assessment based on the historical value of statement of

financial position items will be incorrect and distort the analysis
 Non-monetary items – Financial statements fail to show the value of non-monetary
items such as goodwill, patents, brands, trademarks, etc.
 Market forces – the statement of income and statement of financial position do not
disclose future expectations in the market.
 Accounting policies – When comparing a company’s performance with that of other
companies, it gets quite difficult due to differences in accounting policies used by the
different companies.
The Calculation and Interpretation of Ratios
Liquidity Ratios
The ability of the firm to meet current debts is important in evaluating a firm’s financial position
as well as its ability to survive and grow. Certain basic ratios can be computed that provide
some guides for determining the enterprise’s short term debt paying ability.
A. The Current ratio

The current ratio is the ratio of total current assets to current liabilities. The components of
current assets are: inventories, trade and other receivables and cash. It is expressed as:
Current ratio = Current Assets

Current Liabilities
This ratio indicates the extent to which the claims of short term creditors are covered by
current assets that can be translated into cash readily (or is already in the form of cash) in
the short term. The popular rule of thumb for this ratio is 2:1. Ratios marginally lower than
2:1 are acceptable. Strangely enough ratios higher that say, 3:1 could be masking liquidity
issues, like, the business is holding too much of stock (but more of that later), its investment

in receivables is too high (thus resulting in exposure to bad debts and holding too much cash
in short term accounts. This is not the ideal situation, as the task of the FM is to ensure that
the business’ resources are well invested. It must be noted that the current ratio is only one
measure of determining liquidity, and does not answer all the liquidity questions.
B. Acid-test (quick) ratio

As it normally takes longer to translate inventory into cash, it is useful to measure the
firm’s ability to pay off short term debt without relying on the sale of inventory. The ratio is:
Acid Test Ratio = Current assets – Inventory

Current liabilities
Stated differently, current assets – Inventory = Receivables + Cash.
The popular rule of thumb is 1:1, but blind application should be avoided. If the ratio is low, the
firm may have difficulty in meeting its short term needs unless it is able to obtain additional
current assets through conversion of some of its long term assets, through additional financing,
or through profitable operating results. Another way of evaluating liquidity is to determine how
quickly certain assets can be turned into cash. How liquid, for example, are the receivables and
inventory?
C. The Cash Ratio: this measures the amount of cash available as compared to current
liabilities. There is no rule of thumb ratio for this suffice to say, that a firm should have an
open line of credit available if they do not have sufficient cash reserves. The ratio is:
Cash ratio = Cash_____

Current liabilities

D. Interval Measure
This ratio measures how many days of operating expenses are covered by current assets.
This ratio is useful as it gauges how long it will take for cash to dry up in the event of a
strike and a business is unable to receive any cash inflows. The formula is:
Interval Measure = __Current assets

Average daily operating Costs
Average daily operating costs = [Operating expenses – depreciation – interest
expenses]/365
Profitability
Profitability ratios indicate how well the enterprise has operated during the year. These
ratios answer such questions as: was the profit adequate? What rate of return does it
represent? What amount was paid in dividends? Generally, the ratios are either
computed based on sales or on an investment base such as total assets. Profitability is
frequently used as the ultimate test of management effectiveness.
A. Gross margin on sales

This is essentially the mark up ratio. This ratio is calculated as follows:
Gross Margin on Sales = Gross Profit x 100

Sales 1
This should be compared with the margins obtained over a number of years. A fall in this ratio
would indicate one or all of the following:-
a. A reduction in sales price to attract new customers or because of price competition.

b. An increase in cost of purchases without a corresponding increase in sales price.
c. An undervaluation of closing stock.
d. Possible stock theft.
e. Changes in sales mix.

B. Profit margin on sales

This is also known as the net profit margin. The formula is as follows:
Profit margin on sales = Net Income x 100

Net Sales 1
A decrease in the ratio in comparison to previous years would be the result of low mark-ups,
higher costs or a combination of these factors. One would have to analyse individual
components included in overheads to ascertain whether any specific item has contributed to
this decrease, e.g. disproportionate increases in advertising expenditure.
C. Return on total assets

The return on total assets measures the profitability of the firm as a whole in relation to the
total assets employed. It is frequently referred to as the return on investments. This ratio is
calculated by dividing earnings by total assets.
Return on Total Assets = Net income after tax X 100

Total Assets 1
D. Return on equity
In order to measure the earnings power on the shareholders equity, we calculate the return
on equity ratio. This ratio relates to net income after tax, after deducting preference dividends
to shareholders’ equity, and is computed as follows:
Return on Equity = Net Income after tax – Preference Dividends

Equity (net worth)
Ordinary Shareholders Equity is made up of the following components:
 Ordinary share capital

 Share premium
 Distributable reserves (Retained Income)
 Non-distributable reserves (Revaluation of Assets)

Asset Management and Solvency Ratios

A. Inventory Turnover Ratio
This ratio measures how quickly inventory is sold. Generally, the higher the inventory turnover,
the better the enterprise is performing. It is possible; however, that the enterprise is incurring
high “stock out costs” because not enough inventory is available. This ratio is useful because it
may indicate that some items may be turning over quite rapidly whereas others might have
failed to sell at all. The inventory turnover ratio is:
Inventory turnover = Cost of Goods Sold

*Average Inventory
*Average inventory = (inventory at beginning of year + inventory at end of year) divided by 2
B. Stock Holding Ratio or Days Sales in Inventory
The ratio indicates the quantity of inventory on hand in relation to the quantity purchased (the
number of days the stock is held before it is sold).This ratio is calculated as follows:
Days sales in Inventory = Inventory x 365

Cost of Sales 1
C. Debtors (Accounts Receivable) Collection Period
This ratio measures the average number of days that it would take for the outstanding accounts
receivable to be collected and it is computed as follows:
Debtors Collection period = *Average Accounts Receivable (Debtors) x 365
Credit Sales 1
*Average Accounts Receivable = Accounts Receivable at beginning of year + Accounts
Receivable at end of year) divided by 2.

If this ratio is unduly high it may point towards an inefficient accounts receivable collection
department. To expedite collections, discounts may be offered to customers paying within a
certain time period say 15, 30 or 45 days.
The following methods may be used to ensure proper control of accounts receivable:
 Offer discounts for prompt settlement

 Send statements timeously
 Use reminder options, like SMS, emails, telephone calls, etc.
 Charge interest on overdue accounts.
 Reduce credit limits
 Freeze available credit altogether on certain accounts
 Hand over errant accounts for collection.
 Blacklist clients who default.
 Sue habitual offenders.
D. Creditors (Accounts Payable) Payment Period
This ratio is computed as follows:
Creditors payment period = Accounts Payable (Creditors) x 365

Credit Purchases 1
This ratio calculates the number of days it takes before creditors are settled. An increasing trend
in this ratio could indicate inability of the company to meet credit obligations within a certain time
period. And this will arise directly out of a poor debtors’ collection ratio. It is important to ensure
the business has a good reputation in the eyes of creditors. Poor reputations tend to spread and
may have a damaging effect on the credit worthiness of the business.

E. Fixed Assets (Tangible Assets) Turnover Ratio

This ratio indicates the utilisation of plant, machinery and equipment relative to operating levels
as reflected by turnover and is calculated as follows:
Fixed Asset Turnover = Sales (Turnover)

Fixed Assets
It indicates the efficiency with which operating assets are utilized to generate sales.
Market Value Measures

A. Earnings per Share (EPS):
The earnings per share figure ratio is probably the ratio most used by investment analysts. EPS
is computed by dividing earnings, by the ordinary shares in issue.
Earnings per share= Net Income after tax and Preference Dividends
Number of Ordinary Share Issued
Essentially, this ratio answers the question, how much has each share earned. The trend in the
earnings per share ratio is a useful indicator of performance of the company. Generally, the
higher this ratio is, the better the performance of the company.
B. Dividends per Share (DPS)
This indicates the amount of dividend attributable to each share. From the investors’ point of
view, the higher this ratio the better, as the dividend per share will be greater. The formula is:
Dividends per share = Dividends

Issued Shares

C. Price Earnings Ratio
The price earnings ratio (P/E) is a statistic used by analysts in discussing the investment
possibility of a given enterprise. It is computed by dividing the market price of the share by its
earnings per share.
Price earnings ratio = Market Price of Share

Earnings per Share
If a company’s P/E ratio drops steadily this indicates that investors are not confident of the firm’s
growth potential. Generally, the greater the P/E ratio, the better the perception of investors
regarding the future growth of the company. The P/E ratio is also an indicator of the value of a
business as it essentially asks the question: over how many years will earnings take to pay off
the purchase price?
D. Dividend Cover
This ratio, although not based on market values, affect the market value of shares. It measures
the extent of earnings that is being paid out in the form of dividends. A high dividend cover
would indicate that a large percentage of earnings is being retained and reinvested within a firm
while a low dividend cover would indicate the opposite. The formula is:
Dividend cover = Earnings per Share

Dividend per Share
Generally, growth companies are characterised by high dividend cover since they re-invest most
of their earnings.

E. Dividend Yield
The dividend yield ratio indicates the return that investors are obtaining on their investment in
the form of dividends and is calculated as follows:
Dividend yield = Dividend per share

Market Price per share
F. Earnings yield
The earnings yield is calculated by taking the earnings per share and dividing it by the market
value of the share. This ratio indicates the yield that investors are demanding.
Earnings Yield = Earnings per share

Market price per share
G. Market to Book Ratio

The market to book ratio compares the market value of the firm’s investment to their cost. A
value of less than 1 means that the firm has not been very successful in creating value for its
shareholders. The formula is:
Market to Book Ratio = Market value per share

Book value per share
Gearing and Insolvency

Debt management plays an important role in financial management and the extent of financial
leverage of the firm has a number of implications. The higher the leverage a firm has, the
higher the risk attached to it. However, the greater the risk, the greater the return and if a firm
earns more on the borrowed funds than it pays in interest, the return on owners equity is
increased. Furthermore, by raising funds through debt, the shareholders can obtain finance
without losing control of the firm.

Equity is the basic risk capital of an enterprise. Every enterprise has some equity capital which
bears the risk to which it is unavoidably exposed. Equity capital is permanent capital and not
guaranteed to be repaid to the providers. Because of their permanence, an enterprise can
invest such funds in long term assets and expose these to greater risks. However, debt (both
short and long term) has to be repaid. Funds are often raised from other sources than equity –
the intention being to increase the rate of return on equity – this is known as gearing or
leverage. The borrowed funds are used to generate a return and if this return exceeds the
borrowing cost then the company is trading profitability on the borrowed funds.
A. Debt Ratio
The debt ratio is the ratio of total debt to total assets and measures the percentage of total
funds provided by creditors. Total debt includes long term liabilities and current liabilities. Total
assets include fixed assets, investments and current assets. It means that the higher the debt
ratio, the higher the financial risk. The ratio is calculated as follows:
Debt Ratio = Total Debt

Total Assets
B. Interest Cover
This ratio is determined by dividing earnings before interest and tax (EBIT) by interest charges.
This ratio measures the extent to which earnings can decline without causing financial losses to
the firm and creating an inability to meet interest costs.
Interest cover = EBIT

Interest
A high interest cover ratio i.e. a situation where the interest expense is covered several times by
the EBIT earned reflects a very low interest charge in relation to profitability and could be due to

a large percentage of the debt finance being accounts payable (creditors) which is effectively a
free form of finance. One can conclude that the interest cover ratio must be taken into account
in determining the overall risk attached to the company.
C. Debt Equity Ratio

This ratio indicates the extent to which debt is covered by shareholders funds/equity. The debt
equity ratio is calculated as follows:
Debt Equity = Total Debt

Total Equity
This ratio indicates the relationship between borrowed capital and invested capital and provides
creditors with some idea of the company’s ability to withstand losses without impairing the
interests of creditors. The higher this ratio is, the less “buffer” there is available to creditors if
the company becomes insolvent. From the creditor’s point of view, a low ratio of debt to equity
is desirable. A high debt equity ratio would reduce the company’s chances of borrowing
additional funds without an increase in shareholders’ equity because of the high risk factor
attached to the company.
Du Pont Analysis
No individual ratio provides an adequate assessment of all aspects of a firm’s financial health.
However, the Du Pont system introduces a systematic approach to ratio analysis. It is a financial
analysis and planning tool that uses basic accounting relationships, and is designed to provide
an understanding of the factors that drive the return on equity of the firm.

Operational Efficiency is measured by the profit margin

Asset Use Efficiency is measured by the Total Asset Turnover
Financial leverage is measured by the equity multiplier
End of chapter example 25 marks
Netforce Security (Pty) Ltd Statement of financial position for 2014 and 2013 – 28 February
financial years are presented below:
Assets 2014 2013
Non Current/Fixed 7 000 000 6 000 000
Inventory 500 000 300 000
Receivables 450 000 420 000
Cash 650 000 80 000
8 600 000 6 800 000
Equity and Liabilities
Share Capital (R2 shares) 5 000 000 4 400 000
Share premium 200 000 100 000
Retained Income 700 000 400 000
Long term Debt 2 000 000 1 000 000
Payables 700 000 900 000
8 600 000 6 800 000
The abbreviated statement of comprehensive income for the year ended 28 February
2014:
Sales (50% on credit) 3 000 000
Cost of sales 2 000 000
Depreciation 120 000
Interest Expense 80 000
Net Income before Tax 900 000
Dividends 330 000
Retained Income 300 000

Notes:
a. Shares are currently trading at R2.30 per share.

b. The new shares were issued at the beginning of the year.
Required
1.1. Calculate the following ratios for 2014 and comment. Ratios for 2013 are given in
brackets.
1.1.1. Current ratio (0,89:1) (3)
1.1.2. Acid test ratio (0,56:1) (3)
1.1.3. The debtors collection period (81 days) [all debtors are on 60 days accounts] (4)
1.2. Share capital and equity
1.2.1. Calculate the earnings per share and dividends per share for 2014. (4)
1.2.2. How many shares were issued in 2014? (2)
1.2.3. Were the shares issued at a premium? If so what was the premium per share? (2)
1.3. Calculate the market to book ratio. Explain the significance of this ratio. (3)
1.4. Calculate the return on equity using the Du Point Identity/Formula. Will management be
happy with this return? (4)

BIBLIOGRAPHY
Correia, C.; D.; Uliana, E. and Wormald, M. (2008), “Financial Management”, 4th Edition, Juta
Publishing
Gitman, L.J. (2010), Principles of Managerial Finance, Global and Southern African Perspective.
New York: Pearson
Firer, C; Ross, S.A.; Westerfield, R.W. and Jordan, B.D. (2012), Fundamentals of Corporate
Finance. 5th South African Edition. McGraw-Hill
Vigario, F. (2007), Managerial Accounting, 4th edition, LexisNexis
Drury C. (2009), Management Accounting for Business, 4th edition, Cengage Learning
Vigario F et al (2011), Managerial Finance, 5th edition, LexisNexis
Brechner R.A. (2009), Contemporary Mathematics for Business and Consumers, 5th edition
http://www.investopedia.com/terms/b/businessrisk.asp Business Risk Definition - Investopedia

[Date accessed 7 July 2014]

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REGENT Business School

General Objectives of this module:

The purpose of this module is:

The prescribed textbooks are as follows:

 Managerial Accounting, Fourth Edition, F Vigario, LexisNexis

It is essential to get the prescribed textbooks

REGENT Business School Page 1

REGENT Business School Page 2

INTRODUCTION TO MANAGEMENT ACCOUNTING

REGENT Business School Page 3

INTRODUCTION TO MANAGEMENT ACCOUNTING

REGENT Business School Page 4

A management accounting/ cost statement provides information to allow managers to plan,

REGENT Business School Page 5

Differences between Management Accounting and Financial Accounting:

Management Accounting Financial Accounting

Nature of Reports tend to be specific Reports tend to be general-purpose

Legal Management accounting reports Financial reports are required by law

GAAP/IFRS Management accounting reports Financial reports must conform to

REGENT Business School Page 6

We therefore have the following analysis:

REGENT Business School Page 7

SYSTEMS FOR RECORDING AND CONTROLLING PRODUCT

REGENT Business School Page 8

SYSTEMS FOR RECORDING AND CONTROLLING PRODUCT COSTS

Accounting profit vs contribution

REGENT Business School Page 9

Answer: R4 000 / R6 = 667 units

Key Costs Related to Managerial Accounting

REGENT Business School Page 10

Product valuation for financial accounting purposes – Absorption costing system

REGENT Business School Page 11

Cost allocation procedure

The Direct Method:

REGENT Business School Page 12

REGENT Business School Page 13

Total Service % of services provided by the service

R 80 000 H.R. -- 20% 10% 40% 30%

120 000 D.P. 8% -- 7% 30% 55%

H.R. D.P. R.M. Machining Assembly

REGENT Business School Page 14

Administration - R138 000

Maintenance - R98 000

Production A - R309 000

Production B - R210 000

Production C - R225 000

REGENT Business School Page 15

Using Linear Algebra Equations:

Let total allocated cost of administration =a

Let total allocated cost of maintenance =b

a = 138 000 + 0.05b

a = 138 000 + 0.005(98 000 + 0.1a)

a = 138 000 + 4 900 + 0.005a

Admin 143 618 28 724 57 447 43 085

Maint 112 362 33 709 44 945 28 090

62 433 102 392 71 175

Pre-determined overhead rates

REGENT Business School Page 16