Accounting 00724

Assignment 2

Question one
Solution Kankams restaurant is a Ghanaian based restaurant that serves both local African dishes and global continental food, aside with all sorts of drinks. The restaurant is Licensed under the Tema Municipal Assembly(TMA) in the Accra/Tema municipality. It has over a 100 setted tables and a number of worker both on wages and on full salary. 1.1 Costs in sensible categories. A fixed cost is a cost that remains constant in total as the level of activity changes. For all practical purposes a fixed cost will not vary with the level of activity or output on a monthly basis, or what so ever in a short span, hence, it remains constant over a short time frame. Although fixed costs remains constant in total, the cost per unit decreases as volume increases. That is fixed cost per unit varies inversely with changes in the activity base. (Lane et al, 1991). In the case of an establishment like this, items that could be identified as fixed costs are: Building rental Insurance license fees Managers salary Rent and rates Advertising expenditure Variable costs- They are costs that changes in total in direct proportion to changes in the activity base, such as sales for selling function or machine hours for a production function. If a cost is variable, a 10% reduction in activity will result in a 10% reduction in the cost. Likewise, an increase in activity brings a proportionate increase in total variable costs. (Lane et al, 1991) In the case of an establishment like the Kankams restaurant, items that could be identified as variable costs are:

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Some direct labor Perishable goods (vegetables, foodstuffs) Normal spoilage Sales commission Discounts Some supplies Wages Mixed costs- These types of costs can be defined as a cost containing both fixed and variable components and which is thus partly affected by fluctuations in the level of activity. Rarely its a cost purely variable; frequently there are elements of both classifications in a cost (Lucy T, 1993) In the case of an establishment like Kankams restaurant, items that could be identified as mixed costs are: Electricity (incurring up to 72% fixed and 28% variable) Gas (incurring up to 30% fixed and 70% variable) Maintenance of plant and machinery (incurring up to 60% fixed and 40% variable) Fuel oil (incurring up to 82% fixed and 18% variable) Coil (incurring up to 46% fixed and 54% variable)

1.2. Cost behaviour as output increases (Variable and Mixed costs) Variable costs will increase in total proportionately when there is an increase in output and will decrease proportionately when an output decreases. Variable costs can usually be directly identified with an activity that gives rise to the incurrence of cost. Mixed costs: As already mentioned above in solution one, mixed cost has 2 main variables thus fixed and variable costs. The fixed costs portion is the minimum cost

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Accounting 00724

Assignment 2

required if some activity takes place, however when there is an increase in output, total cost will increase above this minimum at the proportionate rate. (Lane et al, 1991). The identification of a cost as fixed or variable is valid only within a certain range of activity (Maher, pg35). For example, if the manager of the restaurant increases the capacity of seats. Requiring increase in rental costs, utilities, and many other costs. Although these costs are usually thought of as fixed, they change when activity moves beyond a certain range.

1.3. Specification of cost (units, $, %, etc) Variable costs; for calculations and analysis it is usually more convenient to express variable cost algebraically thus: Cost = bx, Where x = volume of output in units b = a constant representing the variable costs per unit. By this we can see that variable costs can be best specified in dollar per unit $/unit Fixed costs: the main point here is that the change in the cost is not caused by changes in the volume of activity. Fixed cost can also be expressed algebraically as: Cost = a Where a = a constant We can therefore say that fixed costs can be specified in dollar per of job, $/unit Mixed costs can also be expressed algebraically by combining all expressions for variable cost and fixed cost, thus Cost = a + bx Where: a = constant b = a constant representing the variable costs per unit. x = volume of output in units

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Accounting 00724

Assignment 2

1.4 limits to activity growth (a) In the short run, in an instance where there in nothing going on in the business or no activity the business will still be paying for example, rent and salaries at least in the short run. This is because fixed cost is augmented by the amount of the relevant variable costs as the volume of activity increase. (Atrill et al) (b) In the long run: inflation can affect fixed cost to be greater in the long run thereby affecting activity growth.

1.5. Break-even analysis (a)Break-even analysis is a useful tool to determine how many units must be sold or how much sales volume must be achieved in order to break even. It is achieved at the point where sales equal expenses. To be able to specify level of business activities we can look at: The sales volume, here you would have to look at the trend of sales in the past, then by that your specification will be heading to accurate. The cost of sales, this is the estimated total cost associated with the actual operations of the restaurant such as salaries. We will need to use this alongside the sales so that we will be able to know how much we need to break-even.

(b) The Contribution margin is an intermediate step in the computation of operating profits. For example, in BEP if the restaurants management want to make desired profit, they will compute the number of customers they need per month to cover up their costs as contribution margin calculation following: Contribution per unit = Sales per unit(S) Variable cost per(VC)

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Accounting 00724

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Note: Contribution per unit is calculated by deducing variable costs per unit from selling price per unit. BEP = Fixed cost / Contribution. Desired profit =
Fixed cost + Profit Contribution per unit

(C) Usefulness of Break Even analysis future is its simplicity in showing the impact of sales prices, costs, and volume on operating profits. But the cost of this simplicity is often lack of realism. Some costs can not be easily classified, and costs seldom behave in a neat linear fashion. BE is based on the assumption that within a specific range of activity, the linear expression approximates reality closely enough that the results will not be badly distorted. Assumed linear relationships are more likely to be valid for short time periods (one year or less) and small changes in volume than for long periods and large changes in volume. Most fixed costs are fixed only in the short run.

A linear Break Even Analysis assumes that: Revenues change proportionality with volume Total variable costs change proportionality with volume Fixed costs do not change with volume (Maher, pg403)

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Accounting 00724

Assignment 2

Question two
Solution 2.1. In a partnership of architects: Direct costs will be: Direct material (stationeries EG. pens, pencil, A4 printing papers) Electricity Salaries Mathematical instruments for measuring and drawing Drawing papers Indirect costs will be: Rental of premises Depreciation of equipment Equipment repairs Office cleaning Premises cleaning 2.2 The best source of this information will be: The activities the firm undertaken The client information The cost drivers 2.3 2.4 Overheads do not just occur but are caused by activities, such as holding products in stores. Therefore in such an instance we might estimate an occurring overhead in the next period. Where the firm moves from a labor based system to a machine based production system. There will be a probability of a change in overhead.

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Accounting 00724

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A situation where the firm plans to move from a lower to a higher-level business operation thereby increasing indirect cost. And where the company plans to move from a relatively imcompetitive market to a global competitive. 2.5 Overheads can be broken down into several cost pools by looking at its nature and activity drivers. Also in assigning overhead costs, it is necessary to know the expected number of cost drivers for each product. (Tiong, A. 1993) 2.6 Reasons for choosing to put various costs into each pool are that each activity has a unique activity driver to trace its cost to the products. Example, solving customer problem is traced to products based on the number of phone calls. This makes sense because the product that creates the most customer problems is likely to generate the most phone calls. (Turney, P. 1997) 2.7 When allocating total overheads we can use only one base (example machine time, material cost, labor costs and labor hours), however we can break down the overhead costs down into components such as Depreciation Equipment repairs Insurance Indirect labor Indirect materials Security Then for each component a specific allocation basis could be used like: Centre employees Floor space Machine hours Labour hours Value of services/product

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Accounting 00724

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2.8. Being a consultant I will look at the various activities they undertake and their cost centers, and then I will advise them to make appropriate allocations, eg. Charging overhead on the basis of labor hours would be appropriate where the overhead costs are made up largely of labor components 2.9 In a period where overheads are under allocated, meaning less overhead than was actually incurred was allocated to product. In this situation the total of the unit costs of production for the period is less than the total actual costs incurred. Also where overheads are over allocated in a particular budgeted period, thus more overheads than was actually incurred has been allocated to product thus overstating the actual costs of the product. 2.10 In cases where predetermined overhead rates are used, thus using estimates of both manufacturing overhead dollar amounts as well as level of activity. If either the estimated overhead cost of the level of activity differs from the actual cost or the actual activity level attained for the period the overhead rate will be inaccurate, and being inaccurate means either more or less overhead had been applied to products than actually incurred. In each it might be either one of the two thus under or over allocation.

Question three Solution 3.1 CONCEPTS OF NPV NPV is the present value of the net cash flow less the projects initial investments outlays. If the rate of return from the project is greater than the return from an equivalent risk investment in securities traded in the financial market the NPV will be positive. Alternatively, if the rate of return is lower the NPV will be negative. A positive NPV

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therefore indicates that an investment should be accepted, while a negative value indicates that it should be rejected. A zero NPV calculation indicates that the firm should be indifferent to whether the project is accepted or rejected. I will now like to touch on why NPV makes sense, the main rationale for the NPV approach may be summarized as follows Managers are assumed to act in the best interest of the owners or shareholders, even if agency cost-in the form of incentives or controls have to be incurred. They seek to increase shareholders wealth by maximizing cash flows through time. The market rate exchange between current and future wealth is reflected in the current rate of interest. Managers should undertake all projects up to the point at which the marginal return on the investment is equal to the rate of interest on equivalent financial investments in the capital market. This is exactly the same as the net present value rule: accept all investments offering positive NPVs when discounted at the equivalent market rate of interest. The result is an increase in the market value of the shareholders stake in the firm. Management need not concern itself with shareholders particularly time patterns of consumptions or risk preferences. In well functioning capital markets, shareholders can borrow or lend funds to achieve their personal requirements. Furthermore, by carefully combining risky and safe investments they can achieve the desired risk characteristics for those consumption requirements. Wealth is maximized by accepting all projects that offer positive NPVs when discounted at the required rate or return for each investment. Most of the main elements in the NPV formula are largely externally determined. For example, In the case of investment in a new piece of manufacturing equipment, management has relatively little influence over the price paid, the life expectancy or the discount rate. These elements are determined respectively by the price of capital goods, the rate of new technological and the returns required by the capital market. Managements

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Accounting 00724

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main opportunity for wealth creation lies in its ability to implement and manage the project so as to generate positive net cash flows over projects economic life.

3.2 The usefulness of NPV In investment Decision Adjustment for the timing of the projects cash flows. A good investment decision may take into consideration the timing of the investment expected cash flows. Does the net present value consider this rule? A projects NPV is the difference between the present value of its expected cash flows and its current cost. The present values of cash flows are obtained by discounting each of them at the projects opportunity cost of capital. The more distant the cash flows, the lower their contribution to the investments present value because the discount factor by which the cash flows are multiplied in the net present value formula becomes smaller as it increase. This is the net present value rule adjusts for the timing of a projects expected cash flows. Adjustment for the risk of the projects cash flows. Does the net present value rule consider the risk of a project? It certainly does. The risk adjustment is made through the projects discount rate. As the risk of the stream of future price cash flows expected from the investment increases, the discount rate (the opportunity cost of capital) used to calculate the present value of the expected cash flow stream should also increase. The reason is that investors are risk averse. The shares of firms with riskier projects only if they expect to earn a higher return to compensate them with the higher risk they have to bear. By discounting the future streams of expected cash flows at a rate that increases with risk, the net present value rule adjusts not only for the time value of money but also for the projects risk. The higher the risk attached to a projects stream of expected cash flows, the higher the opportunity cost of a capital required to discount those cash flows, and the lower the projects NVP. In other words, the net present value method adjusts for the risk of a project by raising the projects cost of capital to reflect the higher risk of the projects expected cash flows. The effect of this adjustment is to reduce the projects NPV, thus making it less attractive to the firm.

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Takes into consideration the objectives of the business NPV is the only method of appraisal where the output of the analysis has a direct bearing on the wealth of the firm or business.(positive NPVs enhance wealth, negative ones reduce it). NPV provides clear decision rules concerning acceptance/rejection of projects and the ranking of projects. It is fairly simple to use. 3.3 An investment situation. Romeo and Robert Company limited is contemplating investing $ 1 million in the Sarawak football club. R. Eshun, the finance director of the company has estimated that the investment will pay out cash flows of $ 200,000 per year for nine years and nothing thereafter. Mr. Eshun has determined that the relevant discount rate for this investment is 15 percent. Should Romeo and Robert Company limited make this investment? As the question puts it, there is an option either to accept or reject such an investment. Even though there are other formulae for determining such decisions, I will opt for the NPV method which is much easier and globally preferred to other formulae. Therefore:

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Accounting 00724

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Inflow $ Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000 x x x x x x x x x

Present Value Factor 15% 0.8695 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2842 = = = = = = = = =

$ 173,912 151,220 131,500 114,360 99,440 86,460 75,180 65,380 56,854 954,305

- $1000,000 + 954,305 = - $45,695

The Romeo and Robert Company limited should not make the investment, because the NPV help us to realize that when they make such an investment, they will realize a negative returns of -$45,695 at the end of the 9 years. If the company requires a 15% rate of return the investment is not good. Mr. Osei Tutu 12

Accounting 00724

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A positive NPV from an investment indicate an increase in the market value of the shareholders, funds which should occur once the stock market becomes aware of the acceptance of the projects. Acceptance of projects should enable ordinary shareholders present consumption to be increased by the net NPV. Hence the acceptance of all available projects with a positive NPV should lead to the maximization of shareholders wealth. NPV is the most straight forward way of determining whether a project yields a return in excess of the alternative equal risk investment in traded securities.

Question four Solution A budget is a quantitative expression of the plan of action prepare in advance of the period to which it relates. Budgets may be prepared for the business as a whole, for departments, for functions such as sales and production, or for financial and resources items such as cash, manpower purchases and capital expenditure. The process of preparing and agreeing budgets is a means of translating the overall objectives of the organization into detailed, feasible plans of action. The underlined processes are the various steps, which greatly affects management attitude in the budget setting process of a firm: Planning and control: the budgetary process is an integral part of both planning and control. Too often budgets are associated with negative, penny-pinching control activities whereas the full process is much broader and more positive than that. Budgeting is about making plan for the future, implementing those plans and monitoring the activities to see whether they conform to the plan. To do successfully requires full top management

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Accounting 00724

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support, cooperative and motivated middle management and staff, and well organized reporting systems. Planning and coordinating: the formal process of budgeting works within the framework of long term, overall objectives to produce detailed operational plans for different sectors and facets of the organization. Planning is the key to success in business and budgeting forces planning to take place. The budgeting process provides for the coordination of the activities and departments of the organization so that each facet of the operation contributes towards the overall plan. The budget process forces managers to think of the relationship of their function or department with others and how they contribute to the achievement of organizational objectives. Clarification of Authority and Responsibility: the process of budgeting makes it necessary to clarify the responsibility of each manager who has a budget. The adoption of the budget authorizes the plans contained within it so that management by exception can be practiced, that is a subordinate is given a clearly defined role with the authority to carry out the task assigned to him and when activities are not proceeding to plan, and the variations are reopened to a higher level. Thus the full budgetary process is an excellent example of management by exception in action. Communication: the budgetary process includes all levels of management. Accordingly it is an important avenue of communication between top and middle management regarding the firms objective and practical problems of implementing these objectives and, when the budget is finalized, it communicates the plans to all the staffs involved. As well as vertical communication, example there must be full liaison between the sales and production functions to ensure that coordinated budgets are developed. Control: this aspect of budgeting is the most well known and is the aspect most frequently encountered by the ordinary staff members. The process of comparing actual

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results with planned results and reporting on the variations, which is the principle of budgetary control, sets a control a control framework which helps expenditure to be kept within agreed limits. Deviations are noted so that corrective action can be taken. Motivation: the involvement of lower and middle management with the preparation of budgets and the establishment of clear targets against which performance can be judged have been found to motivating factors. However, there are many factors to be considered n relation to the human aspects of budgeting. Managers also allocate resources in accordance with corporate strategic direction; Focus budgeting and management control on results, not just spending; Budget and manage total resources (capital and O M); Provide timely, relevant information in the right amount of detail; Create a change in individual behavior; and Focus the process outward, creating value for customers.

We can say, the annual budgeting process is a trap, pressured by fixed targets and performance incentives. Managers focus on making the numbers instead of making a difference, meeting set goals instead of maximizing potential. With their compensation at stake, managers often resort to deceitful-even unethical-behavior. In the end, everybody loses-the employee, the company, and ultimately the customer.

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