BSBFIM501

B S B F I M 5 0 1

M a n a g e b u d g e t s

a n d f i n a n c i a l

p l a n s

Document Name: BSBFIM501 CAC Learner Guide - Manage budgets and financial Created Date: 4 Jan. 13 plans_Ver2.1_NH.doc_CAC_Ver2.1_no activities

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BSBFIM501 - Manage budgets and financial plans

Author: John Bailey

Copyright

Text copyright © 2009, 2011 by John N Bailey.

Illustration, layout and design copyright © 2009, 2011 by John N Bailey.

Under Australia’s Copyright Act 1968 (the Act), except for any fair dealing for the purposes of study, research, criticism or review, no part of this book may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without prior written permission from John N Bailey. All inquiries should be directed in the first instance to the publisher at the address below.

Copying for Education Purposes

The Act allows a maximum of one chapter or 10% of this book, whichever is the greater, to be copied by an education institution for its educational purposes provided that that educational institution (or the body that administers it) has given a remuneration notice to JNB Publications.

Disclaimer

All reasonable efforts have been made to ensure the quality and accuracy of this publication. JNB Publications assumes no responsibility for any errors or omissions and no warranties are made with regard to this publication. Neither JNB Publications nor any authorized distributors shall be held responsible for any direct, incidental or consequential damages resulting from the use of this publication.

Published in Australia by:

JNB Publications

PO Box, 268,

Macarthur Square NSW 2560 Australia.

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BSBFIM501 - Manage budgets and financial plans Contents

Description: .................................................................................................................................................... 8

Employability Skills: ........................................................................................................................................ 8

Application of Unit: ........................................................................................................................................ 8 Introduction ................................................................................................................................................... 8 This Learning Guide covers: ........................................................................................................................... 8

Learning Program .......................................................................................................................................... 8

Additional Learning Support .......................................................................................................................... 9

Facilitation ..................................................................................................................................................... 9

Flexible Learning .......................................................................................................................................... 10 Space ............................................................................................................................................................ 10 Study Resources ........................................................................................................................................... 10

Time ............................................................................................................................................................. 10

Study Strategies ........................................................................................................................................... 11

Using this learning guide: ............................................................................................................................ 11

THE ICON KEY ................................................................................................................................................ 12

How to get the most out of your learning guide .......................................................................................... 13

PERFORMANCE CRITERIA ............................................................................................................................... 14

SKILLS AND KNOWLEDGE ............................................................................................................................... 16

Required Skills .............................................................................................................................................. 16

Required Knowledge .................................................................................................................................... 16

RANGE STATEMENT ....................................................................................................................................... 17

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EVIDENCE GUIDE ............................................................................................................................................ 20

1. PLAN FINANCIAL MANAGEMENT APPROACHES. ........................................................................................ 21

Managing Budgets ..................................................................................................................................... 21

1.1 ACCESS BUDGET/ FINANCIAL PLANS FOR THE WORK TEAM. ............................................................................... 21 Common Definitions ..................................................................................................................................... 22

Asset .......................................................................................................................................................................... 22 Liability ...................................................................................................................................................................... 23 Equity ........................................................................................................................................................................ 23 Capital ....................................................................................................................................................................... 24 Income....................................................................................................................................................................... 24 Expenses .................................................................................................................................................................... 24 Liquidity ..................................................................................................................................................................... 25 Solvency .................................................................................................................................................................... 25

Balance Sheet ............................................................................................................................................... 25 Table 1: Example of a Balance Sheet ........................................................................................................... 26

Profit and Loss Statement ............................................................................................................................ 27

Figure 2: Profit and Loss Statement Example .............................................................................................. 27

Adjusted Net Profits .................................................................................................................................................. 28 The Sole Trader ............................................................................................................................................ 29

Advantages of a Sole Trader Business ....................................................................................................................... 29 Disadvantages of a Sole Trader Business................................................................................................................... 30 Taxation for the Sole Trader ......................................................................................................................................

30 Corporate Entities ........................................................................................................................................ 30 Figure 3: Main types of Corporations ...........................................................................................................30

Companies Limited .................................................................................................................................................... 31

Figure 4: 2 Types of Limited Companies ....................................................................................................... 31

A Company limited by Shares .................................................................................................................................... 32 A Company limited by Guarantee ............................................................................................................................. 32 No Liability Companies .............................................................................................................................................. 32 Unlimited Companies ................................................................................................................................................ 32 Holding Companies and Subsidiaries......................................................................................................................... 33 The Constitution ........................................................................................................................................................ 33

Partnership vs. Company ............................................................................................................................. 33 Trusts ........................................................................................................................................................... 33

Family Trusts ................................................................................................................................................ 35

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Ratio Analysis ............................................................................................................................................... 35

Profitability Ratios........................................................................................................................................ 36

Net Profit Margin Ratio ............................................................................................................................................. 36 Gross Profit Margin Ratio .......................................................................................................................................... 36 Return on Assets Ratio .............................................................................................................................................. 37 Operating Expenses to Sales Ratio ............................................................................................................................ 37 Working Capital Ratio ................................................................................................................................................ 37 Quick Assets Ratio ..................................................................................................................................................... 38 Stock Turnover Ratio ................................................................................................................................................. 38 Debtor Ageing Ratio .................................................................................................................................................. 38 Creditor Ageing Ratio ................................................................................................................................................ 39 Debt Ratio ................................................................................................................................................................. 39 Debt to Income Ratio ................................................................................................................................................ 39 Interest Cover Ratio .................................................................................................................................................. 40 Asset Turnover Ratio .................................................................................................................................................

40 Interpreting a Statement of Assets and Liabilities ....................................................................................... 40 Figure 5: Statement of Assets and Liabilities Example ................................................................................. 41

1.2 CLARIFY BUDGET/ FINANCIAL PLANS WITH RELEVANT PERSONNEL WITHIN THE ORGANISATION TO ENSURE THAT

DOCUMENTED OUTCOMES ARE ACHIEVABLE, ACCURATE AND COMPREHENSIBLE. ................................................................ 42 Communicating Budgets and Financial Plans ............................................................................................ 42 Monitoring and Controlling Activities Against Plans ................................................................................... 43 Variance report format ................................................................................................................................ 45

Figure 6: Variance ........................................................................................................................................ 45

Format of a report........................................................................................................................................ 45

Sales variance .............................................................................................................................................. 45

Figure 7: Sales variance example ................................................................................................................ 46 Production cost variance .............................................................................................................................. 46

Production units variance ............................................................................................................................ 46

Figure 8: Production Units Variance ............................................................................................................ 46

Direct material units variance ...................................................................................................................... 47 Figure 9: Direct Materials Units Variance example ..................................................................................... 47

Direct material cost variance ....................................................................................................................... 47

Figure 10: Direct material cost example. ..................................................................................................... 47

Production cost variance .............................................................................................................................. 47 Figure 11: Production cost variance example .............................................................................................. 48

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Expenses variance ........................................................................................................................................ 48

Figure 12: Expenses variance example ......................................................................................................... 48

Outcomes of Financial Plans ........................................................................................................................ 49

In Summary .................................................................................................................................................. 50

1.3 NEGOTIATE ANY CHANGES REQUIRED TO BE MADE TO BUDGET/ FINANCIAL PLANS WITH RELEVANT PERSONNEL

WITHIN THE ORGANISATION. .................................................................................................................................... 51

Financial Analysis ......................................................................................................................................... 51 Cost-Volume-Profit Analysis ......................................................................................................................... 51

Break- even point ......................................................................................................................................... 52

Figure 13: Graph showing break-even point ................................................................................................ 53

Figure 14: Example of Break-even point calculation. ................................................................................... 53

Break-even point and margin of safety ........................................................................................................ 54 Example 1 .....................................................................................................................................................54

Example 2 ..................................................................................................................................................... 55

Activity 6: ..................................................................................................................................................... 56

Trend Analysis .............................................................................................................................................. 56

Horizontal analysis ....................................................................................................................................... 56

Example 1 ..................................................................................................................................................... 56

Example 2 ..................................................................................................................................................... 56

Example 3 ..................................................................................................................................................... 57 Vertical analysis ........................................................................................................................................... 58

Example 1: .................................................................................................................................................... 58

Example 2: .................................................................................................................................................... 58

Ratio Analysis ............................................................................................................................................... 59 Figure 15: Examples of Ratios ...................................................................................................................... 59

Figure 16: Financial ratios ............................................................................................................................ 60 Ratios - their calculations and significance .................................................................................................. 61

Investor ratios .............................................................................................................................................. 66

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Illustration .................................................................................................................................................... 67

Figure 17: Calculation of ratios .................................................................................................................... 69

1. 4 PREPARE CONTINGENCY PLANS IN THE EVENT THAT INITIAL PLANS NEED TO BE VARIED ........................................... 71 Communication Packages for Budgets and Financial Plans ......................................................................... 71

Reviewing Communication Packages ........................................................................................................... 72

Amending/Revising Planned Communication Packages .............................................................................. 73

2. IMPLEMENT FINANCIAL MANAGEMENT APPROACHES. ........................................................................ 75

2.1 DISSEMINATE RELEVANT DETAILS OF THE AGREED BUDGET/ FINANCIAL PLANS TO TEAM MEMBERS. .......................... 75

Training Activities......................................................................................................................................... 75

Informal meetings ..................................................................................................................................................... 75 Formal, structured competency standards/training ................................................................................................. 76 Small group discussions ............................................................................................................................................. 76 Tele- and videoconferencing ..................................................................................................................................... 76 E-learning .................................................................................................................................................................. 77

Need For Definition of Data and Terms ....................................................................................................... 77

2.2 PROVIDE SUPPORT TO ENSURE THAT TEAM MEMBERS CAN COMPETENTLY PERFORM REQUIRED ROLES ASSOCIATED

WITH THE MANAGEMENT OF FINANCES. ..................................................................................................................... 78

Testing the Communication Outcomes ........................................................................................................ 78

2.3 DETERMINE AND ACCESS RESOURCES AND SYSTEMS TO MANAGE FINANCIAL MANAGEMENT PROCESSES WITHIN THE

WORK TEAM ......................................................................................................................................................... 80 Delegations and Budget Responsibilities ..................................................................................................... 80 Figure 18: Delegation of responsibilities ...................................................................................................... 81

3. MONITOR AND CONTROL FINANCES.

......................................................................................................... 82 3.1 IMPLEMENT PROCESSES TO

MONITOR ACTUAL EXPENDITURE AND TO CONTROL COSTS ACROSS THE WORK TEAM ......... 82

3.2 MONITOR EXPENDITURE AND COSTS ON AN AGREED CYCLICAL BASIS TO IDENTIFY COST VARIATIONS AND

EXPENDITURE OVERRUNS. ....................................................................................................................................... 83

Cost Control .................................................................................................................................................. 83

Controllable and Non - Controllable Costs ................................................................................................... 84

Controllable costs ...................................................................................................................................................... 85

Example ........................................................................................................................................................ 85

Non -controllable costs ................................................................................................................................ 85

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Example ........................................................................................................................................................ 86

3.3 IMPLEMENT, MONITOR AND MODIFY CONTINGENCY PLANS AS REQUIRED TO MAINTAIN FINANCIAL OBJECTIVES. .......... 86

Risk Management ....................................................................................................................................... 86 Figure 19: Process of risk management ....................................................................................................... 87

Establish the context .................................................................................................................................... 87

Identify the risk ............................................................................................................................................ 88 Analysing risk ............................................................................................................................................... 88 Risk evaluation ............................................................................................................................................. 88 Figure 20: Likelihood and consequences of risk ...........................................................................................89

Figure 21: The process of analysing risk ....................................................................................................... 89

Monitor and review ...................................................................................................................................... 90

Communicate and consult ........................................................................................................................... 91

Contingency plan ......................................................................................................................................... 91

Proper records .............................................................................................................................................. 91

3.4 REPORT ON BUDGET AND EXPENDITURE IN ACCORDANCE WITH ORGANISATIONAL PROTOCOLS ................................ 92

Budget Documentation .......................................................................................................... ...................... 92 Illustration .................................................................................................................................................... 93

Figure 22: Organisation Chart of The Fitzroy Falls Clothing Store ............................................................... 93

Figure 23: Budget for Sales – Manchester Department ............................................................................... 94 Figure 24: - Budget for Purchasing Department .......................................................................................... 95

Fitzroy Falls Clothing Store ........................................................................................................................... 95 Purchasing Department ............................................................................................................................... 95

Budget-July 200X.......................................................................................................................................... 95

Figure 25: Complete budget for the store .................................................................................................... 96

Allocation of Funds....................................................................................................................................... 96

4. REVIEW AND EVALUATE FINANCIAL MANAGEMENT PROCESSES. ......................................................... 99

4.1 COLLECT AND COLLATE FOR ANALYSIS, DATA AND INFORMATION ON THE EFFECTIVENESS OF FINANCIAL

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MANAGEMENT PROCESSES WITHIN THE WORK TEAM. ................................................................................................... 99 Audit Requirements and Legal Obligations .................................................................................................. 99

Compliance with accounting standards ..................................................................................................... 100 Compliance with legal obligations ............................................................................................................. 100

Monitoring of Performance ....................................................................................................................... 101

Example ...................................................................................................................................................... 101

Variances.................................................................................................................................................... 101 Variances and their Causes ........................................................................................................................ 102 Sales variances and their causes ................................................................................................................ 103 Direct material cost variances and their causes ........................................................................................ 105

Figure 26: Diagrammatic representation of direct material variances ...................................................... 106

Example ...................................................................................................................................................... 106 Direct labour cost variances and their causes ............................................................................................ 108

Figure 27: Diagrammatic representation of direct labour variances ......................................................... 109

Example ...................................................................................................................................................... 109

Overhead variances and their causes ........................................................................................................ 111

4.2 ANALYSE DATA AND INFORMATION ON THE EFFECTIVENESS OF FINANCIAL MANAGEMENT PROCESSES WITHIN THE

WORK TEAM AND IDENTIFY, DOCUMENT AND RECOMMEND ANY IMPROVEMENTS TO EXISTING PROCESSES. ........................... 114

Restructuring the Budgets ......................................................................................................................... 114 Flexible budgets ......................................................................................................................................... 115

Figure 28: ................................................................................................................................................... 115 Figure 29: ................................................................................................................................................... 116

Figure 30: ................................................................................................................................................... 117

Figure 31: ................................................................................................................................................... 117

4.3 IMPLEMENT AND MONITOR AGREED IMPROVEMENTS IN LINE WITH FINANCIAL OBJECTIVES OF THE WORK TEAM AND

THE ORGANISATION ............................................................................................................................................. 119

Financial Performance ............................................................................................................................... 119 Records of Financial Performance .............................................................................................................. 119

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Recording costs .......................................................................................................................................... 119

Example ...................................................................................................................................................... 120

Figure 32: Job Cost Sheet ........................................................................................................................... 120

Direct versus indirect costs ......................................................................................................................... 121 Analysis of material costs........................................................................................................................... 121 Analysis of labour costs .............................................................................................................................. 122 Figure 33: Payroll analysis Sheet ................................................................................................................ 122

Analysis of overhead costs ......................................................................................................................... 123

Recovery of overheads ............................................................................................................................... 123 Figure 34: Overhead analysis sheet ........................................................................................................... 123

Example-1 .................................................................................................................................................. 124

Example-2 .................................................................................................................................................. 124

Example-3 .................................................................................................................................................. 124

Reporting ................................................................................................................................................... 124

Financial Performance Reports and Contents ............................................................................................ 125

Information from reports ........................................................................................................................... 125

Report deficiencies ..................................................................................................................................... 126

Timing of reports ........................................................................................................................................ 128 Distribution of reports ................................................................................................................................ 128 Other issues ................................................................................................................................................ 129

Reporting Non-Financial Objectives ........................................................................................................... 129

Revision of Strategies and Plans ................................................................................................................ 131

Financial Performance ............................................................................................................................... 132

GLOSSARY .................................................................................................................................................... 134

RESOURCE EVALUATION FORM ................................................................................................................... 146

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BSBFIM501A - Manage budgets and financial plans

Description:

This unit describes the performance outcomes, skills and knowledge required to undertake financial management within a work team in an organisation. This includes planning and implementing financial management approaches, supporting team members whose role involves aspects of financial operations, monitoring and controlling finances, and reviewing and evaluating effectiveness of financial management processes in line with the financial objectives of the work team and the organisation. No licensing, legislative, regulatory or certification requirements apply to this unit at the time of endorsement

Employability Skills:

This unit contains employability skills.

Application of Unit:

This unit addresses the requirement for managers to ensure that financial resources are used effectively. This is done by ensuring access to budget/s and ongoing monitoring expenditure against the budget/s.

The unit applies to managers working in small and large business environments and not for profit organisations.

Introduction

As a worker, a trainee or a future worker you want to enjoy your work and become known as a valuable team member. This unit of competency will help you acquire the knowledge and skills to work effectively as an individual and in groups. It will give you the basis to contribute to the goals of the organization which employs you.

It is essential that you begin your training by becoming familiar with the industry standards to which organizations must conform.

This unit of competency introduces you to some of the key issues and responsibilities of workers and organizations in this area. The unit also provides you with opportunities to develop the competencies necessary for employees to operate as team members.

This Learning Guide covers:

• Plan financial management approaches.

• Implement financial management approaches.

• Monitor and control finances.

• Review and evaluate financial management processes.

Learning Program

As you progress through this unit you will develop skills in locating and understanding an organizations policies and procedures. You will build up a sound knowledge of the industry standards within which organizations must operate. You should also become more aware of the effect that your own skills in dealing with people has on your success, or otherwise, in the workplace.

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Knowledge of your skills and capabilities will help you make informed choices about your further study and career options.

Additional Learning Support

To obtain additional support you may:

• Search for other resources in the Learning Resource Centres of your learning institution. You may find books, journals, videos and other materials which provide extra information for topics in this unit.

• Search in your local library. Most libraries keep information about government departments and other organizations, services and programs.

• Contact information services such as Infolink, Equal Opportunity Commission, and Commissioner of Workplace Agreements. Union organizations, and public relations and information services provided by various government departments. Many of these services are listed in the telephone directory.

• Contact your local shire or council office. Many councils have a community development or welfare officer as well as an information and referral service.

• Contact the relevant facilitator by telephone, mail or facsimile.

Facilitation

Your training organization will provide you with a flexible learning facilitator. Your facilitator will play an active role in supporting your learning, will make regular contact with you and if you have face to face access, should arrange to see you at least once. After you have enrolled your facilitator will contact you by telephone or letter as soon as possible to let you know:

• How and when to make contact

• What you need to do to complete this unit of study What support will

be provided.

Here are some of the things your facilitator can do to make your study easier.

• Give you a clear visual timetable of events for the semester or term in which you are enrolled, including any deadlines for assessments.

• Check that you know how to access library facilities and services.

• Conduct small ‘interest groups’ for some of the topics.

• Use ‘action sheets’ and website updates to remind you about tasks you need to complete.

• Set up a ‘chat line”. If you have access to telephone conferencing or video conferencing, your facilitator can use these for specific topics or discussion sessions.

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• Circulate a newsletter to keep you informed of events, topics and resources of interest to you.

• Keep in touch with you by telephone or email during your studies.

Flexible Learning

Studying to become a competent worker and learning about current issues in this area, is an interesting and exciting thing to do. You will establish relationships with other candidates, fellow workers and clients. You will also learn about your own ideas, attitudes and values. You will also have fun – most of the time.

At other times, study can seem overwhelming and impossibly demanding, particularly when you have an assignment to do and you aren’t sure how to tackle it…..and your family and friends want you to spend time with them……and a movie you want to watch is on television….and…. Sometimes being a candidate can be hard.

Here are some ideas to help you through the hard times. To study effectively, you need space, resources and time.

Space

Try to set up a place at home or at work where:

• You can keep your study materials

• You can be reasonably quiet and free from interruptions, and

• You can be reasonably comfortable, with good lighting, seating and a flat surface for writing.

If it is impossible for you to set up a study space, perhaps you could use your local library. You will not be able to store your study materials there, but you will have quiet, a desk and chair, and easy access to the other facilities.

Study Resources

The most basic resources you will need are:

• a chair

• a desk or table

• a reading lamp or good light

• a folder or file to keep your notes and study materials together

• materials to record information (pen and paper or notebooks, or a computer and printer)

• reference materials, including a dictionary

Do not forget that other people can be valuable study resources. Your fellow workers, work supervisor, other candidates, your flexible learning facilitator, your local librarian, and workers in this area can also help you.

Time

It is important to plan your study time. Work out a time that suits you and plan around it. Most people find that studying in short, concentrated blocks of time (an hour or two) at regular intervals (daily, every second day, once a week) is more effective than trying to cram a lot of learning into a whole day. You need time to “digest” the information in one section before you move on to the next, and everyone needs regular breaks from study to avoid overload. Be realistic in allocating time for study. Look at what is required for the unit and look at your other commitments.

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Make up a study timetable and stick to it. Build in “deadlines” and set yourself goals for completing study tasks. Allow time for reading and completing activities. Remember that it is the quality of the time you spend studying rather than the quantity that is important.

Study Strategies

Different people have different learning ‘styles’. Some people learn best by listening or repeating things out loud. Some learn best by doing, some by reading and making notes. Assess your own learning style, and try to identify any barriers to learning which might affect you. Are you easily distracted? Are you afraid you will fail? Are you taking study too seriously? Not seriously enough? Do you have supportive friends and family? Here are some ideas for effective study strategies.

Make notes. This often helps you to remember new or unfamiliar information. Do not worry about spelling or neatness, as long as you can read your own notes. Keep your notes with the rest of your study materials and add to them as you go. Use pictures and diagrams if this helps.

Underline key words when you are reading the materials in this learning guide. (Do not underline things in other people’s books). This also helps you to remember important points.

Talk to other people (fellow workers, fellow candidates, friends, family, your facilitator) about what you are learning. As well as helping you to clarify and understand new ideas, talking also gives you a chance to find out extra information and to get fresh ideas and different points of view.

Using this learning guide:

A learning guide is just that, a guide to help you learn. A learning guide is not a text book. Your learning guide will

• describe the skills you need to demonstrate to achieve competency for this unit

• provide information and knowledge to help you develop your skills

• direct you to other sources of additional knowledge and information about topics for this unit.

The Icon Key

Key Points

Explains the actions taken by a competent person.

Example

Illustrates the concept or competency by providing examples.

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Chart

Provides images that represent data symbolically. They are used to present complex information and numerical data in a simple, compact format.

Intended Outcomes or Objectives

Statements of intended outcomes or objectives are descriptions of the work that will be done.

Assessment

Strategies with which information will be collected in order to validate each intended outcome or objective.

How to get the most out of your learning guide

1. Read through the information in the learning guide carefully. Make sure you understand the material.

Some sections are quite long and cover complex ideas and information. If you come across anything you do not understand:

• talk to your facilitator

• research the area using the books and materials listed under Resources

• discuss the issue with other people (your workplace supervisor, fellow workers, fellow candidates)

• try to relate the information presented in this learning guide to your own experience and to what you already know.

Ask yourself questions as you go: For example “Have I seen this happening anywhere?” “Could this apply to me?” “What if….?” This will help you to make sense of new material and to build on your existing knowledge.

2. Talk to people about your study.

Talking is a great way to reinforce what you are learning.

3. Make notes.

4. Additional research, reading and note taking.

If you are using the additional references and resources suggested in the learning guide to take your knowledge a step further, there are a few simple things to keep in mind to make this kind of research easier.

Always make a note of the author’s name, the title of the book or article, the edition, when it was published, where it was published, and the name of the publisher. If you are taking notes about specific ideas or information, you will need to put the page number as well. This is called the reference information. You will need this for some assessment tasks and it will help you to find the book again if needed.

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Keep your notes short and to the point. Relate your notes to the material in your learning guide. Put things into your own words. This will give you a better understanding of the material.

Start off with a question you want answered when you are exploring additional resource materials. This will structure your reading and save you time.

BSBFIM501A - Manage budgets and financial plans

Element Performance Criteria

1. Plan financial management approaches.

1.1 Access budget/ financial plans for the work team.

1.2 Clarify budget/ financial plans with relevant personnel within the

organisation to ensure that documented outcomes are achievable,

accurate and comprehensible.

1.3 Negotiate any changes required to be made to budget/ financial

plans with relevant personnel within the organisation.

1.4 Prepare contingency plans in the event that initial plans need to

be varied.

2. Imple ment financial management approaches.

2.1 Disseminate relevant details of the agreed budget/ financial plans

to team members.

2.2 Provide support to ensure that team members can competently

perform required roles associated with the management of

finances.

2.3 Determine and access resources and systems to manage

financial management processes within the work team.

3. Monitor and control finances.

3.1 Implement processes to monitor actual expenditure and to control

costs across the work team.

3.2 Monitor expenditure and costs on an agreed cyclical basis to

identify cost variations and expenditure overruns.

3.3 Implement, monitor and modify contingency plans as required to

maintain financial objectives.

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3.4 Report on budget and expenditure in accordance with

organisational protocols.

BSBFIM501A - Manage budgets and financial plans

Element Performance Criteria

4. Review and evaluate financial management processes.

4.1 Collect and collate for analysis, data and information on the

effectiveness of financial management processes within the

work team.

4.2

Analyse data and information on the effectiveness of financial

management processes within the work team and identify,

document and recommend any improvements to existing

processes.

4.3 Implement and monitor agreed improvements in line with financial

objectives of the work team and the organisation.

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Skills and Knowledge

Required Skills

• numeracy skills to read and understand a budget and to update a budget

• technology skills to use software associated with financial record keeping.

Required Knowledge

• basic accounting principles

• organisational requirements related to financial management

• relevant legislation and current requirements of the Australian Taxation Office, including GST

• requirements for organisational record keeping and auditing principles

and techniques involved in:

 budgeting

 cash flows

 electronic spreadsheets

 GST

 ledgers and financial statements  profit and loss statements.

Range Statement The range statement relates to the unit of competency as a whole. It allows for different

work environments and situations that may affect performance. Bold italicised wording, if

used in the performance criteria, is detailed below. Essential operating conditions that may

be present with training and assessment (depending on the work situation, needs of the

candidate, accessibility of the item, and local industry and regional contexts) may also be

included.

Budget/ financial plans

may include:

• cash flow projections

• long-term budgets/plans

• operational plans

• short-term budgets/plans

• spreadsheet-based financial projections

• targets or key performance indicators for production,

productivity, wastage, sales, income and expenditure

Relevant personnel may

include:

• financial managers, accountants or financial controllers

• supervisors, other frontline managers

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Contingency plans may

include:

• contracting out or outsourcing human resources and other functions or tasks

• diversification of outcomes

• finding cheaper or lower quality raw materials and consumables

• increasing sales or production

• recycling and re-using

• rental, hire purchase or alternative means of procurement of required materials, equipment and stock

• restructuring of organisation to reduce labour costs

• risk identification, assessment and management processes

• seeking further funding

• strategies for reducing costs, wastage, stock or consumables

• succession planning

Support may include:

• access to specialist advice

• documentation of procedures

• help desk or identified experts within the organisation

• information briefings or sessions

• intranet-based information

• training including mentoring, coaching and shadowing

Required roles may

include:

•

•

•

•

•

arranging for use of corporate credit cards banking

debt collection ensuring security, accuracy and

currency of financial operations invoicing clients,

customers and consumers

maintaining journals, ledgers and other record keeping

systems

maintaining petty cash system

purchasing and procurement

wages and salaries payments and record keeping

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Resources and

systems may include:

•

•

•

hardware and software human, physical or financial

resources record keeping systems (electronic and

paper-based)

specialist advice or support

Processes to monitor

actual expenditure and

to control costs across

the work team include:

reporting of:

o assets o

consumables o

equipment o

expenditure o

income o

stock o

wastage

Reporting may include

data from:

•

•

•

•

•

bank statements

credit card

statements financial

reports invoices and

receipts ledgers and

journals

logs

petty cash records

spreadsheet-based records

Data and information

on the effectiveness of

financial management

processes may include

records (paper-based

and electronic) related to:

•

•

•

•

•

•

•

•

•

bank account records cash flow data

contracts credit card receipts employee

timesheets files of paid purchase and

service invoices income and

expenditure insurance reports invoices

job costings

petty cash receipts

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quotations

taxation records

wages/salaries books

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Evidence Guide The evidence guide provides advice on assessment and must be read in conjunction with

the performance criteria, required skills and knowledge, range statement and the

Assessment Guidelines for the Training Package.

Critical aspects for

assessment and evidence

required to demonstrate

competency in this unit

Evidence of the following is essential:

• financial skills required to work with and interpret budgets, ageing summaries, cash flow, petty cash, GST, and profit and loss statements

• knowledge of the record keeping requirements for

the ATO and for auditing purposes.

Context of and specific

resources for assessment

Assessment must ensure:

access to appropriate documentation and resources

normally used in the workplace.

Method of assessment

A range of assessment methods should be used to assess practical skills and knowledge. The following examples are appropriate for this unit:

• assessment of written reports indicating broad knowledge of managing budgets and managing financial resources in the organisation

• demonstration of techniques using financial record keeping software

• direct questioning combined with review of portfolios of evidence and third party workplace reports of onthe-job performance by the candidate

• oral or written questioning to assess knowledge of requirements for organisational record keeping and auditing

• review of contingency plans

• review of identification of cost variations and expenditure overruns

• evaluation of documentation reporting on budget and expenditure

• review of documentation identifying and

recommending improvements to financial

management processes.

Guidance information for

assessment

Holistic assessment with other units relevant to the industry sector, workplace and job role is recommended, for example:

other units from the Diploma of Management.

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1. Plan financial management approaches.

1.1 Access budget/ financial plans for the work team. Clarify budget/

financial plans with relevant personnel

1.2 within the organisation to ensure that documented outcomes are achievable, accurate and comprehensible.

Negotiate any changes required to be made to budget/

1.3 financial plans with relevant personnel within the organisation.

1.4 Prepare need to be varied.contingency plans in the event that initial plans

Managing Budgets

Each organisation, no matter how large or small, will have key strategies to achieve its objectives. How the strategies are to be employed is expressed in the plans of an organisation and supported by the organisation's budgets.

Budgets, being set targets, provide the basis for determining whether plans are on track. The tracking is facilitated as budgets are expressed in a common denominator namely, dollar values. The actual results are compared to the budget as a means of controlling the activities of the organisation.

When actual results deviate from the budget there is a signal that some correction is required to the execution of the plan or the plan itself. It may be that a plan needs to be better executed or that the assumptions that underpin the strategies and in turn the various plans are incorrect.

1.1 Access budget/ financial plans for the work team.

Accounting Standards are regulated by the Australian Accounting Standards Board (AASB). On 1 January 2005, the AASB implemented the Financial Reporting Council's policy of adopting the Standards of the International Accounting Standards Board (IASB). The MSB replaced and/or adopted existing AASB Standards with the Australian Standards equivalent to those of the IASB to ensure that there is consistency.

The MSB website is http://www.aasb.com.au/.

The main terminology change for the new Standard has seen the Profit & Loss Statement called the Income Statement.

Financial reports are prepared and presented at least annually and provide information about the financial position, financial performance and cash flow of an entity. Financial reports meet the common needs of most users, however they do not necessarily provide all the information that users may

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need to make economic decisions since they largely portray the financial effects of past events.

A complete financial report normally includes a balance sheet, an Income Statement, a statement of cash flows and a statement of changes in equity, and any notes or explanatory material. They may also include supplementary schedules and information.

An evaluation will assess whether the client can generate cash and cash equivalents and also their timing and reliability. A review of the financial performance, financial position and cash flows of a client can assist in determining, for example, the ability of a client to pay its employees and suppliers, meet interest payments or repay loans.

The financial position of clients will be affected by many things, including their resources, financial structure, their liquidity and solvency. Financial structure information can be useful in predicting future borrowing needs and how future profits and cash flows will be distributed among those who may have an interest in the business. It also assists in predicting how likely the client would be in raising further finance. Information about liquidity and solvency is useful in predicting the ability of the client to meet their future commitments.

Information about financial position is primarily provided in the Balance Sheet. Information about performance is primarily provided in the Income Statement. Information about cash movements is provided in the Cash Flow Statement. Information about movements in an entity's equity during the period is provided in the Statement of Changes in Equity.

The different parts that make up the package of financial statements interrelate as they reflect different aspects of the same transactions or other events. Although each statement provides information that is different from the others, none is likely to serve only a single purpose or provide all the information necessary for particular needs of users. For example, an income statement provides an incomplete picture of performance unless it is used in conjunction with the balance sheet, cash flow statement and the statement of changes in equity.

Financial reports are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the need to liquidate or curtail the scale of its operations; if such an intention or need exists, the financial report may have to be prepared on a different basis and, if so, the basis used is disclosed.

Common Definitions

Asset

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Many assets, for example, property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are assets if future economic benefits are expected to flow from them to the entity and if they are

controlled by the entity.

Many assets, for example, receivables and property, are associated with legal rights, including the right of ownership. In determining the existence of an asset, the right of ownership is not essential; for example, property held on a lease is an asset if the entity controls the benefits which are expected to flow from the property.

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Although the capacity of an entity to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For example, know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an entity controls the benefits that are expected to flow from it. However, transactions expected to occur in the future do not create assets. For example, an intention purchase inventory does not, of itself, meet the definition of an asset.

An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. An asset is not recognised in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period. Instead, such a transaction results in the recognition of an expense in the income statement. This treatment does not imply either that the intention of management in incurring expenditure was other than to generate future economic benefits for the entity or that management was misguided. The only implication is that the degree of certainty that economic benefits will flow to the entity beyond the current accounting period is insufficient to warrant the recognition of an asset.

Liability

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources.

An essential characteristic of a liability is that the entity has a present obligation. An obligation is a duty or responsibility to act or perform in a certain way.

Liabilities result from past transactions or other past events. For example, the acquisition of goods and the use of services give rise to trade payables (unless paid for in advance or on delivery) and the receipt of a bank loan results in an obligation to repay the loan. An entity may also recognise future rebates based on annual purchases by customers as liabilities; in this case, the sale of the goods in the past is the transaction that gives rise to the liability.

Equity

Equity is the residual interest in the assets of the entity after deducting all its liabilities.

In assessing whether an item meets the definition of an asset, liability or equity, we need to look at its substance and economic reality and not merely its legal form. For example, in the case of finance leases, the substance and economic reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. The finance lease then gives rise to items that satisfy the definition of an asset and a liability and are recognised as such in the lessee's balance sheet. The amount at which equity is shown in the balance sheet is dependent on the measurement of assets and liabilities. Normally, the aggregate amount of equity by coincidence corresponds with the aggregate market value of the entity or the sum that could be raised by disposing of either the net assets or the entity as a whole on a going concern basis.

Capital

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The financial concept of capital is adopted by most entities in preparing their financial report. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.

Income

Income equals increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

Expenses

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or where liabilities occur that result in decreases in equity, other than those relating to distributions to equity participants.

The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Expenses that arise in the course of the ordinary activities of the entity can include cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash or cash equivalents, inventory, property, plant and equipment.

Income and expenses may be presented in the Income Statement in different ways so as to provide information that is relevant for economic decision-making. For example, it is common practice to distinguish between those items of income and expenses that arise in the course of the ordinary activities of the entity and those that do not. This distinction is made on the basis that the source of an item is relevant in evaluating the ability of the entity to generate cash and cash equivalents in the future. For example, incidental activities such as the disposal of a long-term investment are unlikely to recur on a regular basis. When distinguishing between items in this way, consideration needs to be given to the nature of the entity and its operations. Items that arise from the ordinary activities of one entity may be unusual in respect of another.

Losses represent other items that meet the definition of expenses and may or may not arise in the course of the ordinary activities of the entity. Losses represent decreases in economic benefits and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element. Losses include, for example, those resulting from disasters such as fire and flood, as well as those arising on the disposal of non-current assets. The definition of expenses also includes unrealised losses, for example, those arising from the effects of increases in the rate of exchange for a foreign currency in respect of the borrowings of an entity in that currency. When losses are recognised in the Income Statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Losses are often reported net of related income.

Liquidity

Liquidity refers to the availability of cash in the near future after taking account of financial commitments over this period.

Solvency

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Solvency refers to the availability of cash over the longer term to meet financial commitments as they fall due.

Balance Sheet

Financial statements can include cash flow statements, balance sheets and profit & loss (income) statements. All of these statements give an indication of the financial state of a business or self- employed client. The Balance Sheet and the Profit and Loss Statement are the two key statements used. We are not looking here at how you would manage your own business,

but rather how you would interpret the financials of clients who come to you seeking a loan.

The Balance Sheet is a statement of what the business owns (assets), what it owes (liabilities) and the difference between these two amounts which is the net worth of the business (owner's equity). The owner's equity represents the cash that would be left if they sold up all their assets and used the money to settle all their debts.

Because the level of assets, liabilities and owner's equity are changing all the time, the Balance Sheet reflects all of these things at one point in time. A Balance Sheet typically follows a standard format and is normally compiled at least once a year.

The assets include current and non-current assets. Current assets include cash, accounts receivable and stock. They are things in the business which will be used up within the year. Non-current assets are things that will not be used up within the year. Assets such as equipment, land, furniture and fixtures are considered non-current assets. Some items, such as land, will never be used up. Other assets, such as equipment and furniture and fixtures will be used until they need to be scrapped or until it is time to sell them and buy newer items.

The liabilities also include current and non-current. Current liabilities are current debts and short terms loans which need to be paid in full within the following year. For example, monthly bills, credit card loans, etc. Noncurrent liabilities will be paid off over a period greater than one year e.g. A long-term bank loan, house mortgages, etc.

Below is an example of a Balance Sheet for a small business. (Table 1)

Working capital is the net amount of liquid funds the business will have available to meet its commitments in the next accounting period.

The Balance Sheet provides information which helps us to assess three main aspects: profitability, liquidity and solvency. Profitability measures how effective an enterprise is and liquidity and solvency show the ability to meet liabilities.

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Table 1: Example of a Balance Sheet

Frost Foods Balance Sheet as at June 30, 2010

OWNER’S EQUITY

Capital - J Frost 140,000 Add: Net Profit 40,000

180,000

Less: Drawings 14,800

ASSETS

Current Assets

Cash At Bank 4,000

Accounts Receivable 5,000 Stock on

Hand 22,000 Prepaid Expenses 100

Accrued Revenue 50

Working Capital

Fixed Assets

Vehicle 21,000 Furniture 27,000

Buildings 42,000

Land 58,000

Share Investments 5,400

Goodwill 22,000

Patents 3,000

Total Assets LIABILITIES

Current Liabilities

Accounts Payable 4,000 Accrued

Expenses 250

Revenue received in advance

Non-Current Liabilities

Mortgage 25,000

Loan From Finance Co 15,000

Total Liabilities

Assets less Liabilities

165,200

31,150

148,000

30,400

209,550

4,350

40,000

44,350

165,200

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Profit and Loss Statement

The Profit and Loss Statement (or Income Statement) reveals what expenses and revenues were incurred for the year and if a profit or a loss was made.

Revenue (income) less Expenses (payments) equals Profit.

Revenue is what the business earns e.g. sales of product, sale of equipment, supply of a service.

Expenses are the costs of running a business, e.g. Salaries and commissions, advertising, telephone expenses, etc.

An example of what a Profit and Loss Statement might look like for a small business follows. A Profit and Loss Statement reflects what has happened in the business to a certain point in time. A Profit and Loss Statement should be done once a month.

Figure 2: Profit and Loss Statement Example

Frost Foods Profit and Loss as at June 30, 2010

Sales

Cost of Goods Sold Opening Stock 15,000

Purchases Less 150,000

Closing stock 25,000

Gross Profit Operating 160,000

Expenses

Employee Wages 5,000

Electricity 2,000

Advertising 75,000 Insurance 15,000

Lease Rental 15,000

Other 8,000

Net Profit Before Tax

Taxes

Net Profit After Tax

300,000

140,000

120,000

40,000

10,800

29,200

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Adjusted Net Profits

Profit "addbacks" will sometimes be seen to be added to the Net Profit in the Profit and Loss Statement. Add backs are to be considered when arriving at the business actual profit. They are the amounts determined to be able to be "added back" to increase their income figure and therefore help with serviceability.

Items such as plant depreciation and leasing amortisation, because they are such indecisive items, may not necessarily be included.

Examples of some addbacks follow:

• Accountancy extraordinary costs such as preparation to sell business, amalgamations, etc.

• Abnormal bad debts and collection charges

• Borrowing costs

• Borrowing and bank interest

• Donations

• Depreciation

• Entertainment (private)

• Hire purchase charges and interest

• Leasing initial costs

• Leasing interests Leasing residuals Personal:

 Travelling expenses - gifts, food

 Telephone expenses - beverages

 Petrol - home rental

 Car service - maintenance

 Insurance - medical

 Superannuation (non-employer sponsored i.e. the amount over 9%)

• Wages for work not performed by spouse

• Rental payments on unproductive property

• Difference between interest on Director or Shareholders' loans compared to commercial loans

• Owners, Shareholders, Employees above average bonuses

Accumulated long -term tax losses.

Also consider "one off income" for example a sale of an asset and "one off expenses" such as a purchase of an asset.

Consider the following:

• Gross Profit - Income Less Expenses - Are the Gross Profit levels constant over the past 3 years or more - watch for recent high's and question the explanations.

• Net Profit Income less Expenses - less taxes and addbacks - can be used to pay proprietors as drawings or shareholders as dividends, or retained.

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• Addbacks - The most common addbacks are personal superannuation and insurances, owner's wages, depreciation, private motor vehicle expenses, interest paid, financial costs, etc. Although it may be difficult, try to determine whether alt expenses are shown and whether or not the addbacks are presented realistically.

• Depreciation - Depreciation is an expense item and occurs when the initial cost of an asset is progressively "written off" over the expected useful life of the asset. Although an expense which reduces the profit figure, it is not a cash expense and therefore not necessarily acceptable as an addback.

• Superannuation - The current compulsory payment is at 9%. If more than 9% has been paid by the company into a superannuation fund this amount can be classified as an addback.

• Wages/salaries - Determine whether the profit margin allows for an adequate salary for any work performed by the owner and/or family members - is the gross profit margin increasing or decreasing?

The Sole Trader

A sole trader can be defined simply as a business enterprise which is owned by one person. It is the responsibility of this one owner to supply the necessary funds to commence the business. In turn, any profits of the business go to the owner and the owner is responsible for any losses the business may incur. The debts of the business are the sole responsibility of the owner. Because the owner has unlimited liability in the eyes of the law, the owner's personal assets can be sold to meet the debts of the business.

The popularity of this type of business enterprise no doubt stems from the fact that the owner is his or her own boss. The growth of the business is limited to the owner's personal wealth and capacity to raise funds. If the owner does not operate the business under his or her own name, the business name must be registered under the Business Names Act. Not being a separate legal entity, the business itself is not subject to tax, but the owner must pay tax on the business profits.

Advantages of a Sole Trader Business

• The owner has a great deal of control over the business

• The owner is entitled to all the profits

• It is simple to establish with minimal formalities

• Business dealings do not have to be revealed to outsiders, except for those reports required by the various levels of government.

Disadvantages of a Sole Trader Business

• The owner has unlimited liability for the debts of the business

• The size of the business is generally restricted by the amount of the owner's wealth and capacity to raise funds

• Some sole traders have difficulty in taking holidays and sick leave because they have problems finding someone to replace them

• The success of the business may be limited by the abilities and talents of the owner, unless gaps can be filled by good quality employees.

Taxation for the Sole Trader

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A tax return and a tax assessment are both required when a selfemployed/sole trader applicant is providing supporting documentation. The tax assessment is the official assessment of the applicant's earnings from the tax department whereas the tax return provides the complete picture of expenses and income. The tax return is what would be sent to the ATO detailing all income earned, expenses incurred and any deductions claimable.

Corporate Entities

Company law is a difficult subject, even for some lawyers. For practical purposes the Corporations Act is the only legislation which would be relevant to understanding the subject of corporate entities.

This diagram outlines the basic structure and demonstrates that registered companies are a type of corporation, companies limited by shares are a type of registered company and companies limited by shares are either public or proprietary companies. These are the main types of corporations you will encounter as a broker.

Figure 3: Main types of Corporations

It is important to remember that just because the name of a business has "company" as part of the name it does not necessarily mean that it is a registered company. Look for "Limited" or 'Ltd" at the end of the name to determine whether or not you are dealing with a registered company. If not, you will usually be dealing with a registered business name, which may well

be owned by a company or it could be owned by a sole proprietor or a partnership.

A company is entitled to purchase, own, sell or lease any kind of property, keep a bank account, be a creditor or debtor, enter into partnerships and engage in any kind of lawful business. As the company can incur debts, it may become insolvent, and this or some other reason may cause it to go out of business. It is then said to go into liquidation and a liquidator would be appointed to wind up its affairs.

Companies Limited

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This form of company allows the shareholders and members to have limited liability. This means that shareholders are only liable for the company's debts up to the face value of their shares. All limited companies must have the word "Limited" or the abbreviation "Ltd" as part of the firm's name. As shown in the diagram, there are two types of limited companies:

Figure 4: 2 Types of Limited Companies

A Company limited by Shares

Most limited companies have share capital and are technically known as "companies limited by shares". A share is an interest in a company (not its assets) measured by a sum of money consisting of various statutory and contractual rights. "A company's share capital is the amount of money or assets contributed to the company by its members when they subscribe for shares in the company. A person who wishes to become a member takes

some of their own money or assets and contributes that amount to the company. The money or assets contributed then belong to the company. In return, the member is issued

[1] with shares in the company." . The decision to issue shares is made by the directors who also determine the issue terms and price.

1. Proprietary Companies

These can be formed with up to a

maximum of fifty shareholders. Certain

restrictions are placed on the transfer of

shares. All proprietary companies must

have the words "Proprietary" or the

abbreviation "Pty" as part of the firm's

name. Over 90% of companies in

Australia are proprietary companies.

2. Public Companies

These can be formed with a minimum of five people, with no set maximum number. Public companies can be limited by:

a) Shares:

These may be offered to the public and are usually transferable on the stock exchange. This is the most common type of company in Australia.

b) Guarantee:

Members agree to contribute a

guaranteed amount in the event of the

company being wound up. Clubs and

non-profit organisations are commonly

associated with this type of company.

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Even in companies limited by shares it is possible for owners to be exposed to personal liability. For example:

A bank may require a personal guarantee against loans or overdrafts; or

Sometimes a director can be held personally responsible for actions that are clearly beyond the ability of the company to pay.

A Company limited by Guarantee

Another type of limited company is a company limited by guarantee which is, as per the Corporations Act, section 9, formed on the principle of having members' liability limited to the respective amounts that the members guarantee to contribute to the property of the company if it is wound up. They do not have any share capital and members cannot be shareholders.

A shareholder is always a member, but a member is not always a shareholder. A company limited by guarantee does not normally have any shares or shareholders, but it does have members. This class of company is usually confined to not-for-profit associations.

No Liability Companies

A no-liability company must be a mining company and must have the words "No Liability" or the abbreviation "N.L" in the firm's name. The company can ask shareholders to pay a call on their shares but the shareholder is under no obligation to pay. Shareholders are therefore not required to make any payment towards the debts of the company. When holders take up shares in no liability companies, they usually only pay a small portion of the subscription value of their shares. As the mining operation goes through the prospecting, feasibility, mining and other development stages, the company makes calls for an appropriate portion of the uncalled value of the shares.

Unlimited Companies

In this type of company, members are liable for the debts of the company - there is no limit on the contribution required by the holders of the shares if the company was to be wound up. These companies have the advantage that they can more easily return capital to members and can purchase their own shares. Despite this, unlimited liability companies are not common in Australia. Unlimited companies can now only be those with a share capital, but can be either public or proprietary.

Holding Companies and Subsidiaries

A subsidiary is usually a company in which more than half the share capital is held by another company, known as a holding company.

The Constitution

Any company may formulate a set of rules, consistent with the provisions of the law, to regulate its operations internally. Such a set of rules may vary

and replace rules in the Corporations Act, and is known as the Constitution of the company. Unless a company has a constitution, it will have no formalised internal governance under the Corporations Act.

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Partnership vs. Company

Everything in a partnership is shared in accordance with each partner's shareholding in the partnership. Assets and liabilities are likewise shared between the partners in accordance with each partner's shareholding. It is important to remember that, unlike companies, partnerships have unlimited liability. This means that if one or more of the partners is found liable for doing or failing to do something, then all the partners in the whole partnership are personally liable. In a company, shareholders' liability is limited to the extent of their shareholding, which means the most they can lose is the value

of their shares. In a partnership, on the other hand, there is no limit on the potential liability of partners.

From an accounting viewpoint, partnerships are treated as entities separate from their owners. Like single proprietorships, partnerships are widely used for small service enterprises, retail stores and professional practices.

Trusts

A trust is an obligation imposed on a person - who may be a natural person or a company -to hold property or income for the benefit of others, known as 'beneficiaries'. Income generated by the trust for the beneficiaries is generally taxable in the hands of the beneficiaries.

A trustee can be a natural person or a company, and as a trustee is personally liable for the liabilities of a trust it is usually not desirable for a natural person to hold this office where the trust is incurring commercial risk.

For this reason, trustees of trusts carrying on business are usually companies (e.g. XYZ Pty Ltd as trustee for the MG Trust)

Distributions of income from any trust investment product, such as a cash management trust, money market trust, mortgage trust, property trust or unit trust, are treated as trust income. Income (including capital gains) will generally retain its character as it flows through the trust. Public trading trusts and corporate unit trusts however are treated as companies for tax purposes, so income from an equity investment in these types of trusts is treated as a dividend.

An inheritance is not assessable income. However any income earned from the inheritance - such as interest from the investment of an inheritance - is assessable.

All income earned by the trust, and deductions claimed for expenses incurred in earning that income, must be shown in a Trust tax return.

If deductible expenses are incurred in earning trust income, and they are not claimed by the trust and the beneficiary was entitled to the trust income when the expenditure was incurred, then a deduction can be claimed by the beneficiary in their individual tax return.

A trust generally does not pay tax on its income. Instead, the trustee distributes the income to some or all of the beneficiaries of the trust. Each beneficiary in receipt of a distribution must include the whole of their share

of the net income in their personal tax return.

The trustee is generally taxed only on the balance (if any) of income to which no beneficiary is at that time entitled or where the beneficiary is a non- resident at the end of the year or is under 18 or classified as insane.

Most trust distributions paid after the end of a financial year need to be included in that person's tax return for that year. This is because they were entitled to this income as at 30 June.

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For example: Mr Smith receives a distribution of $1,000 from a family trust on 25 July 2004. The statement from the trustee states that it is income for the year ended 30 June 2004. Mr Smith must include this income in his individual tax return for the year ended 30 June 2004.

A trust estate cannot distribute an overall loss. The losses of a trust estate in one year may be carried forward and offset against its income of future years. The trust needs to satisfy certain tests before a deduction is allowed for carried forward losses.

A Discretionary Trust is one in which the entitlement of the beneficiaries to income or capital is not immediately ascertainable. Rather any entitlement is determined by the trustee (or some other person) from time to time or at maturity of the trust. Where a discretionary trust is initially created over unidentified property or non-dutiable property (for example a sum of money) concessional duty of $200 may apply (see Section 58 of the Duties Act.)

Where there is a subsequent transfer of trust property from the trustee of a discretionary trust to one or more beneficiaries, the duty payable on the transfer will be dependent on a number of factors.

A Unit Trust is one in which ownership of trust assets are divided into a number of units and any profits are distributed proportionately amongst the unit-holders according to the units held. A Unit Trust is cheaper and more flexible than a company. In a company you get shares. In a Unit Trust you get Units. The number of Units you hold determines your share of the income and voting power. A Unit Trust can be owned by an individual or by a Family Trust.

A Non-Resident Trust is a trust where a trustee was not an Australian resident at any time during the year of income, or the management and control of the trust was not in Australia at any time during the year of income.

A trust has some tax advantages and asset protection. Family Trusts

Similar to Trusts, a Family Trust is one of the most common small business structures in Australia. Unlike a Unit Trust a Family Trust is a type of Discretionary Trust and is established to benefit the members of a family. Family Trusts provide families with a great deal of flexibility in sharing the tax burden among family members and protecting family assets.

The Family Trust structure is useful if the family holds capital growth or income-generating assets. Some of the key attributes of the Family Trust are:

• It is a relatively low cost and simple structure to use.

• It allows distribution of income to family members who are on low tax rates.

• It offers some protection from bankruptcy and insolvency.

• It allows income to be distributed as one type of income to one person and another type of income to another person.

• A Family Trust can operate for up to 80 years.

• It can have single or multiple directors for example a couple may be the trustees or they may have a company as the trustee and they and the children the beneficiaries.

You will often be presented with financials for Trusts when assessing loans and it is important to assess them in income calculations. It would be worthwhile for any new broker to do their own research on the different types

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of trusts as there are many small details which may affect your understanding.

Ratio Analysis

Ratio Analysis is an examination of a company's ratios, such as gearing and liquidity, to determine its financial worth and to assist in the identification and analysis of "trends". There are numerous types of Ratios used and what one lender considers important another may not. Calculations may also differ from one lender to another.

Gearing is the relationship between a company's shareholders' funds and some form of outside borrowing. Gearing is generally expressed as a ratio. A company is described as 'highly geared1 if borrowed funds are high in

relation to shareholders' funds. Analysts talk of a company's gearing when referring to its solvency and its ability to take on new commitments.

Liquidity refers to the company's capacity to be converted easily and with minimum loss into cash.

Ratio analysis was developed to determine the stability of various financial aspects of a business. It shows the relationship between two figures, or two aspects of a business. It helps to calculate a financial weaknesses and strengths of a business. Ratio analysis also offers a view of a business' competitive performance in relation to similar businesses in the same industry. Used predominantly in commercial lending it allows assessment of categories of the trading history of a company. The major categories are:

• Profitability

• Efficiency

• Liquidity measure (cash)

• Financial structure (debt levels).

Commercial lending is a challenging field for a broker and in the early days it is unusual for a mortgage broker to become involved in this kind of analysis. However, as your knowledge and experience grows, you may find it a challenge worth pursuing.

When you are analysing a financial statement, it is best to reduce amount comparisons to percentages or ratios so that you have an easy way to judge those comparisons. And if you compare those ratio results with what you know to be good, fair or bad, you have a way of determining the health of a business.

Simply put, ratio analysis is changing amount comparisons to ratios and then comparing those ratios to a known standard.

Everyone in the business of analysing financial statements has a few favourite ratios they utilise when determining the strengths or weaknesses of a specific financial statement. The ratios that are used could change depending upon the industry the business is in, the size of the business, the accounting method that is used by the business and the amount of the credit desired and how healthy the company is. If you are dealing with a high-risk business, you will probably want to use more ratios than if you were dealing with a healthy, low risk business

Ratios are classified and presented in several different ways. These are commonly used to evaluate a company's profitability, liquidity and financial stability.

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Profitability Ratios

Net Profit Margin Ratio

For a business to survive in the long term it must generate profit. Therefore the net profit margin ratio is one of the key performance indicators for a business. Information from a business annual profit and loss statements is used in the calculation, as follows:

Net Profit Margin (%) = (Net Profit [before tax]/Sales) x 100

The net profit margin ratio indicates profit levels of a business after all costs have been taken into account.

It is worth analysing the ratio over time. A variation in the ratio from year to year may be due to abnormal conditions or expenses.

A decline in the ratio over time may indicate a margin squeeze suggesting that productivity improvements may need to be initiated. In some cases, the costs of such improvements may lead to a further drop in the ratio or even losses before increased profitability is achieved.

Gross Profit Margin Ratio

A business' gross profit margin is one of its key performance indicators. The gross profit margin gives an indication on whether the average mark up on goods and services is sufficient to cover expenses and make profit.

Information from a business' annual profit and loss statements is used as follows:

Gross Profit Margin (%) = (Gross Profit/Income) x 100

The gross profit margin should be stable over time. A persistent gradual decrease is likely to indicate that productivity needs to be increased to return

profitability back to previous levels.

Return on Assets Ratio

The return on assets ratio indicates how effectively the assets of a business are working to generate profit.

Information from a business' annual profit and loss statements and balance sheet is used as follows:

Return on Total Assets =Net Profit (before tax)/Total Assets x 100

This ratio gives an indication of the effectiveness of a business in generating a profit. The higher the ratio the greater the return on assets. However this has to be balanced against such factors as risk, sustainability and reinvestment in the business through development costs.

Operating Expenses to Sales Ratio

The operating expenses to sales ratio gives an indication of the efficiency of the cost structure of a business.

Information from a business1 annual profit and loss statement is used as follows:

Operating Expenses to Sales = (Cost of Goods Sold + Total Expenses - (Finance + Depreciation))/Sales x 100

This ratio gives an indication of the ability of a business to convert income into profit. Businesses with low ratios will generate more profit than others.

In general business operations with larger and more stable cashflow can sustain higher ratios than smaller and less stable operations. Scale and

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income stability are important considerations although it is up to the management of a business to monitor costs in an appropriate manner whatever its size.

There should be a balance between reducing or maintaining tight control of running costs in the short term and reinvestment in the future. This balance needs to be considered in terms of the current needs and strategy of the business and where it is heading in the medium to long term.

Liquidity is the capacity of a business to be converted easily and with minimum loss into cash. A liquid market is one in which there is enough activity to satisfy both buyers and sellers. The liquidity ratio is the proportion of a financial institution's assets held in easily cashable form. Liquidity ratios can take the form of current ratio, quick ratio, etc. and act to quantify a company's ability to discharge debt obligations.

Working Capital Ratio

The working capital ratio can give an indication of the ability of a business to pay its bills. Information from a business1 annual balance sheet is used as follows:

Working Capital ratio = Current Assets/Current Liabilities

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Generally a working capital ratio of 2:1 is regarded as desirable. However the circumstances of every business vary and how a business operates should be considered when setting an appropriate benchmark ratio.

A stronger ratio indicates a better ability to meet ongoing and unexpected bills therefore taking the pressure off cash flow. Being in a liquid position can also have advantages such as being able to negotiate cash discounts with suppliers.

A weaker ratio may indicate that a business is having greater difficulties meeting its short-term commitments and that additional working capital support is required. Having to pay bills before payments are received may be the issue in which case an overdraft could assist. Alternatively building up a reserve of cash investments may create a sound working capital buffer.

Quick Assets Ratio

The quick assets ratio gives an indication of the level of liquid assets that can be used to meet short term liabilities.

Information from a business1 annual balance sheet statement is used as follows:

Quick Assets ratio = (Current Assets-Stock)/Current Liabilities

The quick assets ratio provides a more conservative measure than the working capital ratio in that it excludes stock (inventory). A ratio greater than 1:1 (i.e. 2:1) indicates that current liabilities can be met from current assets without having to liquidate stock

Stock Turnover Ratio

The stock turnover ratio indicates how quickly a business is turning over stock.

Information from a business annual profit and loss statements and balance sheet is used as follows:

Stock Turnover ratio = Cost of Goods /Average Stock

A high ratio may indicate positive factors such as good stock demand and management. A low ratio may indicate that either stock is naturally slow moving or problems such as the presence of obsolete stock or good presentation. A low ratio can also be indicative of potential stock valuation issues. It is a good idea to monitor the ratio over consecutive financial years to determine if a trend is developing.

It can be useful to compare this financial ratio with the working capital ratio. For example business operations with low stock turnover tend to require higher working capital.

Debtor Ageing Ratio

The debtor ageing ratio indicates the average time it takes a business to collect its debts. It is worth looking at this ratio over a number of financial years to monitor performance trends.

Information from the annual profit and loss statement along with the trade debtors figure from the balance sheet for that financial year are required to calculate this ratio.

Debtor Ageing ratio (in days)= (Trade Debtors /Sales) x 365 Creditor Ageing Ratio

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The creditor ageing ratio indicates the average time it takes for a business to pay its bills.

Information from the annual profit and loss statement along with the trade creditors figure from the balance sheet for that financial year is used as follows:

Creditor Ageing ratio (in days) = (Trade Creditors/ Purchases) x 365

This ratio provides an indication of the average time it takes for a business to pay its bills. It is worth looking at the figure over a number of financial years to see if a trend is developing. A lengthening in the ratio could indicate a problem with working capital, such as decreasing stock turnover or slower debt collection.

To assess a company's ability to continue operations in the long term and still have sufficient working capital left over to operate successfully there are additional ratios concepts to look at.

Debt Ratio

The debt ratio gives an indication of the gearing level of a business. To gauge a business’ overall position you may need to combine the input figures if there is more than one entity, for example if the assets are held in a different entity to the trading entity. Information from the business1 annual balance sheet is used.

Calculated as the relationship between total liabilities and total assets as follows:

Debt ratio = Total Liabilities / Total Assets x 100

The debt ratio gives an indication of the level of debt to equity. The right level of debt for a business depends on many factors. Some advantages of higher debt levels could be:

• The deductibility of interest from business expenses can provide tax advantages.

• Returns on equity can be higher.

• Debt can provide a suitable source of capita! to start or expand a business.

Some disadvantages could be:

• Sufficient cash flow is required to service a higher debt load. The need for this cash flow can place pressure on a business if income streams are erratic.

• Susceptibility to interest rate increases.

• Channelling cash flow to service debt may starve expenditure in other areas such as development which can be detrimental to overall survival of the business.

Debt to Income Ratio

The debt to income ratio gives an indication of the sustainability of the debt load of a business. Information from a business1 annual profit and loss and balance sheet is used. The ability of a business to service debt depends on its income and cost structure. The debt to income ratio provides a simple measure of the total liabilities of a business compared to its income. Both the amount and the stability of income streams have a bearing on the level of sustainable debt.

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In general, larger business operations and those with stable cashflow can sustain higher debt ratios provided they have efficient costs structures. The debt to income ratio can be important in the risk management process of a business.

Calculated as the relationship between total liabilities and total income as follows:

Debt ratio = Total Liabilities / Total Income

Ratios should be considered over a period of time (say three years), in order to identify trends in the performance of the business.

Interest Cover Ratio

The interest cover ratio gives an indication of the ability of a business to meet ongoing interest bills and therefore service debt.

Information from a business’ annual profit and loss statements is used. The calculation used to obtain the ratio is:

Interest Cover ratio= (Net profit before tax + Finance expenses)/ Finance expenses

A result below 1 would indicate that interest cover is insufficient to cover ongoing finance expenses.

Asset Turnover Ratio

The asset turnover ratio is a measure of how effectively assets are being utilized. The calculation used to obtain the ratio is:

Asset Turnover ratio = Annual Sales /Total Assets

Interpreting a Statement of Assets and Liabilities

An accurately drawn up Statement of Assets and Liabilities enables you to determine net worth, that is, how much would be left in the business if it were sold and all debts paid off. It also enables identification of what assets could be sold or redeemed in order to cover periods of tight liquidity.

The following illustrates (Figure 5) a simple example of a Statement of Assets and Liabilities which calculates net worth and equity percentage.

Your client, John Citizen has approached a broker to assist in the purchase of a new 200-hectare farm. The farm will cost $200,000 and John wishes to purchase it in his own name.

High levels of equity are associated with low levels of debt which in turn result in low debt servicing coasts. Consequently viability is enhanced when equity is high

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Figure 5: Statement of Assets and Liabilities Example

John Citizen

Statement of Assets and Liabilities as at 30/06/20XX

Before Land

Purchase

After Land

Purchase

CURRENT ASSETS

Cash

$ $

1,000 1,000

Existing Livestock 20,000 20,000

Share in Friend’s Livestock

NON-CURRENT ASSETS

61,000 61,000

82,000

82,000

Share in grazing land property 480,000 480,000

New Land Purchase 200,000

Machinery

TOTAL ASSETS

CURRENT LIABILITIES

30,000 30,000

510,000 710,000

592,000 792,000

Existing land loan (John’s Share) 50,000 50,000

New Loan to John

TOTAL LIABILITIES

NET WORTH

EQUITY

200,000

50,000 250,000

542,000

542,000

92%

68%

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1.2 Clarify budget/ financial plans with relevant personnel within the organisation to ensure that documented outcomes are achievable, accurate and comprehensible.

Communicating Budgets and Financial Plans

Once budgets are formulated, they need to be communicated to the affected parties - that is, to the people who are responsible for managing them. The process of communication is carried out through a combination of different methods called a communication package. The communication package includes visual aids, such as listing of various values of budgets presented in the form of tables, together with diagrams, graphs and charts such as pie charts. There need also be explanations provided on these visual media. In

addition, information about meetings and training activities for users of the budgets would form part of the communication package. Once the communication package, incorporating the visual aids, is planned, they are reviewed by the finance and communication specialists. Finance specialists get involved since a budget is mainly a financial representation of plans and any errors would create confusion, if not chaos, among the users of the budget.

As a result of the review undertaken, some of the items may need to be amended or revised. There is also the possibility that the planned communication methods themselves will be amended or revised. These amendments or revisions are necessary to ensure the success of the communication package.

Training activities are of paramount importance for the communication package. Training activities have a dual role: one is communicating the budget to members of the staff; the other is educating them in the techniques of managing budgets.

The selection of participants for the training activity depends on the size of the organisation, the skills available within the organisation and the expectations of the management. Training could be undertaken by either external contractors or internal staff. Training could be provided to all the staff by specialist trainer(s) or through a train-the-trainer program in which a team of trained staff train their colleagues.

The communication package could also incorporate documents in which all data items and budget terms are defined. The definitions should use simple language and avoid ambiguity. The selection and use of words should be appropriate to the users for ease of comprehension. The success of the communication package, in terms of the staff's understanding of the budget objectives, processes and accountabilities, needs to be tested. The testing also would incorporate checks as to whether the definitions of all data and terms are clearly understood by the users. The testing process may include feedback from staff using techniques such as questionnaires and face-to- face interviews. Conclusions as to the suitability of the communication package could also be reached through direct observation of the tasks carried out by the staff. However, this needs to be done in conjunction with other techniques. Proper recording and analysis of complaints from staff could also assist in assessing the effectiveness of the communication package.

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Monitoring and Controlling Activities Against Plans

For the proper management of budgets there should be delegation of authority and assignment of budget accountability to various people or teams in the organisation. The delegation of authority with respect to expenditure controls and accountability involves monitoring of expenditure, reporting the variances from budgets and plans, and taking remedial action within budget authority. This delegation of authority and budget accountability is to be confirmed in writing with the appropriate persons. This confirmation should take place before the budget period begins as any confirmation after the beginning of the

budget period would defeat the purpose.

After setting the budget and assigning responsibilities, the funds required to carry out the activities are to be allocated for the respective budget areas. The allocation of funds needs to be in accordance with the budget objectives. Allocation of funds to each area or section is of paramount importance as non-availability of funds when required would severely hinder the operations of these areas or sections of the organisation. These hindrances will not only affect those areas or sections, but may affect the whole of the organisation depending on the interdependence of its activities on other sections of the organisation.

The activities of an organisation are to be recorded for future reference. These records are used to analyse the activities and to produce reports for monitoring purposes. The systems of recording and other documentation should meet the requirements for producing suitable and meaningful reports. In addition, they should conform to audit requirements and other legal obligations. Internal auditing is involved with internal controls, processes and systems to reduce the risk of loss due to the accidental or deliberate actions of people, while external auditing requires that, in addition to conforming to internal controls, other legal and professional obligations are fulfilled. Legal obligations cover, among other things, compliance with the requirements of companies' codes and accounting standards.

Risk, the probability of a certain event happening, is inherent in all the activities of an organisation. Risk could be positive, where an unexpected gain occurs, or negative, where an unexpected loss occurs. It is imperative that risk-management plans are in place to safeguard against the negative risk. These plans are to be implemented and, in addition, there should be contingency plans formulated and ready for action in the event of a loss occurring. Risk management encompasses risk acceptance, risk avoidance and passing of the risk to someone else.

It is important to review the ongoing performance of tasks or activities against the budget to determine whether performance requirements have been met. A problem may exist that continually prevents an organisation from meeting its plan. There is, therefore, a need to focus on any variances between actual performance and the plan, so that adjustments can be made to the performance to ensure that it is in line with the plan and remedial action taken where appropriate. Sometimes the plan has to be revisited as the organisation may encounter an unanticipated event. Despite budgets being developed on best assumptions, things do go wrong and plans have to be revised.

Furthermore, an organisation is a system with constituent sub-systems. Each sub-system would have its own input and output, which could become an output or input of a related system. The aggregated input and output becomes the system's input and output.

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For example, the ABC Bus Building Company (a system) buys many items (inputs) and sells built buses (outputs). One of the items bought is cloth for seat covers (input), which is used by the seat-making section (a subsystem) to make seats (output), which will be used by the assembling section (sub- system) as an input to build bus bodies (output).

Each of the inputs and outputs when measured indicate the performance of the system or sub-system. The performance is monitored on a regular basis. The regularity depends on the needs of the organisation, and is generally decided by the costs and benefits of carrying out the measurement. The prime motive of measuring the performance is to compare it with the planned performance to reveal the deviations from the plan. These deviations or variances are either positive or negative.

The variances are identified to take immediate remedial action to reduce, if not eliminate, the negative variances. Any delayed action would be futile. Modern technology enables variances these days to be identified on a real- time basis (ie online, instantaneous monitoring of performance).

The process of identifying the variances is variance analysis. This concept is explained by the budget for Sam's holidays. Sam's holiday budget included $300 for fuel expenses for the car. When the holiday was over, the actual fuel expense was found to be $325. Thus Sam had overspent $25. In other words, there is a negative variance of $25 compared to the original budget.

The variance could be due to an actual expense being 'over' or 'under' the budget. If Sam's actual expenditure was $275, the variance would still be $25. These two variances, though represented by the same amount, are not really the same. The two variances are differentiated by assigning to them positive and negative symbols (+ and -). When the actual expenditure is lower than the budget, it is a positive and favourable outcome; when it is higher than the budget, the outcome is negative and unfavourable. The positive variance is also termed favourable variance, and the negative variance is called unfavourable variance or adverse variance.

The variance of $25 in our example here is the result of spending $25 over the budgeted amount - a negative or unfavourable (adverse) variance. If the actual expenditure was $275, the variance would be $25 under the budget and therefore the variance would be positive or favourable. A favourable variance in income or expense increases the planned profit; an unfavourable variance in income or expense variance decreases it.

In addition to financial measures of variance, there are non-financial measures as well.

For example, Sam might plan the travel in kilometres.

Planned travel : 5 000 km

Actual travel: 5 400 km

Variance: 400 km (unfavourable or adverse)

It must be noted that any variance is to be investigated in conjunction with any related variances. For example, a favourable variance in respect to dollar sales might be due to an unfavourable variance in a salesperson's travelling expenses, as they might have incurred additional expenditure to gain additional sales. Variances should always be analysed to reveal such cross relationships and any historical trend.

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Variance report format

Variances identified by comparing actual outcomes with the budget must be reported to the involved parties so that inferences can be made. The report must be in a format that can be understood easily. Generally, the report should contain the budgeted amount, actual amount and the variances, presented in columns as shown below. The first column shows the line item, the second shows the budgeted amount for each item, the third shows the actual outcome and the fourth column shows the variance. The favourable variance is denoted by the letter 'F' and the unfavourable variance is denoted

by 'U'. An alternative to using 'F' and 'LP is to show an unfavourable variance in parenthesis. For example, in the format below, direct material variance is shown as $250 and direct labour variance as $200.

Figure 6: Variance

Format of a report

A further column at the extreme right may be created to show any known reasons for variances, as these would be useful.

Following are a few examples of variance analysis in a manufacturing organisation. The same principles could be used in a service or trading organisation.

Sales variance

Sales variance arises from comparing actual sales with the budget. It can be expressed in quantity or dollar values, depending on the basis on which the budgets were prepared and on the measurements of outcome. The depth of analysis depends on the availability of the details in the budget.

LINE ITEM BUDGET ACTUAL VARIANCE

$ $ $

Direct material 10000 10250 250 U

Direct labour 8000 7800 200 F

Overheads 7000 7500 500 U

Total 25000 25550 550 U

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Note: For sales variance calculation, unlike expenses calculation, actual outcomes over the budget are favourable and actual outcomes under the budget are unfavourable.

Production cost variance

The production cost budget consists of the following component budgets:

• Direct material cost budget.

• Direct labour cost budget.

• Overhead cost budget.

The net production cost variance is the sum of the variances arising in direct material, direct labour and overheads.

Production units variance

The deviation of actual units of output from the budgeted output units is the production units variance.

Figure 8: Production Units Variance

Direct material units variance

Direct material unit variance occurs when the number of units actually purchased for production differs from the budgeted units.

Product Budget Units Actual Units Variance Units

Product A 200 210 ) (F 10

Product B 300 280 20 (U )

Product C 250 275 25 (F )

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Direct material cost variance

Direct material cost variance is the result of a deviation of the actual cost of the direct materials from the budgeted amount.

Figure 10: Direct material cost example.

Note: A similar variance analysis can be done for direct labour and overheads.

Production cost variance

The comparison of the actual production cost with the planned cost gives

the production cost variance.

Figure 9 Direct Materials Units Variance example :

Material Budget

Units

Actual

Units

Variance

Units

Material 1 4000 4250 250 ( U )

Material 2 5000 4900 100 ( F )

Material 3 7000 7050 50 (U )

Material Budget Actual Variance

$ $ $

Material 1 40000 39000 000 (F ) 1

Material 2 60000 63000 3 ) 000 (U

Material 3 77000 73000 4 000 (F )

Total 177 000 175 000 2 000 (F )

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Expenses variance

When the actual expenditure for a period differs from the budgeted expense, the difference is the expense variance.

The variances shown above are by way of examples only. Numerous types of analysis of variances could be performed based on the control needs of the organisation. Again, it is not sufficient merely to analyse the variances but a determination of what causes them and their

effect is also necessary. The determination of causes and effects should be undertaken in conjunction with relevant experts. It may be that they do not get involved in each and every analysis, but when the methods and items to be analysed are decided there should have been some input from the relevant experts. The relevant experts could be, for example, manufacturing or sales personnel.

The relevant experts are assigned the responsibility to take remedial action to minimise any negative impact and to maximise the benefits for the organisation. It is not always the negative variance that requires remedial action. Sometimes remedial action may have to be taken when there is consistent positive variance. This is explained by the following example. Assume that salespersons are paid their commission based on number of units sold. A salesperson gets positive variances on the units of items sold as well as the value of sales. Further analysis may show that this salesperson achieved the increased sales by giving the customers maximum possible discounts. Though one would expect this action would have shown a negative variance in the total sales value, this may not happen as the sales

Figure 11 Production cost variance example :

For Product A Budget $ Actual $ Variance $

Direct material 1 50000 52000 ) 000 (U 2

Direct labour 2 20000 19000 1 000 ( F )

Overheads 30000 33000 ) 3 000 (U

Total 100 000 104 000 4 000 (U )

Figure 12: Expenses variance example

Expense it em Budget $ Actual $ Variance $

Rent and rates 9000 9500 500 ( U )

Motor vehicle 1000 840 160 ( F )

Electricity 1500 1400 100 ( F )

Total 10500 11 740 240 ( U )

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value is not adjusted or 'flexed' to reflect the increased sales quantity. If the budget was flexed, ie to reflect the expected sales value for the increased number of units sold, the total sales value variance would have become negative and remedial action would have to be taken by the sales manager to reduce that 'positive variance'.

Despite all possible remedial actions taken, a negative variance situation may continue. Similarly, continued positive variance on certain items would exist.

These situations may, on further analysis, reveal that the targets set in the budget were either too high or too low. These situations will lead to the budgets and plans being restructured by renegotiation with the involved parties. This is necessary as a continued negative variance will not only frustrate the people involved but also make them inefficient as they get accustomed to the negative situation. A continued positive variance on the other hand, by not bringing out the real potential in the personnel, makes them inefficient also. The restructuring of budgets and plans help to optimise the organisational performance.

Outcomes of Financial Plans

Reports on financial performance form an integral part in managing budgets and are produced from records of financial transactions as a result of the activities. For the reports to be accurate, these records of financial transactions must be properly maintained within the organisational system. Reasonable care in classifying and summarising the financial and quantitative aspects of various transactions should be exercised. The recording systems of the organisation should be carefully planned to cater for the needs of internal reporting for control purposes and external reporting for legal and professional obligations. The

recording system should be regularly tested for its performance and adequacy for the purposes for which it is intended. Also, the recording system needs to be modified whenever changes to the external legal and professional requirements take place, in addition to the changing requirements of management control.

The reports reveal the financial performance of the organisation as a whole and of its constituent parts or sub-systems. Due care and diligence should be exercised in the analysis of financial performance for reporting purposes. Different reports are prepared for different levels of staff in the organisation. The reports should be in a form appropriate to the target audience. The reports should be simple enough to be easily understood by the target audience and an appropriate level of language is to be used. Ambiguity should be avoided at all cost for the reports to be effective.

There are non-financial objectives in addition to financial objectives for an organisation. The non-financial objectives affect the financial performance of the organisation. For example, a reduction in the number of staff absences or in the rate of staff turnover could be the non-financial objective. The number of staff absences could cause diminished performance in a particular section, thus affecting the output of that section. Similarly, high staff turnover might cost the organisation in extra training and development of personnel. Since these items affect the overall organisational performance, they need to be reported to the appropriate level of management to identify the probable causes and for remedial action to be taken to improve overall organisational performance.

The budgets and plans are the ultimate end products of strategic objectives. The performance reports could reveal a trend of continuous negative or positive variance despite all efforts to remedy such situations. This trend might lead to a review of the budgetary targets and their revision to optimally utilise the organisational resources. It is advisable also to critically review the framework of strategies and their tactical plans. One of the possible outcomes of this critical review is the revision of the strategies and plans themselves with a view to optimise organisational performance.

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In Summary

Budgets are the financial representation of the strategies of an organisation. They provide the basis for determining whether plans are on track and will be achieved.

For budgets to be achieved, they must be communicated to those people affected by the budget, in particular the people who are to achieve the budget. The process of communicating budget requirements - the communication package - can include a variety of different communication methods. Such information may be presented in a visual form using graphs and charts, as well

as in a numerical or written form. Training may be provided to those responsible for achieving a budget to ensure that they are aware of the requirements of a budget and the consequences of not achieving it.

It is important that the people who are to achieve the budget are delegated with authority and budget accountability for them to be effective in carrying out their responsibilities. Appropriate funds need to be allocated for the budget objectives. The activities have to be properly recorded to enable production of useful reports. This recording system should conform to the audit requirements and other legal obligations. The risk of events happening that might positively or negatively impact on meeting budgetary targets should be anticipated.

To ensure that targets are being reached, there needs to be ongoing monitoring and control of activities against the budget. This is achieved through comparing the results of actual performance with the budgeted performance to produce variance reports. Various variance reports may be used by an organisation, including reports on sales variance, production cost variance and overhead expense variance.

The sales variance report reveals the variances between the planned and actual level of sales or services. The variations may be between planned and actual units sold/services provided and/or variations between the anticipated and actual value of sales/services.

Production cost variance reports are used to review any discrepancies between actual and planned production cost figures, including variances related to differences between actual and planned units produced, actual and planned material costs, and actual and planned labour costs.

Overhead expense variance reports deal with variations between planned and actual costs related to activities other than those involved in direct production of products and services.

The reports, the results of analysis of financial performance, should conform to a language appropriate to the audience. Non-financial objectives in the context of overall organisational performance are also to be reported. The trends in the reported performance might lead to the reviewing and updating of strategies and plans to optimise organisational performance.

1.3 Negotiate any changes required to be made to budget/ financial plans with relevant personnel within the organisation.

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Financial Analysis

The financial activities of an organisation need to be analysed for the purposes of planning, including readjustment of existing plans. The techniques most commonly employed for financial planning are costvolume- profit analysis and trend analysis.

Trend analysis highlights the changes taking place over a number of accounting periods. Financial ratio analysis is a technique used in trend analysis. The cost-volume-profit (CVP) analysis assists a business in

determining the sales required for its survival in difficult times or that required to achieve a desired profit in prosperous periods. Financial ratios on the other hand help the business to determine whether its assets are being managed efficiently in order to maximise the profit potential.

A detailed discussion of these techniques forms the subject matter of this performance criterion.

Cost-Volume-Profit Analysis

Costs, volumes of output and profits are all interrelated. If costs or output volumes change, profit will be affected. Analysis of the relationships between these three factors is referred to as cost-volume-profit (CVP) analysis. CVP analysis is a planning, performance evaluation and control tool, which can be used to analyse alternative decisions relating to sales prices, sales product mix, and changes in costs and operating methods. It is used to establish product prices and determine an appropriate sales mix, and also to help decide whether to add or delete a product line or to accept or reject a special sales order.

A business incurs costs, some of which are fixed in nature and others variable. A fixed cost is one that does not change in direct proportion to the level of activity. For example, the rent of a factory building will remain the same until the production level reaches the maximum capacity of the rented space. If the production level exceeds the capacity, then additional space incurring additional cost is required. Thus, the cost of rent is fixed for a range of production levels. On the other hand, a variable cost is one that varies in direct proportion to the level of activity. For example, the cost of timber used to manufacture tables will be a multiple of the cost per unit of table (or in direct proportion to the number of tables produced).

Some costs contain both fixed and variable costs. Examples include telephone costs and salespersons' commissions. These costs are called semi-variable costs.

The revenue earned by the business should be sufficient to cover these costs and at least allow it to survive. The difference between the business' revenue and its total variable costs is called the contribution margin. This margin should be adequate to cover the fixed costs of the business and provide the desired profit. When the contribution is just equal to the fixed costs, the business is said to break-even. Any excess contribution is a profit for the business.

It is essential that the business' owner(s) determine the break-even point, so that the minimum activity level (for example, minimum sales) the business needs to operate at to be viable is known.

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Break- even point

The break-even point is calculated by first determining the contribution per unit of product, which is the sale price of a unit less the variable cost of the unit. When divided into the fixed cost this gives the break-even point expressed in break-even units. It can also be expressed in break-even dollar value, by multiplying the break-even units by the sale price per unit. The contribution made by any units sold above the break-even point will provide profit.

If we denote the total sales dollars by S, the total variable costs of sales by V, the total fixed costs by F and the profit by P, we could represent their relationships mathematically as follows:

S - V - F = P

At the break-even point profit is zero. That is,

S- V-F = 0

Or S = V + F

In other words, the sales just equals total costs at the break-even point.

The total contribution is sales value less all variable costs. That is,

Total contribution dollars = S — V

The contribution per unit of sales = S – V

Total Units Sold

On the other hand, the contribution per dollar of sales is arrived at by dividing the contribution per unit by the sale price. This is called contribution to sales ratio or C/S ratio.

The break-even point in terms of sales units and sales dollars can be obtained by using formulas as follows:

Break –even sales (units) = Fixed Cost

Contribution per unit

Beak – even sales (dollars) = Fixed Cost

C/S Ratio

If break-even sales units are known, the break-even sales dollars can be calculated by multiplying the break-even sales units by the selling price per unit. Conversely, if the breakeven sales dollars are known, the break-even sales units can be obtained by dividing the break-even sales dollars by the selling price per unit. These can be represented by:

Break-even sales dollars = Break-even sales units X Selling price per unit

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Break-even sales units = Break-even sales dollars

Selling price per unit

Figure 14: Example of Break-even point calculation.

Calculate the break-even point in dollar sales and units from the following information.

Sales = $120 000

Variable cost = $5 per unit

Fixed cost = $75 000

Selling price per unit = $20

Solution

Contribution per unit = $20 — $5 = $15

Contribution to sales ratio = 15/20 = 0.75

Break-even dollar sales = 75 000/0.75 = $100 000 Break-even units = 75 000/15 = 5 000 units

Break-even point and margin of safety

The difference between the total sales and the break-even sales is called the margin of safety (see Figure 13). This margin is usually expressed as a percentage of the total sales. The formulas for calculating the margin of safety and the percentage margin are:

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Margin of safety = Total sales - Break-even sales

% Margin or safety = Margin of Safety X 100

Total sales

Example 1

A company manufactured and sold 36 000 units of its only product at $5 per unit. The following information relates to the costs it incurred.

Production: Total cost $96 000

Fixed costs $25 000

Administration: All fixed $60 000

Marketing Variable cost $10 000

Fixed $15 000

Financial: All variable 5% of sales value

Calculate the company's:

a. C/S ratio

b. Break-even point in dollars

c. Margin of safety

d. % Margin of safety

Solution

Total sales value = 36 000 X $5 = $180 000

Total variable costs = (106 000 - 25 000) + 180 000 X 0.05

= 81 000 + 9 000

= $90 000

Total contribution towards fixed cost = $180 000 - $90 000 = $90 000 Contribution per unit sold = $90 000 ÷36 000 = $2.50

a. C/S ratio = 2.50 ÷ 5 = 0.5

b. To recover the fixed cost of $40 000 with $2.50 contribution from each unit, the company has to sell 16 000 units (that is, $40 000 ÷ $2.50).

Break-even point = 16 000 units.

Break-even sales dollars =16 000 X $5 = $80

000. Alternatively, we could divide the fixed cost by

C/S ratio.

That is, 40 000 ÷ 0.5 = $80 000

(c) Margin of safety = 180 000 - 80 000

= $100 000

(d) % Margin of safety = Margin of safety X 100

Total sales

= 100000 x 100

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180 000

= 55.56%

Example 2

From the following information relating to a business, calculate its:

a. Break-even point in units

b. Break-even point in dollars

c. C/S ratio?

Annual sales 20 000 units

Selling price per unit = $18

Annual rent $24 000

Straight-line depreciation of equipment = $6 000 pa

Salespersons' commission (5% on the value of units sold)

Regular staff salary = $105 000 pa

Miscellaneous costs (all variable) = $162 000 pa

Solution

Total sales = 20 000 X 18 = $360 000

Total fixed costs = 24 000 + 6 000 + 105 000

= $135 000

Total variable costs = 5% of 360 000 + 162 000

= $180000

Total contribution = 360 000 - 180 000

= $180000

Contribution per unit = $180 000 + 20 000

= $9

(1) Break-even sales (units) = $135 000 + 9

= 15 000

(2) Break-even sales (dollars) = 15 000 X $18 = $270 000

(3) C/S ratio = Contribution per unit + Sale price per unit

= 9 ÷ 18 = 0.5

It should be remembered that the concept of break-even analysis is built on specific assumptions. That is, a variable cost changes in direct proportion to production levels; a fixed cost remains unchanged over the possible different levels of production; and there is no change to the selling price of each unit at different levels of sales.

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Activity 6:

Organisations may not know the break-even point of their operations.

Contact a few organisations that are known to you and ask the appropriate manager whether they know the level of activity at which they break even and how changes in costs and revenue affect the break-even point.

Trend Analysis

Analysis of trend plays an important part in identifying the pattern of general direction taken by, or tendency of, certain items or events. In the activities of an organisation it can refer to changes in financial or nonfinancial items.

Horizontal analysis

In this type of trend analysis, trend is identified by progressively comparing the occurrence of items at different points in time or for different periods. Therefore, to determine the trend, there must be at least two points in time or periods to consider. The value of the first occurrence of an item at a point in time or for a period is customarily given a weighting of 100 and the other values are related to this base figure of 100.

This method of representing the trend with percentage changes from one year to the other, using a chosen year as the base year, is referred to as horizontal analysis. Example 1

The analysis shows that the accounts receivable balance at each year-end has been increasing.

Example 2

From this analysis of the sales trend, we could conclude that there have been increases in sales of 50% and 100% in 2010 and 2011, respectively, compared to those of 2009.

Alternatively, we may conclude that the 2010 increase is 50% of its previous year, but the 2011 increase is only 33.33% of its previous year.

As at June 2009 2010 2011

Actual Sales $100,000 $150,000 $200,000

Trend 100% 150% 200%

As at June 2009 2010 2011

Accounts Receivable $40,000 $50,000 $64,000

Trend 100% 125% 160%

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Here we may conclude that the staff turnover doubled in 20X2 compared to 20X1; and is still high at 160% in 20X3 compared to 20X1. Or we could say that though the increase in 20X2 is 100% of the previous year's figure, there is a 20% decrease in 20X3 compared to 20X2.

Other techniques used to determine trend are vertical analysis and ratio analysis.

Vertical analysis

When analysing a financial statement, the analyst is interested in knowing what trend, in terms of increases and decreases, exists between the relationships of two key figures in the statement from year to year. For example, in a profit and loss statement, how does the relationship between net profit and total sales change from year to year? Does it increase, decrease or remain the same?

Example 1:

The trend can be easily seen in the following graph.

Example 3

1 X 20 20 2 X 3 X 20

Staff turnover 5 10 8

Trend 100 % 200 % 160 %

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Here, the net profit as a percentage of sales in 20X1 was 40% and the same value for 20X2 was only 25%, a reduction of 15%. The expenses increased by 15% in 20X2.

Note: The vertical analysis statement is sometimes referred to as a common size statement because comparison of figures for a number of years is made by taking one and the same key figure (sales in example 1) in each year as representing 100%.

Here, the current assets expressed as a percentage of total assets (representing 100%) in 20X1 was 20% and the same value for 20X2 is only 18%, a reduction of 2%. However, the non-current assets increased by 2% in 20X2.

Ratio Analysis

Ratio analysis is commonly used to highlight the relationship between selected pairs of reported data to identify trends in certain key areas of business operations, in order to arrest unfavourable situations and/or enhance favourable situations. Each relationship is a ratio and in most cases is expressed as a percentage. Many such ratios can be calculated and reported for highlighting both financial and non-financial performance depending on the differing control needs of the organisation.

In the figure below some examples of ratios are:

Figure 15: Examples of Ratios

Statement of financial performance items

20 X 1

$ %

2 20 X

$ %

Sal es 10000 100 12000 100

Expenses 6000 60 9000 75

Net profit 4000 40 3000 25

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Although numerous ratios could be extracted, the discussions that follow are limited to certain significant financial ratios commonly used in practice. Generally, financial ratios are extracted from the profit and loss statement and balance sheet figures. Financial ratios can be grouped under five main categories. Some of the important ratios, their definitions, method of calculation and significance are given below.

Figure 16: Financial ratios

Category Ratio Definition

Profitability Ratios

Return on capital

Measures an organisation’s

profitability as a ratio to the

capital invested in it

Return on total assets

Measures an organisation’s

profitability as a ratio to the total

assets employed

Gross Margin Expresses the gross profit as a

percentage of total sales

Net Margin Expresses the net profit as a

percentage of total sales

Liquidity ratios Current Ratio

Indicates the capacity of the

organisation to meet its

shortterm debt

Ratio Reason for choice

Labour cost to sales Measures the effectiveness-of usage of human

resources

Wastage to Stock held Measures the effectiveness of store management to control wastage through damage, perishability and theft of stock

Sales per employee Measures productivity of employees

Sales per square metre of

space

Measures the effectiveness of floor space

utilised

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Liquid Ratio Measures the short-term cash

position of the organisation

Activity ratios

Inventory turnover

Shows the number of times the

inventory has been turned over

each year

Collection period Indicates the average time taken

to collect outstanding accounts

Leverage Ratios

Gearing or leverage Indicates the ratio of the debt

capital to the owner’s capital

Times interest covered

Measures the

organisation’s ability to

pay interest liability from its pre-

tax profits

Ownership ratio

Provides the owner (shareholders) with a measure of their equity in the business against the debt owed to outside creditors

Valuation ratios Earnings per ordinary share

Indicates the profit that is

available to each ordinary share

Ratios - their calculations and significance

In relation to calculation of ratios, an important point to bear in mind is that when comparison is to be made between ratios, the ratios to be compared should have been calculated in the same way. For example, in calculating the return on capital for different years, or for different businesses, for comparison, the net profit used could be that after interest and taxes and the capital could be the original capital plus any retained profits.

The net profit of a business could be expressed in practice in a number of different ways for various reasons. It may be calculated as sales less all expenses including interest and tax payable, ie net profit after interest and tax. It may also be sales less expenses including interest but before tax, ie net profit after interest but before tax. Sometimes the interest expense and tax are excluded in calculating the net profit. Net profit is then referred to as net profit before interest and tax.

The term 'capital' refers to the owner's equity in the case of a sole trader and a partnership, or shareholders' funds (ie total assets less total liabilities of the company) in the case of companies. Owner's equity is the total of the owner's investment in the business and any retained profit. Sometimes the average capital - the average of the capital at the beginning and the end of an accounting period - is used.

What we include in the numerator and denominator totals of a ratio depends on whether the ratio is to be used for internal management control or for public information. Whatever the case, one should be consistent in the method of calculation of each ratio.

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Return on capital - Shows the profitability or the success of the business.

Return on capital = Net Profit x 100

Capital

(Net profit used may be after tax or before tax.)

This ratio measures the performance of a business in terms of net profit generated. Dividing the net profit by the capital invested and expressing the result as a percentage for each year enables the business to compare its performance of a number of years and also with the performance of similar businesses in the same industry. The net profit used in comparisons could be any of the three forms (ie net profit after interest and tax, net profit after interest but before tax, and net profit before interest and tax) depending on the specific need of the ratio. Similarly, the capital could either be owner's equity at the beginning of the year or average capital depending the situation and the information need.

Return on total assets - Shows the net profit for every dollar invested in assets

Return on total assets = Net Profit x 100

Total assets

(Net profit used may be after tax or before tax.) This ratio shows the efficiency in the use of assets by a business. Owner's equity and other borrowing are used to invest in the assets of a business. The same investment could have been used elsewhere. The ratio of net profit to total assets of a business gives an indication of the performance of its assets. This performance is compared with the possible return of other investment opportunities. The net profit used could be net profit after interest and tax, net

profit after interest but before tax, and net profit before interest and tax, depending on the specific need of the ratio.

A variation of this ratio is to use fixed assets instead of total assets. In this case the efficiency of utilisation of fixed assets is measured. The net profit to assets ratio is also used by organisations to compare the performance of their divisions (intracompany comparison) as well as the performance of other organisations in the same industry (inter-company comparison).

Gross margin - Measures profit earned by every dollar of sales before operating expenses are taken into account

Gross margin = Gross Profit x 100

Sales

Gross profit is the difference between sales and the cost of sales. By comparing the gross profit to sales on a regular basis, a business is able to determine the causes for variation in the profit earned per dollar of sales before operating expenses are taken into account. The variation may be due to efficiency or inefficiency in purchasing and/or production, thus decreasing or increasing the cost of goods sold. General increases or declines in sales due to market conditions or setting the selling price too low or too high due to competition, or lack of it, may be other causes of variation. Also variation could have been caused by the effectiveness of discounts given on sales

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(whether increased discounts resulted in increased sales as expected or not).

Net margin - Measures profit earned by every dollar of sales after operating expenses are taken into account.

Net Margin = Net profit x 100

Sales

The operating expenses fall under three categories: general and administration expenses, selling and distribution expenses and finance expenses. Net profit is calculated by subtracting all these operating expenses from the gross profit. Net margin ratio measures the net profit earned by a dollar of sales either before or after tax, depending on the information need. When considering whether to take off tax from net profit or not for comparison purposes with other businesses, it is important to bear in mind the differing tax situations of the various businesses, especially the amount of provisions made for tax. The net margin in conjunction with gross margin provides a starting point for the analysis of the possible causes for variation of operating expenses. Further analysis of expenses, using sales as a common platform for comparison, could reveal their effectiveness. For example, the trend of general and administration expenses as a percentage of sales over a period of time may reveal the extent of the productive use of these resources.

Current ratio - Shows the short-term debt paying ability.

Current ratio = Current assets

Current liabilities

Current assets of a business are usually the cash at bank, accounts receivable and inventory. It may also include prepayments and short-term investments.

The current liabilities are generally accounts payable but may include any accrued expenses, bank overdrafts and other short-term loans. Current ratio is calculated by dividing the current assets by current liabilities. This ratio will be at least greater than 1:1 if the business is able to meet all debt obligations as and when they fall due. As a rule of thumb a ratio of at least 2:1 indicates the financial soundness of the business and that it is able to avoid liquidity problems. However, the business should not allow the ratio to be too high as this may indicate overstocking (increases the value of inventory held), a liberal credit policy for customers (increases the value of accounts receivable) or not taking full advantage of suppliers' terms of credit (reduces account payable).

Liquid ratio - Indicates the short-term ability to pay debts using liquid assets.

Liquid ratio = Current assets - Inventory - Prepayments

Current liabilities - Overdraft

This ratio is a modified current ratio. As the name suggests, this ratio gives a better indication of the business' liquidity position in the short term than the current ratio. This is because the less liquid current asset items - inventory and prepayments - are left out of the current assets and the bank overdraft, which is usually a long-term facility, is left out of the current liabilities in calculating liquid ratio. Inventory is not readily convertible into cash. Prepayments are usually considered as 'expense items' but only book entries to comply with accrual concepts. For example, insurance, if paid fully in

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advance, will be shown as a prepayment and will not be refunded unless the business ceases to operate. As a rule of thumb, liquid ratio must be at least 1:1. Anything less than this would indicate that the business is in serious financial difficulties, that is, the business may not be able to meet its obligation to pay its creditors when the payments fall due. This ratio is also referred as the quick asset ratio or acid test ratio.

It is important to remember that it is not enough to have sufficiently large liquid assets or quickly convertible assets on paper alone. For example, there is no merit in having a high accounts receivable amount in the books if the credit collection procedure is not sound. The high accounts receivable amount may possibly be a result of delayed payments from customers and not due to high credit sales. The business must therefore, while giving customers reasonable credit terms, institute a sound collection procedure.

Inventory turnover - Measures how many times per year the inventory is replenished.

Inventory turnover = Cost of Goods Sold

Average Inventory

Inventory turnover is obtained by dividing the cost of goods sold by the average inventory. The average inventory is the average of the opening and closing

inventories for the period. A measure of how many times the inventory is replenished is important and this ratio achieves that. A high figure for this ratio reveals that the stock is selling fast, thus giving the business a good cash flow. It also indicates that there is a comparatively low danger of stock becoming obsolete. Further, the high figure for this ratio shows that a lower amount of capital is tied up in the inventory and thus the working capital is being effectively used.

When cost of goods sold figure is not available an approximate value could be obtained for the inventory turnover by using the sales value instead of cost of goods sold. If the opening inventory is not known (when the balance sheet for the previous period is not available), then the closing inventory in place of the average inventory is used.

Collection period (in days) - Indicates efficiency of collections from credit customers.

Collection period = Average accounts receivable

Daily average credit sales

Collection from accounts receivable is a source of finance for a business. An efficient collection procedure is thus important for any business. Too much money tied up in accounts receivable for too long would make the business face the risk of bad debts. The collection period - calculated by dividing the average accounts receivable (average of opening and closing accounts receivable for the period) by the daily average credit sales (obtained by dividing the total credit sales for the period by the number of days in that period) - gives an indication of how efficiently the business is implementing the credit control procedures. The collection period also indicates the efficiency with which the working capital tied up in accounts receivable is utilised. There is an element of interest cost and an opportunity cost associated with the management of accounts receivable working capital. The effective use of working capital would save these costs.

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If the opening accounts receivable amount is not known (when the balance sheet for the previous period is not available), then the closing accounts receivable amount in place of average accounts receivable is used.

Gearing or leverage ratio - Shows the extent of long-term borrowings.

Gearing or leverage = Debt

Equity This ratio is calculated by dividing the external debts (long-term debts) of the business by the owner's equity. When the debt is greater than the owner's equity there is said to be a high gearing or leverage. When there is a high proportion of loan capital, the business pays a substantial amount of interest and this reduces the otherwise available profits for the owner(s). An advantage of being highly geared is that interest is a tax-deductible expense for the business and thus the tax saved effectively reduces the rate of interest

paid and consequently the cost of the debt. Hence the profit saved is available for distribution to the owners. On the other hand, a business with high gearing runs the risk of liquidation if earnings are not enough to pay interest as it falls due.

Times interest covered - Indicates how many times the earnings before interest and tax covers the interest.

Times interest covered = Net profit before interest and tax

Interest

This is calculated by dividing the profit before interest and tax by the interest. It gives an indication of the ability of the business to pay the interest on the debt. The higher the figure for this ratio, the better the business is able to meet such commitments.

Ownership ratio - Indicates the extent of owner's interest in the business.

Ownership ratio = Liability to owner x 100

Total liability

This ratio is a variation of the gearing ratio and shows what proportion of the total liability is owed to the owner by the business. If this ratio is one (or 100%) the owner has funded the entire assets. In general, this ratio reveals whether the owner or outsiders (ie creditors) have a greater stake in the business. An increase in the ownership ratio will indicate a decrease in borrowing and vice versa.

Earnings per share - For a company this reveals how much has been earned for an ordinary share during the year.

Earnings per share = Net profit after tax - preference dividend

Number of ordinary shares

Some companies issue ordinary shares as well as preference shares. The preference share dividends are paid first out of net profit after tax and any

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balance belongs to ordinary shareholders. The greater the net profit after tax, the greater will be earnings per ordinary share, as preference dividends are fixed irrespective of the level of profits.

Investor ratios

Individuals and businesses investing in shares are interested in knowing the performance of their current and potential investments. In addition to earnings per share, there are other valuation ratios to help these investors to make appropriate decisions on their investments. Some commonly used investor ratios and their significance follow.

Dividend per ordinary share - This is a measure of the dividend (distributed out of profits) entitlement of an ordinary shareholder for every ordinary share

held.

Dividend per ordinary share = Net profit after tax distributed to ordinary shareholders

Number of ordinary shares

Dividend yield - This is a measure of the dividend per ordinary share as a percentage of market price of the share.

Dividend yield = Dividend per share x 100

Market price

This ratio gives the investor an idea of what percentage of the investment is received back in the form of dividend.

Earnings yield - This is a measure of the earnings for the ordinary shareholders as a percentage of the market value of the ordinary shares. The earnings for ordinary shareholders is net profit after tax less preference dividend.

Earnings yield = Earnings for ordinary shareholders

Market valuation of ordinary shares

Price Earnings ratio - This is a measure of the market price of an ordinary share to the business' earnings per share.

Price Earnings ratio (P/E) = Market price of ordinary share

Earnings per ordinary share

This ratio is a reciprocal of earnings yield. This ratio reveals how much a prospective shareholder will pay to acquire one dollar in profits of the business. This ratio is important to an investor as it gives an indication of the number of years it will take for the investor to recoup the amount invested.

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Illustration

How each of the above ratios is calculated is now illustrated by simple financial statements of ABC Ltd for two years ending 30 June 20X1 and 20X2. Trends are then discussed.

ABC Ltd

Statement of financial position as at 30 June

20X1

$

20X2

$

Assets

Cash 10,000 -

Accounts receivable 40,000 64,000

Inventory 80,000 124,000

Plant and equipment 220,000 200,000

ABC Ltd

Statement of financial performance for the year ended 30 June

20X1

$

20X2

$

Sales (all credit) 120,000 I50,000

Less: Cost of goods sold 72,000 90,000

Gross profit 48,000 60,000

Operating expenses 20,000 24,000

Net profit before interest and tax 28,000 36,000

Debenture interest 8,000 8,000

Net profit before tax 20,000 28,000

Tax 6,800 8,960

Net profit after tax 13,200 19,040

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TOTAL

Liabilities

350, 000

388,000

Accounts payable 43,200 45,000

Provision for tax 6,800 8,960

Bank overdraft 15,000

Retained profit 19,040

8% Debentures 100,000 100,000

Ordinary shares ($1 each) 200,000 200,000

TOTAL 350,000 388,000

Figure 17: Calculation of ratios

Name of ratio 20X1 20X2 Comments on trends

Return on Capital (before

tax)

13200 / 200 000 x 100

= 6.60%

19 040 / 200 000 x 100

= 9.52%

The increased return on capital may

be a sign that the business is run

efficiently.

Return on total

assets (before

tax)

13,500 / 350 000 x 100

= 3.77%

19040 / 388 000 x 100

= 4.91%

The increase in return on total

assets may be due to efficient

usage of assets.

Gross Margin 48,000 / 120000 x 100

= 40%

60 000 / 150 000 x 100

= 40%

The percentage gross profit has

been steady at 40% in both years,

indicating that there were no

changes in the purchase price of

goods.

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Net margin

(before tax)

20 000 / 120 000 x 100

= 16.67%

28 000 / 150 000 x 100

= 18.67%

There was a 2% rise in net profit,

indicating that the operating

expenses are kept under control

Current Ratio

130 000 / 50 000

= 2.60

188 000 / 68 960

= 2.73

The general debt-paying ability of

the business is good It is better in

20X2 than it was in 20X1

Liquid ratio 50 000 / 50 000

x 100

= 1.00

64 000 / 53 960 x 100

1.19

The liquidity of the business is better

in 20X2 than it was in 20X1. a ratio

of above 1 is generally good

Inventory

turnover

72 000 / 80 000

= 0.90%

90 000 / 124 000

= 0.72%

The inventory management seems

poor; overstocking is evident

Collection

period

40 000 / 120 000 x 365

= 121.7 days

64 000 / 150 000 x 365

= 155.7 days

The credit control is very poor. the

customers are allowed far too long

a credit period. receipts from

creditors are a source of finance for

the business, and efforts should be

made to collect the debts as soon as

possible.

Gearing or

leverage

100 000 / 200 000

= 0.5

100 000 / 200 000

= 0.5

There has been no change in the

gearing

Figure : Calculation of ratios (continued)

While variance analysis helps management to control costs, the other analyses we have learnt, especially when used with industry averages as benchmarks, help a business to alter its strategic direction to make it fit the long-term vision. These analyses also help maintain a competitive advantage and facilitate better planning.

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The budgetary plans of an organisation guide its activities. Financial activities are analysed regularly or on an ad hoc basis to check the organisation's performance in order to take timely decisions to get its activities back on track and/or determine what should be done next time to ensure that a particular variance does not recur. Tools used in financial statement analysis include:

• Cost-volume-profit analysis, which reviews the relationship between changing costs and revenue to determine the level of activity required to break-even - the activity level at which an organisation neither makes a profit nor a loss.

• Trend analysis reviews changes in revenue and expenses. Horizontal trend analysis looks at the changes in a particular item of revenue or expense over different trading periods. Vertical trend analysis looks at changes in relationships between two key figures in financial statements over time. Trend analysis highlights whether any long-term trend is developing that needs to be addressed.

• Ratio analysis is used to highlight the relationship between selected pairs of reported data to identify trends in certain key areas of business operations. These include profitability, liquidity, activity, leverage and valuation.

1. 4 Prepare contingency plans in the event that initial plans need to be varied

Communication Packages for Budgets and Financial Plans

Every organisation should have strategic objectives and plans. The operational plans of an organisation will involve the day-to-day activities of the organisation to ensure that operational objectives are met and that, in meeting these operational objectives, each operational group or team contributes to the tactical direction of the organisation and ultimately realises the organisation's strategic plan. The operational plan incorporates the financial and non-financial plans. The financial plan involves budgets, which are a combination of targets and plans to be achieved by the organisation to reach the organisational

objectives.

The financial plans and supporting detailed budgets serve as a reference point for the activities of the organisation. They provide the basis of communication of financial information within an organisation and a point of control for the organisation. For the organisation as a whole, the financial plan and its supporting budgets are developed in a hierarchical order so that

Name of ratio 20X1 20X2 Comments on trends

Times interest covered

28 000 / 8 000

= 3.5 times

36 000 / 8 000

= 4.5 times

The earnings in 20X2 covers the

interest more adequately than in the

previous year

Ownership ratio

200 000 / 350 000 x 100

= 57.14%

219 040 / 388 000 x 100

= 56.45%

The slight decrease in ownership

ratio indicates an increase in

external borrowing

Earnings per

share

13 200 / 200 000

= 6.6 cents

19 040 / 200 000

= 9.52 cents

The 20X2 after tax earning has

significantly increased from

previous year.

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the detailed budgets of different sections of one level are summarised to form the major component of the budget of the next level up.

If a target is to be achieved, the various processes that contribute to that target must operate as expected. If all aspects of all processes are to operate smoothly, then there needs to be communication throughout an organisation. People need to be involved in the planning process and take ownership of the target(s) to be achieved. If staff are involved in the planning process, and the targets and plans, including the financial plans of an organisation, are shared with staff, then the staff are more likely to positively contribute towards developing the plans to be achieved and meeting the target.

It is important to communicate the financial plans of an organisation to all the people involved and in particular to ensure that communication is specifically made to those people responsible for meeting a particular target(s). Team members should also be aware of the budgetary targets of the team. Such budgets need to be communicated in an appropriate manner to the individuals and groups affected.

Such communication should be presented in a manner so as to convey maximum information to the recipient. The way information is communicated to people can be termed a communication package. The communication package should be designed to provide individual team members with information in a form that is useful for them in making informed decisions and to measure their progress against plans and budgets.

The communication package could take various physical forms, such as newsletters, memos, bulletins and posters, that could be made available electronically or on paper. The medium we use to communicate financial information to people within an organisation should reflect the preferred approach of a team member to receiving information that allows them to know what action needs to be taken. Some people will prefer a description of what is to be achieved and written information on budgets. Others will prefer charts, while some others will prefer financial information presented in a pictorial form. Yet other people will prefer information such as budgetary information to be presented in tables.

The communication package could also include discussions with the staff from a section where all are involved in achieving the budgetary target(s). If there are large groups or teams of people it may be preferable for staff representatives from various sections to be addressed, who would in turn discuss the plan with the group they belong to. These discussions mainly supplement the written form rather than replacing them. Sometimes informal discussions replace formal staff discussions. Such discussions could occur during work breaks, an environment in which a team member may feel more comfortable. Taking team members out of their normal environment and placing them in a meeting room and free from distraction may sometimes serve to stall rather than encourage discussions on budgets and budget goals.

Reviewing Communication Packages

It is important to check the suitability of a planned communication package against the organisation's needs with respect to the following:

• The medium used for the communication is consistent with the organisation's protocols.

 Is it appropriate for budgetary information to be furnished by email?

 Can the information be sent by a general memo or should it be in the specific form of an official budgetary document?

• The format of the communication conveys the correct message as required by an organisation.

 Can the budgetary information be appropriately displayed in graphs?

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 Is there a set format in which budgetary information must be presented to the staff?

• The nature of the budget meetings.

 Are these meetings for information only or can valid suggestions be made for budget implementation procedures?

 Who is expected to attend such meetings?

 What are the topics to be discussed at the meeting?

In general terms, the contents of a written communication package would have the budget plan showing the budget targets, the persons/positions responsible for them and the timelines for these targets to be achieved (particularly when the budgets are for a project). Also, the written communication would have been expressed in a suitable form, such as numbers, graphs, charts and/or a combination of these, in a manner that will enable the target groups to understand them easily.

Generally, the format of meetings held to communicate budgetary targets could be structured so as certain aspects of the contents of the written form of communication are explained/expanded to increase the knowledge level of the participants. The meetings could be unstructured, whereby participants are expected to ask questions on matters on which they have no clear understanding, for instance as to the requirements of the budgets to be achieved and the financial plan that underpins those budgets. In such circumstances, it is possible for participants to send in the questions so that the organisers of the meeting can prepare the answers in advance. In any case, it is important for the facilitator of the meeting to be well versed in the information being presented and/or have additional expertise on hand for anticipated questions.

The participants could be representatives from various groups or all the members of one group or a number of similar groups. This selection depends on various factors, such as the organisation's policies and procedures, the importance of the subject matter as to whether it needs to be conveyed with a single message to all the staff in a group, and the availability of the participants' time for their involvement in the meeting. It is important to ensure that everyone receives the same information. When people are left out, they become distrustful and may not

commit themselves to the plan. Sharing information fosters a sense of belonging in the group and helps it to take ownership of the plan and meet its goals.

The items to be discussed at the meetings are generally explanations of the contents of the budgets and plans. In addition, any major deviation in budgets and plans compared to previous periods could be explained. The responsibilities for the achievement of the budgets and the consequences of

non-achievement, such as the effect on other related groups, could also be explained. The items to be discussed at the meeting should be carefully considered and they need to be clearly listed so that a uniformity is maintained in the presentation.

The financial specialists, due to their close working relationship with the budgets and plans, review the communication package to ensure its suitability. They cannot review all the aspects of the contents of a communication package. For example, the format of the planned meeting or the selection of participants needs to be reviewed by the communication specialists. The finance specialists' review would be limited to the relevance and accuracy of the contents of the written communication of the approved budget. They also ensure that responsibilities and timelines mentioned in the written communication are as stipulated in the approved budgets. The explanations and planned answers for questions, if any, could also be reviewed by finance specialists for their conformity with approved budgets.

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Amending/Revising Planned Communication Packages

It is possible that changes to a communication package are recommended as a result of a review by the finance specialists. As discussed earlier, there may be other specialists apart from finance specialists involved in the review of the proposed budget communication package. The amendments or revisions suggested could refer to the format of meetings, including the composition of the participants proposed in the package, the items to be discussed and/or to the contents of the written communication.

The reasons for suggesting corrections could be:

• The dissemination method, such as structured or unstructured format, may not be suitable for the target participants. For example, where the group attending the meeting is not expected to read the contents of the written communication in advance and send in questions to facilitate an unstructured set up, a structured format discussing the budget item by item could be useful.

• The need to include/exclude certain individuals or groups proposed as participants for the meeting.

• Some important items may have been missed, or some unimportant/unsuitable items included, in the proposed items to be discussed at the meeting.

• The proposed contents of the written communication, or any other items to be discussed, do not reflect the approved budget or contradict it.

• The proposed contents may not have the appropriate details for the target participants, or it may be in a form that is not readily understood by the participants because of their work background, lack of training or lack of experience within an organisation.

• The contents of the package might provide too many details or may not be appropriate to the target participants and hence confuse them.

• Sometimes it might be necessary for the details of the connectivity of the actions of the target groups to other groups of the organisation to be provided so the participants can better understand their role in the context of the whole of the organisation.

• It is possible that an important item might have been missed in the written communication or an unimportant item might have been included.

The specialist reviewing the proposed package not only forms their own opinion but may also test the package and its contents with a selected sample audience to determine if changes are required. The package and its contents may be modified before any activities are undertaken to avoid unnecessary confusion by the participants/recipient.

2. Implement financial management approaches.

2.1 Disseminate relevant details of the agreed budget/ financial plans to team members.

Provide support to ensure that team members can

2.2 competently perform required roles associated with the management of finances.

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Determine and access resources and systems to

2.3 manage financial management processes within the work team.

2.1 Disseminate relevant details of the agreed budget/ financial plans to team members.

Training Activities

Disseminating the budgets and plans to the users across the organisation is an important aspect in the budgeting process. This activity, apart from communicating the budget targets to the users who are expected to act on them, seeks their cooperation, coordination and willing participation in the budgetary control process. The activity of disseminating budgets and plans could be termed training activity. The training activity is part and parcel of the budget communication package. Once the written communication has been developed, the training activity is undertaken. The training activity targets the

users of budgets and plans throughout the organisation. The training activity could take various forms such as:

• Informal meetings.

• Formal, structured competency standards/training.

• Small group discussions.

• Tele- and videoconferencing.

• E-learning.

Informal meetings

Informal meetings are meetings that are spontaneous and not generally structured. Though they are not planned for in a structured manner, these meetings can have positive outcomes. A typical informal meeting is a 'lunch room' discussion during a coffee or lunch break. Such meetings are more flexible and generally cannot be used as a standard for training activity. However, they can be used as a means of casual clarification of certain issues.

A person who begins a conversation in order to get their questions answered should be aware that once they have 'opened the door' they should also be responsive to the other person's need for answers.

Informal meetings may generate discussion and learning that would not have occurred in a formal training context. The person who answers should be aware that the answers should be appropriate, correct and conform to the policies of the organisation, as there is a possibility that these answers will be treated as if they had been given in a formal training situation.

Informal meetings may not have a formal leader but could have an informal one. This leader may keep informal meetings short and focused, as each person has been doing something else that they need to return to.

Though informal meetings are productive in clarifying certain issues, they cannot be expected to be a complete training activity. However, they may serve as complementary to the formal training activity.

Formal, structured competency standards/training

In a formal meeting, there's typically a clear meeting leader who determines the agenda and outcomes. The target audience would be carefully selected as planned in the training package.

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Training will be delivered using the organisation's training package, which has been thoroughly checked by various financial and other training experts for its content and suitability to the target audience. The training would be organised and timetabled to include all the target audience. An accredited training provider, internal or external, should deliver the training. While it may be impossible to identify the competency levels of each training participant, it is possible to generalise a group competency level and the training package built to suit that competency.

The management will be responsible for releasing the trainees from their normal duties to attend the training and for providing conducive facilities to make the training effective. They also should get feedback from the trainees with a view to making improvements to the training package. Trainees will be expected to take all reasonable steps to acquire the specified knowledge and skills, and to provide any feedback that they think would improve the learning process.

Small group discussions

Small group discussions are ideal for concentrated training with a small number of trainees, where all the participants would be expected to acquire the same standard of specified knowledge and skills. Though this has all the characteristics discussed under formal training above, it would have a small number of participants and allow individual attention to trainees. This would be a useful course of action where a train-the-trainer situation arises.

Tele- and videoconferencing

Tele- and videoconferencing are useful training methods where a large number of participants from geographically dispersed locations are to be trained. Teleconferencing involves linking any number of telephone lines into a single call. It can be thought of as one virtual meeting room where everyone can share ideas, listen to others' comments and learn about budget issues. It's virtual because the participants can be anywhere in Australia as long as they can access a telephone. Teleconferences could be termed flexible meetings, as they are ideal for remote offices. The service could be used from one's own desk or while the person is on the move. Since the staff need not travel to one meeting spot, there is no time wasted in booking travel and travelling. Travel costs are

avoided. Because of this, teleconferences can be organised at very short notice and are often convenient for participating staff.

Videoconferencing is an advanced form of teleconferencing where, in addition to hearing the voices of the participants, their images can also be seen by each other. It is now used in a wide variety of settings and is sometimes known as tele-education. It has many advantages over traditional training methods and is increasingly becoming a preferred medium for training larger groups. The training can be video-recorded for future training.

The disadvantage of tele- and videoconferencing is that often the reactions of the participants go unnoticed. The trainers cannot be satisfied that the trainees have acquired the specified knowledge and skills unless a suitable feedback system is in operation.

E-learning

E-learning is another training technique that allows the trainees to learn in their own time and at their own pace. The medium of e-learning is the computer and the training program is delivered through the Internet. Any training using e-learning should be carefully planned, considering the specified knowledge and skills and the target trainees. Generally, the learning program has a built-in assessment at the end of each stage, the

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successful completion of which allows the participant to proceed to the next stage of learning.

E-learning makes training available anytime, not just at scheduled times in formal meetings, thus putting the self-development tools in the hands of employees. In e-learning programs, the contents should be tailored to the specific needs of a particular user. Unless the right technology is chosen to assist the slower learner, it will be frustrating to some of the participants and thus inhibit their learning process.

While effective e-learning dramatically cuts down the time it takes for people to become knowledgeable on budget issues, an ineffective elearning experience could frustrate trainees and defeat the purpose of putting e- learning in place. The learning process should be carefully monitored. The monitoring is assisted by built-in programs on the computer that collect data on the progress of individual participants. Though there is flexibility on the pace of learning, the whole process needs to be completed by a specified date for the training to be of any value to the participants.

Need For Definition of Data and Terms

Budgets and plans contain a number of items or terms mentioned in them against which the numerical targets or data are set. For example, 'overseas sales' is an item and $2.5 million is the target set for overseas sales for the budget year for a medium-sized organisation. Consistency of interpretation of various terms contained in a budget is of paramount importance. If the terms are interpreted differently by different people, or for different periods, the comparison of budget reports between periods will be meaningless. For example, the item 'overseas sales' could have been taken by the preparer to

include data about overseas sales made directly by the organisation and through its agents. Data collectors, if they don't know the exact definition, may report only the overseas sales directly made by the organisation. This action may be reflected in the reports as under-performance by the organisation in the area of overseas sales. If the overseas sales through the agents were included, then the performance would have been better. If we extend this example further, the inclusion of overseas sales through agents in the first year and non-inclusion in the second year, due to a change in the personnel who collected the information, would distort the results in the reports.

In order to avoid ambiguity and inconsistency, a definition of all the terms and data is necessary. These definitions are provided in the organisation's budget manual, the major function of which is to specify the procedures and processes of budgetary control. The definitions of data and terms help the preparers of data as well as the users. These definitions need to be clearly understood by all the people involved in the budgetary control process. This is achieved through the training activities undertaken by the organisation on the budgeting process. It is of paramount importance, if any confusion is identified at training level and in practice that an attempt be made to redefine the items or data.

2.2 Provide support to ensure that team members can competently perform required roles associated with the management of finances.

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Testing the Communication Outcomes

The success or failure of communication packages needs to be measured. This could take place by testing the communication outcomes. The testing should take place to ensure there was a clear understanding of the objectives and processes of the budget, and the accountabilities of personnel responsible for meeting the budget.

The testing could take various forms. Testing can be classified as direct or indirect. Direct testing consists of setting questionnaires for various people involved in the budgeting process and collating their responses. The

questionnaires should be designed to avoid ambiguity and simple language should be used throughout. Wherever possible, the questions should be of a closed type, where the answer is either 'yes' or 'no', or a scaled approach, where a number represents a condition, such as:

• Excellent (everything fully understood)

• Good (most things understood)

• Satisfactory (understood reasonable amount of the presentation)

• Poor (understood only a few aspects)

• Very poor (no understanding of any information supplied)

Also, there could be provision for explanation or comment if the respondent wishes to do so. The questions should be designed to discover whether there is a clear understanding of the objectives/goals of the organisation, processes (methods of achieving the goals, ie to meet the budget) and accountabilities (who is responsible for what). The collated answers of the questionnaire will give insights into the strengths or weaknesses of the communication package. The comments provided could provide further direction on how to minimise the weaknesses. The results help to make improvements to the communication packages or strengthen the positive aspects of the packages.

Another direct method employed to test the communication package outcome is to interview the involved parties. While it is possible to request that all the involved parties complete questionnaires, it may not be possible in the case of interviews due to resource constraints. A carefully administered random sample of involved parties could be interviewed. The questions asked at the interview could be similar to that of questionnaires, the advantage of an interview being that the interviewee could be given explanation of the questions thus avoiding guesswork answers. The evaluation of the responses at the interview, and the action on the improvement of communication packages as a result of the evaluation, are similar to that discussed under questionnaires.

Indirect testing involves observation of the performance of the involved people in their activities regarding budgets. While the continuous failure of a single person to conform to the standard practices could generally be attributed to a personal failure, the failure of a number of people may indicate the failure of a communication package. Indirect testing, due to its subjective nature,

should not be relied upon on its own but could be used as a supplementary method to validate the outcomes of questionnaires or interviews.

While direct testing methods could be carried out as soon as the dissemination process of the budget is completed, the indirect method described above should be delayed for a while in the actual budget control process in order to observe the performance of the involved people.

Budgets indicate in numerical/financial terms the direction an organisation plans to take. If the budget process is to work effectively then information must be communicated to the people involved in meeting budget outcomes. The way of communicating budget goals and financial information is known as the communication package.

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The communication package needs to be in a language and in a form that each of the people involved understands, and upon which they can make informed decisions. For a budget plan to work effectively, it is essential to involve those responsible for achieving budgets as early in the process as is practical. There should also be information that shows the connection between one section's budget and the budgets of other sections, and how non-achievement in one area affects other areas of an organisation.

Budget information may be communicated using a variety of media, including informal meetings, formal meetings, small group discussions, tele- and videoconferencing, and through e-learning. The medium used should reflect the needs of the group that is receiving the information.

There is always a need to test whether information is understood and to improve on aspects of a communication plan that are not giving the desired results. Review of the understanding level of those who are receiving information provided in the communication package should be a regular occurrence. Improvements should be made to the package where understanding is less than that desirable.

2.3 Determine and access resources and systems to manage financial management processes within the work team

Delegations and Budget Responsibilities

The operational activities of an organisation are carried out by a number of people who either own the organisation or are employed by the organisation to run the business of the organisation. These people should have the requisite authority and responsibility conferred upon them and be assigned boundaries within which they can act on behalf of the organisation.

Authority is the right inherent in a managerial position to give orders and to expect those orders to be obeyed. The authority flows down the vertical

hierarchy. The positions at the top of the hierarchy have more formal authority than the positions below. Responsibility is the flip side of authority.

Delegation means empowering someone, particularly a person who occupies a position at a level lower than the position occupied by the person empowering, to carry out the responsibility; but the person who is empowering is ultimately responsible for the actions of the empowered person. Delegation of authority would be made with respect to the allocation of the organisation's resources, which include various expenditure delegations (financial delegations) and responsibility for budgets. Accountability is the mechanism through which authority and responsibility are brought into alignment.

Delegated authority is vested in the positions of an organisation. The hierarchy of the organisation chart generally represents the chain of command and delegation. Every organisation will have a defined chain of management/command. For a small business, with possibly only one level of management, there will be a short chain of command/control. On the other hand, for large complex organisations, with many levels of management, there will be a longer chain of management/command. Generally, each level will have delegated authority for expenditure commitment and revenue generation decisions, which relate to that level's and position's importance to the organisation. For example, the purchasing manager and administration manager may be on the same level in an organisation, but the purchasing manager may have a larger expenditure delegation due to the fact that this position makes purchases for the whole organisation.

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In a small organisation with one level of management, where there is an absentee owner/manager, there may be wide delegations of decision making to staff. Equally true, there could be narrow delegations to staff, with all decisions needing to be approved by the owner/ manager.

Delegation of authority within an organisation enables staff to make decisions within an agreed boundary. In large organisations with many levels, there will be a series of delegations from the top of the organisation down to the bottom of the chain of command/management. Each level within an organisation structure will have delegations attached to that level, as described in the following table.

Figure 18: Delegation of responsibilities

Level of Management

Likely level of

delegation Examples of delegated tasks that directly or

indirectly relate to expenditure of an

organisation's resources

Strategic

level

management

The strategic level

management of an

organisation, generally the

Board of an organisation, will

delegate responsibilities to

the Chief Executive Officer of

the organisation to make

decisions in line with the

strategic direction of the

organisation that are

intended to impact positively

on an organisation's long-

term survival and

sustainability

• Capital raisings for the future financing of the organisation

• Budget and purchase of non-current assets required to sustain an organisation's activities

• Budgeting for and making

decisions on recruitment

of an organisation's

executive staff

Tactical/Middle

level management

The tactical level

management of an

organisation is required to

translate the long-term goals

into short-term plans. This

level of management is

delegated with the

responsibility for ensuring

that regular key performance

objectives are met. They will

be able to make decisions up

to a level of delegation

specified for middle

management

• Budgeting for recruitment and appointment of operational team leaders and managers

• Responsibility for meeting budget requirements for sections or operational teams of an organisation on a regular basis that fall under the tactical manager's area of control

• Expenditure control

across the organisation

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3. Monitor and control finances. 3.1 Implement processes to monitor actual expenditure and to

control costs across the work team. Monitor expenditure and costs

on an agreed cyclical

3.2 basis to identify cost variations and expenditure overruns.

3.3 Implement, monitor and modify contingency plans as required to maintain financial objectives.

3.4 Reportorganisational protocols. on budget and expenditure in accordance with

3.1 Implement processes to monitor actual expenditure and to control costs across the work team

Though the degree of delegation is dependent on the level of management, as stated above, the different positions would have differing delegations depending on the complexity of the position.

The starting point of the budget process is the evaluation of the sales and profit objectives of top management. These provide the guidelines for the sectional managers in the development of their budgets. There are two differing approaches that can be used in the preparation of budgets.

One method is for the top management to impose on lower level managers the budget they have prepared, with little or no consultation with the latter (top-down budgeting). The second method is to let the lower level managers prepare their budgets initially and then require them to send it for approval by top management (bottom-up budgeting). The advantage of the second method is that the lower level managers may have more intimate knowledge of their particular needs than the top management, and thus can be more realistic with their proposals. In addition, the lower level managers are more

Operational

level

management

The frontline manager/team leaders of an organisation will be responsible and accountable for teams and team outcomes within their area of control and expertise.

They will be able to make

decisions up to a level of

delegation specified by

middle level management

• Decisions on operational budgets for revenue generation

• Expense budgets appropriate to their area of control and expertise

• Staffing decisions that

relate specifically to the

work of the team and the

expenditure that flows

from such decisions

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likely to take ownership of the budget outcomes and would tend to be highly motivated to meet the budgets that they have had a hand in shaping. Top- down budgeting has the advantage that, as establishers of the corporate goal, the top management is in a better position to tailor the overall budget to fit the available resources. The joint benefits can be achieved by appropriate planning by top management and consistent bottom-up budgets. Once the budgets are formulated, these need to be disseminated to the influenced parties as discussed in the previous chapter. The ultimate responsibility for an organisation's budget achievement lies with the top management.

The budgets of an organisation also form a hierarchical pattern in that the lower level budgets would contain more detailed information. Higher level budgets tend to be summaries of lower level budgets and thus have fewer details. The budget responsibility needs to be delegated for the successful operation of an organisation. The delegation normally involves a position that is in charge of a responsibility centre for which there will be a budget.

Regardless of the level of management and control, a team-based approach to work can also be used to encourage budgets to be met. When establishing a team-based culture, it should include empowerment of the team to meet its goals. Empowerment means that the team is accountable and responsible for meeting team goals and can decide how best to meet those goals without referring every decision to a manager at a higher level. However, such empowerment will be limited to the level of financial delegation that a team is

given.

The team should accept accountability and responsibility for team outcomes. Individual members of a team should be accountable for their individual actions as well as the actions of the team. Each team, regardless of their level in the organisation structure, will have a delegated level of responsibility and should become accountable and responsible up to the level of financial responsibility delegated to a specific team.

The activities of an organisation revolve around attaining desired revenue and incurring various expenses in attaining that revenue. An organisation - whether trading, manufacturing or providing a service - should concentrate on sales and marketing to increase its revenue. An organisation that deals with a variety of products or services will have a number of sections specialising in selling the different products or services, or a group of them. Generally, to sell a product or service these should be of high quality and cost less compared to that of competitors. Therefore, control of costs is of paramount importance to an organisation.

3.2 Monitor expenditure and costs on an agreed cyclical basis to identify cost variations and expenditure overruns.

Cost Control

Cost control involves measuring the performance of the whole organisation, and that of its separate parts. This is achieved by comparing the inputs, the actual cost elements with the anticipated cost elements, and also comparing the outputs, the actual operating performance with the anticipated performance. The trends revealed by the results of these comparisons serve as performance indicators.

In order to control cost elements and operating performance effectively, the following points should be borne in mind:

• Realistic, measurable and achievable targets must be set. If the targets are seldom met, the work groups and individuals become frustrated.

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• All employees with responsibility must be involved when targets are set. This gives them a sense of belonging and encourages them to contribute their ideas on the achievability of targets. They may also point out difficulties or bottlenecks, and may suggest valuable solutions.

• Senior management should provide effective leadership. The leader should review employees' ideas and efforts in relation to the organisation's goals.

• Quality procedures and practices must be in place to harmonise the activities of inter- and intra-work groups.

• There must be open, clear lines of communication between individuals and work groups to reduce friction between individuals and work groups, and to verify their efforts to achieve targets.

The primary objective in cost control is the minimisation of costs. This is achieved by:

• The efficient actions of the team leader immediately responsible for the incurrence of costs.

• The team leader evaluating the performance of the subordinates/work groups continuously.

• The timely recognition and elimination of the differences between the actual and planned costs.

• Standard organisation protocols, practices, procedures and work activities that give predictable outcomes

The targets and procedures, generally formulated as budgets, provide a set of directives to the subordinates who are responsible for the administration of the activity. If the subordinates are succeeding and the activities are proceeding according to plan, the business is under control.

Controllable and Non - Controllable Costs

Not all costs incurred by a responsibility centre are controllable by the responsible manager. There are non-controllable costs as well. The cost of material purchases, for example, is controllable by the purchasing manager, who is responsible for obtaining the raw materials required for the production department, but is not controllable by the manager responsible for the production department. Should the cost of material rise, a new supplier might be sought or a long-term purchasing agreement concluded, which may either reduce or at least stabilise costs. This activity will be attributed as the performance of the purchasing manager. An important step in evaluating the

performance of a manager, therefore, is to classify the costs that are controllable by a manager. Costs that are not controllable by a manager are generally irrelevant to any evaluation of the manager's performance and he or she should not be held responsible for them.

Variable costs are generally controllable at the departmental level, with some controlled at a higher level of management (for example, fringe benefits). Generally, fixed costs are not controllable and are not used to evaluate managers' performance.

Performance outcomes are generally thought to be controllable by the responsibility centre managers, but in some instances external factors force responsibility centre managers to modify their performance. For example, the reduced sales of a particular product might lead to production being curtailed, thus affecting the performance of the production manager.

Though the responsibility centre could be held responsible only for the controllable costs, the budget of the centre would show non-controllable costs that are applicable to the centre in addition to the controllable costs.

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This is done so as to give a complete picture of the budget and the 'true cost' of that centre.

Controllable costs

A manager heavily influences controllable costs. However, they are controllable only within limits. For example, a manager in charge of a maintenance department has the power to authorise the type of supplies to be used in repair work. The cost of these supplies is controllable by the maintenance manager.

Another cost that is controllable by a manager of a cost centre is the cost of materials wastage. Using cheaper substitute materials without sacrificing quality is another method of cost control.

Example

A manufacturing operation requires 100 kg of a material at $5 per kg. The normal wastage of 2% is expected on top of this quantity. If a substitute material was used, the requirement would be 110 kg at $4; the normal wastage expected is 5%,

a. What is the percentage increase in the cost of wastage?

b. What is the reduction in the total cost of material used?

c. Would you choose the substitute material?

Solution

Expected

usage

Wastage Actual

usage

Cost of

usage

Cost of

wastage

Original

material

100kg

2kg

102kg

102 X $5

= $510

2 X $5

= $10

Substitute

material

110kg

5.5kg

115.5kg

115.5 X $4

= $462

5.5 X $4

= $22

a. Increase in cost of wastage = $22 - $10 = $12

Percentage increase in cost of wastage = 12 /10 X 100 = 120%

b. Reduction in the total cost of material used = $510 — $462 = $48

c. Yes, the net saving is $48 despite the increase in wastage of 120%

It should be noted that cost control does not always mean doing things for the cheapest possible cost. For a product that might be regarded as an exclusive product, costs may be budgeted at a level to ensure that the product meets certain quality standards. Saving money by substituting a low quality material in products or using low paid unskilled staff to provide a premium service may reduce the quality and affect, in the long term, the income generating capacity of an organisation. Cost control should always be linked to meeting budget requirements. Budget requirements should be linked to the goals, policies and procedures, and culture of the organisation.

Non -controllable costs Non-controllable costs are those over which a manager has no significant influence. A responsibility centre manager may not have any say on the rent paid for the area occupied by the centre, but certain costs - though they may appear to be non-controllable from one point of

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view - might be controllable from another. A manager, for example, has no control over subordinates' salaries or wages; award wages are based on the skills of the labour force. However, by selectively deploying labour in an appropriate manner, the manager can save on labour costs. Using unskilled employees who can complete a task just as well as skilled employees can sometimes create savings. So what seems to be an uncontrollable cost does have some measure of control attached to it at times.

Example

A skilled worker can complete a certain task in six hours. The hourly labour rate for this worker is $24. An unskilled worker, whose hourly rate of pay is $12.50, can complete the same work in 10 hours. Would you recommend hiring the unskilled worker?

Solution

Labour cost of skilled labour = 6 X $24 = $144

Labour cost of unskilled labour = 10 X $12.50 = $125 Savings made = $144 - $125 =

$19.

Therefore, the use of unskilled labour is recommended.

3.3 Implement, monitor and modify contingency plans as required to maintain financial objectives.

Risk Management

Risk management is the process of identification of potential negative events and development of plans to mitigate or minimise their likelihood and/or consequences. Many organisations may manage the risks to their business fairly well without having any organised plans, but a number of factors make it necessary that risk management is approached in a structured manner. The factors include:

• Organisations operate in a rapidly changing environment.

• Organisations operate in a highly competitive environment.

• High cost of managing a disastrous event.

• Organisations undertake new and untried technology and methodology for production or service delivery.

At the financial planning stage risk-management plans are incorporated into the general plans. These plans could be made for:

• Individual projects including capital projects:

• At the whole-of-organisation level.

• At a sub-unit level. The process of planning and implementation, though it ultimately rests with the top management of the organisation, should be empowered to other lower levels of staff. This helps the personnel closer to the action to estimate the anticipated risks and to suggest risk-management procedures.

Risk management requires a logical and systematic method of establishing a context, and involves identifying, analysing, evaluating, treating, monitoring and communicating risks associated with any activity, function or process in a way that will enable organisations to minimise losses and maximise

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opportunities. The Australian Standard on risk management, AS/NZS 4360:1999, provides a framework for managing risk in a structured and systematic way. A summary of the process of risk

Establish the context

Though it appears that risk identification is the first step in the process of risk management, it is important to recognise what is at risk. In other words, the organisation has to establish the context in which the risk resides. A few key areas that can be exposed to risk are:

• The strategic objectives of the organisation, eg the assumptions on which strategic objectives are decided.

• Financial, eg. reduction in sales.

• Legal, eg. a customer suing for faulty product.

• Human resource management, eg loss of key personnel.

• Information technology, eg. computer fraud.

• Environmental, eg. unforeseen mild weather affects sales of air conditioners.

• Fraud, eg. theft by employees.

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In establishing the context, consideration should be given to the environment for which risk identification, analysis, evaluation and treatment are to be considered. To establish the context, it is necessary to consider:

• The activity for which risk management is to be established.

• The outcomes expected from that activity.

• The critical factors relative to the activity.

• The criteria for risk acceptability or otherwise.

• The stakeholders of the activity.

Identify the risk

After establishing the context or activities for which risk management has to be planned, the risks need to identified. This is done by answering two questions:

1. What can happen?

2. How and why will it happen?

This could be established using a checklist with all previously known risks and ticking the items that are applicable to the particular activity. But this limits identification of all the potential risks and therefore a brainstorming process could bring out more potential risks.

Analysing risk

Analysing the risk is an exercise in which each risk is given a significance rating based on some scale, taking into account any existing controls that operate to reduce the risk. Where the risk cannot be rated, a matrix could be created using the likelihood of this risk occurring and the consequences of it, to identify a rating. The likelihood means the combination of probability and frequency of a risk occurring, while consequences refer to the outcome of an event such as loss, injury, disadvantage or gain. This matrix is shown in Figure

20. The process of analysing risk is shown in Figure 21

Risk evaluation

When the risk rating is set, utilising risk analysis for each risk, these ratings are reviewed against the organisation's known priorities and requirements. The major risks are separated from those with low priority so that more resources can be diverted for managing the major risks.

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Risk treatment

Risk treatment is determining what is to be done in response to the identified risk. Various options of treating risk are evaluated and the best response is selected. The options are:

• Avoid - Avoidance is either not to proceed with the activity for which the risk is identified, or changing the conditions to prevent such a risk occurring but which might bring in other risks. For example, if an organisation plans to build a water skiing resort and in the risk analysis it finds high potential for litigation for potential injury, it could abort its plan to avoid the risk. Alternatively, if it finds that statistically people over a certain age succumb to high rates of injury, it could make a condition of entry, such as 'admissions restricted to patrons of certain age'. This condition may contravene the Anti-Discrimination Act.

• Accept - Sometimes organisations have to 'take' or accept certain risks, as the cost of taking any other action might outweigh the potential benefit from the activity. For example, it is possible that an organisation could go ahead and develop the resort, after having compared the cost of potential litigation against the potential income from the tourists.

• Control - The risk is controlled by reducing either the likelihood of the risk occurring and/or the consequences of the risk. Various strategies could be employed to reduce the likelihood of risk, such as training staff, increased supervision, testing and inspection of the process, equipment or system, and preventive maintenance. Following the previous example, the organisation might conduct a short training course for customers on entry to reduce the likelihood of the risk of accidents.

Strategies to reduce the consequences of risk include: minimising exposure to sources of risk and putting certain barriers in place. The organisation could put soft lining on the river embankment so that customers water-skiing will not suffer serious injury if they hit the embankment. Also, customers might be requested to wear certain protective gear. In addition, inspectors could be appointed to watch the movement of customers and remove erratic ones from further participation.

• Transfer - The risk is transferred or shared with a third party. For example, the organisation could insure against litigation from injured customers.

Once the options are evaluated and a cost-benefit analysis is performed, plans to implement the selected options are prepared. These plans are implemented to reduce the risk.

Monitor and review

For risk management to be effective it needs to be monitored and reviewed. Monitoring and reviewing should be carried out at every step of the risk- management process. As soon as possible, measures should be taken to rectify any discrepancies found as a result of the review. Monitoring and reviewing are ongoing processes to maintain the quality of risk management. Communicate and consult

Communication and consultation with all the involved staff within the organisation are the key components of the risk-management process. Every step of risk management should be communicated and consulted before the risk-management plans are prepared, so that the cooperation from the staff on implementing the plans is obtained. Consultation with outside experts or consultants might also be important, depending on the

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circumstances, for effective risk management. A register of risky events and subsequent treatment of them would be useful in risk management.

Contingency plan

Associated with risk management are contingency plans. Contingency plans are the plans of action if and when a negative event is occurring. Contingency plans function to mitigate any loss due to a negative event and thus they form part of control in risk management. A

contingency plan is a well thought out, alternate or radical course of action that avoids disruptions in normal business operations due to any type of operational error or brings back normality to business operations within a short period of time should an error occur.

Generally, a contingency planning policy is developed by the organisation and, in the light of the policy; a business impact analysis is conducted to identify the possible impacts a contingency would have on the business. The existing preventive controls to avoid the negative incident occurring are identified. Based on these, recovery strategies are developed. Using these strategies, contingency plans are developed and tested. The staff are trained on these plans. It is important that these plans are reviewed and updated as the conditions and assumptions on which the contingency plans are based and developed might change over a period.

Proper records

Every organisation must keep proper records of all of its transactional activities. The records should be detailed enough to produce the required information as per internal needs for management control purposes. These also satisfy the external needs of accounting standards, as well as other legal requirements. Australian Accounting Standards need to be adhered to in the preparation and presentation of financial reports.

It is also necessary that risk-management plans are implemented by organisations and contingency plans put in place as part of the financial plan.

The process of risk management includes establishing the context - the areas that are exposed to risk; identifying the risk - the probable risk occurring in those areas; analysing risk - the probability and frequency of a risk occurring and its consequences; evaluation of risk - rating of risk and reviewing against the organisation's priorities; and requirements and treatment of risk - determining the action in response to the identified risk. Also the risk management needs to be monitored and reviewed in an ongoing manner for it to be effective. There should be communication and consultation with staff for the risk management to be successful. Based on the contingency planning policy of the organisation and on the existing preventive controls, recovery strategies are developed. The contingency plans are developed based on these strategies and must be reviewed and updated continually.

3.4 Report on budget and expenditure in accordance with organisational protocols

Budget Documentation

Budgets are presented in a format that clearly shows the responsibility of each appropriate person. Budgets should be detailed enough to give a clear picture to the user of the responsibility and the target to be achieved. Care should be taken to avoid too many details that would curtail the freedom of the user to adjust spending. For example, a budget of $3 000 for general expenditure, which covers staff amenities, stationery and telephone costs, for the business school of the local TAFE college for the month of January 200X is more appropriate than $300 for staff amenities, $2 000 for stationery and $700 for telephone calls. The budget of $3 000 for general expenditure gives the choice to the

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director of the school to reduce the expenditure on, say, staff amenities to provide more stationery for handouts to the students, thus still maintaining the total expenditure within the budget.

The budget should be in a written form, as it needs to be frequently referred to. Where possible, the budget should show its relationship to other subsidiary budgets and to the main budget of which it is an integral part. It is possible that budgets written on paper could be misplaced. Also, showing the linkage between the various paper-based budgets may be difficult. The use of electronic communication assists in maintaining the budget in an easily accessible form and helps in conveniently linking the related budgets.

The budgets should be delivered to the responsible persons prior to the beginning of the period any budget refers to. Alternatively, these persons must be made aware of where to find (in an electronic form) the budget that they are involved with. This is necessary to allow enough time for the persons to take any action before the period begins.

The budget authorises the person or group responsible for it to spend money on behalf of the organisation, within the set limits and for the set purposes. For example, the director of the business school at the local TAFE college could spend up to $3 000 on general expenditure for the month of January 200X. If the director is forced into a situation in which the school has to spend more than the budgeted amount, a last attempt may be made to approach the college director (their superior) to get special approval for this expenditure. In this example, it might be possible for the business school director to cut down the expenditure in the month of February 200X to make the total expenditure fall within the budget for the year. Thus, the director of the business school has taken a remedial action within the budget authority.

The person delegated with budget accountabilities is responsible for monitoring expenditure, making expenditure within the authorised limit and taking remedial action on the reported variances to the budget.

Illustration

The matters discussed so far in this section could be illustrated using an example of a large clothing store. A chief executive officer is responsible to the owners of The Fitzroy Falls Clothing Store. The store operates from its own building and is divided into five functional departments, three of which are involved in sales. Each of the sales departments specialises in manchester, adult's clothing and children's clothing. The departmental managers are responsible for running each department independently. A purchasing department, whose responsibility includes finding suppliers for items requested by the sales departments and negotiating the supply terms,

supports these three sales departments. The final decision on what items to purchase and at what prices rests with the sales departments. The administration, including human resource management and record keeping, is the responsibility of the administration and finance department. Figure 22 shows the organisation chart.

A sample budget for a sales department would appear as in Figure 23. Note that for simplicity, details such as opening stock and closing stock are not given though the stock level would be the responsibility of the departmental manager. In addition to sales and purchases, the department manager will be responsible for other expenses of the department.

The expenses include an amount for rent. This rent is a notional amount that is provided to identify a major expenditure to arrive at the real expenses of

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the department. The departmental manager has no control over this, as well as on the depreciation expense.

Figure 23: Budget for Sales – Manchester Department

Fitzroy Falls Clothing Store

Sales - 'Manchester' Department

Budget-July 200X

Depreciation depends on the depreciation policy of the organisation and the value of the assets held by the department. The manager would have played a part in deciding what assets the department needed and in acquiring them, and therefore the manager was only indirectly responsible for the depreciation.

The budget for the purchasing department for the same period is depicted in Figure 24. Here, there are no budget amounts for sales or cost of sales, as this department is not involved in sales but only in providing services to the sales department. If the management feels that this department should run at a 'profit'

$

Sales 150,000

Cost of sales 100,000

Salaries and wages 15 ,000

Salary on cost 3 ,000

Telephone 800

Electricity 1 ,200

Stationery 300

Rent 5 ,000

Depreciation 1 ,000

Total e xpenses 26 ,300

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then an internal price (or transfer price) for its services could be charged to the sales department. This internal price may be decided based on normal market prices and will be shown as an income for the purchasing department and as an expense for the sales department.

Figure 24: - Budget for Purchasing Department

Fitzroy Falls Clothing Store

Purchasing Department

Budget-July 200X

$

Salaries and wages 7,000

Salary on cost 1,400

Telephone 1,200

Electricity 500

Stationery 300

Rent 800

Depreciation 500

Total expenses 11,700

Similar to the situation in the sales department, the purchasing department manager will not be responsible for the expenses on rent and depreciation.

The budgets of the various departments show the budget accountabilities of those departments. These also empower the manager with the necessary authority to take remedial action to improve the performance of the department to stay within the budget. The budget confers the authority to the manager to spend within the limits set by it.

Figure 25 shows a 'complete' budget for the Fitzroy Falls Clothing Store for July 200X depicting the relationship between the budgets of the separate departments and the organisation as a whole. It should be noted that some expense items, such as audit fees in this example, are not distributed across the departments of the organisation as there is no meaning in doing so.

Some items, like gross profit and net profit, are not shown in the individual departmental budgets as they are meant to highlight the individual budget items of revenue and expenses only of the respective departments. If the management expects stringent controls, each line item shown in the examples could be further subdivided. For instance, if there were, say, two telephone lines available for the Manchester Sales Department, one for the departmental manager's office and the other for general sales staff, the budget for telephones could be split into $600 for the departmental manager's telephone and $200 for the other line.

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However, it should be remembered that once information becomes too detailed the value of that information is diminished. Controls of small dollar budget items may see people concentrate on issues that are insignificant

and lose focus on important cost items. The cost of trying to trace and control

telephone accounts of the amount of $200 listed above could result in a larger control

cost than the cost attributable to a budget over run. The control may cost more than

the waste. Figure 25: Complete budget for the store

Allocation of Funds

During the preparation of budgets, consideration would have been given to the availability of funds as the budgets are part of the financial plan. The funds are allocated strategically to support the overall mission of the organisation. Allocations are based on available resources. It is almost always impossible to perfectly match the inflow of funds with the outflow in the short term. The shortfall or excess of funds for a short term (for a whole period or part of it) would have been identified

at the time of preparation of the budgets. Using this data, plans would have been made either to make good the shortfall by borrowing, or to invest the excess. Any deviations in the movement of funds due to unexpected events during the budget period could be generally covered through contingency plans. The day-to-day allocation of funds should be in accordance with the budget objectives and parameters. A section of the organisation or responsibility centre that is performing

Details Sales

Manchester

Sales Adult

Clothing

Sales

Children’s

Clothing Purchasing

Administration

and Finance Chief

Executive Total

Sales 150,000 250,000 200,000 600,000

Cost of

Sales 100,000 120,000 100,000 320,000

Gross Profit 50,000 130,000 100,000 280,000

Salaries and Wages

15,000 15,000 15,000 7,000 11,000 12,000 75,000

Salary on

cost 3,000 3,000 3,000 1,400 2,200 2,400 15,000

Telephone 800 800 800 1,200 1,000 400 5,000

Electricity 1,200 1,200 1,200 500 500 400 5,000

Stationery 300 300 300 300 500 100 1,800

Rent 5,000 5,000 5,000 800 800 400 17,000

Audit fees 15,000 15,000

Depreciation 1,000 1,000 1,000 500 500 500 4,500

Total Expenses

26,300 26,300 26,300 11,700 16,500 31,200 138,300

Net Profit 23,700 103,700 73,700 -11,700 -16,500 -31,200 141,700

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well and thus making savings on its available funds should not be made to sacrifice any funds earmarked for it to another responsibility centre not doing so well.

Funds would have been generally allocated for operational budgets as well as for capital budgets. Any increased demand for funds for operational budgets would be expected to be due to an increase in operational activities. These increases would be expected to bring fund inflows in the near future, thus any shortfall experienced would only be for a short period. Therefore, the organisation should be able to cover the shortfall with a short-term borrowing. Alternatively, the demand for an increase in the operating budget could be due to inaccurate original guesswork allocation, price increases due to inflation and so on. Under these circumstances, it may be difficult to repay any short-term borrowings, as the fund inflow will not match the outflow. This situation should be clearly identified and remedial action taken to, say, increase the fund inflow by increasing the selling price of the product or service.

Any capital expenditure budget is expected to produce only long-term returns. A management facing a condition that prevents it from undertaking all acceptable projects would have resorted to capital rationing at the time of budget preparation for the capital budgets. The rationing is done through the ranking of projects. The ranking takes place considering the objectives of the project and parameters limited by its profitability. Further, the borrowing capacity, ie ability to borrow money for the project, the cost of borrowing and whether it could be covered by the anticipated returns, and expected additional benefits both tangible and intangible, are also taken into account. If the management realises that rationing could be softened by borrowing funds at a favourable rate (to benefit from the investment), then this will be implemented. The capital expenditure, mainly those on larger projects, tends to deviate from the plan during implementation due to inaccurate estimations in the original plan and price increases due to inflation. Another factor, which could have an effect at the implementation stage, is technology changes that have occurred since the plans were made. There will be a tendency to invest in new technology that may be highly efficient but could be very expensive. Management needs to find the necessary funding to cover the additional cost.

A business can fund the shortfalls either from internal resources or funds raised externally. The internal sources include cash balances currently held, short-term investments, early settlement by debtors, running down stock levels and a lengthened period before paying creditors.

External sources of funds could take the form of private equity funding and debt funding. The external funds obtained through flexible private equity finance (usually by corporate businesses) include convertible notes, ordinary shares and preferred shares. Privately owned businesses can opt for partnerships thus bringing in the necessary capital. Alternatively, the organisation could seek long-term debt finance. Debt finance is usually cheaper than equity finance. It is safer from the lender's point of view.

The factors to consider when deciding on the type of external funding are:

• Quantum of funding.

• Peculiarities of the industry, such as competition, in which the organisation operates.

• Expected financial performance of the project for which funding is sought, such as return on capital investment.

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• Projected cash inflows from the project.

There are financiers for start up and expansion stage businesses. Whatever the selected funding source, it should be able to provide longterm and follow-on funding. The organisation should be careful not to allocate the funds from any short-term sources to a capital (long-term) budget.

All organisations have broad objectives that they pursue. To achieve those objectives it is necessary to delegate responsibilities to appropriate people within the organisation.

Responsibility for achieving budgetary objectives is delegated to different management levels of the organisation commensurate with their level of responsibilities. There are three key levels of budgetary responsibility. These are the strategic, tactical and operational levels. The strategic level management sets the future direction, the tactical level management turns the

strategic level imperatives into plans and the operational level management acts on the plans, taking responsibility for cost control and revenue generation.

Cost control is a key aspect of the delegated responsibility. Cost control generally means minimising costs. Cost minimisation involves the efficient actions of the team leader immediately responsible for the incurrence of costs, evaluating the performance of the subordinates/ work groups continuously, the timely recognition and elimination of the differences between the actual and planned costs, as well as following standard organisation protocols, practices, procedures and work activities that give predictable outcomes.

Costs can be defined either as controllable or non-controllable costs. Controllable costs are those costs over which a manager has heavy influence. Non-controllable costs are those costs over which a manager has little or no control.

Budgeted revenues and costs should be documented and presented in a format that clearly shows the responsibility of the appropriate person and/or team. Budgets should be detailed enough to give the user a clear picture of the responsibility and the target to be achieved. Though care should be taken to avoid too many details, budgets should be detailed enough so that those people responsible for achieving a budget are clear on what has to be achieved.

Budgets provide the basis for the allocation of funds to various sectional activities. Any well-developed financial plan would ensure that the allocation of funds matches the proposed activities of each of the sections within the organisation.

4. Review and evaluate financial management processes.

4.1 Collect and collate for analysis, data and information on the effectiveness of financial management processes within the

work team.

Analyse data and information on the effectiveness of

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4.2 financial management processes within the work team and identify, document

and recommend any improvements to existing processes.

Implement and monitor agreed improvements in line

4.3 with financial objectives of the work team and the organisation.

4.1 Collect and collate for analysis, data and information on the effectiveness of financial management processes within the work team.

Audit Requirements and Legal Obligations

Proper record-keeping of its transactional activities is vital to the successful operation of any organisation. Records are kept for both the quantity and the value of transactions. For example, when a trading organisation buys 15 bicycles to resell, each costing $100, the stock records will show an increase of 15 units and the purchase records will show an increase in value of purchases of $1,500.

These records are maintained using a set of rules, termed accounting methods. These methods are controlled by external standards as well as

internal standards. The external standards are set by professional bodies and also various legislation. The internal standards are set by the management considering the information and control needs of the organisation. Generally, the requirements of the internal standards of the organisation far exceed those of external standards. Therefore, the detailed records kept to satisfy the internal needs could be used to produce the information as required by external standards. For example, an internal standard may be that the internal recording system records all the telephone expenses of the organisation in one account, whereas the external standard does not require telephone expenses to be reported separately. For external reporting therefore, telephone expenses will be totalled together with other expenses of administration, such as rent, rates, electricity and stationery, and described as administrative expenses. For internal control purposes, the organisation might decide to record separately the expenses of each and every telephone line.

The recording system and documentation should conform to the internal standards. These internal standards would be frequently reviewed by internal auditors for their suitability for management control purposes. The external auditors also review these for their suitability to conform to audit and other legal requirements.

For management control purposes, the results of the actual activity as recorded in the system needs to be compared with the budgeted activity. Therefore, the budgets are also recorded in the system to obtain a comparison report. The budgets need to be prepared to that degree of detail as per management requirement to facilitate the comparison process. With the development of computer technology capable of handling a large number of transactions, it is possible that a system could be developed to record the transactions in great detail.

The external audit requirements are that auditors must satisfy themselves, amongst other things, that the items recorded are at appropriate amounts in accordance with generally accepted accounting principles, standards and other legal requirements. The proper source documents should be maintained by the organisation to help the auditor in the process of checking the appropriate values of the transactions. A full discussion of all accounting

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standards and other legal obligations is beyond the scope of this book. What follows are general discussions on the compliance with accounting standards and legal obligations expected of an organisation.

Compliance with accounting standards

Accounting standards are the main basis for the accounting rules that are used in the accounting data and the production of reports by an organisation for use by external parties. The

power to make accounting standards is given to Australian Accounting Standards Board (AASB) by the Corporations Act (the Australian legislation covering the conduct of public and private sector

organisations). AASB is a quasi arm of the government that is responsible for developing accounting standards that are not

in conflict with the Corporations Act. The AASB standards, which are identified by AASB number codes, have the force of law.

From 1 January 2005, Australia adopted the International Financial Reporting Standards (IFRS) as its AASB standards.

Compliance with legal obligations

Since the Corporations Act governs all reporting entities incorporated in Australia, this Act controls the contents, style and timing of reports produced by an organisation for the use of external parties. Therefore, recording systems should be designed to satisfy the requirements of the Act. The Australian Securities and Investment Commission (ASIC), an independent Commonwealth government body established by Parliament, is responsible for the administration of the Corporations Act.

The Corporations Act amongst other things:

• Protects the rights attaching to company shares by setting out a procedure for variation of class rights.

• Sets out the duties of the directors of a company, including disclosure of personal interests in the company and the duty to prevent trading while the company is insolvent.

• Requires a company to set up and maintain a register of members, keep a register of charges on the property of the company and a register of debenture holders and to have their accounts audited.

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The Corporations' Act requires that all the companies under the Act abide by the accounting standards. Thus, the practical aspects of accounting standards, supported by their legal status conferred by Corporations' Act, have a significant impact on the presentation of the report by a company for the use of outside parties.

Monitoring of Performance

An organisation carries out a number of activities for its existence. An activity is carried out with an objective. The objective includes output as well as input. For example, for an activity such as making ice-cream, the input would include raw materials such as milk and sugar; labour; and overheads such as electricity. The output is ice-cream. The term 'performance' is used to indicate the amounts of input as well as output. Performance may be defined as the quantitatively or qualitatively measured input and output of an activity or series of activities. When a series of activities is involved, the output of the

first activity becomes the input of the next activity, and so on, until a measurable ultimate output is produced.

Each activity has a planned input and a desired output, although the planned quantity and/or quality of input may not always result in the desired output. To achieve the desired output, the input may have to be adjusted from the planned quantity or quality.

Example

The ingredients usually required by an ice-cream parlour to make 10 litres of ice-cream are 6 litres of milk and 3 kilograms of sugar. Of late, only 9.5 litres of ice-cream were being produced with these quantities of input. By increasing the milk quantity to 6.5 litres, the production of ice-cream was increased to 10 litres.

The performance of an activity or a group of related activities is monitored by comparing the actual input and output with the planned input and output.

Variances

Variances are the results of comparison of the actual input or output with those planned or budgeted. In the case of revenue, the variance arises because of the differences in the actual price charged and volume sold compared to those budgeted. In the case of expenses, the variances arise because of the differences in the actual price paid and quantity used compared to those budgeted. The price charged or paid for a unit of an item could be either higher or lower than that budgeted. A unit of an item might be, for example, a metre of wood or an hourly rate of pay for a carpenter. Similarly, the volume of an item sold or quantity used in production could be higher or lower than

the budgeted units of those items.

Just as budgeted and actual dollar amounts are compared, either in total or per unit, 'budgeted allowances' are used in operational activities to assess workers - for example, the number of errors tolerated in clerical work, or the number of defective items allowed in a batch of manufactured components or assembled finished products. All operational reports should have some sort of budget against which actual performances are to be measured to determine any variances. Several factors may cause these variances. Some of the most common causes encountered in a business are discussed in the following paragraphs.

When establishing budgets, it is desirable to incorporate some form of norm or standard. For example, the standard may be a desired number of hours of labour required to complete an operation, a certain ideal weight of a raw

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material to be used per unit of finished goods manufactured, or the most economic price for a unit of material. In other words, we predetermine standard prices or rates, standard quantities and standard costs. The standards are arrived at after a careful study of past data and/or applying scientific techniques, such as method study, motion study and so on. If these standards are poorly structured or based on wrong assumptions, the purpose of budgeting is defeated.

When budgets (prepared by using standards) are available, it is possible to compare the actual outcomes against those budgets to see how we have performed. The difference between the budget and the actual outcome is then called the variance.

If the actual price, rate of pay, quantity used, costs and so on are less than those budgeted, the resulting difference in each case is a positive or favourable variance. If the actual price, rate of pay, quantity, costs and so on are greater than those budgeted, the difference in each case would be a negative or unfavourable variance (also called adverse variance).

Variances can occur if a budget is poorly structured or based on wrong assumptions, or if incorrect information about the measurement of actual outcome or the budget is put into a reporting system. A critical analysis of the variances and their trend may reveal these discrepancies, which should be rectified as soon as possible.

The measurements of variances provide a basis for continuous improvement. There is a time lapse between the activity occurring and the reporting of measurements to the persons responsible for taking corrective action, if any. This time lapse may sometimes be too long for any corrective action, or the system may have corrected itself and any corrective action taken would tend to overcorrect thereby upsetting the balance. Though it is intricate, it is preferable to have an online, instantaneous monitoring of the performance of an activity, ie identifying variances on a real-time basis. Various computer packages and automated systems are being developed to carry out the monitoring function more efficiently in this manner.

Variances and their Causes

Variances are analysed generally in conjunction with relevant experts attached to that activity or group of activities to determine the cause and effect. This analysis leads the relevant personnel to take corrective action to avoid any adverse or negative variance.

Negative variances are detrimental to the organisation as they decrease the planned profit of the organisation. Although the performance of individual activities results in either negative or positive variance, it is the performance of the organisation as a whole that decides whether the organisation is run

efficiently or not. The analysis of variances begins with their calculation. It should be noted that variances explored in this chapter are by no means exhaustive. Various types of variances could be extracted as far as they produce some meaningful information for control purposes for the appropriate personnel.

The following notations are commonly used in connection with variance calculations:

BSP = Budgeted selling price

ASP = Actual selling price

BSQ = Budgeted sales quantity

ASQ = Actual sales quantity

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BSV = Budgeted sales value

ASV = Actual sales value

SS = Standard sales

BP = Budgeted buying price

AP = Actual buying price

BPQ = Budgeted purchase quantity

APQ = Actual purchase quantity

BR = Budgeted rate of pay

AR = Actual rate of pay

BC = Budgeted cost

AC = Actual cost

We shall now consider the sales value variance, followed by cost variance in direct materials, direct labour and overheads, and analyse them by causes.

Sales variances and their causes

We calculate the difference between the budgeted sales value and the actual sales value and call it the sales value variance. This variance could be due to either or both of (i) a change in selling price per unit, or (ii) a change in volume sold.

The sales value variance is thus the total of two separate variances called the sales price variance and the sales volume variance, as explained below.

Calculation

Assume the following data:

BSP = $6.00 per unit

ASP = $5.50 per unit

BS = 1 000 units

AS = 1 400 units

The sales value variance is calculated as the difference between the budgeted sales value and the actual sales value. That is: Sales value variance = BSV – ASV

= 1 000 X 6 - 1 400 X 5.50

= 6 000 - 7 700

= $1 700 (favourable)

The sales value variance is affected by the selling price and the volume of sales.

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The effect of the actual selling price differing from the budgeted selling price on the sales value variance is called the sales price variance and is calculated as follows:

Sales price variance = Standard sales - Actual sales

= Actual sales @ budgeted price - Actual sales

@ actual price

= 1 400 X 6 - 1 400 X 5.50

= 8 400 - 7 700

= $700 (unfavourable)

The effect of the actual volume of sales differing from the budgeted volume of sales is called the sales volume variance.

This variance is calculated as:

Sales volume variance = Budgeted sales — Standard sales

= Budgeted sales @ budgeted price - Actual

sales @ budgeted price

= 1 000 X 6 - 1 400 X 6

= 6 000 - 8 400

= $2 400 (favourable)

The combined effect is thus: $700 (unfavourable) + $2 400 (favourable)

= $1 700 (favourable)

This will be in agreement with the sales value variance calculated above.

Causes

Changes in selling price usually occur in response to competition. Other causes of selling price changes include:

• reduction in manufacturing costs;

• more trade discounts granted than those allowed in the budget; and

• 'seasonal sales' to dispose of old stock in line with changing fashion or obsolescence, for example.

The causes of change in the volume of sales include:

• extensive advertising, leading to increased demand; superiority of

the product over that of competitors; and change in the 'mix' of

sales.

Relevant personnel

Sales department personnel

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Direct material cost variances and their causes

In connection with the direct material used in manufacturing, service or other businesses, the total direct material cost variance is the difference between the budgeted cost and the actual cost incurred. There are two reasons for the total variance:

1. the price actually paid may have been more than or less than that budgeted; and

2. the material actually used per unit of output is more than or less than that budgeted.

Calculation

Suppose we have the following data for a particular direct material:

BPQ = 5 kilograms per unit of output

BP = $10 per kilogram

APQ = 6 kilograms per unit of output

AP = $9 per unit

Output = 50 units

Budgeted cost of direct material = 50 units X 5 kg X $10 = $2 500 Actual cost of direct material = 50 units X 6 kg X $9 = $2 700

Total direct material cost variance = BC - AC

= $2 500 - $2 700

= $200 (unfavourable)

The effect of price difference on the total direct material variance is calculated by multiplying the difference between the budgeted price and the actual price by the actual quantity used. The result is called the direct material price variance. That is:

Direct material price variance = (10 - 9) X 50 X 6

= $300 (favourable)

The effect of material usage on the total direct material cost variance is calculated by multiplying the difference between the budgeted usage and actual usage by the standard price per unit. The result is called the direct material usage variance. That is:

Direct material usage variance = (5 - 6) X 50 X 10

= $500 (unfavourable)

The net effect of the price and usage variance is:

$300 (favourable) + $500 (unfavourable) = $200 (unfavourable).

Note: This net amount agrees with the total direct material cost variance calculated.

The total direct material cost variance and its analysis into the price and usage variances are illustrated by Figure 17.1.

Figure 26: Diagrammatic representation of direct material variances

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Formulas for calculating the three variances are as follows;

Total direct material cost variance = BC – AC

Direct material price variance = (BP – AP) X AQ

Direct material usage variance = (BQ – AQ) X BP

Example

The direct material cost budgeted to be used by a manufacturer was 2 kilograms per unit of finished product at $5 per kilogram of the material. Production of finished goods was 100. The actual price paid for the material was $5.50 per kilogram. The units of direct material used per finished product remained the same, but the number of units of finished product was 110.

Calculate the direct material cost variance and analyse it. Solution

Budgeted cost of direct material = 100 units X 2 kg X $5 = $1 000

Actual cost of direct material = 110 units X 2 kg X $5.50 = $1 210

Total direct material cost variance = BC -AC

= $1 000 - $1 210

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= $210 (unfavourable)

Check: Total direct material cost variance

Direct material price variance = {BP - AP) X AQ

= (5-5.50) X 110 X 2

= $110 (unfavourable)

Direct material usage variance = (BQ - AQ) X BP

= [(100 X 2) - (110 X 2)] X 5

= (200 - 220) X 5

= $100 (unfavourable)

= $110 (U) + $100 (U) = $210 (U).

Causes

Causes of the price paid per unit of direct material being higher than the budgeted price include:

• not investigating the market for a cheaper supply;

• not taking advantage of bulk purchase discounts;

• use of an expensive substitute material; and

• an increase in market price due to various reasons such as foreign currency exchange rate variations.

If direct materials are bought at prices lower than the budgeted prices, then reasons opposite to those listed above could apply.

Causes of the actual usage of direct material per unit of product differing from the budgeted usage include:

• use of substitute materials requiring more/less than the originally intended

• material quantity;

• wastage due to workers' carelessness;

• unavoidable spoilage during operations;

• more/less than expected normal losses of materials;

• a deliberate, experimental use of excessive materials;

• use of a material mix that is different from the budgeted mix; • an increase in material usage due to incorrect machinery settings; and

• an increase/decrease in material usage due to inferior/superior quality of material.

Relevant personnel:

Purchasing and production department personnel.

Direct labour cost variances and their causes

For direct labour used in manufacturing, service or other businesses, the total direct labour cost variance is the difference between the budgeted cost and the actual cost incurred. The total variance could be due to two factors:

1. the rate of pay actually paid is more/less than that budgeted; and

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2. the labour hours actually used per unit of output are more/less than those budgeted.

Calculation

Suppose we have the following data for a particular direct labour:

BH = 10 hours per unit of output

BR = $20 per hour

AH = 12 hours per unit of output

AR = $19 per hour

Output = 50 units

Budgeted cost of direct labour = 50 X 10 X 20 = $10 000

Actual cost of direct labour = 50 X 12 X 19 = $11 400

Total direct labour cost variance = BC - AC

= $10000 - $11400

= $1 400 (unfavourable)

The effect of rate difference on the total direct labour cost variance is calculated by multiplying the difference between the budgeted rate and the actual rate of pay by the actual labour hours used. The result is called the direct labour rate variance. That is:

Direct labour rate variance = (20 - 19) X 12 X 50

= $600 (favourable)

The effect of hours used on the total direct labour cost variance is calculated by multiplying the difference in hours between the budget and actual by the standard rate of pay. The result is called the direct labour efficiency variance. That is:

Direct labour efficiency variance = [(50 X 10) – (50 X 12)] X 20

= (500 – 600) X 20

= $2,000 (unfavourable)

The net effect of the rate and efficiency variance

= $600 - $2,000

= $1,400 (unfavourable) Figure 27: Diagrammatic representation of direct labour variances

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Formulas for calculating the three variances are as follows:

Total direct labour cost variance = BC -AC

Direct labour rate variance = (BR - AR) X AH

Direct labour efficiency variance = (BH - AH) X BR

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Example

Sam's Burger Company's budgeted direct labour costs are $20 per hour. Management has established standards per 'equivalent meal', which typically consists of a burger, a drink and a side order. Budgeted labour is 15 minutes per equivalent meal.

During June, Sam's Burger sold 4 000 equivalent meals and incurred a labour cost of $25 000 for 1 200 hours.

Calculate the direct labour cost variance and analyse it.

Solution

Budgeted cost of direct labour = 4 000 X 15 X 20 / 60 = $20 000

Actual cost of direct labour = $25 000

Total direct labour cost variance = BC - AC

= $20 000 - $25 000

= $5 000 (unfavourable)

Direct labour rate variance = (BR - AR) X AH

= [(BR X AH) - (AR X AH)]

= (20 X 1 200) - 25 000

= $1 000 (unfavourable)

Direct labour efficiency variance = (BH - AH) X BR

= (1 000 - 1 200) X 20

= $4 000 (unfavourable)

Check: Total direct labour cost variance

= $1 000 (U)+$4 000 (U) = $5 000 (U)

Causes

Causes of the actual rate of pay differing from the budgeted rate of pay could include:

• hiring employees more/less qualified or skilled than originally intended;

• changing the planned mix of the skill levels of the employees; and

• award, enterprise agreement or market rates increasing since the budget was prepared.

Causes of the actual time taken to complete a job differing from the time it

was expected to take (that is, budgeted for) could include: hiring

employees who are untrained and inexperienced;

• hiring more highly skilled employees than originally intended;

• increasing staff productivity with enhanced training;

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• using high-speed modern machinery or sluggish old machinery;

• changing to new technology of production, or changing the process of production (process re-engineering);

• frequent machine breakdowns;

• unavailability of materials, causing delays; and poor production

scheduling.

Relevant personnel

Human resource and production department personnel Overhead variances and their causes

Overhead variance calculations are more involved than those of material and labour. The complication arises because of the fixed nature of some overhead expenses and the variable nature of others. Fixed overheads, by definition,

do not change with output. Variable overhead expenses generally change directly with the output. It is therefore necessary to calculate variances for the

two types of overhead expenses separately. As overhead expenses are not known precisely when a particular job is costed, an estimate is generally used.

An estimated rate of overhead per unit of output for each type of overhead is calculated by dividing the corresponding budgeted overhead expense by the budgeted number of units produced (or output). The estimated overhead thus calculated and costed by using this rate of overhead per unit is called the recovered overhead. For example, if 1 500 actual units are produced and the rate per unit of fixed overhead is $2 per unit, then the recovered fixed overhead is 1 500 X $2 = $3 000. Similarly, if the rate per unit of variable overhead is

$1.50 per unit, the recovered variable overhead is 1 500

X $1.50 = $2250.

The total fixed overhead cost variance is the difference between the actual fixed overhead incurred and the recovered amount of the fixed overhead. This is composed of two separate variances:

1. the difference between the recovered fixed overhead and the budgeted fixed overhead (this is called the fixed overhead capacity variance); and

the difference between the actual fixed overhead and the budgeted fixed overhead (this is called the fixed overhead expenditure variance).

The total variable overhead cost variance is the difference between the actual variable overhead incurred and the recovered amount of the variable overhead. As with fixed overhead variance, this is composed of two separate variances:

the difference between the recovered variable overhead and the budgeted variable over head (this is called the variable overhead efficiency variance); and

the difference between the actual variable overhead and the budgeted variable overhead (this is called the variable overhead expenditure variance). Calculation

Assuming that: Budgeted fixed overhead costs = $1 000

Budgeted variable overhead costs = $2 000

Budgeted number of units = 1000

Actual number of units produced = 900

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Actual fixed overhead = $1 000

Actual variable overhead = $1 900

Calculate the total fixed and variable overhead cost variances and analyse them.

Solution

Fixed overhead variances

Rate of fixed overhead recovered = $1000/1000 = $1 per unit Total recovered fixed overhead = 900 x 1 = $900

We observe that the fixed overhead has not changed in this instance but may, of course, change in other circumstances. We are assuming that the fixed overhead remains fixed within a relevant range of activity.

The total fixed overhead variance is calculated as the difference between the

recovered fixed overhead and the actual fixed overhead. Total fixed

overhead cost variance = $900 - $1 000

= $100 (unfavourable)

The fixed overhead capacity variance is calculated as the difference between the recovered fixed overhead and the budgeted fixed overhead. That is:

Fixed overhead capacity variance = $900 - $1 000

= $100 (unfavourable)

The fixed overhead expenditure variance is calculated as the difference between the actual fixed overhead and the budgeted fixed overhead. That is:

Fixed overhead expenditure variance = $1 000 - $1 000 =$0

Check: Total fixed overhead cost variance = $100 (U) + $0 = $100 (U).

Solution

Variable overhead variances

Rate of variable overhead recovered = $2 000/1 000 = $2 per unit

Total recovered variable overhead = 900 X 2 = $1 800

The total variable overhead variance is calculated as the difference between the recovered variable overhead and the actual variable overhead.

Total variable overhead variance = $1 800 - $1 900

= $100 (unfavourable)

The variable overhead efficiency variance is calculated as the difference between the recovered variable overhead and the budgeted variable overhead. That is:

Variable overhead efficiency variance = $ 1 800 — $2 000

= $200 (unfavourable)

The variable overhead expenditure variance is calculated as the difference between the actual variable overhead and the budgeted variable overhead. That is:

Variable overhead expenditure variance = $1 900 — $2 000

= $100 (favourable)

Check:

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Total variable overhead cost variance = $200 (U) + $100 (F) = $100 (U). Causes

Actual factory overhead differs from that budgeted, generally when the actual production level differs from the budgeted level. The variance should be analysed only after the budget has been flexed to the production level actually attained.

If there are still variances in the expenditure on various overhead items after the budget is flexed to the actual attained level, they could be due to the following:

• efficiency or inefficiency in purchasing;

• effective or ineffective supervision of labour;

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4.2 Analyse data and information on the effectiveness of financial management processes within the work team and identify, document and recommend any improvements to existing processes.

Restructuring the Budgets

At times it may be necessary to revise the budget for various reasons. The frequency at which the budgets are revised varies from organisation to organisation, and is based on the type of industry, the requirements of the management and the cost of revising compared to the benefits to be derived.

A continued favourable variance does not necessarily mean that there has been good performance. It could be due to an error in budget setting. For example, a production line employee may continually produce well over the allocated quota

of units to earn a bonus for extra production. Similarly, a continued unfavourable variance, despite every effort made to rectify it, may indicate that unattainable budgets are being set. For example, an employee in a different production line is constantly unable to attain the budgeted production numbers even though there is a bonus scheme for producing more than the budgeted quantity.

These facts indicate that the budgets have to be revised to reflect the true situation. Hence, the resulting budget will be a revised one. Some organisations review their budget situation every three months within the framework of the overall yearly budget. This revision of the budget is achieved by detailed discussions with the involved and influenced parties, and the issue is usually raised by the involved parties. The size of the revision is discussed further and agreed upon.

There also could be external factors, in addition to the internal factors discussed above, that may cause a revision of budget. A factor could be competition, where a gain or loss of market share of products by the organisation would lead to an increased or reduced level of operations. An organisation would find it difficult to survive or prosper if it doesn't restructure its budget to react to a slump or boom in general economic conditions.

It may be possible for some organisations to prepare at least three different sets of budgets - one for a worst-case scenario, one for the bestcase scenario, and a third to cater for a realistic, current economic and competitive situation.

A restructured or revised budget is an overall revision of the plan. It is a result of renegotiation with involved parties to restructure the original budgets and plans with a view to optimising the organisation's resources, and thus the organisational performance. These budgets could be referred to as static budgets as they are prepared to cater for only one level of activity and this volume of activity is the organisation's goal. Generally, the static budget has no flexibility, unless it is restructured, as to changes in volume of activity. As opposed to this, a flexible budget to cater for various levels of activities could be prepared to control the situation where various levels of activities are attained by the organisation.

Flexible budgets

The principles of a flexible budget are illustrated by using Budget Swimming Pools Pty Ltd, which is owned by Peter Smith. Peter Smith, an owner-operator, builds

affordable swimming pools and plans for only 12 to be built in a year. The sale price per pool is $20 000. The following is the summary of the performance report for the organisation to the year ending 30 June 200X, when 14 pools were built.

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Figure 28:

Budget Swimming Pools Pty Ltd

Performance Report

(Static Budget) For Year Ending 30 June 200X

This report is difficult to analyse because the static budget is based on 12 pools and the following questions arise:

• Why did the $28 000 unfavourable total cost variance occur?

• Was there any excessive wastage in direct materials, direct labour or other expenses?

The use of a flexible budget helps not only answer questions such as those given above, but also to give effective control.

Flexible budgets are prepared to cater for different levels of operational activities of an organisation. These budgets are used to predict the varying amounts of costs that are expected to be incurred at those differing levels of activity, and to control them. The use of flexible budgets in budgetary control systems to control costs is practical, effective and conceptually justified.

Flexible budgets are prepared by identifying the fixed costs that remain constant at all levels and the variable costs that change as the activity levels change. A variable cost is a cost that remains constant per unit but varies in total with the output. An example of variable cost is the cost per unit of direct material. A fixed cost on the other hand is one that remains fixed in total (within a relevant range) but varies per unit of output, such as the rent of a factory building.

The budget for the level of activity planned by the organisation is the static budget. The budget prepared for any other level of activity is the flexible budget for that level.

The flexible budget formula for total cost at a particular level of activity is stated as follows:

Flexible budget total cost = Fixed costs + (Variable costs per unit X Number of units produced)

Flexible budgets are prepared for Budget Swimming Pools Pty Ltd for the activity levels of 10 and 14 pools, in addition to the static budget level of 12 pools. In this process budgeted fixed costs of $10 000 were identified, thus making the budgeted variable cost per pool $12 000 (ie $12 000 X 12 + $10 000

= $154 000).

Computation of flexible budgets for installing 10 and 14 pools are as follows:

Flexible budget total cost = Fixed costs + (Variable costs per unit X

Static Budget

12 Pools

Actual Results

14 Pools

Variance

2 Pools (F)

Revenue

Total costs

Operating profit

$240 000

$154 000

$86 000

$280 000

$182 000

$98 000

$40 000 (F)

$28 000 (U)

$12 000 (F)

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(for 10 pools) Number of units produced)

= $10,000 + (12,000 X10)

= $130,000

Flexible budget total cost = Fixed costs + (Variable costs per unit X

(for 14 pools) Number of units produced)

= $10,000 + (12,000 X 14)

= $178,000

Budget Swimming Pools Pty Ltd

In the previous performance report the static budget was based on 12 pools, but actual results are for 14 pools. a realistic approach would be to compare the actual results for 14 pools with the flexible budget for 14 pools as shown below.

Figure 30:

Figure 29 :

Sales

Variable costs

Fixed costs

Total costs

Operating profit

Flexible Budget

Per Unit Activity Levels

10 Pools 12 Pools Pools 14

$20,000 $200,000 $240,000 $280,000

$120,000 $144,000 $168,000

$10,000 $10,000 $10,000

$130 ,000 $154,000 $178,000

$70,000 $86,000 $102,000

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A performance report could also be prepared by showing the flexible budget alongside the static budget and the actual results. These sets of data together with the variances would give better information on cost behaviour. A sample report to illustrate this is shown below:

Figure 31:

Budget Swimming Pools Pty Ltd

Performance Report

(Static and Flexible Budget)

For year ending 30 June 200X

From the above report it could be observed that a favourable variance for sales when compared to the static budget becomes nil variance when compared with the flexible budget. This reflects the true situation since two extra pools were installed. The variance for variable costs changes from

Static

Budget Flexible

Budget

Actual

Results

Static Budget

Variance

Flexible Budget

Variance

12 Pools 14 Pools 14 Pools 2 Pools -

Sales $240,000 $280,000 $280,000 $40,000 (F) 0

Variable Costs $144,000 $168,000 $167,000 $27,000 (U) $1,000 (F)

Fixed Costs $10,000 $10,000 $15,000 $5,000 (U) $5,000 (U)

Total Cost $154,000 $178,000 $182,000 $28,000 (U) $4,000 (U)

Operating Profit

$86,000 $102,000 $98,000 $12,000 (F) $4,000 (U)

Budget Swimming Pools Pty Ltd

Performance Report

) Flexible Budget (

For year ending 30 June 200X

Flexible

Budget 14 Pools

Actual result Pools 14

Variance

-

Revenue $280,000 $280,000 -

To tal costs $178,000 $182,000 $4,000 (U)

Operating Profit $102,000 $98,000 $4,000 (U)

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unfavourable to favourable. An unfavourable variance in fixed costs is identified. Though the operating profit is favourable compared to the static budget, when a flexible budget is used the variance becomes unfavourable, thus needing an investigation. It appears that the cause could be the increase in fixed costs, which might be due to an increase in sales volume.

Original or static budgets are invaluable when planning and forecasting for the future, but the flexible budget helps in accurately identifying the 'real' variances

for the past. The absence of flexible budgets might lead the decision makers to wrong conclusions.

It is possible that a flexible budget to suit the actual volume of activity could be prepared at the end of the budget period in order to make a realistic comparison. In the above example, if Budget Swimming Pools Pty Ltd didn't have a budget for 14 pools, it would at the year ended 30 June 200X flex its budget to suit the actual output of 14 pools to make a realistic comparison of actual activity with the budget.

Variances from budget can occur for various reasons. Variance analysis is performed to identify the causes of variances. These causes could be changes in, amongst other things, the material price, the labour rate, and material and labour usage. Management control is the process of taking the appropriate action to remedy a cause or situation revealed by variance analysis.

An appropriate remedial action is arrived at by considering the cause and other factors, such as the organisation's past experience and outside experts' or consultants' advice. Remedial action is taken by different levels of management depending on the responsibility of each level of management. These actions are taken generally in consultation with other involved persons. This is necessary for the action to be effective. Also, the remedial action should be taken as soon as possible to save wastage of the organisation's resources.

At times, the variance analysis may reveal that the assumptions upon which the budget was based are incorrect. Also the plan itself may be found to be wrong. These situations lead to a need for the budgets to be restructured.

Where the variance is because of a change in the actual level of operations as compared to that budgeted, the budgets need to be adjusted or flexed to reflect that activity level.

4.3 Implement and monitor agreed improvements in line with financial objectives of the work team and the organisation

Financial Performance

The budget and financial plans contain the details of the planned allocation of the organisation's resources to achieve the organisation's goals. The outcome of

the activities of the organisation is to be measured and matched against these plans to identify the extent of adherence of the performance to the plan. The

information on the financial performance gathered from properly maintained records within an organisational system is analysed and reported to the target audience in a form and language appropriate to them. Similarly, the non- financial performance is compared against the objectives to identify the

overall organisational performance in this area. As a result of this analysis, the strategies and plans of the organisation may have to be reviewed and updated to optimise the organisational performance.

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Records of Financial Performance

In earlier chapters cost elements were identified and classified as controllable or non-controllable. Operational performances and cost behaviours were also

discussed.

Performance indicators are produced by comparing the actual results with the standards (or benchmarks) or with planned performances. The performance indicators are thus calculated values. To calculate these values, the actual

cost of the input resources that were expended to produce the output and the planned costs have to be recorded. The performance indicators must be disclosed in the form of a report that will be easily understood by any manager who is responsible for an activity and is expected to take corrective measures if unexpected deviations occur. As discussed in the previous chapters, the three cost elements are recorded separately to identify the deviations (or variances).

Recording costs

The basic recording is explained in the following situation, in which a product is manufactured at the request of a customer.

The identification process of a particular job, especially when a number of jobs are carried out simultaneously, is achieved by assigning a job number to each job. The segregation of jobs leads to the determination of profit or loss on each job (that is, performance outcome), and therefore it is essential that each job is

continuously identifiable as it passes through various manufacturing processes, particularly when the raw material changes form or shape. The

product may also pass through a number of different cost centres during production.

A cost centre is a physical area in which one or more persons and pieces of machinery are operating and performing tasks in connection with the production of goods or the provision of services. Sometimes a single person or a piece of equipment can be treated as a cost centre, depending on whether or not management has to control costs closely.

The cost identification of a job is facilitated by gathering the costs incurred on the job at each cost centre and by using job order numbers. These gathered costs are generally grouped as direct material, direct labour and overheads, and the grand total of these gives the total cost.

Example

When a customer places a manufacturing order, it relates to the quantity of finished units to be delivered. A job number is allocated for either a single unit or a batch of units of production. This allocation depends on the convenience of the manufacturer, the complexity of the product and the time it takes to complete production.

Suppose that the order is for 10 chairs and 50 desks. Here each item may have a job number allocated. If, for instance, there were two orders - one for 10 chairs and another for 20 chairs - one job number consisting of 30 chairs may suffice, as the two jobs are similar. The costs for a job are recorded on a cost sheet, which is designed to show details such as quantity, unit price and total value for each of the cost elements, direct material, direct labour and overheads. Figure 32: Job Cost Sheet

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The maintenance of cost sheets involves a considerable amount of clerical work, but computers may reduce this burden.

The material cost information is initially recorded on inventory records when the materials are purchased. The cost of direct materials used is recorded on the job cost sheet from the material requisitions note.

The labour costs are initially recorded in detail on payroll records and time sheets and the n summarised on payroll analysis sheets.

Similarly, various overheads such as indirect materials and indirect labour

already recorded elsewhere are extracted and an overhead analysis sheet is prepared.

JOB COST SHEET

Customer ……………………. Customer Order No ………... Job Number

……………........ Job Description:

…………………………………………………………………………….………….

Material Labour Overheads

Qty Price Value Qty Price Value Qty Price Value

$

$

$

$

$

$

Total Total Total

Job cost summary $

Materials

Labour

Overheads

TOTAL COST

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The direct labour and overheads are recorded from the payroll analysis sheet and overhead analysis sheet respectively, onto the job cost sheet.

Direct versus indirect costs

In collecting cost information, there has to be a decision on the classification of costs. The nomination of costs as direct or indirect usually reflects the arrangement of work within an organisation. One organisation may classify costs such as

labour costs as direct costs, but another organisation may see the same costs as indirect costs because of how the work is structured.

Take the case of maintenance staff who carry out routine maintenance on designated machinery. This cost might be treated as a direct cost. Another organisation might employ staff as maintenance staff who move around the organisation. The maintenance staff salaries, in this case, may be treated as indirect costs. The decision to classify maintenance costs as direct or indirect may reveal how an organisation views such costs. One organisation may believe it is important to charge all costs to a particular section as a direct cost; while another may determine that such costs are an overhead or indirect cost of its operations. The different approaches to the classification of cost will affect the information gathered and the decisions made based on that information.

Analysis of material costs

Direct material costs are material costs that are clearly identifiable as forming part of the goods manufactured or services provided. The cost of wood used in

furniture manufacture, and the cost of sheet metal for tank building, for example, are direct material costs. Similarly, in service organisations such as plumbing, copper tubing is a direct material. Materials that are used in manufacturing goods or providing a service, and which cannot be directly attributed to a finished product or service but are nevertheless essential, are called indirect materials. Nails, glue, lubricants, cotton thread and welding rods

are examples of indirect materials. The materials are issued on the authority of a materials requisition note, which is also used to record the cost of direct materials issued, the job number to which these materials are issued, and whether any issued materials are indirect materials. The cost of direct materials is transferred to the job sheets. The cost of indirect materials is added with other overheads, such as indirect labour, and then transferred to the job sheet on a proportionate basis.

Analysis of labour costs

The salaries and wages paid to employees for a period can be for a variety of work performed during that period. Some may work directly on producing an item

or performing a service. Others may be contributing indirectly to the production or the services performed. That is, there are direct and indirect kinds of labour. The

indirect labour has to be isolated, as it forms part of the overhead costs. Apart from salaries and wages, there are other costs, such as overtime premiums, sick pay and holiday pay. Workers may not do any productive work when there is a

machine breakdown, power failure or a shortage of material, all of which are beyond their control. However, they have to be paid for this period, and this pay is called idle-time pay. These are all indirect labour costs.

The following grid shows how the various employees' labour costs can be analysed to isolate the direct labour cost of each job and the indirect labour costs that are to be included with other overhead costs.

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Figure 33: Payroll analysis Sheet

Payroll Analysis Sheet – Department X

For the week ended ………………………………..

Direct Labour Indirect Labour Total

Labour

Employee Jobs Total

Pay

O/time

Prem.

Sick

Pay

Holiday

Pay

Idle

Time

Total

J1 J2 J3 J4

$ $ $ $ $ $ $ $ $ $ $

A. Atkins 160 144 160 160 624 60 16 76 700

B. Ballard 192 144 336 72 24 24 120 456

C. Carter 240 210 450 112 112 562

D. Dallas 612 612 0 612

TOTAL 980 1050 1170 2010 5210 220 90 310 70 690 5900

Analysis of overhead costs

Some overhead costs are directly incurred specifically for a cost centre, while others are incurred for the benefit of a number of cost centres. The latter common costs have to be apportioned to the various cost centres on some equitable basis. This basis may be the area of space occupied by different cost centres, the capital invested in these centres, or some other logical basis decided by the managers. There may also be service cost centres whose costs

may have to be reallocated to the main cost centres, such as production cost centres. These allocations are carried out on an overhead analysis sheet, a sample of which is shown below

Recovery of overheads

When completing a job cost sheet, the overheads applicable to the job have to be calculated and inserted. The actual overheads are seldom known when a job has to be costed. To overcome this problem, an overhead cost absorption method based on

budgeted figures is employed. For example, the overhead budget for a cost centre may be $ 1,200 for a year, and the budgeted number of similar units to

be completed may be 10 for the year. This would give us a budgeted overhead cost of $120 per unit. Instead of the number of units being the budgeted activity, it is possible to express the activity in terms of the number of direct labour hours or number of machine hours expected to be worked by that cost centre. In such

cases, the overhead rate is expressed as so many dollars per direct labour hour or per machine hour. Otherwise, the overhead rate can be expressed as a percentage of direct labour cost or direct material cost. This percentage is obtained by dividing the total budgeted overhead cost for the cost centre by the budgeted direct labour cost or direct material cost, depending on the rate required. Figure 34: Overhead analysis sheet

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Overhead Analysis Sheet

Period …………………………….

Overhead cost Basis of allocation Cost

centre

Cost

Centre

Cost

Centre Total

Indirect materials Direct materials cost 200 100 150 450

Indirect labour Direct labour cost 1,800 1,400 1,600 4,800

Rent Area 3,000 2,000 1,000 5,000

TOTAL 5,000 2,000 2,750 10,250

Once the budgeted overhead rate is known, the amount of overhead to charge to the job is obtained by multiplying the actual activity (units, direct labour hours, machine hours, direct labour cost, direct material cost, as appropriate) by the appropriate budgeted overhead rate. This method of charging overhead is referred to as overhead recovery. The total recovered overhead is likely to differ from the actual overhead incurred during the year. The difference is treated in the profit and loss account at the end of the year as an expense or an income, depending on whether it is an under-recovery or an over-recovery.

The following examples will make the above overhead recovery concept easy to understand.

Example-1

A company's budgeted overheads for the year are $2,800 and the number of units to be produced is 1,400, utilising 700 direct labour hours. Calculate the overhead recovery rate based on: a. the number of units

b. direct labour hours.

Solution

a. Overhead recovery rate per unit = $2,800 ÷ 1,400 = $2

b. Overhead recovery rate per direct labour hour = $2,800 ÷ 700 = $4

Example-2

If the company in the example above actually produced 1,300 units, utilising 750 direct labour hours, how much overhead will be recovered, based on:

a. the number of units

b. direct labour hours?

Solution

a. Recovered overhead = 1 300 X 2 = $2,600,

b. Recovered overhead = 750 X 4 = $3,000.

Example-3

Referring to the above examples, calculate the overheads under- or overrecovered in each case.

Solution

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a. Under-recovery = $2,800 - $2,600 = $200.

b. Over-recovery = $3,000 - $2,800 = $200.

Reporting

The completion of the cost sheet by recording the costs of producing a batch of a product enables the determination of its total cost. When the total cost is

divided by the units in that batch, the result is the cost of a unit of product (that is, unit cost).

The unit cost is reported to the manager responsible. The report should include the planned costs and the output achieved. A comparison of the actual costs and planned costs is made to identify the variances, and these are included in the report to help management carry out the control function. Financial Performance Reports and Contents

Performance reports can serve as records of achievements, or the presentation of an analysis that compares achievements with plans - information for decision making.

The record of achievements (basic performance report) contains only the actual outcome: input as well as output. Information about the activity of the organisation is gathered from these reports; they do not provide any information that is useful for management control or planning.

A report becomes useful only when it combines information on actual outcome with information on planned outcome. A deviation or variance analysed by using these two sources of information helps management to make a decision on remedial action. The basic information combined with the planned outcome showing the trend and the extent of realisation of the overall objective helps the organisation to plan its future activity.

An ideal performance report provides expert information that helps in management decision making and encourages corrective action. The objective of the report should be to provide concise yet complete and relevant information, not high-volume irrelevant information. The format of a performance report should be such that the presentation is easily understood and enhances the user's capacity to carry out their role efficiently and effectively.

The report should also fulfil the expectations and perceptions of the recipient. Senior management should identify the information needs of junior management when a report is intended for them, and make sure that it fulfils these needs.

The fulfilment of these needs by the reports should be measured by tracking the outcomes of the decisions made by junior managers and matching them with the expected outcomes.

It should be reiterated that an ideal report should be:

• Complete - everything needed to make a decision should be included in the report.

• Accurate - it should reflect the true picture.

• Authentic - it should originate from a credible source.

• Forward looking - it should point the way forward.

• Understandable - the language and visual aids used in the report must be easily understood by the user of the report.

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• Timely - it should be available at a time of decision making.

Information from reports

Reports can be periodic, progressive or specific. A periodic report is prepared at predetermined regular periods, to reflect the outcome of the organisation's activities for that period. It may contain only basic information - that is, a basic record of activities

(for example, the number of customers visited by a salesperson). Alternatively, an additional analysis of the activities, based on targets, included with this report

will assist the users in decision making - for example, a comparison of the number of visits made against the planned visits by a salesperson and average value of

sales made per visit. An example of a periodic report is a weekly production (quantity) report.

A progress report, though similar to a periodic report, is prepared at infrequent intervals, determined as the time lapse between significant achievements.

The timetable for the future work and completion date are also provided in the progress report, which is generally produced for a project - for example, a

report on the progress of a highway's construction. A specific report is produced by special request to highlight a specific situation of interest to the recipient - for example, a report identifying the number of potholes that appeared over a

new stretch of highway within two months of its opening.

The information in reports should address the needs of both the receiver and the creator. Note that in the case of a periodic report, it is difficult to identify a creator since the report is produced by someone who produces reports as part of their routine tasks. In this case, the person who caused the existence of these reports is the creator.

Reports should be user-friendly, presenting information in simple language and at a level appropriate to the knowledge of the recipient. Charts, graphs and pictures may help to make the information easily understood. The contents of the reports should be arranged and styled to conform to a standard pattern for the organisation and the industry. An example of a standard report is a budget report showing budget figures in the first column, actual figures in the second column and variances in the third column. A budget report by another organisation might show the actual figures in the first column and the budget figures in the second column. Some reports show the variances as favourable or unfavourable (adverse); others describe the variances as positive or negative.

Routine reports (periodic and progress) are generally produced with the aid of computers. Most of the basic data, such as on targets or budgets, are stored in the computer and the actual outcomes of the activity are either fed into or captured by the computer. On command, the computer produces a report in a predetermined format. The report should be closely scrutinised before releasing it to the user, as any non-validated or misfed data might provide incorrect information.

Report deficiencies

The gap between the requirements of the recipients and the actual presentation, style and contents of the report is a deficiency of the report. A deficiency could also arise if the purpose

intended by the creator of the report is not fulfilled by the information conveyed by the report. The following points give an insight into the reasons

for content and other related deficiencies. These are examples only and the list is not exhaustive.

• Relevant and important information is omitted. The 'importance' of the information is subjective; the creator of the report may disagree with the user about its relevance and importance, due to different personal

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management styles. It may be necessary for the creator and the user to discuss the importance of the information.

• Irrelevant or unnecessary information is included. 'Irrelevancy' is, again, a subjective issue here, and may require discussion.

• The title of the report is misleading. If, for example, the report was modified, the title may no longer reflect the contents.

• The subheadings are inappropriate. For example, the column heads may not reflect the information conveyed in those columns. This again might be a result of modification.

• The format is wrong. For example, it may not be suitable to the level of the user. A picture format is suitable to show trends, though not for variances. For a report presented in picture form, the scale should be accurate according to the numbers it represents. Any attempt to add artistic imagination to the picture may distort the information.

• There are unwanted attachments that do not convey new information or assist in understanding the reports.

• Attachments are missing. The omitted material may clarify or convey supplementary details.

• Computer outputs haven't been checked. A report produced by an automated computer system must be critically reviewed for input errors.

• The wrong reporting system is used. The desired features or formats may not be achieved due to an unsuitable accounting/reporting software package.

• Information is duplicated. Two reports producing information may overlap. For example, the year to date budget report and the monthly budget report carry the same information on the monthly expenses. This may happen if the reports are created at different times to suit the specific information needs of certain users. In this case, the first report could have been modified instead of creating a new report.

Deficiencies are rectified by making changes to a report that will satisfy the requirements of the recipient or by making additional reports to cater for their requirements.

Deficiencies in the contents of reports are rectified by modification to the existing reports using one or more of the following:

• additional information;

• deletion of redundant information; and/or

• adjustment to existing information - for example, changing the format.

The improvements made by adding or deleting information and by adjusting a report's style may not fix all the deficiencies. Additional reports may solve this problem. The need to develop additional reports might arise as follows:

• The information is more detailed and cannot be incorporated in the existing report. A supplementary report (or several) may provide extra details and can be distributed only to users who need these details.

• An existing report, even when adjusted, might not necessarily be useful to current users and may result in information overload. In this case, an additional report for certain users will be more appropriate.

• An improvement to the present format might be suggested - for example, graphical representation to supplement numerical representation. Here, again, the needs of the relevant users might differ, so an additional report might be useful.

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• An aggregate or summary of a report may be required. If management does not want an open display of this aggregate, for fear of information reaching competitors, it can be confined to an exclusive report for the management.

• Additional information of high managerial value may be required, which is not included in existing reports.

• Changes may occur in the legal requirements of performance reporting - for example in the annual published reports as required by the Corporations Act.

• A change of format might make a report more user-friendly, but also might make it hard to relate to the original format.

Timing of reports

The internal performance report is a management tool used for planning and controlling the affairs of the organisation, and is prepared at intervals decided

by the management according to its needs. The management also decides the timing of its release after giving due consideration to human and other resources, to the facilities available for preparing the report and to the needs of the recipient.

Regular reports must be timed so that they assist management control. That is, timing should ensure that remedial action can be taken before the situation

changes. A delayed remedial action will not have the desired effect on the situation because this may have changed in the meantime. Special reports should always be prepared as soon as an error occurs - the sooner the better for management control. Therefore, every effort should be made to improve on the current timing of reports, bearing in mind that the cost incurred by improving the timing should not exceed the potential benefits. The appropriateness of the timing, and whether any more improvement could be made, could be determined by comparing the timing with a benchmark. For example, if a leading company prepares a particular report within five days and if we take eight days to produce the same report, there is obviously room for improvement in our company.

Distribution of reports

The recipients of reports are usually nominated staff who hold positions of responsibility and who are expected to take remedial action or other appropriate decisions based on the reports. Sometimes reports might be distributed to staff to whom they are not useful, and staff who should receive reports might be left off the distribution list. These situations may arise as a

result of matching the distribution to staff names instead of positions; or an organisational restructuring could have taken place, so that the titles of

certain positions remain unchanged but the responsibilities change significantly. Once these anomalies and/or changes are identified, a new distribution list should be created and adhered to. This new list must then be continually reviewed to ensure that all reports are distributed in an efficient manner.

Other issues

Operating performance reports are generally 'adjusted' according to successive higher levels of responsibilities within the organisation. For example, a technical report to a senior executive or to a government department minister will be more useful if the key points are presented in a summarised form using non-technical language. Alternatively, technical staff

might like to have detailed technical reports for their use. It is better to append explanatory material separately so that the recipient may refer to it if they

need to know how certain figures were arrived at.

The non-financial reporting requirements could differ from one activity to another. However, the need for financial information will be the same for all

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activities and would generally capture items such as the cost of operations, capital invested and the efficiency of asset utilisation.

Any improvement to the reports should be a continuous process, and this is achieved by a regular critical review of them. This process needs commitment from the highest management level.

Reporting Non-Financial Objectives

Plans of an organisation are not limited to quantitative items where dollars and units only are involved, as in the case of budgets. The qualitative factors or non-financial

objectives also play an important part in the planning process of an organisation. These could be legislative standards or self-imposed standards.

Some examples of legislative standards include environmental issues and occupational health and safety.

Self- irnposed targets are set to control certain aspects of the organisation's performance that may result in its successful operation and include targets for quality standards, market share, customer service and security.

Generally, the non-financial objectives cannot be directly measured. For example, customer satisfaction could only be measured by indirect methods such as the number of complaints or compliments received on a particular type of service, or the increased sales of a particular item in the case of a trading item. Therefore, targets set for indirect items would reflect this situation. For example, in the case of a provision of service, if the organisation receives complaints from more than 5% of customers who received that service, then the organisation should be concerned about the process of providing this particular service. Again the level of complaints should also be categorised for any decision making, as any serious complaints would not be treated the same as minor complaints.

The legislative standards to be complied with are set by federal, state or local government legislation. For example, with regard to environmental issues, there are certain standards set by legislation for effluent or byproducts that some industries must conform to. An organisation could set its own standards higher than the standards required by legislation. It is not uncommon for organisations to set certain standards on environmental issues of their own where there is no legislation yet for reporting. The measurements of actual quality of effluent, for example, could be reported against the standard to monitor the effect of this effluent on the environment. Another environmental issue for which a target could be set is the restoration of a site to its natural state. For example, open-cut mines could be reforested once production is complete. Targets for an area to be reforested and a time frame could be set by the mining organisation, which could then report on the actual outcome. Since environmental issues are vital for the general public, organisations feel proud and report their achievements in their annual reports as a means of marketing themselves.

Occupational health and safety regulations that set certain standards for the working environment and working conditions are other legislative factors. Occupational health and safety issues are monitored by recording various incidents like accidents and complaints from staffer customers, and inquiring into these matters to identify any breach in the governmentimposed standards. Here again, the standards of an organisation could be set higher than that imposed by legislation. Recording, analysing and categorising of all the incidents and complaints - whether minor or major - would lead to taking remedial action to prevent them happening in the future.

Self-imposed non-financial objectives generally assist an organisation to build its general image with the public and thus in turn assists its objectives.

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Quality plays an important part in an organisation's existence. Customers expect a quality product or service at a reasonable price. Many customers

are prepared to pay a premium price for a superior quality product or service as they expect to save money in the long run. Both quality and customer service are

customer-related factors. The improved quality of a product is a factor that increases customer satisfaction. Changes to work practices in a service industry could either improve the quality of service or marginally decrease it, affecting the customer satisfaction in one way or another. For example,

reducing the number of service counters in a supermarket may lead to long queues and unhappy customers.

The quality of products or services could be identified only by a customer survey. It is usual for most service organisations these days to make follow- up calls after a service is provided to their customers. Product quality is measured through a general customer survey. The results of the surveys are reported for action by the organisation. Customer service could be negatively measured by analysing the complaints received from the customers. Though there could be a few compliments from customers, these could not be completely relied on. The reported analysis of customer satisfaction leads to remedial action. Customer satisfaction and quality generally lead to an increase in the organisation's market share. The market share is determined by matching the external published reports on total market revenue etc. with internally generated sales reports.

Employee-related factors could be another area of non-financial objectives for an organisation to consider. Employee satisfaction keeps the productivity level up. Dissatisfied employees are wasted resources. Changing work practices or a decision to lay off employees without a proper consultation process generally lowers staff morale. The employee satisfaction level might be reflected in employee absenteeism. A highly satisfied staff means fewer unapproved absences. The absences measured and reported should indicate the employee satisfaction level.

Another report which could highlight the employee satisfaction level is the staff turnover rate. The reported staff turnover rate, particularly in large organisations, shows the satisfaction level of staff from different sections. Dissatisfied staff cost the organisation in terms of delayed delivery of a product or service, which might lead to dissatisfied customers and thus a loss of future sales. A high staff turnover costs the organisation in terms of training and developing new staff. Security is another area where an organisation should focus as it affects overall organisational performance. The loss of physical assets costs money to the organisation. The basic loss generally involves inventory of goods for sale or for provison of service. This inventory could be stolen by outsiders or pilfered by the organisation's own staff. The reports of unaccounted loss of inventory in an organisation should lead to an inquiry and an increase in the security levels, which prevents both outsiders as well as staff from removing goods without authorisation. The reports on the analysis of various incidents of theft also assist in securing the stock. Similarly, other physical assets such as equipment used by an organisation in production or provision of services should also be safeguarded. Reports on various breaches of security and/or incidents of fire, whether minor or major, should lead to steps being taken to avoid future major incidents.

Organisations depend on computers for their operations. Computers could be used for maintaining very basic financial and other records, or employed in complex situations such as computer-aided production. Security should be in place to safeguard computer equipment as well as to prevent it being hacked or attacked by computer viruses and worms. Such incidents could mean a delay in the supply of goods or the provision of services. This would be very serious in an organisation such as an accountant's office, where the provision of service is solely dependent on computers. Also,

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safeguards should be in place to ensure that the software used in computers is not accidentally or deliberately corrupted or destroyed. All incidents regarding

computers should be recorded and reported for appropriate action.

Proper and timely reports on non-financial objectives, and timely and appropriate actions taken, improve overall organisational performance.

Revision of Strategies and Plans

An organisation decides its strategies based on its objectives and the opportunities available. Tactics are developed to fulfill those strategies. The

tactics lead to the development of budgets and other plans, which allocate the resources of an organisation for its activities to optimise the organisational performance. The actual performance of the organisation or sections of it are reported against the budgets and other plans. The reported variance and

their trends reveal either under-performance or over-performance of various sections of an organisation, or that of the organisation as a whole. These deviations from the plan could be due to either errors in forecasts on which

the plans were based or due to changes in the environment, such as legislative changes, which were not contemplated when plans were made.

It could be identified from the reports that differing levels of performance of different sections of an organisation could be due to errors in original planning in allocating resources to various sections. An over-performing section might be over-resourced while an under-performing section might be under-resourced. Conclusions as to resourcing are arrived at only after taking all other remedial action to increase the under-performing section's level of performance. Once it is identified that the inequity in resourcing is the cause of differential performance, it is necessary to reallocate resources to balance the performances so as to optimise the organisational performance as a whole. Therefore, the operational plans need to be revisited and updated. If it is revealed, on analysing the reports, that there were errors in the forecast on which the plans were based, the plans are to be revised using the revised forecast. If there were unforeseen environmental changes that caused variances, then the new environmental conditions should be taken into consideration when revising the plans. To effect the changes in operational plans it may be necessary to review the tactical plans and make changes to them. In this process, it might be necessary to review the strategies and modify them to optimise organisational performance.

Changes to strategies and tactics are triggered not necessarily only by trends in reported variances. Environmental changes such as new government legislation, increased/decreased competition, or developments in the world or local economy would also trigger changes in the strategies of an organisation to defend its continued existence. An organisation that does not respond to the changes in the environment by changing its strategies will not survive long.

Generally, long-term strategies and plans cover a long period, say, five years and short-term ones cover a year and are divided into quarterly or monthly plans. An organisation should not wait to review its strategies until its long- or short-term plans are due for review. The strategies and plans should be continually reviewed. Successful organisations make fixed plans for only a very short period and continually review their plans for other periods. A technique known as a 'rolling budget' is usually employed by organisations where budgets are prepared for each month or quarter and added together to form a budget for 12 months. As conditions affecting the budgets become more certain closer to the period for which they are prepared, the budgets for that period are updated to cater for such conditions, and also the budgets for the following periods are modified to suit these changes. Thus, the 12-month budgets are constantly updated by adding a further period and deleting the period that has just passed.

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Financial Performance

Financial performance must be recorded in a logical form that reflects the users' need. This information should conform to the nature of the organisation's activities and be useful for decision making. Costs

are generally recorded in three groups: direct material, direct labour and overhead costs. Each of these costs is analysed separately and put together on a job cost sheet, which on a single job is identified by a number. A job consists of a single item or a number of similar items. There are different methods of recovering overheads to arrive at the actual cost of a job. Actual cost incurred is matched with the planned cost to assist the cost control function.

The financial performance of the organisation is reported by comparing the actual and planned outcome of an organisation's activities. A report is useful to the reader only when it reports on the specific area that requires review, provides the appropriate details for decision making, is produced in time for important decisions to be made, and is in a format and language that are easily understood by the users. These reports should be free of deficiencies, such as the omission of relevant information, the inclusion of misleading or irrelevant information, inappropriate titles, a user-unfriendly format, unwanted attachments, the omission of necessary attachments and the duplication of information. An organisation may need to develop and present new information or present information in a different way. This need calls for additional performance reports if they cannot be incorporated in the existing reports. There is always a need to monitor the usefulness, reliability and timeliness of performance reports. The distribution list should also be revised regularly to ensure that the correct people are receiving the reports.

Not only quantitative items but also qualitative non-financial objectives need to be monitored and reported. The reports reveal the overall performance of the organisation. The reported items include legislative standards, such as environmental issues and occupational health and safety issues. It is not uncommon for organisations to set higher standards on these matters than the ones imposed by legislation. Organisations report their achievements to the public through annual reports. The reported items may also include self- imposed targets, such as customer satisfaction and employee-related factors.

It is also vital for organisations to review their strategies and plans, and modify them if all other remedial actions fail to bring the performance into line with existing

plans. The failure to achieve plans could be due to an inappropriate strategic plan and/or inappropriate distribution of resources in the plans. The review of

strategies and plans could also be triggered by changes to the environment, such as new government legislation and increased/decreased competition. For it to be successful an organisation should continually review its strategies and plans.

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Glossary

Accounting:

The classification and recording of monetary transactions

and the presentation and interpretation of the results of

those transactions for decision making.

Accounting standards:

The concept that accounting information relates only to the

activities of the business and not to the activities of its

owner(s).

Accounting period: The time period covered by the accounting statements of

an entity.

Accounting rate of return: The average annual profit expressed as a percentage of

the original capital investment.

Accounting standards:

An authoritative statement of how particular types of

transactions and other events should be reflected in

financial statements to give a true and fair view.

Accounts payable: The money owed by a business for purchases made from

suppliers of goods and/or services.

Accounts receivable The money owed by customers to a business in respect

of the sale of goods and/or services.

Accrual-basis accounting: An accounting system that recognises revenue when

earned and expenses when incurred regardless of when

the money is exchanged.

Accrued expense: The payment not yet made for an expense already

incurred.

Accrued revenue:

The payment not yet received for goods delivered or a

service already performed.

Accumulated depreciation:

That portion of the original cost of a non-current asset

written off as a depreciation expense to date.

Activity-based budgeting:

A method of budgeting based on an activity framework

and utilising cost driver data in the budget-setting and the

variance feedback processes.

Ad-hoc report: A report prepared as and when required.

Annuity: Equal amount of receipts (or payments) at equal intervals

of time.

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Assets:

The items of value owned by a business that would be of

benefit in the future.

Audit: A systematic examination of the activities and status of

an entity based primarily on the investigation and

analysis of its systems, controls and records.

Balance sheet:

A statement of the financial position of an entity at a

given date disclosing the assets, liabilities and

accumulated funds, such as shareholders' contributions

and reserves, prepared to give a true and fair view of

the financial state of the entity at that date.

Benchmarking:

The comparison of activities to world class best

practices or the establishment, through data gathering,

of targets and comparators to identify relative levels of

performance.

Benefits/cost ratio:

A ratio that compares the benefits of a proposed

solution with the total cost of initial investment and

operating costs.

Break-even point: The level of activity at which there is neither a profit nor a

loss.

Bridging finance: Supplementary finance made available on the evidence of

a main borrowing.

Budget:

A quantitative statement, for a defined period of time,

which may include planned revenues, expenses,

assets, liabilities and cash flows.

Budget period: The period for which a budget is prepared; it may be a

year, a quarter, a month or a week.

Capital expenditure: The expenditure on long-lived assets.

Capital rationing:

Allocating limited capital funds among competing

projects in order to maximise the total net present value.

Capital reserves:

A major owner's equity classification that shows the

unrealised profit resulting from capital accretions and

indicates the limitations placed on directors of a company

to make distributions out of it.

Capital structure: The mix of different forms of capital employed by a

business.

Cash-basis accounting: Accounting system that recognises transactions only when

cash is received or paid.

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Cash budget (cash flow plan): A detailed budget of cash inflows and outflows

incorporating both revenue and capital items.

Cash flow statement: A statement that shows cash inflows and cash outflows

during an accounting period.

Cash inflows: The cash receipts from operations.

Cash outflows: The cash outlays on projects and operations.

Chart of accounts: A list of all the accounts and their identifying numbers in

the ledger.

Collection period: The average number of days it takes to collect accounts

receivables.

Commercial bills:

The bills of exchange (described also as accommodation

bills or trade bills) that are documents prepared by the

seller and accepted by a buyer as a promise to pay the

seller a certain sum of money on a specified due date.

Compound interest:

The interest obtained by adding separate interests for

several periods, the principal and interest for one period

becoming the principal for the next period.

Continuous action control:

The making of adjustments periodically to bring the

business back into line if deviations occur, in order to meet

its objectives.

Contribution margin: The excess of sales value over variable expenses during

an accounting period.

Controllable costs: Costs that are heavily influenced by a manager.

Cost-benefit analysis: A model that calculates the benefits/cost ratio of possible

alternative solutions.

Cost centre: An area (or division) of an organisation where costs are

conveniently accumulated.

Cost drivers: Activities or factors that cause a change in the level of

costs.

Cost of capital: The cost of finance employed by the business.

Cost of goods sold: The cost of the inventory that a business has sold to its

customers during a given period.

Current assets: A business' cash and its other assets that are convertible

to cash within one year.

Current Liabilities: Business debts that are payable within one year.

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Current ratio: The ratio of current assets to current liabilities.

Debenture: A document that acknowledges a long-term loan obtained

at a fixed interest rate.

Depreciation: The expense associated with the spreading of the cost of

a non-current asset over its useful life.

Direct costs: The costs that can be economically identified with a

specific saleable cost unit.

Direct labour cost variance: The sum of the direct labour rate variance and the direct

labour efficiency variance.

Direct labour costs:

The labour costs (that can be economically identified with

a product) incurred on employing workers who transform

raw materials into finished products.

Direct labour efficiency

variance:

The variance in direct labour costs that occurs when hours

of labour actually worked differ from those budgeted for.

Direct labour rate variance: The variance in direct labour costs due to the actual rates

of pay differing from those budgeted for.

Direct material cost variance: The sum of the direct material price variance and the direct

material usage variance.

Direct material costs: Cost of materials that become part of a product and can be

easily traced to the product.

Direct material price variance: The variance in direct material cost due to price

differences.

Direct material usage variance: The variance in cost that occurs when quantity of direct

material actually used differs from the budget.

Discounted cash flow: An amount obtained by discounting a future cash flow.

Discounting: Converting a future cash flow to present value using an

assumed interest rate.

Dividend: The periodic payment of cash by a company out of its

profits to its shareholders.

Double entry rule: The rule in accounting that every debit entry in an account

must have a corresponding credit entry in another account.

Earnings per share: The amount of after-tax profit earned by a company for its

ordinary shareholders in a year.

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Expected value: The product of the probable value of an outcome and its

probability of occurrence.

Expense: A decrease in owner's equity that results in the course of

delivering goods or services.

Factoring:

A short-term borrowing backed by accounts receivables

whereby the borrower sells the accounts receivables to a

factor.

Fees revenue: The revenue collected by service industries by charging a

fee for the services rendered.

Finance leverage: The percentage change in after-tax profits that results from

a change in earnings before interest and taxes.

Financial budget: A business plan expressed in financial terms.

Financial performance

indicators: Monetary measures of business performance.

Financial report: A business' report that deals mainly with its financial

performance in a given area for a given period.

Financial statements: Summaries of accounts to provide information to

interested parties, whether internal or external.

First-in first-out: The principle that the oldest items or costs are the first to

be used.

Fixed cost:

A cost which is incurred for an accounting period, and

which, within certain output or turnover limits, tends to be

unaffected by fluctuations in the level of activity.

Fixed overhead cost variance: The difference between actual fixed overhead costs and

absorbed fixed overhead costs.

Fixed overhead expenditure

variance:

The difference between actual fixed overhead costs and

budgeted fixed overhead costs.

Fixed overhead volume

variance:

The difference between budgeted fixed overhead costs

and absorbed fixed overhead costs.

Flexible budget:

A budget which by recognising different cost behaviour

patterns is designed to change as the volume of activity

changes.

Forecast:

A prediction of future events for planning purposes.

Gantt chart: A chart that shows the sequence and duration of each

activity within a project.

Gearing ratio:

The ratio of long-term debts of a business to its equity.

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Goods and services (GST):

tax An indirect, broad-based consumption tax.

Gross profit:

The excess of sales revenue over cost of goods sold.

Gross profit ratio:

The ratio of gross profit to sales.

Historical cost: The original acquisition cost of an asset, unadjusted for

subsequent price or value changes.

Horizontal analysis: The comparison of proportional changes in a specified

item of financial statements from one period to another.

Independent project:

A project that is not dependent on another project.

Indirect cost:

An expenditure on labour, materials or services that

cannot be economically identified with a specific saleable

cost unit.

Industry code of practice:

A set of standard practices followed in an industry.

Influenced parties: Decision makers at the point of activity whose actions

affect the budget.

Internal rate of return: The discount rate that makes the net present value of a

project equal to zero.

Internal reporting: The formal reporting between inter-departmental

managers of a business.

Inventory:

The stocks held of goods for sale by a trader and stocks

of raw materials, finished goods or work in progress in

the case of a manufacturer.

Inventory turnover: A ratio that measures how many times a business sells

its average level of inventory during a year.

Investment centre: A cost centre that has a heavy investment of resources

such as machinery.

Just in time inventory: An inventory management system that aims to do away

with all inventories held.

Labour turnover: The frequency with which staff leave their employment.

Ledger: A collection of accounts, maintained by transfers from the

books of original entry (or journals).

Leasing:

The owner of an asset, called the lessor, allows another

party, called the lessee, to use the asset over a period for

an agreed regular payment.

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Liabilities: The amounts owed by a business to individuals or

organisations outside the business.

Liquid ratio: The ratio of current assets easily convertible into cash to

current liabilities.

Management by objective: A set of goals formulated by a work group to be achieved

during a forthcoming period.

Margin of safety:

The units sold or expected to be sold, or sales revenue

earned or expected to be earned above the break-even

point.

Master budget:

The budget into which all subsidiary budgets are

consolidated, normally comprising the budgeted profit and

loss account, the budgeted balance sheet and the

budgeted cash flow statement.

Mutually exclusive projects: Two projects where the adoption of one project rules out

the adoption of the other project.

Net present value: The present value of cash inflows less present value of

cash outflows

Net profit: The excess of total revenues over total expenses.

Net profit ratio: The ratio of net profit to sales.

Network diagram: A diagram that depicts the order in which various activities

in a project are performed and their duration.

Non-controllable costs: The costs over which a manager has no significant

influence.

Non-current assets: Assets other than current assets that are acquired and

kept in a business for long-term use.

Non-current liabilities: Business debts that are not due and payable within one

year

Non-financial budget: A budget prepared for items, such as units produced and

units sold, which is not expressed in monetary terms.

Non-financial

performance indicators: Non-monetary measures of business performance.

Non-financial report: A business' report that deals mainly with its performance

in some or all areas other than finances in a stated period.

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Operating cycle:

The total time taken to convert inventory to accounts

receivable and the time taken to convert accounts

receivable to cash.

Operating expenses: Expenses other than the cost of goods sold incurred by a

business during a given period.

Operational plan: The fully detailed specifications of actions aimed at

achieving the operational goals of an organisation.

Opportunity cost: The value of benefits sacrificed when one course of action

is chosen, in preference to an alternative.

Overdraft facility:

A facility given by a bank that allows customer to continue

to draw against their current account, up to a pre-set limit,

when the balance of their own funds has reached zero.

Overhead costs:

The expenditure on labour, materials or services that

cannot be economically identified with a specific saleable

cost unit.

Overhead recovered (absorbed overhead):

Actual activity units multiplied by budgeted overhead rate.

Overhead variance: The difference between actual overhead costs and

absorbed overhead costs.

Ownership ratio: A measure of the proportion of total assets of a business

that belongs to the owner(s).

Payback period: The time required by a project to return its investment.

Performance indicators:

The measures of the inputs and outputs of a system, which

are organised in a way that reveals a trend in its

performance.

Performance report:

A report that provides feedback to managers on how

actual inputs/outputs/outcomes compare with planned

inputs/outputs/outcomes.

Periodical report: Reports prepared for management at regular intervals.

Policy statement: A statement of specific principles or rules adopted by an

organisation.

Post-action control: The making of adjustments after business operations are

completed.

Prepaid expense: Payments made in advance for expenses yet to be

consumed.

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Prepaid revenue: Payments received for goods not yet delivered or services

not yet performed.

Prepayments:

Expenses such as insurance premiums paid in advance,

the benefits of which will be realised in the near future,

usually within one year.

Present value: The cash equivalent now of a sum receivable or payable

at a future date.

Present value of an annuity: Today's value of equal amounts of money to be received

(or paid) at equal intervals of time.

Process re-engineering: The changing of processes into what they should be.

Production cycle: The time taken to convert raw materials into finished

products.

Profit centre: A part of a business accountable for both costs and

revenue.

Profit and loss statement

(Statement of financial

performance):

A report on the relationship between a business' revenues

and expenses during a given period showing the amount

of net profit or net loss made.

Qualitative factors:

Those factors for which accurate measurements cannot be

made in commonly known units such as dollars, metres

and kilograms.

Quantitative factors: Those factors that can be easily measured in commonly

known units such as dollars, metres and kilograms.

Rate of interest: The interest for one year expressed as a percentage of the

principal.

Ratio analysis:

The expression of the relationship between two relevant

items in financial statements as a ratio or percentage and

the interpretation of the result.

Responsibility centre: A collective name for cost centres, profit centres and

investment centres.

Retained earnings: The profit belonging to ordinary shareholders of a

company not distributed by way of dividends.

Return on capital: After-tax profit expressed as a percentage of the capital

invested in a business.

Return on investment: The ratio of the income per period to the average

investment for the period.

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Revenue: The increase in owner's equity as a result of a variety of

earnings by the business.

Revenue reserves: A major owner's equity classification that shows the portion

of retained profit that is earmarked for a particular purpose.

Rolling budget: A budget that is updated by deducting the figures from the

past period and adding the figures for the new period.

Sale and lease back: The owner of an asset sells an asset and enters into an

agreement with the buyer to lease it back

Sales revenue: The amount that a business earns by selling goods or

services that increases the owner's equity.

Sales variance: The difference between the actual sales margin and the

budgeted sales margin.

Secured loan:

A loan where the borrower pledges some asset as

collateral to act as a guarantee that the loan will be repaid

to the lender.

Semi-variable costs: Costs that are a mixture of fixed and variable costs.

Simple interest: Interest that is calculated on the original principal only.

Static budget:

A budget that is prepared at the beginning of the budget

period and not modified for comparison with the actual

result.

Strategic objective: The stated intentions of what an organisation wants to

achieve in the long term.

Strategic plan:

A statement of long-term goals along with a definition of

the strategies and policies that will ensure achievement of

these goals.

Tactical plan: A short-term plan for achieving an entity's objectives.

Target costing:

A cost management method for reducing the overall cost

of a product or service by employing better specification

and design procedures.

Targets: The goal aimed for - generally numerical values set by

management.

Time series: Any variable data collected over equal intervals of time.

Time value of money: A dollar in hand today is worth more than a dollar

receivable in the future because of the interest element.

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Trade credit: The delayed payment granted to a purchaser by a

supplier.

Trend: An overall tendency for a set of data to rise or fall.

Trend analysis: A technique used to assess the growth rates of business

items such as sales and profits over a number of periods.

Unsecured notes: A form of borrowing by a company for which security is not

given.

Value statement:

A statement listing an organisation's convictions about

what is right and wrong and its understanding of its social

responsibilities.

Variable cost A cost that changes in direct proportion to changes in the

volume of activity.

Variable overhead variance: The difference between actual variable overheads and

absorbed variable overhead.

Variable overhead efficiency

variance:

The variance in variable overheads due to actual direct

labour hours differing from the budgeted hours allowed for

the output.

Variable overhead expenditure

variance:

The difference between the actual variable overheads and

the budgeted variable overheads based on actual hours

used.

Variance: The difference between a planned, budgeted or standard

costs (or revenue) and the actual costs (or revenue).

Variance analysis: The comparison of actual output and input with the

budgeted output and input to isolate differences.

Vertical analysis:

The expression of items in financial statements as a

percentage of a base amount (eg sales) in the same

statement.

Weighted average: An average calculated by assigning different weights to the

items averaged to give effect to their relative importance.

Work groups: The subsections of an organisation with several workers

who perform a common task.

Working capital:

A measure of a business' ability to meet its short-term

obligations using its current assets, obtained by deducting

current liabilities from current assets.

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Zero-based budgeting:

A method of budgeting that requires each cost element to

be specifically justified, as though the activities to which

the budget relates were being undertaken for the first time.

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