ilm level 5
DESCRIPTION
ILM Level 5 . Making a Financial Case Presenter name . Two financial units to the level 5 programme. Making a Financial Case Understanding Financial Management. Your personal objectives. Areas to be covered . Over the unit we will be considering how to: Day 1: - PowerPoint PPT PresentationTRANSCRIPT
ILM Level 5 Making a Financial Case
Presenter name
2
Two financial units to the level 5 programme
Making a Financial Case
Understanding Financial Management
5
Areas to be covered
Over the unit we will be considering how to:Day 1: Differentiate between the direct and indirect costs of the business Identify the fixed and variable costs of the business Use break-even and contribution analysis Understand the principles of three costing systems Consider some simple strategies for profit improvementDay 2: Understand and apply the main investment methods used in business Discuss the strengths and weaknesses of each method Understand the importance of risk and the need for sensitivity analysis Identify a structure for controlling and reviewing capital projects
Direct Costs
Front Line Service
Direct Materials
Direct Labour
Direct Expenses
Direct CostsCost Code Cost Category Description
Direct Costs:These costs are normally directly attributable to the manufacture of the product, or the provision of the front line service.
A Direct Labour The people who directly make the product, or provide the front line service
B Direct Materials Any materials consumed in the manufacturing process /provision of the front line service
C Direct Expenses Associated directly with the manufacture of the product/ provision of the service, eg. hire of specialised equipment, any royalties payable as commission
Indirect ‘Overhead’ CostsIndirect Costs:These costs are commonly known as ‘overheads’. They comprise those factors that are not directly attributable to the manufacture of the product, or provision of the front line service, eg.
D Indirect labour
Managers, supervisors, maintenance and cleaning staff
E General administration
General office staff and office materials
F Reception Staff
G Marketing and distribution
Advertising, selling, promotions, transport costs, marketing and distribution staff
H Buildings occupancy
Rent/rates, property taxes, insurance, heating, lighting, water rates, electricity, repairs and maintenance
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Direct and Indirect Costs
Direct Costs Indirect Costs
Activity: Now consider your own operational area and see if you can divide it up into the front line service and support service and, consequently, make a brief list of the direct and indirect costs.
Fixed Costs: in the short-term stay the
same each month
Variable Costs: vary with changes
in activity
Fixed and Variable Costs
Activity: workbook p.9 - For the focus of this activity, let’s use the example of the Olympic swimming pool. Working with a partner consider
which of the following costs should be treated as fixed or variable by ticking the appropriate column.
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Fixed and Variable Costs
Fixed Costs Variable Costs
Activity: Consider your own operational are – what are your fixed and variable costs?
Break Even Analysis
Break-even analysis helps the business to:1. calculate the total costs of providing a service2. forecast the revenue that needs to be generated in
order to cover costs and start making a profit
The break-even point occurs where total costs equals total revenue
Any revenue below the break-even point is at a financial loss to the organisation for that particular product/service. Once revenue has exceeded the break-even point, then the organisation will be operating at a profit.
Activity: Constructing a Break Even Table
To illustrate the break even concept, you can construct a break-even table. For this example we will use the University Sports Centre
Activity: The centre has fixed costs of £10,000 per month It charges an entry fee to the centre of £1.50 It incurs variable costs per customer, eg electricity to power
fitness machines, use of shower etc, of £0.50 per customer. The monthly break-even point can be calculated by completing
the table below.
Break-Even AnalysisDemand
no. of customers
Fixed Costs
£10,000
Variable Costs(£0.50 per customer)
multiply by demand (customers)
Total Costs(Fixed Costs +Variable Costs)
Sales Revenue(£1.50 per customer)
multiply by demand (customers)
0 10,000 0 10,000 0
2,000 10,000 1,000 11,000 3,000
4,000
6,000
8,000
10,000
12,000
Break-Even AnalysisDemand
no. of customers
Fixed Costs
£10,000
Variable Costs(£0.50 per customer)
multiply by demand (customers)
Total Costs(Fixed Costs +Variable Costs)
Sales Revenue(£1.50 per customer)multiply by demand
(customers)
0 10,000 0 10,000 0
2,000 10,000 1,000 11,000 3,000
4,000 10,000 2,000 12,000 6,000
6,000 10,000 3,000 13,000 9,000
8,000 10,000 4,000 14,000 12,000
10,000 10,000 5,000 15,000 15,000
12,000 10,000 6,000 16,000 18,000
REV
ENU
E/C
OST
S
SALES(UNITS)
FIXED COSTS
VARIABLECOSTS
TOTALCOSTS
REVENUE
The Contribution MethodNeed to know: Fixed cost allocation Variable costs per unit (customer) Sales price per unit (revenue per customer)
Contribution = selling price less variable costs
Contribution means the ‘contribution’ of each unit sale to: Payment of fixed costs The generation of a profitExample: £
Price 1.50
(Less) Variable cost 0.50 Contribution 1.00
Break-Even Point (BEP) = Fixed costs / contribution per unitTherefore the BEP = 10,000 / 1 = 10,000 customers (customers)
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Activity Using the contribution method, calculate the following break even
points (BEPs). Complete the table in your workbook on p. 14.
(The original figures may change for each subsequent calculation where stated. You should always use the most recent figure. The BEP should be expressed in units of demand. Use the table below, to enter your calculations.)
The first BEP has been calculated for you. Follow exactly the same approach to calculate the BEPs for scenarios 2 to 6.
Scenario: The Sports Centre has expanded and it is now including
some premium extra value added services in the price charged to the customer, hence the increased entry price. This decision is taken in a bid to compete with two new private leisure centres which have opened locally.
Selling Price (less)Variable Costs =
Contribution
Fixed costs / Contribution per
customer
Break-Even Point(no. of customers)
1. 9.006.502.50
2.
3.
4.
5.
6.
15,000/2.50 6,000
Selling Price (less)Variable Costs =
Contribution
Fixed costs / Contribution per
customer
Break-Even Point(no. of customers)
1. 9.006.502.50
15,000/2.50 6,000
2. 7.006.500.50
15,000/0.50 30,000
3. 11.00 6.50 4.50
15,000/4.50 3,333
4. 11.00 8.50 2.50
15,000/2.50 6,000
5. 9.008.500.50
15,000/0.50 30,000
6. 9.008.500.50
9,000/0.50 18,000
Costing Methods
The aim of a costing system is to ensure that all the costs of a business are recovered by being charged to that part of the business making the money, which is normally the front line operation.
Absorption costing Marginal costing Activity-based costing
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Marginal Costing Vs Absorption CostingA technique for dealing with variable costs
Producing one extra unit will incur an increase in variable costs (direct labour, materials and expenses) = marginal cost
Absorbs all costs (the direct costs and a proportion of the indirect [overhead] costs) into each unit of sale
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Absorption Costing
Direct Costseg. £30,000 for the yearbased on 100 members
Gym
Direct Costseg. £25,000 for the yearbased on 100 members
Sports Hall
The sports centre allows admission only through a one year membership scheme. It has 2 key income earning facilities: its gym and sports hall. It allocates the direct costs for each facility accordingly
Absorption CostingIf each of the above sports centre facilities accounted for
50% of sales, the decision could be made to allocate 50% of the centre’s indirect (overhead) costs to both the gym and
the sports hall respectively
Direct Costs +50% of Indirect
‘Overhead’ Costs= Total Cost
Gym
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Total Costs for running the Gym
for a year(based on 100
members)
Direct Costs (£30,000) +50% of Indirect ‘Overhead’
Costs (£10,000)= Total Cost (£40,000)
If total indirect (overhead) costs for the sports centre over the period are forecast to be £20,000, then:
50% of £20,000 = £10,000 = the total indirect costs to be allocated to the gym for the period
I
Absorption Costing
Calculating the Total Cost to be allocated to each Membership FeeScenario 1:
Based on 100 paying members Direct costs for running the gym for the year = £30,000 Indirect costs allocated to the gym = £10,000
Direct costs to be allocated to each annual membership fee:£30,000 direct costs / 100 customers = £300
Indirect costs to be allocated to each annual membership fee:£10,000 indirect costs allocated / 100 customers = £100
Total costs per member:
£300 direct costs + £100 indirect cost = £400 The membership card fee for the gym is, therefore, £400 plus the profit margin
Pairs Activity: complete the financial calculations in scenario 2 on p.18 of the workbook
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Marginal Costing Vs Absorption CostingWhen is it appropriate to use each technique?
Absorption Costing - when forecasting demand for the year ahead – because at this stage of planning, we need to ensure that all costs will be absorbed into the forecast demand for the period.
Marginal Costing - when taking on a non-forecast job – assuming that forecast demand is on target, the indirect overhead costs will have already been accounted for; we have, therefore, the opportunity to cost the job only taking into consideration an increase in the variable costs (the marginal cost).
Activity: To compare both costing techniques in action let’s look at the following mini case study on pps. 19/20 of the workbook
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Existing Production:100 bikes @ £100 per bike
ExistingProduction:100 bikes @ £100 per bikePlusOption A:50 bikes @ £60 each
ExistingProduction:100 bikes @ £100 per bikePlusOption B:100 bikes @ £40 each
Sales Revenue per month: £ £ £
100 bikes @ £100 each
50 bikes @ £60 each
100 bikes @ £40 each
Total Sales Revenue Less Production Costs:Direct Materials (£20 per unit)
Direct Labour (£25 per unit)
Fixed Factory OverheadsTotal Production Costs
Gross Profit(Total Sales Revenue less Total Production Costs)
Existing Production:100 bikes @ £100 per bike
ExistingProduction:100 bikes @ £100 per bike Plus Option A:50 bikes @ £60 each
ExistingProduction:100 bikes @ £100 per bike Plus Option B:100 bikes @ £40 each
Sales Revenue per month: £ £ £
100 bikes @ £100 each 10,000 10,000 10,000
50 bikes @ £60 each 3,000
100 bikes @ £40 each 4,000
Total Sales Revenue 10,000 13,000 14,000
Less Production Costs:
Direct Materials (£20 per unit) 2,000 3,000 4,000
Direct Labour (£25 per unit) 2,500 3,750 5,000
Fixed Factory Overheads 3,500 3,500 3,500
Total Production Costs 8,000 10,250 12,500
Gross Profit(Total Sales Revenue less Total Production Costs)
2,000
2,750
1,500
Marginal Pricing
A contribution to fixed costs can be attractive Useful to gain market entry or increase
market share Be careful, this is a short-term tactic Don’t let the marginal price become the
market price Don’t undermine full paying customers
ABC CostingProcess: identify each necessary supporting activity in
the production process and collect costs into a separate pool for each identified activity
develop a measure for each activity, eg. a measure for the engineering department may be hours, whereas the measure for the maintenance department may be square metres
use activity measures as cost drivers to allocate costs to products
ABC in Action
91% engineering cost allocated
9% engineering cost allocated
20 hours engineering time
200 hours engineering timeProduct A
Product B
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Activity
In what ways can the profitability of an
organisation be improved?
Increase Profits?
Increase Sales Volume Improve Selling Price Re-negotiate Supplier Prices Reduce Waste & Cut Bureaucracy! Improve Quality (right first time) Reduce COS & Overheads
PRICE
FIXEDCOSTS
VARIABLECOSTS
CLIENTS
PRICE
FIXEDCOST
VARIABLECOST
PROFIT9.1
101 10.1
66.4
24.5
Price increase of 1% = Profit increase of 11%
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Cost Efficiency
Activity: using the post-it notes and flip chart pens provided in the workshop, identify
opportunities for greater cost efficiency within your operational area or other areas in the
University that you have observed. Note the outcome of this exercise below.
Today’s Objectives Understand and apply the main investment
methods used in business Discuss the strengths and weaknesses of
each method Understand the importance of risk and the
need for sensitivity analysis Identify a structure for controlling and
reviewing capital projects
Investment Appraisal Objectives
Expected benefits Choice between competing
alternatives If there is a shortage of funds
available, which proposals should be chosen
Project Evaluation Does the project fit within overall objectives of
the business? How will it be funded? What other resources will be required and
timescales? How long will the project last and what are its
key stages? What is the expected pattern of cash flows? What are the ‘key sensitivities’ and what if…
scenarios? How does the investment compare with other
opportunities available? The opportunity cost!
Investment Appraisal Methods
Payback period (PP) Accounting rate of return (ARR) Net present value (NPV) Internal rate of return (IRR)
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Payback Scenario 1 Activity: Let’s assume that the University’s Sports Centre has 3
projects in mind for developing the business, for example, different sports hall layouts combining different activities. Each project is forecast to generate different cash inflows but cost roughly the same at £10,000 per project. The business can only choose to go ahead with of the three projects and, therefore, constructs a table below to make a comparison in order to help the decision. See the following slide.
If you were advising the Sports Centre management, which of the 3 projects would you recommend from a financial perspective? Explain your choice and reasons below.
Payback PeriodProject A B C
Initial Capital Outlay
£10,000 £10,000 £10,000
Cash Inflows:Year
Cost less Cash
inflows
Cost less cash
inflows
Cost less cash
inflows
1 1,000 (9,000) 7,000 (3,000) 1,000 (9,000)2 1,000 (8,000) 2,000 (1,000) 8,000 (1,000)3 1,000 (7,000) 2,000 1,000 2,000 1,0004 7,000 0 0 0 0 05 10,000 10,000 0 0 0 0Total 20,000 10,000 11,000 1,000 11,000 1,000Payback Period 4 years 2.5 years 2.5 years
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Payback Scenario 2
Activity: Let’s assume that another opportunity for business expansion has been identified by the Sports Centre. Calculate the payback periods for each of the three projects below. We will be using exactly the same figures below throughout the rest of this section, to evaluate the 3 projects using the other financial appraisal methods. See p.28 of the workbook.
If you were advising the Sports Centre management, which of the 3 projects would you recommend from a financial perspective? Explain your choice and reasons below.
Project A B C
InitialCapitaOutlay
£240,000 £240,000 £240,000
Year Cash Inflows: Cost less Cash
inflows
Cash Inflows: Cost less cash inflows
Cash Inflows: Cost less cash
inflows
1 60,000 (180,000) 40,000 (200,000) 140,000 (100,000)
2 100,000 (80,000) 40,000 (160,000) 100,000/120,000= 1.83 years
20,000
3 80,000/100,000= 2.8 years
20,000 40,000 (120,000) 48,000 68,000
4 80,000 100,000 120,000/140,000= 3.86 years
20,000 40,000 108,000
5 60,000 160,000 140,000 160,000 20,000 128,000
Total 400,000 160,000 400,000 160,000 368,000 128,000
PaybackPeriod
2.8 years 3.86 years 1.83 years
Payback Period Answer
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Accounting Rate of Return
PP measures time not profitability ARR method actually measures
profitability. An organisation will set a required
rate of return on its investment. See example on following slide
ARR: Project AProject A: initial capital outlay - £240,000Year Cashflow (less) Depreciation = Net Profit
£000 £000 £0001 60 48 122 100 48 523 100 48 524 80 48 325 60 48 12
Total Net Profit 160
EvaluationTotal Net Profit 160 Average Annual
Profit32 (160/5 years)
Rate of Return:Average Net Profit/Capital Expenditure x 100
32/240 x 100 = 13.33%
Activity: now calculate the ARRs for projects B and C on p.31 of the workbook
ARR: Project BProject B: initial capital outlay - £240,000Year Cashflow (less) Depreciation = Net Profit
£000 £000 £0001 40 48 (8)2 40 48 (8)3 40 48 (8)4 140 48 925 140 48 92
Total Net Profit 160
Evaluation
Total Net Profit 160 Average Annual Profit
160/5 years = 32
Rate of Return:Average Net Profit/Capital Expenditure x 100
32/240 x 100 = 13.33%
ARR: Project CProject C: initial capital outlay - £240,000Year Cashflow (less) Depreciation = Net Profit
£000 £000 £000
1 140 48 922 120 48 723 48 48 04 40 48 (8)5 20 48 (28)
Total Net Profit 128
Evaluation
Total Net Profit 128 Average Annual Profit
128/5 = 25.6
Rate of Return:Average Net Profit/Capital Expenditure x 100
25.6/240 x 100 = 10.67%
Net Present Value
The Net Present Value (NPV) measures the value of the money received at the end of the project, eg. in 5 years’ time.
NPV takes into account all of the costs (except depreciation) and benefits of a project as well as addressing the issue of timing of cash flows.
PERIOD 5% 10% 15% 20%1 0.952 0.909 0.870 0.8332 0.907 0.826 0.756 0.6943 0.864 0.751 0.658 0.5794 0.823 0.683 0.572 0.4825 0.784 0.621 0.497 0.4026 0.746 0.564 0.432 0.3357 0.711 0.513 0.376 0.2798 0.677 0.467 0.327 0.2339 0.645 0.424 0.284 0.194
10 0.614 0.386 0.247 0.162
NPV: Project AProject A: initial capital outlay £240,000Year Cashflow (X) Discount Factor
(=)Present
£ 10% £0 -240,000 - -240,0001 60,000 .909 +54,5402 100,000 .826 +82,6003 100,000 .751 +75,1004 80,000 .683 +54,6405 60,000 .621 +37,260
Net Present Value
+64,140
Activity: now calculate the NPVs for projects B and C on p.35 of the workbook
NPV: Project BProject B: initial capital outlay £240,000Year Cashflow (X) Discount
Factor (=)Present
£ 10% £
0 -240,000 - -240,0001 40 .909 +36,0302 40 .826 +33,0403 40 .751 +30,0404 140 .683 +95,6205 140 .621 +86,940
Net Present Value
+42,000
NPV: Project CProject C: initial capital outlay £240,000Year Cashflow (X) Discount Factor
(=)Present
£ 10% £0 -240,000 - -240,0001 140 .909 +127,2602 120 .826 +99,1203 48 .751 +36,0484 40 .683 +27,3205 20 .621 +12,420
Net Present Value
+62,168
Internal Rate of Return
If the discount rate is increased sufficiently, eventually a rate will be identified which will cause the NPV to exactly equal zero at the end of the project life = the IRR
Where there are competing projects, the one with the highest IRR should be preferred
See example on following slide
IRR: Project AProject AYear Cashflow (x) Discount Factor (=) Present
£ 20% £
0 -240,000 - -240,0001 60,000 .833 + 49,9802 100,000 .694 + 69,4003 100,000 .579 + 57,9004 80,000 .482 + 38,5605 60,000 .402 + 24,120
Net Present Value + 40
Activity: now fill in the table on p.38 of the workbook with the summary of all the PPs, ARRs, NPVs and IRRs
Final Investment Evaluation
Project A Project B Project CPP 2.8 3.86 1.83ARR 13.33% 13.33% 10.67%NPV +£64,140 +£42,000 +£62,168IRR 20% 15% 24%
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Investment Appraisal Summary
The choice of project will depend on the relative importance to the business of:
Liquidity Profitability Cost of capital investment
Risk in Appraisal Investment
Project Investment
Cash Inflows
Project Life
Interest CostsOperational
Costs
Sales Prices and Margins
Risk Analysis and Contingency PlanningWhat is risk?
the chance of exposure to the adverse consequences of future events …
Response What this means Examples
Avoidance Taking the risk out of the project altogetherGenerally used on RED status risks
Reduce the scope of the project to remove the risky task from itBuy in specialists to eliminate a skills gapSupplement a team to eliminate a capacity issueCancel the project!
Transference Transfer the risk to a 3rd party outside the organisationCould apply to any High Impact Risk regardless of RAG status
Insure against the risk, we do this without thinking on our premises burning down!Use fixed price or shared risk contracts with 3rd parties where risk of overspend is identified (which in turn leads to other risks)
Mitigation Do something to reduce the probability or impact of the riskGood for reducing Red to Amber or Amber to Green
Introduce QA and Testing procedures to deal with product quality risks (Reduces probability)Develop change management processes to reduce risk of resistance to the project (Reduces probability)Bring tasks that could cause delay forward in the project schedule (Reduces Impact)
Acceptance Accept the risk could happen and either ignore it or put a contingency plan in place for when it occurs“Ignore” should only be used for Green status risks“Contingency” best for Green status risks but can be acceptable for Amber. Most common use is low probability, high impact risks.
Invest in backup and recovery solutions as a contingency for an IT system failure
Risk LogRisk Description Probability Impact Response
Amount allowed for in business plan is insufficient to purchase and implement the chosen tool
Medium High Reduce amount of licences to essential number of users rather than optimum level
Procurement process delays project delivery
Low Medium Accept risk as delay would not be significant and project benefits would still be realised
Project not delivered to programme
Medium Medium Accept risk as delay would not be significant and project benefits would still be realised
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Performing a Risk AnalysisActivity: Within your group, select a potential capital investment programme.
Identify the potential risks Assess the risk using the probability/impact matrix Assess how you are going to respond to each risk by
selecting one of the responses in the table on p.42 of the workbook
Complete the risk assessment template on p.43 of the workbook
Flip chart and feedback
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The Criteria MatrixAnother method for screening decisions is the criteria matrix. An example of this is presented on the next slide. In this scenario, the purchasing department of an organisation has decided to renew its fleet of 4 wheel drive vehicles. It has shortlisted 4 vehicles from the original list of ten:
Honda CR –V Nissan X-Trail Toyota Rava Land Rove Freelander
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Criterion Weighting (W)
Honda CR – V
Rating (R)Out of 4
Score (W x R)
Nissan X-Trail
Rating (R)Out of 4
Score (W x R)
Toyota Rava
Rating (R)Out of 4
Score (W x R)
Land Rover Freelander
Rating (R)Out of 4
Score (W x R)
Price 10 £20,150 £19,800 £19,600 £22,000
MPG (Urban)
8 35 32 29 28
Cost per mile
7 45.7p 44.4p 46.0p 43.8p
Service Intervals
5 12,500 12,000 10,000 15,000
0 to 60 Mph
3 10.5 secs.
12.4 secs.
12.6 secs.
15.2 secs.
TOTAL SCORES
Criterion Weighting (W)
Honda CR – V
Rating (R)Out of 4
Score (W x R)
Nissan X-Trail
Rating (R)Out of 4
Score (W x R)
Toyota Rava
Rating (R)Out of 4
Score (W x R)
Land Rover Freelander
Rating (R)Out of 4
Score (W x R)
Price 10 £20,150 2 20 £19,800 3 30 £19,600 4 40 £22,000 1 10
MPG (Urban)
8 35 4 32 32 3 24 29 2 16 28 1 8
Cost per mile
7 45.7p 2 14 44.4p 3 21 46.0p 1 7 43.8p 4 28
Service Intervals
5 12,500 3 15 12,000 2 10 10,000 1 5 15,000 4 20
0 to 60 Mph
3 10.5 secs.
4 12 12.4 secs.
3 9 12.6 secs.
2 6 15.2 secs.
1 3
TOTAL SCORES
93 94 74 69
Criteria Matrix Answer
Management and Control of Projects
Step 1
What fundsare available?
Step 2
IdentifyProject
Opportunities
Step 3
EvaluateProject
Proposal
Approvethe
Project
Step 4
Monitorand
Control
Step 5
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Case Study
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Module Learning Objectives Review
By the end of this unit, you will be able to:Day 1: Differentiate between the direct and indirect costs of the business Identify the fixed and variable costs of the business Use break-even and contribution analysis Understand the principles of three costing systems Consider some simple strategies for profit improvementDay 2: Understand and apply the main investment methods used in business Discuss the strengths and weaknesses of each method Understand the importance of risk and the need for sensitivity analysis Identify a structure for controlling and reviewing capital projects