3.1 ANALYSE BUDGETS AND MAKE APPROPRIATE DECISIONS .

A budget is subject to a number of problems, such as the "use it or lose it" mentality,
whereby managers spend all funds allocated to their departments on the grounds that
those expenditures form the basis for their budgets in the following year; not spending all
allocated funds will therefore mean that the budget will likely be reduced in the following
year. (accountingtools)
In the case of Holyrood Products Ltd, the company informs the cost and sales of three
products: DVD recorders, calculators and watches. According to the income statement in
the year ended 30 June Year 3 , selling price of DVD recorders is calculated by:
Selling price = Sales revenue : units of sales = 375,000 : 30,000 = 12.5
In Year 4, most of the costs will change that is the reason why if production of DVD
recorders is at the same level as that achieved in the year to 30 th June Year 3, the price
will not maintain as its past. Thus, all budgets have to be changed according to the selling
price. As figured out in the case study, budgets of three products, which are divided into
fixed and variable costs will be calculated :

DVD RECORDERS:
VARIABLE COST:

) Materials costs will be increased by 1 per unit (case study), so:

Direct materials cost = 128,000 + 1 30,000 = 158,000
) Other variable costs will be held at the level attained in the year ended 30 th June
Year 3 (case study), so:
Direct labour cost = 96,000
Works and administration overhead = 64% 50,000 = 32,000
Selling overhead = 75% 20,000 = 15,000

FIXED COST:
) Working and administration overhead = 36% 50,000 = 18,000
) Selling overhead = 60% 25%

20,000 + 25% 20,000 = 8,000

TOTAL COST:

158,000 + 96,000 + 32,000 + 15,000 + 18,000 + 8,000 = 327,000

CALCULATORS:

TOTAL COST:
15,000 + 10,000 + 2,500 + 4,500 + 8,000 + 2,250 = 42,250

WATCHES:

TOTAL COST:
10,000 + 25,000 + 15,000 + 2,250 + 13,500 + 6,750 = 72,500

Variable cost ()

Direct materials
Direct labour
Works and administration overhead
Selling overhead
Works and administration overhead
Selling overhead

Fixed cost ()
Total cost ()
Total cost of 3 products ()

Profit = 25% 441,750 = 110,438

Proportion of each product comparing with total cost:
DVD:

327,000 : 441,750 100% = 74.02%

CALCULATOR: 42,250 : 441,750 100% = 9,56%

WATCH:

72,500 : 441,750 100% = 16,42%

DVD
158,000
96,000
32,000
15,000
18,000
8,000
327,000

CALCULATOR
15,000
10,000
2,500
4,500
8,000
2,250
42,250

WA

In fact, the percent of producing DVD out of total cost should be applicable to expected
profit from those products:
74,02% 110,438 = 81,746

DVD:

CALCULATOR: 9.56% 110,438 = 10,557

16.42% 110,438 = 18,135

WATCH:

Sales revenue = Profit + Expenses

Selling price = Sales revenue : Units of sales
Calculators

Watches

DVD Recorders

Expenses

42,250

72,500

327,000

Profit

10,557

Sales revenue

52,807

18,135
90,535

81,746
408,746

Units of sales

5,000

10,000

30,000

Selling price

10.6

9.1

13,6

Figure 2: Selling price of DVD recorders, calculators and watches

Revenue
Less: Variable cost of sales
Less: Fixed production overhead
Cost of good sold
Gross margin
Budgeted net profit

552,188
385,250
56,500
441,750
110,438
110,438

Figure 3: The Budgeted Income Statement for Holyrood Products Ltd in Year 4.
Source: Case study

3.2 EXPLAIN THE CALCULATION OF UNITS COSTS AND MAKE PROCING DECISIONS.

3.2.1 Return on investment is 20%.

The formula for return on investment, sometimes referred to as ROI or rate of return, measures the
percentage return on a particular investment. ROI is used to measure profitability for a given amount of
time. (financeformulas)

As it can be seen from the equation, profit are divided into dividends for shareholders,
that is the reason why it is profit after tax. Tax rate ( Tc) is 40%.
Profit after tax = 300,000 20% = 60,000
Profit before tax (PBT) - Tax expenses = Profit after tax (PAT)
PBT - 40% PBT = PAT
PBT - 0.4 PBT = PAT
PBT (1 - 0.4) = PAT
PBT 0.6 = PAT
PBT = PAT : 0.6 = 60,000 : 0.6 = 100.000
Total expenses = 300,000
Sales revenue = total expenses + profit before tax
= 300,000 + 100.000 = 400.000
Price per unit = Sales revenue : number of units
= 400,000 : 40,000 = 10
3.2.2 6% profit on list sales. 40% trade discount.
A trade discount is the amount by which a manufacturer reduces the retail price of a
product when it sells to a reseller, rather than to the end customer. The reseller then
charges the full retail price to its customers in order to earn a profit on the difference
between the amount by which the manufacturer sold the product to it and the price at
which it then sells the product to the final customer. The reseller does not necessarily
resell at the suggested retail price; selling at a discount is a common practice, if the
reseller wishes to gain market share or clear out excess inventory. (accountingtools)
If sales price is regarded as letter a , sales revenue is 40,000 a.
Profit before tax : 40,000 a - 300,000 - 40% 40,000 a = 24,000 a - 300,000

PAT = PBT (1- Tc)

= (24,000 a - 300,000) (1- 0.4)
= 14,400 a - 180,000
PAT = 6% Sales Revenue
= 6% 40,000 a
= 2,400 a
There is an equation: 14,400 a - 180,000 = 2,400 a
12,000 a = 180,000
a = 15.

3.3 ASSESS THE VIABILITY OF A PROJECT USING INVESTMENT APPRAISAL TECHNIQUES.

3.3.1 Accounting rate of return.( ARR)

Accounting rate of return (also known as simple rate of return) is the ratio of estimated
accounting profit of a project to the average investment made in the project. ARR is used
in investment appraisal. Accounting Rate of Return is calculated using the following
formula:
Average Accounting Profit
ARR =

Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be

earned during each year of the project's life time. Average investment may be calculated
as the sum of the beginning and ending book value of the project divided by 2. Another
variation of ARR formula uses initial investment instead of average investment .
(accountingexplained.)

Total Cash flows

Total depreciation
Total profit after depreciation

A ()
95,000
40,000
55,000

Average profit (5 years)

11,000

Value of investment initially

Eventual residual value

60,000
10,000

Average value of investment (/2)

30,000

ARR for new machine is 11,000 : 30,000 100% = 36.7%

This method of investment appraisal is easy to calculate. It recognizes the profitability factor of investment.
However, it ignores time value of money. Suppose, if Holyrood Products Ltd uses ARR to compare two
projects having equal initial investments, the project which has higher annual income in the latter years of
its useful life may rank higher than the one having higher annual income in the beginning years, even if the
present value of the income generated by the latter project is higher. It can be calculated in different ways.
Thus there is problem of consistency. It uses accounting income rather than cash flow information. Thus it
is not suitable for projects which having high maintenance costs because their viability also depends upon
timely cash inflows.(Irfanullah Jan)

3.3.2 Net present value

Net present value is the present value of net cash inflows generated by a project including salvage value, if
any, less the initial investment on the project. It is one of the most reliable measures used in capital
budgeting because it accounts for time value of money by using discounted cash inflows. Before
calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project.
Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating
the cash inflow.

When cash inflows are even:

NPV = R

1 (1 + i)-n
i

Initial Investment

In the above formula,

R is the net cash inflow expected to be received each period;

i is the required rate of return per period;

n are the number of periods during which the project is expected to operate and generate
cash inflows.
When cash inflows are uneven:
R1

NPV =

(1 + i)1

R2
(1 + i)2

R3
(1 + i)3

+ ...

Initial Investment

Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...
In the case of Holyrood products Ltd, managers use the net present value rule to decide
whether or not to acquire a new machine because NPV will helps them find out if the
projected future cash inflows cover the future costs of starting and running the project.

Outlay cost
Estimated future cash flows
Year 1
Year 2
Year 3
Year 4
Year 5
Discount rate

Year
0
1
2
3
4
5

Cash flow

(50,000)
10,000
15,000
20,000
25,000
25,000

A project
50,000
10,000
15,000
20,000
25,000
25,000
10%

Present value factor

10%
1.000
0.909
0.826
0.751
0.683
0.621
NPV

Present value

(50,000)
9,090
12,390
15,020
17,075
15,525
19,100

Present value in Year 0 is (50,000)/ (1+0.10)0 = (50,000)

Present value in Year 1 is 10,000/ (1 + 0.10)1 = 9,090
Present value in Year 2 is 15,000/ (1 + 0.10)2 = 12,390
Present value in Year 3 is 20,000/ (1 + 0.10)3 = 15,020
Present value in Year 4 is 25,000/ (1 + 0.10)4 = 17,075
Present value in Year 5 is 15,000/ (1 + 0.10)5 = 15,525
Net Present Value is -50,000 + 9,090 + 12,390 + 15,020 + 17,075 + 15,525 = 19,100.
Therefore, NPV = 19,100 (> 0) , which means that present benefits is greater than present
cost. Thus, the project could be accepted. In addition, NPV will add value to the company
and benefits to shareholders.
Net present value accounts for time value of money. Thus it is more reliable than other investment appraisal
techniques which do not discount future cash flows such payback period and accounting rate of return.
However, it is based on estimated future cash flows of the project and estimates may be far from actual
results.(Irfanullah Jan)

3.3.3 Discounted payback period

In the case of Holyrood Products Ltd, when having produced a net present value analysis,
the company could calculate the discounted payback period as follows.
Year

Present value()

Cumulative PV()

0
1
2
3
4
5

(50,000)
9,090
12,390
15,020
17,075
15,525

(50,000)
(40,910)
(28,520)
(13,500)
3,575
19,100

The cash flows of this project are called conventional cash flow and the project is called
conventional project. A conventional project can be defined as one which requires a cash
investment at the start of the project, followed by a series of cash inflows over the lift of
the project. After three years the project has generated total cash inflows of 36,500.
During the fourth year, the remaining 13,500 of the initial investment will be recovered.
As the cash inflows in this year is 17,075 and assuming that it occurs evenly during the
year, it will take a nearly 9 months and 18 days or 0.8 years for the final 13,500 to be
recovered. The payback period is therefor 3.8 years.
An investment project with a short payback period promises the quick inflow of cash. It
is therefore, a useful capital budgeting method for cash poor firms. A project with short
payback period can improve the liquidity position of the business quickly. The payback
period is important for the firms for which liquidity is very important. An investment
with short payback period makes the funds available soon to invest in another project.A
short payback period reduces the risk of loss caused by changing economic conditions
and other unavoidable reasons. Payback period is very easy to compute. However, the
payback method does not take into account the time value of money. It does not consider
the useful

life

of the assets

and inflow

of cash after

payback

period.

(accountingformanagement)

4.1: DISCUSS THE MAIN FINANCIAL STATEMENTS OF HOLYROOD PRODUCTS LTD.

Income statement reports financial performance for an accounting period, which is usually one calendar
year ending on the date given in the financial position statement. In the case of Holyrood

Products Ltd,

the management accountant has produced the summary os the companys trading in the
year ender 30th June. The income statement in Year 3 begins with sales and subtracts costs
incurred in producing DVD recorders, calculators and watches to give gross profit. Costs
incurred by supporting activities such as administration and distribution are then
subtracted to give operating profit , known as profit before interest and tax. The financial
cost of meeting interest payments is subtracted to give profit before tax, and the annual
tax ability is subtracted to give profit after taxation. (Business study guide)

While the income statement shows the financial performance of

Holyrood Products Ltd during an

accounting period, the balance sheet shows the financial position of Holyrood Products
Ltd at the end of the accounting period. During two years, the company still has positive
closing balance.

4.2: COMPARE APPROPRIATE FORMATS OF FINANCIAL STATEMENTS FOR DIFFERENT TYPES

OF BUSINESS.
4.3: INTERPRET FINANCIAL STATEMENTS USING APPROPRIATE RATIOS AND COMPARISONS,
BOTH INTERNAL AND EXTERNAL.

4.3.1: The return on capital employed (ROCE)

The return on capital employed (ROCE) relates the overall profitability of a company to the finance
used to generate it.

ROCE = Profit before interest and tax : Capital employed 100

Capital employed is simply total assets less current liabilities or shareholdersfunds plus long term debt.
(Business study guide)

Profit on ordinary activities before interest and taxation (PBIT) is the amount of
profit which the company earned before having to pay interest to the providers of
loan capital.
2013

2012

Profit on ordinary activities before tax

56,139

53,568

Interest payable

18,884

16,517

PBIT

79,983

70,085

ROCE = Profit before interest and tax : Capital employed 100

Capital employed = Shareholders funds + creditors
In Holyrood

Products Ltd, capital employed in.

2013 is (318,628 + 299,942 + 62,419) = 680,989

2012 is (310,133 + 292,915 + 57,399) = 660,447
ROCE (2013) = 79,983 : 680,989 = 11.75%
ROCE (2012) = 70,085 : 660,447 = 10.6%

The ROCE of Holyrood Products Ltd has increased by 1.16%, which means that a higher
ROCE indicates more efficient use of capital to make higher profit.
4.3.2: Profit margin
Profit margin indicates the efficiency with which costs have been controlled in generating
profit from sales.
Profit margin = Profit before tax and interest : Sales or turnover 100
For instance, profit margin of Holyrood Products Ltd is calculated as follows.
Profit margin (2013) = 79,983 : 730,913 = 10.94%
Profit margin (2012) = 70,085 : 601,295 = 11.66%
4.3.3: Asset turnover
Asset turnover gives a guide to production efficiency, for example, how well assets have
been used ingenerating sales. (Business study guide)
Asset turnover = Sales : Capital employed
In the case of Holyrood Products Ltd, asset turnover will be calculated by the formula:
Asset turnover (2013) = 730,913 : 680,989 = 1.07 times
Asset turnover (2012) = 601,295 : 660,447 = 0.9 times
4.3.4: Gross profit to sale
Gross profit margin show how well costs of production have been controlled, as opposed
to distribution costs and administration costs.
Gross profit to sale = (Gross profit 100) : Sales
Gross profit to sale (2013) = (109,019 100) : 730,913 = 14.9%
Gross profit to sale (2012) = (97,596 100) : 601,295 = 16.2%
4.3.5: Current ratio
Current ratio measures a company ability to meet its financial obligations as they fall
due. It is often said that the current ratio should be around two, but what is normal will in
fact vary from industry to industry: sector averages are a better guide than a rule of
thumb. (Business study guide)
Current ratio = Current assets : Current liabilities
Current ratio (2013) = 42,527 : 135,361 = 0.3
Current ratio (2012) = 38,325 : 122,919 = 0.3

In fact Holyrood Products Ltd is a manufacturing company, thus the current ratio has low
value (0.3 < 1.5). A low current ratio indicates that the company has some difficulties in
meeting financial obligations.
4.3.6: Quick ratio
The quick ratio compares liquid current assets with short term liabilities.

Quick ratio = current assets less inventory : current liabilities

In the case of Holyrood Products Ltd, the quick ratio is calculated :
Quick ratio (2013) = (42,527 - 9,601) : 135,361 = 0.24
Quick ratio (2012) = ( 38,325 - 8,594) : 122,919 =0.24
4.3.7: Liabilities ratio
Liabilities ratio is the ratio of a companys total liabilities to its total assets (Business
study guide).
Liabilities ratio = Total liabilities : Total assets
In the case of Holyrood Products Ltd, the liabilities ratio is calculated:
Liabilities ratio (2013) = (135,361 + 299,942 + 62,419) : (773,823 + 42,527) = 53.3%
Liabilities ratio (2012) = ( 122,919 + 292,915 + 57,399) : (745,041 + 38,325) = 53.1%
In this case, the ratio has increased by 0.2% from 2012 to 2013, which means that the
company's position will be worth looking at more carefully.
4.3.8: Gearing ratio
A gearing ratio or leverage ratio relates to how a company is financed with respect to debt and equity and
can be used to assess the financial risk that arises with increasing debt.
Capital gearing ratio = ( longterm debt 100) : capital employed
Debt/equity ratio = ( longterm debt 100) : share capital and reserves
In the case of Holyrood

Products Ltd, the gearing ratio and Debt/equity ratio will be calculated .
2013

2012

Capital gearing ratio

299,942 100 : 680,989

Debt/equity ratio

299,942 100 : 318,628 = 94,1%

= 44,4%

292,915 : 660,447 100 = 44,4%

292,915 : 310,113 100 = 94,4%

4.3.9: Interest coverage ratio

The interest coverage ratio shows how many times a company can cover its current interest payments out of
current profits and indicates whether servicing debt may be a problem. An interest coverage ratio of more
than 7 times is usually regarded as safe, and an interest coverage ratio of more than three times as
acceptable.

Interest coverage ratio = Profit before tax and interest : interest charges

Interest cover (2013) = 79,983 : 18,844 = 4.2 times

Interest cover (2012) = 70,085 : 16,517 = 4.3 times
Interest coverage ratio in 2012 and 2013 has been more than three times. In this case,
interest cover of Holyrood Products Ltd is acceptable.

Financial Ratios
ROCE

2013
11.57%

2012
10.6%

10.94%
1.07 times
0.3
0.24

11.66%
0.9 times
0.3
0.24

Liabilities ratio
Capital gearing ratio

53.3%
44%

53.1%
44.4%

Debt/Equity ratio

94.1%

94.4%

4.2 times

4.3 times

Profit margin
Asset turnover
Current ratio
Quick ratio

Interest cover

http://www.accountingtools.com/dictionary-budget
http://www.financeformulas.net/Return_on_Investment.html
http://www.accountingtools.com/questions-and-answers/what-is-a-trade-discount.html
http://accountingexplained.com/managerial/capital-budgeting/arr
http://accountingexplained.com/managerial/capital-budgeting/npv
http://www.accountingformanagement.org/payback-method/