Financial Controls in Management Activities Objective Complete hands-on exercises to apply cost control techniques Budgeting Budgeting Process Overview Budgeting Budgeting - aggregating the estimated costs of individual activities or work packages to establish a cost baseline. Inputs scope scope statement statement Work Work breakdown breakdown structure structure WBS WBS dictionary dictionary Activity Activity cost cost estimates estimates 5. 5. Activity Activity cost cost estimate supporting estimate supporting detail detail 6. 6. schedule schedule 7. 7. Resource Resource calendars calendars 8. 8. Contract Contract 9. 9. management management plan plan Tools & Techniques aggregation aggregation Reserve Reserve analysis analysis Parametric Parametric estimating estimating Funding Funding limit limit reconciliation reconciliation 5. 5. Capital Capital budgeting budgeting Outputs baseline baseline funding requirements funding requirements management management plan plan Requested Requested changes changes Source: The Management Body of Knowledge P167 Activity (1) Robots R Us estimates to invest the following in a project to make sophisticated robotic toys for children. Design $90 million Engineering $110 million TOTAL $200 million The total cost of the project is $200 million of which $40 million is invested by the company in cash and the balance $160 million is obtained through a bank loan. It is agreed that the loan principal will be repaid by 5 equal end of year payments of $32 million. The interest on the loan is 10 percent per annum and will be paid at the end of the year based on the remaining balance of the loan. The company estimates that its sales will be 100,000 robotic toys per year. The anticipated selling price is $700 per robotic toy and sales are expected to grow at 20,000 robots per year. The anticipated operating and maintenance costs are $50 million the first year and, due to production efficiencies, it is expected t decrease by $3 million per year. The effective tax rate is 40.%. The design and engineering costs are 1
capitalized and the depreciation of the equipment manufactured to produce the robotic toys is based on MACRS. For tax purposes, under MACRS, the equipment is depreciated over six calendar years and the percentages are as follows: Year Percent 1 20.00 2 300 3 19.20 4 152 5 152 6 5.76 Required Prepare a statement showing the cash flows for the business. Compute the net present value (NPV) and determine if the project is feasible. Compute the internal rate of return (IRR) of the project. What additional factors may have to be taken into account in deciding whether to go ahead with the project? 5. Would you recommend the project? Why or why not? 2
Solution to parts (1) and (2) Yr 0 Outflow* Additional Outflow** After tax Net inflow*** All numbers in 000 s Depreciation Cash savings**** Salvage Value of Equipment ***** Net Cash Discount @15% 0 Present worth Yr 1 ** 2,400 16,000 (13,600).87 (11,832) Yr 2 14,520 25,600 8,120.756 6,138 Yr 3 26,640 15,360.658 6,580 Yr 4 38,760 9,216 17,976.572 17,976 Yr 5 50,880 9,216 34,680 62,776.497 31,200 Yr 6 4,608 4,608.432 1,990 Net present value 12,052 WORKINGS FOR PARTS (1) AND (2) * Note 1 Cash paid for equipment = (200,000) Loan obtained = 160,000 Net cash outflow = 40,000 ** Note 2 Additional outflow is the principal repayment on the loan $32,000 per year. (You do not get a tax saving on this) ***Note 3 Please see workings below 3
Yr 1 Inflow (Sales) 70,000 (All numbers in 000s) Outflow Outflow (Operating (Interest on costs) loan) (50,000) (16,000) Net inflow After tax inflow Tax @ 40% 2,400 Yr 2 8 (47,000) (12,800) 24,200 14,520 Yr 3 98,000 (4) (9,600) 44,400 26,640 Yr 4 1 (41,000) (6,400) 64,600 38,760 Yr 5 126,000 (38,000) (3,200) 84,800 50,880 Yr 6 **** Note 4 To get cash savings from MACRS depreciation you multiply the depreciation by the tax rate. Depreciation Tax @40% Cash savings due to tax Yr 1 40,000 0.4 16,000 Yr 2 6 0.4 25,600 Yr 3 38,400 0.4 15,360 Yr 4 23,040 0.4 9,216 Yr 5 23,040 0.4 9,216 Yr 6 11,520 0.4 4,608 *****Note 5 First you have to compute profit from sale of equipment Market value $50,000 Book value $11,520 Profit on sale $38,480 Tax on profit @40% $15,392 4
Second you now have to compute net cash inflow from sale Salvage value $50,000 Less tax $15,392 Net cash collected $34,680 Solution to part (3) Yr 0 Outflow* Additional Outflow** After tax Net inflow*** Depreciation Cash savings**** Salvage Value of Equipment ***** Net Cash Discount @32% 0 Present worth Yr 1 ** 2,400 16,000 (13,600).757 (10,303) Yr 2 14,520 25,600 8,120.573 4,660 Yr 3 26,640 15,360.434 4,348 Yr 4 38,760 9,216 17,976.329 5,921 Yr 5 50,880 9,216 34,680 62,776.249 15,662 Yr 6 4,608 4,608.189 870 Net present value (18,842) To compute IRR you have to find a discount rate that generates a negative net present value. Now, we have a positive net present value at 15% i.e., 12,052 and a negative net present value, i.e., (18,842) at 32%. If you see the graph below, for a change of 17% the net present value changes by a total of 30,89 If we take the distance from 15% to the point at which NPV is 0 as X, then X / 17 = ( 12,052 \ 30,894) times 17 X = 6.63 Hence the rate of return where NPV is 0 is 15 plus 6.6 The IIRR is 263%. This is the exact rate of return of the project. 5
Solution to part (4) The additional factors that have to be taken into account to decide whether to go ahead with the project are: Financial How accurate are the projected numbers? How sensitive is the project to even a 5 percent decrease in anticipated revenue or increase in projected costs? Technological Is there any possibility of new technology that could make our system and products obsolete? Economic Is there a chance of a recession that could adversely affect the projected numbers? This include the possibility of inflation and interest rate hikes Legislative Does this project create waste that is difficult to dispose of in the traditional way? Is there a chance of environmental legislation that could adversely affect waste disposal? Are there any other legislation that the company should be concerned about? Competitors Who are the key competitors? What are the competitors doing that could adversely affect this business? Ethical Is there any possibility that existing work force and personnel could be laid off as a result of this project? What are the social costs to the community in such a case? 6
Activity (2) The QQQ Manufacturing Company prepared a budget for manufacturing overhead for the month of January 200X. The budget is shown below: QQQ Manufacturing Company Manufacturing overhead static budget January 200X Production in units 90,000 Variable : Power Repairs Payroll Total Variable $2,700 4,500 63,000 9,000 79,200 Fixed Superintendence Factory rent Maintenance Indirect labor Depreciation of equipment Total Fixed TOTAL OVERHEAD $8,000 3,000 5,000 42,000 $121,200 At the end of the month it was determined that only 80,000 units were produced. Required: Question 1 Prepare a static budget showing the variances between actual and budgeted numbers. 7
QQQ Manufacturing Company Manufacturing Performance Report January 200X Budget Actual Variance Units 90,000 80,000 Variable Power Repairs Payroll Total Variable Fixed Superintendence Factory rent Maintenance Indirect labor Depreciation $2,700 4,500 63,000 9,000 $2,500 4,200 56,800 8,500 $ 200 F 300 F 6,200 F 500 F 79,200 72,000 7,200 F 8,000 3,000 5,000 8,500 2,500 5,200 4,300 500 U 0 500 F 200 U 0 300 U Total Fixed TOTAL OVERHEAD 42,000 42,500 500 U $121,200 $114,500 $6,700 F Solution The chart above is called a static budget performance report. Here, you compare actual performance with the static budget. In evaluating this performance report, managers would first compare the actual production to the budgeted production to determine if there is a difference, and, if so, why the difference occurred. The results show that, during January, the company produced fewer units than anticipated. This might have been a planned reduction due to an unexpected reduction in sales, or it might have been a production shortfall due to problems in the factory. If the former is the case, no management action is necessary. If the latter occurred, management should take action because of the failure in effectiveness. Required Question 2 What is your opinion of this report? Is this report meaningful, why or why not? Solution The report is not meaningful. It is highly unlikely that, for any given period, actual production will coincide exactly with budgeted production. Thus, a single static budget 8
is usually useful only for planning but not for controlling. To be meaningful, the company has to flex the static budget and prepare a flexed budget. Required Question 3 Prepare a flexed budget, compute the variances and comment. Solution QQQ Manufacturing Company Manufacturing Performance Report January 200X Budget Actual Variance Units 80,000 80,000 0 Variable Power @.03 Repairs @.05 Payroll @ 0.70 @ 0.10 Total Variable Fixed Superintendence Factory rent Maintenance Indirect labor Depreciation $2,400 56,000 8,000 $2,500 4,200 56,800 8,500 $ 100 U 200 U 800 U 500 U 70,400 72,000 1,600 U 8,000 3,000 5,000 8,500 2,500 5,200 4,300 500 U 0 500 F 200 U 0 300 U Total Fixed 42,000 42,500 500 U TOTAL OVERHEAD $121,200 $114,500 $2,100U The flexed budget shows that the performance, overall is actually unfavorable. Managers use a technique called variance analysis to determine who is responsible. For the variable overhead the variances can be broken down into (a) spending variance and (b) efficiency variance. Generally, the department supervisors will be responsible for spending variance and the factory manager will be responsible for efficiency variance. However, an unfavorable spending variance is not necessarily the fault of the supervisor. States may have increased electricity charges etc hence increasing the total spending of the departmental managers.. Similarly, efficiency variances may not always be attributable to the production manager. It could be due to no fault of the manager. Hence, both variances are broken down into (a) controllable and (b) uncontrollable. Managers are held responsible for the controllable components only. 9