Lecture 15a: The External Environment – PEST Analysis; Economic

Factor
Economic Structure
Three sectors:
 Primary - (Farming, mining)
 Secondary - (Manufacturing)
 Third – (Services)
Size of sectors measured by:
 Share of Gross Domestic Product (GDP)
 Proportion of labour force employed

 Third sector has grown a lot and is still growing, manufacturing sector
has decreased in Western countries.
 There has been a migration of manufacturing to lower labour cost
countries.

The Circular Flow of Income

 Firms and households are inter-dependent
 Basic model based on a closed system
 Withdrawals slow down the flow
 Injections speed up the flow
The Multiplier Effect
Can be compared to the effects of throwing a stone into a pond of water. An
initial wave formed, but beyond this will be waves of ever-decreasing strength.
Sporting events often provide significant multiplier benefits.
E.g. – If you have a new sports stadium built somewhere, that will attract
crowds of people at certain times, those people will be spending money within
that area. The construction of the facility will draw labour into it, they will use
the local facilities, so money is spread causing a ripple effect.
The Accelerator Effect
 A small change in consumer demand can lead to a big change in demand
for industrial goods and services.
 E.g., a small reduction in air passengers produces big reduction in new
aircraft orders and hence engineers.

Lecture 15b: The External Environment – PEST Analysis; Economic

Factor
The Business/Economic Cycle
 Economies are seldom in a stable state
 Periods of ‘Boom’ alternate with periods of recession (‘Bust)

Implications of Economic Cycle for UK Firms

 Recovery and boom periods general create more disposable income
which consumers spend on more goods and services.
 Differentiated products and services would expect to have higher
demand in a recovery or boom but it depends on the price elasticity.
  The opposite tends to be true for low-cost products and services, with
more demand in slowdowns and recessions.
 If the UK cycle is slowing down or in recession can products and services
be exported to countries experiencing recovery of booms?
Fiscal and Monetary Policy
Fiscal Policy:
 Concentrates on stimulating the economy through changes in the
government income and expenditure.
Monetary Policy:
 Influences circular flow of income by changes in the supply of money &
interest rates.
Fiscal vs Monetary Policies

The Central Bank (Bank of England)

 Central banks plays and important role in the management of the
national economy
 Regulates the volume of currency in circulation within the economy
 Intervenes to influence the exchange rate for sterling
 Bank of England has a supervisory role over private banks
 European Central Bank is the central for the EU
Measuring Economic Activity to Help Set Monetary and Fiscal Policy
Key Indicators:
 Gross Domestic Product (GDP)
 Inflation rate
 Interest rates
 Exchange rates
 Unemployment rates

Inflation
The general level of prices in the economy is rising
 Common measures of inflation – RPI (Retail Prices Index) and CPI
(Consumer Prices Index)
 Demand pull inflation – Too much money chasing an inadequate
supply of goods and services
 Cost-push inflation – Caused by increases in production costs
If inflation gets too high, things will get out of control. Western Governments
say around 2-3% is a good amount of inflation, which is what the Bank of
England aims to maintain.
Implications of Price Inflation for UK Firms
 Makes it more difficult for firms to plan & compete as costs rise
 Increases pressure to improves productivity or reduce profit margins to
avoid price increases for customers
 Lecture 15c: The External Environment – PEST Analysis; Economic
Factor

Implication of Interest Rates for UK Firms

 High interest rates increase borrowing costs but may be linked to a
stronger economy and high sales demand
 Low interest rates decrease borrowing costs, encouraging investment,
but can be linked to a recession with low demand
 Overseas competitors maybe able to borrow money at lower interest
rates, posing a threat
Implications of Exchange Rates for UK Firms
 A high, or strong £ makes exports more difficult and imports of
competitor products cheaper but typically linked to a stronger economy
and high sales demand. The stronger the pound, the cheaper it is to buy
thinks abroad as for example, you get more dollars for your pound.
  A low, or weak £ makes exports easier but imports of materials more
expensive and can be linked to a recession with low sales.
The Credit Crunch
 Circular flow of income depends on money being re-circulated within
economy.
 2008 ‘Credit Crunch’ – banks reluctant to lend money
 Quantitative easing – extreme form of monetary policy to easy credit
markets. Used when lowering interest rate has no effect
Types of Unemployment
 Frictional Unemployment – related to normal level of ‘job turnover’.
Takes time to find a new job
 Structural Unemployment – jobs available but mismatch with skills of
the unemployed, shortage of graduate engineers in UK.
 Cyclical Unemployment – not enough jobs available in a recession.
Linked to an economic cycle.
Implication of Unemployment for UK Firms
 Low unemployment makes it more difficult & expensive to recruit and
puts upwards pressure on wages
 High employment makes it easier to recruit, reduces pressure on wages
but may reduce sale levels
 Engineering is affected by a skills shortage and structural unemployment

Lecture 16a: The External Environment – PEST Social Factors

Social
 Changing trends in values, lifestyles, leisure, health
 Demographic & population trends
 Lobby groups
 Environmental
 Education levels
Social Change and its Effect on Business
 Many goods and services are no longer considered socially and culturally
relevant – e.g., formal clothing, or horses (for personal transport rather
than sport/leisure activities)
 New opportunities emerge for businesses – e.g., Halal butchers, delivery
options arising from internet shopping
 This can be a two-way effect – businesses and new technology and
cultural environment (e.g., microwaves oven)

The Effects of Cultural Changes

Cultural sensitivity affects many aspects of business planning and operations,
e.g.:
 Understanding processes of buyer behaviour
 Distribution channel decisions are partly a reflection of cultural attitudes
 Advertising messages do not always translate easily between different
cultures
 Methods of procuring resources can vary between cultures
Cultural Convergence?
 Are cultures converging in their values and attitudes?
 Or do multi-cultural societies lead to a grow need for cultural identity?
Multi-Ethnic Societies
New challenges and opportunities for businesses
 More diverse patterns of demand, e.g., ethnic foods
 Increasingly multi-ethnic workforce
Impact of Social Aspect to Firms
Important considerations are:
 The elderly are a ‘growth area’ (and the population is generally living
longer)
 Environmental issues, ‘green’ lobbies
 Globalised businesses need to be aware of the effect of cultural
differences
  Health and Safety issues – society is becoming more litigious (ready to
take legal action) and legislative
 Skills and education in the workforce need to increase to keep abreast of
technological advances.

Lecture 16b: The External Environment – PEST Technical Factors

Technical
 University/Government R&D
 Industry-Wide R&D
 Transport Infrastructure
 ICT Infrastructure
 Possible Substitutes
Main Impacts of Technology
 Improved products
 Improved communication
 Improved distribution
 Improved measurement of performance
 May affect social environment (e.g., microwave cooker, autonomous
vehicles, drone delivery of internet purchases)
 May affect economic environment (e.g., internet access helps local
economies)
Manufacturing and Processing
Technology impacts on manufacturing and processing system:
 Computerised Numerical Control (CNC)
 Computer-Aided Manufacturing (CAM)
 Integrated Manufacturing System (IMS)
 Just-In-Time (JIT) systems (a management method in which goods are
received from suppliers only as they are needed)
All contributing to greater flexibility and lower costs.
Benefits of Electronic Business:
 Customer profiles can be established to develop better marketing and
business strategies
 New technology can be integrated with existing sales and inventory
infrastructure
 Cross-selling of products can be generated
 Sales can be safeguarded by identifying alternatives when a requested
item is unavailable
 Customers can be targeted with promotions based on the customer’s
individual preferences
 Supply chain efficiency and effectiveness can be increased
What this Means to Firms:
 Technological change can have a great impact on firm’s product,
promotion, and distribution decisions
 Investment in research and development makes an essential
contribution to sustainable and competitive advantage
 Rapid developments in information technology are facilitating
communication between firms and their customers and suppliers

Lecture 17a: The Firm: Reviewing Strategy

What is Strategic Management
Essentially:
 Where are we?
 Where do we want to be? (Goals and objectives)
 What do we need to do to get there? (Policies and guidelines)
 How do we do those things? (Programs and procedures)
Gap Analysis
 Over time, the current strategy is likely to get more out-of-line with the
target.

Strategic Choice involves:

 Generating options
 Evaluating options
 Selecting best options to minimise this gap
Strategic implementation considers:
 Resource planning
 Organisational structure
 Systems
 Change management techniques etc. to bring about the changes
Porter’s Generic Strategies:
Michael Porter (1985) proposed three possible strategies:
 Cost Leadership – Achieve lower costs than competitors but sell
products at or near industry average price
 Differentiation – Produce a differentiated product at industry average
costs but sell at a premium price
 Focus – Concentrate on niche market
When choosing strategies firms not only need to consider the external
opportunities and threats arising from PEST, the impact of Porter’s 5 forces,
the potential attractiveness of the industry but also whether the strategies
will ‘fit’ with their ethos, culture, and attitude to risk.

Lecture 18a: Intro to Management Accounting, Direct Labour &

Direct Material Costs
Cost Accounting
To be effective we need to learn the accounting the language associated with
costing. Costs can be used to help make many decisions in engineering
industries including:
 Product Costing (or Absorption Costing) – Using direct and indirect cost
classifications
 Short-term decision making (or marginal costing) – Using variable and
fixed cost classifications
 Assessing management performance (or Responsibility Accounting) –
Using controllable and uncontrollable costs
Different Cost Classifications for Different Users
To calculate a product’s cost in a muti-product firm you need to determine the
direct costs associated with making that product and allocate the product a
share of the indirect costs.

Direct Cost (Prime Cost)

Direct Costs are specifically identified with a product or service. These are 3
main types:
 Direct Labour
 Direct Material
 Direct Expenses
Indirect Costs
Not specifically identified with a product or service but associated with
manufacturing or delivery of the product/service:
 Indirect Labour – Stores personnel, team leaders, quality engineers,
industrial engineers
 Indirect Materials – Cutting fluids, lubrication oils, packaging
Indirect Expenses
Not specifically identified with a product or service but can include the labour
costs associated with indirect activities:
 Establishment Costs – To set up the factory or office
 Selling, Marketing & Distribution Costs
 Administration Costs – Accounting, Human Resource Management
 Finance Costs – Interest costs, Dividends
Different Cost Classifications for Different Uses
Short-term decision making (marginal costing)
 How many products do we need to sell to break-even?
 In a recession we may not be able to sell at a price that covers the ‘full
product cost’ but how much discount should we give?

Lecture 18b: Intro to Management Accounting, Direct Labour &

Direct Material Costs
Cost Behaviour
Cost behaviour is the study of the way costs fluctuate and the rationale for
such variation. There are 2 major influences: volume (or activity level) and
time. The main categories of cost that result are:
 Variable Costs
 Fixed Costs
 Semi-Variable (Semi-Fixed) Costs – Starts with a based value and as you
use it more you get more cost
 Step Costs - Expenses that are constant for a given level of activity, but
increase/decreases once a threshold is crosses (E.g., a machine that can
only make so much product, so to make more product you have to buy
another machine)
 In

the short-term there are limited opportunities to control costs. Major cost
reductions need major changed to how the company operates and take time
to achieve.
Recording Actual Direct Labour Costs
You need to measure:
 Estimated time for the task – using work study or time and motion study
techniques
 Actual time taken
 Rates of pay
 Output achieved
Systems for collecting actual direct labour time:
 Paper-based, relying on workers to input data into time sheets
 Semi-automated, paper-based using bar codes, tracking output via
computer
 Fully automated using swipe cards or radio frequency identification
(RFID) tags signaling start & finish times
Rates of Pay: Remunerations or Pay Schemes for Direct Labour
 Time Related – Simply based on time worked (Hourly salary)
 Output Related – Incentive schemes (More efficient you are the more
you are paid)
 Lecture 18c: Intro to Management Accounting, Direct Labour &
Direct Material Costs
Direct Material Costs
Objective of material pricing/costing:
 Charge cost units on a realistic basis
 Provide a fair and consistent basis for stock (or inventory) valuation
Problems faced:
 Stocks of one type of material can be made up of many deliveries from
different suppliers at different prices
 Can be impossible to tell which unit material came from which supplier
 Prices can fluctuate over time even from the same supplier
Calculating Direct Material Costs
How do you know what to charge to production if you have stocks of the same
item with different purchase prices?
 First In First Out (FIFO)
 Average Cost
 Standard Cost
First In First Out (FIFO)
 Charges production with the first material price paid until all material is
used
 Then takes the second material price paid and charges this to production
until all the material is used.
 Requires detailed records of when each material order is received and
which production order it is used on

Average Price
  Avoids keeping detailed records of when each material order is received
and which production it is used on
 Each time material is received the average price per unit of the material
held in stock is calculated
 This average price is charged to production
 The average price charged will vary over the year if material prices
change frequently

Standard Costing
 Avoids keeping detailed records of when each material order is received
and which production order it is used on
 Creates a standard price for a set time periods, typically 1 year
 Assumes material prices will not vary much over the set time periods
 The same standard cost is charged to production throughout the set
time
How can you stop material prices changing?
 Make to order – buy materials for each order and charge actual costs
 Make stock so fast prcie can not change ( Just In Time, Lean production
or time compression programmes)
 Negotiate long-term contracts with suppliers and fix price
Financial Accouting Test for Valuing Inventory
Regardless of the method used for valuing stocks or material the firm must
check the valuation is less or equal to ‘the net realisable value’. This is what
you can sell it for, also known as the market value.

Lecture 19a: Dealing with Indirect Costs; Full/Absorption Costing

and Activity Based Costing
Absorption/Full Costing
 Takes all costs, regardless of whether they are Fixed or
Variable
 Cost per unit is made up of Direct Materials, Direct Labour
and Overhead (or Indirect Costs)
 As all costs of production are included it is often called the
Full Cost method
Choosing an allocation base for Overhead Cost
Most firms make more than one product or service. The overhead
costs are difficult to allocate because:
 They are indirect and difficult to trace to a product or service
 They consist of many different items from lubricating oil to
directors’ salaries
 They remain relatively fixed in relation to output
Most firms use one of two allocation bases:
 Direct Labour hours
 Machine hours
This means that if overheads are allocated using Direct Labour hours, as
opposed to machine hours, order number 123 is charged £5 more for
overheads. It therefore follows that other orders will be charged #35 less.
The Total Overhead costs in the firm have not changed. The firm must
decided which method of allocation produces the most accurate costs. If
prices are set on a ‘cost-pus-profit-margin’ basis and demand is elastic the
choice of costing system can have a major impact on total sales and profit
levels.

Lecture 19b: Dealing with Indirect Costs; Full/Absorption Costing

and Activity Based Costing
Different types of manufacturing industries:
 Job – Where you do one thing at a time (e.g., ship building,)
 Batch – Where you make batches of the same product and moving
between those batches
 Flow – Where you are continuously making something (e.g., car line)
Are Overhead Costs directly related to the volume of production?
Compare the overheads in the following companies:
 Factory A makes 1 million black ball point pens per month and sells them
all to Asda – What drives the overhead costs?
 Factory B makes 1 million ball point pens in total. It makes 10 different
colours in 4 different product designs and sells to 50 different retailers -
What drives the overhead costs?
The CIMA (Charted Institute of Management Accountants) definition of
Activity Based Costing (ABC) is:
‘An approach to the costing and monitoring of activity which involved tracing
resource consumption and costing final outputs’
Allocating Overheads Using Activities – Activity Based Costing
Assumptions:
 Activities create Overhead Costs
 Products consume activities
Process for ABC Costing:
 Identify the major activities of the firm
 Identify what drives each activity; the cost driver (e.g., the number of
purchase orders placed)
 Groups the Indirect Costs associated with the activities driven by the
same cost driver to create a cost pool (e.g., buyers’ remuneration, office
costs of purchasing department, store man’s wages)
 Determine a rate per cost driver estimating the volume (e.g., number of
purchase orders placed per year)
The
Impact of Activity Based Costing:
 In a multi-product firm traditional Absorption Costing usually: - Under-
estimates the cost of low volume/customised products and over-
estimates the cost of high volume/standard products
 ABC will allocate a much higher proportion of overhead cost to low
volume/customised products
 ABC will allocate a lower proportion of overhead costs to high volume/
standard products
 ABC will have a much greater impact on the cost per unit for low
volume products
 Lecture 20a: Cost-Volume-Profit Analysis (Single & Multiple
Products

Cost-Volume-Profit (CVP) Analysis: Accountant’s POV

Assumptions:
 Single product or multi-products have a constant sales mix
 Analysis applies to short-term horizon, the relevant range
 All other variables remain constant
 Costs can be accurately divided into fixed and variable elements
 Total costs and total revenue are linear functions of output
Contribution = Sales price – Variable cost
Break-Even Formula:
If:
 F = Fixed Costs
 S = Sales price per unit
 V = Direct variable cost per unit
 P = Profit
 x = Production Volume
 x-BE = Break-Even Volume
Profit (Loss) = Revenues – Total Costs
P = S(x) – [ F + V(x) ]ra
At Break-Even Point, P = 0
xBE = F / ( S – V ) ( S – V ) = Contribution Margin

Margin of Safety:
Indicated by how much sales may decreases before a loss occurs.
% Margin of Safety = ( Expected sales – Break-Even Sales ) / Expected sales
Expected sales = S(x)
Break-Even sales = S(xBE)
 Lecture 20b: Cost-Volume-Profit Analysis (Single & Multiple
Products
Multiproduct Break-Even Formula
At break-even point, P = 0
XBES of standard products = F/ Weighted ( S – V ) for products a ,b, ….

For product a, XBE = XBES (Weight of product a)

For product b, XBE = XBES (Weight of product b)
Assumption – That we have continual sales and the same amount of sales of
each of those individual products.

Break-even = Fixed Costs/ Weighted Unit Contribution

Consider:
 Overall break-even sales – Calculated from the charge/hr, given in
question
 Profit of the firm if there is a 10% increase in the number of hours for
each service – Simply the positive difference between total revenues
and total costs
 Margin of safety (in units) in the above case – Break-even hours x 1.1
for each service
 Percentage margin of safety for each – Percentage margin of safety will
be 10%
CVP analysis applies to a relevant range as outside this, the unit selling price
and the variable cost are no longer constant and results from the formula will
be incorrect
CVP analysis assumes that total costs and total revenues are linear functions
of output
If there are multi-products, CVP analysis assumes that the sales mix is
constant

Lecture 21a: Relevant Costing; Opportunity Cost, Marginal Cost

Analysis & Standard Costing

Relevant Costs:
 Costs that are specific to the management’s decisions
 The concept of relevant costs eliminated unnecessary data that could
complicate the decision-making process
 Sunk costs are eliminated – Something that you have already
purchased, but for some reason it isn’t doing what you think it is doing,
but you cant put that into the decision again (Money that has been
spent and cannot be recovered)
 Incremental costs are considered – Cost which will vary according to
what decision is made ( the cost added by producing one additional unit
of a product or service)
Opportunity Costs:
The value of the next best choice that one gives up (sacrifices) in making that
decision
E.g. An entrepreneur who invests in stocks will not receive the interest he
would have earnt had he put that money in a bank account instead. The vale of
that interest represents the Opportunity Costs
Marginal Cost Analysis:
Marginal Costing – The extra cost or incremental cost needed to produce on
more good or service
 Marginal Analysis – concerned with costs and revenues that vary with
decision
 From an economist’s POV, that extra cost could include fixed cost if
capacity has to be expanded
Limiting Factor of Production:
Limiting Factor of Production – A key resource input which is in scarce supply
and as a result, its use may be limited or restricted
 Strategically, you therefore want to maximise the contribution of the
limiting factor
 Lecture 21b: Relevant Costing; Opportunity Cost, Marginal Cost
Analysis & Standard Costing
Costing and Budgeting for Future Periods Using Standards:
 Standard – The amount or level set for the performance of a particular
activity under defined conditions.
 Standard Cost – The planned cost for a particular level of activity
 Variance Analysis – An investigation into, and an explanation of, why
variances occurred
What type of business benefits from Standard Costing?
 High volume service or manufacturing
 Larger companies who can afford to create standards
 Services or products where material, labour or overhead costs can be
identified per unit
 Customised or make to order services or products that contain many
standard elements or modules
Variances could be found in:
 Sales Volume
 Sales Prices
 Direct Materials Usage
 Direct Materials Price
 Labour Efficiency
 Labour Rate
 Fixed Overhead
Sales Volume:
 Standard incorrect (Standards may have changed over time)
 Market downturn reduces demand
 Competitor launches superior product
 Poor performance or staff
 Staff poorly trained
Sales Price:
 Standard incorrect
 Competitors reduce prices forcing own price reduction
 Poor performance by staff
Direct Materials Usage:
 Standard incorrect
 Poor quality materials supplied
 Poorly trained direct labour
 Damaged tooling resulting in damage to the materials
Direct Materials Price:
 Poor performance by buying staff
 Market price increases
 Supplier abusing monopoly power
Labour Efficiency:
 Standard incorrect
 Poorly trained direct labour
 Poorly motivated direct labour
Labour Rate:
 Poor performance by staff
 Higher grade of work used
 Unplanned use of overtime due to higher demand
 Machine breakdown, etc.
 Unplanned wage rise
Fixed Overhead:
 Poor supervision in overheads departments
 Poor performance of staff
 Unplanned increase in market prices of fixed overheads
 Inefficient use of resources
 Lecture 22a: The Annual Budget: Budget Setting
Budget:
 A financial plan for a future period of time
 Money allocated for a specific purpose
The Strategic and Budgeting Planning & Control Process:

Types of Budget:
Approaches to Budget Setting:
 Incremental budgeting – Take a previous budget and tweak, modify
it according to your perception of differing volumes of
production/demand, etc.
 Zero-based budgeting – Do the budget from scratch
 Activity based budgeting – Records, researches and analyses
activities that lead to costs for a company
Incremental Budgeting:
Advantages:
 Ease in computation
 Often used for discretionary budgets where input and output are
indirectly linked (e.g. R&D)
Disadvantages:
 Slack in past budget is carried over to next budget
 May inhibit innovation on activities, methods
 Often, only the proposed increases in these budgets are closely
scrutinised
 Tends to use past costs and ignores opportunity costs
Zero-Based Budgeting
Advantages:
 Managers are encouraged to have a questioning approach to area of
responsibility
 Managers have a sense of ownership of planed activities
 Managers are forced to think carefully about ways in which projects are
undertaken
Disadvantages:
 Time-consuming
 Managers whose sphere of responsibility is subjected to ZBB can feel
threatened it
Activity Based Budgeting
Advantages:
 By identifying key organisational activities, it could note those which
require particular attention
 The control of inessential costs is enhanced
 Ease in identifying the Manager who has control over cost drivers and
make him accountable for the costs that are caused
 Easy and cheap if you are already operating ABC (Activity Based Costing)
Disadvantages
 Time-consuming and costly (especially if ABC is not being used)
 Tends to use past costs and ignores opportunity costs

Lecture 22b: The Annual Budget: Budget Control

Fixed Budget: - Compares actual results with original targets
Advantages:
 Ease in conducting prompt variance analysis
 Useful for discretionary areas of spend
Disadvantages:
 Manager is questioned for unfavourable variances resulting
from increase in activity level
 Does not reflect any changes in the scenario (e.g. raw material
costs), hence variance analysis may not be realistic
Flexible Budget: - Tweaks targets to match actual levels of activity
Advantages:
 More realistic
 Manager is not penalised for consequences of an increase in
activity level
 Enables a management-by-exception environment to be
created
Disadvantages:
 More complicated to calculate (but computers ease this
problem)
 Nobody is held accountable to the original plan. This is
important with respect to constrained cash flow
Behavioural Aspects of Budgetary Control:
 Budgets generally tend to improve performance
 Demanding, yet achievable budget targets tend to motivate
better than less demanding targets
 Unrealistically demanding targets frustrate and demotivate
managers
 Participation of managers in setting targets tend to improve
motivation and performance
 Organisational demands for cost cutting can lead to artificially
inflated predictions
 Lecture 23a: Managing Work Capital
Assets:
 Simple definition – things you own, or money owed to you
 Academic definition – Any item of economic value owned by an
individual or corporation, especially that which would be
converted to cash
 Current assets can be converted to cash in < 1 year
 Non-current/Fixed assets take more than a year to convert to
cash
Liability:
 Simple definition – what you owe to others
 Academy definition – an obligation that legally binds an
individual or company to settle a debt
 Current liabilities are due for payment within 1 year
 Non-current/Long-term liabilities are debts where you have
more than 1 year to pay
The Balance Sheet Equation:

Assets – Liabilities = Capital (Also referred to as Equity,

Shareholders’ fund or Reserves)

The working Capital Cycle

Current Assets e.g.
 Inventories (Stock)
 Trade receivables or debtors (your customers)
 Cash (in hand and at bank)
Current Liabilities e.g.
 Trade payables or creditors (your suppliers)
 Bank overdraft
 Proposed dividends
Measure of Working Capital (WC)
Working Capital = Current Assets – Current Liabilities

Measuring Short-Term Liquidity

Liquidity – The availability of liquid assets (current assets minus
stock/inventory) to a market or company
If the business ceased trading could it pay for its short-term
liabilities?
Are the Current Assets greater than the Current Liabilities?

Current Ratio = Current Assets/ Current Liabilities

Want to be 2:1
If the business ceased trading could it really expect to sell its stocks
of raw or finished goods?

Are the Current Assets, excluding stock, greater than the Current
Liabilities?
Acid test/Liquidity = Current Assets minus
stocks(Inventory)/Current Liabilities
Want to be 1:1

Liquidity Ratios for Different Industries:

 If the inventory is easy to sell even if the business is bankrupt
then investors will accept a low liquidity ratio
 Th inventory held by supermarkets is all finished goods and we
always need to eat, whatever the state of the economy
 Work-in-progress, or part finished products are not as easy to
sell as finished products
 Manufactures normally need a higher liquidity ratios than
supermarkets
 Investors will still have confidence in large firms with a long
history of success even if they have a difficult year with a very
low liquidity ratio
Overtrading
 Having too little working capital
 In a boom time it can be caused by doing too much with too
little capital (Investing too much into expansion such as new
production facilities or selling too much)
 In a recession it can be caused by failure (Not selling enough or
not enough stock/inventory)
Managing Working Capital Aim – Minimise Working Capital
Managing payables or creditors:
 Paying the suppliers
 Take a long time to pay but not so long they refuse to sell to
you or you bankrupt them
Managing receivables or debtors:
 Getting the money from customers
 Collecting money as quickly as possible but not so quick the
customers go to your competitors
Managing inventories:
 Material, components etc. in stores, part-finished products in
the factory and finished products in your warehouse and
distribution system
 Aim for as little as possible but not so little you stop production
or are late delivering to the customer.

Lecture 23b: Managing Work Capital

Managing Payables or Creditors
Benefits:
 Interest free source of working capital in the short-term
 Can solve temporary cash flow problems by delaying payment
Risks:
 May receive lower priority
 Supplies may be withheld
 Long-term relationships may be damaged
 Supplier may refuse to supply
Managing Receivables or Debtors: Selling on Credit:
Benefits:
 Maintaining sales (matching competitor’s policies)
 Increasing sales
Risks:
 Cost or capital (interest rate)
 Administration
 Bad debts
 Opportunities foregone
Managing Debtors: Policies
 Which customers should receive credit?
 How much credit should be offered?
 What length of credit should be offered?
 Should discounts be offered for prompt payment or penalty
charges for late payments?
 How should we collect the debts?
 Should we take out insurance against bad debt?
Offer an Early Payment Discount
Collecting Debts:
 Phone and visit
 Threaten to stop supply
 Threaten with legal action
 Outsource debt collection to a debt factoring specialist for a
fee (0.75% to 2% of debtors)
 Sell the debtors or ‘invoice discounting’ to raise cash but
retain administration
Managing Cash: Good Practice:
 Prompt banking of money received
 Centralised banking for larger firms
 Maximise receipts in cash, by direct debit, by electronic
transfer
 Maximise payments by cheque
 Plan to make payments when fund are available
Emergency Measures:
 Increase the overdraft
 Delay payments to creditors
 Press debtors to pay quickly
 Do not by new materials for production
 Postpone capital expenditure
 Sell surplus assets
 Delay, reduce or halt dividends
 Ask the Government for a loan?
A: Long as possible to pay – increases Debtors, increases Current Asset (CA) &
Working Capital (WC). Pays suppliers quickly – reduces cash (CA) reduces
current liabilities, no effect on WC. Large inventories increases current assets
therefore WC.
B: Customers pay quickly – increases cash flow, decreases Debtors (both in CA)
– no effect on WC. Pays suppliers quickly – reduces cash (CA) reduces current
liabilities, no effect on WC. Large inventories increases current assets therefore
WC.
C: Customers pay quickly – increases cash flow, decreases Debtors (both in CA)
– no effect on WC. Pays suppliers slowly – increases cash (CA) increases
Current Liabilities, no effect on WC. Small inventories decreases CA, therefore
WC.
 Lecture 24a: Intro to Capital Investment Appraisal: Simple and
Discounted Payback

Investment
An investment requires expenditure ( the action of spending funds)
on something that is expected to provide a benefit in the future. The
decision to make an investment is extremely important because it
implies
 The expectation that expenditure today will generate future
cash gains, in real terms, that greatly exceed the funds spent
today
What needs Capital Investment Appraisal?
 New product development
 Expansion
 Upgrading of fixed assets
 Acquisition of companies
Cash flows for a new piece of equipment
Cash outflows:
 Initial investment – To buy and install the equipment
 Increased working capital needed – To repair and operate the
equipment
 Incremental operating costs – Electricity to power the machine,
direct labour costs to operate it
Cash inflows:
Incremental revenues or sales
 The new equipment may improve quality standards generating
higher sales
 The new equipment may reduce operating costs
Salvage value
 At the end of its life it may be possible to sell the equipment

What do capital investment decisions have in common?

 Needed to deliver strategic objectives
 Lot of irreducible risk & uncertainty – resulting from; Need to
forecast/benefits, Large amounts of resources involved, No
turning back
 Involve long time periods with benefits arriving in a series of
smaller amounts after large initial outlay of capital
What should be appraised (assessed)?
Financial:
 How much will it cost?
 How much will it last?
 Are there any set-up costs?
 What are the benefits; costs savings, extra revenue, extra
profit?
 What are the tax implications?
 How risky is the project?
Non-Financial:
 Environmental, social or safety issues?
 Political issues?
 Essential core skill?
 Future technology?
 Best fit with existing equipment/personnel?
 Pressure to match competitors’ investment patterns

Capital Investment Appraisal Techniques:

 Payback
 Discounted Payback
 Net Presented Value (NPV)
 Lecture 24b: Intro to Capital Investment Appraisal: Simple and
Discounted Payback

Residual Value = What it will be worth at the end of those 5 years

Selecting Investments using Simple Payback

 The firm will set a maximum payback period
 A project or investment that pays back within this time should
be accepted
 If there are several projects to choose from the project with the
shortest payback period should be accepted
Simple Payback
Advantages:
 Simple, quick and easy to understand
 Widely used in industry
 Incorporates a ‘crude’ assessment of risk; risk & uncertainty
reduce as the pay period reduces
Disadvantages:
 Cash inflows after payback are ignored
 Total cash inflow is ignored
 Not linked to increasing profitability or wealth of the business
 Takes no account of the time value of money

Discounted payback and NPV are classified as Discounted Cash Flow

(DCF) techniques
Time Value of Money
A receipt of £100 today has a greater value than a receipt of £100 in
one years’ time. There are two main reasons for this:
 Money could have been alternatively invested in say risk-free
Government gilt-edged securities. The actual rate of interest
will have to be paid will be higher than the Government rate, to
include a risk premium
 Purchasing power will have been lost over a year due to
inflation
Discounted Cash Flow (DCF)
 Projects needing capital investment have cash inflows and
outflows over many years
 It is important to recognise the time value of money
 To calculate the value of money in the future we need to apply
a discount factor because £1 today is worth more than £1 in 5
years
 The technique of DCF discounts the projected net cash flows of
a capital project to ascertain its present value, using an
appropriate discount rate, or cost of capital
Calculating the Time Value of Money
How would you determine the discount rate?
 Inflation
 Current interest rate (e.g. UK Bank of England base rate)
 Firms’ cost of capital
 Firms’ target for capital investments
 Performance of similar past investments
 Risk ( of failing/ of not investing)

Discounted Payback
Advantages:
 Fairly simple and easy to understand
  Intuitive and fairly common in industry
 Risk is reduced as you get closer to the payback point
 Time value of money is considered
Disadvantages:
 Cash inflows after payback are ignored
 Total cash inflow is ignored
 Not linked to increasing profitability or wealth of the business
 Have to estimate the discount factor

Lecture 25a: Capital Investment Appraisal: NPV & Sensitivity

Analysis
Net Present Value (NPV)
 Select the discount rate to cover interest costs, inflation, a risk
premium etc.
 Calculate the discounted cash flows each year and the
cumulative cash flows, as for Discounted Payback
 Accept the investment if the cumulative Net Present Value of
the project is zero or greater
 At Net Present Value equal to zero the investment pays for the
interest costs, inflation, a risk premium, etc.
 A Net Present Value greater than zero increases the wealth of
the
business
Advantages:
 Cash inflows after payback are not ignores
 Timing of cash flows is considered
 Total cash inflow is taken into account
 Time value of money, interest costs, inflation and risk can all be
taken into account in the discount factor
 Linked to increasing profitability or wealth of the business
Disadvantages:
 More complicated and not as intuitive as Payback or
Discounted Payback
 Not as widely used as Simple Payback
 Have to estimate the discount factor
 Lecture 25b: Capital Investment Appraisal: NPV & Sensitivity
Analysis
How can you try to take account of risk and uncertainty
 Use a higher discount factor
 Use a range of estimates (worst case best case)
 Use probability testing
 Use sensitivity analysis
Sensitivity Analysis
There may be a number of risks associated with each of the
variables included in a Capital Investment Appraisal decision:
 Estimates of initial costs
 Uncertainty about the timing and values of future cash
revenues and cost
 The length of the project
 Variations in the discount rate

How it works:
 Same method as using a range of values
 Factors are varied, one at a time to see the impact on the
project
 Typical factors to vary shown in diagram
 Enables you to be sensitive to a particular factor and this might
help you to decide whether to invest or not
 Lecture 26a: Financing the Business: The Need for Funds and the
Cost of Equity
How can a business be financed?
 Use your own money
 Crowdfunding (‘alternative finance’)
 Personal contacts
 Employee share options & stakes
 Franchising: both franchisor & franchisee
 ‘Business Angel’: typically $50,000 - £300,000
 Venture Capital: typically £500,000 - £7,000,000
Need of financial support for ongoing firms
 Acquisition of a new firm (Long term)
 Reorganization (Long term)
 Purchase of new machines (Long term)
 Extension of the plant (Long term)
 Establishing distribution links (Long term)
 -
 Additional fringe benefits (Short term)
 Launching new products (Short term)
 Advertising and promotion (Short term)
 Purchase of raw materials (Short term)
 Day to day operations (Short term)
Activities in the Product Life Cycle:

Sources of Finance:
Cost of Equity (RE)
 RF is the risk-free rate of interest
 RR is the risk premium and has accepted levels (which may be
found in tables) for different industries.
RE = R F + R R
RE will determine the return investors expect due to the risk in
investing (compare with Opportunity Costs)

Weighted Cost of Capital (RT)

  Even the most successful companies will have good reason to
require funds from time-time-time to enable them to conduct
their business
 Different sources of funds are appropriate for the various
different financing needs of the company
 Cost of Equity is a measure of the incentive to investors that
balances the risk they are adopting in lending money to a
company

Lecture 26b: Financing the Business: Sources of Finance

Internal Finance
Short-term:
 Reduced Stock Levels
 Delayed Payment to Creditors
 Tighter Credit Control
Long-term:
 Retained Profits
Retained Profits:
 The company reinvests the profits back into its business
 The main advantage is, it does not have to pay interest to use
this
 Available if other sources of credit are hard to access
External Finance
Short term:
 Bank Overdraft
 Invoice Discounting
 Debt Factoring
Long term:
 Ordinary Shares
 Preferences Shares
 Loans/ Debentures
 Leases

Share Capital:
 Money is raised from shareholders
 Company pays dividends
Ordinary Shares:
 No fixed rate of dividend
 Will receive dividends after other investors
 Will have control over the business
Preferences Shares:
 Receives a fixed dividend
Types of Shares:

Long-Term Loan:
 Money is borrowed from banks or debt holder
 Company repays interest
Forms of Long-Term Loans:
 Term Loan – Offered by banks and financial institutions and can
be tailored to the needs of the client business
 Debenture – May be secured or unsecured against company
assets
 Eurobond – Issued by businesses in various countries and
finance in raised on an international basis
Finance Lease:
 Instead of buying a particular asset, the company may arrange
for another business (typically a bank) to buy it and then lease
it to the company
  The company makes lease payments to the lessor
Benefits of Finance Leasing:
 Ease of borrowing
 Cost
 Flexibility
 Cash flows

Lecture 27a: Strategic

Management Accounting; Measures of Success
Strategic Management Accounting:
A form of management accounting which considers both an
organisation’s internal and external environments.
Strategic Approach:

Key

Stakeholders
Key Measures of Success for Stakeholders:
Consider, for each established stakeholder, what an appropriate
measure of success might be:
 Shareholders
 Customers
 Suppliers
 Employees
 Competitors

Measures of Success for Suppliers:

 Higher margins, high prices from customers
  Regular orders
 Volume – economies of scale
 Regular, on-time payment
 Stock turnover – constant orders
 Long-term relationships
 Help with improvement activities (supplier development)
Measures of Success for Employees:
 High salaries
 Job security
 Good pension provision
 Medical benefits
 Promotion prospects
 Perks – company car?
 Bonus
 Training
 Job satisfaction
 Communication on strategy
 Generous holiday entitlement
Measure of Success for Competitors:
 Market size
 Competition – within reasonable levels
 Normal profit levels
 Stability
 Reasonable relationship
 Co-ordination on lobbying (improve supply chain, deter new
entrants)

Stakeholders – Measure of Success:

 Lecture 27b: The Balanced Scorecard

Kaplan & Norton’s Balanced Scorecard for Managing Strategy: 4

Processes:

Balanced Scorecard Illustration:

Organisational Chart:
Financial Perspective:

Customer Perspective:
Internal Perspective:

Learning Perspective:
Designing Balanced Scorecard Systems:
From a survey of 23 ‘Best Practice’ organisations:
• Best-practice organisations take a simple approach to ensure
the link between measures and business strategy
• Even the most advanced users do not have fully integrated
scorecards throughout the organisation
• Simple structures for the balanced scorecard will yield the
most effective system
The Balanced Scorecard is used to translate the corporate financial
goals down to meaningful operational targets.

Lecture 27c: Benchmarking

Appraisal of the Current Business Position:
  Benchmarking – Comparison of business with direct
competitors or industry norms and consequent adoption of
best practices to improve performance
Types of Benchmarking:
 Internal – comparing internal operations across departments of
business units
 Competitive – comparing the product or operations with a
direct competitor
 Functional/Industry – comparing similar functions in the same
broad industry
 Generic – comparing business functions or processes regardless
of industry
 Customer – comparing performance against customer
expectations
Benchmarking Relationship to Size:
% Benchmarking per Sector:

Reasons for Not Benchmarking: