London Conference - David Palmer - AUA Finance presentation

This is one of a series of documents produced by David A Palmer as a guide for managers on

specific financial topics to assist informed discussion. Readers should take appropriate advice

before acting upon any of the issues raised. Other documents are freely available on the

website: www.FinancialManagementDevelopment.com

FINANCIAL MANAGEMENT DEVELOPMENT

THE AUA LONDON CONFERENCE

DECEMBER 2011

Changing Times in Higher Education

FINANCE - A Blessing not a Curse

An overview of

Financial and Management Accounting

££££

££££££

1333

35753

FINANCIAL MANAGEMENT

DEVELOPMENT

Rev. David A Palmer BA FCA CTA MCIPD

20 Brooke Road, Kenilworth

Warwickshire, CV8 2BD

01926 511720

E-mail: [email protected]

Website: www.FinancialManagementDevelopment.com

University Finance - A Blessing not a Curse of 20

www.FinancialManagementDevelopment.com © David A Palmer 2011

As with all human endeavour Let us start with the question Why?

WHY KEEP FINANCIAL ACCOUNTS?

If you had invested money in a company you would want to know what the managers of the

company had spent your money on and whether they had spent it wisely. As a sophisticated

investor you would recognise that some spending is by way of an investment for the future as

opposed to an expense. Because some transactions do not involve paying cash, you would

want a record of commitments as well as cashflow. Financial accounting in its current form

was designed several centuries ago to meet these needs. It provides the basis for the

production of the Published Report and Accounts. Used properly it protects investors (in the

case of Universities the Government) from the enthusiasm and excesses of management to

whom they have entrusted a vital national task - the education of students. It provides a record

of past performance and therefore may give no guidance regarding the future.

WHY HAVE MANAGEMENT ACCOUNTS?

The short answer is because managers want to. There is no duty to keep management

accounts. Provided the financial records are sufficient to satisfy statutory obligations, there is

no need to add to costs and waste valuable management time preparing and reviewing extra

management data. In many organisations, management information is produced on a routine

basis, in a format which is production rather than customer led. In too many instances they

follow the format and content of Financial Accounts which have a different role and are

frequently unsuitable as an aid to management decisions. Such documents are then the cause

of considerable time wastage because people wish to find a use for them.

The only reason to have management accounts is to help managers manage by providing

information that enables better decisions to be made.

FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING

RECORDS THE PAST HELPS IMPROVE THE FUTURE

HAS RIGID DEFINITIONS CHANGES TO SUIT NEED

PROTECTS THE SHAREHOLDER HELPS THE MANAGER

IS CONTROL ORIENTATED HAS MULTIPLE USES

IS FOR EXTERNAL REPORTING IS FOR INTERNAL REFERENCE

IS A LEGAL REQUIREMENT IS SELF INFLICTED

MERELY KEEPS THE SCORE ADDS VALUE TO DECISIONS

BOTH RELY ON ACCURATE RELIABLE TIMELY DATA

This document covers some of the principles underlying the two of the three key reporting

documents in the Financial Report and Accounts, some comments on key performance

indicators and some illustrations of the use to which good costing information can be put to

make ad hoc management decisions. It is in four sections:

Pages 2 - 5 The Income and Expenditure Account

Pages 6 - 8 The Balance Sheet

Pages 9 - 12 Key Performance Indicators

Pages 13 - 19 Costing

For further information - particularly regarding Budgets and their use to plan and control

activities please see the website. www.FinancialManagementDevelopment.com



THE INCOME & EXPENDITURE ACCOUNT

(UNIVERSITIES)

OBJECTIVE

The objective of the Income and Expenditure Account is to match earnings from activities

with the costs of providing goods and services for a given period of time. It says nothing

about the assets involved in generating surpluses (or deficits) nor does it necessarily indicate

whether cash is being generated. It is a key document in assisting measurement and therefore

improvement of Business Performance, which ultimately determines the sustainability of the

organisation. A surplus arises when Income exceeds attributable Cost. All incomes and all

revenue costs (i.e. not the cost of assets purchased - which are capital costs) should appear in

the Income and Expenditure Account. Note that it is not the cash received or paid which is

shown but the amounts earned or incurred. (The Accruals concept of Accounting).

INCOME

Income represents amounts earned from activities during the period. It will normally be the

invoiced value of goods and services provided to customers. It may therefore bear little

relation to cash received. To the extent that income is generated without receiving cash the

figure for debtors in the Balance Sheet will change. For a University the recognition of

income can be problematic - not least because the income does not necessarily come from the

customers. The key sources of income with some notes as to how income might be recognised

are shown below:

Grants from Funding Councils - Normally received for an academic year on the basis of

student numbers, grant income can therefore be recognised fairly easily as having been fully

earned by the end of the year. If the grant has been based (and received) on expected student

numbers and these turn out to have been lower than anticipated then there will need to be a

provision for clawback i.e. the income will eventually be recognised on the actual number of

students and the excess will have to be repaid. Recognition of extra income earned, to be

received next year may be required - if actual numbers were higher than expected and the

funding body allows such additional amounts to be claimed. The recognition of income

earned from grants during the academic year is fraught with problems (e.g. how much is

earned in August?). Many institutions sensibly adopt a high level approach - releasing income

based on proven student numbers on a monthly basis - thus spreading annual income in line

with costs incurred.

Tuition Fees - For annual courses these are similar to Grants. For short courses the income is

normally recognised at the completion of the course, or apportioned on the basis of days

completed compared to total days if courses run over a month end. This latter approach is also

used for longer courses which run over the year end.

Research Grants - Income is recognised on the basis of the percentage completed, often

calculated by reference to costs incurred/total costs anticipated at completion.



Other Income - Most other income e.g. rents, catering, interest etc. are recognised when

received, only allowing for accruals and prepayments if material. Donations are normally

recognised when received, but can be accrued for if future receipt is certain e.g. a legacy is

notified, or the tax on gift aid is claimed but not received.

Expenditure In Retailing and Manufacturing organisations it is normal to calculate the Direct Costs of

Goods sold to enable a comparison of the Gross Margin (Sales less Direct Costs) for different

products. In the University sector this is often difficult as:

1. A major part of costs are staff costs (or directly related to staff time) and without a

vast expenditure of effort in keeping detailed records it is not possible to allocate staff

time to different "products" i.e. courses.

2. Cost allocation methods of the "overheads" premises, administration, human

resources, student records, finance etc have, of necessity, to be based on relatively

arbitrary bases rather than detailed usage records, yet they often form part of the direct

costs of delivering the service.

3. The increasing popularity of modular courses and the practice of allowing students to

change courses mid year adds a considerable degree of complexity.

Thus many institutions have a summary Income and Expenditure Account with costs shown as

staff and non-staff (analysed as appropriate) plus some form of resource allocation model,

which is used for management purposes to help allocate summary totals of budgets and actual

data across the academic departments or campuses.

In any event the basis for the recognition of costs is, or should be, the same as for income.

Costs are recognised as incurred. Thus the cost is shown in the period when the goods and/or

services are used - not when they are ordered nor when they are paid for. An example of the

problems this can cause is in the provision for pay rises. In some institutions the September

payroll costs are shown as the amount paid. In December an annual pay rise is agreed and

then backdated. Thus unless a central accrual is made for the pay rise in September the

accounts may be seriously wrong. It is easy to say that agreeing the pay rise in July for the

following year would solve the problem - but until student numbers are reasonably certain, the

affordability of the pay rise may not be known. However, in accounting it is generally agreed

that: It is better to be approximately right than to be precisely wrong. It is better to have

an approximate accrual than to ignore the problem and just let December be a horrible month.

The breakdown in communications between Accountants and Actuaries on the true cost of

Pension provisions during the last Century which resulted in the belated recognition of some

billions of pounds worth of costs appearing in company and University accounts in this

Century, is an example of what happens when you fail to account properly.

Classification of Overheads Overhead analysis should always be determined by the business need. Having one account

code avoids the possibility of miscoding but does not help informed analysis. Too many

codes or headings causes inefficiency and destroys the value of the analyses; which are

designed to help, not hinder informed management decision making.



Revenue not Capital Expenditure

The costs which appear in the Income and Expenditure Account are those for resources

consumed. Where money is spent on substantial items which last for more than one

accounting period e.g. buildings or equipment, the cost of this is effectively spread over their

useful lives by "Capitalising" them i.e. putting the cost on the Balance Sheet and reducing it

over the useful life by making a book entry charging for "Depreciation." Thus the purchase of

an asset costing £10,000 with a five year life will result in an annual charge of £2,000. The

£10,000 does not appear in the Income and Expenditure Account - but it will appear in the

record of cashflows. Something similar occurs when large stocks of items e.g. stationery, are

bought in one period but not used until future periods. If material these may be shown as

assets on the Balance Sheet until they are used.

Bad Debts

A University may recognise income e.g. for Tuition fees or rent, but subsequently find that it

cannot obtain the money. The charge for writing off these amounts will be shown separately -

normally as a cost rather than as a reduction of Income.

Provisions and Contingencies

It is reasonable and indeed highly desirable, to make a provision for known future costs e.g.

provision for bad debts, provision for redundancy costs, provision for pension liabilities.

However these should only be for realistic items. It is not acceptable to make a contingency

provision to smooth out the surplus for one year so that it can be released later to avoid a

future deficit. If known future eventualities are to be provided for, this is best done by

designating part of the reserves for that specific purpose.

Interest

If the University has borrowings, one of the costs will be the interest on these. To some extent

this cost may be reduced by any interest earned on bank deposits which may be shown as

income - in internal accounts these two amounts may be shown netted off.

Taxation Most Universities are Charities and thus do not pay tax on their surpluses, nor reclaim tax on

deficits! If they have substantial "Trading activity" which might be taxable, this is normally

carried out through a subsidiary company which then donates its profits to the University - so

no tax is suffered.

If a University has to charge Value Added Tax on some activities it shows the income from

those without addition of the VAT, which it has collected from customers on behalf of the

Government, it may then be able to recover some of the VAT it has suffered on related costs.

Otherwise the costs in the Income and Expenditure Account will include any VAT charged by

suppliers, since the main activity of education provision precludes recovery of VAT.

Surplus or (Deficit) This is the amount of the difference between Income and Expenditure. For a University it is

reasonable that over the long term it should generate modest surpluses. Any large or

exceptional items may be worthy of separate identification. A Surplus will add to the

University's Reserves in the Balance Sheet. A Deficit will reduce them.



THE BALANCE SHEET

(UNIVERSITIES)

OBJECTIVE

The Balance Sheet, as its name implies, balances. It sets out items owned (assets) and items

owed (liabilities) by an organisation. If there are Net Assets these will have been funded by

either capital which has been paid in (share capital, or some other form of equity) or by the

retention of surpluses or profits from the past - called Reserves.

The objective of the Balance Sheet is to identify the constituent parts of the Net Assets in

order to show the owners where their money has been invested. It is not a statement of the

value of the business. The layout and headings are defined for businesses by the Companies

Acts, and for Universities by the provisions of SORP (Statement of Recommended Practice on

Accounting and Reporting by Charities). The Board of Governors are responsible for the

University even though they are not its "owners". (NOTE - For all practical purposes ignore

columns in published accounts headed "University". Always look at the "Consolidated"

figures. For those who want to know why - see Acquisition Accounting on the website.)

ASSETS

Fixed Assets

Fixed Assets are items purchased by the business (or transferred to it) which are for use rather

than for resale. The main categories are:

1. Intangibles - Goodwill, Brand Names, Patent Rights etc. These are normally only

shown when purchased.

2. Land and Buildings - Some organisations separate the Land from the Buildings. This

also includes the value of any premiums paid for leasehold properties.

3. Equipment - Any asset live or dead used to assist the trade. There are rules about

what is equipment and what is not. A few organisations e.g. Football Clubs, treat

people as assets by showing the cash paid for them (transfer fees).

4. Vehicles - Lorries, cars etc.

5. Investments - Long term investments e.g. shares in associated companies.

It is normal to write off (charge as an expense) the cost of a fixed asset by depreciating it. The

annual depreciation charge is merely the cost less any expected value on disposal spread over

the asset's useful life. For intangibles the charge is called amortisation - effectively this is the

same as depreciation.

For many Universities land and buildings were inherited when they were founded or created as

separate institutions. A value will normally have been placed on these as at the date of

incorporation. Land is not normally depreciated and some organisations recognise any

increase in land value by showing the revalued amount in the Balance Sheet together with a

balancing increase in the Equity (a Revaluation Reserve - see below).



Stocks and Work in Progress

Stocks are normally shown at cost. This includes the cost of any work done on them e.g.

delivery or packing costs. If the value of the stock has declined then the reduction should be

made to reduce the value together with an equivalent charge against profits. Universities tend

to show low figures for stock - most items being written off when purchased.

Prepayments

Where cash has been paid in advance of receiving a service, it is held as an asset and only

charged against profit as it is used up or the service is received.

Debtors

The amounts owed by customers who have not yet paid are shown as assets. This will include

any associated VAT i.e. the amount is the true cash owing. If there is any doubt about gaining

payment then it is normal to make a provision against the debt. (i.e. reduce its value in the

Balance Sheet and charge the reduction as a cost). The main debtors for a University will be

Grant Funds and Tuition Fees owing. There may also be accrued income e.g. work done

under a research grant which has yet to be received.

Cash

This is the cashbook cash figure and will therefore need to be reconciled to the bank statement

to allow for unpresented cheques or lodgements in transit.

LIABILITIES

Overdrafts

Normally overdrafts are shown separately from cash balances. Again it is the cashbook figure

which is shown.

Creditors

Creditors are the amounts owed to third parties for goods or services received but not yet paid

for. Normally this is the total of unpaid invoices including VAT. VAT is not recoverable by

Universities since their "output" - education - is exempt from VAT. Although if they provide

some VATable services e.g. catering or exports (even if these are zero rated for VAT) they

may be able to recover some proportion of the VAT on inputs. There may be a separate

creditor for VAT charged but not yet paid to the Government, just as there will commonly be a

creditor for PAYE and NI deducted from salaries, but not yet paid over.

Accruals

Accruals are amounts owed for which no invoice has been received. It is normal to have

accruals for items such as electricity, phone etc. where bills are received in arrears as well as

for bank interest, audit and professional fees.

Deferred Income

Sometimes income has been received in advance of it being earned - e.g. research grants, or

payments in advance for courses. These are held on the Balance Sheet as an amount owing

and only released as income when the work is done.



Provisions

In addition to creditors and accruals most Universities have provisions for future liabilities e.g.

pension liabilities.

Loans

Loans, whether from a bank or elsewhere are liabilities and therefore will be shown at the

amount owing. Normally any related interest owing is shown under accruals.

EQUITY (or the way in which the net assets have been funded)

In Companies this is called Shareholders' Funds, in Universities it may be called Reserves or

Funds. It includes:

Deferred Capital Grants

Amounts received to fund the acquisition of assets, which are released to the Income and

Expenditure account as the assets are depreciated.

Endowments

Specific monies received to fund future activities e.g. to provide scholarship funds. Some are

permanent i.e. only investment income can be spent, the capital must be retained. Some are

Expendable i.e. can be spent at the Governors' discretion (within the terms of the endowment).

Revaluation Reserves

A recognition of the increase in values of assets - commonly the increase in value of land and

buildings since acquisition, or incorporation. (It is silly to show the value of a building at its

original cost of 32 Shillings and a Groat, but if you show its proper value the Balance Sheet

does not balance so the difference is shown as a Revaluation Reserve.) Where assets have

"inestimable value" eg The Book of Kells at Trinity College Dublin, the normal treatment is to

mention them in a note but not attempt to value them.

Balance on the Income and Expenditure Account

This consists of the Surpluses, less Deficits since the University was Founded or Incorporated.

In some cases a part of the Reserves may be designated as being set aside for a specific use eg.

to pay future pensions. It is beyond the scope of this paper to point out that pension

obligations are a real liability - showing them separately does not make them disappear.

Minority Interests

These arise when a University decides to share the risk of ownership of specific assets or

activities e.g. an overseas campus, student accommodation or buses. The University sets up a

subsidiary company and sells (say) 30% of the shares to another party (a local overseas entity,

landlord or bus company). Since the University owns 70%, it controls the whole company,

but it has only paid for 70%. The way the books are balanced is to bring in 100% of the assets

and liabilities, but to show the value of the remaining 30% as a deduction - thus indicating it is

not owned by the University. This is called the Minority Interest.



KEY PERFORMANCE INDICATORS

WHY USE KEY PERFORMANCE INDICATORS

The use of Key Performance Indicators and Ratio Analysis is a common management

technique. It assists management by exception and enables the reviewer to compare and

contrast different business units easily. This paper sets out some of the main financial and non

financial indicators and ratios used to analyse performance. There are many financial and non

financial indicators. Each organisation should produce its own relevant ratios to suit its unique

needs; and review these regularly to ensure they remain fit for purpose.

Ratios provide an insight into how results compare on a like for like basis with another set of

results. They help comparisons over time, against budget, against other organisations, within

an organisation between departments, products etc.

They rarely answer questions but they help the reviewer identify the right questions to

ask, by highlighting anomalies and trends.

In many cases, perfecting the calculation of the components of an indicator is less important

than consistency of approach.

FINANCIAL PERFORMANCE INDICATORS

There are many different types of users of financial data. For Universities these include

1. Managers who want to examine operational performance

2. Creditors who wish to establish future stability

3. Government as funder, taxation authority, etc.

MANAGEMENT OPERATIONAL RATIOS

The key management ratio in commercial business is Return on Capital Employed (ROCE). It

is also known Return on Net Assets (RONA). It has many different definitions and most

organisations have their own version.

It is normally defined as OPERATING PROFIT

SHAREHOLDERS' FUNDS PLUS BORROWINGS

As a measure this is similar to the return on an investment, where profit is seen as the return

and the value of the funds employed in the business are seen as the amount invested. In a

University this would be "Surplus/(Deficit)" divided by Reserves. However, care would need

to be taken regarding the valuation of assets - particularly property, in the Balance Sheet, since

this impacts on the value shown for Reserves.

The profit normally used for this purpose is Profit before Interest and Tax (if applicable) as

interest is affected by Gearing (see below) and tax is frequently seen as outside operational

management control. Most Universities use Operating Surplus as the denominator.



Because Capital Employed must equal Net Assets, ROCE should be the same as Return on

Net Assets (RONA) and it is RONA which is used as a basis to split the return down into its

component parts as shown in the Hierarchy of Ratios. The first step is to introduce Sales

(Income) into the equation.

PROFIT = PROFIT x SALES

NET ASSETS SALES NET ASSETS

or ROCE = MARGIN x ASSET TURNOVER

This forms the basis for a number of ratios as follows

MARGIN

All costs can be expressed as a % of sales. Profit can be taken at Gross Profit level to reveal

Gross Profit Margin (Sales less Variable or Direct Costs) as a %. This is particularly useful at

budget time to see which costs are moving with sales and identify any anomalies. It is also

common in interfirm and inter departmental analyses. The level of specific overheads as a

percentage of income is frequently cited in interfirm comparisons.

In Universities the Contribution from Faculties, Modules, Courses, etc. is often calculated

using some form of Resource Allocation Model. Care needs to be taken with this data as

sometimes fixed costs can be treated as variable costs by being allocated on usage.

ASSET TURNOVER

ROCE can be improved by reducing asset levels or by increasing sales. Analysing the Net

Assets into their constituent parts will prove a useful indicator over time.

BEWARE

1. One way of improving ROCE is to increase the Fixed Asset Turnover. This is good if done

through efficiency but dangerous if it is done by failing to buy new fixed assets and

allowing the ratio to improve through the action of Depreciation. New Capital Expenditure

should exceed the Depreciation charges. If not, the assets are being run down.

2. Many assets are not recorded on the Balance Sheet e.g. Employees, Customers, Patents,

Knowledge, Brand Image and Supplier relationships. There is a danger in ignoring these as

over time their value needs to be maintained if the business is to continue.

FIXED ASSET TURNOVER

A useful measure in capital intensive industries. SALES

FIXED ASSETS

For universities care needs to be taken that the values placed on fixed assets, especially

property, are reasonable. A ratio based on utilisation rather than values may be better.



DEBTOR DAYS

The comparison between Sales and Debtors is normally expressed as a number of days sales.

DEBTORS x 365 = Days Sales Outstanding

SALES FOR A YEAR

There are norms in each industry for the appropriate level. An aircraft manufacturer may have

180 days, a Retailer zero. In some countries it is wise to allow for Sales Taxes which will be in

the Debtors figure but not in the sales figure. As Universities become more reliant on non-

governmental sources of income the risk of non payment will grow and this may become a

more important measure.

STOCK DAYS

The comparison between Sales and Stock is also expressed as a number of days sales.

STOCK x 365 = Stock Days

SALES FOR A YEAR

There are norms in each industry for the appropriate level. A builder may have 180 days, a

food retailer 2 days, and a dairy 2 hours! The figure does not represent the number of days of

sales in stock, because the stock is at cost price while sales are at sales price. For most

Universities stock levels are trivial for the organisation as a whole, but they may be significant

in specific trading areas or subsidiaries.

CREDITOR DAYS

The ratio between Sales and Creditors is also expressed as a number of days sales.

CREDITORS x 365 = Creditor Days

SALES FOR A YEAR

Again there are norms in each industry for the appropriate level. Like the Stock Days, the

figure does not represent the number of days of sales financed by creditors, because they are

also at cost price while sales are at sales price. However it provides a useful basis when the

data is extracted from consecutive published accounts. In internal accounts it can be and

should be related to the purchases figure, although there may again be a need to adjust for

Sales Taxes.

CREDITORS RATIOS

Creditors, both Trade Creditors for goods supplied and Loan Creditors who have lent money,

are mainly interested in whether they will be repaid. They are thus interested in short term

liquidity and in levels of risk. They will look at:

THE CURRENT RATIO

Defined as Current Assets

Current Liabilities

The higher the ratio, the safer the company for creditors. However a high figure will mean a

lower ROCE which suggests inefficiency on the use of working capital.



INTEREST COVER is a Banking concept. It is defined as OPERATING PROFIT

INTEREST PAYABLE

It merely calculates that there is sufficient scope for profits to fall before interest payments are

at risk. Loan agreements may include covenants based on interest cover or on gearing levels.

GEARING, sometimes called the Debt to Equity Ratio or Leverage, is a measure of the

relative risk of a company's capital structure. A high GEARING is relatively risky. For

Universities funding bodies or lenders may set a limit on the ratio of borrowings to reserves

(or free reserves i.e. excluding designated or restricted funds). It is normally calculated as

Borrowings -net of any cash, as a percentage of Reserves.

NON FINANCIAL RATIOS

Non financial ratios are almost exclusively used by Management, since for outsiders the scope

for different definitions makes comparison between organisations difficult. The key

approaches are based on Employees, Operational activities, Assets, Customers or Suppliers.

They take many forms. In commercial organisations they include:

EMPLOYEES - Output per Hour, Employee cost per hour, Employee cost per unit, Staff

Retention (or Turnover), Employee Satisfaction Survey Statistics

OPERATIONAL - Units per Day, Rejects per ‘000, Waiting time (or order fulfilment time),

Cost per Hour, Cost per Unit

ASSETS - Machine Utilisation (or idle time), Cost per unit, Downtime, Repair statistics

CUSTOMER - Customer Satisfaction, Order fulfilment, Complaint levels, Returns, Repeat

Orders

SUPPLIER - Order fulfilment, Complaint levels, Returns

IN UNIVERSITIES THE MOST COMMON FINANCIAL RATIOS USED ARE:

Margin, Contribution, Unit cost (after allocations), Gearing, Interest cover, Current ratio,

Level of free cash, Reserves as a percentage (or number of days) of recurrent costs.

AND SOME COMMON NON FINANCIAL INDICATORS ARE:

Employee - Staff Costs as a percentage of Income (or income as a multiple of staff costs),

average salary, Staff/student Ratio, Academic Staff/Non Academic Staff

Space - Utilisation statistics, Investment/Depreciation

Sustainability - Government/non Government income, Research Income/Total Income,

Other - International Students/Total Students, New Project Income/Total Income

In addition to satisfaction surveys etc, etc.

KEY PERFORMANCE INDICATORS ARE A MANAGEMENT TOOL. WHAT IS

IMPORTANT IS THAT THE DECISION MAKING IS IMPROVED. KPI'S SHOULD

BE REGULARLY REVIEWED TO ENSURE RELEVANCE. DATA COLLECTION

AND REPORTING IS NOT AN END IN ITSELF.



COSTING IN UNIVERSITIES

THE NATURE OF COSTS

Much of Management Accounting involves consideration of costs. There are many different

types of cost. However it is vital to realise that no one cost is appropriate for all decisions.

True cost analysis and its use in decision making involves considering the future, not just

relying on the past. The most commonly used cost is the amount spent on an item to get it to

its current state or the amount of an expense. This is the Historic Cost. It is the keystone of

Financial accounting and is used to calculate profit by deducting it from sales value. Other

categories of cost are:

Variable costs Costs which directly vary with the volume sold or produced.

Examples include materials or overtime.

Fixed costs Costs which are not related to volume. E.g. rent or heating costs.

Direct Costs Costs which can be identified with particular courses, processes

or parts of an organisation. E.g. the materials on a technology

course or the depreciation cost of equipment used on a course.

Indirect Costs Costs which are not directly connected with that particular

course, process or part of the organisation and which therefore

may have to be allocated or apportioned on some arbitrary basis.

An example is the rent of a campus which is apportioned to the

various faculties on the basis of floorspace occupied.

Marginal Cost The cost of one more unit. This may be a little or a lot depending

on the state of capacity. It will change with circumstances.

If a campus is working at half capacity then there may be no

marginal cost of performing an extra task. If it is already at full

capacity then the cost of accepting one more unit might be the cost

of setting up a new campus.

Sunk Cost A past cost irrelevant for future decisions. e.g. the cost of a machine

which is obsolete, the original cost is of no assistance in any

management decision for the future. An example is original cost of the

Channel Tunnel. Who cares what it cost, we will not build another.

Opportunity cost The cost of the next best alternative which would be foregone if

a particular course of action were taken. e.g. The cost of your time on a

training course is not your salary but the loss of the value you would

have added to your organisation if you had done something else.

FIXED AND VARIABLE COSTS FOR RISK ASSESSMENT

In the short term all costs are fixed, in the long term all costs are variable. It depends on

timescale and the level of the review. However the split between fixed and variable costs is

vital to assess the impact of changes in the level of demand. Consider two companies. One has

mainly variable costs and one has mainly fixed costs.



TWO COMPANIES - SAME SALES, SAME COSTS DIFFERENT STRUCTURES

COMPANY A £ COMPANY B £

SALES 10,000 SALES 10,000

VARIABLE COSTS 8,000 VARIABLE COSTS 1,000

______ ______

CONTRIBUTION 2,000 CONTRIBUTION 9,000

FIXED COSTS 1,000 FIXED COSTS 8,000

______ ______

PROFIT 1,000 PROFIT 1,000

===== =====

Both companies have the same profit but which company would you rather work for?

Hopefully those who are sales orientated would opt for company B, while those who are risk

averse would opt for company A. The answer depends upon your view of the future.

To illustrate this, recalculate profits under two different scenarios. In the first, sales are

expected to rise by 20%. In the second, sales are expected to fall by 20%. Notice that

contribution is defined as sales less variable costs, and that variable costs vary directly with

sales whereas fixed costs do not.

SALES SALES

UP 20% DOWN 20%

COMPANY A £ £ £

SALES 10,000 12,000 8,000

VARIABLE COSTS 8,000 9,600 6,400

______ ______ ______

CONTRIBUTION 2,000 2,400 1,600

FIXED COSTS 1,000 1,000 1,000

______ ______ ______

PROFIT 1,000 1,400 600

===== ====== =====

When Sales are good the contribution rises and since fixed costs do not change the profit is

automatically improved. When sales fall by 20% profits are reduced. However, because the

majority of costs are variable the company is protected when times are hard. The price it pays

for the low risk is the lower reward when sales are good. Examples of such companies are

supermarkets, staff agencies and training companies.

COMPANY B £ £ £

SALES 10,000 12,000 8,000

VARIABLE COSTS 1,000 1,200 800

______ ______ ______

CONTRIBUTION 9,000 10,800 7,200

FIXED COSTS 8,000 8,000 8,000

______ ______ ______

PROFIT 1,000 2,800 (800)

===== ===== =====



Because company B has low variable costs it does well when times are good and badly when

sales fall. Such companies have cyclical profits and tend to hit the headlines in both good and

bad times. Examples are the car industry, merchant banks, estate agents etc. Such companies

need to concentrate all their efforts on making sales and because of their cost structure are

frequently found to be dumping surplus capacity at marginal cost.

Employers try to alter the cost structure, by making fixed costs variable to reduce the risk of a

down turn in demand. Outsourcing and subcontracting are one approach. More common is

redundancy for some, with those retained being asked to work overtime. Employees are a

variable cost for companies but a fixed cost for the nation!

Are the costs at your University mainly fixed or variable? (are you fixed or variable?)

What does this mean for strategy? Should you focus on income generation or cost reduction?

FIXED AND VARIABLE COSTS FOR PRODUCT RISK APPRAISAL

The split between fixed and variable costs is vital to assess the break-even point for sales when

evaluating a new product or when considering delisting an existing product. For a University

this could be a new Course or a new Campus.

The break-even point is defined as being the level of sales when profit is zero. At this point

sales less variable costs less fixed costs equals zero.

IF SALES - VARIABLE COSTS - FIXED COSTS = 0

THEN SALES - VARIABLE COSTS = FIXED COSTS

OR CONTRIBUTION = FIXED COSTS

Consider the data above as being for two new potential products:

Product A has a contribution ratio of 20%. That is the ratio of contribution to sales value is

20% (2,000/10,000). Thus for every £1 of sales the contribution and therefore the profit for

product A increases by 20p.

How many sales of 20p contribution are needed to cover the fixed costs of £1,000?

5,000 or £5,000 worth because 20p x 5,000 = 1,000

The same calculation can be carried out for product B

Product B has a contribution ratio of 90% (9,000/10,000). Thus each £1 of product B sold will

add 90p contribution and therefore 90p profit.

For product B, fixed costs are £8,000. How many 90p's are required to cover £8,000?

8,889 or £8,889 worth because 90p x 8,889 =8,000

Thus if the sales forecast for each product is 10,000, the manager of product A can afford a

shortfall of 50% before he makes a loss, while the manager of product B can only afford a

shortfall of 11%. If these were two competing potential new products then the prudent

accountant would accept product A before product B, because it is less risky.



Break-even analysis can be a useful mechanism for quantifying risk and identifying the action

to take to mitigate it. For example if firm orders of 9,000 can be proved for B then there is no

risk of it making a loss. Using spreadsheets different levels of demand, prices and costs can be

used to establish the best course of action if a reasonable estimate is made of the fixed and

variable costs. Estimates are fine in management accounting. It is better to be approximately

right than precisely wrong.

FIXED AND VARIABLE COSTS FOR RESOURCE ALLOCATION

When considering whether to take a particular course of action it is vital to consider only those

costs which will vary and ignore those which are fixed. Assume a new salesperson is to be

recruited and they can sell £10,000 worth of either product A or product B. Which product

should they be asked to sell?

If they sell £10,000 of product A the extra profit generated will be £2,000, because each extra

£1 brings in an extra 20p. If they sell £10,000 of product B the extra profit generated will be

£9,000, because each extra £1 brings in an extra 90p.

It does not take a degree in finance to appreciate that the sales person should sell product B,

the product with the higher contribution ratio. However, many organisations have no clear

picture of the contribution ratios of the various products in their portfolio and thus do not

know which products to promote. In Universities are those involved in promoting courses

aware which are high contributors and which are not?

DIRECT AND INDIRECT COSTS - THE DANGERS OF COST ALLOCATION

The direct and indirect definition varies with level. All a University's costs are direct for the

University as a unit but some will be indirect for the departments within it. It is right to use

costs to guide to decisions on pricing, but external pricing needs consideration of direct costs,

uncorrupted by allocations which can lead to misleading conclusions.

Assume a campus costs £100,000 per month to run. It expects to teach 1,000 students per

month and therefore when budgeting, each student is costed at £100. During the year demand

is poor and volume falls to 500 students. There are too many examples of costing systems

which would suggest to management that the cost of each student is now £200 and that

therefore the price charged should be doubled! This will not improve income.

In cost conscious organisations "Cost per unit" is often a key measure of efficiency. Beware

improvements in cost per unit that result from purchasing more than is required for current

needs. Since the units will stay in stock, profit looks fine. Management frequently only

discover the problem when they run out of storage space, or worse, cash.

Direct costing is an approach when considering new activities. True cost increases should be

identified or estimated, rather than arbitrary allocations of overheads based on existing ratios.

It is true that all costs have to be covered, but that does not mean that lower priced business

should be turned away. It merely means that due consideration needs to be given to the cost

structure and the market place in both the short and long term.



MARGINAL COSTS

Marginal cost is the cost of the next unit. It embodies the consideration of both the

Fixed/Variable analysis and the Direct/Indirect analysis. As a concept it can be very valuable

in assisting pricing decisions but it can be very dangerous unless used carefully. Marginal

costing of activities is fine, marginal pricing can be disastrous. Here are some examples:

1. Costing and Pricing (Standard) You have established the following data for a three day course:

Tutor £500 per day

Room £300 per day

Materials £30 per delegate

Admin Support £50 per delegate

Overhead and IT costs £400 per course

How many students are required to break even at a price of (a) £375 each, (b) £400?

£

Fixed Costs: Tutor 3 x 500 1,500

Room 3 x 300 900

Overheads 400

2,800

Income per Student 375 or 400

Variable Cost Materials (30) (30)

Variable Cost Admin Support (50) (50)

Contribution per Student 295 320

(a) At £375 10 students covers the fixed costs and yields a surplus of £150.

(b) At £400 9 students covers the fixed costs and yields a surplus of £80.

What is the "profit" if there are 12 students paying £375

(12 x 295) - 2,800 = £740

What is the "profit" if there are 10 students paying £400

(10 x 320) - 2,800 = £400

2. Costing and Pricing (Marginal) Assume you have 10 students booked at £375 and another student rings up and asks to

join the course; what is the minimum price you should charge?

The variable costs are £80 so the minimum charge is £80. BUT The assumptions include:

The other students will not want a similar deal.

The room can take another person.

The materials are available.

The materials are extra (if there is a spare set then there is no extra cost).

The Admin Support is truly variable.

You are certain that the late booking will not mean that they will not book a future

course at £375.



3. Costing and Pricing (Sunk) (a) You discover that the course had a development cost last year of £2,000. Does

this change your earlier answers? No. What has been spent is spent; it cannot affect decisions for the future.

(b) You calculate that updating the course material will cost £150. Does this change

your earlier answers?

The breakeven remains at 10 students, profits will fall by £150. The answer to 2. is

unaffected.

(c) You have four training rooms empty. Heating etc. costs are trivial - What is the

minimum you should charge for their use; what is the maximum?

Zero is the minimum. The maximum is much as you can without losing the business but bear

in mind the alternative uses.

(d) You have four tutors with no courses to run. Why is the answer to (c) less

applicable to people.

Tutors not running courses can be usefully employed:

Developing material

Generating new business - advertising the University name

Doing Research for which grants or funding may be available

Pastoral care of Students (to reduce likelihood of leaving)

Chasing payments etc.

In fact anything to increase income or reduce costs!!!!! (if you ask nicely)

Starting new courses, ceasing to run old courses, scheduling, decisions on short term hire or

purchase, overtime or recruitment should all be driven by consideration of marginal and

average cost and demand forecasts. Because demand is difficult to forecast, it may be better to

accept fixed contracts at below normal price in order to avoid or reduce risk.

OPPORTUNITY COSTS

Opportunity costs are difficult but it can be dangerous to ignore them. The opportunity cost is

the lost profit or benefit from using a scarce resource in one activity in preference to the next

best alternative. The "cost" is the benefit foregone from the alternative.

An employee could walk home or drive home each day. To walk home takes one hour more

than driving home. If he stayed at work he could earn an extra £10 in overtime. The

opportunity cost of walking is the loss of £10 earnings. (If he would merely go to the pub

instead and spend £5 before driving home then the opportunity gain from walking is £5 which

is cash saved). Some individuals would say that quality of life is relevant - Accountants

would agree and then try to put a value on it by asking how much would you require to

compensate for a lower quality of life.

Beware of fictitious opportunities "I could hire a Rolls Royce to go home in for £1,000" so

look how much I have saved! The earlier example on fixed and variable costs can be used to

illustrate the concept of opportunity cost. The benefit from the new sales person will be

£9,000, if they sell product B. The opportunity cost of using them to sell product B is the

contribution from the sales of A which will now not be made i.e. the £2,000.



COST ALLOCATIONS

In most large organisations costs are allocated to products because Direct Costs are only part

of the total cost. In order to arrive at full cost, various methods of cost absorption/allocation

have been used to simulate the fact that costs have been incurred over the product range.

Activity Based Costing is merely an application basis which is a more refined approach than

floorspace, headcount etc. The important factor is that whatever allocation is used it should be

relevant. The most common bases are:

Basis Used For (for example)

Employee Headcount Personnel Dept.

Non-productive space costs.

Floorspace Occupied Heat/Light/Insurance/Rent

Students Administration Costs

Finance Costs

Purchasing Department Costs

Hours Worked/Taught Management Costs

By definition the results will be approximate. The objective is to ensure all costs are included

when considering strategic decisions. The allocation methods may be misleading if used for

tactical decisions or performance measurement. In particular, managers who have cost targets

which include allocated costs may seek to play games to reduce the costs e.g. if allocated on

employee headcount - take on expensive agency staff rather than employees; if allocated on

floorspace - rope off areas as "not being mine so you can't charge me". In addition, allocated

costs may cause external suppliers to appear cheaper. e.g. food for internal meetings is bought

from outside suppliers rather than in-house because the in house catering cost includes

allocated premises costs. Unintended consequences of cost allocation must be avoided.

Cost Estimation is an art not a science. It involves consideration of the future, the

opportunities and the past. It involves consideration of risk and common sense.

If costing is an Art, Pricing is even more so!

SUMMARY

It is vital for the health of an organisation that managers realise that different information is

needed for different decisions. The management information required on a routine basis is not

necessarily appropriate for all purposes.

The exact format of the management accounts will be unique to each organisation. In addition

it is perfectly reasonable to change the format to highlight particular areas of information

need. Management reports should be subject, like every other activity, to cost/benefit analysis.

They should be produced to aid specific decisions and then stopped. Too many organisations

suffer from excess management information because no-one has the courage to say that they

no longer wish to look at data which the purpose of which is lost in the past.

The acid test for all management information is "Does it produce a noticeably better

decision which demonstrably added value?" Has reading this caused you to do

something differently which will result in more money? If not why have you read it?



Rev. DAVID A. PALMER BA (Financial Control) FCA CTA MCIPD

An experienced financial professional who has devoted his skills to management training in

practical understanding and utilisation of financial information. Having graduated from

Lancaster University, he qualified as a Chartered Accountant and as a member of the Institute

of Taxation while with Price Waterhouse. In 1993 through his training expertise, he was

accepted as a member of the Chartered Institute of Personnel and Development.

He has worked as a Financial Controller and Company Secretary in the Finance Industry and

as a Director of Finance and Administration in the Computer Services industry. Since 1990 he

has run management programmes for over thirty major organisations including Arla Foods,

BP, CSC, Conoco, Department of Social Security, Lloyds Bowmaker, Royal Mail, Unilever

and Zeneca. International training experience includes work in Denmark, Kenya and the

Czech Republic for Unilever, in Holland and the US for Zeneca, and in Bahrain and Saudi

Arabia for Cable & Wireless. He also runs a variety of financial management development

programmes for the management teams at a number of Universities – including Central

Lancashire, Coventry, Hertfordshire, Middlesex, and Trinity College Dublin– as well as for

the Leadership Foundation.

He specialises in programmes in financial management for both tactical and strategic decision

making. He has run courses in acquisition evaluation (The Economist, Eversheds, Blue

Circle) and in post-acquisition management (Unilever). All training is specifically tailored to

the needs of the organisation with the emphasis on practical applications to enhance

profitability and cashflow. He has developed material for delivery by in-house personnel

(Royal Mail, Lloyds Bowmaker and Conoco), computer based training packages (The Post

Office, Unilever and BP), and post course reinforcement self-study workbooks (CSC and

Zeneca). He has also produced a training video on Cashflow Management.

A prolific writer of case studies, role plays and course material, he has published articles on

the financial justification of training, financial evaluation of IT investment, commercial

realities for consultants, financial considerations for retailers, activity based costing, central

service function charging mechanisms, customer profitability analysis, stakeholder value and

the need for taxation awareness training for general managers. Many of his generic

documents are freely available on his website: FinancialManagementDevelopment.com

including papers on Charity Management.

He is married with one daughter and three granddaughters. He is a Deacon in the Catholic

Church. He is a member of The Court of the University of Bedfordshire and a Trustee of the

Ten Ten Theatre. He has formerly held voluntary positions as Hospice Trustee (treasurer),

Governor of Luton University, Governor of Dunstable College, school Governor, Trustee for

various charities and was a member of the Catholic Alpha Training Team (Promoting the

Alpha course on Basic Christianity).

This series of papers is designed to help managers by providing a basic understanding of

key financial concepts to assist them in their work. It is provided at no cost since this

knowledge is a Gift from God and thus to be shared (Matthew 10:8).

London Conference - David Palmer - AUA Finance presentation

Education

Transcript of London Conference - David Palmer - AUA Finance presentation