Week 7 - Audit and Controls and Assurance PDF

Week 7 - Audit and Controls and Assurance Understand Key Auditor Interactions, Governance, Explain the need for internal controls and internal auditing, understand the need for audit committee. Governance is the exercise of economic and administrative authority to manage an entities affairs, applic...

Week 7 - Audit and Controls and Assurance Understand Key Auditor Interactions, Governance, Explain the need for internal controls and internal auditing, understand the need for audit committee. Governance is the exercise of economic and administrative authority to manage an entities affairs, applicable to all entities. Concerned with processes by which decisions are made and implemented so that the entities affairs are conducted properly and in accordance with the laws and other applicable regulations. Objective for an auditor: the effectiveness of the assurance engagement is a function of the auditors relationship with the entities management and the governance body. The auditor and governance ISAs NZ provide examples of the auditors interactions with those charged with governance. ISA 250, consideration of laws and regulations in an audit of financial statements. ISA 260, Communication with those charged with governance. ISA 265, Communcating deficiencies in internal control to those charged with governance and management ISA 315, IDentifying and assessing the risks of material misstatements through understanding the Entity and its environment. ISA 330, The auditors responses to assessed risks. Issues in governance RIsk Management and internal control Effective governance and accountability based on effective functioning of internal control and risk management. RIsk management is the culture, process and system established to manage opportunities and minismse or control risks. Internal control The term controls refers to any aspect of one or more of the components of internal control. Internal control is the process designed, implemented and maintained by those charged with governance, management and other personnel provide reasonable assurance about the achievement of the entities objectives with regard to, reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. COSO : Internal control and integrated framework Committee of Sponsoring Organisations of the treadway Commission. Five elements of Internal control - Control Activities - RIsk Assesment - The control Environment - Information and Communication - Monitioring Control prevents and detects CRIME ( Anagram used to remeber 5 internal controls) Internal Audit encompasses examination and evaluation of - Adequacy and effectiveness of governance and internal control structure - The quality of performance - The procedures of risk identification and management - Mechanisms to ensure regulatory compliance Supplements the work of independent auditors Internal auditors should Review the reliability and integrity of financial and operating information Review the systems established to ensure compliance with policies, plans, procedures, laws and regulations Assess risks within and outside the business Review the means of minimizing risks Appraise the economy and efficiency of resources Review operations or programs. Criteria external auditors use to assess the performance of the internal auditor include - Organisational status - Should report to the highest level of management and free of any operational responsibility. Need to be free to communicate with external auditors - Scope of internal auditing - External auditors consider the nature and extent of the internal auditors - Technical competence.  - Internal audit function should be performed by those with technical training and proficiency - Due professional care - Internal audit should be planned, supervised, reviewed and documented - External auditors should consider the adequacy of audit manuals, work programs and internal audit working Operational Auditing Examines the use of resources to evaluate whether they are being used in the most efficient and effective manner. Three approaches Risk Based audit approach - Identify areas of greatest risk and make an audit program - Distinguishes between control adequacy ( what should be) and control effectiveness ( what is) - Values for money approach - Defines attributes of effectiveness and focuses on effectiveness, efficiency and economy of operation from customer viewpoints. - Process audit approach - Examines the effectiveness of process and distinguishes value added from non value added activities, building the control framework into the process. Operational Auditing - Five Phases Preliminary preparation - gain a comprehensive understanding of the organisation Field survey - identify problem areas and sensitive issues Program development - step by step program Audit application - detailed review Reporting and follow up - with senior management and the audit committee Skill sets of an internal auditor Internal auditors require a broad range of skills such as Strong business acumen Canvassing leading ideas from around the globe Forming solid partnershups with the risk function and management Being innovative in the way they report. Audit Committees Enhance effective accountability within organisation in both the private and public sectors Facilitate participating of independent directions in governance process Provide a forum where directors, management and auditors can discuss and resolve issues relating to management risk and financial reporting obliglations. Audit Committes should - Be of sufficient size, independence and technical expertise to discharge its mandate effectively - Be made up of only independent directors - Include members who are all financially literate - Include at least one member with financial expertise - Include some members who have an understand of the industry The role and objectives of the audit committee - Assist directors in discharging their responsibilities - Improve the credibility and objectivity of the accounting process - Improve the effectiveness of the internal and external audit functions and facilitate communications between the board and the internal and external auditors - Facilitate the independence of the internal and external auditrs - Strengthen the role and influence of the non executive directs - Foster an ethical culture throughout the organization Relationships of the audit committee with the internal and external auditors Assurance and Auditing Defined. An assurange engagement is defined as an engagement in which an assurance practitiorner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria Auditing is the accumulation and evaluation of evidence about the information. The degree of corespondence between the information and established criteria is ascertained. Results are communicated to interested users. Auditors should be competent and independent. Auditing of financial statements is the most common assurance. Audtiing of financial statement is the most common assurance engagement. Assurance and auditing defined Whom the auditor prepares their report eg shareholders, creditors and employees. Responsible party - the person or organisation responsible for preparing the financial statements eg company management Subject matter - that which the auditor is expressing a conclusion eg financial reports Criteria - the rules or principles by which the subject matter is being evalusated , eg accounting standards and interpretations and and corporation laws. Overall objectives of the auditor F/S Auditor To obtain reasonable assurance whether the F/S are free from material misstatements due to fraud or error, thereby enabling the auditor to express an opinion on whether the F/S are prepared, in all material respects, in accordance with an applicable financial reporting framework. To report on the F/S and communicate as required by ISAs in accordance with the auditors findings. Professional standards, ISA, the auditor is performed in accordance with ISA ( International standards of auditing) Who is required to have a financial statement audit All companies considered FMC reporting entities ( FMC) expanded definition os issuer companies. For non-FMC entities all large companies. A large company other than an overseas company or subsidiary of oversea company has assets or revenue. Assets worth ? 60M or Revenues > 30 m for 2 consecutive periods. Different assurance services The most common assurance services are - Financial report audits: An engagement designed to express an opinion about whether the report is prepared in all material respects in accordance with a financial reporting framework - Compliance audits: Involves gathering evidence to ascertain whether rules, policies procedures, laws and regulations have been followed - Performance audit: Refers to the economy, efficiency and effectiveness of an organization's activities - Comprehensive audit: Combines elements of financial report audit,compliance audit and performance audit and often occurs in the Public sector. - Internal audit Provides assurance of financial report audit compliance audit and performance audit - CSR assurance Provides assurance about various aspects of an organisations activities. Often contains elemts of performance audits, compliance audits, internal control assessments and reviews. Includes voluntary reporting about environmental, employee and social subject matter. Incorporates both financial and non-financial information Auditor must consider environment issues on their clients financial reports even if reports do not include any disclosures. Preparers and Auditors It is the responsibility of those charged with governance to prepare the financial statements. The information should include the following attributes. Relevant: has an impact on the decisions made by users regarding the performance of the entity Reliable. Information is free from material misstatements (errors or fraud) Comparable. Information needs to be comparable through time. Comparable against the same entity over time and against other entities. Understandable. Users need to be able to interpret the information presented in order to make decisions True and Fair requires the consistent and faithful application of an applicable framework when preparing a report. Auditors responsibilities relating to the audit Professional skepticism - being independent of the entity and having a questioning mind to thoroughly investigate all evidence presented. Professional judgement - use of judgement based on level of expertise, knowledge and training obtained by the auditor Due Care - being diligent applying standards and documenting each stage of the audit process. Three tiers of assurance providers in NZ and Aus Assurance services are provided by accounting and consulting firms First tier comprises of the “ Big 4” which includes Deloitte, Ernst and Young, KPMG, and PWC Mid tier compromises of firms with significant presence and most have international affiliations, Grant Thorndon, BDO…. Next tier is made up of local accounting firms. Demand for audit and assurance services The users of the financial statements are not limited to the shareholders or owners of the business. Other users can include: Investors: can include current or potential investors. Decisions include to buy, hold or sell stake in the organization. Suppliers: may want to assess whether the entity can pay them back for goods supplied. Customers: may look into going concern if it is to rely on the entity for goods. Lenders: to assess whether loan repayments can be made as and when they fall due. Employees: to assess whether they can pay entitlements, and stability may be assessed for job security. Governments: whether the entity is complying with regulations and paying appropriate taxes. General public: whether they should associate with the entity (future employee, customer or  supplier,) what it does and plans to do in future. Reasons why users demand financial reports include: Remoteness: users do not have access to information themselves. Complexity: users do not have knowledge to be able to make disclosure choices. Competing incentives: users may find it difficult to identify when the incentives of management have been over-represented. Reliability: as decisions are being made based on information presented, it is important that it be reliable.08/29/2024 Theoretical frameworks Agency explains the relationship between owners and managers. Due to the remoteness of the owners from the entity, the owners have an incentive to hire an auditor to assess information provided by management. Theoretical frameworks : information hypotheses Information hypotheses explains the demand for external audits Auditing as an information risk reducing activity The need for reliable information, users demand that information be audited to aid in decision making. Theoretical frameworks - Insurance hypotheis Auditing provides investors a form of insurance The insurance hypothesis predicts that auditors are demanded ( so that they may be sued in case their is a business failure The law provides some degree of recourse against the auditor The auditors depending on how the courts reasoning works, act as an indemnifier against investment losses. Demand in a voluntary setting It is becoming more common to voluntarily disclose CSR information in various forms. This is a stakeholders are demanding information regarding the entities impact on the environment and actions taken to reduce their impact Entities are not required to have CSR disclosures assured These services are provided to meet user demands for high quality, reliable information and to demonstrate a high level of CSR. Different audit opinions Audit opinions are contained in audit reports provided by the auditor An unmodified audit report contains an unqualified or clean opinion All others reports are modified opinions A report can be unqualified modified report when an emphasis of matter is added. An emphasis of matter is used so that the reader can pay appropriate attention to the issue raised but does not change the auditors opinion. Week 8 Professional Ethics - What defines a professional - Making a distinction between a professional and a technical expert in fields like accounting and auditing holds significance - To enable a group to possess vocational expertise, like financial auditors, to become professional suggests that its members share common principles, ethical boundaries, and a genuine dedication to performing at their highest level - A professional is often anticipated to serve the broader public interest and uphold ethical standards, even in situations where it may pose challenges Understanding ethical issues The knowledge of ethics is important to the profession Ethics is concerned with the evaluation of choices where options are not clear or where there is no absolute right or wrong answer The study and practice of ethics enable an accountant to critically examine a situation in which there is a conflict of loyalties and interests, involving issues that relate to roles and responsibilities. Generally ethical behaviour requires - An understanding of ethical issues, a framework within which a responsible decision can be made and an awareness of the consequences of such decisions. The word ethics is derived from the greek word ethos meaning character whereas ‘ morality’ focuses on the good and bad of human behaviour, ethics focuses on what is right and wrong and how and why people act in a certain manner./ Ethics focuses on a study of choices, standards and behaviours. The nature of ethics ( teleology) consequentialism - utilirianism Forward looking rationale Deontology ( non-consequentialism) past or present Virtue ethics - act morally based on character Ethical relativism - environment based Regulating the accounting profession The requirements with which professional accountants must comply with Technical standards such as ISAs The code of ethics - the code is designed to encourage ideal behaviour it should be realistic and enforceable Ethical and other standards governing behaviour set by professional bodies and national standard- setters such as XRB The requirements of accounting standards,company law and securities regulations Co regulation of audit independence and standard setting Government intervening in the regulation of accountants and financial reporting PES 1 (Revised): Professional and Ethical Standard (Issued December 2018). New version: periods beginning on or after 15 Dec 2023. An assurance practitioner that is required to apply this Standard is required to apply it as follows: Parts 1: Complying with the Code, Fundamental Principles and Conceptual Framework. Part 2: Assurance Practitioners Performing Professional Activities Pursuant to their Relationship with the Firm. Part 3: Application of the Code, Fundamental Principles and Conceptual Framework. Part 4A: Independence for Audit and Review Engagements. Part 4B: Independence for Assurance Engagements Other than Audit and Review Engagements. Purpose of the code Professional and ethical standard 1, international code of ethics for assurance practitionaers defines Fundamental ethical principles ( intergrity, objectivity, competence, confidentiality, conduct) for practitioners, highlighting their responsibility to the public interest The code provides a framework for practitioners to  - Identify, assess and manage threats to complying with these ethical principles - Offereing guidance on various topics to apply this framework effectively For audits, reviews, and other assurance engagements the code establishes IIS NZ derived from this framework to maintain independence in these specific professional roles. Fundamental principles of professional ethics 110 the fundamental principles Sections where the fundamental principles are located within PES 1 111 - Integrity - Being straightforward and honest in all professional and business relationships, which means Not knowingly being associated with materially false or misleading statements or statements made recklessly 112 - Objectivity - Avoiding bias, conflicts of interest, or external pressures overpowering professional or business decisions is crucial. Objectivity, a mental state, can exist without complete independence. Independence, vital for assurance tasks like audits and reviews, demands both:independence of mind, independence in appearance. 113 - Professional competence and Due care - Maintaining expertise, professional knowledge and skill to deliver services to clients or employers diligently, complying with technical and professional standards. Competence demands the following: Sound judgement in applying professional knowledge; Ongoing education and continuing professional development (CPD) to stay current with business, professional and technical developments;Keep up-to-date with changes in regulations. Training, supervision, and awareness of service limitations for clients and employers. 114 - Confidentiality - The principle of confidentiality necessitates that the professional abstains from revealing information obtained through professional or business relationships unless authorized by the client or legally obligated. Additionally, it mandates refraining from exploiting confidential data for personal gain or that of others, such as avoiding insider trading. These obligations extend to information shared by potential clients and employers and continue even after the professional relationship ends. Practicing confidentiality also involves vigilance against accidental disclosures to close associates, family members, or in social settings. 115 - Professional Behaviour -Complying with relevant laws and regulations and avoiding any action that discredits the profession. Be honest in representations to current and prospective clients. Do not claim to provide services they cannot provide, or qualifications they do not possess, or experience they do not have. Do not undermine reputation of, or quality of work produced by, others. Auditor Independence Auditors’ independence is challenging to uphold despite its apparent simplicity. Maintaining independence in appearance, where auditors are perceived to be independent, is particularly difficult. Since auditors are remunerated by the entities they assess, stringent standards for independence are crucial. While objectivity is a mental state distinct from independence, both are essential for assurance engagements. Independence, akin to objectivity, requires a certain mindset. Yet, the aspect of appearing independent is equally vital. This implies avoiding situations that might compromise integrity, objectivity, or skepticism in the eyes of external observers. Therefore, independence = the ability to act with integrity, objectivity and with professional scepticism (questioning mind) Threats to Auditor Independence: Independence may be threatened by: Self-interest: involves the threat of inappropriate influence from financial or other personal interests. Self-review: pertains to the effective evaluation of one's own work or that of colleagues within the same firm or employer. When assurance team need to form an opinion on their own work or work done by others in their firm. Advocacy: represents the danger of compromising objectivity by excessively advocating for a client's or employer's position. This Can lead to questioning of auditor’s objectivity. Familiarity: the threat of developing excessive sympathy or a predisposition to accept the work due to an excessively long or close relationship with a client or employer. Assurance staff canbecome too sensitive to needs of client and lose objectivity due to familiar Intimidation: the threat actual or perceived pressures may deter one from acting objectively. Safeguards implemented by the profession Requirements for entering the profession, including educational, training, and experience criteria, intertwine with the necessity for continuous professional development. Corporate governance regulations, which demand discussion or approval of audit and non audit services by the governing bodies. Professional standards and pronouncements, along with the monitoring and disciplinary procedures governed by professional and regulatory bodies. The duty to report breaches of ethical requirements, ‘whistle blowing’ mechanisms facilitating the exposure of unethical behaviour External legal reviews of reports by professional accountants. Firm-wide or engagement-specific safeguard Leadership highlights the importance of complying with professional ethics and the public interest. Quality control and review measures are in place for all client engagements. Policies to ensure the disclosure of all relationships or interests, with different partners and teams having separate reporting lines. Senior management oversees the safeguarding system. Timely communication of policies and procedures extends to all partners and professional staff. Using different partners and staff for non-assurance services provided to an assurance client, as well as rotating senior team members. Involving another firm to perform or re-perform part of the engagement Safeguards created by the client Appointment of an independent firm to ratify the engagement Competence of employees Internal procedures to ensure objective decisions on engagements Proper corporate governance structure with appropriate oversight and communications. Week 9 - Pricing Decisions Determining the appropriate price for goods and services having both short-term and long term consequences for businesses. How should managers of organisations price their products and services. What is the crucial role of demand and supply. Pricing decisions is fundamental to business survival and success - especially in a competitive market. An organisations ability to set correct prices depends on the nature of the market it operates in. Several factors influence pricing decisions and determine the pricing approach that is followed in the organisation Approached to pricing Broadly , pricing decisions follow two main management approaches - Cost based approach Pricing decision here is focused on the cost of producing a product or rendering a service that can deliver expected return on the investment - Market based approach Pricing decisions is reached here based on the market factors and customers want. - Are these approaches exclusive , or can they be used together It depends on the market and the product Pricing decision starts from understanding the cost of the product or service ie the cost based, or based on customers desire and current competition ie market based Both approaches are influences by costs, customers, competition, political and ethical issues. Price influence Costs Cost is a critical determinant of the price of a product or service, or at least the starting point to know what price can be changed. As a rule, companies would expect to produce or provide a service if the unit selling price exceeds the variable cost of producing one more unit. An understanding of production costs is important in price setting that is attractive to customers. Several considerations are made with respect to determining the cost of product or service. Identification and use of the relevant costs for the decision. Use of the value chain analysis and life cycle costing tools. Customers are the primary source of generating revenue. They influence pricing decisions primarily through demand. Customers demand are driven by several factors including - design and feature of the product, quality of the product or service, in recent times the carbon footprint of the product and its sustainability impacts , the social values and ethical principles of the company. Pricing influence competitors Market competition is another key infleucning factor in price setting For example companies always look out for what their competitors charge for similar products or services. Competition can force companies to lower their prices than anticipated. In a globalised economy it can have implications across countries and inpacted by the currency fluctuations and interest rates. Companies must be knowledgable about the legal and political factors that impact their pricing decisions. Eg businesses are prohibited from engaging in price collusion, among other bad pricing practices. Politically, businesses that are making unusually high profits due to overprices oroducts or services, could attract public backlash that can lead to the enactment of legalisation to hugely tax or cap such profits. Approaches to pricing Cost Based Pricing Managers use cost based pricing as the starting point for pricing decisions Cost based prices are determined by adding a mark-up to some calculation of a product or service cost. The cost base can be calculated in various ways Mark up rates may originate from general industry practice or be found in trade journals. Because a mark up is added, the cost based pricing method is also called cost plus pricing. Cost based pricing can be used in many contexts inclduing tender bid pricing Various strategic factors influence the mark up for tender bids Cost based price = cost base + mark up Mark up = selling price - cost base / cost base Cost based Pricing 1 Morala have designed new hoverboard 15% markup on full cost of production , current cost of producing one hoverboard is 540. = 540*0.15 - 81 dollars = 540+81 = 621 selling price Cost Based pricing 2 What is the mark up for the hoverboard if the company wishes to icnrease the prospective selling price by 45%. Selling price 621,Increased by 45% = 621*0.45 = 279.45 621+279.45 = 900.45 Or using mark up (900.45-540) / 540 = 66.75% Cost of prudction = 540 Mark up compotent 65.75% = 540*0.6675 = 360.45 540+360.45 = 900.45 Cost based pricing facts Choosing a mark up involves setting a target to earn a particular rate of return. The target set by the company would depend on what the managers expect to deliver to owners of the company as return on their investment. In practice the cost based approach can be used along with different cost base. For example, a company may prefer to apply the cost based pricing using any of the following bases. Variable manufacturing cost, total variable cost of the product, manufacturing cost, full cost of the product. The popular practice in cost based pricing is the use of full cost Some of the advantages of using the full cost ie variable plus fixed cost include It is simple to use and apply, allows for full recovery of production costs, price stability is likely achieved, allows for long term planning and forecasting, uses readily available cost accounting data. Market based pricing Market pricing begins with target pice ( ie a price that a potential customer is willing to pay for a product or service) Determined using some measure of customer demand Managers strive to identify what customer are willing to pay Market prices are influenced by the degree of product differentiation and competition Under market based pricing, organisations with differentiated products can formally/informally incorporate consumer demand into their pricing policies As price increase,demand usually falls - the sensitivity is casued by price elasticity of demand. Price elasticity of demand is the sensitivity of sales to price changes. It is a formal way to incorporate demand into prices. Eg evidence has shown that a price increase in ciggies overtime has reduced its demand making the demand for ciggies elastic. Under market based pricing Historical information is used to estimate the effects of price changes on sales volume. It is based on understanding customers perceived value, estimates how competitors would react to a prospective price. Includes using competitors prices to establish a product/service price and using online auction websites for difficult to value products. Target pricing under market based approach Target pricing allows companies to collect data that will inform their market based pricing approach Using a target pricing technique to know customers perception is important because - There are more knowledgable customers today who demand for quality and sustainable products at appropraite prices - Pressure from low cost competitors limits the scope for increasing prices - It is becoming difficult to bounceback from , a pricing mistake, a loss of market share, loss of profitability. Cost based v market based pricing Cost based pricing is more common - major drawback is that it ignores customer demand Sales volume inapproprieatly influences price casuing a downward demand spiral. Prices calculated from readily available cost data Market based prices lead to better decisions about sales volums But it is difficult to estimate market demand and prices. Other factors of price Peak load pricing - charging different prices at different times to reduce capactiy constraints eg peak times on train increase price cheaper price Price skimming - occurs when a higher price is charged the product or service is first introduced. Penetration pricing - setting low prices when new products are introduced to increase market share Price gouging - charging a price viewed by customers as high or unreasonable. Transfer prices - are prices charged for transactions that take place within an entity. Price Discrimination Definition: Price discrimination involves charging different prices to different groups of consumers for the same product or service based on their willingness to pay1. Example: Movie theaters often charge different prices for tickets based on age groups. For instance, children and seniors might pay less than adults for the same movie Predatory Pricing Definition: Predatory pricing is the practice of setting prices extremely low with the intent to eliminate competition. Once competitors are driven out, the prices are raised to higher levels Example: A large retail chain might sell products at a loss to drive smaller competitors out of business. Once the competition is gone, the chain raises prices to recoup losses Collusive Pricing Definition: Collusive pricing occurs when rival firms agree to set prices at a certain level, rather than competing against each other. This often leads to higher prices for consumers Example: Several airlines might agree to set similar prices for flights on certain routes, reducing competition and keeping prices high3. Dumping Definition: Dumping is when a company exports a product at a price lower than the price it normally charges in its home market. This is often done to gain market share in a foreign market Example: A steel manufacturer in Country A sells steel in Country B at a price lower than it sells in Country A, aiming to undercut local producers in Country B Pricing in not for profit entities Pricing methods for non profits tend to be more complex than for profit entities because major conern is not profit maximisation. Grants, donations, and interest from endowments help to defray costs, therefore, non profits to not always expect to recover all their costs from prices or fees. prices / fees may be based on clients income or achieving organisational goals. Most government would intervene against illegal pricing practices eg they would discourage Price discrimination - setting prices for different customers based on their looks and ethnicity Predatory pricing- the deliberate act of setting prices low to drive out competitors and then raising prices Collusive pricing - when 2 firms conspire to set prices above competitive prices, which harms consumer welfare Price dumping - whena foreign based entity sells products in a country at prices below the market valye in the country where the product is produced and the price could harm the local industry. Week 10 Cost Volume analysis Cost volume profit analysis examines the effects of changes in costs and volume on an entities profits CVP analysis is important for Planning,setting prices, determining the best product mix and making the maximum use of production facilities. CVP analysis is used by managers to evaluate the interrelationships of selling price, sales volume and sales mix and costs to plan future profits In order to plan profits, managers must estimate the selling price of each product, the variable costs required to produce and sell it, and the fixed costs expected for a given period. CVP analysis can help answer questions like What is the entities break even point ie the sales level at which the business will make neither a profit nor a loss? What will be the impact on sales volume and profit of increasing advertising costs? What level of sales must be achieved to earn a desired level of profit? What level of sales must be achieved to earn a desired level of profit? If selling prices are increased or decreased, what will be the effect on sales volume and the break even point? If a variable cost ( labour) is eliminated and replaced with a fixed cost ( eg depreciation) what would be the impact on mt profits What additional sales volume is required to offset an increase in purchasing cost? If additional plant capacity is acquired and increases fixed factory overhead cost, what will happen to profit? What is the most profitable sales mix? 5 Basic assumptions underline CVP application Costs and revenues are linear within the relevant range All costs are identifiable as variable or fixed Costs are affected only by changes in activity level All units produced are sold Sales mix is constant if there is more than one products Sales mix assumptions make CVP complicated and when it is inaccurate or difficult to estimate invalidates CVP analysis Sales mix assumption requires that sales of products would be in constant mix - which is difficult to achieve because different products will have different cost relationships. Understanding contribution margins One of the key relationships in CVP analysis is contribution margin Contribution margin (CM) = revenue - variable costs CM can be calculated per unit - how much of each sales dollar is left to contribute towards fixed costs and profits CM cab be calculated as a ratio Eg what percent of each sales dollar is left to contribute towards fixed costs and profits. Contribution margin unit and ratio Unit selling price - unit variable cost = contribution margin unit Contribution margin ratio = contribution margin unit/ unit selling price Example Morola sells 700 hoverboards per month. Unit selling price 750, variable cost 540,fixed cost is 84000. A) Contribution margin = 525,000 - 378,000 = 147,000 To check 210x700 = 147,000 B) Contribution margin per unit = 750-540 = 210 What is the companies estimated profit if each unit is sold = C estimated profit and insights from analysis The contribution per unit indicates that for every hoverboard sold the company generates 210 to cover its fixed costs and contributes to profits. Since fixed costs is 84000 morola limited will need to sell 400 hoverboards per month ( 840,000/210) before it can make profit for that period Eg Sales ( 400x700) = 300,000 Less variable costs ( 400x540) =216,000 Conitrbution margin 84,000 Less fixed costs 84000 = estimated profit We can further confirm this analysis through any additional sale above 400 units will contribute 210 to the company profits. Since 700 units are expected to be sold, profit will be 63000 ( 300 units x 210) Sales 525,000 Less variable costs 378,000 Contribution margin 147,000 Less fixed costs 84,000 D) determine the contribution margin ratio of the company 210/750 = 0.28 or 28% Also the ratio can be found dividing contribution margin by total sales = 147,000 / 525/000 =0.28 CM ratio of 28% means that 28 cents of each sales dollar (1x0.28) contributed to fixed cost and profit in the company. How much profit will an increase in sales of 50,000 produce for the company CM ratio is 28%, 28 cents of each sales dollar contributes to the fixed cost and profit of company, easily the profit of the company would make if sales increased. 50000 increase in sales = 14000 ( 50,000 x 0,28) Break Even Analysis Break even analysis is the second key relationship for cost volume profit analysis Break even point - is the point where sales volume at which revenues and total costs are equal , so neither a profit or loss is made. Profit arises above the break even point, a loss is incurred below it. Although a break even point is not a desired performance target because of the lack of profit, it does indicate the level of activity necessary to avoid a loss. Determines the level of activity where TR = TC At the break even point there is 0 profit or loss Can be expressed in terms of sales dollars or sales units Formulas BEP in sales = variables cost + fixed costs Above can be defined as the required level of sales dollars or the equires units of sales volumes. In the equation variable costs as a percentage of unit selling price can be expressed as a dollar amount. 540/750 = 0.72 or 72% For Morola X = 0.72X + 84000 0.28X = 84000 X = 84,000/0.28 X = 300,000 Calculation for BEP in units 750X = 540 X +84000 210X = 84000 X = 84000/210 X = 400 units Contribution margin technique BEP in Unites = fixed costs / contribution margin per unit Contribution margin ratio technique BEP in sales = fixed costs / contribution margin ratio Break even analysis graphic presentation Break even point is determines visually at intersection of, total sales revenue line total costs line ( fixed plus variable) Level of activity ( unit ) recorded on a horizontal axis Dollars ( revenue and costs) are recorded on vertical axis. Net profit and loss at all levels of activity is also visually portrayed. Also known as the CVP graph because it shows cost, volume, and profits. The break even point is the intersection of all lines Profit area is the gap between red blue line at top. Loss is the opposite. Margin of Safety The difference between expected sales and break even sales It can be expressed in dollars or as a ratio It indicates the amount by which sales can drop before a loss is incurred It measures the breathing space or cushion that a business has if its expected sales fails to materialise The adequacy of margin of safety depends on the characteristics of the business For example competitive position general economic conditions. Margin of safety calculation ( in $) Margin of safety = Actual expected sales - break even sales Margin of safety ratio = margin of safety / expected sales For Morola limited If the expected sales is 700 hoverboards, BEP is 400 units or 300,000 Margin of safety = 700 - 400 = 300 units Margin of safety ratio = 300/700 = 0.43 Week 11 - Short and Long Term planning Planning involves - making future decisions in the present, establishing goals and targets ( short and long term), forward looking, scenario analysis, risks evaluation, core of management accounting tasks. Planning Planning is continuous and starts before operations commences. A plan provides a benchmark against which future performance can be assessed. Comparing actual performance with plans, and determining the reason for any variance, is referred to as the control phase of operations. Plans also provide targets which can be used as a basis to motivate and reward people undertaking roles in relation to those plans. When planning future activities and performance we should extend the focus of performance beyond just the financial. Components of planning Planning for sustainable development Sustainable development is development that meets the needs of the present world without compromising the ability of future generations to meet their own needs. Related to both intergeneration and intragenerational equality. Incorporating considerations of sustainability into our planning process necessarily means prioritising the longer term performance of an organisation Across time legislation will become more demanding with respect to social and environmental performance, markets and consumers will be more reactive to this performance. Organisation not embracing sustainability will be regarded as higher risk, which will increase the cost of attracting sources of finance. Generally speaking, the higher the perceived risk the higher the cost of finance. Short and long term planning Planning needs to be both long term and short term in orientation Supported by appropriate remuneration structures Must be aware that there are pressures which might encourage managers to be short term in orientation. Short term bonus plans, yearly calculation of profit. Short term planning for a target profit Target profit is the profit objective for a product line. Management plans for short term profit could be aimed at achieving a certain level of profit It is important to determine the sales required to achieve the target profit. Break even analysis can be expanded by adding target net profit to total costs to determine this information. This can be done using math or contribution margin technique. Since we know that BEP, profit and loss = 0, adding a target profit factor to the BEP equation will help determine the required sales. Required sales = variable costs + fixed costs + target profit The required sales can be expressed in sales dollars or sales units. EXAMPLE For morola If mgmt plans to achieve a target profit of 52,500 for the next financial period What would be the required sales For Morola Required sales = variable costs + fixed costs + target profit Calculatings of the required sales in dollars X = 0.72X + 84,000 + 52,500 = x - 0.72 = (84,000+525,00) X (1-0.72) = ( 84,000 + 52,500) 0.28 X = 136,500 X = 136,500 / 0.28 X = 487,500 Calcuation of the required sales in units 750X = 540 + 84,000 + 52,500 = (750 - 540) = (84,000 + 52,500) 210X = 136,500 X = 136,500 / 210 X = 650 units 487,500 / 750 = 650 units to check So to make a profit of 52,500 they need to sell 650 units or achieve sales of 487,500 Required sales = fixed costs + target profit / contribution margin ratio Required sales = (84,000 + 52,500) / 28% = 487,500 CVP for profit planning Management can use CVP to quickly predict effects of events such as Changes in sales revenue or costs, matching competitors discount on sales per price unit, investing in equipment ( fixed costs) in order to reduce labour ( variable costs), changes in profitability with changes in variable or fixed costs. EXAMPLE What effect a 8% discount on selling price would have on the BEP of Morola EXAMPLE 2 Increase fixed and variable costs by 10%, new investment on sales volume for BEP. Example 3 Increase variable costs by $60, MGMT decided to increase selling price to 1000, or cost reduction programme which will save 8400. What increase in sales would be needed to maintain the same level of profit Using CVP analysis with multiple products Management can use BEP with two or more products to determine with sales mix with the highest profitability. A sales mix is a relative combination of different products sold. When undertaking the analysis sales mix is assumed to be constant. BEP sales can be calculated for a mix of two or more products by determining the weighted average unit contribution margin of all products. Per unit data sales mix BEP units = Fixed costs / weighted average contribution margin. Morola example 2 hoverboards, LED and Hip Hop. Sales data mix per unit LED HOVER HIP HOP HOVER Unit selling price 750 1000 Unit variable cost 540 580 Contribution margin 210 420 Sales mix 3 1 What is total contribution margin Weighted average unit contribution margin BEP in units Per unit data sales mix for morola limited As the sales mix is based on 3 units of LED hover per 1 unit of HIP Hop for morola to break even, company must sell 240 units of LED hover ( ¾ x 320units ) and 80 units of hip hop ( ¼ of 320 units) Limited resources As with everyone, companies do not always have the resources they need to accomplish their objectives, hence they must carefully think about how available resources are allocated to achieve the optimal product mix needed to deliver the desired profit. Essentially, the management of the company will need to make the best use of limited resources to maximise net profits. Eg floor space, labour hours and skills, machine hours, need to be planned and managed If there are limitation on some part of the business management should use conitrbution margin per unit of limited resources Eg Contribution margin per unit / amount of resources needed per unit. Assume that mgmt of morola has maximum machine capacity for period is 2500 hrs, machine hours required to make each hoverboard is LED 2 hrs , hip hop , 5 hrs. Determine the contribution margin per machine hour CVP statement profit or loss CVP statement of profit or loss is used for internal decision making only Expenses are classified as variable or fixed Hence, discloses the behaviour of cost and expenses Specifically reports contribution margin in the body of the statement In contrast, traditional financial reports are produced with external users in mind Expenses are classified by function eg cost of sales and selling expenses or nature employee expenses depreciation expenses These reports do not show contribution margin Morola CVP statement of profit or loss Prepare statement of profit or loss traditional format CVP format of statement of profit or loss Contrast the traditional and CVP formats