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Transcript of 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 Page 2 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
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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.
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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.
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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.
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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).
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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)
===== ===== =====
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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.
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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.
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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.
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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.
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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?
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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).