The Paper FFM Study Guide references E3 c) and E3 d) require candidates to be able to both discuss the concept of relevant cash flows and identify/evaluate relevant cash flows. Show Relevant cash flows can be examined in either a written or calculation format. It is also important that candidates can identify relevant cash flows in order to be able to use them in the context of investment appraisals, for example net present value calculations. Finally, relevant cash flows are not just an important part of the syllabus for Paper FFM as they can also be examined in later studies, for example Paper F9.
|
$ per unit | |
---|---|
Sales revenue | 25 |
Materials | 10 |
Labour (2 hours @ $3 per hour) | 6 |
Variable overhead | 2 |
Contribution | 7 |
Labour is now required for manufacturing process B within the same organisation. Each unit within manufacturing process B uses two hours of labour. No more labour can be hired and so it would have to be moved from manufacturing process A. What is the relevant cash flow for labour in process B?
Relevant cash flows for scenario 4
Using our definition of a relevant cash flow to be a future, incremental cash flow, we can ignore the
labour cost of $6 as it is not incremental, it will be paid anyway, either within process A or process B. However, if we move the labour from A to B, the organisation will have to forgo the sales revenue of $25 per unit, but they will not suffer the material cost of $10 per unit or the variable cost of $2 per unit. Thus the net effect, the net cost of moving the labour to process B is ($25 – $10 – $2) = $13 per unit. This $13 is the opportunity cost, the net revenue lost from moving the labour
from its current use. You may see a short cut to this calculation – that of adding together the contribution lost of $7 to the labour cost of $6. The total again being $13 per unit. Although this seems theoretically incorrect, as the non-incremental labour cost of $6 is being included, it is just a short cut to the answer.
Conclusion
In a Section B question, candidates need to be able to both explain the principles behind relevant cash flows and be able to identify/calculate such cash flows, possibly for further use within an investment appraisal calculation. The question in the appendix is the typical example and I would strongly recommend you work through the question. The answer is provided in Appendix 2. It is hoped this article will help candidates with these elements.
Written by a member of the Paper FFM examining team
Appendix 1: Question
Mrs Clip runs a hairdressing business from her home. Mrs Clip’s business has expanded, with revenue now reaching $40,000 per year. Mrs Clip is considering moving her business into town centre premises, and employing another hairdresser, who would cost $6,000 per year.
She has found premises that could be leased for $3,500 per year payable in advance.
Mrs Clip currently advertises her business in the local newspapers and business directories, at a cost of $1,000 per year payable in advance. Mrs Clip will carry on with this advertising, but she will also need extensive ‘one off’ advertising to promote the move to the new premises, and the new hairdresser joining the business. This ‘one off’ advertising in the local newspapers will cost $2,000, which will be paid immediately. In addition to advertising the move in the local newspapers, Mrs Clip could advertise the move on the local radio. The cost of this would be $5,000, also payable immediately.
Mrs Clip believes that having a town centre presence and the associated publicity in the local newspapers will increase revenue by 40% in the first year and that it would remain at this new increased level. If Mrs Clip also advertised on the local radio, she believes that revenue would increase by 45%, rather than 40%, and would again remain at this new increased level.
Overheads, excluding advertising, would increase to a total of $4,000 per year. Overheads currently charged to the business are $1,500 per year. Direct costs such as shampoo are budgeted at 5% of revenue.
Assume that all cash flows arise at the year end, unless otherwise stated.
The cost of capital is 10% per annum.
Required:
(a) Assuming that both radio and newspaper advertising is used, calculate, over a five-year time period, the net present value of the proposed move to the new premises. On the basis of your calculation, advise Mrs Clip as to whether or not she should move her business into the new premises.
(11 marks)
(b) Prepare a net present value calculation over a five-year time period, that justifies the additional spend on radio advertising rather than advertising in newspapers alone.
(5 marks)
Access Appendix 2: Answer