(43).---PORTFOLIO MANAGEMENT.

Portfolio Theory.

(1). Introduction.

The analysis of risk and uncertainty concentrates in some way on altering future returns to allow for uncertainty of outcome (e.g. using probability distributions of returns). An alternative approach is to allow for uncertainty by increasing our required rate of return on risky projects.

This latter approach is commonly taken by investments. For example, if we were comparing a building society investment with one in equities we would normally require higher return form equities to compensate us for their extra risk. In a similar way if we were appraising equity investment in a food retailing company against a similar investment in a computer electronics firm we would usually demand higher returns from the electronics investment to reflect its higher risk.

Clearly use of a risk adjusted discount rate can be employed in almost any situation involving risk. The practical problem is how much return we should demand for a given level of risk. To solve this problem we can turn to the stock exchange-a place where risk and return combinations (securities) are bought and sold every day. If for example, we can better the return earned by investors on the stock market by investing in a physical asset offering the some level of risk, we can increase investor wealth and the investment should be adopted.

Unfortunately the required approach is not as simple as this. Investors seldom hold securities in isolation. They usually attempt to reduce their risks by ‘not putting all their eggs into one basket” and therefore hold portfolios of securities. Before we can deduce a risk-adjusted discount rate from stock exchange returns we need to identify the risks investors in their diversified investment portfolios.

(2). The portfolio effect.

A portfolio is simply a combination of investments. If an investor puts half of this funds into an engineering company and half into a retail ships firm then it is possible that any misfortunes in the engineering company (e.g. A strike) may by to some extent offset by the performance of the retail investment. It would be unlikely that both would suffer a strike in the same period.

(3). Correlation.

Correlation is a statistical measure of how strong the connection is between two variables. In portfolio theory the two variables are the returns of two investments. High positive correlation means that both investments tend to show increase (or decrease) in return at the same time.

The degree of risk reduction possible by combining the investments depends on the carrel between them.
The more negative the correlation the greater the possibilities for risk reduction.

(4). Portfolio theory- the two-security portfolio.

A formal analysis of the combination of two investments is now presented. Because portfolio theory has its roots in the management of stock exchange investments, this is referred to as the two security portfolio.

The analysis is usually presented in terms of rates of return over a single time period is simply:

(End of period value – start of period value) + dividend paid /Start of period value.

(5). Covariance and correlation.

The risk reduction in the last example was made possible by low correlation between the investments. Jest looking at the possible reruns of A and B shows that there is no consistent positive or negative relationship between them. The correlation coefficient will probably be jest higher then zero.

The covariance will be positive for positive correlation and negative for negative correlation, but its size depends on the size of the figures in the original data and is difficult to interpret.

(6). Formulae for the two – security portfolio.

In general, the risk of a two –security portfolio will depend on:
a. The risk of the constituent investments in isolation;
b. The correlation between them ; and
c. The proportion in which the investments are mixed.

(7). Two – security portfolios-Effect of the correlation coefficient.

Maximum risk reduction is possible with a correlation of -1. In this case, risk can be (but is not always) reduced to zero. If correlation is +1, the portfolio risk is simple a weighted average of the investment risks.

(8). Combining a risky security and a risk-free security.

There is a special case of the two-security portfolio which is particularly important for our later studies. This is the case of combining a risk-free security with a risky security.

A risk-free security is one which shows no variability in its predicated returns. In other words its return is known with certainty. In practice it can be approximated by an investment in government stocks or bank deposit accounts at fixed interest (although varying rates of inflation would mean the real on these investments becomes uncertainty.

A risk free security has a zero variance and a zero covariance with any other security.
In the other words the portfolio standard deviation is simply the standard deviation of the riskily investment times the proportion of that investment in the portfolio.

The expected returns of the portfolio will still be weighted average of the expected returns of the two investments.

(42).---PORTFOLIO MANAGEMENT.

INTRODUCTION.

(1).Definition .
Asset allocation is the process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment purposes.
This process will be guided by the investor’s policy statement which will specify;

• The types of risks the investor is willing to take; and
• His or her investment goals and constraints.
  For an individual investor, needs change over the investor’s life cycle. The policy statement will be related to an investor’s;
• Age;
• Financial status;
• Future plans; and
• Needs.

(2).Phases of wealth assimilation-investor’s life cycle.

The investor’s life cycle stage can have an impact on his or her risk and return preferences.
a) Accumulation phase
Individuals are in the early-to-middle years of their working careers. The features of this phase are;
Net worth small relative to liabilities;
Priorities will include:

• Saving for fairly immediate needs;
• Life and disability insurances; and
• Investments for future financial independence;
  Very long time horizon and growing income stream and hence can undertake more high Return, high-risk investment.

a) Consolidation phase.Individuals are in the mid-to-late career stage. The features of this phase are:
-Income exceeds expenses;
-Investment portfolio is accumulating (including equity and retirement programs):
Shorter time to retirement leads to some risk control and capital preservation and hence high capital gain investments are balanced with some lower risk assets.

a) Spending phase,
This generally starts with retirement. The features are:
-Individuals are financially independent;
-No earned income and therefore reliant on capital;
-Focus on assets with relatively secure values and high income streams.

a) Gifting phase,
This generally coincides with the spending phase and the features are:
-Assets exceed needs:
-Risk & return preferences are unchanged but the purpose of the investments changes.
The above analysis is oversimplified. The basic personality that each investor brings to his stage in the life cycle greatly influences where he falls on the risk and return continuum.

(3).Goal setting.

All individual investor must be investing to achieve a goal, either tangible or intangible. These goals can be categorized as follows,
Near-term high priority goals, for example, a house down-payment-
Low risk investment chosen.Long term high priority goals-More aggressive investment approaches but diversified to avoid unnecessary risk.Lower priority goals -Speculative kinds of investmentsEntrepreneurial or money-making goals-All investor in one stock (often own company or employee)

(4).The policy statement.

The process of formulating a policy statement serves several purposes:
(a).It helps investors understand their own needs, objectives & investment constraints by learning about financial markets & the risks of investing.
(b).It will assist the advisor or portfolio manager in managing client’s funds.
(c).It crates a standard by which the performance of the portfolio manager can be judged.

The construction of the statement is mainly the responsibility of the investor. The investor has to be in a position where he or she can articulate & communicate his or her needs & goals to the portfolio manager.

(5).Investment objectives.

These are the investors investment goals expressed in terms of both risk & return. A careful analysis of the investors risk tolerance should precede any discussion of return objectives & this will be influenced by the following:
(a).The inventors psychological make up current insurance coverage & cash reserves.
(b).The investor’s family situation number of dependents & age.
(c).The investor’s current net worth & expectation of future income & salary.

The return objective may be stated as a general goal or in terms of & absolute or relative percentage return.

Capital preservation
Minimize the risk of loss appropriate objective for very risk-averse investors.
Capital appreciation
Want the portfolio to grow in real terms over time. Very aggressive strategy. Appropriate objective for investors willing to take on risk to meet their objective.
Current income
Minimize income generation rather than capital gins. Low risk strategy appropriate for investors who want to suppliant their earnings.
Total return
Increase portfolio value by both capital gains & reinvesting current income. Risk exposure lies between that of the current income & capital appreciation strategies.

(6).Investment constraints.

The policy statement, in addition to stating the investors risk & return objectives, will specify certain constraints which will have an impact on the investment plan.
In outline the constraints are as follows

(a).Liquidity needs.
1. Emergency cash.
2. Near term goal spending.
3. Income taxes.
4. Investment flexibility.

(b).Time horizon.
The discussion of an investor’s life cycle phases highlighted the time horizon as an investment constraint. In addition, an investor’s time horizon, liquidity needs and ability to handle risk are all related.

(c).Tax concerns.
In general terms the objective is to,

• Defer tax
• Avoid tax or
• Pay tax at the lowest rate possible
  It is important to appreciate the different tax treatment of income versus capital gains.

(d).Legal and regulatory factors.
There can be divided into three categories
(a).investment specific regulations.
(b).Fiduciary duties.
(c).Trading laws.

(e).Unique needs and preferences.
There are certain investments which an investor may want to include or exclude form his or here portfolio for personal or social consciousness reasons.

(f).The portfolio construction process.The portfolio management process consists of the following steps

1. Identification and evaluation of the investor’s objectives, preferences and constraints as a basis for constructing the investor’s policy statement.
2. Formulation of appropriate investment strategies (asset allocation) & hence the selection of optimal combinations of financial & real assets.
3. Monitoring of market conditions, relative asset values, and the investors circumstances.
4. Adjustments of the portfolio as are appropriate to reflect significant changes in any of the relevant variables.

(41).---PORTFOLIO MANAGEMENT.

PORTFOLIO MANAGEMENT.

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Topics to be discussed-

INTRODUCTION (POST 42)
1. Definition.
2. Phases of wealth accumulation-investors life cycle.
3. Goal setting.
4. The policy statement.
5. Investment objectives.
6. Investment constraints.
7. The portfolio construction process.

PORTFOLIO THEORY. (POST 43)
1. Introduction.
2. The portfolio effect.
3. Correlation.
4. The two security portfolio.
5. Covariance and correlation.
6. Formula for the two security portfolio.
7. Two-security portfolios-effect of the correlation coefficient.
8. Combining a risky security and a risk-free security.

THE DIVERSIFIED SHAREHOLDER AND THE CAPITAL MARKET (POST 44)1. Mixing, many risky securities.
2. Efficient portfolio.
3. The market portfolio.
4. Constructing the capital market line.

THE CAPITAL ASSET PRICING MODEL (POST45,46,47)1. Introduction.
2. Systematic and non-systematic risk.
3. Systematic risk and return.
4. Establishing beta factors for individual securities.
5. Regression analysis.

1. Aggressive and defensive shares.
2. Some further CAPM examples.
3. Application of the CAPM to project appraisal.
4. Example of project appraisal.
5. Certainty equivalents.
6. CAPM conclusion.
7. Advantage of the CAPM.
8. Limitations of the CAPM.

THE ARBITRAGE MODEL (POST 48)

THE EFFICIENT MARKET HYPOTHESIS (POST 49,50)
1. Stock prices follow a random walk.
2. Stock prices respond to new information.
3. Assumptions underlying efficient capital markets.
4. The three forms of the EMH.
5. Empirical testing of the EMH.
6. Implications of the EMH.
7. Summary of EMH.

(40).---INTERPRETATION AND INTERRELATIONSHIP OF VARIANCES.

Interpretation and interrelationship of variances.

To investigate or not to investigate.Before management decides whether or not to investigate a particular variance, there are a number of factors which should be considered.

• Materiality. Small variations in a single period are bound to occur and are unlikely to be significant. Obtaining and ‘explanation ‘is likely to be time-consuming and irritating from the manager concerned. The explanation will offer be ‘chance ‘which is not, in any case,
  Particularly helpful. For such variations further investigation is not worthwhile.
• Controllable. Controllable must also influence the decision whether to investigate further. If there is general worldwide price increase in the price increase in the price of an important raw material there is nothing that can be done internally to control the effect of this. If a central decision is made to award all examples a 10% increase in salary, staff costs in division A will increase by this amount and variance is not controllable by division A’s manager. Uncontrollable
  Variances call for a change in the plan’ not an investigation into past.
• Variance tread. If, say, an efficiency variance is RS. 1,000 adverse in month 1, the obvious conclusion is that the process is out of control and that corrective action must be taken. This may be correct but what if the same variance is Rs. 1,000adverse every month? The trend indicates that the process is in control and the standard has been wrongly set. Suppose, though, that the same variance is consistently Rs.1,000 advise for each of the first six months of the year but that production has steadily fallen form 100 units in month 1 to 65 units by month6.The variance trend in absolute terms is constant, but relative to the number of units produced, efficiency has tot steadily worse.

Management signals from variances trend information.
Variance analysis is a mend of assessing performance, but it is only a method of signaling to management areas of possible weakness where control action might be necessary. It does not provide a ready-made diagnosis of faults, nor does it provide management with a reedy made indication of what action needs to be taken. It merely highlights items for possible investigation.
Individual variances should not be looked at in isolation. As an obvious example, favorable sales price variance is likely to be accompanied by an adverse sales volume variance: the increase in price has caused a fall in demand. We now know in addition that set of variances should be scrutinized for a number of successive periods if their full significance is to be appreciated.

Here are some of the signals that may be extracted form variance trend information,

• Materials price variances may be favorable for a few months, then shift to adverse variances from the next few months and so on. This could indicate that process are seasonal and perhaps stock could be built up it cheap seasons.
• Regular, perhaps fairly slight, increase in adverse rice variances usually indicates the working of general inflation. If desired allowance could be made for general inflation when flexing the budget.
• Rapidly large increases in adverse price variances may suggest a scudded scarcity of a resource.
• Gradually improving labour efficiency variances may signal the existences of a learning curve , or the success of a productivity bonus scheme. In either case opportunities should be sought to encourage the trend.
• Worsening trends in machine running expenses may show up that equipment is deteriorating and will soon need repair or even replacement.

Interrelationships between variances.Quite possible, individual variances should not be looked at in isolation. One variance might be inter-related with another, and much of it might have occurred only because the other, inter-related variance occurred too. When tow varies is interdependent (interrelated) one will usually be adverse and the other one favorable.

Here is an example,

• Material price and usage—if cheaper materials are purchased in order to obtain a favorable price variance, materials wastage might be higher and an adverse usage variance will occur. If the cheaper material is more difficult to handle, there might be an adverse labour efficiency variance too. If more expensive material is purchased, however the price variance will be adverse but the usage variance might favorable.

(39).---SALES VARIANCES.

Sales Variances.

Total sales marginal variances.
The total sales margin variance seeks to identify the influence which the sales function has on the difference between budget and actual profit. The sales function is responsible for the volume and the unit selling price but not the unit manufacturing costs. Therefore the standard cost of sales and not the actual cost of sales is deducted form the actual sales revenue.

Using the standard cost to calculate both the budgeted and actual profit ensures that the production variances do not distort the calculation of the sales variances.

The effect of using standards costs throughout the profit margin calculations mires that the sales variances arise because of changes in those variables which are controlled by the sales function.

• Selling prices (Sales Margin Price Variance)
• Sales quantity (Sales Margin Volume Variances)

Sales Margin Price VarianceThe sales margin price variance is the difference between the actual margin and the standard margin (both based on standard unit costs) multiplied by the actual sales volume.

Sales Margin Volume Variance.To ascertain the effect of changes in the sales volume on the difference between the budgeted and the actual profits we must compare the budgeted sales volume with the actual sales volume.
The use of the standard margin (standard selling price less standard cost ensure that the standard selling prices is used in the calculation and the volume variance will not be affected by any changes in the actual selling prices
The sales margin volume variance is the difference between the actual sales volume and the budgeted volume multiplied by the standard profit margin.

Sales mix and quantity variances.If a company sales more than one (1) product, it is possible to analyze the overall sales volume variance into a sales mix variance and a sales quantity variance.
A sales mix variance and a sales quantity variance are only meaningful where management can control the proportions of the product sold.

The Unit Method of Calculation.
There are two methods of calculating sales mix and quantity variances. Using the units method, the sales mix variances is calculated in a very similar way to the materials mix variance, while the sales volume variances is calculated as the difference between the actual sales volume in the budgeted proportions and the budgeted sales volumes, multiplied by the standard margin.

The Revenue Methods of Calculation.There is another method of calculating sales mix and quantity variances which is based on the value of sales rather than on the number of units sold. It is most useful when the unit selling price for each product is very different so that basing the standard mix on the number of units could cause distortions.

It in important to remember two aspects of sales mix and quantity variances by the sales revenue method, which can be a source of great confusion. These are as follows ,

• Sales mix and quantity variances calculated by the revenue method will be totally different form the variances calculated by the previous (sales units) method. They have completely different meanings.

Variances calculated using the units method should help control the proportion of units sold of each product whereas variances calculated using the revenue method should help control the proportion of revenue obtained form each product.
The numerical value of mix and quantity variances will differ according to the method used.

• In the revenue method, revenue is measured at standard sales process, not actual sales price. The “actual sales revenue” should be actual sales units at the standard sales price per unit.

(38).---OVERHEAD COST VARIANCES.

Variable overhead variances.

The total variable overhead variance is the difference between standard variable overheads charged to production and the actual variable overheads incurred.
It is normally assumed that variable overheads vary with direct labour hours of input and that total variable overhead variance will therefore, be due to one or both of the following;

• Actual expenditure may be different form budgeted expenditure.
• The actual direct labour hours of input may be different form the direct labour hours input which should have been used.

The reasons give rise to the two sub variances;

• Variable overhead expenditure variance
• Variable overhead efficiency variance

Variable overhead Expenditure variance
To compare the actual overhead expenditure which the budgeted expenditure it is necessary to flex the budget. It is assumed that variable overhead will vary with direct labour hours of input and therefore, the budget is fixed on this basis.

Variable overhead Efficiency variance
The variable overhead efficiency variance is the difference between the standard hour of output and the actual hours of input for the period multiplied by the standard variable overhead rate.

Fixed Production overhead variances.

You keep in maid the whole time the fact that you are trying to explain the reasons for any under or over absorption fixed production overhead. Remember that the absorption rate is calculated as follows:
Overhead absorption rate =Budgeted fixed production overhead / Budgeted level of actively.
If either the numerator or the denominator or both in the absorption rate calculation are incorrect than we will have under-or over-absorption production overhead.

• The fixed production overhead expenditure variance measure the under or over absorption caused by the actual production overhead expenditure betting different from budget, that is the numerator being incorrect.
• The fixed production overhead volume variance measures the under or over absorption caused by the actual production or hours of activity being different from the budgeted production or budgeted number of hours used in calculating the absorption rate.

Fixed production overhead Expenditure or Spending variance
This variance seeks to identify that portion of the total fixed overhead variance which is due to actual fixed overhead expenditure differing from the budgeted fixed overhead expenditure.

Volume variance
This variance seeks to identify that portion of the total fixed overhead variance which is due to actual production being different from budgeted production. If the actual production is less than the budgeted production, the fixed overhead changed to production will be less than budgeted cost & the volume variance will be adverse variance. The difference between actual production & the budgeted production for a period multiplied by the standard fixed overhead rate.
Sum of these factors may be controllable by production or sales management while other may not. If we wish to identify the reasons for the volume variance we may ask why the actual production was different from the budgeted production. It could be due to two reasons,

• Labour force worked at a different level of efficiency from that which was anticipated in the budget , & /or
• The company had failed to utilize the planned capacity

The two reasons relate to the two sub variances of the total volume variances;

Volume efficiency varianceThe volume efficiency variance is the difference between the standard hours of output (SH) & the actual hours of input (AH) for the period multiplied by the standard fixed overhead rate (SR) , or
Physical content of this variance is a measure of labour efficiency & is identical to the labour efficiency variance. Consequently, the reasons for this variance will be identical to labour efficiency variance.

Volume capacity variance
The volume capacity variance is the between the actual hours of input (AH) & the budgeted hours of input for the period multiplied by the standard fixed overhead rate (SR) , or volume efficiency variance indicates a failure to utilize capacity efficiently, the volume capacity variance indicates a failure to utilize capacity at all.

(37).---DIRECT LABOUR COST VARIANCES.

Direct Labour Cost Variances.

The direct labour total cost variance ( the difference between that output should have cost & what it did cost, in terms of labour) can be divided into two sub variances.

• The direct labour rate variance
  This is similar to the direct materials price variance. It is the difference between the standard cost & the actual cost for the actual number of hours paid for.
  In other words, it is difference between what the labour did cost and what it should have cost.
• The direct labour efficiency varianceIt is the difference between the hours that should have been worked for the number of units actually produced, and the actual number of hours worked, valued at the standard rate per hour.
  In other it is the difference between how many hours should have been worked and how many hours were worked, valued at the standard rate per hour.
• Idle time varianceA company may operate a costing system in which any idle time is recorded. Idle time may be caused by machine breakdowns or not having worked to give to employees, perhaps because of bottlenecks in productions or a shortage of orders from customers. When idle time occurs, the labour forces are till paid wages for time at work, but not actual work done. Time paid for without any work being done is unproductive and therefore inefficient. In variance analysis, idle time is an adverse efficiency variance.
  When idle time is recorded separately, it is helpful to provide control information which identifies the cost of idle time separately, & in variance analysis three will be an idle time variance as a separatist pf the total labour efficiency variance. The remaining efficiency variance will then relate only to the productivity of the labour force during the hours spent actively working.
• Labour mix and yield variances.A labour mix variance ( or team composition variance )can be calculate when more than one type or grade of labour is involved in marking a product. It is a measure of whether the actual miss of labour grades is chapter or more expensive than the standard mix .
  A labour yield variance ( or labour output variances or team productivity variance) can be calculated to see how productively people are working.
  The calculations are the same as those required for materials mix & yield variances.

(36).---VARIANCE ANALYSIS.

Variance Analysis.

A variance is the difference between planned, budgeted, or standard cost & actual cost; and similarly for revenue.

The process by which the total difference between standard & actual results is analyzed is known as variance analysis.

Variance can be divided into three(3) main groups.

• Variable cost variances,
• Sales variances,
• Fixed production overhead variances,

Direct Material Cost Variances.

The Direct material total variance (The difference between what the output actually cost and what it should have cost , in terms of material) can be divided into two sub-variances.

• The direct material price variance,

This is difference between the standard cost and the actual cost for the actual quantity of material used or purchased. In other words it analysis the difference between what the did cost and what it should have cost.

• The direct material usage variance,

This is the difference between the standard quantity of materials that should have been used for the number of units actually produced and the actual quantity of materials used, valued at the standard cost per unit of material. In other words it is the difference between how much material should have been used and how much material was used, valued at standard cost.

When a production requires two or more raw materials in its make-up , it is after possible to sub-analyze the materials usage variance into materials mix and materials yield variances,

• Direct materials mix and yield variances,

The mix variance is calculated as the difference between the actual total quantity used in the standards mix and the actual quantities used in the actual mix, valued at standards prices. If a greater proportion of the more expensive materials is used, there will be and adverse mix variance.

A yield variance is calculated as the difference between the standard output form what was actually input, and the actual output, valued at the standard cost per unit of output.

Mix & yield variances have not meaning and should never be calculated, unless they are a guide to control action. They are only appropriate in the following situation,

1. Where proportions of materials in a mix are changeable & controllable,
2. Where the usage variance of individual materials is of limited value because of the variability of the mix, and a combined yield variance for all the materials together is more helpful for control.

Materials variances and opening and closing stock--

In variance analysis , the problem is to decided the material price variance. Should it be calculated on the basis of materials purchased or on the basis of materials used.

The answer to this problem depend on how closing stocks of the raw materials will be valued.

• If they are valued at standard cost, the price variance is calculated on material purchases in the period.
• If they are valued at actual cost (FIFO) the price variance is calculated on materials used in production in the period.

A full standard costing system is usually in operation and therefore the price variance is usually calculated on purchases in the period.

There are main advantages in extracting the material price variance at the time of receipt,

• If variance are extracted at the time of receipt they will be brought to the attention of managers earlier than if they are extracted as the material is used if it is necessary to correct any variances than management action can be more timely,
• Since variances are detracted at the time of receipt , all stocks will be valued at standard price. This is administratively easier & it means that all issues from stocks can be made at standard price. If stocks are held at actual cost is necessary to made in a number of small batches this can be a time-consuming task, especially with a manual system.

(35).---BUDGETS AND STANDARDS COMPARED.

Budgets and Standards Compared.

A budget is a quantified monetary plan future period, which managers will try to achive. Its majour functions lies in communication activities within an organization.

A standard is a carefully predetermined quantity target which can be achived in certain conditions.

Budgets & standards are similar in the following ways,

• They both involve looking to the future & forcasting what is like to happen given a certain set set of circumstances.
• They are both used for control purposes. A budget aids control setting financial targets or expenditures are then compared with the budgets & action is taken to correct any variances where necessary. A standard also achives control by comparison of actual results against a predetermined target.

As well as being similar , budgets & standards are interrelated.

For example- A standard unit production cost can act as the basis for a production cost budget.The unit cost is multiplied by the budget activity level to arrive at the budget expenditure on production costs.

There are however, important differences between budgets and standards,

• Budget gives the planned total aggregate costs for a functional or cost center where as a standard shows the unit resource usage for a single task for example the standard labour hours for a single unit of production.
• The use of standards is limited to situations where repetitive actions are performed and output can be measured. Budgets can be prepared for all functions, even where output can be measured.
• A standard need not be expressed in monetary terms. For example a standard rate of out putcan be determined for control purposes without the need to put a financial value on it. In contrast , a budget is expressed in money terms.

In summary, budgets & standards are very similar & interrelated, but there are important differences between them.

(34).---TYPES OF PERFORMANCE STANDARD.

Types Of Performance Standard.

The setting of standards raises the problem of how demanding the standard should be, Should the standard represent a perfect oerformance or an easily attainable performance.There are four types of standard.

(1)-Ideal Standard.

These are based on perfect operating conditions: no wastage , no spoilage , no inefficiencies , no idle time , no breakdowns. Variances from ideal standards are useful for pinpointing areas where a close examination may result in large savings , but they are likely to have an for unfavourable motivational impact because reporter variances will always be adverse. Employees will often feell that the goals are unattainable & not works so hard.

(2)-Attainable Standard.

These are based on the hope that a standard amount of work will be carried out efficiently, machines properly operated or materials properly used , some allowance is made for wastage & inefficiencies, If well-set they provied a useful psychological incentive by giving employees a realistic , but challenging target of efficiency.The consent & co-operation of employees involved in improving the standard are required.

(3)-Current Standard.

There are standard based on current working conditions (current wastage , current inefficiencies).The disadvantage of current standards is that they do not attempt to improve on current levels of efficiency.

(4)-Basic Standard.

These are standard which are kept unaltered over a long period of time , & may be out of date they are used to show changes in efficiency or performance over a long period of time basic standards are perhaps the least useful & least common type of standard in use.

Revision Of Standards.

In practice standard costs are usually revised once a year to allow for the new overheads budget , inflation in prices & wage rate , & any changes in expected efficiency of material usage , labour or machinery.

Some argue that standard should be revised as soon as there is any change in the basis upon which they were set. Clearly , for example , if a standard is based on the cost of a material that is no longer available or the use of equipment which has been replaced, it is meaningless to conpare actual performance using the new material & equipment with the old standard.

Frequent changes in standard can cause problems.

• They may become ineffective as motivators & measures of performance , since it may be perceived that target setters are constantly "moving the goal posts".
• The administrative effort may be too time consuming.

The most suitable approach would therefore appear to be a policy of revision the standards whenever changes of a permanent & reasonably long-term nature occur but not in response to temporary "blips" in price of efficiency.

(33).---MANAGEMENT ACCOUNTING FOR BUSINESS

The term ‘Management accounting for business’ is referred to the arrangement and adoption of all information related to accounts which assists the department heads to take various decisions in concern to managerial operations and control in an organization.

Management accounting for business is also associated with various accounting processes at different steps like preparing accounting statements, finding the cots of products, identifying labor costs, preparing budgets and thus communicating all the information to decision makers which could help them in taking important decisions related to the organization. Management accounting for business also includes preparing accounting reports for shareholders, creditors and other authorities.

There have been some significant changes in the working practices related to management accounting for business in past 20 years. Traditionally, accounting practices were only related to comparing the budgeted cost and the actual costs of labor and raw material. But with the changing time, the innovative accounting practices have been used in the whole process of cost analysis in accordance with the modern business developments.

Management accounting for business plays a vital role in determining the manufacturing cost of a product, especially when the product is in the designing stage. This helps the organization in saving huge money by making some insignificant changes. Modern accounting techniques also help in defining the amount of work activities and the ways of controlling the cost effectively.

To conclude, management accounting for business plays a key role in defining the product cost, budget, service and labor costs, assisting the decisions makers and communicating the information in order to benefit the organization.

(32).---SETTING STANDARD FOR OVERHEADS , SELLING PRICE & MARGIN.

Setting Standards For Overheads , Selling Price & Margin.

Setting Standards For Overheads.

The standard overhead absorption rate is the same as the predetermined overhead absorption rate as calculated for an absorption costing system.

The standard absorption rate will depend on the planned production volume for a period. Production volume will depend on two (2) factors,

1. Production capacity ( or volume capacity) measured perhaps in standard hours of output.
2. Efficiency of working , by labour or machines , allowing for rest time & contingency allowances. This will depend on the type of performance standard to be used ( ideal,current,attainable & so on).

Capacity levels.

Capacity levels are needed to establish a standard absorption rate for production overhead, when standard absorption costing is used. Any one of three (3) capacity levels might be used for budgeting.

1. Full capacity is the theoretical capacity, assuming continuous production without any stopages due to factor such as machine down time, supply shortages. Full capacity would be associated with ideal standards.
2. Practical capacity acknowledge that some stopages are unavoidable such as maintains time for machines, & resetting time between jobs, some mechine breakdowns & so on practical capacity is below full capacity , & would be associated with attainable standards.
3. Budgeted capacity is the capacity ( labour hours, machine hours) needed to produce the budgeted output, & would be associated with current standard which relate to current conditions but may not be representative of normal practical capacity over a longer period of time.

Setting Standards For Selling Price & Margin.

The standard selling price will depend on a number of factors including the following,

• Anticipated market demand,
• Competing products & competitors "actions",
• Manufacturing costs,
• Inflation estimates.

The standard sales margins is the difference between the standard cost & the standard selling price.

(31).---SETTING STANDARDS FOR MATERIAL COSTS-LABOUR COSTS.

Setting Standards For Materials Costs.

Direct material prices will be estimated by the purchasing department from their knowledge of the following

• Purchase contracts already agreed.
• Pricing discussions with regular suppliers.
• Quotations & estimates form potential suppliers.
• The forecasts movement of prices in the market.
• The availability of bulk purchase discounts.
• Material quality required.

Price inflation can cause difficulties in setting realistic standard prices,

(a)-If the current price were used in the standard, the reported price variance would become adverse as soon as prices go up, which might be very early in the year. If prices go up gradually rather than in one big jump, it would be difficult to select an appropriate time for revising the standard.

(b)-If an estimated mid year price were used, price variance should be favourable.In the first half of the year and adverse in the second half again assuming that price go up gradually.

Standard costing for material is therefore more diffcult in times of inflation but it is still worthwhile.

• Usage & efficiency variances will still be meaningful.
• Inflation is measurable; there is no reason why its effects cannot be removed from the variances reported.
• Standard costs can be revised, so long as this is not done too frequently.

Setting Standards For Labour Costs.

Direct labour rates per hour will be set by discussion with the personal department & by reference to the payrool & to any agreements on pay rises &/or bonuses with trade union representatives of the employees.

(a)-A separate hourly rate or weekly wage will be set for each different labour grade/type of employee.

(b)-An average hourly rate will be applied for each grade ( even though individual rates of pay may vary according to age & experiance).

Setting Standards For Material Usage & Labour Efficiency.

To estimate the materials required to make each product ( material usage) & also the labour hours required ( labour efficiency ), technical specifications must be prepared for each product by production experts.

( Either in the production department or the work study department) Material usage & labour efficiency standards are known as performance standards.

• The standard product specification for materials must list the quantities must be made known to the operators in the production department ( so that control action by management to deal with excess material wastage will be understood by them)
• The standard operation sheet for labour will specify the expected hours required by each grade of labour in each department to make one unit of product. These standard times must be carefully set & must be understood by the labour force. Where necessary , standard procedures or operating methods should be started.

(30).---STANDARD COSTING.

Standard Costing.

The Uses Of Standard Costing.

A standard cost is a carefully predeternined estimated unit cost.

Standard costing is "a control technique which compares standard costs & revenues with actual results to obtain variances which are used to stimulate improved performance".

Standard costing is the preparation of standard costs to be used in the following circumstances.

(a)--To assist in setting budgets & evaluating managerial performance.

(b)--To act as a control device by establishing standards, highlighting (via variance analysis) activities that do not conform to plan & thus alerting management to those are as that may be out of control & in need of corrective action.

(c)--To enable the principal of "management by exception" to be practiced a standard cost, when established, is an average expected unit cost. Because it is only an average, actual results will vary to some extent above & below the average variances should only be reported where the difference between actual & standard is significant.

(d)--To provide a prediction of future costs to be used in decision-making citoation.

(e)--To value stocks & cost production for cost counting purposes it is & alternative method of valuation to methods like FIFO, LIFO or replacement costing.

(f)--To motive staff & management by the provision of challenging targets.

(g)--To provide guidance on improvement of efficiency.

Setting Standards.

A standard cost implies that a standard or target exists for every single element that contributes to the product;the types, usage & prices of materials & parts, the grades, rates of pay & times for the labour involved, the production methods, tools & so on.The standard cost for.

Each part of the product is recorded on a standard cost card, an example standard costs may be used in both marginal & absorption costing systems.

The responsibility for setting standard costs should be shared between managers able to provide the necessary information about levels of expected.

Efficiency, prices & overhead costs. Standard costs are usually revised once a year (to allow for the new averheads budget, inflation in prices, & any changes in expected efficiency of materials usage or of labour). However they may be revised more frequency if conditions are changing rapidly.

Setting Up Standard.

1. Setting standards for material costs.
2. Setting standards for labour costs.
3. Setting standards for material usage & labour efficiency.
4. Setting standards for overheads.
5. Setting standards for selling price & margin.

Please see our further post for next details.........

(29).---UNIT TRUSTS AND INVESTMENT TRUSTS.

Unit Trusts & Investment Trusts.

A unit trusts is a fund organization which mobilies savings /funds from small investors by selling units in the market. Therefore this is the collective or mutual fund. Sales proceeds of units or funds are then invested in the share/stock market. Units are periodically revalued by the trust managers & offered for purchase & sale at new prices. Individual investors or unit holders, trustee & the fund manager are three parties involved in a unit trust. The fund manager will invest money in shares to get maximum profit for the fund. Also dividends are distributed among the unit holders. Since small savers do not have information, knowledge & opportunity to invest in the share market, they can get the benifits of the share market investment through a unit trust. Also share market will expand due to unit trusts through the increased funds to the market. Unit trusts are open-ended institutions since they can buy back their units from unitholders. Unit trusts buy & sell one units dailly with unit holders.

Investment trusts are close -ended institutions since they cannot buy back one shares from the market. Investment trust is a company raising funds by selling shares to public for investment business in the stock market & is similar to other companies. Also, an investment trust is a corporate body setup under the companies act. A unit trust is setup under the trust ordinance & it is not a corporate body.

(28).---TYPES OF SWAPS.

Types Of Swaps.

There are four types of swaps.

(1).Interest Rate Swaps.

(2).Currency Swaps.

(3).Commodity Swaps.

(4).Equity Swaps.

(1).Interest Rate Swaps.

An interest rate swap is an exchange between two counter parties of interest obligations (payments of interest) or receipts (investment income), in the same currency on an agreed amount of notional principal for an agrred period of time. The agreed amount is called "notional principal" because, since it is not a loan or investment.The principal amount is neither exchanged at the outset nor rapid at maturity.The most common interest-rate swaps involve the exchange of interest from a fixed to a floating basis or vice versa.

(2).Currency Swaps.

A currency swap is an agreement to exchange interest obligations or interest receipts between two different currencies.The market standard is to quote a fixed rate of interest in one currency against a floating rate of interest (generally in the US $). A rate of exchange between the two currencies must be established at the outset.This will produce principal amounts in the two currencies upon which payments of interest will made. At the final maturity of the transaction, along with the final periodic payment of interest, the swap counterparties must exchange the principal amounts of the two currencies. Which were fixed at the outset. The exchange of two principal amounts at the beginning of the swap is not necessary, but it can take place if required. The exchange of principal at the end of the transaction must take place. It is this exchange, which offsets interest-rate differentials between the two currencies.

(3).Commodity Swaps.

This is a swap where payments are based on the prices of commodities. One party pays a fixed price for the good over life of the swap while the other pays a floating price for the good, depending on current market prices.

(4).Equity Swaps.

With an equity swap, payments are made based on a notional principal. Which is an equity portfolio. The payments are fixed & floating. The floating rate sum is based on the return on the relevant index for the period while the fixed rate sum is agreed in advance.

(27).---DERIVATTIVES / DERIVATIVE INSTRUMENTS.

Derivattives / Derivative Instruments.

A derivattives is an instrument , value of which is derived from the value of another investment / asset.Called a underliying asset or security. A brief description on derivattives are given below;

(1)-Forward Contracts.

A forward contract is an agreement made between two parties to exchange an asset at a specified price at a specified date. Because it is a contract , the buyer is obliged to purchase the asset the seller is obliged to sell at the predetermined price ( the exercise price ) on the specified date ( the expiration date ).

(2)-Futures.

A "future" is an agreement to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today. There are two parties to a futures contract, a buyer & a seller whose obligations are as follows,

• The buyer of a future enters into an obligations to buy on a specified date.
• The seller of a future is under an onligation to sell on a future date.

These obligations relate to a standard quantity of a specified asset on a fixed future date at a price agreed today.

Types of Futures-

(1). Commodity futures,
Based on underline commodities & could be used to hedge an underline commodity position or to speculate on the commodity.

(2). Index Futures,
Based on stock indexes.
(3). Interest Rate Futures.
Based on movement in interest rates & could be used to hedge diposits or borrowings or speculate on interest rate movements .

(4). Currency Futures.
Based on foreign exchange rates between two specified currencies & could be used to hedge underlying currency positions or to speculate on currency movements.

(3)-Options.
An option is a contract that confers upon the buyer the right , but not the obligation, to buy or sell an asset at a given price on or before a given date. All the comments related to standard quantities , specified assets , fixed future dates & price agreed today that we noted for futures still apply for options as well.



In the definition above , on option was discribed as being the right , but not the obligation to buy or sell. The right to buy & the right to sell are given different names, as follows ,

• The right to buy is known as a call option.
• The right to sell is known as a put option.

(4)-Swaps.
A swap is a contractual agreement evidenced by a single document in which two parties. Called counter parties, agree to make periodic payments to each other.In other words , it is the transformation of one stream of future cash flows with another stream of future cash flows with different features.



Swaps have become one of the most important & flexible instruments available to banks & corporate treasurers for asset & liability management.Like other hedging & treasury management models, swaps themselves are not instruments for rising new funds. They are transacted to make new or existing cash flows more attractive, Swaps are often combined with bond issues to achieve particularly favorable funding costs. They also allow a borrower , unable to raise funds efficiently in the bond markets , acces to fixed rate finance. For banks, the swap market provibes a means of laying off risk when they are providing clients with medium-term fixed rate loans. Bank can also make profits from trading swaps.

(26).---EFFICIENT CAPITAL MARKET & EMH ( Efficient Market Hypothesis ).

Efficient Market & EMH.

In an efficient capital market, security prices adjust rapidly to the infusion of new information. And therefore current security prices fully reflect all available information. This is to as an informationally efficient market.

Why Capital Markets Should Be Efficient ?

Following set of assumptions imply an efficient capital market:

1. A large no of profit maximizing participants analyze & value securities, each independent of others.
2. New information regarding securities comes to the market in a random fashion, & timing of one announcement is generally independent of others.
3. Profit maximizing investors adjust security prices rapidly to reflect the effect of new information.
4. Because security prices adjust to all new information, these security prices should reflect all information that is publicly available at any point in time.

Efficient Market Hypothesis ( EMH ).

The three (3) forms of efficient market hypotheses are:

1. Weak for EMH.-----The week for EMH assumes that current stock prices fully reflect all security market information. Including the historical sequence of prices rates of return trading volume data & other market generated information. This hypothesis implies that past rates of return & other market data have no relationship with future rates of return.
2. Semi Strong Form EMH.-----This assets that security prices adjust rapidly to the release of all public information; that is, current security prices fully reflect all public information, The semi strong for EMH encompasses the weak form hypothesis, because all the market information considered by the weak form hypothesis, such as stock prices, rates of return , trading volume is public. Public information also includes all non-market information such as earnings & dividend announcements price earnings ratio, dividend yields,book value etc. This hypothesis implies that investors who base their decisions on any important new information after it is public should not derive above average risk adjusted profits from their transactions, because the security price already reflects all such new public information.
3. Strong Form EMH.-----The strong form EMH contends that stock prices fully reflect all information public & private sources. This means that no group of investors has monopolistic access to information relevant to the information of prices.Therefore this hypothesis contends that no group of investors should be able to consistently drive above avarage risk adjusted rates of return.This hypothesis encompasses both the wake form & semi strong form EMH.Further , the strong form EMH extends the assumption of efficient markets, in which prices adjust rapidly to the release of new public information to assume perfect markets , in which all information is cost free & available to everyone at the sometime.

(25).INTEREST RATE RISK MANAGEMENT.

Interest Rate Risk Management.

CONTINUE FROM POST 24...

The traditional method of managing interest rate risk has been fixed -rate borrowing in the form of loans . If is simple , & companies know how much they will need each year to service the debt, However, it is not always possible to obtain a loan at the rates, or for the amounts required.

An enterprise may wish to take precautions against interest rates moving up or down in the future , or many wish to change the existing structure of its funding or deposits , for instance for a fixed rate of interest to a floating rate. With the devolopmentof the financial markets & , in particular , the financial futures markets , a number of instruments have arisen which allow the treasurer to hedge interest rate risk.

Interest Rate Swaps.

An interest rate swap is an exchange of interest rate commitments , serch that a fixed -rate.

Commitment is exchanged for a floating-rate commitment. The parties to a swap retain their obligations to the orginal lenders . Which means that the swap parties must accept counter - party risk.

Interest rate swaps are used for purposes other than obtaining a cheaper financing rate. They could , for example- be used to change future case flows or to enhance returns.

Interest rate swaps are off balance sheet items , as the principal amount of the contract is not paid , & it is just an agreement to swap future cash flows. However, the existece of the swap should be maintained in the notes to the financial statements. The interest payments & receipts should be accrued over the life of the swap on a straight-line basis. Financial institutions which actively trade swaps revalue their positions the current market value.

Forward Rate Agreements.

A forward rate agreement ( FRA) is an agreement whereby an enterprise can lock in an interest rate today for a period of time starting in the future. On the future date the two counter parts in the FRA settleup & , depending on which way rates go , one will pay an amount of money to the other representing the difference between the FRA rate & the actual rate.

Example---

Thomas plc has $ 1 m loan outstanding on which the interest rate is reset six months for the following six months. And the interest is payble at the end of that six month period.

The next six monthly reset period may now be just three months away , but the treasurer of Thomas plc thinks that interest rates are likely to rise between now & then. Current six month rates are 8% & the treasurer can get a rate of 8.1% for a six month FRA starting in three months time.

By transactions an FRA the treasurer can lock in a rate today of 8.1%. If interest rates rise as expected to say 9% Thomas plc has reduce its interest charge as it will pay the current 9% rate on its loan but will recive from the FRA counterpart the difference between 9% & 8.1%.

If however rates drop to 7% Thomas plc will still end up paying an effective rate of 8.1% because although the interest rate on the loan is lower , the company will pay the FRA counterpart the difference between 7% & 8.1%.

If rates are 9% in three months time,

$

Interest payable on the loan 9% x $1 m x 6/12------------------------------------------ 45000

Amount receivable on FRA (9%-8.1%)x$1 m x 6/12------------------------------------ (4500)

net amount ---------------------------------------------------------------------------40500

The 40500$ is the net amount payable , giving an effective rate of 8.1%, If rates are 7% in three months time

$

Interest payable on the loan 7% x $1m x6/12--------------------------------------------35000

Amount payable on FRA ( 8.1% - 7%) x $ 1m x 6/12--------------------------------------5500

net amount---------------------------------------------------------------------------40500

The $ 40500 is the net amount payble , again giving an effective rate of 8.1%.

(24).MANAGEMENT OF INTEREST RATE RISK.

Management Of Interest Rate Risk.

Matters To Be Discussed--

• -Influences on Interest Rates;
• -Methods of Hedging Interest rate risk;
• -Illustrating the effect of interest rate risk management techniques such as Swaps,Forward rate agreements,Futures & options.

Interest Rate.

Business wish to reduce their exposure to risk in all its forms & much has been written on this topic, ranging from the identification of different elements of risk ( interest rate,foreign , political) through to this quantification ( portfolio theory & CAPM). There remain ,however ,large areas of uncertainty.

Interest rate risk deals with the possibility of loss arising from a change in the level of interest rates.

Example--

As both a borrower & an investor of funds a company is exposed to variations in the interest rate.For example ,if a medium-term loan is taken out at a rate of say 15% ( variable) & interest rates are falling ,the changing interest rates will work to the advantages of the company. Conversely if interest rates were rising , or if the loan was fixed-rate the change would be detrimental to the company.

One important aspect of the treasury function is management of debt in such a way as to reduce the company's exposure to risk resulting interest rate movements.

Term Structure Of Interest Rates.

One of the primary considerations in evaluating debt is the likely movement in interest rates. This will affect the relative costs of long & short-term debt, as well as increasing or decreasing the preference for fixed interest rates. In practice , long-term rates will normally be higher than short-term rates, owing to the additional risk borne by the lender. Hence an interest premium is required to attract investors to longer-term securities.

This effect may be magnified or reversed by investors expectations of future rates, an anticipated rate rise producing higher longer-term rates. This difference between long & short-term rates is known as term structure.

In the general terms ,an increasing term structure results from two factors:

• Increased risk of longer debt
• Anticipated genaral interest rate rate rises.

More details analysis is littled required , however, below are listed formal theories as to why interest rates increase with time.

• Expectations Theory.

This is states that the forward interest rate is due solely to expections of interest rate movement.

If an indidual wishes to borrow for two years, to obvious possibilites present themselves,

- Borrow for two years at an agreed rate,

-Borrow for one year & refinance for the second year ( i.e. pay off the first loan by talking out a second).

In option (a) the interest paid on the loan will be based on the current interest rate & the forward rate for one year. In option (be) the individual will consider the current interest rate & the expected interest rate for year. Thus the choice between the options hinges on whether the forward rate for year two is higher or lower than the expected rate.

From the lenders point of view if the expected rate was higher they would only lend short , preferring to renegotiate at the end of one year & take advantage of the anticipated rate rise. A similar argument could be made if the expected rate was lower than the forward rate, Thus for long -& short - dated dent to coexist, expected future rates & forward rates must be equal. Thus the term structure of interest rates is due purely to investor expectations.

• Liquidity Preference Theory.

The problem with the expectations theory is that it ignores risk- if the expected rate for year two is the same as the forward rate then & individual needing to borrow for two years would choose a two- year loan since this eliminates the uncertainty of the actual interest rate to be paid in year two. Thus ,borrowers will aim to borrow for the period for which they need funds. If lenders wish only to lend for one year there will be a shortage of long funds & an.


Excess of short funds. This will lead to a premium on forword rates -(i.e.-Lenders will get a bonus for lending for two years & borrowers will have to pay extra if they insist on a two year loan.
In this case the term structure of interest rates would again be upword sloping but now it would be due to the liquidity preference of lenders & borrowers.

• Market Segmentation.

It has been argued that demand for capital funds in practice can be segmented , particularly on a time basis. Thus , for example- Companies tend to finance stocks with short-term funds & equipment with long term funds. This leads to different factors affecting long- & short - term rates & a lack of a clear trend in the yield curve , characterized by irregularities such as humps & dips.


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