Managing Finance and Budgets

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Managing Finance and Budgets

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Title: Managing Finance and Budgets

1
Managing Finance and Budgets

Lecture 5
Profit Loss Accounts

2
Session 5 Learning Outcomes

Learning outcomes
Understand the terms within the Profit Loss
Account, and be able to interpret a Profit Loss
account relating to a particular organisation.
Be able to discuss certain key issues
Cash versus Profit
Capital/Revenue expenditure
Depreciation
Cost of Sales Valuation of Stocks
Provision for Bad Debt.

3
Presentation 5 Menu

Section
A Profit Loss Some Terms
B The Profit Loss Account Format
C Profit Loss Some Issues
D Preparation for Seminar 5

4
Section A The Profit Loss Account
5
The Profit and Loss Account

In Week 2 we saw an example of a Profit and Loss
account for a days trading in a lemonade stall.
Before we see an example of a real Profit and
Loss account, we need to understand
the idea of revenue
the idea of expenses

6
Further Financial Terms

Income An amount of money which comes in to, or
is earned by, the business during an accounting
period - sometimes called Revenue
Turnover - total value of sales over a given
period this is sometimes called Income or
Revenue
So what is actually meant by the term Revenue?
Revenue technically this simply refers to the
inflow of assets, or the reduction in claims that
arise as a result of trading operations.

7
Financial Terms

Expenditure An amount of money which has been
spent by, or goes out from, the business during
an accounting period.
Cost - the amount of actual or notional
expenditure incurred on or attributable to a
specified thing or activity (fixed, variable,
direct, indirect )

8
Profit Loss Equation for a period
9
The Format of the P L Account

Normally a Profit Loss Account will consist
of
Sales (Turnover)
Less Cost of Sales
Gross Profit
Less Overheads
Net profit
Less Interest on Loans
Profit Before Tax
Less Tax
Profit after Tax
Less Dividends
Retained profit for the year

P L Terms For a quick explanation Click Here
10
Terms on the Profit and Loss Account

Turnover Total value of sales over a given
period - sometimes called Income or Revenue
Cost of Sales The costs incurred in making the
sales in a given period
Overheads Other costs incurred in running the
business, but not directly related to making
sales
Interest on Loans Money paid to lenders for the
privilege of borrowing money.
Tax Money paid to the government as a
contribution to the National Exchequer.
Dividends Money paid to shareholders as a
reward for investing in the company.

For a more in-depth explanation, please click on
the item
11
Turnover

Sale of goods or Fees for services
Subscriptions
Interest earned
To all intents and purposes,
Income Revenue Sales Turnover
VAT is excluded from Sales figures (and all other
figures)

12
Cost of Sales (Direct Costs)

Costs which are directly related to the cost of
providing the goods or service (Cost of Sales)
For example Goods purchased for resale
Direct Labour costs
Raw materials, Packaging, Energy
Direct Costs often vary with sales
(though some Direct Costs can be FIXED)

13
Overheads (Indirect Costs)

Operating Expenses
Costs which are not directly related to sales.
Costs which are incurred even when an
organisation produces no output. Often Fixed
Costs
For example Administrative salaries
Advertising, Stationery, Rent
Rates
Insurance, Bank charges
Depreciation
Indirect Costs do not (necessarily) vary with
sales
Interest usually shown later

14
Interest on Loans

Includes
Interest on Bank loans and other formal loan
arrangements (e.g. debentures). These are
normally charged at some fixed rate e.g. 12 of
the loan
Interest on Overdrafts (rates may be variable),
and more expensive (e.g. up to 15)
Does not include
Money paid to shareholders in dividends
Interest charged by creditors for late payment

15
Tax

Corporation Tax is charged on profits made after
all costs and interest charges (but not
dividends) have been accounted for.
The current rate of tax is 19 for SMEs and 30
for large companies, but there are allowances
which mean that this will be reduced.
In the examples in the slides, a flat rate of
20 is used, to simplify calculations
For more on tax, consult
http//www.inlandrevenue.gov.uk/rates/corp.htm

16
Dividends

Limited companies are financed primarily through
shareholding.
Shareholders buy shares in the company. These may
have a face value ranging anywhere from 1 penny
to thousands of pounds.
At the end of each financial period, the
directors of the company may decide to issue
dividends. This is money paid to the shareholders
out of net profit after tax , as a reward for
their continued investment.
The dividend paid does not affect the face value
of the share.

17
Profit or (Loss)

There are many different sorts of profit
Gross Profit Sales less Direct Costs
Operating Profit Sales less Direct Costs less
Indirect Costs
Profit before tax Operating Profit less
Interest
Profit after tax Profit before tax less tax
Retained profit Profit after tax less dividends

18
Section B The Profit Loss Account Format
19
Sample Profit Loss Account

The next slide shows a profit and loss account
for a company over a one-year period.
The format varies according to the type of
business, but there is a fairly uniform
convention to structure the accounts in the
following way
Total Income
Less expenditure item 1
Less expenditure item 2
Less expenditure item 3 etc.
Earned Surplus (Profit)

Turnover (Sales) (Income) 100,000
Cost of Sales (Direct Costs)
Materials 10,000
Transport 5,000
Labour 15,000
Total Cost of Sales
30,000 30
Gross Profit (Gross Margin) 70,000 70
Overheads (Indirect Costs)
Administrative salaries 18,000
Depreciation 5,000
Rent Rates 4,000
Total Overheads 27,000 27
Operating Profit (Net Margin) 43,000 43
Interest on loans 3,000
Profit before tax 40,000 40
Corporation tax due 8,000
Profit after tax interest 32,000 32
Dividends payable 22,000
Retained Profit (Earned Surplus) 10,000 10

Turnover (Sales) (Income) 100,000
Cost of Sales (Direct Costs)
Materials 10,000
Transport 5,000
Labour 15,000
Total Cost of Sales
30,000 30
Gross Profit (Gross Margin) 70,000 70
Overheads (Indirect Costs)
Administrative salaries 18,000
Depreciation 5,000
Rent Rates 4,000
Total Overheads 27,000 27
Operating Profit (Net Margin) 43,000 43
Interest on loans 3,000
Profit before tax 40,000 40
Corporation tax due 8,000
Profit after tax interest 32,000 32
Dividends payable 22,000
Retained Profit (Earned Surplus) 10,000 10

The first part of the account is usually
concerned with the total amount of income and
working out the Gross Profit. This is called the
Trading Account
22

Turnover (Sales) (Income) 100,000
Cost of Sales (Direct Costs)
Materials 10,000
Transport 5,000
Labour 15,000
Total Cost of Sales
30,000 30
Gross Profit (Gross Margin) 70,000 70
Overheads (Indirect Costs)
Administrative salaries 18,000
Depreciation 5,000
Rent Rates 4,000
Total Overheads 27,000 27
Operating Profit (Net Margin) 43,000 43
Interest on loans 3,000
Profit before tax 40,000 40
Corporation tax due 8,000
Profit after tax interest 32,000 32
Dividends payable 22,000
Retained Profit (Earned Surplus) 10,000 10

The next part of the account is usually concerned
with the indirect costs and working out the Net
Profit.
23

Turnover (Sales) (Income) 100,000
Cost of Sales (Direct Costs)
Materials 10,000
Transport 5,000
Labour 15,000
Total Cost of Sales
30,000 30
Gross Profit (Gross Margin) 70,000 70
Overheads (Indirect Costs)
Administrative salaries 18,000
Depreciation 5,000
Rent Rates 4,000
Total Overheads 27,000 27
Operating Profit (Net Margin) 43,000 43
Interest on loans 3,000
Profit before tax 40,000 40
Corporation tax due 8,000
Profit after tax interest 32,000 32
Dividends payable 22,000
Retained Profit (Earned Surplus) 10,000 10

The final part of the account is usually
concerned with the interest which needs to paid,
tax, and dividends to shareholders.
24

Turnover (Sales) (Income) 100,000
Cost of Sales (Direct Costs)
Materials 10,000
Transport 5,000
Labour 15,000
Total Cost of Sales
30,000 30
Gross Profit (Gross Margin) 70,000 70
Overheads (Indirect Costs)
Administrative salaries 18,000
Depreciation 5,000
Rent Rates 4,000
Total Overheads 27,000 27
Operating Profit (Net Margin) 43,000 43
Interest on loans 3,000
Profit before tax 40,000 40
Corporation tax due 8,000
Profit after tax interest 32,000 32
Dividends payable 22,000
Retained Profit (Earned Surplus) 10,000 10

The bottom line here is what the company has
actually made as a profit over the year. This is
the Surplus.
25
Activity 5.2
Re-examine P L Account

Suppose the company in the example just explored
needed money for business expansion.
Which items of expenditure would you consider
reducing, so as to increase the amount of
retained surplus?

Answer
26

Turnover (Sales) (Income) 100,000
Cost of Sales (Direct Costs)
Materials 10,000
Transport 5,000
Labour 15,000
Total Cost of Sales
30,000 30
Gross Profit (Gross Margin) 70,000 70
Overheads (Indirect Costs)
Administrative salaries 18,000
Depreciation 5,000
Rent Rates 4,000
Total Overheads 27,000 27
Operating Profit (Net Margin) 43,000 43
Interest on loans 3,000
Profit before tax 40,000 40
Corporation tax due 8,000
Profit after tax interest 32,000 32
Dividends payable 22,000
Retained Profit (Earned Surplus) 10,000 10

Turnover (Sales) (Income) 100,000
Cost of Sales (Direct Costs)
Materials 10,000
Transport 5,000
Labour 15,000
Total Cost of Sales
30,000 30
Gross Profit (Gross Margin) 70,000 70
Overheads (Indirect Costs)
Administrative salaries 18,000
Depreciation 5,000
Rent Rates 4,000
Total Overheads 27,000 27
Operating Profit (Net Margin) 43,000 43
Interest on loans 3,000
Profit before tax 40,000 40
Corporation tax due 8,000
Profit after tax interest 32,000 32
Dividends payable 22,000
Retained Profit (Earned Surplus) 10,000 10

Reduce Labour Costs 15 is a large proportion of
turnover. May be difficult.
Reduce Admin 18 is a very large proportion of
turnover.
Reduce Dividends 22 is far too high if we are
looking to expand the business.
28
Section C The Profit Loss AccountSome Issues
29
Some Issues

Cash versus Profit
Capital Revenue Costs
Cost of Sales
Valuation of Stocks
Depreciation
Bad Debt Provision
Prepaid Expenses
Accrued Expenses

30
Cash Versus Profit

In accounting terms, to calculate Profit (or
Loss) Sales Income must be matched against
relevant expenditure for a given period
Some goods may be purchased on credit, some sales
may be sold on credit
Some purchases may have a useful life which lasts
longer than the given period
Therefore Profit in accounting terms is NOT
equivalent to Cash in less cash out during that
period

31
Capital Revenue Costs

Capital Costs are incurred in purchasing assets
Revenue Costs are incurred in delivering the
goods or services and operating the company
Capital Costs are not charged directly to the
Profit Loss Account. They are reflected in a
depreciation charge over their useful life.
Accounting profit Revenue Income less Revenue
Expenditure - Capital expenditure is only
deducted from Accounting profit through
depreciation
To capitalise an item means to treat it as
capital expenditure

32
Cost of Sales (1)

This is the cost of goods sold over a period.
For retail and manufacturing companies this will
mainly be the amount of stock throughput, and can
be calculated by

Opening stock level for the Period
Amount of stock purchased during the period
- Closing stock level for the Period
Cost of materials during the Period

33
Cost of Sales Example

At the start of January, a small furniture
retailer held 35,000 worth of stock. During the
month, a further 12, 000 was bought in, and at
the end of the month, the stock level was
27,000.
Calculate the cost of Sales for January.

Opening stock 35,000
Purchases 12,000 Total 47,000 less
Closing stock 27,000 Cost of
materials 20,000
34
Cost of Sales (2)

In service and some manufacturing industries, The
cost of sales may also include other Direct
Costs. These are costs directly incurred as a
result of making the sale, manufacturing the
item, or in carrying out the service.

Direct Costs
Cost of Materials
Labour costs incurred
Transportation costs
Fuel other costs

35
Stock Valuation

Opening and Closing Stocks must be taken into
account when calculating Direct Costs to in order
to keep to the matching convention
Where sales volume is high (or prices are
standard) an average price may be used
Manufacturing Companies may incorporate cost of
manufacture into stock value (e.g. materials,
power, labour)

36
Stock Valuation Conventions

Where stock is bought in at different times, from
different suppliers and at different prices, the
valuation of stock may be an issue.
There are basically three conventions
FIFO (First In First Out)
LIFO (Last In First Out)
AVCO (Weighted Average Cost)

37
Stock Valuation Methods
38
Stock Purchases and Sales

Opening Stock Level 200 items _at_ 10 each
Purchase 1 100 items _at_ 12 each
Purchase 2 200 items _at_ 15 each
Sales 400 items _at_ 20 each

39
FIFO Stock Valuation Example

Opening Stock Level 200 items _at_ 10 each
Purchase 1 100 items _at_ 12 each
Purchase 2 200 items _at_ 15 each
Sales 400 items _at_ 20 each
FIFO First in, First Out
Items will be sold in the order in which they
were bought.
The 400 items sold will be made up of
200 items _at_ 10 each 2000 (prev. stock)
100 items _at_ 12 each 1200 (purch. 1)
100 items _at_ 15 each 1500 (purch. 2)
Total Cost of Sales 4700

40
LIFO Stock Valuation Example

Opening Stock Level 200 items _at_ 10 each
Purchase 1 100 items _at_ 12 each
Purchase 2 200 items _at_ 15 each
Sales 400 items _at_ 20 each
FIFO First in, First Out
Items will be sold in the reverse order of
purchase.
The 400 items sold will be made up of
200 items _at_ 15 each 3000 (purch. 2)
100 items _at_ 12 each 1200 (purch. 1)
100 items _at_ 10 each 1000 (prev. stock)
Total Cost of Sales 5200

41
AVCO Stock Valuation Example

Opening Stock Level 200 items _at_ 10 each 2000
Purchase 1 100 items _at_ 12 each 1200
Purchase 2 200 items _at_ 15 each 3000
Sales 400 items _at_ 20 each
AVCO Weighted Average Cost
An average cost will be calculated.
All items sold will be charged at that cost.
Total value of stock 2000 1200 3000
6200
Total no. of items 200 100 200 500
Average value of stock 6200/500 12.40 per
item
Total Cost of Sales 400 _at_ 12.40 4960

42
Depreciation

Depreciation is the method used to spread the
cost of a purchase (normally of a fixed asset)
over a number of time periods (usually years)
This is a way of charging to the business the
cost of the asset, in a way which accounts for
the wear and tear of the asset, and the fact
that over time it is reducing in value.
Depreciation is shown in the Profit Loss
Account as an Overhead

43
Calculating a depreciation charge

The depreciation charge is calculated as a
result of these four factors
Initial Cost
How long it will be used for
What it will be worth at the end
Calculation method

44
Calculating an annual depreciation charge
Whatever method is used, the procedure is the
same
45
Depreciation Methods

There are two main methods used
Straight-line depreciation Cost of item divided
by number of years over which it is to be written
off
Reducing balance Current value x Depreciation

46
Graph of written-down value against time using
the straight-line method
The same amount is used to reduce the asset
value each year.
47
Graph of written-down value against time using
the reducing balance method
The amount used to reduce the asset value
decreases year on year.
48
Depreciation calculation

Purchase of a piece of equipment costing 10,000
Straight-line over 5 years
Reducing balance at 30
Written down
Written down
Depreciation Value
Depreciation Value
Year 1 2,000 8,000
3,000 7,000
Year 2 2,000 6,000
2,100 4,900
Year 3 2,000 4,000
1,470 3,430
Year 4 2,000 2,000
1,029 2,401
Year 5 2,000 0
720 1,681
Year 6 0 0
504 1,176

49
The Problem of Bad Doubtful Debts

Many businesses sell goods on credit. The revenue
generated is recognised in accounts as soon as
the goods are passed to the customer.
As soon as this happens, the sale is recorded,
and the amounts appear as Turnover on the P L
account, and as Trade Debtors on the Balance
Sheet.
There is a risk that the customer will not, or
cannot pay. If this occurs then this is called a
bad debt and must be written off.
This involves reducing debtors on the Balance
Sheet, and creating an expense in the Overheads
section for Bad Debt.

50
Provision for Doubtful Debt

In some enterprises the problem of bad debt is
endemic, and it may not be possible to identify
with certainty the amount of debt which is bad,
or which will not be retrieved.
In this case, the business will use past
experience to estimate the amount of debt which
might be lost in the accounting period.
The Provision for Doubtful Debt is calculated as
an estimate and this will be used to reduce
debtors on the Balance Sheet, and create an
expense in the Overheads section called
Provision for Doubtful Debt.

51
Prepaid Expenses

Pre-paid expenses - goods or services which have
been paid for in advance.
When you eat in MacDonald's, they require you to
pay up front before you get the food. At the
point at which you have paid, before you get your
meal. This is a prepaid expense.
Prepaid expenses are things like rent rates
paid in advance, as well as some consultancy
fees.

52
Accrued Expenses

Accrued expenses - any amount which the
organisation owes for expenses already consumed
but for which a bill has not been yet received or
paid
When you eat in a posh restaurant they
normally provide you with the food, then present
you with the bill at the end. At the point at
which you have eaten the meal, but not paid, this
is an accrued expense.
Accrued expenses are things like tax, dividends,
wages and fuel bills.

53
Seminar 5 - Activities