Strategic Business Leader (Cost and Finance part)

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(COST AND FINANCE PART)

(FOR FINANCE AND COSTING PART ONLY)

G Apply high level financial techniques from Skills exams in the planning,
implementation and evaluation of strategic options and actions.

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Finance in planning and decision-making

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CHAPTER 1

FINANCIAL FUNCTION AND DECISION-

MAKING TECHNIQUES
Organisations must consider the following financial aspects when developing their business strategy:

Financial Risk

Financial Return

Funding

Launch Growth Maturity Decline

Business risk
Financial risk
Funding
Dividends

Financing Requirements

There are three types of decision relevant to the financial requirements of the business:

1. Investment decision
2. Financing decision
3. Dividend decision

Sources of Finance

Suitable, Acceptable and Feasible?

Sources of finance can be evaluated using the SAF model:

• Suitability

• Acceptability

• Feasibility

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METHOD ADVANTAGES DISADVANTAGE

Operating cashflows

Equity

Debt

Overdraft

Investment Appraisal

These are techniques in choosing the best investment from all the investment available. The common techniques
will be:

• Payback period

This measures how many years it takes for cashflows affected by the decision to invest to repay the cost
of the original investment. The longer the payback, the higher the risk, so this is a good way of screening
out risky investment. However, it ignores the timing of cashflows and also ignores cashflows which
happen after the payback period.

• Accounting rate or return (ARR) @ Return on capital employed (ROCE)

It’s a simple measure and allows a simple decision rule – accept all projects with ROCE above the
company’s target return. However, it ignores the timing of cashflows and also ignores cashflows which
happen after the payback period.

• Net present value (NPV)

This includes all relevant costs and benefits of a project, and then discounts them to allow for the time
value of money, The discount rate used should reflect the company’s cost of capital, although may also
be adjusted to reflect risk. If the final net present value of all cashflows is positive, then, subject to non-
financial factors the project will be beneficial for the organisation and should go ahead.

• Internal rate of return

This is the discount rate which, when applied to a set of cashflows, results in a NPV nil. It is effectively
a percentage return and, if it is higher than the organisation’s cost of capital, the project should be
accepted, subject to any non-financial considerations.

Note: Candidates will not be required to prepare these analyses but may well be required to review them and use
them for decision making.

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EXAMPLE

You are a Financial controller providing support to an operational division. The manager of the division has shown
you an NPV analysis and made some comments on the approach used. This is given below as Appendix.

Required:

Critically evaluate the manager’s comments on the investment appraisal approach used to evaluate internal
projects. (10 marks)

Appendix – Meeting debrief

The company uses the Net present value (NPV) technique as a way of choosing which projects should be
undertaken. Below shows an example comparison of two computer system applications that had been under
consideration. Project 1 was selected as it has higher NPV $25,015 compared to Project 2 NPV $2,090.

In discussing this, the manager of the division said to you, ‘In the end, Project 1 was a disaster. Looking back, we
should have gone with Project 2, not Project 1. We should have used simple payback, as I am certain that Project
2, even on the initial figures, paid back much sooner than Project 1. That approach would have suited our mentality
at the time – quick wins. Whoever chose a discount rate of 8% should be fired – inflation has been well this for
the last 5 years. We should have used 3% or 4%. Also, calculating the IRR would have been useful, as I am sure
that Project 2 would have shown a better IRR than Project 1’.

Project 1 Year 0 Year 1 Year 2 Year 3 Year 4

Staff savings 0 40 5 0 0
Contractor savings 0 20 10 10 10
Maintenance savings 0 0 10 40 60
Hardware costs (50) 0 0 0 0
Software costs (50) 0 0 0 0
Maintenance costs (10) (10) (10) (10) (10)
Net cash flow (110) 50 15 40 60
Discount factor 8% 1.000 0.926 0.857 0.794 0.735
Present Value (110) 46.30 12.855 31.76 44.10

Project 2 Year 0 Year 1 Year 2 Year 3 Year 4

Staff savings 0 30 10 5 15
Contractor savings 0 30 10 10 10
Maintenance savings 0 0 10 40 60
Hardware costs (50) 0 0 0 0
Software costs (30) (10) (10) (10) (10)
Maintenance costs (10) (10) (10) (10) (10)
Net cash flow (90) 40 15 40 60
Discount factor 8% 1.000 0.926 0.857 0.794 0.735
Present Value (110) 43.30 12.855 31.76 44.10

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Dealing with risk and uncertainty

Decision making involves making decisions now which will affect future outcomes and it is unlikely that future
cash flows will be know with certainty

Risk

• Knowledge is available that several possible future outcomes are possible, usually due to past
experience. This past experience makes a decision maker to estimate the probability of the likely
occurrence of each potential future outcome. Risk can be quantified.

Uncertainty

• Future is unknown and the decision maker has no past experience and cannot be quantified but techniques
can be adopted to reduce uncertainty. These may include market research and focus groups

Risk preference

a) Risk seeker – An optimist. A decision maker who is interested in the best outcomes no matter how small
a chance that they may occur.

b) Risk neutral – A decision maker who is concerned with the most likely outcome.

c) Risk averse – A pessimist. A decision maker who acts on the assumption that the worst outcome might
occur.

Data tables

If there is one decision and one uncertain variable it is often easiest to display all options on a data table, which
may be generated easily by a spreadsheet.

Example

Datar Co must decide how best to use a monthly factory of 1,200 units. His demand from regular customer is
risky and as follows.

Monthly demand
(units) Probability

300 0.2
500 0.6
700 0.2
1.0

Regular customers generate contributions of $5 per unit. Datar Co has the opportunity to enter a special contract
which will generate contribution of only $3 per unit. For the special contract John must enter a binding agreement
now at a level of 900, 700 or 500 units.

Required

Display all possible contributions in a data table.

Demand (units) 900 700 500

300
500
700

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Expected Values

Is the weighted average of all outcome

EV = Ƹpx

Decision criteria is to choose the highest EV

Example
Suppose we assume that in earlier example Datar Co wants to maximise profits over the long term. Find the
optimal level of special contract to commit to every month using expected values.

Demand (units) P(x) 900 700 500

300 0.2 4200 3,600 3.000
500 0.6 4,200 4,600 4,000
700 0.2 4,200 4,600 5,000
EV

Limitations of expected values

a) EV is a long-term average, so that the EV will not be reached in the short term and is therefore not
suitable for one-off decisions.
b) The results are dependent on the accuracy of the probability distribution. In particular it uses discrete
variables (i.e. variables are point estimates rather than a continuous range) This may not accurately model
the real situation.
c) EV takes no account of the risk associated with a decision
d) The EV itself may not represent a single outcome.

Decision methods

Maximin decisions

Maximise the minimum return of each decision.

Risk averse decision maker

Example

Risk averse

Required

Assuming a totally risk adverse attitude, what would be taken using the data table in example earlier?

Solution

Demand (units) 900 700 500

300 4200 3,600 3.000
500 4,200 4,600 4,000
700 4,200 4,600 5,000

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Criticisms of maximin

• Ignores the probability of each outcome occurring

• Is conservative (does not try to maximise profit)

Maximax decisions

• Aims for the best possible return

• Return seeking decision maker

Example

Risk seeking

Required

Assuming a risk seeking attitude what decision would be taken using the data table in example above?

Solution

Demand (units) 900 700 500

300 4200 3,600 3.000
500 4,200 4,600 4,000
700 4,200 4,600 5,000

Criticisms of maximax

• Ignores the probability of each outcome occurring

• Is overly optimistic

Minimax regret decision rule

• Regret means opportunity cost from making the wrong decision

• The decision rule chooses the option which minimises opportunity cost from making the wrong decision.

Example

Required

Using the minimax regret rule, what decision would be taken using the data table in example above

Solution

Demand (units) 900 700 500

300 4200 3,600 3.000
500 4,200 4,600 4,000
700 4,200 4,600 5,000
Opportunity cost table

Demand (units) 900 700 500

300
500
700
Maximum regret

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Example

Required :

Which daily supply will Mylo choose if the decision making criteira is based on:

a) Expected value
b) Maximin
c) Minimax regret

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Decision trees

A decision tree is a pictorial method of showing a sequence of interrelated decisions and their expected outcomes.
Decision trees can incorporate both the probabilities of and value of expected outcomes and are used in decision
making.

Decision trees are most useful when there are several decisions and ranges of outcome.

Constructing a decision tree

Constructing a tree requires all the choices and outcomes are to be drawn and the numbers (probabilities, outcomes
and EVs) to be entered.

The steps involved are:

✓ Plan the tree diagram and tick off all information given in the question as you use it in the plan
✓ Draw the tree from left to right, using a ruler, giving yourself as much space as possible.
✓ Show a key in the answer detailing the different symbols for decisions and outcomes.

Evaluation a decision tree

Once drawn the optimal decision can be calculated using rollback analysis.

a) Evaluate the tree from right to left.

 Calculate expected values at outcome points

 Take highest benefit at decision points

b) Keep your workings on a different page

c) State clearly the initial decision to be made.

Example

Required:

From the decision tree produced the company need to decide whether to test market it or abandon it.

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Limitations using a decision tree in making decisions

• Time value of money may not be taken into account

• Decision tree are not suitable for use in complex situations
• The outcome with the highest EV may have greatest risk attached to it. Managers may be reluctant to
take risks which may lead to losses
• The probabilities associated are mere estimates and may not be unreliable or inaccurate.

Sensitivity analysis

Assessing probabilities of a range of variables may be difficult with certainty. Sensitivity analysis permits an
alternative way of assessing risk

Decisions are assessed for their response to a change in variable.

Approached to sensitivity analysis are:

a) Calculating the maximum percentage change in a variable before the decision would change.
b) Assessing if the decision would change if a variable changed by x% of the estimate.
c) Estimating by how much costs/revenues would need to change before the decision maker would be
indifferent between two options.

Limitations of sensitivity analysis

• Only one variable can be tested at a time

• There is no decision rule
• It does not quantify the probability of the variable changing

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Example

Bence Co is considering the launch of a new product

Details are as follows:

$
Sales 10,000 units @ $10 100,000
Material costs $2 per unit 20,000
Labour cost $3 per unit 30,000
(50,000)
Fixed overheads (30,000)
Profit 20,000

Assess the sensitivity of the product to a change in

a) Material cost
b) Units sold

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CHAPTER 2

MANAGEMENT ACCOUNTING – DECISION

MAKING AND CONTROL
Decision making scenarios

• Accept or reject
• Make or buy
• Outsource
• Shutdown
• Minimum price of an order/job/contract

Relevant costs

Meaning

• Future
• Cash flow
• Incremental (specific to the decision)

Relevant cost may also be

• Opportunity costs – the value of benefits sacrificed aka potential benefit foregone

• Avoidable costs – specific cost of an activity or sector of a business which would be avoided if that
activity or sector did not exist.

Avoidable costs are usually associated with shutdown decisions. Fixed cost may be avoidable if they are
specific to a department or product. Allocated fixed cost are unlikely to change.

So what are not relevant?

• Sunk cost – cost that have already been incurred

• Committed costs – cost that have to be paid irrespective of any decisions
• Non-cash items – depreciations or apportionment of general overheads

Relevant cost of materials

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Example

A job requires 400 kg of X and 200 kg of Y.

The followings data is available

In Inventory Historic cost Current Purchase Scarp Value

X 300 kg $2/kg $3/kg $2.20/kg

Y 300 kg $0.50/kg $2/kg $1.50/kg

X is no longer used by the company; Y is regularly used for other products/purposes within the business.

Required

What is the relevant cost of X and Y to be included in the job cost?

Relevant cost of labour

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Example

Aeon Plc is deciding whether to undertake a new contract

15 hours of labour are required for the contract. Labour is currently at full capacity producing X.

Cost card for X $/unit

Direct materials (10 kg @ $2) 20
Direct labour (5 hours @ $6) 30
50
Selling price 75
Contribution 25

Required

What is the cost of using 15 hours of labour for the contract?

Accept or reject decisions

Example

Proposal received: To manufacture 12,000 units of T over 12 months at a selling price of $3 per unit.

The flowing statement has been prepared:

$ $
Sales revenue 36,000
Costs: Material X at historical cost 5,000
Material Z at contract price 9,000
Manufacturing labour 10,000
Depreciation of machine 4,000
Variable overheads @$0.30 per unit 3,600
Fixed overheads
(absorbed @ 80% of manufacturing labour) 8,000
(39,600)
(3,600)
Further information

1 Material X cannot be used or sold for any other product. It would cost $200 to dispose of the existing
inventories.
2 Each Unit of new production uses 2 kilos of material Z. The company has entered into a long-term
contract to buy 24,000 kilos at an average price of $0.375 per kilo. The current price is $0.175 per
kilo. This material is regularly used in the manufacture of the company’s other products.
3 The machine which would be used to manufacture T was bought new 3 years ago for $22,000. It
had an estimated life of 5 years with a scrap value of $2,000.
If the new product is not produced the machine could be sold immediately for $7,000. If it is used
for one year it is estimated that it could then be sold for $4,000.
4 The new product requires the use of skilled labour, which is scare. If product T were not made this
labour could ti be used on other activities, which would yields a contribution of $1,000.
Required

Prepare a statement of relevant cost and revenue and determine whether or nit the proposal should be accepted.

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Make or buy decisions

Example

Alecto Co makes units Blooper and Clooper, for which costs in the forthcoming year are expected to be as follows:

B C
Production (units) 1,000 1,500
$ $
Direct materials 3 5
Direct labour 6 9
Variable production overheads 2 3
11 17

Directly attributable fixed cost per annum and committed costs:

$
Incurred as direct consequences of making B 1,500
Incurred as direct consequences of making C 3,000
Other fixed costs (committed) 10,000
14,500

A sub-contractor has offered to supply units of B for $12 and C for $21. Should Alecto make or buy the
components? What other factors should be considered before making a decision?

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• Decisions should also consider non-financial factors

• Also need to see the impact on
➢ Employee
➢ Customers
➢ Competitors

Outsourcing decisions

Very similar to make or buy decision

Consideration depends on many factors

ADVANTAGES DISADVANTAGES
Cost savings Loss of control
Access to expertise Impact on quality
Release capital How flexible, reliable supplier?
Frees up capacity Potential loss of confidential information
Loss of in house skill and impact on employee
morale

Shutdown decisions

These decisions may involve the closure of

a) A division
b) A product
c) A department

of a business that appears to be loss making.

Shutdown decisions should not involve general fixed overheads

Should consider

➢ Variable cost
➢ Avoidable cost
➢ Directly attributable cost

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Example

Durham Ltd manufactures 3 products, A, B and C. Forecast income are as follows :

A B C Total
$’000 $’000 $’000 $’000
Sales 600 300 200 1.100
Cost of production
Material 200 60 30 290
Labour 95 20 10 125
Variable overhead 75 10 5 90
Fixed overhead 200 50 80 330
Gross margin 30 160 75 265
Selling cost 40 20 15 175
Net margin (10) 140 60 190

The directors are considering the closure of the A product line, due to the losses incurred. You obtain the following
information:

1) Fixed production overheads consist of an appointment of general factory overheads based on 80% of the
direct materials cost. The remaining overheads are specific to the product concerned.
2) Selling cost are based on commission paid to sales staff.

Required

a) Determine if the A product line should be closed down

b) Suggest other factors that should be considered prior to a final decision,

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BUDGETARY CONTROL

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BUDGETARY SYSTEMS

Fixed budgets

A fixed budget is one that is not adjusted regardless of the level of activity attained in a period. The fixed budget
is the master budget prepared before the beginning of the budget period.

It is based on budgeted volumes and cost/revenues and such often unrealistic as the actual level of activity will be
almost certainly different from the level of activity originally planned.

Flexible budgets

The flexible budget is a budget which is designed to change as volume of activity changes. This can be done by
recognising the behaviour of different cost (fixed, variable, semi-variable etc)

Useful at the planning stage to show different results from various possible activity levels (what-if analysis)
allowing better planning for uncertainty in the future.

Flexed budgets

Used at the control stage budgets need to be flexed to reflect the actual activity level achieved in a given period
before the budget can meaningfully be compared with actual results and variance analysis performed.

Purpose of flexible / flexed budgets

a) Designed to cope with different activity levels to keep the budget meaningful and hence preserve the
relevance of variances for effective control.
b) Useful at planning stage to show different results possible activity levels
c) Necessary as control device because we can meaningfully compare actual results with relevant flexible
budget, i.e. budgetary control.

Example

Fizzy Co has a bottling plant for its juice drinks and has prepared flexible budgets:

Flexible budgets

Bottles 10,000 12,000 14,000

Productions costs $ $ $
Material 30,000 36,000 42,000
Labour 27,000 31,000 35,000
Overhead 20,000 20,000 20,000

Required

If actual production was 12,350 bottles and the production costs incurred totalled $90,000, what is the meaningful
total variance for performance evaluation purposes?

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BUDGETING AND STANDARD COSTING

STANDARDS

A standard is prepared by management in advance, and details their expectations of the future.

Standards are not just items of production in manufacturing business. They exist in many different spheres.
Standard times for cutting hair, standard punctualities of Air Asia and standard response times for ambulances are
just some of the many examples encountered.

A standard cost is an estimated unit cost.

PURPOSE OF STANDARDS

The uses of standard costing are as follows:

a) Prediction of costs and times for decision making, eg for allocating resources.
b) Standard costing is used in setting budgets – an accurate standard will increase the accuracy of the budget.
c) Variance analysis is a control technique which compares actual with standard costs
d) Performance evaluation system make use of standards as motivators and also as a basis for assessment.
e) Inventory valuation – this is often less time consuming than alternative valuations method such as FIFO
or weighted average.

BASES

a) Ideal standard – assumes an optimum level of efficiency

b) Attainable standard – makes an allowance for normal inefficiencies but also includes hoped for
improvements
c) Current standard – based on current efficiency levels and achievements.
d) Basic standard/historic standard – not updated regularly, used to show changes over the long term.

Example

How do you think each of the bases of standard would impact an employee’s motivation?

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DERIVING STANDARDS

The standards cost of materials will estimated by the purchasing department

Example

What considerations will

a) The purchasing department take into account when trying to establish the standard cost of material?
b) The production department take into account when trying to establish the quantity of material needed per
unit?

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ACTIVITY BASED COSTING

Introduction

This will be an alternative method of cost accumulation, in which ABC is considered a modern alternative to
absorption costing which is a solution to overcome the issues and problems of costing in a modern manufacturing
environment.

Traditional absorption costing

• Uses a single basis for all overheads into cost units for a particular production department cost centre.
• Must use the best way to reflect the way in which overheads are being incurred e.g. machine hour if
machine intensive or labour intensive.

Activity based costing

• Single rate is not reflective. Its should be based and reflects its complexity of producing certain
product/cost units.
• ABC is based on extension of absorption costing as it is based on causes each type of category to occur.
i.e its cost drivers are. Each type of overhead is absorbed using a different basis depending on the cost
driver.

Activities Cost drivers

Production set up costs Number of production set ups

Machine repeirs Total machine hours

Supervisors salary Total labour hours

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Steps in ABC

• Group overheads into activities, according to hoe they are driven. These are known as cost pools
• Identify the cost drives for each activity, i.e what causes the activity cost to be incurred
• Calculate a cost per unit of cost driver
• Absorb activity cost into production based on usage of cost drivers

Absorption costing Vs Activity based costing

• Overhead absorption rates using ABC should be more closely linked to the causes of the overhead
costs

The modern business environment has much wider product ranges than seen before, complex
production process and decreasing product lifecycles. ABC recognises these factors by using multiple
cost drivers when absorbing overheads.

Example

Premier Co manufactures products, A, B and C, Dara for the period just ended is as follows:

A B C

Output(units) 20.000 25,000 2.000

Sale price $ 20 20 20
Direct material cost $
Labour hours/unit 5 10 20
Wages paid at $5/hour 2 1 1

Total production overheads for Premier Co amounts to $190,000

Required:

a) Calculate the profit per unit obtained on each product if production overhead is absorbed on the basis
of labour (Traditional absorption costing)

Additional data is now available (these are known as cost pool)

$
Machining 55,000
Quality control and set-up costs 90,000
Receiving 30,000
Packing 15,000
190,000

A B C
Output(units) 20,000 25,000 2,000
Cost driver data
Labour hour/unit 2 1 1
Machine hours/unit 2 2 2
No. of production runs 10 13 2
No. of component receipts 10 10 2
No. of customer orders 20 20 20

b) Using ABC, show the cost and gross profit per unit for each product during the period and contrast this
with the profit calculated using absorption costing.
c) What factor should be considered when comparing the results?

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Cost driver analysis

With changing business environment and its complex nature would mean the cost are incurred because cost
drives occur at different levels.

There are four key categories for activities and their related costs.

Categories Types of cost Cost driver

Unit Direct Units produced

Batch Set ups Inspection Batch produced
Product R&D and marketing Products produced
Facilities sustaining Depreciation, Rent None

The difference between unit costs under absorption costing and ABC depends upon the proportion of overhead
in each category.

If most overheads are unit level or facility sustaining the costs will be similar.

If overheads are batch or product sustain costs, the resulting unit costs will be very different.

Implication of ABC

When is ABC applicable?

• When production overheads are high relative to prime costs (eg service sector)
• When there is a whole diversity of production range
• Wen there are considerable difference in the use of resources by products
• Where consumption of resources is not driven by volume

Benefits of ABC

• Cost control and reduction by the efficient management of cost drivers

• Better coasting information used to assist pricing decisions
• Re-analysis of production and output/product mix decisions
• Profitability analysis ( by customer, product line etc)

Problems in ABC

• Takes more time to work on it and becomes an expensive process

• Complex situations usually has many cost drivers
• Some arbitrary apportionment may still exist
• ABC may be not useful if overheads are primarily are related to only volume
• Reduced benefit if the company is producing only one product or a range of products with similar costs

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CHAPTER 3

FORECASTING TECHNIQUES IN BUDGETING

In this chapter we will study methods of forecasting using

• Range or High low methods

• Regression analysis
• Time series

1. Range or High low methods

• Scattergraph

Is a method where the data are plotted using two pairs of variables on a graph and then use judgement to draw
the line of best fit through the data.

• High low method

Example

Units 10,000 12,000 14,000

Labour ($) 27,000 31,000 35,000

Required
Calculate the variable cost per unit and the fixed labour cost.

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• Total cost function

When determining price and output levels we need to bear in mind the cost and revenue behaviours. These can be
expressed as equations and graphed.

Most simply the cost of producing an item are expresses as y = a + bx

Y = total cost
a = fixed cost (the intercept on the y axis)
b = variable cost per unit (the gradient of the line)
x = output

This assumes fixed costs remain unchanged and variable costs per unit are constant. However, this will not always
be the case.

In the short term we may be able to assume that fixed costs stay the same but variable costs could change due to
bulk buying or learning curves.

2. Least Square Regression

(This method is no longer tested in PM (F5))

The scattergraph is the initial scanning process for the application of the least square regression. If the line of best
fix can be drawn without difficulties, then least square regression method can be used to find the equation of the
line best fit.

The least square regression line is derived as follows:

Y = a + bX

Where a is the intercept (Total fixed cost) and b is the gradient (variable cost per unit) of the linear regression line.

Y is the dependent variable which changes according to change in the values of X (the independent variable).
Therefore, the regression line can be used to estimate the value of Y given the X but not vice versa as changes in
X value cannot be explained (is not due to) by changes in Y values, for example, if we construct a regression line
of total cost (Y) against units produced (X), we cannot estimate the units produced from the total cost. This is
because cost is influenced by units produced is not influenced by cost, the latter is influenced by , say demand.

The value of a and b can be found with the following formula:

b = n ƩXY - ƩX Ʃ Y
n Ʃ X² - (ƩX)²

a = Y – bX

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Example 1

The following cost was collected for the period of Jan to Mar last year:

Sales Total cost

(units) ($)

3,000 8,000
3,500 8,400
4,500 10,100

Required:

Estimate the cost when output is 15,000 units using regression method.

Correlation

It measures the strength of the relationship between two variables. Correlation is measured by the product moment
correlation coefficient (r )

r = nƩXY - ƩX ƩY

√(nƩX² - (ƩX²) ) ( n ƩY² - (ƩY)²)

Values of r can be between -1 to +1

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Premier Course Notes

3. Times series

Definition

It’s a name given to a set of observations taken at equal intervals of time, for example weekly or daily. This
observation can be plotted against time to give an overall picture of what is happening. The horizontal axis is
always the time axis. Examples of time series are total annual sales report, unemployment figures etc.

Components of Time series

The are 4 components:

• Long term trend (T)

This is the way in which the graph of time series appears to be moving over a long interval of time when
the short-term fluctuations are ignored. The trend may be rising, falling or unchanged.

There are three different techniques of finding trend.

1. A line of best fit (the trend line) can be drawn by eye on a graph.
2. Use least square regression method to find the trend line
3. Use the moving averages technique

• Seasonal variation (S)

This is a regular rise and fall over specified intervals of time (short term). The interval of time can be
hourly, daily, weekly etc. The variations are of periodic type, example rise in number of goods sold
during Christmas period, the rise in no of vehicle on roads during peak hours, etc.

The seasonal variation of set of data can be found by using the additive or multiplicative model of time
series.

• Cyclical variation ( C )

This is the wave-like appearance of a time series graph when taken over a number of years. Generally, it
is due to the influence of booms and slumps in the industry, the period in time from one peak to the next
is approximately 5 to 7 years.

• Residual or random variation (I)

This covers any variation which cannot be attached to any factor described above, and is normally refer
to unexpected, one off non-recurring events such as fire, strikes, sudden change in government policies,
etc.

All four comonebts are assmend to be combined together to form the time series based on one of two models
below:

1. The additive model assumes all the componets of time series are added together to make up the observed
data (Y)

Y = T+S+I+C

2. The multiplicative model assumes the observed data (Y) is the product of all the componetents of time
series.

Y = T xSxIxC

Note: I and C are normally ignored in forecasting in ACCA

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Premier Course Notes

Sources of Finance – Initial coin offering (ICO)

ICO – ways organization raise capital. Like IPO and ICO raises finance from investors i.e. a way for a project to
publicly fund their work

Differences – Investors will receive a new type of coin or token and the coin will be a cryptocurrency such as
bitcoin or ether.

Types of tokens/coins

a) Investment tokens – Equity tokens which offer a share in the company

b) Asset tokens – represents a physical asset or product e.g. allowing investors to purchase difficult-to-
store physical assets such as gold online.
c) Utility tokens – Provides users with access to a product or service; e.g. Filecoin raised over $250million,
its tokens enable access to its decentralised cloud storage service.

The future value of these tokens depends on the success of the venture.

Regulatory status

• The attitudes of regulators to ICOs differs around the world; in some countries e.g. China and South
Korea ICOs are banned.
• In general regulators are less concerned with ICOs that do not offer investors the reasonable expectation
of profits e.g. whew an ICO aims to simply develop technology or where investors receive utility tokens
to exchange for future services (these ICOs currently tend to be outside the definition of ‘security’ and
therefore are not normally of interest to regulators).
• ICOs that in some way offer future income streams are likely to be judged to be securities (eg equity
tokens of tokens that can also serve as a “payment voucher’ for an underlying service). These ICOs are
likely to have to fulfil the related regulatory criteria for an issue of securities (full prospectus etc). There
may also be a risk that if this has not been done then fines may be levied (which may be severe), or the
regulator puts a stop to the ICO.

Mechanism for an ICO

• One of the attractions of an unregulated ICO is its simplicity, the issuer raises money by issuing a ‘white
paper” providing details of the concept that the venture intends to build, and details of the tokens that
will be issued in exchange for cryptocurrency.
• The white paper is available via the venture’s website, which also provides the mechanism for payment
of cryptocurrency to the venture’s account (typically bitcoin or ether). In is now more common for
payments to be made into an escrow account (an account established by an independent third party), to
provide greater assurance of the venture validity.

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• Most ICO sites include instructions for how investors should go about their bitcoins or either – the
assumption being that they do not already own any cryptocurrency

Advantages of an ICO

• Speed and ease of use as a source of finance for new ideas, compared to traditional methods
• Investor interest, often based on a speculative expectation of rapid, high returns

Disadvantages of an ICO

To the investors

• Fraud risk
ICOs tend to be launched by start-ups. Organisation details are often vague with just website, and no
specific geographic location. White papers may make claims about the potential being financed.

• Valuation risk
Valuation of tokens is speculative, in addition the entities involved are generally start-ups.

• Security risk
If a token repository is hacked and tokens stolen, investors typically have no recourse.

To the issuer

• Value of cryptocurrency
For example, the value of bitcoin fell by over 50% between mid-December 2017 and early Feb 2018 and
early.
• Risk of money laundering
The anonymity of transactions makes ICOs a target for investment from funds belonging to organised
crime.
• Risk to investors
As discussed earlier, this may reduce the availability of funds and the price that investors are willing to
pay

• Risk of regulation
This is illustrated by Protostarr, which abandoned its ICO in 2017 after being contacted by the US SEC
to discuss its status.

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