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Learning Outcomes Assessed
L O 1 Demonstrate understanding of how to account for all the transactions of a small business, including those involving PAYE, NI and VAT
L O 2 Construct a semi-automated accounting information system using a spreadsheet package (Microsoft Excel).
PRO RACKETS LIMITED
Introduction
Your client is Pro Reflex Rackets Limited, a small company which manufactures specialist tennis rackets. The company has been in existence for several years, and has developed a decent reputation over that time. You visit the company at the end of November 2016 and learn a great deal from discussions with the owner and managing director, Chris Gittings.
After the opening pleasantries have been exchanged over coffee, the first area that you talk about revolves around the company’s financing arrangements:
Financing arrangements
Chris explains ‘Since the business is seasonal, we usually require short-term operating loans from the bank in order to meet the working capital demands of the peak sales season.’ ‘On the first day of each month, we pay the interest on the overdraft account amount outstanding during the preceding month. The monthly interest rate is 1.25%.
Manufacturing policy
‘As I will show you in a minute, the sales pattern is seasonal, but production takes place year-round,’ explains Chris.
You ascertain that the manufacturing policy is to have on hand, at the start of each month:
- a raw materials stock level at least equivalent to that needed for that month’s planned production;
- a finished rackets stock level that equals the expected racket sales for that month.
‘At any one time the level of work in progress is pretty much zero,’ Chris explains. ‘We make each racket in one sitting, as it were; we don’t have rackets left unfinished overnight. The workers are on temporary work contracts and work the hours dictated by the production programme. However, a full-time supervisor (named Dave) is employed permanently.’
Sales
‘We produce an almost unique type of racket, which contains a very unusual stringing pattern’, explains Chris. ‘It’s unusual, but it has slowly grown in popularity over the years. We sold pretty much going on 25,000 this year.’
‘We’ve been growing at about 4% each year, pretty steadily. I can tell you our sales units in the last three months of this year were 748 in September, 2,252 in October and it looks like 1,750 rackets for this current month (November 2016).’
You also learn that monthly sales, as a percentage of annual sales, have had the following pattern over the last few years:
Dec 3% Mar 7% June 16% Sept 3%
Jan 2% Apr 11% July 15% Oct 9%
Feb 4% May 12% Aug 11% Nov 7%
‘The pattern is fairly predictable,’ says Chris. ‘Tennis is obviously a summer sport, but there are more indoor courts these days, so we do alright in the winter as well.’
You also learn that the selling price per racket is £67. All sales are credit sales. The usual pattern of collections has been as follows:
11% in the month of sale
34% in the month following the month of sale
32% in the second month following the month of sale 23% in the third month following the month of sale
‘The collection situation is a pain in the neck’, comments Chris. ‘We sell a lot of rackets to small club shops, little businesses that aren’t really run properly. In the past we’ve always tried to make as many sales as possible and we’ve been too generous with the credit we’ve given.’
Direct costs and overheads
‘Here’s the full standard cost of making a racket this year,’ says Chris as he hands you the following:
Direct materials £5.87
Direct labour (4 hours @ £6.68) £26.72
Manufacturing overhead (4 hours @ £2.83) £11.32
£43.91
Standard cost is the amount at which stock is valued for the purpose of the monthly management accounts.
The amounts for fixed manufacturing overhead includes:
Factory insurance £19,500
Business rates £60,200
Factory rent £66,000
Production supervisor’s salary £33,750
Repairs and maintenance £15,000
Heat, light & power £24,000
Depreciation on machinery £39,580
‘Our non-production expenses are various selling and admin things,’ Chris tells you. He hands you a list of what these expenses are expected to be this year:
Administrative salaries £26,300
Distribution costs £1.42 per racket
Sales Commissions 7% of selling price
Other office expenses £18,450
Chris Gittings’s salary £65,000
Chris also tells you: ‘The only other cost is a storage cost paid to a warehouse for storing the completed rackets. The storage charge is £1.19 multiplied by the average number of rackets in storage during the month. The storage company works out the average using the opening and closing stock levels.’
‘All these budgeted costs are pretty much the same as last year’s. The cost environment is pretty calm and predictable at the moment, touch wood.’
Payment policies
‘70% of direct material purchases are paid for in the month following their acquisition with the remaining 30% paid for in the following month,’ says Chris. ‘
‘Direct labour costs are paid for on a current basis. On the present payroll, employee NI/PAYE deductions accounts for approximately 24.5% of gross wages and employers’ NI contributions are equal to approximately 12% of gross wages. NI/PAYE returns to HMRC are, of course, made by the 19th of the month following the month in which the deductions are made.’
‘The business rates, insurance, utilities and supervisor’s salary are paid monthly and in equal amounts. The maintenance expenses are incurred in three equal amounts in January, August and October. The factory rent is paid quarterly, at the end of December, March, June and September. We’ve been talking to the landlords and the rent has been frozen this year at the same level, which is nice.’
‘The clerical salaries and other office expenses are incurred and paid in equal monthly amounts. Distribution costs and sales commissions are paid in the month following the month in which they are incurred.’
‘Storage costs are paid at the end of each month, one month in arrears.’
Estimated opening balances
‘As for opening balances,’ Chris continues, ‘Cash in the bank on 30 November 2010 should be about £35k. We haven’t taken any loans out this month, there was no need.’
‘I can tell you that the opening net book value of fixed assets will be £95,608. That’s an exact figure, straight off the Fixed Assets Register.’
‘And the share capital of the company is 300,000 shares of 50p each. My wife and I own most of the shares. I can’t remember what the balance on retained profits is. Is that something you need to know?’
Your client’s request:
The MD of the company, Chris Gittings, has asked you to develop a financial model to help him to make decisions over the next 12 months (Dec 2016 – Dec 2017)
Chris has seen a financial model which a friend of his uses at his company.
This model allows this friend to simulate the monthly profit and loss account, cashflow and monthly balance sheets for the business