Limitations of financial statements

The limitations of financial statements are those factors that a user should be aware
of before relying on them to an excessive extent. Knowledge of these factors could
result in a reduction of invested funds in a business, or actions taken to investigate
further. The following are all limitations of financial statements:

 Dependence on historical costs. Transactions are initially recorded at their cost. This
is a concern when reviewing the balance sheet, where the values of assets and
liabilities may change over time. Some items, such as marketable securities, are
altered to match changes in their market values, but other items, such as fixed
assets, do not change. Thus, the balance sheet could be misleading if a large part of
the amount presented is based on historical costs.
 Inflationary effects. If the inflation rate is relatively high, the amounts associated with
assets and liabilities in the balance sheet will appear inordinately low, since they are
not being adjusted for inflation. This mostly applies to long-term assets.
 Intangible assets not recorded. Many intangible assets are not recorded as assets.
Instead, any expenditures made to create an intangible asset are immediately
charged to expense. This policy can drastically underestimate the value of a
business, especially one that has spent a large amount to build up a brand image or
to develop new products. It is a particular problem for startup companies that have
created intellectual property, but which have so far generated minimal sales.
 Based on specific time period. A user of financial statements can gain an incorrect
view of the financial results or cash flows of a business by only looking at
one reporting period. Any one period may vary from the normal operating results of
a business, perhaps due to a sudden spike in sales or seasonality effects. It is better
to view a large number of consecutive financial statements to gain a better view of
ongoing results.
 Not always comparable across companies. If a user wants to compare the results of
different companies, their financial statements are not always comparable, becau se
the entities use different accounting practices. These issues can be located by
examining the disclosures that accompany the financial statements.
 Subject to fraud. The management team of a company may deliberately skew the
results presented. This situation can arise when there is undue pressure to report
excellent results, such as when a bonus plan calls for payouts only if the reported
sales level increases. One might suspect the presence of this issue when the reported
results spike to a level exceeding the industry norm.
 No discussion of non-financial issues. The financial statements do not address non-
financial issues, such as the environmental attentiveness of a company's operations,
or how well it works with the local community. A business reporting excellent financial
results might be a failure in these other areas.
 Not verified. If the financial statements have not been audited, this means that no
one has examined the accounting policies, practices, and controls of the issuer to
ensure that it has created accurate financial statements. An audit opinion that
accompanies the financial statements is evidence of such a review.
 No predictive value. The information in a set of financial statements provides
information about either historical results or the financial status of a business as of a
specific date. The statements do not necessarily provide any value in predicting what
will happen in the future. For example, a business could report excellent results in
one month, and no sales at all in the next month, because a contract on which it was
relying has ended.

Financial statements are normally quite useful documents, but it can pay to be aware
of the preceding issues before relying on them too much .

Limitations of Cash Flow

Even if cash flow analysis is one of the best tools for investors to find out whether a

company is doing well or not, cash flow analysis also has few disadvantages.

 One of the most significant things about cash flow analysis is that it doesn’t take into

account any growth in the cash flow statement. The cash flow statement always

shows what happened in the past. But past information may not be able to portray

the right information about a company for investors who are interested in

investing in the company.

For example, if the company has invested a large amount of cash into R&D and

would generate a huge amount of cash through its ground-breaking idea, these

should come in the cash flow statement (but they don’t get included in the cash flow).

 Another disadvantage of cash flow statement is this – it can’t be easily interpreted. If

you ask any investor to interpret the cash flow statement, he wouldn’t be able to

understand much without the help of the income statement and the other information

about transactions occurred throughout the period.

For example, it’s difficult to understand from a cash flow statement whether a

company is paying off its debt or investing more in assets.

 Cash Flow Statement is inappropriate if you want to understand the profitability of the

firm because, in the cash flow statement, non-cash items are not taken into account.

Thus, all the profits are deducted and all the losses are added back to get the actual

cash inflow or outflow.

 Cash Flow Statement is articulated on the basis of cash basis of accounting and it

completely ignores the accrual concept of accounting.

Summary
Line Item Comments

Cash flow from Operating activities

Net Income From the Net Income line on the inc

Adjustments for

From the corresponding line item in

Depreciation & Amortization
Statement

From the change in the allowance fo

Provision for losses on accounts receivables
accounts in period

Gains / Loss on sale of facility From gain/loss accounts in the Incom

Change in trade receivables during t

Increase/Decrease in trade receivables
balance sheet

Change in inventory during the perio

Increase/Decrease in inventories
balance sheet

Change in trade payable during the

Increase/Decrease in trade payables
balance sheet

Cash generated from Operations Summary of preceding items in the S

Cash Flow from Investing Activities

Purchase of Fixed Assets Itemized in the fixed asset accounts

Proceeds from sale of Fixed Assets Itemized in the fixed asset accounts

Net Cash used in Investing Activities Summary of preceding items in the S

Cash Flow from Financing Activities

Net Increase in Common Stock & ad

Proceed from issuance of common stock
Capital accounts during the period

Itemized in the Long Term Debt acco

Proceeds from issuance of Long Term Debt
period

Itemized in the Retained Earnings ac

Dividends Paid
period

Net Cash Used in Financing Activities Summary of preceding items in the S

Net Change in Cash & Cash Equivalents Summary of All the Preceding Sub

Conclusion
If you want to understand a company and its financial affairs, you need to look at all three statements
and all the ratios. Only cash flow analysis would not be able to give you the right picture of a company.
Look for net cash inflow, but also make sure that you have checked how profitable the company is over
the years.
Also, cash flow analysis is not an easy thing to compute. If you want to compute cash flow
analysis, you need to understand more than the basic level of finance. And you also need to
understand financial terms, how they are captured in the statements and how they reflect the
income statement. Thus, if you want to do a cash flow analysis, first know how to see the
income statement and understand what to include and what to exclude in the cash flow
statement.

July 29

Computerized Accounting represents a technological advancement in the field of

business accounting.

Accounting has been done manually till the 1980s, when the advent of fast computers
and easy-to-use, accurate and reliable software started. An accounting system is a
collection of processes, procedures and controls designed to collect, record, classify and
summarize financial data for interpretation and management decision-making.

Computerized Accounting involves making use of computers and accounting software to

record, store and analyze financial data. A computerized accounting system brings with
it many advantages that are unavailable to analog accounting.

Spreadsheets do not provide a accessible solution for accounting purposes and therefore
are a dangerous solution to invest in.

Here are the advantages of using computerized accounting software

· Automation: Since all the calculations are handled by the software, computerized
accounting eliminates many of the mundane and time-consuming processes associated
with manual accounting. For example, once issued, invoices are processed automatically
making accounting less time-consuming.
· Accuracy: This accounting system is designed to be accurate to the minutest detail.
Once the data is entered into the system, all the calculations, including additions and
subtractions, are done automatically by software.
· Data Access: Using accounting software it becomes much easier for different
individuals to access accounting data outside of the office, securely. This is particularly
true if an online accounting solution is being used.
· Reliability: Because the calculations are so accurate, the financial statements prepared
by computers are highly reliable.
· Scalable: When your company grows, the amount of accounting necessary not only
increases but becomes more complex. With computerized accounting, everything is kept
straightforward because sifting through data using software is easier than sifting through
a bunch of papers.
· Speed: Using accounting software, the entire process of preparing accounts becomes
faster. Furthermore, statements and reports can be generated instantly at the click of a
button. Managers do not have to wait for hours, even days, to lay their hands on an
important report.
· Security: The latest data can be saved and stored in offsite locations so it is safe from
natural and man-made disasters like earthquakes, fires, floods, arson and terrorist
attacks. In case of a disasters, the system can be quickly restored on other computers.
This level of precaution is taken by Clever Accounting.
· Cost-effective: Since using computerized accounting is more efficient than paper-
based accounting, than naturally, work will be done faster and time will be saved.
· Visuals: Viewing your accounts using a computer allows you to take advantage of the
option to view your data in different formats. You can view data in tables and using
different types of charts.

GROSS PROFIT
Gross profit is the difference between net sales and cost of goods sold and is computed
as a part of income statement or profit and loss account of a business. It is computed for
a specific period by deducting the cost of goods sold (COGS) from net sales revenue
realized during that period. In equation form, it can be presented as follows:

Gross profit = Nets sales revenue – Cost of goods sold

For example, if the annual net sales revenue of a company is $1,000,000 and its cost of
goods sold is $600,000, the gross profit would be $400,000 (= $1000,000 – $600,000).
The gross profit figure is very important for any business because it is used to cover all
operating expenses and provide for operating profit. The higher the gross profit, the better
it is.

A company or firm may experience a significant positive or negative change in gross

profit. In order to maintain profitability and avoid operating losses, any unexpected or
significant change in gross profit for a period must be timely investigated.

Gross profit analysis is the procedure of finding the causes of changes in gross profit
percentage from budgeted to actual or from one period to another period. The major
purpose of gross profit analysis is to reveal the unexpected changes in gross profit and
their causes so that they can be brought to the attention of management in a timely
manner.

Reasons of change in gross profit:

1. Changes in total revenue for the period due to changes in selling prices of goods and
services.
2. Changes in total revenue for the period due to changes in quantity of goods and
services sold during the period.
3. Changes in proportion in which a multi-product company sells its products (usually
termed as shift in sales mix or product mix).
4. Changes in basic manufacturing cost elements i.e., direct materials, direct labor and
manufacturing overhead.

Procedure of gross profit analysis

The procedure of determining the gross profit variation is identical to the computation of
variances in a standard costing system. However, the gross profit analysis is possible
without the use of budgets or standard costs. In that case, the prices and costs data of
any year may be used as the basis for the computations of variances involved in gross
profit analysis. The usual approach is to use the prices and costs of any previous year as
the basis to find the variations.

However, to achieve a greater degree of accuracy and better results, it is always

recommended to employ standard costs and budgeted figures to carry out the analysis.

Variances involved in gross profit analysis

For performing a gross profit analysis, the standard sales and cost figures (or a previous
year’s sales and cost figures) are used as the basis.

The analysis is performed in three steps.

1. the sales price variance and the sales volume variance are computed.
2. the cost price variance and cost volume variance are computed.
3. the sales volume variance and cost volume variance are further analyzed by
computing sales mix variance and a final sales volume variance.

Gross profit analysis is designed to pick apart the reasons why the gross profit
margin changes from period to period, so that management can take steps to bring
the gross margin in line with expectations. A decline in gross profits can be an
indicator of serious problems, so the figure is closely watched. Gross profit is
calculated as:

Gross profit = Sales - direct materials - direct labor - manufacturing overhead

A change in gross profit can be caused by any of the following events:

 Sales prices have changed
 The unit volume of items sold have changed
 The mix of products sold has changed (which alters the gross profit if different
products have different gross margins)
 The purchase price of direct materials have changed
 The amount of direct materials required has changed, which in turn can be due to:
o Altered scrap levels
o Altered spoilage levels
o Altered amounts of rework
o Changes in the design of the product
 The amount of direct labor has changed, due to altered efficiency levels
 The cost of direct labor has changed, which in turn can be due to:
o Altered overtime levels
o Changes in the mix of employees having different pay rates
o Changes in the amount of shift differentials paid
o Changes in the equipment used
o Changes in the design of the product
 The amount of fixed overhead incurred has changed
 The amount of variable overhead incurred has changed

The preceding list is not comprehensive, since gross profit analysis may also uncover
problems in such as areas as late or double-counted inventory, incorrect units of
measure, and theft. Also, the broad scope of this list of events should make it clear
that controlling gross margin requires the input of many parts of a business, including
the engineering, materials management, sales, and production departments.

A gross profit analysis involves comparing the gross profit for the period being
reviewed to either the budgeted level or the historical average. If you are
using standard costing, then you can use any of the standard cost variance formulas
for gross profit analysis, which are:

 Purchase price variance. The actual price paid for materials used in the production
process, minus the standard cost, multiplied by the number of units used
 Labor rate variance. The actual price paid for the direct labor used in the production
process, minus its standard cost, multiplied by the number of units used.
 Variable overhead spending variance. Subtract the standard variable overhead cost
per unit from the actual cost incurred and multiply the remainder by the total unit
quantity of output.
 Fixed overhead spending variance. The total amount by which fixed overhead costs
exceed their total standard cost for the reporting period.
 Selling price variance. The actual selling price, minus the standard selling price,
multiplied by the number of units sold.
 Sales volume variance. The actual unit quantity sold, minus the budgeted quantity to
be sold, multiplied by the standard selling price.
 Material yield variance. Subtract the total standard quantity of materials that are
supposed to be used from the actual level of use and multiply the remainder by the
standard price per unit.
 Labor efficiency variance. Subtract the standard quantity of labor consumed from the
actual amount and multiply the remainder by the standard labor rate per hour.
 Variable overhead efficiency variance. Subtract the budgeted units of activity on
which the variable overhead is charged from the actual units of activity, m ultiplied by
the standard variable overhead cost per unit.

If you are not using standard costs, you can still use the preceding variances, except
that you use budgeted or historical cost information as the baseline, rather than
standard costs.

The gross profit analysis reported to management should describe the total variance
from expectations, and then itemize the exact reasons for the differences. The report
should contain actionable items, so that management can identify specifically what is
wrong and proceed to fix it. An even better gross profit analysis is one that clusters
identified problems into categories and shows the frequency of occurrence of the
categories over time. Doing so shows management which problems are causing the
most trouble on a repetitive basis, and which are therefore most worthy of attention.

While gross profit analysis is important, it only covers product-related costs.

Thus, if you want a comprehensive review of all aspects of a company's financial

results, you must also evaluate all costs of selling and administration, as well as all
financing and other non-operational expenses.

Gross profit analysis also ignores the amount of investment in working

capital and fixed assets in proportion to sales. That is, it does not account for the
efficiency of asset usage in creating gross profits.

Required: Using the data of Steward Company given above, compute:

1. sales price variance and sales volume variance

2. cost price variance and cost volume variance
3. sales mix variance and final sales volume variance
Solution
1. Sales price variance and sales volume variance

2. Cost price variance and cost volume variance

Interim recapitulation:
 3. Sales mix variance and final sales volume variance

Final recapitulation:

Usefulness of gross profit analysis

The gross profit figure is very important for any business and must be closely watched.
The gross profit analysis uncovers inefficiencies in company’s performance during the
period and enables management to take remedial actions to correct the situation. The
manufacturing and marketing departments of business are mostly responsible to meet or
exceed the planned gross profit. In case the business fails to achieve the desired gross
profit, the manufacturing department must explain the changes in manufacturing costs
and marketing department must explain the changes in prices, decrease in number of
units of each product sold and/or shift in sales mix during the period. This way, the gross
profit analysis brings together the two major functional areas of the business and focuses
on the need of more study by these two departments.

The limitations of financial statements are those factors that a user should be
aware of before relying on them to an excessive extent. Knowledge of these factors
could result in a reduction of invested funds in a business, or actions taken to
investigate further. The following are all limitations of financial statements:

 Dependence on historical costs. Transactions are initially recorded at their cost. This
is a concern when reviewing the balance sheet, where the values of assets and
 liabilities may change over time. Some items, such as marketable securities, are
altered to match changes in their market values, but other items, such as fixed
assets, do not change. Thus, the balance sheet could be misleading if a large part of
the amount presented is based on historical costs.
 Inflationary effects. If the inflation rate is relatively high, the amounts associated with
assets and liabilities in the balance sheet will appear inordinately low, since they are
not being adjusted for inflation. This mostly applies to long-term assets.
 Intangible assets not recorded. Many intangible assets are not recorded as assets.
Instead, any expenditures made to create an intangible asset are immediately
charged to expense. This policy can drastically underestimate the value of a
business, especially one that has spent a large amount to build up a brand image or
to develop new products. It is a particular problem for startup companies that have
created intellectual property, but which have so far generated minimal sales.
 Based on specific time period. A user of financial statements can gain an incorrect
view of the financial results or cash flows of a business by only looking at
one reporting period. Any one period may vary from the normal operating results of
a business, perhaps due to a sudden spike in sales or seasonality effects. It is better
to view a large number of consecutive financial statements to gain a better view of
ongoing results.
 Not always comparable across companies. If a user wants to compare the results of
different companies, their financial statements are not always comparable, because
the entities use different accounting practices. These issues can be located by
examining the disclosures that accompany the financial statements.
 Subject to fraud. The management team of a company may deliberately skew the
results presented. This situation can arise when there is undue pressure to report
excellent results, such as when a bonus plan calls for payouts only if the reported
sales level increases. One might suspect the presence of this issue when the reported
results spike to a level exceeding the industry norm.
 No discussion of non-financial issues. The financial statements do not address non-
financial issues, such as the environmental attentiveness of a company's operations,
or how well it works with the local community. A business reporting excellent financial
results might be a failure in these other areas.
 Not verified. If the financial statements have not been audited, this means that no
one has examined the accounting policies, practices, and controls of the issuer to
ensure that it has created accurate financial statements. An audit opinion that
accompanies the financial statements is evidence of such a review.
 No predictive value. The information in a set of financial statements provides
information about either historical results or the financial status of a business as of a
specific date. The statements do not necessarily provide any value in predicting what
will happen in the future. For example, a business could report excellent results in
one month, and no sales at all in the next month, because a contract on which it was
relying has ended.

Financial statements are normally quite useful documents, but it can pay to be aware
of the preceding issues before relying on them too much.
What is business valuation?

Quite simply, business valuation is a process and a set of procedures used to determine
what a business is worth. To create a credible business valuation you need knowledge,
preparation, and a good deal of thought.
Assumptions drive your business valuation results

To make things interesting, there are a number of ways to measure business value.
Business value is seen differently by different people.
For example, a business owner may believe that the business value is defined by its
contribution to the local community it serves. On the other hand, a financially minded
investor may gauge a business solely based on its ability to generate desired returns.
Business value does not stand still. Market conditions change all the time and business
people may see greater value in companies as their fortunes shift. It is common
knowledge that competition for private businesses increases when jobs are scarce as
more people enter the business buying market in search of income. This tends to drive
up the business selling prices based on supply and demand.
Market is the ultimate test of business value. It does make a big difference how the
company is marketed. The selling price for a business presented to a well-funded group
of strategic investors is likely to be much higher than even the highest bid at an auction
for used equipment.

Are business value and expected selling price the same?

In theory the reason to figure out business value is to estimate what it would sell for. In
practice, the business value could vary quite a bit depending on who wants to know.
For example, a highly motivated business buyer seeking to replace lost income may pay
a premium to get that dream business. A financial buyer is the type who plays the low-
cost acquisition game.
Market exposure also plays a role. Getting the business in front of the right buyers is half
the battle in fetching the top selling price.

Three approaches to business valuation

Asset approach

Under the asset approach you adopt the view of a business as a set
of assets and liabilities. The balance sheet elements serve as building blocks to create
the picture of business value. A finance professor would tell you that the asset approach
is based on the economic principle of substitution. It answers this question:
What will it cost to create another business that will produce the same economic
benefits for its owners?
The costs include coming up with the actual business equipment and machinery, office
furniture, and the like. Costs also include lost income as you are staking out the
company's position in the market.
Also, there is a need to account for functional and economic obsolescence of business
assets.
Intangible assets, such as technology, have a tendency to wear out because it is a bit
old and need to be replaced at some point. So if the company's financial condition is
defined by its assets and liabilities, why not just figure out the values of these and
calculate business value as the difference, much like on the balance sheet?
Market approach

Under the market approach, you look for signs from the real market place to figure out
what a business is worth. The market is a competitive place, so the economic principle
of competition applies. The market approach to business valuation is a great way to
determine the company's fair market value – a monetary value exchanged in an arms-
length transaction with the buyer and seller each acting in their best interest.

Income approach

The income approach cuts at the core of why people go into business – making money.
Unsurprisingly, the economic principle of expectation prevails. The income valuation
approach helps you to figure what kind of money the business is likely to bring as well as
to assess the risk.
The real power of the income valuation is that it lets you calculate business value in the
present. To do so, the expected income and risk must be translated to present time.

There are two ways you can do this translation:

1.) Business valuation - by income capitalization

The capitalization valuation method is essentially the result of dividing the

expected business earnings by what is known as the capitalization rate. The idea
is that the business value is defined by business earnings and the capitalization
rate is used to relate the two. Capitalization uses a single income figure such as
the average of the earnings over several years or the most recent number.
For example, if the capitalization rate is 33%, then the business is worth about 3
times its annual earnings. An alternative is a capitalization factor that is used to
multiply the income. Either way, the result is what the business value is today.
The capitalization method works really well for businesses with steady, predictable
earnings.

2.) Business valuation - by discounting its cash flow

The discounting valuation method: a.) you forecast the business income
some time into the future, usually a number of years. b), you figure out
the discount rate which captures the risk of getting this income on time and in
full measure. c.) you estimate what the business is likely to be worth at the end
of your forecast period. If you expect the company to keep running, there is some
residual value, also known as the terminal value. Discounting the forecast
earnings and the terminal value together gives you the present value of the
business, or what it is worth today. The discounting is run on a sequence of
income numbers, one for each year in your forecast.

Business valuation: how discount and capital rates are related

Since both income valuation methods do the same thing, the capitalization and discount
rates are related:
CR = DR - K
Where, CR is the capitalization rate, DR is the discount rate, and K is the expected
average growth rate in the income stream.

As an example, the discount rate is 25% and your forecast suggests that the business
profits would be growing at a steady 5% per year. Then your capitalization rate is 25 - 5
= 20%.
What is the real difference between capitalization and discounting?
If your business shows smooth, steady profits year after year, the capitalization valuation
is a good way to go. For a young start-up or businesses with rapidly changing earnings,
discounting gives the most accurate results.

Can business valuation methods produce different results?

Consider two business buyers doing earnings forecasts and sizing up the risk of owning
a given business. Each buyer may see business risk differently so their capitalization and
discount rates will differ. In addition, the two buyers may have different ideas of where to
take the company. This will affect their income stream projections.
So even if they use the same valuation methods, the business valuation results may differ
quite a bit. The financial gurus call it the investment value standard of valuing a
business. Each business buyer acts as an investor and measures the business value
differently, based on their unique investment.

VIII - COST TERM AND CONCEPTS

Types of Costs and their Basis of Classification

Cost classification can be done in various ways depending on its nature and a specific
purpose. Classifications of costs make the cost information meaningful. It is of utmost
importance to the management of a manufacturing concern. It is the first step towards
their decision-making process relating to costs and costing.

For example, if we know total expenses are of $500 Million against $550 Million revenue.
What insight can we derive? Nothing. Now if we add one more information say $350
Million is direct material cost and $100 Million is a direct labor and other overheads. Now,
the management can focus on direct material cost because that forms the major part of
the total cost as far as cost control initiatives are concerned.

BASIS OF CLASSIFICATION OF COST

There can be various basis on which classification of costs can be done.

1. Nature of Expense: By nature of expenses, costs are classified into material, labor and
expenses.

2. Relation to Cost Object – Trace-ability: This classification is based on the relation of

cost element with the cost object. The classification is done into direct and indirect
costs. The basis is cause and effect relationship between cost element and cost object
or trace-ability of costs to its cost object. Classification based on traceability is
important for accurate costing of jobs and units produced.

3. Functional classification of costs are

 Production
 Administration
 Finance
 Selling
 Distribution
 Research and Development
 Quality Check etc.
4. The behavior of Costs: The behavior of costs is seen with respect to the change in
volume. On this basis, costs are classified into Fixed Costs, Variable Costs, and
Semi-variable Costs. Fixed costs do not change with the change in volume, variable
costs do change. Semi-variable costs does not change up to a particular level of
activity, beyond that it will change. Classification of costs based on behavior helps
in cost-volume-profit analysis

5. The purpose of Decision Making by Management: For decision-making purpose of

management, costs can be classified into various types such as opportunity
 cost, marginal cost, differential cost, relevant cost, imputed cost, replacement cost,
sunk cost, normal/ abnormal cost, avoidable/ unavoidable costs, etc. Classification
for the purpose of decision-making is important to help management identify costs
which are relevant for a decision.

6. Production Process: It’s an important classification for cost accounting of different

manufacturing industries. Based on the production process of the industry, costs can be
classified into following:
 Batch Cost
 Process Cost
 Operation Cost
 Operating Cost
 Contract Cost
 Joint Cost
 Prime Cost
 Factory Cost or Works Cost
 Cost of Production
 Cost of Goods Sold

7. Time Period: Based on a time period of assessment or any other specific purpose,
costs can be classified into historical cost, pre-determined cost, standard cost, and
estimated cost.

What is cost behavior?

Cost behavior is an indicator of how a cost will change in total when there is a change in
some activity.

In cost and managerial accounting, three types of cost behavior are:

 Variable costs. The total amount of a variable cost increases in proportion to the
increase in an activity. The total amount of a variable cost will also decrease in
proportion to the decrease in an activity.
An example of a variable cost is the cost of flour for a bakery that produces artisan
breads. The greater the number of loaves produced, the greater the total cost of the
flour used by the bakery.

 Fixed costs. The total amount of a fixed cost will not change when an activity increases
or decreases.
An example of a fixed cost is the depreciation and insurance on the bakery facility
and equipment. Regardless of the quantity of artisan breads produced in a month, the
total amount of depreciation and insurance cost for the month will remain the same.

 Mixed or semi-variable costs. These costs are partially fixed and partially variable.
Understanding how costs behave is important for management's planning and
controlling of its organization's costs, and for cost-volume-profit analyses (including
the calculation of a company's break-even point).

An example of a mixed cost or semi-variable cost is the bakery's cost of natural gas.
Some of the monthly gas bill is a flat fee charged by the utility and some of the gas bill
is the cost of heating the building. These two components of the gas bill are fixed since
they will not change when the bakery produces more or less loaves of its bread.
However, a third component of the gas bill is the cost of operating the ovens. This
component is a variable cost since it will increase when the ovens must operate for a
longer time in order to produce additional loaves of bread.
Cost Classification Diagram

The following diagram summarizes the different categories into which costs are classified
for different purposes:
Cost Classification on Financial Statements

Product costs (also called inventory costs) are costs assigned to the manufacture of
products and recognized for financial reporting when sold.

The product costs are further classified into:

 Direct Materials: Represents the cost of the materials that can be identified directly
with the product at reasonable cost. For example, cost of paper in newspaper
printing, etc.

 Direct labor: Represents the cost of the labor time spent on that product, for
example cost of the time spent by a petroleum engineer on an oil rig, etc.
 Manufacturing overhead costs: Represents all production costs except those for
direct labor and direct materials, for example the cost of an accountant's time in an
organization, depreciation on equipment, electricity, fuel, etc.

Period costs are on the other hand are all costs other than product costs. They include
marketing costs and administrative costs, etc.

Direct Costs

The product costs that can be specifically identified with each unit of a product such as
direct material cost and direct labor cost.

Indirect Costs are the product costs which cannot be traced to a specific unit, i.e.
manufacturing overhead is indirect product cost.

Prime costs are the sum of all direct costs such as direct materials, direct labor and any
other direct costs.

Conversion costs are all costs incurred to convert the raw materials to finished products
and they equal the sum of direct labor, other direct costs (other than materials) and
manufacturing overheads.

Fixed costs are costs which remain constant within a certain level of output or sales.
This certain limit where fixed costs remain constant regardless of the level of activity is
called relevant range. For example, depreciation on fixed assets, etc.

Variable costs are costs which change in the level of activity. Examples include direct
materials, direct labor, etc.

Mixed costs (also called semi-variable costs) are costs which have both a fixed and a
variable component.

Sunk costs are those costs that have been irreversibly incurred or committed; they may
also be termed unrecoverable costs.

Opportunity costs are costs of a potential benefit foregone. For example the opportunity
cost of going on a picnic is the money that you would have earned in that time.

Flow of costs in Manufacturing

The flow of costs is the path taken by costs as they move through a business. The
concept is most applicable to a manufacturing firm, where costs are first incurred
when raw materials are purchased.

The flow of costs then moves to work-in-process inventory, where labor, machining,
and overhead costs are added to the cost of the raw materials.
Once the production process is complete, the costs move to the finished goods
inventory classification, where the goods are stored prior to sale.

When the goods are eventually sold, the costs move to the cost of goods sold. During
this process flow, the costs are initially recorded in the balance sheet as assets, and
are eventually flushed out at the point of sale and shifted to the cost of goods sold
section of the income statement.

The flow of costs concept also applies to the cost layering system bein g used to
record inventory. In the first in first out (FIFO) system, the cost of those inventory
items that were acquired first are charged to expense when goods are sold; this
means that only the cost of the most recently-acquired goods are still recorded in
inventory. In the last in first out (LIFO) system, the cost of those inventory items that
were acquired last are charged to expense when goods are sold; this means that only
the cost of the oldest goods are still recorded in inventory.

The flow of costs concept is less applicable in a services firm, where most costs are
incurred and charged to expense at the same time.

Service Organization Trading Organization Manufacturing

Organization

An Organization which Goods are Purchases Raw materials are

Provides Services to & Sold without purchased and
others as an occupation Further Processing. converted into a new
or business. final product for sales.

The major business The major business

process of a service processes of
 organization is to
provide service at the
point of consumption by
the customers.
There is no
Procurements of
Products involved for
service organization.
The cost of services
provided depends on
the demand for such a
service as there is no
inventory.
1.) COST MANAGEMENT SYSTEM
Cost management is concerned with the process of planning and controlling the budget of a project or
business. It includes activities such as planning, estimating, budgeting, financing, funding, managing, and
The major business
process of Trading
concerns are
Procurements &
Sales.
The time required from
procurement to sales
will be relatively less
for trading
Organization.
The Cost of Goods sold
for the trader=(opening
trading goods +
purchases of trading
goods – closing trading
goods).
manufacturing concerns
are procurement,
production and sales.
The time required from
procurement to sales will
be relatively more for
manufacturing
organizations since the
manufacture requires
conversion time for
processing the goods.
The cost of goods sold for
the
manufacturer=(opening
finishing goods + cost of
goods manufactured –
closing finished goods).
controlling costs so that the project can be completed within the approved budget. Cost management covers
the full life cycle of a project from the initial planning phase towards measuring the actual cost performance
and project completion.

Step 1: Resource planning

In the initial phase of a project the required resources to complete the project activities need to be
defined. Work Breakdown Structures (WBS) and historical information of comparable projects can
be used to define which physical resources are needed. You can think of the required time, material,
labor, equipment, etc. Once the resource types and quantities are known the associated costs can
be determined.

Step 2: Cost estimating

Several cost estimating methods can be applied to predict how much it will cost to perform the
project activities. The choice for the estimation method depends on the level of information
available. Analogous estimating using the actual cost of previous, similar projects can serve as a
basis for estimating the current project. Another option is to use parametric models in which the
project characteristics are mathematically represented. Estimates can be refined when more
information becomes available during the course of a project. Eventually this results in a detailed
unit cost estimate with a high accuracy. Remaining uncertainties in estimates that will likely result
in additional cost can be covered by reserving cost (e.g. using escalation and contingencies).

Step 3: Cost budgeting

The cost estimate forms together with a project schedule the input for cost budgeting. The budget
gives an overview of the periodic and total costs of the project. The cost estimates define the cost
of each work package or activity, whereas the budget allocates the costs over the time period when
the cost will be incurred. A cost baseline is an approved time-phased budget that is used as a
starting point to measure actual performance progress.

Step 4: Cost control

Cost control is concerned with measuring variances from the cost baseline and taking effective
corrective action to achieve minimum costs. Procedures are applied to monitor expenditures and
performance against the progress of a project. All changes to the cost baseline need to be recorded
and the expected final total costs are continuously forecasted. When actual cost information
becomes available an important part of cost control is to explain what is causing the variance from

the cost baseline. Based on this analysis, corrective action might be required to avoid cost overruns.
2.) Design and development system

Core activities in system design and development include developing system-level technical
requirements and top-level system designs and assessing the design's ability to meet the system
requirements.

System-level technical requirements describe the users' needs, and provide information for the
finished system to meet legal restrictions, adhere to regulations, and interoperate or integrate
effectively with other systems. They are used in several ways:

 By the government to acquire a capability, system, or product to meet a user need.

 As part of a procurement contract solicitation or prototyping/experimentation effort.
 By the product vendors as their design criteria.
The decisions made when defining system-level technical requirements can affect the number of
potential solutions, the technical maturity of the potential solutions, system cost, system evolution,
and development time and phasing.

System-level technical requirements are a critical precursor to and foundation of system design
and development. A top-level system design is generally under the stewardship of the government
team and represents the government team's independent projection of the way a system could be
implemented to meet requirements with acceptable risk. The primary reason for developing a top-
level system design is to provide a technical foundation for planning the program. It is the
government's de facto technical approach to meeting the customer's needs. A top-level system
design developed early in an acquisition program can be used to assess system feasibility and
provide some assurance that the implemented design will satisfy system requirements. Done early
in a program, a government design effort can be a powerful basis for developing fact-based
government projections of cost, schedule, performance, and risk, and it can provide the foundation
for subsequent contractor design efforts.

Requirements traceability is a critical activity during the design, development, and deployment of
a capability that starts with the translation of the users' operational needs into technical
requirements and extends throughout the entire system life cycle. It is a technique to develop a
meaningful assessment of whether the solution delivered fulfills the operations.

3.) PRODUCTION SYSTEM

 4.) CUSTOMER SERVICING SYSTEM

5.) MARKETING AND DISTRIBUTION SYSTEM

What Is a Distribution Channel?

A distribution channel in marketing refers to the path or route through which goods and
services travel to get from the place of production or manufacture to the final users. It has
at its center transportation and logistical considerations. The distribution function of
marketing is comparable to the place component of the marketing mix in that both center
on getting the goods from the producer to the consumer.
Business-to-business (B2B) distribution occurs between a producer and industrial
users of raw materials needed for the manufacture of finished products. For example, a
logging company needs a distribution system to connect it with the lumber manufacturer
who makes wood for buildings and furniture.
Business-to-customer (B2C) distribution occurs between the producer and the final
user. For instance, the lumber manufacturer sells lumber to the furniture maker, who then
makes the furniture and sells it to retail stores, who then sell it to the final customer.

Two main types of channels

Direct Distribution
A distribution system is said to be direct when the product or service leaves the producer
and goes directly to the customer with no middlemen involved. This occurs, more often
than not, with the sale of services. For example, both the car wash and the barber utilize
direct distribution because the customer receives the service directly from the producer.
This can also occur with organizations that sell tangible goods, such as the jewelry
manufacturer who sells its products directly to the consumer.
Indirect Distribution
Indirect distribution occurs when there are middlemen or intermediaries within the
distribution channel. In the wood example, the intermediaries would be the lumber
manufacturer, the furniture maker, and the retailer. The larger the number of
intermediaries within the channel, the higher the price is likely to be for the final customer.
This is because of the value adding that occurs at each step within the structure.
Direct or indirect distribution structures may include any combination or all of the following
entities:

 A wholesaler or distributor
 The Internet (direct)
 Catalogs (direct)
 Sales teams (direct)
 The value-added reseller (VAR)
 Consultants
 Dealers
 Retailers
 Agents
Cost of Goods Sold & Cost of Services

Cost of Goods Sold, (COGS), can also be referred to as cost of sales (COS), cost of
revenue, or product cost, depending on if it is a product or service. It includes all
the costs directly involved in producing a product or delivering a service. These costs
can include labor, material, and shipping.
The idea behind COGS is to measure all costs (which are variable) directly associated
with making the product or delivering the service.
Example:

Let’s assume you start a delivery company and line up a few customers. In the first full
month of operation you do $10,000 worth of business (this becomes our revenue line).
For that month we also had expenses, including the cost of gas for the delivery truck in
the amount of $2,000, and the salary of the driver at $3,000. These costs are directly
related to our service and fall into the Cost of Goods Sold (COGS) line. There are more
line items that would be included in COGS. COS in a service company typically includes
labor associated with delivering the service. All other expenses not directly related to the
product or service goes under a category called Operating Expenses such as
receptionists’ or accountants’ salary. The top part of our income statement (with our
COGS line) would look like this:

Activity- Based Costing and Management

X. Costing System

Six types of costing systems are: 1. Historical Costing 2. Absorption Costing 3. Direct
Costing 4. Marginal Costing 5. Standard Costing 6. Uniform Costing.

Type # 1. Historical Costing:

The main objective is to ascertain accumulation of costs that have been incurred in past
in a systematic manner. The historical costs are used only for postmortem examination
of actual costs incurred and it would be too late to control. The actual figures can be
compared only when the standards of performance exists.

Type # 2. Absorption Costing:

All fixed and variable costs are allotted to cost units and total overheads are absorbed
according to activity level. In absorption costing system, fixed manufacturing overheads
are allocated to products, and these are included in stock valuation. It is based on the
principle that costs should be charged or absorbed to whatever is being costed – be it
cost unit, cost centre – on the basis of the benefit received from these costs.
Type # 3. Direct Costing:
It is a method of costing in which the product is charged with only those costs which vary
with volume. Variable or direct costs such as direct material, direct labor and variable
manufacturing expenses are examples of costs charged to the product.

All indirect costs are charged to profit and loss account of the period in which they arise.
Indirect costs are disregarded in inventory valuation.

Type # 4. Marginal Costing:

Costs are classified into fixed and variable costs. Variable costs are charged to unit cost
and the fixed costs attributable to the relevant period are written-off in full against the
contribution for that period.

Contribution margin indicates the recovery of fixed cost before contributing towards the
operational profit. This technique is widely used for internal management purpose for
decision making rather than for external reporting.

Type # 5. Standard Costing:

Standard cost is a predetermined cost which is computed in advance of production on
the basis of a specification of all the factors affecting costs and use. Its main purpose is
to provide a base for control through Variance Accounting, for valuation of stock and
work-in-progress and, in some cases, for fixing selling prices.

Under standard costing system, the measurement and analysis of variances is done for
control purpose.

Type # 6. Uniform Costing:

It is the adoption of identical costing principles and procedures by several units of the
same industry or several undertakings by mutual agreement. It facilitate valid
comparisons between organizations and helps in elimination of inefficiencies.

The Concept of Profit Contribution

Profit

All organizations that are run with the objective of making a profit will complete a profit
and loss report at the end of each financial period. This will show the revenue they have
received, the amount that has been paid out in expenses, and the remaining amount of
profit that has been made. The profit and loss report takes into consideration all types of
sales for all products and services. Profit, is the difference between sales and costs for
the whole of the business. The profit can either be reinvested into the business, or taken
out as dividends.

It also takes into account all the expenses of running the business, including both variable
and fixed costs.

Variable costs - are those that vary with the amount of output by the business. This
includes the wages of staff involved in production, as well as the materials used to
make products.
Fixed costs - are those that remain the same regardless of the amount of product that
is made. This includes things like rent, rates, salaries, fuel, and depreciation.
Contribution

As well as overall profit, organizations are often interested in the of contribution of specific
products towards paying fixed costs and making a profit. Contribution shows the
difference between the sales price and variable costs for specific products. This then
contributes to the fixed costs, and goes towards the profit of the business. To calculate
contribution per unit, you use the sales price per unit, minus variable cost per unit.

The distinction between contribution and profit is given below:

Contribution:
1. It includes fixed cost and profit.
2. Marginal costing technique uses the concept of contribution.
3. At break-even point, contribution equals to fixed cost.
4. Contribution concept is used in managerial decision making.

Profit:
1. It does not include fixed cost.
2. Profit is the accounting concept to determine profit or loss of a business concern.
3. Only the sales in excess of break-even point results in profit.
4. Profit is computed to determine the profitability of product and the concern.

The difference between marginal costing and absorption costing

Marginal Costing applies only to the costs of inventory that were incurred when
each individual unit was produced, Overhead costs are charged to expense in the
period under marginal costing. Marginal costing is not allowed for financial reporting
purposes, so its use is restricted to internal management reports.

The Marginal Cost Formula is:

Marginal Cost = (Change in Costs) / (Change in Quantity)

1. What is “Change in Costs”?

At each level of production and during each time period, costs of production may increase
or decrease, especially when the need arises to produce more or less volume of output.
If manufacturing additional units requires hiring one or two workers and increases the
purchase cost of raw materials, then a change in the overall production cost will result.
To determine the change in costs, simply deduct the production costs incurred at during
the first output run from the production costs in the next batch when output has increased.

2. What is “Change in Quantity”?

Since it’s inevitable that the volume of output will increase or decrease with each level of
production. An increase or decrease in the volume of goods produced translates to costs
of goods manufactured (COGM). To determine the changes in quantity, the number of
goods made in the first production run is deducted from the volume of output made in the
following production run.

Characteristics of Marginal Costing

 Classification into Fixed and Variable Cost: Costs are split, on the basis of
variability into fixed cost and variable costs. In the same way, semi variable cost is
separated.
 Valuation of Stock: While valuing the finished goods and work in progress, only
variable cost are taken into account. However, the variable selling and distribution
overheads are not included in the valuation of inventory.
 Determination of Price: The prices are determined on the basis of marginal cost and
marginal contribution.
 Profitability: The ascertainment of departmental and product’s profitability is based
on the contribution margin.
In addition to the above characteristics, marginal costing system brings together the
techniques of cost recording and reporting.
Marginal Costing Approach

The difference between product costs and period costs forms a basis for marginal costing
technique, wherein only variable cost is considered as the product cost while the
fixed cost is deemed as a period cost, which incurs during the period, irrespective of
the level of activity.

Facts Concerning Marginal Costing

 Cost Ascertainment: The basis for ascertaining cost in marginal costing is the nature
of cost, which gives an idea of the cost behavior, that has a great impact on the
profitability of the firm.
 Special technique: It is not a unique method of costing, like contract costing, process
costing, batch costing. But, marginal costing is a different type of technique, used by
the managers for the purpose of decision making. It provides a basis for understanding
cost data so as to gauge the profitability of various products, processes and cost
centers.
 Decision Making: It has a great role to play, in the field of decision making, as the
changes in the level of activity pose a serious problem to the management of the
undertaking.
Marginal Costing assists the managers in taking end number of business decisions,
such as replacement of machines, discontinuing a product or service, etc. It also helps
the management in ascertaining the appropriate level of activity, through break even
analysis, that reflect the impact of increasing or decreasing production level, on the
company’s overall profit.

Absorption Costing applies to all production costs to all units produced. It is required
by the applicable accounting frameworks for financial reporting purposes, so
that factory overhead will be included in the inventory of asset.
 Cost application. Only the variable cost is applied to inventory under marginal
costing, while fixed overhead costs are also applied under absorption costing.
 Profitability. The profitability of each individual sale will appear to be higher under
marginal costing, while profitability will appear to be lower under absorption
costing.
 Measurement. The measurement of profits under marginal costing uses
the contribution margin (which excludes applied overhead), while the gross
margin (which includes applied overhead) is used under absorption costing.

Absorption cost formula = (Direct labor cost + Direct material cost + Variable
manufacturing overhead cost + Fixed manufacturing overhead) / No. of units produced)
a
The formula for AC can be computed by using the following steps;

Step 1: the direct labor cost per unit is directly attributable to the production. The direct
labor cost can be determined based on the labor rate, level of expertise and the
no. of hours put in by the labor for production. However, the labor cost can also
be taken from the income statement.
Step 2: identify the material type required and then determine the amount of the material
required for the production of a unit of product in order to calculate the direct
material cost per unit. However, the direct raw material cost can also be taken
from the income statement.
Step 3: determine which part of the manufacturing overhead is variable in nature. The
manufacturing overhead is available in the income statement.
Step 4: determine which part of the manufacturing overhead is fixed in nature and then
divide the value by the number of units produced to arrive at per unit cost.
Step 5: Finally, the formula for absorption cost is derived by adding up direct labor cost
per unit, direct raw material cost per unit, variable manufacturing overhead per
unit and fixed manufacturing overhead per unit as shown above.
Concept and Meaning of Variable Costing and Absorption Costing

Variable Costing

Variable costing is also known as 'Marginal Costing' or 'Direct Costing. It is a method of

recording and reporting costs that regards only those manufacturing costs, which tend
to vary directly with the volume of activity, as product costs. All variable manufacturing
cost are included and all fixed manufacturing are excluded from inventory costs, they
are instead treated as costs of the period in which they are incurred.

Absorption Costing
Absorption costing also known as 'Conventional Costing' or 'Full Costing' is the method
of inventory costing in which all variable manufacturing costs and all fixed
manufacturing costs are included in inventory costs. Inventory 'absorbs' all
manufacturing costs.
Advantages and disadvantages of variable costing

Companies need absorption costing to prepare statements to satisfy external parties

and variable costing for better management. Both the costing methods have benefits
and limitations. Following are the main advantages and disadvantages of variable
costing system:

Advantages

1. Variable costing provides a better understanding of the effect of fixed costs on the
net profits because total fixed cost for the period is shown on the income statement.
2. Various methods of controlling costs such as standard costing system and flexible
budgets have close relation with the variable costing system. Understanding variable
costing system makes the use of those methods easy.
3. Companies using variable costing system in preparing income
statement in contribution margin format that provides necessary information for cost
volume profit (CVP) analysis. This data cannot be directly obtained from a traditional
income statement prepared under absorption costing system.
4. The net operating income figure produced by variable costing is usually close to the
flow of cash. It is useful for businesses with a problem of cash flows.
5. Under absorption costing system, income of different periods changes with the
change of inventory levels. Sometime income and sales move in opposite directions.
But it does not happen under variable costing.

Disadvantages

1. Financial statements prepared under variable costing method do not conform to

generally accepted accounting principles (GAAP). The auditors may refuse to accept
them.
2. Tax laws of various countries require the use of absorption costing.
3. Variable costing does not assign fixed cost to units of products. So the production costs
cannot be truly matched with revenues.
4. Absorption costing is usually the base for evaluating top executive’s efficiency.
Variable Costing VS Absorption Costing
Absorption Costing
Generally accepted accounting principles require use of absorption costing (also known as “full costing”) for
external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included
in inventory.

As sales occur, the cost of inventory is transferred to cost of goods sold, meaning that
the gross profit is reduced by all costs of manufacturing, whether those costs relate to
direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing
overhead. Selling, general, and administrative costs (SG&A) are classified as period
expenses.
The rationale for absorption costing is that it causes a product to be measured and
reported at its complete cost. Because costs like fixed manufacturing overhead are
difficult to identify with a particular unit of output does not mean that they were not a cost
of that output. As a result, such costs are allocated to products. However valid the claims
are in support of absorption costing, the method does suffer from some deficiencies as it
relates to enabling sound management decisions. Absorption costing information may
not always provide the best signals about how to price a product, reach conclusions about
discontinuing a product, and so forth.
To allow for deficiencies in absorption costing data, strategic finance professionals will
often generate supplemental data based on variable costing techniques. As its name
suggests, only variable production costs are assigned to inventory and cost of goods
sold. These costs generally consist of direct materials, direct labor, and variable
manufacturing overhead. Fixed manufacturing costs are regarded as period expenses
along with SG&A costs. In some ways, this understates the true cost of production. How
then can it aid in decision making? The short answer is that the fixed manufacturing
overhead is going to be incurred no matter how much is produced. In the long run, a
business must recover those costs to survive. But, on a case-by-case basis, including
fixed manufacturing overhead in a product cost analysis can result in some very wrong
decisions.
This last point can be made clear with a very simple illustration. Assume that a company
produces 10,000 units of a product, and per unit costs are $2 for direct material, $3 for
direct labor, and $4 for variable factory overhead. In addition, fixed factory overhead
amounts to $10,000. The product cost under absorption costing is $10 per unit, consisting
of the variable cost components ($2 + $3 + $4 = $9) and $1 of allocated fixed factory
overhead ($10,000/10,000 units). Under variable costing, the product cost is limited to
the variable production costs of $9. Now consider a “management decision.” Assume the
company is approached to sell one additional unit at $9.50. This sale will not result in any
added SG&A cost or otherwise impact sales of other units.
Based on absorption costing methods, the additional unit appears to produce a loss of
$0.50, and it appears that the correct decision is to not make the sale. Variable
costing suggests a profit of $0.50, and the information appears to support a decision to
make the sale. Management may well decide to sell the additional unit at $9.50 and
produce an additional $0.50 for the bottom line. Remember, no other costs will be
generated by accepting this proposed transaction. If management was limited to
absorption costing information, this opportunity would likely have been foregone.
Variable Costing In Action
The preceding illustration highlights a common problem faced by many businesses.
Consider the plight of a typical airline. As time nears for a scheduled departure, unsold
seats represent lost revenue opportunities. The variable cost of adding one more
passenger to an unfilled seat is quite negligible, and almost any amount of revenue that
can be generated has a positive contribution to profit! An automobile manufacturer may
have a contract with union labor requiring employees to be paid even when the production
line is silent. As a result, the company may conclude that they are better off building cars
at a “loss” to avoid an even “larger loss” that would result if production ceased.
Professional sports clubs will occasionally offer deep discount tickets for unpopular
games. Obviously, the variable cost of allowing someone to watch the game is nominal.
Likely, variable costing information is taken into account in making the decisions relating
to these types of examples. Each decision is intended to be in the best interest of the
entity, even when a full costing approach causes the decision to look foolish.

Double-Edged Sword
A typical illustration of decision making based on variable costing data looks simple
enough. But, such decisions are actually very tricky. Considerable business
understanding is necessary, and there are several traps that must be avoided.
First, a business must ultimately recover the fixed factory overhead and all other business
costs; the total units sold must provide enough margin to accomplish this purpose. It
would be easy to use up full manufacturing capacity, one sale at a time, and not build in
enough margin to take care of all the other costs. If every transaction were priced to cover
only variable cost, the entity would quickly go broke.
Second, if a company offers special deals on a selective basis, regular customers may
become alienated or hold out for lower prices. The key point here is that variable costing
information is useful, but it should not be the sole basis for decision making.

Avoiding A Downward Spiral

Variable costing data are quite useful in avoiding incorrect decisions about product
discontinuation. Many businesses offer multiple products. Some will usually be more
successful than others, and a logical business decision may be to focus on the best-
performing units, while discontinuing others. Assume that a company offers products A,
B, and C. Each is being produced in equal proportion, and the company is fully able to
meet customer demand from existing capacity (i.e., producing more will not increase
sales). The company is not incurring any variable costs relating to selling, general, and
administration efforts.
From the absorption costing data in the dark shaded area, it appears that Product A is
yielding a negative gross profit. Logically, a manager may target that product for
discontinuation. However, if that decision is reached, Products B and C will each have to
absorb more fixed factory overhead. The revised cost data (in the light shaded area) show
that eliminating Product A will actually reduce overall profitability!
The decline in overall profits from discontinuing the “loser” occurs because the “loser”
was absorbing some fixed cost of production. The $15 selling price for Product A at least
covered its variable cost ($6 + $5 + $3 = $14) and contributed toward coverage of the
business’s unavoidable fixed cost burden. The lesson here is that a company must be
very careful in eliminating “unprofitable” products. This decision can often result in a
series of successive shifts in overhead to other remaining products. This, in turn, can
cause other products to also appear unsuccessful.
A downward spiral of product discontinuation decisions can ultimately destroy a business
that was otherwise successful. This illustration underscores why a good manager will not
rely exclusively on absorption costing data. Variable costing techniques that help identify
product contribution margins (as more fully described in the following paragraphs) are
essential to guiding the decision process.
On the one hand, variable costing has been praised for its benefits in aiding decisions.
On the other hand, it was noted that variable costing should not be used as the sole basis
for making decisions.
Variable costing is not a panacea, and guiding a business is not easy. Decision making
is not as simple as applying a single mathematical algorithm to a single set of accounting
data. A good manager must consider business problems from multiple perspectives. In
the context of measuring inventory and income, a manager will want to understand both
absorption costing and variable costing techniques. This information must be interlaced
with knowledge of markets, customer behavior, and the like. The resulting conclusions
can set in motion plans of action that bear directly on the overall fate of the organization.
Income Statement
Much of the preceding discussion focused on per-unit cost assessments. In addition, the
examples assumed that selling, general, and administrative costs were not impacted by
specific actions. It is now time to consider aggregated financial data and take into account
shifting amounts of SG&A. The following income statements present information about
Nepal Company. On the left is the income statement prepared using the absorption
costing method, and on the right is the same information using variable costing. For now,
assume that Nepal sells all that it produces, resulting in no beginning or ending inventory.

With absorption costing, gross profit is derived by subtracting cost of goods sold from sales. Cost of goods
sold includes direct materials, direct labor, and variable and allocated fixed manufacturing overhead. From
gross profit, variable and fixed selling, general, and administrative costs are subtracted to arrive at net
income. This approach should look familiar. It is the presentation that is typical of financial statements
generated for general use by shareholders and other persons external to the daily operations of a business.
With variable costing, all variable costs are subtracted from sales to arrive at the contribution margin.
Nepal’s presentation divides variable costs into two categories. The variable product costs include all
variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead). These
costs are subtracted from sales to produce the variable manufacturing margin. Some of Nepal’s SG&A
costs also vary with sales. As a result, these amounts must also be subtracted to arrive at the true
contribution margin. Management must take into account all variable costs (whether related to
manufacturing or SG&A) in making critical decisions. For instance, Nepal may pay sales commissions that
are based on sales; to exclude those from consideration in evaluating the “margin” that is to be generated
from a particular transaction or event would be quite incorrect. From the contribution margin are subtracted
both fixed factory overhead and fixed SG&A costs.
Because Nepal does not carry inventory, the income is the same under absorption and variable costing.
The difference is only in the manner of presentation. Carefully study the arrows that show how amounts
appearing in the absorption costing approach would be repositioned in the variable costing income
statement. Since the bottom line is the same under each approach, this may seem like much to do about
nothing. But, remember that “gross profit” is not the same thing as “contribution margin,” and decision logic
is often driven by consideration of contribution effects. Further, when inventory levels fluctuate, the periodic
income will differ between the two methods.

Impact of Inventory
The following income statements are identical to those previously illustrated, except sales and variable
expenses are reduced by 10%. Assume that the units relating to the “10% reduction” were nevertheless
manufactured. What is the effect of this inventory build-up? Income is higher under absorption costing by
$15,000. This is consistent with a general rule of thumb: Increases in inventory cause income to be higher
under absorption costing than under variable costing, and vice versa.
To further examine the reason income is higher, remember that $450,000 was attributed to total production under
absorption costing. Of this amount, 10% ($45,000) is now diverted into inventory. Under variable costing, total
product costs were $300,000 and 10% ($30,000) of that amount would be assigned to inventory. As a result, $15,000
more is assigned to inventory under absorption costing. This logically coincides with the degree to which income is
higher! Another way to view the impact of the inventory build-up is to examine the following “cups.” The top set of
cups initially contains the costs incurred in the manufacturing process. With absorption costing, those cups must be
emptied into either cost of goods sold or ending inventory.

Compare the drawing above to the variable costing illustration that follows. The ending inventory cup contains less
with variable costing because there is no fixed factory overhead in ending inventory!

XI. Opportunity Costing Concept

Opportunity cost
In microeconomic theory, the opportunity cost, or alternative cost, of making a
particular choice is the value of the most valuable choice out of those that were not taken.
When an option is chosen from alternatives, the opportunity cost is the "cost" incurred
by not enjoying the benefit associated with the best alternative choice.
Opportunity cost is a key concept in economics, and has been described as expressing
"the basic relationship between scarcity and choice". The notion of opportunity cost plays
a crucial part in attempts to ensure that scarce resources are used efficiently.
Opportunity costs are fundamental costs in economics, and are used in computing cost
benefit analysis of a project. Such costs, however, are not recorded in the account books
but are recognized in decision making by computing the cash outlays and their resulting
profit or loss.
Opportunity costs are not restricted to monetary or financial costs: the real cost of output
forgone, lost time, pleasure or any other benefit that provides utility should also be
considered an opportunity cost.
Opportunity cost of a product or service means the revenue that could be earned by its
alternative use. In other words opportunity cost is the cost of the next best alternative of
a product or service.
The meaning of the concept of opportunity cost can be explained with the help of following
examples:
(1) The opportunity cost of the funds tied up in the one's own business is the interest
(or profits corrected for differences in risk) that could be earned on those funds in other
ventures.
(2) The opportunity cost of the time one puts into his own business is the salary he could
earn in other occupations (with a correction for the relative psychic income in the two
occupations).
(3) The opportunity cost of using a machine to produce one product is the earnings that
would be possible from other products.
(4) The opportunity cost of using a machine that is useless for any other purpose is nil,
since its use requires no sacrifice of other opportunities.

Opportunity costs in production

Opportunity cost is also named as implied or implicit cost. Sometimes it is also termed as
notional costs but not all notional costs are opportunity costs and care should be taken
while categorizing a particular cost.
Explicit costs
Explicit costs are opportunity costs that involve direct monetary payment by producers.
The explicit opportunity cost of the factors of production not already owned by a producer
is the price that the producer has to pay for them.
For instance, if a firm spends $100 on electrical power consumed, its explicit opportunity
cost is $100. This cash expenditure represents a lost opportunity to purchase something
else with the $100.
Implicit costs
Implicit costs (also called implied, imputed or notional costs) are the opportunity costs
that are not reflected in cash outflow but are implied by the choice of the firm not to
allocate its existing (owned) resources, or factors of production, to the best alternative
use.
For example: a manufacturer has previously purchased 1,000 tons of steel and the
machinery to produce a widget. The implicit part of the opportunity cost of producing the
widget is the revenue lost by not selling the steel and not renting out the machinery
instead of using it for production.

Evaluation
Opportunity cost is not the sum of the available alternatives when those alternatives are,
in turn, mutually exclusive to each other. It is the highest value option forgone.
The opportunity cost of a city's decision to build the hospital on its vacant land is the loss
of net income from using the land for a sporting center, or the loss of net income from
using the land for a parking lot, or the money the city could have made by selling the land,
whichever is greatest. Use for any one of those purposes precludes all the others.
If someone loses the opportunity to earn money, that is part of the opportunity cost. If
someone chooses to spend money, that money could be used to purchase other goods
and services so the spent money is part of the opportunity cost as well. Add the value of
the next best alternative and you have the total opportunity cost. If you miss work to go
to a concert, your opportunity cost is the money you would have earned if you had gone
to work plus the cost of the concert.

Example:

A company is approached by a customer who wants to place an order for certain

goods. Company is currently engaged in manufacturing one of its own product.
Due to limited machine capacity only one type of item can be produced at a time
i.e. either customer’s product or company’s product.

In the above example if company accepts the customer order then it will have to stop the
production of its own product and thus will sacrifice the profit that it was earning or can
earn by selling its own product. This amount of profit sacrificed is the cost of accepting
customer’s order. And this sacrifice should be included in the production cost of
customer’s order because company has abandoned its own product and thus is at “loss”
by not producing its own product as company will stop producing and selling its own
product and thus no profit from its own product. And this “loss” should be recovered from
customer. And if customer is not willing to pay enough price that can also cover the
sacrifice of existing profits than it is not fruitful to accept the customer’s order.

This “loss” is dependent on the company’s decision i.e. if customer accepts the order
then profit on own product will be foregone and if customer’s order is rejected then
company will keep on earning its original profit. Therefore, it is a relevant cost. We can
also understand how opportunity costs are also relevant costs by putting the opportunity
cost accepting customer’s order in our example against the basic three points criteria of
relevant cost.

1. Relevant cost is a future cost. The loss of profits will happen in future if
production is stopped.
2. Relevant costs consists of actual cash flows. Company receives cash by
selling its product and if production is halted this cash flow will also
stop.
3. Relevant costs are dependent on the decision. The loss of existing
profits will occur only if customer’s order is accepted.

Decision Making
Good decision making is rarely done by intuition. Consistently good decisions result from
diligent accumulation and evaluation of information. Managerial accounting provides the
information needed to fuel the decision-making process. Managerial decisions can be
categorized according to three interrelated business processes: planning, directing, and
controlling. Correct execution of each of these activities culminates in the creation of
business value. Conversely, failure to plan, direct, or control is a road map to failure. The
central theme is this: (1) business value results from good decisions, (2) decisions must
occur across a spectrum of planning, directing, and controlling activities, and (3) quality
decision making can only consistently occur by reliance on information.
Core Values — An entity should clearly consider and define the rules by which it will play. Core values can cover a
broad spectrum involving concepts of fair play, human dignity, ethics, employment/promotion/compensation, quality,
customer service, environmental awareness, and so forth. If an organization does not cause its members to understand
and focus on these important elements, it will soon find participants becoming solely “profit-centric.” This behavior
leads to a short-term focus and potentially dangerous practices that may provide the seeds of self-destruction.
Remember that management is to build business value by making the right decisions, and decisions about core values
are essential.
Mission — Many companies attempt to prepare a pithy statement about their mission. For example:

Such mission statements provide a snapshot of the organization and provide a focal point against which to match ideas
and actions. They provide an important planning element because they define the organization’s purpose and
direction. Interestingly, some organizations have avoided “missioning,” in fear that it will limit opportunity for
expansive thinking.
Overall, the strategic structure of an organization is established by how well it defines its values and purpose. But,
how does the managerial accountant help in this process? At first glance, these strategic issues seem to be broad and
without accounting context. But, information is needed about the “returns” that are being generated for investors; this
accounting information is necessary to determine whether the profit objective is being achieved. Actually, though,
managerial accounting goes much deeper.
For example, how are core values policed? Consider that someone must monitor and provide information on
environmental compliance. What is the most effective method for handling and properly disposing of hazardous
waste? Are there alternative products that may cost more to acquire but cost less to dispose? What system must be
established to record and track such material? All of these issues require “accountability.” As another example, ethical
codes likely deal with bidding procedures to obtain the best prices from capable suppliers. What controls are needed
to monitor the purchasing process, provide for the best prices, and audit the quality of procured goods? All of these
issues quickly evolve into internal accounting tasks.
Sustainability — In the years following World War II the economic engines of many companies all over the world
began to consume raw materials and produce products at an unprecedented rate in a largely unregulated business
environment. The corporate culture involved producing the best product or service at the lowest cost and highest
return to the stakeholders involved, primarily the shareholders of the entity. Little regard was often given to the
inability to “replace” depleted resources used, or the toll taken on employees or the general population in such
endeavors. For example, the quality of air suffered, waterways became polluted, and unknown chemicals were
dumped as a by-product of manufacturing processes. In the recent past, the advent of advances in medicine to sustain
the population of people has promoted the wide-ranging discussion of sustaining the planet for future generations,
including its resources.
Most would agree that management has a fiduciary responsibility to shareholders to strategically deploy and manage
the assets of the business to generate profit, but not at the expense of the well-being of its people or the environment.
.

A sign hanging on the wall of a business establishment said: ”Managers are Paid to
Manage — If There Were No Problems We Wouldn’t Need Managers.” This suggests
that all organizations have problems, and it is management’s responsibility to deal with
them. While there is some truth to this characterization, it is perhaps more reflective of a
“not so impressive” organization that is moving from one crisis to another. Managerial
talent goes beyond just dealing with the problems at hand.
What does it mean to manage? Managing requires numerous skill sets. Among those
skills are vision, leadership, and the ability to procure and mobilize financial and human
resources. All of these tasks must be executed with an understanding of how actions
influence human behavior within, and external to, the organization. Furthermore, good
managers must have endurance to tolerate challenges and setbacks while trying to forge
ahead. To successfully manage an operation also requires follow through and execution.
Because each management action is predicated upon some specific decision, good
decision making is crucial to being a successful manager.
Planning
A business must plan for success. What does it mean to plan? It is about deciding on a
course of action to reach a desired outcome. Planning must occur at all levels. First, it
occurs at the high level of setting strategy. It then moves to broad-based thought about
how to establish an optimum “position” to maximize the potential for realization of goals.
Finally, planning must give thoughtful consideration to financial realities/constraints and
anticipated monetary outcomes (budgets).
A business organization may be made up of many individuals. These individuals must
be orchestrated to work together in harmony. It is important that they share and
understand the organizational plans. In short, “everyone needs to be on the same page.”
As such, clear communication is imperative.
Strategy
A business should invest considerable time and effort in developing strategy. Employees,
harried with day-to-day tasks, sometimes fail to see the need to take on strategic
planning. It is difficult to see the linkage between strategic endeavors and the day-to-day
corporate activities associated with delivering goods and services to customers. But,
strategic planning ultimately defines the organization. Specific strategy setting can take
many forms, but generally includes elements pertaining to the definition of core values,
mission, objectives, and sustainability.
Positioning
An important part of the planning process is positioning the organization to achieve its goals. Positioning is a broad
concept and depends on gathering and evaluating accounting information.
Cost/Volume/Profit Analysis and Scalability — A subsequent chapter will cover cost/volume/profit (CVP) analysis.
It is imperative for managers to understand the nature of cost behavior and how changes in volume impact
profitability. Methods include calculating break-even points and determining how to manage to achieve target
income levels. Managerial accountants study business models and the ability (or inability) to bring them to
profitability via increases in scale.
Global Trade and Transfer — The management accountant frequently performs significant and complex analysis
related to global activities. This requires in-depth research into laws about tariffs, taxes, and shipping. In addition,
global enterprises may transfer inventory and services between affiliated units in alternative countries. These
transactions must be fairly measured to establish reasonable transfer prices (or potentially run afoul of tax and other
rules of various countries involved). Once again, the management accountant is called to the task.
Branding / Pricing / Sensitivity / Competition — In positioning a company’s products and services, considerable
thought must be given to branding and its impact on the business. To build a brand requires considerable investment
with an uncertain payback. Frequently, the same product can be “positioned” as an elite brand via a large investment
in up-front advertising, or as a basic consumer product that will depend upon low price to drive sales. What is the
correct approach? Information is needed to make the decision, and management will likely enlist the internal
accounting staff to prepare prospective information based upon alternative scenarios. Likewise, product pricing
decisions must be balanced against costs and competitive market conditions. And, sensitivity analysis is needed to
determine how sales and costs will respond to changes in market conditions.
Decisions about positioning a company’s products and services are quite complex. The prudent manager will need
considerable data to make good decisions. Management accountants will be directly involved in providing such data.
They will usually work side-by-side with management in helping correctly interpret and utilize the information. It is
worthwhile for a good manager to study the basic principles of managerial accounting in order to better understand
how information can be effectively utilized in the decision process.

Budgets
A necessary planning component is budgeting. Budgets outline the financial plans for an organization. There are
various types of budgets. A company’s budgeting process must take into account ongoing operations, capital
expenditure plans, and corporate financing.
OPERATING
Operating Budgets — A plan must provide definition of the anticipated revenues and expenses of an organization,
and more. Operating budgets can become fairly detailed. The process usually begins with an assessment of anticipated
sales and proceeds to a detailed mapping of specific inventory purchases, staffing plans, and so forth. These budgets
oftentimes delineate allowable levels of expenditures for various departments.
Capital Budgets — The budgeting process must also contemplate the need for capital expenditures relating to new
facilities and equipment. These longer-term expenditure decisions must be evaluated logically to determine whether
an investment can be justified and what rate and duration of payback is likely to occur.
Financing Budgets — A company must assess financing needs, including an evaluation of potential cash shortages.
These estimates enable companies to meet with lenders and demonstrate why and when additional financial support
may be needed.
The budget process is quite important (no matter how tedious the process may seem) to the viability of an organization.
Several of the subsequent chapters are devoted to the nature and elements of sound budgeting.

Directing
There are many good plans that are never realized. To realize a plan requires the initiation and direction of numerous
actions. Often, these actions must be well coordinated and timed. Resources must be ready, and authorizations need
to be in place to enable persons to act according to the plan. By analogy, imagine that a composer has written a
beautiful score of music. For it to come to life requires all members of the orchestra, and a conductor who can bring
the orchestra into synchronization and harmony. Likewise, the managerial accountant has a major role in moving
business plans into action. Information systems must be developed to allow management to maneuver the
organization. Management must know that inventory is available when needed, productive resources (people and
machinery) are scheduled appropriately, transportation systems will be available to deliver output, and so on. In
addition, management must be ready to demonstrate compliance with contracts and regulations. These are complex
tasks which cannot occur without strong information resources provided by management accountants.
Managerial accounting supports the “directing” function in many ways. Areas of support include costing, production
management, and special analysis.

Costing
A strong manager must understand how costs are captured and assigned to goods and services. This is more complex
than most people realize. Costing is such an extensive part of the management accounting function that many people
refer to management accountants as “cost accountants.” But, cost accounting is only a subset of managerial accounting
applications.
Cost accounting can be defined as the collection, assignment, and interpretation of cost. Subsequent chapters
introduce alternative costing methods. It is important to know the cost of products and services. The ideal approach
to capturing costs is dependent on what is being produced.
Costing Methods — In some settings, costs may be captured by the job costing method. For example, a custom home
builder would likely capture costs for each house constructed. The actual labor and material would be tracked and
assigned to that specific home (along with some amount of overhead), and the cost of each specific home can be
expected to vary.
Some companies produce homogenous products in continuous processes. For example, consider production of paint
or bricks used in building a home. How much does each brick or gallon of paint cost? These types of items are
produced in continuous processes where costs are pooled together and output is measured in aggregate quantities. It
is difficult to identify specific costs for each unit. Yet, it is important to make a cost assignment. For these situations,
accountants might utilize process costing methods.
Next, think about the architectural firms that design homes. They engage in many activities that drive costs but do not
produce revenues. For example, substantial effort is required to train staff, develop clients, bill and collect, maintain
the office, visit job sites, and so forth. The individual architects are probably involved in multiple tasks throughout
each day; therefore, it becomes difficult to say exactly how much it costs to develop a specific set of blueprints!
The firm might consider tracing costs and assigning them to activities (e.g., training, client development, etc.). Then,
an allocation model can be used to attribute selected activities to a job. Such activity-based costing (ABC) systems
are particularly well suited to situations where overhead is high, and/or a variety of products and services are produced.
Costing Concepts — In addition to alternative methods of costing, a good manager will need to understand different
theories or concepts about costing. In a general sense, these approaches can be described as “absorption” and “direct”
costing concepts. Under the absorption concept, a product or service would be assigned its full cost, including amounts
that are not easily identified with a particular item, such as overhead items (sometimes called “burden”). Overhead
can include facilities depreciation, utilities, maintenance, and many other similar shared costs.
With absorption costing, this overhead is schematically allocated among all units of output. In other words, output
absorbs the full cost of the productive process. Absorption costing is required for external reporting purposes under
generally accepted accounting principles. Some managers are aware that sole reliance on absorption costing numbers
can lead to bad decisions.
As a result, internal cost accounting processes in some organizations focus on a direct costing approach. With direct
costing, a unit of output will be assigned only its direct cost of production (e.g., direct materials, direct labor, and
overhead that occurs with each unit produced). Future chapters examine differences between absorption and direct
costing.

Production
Successfully directing an organization requires prudent management of production. Because this is a hands-on
process, and frequently involves dealing with the tangible portions of the business (inventory, fabrication, assembly,
etc.), some managers are especially focused on this area of oversight. Managerial accounting provides numerous tools
for managers to use in support of production and logistics (moving goods through production to a customer).
To generalize, production management is about running a “lean” business model. This means that costs must be
minimized and efficiency maximized, while seeking to achieve enhanced output and quality standards. In the past few
decades, advances in technology have greatly contributed to the ability to run a lean business. Product fabrication and
assembly have been improved through virtually error-free robotics. Accountability is handled via comprehensive
software that tracks an array of data on a real-time basis. These enterprise resource packages (ERP) are extensive in
their power to deliver specific query-based information for even the largest organizations.
B2B (business to business) systems provide data interchange with sufficient power to enable one company’s
information system to automatically initiate a product order on its vendor’s information system. Logistics is facilitated
by RFID (radio frequency identification) processors embedded in inventory that enable a computer to automatically
track the quantity and location of inventory.
M2M (machine to machine) enables connected devices to communicate information without requiring human
engagement. These developments ultimately enhance organizational efficiency and the living standards of customers
who benefit from better and cheaper products. But, despite their robust power, they do not replace human decision
making. Managers must pay attention to the information being produced, and be ready to adjust business processes in
response. M2M is also becoming known as IOT (internet of things).
Inventory — For a manufacturing company inventory may consist of raw materials, work in process, and finished
goods. The raw materials are the components and parts that are to be eventually processed into a final product. Work
in process consists of goods that are actually under production. Finished goods are the completed units awaiting sale
to customers. Each category will require special consideration and control.
Failure to properly manage any category of inventory can be disastrous. Overstocking raw materials or overproduction
of finished goods will increase costs and obsolescence. Conversely, out-of-stock situations for raw materials will
silence the production line. Failure to have goods on hand might result in lost sales. Subsequent chapters cover
inventory management. Popular techniques include JIT (just-in-time inventory management) and EOQ (economic
order quantity).
Responsibility Considerations — Enabling and motivating employees to work at peak performance is an important
managerial role. For this to occur, employees must perceive that their productive efficiency and quality of output are
fairly measured. A good manager will understand and be able to explain to others how such measures are determined.
Direct productive processes must be supported by many “service departments” (maintenance, engineering,
accounting, cafeterias, etc.). These service departments have nothing to sell to outsiders, but are essential components
of operation. The costs of service departments must be recovered for a business to survive. It is easy for a production
manager to focus solely on the area under direct control and ignore the costs of support tasks. Yet, good management
decisions require full consideration of the costs of support services.
Many alternative techniques are used by managerial accountants to allocate responsibility for organizational costs. A
good manager will understand the need for such allocations and be able to explain and justify them to employees who
may not be fully aware of why profitability is more difficult to achieve than it would seem.
In addition, techniques must be utilized to capture the cost of quality, or perhaps better said, the cost of a lack of
quality. Finished goods that do not function as promised cause substantial warranty costs, including rework, shipping,
and scrap. There is also an extreme long-run cost associated with a lack of customer satisfaction.
Understanding concepts of responsibility accounting will also require one to think about attaching inputs and
outcomes to those responsible for their ultimate disposition. In other words, a manager must be held accountable, but
to do this requires the ability to monitor costs incurred and deliverables produced by defined areas of accountability
(centers of responsibility). This does not happen by accident and requires extensive systems development work, as
well as training and explanation, on the part of management accountants.

Analysis
Certain business decisions have recurrent themes: whether to outsource production and/or support functions, what
level of production and pricing to establish, whether to accept special orders with private label branding or special
pricing, and so forth.
Managerial accounting provides theoretical models of calculations that are needed to support these types of decisions.
Although such models are not perfect in every case, they certainly are effective in stimulating correct thought. The
seemingly obvious answer may not always yield the truly correct or best decision. Therefore, subsequent chapters
will provide insight into the logic and methods that need to be employed to manage these types of business decisions.

Control
Things rarely go exactly as planned, and management must make a concerted effort to monitor and adjust for
deviations. The managerial accountant is a major facilitator of this control process, including exploration of alternative
corrective strategies to remedy unfavorable situations.
In addition, a recent trend is for enhanced internal controls and mandatory certifications by CEOs and CFOs as to the
accuracy of financial reports. These certifications carry penalties of perjury, and have gotten the attention of corporate
executives. This has led to greatly expanded emphasis on controls of the various internal and external reporting
mechanisms.
Most large organizations have a person designated as controller (sometimes termed “comptroller”). The controller is
an important and respected position within most larger organizations. The corporate control function is of sufficient
complexity that a controller may have hundreds of support personnel to assist with all phases of the management
accounting process. As this person’s title suggests, the controller is primarily responsible for the control task;
providing leadership for the entire cost and managerial accounting functions.
In contrast, the chief financial officer (CFO) is usually responsible for external reporting, the treasury function, and
general cash flow and financing management. In some organizations, one person may serve a dual role as both the
CFO and controller. Larger organizations may also have a separate internal audit group that reviews the work of the
accounting and treasury units. Because internal auditors are reporting on the effectiveness and integrity of other units
within a business organization, they usually report directly to the highest levels of corporate leadership.

Monitor
Begin by thinking about controlling a car (aka “driving”)! Steering, acceleration, and braking are not random; they
are careful corrective responses to constant monitoring of many variables like traffic, road conditions, and so forth.
Clearly, each action is in response to having monitored conditions and adopted an adjusting response. Likewise,
business managers must rely on systematic monitoring tools to maintain awareness of where the business is headed.
Managerial accounting provides these monitoring tools and establishes a logical basis for making adjustments to
business operations.
Standard Costs — To assist in monitoring productive efficiency and cost control, managerial accountants may
develop standards. These standards represent benchmarks against which actual productive activity is compared.
Importantly, standards can be developed for labor costs and efficiency, materials cost and utilization, and more general
assessments of the overall deployment of facilities and equipment (the overhead).
Variances — Managers will focus on standards, keeping a particularly sharp eye out for significant deviations from
the norm. These deviations, or variances, may provide warning signs of situations requiring corrective action by
managers. Accountants help managers focus on the exceptions by providing the results of variance analysis. This
process of focusing on variances is also known as “management by exception.”
Flexible tools — Great care must be taken in monitoring variances. For instance, a business may have a large increase
in customer demand. To meet demand, a manager may prudently authorize significant overtime. This overtime may
result in higher than expected wage rates and hours. As a result, a variance analysis could result in certain unfavorable
variances. However, this added cost was incurred because of higher customer demand and was perhaps a good
business decision. Therefore, it would be unfortunate to interpret the variances in a negative light. To compensate for
this type of potential misinterpretation of data, management accountants have developed various flexible budgeting
and analysis tools. These evaluative tools “flex” or compensate for the operating environment in an attempt to sort
out confusing signals. Business managers should become familiar with these more robust flexible tools, and they are
covered in depth in subsequent chapters.

Scorecard
The traditional approach to monitoring organizational performance has focused on financial measures and outcomes.
Increasingly, companies are realizing that such measures alone are not sufficient. For one thing, such measures report
on what has occurred and may not provide timely data to respond aggressively to changing conditions.
In addition, lower-level personnel may be too far removed from an organization’s financial outcomes to care. As a
result, many companies have developed more involved scoring systems. These scorecards are custom tailored to each
position, and draw focus on evaluating elements that are important to the organization and under the control of an
employee holding that position.
For instance, a fast food restaurant would want to evaluate response time, cleanliness, waste, and similar elements for
the front-line employees. These are the elements for which the employee would be responsible; presumably, success
on these points translates to eventual profitability.
Balance — When controlling via a scorecard approach, the process must be carefully balanced. The goal is to identify
and focus on components of performance that can be measured and improved. In addition to financial outcomes, these
components can be categorized as relating to business processes, customer development, and organizational
betterment.
Processes relate to items like delivery time, machinery utilization rates, percent of defect free products, and so forth.
Customer issues include frequency of repeat customers, results of customer satisfaction surveys, customer referrals,
and the like. Betterment pertains to items like employee turnover, hours of advanced training, mentoring, and other
similar items.
If these balanced scorecards are carefully developed and implemented, they can be useful in furthering the goals of
an organization. Conversely, if the elements being evaluated do not lead to enhanced performance, employees will
spend time and energy pursuing tasks that have no linkage to creating value for the business. Care must be taken to
design controls and systems that strike an appropriate balance between their costs and resulting benefits. This means
that the managerial accountant must also be skilled in helping an organization avoid creating bureaucratic processes
that do not lead to enhanced results and profits.
Improvement — TQM is the acronym for total quality management. The goal of TQM is continuous improvement
by focusing on customer service and systematic problem solving via teams made up of front-line employees. These
teams will benchmark against successful competitors and other businesses. Scientific methodology is used to study
what works and does not work, and the best practices are implemented within the organization.
Normally, TQM-based improvements represent incremental steps in shaping organizational improvement. More
sweeping change can be implemented by a complete process reengineering. Under this approach, an entire process is
mapped and studied with the goal of identifying any steps that are unnecessary or that do not add value. In addition,
such comprehensive reevaluations will help to identify bottlenecks that constrain the whole organization.
Under the theory of constraints (TOC), efficiency is improved by seeking out and eliminating constraints within the
organization. For example, an airport might find that it has adequate runways, security processing, and luggage
handling, but it may not have enough gates. The entire airport could function more effectively with the addition of a
few more gates. Likewise, most businesses will have one or more activities that can cause a slowdown in the entire
operation. TOC’s goal is to find and eliminate the specific barriers.
Cost volume profit relationship
C O S T V O L U M E P R O F I T R E L A T I O N S H I P / B R E A K EVEN ANALYSIS

C V P a n a l y s i s i s t h e s t u d y o f t h e inter
relationship of sales (volume & price),costs (FC & VC) & profit. The study
of these factors help the mgt. in planning & decision making.
Break even point is the point of sales where total sales is just enough to cover
the total costs, it is a position where the firm will not make any profit or suffer any
loss.
At break even point, SALES=TOTAL COSTS COMPUTATION OF BREAK EVEN POINT
TARGETED SALES TO ACHIEVE TARGETED PROFIT Determination of Break even
point: Sales - Total VC – Total FC = Profit(SP/unit x unit sold) –(VC/unit x unit sold) – TFC =
Profit BE sales (in unit)= Total Fixed Costs Contribution/unit BE sales (in Conventional /
Traditional BE chartContribution BE chart

Sales (in units) to achieve target net profit=Total Fixed Costs+Target Profit
Contribution/unitSales (in value) to achieve target net profit=Total Fixed Costs+Target Profit
CS ratio ANGLE OF INCIDENCE

Concept of Cost-Volume-Profit Analysis:

Cost-Volume-Profit [CVP] analysis is an analytical tool for studying the relationship
between volume, cost, prices, and profits. It is very much an extension, or even a part of
marginal costing. It is an integral part of the profit planning process of the firm.
However, formal profit planning and control involves the use of budgets and other
forecasts, and the CVP analysis provides only an overview of the profit planning process.
Besides it helps to evaluate the purpose and reasonableness of such budgets and
forecasts.

Generally, CVP analysis provides answers to questions such as:

(a) What will be the effect of changes in prices, costs, and volume on profits?
(b) What minimum sales volume need be affected to avoid losses?
(c) Which product is the most profitable one and which product or operation of a plant
should be discontinued? Etc.
 Importance of CVP Analysis:
The CVP analysis is very much useful to management as it provides an insight into the effects and inter-
relationship of factors, which influence the profits of the firm. The relationship between cost, volume and
profit makes up the profit structure of an enterprise. Hence, the CVP relationship becomes essential for
budgeting and profit planning.

As a starting point in profit planning, it helps to determine the maximum sales volume to

avoid losses, and the sales volume at which the profit goal of the firm will be achieved.

As an ultimate objective it helps management to find the most profitable combination of

costs and volume.

A dynamic management, therefore, uses CVP analysis to predict and evaluate the
implications of its short run decisions about fixed costs, marginal costs, sales volume and
selling price for its profit plans on a continuous basis.

What Is CVP, and How Is It Important to Managerial Accounting?

It's a simple formula that works.

Cost-volume-profit analysis, or CVP, is something companies use to figure out how
changes in costs and volume affect their operating expenses and net income. CVP works
by comparing different relationships, such as the cost of operating and producing goods,
the amount of goods sold, and profits generated from the sale of those goods. By
breaking down costs into fixed versus variable, CVP analysis gives companies strong
insight into the profitability of their products or services.

Uses of CVP analysis

Many companies and accounting professionals use cost-volume-profit analysis to make
informed decisions about the products or services they sell. In this regard, CVP analysis
plays a larger role in managerial accounting than in financing accounting. Managerial
accounting focuses on helping managers -- or those tasked with running businesses --
make smart, cost-effective moves. Financial accounting, by contrast, focuses more on
painting an economic picture of a company so that outside parties, such as banks or
investors, can determine how financially healthy it is.

Elements of CVP analysis

The three elements involved in CVP analysis are:

1. Cost, which means the expenses involved in producing or selling a product or service.
2. Volume, which means the number of units produced in the case of a physical product, or the
amount of service sold.
3. Profit, which means the difference between the selling price of a product or service minus the
cost to produce or provide it.

Assumptions when using CVP analysis

When managers use CVP analysis to make business decisions, the following
assumptions are made:

 All costs, including manufacturing, administrative, and overhead costs, can be accurately
identified as either fixed or variable.
 The selling price per unit is constant.
 Changes in activity are the only factors that affect costs.
 All units produced are sold.

Contribution margin
CVP analysis can help companies determine their contribution margin, which is the
amount remaining from sales revenue after all variable expenses have been deducted.
The amount that remains is first used to cover fixed costs, and whatever remains
afterward is considered profit.
If a company has $500,000 in sales revenue with variable costs totaling $300,000, then its
contribution margin is $200,000. If that company sells 50,000 units in a given year, then
the sales price per unit is $10 and the total variable cost per unit is $6, leaving a
contribution margin of $4 per unit. The contribution margin can help companies
determine whether they need to reduce their variable costs for a given product or increase
the price per unit to be more profitable.
Aims & Objective Of Transfer Pricing:
1. Transfer pricing minimizes the tax burden or arranging direction of cash flow:
Transfer price, as aforesaid, refers to the value attached to transfer of goods, services,
and technology between related entities such as parent and subsidiary corporations
and also between the parties which are controlled by a common entity. Its essence
being that the pricing is not set by an independent transferor and transferee in an arm’s
length transaction. Transaction between them is not governed by open market
considerations.
2. Transfer pricing results in shifting profits:
Whatever the reason for fixing a transfer price which is not arm’s length, the result is
the shift of profit. The effect is that the profit appropriately attributable to one jurisdiction
is shifted to another jurisdiction. The main object is to avoid tax as also to withdraw
profits leaving very little for the local participation to share. Other object is avoidance
of foreign exchange restrictions.
3. Shifting of Profits- Tax avoiding not the only object:
Transfer between the enterprises under the same control and management, of goods,
commodities, merchandise, raw material, stock, or services is made at a price which
is not dictated by the market but controlled by such considerations such as:
• To reduce profits artificially so that tax effect is reduced in a specific country;
• To facilitate decentralization of production so that efforts are directed to concentrate
profits in the State of production where there is no or least competition;
• To remit profits more than the ceilings imposed for repatriation;
• To use it as an effective tool to exploit the fluctuation in foreign exchange to advantage.

TRANSFER PRICING SCHEMES

A transfer price is a price established in business activities between departments of one

company or between participants of one company’s group (those transactions are often
called “regulated”). A transfer price can be different from the price for a similar product
settled on the open market.

Tax considerations are often the reason for managing the transfer price. It is especially
popular at transnational companies and holdings. As taxes are essentially different in
various countries, redistribution of the whole holding’s profit by transfer ring pricing
methods in favor of less ratable elements of the holding is interesting for the financial
management of international holding companies. Particularly, those less ratable
elements can be completely tax-free offshore companies. The easiest variant of this
scheme is the export or import of goods through a transit offshore company with oriented
overstatement/ understatement purchase and sale value of the product or service.

Implementing the transfer pricing rules

You’ve probably heard that some Bureau of Internal Revenue (BIR) examiners are asking
for transfer pricing documentation as part of regular audits. We are also aware that the
BIR International Tax Affairs Division (ITAD) has been asking for transfer pricing
documentation from companies applying for tax treaty relief for transactions involving
related parties.
We may therefore be allowed to wonder, how will the BIR conduct the transfer pricing
audit? What is the advantage of having transfer pricing documentation? How will the
transfer pricing documentation affect our tax treaty relief application (TTRA)?

The Philippine transfer pricing guidelines or Revenue Regulations 2-2013 has among its
objectives to require the maintenance or safekeeping of the documents necessary for the
taxpayer to prove that efforts were exerted to determine the arm’s-length standard for its
transactions with related parties. The guidelines state that adequate documentation will
enable the taxpayers to (i) defend their transfer pricing analysis, (ii) prevent transfer
pricing adjustments arising from tax examinations, and (iii) support their applications for
Mutual Agreement Procedure (MAP).

The documents may include the following:

1. Organizational structure

2. Nature of the business/industry and market conditions

3. Controlled transactions

4. Assumptions, strategies, policies

5. Cost contribution arrangements (CCA)

6. Comparability, functional and risk analysis

7. Selection of the transfer pricing method

8. Application of the transfer pricing method

9. Background documents

10. Index to documents

The documentation must be contemporaneous, that is, it must be in existence before or
at the time of the transaction or at the time of filing the income tax return. It must be
submitted upon request of the BIR.

A company which maintains transfer pricing documentation has taken one big step by
showing that it has exerted effort to provide a basis for its transfer prices. At the very
least, the taxpayer can show that it has diligently followed the transfer pricing guidelines
in preparing the documentation and applied the appropriate transfer pricing method. In
some countries, taxpayers that maintain adequate documentation enjoy the benefit of
exemption from penalties in case transfer pricing adjustments arise. Philippine taxpayers
will be happy if the same advantage can be granted to those who comply.

How and to what extent will the BIR will scrutinize the documentation maintained by the
taxpayer? In case of payments made to related parties, the audit may be focused on
proving that the transaction covered by the payment exists (there were goods delivered
and services provided), that the Philippine company is actually benefiting from the goods
or services that it paid for, and that the fee charged for the good or service is fair, based
on the arm’s length principle. In case of revenue received, the focus will be on determining
whether the price or compensation received for the good or service is reasonable, also
based on the arm’s length principle.

In both cases, the BIR should put a premium on documentation and methodology for the
analyses that comply with the documentation guidelines. Transfer pricing audit guidelines
will hopefully be circularized to enable the taxpayer to prepare well for an audit and to
know his rights and the available remedies.

Taxpayers who have not prepared adequate documentation may find that their transfer
pricing issue would be much more difficult to resolve, according to the regulations. The
BIR may impose its own arm’s length standard and such a standard may result in a
transfer pricing adjustment, and consequently in deficiency taxes. The taxpayer should
be prepared to argue that such standard cannot be validly imposed. Without its own
study, that may be a big challenge for the taxpayer.

How will the transfer pricing documentation affect our TTRA?

There is a standard provision in the tax treaties on payments between related parties,
specifically applicable to interest and royalties. The provision says that, if because of the
relationship between the transacting parties, the amount of the interest or royalties
exceeds the amount which would have been set in the absence of such relationship, the
excess part of the payments shall remain subject to the regular tax. Only the portion that
is deemed reasonable, or arm’s length in the transfer pricing language, shall be entitled
to the preferential tax rates under the tax treaties.

Though a transfer pricing study is not among the enumerated documents for TTRA, the
BIR-ITAD has recently been issuing notices for the submission of a transfer pricing report
within 15 days to companies which have filed for treaty relief for payment of interest and
royalties to related parties. It is not clear though, how the ITAD will treat applicants who
cannot submit a transfer pricing report. Will the TTRA be archived? Will the application
be denied? Does ITAD have benchmarks or data which they will use to determine the
portion of the payment that exceeds that arm’s length amount which shall qualify for the
treaty relief?

In case the TTRA applicant is able to submit a transfer pricing report, will the ITAD
consider the report sufficient or will it further scrutinize the report for acceptability?

In its 2016 Priority Programs (RMC 14-2016), the BIR expressed its intent to implement
a transfer pricing program that will complement the transfer pricing guidelines issued in
2016. The 2016 transfer pricing program has listed among its priorities the subscription
to a commercial database for transfer pricing studies, development of a transfer pricing
test case for LTS, finalization of transfer pricing-related issuances such as the Revenue
Regulations on Advance Pricing Agreement (APA) and the Revenue Memorandum
Orders on transfer pricing documentation and transfer pricing risk assessment.

The issues on transfer pricing can have very significant impact and is best approached
with more caution.
The implementation of our transfer pricing rules affect not only the Philippine taxpayer
but also, companies in the group which are operating in other jurisdictions. Significant
amounts may be involved. For example, BPOs and KPOs whom we have encouraged to
locate in the Philippines are mostly deriving a hundred percent of their revenues from
related parties. Many export-oriented enterprises which we have registered in our eco
zones are manufacturing for or selling to related parties as part of the global supply chain.
A one percent adjustment can translate to significant amounts, hence the need for the
adjustments to be fair.

Furthermore, transfer pricing is not an exact science. Each entity is peculiar -- its
operations are a function of various factors which cannot be exactly the same as with
another entity even in the same line of business. There is no exact formula and there may
be more than one way of analyzing a transaction.

Looking at all the factors that may be considered in evaluating transfer pricing, I’d like to
believe that the objective is, not simply finding an amount that is mathematically correct
that can be assessed, but more towards achieving fairness and equity. This is a big
responsibility.

Lina P. Figueroa is a principal of the Tax Advisory and Compliance division of

Punongbayan & Araullo