Accounting Department

Managerial Accounting
Scientific Framework
&
Practical Application

Compiled and Edited by

Dr
Hatem Abdelfattah Al-Shaarawy
Doctor of Philosophy in Accounting
University of Göttingen - Germany
Accounting Department
Faculty of Commerce - Menoufia University

2022

Contents
Preface:
Management accounting as a branch of accounting science means
providing information that serves the organization management and
employees in the organization in the areas of planning, controlling and
decision-making. The importance of the information provided by the
management accounting system increased; Its practical applications have
increased significantly so that the information available from the
management accounting system has become an important part of the
organization’s managerial information system, and it has also become a
basis for crystallizing the routine and strategic decision-making process,
to the extent that the management accountant has been called the digital
partner in the decision-making process in the organization.

Proceeding from the great and pioneering role that management

accounting plays in the field of planning, controlling, performance
evaluation and rationalizing administrative decisions, and because the
feeling with the need for accounting students at the university and many
organizations and those interested in this field in the world of business to
provide a book that may help them understand the theoretical framework,
methods and practical applications of managerial accounting, it was This
modest book, which focused on a presentation of the most important
methods and applications of management accounting to serve the
organization’s management in the field of planning, control and decision-
making, taking into account the presentation of many applied cases and
practical problems related to practical reality, with the aim of linking the
theoretical side with the practical side, an attempt by us to help the reader
to understand the topics and issues raised.

This book contains five chapters other than the introduction, where
the first chapter includes the framework and concepts of managerial

Contents
accounting, while the second chapter discusses the analysis of the
relationship between cost - volume - profit, the third chapter discusses
planning budgets as a method of managerial accounting in profit
planning, and the fourth chapter discusses the segment reporting And
analysis of the ability to profitability and decentralization, and finally the
fifth chapter, which discusses the subject of financial statements analysis.
We ask God that we have succeeded in presenting a work that is
acceptable to God and that will benefit the reader and achieve the desired
benefit from it.
God bless ,,,,
Shpin-Elkom at: 1/2/2022 Dr. Hatem Al-Shaarawy

Contents
Contents
Contents
Preface: .......................................................................................................................2
Contents......................................................................................................................4
Faculty Mission: ...........................................................................................................7
Faculty Vision: .............................................................................................................7
Course Specifications ....................................................................................................8
Chapter 1: Managerial Accounting (Framework and Concepts)....................................... 10
1.1 Management’s Need for Information: ...................................................................... 10
1.2 Accounting information:......................................................................................... 12
1.3 Management accounting definition: ........................................................................ 14
1.4 The nature of management accounting: ................................................................... 16
1.5 Management Accounting Objectives:....................................................................... 18
1.6 Evolution of Management Accounting: .................................................................... 19
1.7 Management Accounting Scope: ............................................................................. 20
1.8 The similarities and differences between financial accounting and management
accounting: ................................................................................................................ 23
1.9 The relationship between management accounting and cost accounting: .................... 26
1.10 Managerial accounting tools and techniques: ......................................................... 28
1.11 The Certified Management Accountant (CMA): ....................................................... 30
Chapter 2: Cost-Volume-Profit (CVP) Analysis ............................................................... 33
2.1 Introduction:......................................................................................................... 33
2.2 general equation for profit: .................................................................................... 34
2.3 Contribution Margin .............................................................................................. 35
2.4 Contribution Margin Ratio: ..................................................................................... 35
2.5 Break-even point: .................................................................................................. 38
2.6 Some Applications of CVP Concepts: ........................................................................ 42
Chapter 3: Planning Budgets ....................................................................................... 82
3.1 Introduction:......................................................................................................... 82
3.2 A historical look at the preparation of budgets: ........................................................ 82
3.3 Budget Definition: ................................................................................................. 83
3.4 Personal Budget .................................................................................................... 83
3.5 Difference between planning and control:................................................................ 84
3.6 Advantages of Budgeting: ....................................................................................... 85
3.7 Responsibility Accounting ....................................................................................... 86
3.8 Choosing a Budget Period: ...................................................................................... 87
3.9 The self-imposed budget ........................................................................................ 88

Contents
3.10 Human Relations and Budget Program: .................................................................. 90
3.11 The Budget Committee: ....................................................................................... 92
3.12 The Master Budget - a Network of Interrelationships: .............................................. 92
3.13 Sales Forecasting-A critical Step: ........................................................................... 94
3.14 Preparing the Master Budget: ............................................................................... 96
3.14.1 The Sales Budget: .......................................................................................... 96
3.14.2 The Production Budget:.................................................................................. 98
3.14.3 Merchandise Purchases – Merchandising Firm................................................ 100
3.14.5 Direct Material Budget: ................................................................................ 100
3.14.6 Direct Labor Budget ..................................................................................... 104
3.14.7 The Manufacturing Overhead Budget: ........................................................... 106
3.14.8 The Ending Finished Goods Inventory Budget: ................................................ 107
3.14.9 The Selling and Administrating costs Budget: .................................................. 108
3.14.10 The Cash Budget: ....................................................................................... 109
3.14.11 The Budgeted Income Statement: ............................................................... 112
3.14.12 The Budgeted Balance Sheet: ...................................................................... 113
3.15 Expanding the budgeted income statement: ......................................................... 115
3.16 Jit (just in Time) Purchases: ................................................................................. 116
3.17 Zero-Base Budgeting .......................................................................................... 119
3.18 International Aspects of Budgeting: ..................................................................... 120
3.19 An Applied Case:................................................................................................ 121
2.20 Questions and Applied Cases: ............................................................................. 129
Chapter 4: Segment Reporting, Profitability Analysis & Decentralization....................... 133
4.1 Introduction........................................................................................................ 133
4.2 Hindrances to Proper Cost Assignment: ................................................................. 134
4.2.1 Omission of some costs from the assignment process: ...................................... 134
4.2.2 Using Inappropriate Methods for Allocating Costs among Segments: .................. 135
4.2.3 Arbitrary Dividing Common Costs among Segments: ......................................... 136
4.3 Segment Reporting and Profitability Analysis: ......................................................... 138
4.3.1 Levels of Segmented Statements .................................................................... 138
4.3.2 Assigning Costs for Segments:......................................................................... 140
4.3.3 Sales and Contribution Margin: ....................................................................... 141
4.3.4 Traceable and Common Fixed Costs: ............................................................... 141
4.3.5 Identifying Traceable Fixed Costs: ................................................................... 142
4.3.6 General guidelines:........................................................................................ 142
4.3.7 Activity-Based Costing (ABC): .......................................................................... 143
4.3.8 Traceable Costs Can Become Common Costs? .................................................. 144
4.4 Segment margin .................................................................................................. 146

Contents
4.5 Different classifications of Total Sales: ................................................................... 147
4.7 Responsibility Accounting ..................................................................................... 149
4.7.1 Decentralization and Segment Reporting ......................................................... 150
4.7.2 Cost, Profit, and Investment Centers ............................................................... 151
4.7.3 Measuring Management Performance............................................................. 153
4.7.4 Rate of Return on investments for Measuring Managerial Performance: ............. 154
4.7.5 The Return on Investment (ROI) Equation: ....................................................... 154
4.7.6 Net Operating Income and Operating Assets Defined ........................................ 156
4.7.8 Plant and Equipment: Net Book Value or Gross Cost? ........................................ 157
4.7.9 Controlling the rate of return on investment: ................................................... 159
4.7.10 Residual Income - Another Measure of Performance: ...................................... 165
4.8 Transfer Pricing: .................................................................................................. 168
4.8.1 The Need for Transfer Prices:.......................................................................... 168
4.8.2 Transfer Prices at Cost: .................................................................................. 170
4.8.3 Transfers at Market Price - General Considerations: .......................................... 175
4.8.4 Negotiated Transfer Price:.............................................................................. 183
4.8.5 Non-Independent Divisions and less-Optimization: ........................................... 185
4.8.6 International Aspects of Transfer Pricing: ......................................................... 186
4. 9 Questions and Applied Cases ............................................................................... 194
Chapter 5: Financial Statement Analysis ..................................................................... 204
5.1 The Importance of Statement Analysis: .................................................................. 204
5.2 Importance of Comparison: .................................................................................. 205
5.3 The Need to Look Beyond Ratios: .......................................................................... 205
5.4 Statements in Comparative and Common – Size Form ............................................. 206
5.4.1 Value and Percentage Changes on Statements ................................................. 206
5.4.2 Horizontal Analysis: ....................................................................................... 208
5.4.3 Trend Percentages: ....................................................................................... 209
5.4.4 Vertical Analysis (Common- Size Statements): .................................................. 210
5.4.5 Ratios Analysis (For the Common Stockholders): ............................................... 213
5.4.6 Ratio Analysis - The Short-Term Creditors: ....................................................... 228
5.4.7 Ratio Analysis - Long-Term Creditors: .............................................................. 234
5.5 Summary of Financial Ratios and How to Calculate Them: ........................................ 237
5.6 Questions and Applied Cases ................................................................................ 243

Contents
Faculty Mission:
Faculty of Commerce, as one of the faculties of Menoufia
University, is an educational, research, and societal institution. The
faculty provides excellent graduates who are qualified in terms of
knowledge, skills, and professionalism in the areas of
management, accounting, economics, insurance, and statistics to
meet the needs and requirements of the work labor in both the
production and services segments at the local, national, and
international levels. The faculty also seeks to make the continuous
learning opportunities available to its graduates and others through
its postgraduate programs and to develop the local and national
society via its unique and competent academic staff and
employees, by offering high quality services in training,
consultancies, and research

Faculty Vision:
"Excellence and leadership in university education and scientific

research, trade serves development goals, including regional and

national."

Contents
Course Specifications

Code: 2304 Course Title: Managerial Accounting Level: (3)

Specialization: Accounting & Auditing Credits: Theoretical 3 Practical 1

• Explanation of the managerial accounting (MA) role in the

2. Aims organizations.
• Clarify the major differences between managerial & financial
accounting.
• Introduce the students to the recent concepts & use of the
managerial accounting information in planning, controlling, and
decision-making.

3. Intended Learning Outcomes:

3/1- Knowledge and • Concepts, rules & information for managerial accounting use
Understanding within the organization.
• Design of a managerial accounting framework.

3/2- Intellectual Skills • Understanding Managerial accounting functions.

• Design an effective MA system.
• Understanding the managerial accounting theory, practices,
assumptions and cost information.

3/3- Professional Skills • Dealing & understanding of the procedures, tools, & application of
the managerial accounting in planning, controlling, & decision-
making.

3/4- General Skills • Qualify the student to implement the MA framework in either
public or private organizations.
• Developing MA system.

4. Course Contents • Introduction to managerial accounting (nature, definition,

& Aims)
• Managerial Accounting Techniques for producing useful
information
• Cost Volume Profit Analysis
• Management Accounting & short-term planning - Master budget.
• Tools of managerial accounting in guidance of
investment decisions.
• Segment Reporting and performance Evaluation
• Financial Statements Analysis.

Contents
 Chapter One
Managerial Accounting
(Framework and Concepts)

Learning Objectives:
After studying this chapter, you could be able to:
- know the nature, concept, importance, and objectives of managerial
accounting.
- understand the similarities and differences between managerial
accounting and financial accounting.
- understand the relationship between managerial accounting and cost
accounting.
- know the different techniques of managerial accounting.
- know how to become certified managerial accounting (CMA)

Contents
Chapter One: Managerial Accounting (Framework and
Concepts)
1.1 Management’s Need for Information:
Information is the "fuel" that carries the management to movement,
and when the information does not flow continuously, the management
does not strengthen to do anything. Fortunately, a large part of the
management's information needs is met from within the organization
structure itself. The organizational structure of the organization includes
communication channels that cover the entire organization, and through
these communication channels the different administrative levels can
communicate with each other, and through these channels policies and
instructions are also transmitted to subordinates, as well as discussing
problems, formal and informal communication takes place, as well as the
exchange of reports and notes, and from this point of view Management
cannot perform its functions efficiently without these channels of
communication.

The management of the organization also depends on obtaining a

large part of the information on specialists. Economists, marketing
specialists, organizational behavior specialists, accountants and others all
provide information to the management and provide advice in various
aspects of the organization’s activity. For example, we find that the
economist provides information on contemporary economic conditions.
Marketing specialists provide the necessary information needed for the
effective promotion and distribution of goods and services, and
organizational behavior specialists help in structuring and employing the
organization itself.
Information has probably become the most valuable resource in
modern business. In today’s business environment, rational decisions and
actions would be virtually impossible without access to information.
Contents
organizations spend a lot of effort, time, and money on making sure that
the right information is available to the right people to make the right
decisions and initiate the right actions. Information is required for many
different tasks:
• Planning: planning means anticipating potential future events and
developments or future consequences of today’s decisions and
actions, respectively. Plans are by nature uncertain because nobody
can anticipate the future with absolute certainty. But plans can be
made more “robust” when they are based on experience and when
they take into account what is already known about future
developments. Businesses therefore strive to base plans on a solid
foundation of information about past achievements and potential
future developments.
• Decision making: Decisions involve choices between alternatives.
Even the decision not to do anything is a choice – one could have
done something instead. A rational decision maker will try to make
sure that they take the right decision – that is, picking the one
alternative that promises the greatest reward. Generally, decision
makers will try to identify the alternative that offers the highest
probability of achieving the defined goals. Identifying this optimal
alternative is possible only by having information on likely future
consequences of each decision alternative, necessary conditions for
each alternative to be realized, or potential conflicts with other
decisions that must be made at the same time.
• Monitoring and Feedback: Businesses want to make sure that
things evolve in the intended manner, goals have been set with the
intention of achieving them, businesses have been started in order
to be completed as planned, and rules have been set based on the
expectation that they are observed. Planning and decision making

Contents
 therefore inevitably involve an element of control. Again, this
control would be impossible without information –about both the
original goals and plans as well as about actual achievements and
developments.

1.2 Accounting information:

Accounting information has a financial nature that helps the
manager in carrying out his functions of planning, controlling, directing
and making decisions. The following are the most important benefits that
accounting information provides to the manager while he performs his
various functions:
• In the field of planning: The management sets plans related to its
activities, then these plans are formally translated into what are
called "planning budgets". It should be noted that the term budget
preparation is generally used as a synonym for management plans,
and budgets are usually prepared under the supervision and
guidance of the financial controller and with the help of the
accounts department. Also, budgets are prepared on an annual basis
and express the desires and objectives of the management in a
specific and quantitative manner. For example, Toshiba Al-Arabi
Company sets sales plans monthly and for a full year in advance,
these plans are called departmental budgets, which are circulated
throughout the organization.
• In the field of controlling: Planning in itself is not sufficient, but
once the companies’ budgets are set, the management needs a flow
of information that shows how efficiently the plans are
implemented, and accounting helps in achieving this through
information on “performance reports” that draw the attention of
management to problems or opportunities that the company lost in

Contents
 the form of a detailed report which is presented to the management,
comparing the budget data and actual performance data for a
specific period of time. If the performance reports showed to the
management that there are problems, the manager has to find the
causes and correct the situation. While the performance reports
showed that things are going well, the manager devote himself to
his other work, in short, performance reports are feedback to
managers that direct their attention towards the parts of the
organization that management should use its time in efficiently.
• In the field of directing: The management needs accounting
information on a routine basis to carry out its daily work. For
example, the head of the sales department, when pricing the new
goods before offering them for sale, he must rely on the accounting
information to ensure that the relationship between price and cost
is consistent with the marketing strategies that the organization
follows. The warehouse manager also relies on other accounting
information that shows him sales volumes and stock levels when
preparing advertising programs, and the purchase manager relies
on accounting information that shows him the costs of storage and
handling, and thus it becomes clear that the work of the accountant
and the manager is closely related to the daily work.
• In the field of decision-making: Accounting information is the
main factor in determining alternative ways to solve problems, and
this is because each alternative has its measurable costs and
benefits, which are the inputs for choosing the best alternative.
Accounting is generally concerned with collecting data on the cost
and benefit available, as well as informing the responsible manager
of this information in an appropriate manner, for example For
example, Toshiba Al-Arabi Company may discover that
Contents
 competitors are fighting the company so that it can choose between
alternatives to reduce prices, increase advertising, or both to
maintain the company’s share in the market, and in this case, the
company’s management must rely heavily on cost and benefit data
provided by accounting, It is necessary to clarify here that the
required accounting information may not be ready. In fact,
accounting needs a great deal of analysis, including some
forecasting, to prepare the required data.

It should be noted that it is necessary that the information provided

by the management accounting system be in a brief form, where any
accounting system deals in a huge amount of details to record daily
transactions, and providing these details has a significant impact on the
effective management of the organization, but the initial needs of the
manager are not in the details but, they are in the summaries of this
detailed information that is extracted from the accounting records, and
when the manager uses these summaries, he can see where the problem is
and when his time can be used to improve the effectiveness of the
organization.

1.3 Management accounting definition:

In each business, various transactions and events take place daily,
sales are affected, purchases are made, expenses are met or incurred,
payments are received and made, assets are sold and acquired. Aal these
events, arising out of the decisions and actions of management, exercise
their effects and impact on the operational efficiency and position of the
enterprise. Most of these transactions and events can be measured and
expressed in money values. Since they affect the operation and position
of the enterprise, they need to be measured, recorded, analyzed and
reported to the management, so that the management can evaluate their

Contents
effect upon the enterprise. As compared with financial accounting and
cost accounting, management accounting is a later development.

Management accounting links management with accounting. All

such information that is useful to the management is the subject matter of
management accounting. Any information required for decision making
is the concern of management accounting. Management accounting,
unlike financial accounting, provides information for internal users,
though the basic data come from the same accounting system (financial
accounting and cost accounting systems). Management accounting
collects and provides accounting, cost accounting, economic and
statistical information to the management at various managerial levels to
assist them in evaluating performance of managerial functions.

It is the development and application of various techniques of

recording, analyzing, interpreting, and presenting, the financial, costing,
and other data to help management to evaluate the performance of
managerial functions (planning, decision-making and control). It should
be noted that management accounting uses not only accounting
techniques but also of statistical and mathematical techniques.
Management accounting is forward looking and should, therefore, be able
to treat economic information and data to make it suitable for use by the
management.

Management accounting is an information system that relies on a

set of internal accounting processes for measuring and communicating
the necessary information for management at all its different levels in
order to help it in formulating policies, planning, rationalizing decisions,
controlling, following up, evaluating the performance and results, and
managing the organization efficiently and successfully.

Contents
 From this definition, we can identify the distinctive characteristics
of management accounting as follows:
1. The management accounting is directed to serve the internal
parties, where it focuses on preparing reports for internal users
(management).
2. The essence of managerial accounting is measurement and
communication. Measurement includes the measurement of future
values in addition to the actual values, also measurement is
monetary and non-monetary. As for communication of
information, it is done to the management within the organization.
3. The objective of management accounting is to serve the
management in exercising its various functions of planning,
making decisions and controlling.

1.4 The nature of management accounting:

- Management accounting is a decision-making system. it provides
accounting information in such a way to assist management in the
creation of policy and in the day-to-day operations. Though, management
accountant is not taking any decision but provides data which is helpful to
management in decision making. It communicates a variety of facts in a
systematic and meaningful manner.

- Management accounting is futuristic. It unlike the financial accounting,

deals with the future. It helps in planning the future, because decisions are
always taken for the future course of action. In the decision-making
process, management accounting provides selective and fruitful
information out of the data collected.
- Management accounting is a technique of selective nature. it considers
only those data from the financial statements and communicates to the
management which is useful for making decisions.

Contents
- Management accounting analyzes different variables. It helps in
analyzing the reasons for variations in profit as compared to the past
period. It analyzes the effects of different variables on the profits and
profitability of the organization.

- Management accounting does not set formats for information. It

provides necessary information to the management in the form which
may be more useful to the management in making various decisions on
different aspects of the business.
-

-Managerial accounting is targeted more toward a company’s managers

and employees. The information gathered and summarized for these

internal groups is customized to provide feedback for planning, decision
making, and evaluation purposes. Managerial reports do not necessarily
follow any format, but instead they are uniquely designed to meet the
needs of specific users. Analyses are often focused on targeted segments
of a business rather than on a company as a whole.

- Information may be published over periodic time intervals. Managerial

accounting involves not only actual financial data from past periods, but
also current estimates and future projections.

- A manager’s responsibilities in a business include making decisions

related to planning (identifying goals and strategies for accomplishing
them), leading (directing daily operations and carrying out plans), and
controlling (comparing expected and actual results and taking action for
improvement). Since human, financial, and time resources are limited,
managers must select from among many alternatives, foregoing other
options. They try to optimize the collective outcome of their choices.
Managerial accounting provides timely and relevant financial information
that contributes to effective decision making.

Contents
1.5 Management Accounting Objectives:
The main objective of management accounting is to assist the
management in carrying out its duties efficiently so that maximize profits
or minimize losses of management. It includes preparing of plans and
budgets covering all aspects of the business (production, selling,
distribution, research, and finance). Management accounting
systematically allocates responsibilities for implementing plans and
budgets. It analyzes all transactions, financially and physically, to enable
effective comparison to be made between the forecasts and actual
performance. This main objective is achieved by achieving the following
objectives:
• To formulate Plans, policy Planning involves forecasting based on
available information, setting goals; framing polices determining
the alternative courses of action and deciding on the program of
activities. It facilitates the preparation of statements in the light of
past results and gives estimation for the future.
• To interpret financial documents, management accounting presents
financial information to the management. Financial information
must be presented in such a way that it is easily understood. It
presents accounting information with the help of statistical devices
like charts, diagrams, graphs, etc.
• To assist in decision-making process, management accounting
makes decision-making process more scientific with the help of
various modern techniques. Information relating to cost, price,
profit, and savings for each of the available alternatives is collected
and analyzed accordingly which will provide a base for taking
sound decisions.

Contents
 • To help in control, management accounting is a helpful for
managerial control. Management accounting tools e.g., standard
costing and budgetary control, are helpful in controlling
performance. Cost control is affected using standard costing and
departmental control is made possible using budgets. Performance
of each individual is controlled with the help of management
accounting.
• To provide report, management accounting keeps the management
fully informed about the latest position of the organization through
reporting. It helps management to take proper and quick decisions.
It informs the performance of various departments regularly to the
top management.
• To Facilitate coordination of operations, management accounting
provides tools for overall control and coordination of business
operations. Budgets are important means of coordination.
Therefore, the objectives of management accounting are as follows:
• It is a tool for planning and control
• It is a tool concerned with the psychology and behavior of
employees in the organization.
• It is a tool that helps in making decisions
• It is a tool for carrying out the activities of the organization.

1.6 Evolution of Management Accounting:

Management accounting has its roots in the industrial revolution of
the 19th century. During this early period, most firms were tightly
controlled by a few owner-managers who borrowed based on personal
relationships and their personal assets. Since there were no external
shareholders and little unsecured debt, there was little need for elaborate
financial reports. In contrast, managerial accounting was relatively

Contents
sophisticated and provided the essential information needed to manage
the early large-scale production of textile, steel, and other products. After
the turn of the century, financial accounting requirements grow rapidly
because of new pressures placed on companies by capital markets,
creditors, regulatory bodies, and federal taxation of income.

Many firms needed to raise funds from increasingly widespread

and detached suppliers of capital. To tap these vast reservoirs of outside
capital, firms' managers had to supply audited financial reports. Because
outside suppliers of capital relied on audited financial statements,
independent accountants had an interest in establishing well defined
procedures for corporate financial reporting. As a consequence, for many
decades, management accountants increasingly focused their efforts on
ensuring that financial accounting requirements were met, and financial
reports were released on time.

The practice of management accounting stagnated. In the early part

of the last century, where product line expanded operations became more
complex, forward-looking companies saw a renewed need for
management-oriented reports that was separate from financial reports.
But in most companies, management accounting practices up through the
mid-1980s were largely indistinguishable from practices that were
common prior to World War I. In recent years, however, new economic
forces have led to many important innovations in management
accounting.

1.7 Management Accounting Scope:

Management accounting includes financial accounting and extends
to the operation of cost accounting system, budgetary control, and
statistical data. While meeting the legal and conventional requirements
regarding the presentation of financial statements, (income statement,

Contents
balance sheet and cash flow statements) it stresses emphasis upon the
establishment and operation of internal controls. The scope of
management accounting includes:
• Financial accounting, cost accounting, tax accounting and
information systems. Management accountant must construct and
reconstruct these systems to meet the changing needs of
management functions.
• The compilation and preservation of vital data for management
planning. The accounts and the document files are store of vast
quantities of details about the past progress of the organization,
without which forecasts of the future is very risky for the
enterprise. The management accountant presents the past data in
such a way as to reflect the trends of events to the management. He
is supposed to give his assessment of anticipated changes in
relevant areas. Such information provides effective assistance in
the planning process. At times the management accountant may be
called upon to associate with and even supervise the actual
planning process along with other members of the management
team.
• Providing means of communicating management plans to the
various levels of organization. This, on the one hand ensures the
coordination of various segments of the enterprise plans and on the
other defines the role of individual segments in the whole plan and
assists the management in directing their activities.
• Providing and installing an effective system of feed-back reports.
This would enable the management in its controlling function. By
pin-pointing the significant deviations between actual and expected
activities, and by adhering to the principles of selectivity and
relevance, such reports help in installing and operating the system

Contents
 of ‘management by exceptions. The management accountant is
expected to analyze the deviation by reasons and responsibility and
to suggest appropriate corrective measures in deserving cases.
• Analyzing and interpreting accounting and other data to make it
understandable and usable to the management. It is only through
such analysis and clarification that the management is enabled to
place the various data and figures in proper perspective in the
performance of its functions. Such analysis assists management in
locating the responsibilities and the effect necessary changes in the
organizational set up to achieve the objectives of the organization
in a more efficient manner.
• Assisting management in decision-making by (a) providing
relevant accounting, and other data and (b) analyzing the effect of
alternative proposals on the profits and position of the
organization. Management accountant helps the management in a
proper understanding and analysis of the problem in hand and
presentation of factual information obviously in financial terms.
• Providing methods and techniques for evaluating the performance
of the management in the light of the objectives of the
organization, thus assisting in the implementing the principle of
management by objectives.
• Improving, modifying, and sharpening the effectiveness of co-
existing techniques of analysis. The management accountant
should always think of increasing the practicability of existing
techniques. He should be on the lookout for the development of
new techniques as well.

Contents
1.8 The similarities and differences between financial
accounting and management accounting:
Financial accounting and management accounting are not totally separate.
They not only share the company’s basic accounting data as their
common information base. They possess some more common traits. The
most important one is the focus on company performance: They both
measure company success by netting value generated and value
consumed but differ in the value concept used and the scope of activities
considered when measuring value. We can summarize similarities and
differences between financial accounting and management accounting as
follows:
A- Similarities
• In terms of field of use: Financial accounting and management
accounting use data and information that lead to rationalizing
decisions.
• In terms of data source: Financial accounting and management
accounting depend on the accounting information system (inputs -
operation - outputs).
• In terms of interest: Financial and management accounting both
of them are concerned with the income statement, the statement of
financial position and the statement of cash flows.

B- Differences:
• Financial accounting is restricted by accounting principles accepted
by accountants (for example, the historical cost principle). While
management accounting is not restricted by accounting principles.
Fixed assets may be evaluated at the replacement cost.

Contents
• Financial accounting is concerned with the organization as a
whole, while management accounting focuses on the different
sectors (profit centers, departments).
• Financial accounting is concerned with financial
information, while management accounting is concerned with
financial and non-financial information.
• Financial accounting focuses on the past, while management
accounting focuses on the past, present and future (future plans).
• Financial accounting focuses on the objectivity, accuracy
and verifiability of data, and its relevance is a secondary matter.
While management accounting focuses on the appropriateness of
information to the problem under study, and objectivity is
considered a secondary matter
• Financial accounting provides more accurate information
than management accounting, as management may sacrifice some
accuracy to obtain information at the required speed.
• Management accounting depends on other sources of
information such as operations research, statistics, economics other
than the financial accounting system.
• Financial accounting is obligated to keep certain books and
records, while management accounting has complete freedom in
the books and records it uses.
• The information provided by the financial accounting system
is the primary objective of this system. When it is prepared, the
role of financial accounting ends. As for the information provided
by management accounting, it is a means for use in planning,
directing, controlling and making decisions.

Contents
 • Financial accounting focuses on external parties (banks,
investors, government agencies), while management accounting
focuses on management needs (internally).

The following table illustrates comparison between financial accounting

and management accounting.

Basis of Financial Accounting Management Accounting

comparison
Information users External – investors, creditors, Internal – all management
suppliers, government and tax functions within the company
authorities
Purpose of Help investors, creditors, and Help managers to plan and
information others to make investment, control business operations
credit, and other decisions
Focus and time Reliability, objectivity, and Relevance and focus on the
dimension focus on the past future
Obligation for Mandatory Not mandatory
preparation
Type of report, Financial statements restricted internal reports not restricted
regulation by accounting standards (IFRS, by accounting standards –
GAAP, etc.) tailored to specific decisions
Presentation of Content and format highly Not standardized, individual
accounting standardized across companies contents and formats
information
Verification Annual independent audit by No independent audit
certified public accountants
Level of detail Summary reports primarily on Detailed reports on parts of
the company as a whole the company (products,
customers, market segments,
etc.)
Frequency At least on an annual basis, Varying, often on a weekly or
sometimes quarterly monthly basis

Contents
1.9 The relationship between management accounting and
cost accounting:
Cost accounting and management accounting both are internal to
the organization. Both have the same objectives of assisting management
in its functions of planning, decision-making, and controlling. Techniques
like budgetary control, standard costing and marginal costing owe their
existence to cost accounting and have slipped into the kit bag of the
management accountant. There is a good deal of overlapping in their
functions. However, the two systems can be differentiated on the
following grounds:
- Cost accounting is concerned more with the ascertainment, allocation,
distribution, and accounting aspects of costs. Management accounting is
concerned more with impact and effect aspect of costs.
- Cost accounting data generally serves as a base to which the tools and
techniques of management accounting can be applied to make it more
purposeful and management oriented. Whereas the management
accounting data is derived both, from the cost accounts and financial
accounts.
- The management accountant places the data in a wider perspective than
the cost accountant. This accounts for a greater degree of relevance and
objectivity in management accounting than in cost accounting. It is the
management accountant who is supposed to have a clear idea regarding
the items and types of costs required to analyze and decide specific
business problems and the effect of such costs on alternate solutions. A
cost accountant is helpful in collecting such costing data for the
management accountant.
- In the organizational structure, management accountant generally is
placed at a higher level of hierarchy than the cost accountant.
Contents
- The approach of the cost accountant is much narrower than that of a
management accountant, who may have to use certain economic and
statistical data along with the costing data to enable the management to be
more accurate in precising its functions of planning, decision-making and
controlling.
- Management accounting, in addition to the tools and techniques, like
variable costing, break-even analysis, standard costing, etc., available to
cost accounting, also makes use of other techniques like cash flow, ratio
analysis, etc., which are not within the scope of cost accounting.
- Management accounting includes both financial accounting as well as
cost accounting. It also embraces tax planning and tax accounting. Cost
accounting does not include financial accounting and has nothing to do
with tax accounting.
- Management accounting is concerned equally with short-range and
long-range planning and uses highly sophisticated techniques like
sensitivity analysis, probability structures, etc., in the planning and
forecasting prices. Cost accounting is more concerned with short-term
planning. Evaluation of capital investment projects is the specialty of
management accountant.
- Management accounting is concerned with assisting management in its
functions, as well as evaluating the performance of the management as an
institution. Cost accounting is concerned merely with assisting in
management functions and does not provide for the evaluation of the
performance of management.
- Cost accounting is mostly historical in its approach, and it reflects the
past. Management accounting is futuristic in its approach. Management
accounting is more predictive in nature than cost accounting.
- Cost accounting system can be installed without management
accounting. While management accounting cannot be installed without a

Contents
proper cost accounting system. Also, there some differences between cost
accounting and management accounting can be summarized in the
following table:

cost accounting management accounting

The objective Measuring and Assisting in planning,
determining the cost of making decisions, solving
production and various administrative problems,
activities and to assist in and comparing between the
controlling and available alternatives
rationalizing costs.
The accounting is a fixed time (cost There are no restrictions on
period period) time (unspecified period)
The degree of is objective, for example is subjective and predictive
accuracy when counting inventory,

The nature of is historical Concerning the past,

the data present and future

1.10 Managerial accounting tools and techniques:

In fact, there is no agreed list of management accounting tools. The
continuous development in science is reflected in management
accounting tools and techniques, but several tools and techniques have
been used under management accounting to help management in
achieving the desired goals. For this the management accountant
normally uses the following tools and techniques:

1- Financial Planning: Financial planning is the process of deciding in

advance about the financial activities necessary for the organization to

Contents
achieve the desired objectives. It includes determining both long term and
short-term financial objectives, formulating financial policies and
developing the financial procedures etc. Financial policies may relate to
the determination of the capital requirement, sources of funds,
determination and distribution of income, use of debt and equity capital
and the determination of the optimum level of investment in various
areas.
2- Financial Statement Analysis: Financial statements are analyzed to
make data more meaningful. Comparative statement analysis, common
size statement analysis, trend analysis, ratio analysis, cash flow analysis
etc. are the major techniques of financial statement analysis used in
management accounting.

3- Decision Making: Management accounting helps the management

through the techniques of marginal costing, differential costing, capital
budgeting, cash flow analysis, discounted cash flow etc. to select the best
alternative which will maximize the profits or minimize the losses of the
business.

4- Control Techniques: Management should ensure that the plan

formulated by it has been translated into action. Standard costing and
budgetary control techniques are useful control techniques used by
management.
5- Statistical and Graphical Techniques: Management accountant uses
various statistical and graphical techniques to make the information more
meaningful and presentation of the same in such a form so that it may
help the management in decision making. The techniques of linear
programming, statistical quality control, investment chart, sales and
earning chart etc. are of vital use.

Contents
6- Reporting: Management accountant prepares the necessary reports for
providing information to the different levels of management by proper
selection of data to be presented, organizing data, or selecting the
appropriate method of reporting.

1.11 The Certified Management Accountant (CMA):

The management accountant who has professionally enrolled in the
IMA program is called a certified management accountant, and the
primary purpose of this program is to prepare the management accountant
to be successful in today’s complex and competitive world, and the
certified management accountant (who has special and professional
skills) should be considered in the future as an important member of the
management team, and to use effective decision-making skills to solve
problems, face challenges and contribute to the overall success of the
organization. The certified management accountant program focuses on
the dynamic role that the management accountant plays in the
contemporary business world. The program focuses on all aspects of
business, and a key principle which is effective decision-making.
It should be noted that managers in some developed countries such
as USA and England are looking for a certified management accountant
to fill the main positions in management accounting or financial
management positions in the organization, and this is due to the simple
reason that the certified management accountant is highly qualified and
has professional skills.
To obtain the title of a certified management accountant, one must
pass the certified management accountant exam in its various parts at the
Institute of certified Management Accountants, complete the experience
requirements for this, and above all be qualified to enter this exam. It
should be noted that some authorities in Egypt have started to organize

Contents
preparation and qualification courses to take the certified accountant
accountant’s exam, as well as have protocols with some concerned
authorities in this regard to conduct exams for the certified management
accountant.

Contents
 Chapter Two

Cost-Volume-Profit (CVP) Analysis

Learning Objectives:
After studying this chapter, you could be able to:
- know the nature, importance, objectives, and the main assumptions of
cost-volume-profit analysis.
- understand the concept of contribution margin and how to prepare
income statement based on contribution margin
- understand the break-even-point analysis and how use it for analyzing
the target net profit.
- know the different consideration in choosing a cost structure, and the
relationship between cost structure and profit stability.
- understand the concept of operating leverage and its effect on profit
stability
- understand cost-volume-profit analysis under sales mix.

Contents
Chapter Two: Cost-Volume-Profit (CVP) Analysis
2.1 Introduction:
The analysis of the relationship between cost, volume and profit
is one of the important tools that managers use. It helps them to
understand the interrelationships between cost, volume of activity and
profits of the organization by focusing on the interrelationships of the
following five elements:
1. The selling price of the product
2. The size of the activity level
3. Variable costs per unit
4. Total fixed costs
5. Mix of products sold

Because of this analysis helps managers to understand the

interrelationships between cost, volume, and profit, it is considered an
important factor when making decisions. These decisions include, for
example: what products to manufacture or sell, what pricing policies to
follow, marketing strategies to be applied, and types of Production
facilities that you buy. The idea of this analysis is common in managerial
accounting as it touches almost everything the manager knows, and due
to its usefulness, this analysis is undoubtedly one of the best tools for
discovering the reasons for changing profits in the organization.
One of the most important planning tasks in profit-oriented
enterprises is profit planning, this means estimating the volume of sales
that achieves the target profit from operation. To plane profit it is
required to know the relationship between costs, selling price, and sales
volume, also it is required to study the relationship between costs and
volume in production to know the cost elements that change with the
change in volume of production and they are called variable costs, and

Contents
the ones that do not change with the change in volume of production and
they are called fixed costs.
The importance of studying and analyzing the relationship between costs,
selling prices and sales volume refers to that these three variables are the
components of the profit equation, and therefore the expression (CVP) or
(Cost-Volume-Profit) is usually used to describe the process of analyzing
the data necessary for-profit planning.

The management accountant collects the necessary data on:

• The expected selling price per unit of the good or service during
the period that you plan its profitability.
• Elements and rates of variable costs per unit.
• Elements and levels of fixed costs and production capacity related
to each level.
• Management's estimate of target profits.

2.2 general equation for profit:

The data for the unit of the product (sales price and rate of variable costs)
are estimated for each type of goods, while the fixed costs and target
profits are estimated at the level of the firm as a whole.

The analysis of the relationship between costs, sales volume and profits

depends on the general equation for profitability, which is:

Profits = Total Revenues - Total Costs

where:
• Profit = (number of units x selling price) - (total variable costs +
total fixed costs)
• Profit = (number of units x selling price) – {(number of units x
variable costs per unit) + fixed costs}

Contents
 • Profit = number of units (selling price - variable costs per unit) +
fixed costs
• (Sale price - variable costs per unit): It is known as contribution
margin per unit.

2.3 Contribution Margin: As it is clear, the contribution margin per

unit is the difference between the selling price of the unit and its variable
cost, which contributes to cover fixed costs and achieve profits for the
firm, if possible.

2.4 Contribution Margin Ratio: It is possible to find the ratio of the

contribution margin for the unit to the ratio of the selling price of the unit.
This is known as the contribution margin rate or ratio, and it is calculated
as follows:

selling price−variable cost per unit

Contribution Margin Ratio=
selling peice
contripution margin per unit
Contribution Margin Ratio=
selling peice

Example: Yazid Company produces and sells the product X. If the

average rate of variable costs per unit is 39 EGP, and the selling price per
unit is 60 EGP.
Required: Calculate the following:
1. Contribution margin per unit?
2. Contribution margin ratio?
The solution:
1. Contribution margin = selling price - variable cost per unit
= 60 - 39 =21 EGP
This means that whenever the firm produces one unit of the product X, it
achieves a contribution margin of 21 EGP, and this margin contributes to
cover fixed costs and make a profit, if possible.

Contents
 selling price−variable cost per unit
2- Contribution Margin Ratio =
selling peice
60 −39
= = 35%
60
Also, the contribution margin ratio can be calculated as follows:

contripution margin per unit

Contribution Margin Ratio =
selling peice
21
= = 35%
60
The study of cost, volume and profit analysis is based on
studying the behavior of costs and the income statement on the basis of
contribution. The income statement on the basis of contribution has a
number of characteristics that help the manager when trying to evaluate
the impact of changing selling prices, cost or volume of activity on
profits. To clarify this, we present the following income statement for
"Al-Arabi" company, which produces household refrigerators:

Al-Arabi Company
Income statement for the month of October 2020

Total Per unit

Sales (400 Refrigerator) 100,000 250 EGP
- variable costs 60,000 150
Contribution margin 40,000 100
- fixed costs 35,000
Net income 5,000

For facilitating, we assume that Al-Arabi Company produces this type of

refrigerator only. Note that the company expresses its sales, variable

Contents
expenses, and contribution margin on the basis of the total unit, for the
purposes of internal use of management only, to facilitate - as you will
see - profitability analysis.

The contribution margin, as we have previously noted, is the residual

value of sales revenue after deducting the variable costs. Thus, the
contribution margin is equal to the residual value to cover fixed costs, and
then achieve profits for the period. Note the sequence here, the
contribution margin is used first to cover fixed costs and the rest is then
directed to profits. If the contribution margin is not sufficient to cover the
fixed costs, losses will be realized during the period. To clarify this,
suppose that in the middle of one of the months, the company was able to
sell only one refrigerator. At this point, the income statement is as
follows:

Total Per unit

Sales (1 Refrigerator) 250 250 EGP
- variable costs 150 150
Contribution margin 100 100
- fixed costs 35,000
Net income (34,900(

We note that each additional refrigerator that can be sold during

the month provides the company with a contribution margin of 100 EGP,
which helps to cover fixed expenses. (The total contribution margin will
be 200 EGP) and the company’s losses will be reduced by this value to
34,800 EGP as follows:

Contents
 Total Per unit
Sales (2 Refrigerators) 500 250 EGP
- variable costs 300 150
Contribution margin 200 100
- fixed costs 35,000
Net income (34,800(

2.5 Break-even point:

If it is possible to sell 350 refrigerators, a contribution margin of 35.000
EGP will be achieved, and therefore all the fixed costs have been
covered. At this point, the firm will have achieved “break even” in this
month, this means, the firm does not achieve any profits or losses, but
covers all its costs (variable and fixed). In order to reach the break-even
point, the company must sell 350 refrigerators per month, where each
refrigerator achieves 100 EGP a contribution margin.

Total Per unit

Sales (350x250) = 87,500 87,500 250 EGP
- variable costs 52,500 150
Contribution margin 35,000 100
- fixed costs 35,000
Net income Zero

The break-even point can be determined either as the point at

which the total sales revenue is equal to the total variable and fixed costs,
or it is the point at which the total contribution margin is equal to the
fixed expenses, and when the break-even point is reached the net income
will increase by the contribution margin per unit when each additional

Contents
unit is sold, for example, if 351 refrigerators are sold in a month, the net
income will be 100 EGP, since the company sold a refrigerator more than
the number needed to reach the break-even point; the income statement is
as follows:
Total Per unit
Sales (351x250) = 87,750 87,750 250 EGP
- variable costs 52,650 150
Contribution margin 35,100 100
- fixed costs 35,000
Net income 100

But if 352 refrigerators (2 refrigerators in excess of the break-even

point) are sold, then we can expect that the net income in this month will
be 200 EGP, and so on, and accordingly and in order to know what the
net profit will be at different levels of activity, it is not necessary for the
manager to prepare a complete series from the income statements, it
simply determines the number of units to be sold in excess of the break-
even point and multiplies this number by the unit contribution margin,
and the result represents the expected profit for this period. But if there is
a plan to increase sales, and the manager wants to know the impact of this
increase on profits, he multiplies the increase in the units sold by the
contribution margin per the unit, and the result will be an increase in
profits, so if the Al-Arabi company - for example - sells 400 refrigerators
and plans to increase sales to be 425 refrigerators during the month, the
impact of this on the profit will be as follows:
• Increase in sales 25 units
• Contribution margin per unit 100 EGP
• The increase in net income 2500 EGP

Contents
To make sure:
Unit sold DIF. Per
400 unit 425 unit 25 unit unit

Sales 100,000 106,250 6,250 250

- variable costs 60,000 63,750 3,750 150
Contribution margin 40,000 42,500 2,500 100
- fixed costs 35,000 35,000 Zero
Net income 5,000 7,500 2,500

We can Conclude that: the contribution margin covers first the fixed costs
of the organization, and it can also be said that with the achievement of
sales, the losses represented in the fixed costs will continually decrease
by the amount of the contribution margin per unit at each additional unit
sold, and when the break-even point is reached, the total net income will
increase by a margin Contribution per unit at each additional unit sold
over the previous one.

The revenues and variable costs and the contribution margin per unit in
Al-Arabi Company can be expressed in the form of a percentage as
follows:
Total Per unit Ratio
Sales (400 Refrigerator) 100,000 250 EGP 100%
- variable costs 60,000 150 60%
Contribution margin 40,000 100 40%
- fixed costs 35,000
Net income 5,000

Contents
The percentage of total contribution margin to total sales is known as
either the contribution margin ratio (CM ratio) or the profit / volume ratio
(P/V ratio), and this ratio is calculated as follows:

selling price−variable cost per unit

Contribution Margin Ratio = or
selling peice
contripution margin per unit
Contribution Margin Ratio = or
selling peice
sales−total variable cost
Contribution Margin Ratio = or
s ales
total contripution margin
Contribution Margin Ratio =
sales
For Al-Arabi Company, we calculate the contribution margin ratio as
follows:
total contripution margin
Contribution Margin Ratio =
sales
40,000
= = 40% or
100,000
contripution margin per unit
Contribution Margin Ratio =
selling peice
100
= = 40%
40
The contribution margin ratio is very useful, it shows the effect
on the contribution margin as a result of the change in the total value of
sales. For clarification, note that the contribution margin ratio for Al-
Arabi Company is 40%, which means that for every increase of one
pound in sales, the contribution margin increases by 40 piasters (1.00
pounds x 40%) and the net income also increases by 40 piasters
(assuming that there is no change in fixed costs).

That is, we can reach quickly to the effect of the change in total
sales on net income by multiplying the contribution margin ratio by the
value of the change in sales. If Al-Arabi Company plans to increase its

Contents
sales by 30,000 EGP in the next month, for example, it expects that the
contribution margin will increase for 12,000 EGP (30000 x 40%) and as
we noted above, the net income will increase by the same value if the
fixed costs do not change - and to prove this:

Unit sold
current expected Increase Ratio
Sales revenues 100,000 130,000 30,000 100%
- variable costs 60,000 78,000 18,000 60%
(130,000 x60%)

Contribution margin 40,000 52,000 12,000 40%

- fixed costs 35,000 35,000 Zero
Net income 5,000 17,000 12,000

Many managers find that the contribution margin ratio is easier to work
with than the contribution margin per unit, especially if the company has
many products, because the existence of any item in the form of a ratio
makes it easier to compare between products, and if all things remain as
they are, the manager will look for the product that gives the highest
contribution margin, and the reason - of course - is that the increase in
sales in value for this product will lead to a higher value for the
contribution margin to cover fixed costs and achieve profits.

2.6 Some Applications of CVP Concepts:

The concepts and relationships of cost, volume and profit can be
used in several applications in planning and decision-making, and we will
now continue our study by using the example of Al-Arabi Company (a
company for manufacturing home refrigerators) and the following is an

Contents
explanation of some of these applications, and the basic data of the
revenues and costs of this company are:

Per unit Ratio

Sales (400 Refrigerator) 250 EGP 100%
- variable costs 150 60%
Contribution margin 100 40%

The fixed costs amounted 35,000 EGP per month, and we will use this
data to show the impact of the change in variable costs, fixed costs,
selling price and production volume on the company's profitability.

2.6.1 Change in Fixed Costs and Sales Volume:

Suppose that Al-Arabi company now sells 400 refrigerators per
month (monthly sales are 100,000 EGP) and the sales manager thinks that
if the advertising budget is increased by 10,000 EGP, sales will increase
by 300,000 EGP. Is it in the company’s interest to increase the
advertising budget?
The solution
expected contribution margin (130,000 52,000
x40%)
current contribution margin (100,000 x40%) 40,000
Increase in Contribution margin 12,000
Less: change in fixed cost 10,000
Increase in net income 2,000

Based on the foregoing and assuming that the other factors in the
company remain as they are, it is useful for the company to increase the
advertising budget, because this will achieve an increase in sales and an

Contents
increase in net income than what the company was before by the amount
of 2,000 EGP.

Note: Since the change is only in fixed costs and sales volume, in this
case, the same result can be reached in another short way as follows:

Increase in Contribution margin 12,000

Less: change in advertising (fixed) cost 10,000
Increase in net income 2,000

We note that this approach (solution by an abbreviated way)

does not depend on knowing what sales were in the past, and we also note
that in both cases it is not necessary to make an income statement, but
both cases require a differential (Incremental) analysis because it takes
into account only the items of revenue, costs and volume of activity that
will change if the new proposal is implemented, and although in both
cases a new income statement can be made, the majority of managers
prefer differential analysis, and the reason for this is that it is easier and it
is direct and allows the decision maker to focus his attention on specific
items included in the decision.

2.6.2 Change in Variable Costs and Sales Volume:

Referring to the previous data, it is also assumed that Al-Arabi
now sells 400 refrigerators per month, and management intends to use
new, quality components in the refrigerators industry, which will increase
the value of variable costs (and then reduce the contribution margin) by
10 EGP per unit, and sales manager predicts that the increase in quality
will lead the company sells 480 refrigerators. Is it useful to the company
to use these components or not?

The increase in variable costs will lead to a decrease in the contribution

margin from 100 EGP to 90 EGP as follows:
Contents
 Expected contribution margin (480 x90) 43,200
current Contribution margin (400 x100) 40,000
Increase in New Contribution margin 3,200

Accordingly, it is useful to the company to use high-quality components

in manufacturing refrigerators, since as long as fixed costs will not
change, the net income increases by 3200 EGP.

2.6.3 Change in Fixed Cost, Sales Price, and Sales Volume:

Referring to the previous data, it was also assumed that Al-Arabi
Company currently sells 400 refrigerators per month, and in order to
increase the sales volume, it sees reducing the selling price of the
refrigerator by 20 EGP, and increasing the advertising budget by 15,000
EGP per month, and the management believes that if it takes these two
steps, units of sales will Increase by 50%. Assuming that you are the
management accountant at Al Arabi Company, do you agree to make
these changes?

A decrease of 20 EGP in the selling price of the refrigerator will lead to a

decrease in the contribution margin for the unit to become 80 EGP
instead of 100 pounds
Expected Contribution margin 48,000
(400 x150%x80)
Current contribution margin (400x100) 40,000
Increase in contribution margin 8,000
Less: change in fixed cost 15,000
Decrease in net income (7,000)

Based on the previous results, the company should not make these
adjustments, where this is not useful to the company, because the

Contents
company's net income will decrease as a result of these adjustments by
7,000 EGP.

This result can be confirmed by preparing a comparative income

statement as follows:
Current Expected
400 unit 600 unit
Total Per Total Per DIF.

unit unit
Sales (EGP) 100,000 250 138,000 230 38,000
- variable costs 60,000 150 90,000 150 30,000

Contribution margin 40,000 100 48,000 80 8,000

- fixed costs 35,000 50,000 15,000
Net income 5,000 (2,000) (7,000)

Note that: the answer is the same as it was in the differential analysis.

2.6.4 Change in Variable Cost, Fixed Cost, and Sales Volume:

Referring to the previous data and assuming that the company
currently produces 400 refrigerators per month, and the sales manager
sees the conversion of the salesmen to the commission system at 15 EGP
for the refrigerator instead of the fixed wage, which now totals 6000 EGP
per month, and he believes that this will increase the monthly sales by
15%, do you agree with the opinion of the sales manager or not?

The conversion of salesmen from the fixed wage system to the

commission system will affect both fixed and variable costs, so the fixed
costs will decrease by 6000 EGP, so it will become 29,000 EGP per
month instead of 35,000 EGP, and the variable costs per unit will increase

Contents
by 15 EGP to become 165 EGP instead of 150 EGP, and the total
contribution margin will decrease to become 85 EGP instead of 100 EGP.

Expected contribution margin 39,100

(400 x115%x85)
Current contribution margin (400x100) 40,000
Decrease in contribution margin (900)
Add: salaries saved as a result of the 6,000
commission system
Increase in net income 5,100

Based on the previous result, it is useful to the company to agree to the

opinion of the sales manager, because it will achieve an increase in net
income of 5100 EGP, and we can also confirm the same answer by
preparing a comparative income statement as follows:

Current Expected
400 unit 460 unit
Total Per Total Per DIF.

unit unit
Sales 100,000 250 115,000 250 15,000
- variable costs 60,000 150 75,900 165 15,900
Contribution margin 40,000 100 39,100 85 (900)
- fixed costs 35,000 29,000 6,000
Net income 5,000 10,100 5,100

2.6.5 Change in Sales Price:

Using the same previous data, suppose that the Al-Arabi
company currently sells 400 refrigerators per month, and there is a chance
Contents
to make a big deal and sell 150 refrigerators to a wholesaler if an
acceptable price can be given, and that this will not affect the normal
sales, what is the selling price of the refrigerator that the company offers
if it wants to increase its monthly profits by 3000 EGP?
variable costs for Refrigerator 150 EGP
Desired profit per unit (3000/150) 20
Expected price for Refrigerator 170

Note that, there is no item of fixed costs included in these calculations,

because the company's normal activity is over the break-even point and
fixed costs are covered. Therefore, the proposed price of the special offer
should increase enough to cover the variable costs of this offer to achieve
the desired contribution margin of 3000 EGP, and as it is previously clear
that the proposed price of 170 EGP consists of 150 EGP variable costs
per unit and 20 EGP contribution margin per unit.

The question that arises now is: If Al-Arabi company is making a

loss and not a profit, then how does the company calculate the prices of
new refrigerators?

Loss: It means that there is a part of the fixed costs that have not
been covered yet, and the prices of new refrigerators (150 refrigerators)
must be higher enough to cover all or part of these uncovered costs in
addition to the variable costs and the desired profit to be achieved as a
result of these sales.

To clarify this point, suppose that the company achieves a loss of 6000
EGP every month, and the company wants to convert this loss into a
profit of 3000 EGP per month. In this case, the proposed transaction price
is determined as follows:
Contents
 variable costs per Refrigerator 150 EGP
+ current loss (6000/150) 40
+ required profit (3000/150) 20
Expected price per Refrigerator 210

The new price of 210 EGP contains a big discount from the normal price
of 250 EGP per refrigerator, so both the wholesaler and the company will
benefit from this deal.
2.7 Importance of Contribution Margin:
The cost-volume-profit analysis looks for - as we mentioned at
the beginning of this chapter - the most profitable combination of variable
and fixed costs, selling price and sales volume, and the previous
examples showed that the effect of this on contribution margin is
considered as a factor in deciding the most profitable combination of
these factors m and we noticed that profits sometimes can be increased by
reducing the contribution margin if fixed costs can be reduced with a
large amount, also as we noticed that one of the ways to improve profits
is to increase the total contribution margin, and this can happen by
reducing the selling price, which leads to an increase in sales, and
sometimes this can be done by increasing fixed costs (such as
advertising) and then increase the volume of sales, and sometimes this is
done by compensating the fixed and variable costs and the change in the
appropriate sales volume, and there are many other combinations of these
factors.

The value of the contribution margin per unit (and the contribution
margin ratio) has a significant impact on the actions that the company
must take to improve profit, for example, the greater the contribution
margin for the product, the greater the value of what the company can

Contents
spend in order to increase the sales of this product a specific percentage,
and this explains why companies with high contribution margin per unit
spend (e.g. auto manufacturing companies) tend to spend more on
advertising, while companies with low contribution margin per unit (e.g.
household appliances manufacturing companies) tend to spend less on
advertising.

In brief, the contribution margin effect holds the keys of all cost and
revenue decisions in the company.

2.8 Break-even Analysis:

Cost, volume, and profit analysis may sometimes be referred to
simply as break-even analysis, and this is not entirely correct because
break-even analysis is a part of the overall concept of cost-volume-profit
analysis. However, break-even analysis is an important part that makes
the manager goes deep into the data he uses. To simplify and facilitate, it
will continue to use the same data as the past example of Al-Arabi
Company, where the selling price of the unit is 250 EGP per refrigerator,
the variable costs are 150 EGP per refrigerator, and the total fixed costs
are 35,000 EGP, so how does the company calculate break-even point?

2.8.1 Break-even Computation:

As we mentioned earlier, the break-even point is the point which
the total sales revenue equals the total variable and fixed costs, or it is the
point which the total contribution margin equals the total fixed costs. The
break-even point can be calculated by two methods are (1) equation
method and (2) the unit contribution method.

2.8.1.1 The Equation Method:

When calculating the break-even point by the equation method, it
focuses on the contribution approach of the income statement, which was

Contents
previously explained in this chapter. The income statement according to
contribution approach can take the form of an equation as follows:

Profits = Sales - (variable costs + fixed costs(

Or Sales = variable costs + fixed costs + Profits
At the break-even point, the profits are zero. Therefore, the
break-even point is calculated by taking a point when sales equal to the
total of fixed and variable costs. For Al-Arabi Company, the break-even
point is calculated as follows:
Sales = variable costs + fixed costs + Profits
250 * X = (150 * X) + 35,000 + zero
(250- 150) * X = 35,000
100 * X = 35,000
X = 35000/ 100
X = 350 Unit

So: The break-even point for Al-Arabi Company is 350 refrigerators,

meaning that at the level of production and sale of 350 refrigerators, Al-
Arabi Company does not realize any profits or losses.
Where:
• x = break-even point in units (refrigerator)
• 250 = selling price per refrigerator
• 150 = variable cost per unit (refrigerator)
• 35,000 = total fixed costs

After calculating the break-even point in units sold, the break-even point
can be calculated in value (in EGP) by multiplying the number of break-
even units by the selling price per unit (250 EGP):

Break-even point in value = 350 refrigerators x 250 EGP = 87,500 EGP

Contents
In the case of knowing the relative relationship between variable costs
and sales, the break-even point can be calculated as follows:

Sales = variable costs + fixed costs + Profits

X = 0.60 X + 35,000 EGP + zero
0.4X = 35000 EGP
X = (35000 EGP) / (0.4) = 87500 EGP
where:
• X = break-even point in value (in EGP)
• 0.6X = variable costs as a percentage of sales
• 35,000 EGP = total fixed costs

Usually, companies have the data in the form of ratios, so the last method
is used to find the break-even value. Note that existence of the percentage
in the equation produces the break-even point in EGP instead of units,
and the break-even point in units can be determined as follows:
Break-even point in value (in EGP) ÷ selling price per unit
78,500 EGP ÷ 250 EGP = 350 refrigerators

2.8.1.2 The Unit Contribution Method:

The unit contribution method is just another form of the equation
method previously explained, and it focuses on the idea that we explained
that each unit sold produces a certain amount of contribution margin,
which covers fixed costs, and in order to find the number of units that
must be sold to achieve break-even, we divide the total fixed costs by the
contribution margin per unit.

𝒇𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕
𝐁𝐫𝐞𝐚𝐤 − 𝐞𝐯𝐞𝐧 𝐩𝐨𝐢𝐧𝐭 (𝐢𝐧 𝐮𝐧𝐢𝐭𝐬) =
𝐜𝐨𝐧𝐭𝐫𝐨𝐛𝐮𝐭𝐢𝐨𝐧 𝐦𝐚𝐫𝐠𝐢𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭

Contents
 since each refrigerator sold achieves a contribution margin of 100
EGP (250 EGP selling price -150 EGP variable costs), and the total fixed
expenses 35,000 EGP, the break-even point for Al-Arabi is as follows:
Break-even point (in units) = fixed costs / contribution margin per unit
=35000/100
= 350 units (refrigerators)
The break-even point can be calculated in value (in EGP) by
multiplying the number of break-even units x the selling price as follows:
Break-even point in value = 350 x 250 = 87,500 EGP
The break-even point can be calculated in value with knowledge the
contribution margin ratio and fixed costs, as follows:
Break-even point in value = fixed costs / contribution margin ratio
= 35,000/40%
=87,500 EGP
This method is useful in analyzing the break-even when the
company produces and sells several products and wants to calculate one
break-even point for the whole company, and this will be discussed in
detail later when discussing the concept of sales combination (sales mix).
2.9 CVP Relationship in Graphic Form:
The data of Al-Arabi company that sells refrigerators can be
expressed in graphic form by graphing the cost, volume and profit, and
this representation can be very useful to clarify the relationship over a
wide range of activity, and this graphing is sometimes called the Break-
Event map and that is true as long as this graphing clearly shows the
break-even point, and the reader should note that the graphing of cost,
volume and profit shows the relationship between them over the entire
appropriate range and not at the break-even point.

Contents
2.9.1 Presenting the CVP Graphic From:
The process of graphing cost, volume, and profit includes three steps as
shown on Figure 2-1:
1- Draw a line parallel to the volume axis, representing the total
fixed costs. For Al-Arabi Company, the total fixed costs are
35,000 EGP.
2- Determine a sales volume and put a point showing the total
costs (fixed and variable) at the level of activity you have
chosen, in Figure 1-2 the sales volume has been determined
for 600 refrigerators, and the total costs at this volume are as
follows:

Variable costs (600 x 150) 90,000 EGP

Fixed cost 35,000
Total costs 125,000

After placing the point, draw a line showing this point and the point of
fixed costs on the vertical axis.
3- Once again, determine a sales volume and put the total sales
points at the determined sales volume. In Figure 1-2, the
volume of 600 refrigerators is determined, and the sales value
is 150,000 EGP (600 refrigerators x 250 EGP), then draw a
line connecting this point to the point of origin.

Contents
 The translation of the full form into graphing of cost, volume
and profit is shown on Figure (2-2), and the profit or loss of any
level is measured by the vertical distance between the line of total
revenue (sales) and the line of total cost (variable costs and fixed
costs), and the break-even point is at the intersection of the line of
total revenue with the line of total costs, and the break-even point
for Al-Arabi is 350 refrigerators in Figure (2-2), which equals
what has been mathematically arrived at as we mentioned before.

Contents
2.10 Target net profit analysis:
The cost, volume and profit equations can be used to determine the
sales volume required to achieve a target net profit, assuming that Al-
Arabi Company wants to achieve a target net profit of EGP 40,000 per
month. How many refrigerators should it sell?
2.10.1 The CPV Equation:
One of the ways to answer the previous question is by using the
equation of cost, volume and profit, where the profit target can be added
to the basic data of the equation, and the solution will indicate the level of
sales required to cover all costs and achieve the target profit.
Sales = Variable costs + Fixed costs + Profit
250 * X = 150 * X + 35,000 + 40,000

Contents
 100 X = 35,000 + 40,000
X = 75,000 / 100 = 750 refrigerators
Where:
X = number of refrigerators sold
250 = selling price per refrigerator
35,000 = fixed costs
150 = variable cost per unit
40,000= target profit
Accordingly, the target net profit can be achieved by selling 750
refrigerators each month, which represents sales of 18,7500 EGP (750
refrigerators x 250 EGP)
2.10.2 The Unit Contribution Approach:
The second approach is an expansion of the unit contribution
equation, including the target profit. According to this approach, the
number of refrigerators required to achieve a profit of 40,000 EGP is
determined as follows:
fixed cost + target profit
units to achieve target profit =
contribution margin per unit

35,000+40,000
refrigerators number to attain 40,000 =
100
= 750 𝒓𝒆𝒇𝒓𝒊𝒈𝒆𝒓𝒂𝒕𝒐𝒓𝒔
This approach is easier and direct than using the equation of cost,
volume and profit, moreover, it clearly shows that as long as the fixed
costs have been covered, the contribution margin per unit is involved in
achieving the required profit.

Contents
2.11 Safety Margin (SM):
The safety margin can be defined as the increase in actual sales
over break-even sales, where the safety margin determines the amount
that sales can decrease before the company makes losses,
The safety margin calculated as follows:
Safety Margin = total sales - breakeven sales
Table (2-6) illustrates the calculation of the safety margin for the
two companies Al-Esraa and Zamzam. Note that the sales of the two
companies in this figure are equal, as well as the net income, but the Al-
Esraa company has a safety margin of 40,000 EGP, while the safety
margin of Zamzam is only 20,000 EGP, and the difference in the safety
margin refers to the cost structure of each company is different, where the
fixed costs increase in Zamzam Company and therefore it can achieve
losses faster than if Al-Esraa Company decreases sales; As we explained,
the decrease in sales by 2,000 EGP leads Zamzam Company to the break-
even point, while the Al-Esraa Company reaches the break-even point if
sales decreased by 4,000 EGP. The safety margin can be calculated in the
form of a percentage by dividing the safety margin by the total sales:
Safety Margin Ratio = (Safety Margin) / (Total Sales)
Table (2-6) includes this ratio for both companies, and the safety
margin can be expressed in the form of product units (if the company
produces only one product) by dividing the safety margin for the
company by the selling price per unit.

Contents
 Table (2-6): Safety margin
Al-Esraa Company Zamzam Company
Value % Value %
Sales 200,000 100 200,000 100
- variable costs 150,000 75 100,000 50
Contribution margin 50,000 25 100,000 50
- fixed costs 40,000 90,000
Net income 10,000 10,000
Break-Even Point 160,000 180,000
(40,000/25%) (90,000/50%)
Safety Margin 40,000 20,000
(200,000-160,000) (200,000-180,000)
Safety Margin Ratio 20% 10%
(40,000/200,000) (20,000/200,000)

But the question now is: What does the management do if the
safety margin is low as in Zamzam Company? There is no comprehensive
answer to this question other than that management should direct its
efforts towards decreasing the break-even point or increasing total sales
volume. In brief, the safety margin is a tool that draws attention to the
existence of a problem and the solution is to analyze the cost structure
using the cost and volume methods referred to in this chapter.
2.12 CVP Considerations in Choosing a Cost Structure:
The cost structure refers to the relative distribution of fixed costs
and variable costs in the organization and the organizations can
compensate for fixed costs with variable costs in the case of the trend
towards the use of automatic machines (automation) instead of using
direct labor, for example.

Contents
 In the following, we will study the various considerations to test
the cost structure, and we will first study the cost structure and the
stability of profits, then discuss the impact of the cost structure according
to an important concept called operating leverage, then compare capital-
intensive companies and labor-intensive companies from the viewpoint of
risks and return inherent in the cost structure of each other.
2.12.1 Cost Structure and Profit Stability:
What is the best cost structure when the manager is free to
compensate for fixed costs with variable costs? which variable costs are
high and which fixed costs are law, or vice versa? There is no unified
answer to this question, but it can be said that there are advantages for
each direction based on certain circumstances, and to clarify this we refer
to the income statements of Company X and Company Y below. Note
that, each of the two companies has a very different cost structure,
Company X has high variable costs and law fixed costs , and for the
company Y the opposite:
X Company Y Company
Value % Value %
Sales 100,000 100 100,000 100
- variable costs 60,000 60 30,000 30
Contribution margin 40,000 40 70,000 70
- fixed costs 30,000 60,000
Net income 10,000 10,000

The question is which of the two companies has a better cost

structure than the other?
The answer to this question depends on several factors, including
the long-term trend of sales, fluctuations in the level of sales from year to
year, and management’s tendency to take risks. The contribution margin
is higher and the profits will increase at a faster rate with the increase in
Contents
sales. To clarify this, we suppose that both companies expect a 10%
increase in sales, so the income statement becomes as follows:

X Company Y Company
Value % Value %
Sales 110,000 100 110,000 100
- variable costs 66,000 60 33,000 30
Contribution margin 44,000 40 77,000 70
- fixed costs 30,000 60,000
Net income 14,000 17,000

As we expected, despite the same increase in sales in the two

companies, Company Y achieved greater profits as a result of the increase
in its contribution margin.
But what would be the situation if the sales value (100,000 EGP)
represented the maximum limit for both companies? What happens if
sales drop below 10,000 EGP from time to time? In these circumstances,
the cost structure in Company X is better, and this refers to two reasons,
the first is that Company X does not lose the contribution margin as
quickly as Company Y if sales decrease due to the low percentage of the
contribution margin. Therefore, the net income of Company X appears
more stable than Company Y, the second reason is that Company X has
lower fixed costs and therefore will not make losses as quickly as (Y) if
sales drop too much.
But if sales fluctuate between a high and a low period, it is difficult
to say which of the two companies has a better cost structure.
In brief, Company Y will face rapid changes in net income if sales
change, it will achieve more profits in the good years and greater losses in
the bad years, and Company X will enjoy greater stability in net income,
Contents
but it will lose profits that could have been achieved in the case of an
increase in the volume of sales in the long term.
2.12.2 Operating Leverage:
Scientifically, leverage means the possibility of lifting something
big with a small force. For a manager, leverage means greater profits as a
result of a small increase in sales and/or assets. One of these levers that
managers use is called operating lever.
Operating leverage represents a measure of the degree to which the
organization uses fixed costs, which is higher for companies with a higher
percentage of fixed costs compared to variable costs, and on the contrary,
it is lower in companies with a low percentage of fixed costs compared to
variable costs. If the company has a high operating leverage (it has a
higher percentage of fixed costs compared to variable costs), profits are
highly sensitive to changes in sales, and any small increase (or decrease)
will lead to an increase or decrease in profits by a high percentage.
The operating leverage can be clarified by referring to the data of
the two previous companies, X, Y. Company Y has a high percentage of
fixed costs (relative to variable costs) in contrast to X, and although the
total costs are the same in the two companies at a sales level of 100,000
EGP, we note that only a 10% increase in Sales (from 100,000 EGP to
110,000 EGP for both companies) led to an increase in the net income of
company Y by 70% (from 10.00 EGP to 17,000 EGP), while it increased
in company S by only 40% (from 10,000 EGP to 14,000 EGP), so
Company Y achieved Increase in profits by a higher percentage compared
to Company X and the reason for this is that Company Y has higher
operating leverage because of the greater value of fixed costs.
The degree of operating leverage for the company can be measured
at a certain level of sales by the following equation:

Contents
 Operating Leverage Degree = (Contribution Margin) / (Net
Income)
The degree of operating leverage is considered a measure - at a
certain level of sales - of how profits are affected as a result of the change
in sales by a certain percentage. To clarify that, the degree of operating
leverage Company X and Company Y at sales level 100,000 EGP is as
follows:
X company = 40,000 / 10,000 = 4 degree
Y company = 70,000 / 10,000 = 7 degree
This ratio tells us that when the level of sales changes by a certain
percentage, we can expect the impact of this change by four times greater
than the income of company X and seven times in the income of
company Y, and accordingly, if sales increase by 10%, we can expect that
the net income of company X will multiply four times or by 40%, and the
net income of Company Y will multiply seven times, or by 70%.
Increasing in Degree of Increasing in net
sales % operating leverage income %
)1 ( )2 ( 1x2
X Company 10% 4 40%
Y Company 10% 7 70%

These calculations explain why a 10% increase in sales led to an

increase in the net income of Company (X) from 10,000 EGP to 14,000
EGP (an increase of 40%) and Company (Y) from 10,000 EGP to 17,000
EGP (an increase of 70%).
The degree of operating leverage is greater at a level of sales close
to the break-even point and decreases as sales and profits increase. The
following table shows that for Company X:

Contents
Sales 75,000 80,000 100,000 150,000 225,000
- variable costs 45,000 48,000 60,000 90,000 135,000
Contribution margin (a) 30,000 32,000 40,000 60,000 90,000
- fixed costs 30,000 30,000 30,000 30,000 30,000
Net income (b) zero 2,000 10,000 30,000 60,000
Degree of operating ∞ 16 4 2 1.5
leverage (a / b)

Therefore, a 10% increase in sales will lead to a profit increase of

only 15% (10% x 1.5) if the company operates at a sales level of 225,000
EGP compared to 40% when it was operating at a sales level of 100,000
EGP and the degree of operating leverage continues to decrease as the
company continues to move away from the break-even point, and the
degree of operating leverage is infinitely high at the break-even point
(30,000 EGP (contribution margin) ÷ zero (net income) = ∞.
The concept of operating leverage provides a tool for managers to
quickly indicate the effect of a percentage change in sales on profit
without the need to prepare detailed income statements. As is clear in the
previous examples, the effect of operating leverage may be dramatic.
Sales may lead to a significant increase in profits, and this explains why
the management works with great diligence to achieve a small increase in
the volume of sales. If the degree of operating leverage is 5% and sales
increase by 6%, then profits increase by 30%.
2.12.3 Automation: Risks and benefits from a CVP Perspective:
It is noted that the move towards a flexible production system and
other uses of automation led to a trend towards an increase in fixed costs
than variable costs in organizations. This change in the cost structure had
a significant impact on the contribution margin ratio for the product and
the break-even point on other factors of the relationship of cost, volume
Contents
 and profit in automated organizations. Some of these effects are positive
and others are not, as shown in Figure 2-7:
The comparison here is between two companies operating in the
same industry and producing similar products in the same market, one of
them is capital intensive and the other labor intensive.
Item capital working Notes
intensive intensive
companies companies
The contribution margin ratio High Low Variable costs in an automated
for the product tends to be company tend to be lower than in a
relatively labor-intensive company and
therefore CM is higher
Operating leverage tends to be High Low As long as the leverage is the measure
of the use of fixed costs in the
organization, it will necessarily be
high in the automated company
During periods of increased quickly slowly As long as the leverage, and the CM
sales, net income tends to ratio tends to increase in the
increase automated process, net income
increases rapidly after the break-even
point is reached.
In periods of low sales, net quickly slowly quickly in automated after the break-
income tends to decrease even point and therefore net income
decreases rapidly due to decrease of
sales
The rate at which net income High Low As a result of higher operating
decreases with the change in leverage, net income in the case of
sales automation is more sensitive to the
change in sales than in the case of
labor intensive
The break-even point tends to High Low The break-even point in automated
be companies tends to be higher due to

Contents
 Item capital working Notes
intensive intensive
companies companies
increase of fixed costs
Freedom of movement for Low High Due to the increase in fixed costs in
management in periods of automation, management is
economic depression tends to constrained and has few tests in
be downturns
The degree of risk associated High Low The risk factor is considered the sum
with operating activities is of all the other factors mentioned
above

Figure 2.7 Comparison of cost, volume, and profit in capital-

intensive (automation) and labor-intensive firms
There can be many benefits from automation, but as shown in the
figure 2-7 , there are risks arising from the trend towards increasing the
value of fixed costs, and these risks require management to ensure that
investment decisions are made in line with a conscious strategy for long-
term operation.
2.12.4 Structuring Sales Commissions:
Companies usually reward salesmen by either giving them a
commission based on the value of sales, or fixed salaries in addition to
the commission, and the commission on sales may lead to a decrease in
the company’s profits. To clarify this, suppose that the company
manufactures product A and product B, as shown in the following:
Product A Product B
Selling price 100 150
- variable costs 75 132
Contribution margin 25 18

Contents
Which of the two products would the salesmen most strongly promote if
they were to receive 10% of the commission from the sales revenue?
The answer is product B, since its selling price is higher, and on the other
hand and from the view point of the company (assuming stability of other
factors) will the profits be greater if the salesmen direct consumers to
product A or to product B? The answer in this case is product A, because
it gives a higher contribution margin.
To exclude such this conflict, some companies pay the commission
based on the contribution margin, and the reason is as follows:
Since the contribution margin represents the value from sales
revenue that goes to cover fixed costs and profit, the company will be in a
better position as long as the contribution margin is more, and by linking
the salesmen’s commission to the contribution margin, this will
automatically encourage the salesmen to focus on the product of greater
importance to the company. Hence, there is no need for the management
to think about products combination (mix) because they will
automatically sell the combination that maximizes the basis on which
their commissions are calculated. In fact, maximizing their interests is
maximizing the interests of the company.
It should be noted that some companies subtract the value of travel
and other costs from the contribution margin generated by the salesmen,
and this encourages the salesmen to pay attention to their costs when
selling.
2.13 The Concept of Sales Mix:
One of the principles underlying cost, volume, and profit analysis
is that if a company has more than one product, the mix of products must
remain unchanged. Now it is useful to discuss one of the applications of
the ideas which is the use of cost-volume-profit relationships in the
analysis of the sales mix.

Contents
2.13.1 Definition of Sales Mix:
The term sales mix means the relative combination of products
sold by the company. Managers try to determine the combination or mix
that achieves the highest profit. Most companies produce several
products, and usually these products are not equal in terms of
profitability. As long as this is true, the profits will depend on the
combination (mix) of sales that the company is trying to sell, and the
profits increase if the products that give the highest contribution margin
represent a large percentage of the total sales , and vice versa when the
sales consist of products with the lowest contribution margin.
Changing the sales mix may be in favor of the company’s profits,
or sometimes vice versa, and switching from a sales mix that achieves a
high contribution margin to a mix that achieves a low contribution margin
may lead to a decrease in the company’s total profits although the total
sales may increase, and accordingly, the shift from a mix that achieves a
contribution margin low to another that achieves a higher contribution
margin may - on the contrary - lead to an increase in profits, although the
total amount of sales may decrease, so if we take into account the
possibility of these changes in profit, one of the measures of the
efficiency of the sales of the company is the combination or mix of sales
that they can achieve, What matters is not achieving a certain volume of
sales, but rather selling the most profitable combination of products.
2.13.2 Sales Mix and Break-even Analysis:
If the company sells more than one product, the break-even
analysis will be somewhat more complicated than what we studied
previously, and the reason for this is that different products are sold at
different prices, at different costs, and with different contribution
margins, so the break-even point will depend on the mix in which the
different products are sold. For clarity, we assume that the company has

Contents
two products (A) and (B) and that the sales, costs, and the break-even
point in 2020 are as shown in Figure 2-8.
Figure 2-8
Product A Product B Total
Value % Value % Value %
Sales 20,000 100 80,000 100 100,000 100
- variable costs 15,000 75 40,000 50 55,000 55

Contribution margin 5,000 25 40,000 50 45,000 45

- fixed costs 27,000
Net income 18,000

Break-even point in value = fixed costs / contribution margin ratio

= 27,000 / 45% = 60,000 EGP
As shown in the figure 2-8, the break-even point is sales of 60.000
EGP, and this is calculated by dividing the fixed costs by the contribution
margin ratio for the company as a whole 45%, and the break-even point
remains at sales of 60.000 EGP only as long as the sales mix has not
changed. If the sales mix changes, the break-even point will change.
To clarify So we assume that in the following year 2021 the
company changed the sales mix by reducing the sales of product (B) the
most profitable (contribution margin ratio 50%) to product (A) profit
margin ratio of 25%) and assuming that the value of total sales is the
same as shown in Figure 9-2.

Contents
 Figure 9-2
Break-even point analysis of products after switching
from product B to product A.
Product A Product B Total
Value % Value % Value %
Sales 80,000 100 20,000 100 100,000 100
- variable costs 60,000 75 10,000 50 70,000 70
Contribution margin 20,000 25 10,000 50 30,000 30
- fixed costs 27,000
Net income 3,000

Break-even point in value = fixed costs / contribution margin ratio

= 27,000/30% = 90,000 EGP
Although the sales volume did not change by 100,000 EGP, the
sales mix only reflected what was the situation in Figure 2-8, with
increasing the sales volume of product A on account of product B. Note
that changing the sales mix led to a sharp decrease in the ratio of the total
contribution margin and the total profit than last year. The percentage of
the total contribution margin decreased from 45% in 2020 to 30% in
2021, and the net income decreased from 18,000 EGP to 3000 EGP, and
the break-even point is no longer at 60,000 EGP, where the company is
now achieving a lower contribution margin for each pound. It requires
more sales to cover the same value of fixed costs, so the break-even point
has increased from 60,000 EGP to 90,000 EGP of sales per year.
Therefore, when analyzing break-even, we should take into
account a specific thing related to the sales mix, which is that this mix
does not change. However, if the manager knows that the difference in
certain factors (consumer tastes, market share, etc.) can affect the mix
Sales, these factors must be taken into account when analyzing cost,

Contents
volume and profit, otherwise the manager's decisions will be made on the
basis of wrong factors or data.
2.13.3 Sales Mix and per unit contribution margin:
Sometimes the sales mix is measured on the basis of the average
contribution margin per unit. For clarity, we assume that the company
produces two products (X), (Y) and the sales of the two products were in
2020 and 2021, as shown in Figure (2-10(
Figure 2 -10
Contribution Units sold CM
Margin
Per unit 2020 2021 2020 2021
Product X 10 1000 2000 10000 20000
Product Y 6 3000 2000 18000 12000
Total 4000 4000 28000 32000

Average contribution margin per unit in 2020 = (28,000 EGP ÷

4,000 units) = 7 EGP
Average contribution margin per unit in 2021 = (32,000 EGP ÷
4,000 units) = 8 EGP
But the question is: What is the reason for the increase in the
average contribution margin per unit during the two years?
The answer is: The reason for the increase in the average
contribution margin per unit during the two years is the shift in the mix
towards the more profitable product (X), although the sales volume (in
units) has not changed, and both the total average contribution margin
and contribution margin per unit have changed because of the change in
the sales mix.

Contents
2.14 Limiting Assumptions in CVP Analysis:
There are some assumptions on which the cost, volume and profit
analysis is based, which must be taken into account when using cost,
volume and profit data: These assumptions are:
1. The behavior of both revenues and costs is linear over the entire
appropriate range, and economists may disagree with this view, as
they say that a change in volume will lead to changes in both
revenues and costs in such a way that the relationships are non-
linear.
2. The costs can be divided accurately into variable costs and fixed
costs
3. The sales mix should remain unchanged
4. The stock does not change, meaning that the number of units
produced is equal to the number of units sold.
5. The productivity and efficiency of workers and machines shall not
change within the appropriate extent.
6. The stability of the value of the monetary unit.

Review Problem: (CVP Relationships):

Toshiba Al-Arabi Company produces and sells telephone sets, and
the following is the company's income statement for the year 2020:
Total Per unit Ratio
Sales 1,200,000 60 EGP 100%
- variable costs 900,000 45 ?
Contribution margin 300,000 15 ?
- fixed costs 240,000
Net income 60,000
The management wants to obtain some data and information to make
some decisions related to improving profit. Assuming that you are a
management accountant in the company, you are asked the following:
Required:
Contents
1. Calculating the company’s contribution margin ratio
2. Calculating the break-even point of the company in units and in
value. Using the equation method.
3. Suppose that sales have increased by 4,000 EGP and that the
behavior patterns of costs have not changed, by how much does
the company's net income increase? (Use the contribution margin
ratio to illustrate the solution).
4. Referring to the original data, suppose that the company wants to
achieve a net profit for the coming year not less than 90,000 EGP.
How many units should the company sell to meet this goal?
5. With reference to the original data, calculate the safety margin
(SM) in value and as a ratio.
6. a) Calculate the degree of operating leverage of the company at
the current level of activity
b) Assuming that as a result of the central efforts of the sales
department, the ratio of sales increased by 8% for the following
year. What percentage of the increase in net profit do you expect?
Use the concept of operating leverage in the solution.
C) Prove your answer in (B) by preparing a new income statement
based on an 8% increase in sales.
7. In an attempt to increase sales and profits, the company is in the
process of using higher quality headphones, which will lead to an
increase in the variable costs per unit 3 EGP, and the company
will eliminate one of the quality monitors, who will be paid 3,000
EGP annually, and the sales manager expects that this will lead to
an increase in sales by 20%.
a - Assuming that these changes have been made, prepare an
income statement as a proposal for the next year. Show data as a
total, per unit, and as a percentage.

Contents
 b. Calculate the company's new break-even point with both value
and quantity, and use the unit contribution margin method.
c- Do you recommend making these changes?
The answer:
1- Contribution Margin Ratio = (Contribution Margin) / (Selling
Price)

= EGP 15 / EGP 60 = 25%

2- Calculating the break-even point in units and in value:
Variable costs Ratio = (Variable Expenses) / (Selling Price)
= 45 / 60 = 75%
Sales = variable costs + fixed costs + profit
60X = 45X + 240,000 + Zero
15X = 240,000
X= 16000 units (break-even point in units)
16,000 units x 60 EGP = 960,000 EGP (break-even point in
value)
The same results can be obtained in another way, as follows:
X = 0.75X + 240,000 + zero
0.25X = 240,000
X = 960,000 EGP Or
960000 ÷ 60 = 16,000 units
3- Calculating the increase in net income when sales increase by
400,000 EGP

- Increase in sales 400,000 EGP

- Contribution margin ratio x 25%
- The expected increase in the contribution margin is 100,000 EGP
Since the fixed costs are not expected to increase, the net profit increases
by 100,000 EGP when sales increase by 400,000 EGP.

Contents
 4- Calculate the number of units to be sold to achieve a net profit not
less than 90,000 EGP

First: Using the equation method:

Sales = Variable Expenses + Fixed Expenses + Profit
60X = 45X + 240,000 + 90,000
15X = 330,000
X= 330000/15 = 22,000 units
Second: Using the unit contribution method:
= (fixed costs + target profits) / (contribution margin per unit(
= = (90,000 + 270,000) / (15) = 22,000 Units
5- Calculate the safety margin:

Safety margin (in value) = total sales - break-even point

=120,000 – 960,000 = 240,000 EGP
Safety Margin Ratio = Safety Margin / Actual Sales
= 240,000 / 1,200,000 = 20%
6- a) Calculating the degree of operating leverage at the current level
of activity:

Degree of operating leverage = contribution margin / net income

= (300,000) / (600,000) = 5 degrees
b) Calculating the expected increase in net profit when an expected
increase in sales is estimated at 8%:
• The expected increase in sales is 8%.
• Operating leverage degree ×5
• Expected percentage increase in net profit 40%

C) The new income statement in case of an increase in sales by

8%: when sales increase by 8%

Contents
 Sales = 21,600 units (20,000 units x 108%) in the next year, and
the new income statement is as follows:
Total Per unit Ratio
Sales (21,600) 1,296,000 60 L.E 100%
- variable costs 972,000 45 75
Contribution margin 324,000 15 25
- fixed costs 240,000
Net income 84,000

Therefore, the expected profit in the next year is 84,000 EGP,

which represents an increase of 40% over the value of the profits of the
current year, which is 60,000 EGP.
Percentage of increase in profit = (60000 - 84000) / 60,000
= 24000 / 60000 = 40%
Note in the income statement that the increase in sales from 20,000
units to 21,600 units led to an increase in both sales and variable costs. A
common mistake is to forget the change in variable costs.
7- a) The income statement, assuming that the proposed changes are
made:

A 20% increase in sales will lead to the sale of 24,000 units (20000
units x 1.2 = 24,000 units)
Total Per unit Ratio
Sales (24000) 1,440,000 60 EGP 100%
- variable costs 1,152,000 48 80
Contribution margin 288,000 12 20
- fixed costs 210,000
Net income 78,000

Contents
 Variable costs per unit after the increase = 45 + 3 = 48 EGP
Fixed costs = 240000 - 30000 = 210,000 EGP
Note that the change in the variable costs per unit led to the change in the
contribution margin per unit and the change in the contribution margin
ratio
b- Calculate the new break-even point
New break-even point (in unit) = fixed costs / contribution margin per
unit
= 210,000 / 12 = 17,500 units
New Break-even Point (in value) = fixed costs / contribution Margin ratio
= 210,000/ 20% = 1,050,000 EGP
C - Yes, I recommend making the required changes, because these
changes will increase the company's net income from 60,000 EGP
currently to 78,000 EGP next year, although these changes will also lead
to a higher break-even point (17,500 units compared to the current 16,000
units) and thus the safety margin is greater.
Safety margin = total sales - breakeven sales
= 1,440,000 – 1,050,000 =390,000 EGP
And as it becomes clear from Requirement No. (5) above, the
company’s safety margin is 240,000 EGP. Therefore, several benefits are
realized as a result of the proposed changes. Therefore, we emphasize
once again on making the required changes.

Contents
2.15 Questions and applied cases:
2.15.1: Questions:
Q1: The analysis of cost, volume and profit is the result of the interaction
of several factors, what are these factors?
Q2: What is meant by the contribution margin ratio for the product? How
is it useful in planning the company's operations?
Q3: Company X and Company Y are two competing companies, and each
company sells one product in the same market at a selling price of
50 EGP per unit, and the variable costs are the same in the two
companies, which amount to 35 EGP per unit. Company X invented
a way to reduce variable costs 4 EGP per unit and decided to transfer
this reduction to customers in the form of a price reduction, and
although Company Y was not able to reduce its variable cost, it was
forced to reduce the price in order to remain competitive with
Company X. If each company sells 10,000 units annually, what is
the impact of this change on the profits of each company?
Q4: The direct way to decisions is to make a differential analysis based
on the available information. What is meant by differential analysis?
Q 5: The cost structure of Company (A) includes mostly variable costs,
while the cost structure of Company (B) includes costs that are
mostly fixed. Which of the two companies achieves a rapid increase
in profits in the case of increased sales?
Q6: What is meant by operating leverage?
Q7: Do you agree that a 10% reduction in the selling price of the product
will have the same effect on net income as a 10% increase in
variable costs? Why?
Q8: The change in fixed costs is much more important to the company
than the change in variable costs, “Do you agree, explain?
Q9: What is meant by the term "break-even point?"

Contents
Q10: List three approaches to analyze the break-even point, explain
briefly - how can each approach be made?
Q11: Why is the term break-even map misleading?
Q12: What is meant by the safety margin?
Q13: What is meant by the term "sales mix, explain its relationship with
the analysis of cost, volume, and profit, what are the assumptions
concerned with sales mix?
2.15.2: Applied Cases:
Case (1): The income statement of Yazid Company for the last year was
as follows:
Total Per unit
Sales 300,000 15 EGP
- variable costs 180,000 9
Contribution margin 120,000 6
- fixed costs 70,000
Net income 50,000

Required: Preparing a new income statement for the company for each
of the following cases: (Consider each case independent of the other)
1- Increasing sales volume by 15%
2- Reducing the selling price by 1.5 EGP per unit, and increasing
sales by 25%
3- An increase in the selling price by 1.5 EGP, an increase in fixed
costs by 20.00 EGP, and a decrease in the sales volume by 5%.
4- An increase in the selling price by 12%, an increase in variable
costs by .60 EGP per unit, and a decrease in the volume of sales
by 10%.

Contents
Case (2): Al-Roaa Company produces and sells tools for trips, and one of
the company’s products is a stove for trips sold at 50 EGP per unit, and
its variable cost is 32 EGP, and the fixed cost is 108,000 EGP per month.
Required:
1- Calculate the break-even point in terms of quantity and value.
2- If the variable cost per unit increases by a percentage from the
selling price, does this lead to an increase or decrease in the break-
even point? Why? (Assuming fixed costs remain constant).
3- The company currently sells 8000 stoves per month, and the sales
manager believes that reducing the selling price by 10% will lead
to an increase in sales volume by 25% per month. Required:
prepare two income statements one based on the current
conditions, and the other after the proposed changes with the
presentation of data in each of them on a total and unit basis.
4- Referring to the previous required (3), how many stoves must the
company sell at the new price in order to achieve a minimum profit
of 35,000 EGP per month?

Contents
 Chapter 3
Planning Budgets

Learning Objectives:
After studying this chapter, you could be able to:
-know the nature and concept of budget, and the advantages of budgeting.
- understand
- know the role of budget committee at budgeting.
- understand zero-based budgeting.
- how to prepare master budget and all sub-budgets.
- know the effect of some international aspects (such as inflation and
change in foreign currency exchange rate) in budgeting.

Contents
Chapter 3: Planning Budgets

3.1 Introduction:
This chapter focuses on budgets as a method of managerial
accounting in planning the profits of the organizations, as well as the
steps taken by organizations to achieve a certain desired level of profits.
Profit can be planed through preparing a set of planning budgets, which
are combined with each other to form an integrated plan for the company
known as the comprehensive budget. The data used in preparing the
comprehensive budget focuses heavily on the future rather than the past.

3.2 A historical look at the preparation of budgets:

The method of planning and control through budgets is one of the
oldest methods used. Prophet Yusuf (peace be upon him) prepared a
budget of wheat expected to be produced in Pharaonic Egypt, and in light
of this, trends and consumption volume were drawn during the years of
prosperity and drought.
In fact, accountants borrowed the term budgets from economists
from public finance studies. Originally, the word budget refers to the list
prepared by the state to estimate its revenues and expenditures. The word
“Budget” comes from the French word Baguette, which means a bag, as it
is in the initial stages of using budgets in The British Government, The
British Finance Minister was preparing budget estimates and presenting
them to the British Parliament in a leather bag. And based on this, these
estimates became known as Budget.
With the large organizations and complexity of management
problems as well as technological development and increasing
uncertainty, officials in organizations around the world began to use
budgets in the field of planning and control of the various aspects of the
activities of their organizations. It should be noted that in the early stages
Contents
of using budgets, they were estimated tables of what resources would be
required to implement a specific plan, and these tables were prepared on
the basis of experience and results achieved in the past.
The budgets passed through different stages of development in
their preparation, they began as we mentioned as tables to collect the
resources required to implement a specific program, then developed to
include schedules for the timing of program implementation, and then
developed so that they became used with standard costs, until they
reached that they became used as an effective tool that helps the
management in planning, controlling and coordinating the various
activities of the organization and it has become a manifestation of the
success of the organization at the present time.

3.3 Budget Definition:

A budget is defined as a detailed plan for obtaining and using
resources and others during a future period, and it represents a plan for
the future expressed in a quantitative manner. As for the process of
preparing budget is called “Budgeting”, and the process of using budget
in controlling over organization works is called “Budgetary”.

The Master Budget represents a summary of all aspects of the

company's activity, plans and objectives for the future. It sets goals for
sales, production, distribution and financing activities. It generally ends
with preparing a statement of budgeted net income and a statement of
budgeted cash flows. In short, it represents a comprehensive expression
of management's plans in the future and how to achieve these plans.

3.4 Personal Budget

It can be said that everyone prepares their own budget personally in some
way, however, many people who prepare and use budgets do not realize

Contents
that they do so, for example, the vast majority estimate the income they
receive during a period of time in the future and plan to spend on food,
clothing, housing, etc., and as a result of this planning, spending is
determined in the form of predetermined amounts. By taking these steps,
a person performs the budgeting process where:
(1) He makes an estimate of income
(2) He makes a plan for spending
(3) He restricts actual spending within the limits of the plan, and in
other situations some use estimates of income and spending to
predict what their financial position will be in the future, and this
budget may exist in the mind of the person only, however, it can
be said that there is a planning budget that includes plans for how
to obtain Resources and to expend them over a specified period of
time.

The budget in the commercial organizations has the same functions

as the budget that individuals prepare informally, but the budgets of the
organizations tend to be more detailed and require a lot of work (because
they take the formal form), but they are similar to the budgets prepared by
individuals in most ways, and like personal budgets, they help On
planning and controlling costs, it also helps in forecasting activity results
and financial position for future periods.

3.5 Difference between planning and control:

The terms planning and control usually cause some confusion, as
they may be used and have the same meaning, and in fact, each of them
has a different meaning. Planning includes setting future goals and
preparing different budgets to achieve these goals, while control includes
the steps that the management takes to ensure the achievement and
implementation of the predetermined objectives in the planning stage, and
Contents
to ensure that all functions are in line with the organization’s policies. An
effective system of planning budget serves both functions of planning and
control. Good planning without effective control is a waste of time. On
the other hand, without making plans in advance, there will be objectives
to which the control is directed.

3.6 Advantages of Budgeting:

Managers who have not experienced the budget and did not realize
its benefits are quick to say that preparing the budget is a waste of time,
and they may argue that even if the budget is useful in some situations, it
is not useful in their companies because of the complexity of the
operations in them and the high degree of uncertainty surrounding them.
In fact, managers who argue in this way are usually deeply involved in
planning (on an informal basis), and they must formulate their ideas about
what they want to achieve and when. The difficulty arises from if they do
not find a way to share ideas and plans with others, the only possibility
that their companies achieve their goals is chance. In short, if the
enterprise achieves a degree of success without a budget, this success is
not as what the company would have achieved if it had achieved
consistency and synergy through the planning budget.

Perhaps one of the advantages of budget preparation is that it

makes the manager puts planning in the priorities of his work, and
moreover, preparing the budget provides a means for communicating
their plans by a systematic method to all parts of the organization. If the
budget is used, there will be no doubt about what managers want to
achieve and what they are required to accomplish. There are other
advantages and benefits of budgeting are:
1. They provide managers with a way to formalize their planning
efforts.

Contents
 2. It provides managers with a method for setting their goals, which is
used as a criterion for performance evaluation later.
3. It reveals potential or expected bottlenecks before they occur.
4. It works on coordinating the activities of the whole organization
through the integration and consistency of the objectives and plans
of the different departments. Thus, the preparation of the budget
confirms that the plans and policies of the departments must be
consistent with the general objectives of the organization.

In the past, if some managers had failed to prepare and implement

the budget because of the time and costs of this process, then it is
answered that this process may actually be free since it leads to an
increase in the efficiency of profits.

Also, the presence of some computer programs enabled every large

or small company to prepare and implement the planning budget at lower
costs, especially since these programs are available in any
microcomputer.

3.7 Responsibility Accounting

The basic idea of Responsibility Accounting is that a manager's
performance should be judged in light of how he manages the items under
his direct control. To judge the performance of the manager, costs and
revenues must be carefully classified according to the levels of
management having the control over costs. Also, each manager at each
level bears any deviations between the budgeted goals and the actual
results. In fact, responsibility accounting leads to linking accounting
information to people by looking at costs from the viewpoint of personal
control and not from the viewpoint of the organization as a whole.
Around this concept, any actual profit planning and control system
revolves.
Contents
 The idea can be summarized in general in three hypotheses, the
first is that costs can be classified according to the levels of management
responsibility, the second hypothesis that the costs that are incurred at a
certain management level are those that are subject to its control, the third
hypothesis is that it is possible to obtain effective budget data that
represents a basis for evaluating Actual performance, and in this chapter
we will explain and present the steps for preparing the budget.

3.8 Choosing a Budget Period:

Budgets for the acquisition of land, buildings, and other items
(usually called capital budgets) cover a long period of time in the future
that may reach 30 years or more, and the last years covered by these
budgets are not specified, and the long time period is necessary to help
Managers to plan, and to ensure that funds are available when acquisition
of these assets becomes necessary, and over time plans for capital assets,
which were not specified, become clearer and thus budget data is
updated, and without such long-term planning, the organization may find
that it is in dire need of asset acquisition, but it does not have enough
funding for that.

As for operating budgets, they are usually prepared to cover a

period of one year, and this year must be in line with the company’s
financial year so that budget data can be compared with actual
performance data. Most companies divide the budget year into four
quarters, and the first quarter is divided into months and the value of the
budget that covers a short-term period is usually more accurate. The
budget values for the remaining three quarters, they are shown in total
only. As the year progresses, the estimates of the second quarter are
divided into months, and so on. This method is characterized by that it
leads to the continuous review and evaluation of budget data.

Contents
 Continuous or perpetual budget has become quite common, and it
covers a period of 12 months, which continuously adds a new month or a
new quarter at the end whenever a month or quarter of the year elapses.
Supporters of the continuous budget believe that this method is superior
to other, as it makes the management think and plan for 12 months, and
thus stabilizes the planning time range, and under other budget systems,
the planning time period becomes shorter as the days of the year pass.

3.9 The self-imposed budget: The success of any budget program

depends on the way the budget is prepared. In general, the most
successful programs are those that allow managers responsible for
controlling and controlling costs to set their budget estimates, as shown in
Figure 3-1. This approach in preparing the budget is of particular
importance if the budget is used to evaluate the manager's activities after
its preparation. If the budget is imposed on the manager from above, it
may lead to resentment and opposition to him instead of cooperation and
increased productivity. When managers set their own budget estimates,
this budget is considered self-budget in nature, and many advantages
arise as a result of self-budget (sometimes called participative budget) as
follows:
1. All individuals at different levels are considered a member of the
team, whose opinions and judgments are evaluated by the senior
management.
2. The person with direct contact with the activity is in a better
position when preparing budget values, and therefore budget
estimates prepared in this way tend to be more accurate and
reliable.

Contents
 3. A person is more interested in achieving the budget that he
participated in setting than the budget that is imposed on him from
above.
4. Self-budget includes its unique system of oversight in that people
who do not achieve the goals of the budget can only blame
themselves, and on the other hand, if the budget is imposed on
them from above, they can say that this budget is illogical or
unrealistic, which leads to the impossibility of their application.

When the self-budget was prepared, is it subject to any review?

The answer is yes, although the preparation of individuals for budget
estimates is an important matter for the success of the program, the
preparation of these estimates is not taken at all without reviewing the
higher management levels. If there is no such review, the budget will be
very loose and allow a lot of freedom for activities, and the result will be
a lack of efficiency and an increase in waste and extravagance, so before
approving the budget, it must be reviewed directly by the officials. If it
appears that there is a need to modify some of the original items of the
budget, these items should be discussed to reach a situation acceptable to
both parties. The following figure (3-1) shows Initial flow of budget data

Contents
 It is noted that the initial flow of budget data arises from the lowest
level of responsibility to the higher levels of responsibility, and each
person responsible for cost control prepares his own estimates and raises
them to the top level.

All organizational levels must work together to prepare the budget,

and since the top management does not care about the details of the day-
to-day business, so they depend on their assistants in preparing the
detailed budget information, and on the other hand, the top management
represents the overall view of the whole organization which is of vital
importance in setting budget preparation policies and decisions, and it
remains for every administrative level in the organization to contribute in
a way that leads to the best concerted effort to prepare an integrated
budget.

3.10 Human Relations and Budget Program:

Regardless of whether the budget depends on the personnel of the
lower management or not, it will reflect the following:

Contents
 (1) The degree of top management’s acceptance of the budget
program as a vital part of the company’s activities.
(2) The method of senior management in using budget data:

For the budget program to be successful, it must have the full acceptance
and influence of the individuals who occupy key positions in the
company. If the middle management felt the opposite, or if they feel that
the top management views the budget as a necessary evil, this will lead to
a lake of enthusiasm towards the budget program, and thus, this will be
the feeling of every other employee.

And when managing the budget program, top management should

not use it as a tool to pressure the workers, or as a tool to discover
someone’s mistake so that he can be blamed for a specific problem, and
such matters lead to increased nervousness and distrust instead of
cooperation and productivity, and some studies indicated that budgeting
is usually used as a tool of pressure, the greatest focus is on achieving
budget estimates under any circumstances.

Instead of using the budget as a pressure tool, it is preferable to use

it as a positive tool to help to achieve goals, measure business results, and
identify areas that need greater efforts. Any objections from workers to
the budget program can be overcome by involving workers from different
levels in the program, and by good use of the program during the period.

Managing the budget program requires a great deal of foresight and

sensitivity from the management, and the main purpose is to form the
perception that the budget is designed to be a positive tool to achieve both
personal and corporate goals.

And it must be clear in the mind of management the importance of

the human dimension of the budget. It is easy for the management to

Contents
caught up in the technical aspects and neglect the human aspects, and
accountants are exposed to criticism in this field, as the use of budget in
an inflexible and strict manner may be only complaint of persons subject
to evaluation of their performance through the budget process, and in
light of these facts, the administration must remember that the goal of the
budget is to motivate the workers and the coherence of efforts, and
paying attention to pounds and piasters in the budget and the lack of
flexibility and strictness in managing the budget may lead to the
destruction of these purposes.

3.11 The Budget Committee:

The budget committee is usually responsible for matters related to
the general policy of the budget program, and for coordinating the efforts
of preparing the budget itself. This committee consists of the company’s
president and the company’s vice presidents responsible for sales,
production and purchases, as well as the financial controller (financial
manager). The budget committee solves problems arising from the
difficulties that arise between the sectors of the organization. In addition,
it approves the final budget, and receives periodic follow-up reports that
show the company's progress in achieving budget goals.

3.12 The Master Budget - a Network of Interrelationships:

The master budget consists of a network that contains several
separate sub-budgets, as shown in Figure 2-3:

Contents
 Looking at Figure 3-2, we find that it begins with the sales budget,
which is a detailed table showing the budgeted sales for the coming
period. The sales budget, as we will see later in this chapter, reflects the
sales figures in terms of quantity and value. Effort and time must be spent
to prepare a correct sales budget because it is considered the key and
basis for sub-budgets or the other detailed, because the parts of the
comprehensive (main) budget are based on the sales budget, either
directly or indirectly, as is clear from Figure 2-3. If the sales budget is
prepared without care and attention, this will affect the other budgets, and
its preparation will become a waste of time and effort.

After preparing the sales budget, a decision can be made about the
volume of production to be produced during the period to meet the sales

Contents
needs, and thus the production budget can be prepared, and then the
production budget becomes the main determining element for the rest of
the budgets, including the direct materials budget, the direct labor budget,
the overhead costs budget, and these budgets in turn, are considered
necessary to prepare the cash budget for the budget period, so as we
mentioned before, the sales budget represents the starting point or the
signal that is followed behind it and a series of procedures are built on it
that lead to the formation of other budget figures.

It is also clear from Figure 2-3 that the budget of selling and
administration expenses also depends on the sales budget, and this
relationship arises from the fact that sales represent a specific part of the
funds needed for advertising and sales promotion.

After preparing the operational budgets (sales, production, etc.),

the cash budget and other financial budgets can be prepared. The cash
budget is a detailed plan showing how to obtain cash resources and how
to use them for a specific period of time, and as is noted in Figure 2-3, all
operational budgets, including the sales budget, have an impact on the
cash budget, and the effect of sales budget on the cash budget comes from
cash receipts planned to be collected from sales, as for the other operating
budgets, their impact on the cash budget is the amount of the budgeted
cash disbursement.

3.13 Sales Forecasting-A critical Step:

The preparation of the sales budget depends on the sales forecast,
and the sales forecast is more comprehensive than the sales budget, as it
usually includes the expected sales of the whole industry as well as the
budgeted sales of the enterprise that prepares this forecast. Factors related
to the preparation of the sales forecast include the following:

Contents
 1- Previous experience in the form of sales volume.
2- The applicable price policy.
3- Unexecuted customer orders.
4- Market research studies.
5- General economic conditions
6- Economic conditions of the industry
7- Economic indicators such as gross national product,
employment, prices, personal income.
8- Advertising and promotion of products
9- Competition in the industry
10- Market share.

Sales of previous years are used as a starting point for preparing a

sales forecast. Forecasters study sales data in relation to various factors
including prices, competition factors, supplier capabilities and general
economic factors. Future forecasts are prepared on the basis of factors
believed to have an impact during the budget period. Discussions
determine characteristics of the data to be collected for sales forecasting.
These discussions are held at all levels of the organization to ascertain the
importance of the usefulness of the data.

Statistical methods such as regression analysis, trend and cycle

forecasting, and correlation analysis are used in sales forecasting, and
some enterprises find it useful to build quantitative econometric models
for the industry or for the whole country to help in forecasting, and such
models support improving the quality of budget data.

Contents
3.14 Preparing the Master Budget:
To clarify how to prepare independent budgets up to the
comprehensive budget, we will indicate in this chapter to “Toshiba Al-
Arabi” company, as an example, assuming that the company produces
and sells a single product, which is labeled product A, and the company
prepares the following budgets annually:
1. The sales budget including the budgeted cash receipts.
2. The production budget (or the purchase budget in
merchandising companies).
3. Direct materials Budget including budgeted cash payments.
4. Direct labor budget.
5. Overhead costs budget.
6. Ending finished goods inventory budget
7. Selling and administration expenses budget
8. Cash budget.
9. Budgeted Income Statement
10. Budgeted budget
The following is an explanation of how to prepare each of the
previous budgets, with clarification with practical examples as much as
possible.

3.14.1 The Sales Budget:

The sales budget is the starting point for preparing the
comprehensive budget, as shown in Figure 2-3. Almost all elements of
the comprehensive budget depend on the sales budget, including the
budget of production, purchases, inventory, and expenses. The sales
budget is formed by multiplying the budgeted sales quantity by the
selling price. Table (1) contains the sales budget of Toshiba Al-Arabi
Company for the year 2020 for each quarter. Note in the table that the

Contents
company plans to sell 100,000 units during the year, and sales reach their
peak in the third quarter.

The sales estimates for product (A) for Toshiba Al-Arabi, which is
sold at a price of 20 EGP per unit in 2020, were as follows:
• First Quarter 10,000 units
• Second Quarter 30,000 units
• Third quarter 40,000 units
• Fourth Quarter 20,000 units
• The first quarter (2021) 15,000 units

The company’s policy in collecting the value of sales is to collect

70% of the sales value in the same quarter in which the sale was made
and the rest to be collected in the next quarter, knowing that the debtors’
balance on December 31, 2019 is 900,000 EGP (which represents the
uncollected remainder from Sales value for the last quarter of 2019).
Toshiba Al-Arabi Company
Sales Budget
For the year ended December 31, 2020
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
budgeted sales 10,000 30,000 40,000 20,000 100,000
(in unit)
Selling price 20 20 20 20 20
per unit
Total sales 200,000 60,000 80,000 40,000 2,000,000
Table of expected cash receipts from sales
Receivable 90,000 90,000
Balance on
Dec. 31, 2009

first quarter 140,000 60,000 200,000

sales
(200,000 x
70%, 30%(
second quarter 420,000 180,000 600,000
sales
(600,000 x

Contents
 70%, 30%)
third quarter 560,000 240,000 800,000
sales
(800,000 x
70%, 30%(
fourth quarter 280,000 280,000
sales
)400,000 x
70%, 30%)
Total 230,000 480,000 740,000 520,000 1,970,000

Table of expected cash receipts from sales usually completes the sales
budget,, and this table is useful in preparing the cash budget for the year,
and the expected cash receipts consist of receipts from sales in previous
periods in addition to receipts from sales in the current period, The
previous table (1) includes the schedule of expected cash receipts for
Toshiba Al-Arabi Company.

3.14.2 The Production Budget:

After completing the preparation of the sales budget, the
production needs must be determined for the budget period and these
needs should be organized in the form of a production budget, where a
sufficient quantity of production units must be provided to meet the sales
needs as well as the targeted ending inventory, the beginning inventory
represents a part of these target units and the rest must be produced,
accordingly, the production needs can be determined by adding the
budgeted sales (in units or pounds) to the ending inventory (in units or
pounds) and subtracting the beginning inventory (in units or pounds)
from this total, as it is clear from the following equation:
Sales + Ending Inventory = Production during the period
(purchases) + Beginning Inventory

Production during the period = Sales + Ending Inventory - Beginning

Inventory.

Contents
 As it is clear, to prepare the production budget, data of the
budgeted sales for the same period must be available, as well as data
about the finished goods stock that the company wants to keep at the end
of the period, considering that the ending inventory of the current period
is the beginning inventory of the next period.
Using the 2020 sales budget estimates for Toshiba Al-Arabi
Company, and assuming that the company’s policy in maintaining
inventory is to keep a stock of finished goods at the end of each quarter,
equal to 20% of the sales of the next quarter, and that the stock of
finished goods on December 31, 2019 was 2,000 units. It is possible to
prepare a production budget for Toshiba Al-Arabi Company for the year
2020 as shown in Table 2.
Table (2(
Toshiba Al-Arabi Company
Production Budget
For the year ended December 31, 2020 (in units)
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
budgeted 10,000 30,000 40,000 20,000 100,000
sales (in unit)
Add: ending 6,000 8,000 4,000 3,000 3,000
finished
goods
inventory
Total 16,000 38,000 44,000 23,000 103,000
required
Less: 2,000 6,000 8,000 4,000 2,000
beginning
finished
goods
inventory
Units to be 14,000 32,000 36,000 19,000 101,000
produced

Contents
 Companies must plan inventory carefully, the remaining quantities
at the end of the period may be excessive, which results in the disruption
of funds and incurring unjustified costs as a result of keeping more
inventory than necessary, and on the other hand, inaccurate planning may
result in the inventory level being small, resulting in great pressure on
production in the following period and possibly losing part of sales as a
result of unachievable sales delivery schedules.
3.14.3 Merchandise Purchases – Merchandising Firm
Manufacturing Companies prepare a production budget, while
merchandising companies prepare a Merchandise Purchases Budget
instead of a production budget, that shows the quantity of purchases from
suppliers during the period, and the merchandise purchases budget takes
the same form as the production budget except that it shows The
quantities to be purchased instead of the quantities to be produced are as
follows:
Budgeted sales (in unit) XXX
Add: ending finished goods inventory XXX
Total required XXX
Less: beginning finished goods (XXX)
inventory
Units to be purchased XXX
Manufacturing companies prepare the purchase inventory budget
for each item of inventory, and some major retail companies make these
accounts on different bases (especially at the peak of the season) to
ensure that there is sufficient stock balance to meet the needs of
customers.
3.14.5 Direct Material Budget:
After preparing the production budget and determining the
company’s production needs during the period, the company starts
preparing of the direct materials budget necessary for production
operations, and there must be sufficient quantities of raw materials to

Contents
meet the production needs, as well as the desired stock of raw materials at
the end of the budget period, considering that the stock of raw materials
at the beginning of the period represents a part of the production needs
from raw materials during the period, and the remaining needs are
purchased from suppliers during the period, and the needs of raw
materials during the period are calculated in light of the following
equation:
Raw materials to meet production XXX
schedule needs
Add: ending raw materials inventory XXX
Total required of raw materials XXX
Less: beginning raw materials inventory (XXX)
Raw materials to be purchased XXX
In order to determine the needs of the production schedule of raw
materials, it is necessary to determine the needs of product unit from the
necessary raw material (in kilograms, grams, pounds, ....) and then
multiply the unit needs from raw material by production quantity in order
to arrive at total production needs from the raw material.
The direct materials budget is a step towards material
comprehensive planning, which is considered one of the operations
research tools in which the computer is used to assist the manager in the
comprehensive planning of materials and inventory. The objectives of the
materials need planning is to ensure that the necessary materials are
available at the company’s disposal in the correct quantities and at the
correct time to meet production needs.
In order to prepare the direct materials budget, data about the
quantity of production during the period (which we obtain from the
production budget), as well as the needs of the product unit from the raw
material, must be available, in addition to the availability of data about

Contents
the stock of raw materials that the company wishes to keep at the end of
the period.
Using the production budget data for Toshiba Al Arabi Company
for the year 2020 (Table 3), and assuming that one unit of product (A)
needs to be produced 5 pounds of raw material needed for manufacturing,
which is purchased at a price of 60 piasters per pound, and the company
plans to keep stock of material at the end of every quarter equal 10% of
the needs of the next quarter. The stock of raw materials on December 31,
2020 was estimated at 7,500 pounds. The stock of raw materials was
7,000 pounds on December 31, 2019. The budget of direct materials for
Toshiba Al-Arabi Company for the year 2020 will be as follows in Table
No. (3).
Toshiba Al-Arabi Company
Raw Material Budget
For the year ended December 31, 2020
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
Units 14,000 32,000 36,000 19,000 101,000
produced
(table 2)
X X X X X X
required
material per 5 5 5 5 5
unit
Production 70,000 160,000 180,000 95,000 505,000
needs
Add: ending 16,000 18,000 9,500 7,500 7,500
inventory
Total 86,000 178,000 189,500 102,500 512,500
production
Less: 7,000 16,000 18,000 9,500 7,000
beginning
inventory
Unit to be 79,000 162,000 171,500 93,000 505,500
purchased
X X X X X X
Contents
 Selling price 0.6 0.6 0.6 0.6 0.6
Raw
material 47,400 97,200 102,900 55,800 303,300
cost to be
purchase
Assuming that the company’s policy in paying its payments for the
cost of raw materials is to pay half of the due during the quarter in which
the purchase is made, and the remaining half being paid during the
following quarter. The table of expected cash payments is as follows
(knowing that the balance of creditors on December 31, 2019 was 25800
EGP):
Table of expected cash payments for raw material
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
Payable 25,800 25,800
Balance on
December
31, 2019
first quarter 23,700 23,700 47,400
purchases
(47,400 x
50%, 50%(
second 48,600 48,600 97,200
quarter
purchases
(97,200 x
50%, 50%)
third quarter 51,450 51,450 102,900
purchases
(102,900 x
50%, 50%(
fourth 27,900 27,900
quarter
purchases
)55,,800 x
50%, 50%)
Total cash 49,500 72,300 100,050 79,350 301,200
payment

Contents
 As we have noted, the direct materials budget is usually
accompanied by the calculation of the expected cash payments in the raw
materials, and this calculation is necessary to help preparing the cash
budget. The expected cash payments include payments for previous
periods in addition to purchases payments for the current period. Table
No. (3) includes cash payments of Toshiba Al-Arabi Company.

3.14.6 Direct Labor Budget

The direct labor budget is based on the production budget. The
direct labor needs must be calculated so that the company can know
whether the available direct labor time is sufficient to meet the production
needs. Through early knowledge of the direct labor time needs over the
budget period, the company can prepare the necessary plans to control the
workforce in line with production conditions. Companies that neglect
direct labor budget preparation are exposed to the risks of lack of work
and machine failure, as well as conflicting direct labor policies have bad
effects on the security and efficiency of workers.

To calculate the needs of direct labor, the number of units of

finished goods that must be produced each period (one or three months) is
multiplied by the number of direct labor hours needed to produce one
unit. Several different types or skills of direct labor may be required. In
this case, the calculation is for each type of direct labor types, after this,
direct labor hours can be translated into the cost of direct labor. But how
this is done? it depends on the company’s work policy, and in table No.
(4) we assume that the direct labor force can be adjusted from a quarter to
a quarter during the year, and in this case it can be calculated the total
cost of direct labor by multiplying the production needs of direct labor in
hours by the hourly wage rate for direct labor (and assuming that a unit of
product needs 0.8 of an hour, i.e. 48 minutes of direct labor), and that the
Contents
hourly wage rate of direct labor is 7.5 pounds per hour, then the direct
labor budget of Al-Arabi Company for the year 2020 appears as shown in
the following table No. (4):

Toshiba Al-Arabi Company

Direct labor Budget
For the year ended December 31, 2010
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
Units to be 14,000 32,000 36,000 19,000 101,000
produced
(table 2)
X X X X X X
Direct labor
hour per unit 0.8 0.8 0.8 0.8 0.8
Total 11,200 25,600 28,800 15,200 80,800
required
hours
Direct labor 7.5 7.5 7.5 7.5 7.5
hour rate
Total Direct 84,000 192,000 216,000 114,000 606,000
labor costs
But there are many companies that have labor policies to prevent
them from laying off workers or that they have work contracts that
prevent this. Let’s say, for example, that Toshiba Al-Arabi has 50
workers in direct work and that each of them guarantees a minimum of
480 hours and an hourly wage rate of 7.5 pounds, in this case, the
minimum cost of direct labor hours will be as follows:
50 workers x 480 hours x 7.5 EGP = 180,000 EGP

It is noted in Table No. (4) that in the first and fourth quarters, the value
should increase to become at a minimum of EGP 180,000 if the
company’s policy does not allow for the adjustment of the workforce, and
the inability to lay off workers may have a severe impact on cash flows or
the company’s profitability.

Contents
3.14.7 The Manufacturing Overhead Budget:
The Manufacturing Overhead budget must provide a table for all
production costs other than the cost of direct materials and direct labor,
and these costs are classified according to their behavior for the purposes
of preparing the budget.
The Manufacturing Overhead budget is accompanied by a table of
the expected cash payments for the overhead costs for the purposes of
preparing the cash budget, and we must remember an important thing,
that the depreciation expense is considered one of the expected non-cash
expenses, and assuming that the rate of the variable manufacturing
overhead is 2 EGP per work hour, and that the fixed manufacturing
overhead is estimated at 60,600 EGP every quarter, which includes
15,000 EGP depreciation expenses. All cash manufacturing overhead are
paid in the quarter in which they were incurred. Table No. (5) shows the
manufacturing overhead budget for each quarter, as well as calculating
the expected cash payments for each quarter
Toshiba Al-Arabi Company
Manufacturing overhead Budget
For the year ended December 31, 2020
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
Direct labor hours 11,200 25,600 28,800 15,200 80,800
X
Variable X X X X X
Manufacturing
overhead rate 2 2 2 2 2
Variable 22,400 51,200 57,600 30,400 161,600
Manufacturing
overhead costs
+ + + + + +
Budgeted fixed 60,600 60,600 60,600 60,600 242,400
Manufacturing
overhead costs
Total 83,000 111,800 118,200 91,000 404,000
Manufacturing
overhead costs
- - - - - -
Depreciation 15,000 15,000 15,000 15,000 60,000

Contents
 Total cash 68,000 96,800 103,200 76,000 344,000
payment of
Manufacturing
overhead

3.14.8 The Ending Finished Goods Inventory Budget:

After preparing manufacturing overhead budget, we have sufficient data
to calculate the cost of the finished goods for two reasons: the first is to
know the costs of goods sold that we use in the budgeted income
statement, and the second is to determine the cost of goods non-sold
within the budget period. The cost per unit of goods non-sold is
calculated in the ending finished goods inventory budget.

In our example, the method of determining total costs is used to

calculate the cost of inventory. The top management prefers to use the
determination of total costs usually, where the management performance
is evaluated on this basis in the reports submitted to shareholders with
other reports. For Toshiba Al-Arabi Company, the cost per unit of
finished goods is 13 EGP, which consists of 3 EGP direct materials, 6
EGP direct labor, 4 EGP overhead costs. The total budgeted cost of
ending inventory of the year 2020 of Toshiba Al-Arabi Company is
39000 EGP as shown in Table No. (6) as follows:

Toshiba Al-Arabi Company

Ending Finished Goods Inventory Budget
For the year ended December 31, 2020
Quantity Cost Total
Cost per unit:
Direct material 5P 0.6 EGP 3 EGP
Direct labor 0.8 h 7.5 / h 6
Manufacturing overhead 0.8 h 5/h 4
(404000 EGP/80800 hours)
Total cost per unit 13 EGP
Total cost of budgeted ending
inventory: x

Contents
 Ending finished goods (3000 units)
From (Table No. 2) 3,000
Ending Finished Goods Inventory 39,000
EGP

3.14.9 The Selling and Administrating costs Budget:

The sales and administrating costs budget contain a list of the
expected costs for the budget period that will occur in various activities of
the company other than production, and this budget consists of small
budgets prepared by many individuals who are responsible for controlling
selling and administrating costs. If the number of items of these expenses
is very large There will be a need to prepare several separate budgets of
sales and administration activities.
Table No. (7) contains the budget for sales and administration
expenses of Toshiba Al-Arabi Company for the year 2020 as follows:
Table No. (7)
Toshiba Al-Arabi Company
Selling and Administrating costs Budget
For the year ended December 31, 2020
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
Number of units 10,000 30,000 40,000 20,000 100,000
sold X X X X X
X
Variable selling
and
administrating
costs per unit:
(Commission, 1.8 1.8 1.8 1.8 1.8
transport and
clerical work)
Total Variable 18,000 54,000 72,000 36,000 180,000
costs
Fixed costs:
-Advertising 40,000 40,000 40,000 40,000 160,000
-Managers'
salaries 35,000 35,000 35,000 35,000 140,000
-Insurance - 1900 37,750 - 39,650
-Property Taxes - - - 18,150 18,150
Total fixed costs 75,000 76,900 112,750 93,150 357,800

Contents
 Total selling and
administrating 93,000 130,900 184,750 129,150 537,800
costs

3.14.10 The Cash Budget:

In preparing the cash budget, the cash budget depends on a lot of
data that could be formed in the previous steps (tables). As shown in
Figure 3-2, all operational budgets, including the sales budget, have an
impact on the cash budget. The effect of the sales budget on the cash
budget comes from the cash receipts expected to be collected from sales,
and the impact of the remaining operating budgets on the cash budget is
the amount of expected cash disbursement (payments). The cash budget
consists of four main sections are:
• Receipts
• Payments
• Increase or decrease in cash
• Finance

The section of receipts consists of the cash balance at the beginning

of the period plus all cash expected to be collected during the budget
period. In general, the main source of receipts is from sales as we noticed
before, and the payments section consists of all cash payments expected
to be paid during the budget period, the payments include purchases of
raw materials, direct labor payments, overhead costs, etc. This is as
shown in the relevant budgets, in addition to other payments such as
income taxes, capital asset purchases and stockholder coupon payments.

The cash increase or decrease section consists of the difference

between the totals of the cash receipts section and the totals of cash
payments section. If there is a deficit, the company makes arrangements
to borrow from the banks, but if there is an increase, the money borrowed

Contents
from previous periods can be returned or the unused amounts are invested
in short-term investments.

The finance department gives a detailed account of the borrowing

and loan repayment that is expected to occur during the budget period,
and it also includes details of loan interest payments due for repayment
during the same period. Banks insist that companies wishing to borrow
request early for the amounts they need. This allows the bank to plan
confirmation of the possibility of providing the loan upon request.
Moreover, conscious planning of cash needs through budgeting processes
avoids unpleasant surprises for the company and protects it from
unexpected difficulties in calculating cash. A good budget program
avoids so far the uncertainty regarding the cash position after two months,
six months or a year from now.

The cash budget must be divided into the shortest possible periods.
There are many companies that prepare the cash budget on a weekly
basis, but some companies even go further, where they prepare the cash
budget on a daily basis, but the most common planning in use is to
prepare the cash budget on a basis monthly or quarterly basis. Table No.
8 shows the cash budget on a quarterly basis. When preparing this budget,
we assumed that Toshiba Al Arabi Company has a wide possibility to
borrow from the bank so that it can cover any cash deficit at an interest of
10% annually, and for the purposes of facilitation, we assume that all
payments in within the limits of 100,000 EGP, and also, we assume that
all loans occur at the beginning of each quarter and that all payments are
made at the end of each quarter as the following:

Contents
 Table No. (8): Cash Budget
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
Beginning cash 42,500 40,000 40,000 40,500 42,500
balance
Added
Receipts:
Customer 230,000 480,000 740,000 520,000 197,0000
Receipts
Total Receipts 272,500 520,000 780,000 560,500 2,012,500
less payments:
Direct material 49,500 72,300 100,050 79,350 301,200
Direct labor 84,000 192,000 216,000 114,000 606,000
M. overhead 68,000 96,800 103,200 76.000 344,000
Selling and
administrating
costs 93,000 130,900 184,750 129,150 537,800
Income Taxes 18,000 18,000 18,000 18,000 72,000
Equipment
purchases 30,000 20,000 - - 50,000
stock
dividends 10,000 10,000 10,000 10,000 40,000
Total 35,2500 540,000 632,000 426,500 1,951,00
payments 0
Increase or
decrease in
cash (80,000) (20,000) 148,000 134,000 61,500
Finance
Borrowing (at
beginning) 120,000 60,000 - - 180,000
Payment (at
ending) - - (100,000) (80,000) (180,000)
Interest 10 per
year - - (7500) (6500) (14000)
Total Funding 120,000 60,000 107,500 86,500 14,000
Cash balance
at the end of
the period 40,000 40,000 40,500 47,500 47,500

Contents
Notes:
- The company requires that the cash balance be not less than
40,000, so it was borrowed at the beginning of the first quarter of
120,000 EGP to cover the cash deficit of 80,000 EGP, so that the
cash balance becomes 40,000 EGP at the end of the period.
- Interest payments are calculated at the end of the period on the
principal amount of loan to be repaid only, up to a maximum of
100,000 EGP, for example, the interest in the third quarter is
calculated on the amount of 10,000 EGP as follows:
100,000 x 10% x (3/4) year = 7,500 EGP.
The interest for the fourth quarter is calculated as follows:
20,000 x 10% x 1 year = 2000 EGP
60,000 x 10% x (3/4) a year = 4,500 EGP
6500 EGP
- In the case of Toshiba Al-Arabi Company, all loans
are repaid at the end of the year. If all loans have not been repaid,
and the income statement or the budgeted balance sheet has been
prepared, in this case, the interest on the unpaid loans will be due,
this interest will "not" appear in the cash budget (as long as it is not
paid) but appear with the interest expense in the budgeted income
statement and as a liability within the liabilities in the budgeted
balance sheet.

3.14.11 The Budgeted Income Statement:

The budgeted income statement can be prepared from the data of
tables from 1 to 8. This statement is considered one of the important
tables in the budget process. It is the document that shows what will be
the budgeted profit for the next period. After preparing the budgeted
income statement, it is used as a measure of the company’s performance.
Table 9 shows the budgeted income statement as follows:
Contents
 Table No. (9)
Toshiba Al-Arabi Company
The Budgeted Income Statement
For the year ended December 31, 2020
Sales Table 1 2,000,000
Less: cost of goods sold Table 6 1,300,000
Gross profit 700,000
Less: selling and administrative expense Table 7 537,800
Operating income 162,200
Less interest expense Table 8 14,000
Net income before tax 148,200
Tax expense estimated 72,000
Net income after tax 76,200

3.14.12 The Budgeted Balance Sheet:

The preparation of the budgeted balance sheet begins with the
current budget, then it is modified with data of other budgets dat. Table
No. (10) shows the budgeted balance sheet of Toshiba Al-Arabi
Company on December 31, 2020. The following is the budget on
December 31, 2019 (the beginning of the budget period) from which the
planned budget was derived
Toshiba Al-Arabi Company
The Balance Sheet
at December 31, 2019
Assets
Current assets:
Cash 42,500
Accounting receivable 90,000
Raw material inventory 4,200
Finished goods inventory 26,000
Total current assets 162,700
Fixed assets:
Land 80,000
Equipment 700,000
- Accumulated. Depreciation (292,000)
Total fixed assets 488,000

Contents
Total assets 650,700
Liabilities and equities:
Current liabilities:
Account payable 25,800
Shareholders’ equity:
Common stock 175,000
Retained earnings 449,900
Total of equity 624,900
Total Liabilities and equities 650,700

Toshiba Al-Arabi Company

The Balance Sheet
at December 31, 2020
Assets
Current assets:
Cash 47,500 (a)
Accounting receivable 120,000 (b)
Raw material inventory 4,500 (c)
Finished goods inventory 39,000 (d)
Total current assets 211,000
Fixed assets:
Land 80,000 (e)
Equipment 750,000 (f)
- Accumulated. Depreciation (352,000) (g)
Total fixed assets 478,000
Total assets 689,000
Liabilities and equities:
Current liabilities:
Account payable (H) 27,900
Shareholders’ equity:
Common stock 175,000 (i)
Retained earnings 468,100 (j)
Total of equity
661,100
Total Liabilities and equities 689,000

Contents
The notes at December 31, 2020:
A- ending cash balance from the cash budget Table (8) -
B - 30% of the sales of the fourth quarter (Table 1).
C- From Table (3), the ending stock balance is 7,500 EGP at a
price of 0.60 EGP per pound.
D- from table (6)
E - Unchanged balance from the budget at December 31, 2019
F- The balance from the budget on December 31, 2019 is 700,000
EGP, and 500,000 EGP will be added during 2020.
G- Balance from the budget on December 31, 2019, to which is
added the depreciation for the year 2020 (60.00 EGP) Table 5.
H- Half of the purchases of the fourth quarter of Table (3).
I- Balance from the budget at December 31, 2019 unchanged.
J- Balance on December 31, 2019 449,000 EGP
Add: net income from table (9) 76,200 EGP
Total 526,100 EGP
Less: dividends paid from table (9) 40,000 EGP
Balance December 31, 2010 486,100 EGP

3.15 Expanding the budgeted income statement:

The planned income statement in Table 9 focuses on one activity
level and has been prepared according to the method of determining total
costs. Some managers prefer another form that focuses on the extent of
the activity and using the contribution approach. Figure 3-3 illustrates an
example of this:

Contents
 ABC Company
The Budgeted Income Statement
For the year ended December 31, 2020
Per units 800 U 1400 U 2000 U 2800 U
Sales 75 60000 105000 150000 210000
Less: variable costs
Direct Material 12 9600 16800 24000 33600
Direct Labor 31 24800 43400 62000 86800
Variable Manu. overhead 7.5 6000 10500 15000 21000
Variable selling costs 4 3200 5600 8000 11200
Total variable costs 54.5 42600 76300 109000 152000
Contribution margin 20.5 16400 28700 41000 57400
Less: fixed cost
Fixed overhead 18000 18000 18000 18000
Fixed selling costs 9000 9000 9000 9000
Total fixed cost 27000 27000 27000 27000
Net income or loss (10600) 1700 14000 30400

The budgeted income statement, as in Figure 3-3, is a flexible

statement in its use, that it shows the net income at more than one activity
level. For example, if the company plans to have sales of 2,000 units, but
it sold 1,400 units, in this case, the budget income statement data is used
at 1,400 units. Where costs and revenues at this level are compared to
actual costs, other columns can be added as needed simply using the
shown budget.
In short, the budgeted income statement in this expanded form is
more useful to management for planning and control purposes.

3.16 Jit (just in Time) Purchases:

It is important to differentiate between on-time production and on-
time purchasing, for on-time production is only in industrial companies
where they focus on the production of goods. Production in just time is
based on the concept of attraction, where the stock is greatly reduced or
completely eliminated, as well as the response of all production activities
Contents
with the attraction or pulling of the final assembly stage, and on the other
hand, just in-time purchase can be applied in any organization, whether it
is retail, distribution, services or industrial, and it focuses on obtaining
goods that are resold to customers such as shops Retail or used as raw
materials in the production process.

The basis of the just in time philosophy is to simplify and eliminate

wastage, and this philosophy is fully applicable in the case of just in time
purchasing as well as in the case of just in time production. The main
features related to just in time purchasing are illustrated as follows:

1- Goods are received directly before ordering or use, so companies

that follow just in time purchase need to increase the number of
times received with a decrease in quantity each time. We have
mentioned that the industrial company can receive raw materials
several times per day, this concept of multiple receipts even in
one day is also applied to the level of retail stores, and since
several years ago, food stores received milk and bread daily, and
various other retail stores are now moving towards this concept,
as food outlets refuse to receive baked goods produced since
several hours ago, which means ordering these goods several
times a day, and even in some industrial companies or retail
stores, which must maintain a level of commodity stock, the
level of this stock under the just in time purchase is reduced to a
small percentage of the previous quantities.

2- The number of suppliers is greatly reduced and all purchases are

focused on a small number of suppliers who can be relied upon
and can meet the strict obligations imposed by the company on
receipt. For example, IBM Company excluded 95% of its factory
suppliers, bringing their number to 32 from 640 suppliers. This
Contents
 decrease was accompanied by a reduction in the resources
needed for purchase negotiations and the operation of purchase
data.
3- Signing long-term contracts with suppliers that specify the
delivery schedule, quality and prices. These long-term contracts
do not require independent negotiations for each purchase. This
reduces the written work of purchasing transactions. Delivery
schedules are set for a long time in advance, and the supplier
adheres to these schedules fully, and the most important element
to success just in time program is “quality.” If maximum levels
of quality are not achieved, it becomes impossible to apply this
concept.
4- The need to examine and inspect quantities is reduced or absent.
Through signed long-term contracts, suppliers are fully aware of
the importance of adhering to the exact specified quantities and
completely free from defects, and this eliminates the need for
inspection, as it does not add value under this approach, and
many companies require that the goods are delivered in
containers suitable for immediate use that contain exactly the
number and type of items required for each cell, these containers
eliminate the need for packaging and unpacking the materials,
which the just in time method considers an activity that does not
add value.
5- The value of each supply is not paid, but payments are made to
each supplier. The supplier supplies several batches per day to
the factory or several batches per week to the warehouse. Hence,
it is difficult to pay the value of each batch and therefore
invoices are billed on a monthly basis representing the total
values of batches during the month, and the computer plays an

Contents
 important role in tracking receipts and invoices and determining
the value to be paid, and companies that follow just in time
method have achieved tangible savings in the costs of issuing
purchase orders and managing the purchasing function, noting
that using this approach to purchase just in time does not mean
canceling Inventory totally, retail stores must keep some stock
otherwise they cannot operate, but the time that goods are on the
shelf or in warehouse can be reduced by just in timed approach.

3.17 Zero-Base Budgeting

Preparing zero-based budget have received a lot of attention
recently as a new approach for preparing budget data, especially in non-
profit, governmental, or service organizations, and the budget prepared on
this basis is known as zero-base budgeting.
Zero-based budgeting is called by this name because it requires the
manager to start from zero each year and to justify all costs as if the
program was being prepared for the first time. The justification means
that there is no continuous cost in nature, but the manager must start from
the same beginning every years (zero), and provides justification for all
costs proposed in the budget regardless of the quality of these costs, this
done through a series of decision groups that enables all activities in the
department or section to be arranged according to their relative
importance, starting from those that the manager considers more
important to those that are less important. Top management is allowed to
evaluate each decision group separately and reconsider the areas that
seem less important, and this process differs from traditional budgets in
that it is prepared on a differential basis, meaning that the manager starts
with the previous year’s budget and then adds or subtracts from it
according to the expected needs, and then the matter does not require the

Contents
manager to start each year from zero and justify the ongoing costs (such
as salaries) for the existing programs, and taking into account the broad
concept, preparing the budget on a zero basis is not, in fact, a completely
new concept, managers are accustomed to reviewing the costs of
revenues with some depth, and the difference is the frequency of these
reviews. This review must be done annually when preparing the budget
on a zero basis.

Critics of the zero-base idea say that this is too much and that these
reviews should only done every five years. Annual in-depth reviews take
a lot of time and cost to be practical, and in the short term these reviews
may not be justified compared to the cost savings, as well as, this review
may become mechanical and thus the idea of the zero basis loses all its
purpose, the issue of repeating the reviews on the basis of zero should be
left to the manager judgment, sometimes we find that such annual
reviews are justified and in others they are not justified, and regardless of
the timing of these reviews, but that Most managers will agree that these
reviews are useful and an important part of the budgeting process.

3.18 International Aspects of Budgeting:

Multinational companies face special problems when preparing the
budget, and these problems arise due to two main factors that have an
impact on a company dealing in global markets, and these two factors
are: currency exchange rates and inflation.

The problem of currency exchange rates is an important factor

when preparing the budget because these rates control the exchange of
monetary units between different countries, and these rates change daily,
and there is a common approach to confront this, which is the use of one

Contents
exchange rate throughout the budget period, after that the differences are
attempted to be compensated by coverage transactions.

It must be taken into account that the costs of coverage transactions

should be added in the budget with the rest of the costs items in the
multinational companies.

As for the problem of inflation, sometimes a multinational company may

have business in a country that suffers from severe inflation, which leads
to great difficulties when preparing the budget. In some countries,
inflation may exceed 100% annually. Such inflation is called
hyperinflation, and it requires that the period during which the budget is
prepared be reduced to avoid the effects of this inflation, and even if the
budget preparation time is reduced, it is necessary to review the budget
before applying, so that it can be adjusted with the inflation that occurred
since the beginning of the budget process, and at the end of the budget
period it is necessary to adjust the data with actual inflation during the
year, after these adjustments the manager can only measure the
differences between actual and planned revenues and costs according to
the budget.
The multinational company must be sensitive to the government
policies of the countries in which it operates, which may affect the cost of
labor and purchases of machinery, cash management and other topics
other than inflation and exchange rate change.

3.19 An Applied Case:

Toshiba Al-Arabi Company produces and sells a product whose
demand varies seasonally that its maximum sales are in the third quarter.
The following are data related to sales and other operations for the next
year 2019, and for the first and second quarters of 2020:

Contents
 A- The company’s only product is sold at a price of 8 EGP per
unit, and the following is the volume of sales in units for the year 2019
and for the first and second quarters of 2020:
• First Quarter (2019) 40,000 units
• Second Quarter (2019) 60,000 units
• Third quarter (2019) 100,000 units
• Fourth Quarter (2019) 50,000 Units
• The first quarter (2020) 70,000 units
• The second quarter (2020) 80000 units
B- The sales value is collected as follows: 75% in the quarter of the year
in which it was sold and 25% in the following quarter. On January 1,
2019, the company’s balance sheet showed an amount of 65,000 EGP
owed by accounts receivables, and it was collected in the first quarter of
the year, bad debts can be neglected.
c. The company requires that the ending inventory of finished goods be
equal to 30% of budgeted sales for the next quarter. This requirement was
implemented on December 31, 2018, where there were 12,000 units with
which the new year began.
D- The production of the unit requires 5 pounds of raw materials, and the
company requires that there be a stock of raw materials at the end of each
quarter equivalent to 10% of the production needs for the next quarter,
and this requirement was applied on December 31, 2018, where the
company had a stock of 23,000 pounds Raw materials with the beginning
of the new year.
E- A pound of raw materials costs 0.80 EGP, and the value of purchases
is paid as follows: 60% is paid in the quarter in which the purchase was
made and 40% is paid in the next quarter. The balance of creditors for

Contents
raw materials purchases in the budget on January 1, 2019 was 81,500
EGP, this amount in full is paid in the first quarter of the year.
Required: Prepare the following budgets and schedules on a quarterly
and yearly basis:
1- Sales budget and expected cash receipts schedule
2- Production budget.
3. Budget of direct material purchases and schedule of cash payments
expected for purchases of raw materials.
1- Sales budget for the year 2019
Toshiba Al-Arabi Company
Sales Budget
For the year ended December 31, 2019
First Second Third Fourth Total
Quarter Quarter Quarter Quarter
Budgeted 40,000 60,000 100,000 50,000 250,000
sales (in unit)
Selling price X X X X X
per unit 8 8 8 8 8
Total sales 320,000 480,000 800,000 400,000 2,000,000
Budgeted cash receipts from sales schedule
Receivable 65,000 65,000
Balance On
Jan. 1, 2019

first quarter 240,000 80,000 320,000

sales
(75%, 25%(
Second 360,000 120,000 480,000
quarter sales
(75%, 25%(
Third quarter 600,000 200,000 800,000
sales
(75%, 25%(
Fourth 300,000 300,000
quarter sales
(75%, 25%(
Total 305,000 440,000 720,000 500,000 1,965,000

Contents
 2- The production budget in units for the year 2019 based on the sales
budget as follows:
Toshiba Al-Arabi Company
Production Budget
For the year ended December 31, 2019 (in units)
First Second Third Fourth Total First Second
Quarter Quarter Quarter Quarter 2009 2010r 2010
Budgeted 40,000 60,000 100,000 50,000 250,000 70000 80000
sales (in unit)
Add: ending + + + + +
finished 18,000 30,000 15,000 21,000 21,000 24000
goods
inventory
Total 58,000 90,000 115,000 71,000 271,000 94000
required
Less: - - - - - -
beginning 12,000 18,000 30,000 15,000 12,000 21000
finished
goods
inventory
Unit to be 46,000 72,000 85,000 56,000 259,000 73000
produced

3- The raw materials budget for 2019 (based on the production budget) as
follows:

Contents
 Toshiba Al-Arabi Company
Raw material Budget
For the year ended December 31, 2009
First Second Third Fourth Total First
Quarter Quarter Quarter Quarter 2019 2010
Units to be 46,000 72,000 85,000 56,000 259,000 73000
produced
X X X X X X X
Raw material
per unit 5 5 5 5 5 5
Production 230,000 360,000 425,000 280,000 1,295,000 365000
needs
Add: ending + + + + +
inventory 36,000 42,500 28,000 36,500 36,500
Total 266,000 402,500 453,000 316,500 1,331,500
production
Less: - - - - -
beginning
inventory 23,000 3,6000 42,500 28,000 23,000
Unit to be 243,000 366,500 410,500 288,500 1,308,500
produced
X X X X X X
Selling price 0.8 0.8 0.8 0.8 0.8
Cost of raw
material to 194,400 293,200 328,400 230,800 1,064,800
be
purchased
Based on the cost of raw materials to be purchased shown above, the
schedule of expected cash payments is as follows:
Expected cash Payments for raw material
Payable 81,500 81,500
Balance On
Jan. 1, 2019
first quarter 116,640 77,760 194,400
purchases
(60%, 40%(
second 175,920 117,280 293,200
quarter
purchases
(60%, 40%(

Contents
third quarter 197,040 131,360 328,400
purchases
(60%, 40%(
fourth 138,480 138,480
quarter
purchases
(60%, 40%(
Total cash 198,140 253,680 314,320 269,840 1,035,980
payment

Key Terms and Concerts in Chapter Three:

• Budget: A detailed plan for obtaining and using financial
and other resources during a future period of time.
• Budget Committee: It is a team of key persons in the
management and responsible for the company's general
policy matters in relation to the budget program in terms of
preparing and coordinating the budget itself.
• Capital Budget: It is a budget that covers the acquisition of
land, buildings, and items of machinery and equipment, and
this budget has a period of time that extends to 30 next
years.
• Cash Budget: It is a detailed plan showing how cash
resources will be obtained and how they will be used for a
specific period of time.
• Continuous or Perpetual Budget: It is a budget that covers
12 months, but a new month is added to it continuously at
the end whenever one month of it elapses.
• Control: These are the steps taken by the management to
ensure that the general objectives for which the planning was
set are achieved and that all parts of the organization work in
a manner consistent with its policies.

Contents
• Direct Labor Budget: It is a detailed plan that shows the
needs of the work during a specified period of time.
• Direct Material Budget: It is a detailed plan that shows the
quantity of raw materials that must be purchased during a
specific period of time to meet the needs of both production
and stock of finished goods.
• Ending Finished Goods Inventory Budget: It is a budget
that shows the expected cost to appear in the balance sheet
for the unsold units at the end of the period.
• Manufacturing Overhead Budget: It is a detailed plan
showing all production costs, except for direct materials and
direct labor costs, which will be spent to produce the outputs
during the budget period.
• Master Budget: It is a summary of the plans of all aspects
of the company's activity and its objectives in the future in
the form of targeted sales, production and activities, which
usually ends with the budgeted income statement and the
budgeted balance sheet.
• Material Requirements Planning (MRP): A modern
operations research tool that requires the use of a computer
and helps management in the overall planning of materials
and commodity stocks.
• Merchandise Purchases Budget: It is a budget used by
merchandising companies that shows the volume of
purchases to be purchased from suppliers during the period.
• Production budget: It is a detailed plan showing the
number of units to be produced during the period, to meet
the needs of sales and commodity inventory.

Contents
• Responsibility Accounting: It is an accounting system in
which costs are assigned to managerial levels according to
the responsibility of controlling them, the manager
responsible for these costs is determined accounted for the
differences between the budgeted and the actual.
• Sales Budget: These are detailed tables showing the
expected sales for a full period in terms of quantities and
values.
• Sales Forecast: A table of forecast sales for the entire
industry.
• Self-imposed Budget: It is a method of preparing the budget
whereby each responsible manager sets their budget values
and reviews these values at the highest managerial level and
discusses any inquiries about them face to face.
• Selling and Administrative Costs Budget: These are
detailed schedules for planning the costs to be incurred by
the organization in all the company's activities except for the
production activity during the budget period.
• Zero Base Budgeting: A method of budgeting that requires
the manager to start budgeting activities from zero each year
while justifying the costs as if the program was being
prepared for the first time.

Contents
2.20 Questions and Applied Cases:
2.20.1 Questions:
1- What is the planning budget? What is budgetary control?
2- Discuss some of the most important advantages of the budget.
3- What is meant by the term “responsibility accounting”?
4- The budget is considered as a basis for organizations that have
complexities and simple uncertainty in their daily operations. Do
you agree? And why?
5. What is the master budget? Briefly explain its contents.
6. What is the best basis for judging the actual results, the planned
performance according to the budget or the historical performance?
7. Why are sales forecasts always the starting point for budgeting?
8. Are there any differences between sales forecast and sales budget?
explain.
9. From a practical point of view, planning and control are one thing,
do you agree? explain.
10.Explain the flow of budget data in the organization. Who are the
participants in the budget process, and how do they participate?
11.The success of the budget depends to a large extent on education
and the efficiency of salesmen, do you agree? Explain
12.What is self-imposed budget? What are the main advantages of
self-imposed budget, and the limits of its use?
13.How does the budget help in supporting employment policies?
14.The main purpose of the cash budget is to know the cash balance in
the bank at the end of the year, do you agree? Explain
15.How does just in time purchasing differ from just in time
production?
16.What are the five main ideas for purchasing at the right time?

Contents
 17.Will the company dispense with all the inventory if it follows the
purchase on time?
18.How does the zero-based budget differ from the traditional budget?

2.20.2 Cases:
Case No. (1): Yazid Company produces a popular product and its sales
are highest in the month of May every year. The sales budget for the
second quarter of 2020 shows this increase in sales as follows:
April May June Total

Estimated sales: 300,000 500,000 200,000 1,000,000

Previous experience has shown that 20% of the sales value is collected in
the month in which it was sold, and 70% in the following month, and the
remaining 10% is collected in the month after the next, and bad debts can
be neglected, and February sales amounted to 23,000 EGP. And March
260.00 EGP,
Required:
• Prepare a table of cash receipts for sales for the second quarter of
2020 for each month and for the sum of the second quarter.

Case No. (2): Al-Esraa Company estimated its sales for the following
four months as follows:
sales month
April 50,000 units
May 75,000 units
June 90,000 units
July 80,000 units

The company is now ready to prepare the production budget for the
second quarter of 2020, and previous experience showed that the level of
inventory at the end of each month is equivalent to 10% of the sales of
Contents
the following month, and the inventory at the end of March was 5,000
units.
Required: Preparing the production budget for the second quarter,
showing the number of units to be produced for each month, and for the
second quarter as a total.

Case No. (3): The production of a bottle of a perfume requires three

ounces of musk oil, and the cost of one ounce of musk oil is 1.5 EGP.
The following are estimates of the production of this perfume for each
quarter of the year 2010 and the first quarter of 2011:
2020 2021

first second third fourth First

Planned 60,000 90,000 150,000 100,000 70,000

production

Since musk oil has become commonly used as a basis for the scent
industry, it was necessary to keep a large stock in anticipation of a
shortage of stock, so the stock of musk oil equals 20% of the production
needs of the next quarter, and there were 36,000 ounces of musk oil in
stock at the beginning of the first quarter of the year 2020.
Required: Preparing a budget for purchases of musk oil for each quarter
and for the total for the year 2010, showing at the end of the budget the
value of purchases in pounds for each quarter and for the whole year.

Contents
 Chapter four
Segment Reporting,
Profitability Analysis & Decentralization

Learning Objectives:
After studying this chapter, you could be able to:
-understand the importance of segment reporting to management.
- know the nature of segment income statement and how it is prepared.
- know the constraints to proper cost assignment.
- know the differences between fixed costs traceable costs.
responsibility accounting.
- understand the differences between cost center, profit center, and
investment center, and how the performance is measured of each.
- know the different approaches to improve the rate of return on
investment.
- know the effect of transfer prices at performance evaluation of
segments, and the different methods of transfer prices.

Contents
Chapter four: Segment Reporting, Profitability Analysis &
Decentralization
4.1 Introduction
For managers to work efficiently, they need information about the
results of the departments they manage more than they need a single
income statement for the whole company, where the income statement of
the company as a whole provides summary information for all the
operations of the company and does not contain enough detail to allow
the manager to discover opportunities and problems that may exist in the
organization. For example, one product may be more profitable while
others are unprofitable, some sales offices may be more efficient than
others, or some factories do not use the capacity or resources available to
them efficiently.
To discover such problems, the manager needs not only one
income statement, but several statements, and these statements must be
generalized to focus on the different sectors of the company. The
preparation of this type of reports is known as Segment reporting.
Segment can be defined as any part of the organization’s activities, the
manager responsible for him needs data on the costs, revenues, and
profits of this sector. Examples of these sectors are sales areas,
showrooms, service centers, production departments in a factory, sales
departments, or types of products. In this chapter, we will discuss how to
prepare income statements that show the results of the activities of the
sectors, as well as how to analyze the ability of sectors to profitability and
how to measure the performance of sectors managers, in addition to how
to use the data of the sectors to achieve the concept of responsibility
accounting for the whole company.

Contents
4.2 Hindrances to Proper Cost Assignment:
In order for the Segment reporting to achieve its intended goals,
costs must be analyzed and assigned properly to the remaining segments
in it. For example, if the purpose is to determine the rate of return of a
particular department, all costs that can be attributed to this department
are the only ones that are assigned to it. There are three practices in the
business world that can greatly impede the process of proper assignment
of some costs, which are:
1. Omission (Excluding) of some costs from the assignment process.
2. Using inappropriate methods for assignment costs among the
company's segments.
3. Arbitrary dividing common costs among segments (Assigning
costs to the company's sectors are in fact overhead costs for the
company as a whole).

4.2.1 Omission of some costs from the assignment process:

The costs charged to the segment should include the costs that
pertain to that segment from the point of view of the entire company’s
value chain. Value chain, shown in Figure 4-1, includes the company’s
main functions that add value to the company’s products or services, and
all of these functions starting with research and development, product
design, manufacturing, marketing, distribution, and customer service are
necessary to deliver the product to customers and then generate revenues.
Figure (4-1) Functions that make up the value chain
Research Product Manufacturing Marketing Distribution Customer
and Design Service
Development

But under generally accepted accounting principles (GAAP), the

cost of product must include manufacturing costs only for the purposes of
the financial report, and therefore when trying to determine the

Contents
profitability of the product for the purposes of internal decision-making,
some companies subtract the manufacturing cost of the product only from
the revenues of this product, and as a result, these companies exclude
from profitability analysis some or all of the upstream costs of the value
chain, such as the cost of research and development, product design and
the costs of the end of the value chain downstream, which consists of
marketing, distribution and customer service, but such these costs at
upstream and downstream of the chain which are usually called in the
income statement as selling, general and administrative expenses
(SG&A) can represent half or more than half of the total costs of the
organization. If costs at upstream and downstream of the value chain are
omitted and excluded from the profitability analysis, the product is
underestimated its cost and therefore management can make a mistake by
maintaining a product that will lead to long-term loss instead of profit, for
this reason and others it is necessary to make the proper assignment of
selling, general and administrative expenses on different products or for
other segments to which it belongs.
In order to avoid excluding costs that are a necessary part of the
correct profitability analysis, some companies turn to the concept of life
cycle costing, which focuses on all costs of the value chain that are
generated throughout the life of the product, and this approach of costs
assignment helps in determining the cost to ensure that no costs are
excluded at making profitability analysis.

4.2.2 Using Inappropriate Methods for Allocating Costs among Segments:

Cost distortion occurs when costs are incorrectly assigned to the
company's segments, and this distortion can occur in two ways: First:
When the company fails to track costs directly to segments in cases where
this can be achieved economically, and second: When the company uses
incorrect bases to assign costs.
Contents
First: Failure to Trace Costs Directly:
The costs that can be traced directly to a particular segment should
not be charged to other segments. These costs must be charged directly to
the relevant segment. For example, the value of the rent of a branch office
should be charged directly to the branch that belongs to it instead of being
included in the total additional costs for the whole company and then
published to all sectors of the company.

Second: Inappropriate Allocation Base:

When it is not easily possible to trace costs to segments, some
companies allocate these costs to segments using judgmental basis such
as the value of sales or the cost of goods sold; according to the sales value
basis, costs are allocated to the company's segments on the basis of a
percentage of the sales of each segment, for example, if a segment
achieves sales equivalent to 20% of the total sales of the company, then it
charges 20% of the selling, general and administrative costs considering
that this is its fair share. The same procedures are followed if we use the
cost of goods sold or another measure as a basis for allocation.

The problem facing this approach is the absence of a cause-and-

effect relationship between the cost to be assigned and the basis used, and
this approach assumes that the pound sales per product generates the
same value of selling and administrative costs, and such an assumption is
rarely effective, as some products cost selling and distribution costs More
than others, and some products need customer service more than others,
and therefore using incorrect bases of assignment such as sales value
ignoring the actual consumption of resources will lead to cost distortion.
4.2.3 Arbitrary Dividing Common Costs among Segments:
The third reason that leads to distortion of segmental costs is to
assign costs to segments even if the segment does not cause them. For

Contents
example, companies allocate the costs of the general management
building to products, although these costs are not affected even if the
production line of this product is completely canceled. Such costs are
called common costs, where they pertain to all operating activities and are
not pertain to a specific segment.
It is natural that these costs are necessary for the activities of the
organization and these costs do not decrease substantially even if an
entire segment such as product lines is eliminated, some companies
reduce these costs in any way on the basis that these costs must be
covered by someone, and since it cannot be denied the fact that these
costs must be covered, assigning overhead (general) costs in a judgmental
manner to the segments does not guarantee this. In fact, adding a share of
these costs to the costs of the segment may lead to the transformation of
the sector’s result from profitability to loss. If the manager mistakenly
cancels this segment, the company’s total profits will decrease This
makes it difficult to cover the overhead (general) costs.
generally, the way that many companies apply the segment
reporting leads to cost distortion, and this distortion results from three
practices: failure to track costs directly to a particular segment when
possible, and the use of an incorrect basis for allocating costs, as well as
allocating overhead (general) costs to segments. These practices are
common among companies.
But the question now is: How can costs be assigned to segments?
In the following pages, we will explain an approach for the Segment
reporting and assigning costs that provides more useful data for managers
to take many decisions. This approach clearly separates the costs that can
be linked to segments from others, as well as shedding light on the
behavior of costs.

Contents
4.3 Segment Reporting and Profitability Analysis:
The Segment reporting approach here uses the contribution form in
preparing the income statement previously studied in the previous
chapters, and when using the contribution form, we mention that:
1. The cost of goods sold consists of only the variable
manufacturing cost.
2. presenting variable costs and fixed costs in two independent
sections.
3. The contribution margin is calculated.
And we will discuss in this chapter that if this statement is divided
by segments, it requires a more division of fixed costs, and this division
allows measuring the segment margin for each of the company's
segments, and the segment margin is a tool for estimating the segment's
ability to long-term profitability.

4.3.1 Levels of Segmented Statements

Segmental income statements can be prepared for activities at
many levels of the company. Figure (4-2) shows three possible levels. We
note from this figure that the first division is based on divisions, then one
of these divisions (Division 2) is divided on the basis of product lines
within the division, then one of the product lines is divided into the
regular model on the basis of the areas of sale, and we notice that as you
move from segmental statements to another, we look at the smaller and
smaller parts of the company, and if the management wanted, division (1)
can be divided into smaller parts in the same way that we divided the
Division ( 2) which gives a more detailed picture of the company's
operations.

Contents
 Figure 4-2
Segmented income statement in the form of contribution to
segments in the form of divisions
Company Segments
Total Division Division
1 2
Sales 500,000 300,000 200,000
- variable costs of goods sold 180,000 120,000 60,000
- Other variable cost 50,000 30,000 20,000
Total of variable costs 230,000 150,000 80,000
Contribution margin 270,000 150,000 120,000
- traceable fixed costs 170,000 90,000 80,000
Segment margin 100,000 60,000 40,000
- common fixed costs 25000
Net income 75000

Segments in the form of product lines:

Segment 2 product lines
Total Duplex Regular
Sales 200,000 75,000 125,000
- variable costs of sold production 60,000 20,000 40,000
- Other variable cost 20,000 5,000 15,000
Total of variable costs 80,000 25,000 55,000
Contribution margin 120,000 50,000 70,000
- traceable fixed costs 70,000 30,000 40,000
Product line margin 50,000 20,000 30,000
- common fixed costs 10,000
Net income 40,000

Contents
Segments in the form of sales areas:
line 2 sales areas
Regular
Total Domestic Overseas
Sales 125,000 100,000 25,000
- variable costs of sold production 40,000 32,000 8,000
- Other variable cost 15,000 5,000 10,000

Total of variable costs 55,000 37,000 18,000

Contribution margin 70,000 63,000 7,000
- traceable fixed costs 25,000 15,000 10,000

sales area margin 45,000 48,000 (3,000)

- common fixed costs 15,000

Net income 30,000

Note that the amount of 80,000 EGP is divided into two parts,
70,000 EGP can be traced and 10,000 EGP is general when dividing
Division 2 into product lines, and the reason will become clear later when
studying "the costs that cannot be traced become general."
There are many benefits of statements series such as those shown in
Figure 4-2. By carefully examining the trends and results of each
segment, a manager can have a deeper view of the company's business
from several angles.

4.3.2 Assigning Costs for Segments:

Note how fixed costs are treated in Figure (4-2), fixed costs have
been divided into two parts: the first is traceable costs, and the second is
general (untraceable) costs. They are treated as overhead costs and
remain separate from the segments themselves. Therefore, according to
this approach, these costs should not be allocated or assigned to the

Contents
segments in a judgmental manner. There are two guidelines to be
followed when assigning costs to the company's segments using the
contribution form:
• First: Assigning costs according to cost behavior patterns (such as
fixed and variable costs).
• Second: Assigning costs according to the possibility of tracking the
cost directly to the concerned segment.
The following we discuss Figure (4-2) in more depth.

4.3.3 Sales and Contribution Margin:

To prepare the segmented statements, it is necessary to have sales
records for each segment separately as well as the total sales of the
organization. After subtracting the variable costs, the contribution margin
can be calculated for each segment and for the company as a whole, as
shown in Figure (4-2)
It is necessary to remember that the contribution margin shows us
the change in profit as a result of the change in volume with the
segment’s capacity and costs remaining the same. Therefore, the
contribution margin is of particular importance for short-term decisions
related to short-term use of capacity such as special orders; Important
decisions related to the efficient use of available capacity are concerned
with variable costs and revenues, which - of course - represent the
important components of the contribution margin. By showing the
segment contribution margin, the manager can be in a position to make
short-term decisions that achieve the maximum effective use of available
capacity and then Achieving the maximum profit possible.

4.3.4 Traceable and Common Fixed Costs:

Traceable fixed costs can be defined as the fixed costs that arise as
a result of the existence of a particular segment and therefore can be
attributed to this segment. Whereas the common fixed costs, they are
Contents
fixed costs that cannot be attributed to a specific segment, but arise as a
result of the wholly company's business, for assigning these costs to
segments, they are assigned and allocated to those segments, using
judgmental methods that are independent of cause-effect relationships
such as sales value.
Examples of traceable fixed costs are the cost of advertising for a
segment, the salary of the manager of that sector (such as a supervisor for
a particular product line), the depreciation of buildings and equipment
dedicated to manufacturing a particular product, and examples of general
fixed costs are advertising costs that include all of the company's
segments, salaries of top management, and depreciation of building assets
of general management.

4.3.5 Identifying Traceable Fixed Costs:

The process of differentiating between traceable fixed costs and
general fixed costs is of particular importance for the purposes of the
segment reporting because the traceable costs are charged to the segment
unlike the general costs, and in some circumstances, it may be difficult to
consider a cost as a traceable or general cost. There are two approaches
can be used to help differentiate them: The first is the use of general
guidelines to determine the traceable costs, and the second is the use of
activity-based costing (ABC).

4.3.6 General guidelines:

One of the guidelines or rules is to consider the cost that can be
traced, if the disappearance of the segment results in the disappearance of
that cost, and for example, if the work of Division (1) in Figure (4-2) is
stopped, then there is no need to pay the salaries of the director of this
Division and therefore the salary of the manager of Division (1) is
considered a traceable fixed cost to this division, and on the other hand,
the company’s president’s salary will continue even if that division is
Contents
excluded. On the contrary, his salary will increase if the decision not to
continue this division was correct, so the company’s president’s salary is
considered a general cost for both division and this idea can be expressed
in another way, costs can be traceable to a sector if they arise as a result
of the emergence of that sector.

4.3.7 Activity-Based Costing (ABC):

Some costs, such as the cost of advertising a particular product,
may be easy to consider as a traceable cost, but the situation is more
complex if two or more segments share a building or other resource, for
example, suppose that a multi-product company rents a warehouse used
to store two of its products. The cost of renting this store, a traceable cost
or a general cost? Managers skilled in analyzing profitability in its
modern form may say that if the cost driver can be identified, the
depreciation can be measured, then the rental cost is a traceable cost and
must be assigned to two products on the basis of their use of that
resource, in the same way they may also say that the costs of processing
orders and costs of sales support and other selling, general and
administrative costs must be charged to the segments on the basis of the
segment's use of these services, as followed according to the activity-
based costing approach.
For clarity, it was assumed that Yazid Company produces three
products (A), (B) and (C). the company has rented space as stores on an
annual basis according to its needs in order to store product (A) and
product (B) and the rent value was 4 EGP per square foot annually, and
product (A) occupied an area of 3,000 square feet, and product (B) 7,000
square feet, and the company has an order operation department, which
cost 150,000 EGP last year, and this cost is driven by the number of
orders. Last year, 2,500 orders were issued, including 1,200 orders for

Contents
product (A), 800 orders for product (B) and 500 orders for product (c),
and accordingly the cost allocated is as follows:
Storage space cost:
Product A: 4 x 3,000 square feet = 12,000 EGP
Product B: 4 x 7,000 sq ft = 28000
Total costs involved = 40,000
Order processing cost:
EGP 150,000 ÷ 2500 orders = EGP 60 per order
Product A: 60 x 1200 orders = 72,000
Product B: 60 x 800 orders = 48,000
Product C: 60 x 500 orders = 30,000
Total assigned costs = 150,000 EGP

This method of assigning costs combines the advantages of

activity-based costing with the advantages of the contribution approach,
and generally supports the manager's ability to measure the ability of
segments to achieve profitability.
When assigning costs to segments, the important point that draws
attention to is the necessity to resist the temptation to allocate these costs
(such as the depreciation of fixed assets of the company) of a clearly
general nature. Any allocation of overhead costs will reduce the value of
the segment's margin as a guide to the segment's profitability in the long
run.
4.3.8 Traceable Costs Can Become Common Costs?
Traceable costs in a segment statement can turn into overhead
(general) costs if the company is divided into smaller segments because
there are limits to a good cost segmentation without using judgmental
methods. The higher these limits, the more the cost will turn into a
general cost.

Contents
 This can be seen from Figure (4-3). We note in this figure that
when the segment is one of the divisions, and that division (2) has 80,000
EGP as traceable fixed costs, of which only 70,000 EGP, the remaining
10,000 EGP becomes general costs for the product lines.
But why is the value of EGP 10,000 transformed from traceable
costs to general costs when the division is divided into smaller segments
those are product lines? This amount may be the monthly salary of
division manager (2). Hence, this salary is a traceable cost if we are
talking about the division as a whole, but it becomes a general cost for the
product lines in this division, where any allocation of the cost of this
salary between the product lines will be according to judgmental bases,
and to avoid this, the division manager’s salary must be treated as a
general cost when this division is divided into segments represented by
product lines.
Figure (4-3) Reclassification of Fixed Expenses
Company Segment
Total Division 1 Division2

Contribution margin 270,000 150,000 80,000

- traceable fixed costs 170,000 90,000 80,000

Segment margin 100,000 60,000 40,000

Division 2 product lines

Total 1 2
Contribution margin 120,000 50,000 70,000
- traceable fixed costs 70,000 30,000 40,000

Product line margin 50000 20000 30000

- Common fixed costs 10,000
Division margin 40,000

Contents
 Product sales areas
line 2
Total Dom. Overs.
Contribution margin 70,000 63,000 7,000
- traceable fixed costs 25,000 15,000 10,000

sales area margin 45,000 48,000 (3000)

The amount of 70,000 EGP remains fixed costs that can be traced
even after the division of division (2) into product lines, where it can be
directly attributed to the two products without the need to use judgmental
methods (that is, on the basis of reasons-effect), and the sum of 70,000
EGP may consist, for example, of advertisements that promote the
product line. On the basis of an amount of 30,000 EGP for the promotion
of the duplex model and 40,000 EGP for the promotion of the regular
model, in this case the advertising costs are traceable fixed costs to each
product line and can be assigned to each without the need to use
judgmental methods of allocation.

4.4 Segment margin

We note in Figure (4-2) that the segment margin can be obtained
by subtracting the fixed costs of the segment from the contribution
margin for this sector, that is, the segment margin represents the available
margin after the segment covers all its costs, and the segment margin is
the best criterion for judging the segment ability on profitability in the
long term, where the costs caused by the segment are taken into account.
If the segment cannot cover its costs in the long term, then perhaps this
segment should not be maintained (unless it has side effects on other
segments), and we note in Figure (4-2) for example, the overseas sales
Contents
segment has a negative segment margin, and this means that this segment
does not cover its costs as it generates costs that exceed its revenue, and
in terms of decision-making, the segment margin is a great benefit when
making long-term decisions such as changing production capacity or
pricing long-term or importing production from abroad instead of making
it. Conversely, the contribution margin is considered to be of great benefit
to short-term decisions, as shown before, such as decisions to change the
short-term volume, pricing a special order, or exploiting the current
production capacity.

4.5 Different classifications of Total Sales:

To obtain more detailed information, the company can show its
total sales divided into multiple divisions. For example, the company can
divide its sales in three different ways as follows:
1. Division according to division.
2. Division according to type of products (product lines).
3. Division according to sales regions (geographically).
In each case, the total sales of the divisions must equal the total
sales of the company, and the different divisions allow managers the
ability to look at the company from several directions.
After dividing these sectors, many companies then re-division into
smaller sectors, as shown in Figure (4-2) above.
Another segment division is illustrated graphically in Figure (4-4)
and many companies can now perform the divisions shown in the

Contents
following:

4.6 Customer profitability analysis

We note in the previous figure that companies analyze profitability
in several ways, either according to products, market sectors, or
distribution channels, and one of the analyzes that is used frequently is
the analysis by customer, and although some managers believe that the
profit per pound of sales for a customer is the same as the profit per
pound of sales for any Another customer, but this assumption is not true
in general, and the reason for this is that every customer has his requests
from activities that consume resources, like products or markets or any
other segment division of the company has different requests, and for
example, a customer requests his purchases in small batches and
frequently, which requires more clerical and handling work, and some
customers request modular (standard) spare parts, which require special
engineering work for machines and perhaps special packaging and

Contents
transportation, and some customers are usually in a hurry and request
special services for transportation and delivery, and he should not favor
those Customers with orders that consume more resource-intensive
activities at the account of those customers who do not require many
customer services, special packaging, etc. unless the cost of the activities
provided to support each of the company’s costumers is tracked,
favoritism to one costumer at the account of other customers will surely
occur
After identifying the various activities to support customer of the
company, the cost of providing these activities must be charged to each
customer who requested them, and accordingly the customer who
requests special credit terms and many small orders, special packages and
special services in his location must charge a price that reflects his
consumption of these costly activities, and for this reason the Suppliers
who supply just in time usually demand higher prices than other
suppliers, and these high prices are requested to compensate these
suppliers for the special activities they undertake to support just in time
costumers.
Companies that analyze customer profitability wonder that a small
number of customers makes most of the company's profits, and it is also
usual to find that a small number of customers consume very large
resources compared to the revenue generated from them.

4.7 Responsibility Accounting

The segmental report is an extension of the responsibility
accounting principle, therefore, by assigning costs and revenues to
segments, top management can identify responsibility for control
purposes as well as to measure the performance of segment managers.

Contents
 Below will be discussed the levels of responsibility on the basis of
which companies delegate their segments, and before discussing these
levels of responsibility, the approach of decentralization in decision-
making must be clarified first.

4.7.1 Decentralization and Segment Reporting

It became clear to the managers that the segment reporting is very
valuable for decentralized organizations. The decentralized organization
is the one in which decision-making is not limited to a limited number of
senior managers, but rather spreads throughout the organization, where
managers at their different levels take important operating decisions
within the scope of their responsibilities, and decentralization must be
viewed in terms of degree as long as all organizations are decentralized to
some degree, as some organizations enjoy high decentralization, and their
number is small, as they focus on leaving the freedom of the sector
manager to make decisions even at the lowest levels. Although most
facilities today fall between these two extremes, the trend is increasing
towards decentralization.
There are many advantages of decentralization, including the
following:
1. As a result of distributing the burden of decision-making at the
various levels of management, the senior management is freed
from many daily problems and devote itself to long-term planning
and coordination of efforts.
2. Giving managers the authority to take supervisory decisions in
their sectors leads to the training of these managers in the
organization. In the absence of such training, managers become
unable to take decisions when they are promoted and given
greater responsibilities.

Contents
 3. Increasing responsibility and decision-making powers usually
leads to an increase in job satisfaction and gives an incentive to
the sector manager to make a lot of effort.
4. The best level of decision-making in the organization is at the
level at which problems and opportunities arise. Usually, the
senior management is unable to closely familiarize themselves
with all the circumstances in all sectors of the company.
5. Decentralization gives an effective basis for measuring the
performance of managers, as long as this manager has the power
to control the sector's results.

4.7.2 Cost, Profit, and Investment Centers

Companies that apply decentralization divide their sectors into
three levels of responsibility, and these levels consist of cost centers,
profit centers, and investment centers, as shown in Figure (4-5), where
the level of the degree of responsibility is arranged from the lowest at the
cost centers to the highest at the investment center, as shown in the
following:
Cost Center
The sector that has the authority to control cost limits is called a
cost center, and the distinguishing characteristic of a cost center is that it
does not have the authority to control the realization (generation) of
revenue or the use of investment funds.

Profit Center:
In contrast to the cost center, the profit center is any sector that has
the authority to control both revenues and costs. For example, the
company (A) in Figure (4-5) is a profit center within the “General Trade”
organization, as it is specialized in marketing its products As it is

Contents
responsible for its production, the profit center is like the cost center has
no control over the use of investment funds.

Investment Center
The investment center is any sector in the organization that has the
authority to control costs and revenues, as well as the use of investment
funds. An example of this is the general management of the “General
Trade” organization. The general management has the absolute
responsibility to ensure that production and marketing goals are achieved,
and in addition, they are responsible for Providing the equipment and
capabilities necessary to carry out production and marketing functions
and to ensure that there is sufficient working capital for the needs of
operations, and accordingly, any sector in the organization has the
authority to monitor and control various investments such as buildings,
machinery, equipment, receivables, inventory and entering new markets,
it is called an investment center, and it can be Company (A) in Figure (4-
5) is an investment center if it has the authority to monitor and control the
funds of investments in some of these purposes. Company (A) is usually
a profit center in the large organization and has the majority or all
authority to make decisions that were made in The main center.
We must be aware that a lot of confusion occurs in the business
world between the profit center and the investment center to the extent
that it uses one instead of the other. One of the sectors may be referred to
as a profit center, while the manager in fact has all the control and control
authority in making investment decisions.
We note from Figure (4-5) that all of the cost, profitability and
investment centers are referred to as responsibility centers.

Contents
4.7.3 Measuring Management Performance
These concepts of responsibility accounting are of great
importance as long as they help to determine the scope of the manager
responsibility and also to determine the evaluation of his performance.
Cost centers are evaluated through performance reports, either by
measuring the extent to which they achieve established cost standards, or
by measures based on activities that focus on continuous improvement,
and profit centers are evaluated through a contribution income statement
by measuring the extent to which they achieve costs and sales goals.
Investment centers are evaluated by contribution income statements , but
usually on the basis of the rate of return on investments, and in the
following we discuss the rate of return on investments as a tool for
measuring management performance in a segment viewed as an
investment center.

Contents
4.7.4 Rate of Return on investments for Measuring Managerial
Performance:
When the company follows decentralization, sector managers are
given a great deal of autonomy in managing the businesses that fall
within the limits of their responsibilities. This independence may reach
the point of considering profit centers and investment centers as if they
were independent companies, and managers have the authority to control
and make decisions as if they were managing the business for their own
account, and as a result of this independence there becomes fierce
competition among the managers so that each of them fights to make his
segment the best among the segments of the company.
Competition occurs between investment centers, especially when
distributing the funds necessary to expand production, or when
introducing a new product. How can the top management of the head
office decide which centers need investment funds to provide, and which
of them is more profitable to use?
Perhaps one of the most popular methods of evaluation is to
measure the rate of return on investment that investment center managers
can achieve on their assets. This can be done through the return on
investment (ROI) equation as follows:

4.7.5 The Return on Investment (ROI) Equation:

To understand the elements that make up the return-on-investment
equation, we refer to the following figure (4-6):

Contents
 As shown in the previous figure, the rate of return on investment is
obtained as a result of multiplying the profit ratio by the turnover rate
(asset turnover rate). The profit ratio measures the management’s ability
to control operating costs in relation to sales. The lower the operating
costs for each sales pound, the higher the earned profit ratio. As for the
turnover rate part in the return-on-investment equation, it is a measure of
the sales value that the investment center can achieve for each pound
invested in assets. This equation can be expressed as follows:
Return on Investment = Profit Margin Ratio x Asset Turnover Rate
Return on investment = (net operating income/ sales) x (sales / assets)
Return on investment = net operating income / assets
In the past, managers tended to focus on the profit margin ratio
only and ignore the asset turnover rate, but the profit margin ratio can be
valuable when measuring the manager's performance to some degree, but
it ignores a very important point in the manager's responsibilities, which
is the control of the investments of operating assets. If fixed assets

Contents
include excessive investments it will lead to the same impact on
profitability, such as an increase in operating expenses.
Perhaps one of the real advantages of the rate of return-on-
investment equation is that the manager is forced to control investments
such as controlling costs, and earned profit margin, completely.
DuPont Company was the first company to pay attention to both
the profit margin ratio and turnover rate to measure the performance of
the manager. This company is credited with pioneering the use of the rate
of return on investment in its previous analytical form. This company was
followed by another major company “Monsanto” and others in this use.
And the rate of return on investment in this form is the rate that is now
widely used as the important measure of the manager performance when
the manager has the authority to monitor and control the investment
center. The return-on-investment equation deals with several different
aspects of the manager responsibilities and highlights them in a single
number, which can be compared with the returns resulting from
competing positions in the company, as well as compared to the return in
other companies in the industry.

4.7.6 Net Operating Income and Operating Assets Defined

We note in Figure (4-6) that net operating income, not net income,
is used in the equation for the rate of return on investment when
calculating the profit margin ratio, and net operating income is the net
income before interest and taxes, and it is sometimes referred to in
business language “Earnings Before Interest & Taxes” (EBIT), and we
must be aware of such concepts. The reason for using net operating
income in the equation is that the net income figure used should be
consistent with the turnover basis which consists of operating assets.
Operating assets include cash, debtors, inventory, as well as
buildings, machinery, equipment and other assets. Examples of assets that
Contents
are not included in this group are lands that are kept for use in future
expansions or factory buildings leased to others. Operating assets are
calculated for the purposes of the equation on the basis of its average
value at the beginning and end of the period.

4.7.8 Plant and Equipment: Net Book Value or Gross Cost?

The main issue when measuring the rate of return on investment is
calculating the value of buildings and equipment that are included in the
basis of operating assets. To clarify this, we assume the following values
for the buildings and equipment of a company:
Machinery and equipment 3,000,000 EGP
Minus: Accumulated depreciation 900,000 EGP
Net book value 2,100,000 EGP
But the question now is: What value does the company use as
operating assets when calculating the rate of return on investment? One
of the widely used approaches is to use the net book value of the assets,
i.e., the net value after deducting the accumulated depreciation (i.e.,
2,100,000 EGP in the previous example), and the other approach ignores
the depreciation and then uses the total cost of these assets (i.e.,
3,000,000 EGP in the previous example). In practice, both approaches are
used, although each of them produces a different value for the operating
assets required to calculate the rate of return on investment.
The following are the opinions in favor and against the use of net
book value or total cost of operating assets:

Opinions in favor of net book value:

1. It is consistent with how machinery and equipment are reported
in the balance sheet (the cost minus the accumulated
depreciation).

Contents
 2. It is consistent with the calculation of net operating income,
which includes depreciation as operating costs.
Opinions against net book value:
1. It leads to an increase in the rate of return on investment over
time, as the book value decreases annually as a result of
depreciation operations.
2. It does not encourage the replacement of new assets instead of
the old ones, as the purchase of new assets will have a
significant impact on the rate of return on investment.

The following are the opinions in favor and against the use of total
assets cost as operating assets:
Opinions in favor of total cost:
1. It excludes both machine life and depreciation methods as
affecting factors when calculating the rate of return on
investment.
2. It allows the manager to renew and replace old machines with
less adverse effect on the rate of return on investment.
Opinions against total cost:
1. It is not in line with the income statement or the balance sheet in
terms of ignoring the depreciation value.
2. It includes double counting with the original value of the asset
plus the recovered value from the original value of the assets
(during depreciation operations), as both appear within the basis
of operating assets.
Managers consider the above considerations, and the result is that
most companies use net book value when calculating the rate of return on
investment and in this book net book value will also be used unless one
example assumes otherwise.

Contents
4.7.9 Controlling the rate of return on investment:
When measuring by the equation of rate of return on investment,
this can prompt the investment center manager to improve profitability in
three approaches:
1. By increasing sales.
2. By reducing costs.
3. By reducing assets.
In order to clarify this, let us assume the following data for one of
the investment centers:
Net operating income 10,000 EGP
Sales 100,000 EGP
Average operating assets 50,000 EGP
The rate of return on investment generated by this center is as
follows:
Return on Investment = Profit Margin Ratio x Asset Turnover Rate
Return on investment = (net operating income/ sales) x (sales / assets)
Return on investment = (10,000/ 100,000) x (100,000 / 50,000)
= 20 %
As mentioned earlier, to improve the value of the rate of return on
investment, the manager must either:
1. Increase sales.
2. Reduce costs.
3. Reduce operating assets.

Approach (1): Increase Sales:

In our example, assume that the manager can increase sales from
100,000 EGP to 110,000 EGP, and also assume that as a result of good
control over costs or as a result of the fact that the majority of the
company’s costs are fixed costs, the net operating income increased

Contents
rapidly from 100,000 EGP to 12,000 EGP in the period, and the operating
assets remained without change
Return on investment = (12,000/ 110,000) x (110,000 / 50,000)
= 24%
We note here that when sales increased by 10,000 EGP, and then
the net operating income increased by 2,000 EGP, this led to an increase
in the rate of return on investment from 20 % to 24 %.

Approach (2): Reduce Costs:

Suppose that the manager is able to reduce costs by 1,000 EGP, so
that this leads to an increase in net operating income from 1,000 EGP to
11,000 EGP, and sales and operating assets remain unchanged.
Return on investment = (11,000/ 100,000) x (100,000 / 50,000)
= 22 %
Approach (3): Reduce Assets:
Assume that the manager is able to reduce the working assets from
50,000 EGP to 40,000 EGP and the net operating income remains
unchanged:
Return on investment = (10,000/ 100,000) x (100,000 / 40,000)
= 25%
Perhaps a clear understanding of these three approaches to
improving the rate of return on investment is a very important issue for
the effective management of the investment center, and each of these
approaches will be dealt with in more detail.
Increase Sales:
From the first look at the equation of the rate of return on
investment, some may think that the sales number is neutral, as it appears
as a number for the denominator in the profit margin ratio calculation and
also appears as a number for the numerator in calculating the turnover

Contents
rate, and therefore the sales number can be omitted, but we do not do that
for two reasons:
• First: that this draws attention away from the fact that the rate of
return on investment is a function of the two variables, profit
margin ratio and turnover rate.
• Second: This may hide the fact that the change in sales may affect
either the profit margin ratio or the turnover rate in the company.

To clarify, the change in sales affects the profit margin ratio if

expenses increase or decrease at different rates from sales, for example,
the company may be able to impose strict control on its costs while its
sales increase, allowing net operating income to increase at a faster rate
than sales and allowing a percentage of the profit margin to increase, or
the company may have many fixed expenses, which remain constant
despite the increase in sales, allowing a rapid increase in net operating
income, and then increasing the percentage of the profit margin. One (or
all) of these factors may be responsible for the increase in the percentage
of the profit margin from 10% to 10.91% as indicated by the previous
approach (1).
Moreover, the change in sales may affect the turnover rate if it
increases or decreases without an increase or decrease in operating assets
in the same proportion, and in the first approach - for example - it
increased from 100,000 EGP to 110,000 EGP and operating assets
remained unchanged. As a result, the turnover rate increased from 2 to
2.2 for this period.
In brief, the change in sales may affect either the profit margin
ratio or the turnover rate of the company, and such changes are of special
importance to the manager when trying to control the rate of return on
investment.

Contents
Reduce costs:
Often the easiest way to increase profitability and improve the rate
of return on investment is to make extensive efforts to control costs. If the
profit margin drops, that is the first thing the manager does, and optional
fixed costs are subject to examination first, and some programs must be
reduced or cancelled to reduce costs. But the manager must be careful
when doing so, and he must always remember that frequent reducing can
have a devastating effect on the morale of the company.

Reduce Operating Assets:

Managers are often interested in monitoring and controlling sales,
operating costs, and operating profit margin, but they are not as
concerned with monitoring and controlling investments in operating
assets. Companies that apply the rate of return-on-investment approach to
measure management performance have found that the first reaction of
investment center managers is to reduce their investment in operating
assets, and the reason for this is that these managers believe that
increasing investment in operating assets will reduce the turnover rate of
assets and change the rate of return on investments, and if these managers
reduce their investments in operating assets, this will lead to freeing up
money that can be invested in field another in the company.
But what are the approaches through which the manager of the
investment center can try to control the investment in operating assets?
One of these approaches is the reduction of stock of inventory that is not
needed, and following the on-time purchase and production on time was
very useful in reducing all types of inventory, which led to a clear
improvement in the rate of return on investment in many companies, and
the second of these approaches is to speed up the collection of debtors,
and one of the ways to speed up the collection of debtors is to use “the

Contents
box lock” method, whereby customers can send money directly to the
company’s local post office, which speeds up the process of collection,
which leads to a reduction in the total investments in debtors (excess
funds are used as a result to pay off short-term creditors). If the debtors'
balance decreases, the asset turnover rate increases.

The Problem of Expenses and Assets Allocation:

It is usual in organizations that follow decentralization to allocate
to the independent divisions the costs that occur in the public
management, and when making this allocation an important question
arises: which of these costs is included in the calculation of the rate of
return on investment for each of these divisions.
There is an opinion that says that these allocated costs should be
added when calculating the rate of return on investment as long as they
represent the value of managerial services for the division provided by
the general management, but on the other hand there is an opinion that
says that they are not included in the calculation as long as the division
manager does not have the authority to monitor and control these costs,
they also represent services of undetermined value.
In any case, it should not be included in the calculation of the rate
of return on investment, any allocations that are determined judgmentally.
Where there is a high risk of bias against or with a division as previously
mentioned, the allocated costs should be limited to the costs of actual
services provided to the division which the division cannot undertake
alone. The value assigned to the division shall not exceed the cost of the
division performing these services on its own.
These same guidelines are followed when allocating the value of
assets from the head office to the independent divisions, and the operating
assets of the independent divisions must not include any assets for

Contents
operating the organization as a whole when calculating the rate of return
on investment unless there are clear and traceable benefits to the division
of these assets, and as we mentioned Previously, judgmental assignments
(e.g., assignments on the base of sales value) should be avoided.

Criticisms of ROI:
Despite the wide use of the rate of return on investment in
performance evaluation, it is not a completely complete tool, but is
subject to many of the following criticisms:
1. The rate of return on investment tends to focus on evaluating
profitability performance in the short term rather than the long
term. The manager's attempts to improve the rate of return on
investment may lead to the rejection of profitable investment
opportunities.
2. The rate of return on investment is not consistent with the cash
flow models used in the analysis of capital expending.
3. The rate of return on investment is not subject to the control of
the independent division manager in the presence of committed
costs, and this leads to the difficulty of distinguishing between
the manager's performance and the division performance as an
investment.
In an attempt to overcome these problems, some companies use
some criteria in evaluating performance instead of relying on the rate of
return on investment alone. These criteria include the following:
• Growth in Market Share
• Increase in profitability
• Dollar Profits
• Receivables Turnover
• Inventory Turnover

Contents
 • Product Innovation
• The ability to expand into new profitable areas
There is a feeling that the use of multiple performance
measurement criteria such as those mentioned above gives a more
comprehensive picture of a manager's performance than can be obtained
based on the rate of return on investment alone.
4.7.10 Residual Income - Another Measure of Performance:
We have assumed that the purpose of investment centers is to
maximize the rate of return on investment that can be achieved from
operating assets, and there is another approach to measure the
performance of the investment center, which focuses on a concept known
as “Residual Income”, and the residual operating income is the net
operating income that the investment center can earn above a minimum
for the rate of return on investment in operating assets, and the purpose of
using residual income when measuring performance is to maximize the
total value of residual income and not the rate of return on investment.
The following are comparative data for two divisions in a
company, and that the rate of return on investment will be calculated for
division A, and the residual income for division B:
Performance measure
Rate of return on Residual Income
investment (ROI) (RI)
Division (A) Division (B)
Average Operating Assets 100,000 EGP (a) 100,000
Net Operating Income 20,000 EGP (b) 20,000
Return on investment (b ÷ a) 20%
Assuming the minimum rate of 15,000
return is 15%. (100,000 x 0.15)
Residual income
5,000

Contents
 It is noted that Division (B) achieved a positive residual income of
5,000 EGP, and the performance of the manager of the Division (B) is
judged based on the increase or decrease of this value from year to year,
and the higher the number of the residual income, the better the
performance of the manager of the division.

Motivation and Residual Income

Many companies believe that residual income is a better measure
of performance than the rate of return, because residual income
encourages managers to enter into profitable investments, which he may
reject if his performance is measured by the equation of the rate of return
on investment, and for clarity, we assume that each of the previous two
divisions has an opportunity investment of EGP 25,000 in a new project
that achieves 18% on operating assets, and that the manager of division
(A) may refuse this opportunity. From the previous table it is noticed that
this division achieves a 20% return on its assets, because if the new
project that achieves 18% is accepted, the rate of the return on investment
will decrease as shown in the following:
Current New Total
Average Operating Assets (a) 100,000 25,000 125,000
Net Operating Income (b) 20,000 4,500 24,500
15000x 18%

Return on investment (b ÷ a) 20% 18% 19.6%

Since the performance of the division manager is measured based

on maximizing the rate of return on the invested assets, he will not be
enthusiastic about taking the available investment opportunity as long as
this will lead to a decrease in the rate of return on investment, despite the
fact that taking this opportunity will be in the interest of the whole
company.

Contents
 On the other hand, the manager of division (B) will accept this
investment, as his goal is to maximize the residual income and not the
rate of return on the investment, as any investment that produces an
income of more than 15% is attractive as long as it leads to an increase in
the total value of the residual income, and the new investment, which will
achieves return of 18%, will be attractive, as shown in the following:
Current New Total
Average Operating Assets a 100,000 25,000 125,000
Net Operating Income b 20,000 4,500 24,500
Assuming the minimum rate of 15,000 3,750 18,750
return is 15%. 25000 x15%

Residual income 5,000 750 5,750

Accordingly, when the manager of Division (B) accepts the new

investment, this leads to an increase in the total value of the residual
income, which shows an improvement in the performance of this
manager. The rate of return on the total investment of the division may
decrease as a result of accepting the new investment, but this does not
matter as long as the performance is evaluated on the basis of residual
income and not the rate of return on investment, the interest of the
manager and the interest of the company will be maximized by accepting
any investments with a rate of return greater than 15%.

Comparison among Divisions and Residual Income

A major disadvantage of the residual income approach is that it
cannot be used to compare divisions of different sizes, as it naturally
leads to a bias in favor of larger departments, where we can expect larger
divisions to generate more residual income than smaller divisions, not

Contents
due to the large divisions are better managed, but this is due to the large
numbers used in the calculation.
For example, let us assume the following residual income accounts
for the two divisions (x). (y):
X Y
Average Operating Assets (a) 1,000,000 250,000
Net Operating Income (b) 120,000 40,000
Assuming the minimum rate of return is 10%. 100,000 25,000
Residual income 20,000 15,000

Note that division X has a little more residual income than division
Y, but division X has operating assets of EGP one million, and division Y
has operating assets of no more than EGP 250,000, so the increase in
residual income for division X may be referred to its size and not to the
level of efficiency of its management. In fact, it can be said that the
management of the smaller division is better, as it was able to achieve a
residual income close to the residual income in the larger division with
only a quarter of its investments.

4.8 Transfer Pricing:

Particular problems arise when evaluating the performance of
segments when the divisions deal with each other. This problem revolves
around the question of transfer prices between divisions. The transfer
price is defined as the price that one segment of the company pays to
another segment for the goods or services it provided to it.

4.8.1 The Need for Transfer Prices:

Assuming that a horizontally integrated company consists of three
divisions:
1. Mining division.

Contents
 2. Operation division.
3. Manufacturing division.
The mining division extracts the raw material and transfers it to the
operating division, and after operation, the operating division transfers
these materials to the manufacturing division and enters them as part of
the complete production.
In this example, there are transfers between the divisions of this
company. What are the prices that govern these transfers? Does this price
include "some profit" for the selling division? Or is it at the combined
cost at the transfer point? Or is it determined by any other value? The
problem becomes more complicated if the selling division supplies part of
its production to external customers and the rest to sister divisions, and
other complications occur when the price of one of the divisions
represents a cost to the division transferred to, and the higher this cost,
the lower the rate of return of the buying division, so the buying division
wants to be the transfer price is low, while the selling division wants this
price to be high, and the selling division may even request that the
transfer price for internal divisions is the same as the market price for
external customers.
It should be noted that transfer prices between sectors do not have
an easy solution and usually lead to conflict between managers of
investment centers. However, a certain transfer price must be set so that
the performance of the company’s departments can be evaluated. The
methods generally used in setting transfer prices are:
1. Transfer prices based on cost using:
• Variable costs.
• Total costs.
2. Transfer prices based on the market price.
3. Transfer prices based on a negotiated price.
Contents
 Below we discuss each of these approaches of transfer pricing:

4.8.2 Transfer Prices at Cost:

Many organizations set transfer prices between divisions on the
basis of the total costs of transferred goods and without calculating any
profits for the selling division, and this transfer price may be calculated
on the basis of variable cost, or fixed costs are taken into account and
therefore the transfer price is calculated on the basis of the total cost up to
a point transferring, and although the cost approach when setting transfer
prices is relatively easy to apply, it has some disadvantages, and this
appears from the following clarification:
Suppose that a multi-divisional company, the transformers
division, manufactures a product that is widely used as a part of the
government contracting business component, and the unit production
requires 12 EGP at a variable cost, and it is sold at 20 EGP, and each unit
needs one hour of direct labor, and the division capacity is 50,000 units
annually.
The company also has a motors division, and this division has
created a new motor that requires an electrical transformer, but it differs
from those manufactured by the transformers division. There are two
alternatives available for the motors division:
1. The new electrical transformer can be purchased from an
external supplier at a price of 15 EGP per unit on the
basis of purchasing 50,000 pieces annually.
2. The new electrical transformer can be made in the
transformer division, which differs from the usual
production for this division, since making this
transformer will take all its production capacity, and the
production of the transformer requires a direct labor hour
(which is the same time it takes for the old product) and
Contents
 the variable costs of manufacturing are 10 EGP per unit,
in addition to transformers, the production of the motor
needs 25 EGP, the value of other variable costs, and one
motor is sold at 60 EGP.
Will the transformers division stop producing the old transformer
and start producing the new transformer for the motors division, or will it
continue producing the old transformer and let the motors division buy its
needs from outside suppliers?
Let us assume first: that the motors division decided to buy
transformers from external suppliers at a price of 15 EGP per unit, which
allows the transformers division to continue producing and selling the old
transformer.
At the beginning of Table (4-7) there is a partial income statement
to show the impact of each division decision on the whole company. We
note from the figure in alternative (1) that each division will achieve a
positive contribution margin and that the whole company will achieve a
contribution margin of 1,400,000 EGP per year if accepted the first
alternative.
And let us assume second: that the motors division decided to buy
the new transformer from the transformers division at a price of 10 EGP
(representing the variable cost per unit in the transformers division), and
it required that the transformers division stop producing the old
transformer, and it may seem on the surface that this decision is correct as
long as the variable cost of the new product is 10 EGP, and the variable
cost of the old product is 12 EGP, and that the motors division would
have purchased this transformer from abroad at a price of 15 EGP per
unit, but that seems incorrect if we look at the last part at the end of Table
(4-7) (the second alternative), we note that this alternative will lead to a

Contents
decrease in the contribution margin for the whole company by 150,000
EGP per year.
Here, one of the defects of the cost approach in determining
transfer prices appears: the cost approach to transfer prices may lead to
dysfunctional decisions because there is no mechanism for this approach
in the company that tells the manager what transfers should or should not
take place between divisions, and in our case, the transfer should not be
made, and the transformers division continues to sell old transformers to
government contractors, and the motors division buys new transformers
from outside suppliers, although the matter is ambiguous in the case of
divisions that produce multiple products, so using cost as a basis for
determining transfer prices can affect the profits of the company as a
whole adversely which managers may not realize.
The table (4 - 7) also shows another defect of using costs as a basis
for transfer prices, the only division that will show profits is the last
division that presents final sales to consumers, while other divisions such
as the transformers division as shown at the bottom of the figure will not
make any profits, therefore, evaluation by rate of return on investment or
by residual income becomes not possible.
Table (4 - 7)
The effects of pricing transfers between divisions on a cost basis:

The first alternative: The Motors Division buys new transformers

from an external supplier at a price of 15 EGP per unit, and the
Transformations division continues to produce and sell old transformers:
50,000 units during the year.

Contents
 Transformers Motors The whole
Division Division company
Sales (20 EGP for the old 1,000,000 3,000,000 4,000,000
transformer, 60 EGP for the
motor)
Minus: variable costs
(12 EGP for the old transformer. 600,000 2,000,000 2,600,000
40 EGP * for the motor in a row

Contribution margin 400,000 1,000,000 1,400,000

* 15 EGP the cost of the external supplier of new transformers + 25

EGP other variable costs = 40 pounds for the motor.

The second alternative: The Motors Department buys new

transformers from the Transformers division at an internal transfer price
of 10 EGP per unit (the unit variable cost of new transformers, which
means stopping selling transformers abroad.

Transformers Motors The whole

Division Division company
Sales (10 EGP per transformer, 500,000 3,000,000 3,500,000
60 EGP per motor)
Minus: variable costs
(10 EGP per transformer, 35 500,000 1,750,000 2,250,000
EGP * for the motor)

Contribution margin zero 1,250,000 1,250,000

Contents
 ** EGP 10 internal unit transfer price from the new transformer +
EGP 25 other variable costs = EGP 35 for the motor.

By comparing the results of the two alternatives, the first

alternative is preferred, which is to buy the new transformers motors
division from an external supplier and not buy them from the
transformers division, because this will provide the company with a
contribution margin of 150,000 EGP.
There is an important criticism for determining transfer prices on
the basis of cost, which is that there are no incentives for the departments
to control the cost, If the cost of one division will be transferred to
another division, there will be no incentive for any of them to control the
costs, and the other division shall charge a transfer price that includes all
the loss and inefficiency in the previous divisions, and thus penalized as a
result of achieving a lower rate of return than competitors, and experience
has shown that as long as costs are not subject to any competitive
pressures at the point of transfer waste and inefficiency usually arise.
Therefore, due to these shortcomings, transfer prices based on cost
are not commonly used. However, proponents of this approach argue that
it is easy to understand and convincing, especially if they use standard
costs instead of actual costs, which at least avoids not transferring
inefficiencies from one division to another.

A General Equation for Computing Transfer Prices

There is an Equation that the manager can use as a starting point to
calculate the correct transfer price between divisions or segments of the
multi-division company. The equation is that transfer prices must equal
the variable cost per unit of the products transferred plus the contribution
margin per unit that the selling division can lose as a result of stopping
the sale of products abroad. This equation can be expressed as follows:

Contents
 Transfer price = variable cost per unit + contribution margin per
unit lost as a result of not selling the unit abroad. By applying this
equation to the previous example for the transformers division and for the
motors division, the transfer price is as follows:
Transfer price = 10 EGP Variable costs of the transformer + 8 EGP
(Contribution margin lost from the transformers division as a result of
stopping the sale of transformers abroad: 20 EGP Selling price – 12 EGP
Variable cost = 8 EGP Contribution margin for old transformers) = 18
EGP.
By looking at this transfer price, it seems to the management not to
accept transfers between the two divisions, as the motors division can buy
its need of new transformers from outside the company, where it can be
purchased at an amount of 15 EGP per unit, so this transfer price allows
the management to reach the right decision and avoid any bad effects on
the profits.
There are two points that must be taken into consideration: The
first is that the transfer price equation must always represent the
minimum transfer prices, since the selling division must obtain the price
indicated by the equation in order to be in a position equal to selling to
customers abroad, and in certain circumstances, transfer price can be
increased more than the value indicated by the equation, but it cannot be
less than that, otherwise the whole company will lose. Second, the
transfer price calculated by the equation is based on competitive market
conditions. The rest of our study in this chapter will focus on setting
transfer prices on a market basis.

4.8.3 Transfers at Market Price - General Considerations:

Some forms of competitive market prices (i.e., the price
determined by the open market) are seen as the best approach for
determining transfer prices, and the reason for this is that it is in line with
Contents
the objectives of profit centers, and leads to the possibility of preparing a
performance report on the basis of profitability at different levels of the
organization. And since all of the company's sectors can show profits
from its efforts, not just the last division, the market price also helps in
determining when transfers are made as we saw above, and it leads to
taking the most appropriate decisions related to transfers that arise daily.
The market price approach is appropriate for highly decentralized
organizations, meaning that it is used in organizations in which branches
or divisions managers have sufficient independence to make decisions to
the extent that these divisions are seen as if they were independent
organizations in achieving profits, and the idea behind the market price to
control transfers is to create competition conditions in the market among
divisions as if they were truly separate and independent, and they
negotiate and contribute under open market conditions and to the extent
that they reflect market price results and actual market conditions, and so
divisional results provide an excellent basis for assessing management
performance.
The National Accountants Association describes other advantages
of the market pricing approach as follows:
It is expected that the needs will be managed internally when its
production of goods or services is well designed, of high quality and at a
good price, and it can meet the delivery schedules. As long as these
requirements can be met, the receiving division will not lose anything and
the company will receive the profits that the supplier would have
obtained, the receiving division usually has the advantage of imposing
more control over the quality and ensuring the flow of its needs and
received on time.

Contents
 In addition to the aforementioned equation, there are broad lines
that must be followed when using market prices as a basis for transfers
between divisions, which are:
1. The division continues to purchase internally as long as
the selling division fulfills all requirements for external
purchase in terms of price and all other requirements.
2. If the selling division is not able to meet the price and all
the requirements of purchasing externally, the buying
division is free to purchase from abroad.
3. The selling division shall be free to sell abroad if this is in
its favor.
4. A committee shall be formed to resolve the issues of non-
approval of the transfer prices by the divisions.

4.8.3.1 Transfers at Market Price: Well - Defined Intermediate

Market
Not all companies or divisions may have the same market
conditions. The sole customer of one division may be another brother
division. In other cases, there may be no market in which these products
can be sold immediately and in their current form to customers, instead of
internally transferring them, and therefore if there is this intermediate
market, the division is free to sell its products to external customers in the
intermediate market or sell them to the internal divisions of the company,
and we will assume in the following the existence of a strong and good
intermediate market:
Let us suppose that division A of the international company has a
product that can be sold either to division B or to overseas customers in
the intermediate market, and the following is the revenue and cost
structure for these two divisions:

Contents
 Division (A) Division (B)
- The selling price in the 25 - The final sale price abroad 100
intermediate market - Transfer price from division A 25
- Variable costs 15 (Or buy from the intermediate
market)
- Additional costs in division B 40

What is the transfer price between the two divisions? In this case,
the answer is easy, and it is that the transfer price should be 25 EGP,
which is the price at which division (A) can sell in the intermediate
market, as well as the price at which division (B) can buy from the
intermediate market. This result can be reached by the above-mentioned
equation:
Transfer price = variable costs per unit + lost contribution margin
per unit sold abroad
= 15 EGP + (25 EGP - 15 EGP = 10 EGP) = 25 EGP.
The following figure (4-8) shows the selection opportunities for the
two divisions:

Contents
 As long as division A will receive at a transfer price of 25 EGP
from division B, it is ready to sell all its production internally, and when
selling to division B, division A will be in the same position if it sells its
production abroad at 25 EGP. In the same way, as long as the external
supply price is 25 EGP, division (B) will be willing to pay this price to
division (A), so the intermediate market price of 25 EGP is an acceptable
transfer price for both divisions, and then the transfer at this price can be
summarized in the following table:
Division A Division B Total
Company
Sales per unit 25 100 100
Minus: variable costs per unit 15 40 55
Transfer price per unit - 25 -

Contribution margin 10 35 45

Contents
 The contribution margin achieved by the company as a whole is 45
EGP per unit, and by using the intermediate market price of 25 EGP to
control the company’s internal transfers, this company will be able to
show the amount of this contribution that is realized from the efforts of
division A and the amount achieved from the efforts of division B, These
data are used as a basis for evaluating the managerial performance of the
divisions using the two approaches: rate of return on investment or
residual income.

4.8.3.2.Transfers at Market Price: Price Changes in the Intermediate

Market:
We previously assumed that there is a perfect agreement in the
price in the intermediate market and accordingly division B can buy its
needs from an external supplier at a price of 25 EGP, which is charged by
division A. In fact, there is no such perfect agreement, or it may be
affected as a result of suppliers’ decisions to reduce prices for any reason.
Referring to the previous example, and instead of the normal intermediate
market price of 25 EGP charged by division A, let us assume that one of
the suppliers offers to supply goods at 20 EGP per unit. Does division B
accept this offer? Or does division A accept to reduce the transfer price to
20 EGP so that it can continue to deal with division B? The answer
depends on whether division A (the seller) is operating at or below full
capacity.

First Assumption: Selling Division at Full Capacity:

If division A (the selling division) is operating at full capacity, then
it has refused to sell abroad until it can meet the demands of division B,
and under these circumstances, the transfer price is calculated in the same
previous formula:

Contents
 Transfer price = variable costs per unit + lost margin per unit from
outside sales
Transfer price = 15 + (25 external selling price – 15 variable costs)
= 15 + 10 = 25 EGP
It should be noted that the price determined by the formula usually
represents the minimum transfer price as long as the selling division must
get at least the price that it could have obtained from selling abroad, so
division A must not reduce the price below 25 EGP in order to sell for
division B, if division A reduces its price, it will lose 5 EGP of the
contribution margin, and the loss will befall it and the whole company.
In short, it can be said that as long as the selling division must stop
selling externally in order to sell internally, it charges in this case the
opportunity cost, which must be taken into account when determining the
transfer price. As can be seen from the previous equation, this
opportunity cost is represented in the contribution margin lost as a result
of not selling abroad. If the transfer price is not able to cover the
opportunity cost in addition to the variable costs associated with this sale,
it is better not to transfer.

Second Assumption: Selling Division with Idle Capacity:

If the selling division has idle capacity, then we are facing a
different situation, the opportunity cost in this case is zero (depending on
the alternative uses of this idle capacity), and even if the opportunity cost
is zero, many managers also see that the transfer prices should be based
on the market price so that these prices can be determined accurately and
fairly, and others may see that the presence of idle energy and when the
opportunity cost is zero (or closer to zero), this is a reason to reduce the
transfer price in the market price so that both the seller and the buyer
division can make profits from transfers inside the company.

Contents
 In the case of idle capacity, as long as the selling division gets a
price in excess of the variable cost (at least in the short run), all parties
get benefits from selling internally rather than selling abroad.
This can be proved by referring to the previous example: We
assume again that an external supplier offers to sell the new transformers
for division B at a price of 20 EGP per unit, and we assume that division
A has enough idle capacity to produce the needs of division A with no
opportunity to generate external additional sales at market price 25 EGP
per unit. When applying our equation, the transfer price between the two
divisions A and B is as follows:
Transfer price = variable cost + lost contribution margin per unit from
external sales
= 15 EGP + zero = 15 EGP.
As we mentioned earlier, the price of 15 EGP represents the
minimum transfer price. In practice, the transfer price ranges between this
price and 20 EGP, which the external supplier offers to division B. In this
case, there is a range of the transfer price as follows:

20 ⎯
⎯ Transfer price range ⎯⎯
→ 15

Maximum Transfer price Minimum Transfer Price

If division A (the seller) is reluctant to reduce its price, is it

required to ask it to accept a price of no less than 20 EGP to supply the
needs of division B? The answer is no according to the previous

Contents
explanation, and unless division A gets 20 EGP per unit, it is preferable
to leave its idle capacity and search for another profitable production.
If division A decides not to reduce its price below 20 EGP in order
to face external competition, should division B pay 25 EGP for transfers?
The answer is also no, as the previous explanation say that as long as the
buying division does not obtain the prices offered by the external
supplier, it is free not to sell internally, but if the selling division has idle
capacity and the buying division buys from abroad, then the selling
division will achieve less optimization, and perhaps also for the buyer and
certainly for the whole company, and by less optimization we mean that
the overall level of profitability is less than what can be gained by the
division or the company as a whole.
In our previous example, if division A refuses to accept the price of
20 EGP, it will lose, as well as the whole company, an amount of 5 EGP,
the value of the contribution margin (20 EGP - 15 EGP = 5 EGP). In
short, in the case of idle production capacity, every effort must be made
to negotiate an acceptable transfer price for both seller and buyer, which
maintains the deal between the company's divisions.

4.8.4 Negotiated Transfer Price:

Some situations in which it is possible to justify a transfer price
lower than the market price, for example, selling and managerial costs
may decrease as a result of selling internally, or the volume of purchases
being large enough to justify quantity discounts, and in addition, we have
seen that the transfer price is less than the prevailing market price It may
be justified when the selling division has idle capacity, and in these
circumstances the best method may be the negotiated transfer price,
which is the price agreed upon between the selling division and the
buying division, which reflects such unusual circumstances, and this
method may be more used in the absence of a market price, for example,
Contents
one of the divisions may request one of the products that are not available
in the market and it is required to produce them internally, and in such
circumstances the buying division negotiates with the other division to
agree on the transfer price that tempts the selling division to produce
these items, and it can be clarified how setting the transfer price in such
circumstances, we take into account the following data:
We assume that division X has created a new product that needs
unusual parts, and that there is another division Y that has the experience
and equipment that enables it to produce these parts, and division X
wants to negotiate with division Y about the transfer price of 5,000 units.
division Y defines the variable cost per unit as 8 EGP. In order to
be able to produce these parts, he would have to reduce the production of
another product (product A) by 3,500 units annually. The selling price of
the unit of product A is 45 EGP and its variable cost is 25 EGP per unit.
What is the transfer price that division Y proposes per unit from the
production needed for division X? by using the previous formula, the
price is:
Transfer price = variable cost per unit + lost contribution margin
per unit from abroad sales
The lost contribution margin is calculated as follows:
Selling price of product A 45
- Variable cost per unit of product A - 25
____
Contribution Margin per unit of Product A 20
x
x Number of sales units of product A 3,500 units
Total contribution margin 70,000 EGP

Lost Contribution Margin = Total Contribution Margin for Product A /

Contents
 Number of parts to be produced for division X
= 70,000/5,000 units = 14 EGP
Transfer price = 8 variable cost + 14 lost contribution margin
= 22 EGP per unit
Therefore, the transfer price suggested by division Y should not be
less than 22 EGP per unit, and division Y can offer a higher price if it
wants to increase the total profit, but it should not be less than 22 EGP,
otherwise the company’s total profits will decrease. division X is not
ready to accept this price, so he must obtain an offer at a better price than
that from outside the company.
And if the division Y in our example has idle capacity, the transfer
price will be less than that, and the lowest price per unit it offers is 8
EGP, which is the variable costs as we explained previously. However,
there is no division that accepts to recover its variable cost only, so the
transfer price is more than that, as a result of negotiation between the
managers of the two divisions, in such situations the selling division adds
a target margin to its variable cost to determine the transfer price of the
buying division.

4.8.5 Non-Independent Divisions and less-Optimization:

There are questions often raised about the extent of the
independence that should be granted to departments in setting transfer
prices and making sales decisions internally or externally, and whether
department managers have full authority in making such decisions, or
should the company’s top management intervene if it is cleared that these
decisions can achieve less optimization? For example, if there is idle
capacity in the selling division and the managers of the two divisions do
not agree on the transfer price, does the top management intervene to
force the divisions to agree?

Contents
 Usually, efforts should be made to bring managers closer together,
but managers should not be forced to accept transfer prices. If the
manager of a particular division is insistent not to reverse his decision, his
decision must be respected, and this is considered as the price paid by the
company to achieve the independence of the divisions, but if the top
management intervenes and imposes certain decisions, the company will
turn into a centralized company, and the goal of decentralization will be
lost, if the company considers one of the divisions as an independent unit
responsible for achieving a certain profitability, it must be left free to
control this unit, and it has the right to make decisions even if they are
bad.
It should be noted that if the division management continues to
make bad decisions, this will be reflected in the rate of return on
investment for this division, and this manager will not find anything to
defend the performance of his division, and even in these circumstances,
if the manager is sticking to his position, this must be respected so that
decentralization can be achieved. Experience has shown that independent
divisions with responsibility for making a profit are more successful and
profitable than those whose operations are managed centrally, and
achieving this success and profitability is a result of some of the
situations where the optimization is less.

4.8.6 International Aspects of Transfer Pricing:

Transfer prices are widely used to monitor and control the flow of
goods and services between the organization's divisions. However, the
objectives of transfer prices differ for multinational enterprises, where
goods and services cross international borders. Figure (4-9) summarizes
the objectives of international transfer prices and domestic transfer prices

as follows:

Contents
 Figure (4-9)
International and domestic transfer prices objectives

Transfer pricing
Objectives

Domestic International

more independence for the lower taxes, lower customs

divisions, more incentives for rates, better competitive
managers, better performance position, and better
evaluation, and better government relations
consistency of performance

As shown in the previous figure (4-9), international transfer price

objectives focus on reducing taxes, duties, customs and foreign exchange
risks as well as strengthening the competitive position and improving
relations with foreign governments. Although objectives of domestic
transfer prices such as manager motivation and independence of divisions
are desirable in the organization, they are usually of secondary
importance when international transfer prices are used, where the
objectives are focused on reducing tax values or strengthening overseas
branches and subsidiaries.
For example, charging lower transfer prices for goods exported to a
subsidiary company or branch may lead to a reduction in customs when
crossing the border, or it helps the company or subsidiary branch to
compete in the foreign market as a result of its lower costs, and on the
other hand, charging a high transfer price may help the multinational

Contents
company to withdraw excess profits outside a country that has many
restrictions on foreign transfers, or it may allow a multinational company
to withdraw income from a country with high income taxes to countries
with low income taxes.
In general, managers must be very sensitive to the geographical,
political and economic conditions in which they work and set transfer
prices in a way that achieves the optimal performance of the company.

Applied cases: (Transfer prices):

First case: The valves manufacturing division is one of the divisions of
the “Engineering Company” and it manufactures ordinary valves as
follows:
Production capacity in units 100,000 units
The selling price per unit in the intermediate market 30 EGP
Variable cost per unit 16 EGP
Fixed cost per unit (based on production capacity) 9 EGP
The pump industry division in the same company can use these valves
to manufacture one of its products. Currently, the pump division buys
10,000 valves per year by importing them from an external supplier at a
price of EGP 29 per unit.
Required:
1. Assuming that the valve division has idle production capacity that
is sufficient to produce the needs of the pump division, what is the
transfer price between the two divisions?
2. Assuming that the valve division can sell everything that it can
produce to external customers in the intermediate market, what is
the transfer price between the two divisions? Should the transfer
be made at this price?

Contents
 3. Suppose again that the valves division can sell everything that can
be produced to external customers in the intermediate market, and
also suppose that variable costs of 3 EGP can be avoided when
selling internally as a result of the low selling cost. What is the
transfer price between the two divisions?
The answer:
1. Since the valves division has idle capacity, it will not sacrifice
external sales when it sells to the pumps division, and then the transfer
price equation is applied as follows:
Transfer price = Variable costs + Contribution costs lost per unit
from selling externally
= 16 + zero
= 16
The price of 16 EGP represents the minimum to cover the variable
costs of the valve department, and the actual transfer price is between this
price and 29 EGP, which the pump division pays to the external supplier,
and therefore the transfer price ranges between 16 EGP and 29 EGP per
unit and is determined on the basis of negotiation between the managers
of the two divisions.
2. As long as the valve division can sell all of its production in the
intermediate market, it will sacrifice a portion of these sales to meet the
needs of the pump division. By applying the transfer prices equation, the
price will be as follows:
Transfer price = variable costs + lost contribution margin per unit
from sales abroad
= 16 + 14 (30 - 16)
= 30

Contents
 As long as the pump division can purchase these valves at a price
of EGP 29 from the external market, no transfers should be made
between the two divisions.
3. Applying the transfer prices equation, we get the following:
Transfer price = variable costs + lost contribution margin per unit
from sales abroad
= (16 - 3) + 14
= 13 + 14 = 27
In this case, a transfer price range arises between the minimum
amount of 27 EGP and the external selling price of 26 EGP per unit.

Second case: Referring to the original data in the previous first case,
suppose that the pump division needs 2,000 valves with special
specifications that it can buy from the valve division, and the variable
cost per unit in the valve division is 20 EGP, and in order for the valve
division to meet the needs of the pump division, it has to sacrifice half of
its external sales from regular valves (i.e., its external sales of regular
valves are 50,000 units annually). And you can assume that the valve
division can sell all these regular valves in the intermediate market.
Required: If the valve division decides to meet the needs of the pump
division, what is the transfer price per valve?
The answer:
In order for the valves division to produce 20,000 valves with
special specifications, it will sacrifice half of its sales, i.e., 50,000 regular
valves for customers abroad, and the lost contribution margin for this
quantity is as follows:
50,000 valves x 14 EGP per unit = 700,000 EGP
By distributing these lost profits to 2,000 valves with special
specifications, it results in:

Contents
700,000 EGP lost contribution margin / 20,000 valves with special
specifications = 35 EGP
Using the transfer prices equation, the following is obtained:
Transfer price = variable costs per unit + lost contribution margin
per unit = 20 + 35 = 55
Therefore, the valve division must carry the pump division at an
amount of 55 EGP per unit of valves with special specifications,
otherwise it will produce and sell regular valves in the intermediate
market. current level of earnings.

key Terms in this chapter:

Common Fixed Costs: It is a cost that cannot be attributed to a specific
segment of the company. These costs are also known as indirect costs,
which occur to serve the general operating activities.
Cost Center: It is a segment that has the power to monitor and control
costs without revenues or use of investments.
Decentralized Organization: It is the organization in which the
decision-making authority is not limited to the top management only, but
spreads throughout the organization.
Intermediate Market: It is the market in which product items can be
sold immediately in their current form to customers outside the company
instead of being transferred internally to one of the divisions for use in
manufacturing operations.
Investment Center: A segment that has the power to monitor and control
costs, revenues, and the use of investments.
Life Cycle Costing: It is a costing approach that focuses on all costs
throughout the value chain that arise during the entire life cycle of a
product.

Contents
Profit Margin Ratio: It is a measure of management's ability to control
operating costs in its relationship with sales, and it is calculated by
dividing net operating income by the sales value.
Market Price: It is the price of the product in an open market
(intermediate).
Negotiated Transfer Price: It is the price agreed upon between the
selling division and the buying division, which reflects unusual
circumstances.
Net Operating Income: It is the net income of the organization before
deducting bills and taxes.
Operating Assets: They are cash, receivables, inventory, buildings,
machinery and all other assets used in production in the organization.
Profit Center: A segment that has the power to control costs and
recognition of revenues, but it has not the authority to use investments.
Residual Income: The net operating income that the investment center
can achieve in excess of the minimum rate of return on operating assets.
Responsibility Center: It is a position in the organization that has the
authority to control costs, recognition of revenues, or use of invested
funds.
Return On Investment (ROI): A measure of an organization's
profitability, which is calculated by multiplying profit margin ratio by
asset turnover rate.
Segment: Any part or activity in the organization for which the manager
needs data on its costs, revenues and profits.
Segment Margin: The segment margin is calculated by subtracting the
fixed costs that can be traced to the segment from the contribution margin
of this segment, and it represents the margin available after the segment
covers all its costs.

Contents
Segment Reporting: It is the income statement or any other report in
which the data is distributed according to the types of products, divisions,
regions, or similar segments in the organization.
Less-Optimization: The level of overall profitability that is less than the
level that can be achieved by a segment or company.
Traceable Fixed Cost: A cost that can be attributed to a particular
division or segment, which arises as a result of the existence of that
division or segment.
Transfer Price: It is the price charged by a division or segment when its
production of goods or services is transferred to another division or
segment within the organization.
Turnover: It is a measure of the sales value that an investment center can
achieve for each pound invested in operating assets. It is calculated by
dividing sales by the average value of operating assets.
Value Chain: They are the main functions that add value to the
company's products of goods or services. These activities consist of
research and development, product design, manufacturing, marketing,
distribution and customer service.

Contents
4. 9 Questions and Applied Cases
4.9.1 Questions:
Q1: Mention three practices that impede the correct allocation of costs to
the company's segments?
Q2: Define what is meant by the segment in the organization, mention
several examples of these segments?
Q3: How does the contribution approach attempt to allocate costs to the
company's segments?
Q4: The difference between the traceable cost and the general cost, give
several examples?
Q5: What is the benefit that the manager gets from the income statement
in the form of segments?
Q6: Explain the difference between segment margin and contribution
margin, which is more beneficial to the manager and why?
Q7: Why are public costs allocated under the contribution approach?
Q8: How can the cost be traceable to one segment and become general to
another segment?
Q9: What is meant by the term decentralization?
Q10: What are the advantages that the organization obtains from
decentralization?
Q11: Differentiate between the cost center, the profit center and the
investment center?
Q12: How is performance measured in the cost center and in the profit
center and in the investment center?
Q13: What is meant by the term profit margin ratio and the term turnover
rate?
Q14: How can the return-on-investment equation be more accurate to
measure performance than the ratio of net profit to sales?

Contents
Q15: When using the rate of return-on-investment formula to measure
performance, what are the three inputs that a manager can use to
improve overall profitability?
Q16: It is possible to cancel the sales figure in the return-on-investment
equation by dividing operating income by operating assets, and since
this short equation gives the same result as the rate of return on
investment, why leave sales in the equation?
Q 17: One of the students drew attention to the saying of one of the
writers, “The reduction in the value of operating assets simply
cannot lead to an increase in profitability. The way to increase
profitability is to increase operating assets.” Discuss?
Q18: Company (S) operates at high fixed costs and operates slightly
above the break-even point. From this logic, is the percentage of
increase in net income greater, equal to, or less than the percentage
of increase in total sales? Why?
Q19: What is meant by residual income?
Q20: How can the rate of return-on-investment lead to bad investment
decisions?
Q21: The value of the operating assets for division (A) is 10,000,000
EGP, and the value of the operating assets in division (B) is
10,000,000 EGP. Can the residual income be used to compare the
performance of the two divisions? explain.
Q22: What is meant by the term transfer prices and why do we need
transfer prices?
Q23: Why is the use of transfer prices based on costs so common? What
are the disadvantages of this approach?
Q24: If it is possible to determine the market price of a product, why is it
considered the best basis for transfer prices?

Contents
Q25: What are the circumstances in which it is imperative to use
negotiated transfer prices for transfers between divisions of the
company rather than the market price?
Q26: How can less optimization happen if the manager is given complete
independence in setting and accepting or rejecting transfer prices?
4.9.2 Applied cases:
Case No. (1): Yazeed Company produces product (X). (Y), the following
are their data:
Product x product y
Selling price (EGP) 6 7.5
Variable costs per unit (EGP) 2.4 5.25
Traceable fixed costs (EGP) 45,000 210,000

The general and fixed costs of the company amount to 33,000 EGP
annually, and during the year 2020 the company produced and sold
15,000 units of product (X), 28,000 units of product (Y).
Required: Preparing an income statement for the year 2020, divided by
segments according to products, showing the columns of each of the
amounts and percentages for the whole company?

Case (2): Correct Transfer Price, Good Intermediate Market:

"Al-Roaa" Company produces tree pulp paste, which is used in the
production of many types of paper. The following statement of revenues
and costs per ton of this material:
Selling price 70
Less: Variable costs: 42
Fixed costs (based on a capacity of 50,000 tons per year) 18 60
Net income 10

Contents
 The carton division purchases its raw materials from the paste
division if an acceptable transfer price is reached.
Required: Suppose for each of the following from (1) to (4) that the
paste division can sell all its production in the foreign market at a price of
70 EGP per ton.
1. If the carton division buys 5,000 tons of paste division, what is
the transfer price? And why?
2. With reference to your calculations in (1) what is the minimum
and maximum transfer price? Is the maximum appropriate in
this case?
3. If the paste division accepts the price paid by the external
supplier's carton division and sells 5,000 tons of paste to the
carton division, what will be the impact on the profitability of
the paste division, the carton division, and the company as a
whole?
4. If the price in the intermediate market is 70 EGP per ton, are
there any reasons for the paste department to sell in the carton
division for less than 70 EGP per ton? clear up.
5. If the carton division decides to buy 5,000 tons of the paste
division, what is the acceptable transfer price? And why?
6. If it is assumed that the external supplier of the carton division
reduces the selling price to 59 EGP (net after quantity
discount), will the paste division accept this price? Explain if
the paste division does not accept this price, what is the effect
on the profits of the whole company?
7. With reference to the previous (6): If the paste division rejects
the price of 59 EGP, will the carton division be forced to buy
from the paste division at a higher price for the benefit of the
whole company?

Contents
 8. Referring to the previous (6): Suppose that due to the
inflexibility of the company's policies, the carton division is
required to purchase 5,000 tons of the paste division at a price
of 70 EGP per ton. What is the impact of this on the whole
company?

Case (3): Rate of Return Investment and Residual Income:

Yzeed AL-Ashmony, the manager of the production division at
Almenofia Company, said: I know that the general management wants to
add a new product, but I would like to see the values before any move,
our division has been leading the other divisions in the company for three
years and I don't allow any deterioration.
Almenofia Company follows decentralization, and it has five
independent divisions, and the performance of these divisions is
evaluated on the basis of the return on investment on their assets.
Sales 10,000,000
Minus: variable costs 6,000,000
Contribution margin 4,000,000
Minus: fixed costs 3,200,000
Net operating income 800,000
Operating assets of the division 4,000,000

The company has achieved an overall rate of return on investment

of 15% (for all divisions), and there is an opportunity for the production
division to add a new product that requires adding new assets worth
100,000 EGP, and the annual product revenues and costs will be as
follows:
Sales 2,000,000 EGP
Variable expenses 60% (of sales)
Fixed costs 640,000 EGP

Contents
Required:
1. Calculate the division's rate of return on investment for the last
year, and also calculate the rate of return on investment in case
of adding the new product?
2. Does the division manager accept or reject the new product?
clear up.
3. Assuming that management accepts a minimum rate of return
of 12% on the division's investment of assets, and performance
is measured using the residual income method:
• Calculate the value of the division's residual income
for the last year and also after adding the new
product?
• Do you think that the manager of the division in these
circumstances accepts the addition of the new
product or refuses to do so? clear up

Case (4): Analysis of the rate of return on investment:

The following is the income statement of Al-Esraa Company for the past
year:
Total Per Unit
Sales 4,000,000 80
Minus: Variable costs 2,800,000 56
contribution margin 1,200,000 24
Minus: fixed expenses 840,000 16. 8
Net operating income 360,000 7.2
Minus: Income tax (30%) 108,000 2.16
Net income 252,000 5.04

Contents
The average operating assets of the company, 200,000 EGP during the
year.
Required: Calculate the rate of return on investment for Al-Esraa
Company for the period using the return-on-investment equation?
1. Explain to each of the following questions whether the profit
margin and asset turnover will increase, decrease, or not change
as a result of events, then calculate the rate of return on the
investment (consider each question separately, beginning each
case with the data used to calculate the previous rate of return
on investment).
2. When using the Just In Time method for purchasing control for
some items of raw materials, the company can reduce the
average level of inventory by 400,000 EGP (the available funds
are used to pay off short-term debts).
3. The company can achieve a cost saving of 32,000 EGP
annually by using a less expensive labor.
4. The company issued bonds in the amount of 500,000 EGP and
used its value to purchase machinery and equipment, and the
value of the interest on the bonds was 60,000 EGP annually,
and sales did not change, but the new machines reduced
production costs by 20,000 EGP annually.
5. As a result of the intensive efforts of the salesmen, sales
increased by 20% and the number of operating assets did not
change.
6. Items in inventory are depreciated due to obsolescence, with a
book value of 40,000 EGP and recorded as losses.
7. The company uses 200,000 EGP in cash to pay the purchases of
the company's common stock.

Contents
Case (5): Choosing the correct transfer price:
Al-Habayeb Company has purchased a small company that
produces electric condensers for refrigerators and similar products, This
company will work as one of the divisions of Al-Habayeb Company in
the name of the Condensers Division, the details of which are as follows:
Selling price per unit 50
Unit cost:
Direct material 18
Direct labor 10
Variable overhead 2
Fixed overhead 5
(based on production capacity of 60,000 units) ___
Total unit cost 35

Al-Habayeb Company has a division for electric refrigerators,

which currently buys 20,000 condensers annually from an external
supplier, and the refrigerators department pays 48 EGP per condenser,
(which represents 50 EGP minus 2 EGP, quantity discount at the rate of
4%). The head of Al-Habayeb Company wants the refrigerators division
to purchase condensers from the condensers division, but he is not sure
that the transfer price will lead to that.
Required:
1. Suppose there is sufficient idle production capacity to meet the
demands of the refrigerator division. Explain why any of the following
transfer prices will or may not be the correct transfer price for the
company's internal sales: -
• 50 EGP.
• 48 EGP.

Contents
 • 39 EGP.
• 35 EGP.
• 30 EGP.
2. Suppose the condensers division is currently selling to external
customers all units of condensers that it can produce. Under these
circumstances, explain why each of the prices shown above would be true
or false as an appropriate transfer price for the refrigerator division for the
company's internal sales.

Contents
 Chapter five
Financial Statements Analysis

Learning Objectives:
After studying this chapter, you could be able to:
-know the concept and the importance of financial statements analysis.
- know the different techniques of financial statement analysis.
-understand the differences between horizontal analysis, vertical analysis,
ratios analysis of financial statements.
- know the financial ratios that common stockholders, short- and long-
term creditors interest,

Contents
Chapter five: Financial Statement Analysis

All financial statements, regardless of the degree of care taken in

their preparation, are essentially historical documents, as they tell us what
happened during a particular year or a series of years, but the information
that interests the user of these statements more is knowing what will
happen in the future, so the goal of analyzing financial statements are to
help users of financial statements to predict what will happen in the future
by comparing, evaluating, and analyzing trends.

5.1 The Importance of Statement Analysis:

In fact, users of financial statements are concerned with the
predictive power of statement analysis. For example, shareholders are
concerned with matters related to deciding whether to hold or sell their
shares and whether the existing management team will remain or be
replaced. Lenders are interested in predicting whether net income will be
sufficient to cover the interest of bonds and notes payable. and the
company's ability to pay its obligations to them on time. Managers are
also interested in the policy of dividends or the possibility of financing
the company's expansions and the possibilities of success of the
operations they manage.
The most important thing that users of financial statements look for
is profit forecasting, as profits are the basis for increasing the value of the
shares they hold, which encourage lenders to take the risks of lending
their money to the company, and the company’s profits are what allow
expansion in the future, but the problem is that this Profits are uncertain,
so several analytical tools must be found that help explain the main
relationships and study trends to judge the possibility of success in the
future, and without analyzing the financial statements, these main

Contents
relationships and trends can remain immersed in the sea of details of the
statements, and in this chapter we will discuss some of the most
important analytical ratios that are used to predict future conditions and
events for the organization.

5.2 Importance of Comparison:

Financial statements are not only historical documents, but they are
necessarily documents of a static nature, as they relate only to one period
of time, but the users of these statements interested in what is beyond the
current period, they are interested in the trend of events in the future, for
these reasons, the analysis of financial statements directed towards a
single time period is of limited interest, and the results of the analysis of
financial statements may be of interest for a certain period only if
compared to the results of other periods, and in other cases with the
results of other companies, so only by comparison can gain a close look
at the trends, and also the comparison enables to intelligently judge on
their importance, and unfortunately, the comparison between
organizations in the same industry is usually difficult due to the different
accounting methods and policies. For example, if the inventory in one
company is valued according to the first-in-first-out method, while it is
valued in another company by the weighted average method, then
comparing the value of the inventory between the two companies may be
impossible, and in such cases the comparison must be made according to
a more appropriate basis. Although this comparison may be very difficult,
it is often necessary to provide useful data to the manager for comparative
purposes.

5.3 The Need to Look Beyond Ratios:

We note that the unexperienced analysts see that the ratios in
themselves are sufficient as a basis for judging the future, but the expert

Contents
analyst sees that these ratios are only a beginning and not an end in
themselves, so these ratios should not be seen as the end but rather they
are viewed as the starting point and they are indicators that need to be
more in-depth, as they raise many questions, but they do not answer any
question at the beginning, and the accounting ratios should not only be
looked at, but the analyst should look at other sources of data so that he
can make a proper judgment on the future of the organization. The
analyst must look at industry trends, expected technological changes,
change in consumer tastes, and regional and local economic changes at
the national level or even at the level of the company itself.

5.4 Statements in Comparative and Common – Size Form

There are a few numbers of values that appear in the financial
statements that are significant in their selves. Since the relationships
between the items each other and the amount and direction of change
from one period to another are considered of importance to the financial
analyst, which of the ratios does the analyst start with? And how to reach
the importance of trends and changes in the company?
It can be said that there are three technical methods that are widely
used in this field.
1. The value and percentage of changes in the statements (Horizontal
Analysis).
2. Statements of common -base or volume (Vertical Analysis).
3. Ratios.
These methods will be discussed below:
5.4.1 Value and Percentage Changes on Statements
A good start is achieved in analyzing the financial statements by
placing the statements in a comparative form by placing two or more data
next to each other, as the comparison sheds light on the movements and

Contents
trends and gives valuable indicators of what is expected to be the
financial and operational performance in the future.
Figure (5-1) and (5-2) give an example of financial statements in a
comparative form, and they belong to Toshiba Al-Arabi Company for
Electronics, and the data of these statements is used as a basis for our
study in the rest of this chapter.
Figure (5 - 1)
Toshiba Al-Arabi for Electronics
Comparative balance sheet on December 31, 2021 (value in
thousands)
Increase
2021 2020 or Ratio
decrease
Assets
Current assets:
Cash 1200 2350 (1150) (48,9)%
Account receivable 6000 4000 2000 50%
Inventory 8000 10000 (2000) (20)%
Prepaid expenses 300 120 180 150%
Total Current assets 15500 16470 (970) (5.9)%
Building and equipment 4000 4000 Zero Zero
Land 12000 8500 3500 41.2%
Total Fixed Assets 16000 12500 3500 28%
Total assets 31.250 28.970 2.350 8.7%
Liabilities and Equity:
Current Liabilities:
Accounts payable 5800 4000 1800 45%
accrued expenses 900 400 500 125%
Notes payable (short-term) 300 600 (300) (50)%
Total current liabilities 7000 5000 2000 40%
Long term liabilities:
Bonds 8% 7500 8000 (500) 6.25%
Total liabilities 14.500 13000 1500 11.5%
Shareholders' equity:
Preferred stock 65% 100 EGP 2000 2000

Contents
 common stock 12 EGP 6000 6000 0 0
Paid in capital in excess 1000 1000 0 0
Total paid in capital 9000 9000 0 0
Retained earnings 8000 6970 0 0
1030 14.8%
Total Equity 17000 15970 1030 6.4%
Total liabilities & equity 31500 28970 2530 8.7%

Figure (5 - 2)
Toshiba Al-Arabi for Electronics
Comparative income statement for the years ending on
December 31, 2021 and 2020 (in thousand)
Increase
2021 2020 or Ratio
decrease
Sales 52000 48000 4000 8.3%
- Cost of goods sold 36000 31500 4500 14.3%
Gross margin 16000 16500 (500) (3)%
- Operating costs:
Selling costs 7000 6500 500 7.7%
Administrative costs 5860 6100 (240) (3.9)%
Total operating costs 12860 12600 260 2%

Net operating income 3140 3900 (760) (19.5)%

- interest expense 640 700 (60) (8.6)%
Net income before tax 2500 3200 700 21.9%
- Income tax (30%) 750 960 (210) (21.9)%
Net income 1750 2240 (490) (21.9)%
-Preferred stock dividends 120 120
1630 2120
- Common Stock dividends
600 600
+ Begin. retained earnings 1030 1520
5450 6970
End. retained earnings 6970 8000

5.4.2 Horizontal Analysis:

Comparing financial statements for two years or more is known as
horizontal analysis, and this horizontal analysis is more useful for

Contents
showing changes between years and financial values and in percentage,
as shown in Figures (5-1) and (5-2).
Showing the changes in financial values helps the analyst to
determine the basic factors that affect the profitability ability or the
financial position. For example, it is noted from Figure (5-2), that sales
for the year 2021 exceeded the sales for the year 2020 by four million
EGP, but this increase in sales resulted in an increase in production cost
by 4.5 million EGP.
Showing changes between years in the form of percentages helps
to feel the importance of these changes. The perception and perspective
of the analyst will be different for an increase of one million EGP in sales
if the sales of the previous year were 2 million EGP than if the sales of
the previous year were 20 million EGP, in the first case the increase is 50
%, which is undoubtedly a large increase for any company, and in the
second case, the increase is only 5%, which may reflect material growth.

5.4.3 Trend Percentages:

The horizontal analysis of the financial statements can be done by
calculating the trend ratios, where the financial statements for several
years are placed in a comparative position relative to the base year, and
where the base year is 100%.
Data for other years are attributed to this basis. For clarity, suppose
that the Egyptian Company has collected the following data on sales and
income for five years as follows:

2017 2018 2019 2010 2011

Sales 725,000 700,000 650,000 575,000 500,000

Net income 157,200 156,000 150,000 150,000 120000

Contents
 The sales and net income data can be expressed using trend
analysis of these data during the five years as follows:

2017 2018 2019 2020 2021

Sales 145% 140% 130% 115% 100%

Net income 132% 130% 125% 115% 100%
Note that sales growth has decreased somewhat between 2019 and
2020 and decreased more between 2020 and 2021. Also note that the
growth in net income does not match the growth in sales. In 2021, sales
were 1.45 times greater than 2017 and net income was 1.32 times greater.
Only about 2017.
5.4.4 Vertical Analysis (Common- Size Statements):
The main trends and changes can be shed light on the use of
financial statements according to a common basis or size. They show
items in percentages and financial values. Each item appears as a
percentage of the total that this item is a part of it. The preparation of
relative statements is known as Vertical Analysis.
5.4.4.1 The Balance Sheet:
One of the applications of vertical analysis is to show the ratio of
the company's assets to the total assets, as shown in Figure (5-3) of
Toshiba Al-Arabi Company.
Note from Figure (5-3) that placing all assets according to a
common basis or size clearly shows the relative importance of current
assets when compared to non-current assets, and it also shows the most
important changes that occurred in the structure of current assets during
the past year. Its relative importance has increased, while inventory and
cash have decreased in relative importance. The sharp increase in the
amount of debtors and the decrease in cash may reflect the inability to
collect the value of credit sales from customers.

Contents
 Figure (5-3)
Toshiba Al-Arabi Company
Balance Sheet according to common basis or volume
On December 31, 2021 and 2020 (in thousand pounds)
2021 2020 2021 2020
Assets
Current assets:
Cash 1200 2350 3.8% 8.1%
Account receivable 6000 4000 19% 13.8%
Inventory 8000 10000 25.4% 34.5%
Prepaid expenses 300 120 1% 0.4%
Total Current assets 15500 16470 49.2% 56.9%
Building and equipment 4000 4000 12.7% 13.8%
Land 12000 8500 38.1% 29.3%
Total Fixed Assets 16000 12500 50.7% 43.1%
Total assets 31500 28970 100% 100%
Liabilities and Equity
Current Liabilities:
Accounts payable 5800 4000 18.4% 13.8%
accrued expenses 900 400 2.8% 1.4%
Note payable (short-term) 300 600 1% 2.1%
Total current liabilities 7000 5000 22.2% 17.3%
bonds 8% 7500 8000 23.8% 27.6%
Total liabilities 14500 13000 46% 44.9%
Shareholders' equity:
Preferred stock 65% 100 EGP 2000 2000 6,4% 6.9%
common stock 12 EGP 6000 6000 19% 20.7%
Paid in capital in excess 1000 1000 3.2% 3.5%
Total paid in capital 9000 9000 28.6% 31.15
Retained earnings 8000 6970 25.4% 24%
Total Equity 17000 15970 54% 55.1%
Total liabilities and equity 31500 28970 100% 100%

Looking at Figure 3-5 above. We note that each asset attributed to

the total assets has been calculated, and the calculation of each item of
liabilities or equity is attributed to the total liabilities and equity.

Contents
5.4.4.2 The Income Statement:
Another example of the idea of vertical analysis is to calculate the
ratio of each item of the income statement to sales, and Figure (5 - 4)
shows a model for the income statement according to a common basis or
volume.
Figure (5 - 4)
Toshiba Al-Arabi Company for Electronics
Income statement according to common basis or volume
For the year ended December 31, 2021 and 2020 (in thousand)
2021 2020 2021(%) 2020(%)
Sales 52000 48000 100 100
- Cost of goods sold 36000 31500 69.2 65.7
Gross margin 16000 16500 30.8 34.3
- Operating costs:
Selling costs 7000 6500 13.5 13.5
Managerial costs 5860 6100 11.2 12.7
Total operating costs 12860 12600 24.7 26.2
Net operating income 3140 3900 6 8.1
- interest costs 640 700 1.2 1.5
Net income before tax 2500 3200 4.8 6.6
- Income tax (30%) 750 960 1.4 2
Net income 1750 2240 3.4 4.6

We note in the previous figure (5-4) that all values are related to sales.

It becomes possible by placing all the income statement items

related to sales to identify at a glance the impact of each pound of sales
on different costs, and profits. For example, we note from Figure (5-4)
that 69.2 piasters from each sales pound cover the cost of goods sold in
2021 compared to 65.7 piasters in the previous year, and we also note that
each sales pound left 3.4 piasters in 2021, which is less than the previous
year, when 4.6 piasters were left as profits. The statements, according to a
common basis or volume, show the aspects of efficiencies and

Contents
weaknesses that may be not observed, and for clarification, in 2021 the
selling costs increased by 500,000 EGP over the year 2020. However, by
looking at the income statement according to a common basis or volume,
it becomes clear to us that the selling costs on a proportional basis did not
increase in 2021 than in 2020, representing 13.5% in every year of sales.

5.4.5 Ratios Analysis (For the Common Stockholders):

Common stockholders have the right to claim the rest of the profits
and assets of the organization. After the claims of creditors and preferred
stockholders comes the claim of common stockholders in dividends and
the dividends of assets after their liquidation. Therefore, the measures
from the point of view of shares only provide an assessment of the depth
of protection available to others associated with the enterprise.

5.4.5.1 Earnings per Share:

The investor keeps the stock in the hope of achieving a return,
either in the form of dividends of coupons or capital gains, and since the
gains form the basis for the dividend payments, like any future increase in
the value of the shares, the investor is always interested in what the
company announces about the stock’s earnings, and the investor relies on
one measure, which is the stock’s earnings, although it is dangerous, as
will be seen later.
Earnings per share are calculated by dividing the residual income
of the common stockholders by the number of common shares.
Earnings per share = (net income - preferred stock dividends) /
Number of traded common shares
Using the data of Figure (5-1) and Figure (5-2), the earnings per
share for the year 2021 are calculated as follows:
= (1750,000 – 120,000) / 500,000 shares*
= 3.26 EGP / share ....................................................................... (1)

Contents
 * The number of common shares was calculated by dividing the
value of the common stock capital by the value per a common stock as
follows:
6,000,000 EGP ÷ 12 EGP = 500,000 shares
Two problems may arise when calculating the earnings per share.
The first arises when unusual gains or losses occur within the net income,
and the second occurs when the company has convertible securities on
the balance sheet. We discuss these problems in the following two
sections.

5.4.5.2 Extraordinary Items and Earnings per Share:

In the event that the company achieves extraordinary gains or
losses within the net income, the company must calculate two values or
ratios for the earnings per share. The first shows the share earnings
resulting from the ordinary operation, and the second shows the share
earnings including the extraordinary items. Achieving this income in
calculating the share earnings refers to three things, first: It helps the
users of the statements in recognizing the unusual items that may not
happen again, and secondly: excluding any distortion of the share
earnings as a result of the unusual items being affected, and thirdly: It
helps the users of the financial statements in evaluating the trends of
ordinary share earnings all the time. As long as the extraordinary items
may not be repeated year after year, they should be given less relative
weight in judging the efficiency of profits from ordinary operation.
In addition to reporting the extraordinary items separately, the
accountant must report them net after their tax effects, that is, any effects
of the extraordinary items on income taxes are subtracted from the
extraordinary items in the income statement and only the net income or
losses after taxes are used when calculating share earnings.

Contents
 To clarify this idea, let us suppose that the “Yazeed Company” was
exposed a fire or a loss of 6000 EGP, and the company wants to know
how to show these losses in the income statement, so Figure (5-5) shows
the correct and incorrect way to show the value of these losses.
Figure No. (5-5)
Report on extraordinary items and their tax effects

Incorrect method: Extraordinary gains and

losses should not appear
Sales 100000 within the ordinary items
of revenues and costs,
- Cost of goods sold 60000
because this distorts the
statement of the
organization ability to
produce income.
Contribution margin 40000

Operating costs:

Selling costs 18000

Managerial costs 12000

Fire loss 6000

36000

Net income before tax 4000

- Tax costs 30% 1200

Net income 2800

Contents
correct method: Showing extraordinary
items separately and net,
Sales 100000 excluding the impact of
taxes leads to no impact
-cost of goods sold 60000
on revenues or expenses

Contribution margin 40000

Operating expenses:

Selling expenses 18000

Managerial costs 12000 30000

Net income before tax 10000

- Tax expenses 3000

Net income before 7000 Extraordinary loss 6000

unusual items
minus 30% tax reduction
Extraordinary items:
1800
Fire losses (net of tax)
4200 Net loss after tax 4200

Net income 2800

As shown in the section on the correct method in the previous
figure, the fire loss that is taken into account is only 4200 EGP, not 6000
EGP, and the reason for this is that this loss is deducted completely from
the tax base, and therefore this reduction will reduce the taxable income
by 6000 EGP, if the income decreases with this value, the income tax will
be reduced by 1,800 EGP (6,000 EGP x 30%), which will save the
company 1,800 EGP, which would have been paid as tax, and these tax
savings are subtracted from the amount of the fire loss so that the net loss
becomes 4,200 EGP. This number can be obtained by multiplying the
loss by one minus the tax rate as the following:
= 6000 EGP x (1 - 0.30) = 4200 EGP

Contents
And any item before tax can be converted into an item after tax through
this equation.
The same method is used for extraordinary gains. The only
difference is that extraordinary gains increase the tax. Therefore, any
taxes resulting from these gains must be deducted from it, so that only the
net appears in the income statement.
To clarify more, we assume that the company in (Figure 5-5) has
2,000 ordinary shares, so it can be reported on the earnings per share as
follows:
Earnings (earnings) per common share
= Net income before extraordinary items ÷ number of ordinary shares
= 7000 EGP ÷ 2000 shares = 3.5 EGP per share
Less: Extraordinary items after tax = EGP 4200 ÷ 2000 shares
= 2.1 EGP per share
Net earnings per share = 1.4 EGP per share
Net earnings per share are sometimes called primary earnings per
share. In general, calculating the earnings per share that we have
explained above is necessary to avoid misunderstanding the firm’s ability
to produce ordinary income. Estimated earnings of only $1.4 per share
may be misleading, and may sometimes lead the company to consider
investors less than it should.

5.4.5.3 Fully Diluted Earnings Per Share:

Sometimes the problem of determining the number of common
shares that are used to calculate the earnings per share appears. Until
recent years, the differences between preferred shares, common shares,
and debtors were clear, but now the difference has become unclear as a
result of the increased tendency to issue convertible securities, and
instead of issuing common shares, companies are issuing preferred shares

Contents
or convertible bonds that allow the holders of these securities to convert
their securities into common shares sometime in the future. In the case of
the presence of these securities in the financial structure of the company,
a question arises as to whether these securities remain in their current
form and are not carried or treated as common shares when calculating
the earnings per share. The American Institute of Certified Public
Accountants (AICPA) has indicated that these convertible securities
should be treated in both the current and future cases, and this requires
calculating two values for the earnings per share, the first: for companies
that have convertible securities in trading and represents the earnings per
share assuming that they will not converted into common shares, and the
second: assuming that all these securities will be converted into common
shares, known as Fully Diluted Earnings Per Share.
To illustrate Fully Diluted Earnings Per Share, let's go back to the
example of Toshiba Al-Arabi Company for Electronics in Figure (5-1),
and let us suppose that all the preferred shares have been converted into
common shares, and since there are 20,000 preferred shares, the
conversion requires the issuance of 100,000 common shares, and in this
status the fully transferred earnings per share are calculated as follows:
Earnings per share fully transferred
= Net income / (number of common shares + number of preferred shares)
= 1,750,000 / (500,000 shares + 100,000 shares)
= 2.92 EGP / share ....................................................................(2)

By comparing equation (2) with the previous equation (1), it can be

noted that the earnings per share decreased by 34 piasters, and although
the effect of the entire conversion was simple in this case, the situation is
different when there are a large number of convertible shares.

Contents
5.4.5.4 Price / Earnings Ratio:
The relationship between the market price of the share and the
current earnings per share is called the price-earnings ratio.
Price / Earnings ratio = market price per share /Earnings per share
= 40 / 3.6 = 12.3 times
= 12.3 times ………………………………(3)
This means that the share is sold at 12.3 times the current earnings
per share, and the use of the price-earnings ratio is widespread among
investors as an indicator of the value of the stock, as investors decide to
keep or sell shares according to future expectations, so companies that
have growth opportunities have a high ratio (price-earnings), and vice
versa, companies with limited growth opportunities have a low (price-
earnings) ratio, and for the example of Toshiba Al-Arabi Company for
Electronics, it becomes clear that they have great growth opportunities
and therefore the share price will surly rise, if the price rises to 52 EGP
per share, for example, the price– earnings ratio rise to 16 EGP (52 EGP
price ÷ 3.26 earnings per share = 16 EGP).

5.4.5.5 Dividend Payout and Yield Ratio

Investors prefer to keep a stock over other stocks because the first
is expected to be an attractive return, and the return is not only dividends.
Many investors prefer not to take dividends, rather than the company
retains all these gains and reinvests them internally to support growth,
and the stocks that follow this approach are called growth stocks, and
they usually enjoy a steady rise in the market price. Others prefer to get
regular income from their investments and not gamble on market prices.
Perhaps these investors are looking for stocks with records that show
regular dividends, and therefore they are interested in the percentages of
paid dividends.

Contents
5.4.5.6 The Dividend Payout Ratio:
This ratio measures the amount of current earnings paid per share.
Investors who are interested in market growth prefer this ratio to be low,
while investors who are looking for dividends prefer this ratio to increase.
This ratio is calculated by dividing the dividends per share by the
earnings of the common stock.
Dividend payout ratio = Dividends Per Share / stock earnings
For Toshiba Al-Arabi for Electronics, Dividend payout ratio is calculated
as follows:
= 1.20 EGP (from Figure 5-2) / 3.26 (Equation No. 1)
= 36.8% ...................................................................................... (4)
There is no so-called correct ratio in all cases, and this ratio tends
to be the same in the majority of companies in the same industry, and
companies that tend to increase growth opportunities with a high return
on assets have a low dividend payout ratio, and the opposite occurs in
companies with limited opportunities for reinvestment.

5.4.5.7 The Dividend Yield Ratio:

This ratio is determined by dividing the current dividend per share
by the current market price of the share:
Dividend Yield Ratio = Dividend Per Share / Market price per share

We have assumed that the market price of the common share of

Toshiba Al-Arabi for Electronics was 40 EGP, so the dividend yield ratio
is as follows:
Dividend yield ratio = 1.20 / 40
= 3 % ............................................................ (5)
Note when calculating the dividend yield ratio that the current
market price of the stock is used, not what the investor paid to buy (it
may be greater or less than the market price), and by using the current

Contents
market price, we recognize the opportunity cost of investing in the form
of yield, meaning that this yield is sacrifice cost (opportunity cost) if the
stock is sold at a price of 40 EGP and other securities are bought instead.

5.4.5.8 Return on Total Assets:

The managers have two types of responsibilities: the
responsibilities of financing and the responsibilities of operating, The
responsibilities of financing are how to obtain the funds necessary to
obtain the assets, and the responsibilities of operating are represented in
how these assets are used, and neglecting either of the two responsibilities
will be bad for the company, however, it should not be confused between
the two responsibilities when evaluating the performance of management,
and whether the financing of assets through lenders and shareholders or
through shareholders only, this should not lead to an impact on the
evaluation of the success of the use of these assets since the company
acquired them, and the return on total assets measures the good use of
assets, i.e. it measures operating performance and the rate of return on
total assets is calculated as follows:
Return on Total Assets
= Net Income + (Interest expense x (1 - tax rate)) / average total assets

When we add interest expenses to net income again, we arrive at

the value that shows the profit before making any dividends, whether to
lenders or shareholders, and thus we have excluded the method of
financing assets from affecting the measure of how assets are used, and
note that before adding interest expense again to net income, it must the
interest expense should be “after taxes” by multiplying the interest value
by (1- tax rate). The return on assets for Toshiba Al-Arabi for Electronics
for the year 2021 is calculated (from Figures 5-1, 5-2) as follows:
whereas:

Contents
 - Net Income = 1,750,000 EGP
- Interest expense = 640,000 EGP
Average Total Assets = (Assets at the beginning of the period +
Assets at the end of the period) / 2
= (28,970,000 + 31,500,000) / 2
= 60,470,000 / 2 = 30,235,000 EGP
Return on Total Assets = Net Income + (Interest Expenses x (1 –
Tax Rate)) / average total assets

Return on total assets = 1,750,000 + (640,000 x (1 - 30%)) / 30,235,000

= 7.3% ................................................................ (6)
Thus, Toshiba Al-Arabi for Electronics has achieved a return of
7.3% on average assets used throughout the year.

5.4.5.9 Return on Common Stockholder's Equity:

One of the main objectives of the organization’s management is to
generate income for the common stockholders, and one of the measures
of the company’s success in this is the rate of return on equity for
common stockholders, which is calculated as follows:
Return on equity of common stock = (net income - preferred stock
dividends) / Average Equity of Common Stockholders
Whereas:
Average Equity of Common Stockholders = (Average Equity - Preferred
Stock)
For Toshiba Al-Arabi for Electronics, the return on equity of
common shareholders for the year 2021 is calculated as follows:
Return on equity of common stock = (1,750,000 - 120,000) / 14,485,000*
= 11.3% ........................................ (7)
*Average equity of common stock = 16,485,000 - 2,000,000

Contents
 = 14,485,000 EGP
The average stockholders’ equity has been calculated as follows:
Average Equity = (15,970,000 + 17,000,000) ÷ 2
= 16,485,000 EGP
By comparing the previous return on the equity of common
shareholders (11.3%) with the previous return on total assets 7.3%, it
seems to us a question: Why did the return on the equity of common
shareholders rise so much? The reason for this is the financial leverage,
which we will discuss below.
5.4.5.10 Financial Leverage
Financial leverage involves financing the company's assets with
money it obtains from lenders or preferred stockholders at a fixed rate of
return. If the assets in which these funds are invested are able to achieve a
rate of return greater than the fixed rate of return that is paid to the
lenders of these funds, we will have a positive financial leverage for the
benefit of common shareholders.
Suppose, for example, that the company is able to achieve a rate of
return after-tax of 12% on the assets. If the company is able to borrow at
an interest rate of 10% to finance the expansion of assets, in this case
common shareholders benefit from the positive leverage, as the borrowed
money invested will achieve a return after taxes of 12%, but the interest
cost after taxes will be 7% (10% interest rate x (1 - 0.30) = 7%) and the
difference will return to the shareholders normal.

We can note this in the case of Toshiba AL-Arabi for Electronics,

where the company pays only a fixed interest rate of 8% to bondholders
(as shown in Figure 5-1) and the interest cost after taxes is only 5.6% (8%
interest rate x 1- 0.030 ) = 5.6%) and the leverage is positive, and this
difference benefits the common shareholders, and this explains the reason

Contents
for the increase in the return on the equity of common shareholders
(11.3%) over the return on total assets (7.3%).

5.4.5.10.1 Sources of Financial Leverage

Financial leverage can be obtained from several sources, the first is
long-term borrowing such as bonds or notes payable, in addition to this
two sources are current liabilities and preferred shares, current liabilities
always represent a source of positive financial leverage where the
company obtains funds for internal investment without any interest For
short-term creditors, for example, when the company obtains credit
purchases from suppliers, these purchases are available for investment
within the company, while the supplier does not demand any interest on
the amounts owed to him.
Preferred shares can also be a source of positive financial leverage
as long as the return obtained by these shareholders is less than the rate of
return earned on the total assets used. The return on preferred shares is
6%, while a return on assets of 7.3% is achieved, and the difference is
also in favor of common shareholders, and thus their return increases to
11.3% as was previously calculated.
Unfortunately, the financial leverage is a double-edged sword. If
the assets are not able to achieve a return that covers the cost of the loan
interest or dividends to preferred stockholders, the common stockholders
will suffer in this case, and the reason for this is that part of the earnings
generated by the assets provided by the common stockholders of the
company is directed to fill the deficit of the preferred stockholders or the
owners of long-term loans, and there is a little return after that for the
common stockholders, and in this case there becomes a negative financial
leverage.

Contents
5.4.5.10.2 The Impact of Income Taxes
The efficiency of both preferred stockholders and long-term
lenders in achieving financial leverage is not equal, and the reason for
this is that interest on loans is deducted from the tax base unlike preferred
stock dividends, so long-term debt is a more efficient source for
achieving positive leverage than preferred stock.

To clarify this point, we assume that the company has three sources
of funding for 100,000 EGP for expansions:
1. 100,000 EGP from the issuance of common shares.
2. 50,000 EGP from issuing common shares and 50,000 EGP from
issuing 8% preferred shares.
3. 50,000 EGP from the issuance of common shares and 50,000
EGP from the issuance of 8% bonds.
If we assume that the company can achieve an additional annual
return of 15,000 EGP before interest and taxes as a result of this
expansion, the results of the three alternatives are shown in the following
figure (5-6):
Figure (5-6)
Leverage from preferred stock and long-term debt
alternative alternative alternative
(1) (2) (3)

Return before interest and 15,000 15,000 15,000

taxes

- Interest expense 8%
- - 4,000

Net income before taxes 15,000 15,000 11,000

- income taxes (30%) 4,500 4,500 3,300

Net income 10,500 10,500 7,700

Contents
 - 8% preferred stock return - 4,000 -

Net Income remaining for 10,500 6,500 7,700

Common Stock (A)

Common stock Equity (B) 100,000 50,000 50,000

Return on common stock 10.5% 13% 15.4%

A÷B

As can be seen from the previous figure, if the total required

amount of 100,000 EGP is financed from the issuance of common shares,
the return on common shares will be 10.5% as shown under the first
alternative. But if half of this amount is financed by issuing preferred
shares, the return on common shares increases to 13% as a result of the
positive leverage, but if half of the amount can be financed by issuing
bonds, the return on common shares will jump to 15.4%, as shown by
Alternative (3). Therefore, long-term loans are more efficient to achieve
positive leverage of preferred stock, and the reason for this is that the
interest expense on these long-term loans is tax-deductible.
The idea of financial leverage is that some loans in the capital
structure can bring significant benefits to common stockholders, for this
reason, most companies try to keep a certain level of loans in the
organization at least within the normal level in the industry, although
there may be good reasons for the enterprise to give up loans, in terms of
the benefits that we can get from the positive leverage, the possibility
always remains that this company can deceive the common shareholders,
and as a special case, many companies such as commercial banks and
other financial institutions rely heavily on the financial leverage to
achieve an attractive return on common stock.

Contents
5.4.5.11Book value per share:
One of the measures commonly used in trying to evaluate common
shares is the book value pe share. The book value per share measures the
value that would be divided to common stockholders for each share if all
assets were sold at their value shown in the balance sheet and after all
obligations have been paid. Therefore, the book value per share is based
on historical data. The formula for calculating the book value per share is
as follows:
Book value per common stock = equity of common stock holders /
Number of common stocks
= (Total Equity - Preferred stock) / Number of common stocks
Thus, the book value per common stock of Toshiba Al-Arabi for
Electronics is calculated as follows:
= (17,000,000 EGP – 2,000,000 EGP) / 500,000 shares
= 30 EGP …………………………………….……………… (8)

If the book value per share is compared to its market value (40
EGP), as we have assumed in the case of Toshiba Al-Arabi for
Electronics, it appears that the stock has been valued more than its price,
but this is not necessarily as the market value of the stock, as we have
previously mentioned, is related to the expected gains and dividends in
the future. But the book value, on the contrary, does not reflect anything
about the future earning ability. In practice, it is related to the past, as it
reflects the balance sheet values, which represent transactions that have
already occurred entirely in the past.
The question now is: What is the benefit of the book value per
share?

Contents
 Unfortunately, the book value per share is limited to use for
analysis purposes, but it is sometimes used to determine the share price in
closed companies.

5.4.6 Ratio Analysis - The Short-Term Creditors:

Despite the advice to short-term creditors that they always bear in
mind the rights of common shareholders, expressed in the previously
explained ratios, they focus their interests in another direction, as they are
concerned with the ability of the enterprise to meet its obligations in the
short term. Therefore, they are more interested in cash flow and working
capital management than they are interested in the accounting net income
that the company shows.

5.4.6.1 Working capital:

The excess of current assets over current liabilities is known as
working capital. The working capital of Toshiba Al-Arabi for Electronics
is calculated as follows:

2021 2020

Current assets 15,500,000 1,647,000

- Current liabilities 7,000,000 5000000

Working capital 8,500,000 11,470,000 (9)

The working capital available to the organization is one of the first

concerns of short-term creditors, as it represents assets that have been
financed from long-term capital financing sources that do not require
repayment in the short-term.
Although the greater the working capital, this is always reassuring
for short-term creditors, but this does not in itself guarantee the payment
of the debt on its due date. The capital increase may be the result of an

Contents
idle inventory, so in order for working capital to be put in its correct
place, it must be accompanied by other analyzes, and therefore the
following four ratios are used (the current ratio, the quick ratio, the
debtors’ turnover rate, and the inventory turnover rate) with the working
capital analysis.

5.4.6.2 Current Ratio:

The elements included in working capital are usually expressed in
the form of a ratio, where the current assets are divided by current
liabilities to arrive at the current ratio as follows:
Current Ratio = Current Assets / Current Liabilities
The working capital ratio of Toshiba Al-Arabi Company for the
years 2020 and 2021 is calculated as follows:
2020 2021
Current ratio = 16,470,000 / 5,000,000 15,500,000 / 7,000,000
3.29 : 1 2.21 : 1 ……....10)

Although the current ratio is seen as a measure of the company's

ability to repay short-term debts, this ratio should be viewed with caution,
a decreasing ratio, as shown by the above, may be an indication of a weak
financial position. However, this is the result of getting rid of an idle
inventory or any other idle assets, and the improvement in the ratio may
be a result of irrational storage or it may be the result of improving
financial conditions. In short, the current ratio is useful, but it may be
misleading when interpreting, and to avoid this, the analyst carefully
examines all items of assets and liabilities. As a general rule, a good
current ratio is 2:1. This rule is subject to many exceptions depending on
the circumstances of the business and industry, some firms may operate
quite successfully at a ratio of just over 1:1. The appropriateness of the
current ratio strongly depends on the composition of the assets. For

Contents
example, if both Company (X) and Company (Y) have a current ratio of
2:1, it cannot be easily said that they are in a comparative financial
position, and Company (Y) will face difficulties in meeting its obligations
when they become due. As shown from the following:

Company X Company Y

Current assets

Cash 25,000 2,000

Accounts receivable 60,000 8,000

Inventory 85,000 160,000

Prepaid expense 5,000 5,000

Total Current assets (A) 175,000 175,000

Current liabilities (B) 87,500 87,500

Current ratio A / B 2:1 2:1

5.4.6.3 Liquidity (quick) Ratio:

One of the difficult tests to measure the Company’s ability to meet
its short-term obligations is the liquidity ratio, so inventory and expenses
provided are excluded from the total current assets so that only the most
liquid (quick) assets remain and are divided over current liabilities.

Liquidity Ratio = (Cash + Popular securities + Accounts receivable) /

Current Liabilities
Accounts receivable includes receivables and short-term notes receivable.
The liquidity ratio is designed to measure the company's ability to
meet its obligations without resorting to liquidation or relying too much
on inventory, and since inventory is not a quick source of cash and may
not be sold, especially in periods of economic depression, so there is a
feeling that for the company to be in a properly position, each pound of
Contents
liabilities should match one pound of quick-to-cash assets, so a 1:1 quick
ratio is considered sufficient.
The liquidity ratio for Toshiba Al-Arabi Company for Electronics
for the years 2020 and 2021 is calculated as follows:

2021 2020

Cash 1,200,000 2,350,000

Account receivable 6,000,000 4,000,000

Total quick assets 7,200,000 6,350,000

Current Liabilities 7,000,000 5,000,000

Quick Ratio 1.03:1 1.27:1 (11)

Although the quick liquidity ratio of Toshiba Al Arabi Company

for the year 2021 was within the acceptable range, the analyst must take
into account some trends in the company’s balance sheet, noting that
short-term debts are increasing while cash levels are declining, and the
reason for the weakness of the cash position may be due to the expansion
in the size of accounts receivable, so how did the company allow such a
large increase in these accounts in a short period of time, in short, as is
the case with the current ratio, in order to use the quick liquidity ratio
intelligently, it is necessary to look at its main components.

5.4.6.4 Accounts Receivable Turnover:

Accounts receivable turnover rate measures the number of times
accounts receivable are converted into cash during the year, and this ratio
is usually used with working capital analysis, because the easy flow of
accounts receivable into cash is an indicator of the quality of the
company’s working capital and an important measure of the company
ability to operate. The accounts receivable turnover rate is calculated by

Contents
dividing the credit sales by the average balance of the accounts receivable
during the year as follows:
Accounts receivables turnover rate
= credit sales / average accounts receivable balance
Thus, the accounts receivable turnover rate to Toshiba Al-Arabi for
Electronics for the year 2021 is as follows:
Accounts receivables turnover rate
= credit sales / average accounts receivable

= 25,000,000 / 5,000,000 * = 10.4 times ……………. (12)

*Average accounts receivable balance = (4,000,000 + 6,000,000) ÷ 2
= 5,000,000 EGP
Another ratio can be derived from the accounts receivable turnover
rate by dividing 356 by accounts receivable turnover rate to determine the
average number of days needed to collect accounts receivable, which is
known as the average collection period. The average collection period is
calculated as follows:
Average collection period = 365 days / accounts receivable turnover
= 365 days / 10.4 times = 35 days..............(13)
Considering the average collection period (35 days) as a good or
bad indicator depends on the credit terms that the company grants to its
customers. Credit for a few days, and if this factor is added to slow
accounts receivable, this means an increase in the collection period from
7 days to 10 days, and this is not considered a bad warning.
On the other hand, if the company's credit terms are 10 days, the
collection period (35 days) is considered worthwhile, this may be a result
of old doubtful debts, poor management of daily collections, or failure to
follow up on slow debt collection.

Contents
5.4.6.5 Inventory Turnover rate:
The inventory turnover rate measures the number of times
inventory is sold during the year and is calculated by dividing the value
of cost of goods sold by the average inventory balance, as follows:
Inventory turnover rate = cost of goods sold / average inventory balance
The average inventory balance is calculated by taking the inventory
average at the beginning and end of the period, and where Toshiba Al-
Arabi Company for Electronics had a beginning inventory balance of
EGP 10,000,000, and at the end of the year EGP 8,000,000, so the
inventory average is EGP 9,000,000, and the inventory turnover rate for
2021 is as follows:
Inventory turnover rate = Cost of goods sold / Average inventory balance
= 36,000,000 / 9,000,000 = 4 times................(14)
Another indicator can be calculated is the number of days required
to sell inventory (called the average selling period) by dividing 365 by the
inventory turnover rate as follows:
Average selling period = 365 days / Inventory turnover rate
= 365 /4 = 91.24 days............................ (15)
Grocery stores try to keep their inventory turnover rate fast,
sometimes 12 or 15 days. Whereas inventory in jewelry stores turns
slowly, maybe twice a year.
If the inventory turnover rate in the company is less than the
industry average, there may be idle inventory or the inventory is more
than needed, as the accumulation of inventory leads to restrict the
available funds that can be used in other activities, and some managers
believe that they must buy in large quantities in order to obtain the best
discount opportunities available, these discounts must be carefully
evaluated against the additional costs of insurance, taxes and financing,

Contents
the risk of obsolescence, and the problems of holding additional
inventory.
The faster-than-average inventory turnover rate is an indicator of
one or two things. First, it may be an indicator that the inventory level is
inappropriate. Second, historically this has been the main reason for the
rapid increase in commodity inventory turnover, because in recent years
there have been several factors affect the inventory turnover rate, for
example, if the company follows the method of inventory just in time, in
this method the company intentionally aims to maintain the lowest level
of inventory as previously mentioned, so the inventory turnover rate in
companies that use the method of inventory just in time is very large as
compared to other companies.

5.4.7 Ratio Analysis - Long-Term Creditors:

The position of long-term creditors differs from the position of
short-term creditors, that they are concerned with the company’s ability
to meet its obligations in the long and short term together. They are
interested in the short term, where the interest is paid to them on a
periodic basis, and they are interested in the long term, where their loans
are repaid after a long term.

Providers of long-term loans usually face greater risks than short-

term creditors, so enterprises are required to meet certain rules and
controls to protect long-term lenders. For examples, the necessity to
maintain minimum levels of working capital, and restriction of dividend
payments to common shareholders. Although these controls are widely
used, but it should not be relied on to the company's ability to disclose
protection assessment, as lenders do not want to go to the courts to collect
their debts, so they prefer to guarantee their dues from the interests and

Contents
principal of loans through the continuous flow of funds resulting from
operating.

5.4.7.1 Times Interest Earned Ratio:

One of the most famous measures used to measure the company’s
ability to protect the rights of long-term loan providers is the ratio of the
number of times interest is earned. This ratio is calculated by dividing the
earnings before interest and income taxes by the value of the annual
interest to be paid as follows:
Earnings Earning
= Earnings Before Interest and Income Taxes / interest expense
This same value is the net operating income in many of the
financial statements, and this ratio is calculated for Toshiba Al-Arabi for
Electronics for the year 2021 as follows:
Number of times interest earned
= 3,140,000 / 640,000 = 4.9 times……………… (16)
Earnings before interest expense and income taxes must be used to
calculate this ratio, since the interest expense is subtracted before
calculating income tax, and income tax is considered a secondary matter
to interest payments, that the latter has priority in deduction from
earnings, where the remaining earnings after interest are subject to the
calculation of the amount of income taxes.
There are several rules that are indicators of the adequacy of the
number of times interest is earned, and the earnings are seen as sufficient
to protect the rights of long-term creditors if the number of times is 2 or
more. Before the final judgment, it is necessary to look at the long-term
trend of the earnings and then determine the extent to which the company
is affected by international economic changes.

Contents
5.4.7.2 Debt to Equity Ratio:
Although long-term lenders generally consider the expected
earnings and budgeted cash flows as a measure of their attitude to risk, it
cannot be neglected to maintain an acceptable balance (difference)
between the assets obtained through loans and the assets obtained by
shareholders, this balance (difference) is measured by the debt-to-equity
ratio, and this ratio is calculated as follows:
Debt to Equity Ratio = Total Liabilities / Shareholders Equity
The debt-to-equity ratio for Toshiba Elaraby Electronics is
calculated as follows:

2021 2020

Total Liabilities 14,500,000 13,000,000

Shareholder equity 17,000,000 15,970,000

Debt to Equity Ratio 0.85:1 0.85:1 (17)

This ratio refers to the value of assets obtained by lenders against
every pound of assets obtained by shareholders, and for Toshiba Al-Arabi
Company in 2020, lenders financed 81 piasters of assets against every
pound of assets financed by shareholders. This number increased slightly
to 85 piasters in 2021.
It is not surprising that creditors prefer a lower ratio of debt to
equity, as the lower the ratio, the greater the value of the assets financed
by the owners of the company, and then greater protection for the
creditors. On the contrary, common shareholders prefer the relatively low
ratio in order to benefit from the financial leverage of the assets financed
by the creditors, , and in most industries, rates have been set during the
past years to be an indicator for the enterprise when making a correct
value decision of loans within the capital structure, and different
industries face different risks and for this reason, the level of debt that
Contents
may be appropriate for a company in a particular industry may not
necessarily be a guide to the level of debt in another company operating
in another industry.

5.5 Summary of Financial Ratios and How to Calculate Them:

The following figure (5-7) contains a summary of the ratios
discussed in this chapter, and the figure contains the equation of each
ratio and a summary of its importance to the manager.
Figure (5-7) is a summary of the proportions

Ratio Equitation Importance

Earnings per share (net income - preferred Affects the market price of
(common) stock dividends) ÷ number the share and reflects the
of common shares price: earnings ratio.

Fully diluted Net Income ÷ (Number of Indicates the expected

earnings per shares Shares Traded + effect on the earnings per
Equivalent of Convertible share when converting
Securities) the convertible securities
into common shares.

Price : earnings Market price per share ÷ An indicator that shows

ratio earnings per share whether the stock price is
low or high in relation to
current earnings.

Ratio of dividends Dividends per share ÷ Indicates whether the

paid per share earnings per share company divides most of
its earnings to
shareholders or reinvests
them internally.

Dividend Yield Dividend Per Share ÷ Used to compare the

Ratio Market Price per Share dividend yield per share

Contents
 with the return on other
shares

Return on total Net income + (interest Measures management's

assets, expense x (1- tax rate)) ÷ efficiency in the use of
average total assets, assets

Return on Equity of (Net Income - Dividends It measures, when

Shareholders for Preferred Shares) ÷ compared to the return on
(Average Equity of total assets, whether the
Shareholders - Preferred financial leverage is used
Shares) for or against common
shareholders.

Book value per Equity of common Indicates the value

share shareholders (total equity obtained by the common
of shareholders - shareholders in the event
preferred shares) ÷ of selling all assets at the
number of common shares value shown in the
balance sheet and after
paying all obligations.

Working Capital Current Assets - Current These represent current

Liabilities. assets that are financed
by long-term sources of
capital that do not require
payments in the short
term

Current Ratio Current Assets ÷ Current Tests the ability to pay

Liabilities short-term debt

Liquidity (Quick) (Cash + Popular Testing the ability to pay

Ratio Investments + accounts short-term debt without
receivable) ÷ Current relying on inventory

Contents
 Liabilities

Receivables credit sales ÷ Average Measures the number of

turnover rate receivables balance times receivables are
converted into cash
during the year

Average collection 365 days ÷ accounts Measures the average

period (accounts receivable turnover rate number of days it takes to
receivable term) collect accounts
receivable

Inventory Turnover Cost of goods Sold ÷ Shows the number of

rate Average Inventory Balance times inventory was sold
during the year

Average Selling 365 Day ÷ Inventory Measures the average

Period Turnover number of days it takes to
sell inventory each time.

The number of Earnings before interest Measures the ability to

times of Earning and taxes ÷ interest pay interest to creditors
Interest expense

Debt to Equity Total Liabilities ÷ Equity Measures the value of

Ratio assets financed by
creditors per pound of
assets financed by equity

Contents
Applied Case: (Financial Leverage):
The following are selected data from the financial statements for
the year ended September 30, 2021 for Toshiba Al-Arabi Company:

Total assets 5,000,000

Current liabilities 350,000

Long Term Loan (12% Interest) 750,000

Preferred shares 7% share value 100% 800,000

Total equity of shareholders 3,100,000
Interest paid for long-term debt 90,000
Net income 470,000

The total assets at the beginning of the year were 4,800,000 EGP,
and the total equity of shareholders 2,900,000 EGP, and there was no
change during the year in the account of preferred shares, and the tax rate
is 30%.
Required:
1. Calculation of Return on Total Assets.
2. Calculating the return on equity of the common stock.
3. Is the company's financial leverage positive or negative? explain.
The answer:
1. Return on Total Assets
= net income + (interest expense x (1 - tax rate)) / average total assets
= 470,000 + (90,000 x (1 - 0.30) / (5,000,000 + 4,800,000) ÷ 2
= 10.9%
2. Return on equity of common stockholders:

Net income 470,000

Minus: Preferred stock dividend (7% x 8,000,000 EGP) 56,000

Contents
 Net Income for common Shares (a) 414,000

Average Equity of Shareholders:

(3,100,000 EGP + 2,900,000 EGP) ÷ 2 3,000,000

Minus: Preferred stock 800,000

Equity of common stockholders (b) 2,200,000

Return on equity for common stockholders (a ÷ b) 18.8%

3- The company has a positive financial leverage as the return on equity

of common shareholders (18.8%) exceeds the return on total assets
(10.9%). The positive financial leverage is achieved from current
liabilities that are not bearing interest and long-term debt and its interest
after tax is 8.4% (12% interest rate x (1- 0.30) = 8.4%) as well as from
preferred shares that deserve a dividend rate of only 7%, and both 8.4%
or 7% less than 10.9% return on the total assets of the company, so the
difference goes to common shareholders, which raises the return on
equity for common shareholders to 18.8%.

Key Terms and Concepts of Chapter Five:

statements by Basis or Size - Common Size Statement: It is a
statement that shows items in the form of financial values and
percentages. Percentages are calculated attributable to sales for the
income statement and attributable to total assets and equity in the balance
sheet.
Financial Leverage: It means financing the company's assets with the
money of the lenders or from preferred stock at a fixed rate of return.
Horizontal Analysis: A comparison of financial statements for two years
or more.

Contents
Negative Financial Leverage: It represents a situation in which the fixed
return paid to lenders and preferred stockholders is greater than the return
on total assets, in which case the return to common stockholders is less
than the return on total assets.
Positive Financial Leverage: It represents a situation in which the fixed
return paid to lenders and preferred stockholders is less than the return on
total assets, in which case the return to common stockholders is greater
than the return on total assets.
Trend Ratios: Through these ratios, the financial statements for several
years are expressed in percentages attributed to a base year.
Vertical Analysis: Preparing the company's financial statements
according to a common basis or size.

Contents
5.6 Questions and Applied Cases
5.6.1 Questions:
Q1: What are the three methods used in the analysis of financial
statements?
Q2: Distinguish between horizontal analysis and vertical analysis of the
financial statements?
Q3: What are the main objectives of analyzing trends in financial ratios
and other data? Other than the trends, what are the comparison
criteria that the financial statement analyst turns to?
Q4: Why does the financial analyst calculate the financial ratios instead
of studying the absolute financial statements? What are the possible
errors when using ratios?
Q5: What are the errors that can occur when calculating the earnings per
share? How can these errors be avoided?
Q6: What is meant by the report on extraordinary items net of tax effects
in the income statement? Give an example for each of the
extraordinary gains and losses, net after the impact of taxes,
assuming that the income tax is 30%
Q7: Assuming that there are two companies in the same industry and
achieve the same profits, why can the price-earnings ratio of each
differ?
Q8: Yazeed Company is one of the developing technology companies, so
do you expect that the cash dividends for this company will be high
or low.
Q9: Differentiate between the manager's financial responsibilities and his
operational responsibilities. Which of these responsibilities is
measured by return on total assets?
Q10: What is meant by dividend yield of common shares? Why is the
current market value used instead of the historical purchase price?

Contents
Q11: What is meant by the term financial leverage?
Q12: One of the presidents of medium-sized plastic companies said in a
newspaper, "We have not had any pound interest for ten years, and
many companies cannot say that." Assume that you are one of the
shareholders of this company, what do you feel about this policy of
not borrowing with interest?
Q13: Why is it more difficult to obtain positive financial leverage from
preferred shares than from long-term debt?
Q14: If the market value of the stock exceeds its book value, this means
that it was valued at a higher price? do you agree? explain.
Q15: Bebo Company faces large seasonal variations in its activity. The
peak rise is in the month of June, and the lowest point is in January.
In which month do you expect the current ratio to be at the highest
point? In which month do you propose to end its fiscal year? And
why?
Q16: The bank refused to grant credit to the company, and one of the
reasons for this is that the current ratio of 2:1 is insufficient. Explain
the reasons why the ratio 2:1 is not enough.
Q17: If you are a long-term loan grantor to the company, do you care
more about the company's ability to pay short-term or long-term
debt? Why?

Contents
5.6.2 Applied cases:
Case No. (1): The following is a comparative income statement for Al-
Menoufia Company for Trad and Distribution Inc.:
Menoufia Company for Trad and Distribution Inc.
Comparative income statement for the year
ended June 30, 2020 and 2019

2020 2019

Sales 8,000,000 6,000,000

Less: Cost of goods sold 4,984,000 3,516,000

Gross margin 3,016,000 2,484,000

Less: Operating expenses:

Selling expenses 1,480,000 1,092,000

Administrative expenses 712,000 618,000

Total operating expenses 2,192,000 1,710,000

Net operating income

824,000 774,000
Interest expenses
96,000 84,000
Net income before tax
728,000 690,000

The members of the board of directors are surprised because the net
income increased by 38,000 EGP only, while sales increased by 2 million
EGP.
Required:

Contents
 1. Prepare the income statement for each year on the basis or joint
volume and financial ratios (near your calculations to the nearest
decimal).
2. Comment briefly on the differences between the two years.

Case No. (2): The following is the current assets, current liabilities and
sales of "Al Shabab" company within 5 years:

2021 2020 2019 2018 2017

Sales 2,250,000 2,160,000 2,070,000 1,980,000 1,800,000

Cash 30,000 40,000 48,000 65,000 50,000

Account receivable 570,000 510,000 405,000 345,000 300,000
inventory 750,000 720,000 690,000 660,000 600,000
Total current assets 1,350,000 1,270,000 1,143,000 1,070,000 950,000
Current liabilities
640,000 580,000 520,000 440,000 400,000

Required:
1. Express assets, liabilities, and sales in terms of trends (between the
percentages for each item) using 2017 as the base year and
rounding your calculations to one decimal place.
2. Comment on the results of your analysis.

Case No. (3): The following are the financial statements of the
"Mahjoub" industrial company:

Contents
 Mahgoub Industrial Company
Balance Sheet at December 31, 2021

Assets

Current assets:

Cash 6,500

Accounts receivable 35,000

inventory 70,000

Prepaid expenses 3,500

Total Current assets __________ 115,000

Land, buildings and equipment (net) 185,000

Total assets 300,000
Liabilities and Equity of Shareholders

Liabilities:
Current Liabilities 50,000

10% bond 80,000

Total liabilities 130,000

Shareholders' equity:

Common shares 5 EGP 30,000

Retained earnings 140,000

Total equity of shareholders ________ 170,000

Total liabilities and equity 300,000

Contents
 Mahgoub Industrial Company
Income statement for the year ended December 31, 2021

Sales 420,000

Less: cost of goods sold 292,500

Gross margin 127,500

Less: Selling and Administrative expenses 89,500
Net operating income
38,000
Less: Interest expenses
8,000
Net income before tax
30,000
Less: Tax expense (30%)
9,000
Net income
21,000

The accounts balances on January 1, 2021 accounts receivable were

25,000 EGP. The inventory is 60,000 EGP and all sales are on credit.
Required: Calculate the following financial ratios:
1. Profit Margin Ratio.
2. Current ratio (industry average 2.5:1).
3. Liquidity (Quick) ratio (industry average 1.3:1).
4. Debt to equity ratio.
5. Accounts receivable turnover rate in days (sale terms 2/10, 30 days
net).
6. Inventory turnover rate in days (industry average is 64 days).
7. The number of times interest are earned.
8. The book value of the share (market price 42 EGP).

Contents
Case No. (4): In addition to the previous Mahjoub Company's financial
statements, Case No. (3). assume that the company paid a dividend to
shareholders of 2.10 EGP per share during the year ended December 31,
2021 and also assume that the market value of the common stock was 42
pounds on December 31.
Required: Calculate the following ratios:
1. Earnings per share.
2. Paid dividends ratio.
3. Dividend Yield Ratio.
4. Price-earnings ratio (industry average of 10).

Case No. (5): In addition to the previous data of Mahgoub Company

(Case No. 3), the assets at the beginning of the year were 280,000 EGP,
and the owners' equity of 161,600 EGP.
Required: calculate the following:
1. Return on total assets.
2. Return on equity of common shareholders.
3. Was the financial leverage for the year positive or negative?
Explain.

Contents