Introduction to

Financial Accounting

1
 Accounting is about accountability
Organization Objectives Accountable to

Private company -Making profit -Shareholder

- Creation of -Stakeholder
Wealth
Public Services -Provision of -Govt. ministers
public service -Consumers
-High quality
and reliability of
services 2
Types of accounting information
• Financial Accounts
• Management Accounts

3
 Financial and Management
Accounting
• The major distinction between financial and
management accounting is the users of the
information.
– Financial accounting serves external users.
– Management accounting serves internal users,
such as top executives, management,
and administrators within
organizations.

4
Financial Accounts Management Accounts

Performance of a business Helps management to record,

over a specific period and the plan and control the activities
state of affairs at the end of of a business and assist in the
that period decision-making process

Legally required to prepare No legal requirement to

and publish financial prepare management accounts
accounts
Format of published financial No pre-determined format for
accounts predefined by management accounts
several regulatory elements
5
Financial Accounts Management Accounts
Concentrate on the business Focus on specific areas of a
as a whole rather than business’ activities. Eg
analyse the component as Products, Business Locations,
parts of the business Markets, Departments/divisions
Most financial accounting Includes a wide variety of non-
information is of a financial information Eg:
monetary nature Employees, sales volume,
Customer transactions
Presents a historic Focus on analysing historical
perspective on the financial performance, but usually
performance of the includes forward-looking
business elements eg : Sales Budget;
Cashflow forecast 6
 Accounting as an Aid to
Decision Making
• Fundamental relationships in the decision-
making process:

Accountant’s
Financial
Event analysis & Users
Statements
recording

7
 Accounting

• Language of business
• Grammar of a language
• Communication is the key
• Communication using financial statements

8
 Purpose of Accounting
• Reporting financial position of an entity

• Show how an entity has performed over a

particular period of time

9
 Accounting Principles
• Accounting Principles are man-made
– Can not be verified by experimentation or
observation
– Are evolved overtime – (they change as time
progresses)
• Accounting standards give sufficient lee way to
the accountants while reporting a specific event

10
 Accounting Criteria
• Relevance – meaningful, useful, timely
(information makes a difference in
decisions)

• Objectivity – not influenced by personal

bias/ judgment

• Feasibility – implemented without undue

complexity or cost 11
 Accounting Principles
• 2 categories :
• Accounting Concepts and
• Accounting Conventions

• Accounting Standards

12
 Basic Accounting Concepts
• An understanding of accounting concepts is vital
to understand the process of accounting.
• Accounting concepts underlying the recording of
transactions:
– Entity Concept
– Money Measurement Concept
– Accrual Concept
– Cost Concept

13
 Basic Accounting Concepts
• Accounting concepts underlying financial
reporting:
– Going Concern Concept
– Periodicity Concept
– Matching Concept

14
 Accounting Concepts: Entity and
Money Measurement
• Entity Concept:
– A business entity is an economic unit distinct from its
owner(s). Such entity owns its assets and has its own
obligations. Only those transactions and events which
affect the financial position of the business entity will be
recorded in its books of accounts.
• Money Measurement Concept:
– Only transactions and events which are measurable in
monetary terms should be recorded.

15
Economic Entity Assumption

16
Monetary Unit Assumption

17
 Accounting Concepts: Accrual and
Cost
• Accrual Concept:
– Income and expenses should be recognised as and when
they are earned and incurred, irrespective of whether
money is received or paid in connection thereof. An
alternative of accrual basis of accounting is cash basis
where transactions are recorded only when cash is
received or paid.
• Cost Concept:
– Assets and liabilities should be recorded at historical cost.
The recent trends in accounting show that policy makers
favour fair value accounting in place of historical cost
accounting.
18
 Accounting Concepts: Going Concern and
Periodicity
• Going Concern Concept:
– An entity is said to be a going concern if it has
‘neither the intention nor the necessity of liquidation
or of curtailing materially the scale of the operations’.
The valuation principles of assets and liabilities
depend on this concept.
• Periodicity Concept:
– Accounts are prepared for a defined accounting
period. Such period could be a quarter, half year, a
year or, in exceptional circumstances, more than one
year. This concept is essential to measure financial
performance.
19
Accounting Concepts: Matching
and Prudence
• Matching Concept:
– While measuring periodic financial results, revenue
earned during an accounting period is matched with
expenses incurred (to earn the revenue) in the same
accounting period.
• Prudence Concept:
– This concept suggests that all possible expenses and
losses should be estimated and recorded, but
anticipated gains should be ignored. This concept is
also called the concept of ‘conservatism’.

20
 Accounting Conventions
• Convention of Conservatism
• Convention of Full Disclosure
• Convention of Consistency
• Convention of Materiality

21
 Accounting Standards
• Need
• Function
• Formation
• Scope of Accounting Standards
• Procedure for Issuing an Accounting
Standards
• Type of Accounting Standards
22
Understanding the Balance
Sheet
Elements of an
Annual Report
• Chairman’s Speech
• Financial Statements
– Income Statement
– Balance Sheet
– Statement of Cash Flows
• Management Discussion and Analysis
• Notes to Financial Statements
• Auditor's Report
Financial Accounting Statements
• Income Statement - reports the results
of operations for a specific period of
time
• Balance Sheet - reports the assets,
liabilities, and stockholders’ equity at a
specific date
• Statement of Cash Flows - reports the
cash receipts and payments for a
specific period of time
 Types of Financial Statements - IFRS
Financial Statements

Income Statement /
Profit and Loss
Account/ Statement Balance Sheet
of Comprehensive
Income

Statement of Statement of Changes

Other in Equity
Comprehensive
Income

Cash Flow Statement

 Management Discussion
and Analysis
Covers three aspects of a company:
– liquidity - ability to pay near-term
obligations
– capital resources - ability to fund
operations and expansions
– results of operation
Notes to Financial Statements
• Provide additional information not
included in body of statements
• Does not have to be numeric
• Examples:
– Description of accounting policies or
explanation of uncertainties and
contingencies
– Statistics and voluminous details
 Auditor's Report
• Auditor, a professional accountant who
conducts an independent examination of the
financial accounting data presented by a
company.
• Auditor gives an unqualified opinion if the
financial statements present the financial
position, results of operations, and cash
flows in accordance with GAAP.
 The Balance Sheet
• What are the different sections of the
Balance Sheet?
 The Balance Sheet
Sections of the balance sheet:
• Assets - resources of the firm that are expected
to increase or cause future cash flows
(everything the firm owns)
• Liabilities - obligations of the firm to outsiders or
claims against its assets by outsiders (debts of
the firm)
• Owners’ Equity - the residual interest in, or
remaining claims against, the firm’s assets after
deducting liabilities (rights of the owners)
 Balance Sheet Structure
Assets Equity & Liabilities
Non-Current Assets Equity
Real Assets Reserves and Surplus
Land, Buildings, Vehicles,
Equipment, Non-Current Liabilities
Financial Assets Term Loans, Debentures,
Investments Bonds
Intangible Assets
Patents, Goodwill
Current Assets Current Liabilities
Cash, Accounts Receivable, Accounts Payable,
Inventory, Prepaid Expenses Short Term Loans
 The Balance Sheet
The balance sheet equation:

Assets = Liabilities + Owners’

Equity
or
Owners’ Equity = Assets -
Liabilities
 Balance Sheet Transactions
• The balance sheet is affected by every
transaction that an entity encounters.
• Each transaction has counterbalancing
entries that keep total assets equal to total
liabilities and owners’ equity, i.e., the balance
sheet equation must always be balanced.
 Balance Sheet Transactions
• Just as the balance sheet equation must
always balance, the balance sheet must
also always balance.

• A balance sheet could be prepared after

every transaction, but this practice would
be awkward and unnecessary.
– Therefore, balance sheets are usually
prepared monthly or on some other periodic
schedule.
A Classified Balance Sheet...
Generally contains the following standard
classifications:
– Current Assets
– Long-Term Investments
– Property, Plant, and Equipment
– Intangible Assets
– Current Liabilities
– Long-Term Liabilities
– Stockholders' Equity
 Current Assets
• Assets that are expected to be converted to cash
or used in the business within a short period of
time, usually one year.
• Current assets are listed in order of liquidity.
• Examples:
– Cash
– Short-term investments
– Receivables
– Inventories
– Prepaid expenses
 Long-Term Investments
• Assets that can be converted into cash, but
whose conversion is not expected within one
year.
• Assets not intended for use within the business.
• Example:
– investments of stocks and bonds of other
corporations.
Property, Plant, and
Equipment
• Assets with relatively long
useful lives.
• Assets used in operating
the business.
• Examples:
– land
– buildings
– machinery
– delivery equipment
– furniture and fixtures
 Depreciation is...
• Practice of allocating an asset’s full
purchase price to a number of years
instead of expensing full cost in year of
purchase.
 Accumulated Depreciation
account ...
• Shows the total amount of depreciation
taken over the life of the asset.
 CSU CORPORATION
Assets Balance
ThatSheet
A Company
December 31, 2001
Depreciates...
Should be shown at cost less accumulated
depreciation

Assets
Cash $ 2,000
Accounts receivable 4,000
Supplies 1,800
Equipment 24,000
Less: Accumulated Depreciation 8,000 16,000
Total assets $23,800
 Intangible Assets
• Noncurrent assets
• Have no physical substance
• Examples:
– patents
– copyrights
– trademarks or trade names
– franchise
Intangible Assets have value
because of the exclusive
rights or privileges they possess.
 Current Liabilities
Obligations that are supposed to be paid within
the coming year...
• accounts payable
• wages payable
• bank loans payable
• interest payable
• taxes payable
 Long-Term Liabilities
Debts expected to be paid after one
year
Examples…
– bonds payable
– mortgages payable
– long-term notes payable
– lease liabilities and
– obligations under employee pension
plans
 Stockholders' Equity
• Capital stock - investments in the
business by the stockholders
• Retained earnings - earnings kept for
use in the business
 Accounting for Owners’ Equity
Proprietorships and Partnerships vs.
Corporations
• Owners’ equities for proprietorships and
partnerships are called capital.
• Owners’ equity for a corporation
is called stockholders’ equity or
shareholders’ equity.
 The Meaning of Par Value
• Par value (stated value) - a nominal dollar
amount printed on each stock certificate -
required by most states
– Stock is usually issued and sold at more than par
value.

• Paid-in capital in excess of par - difference

between the total amount received for the
stock (issue price or sales price) and par
value
 A Typical Manufacturing Company
Starts Operation
Two promoters deposit Rs 5 lakhs in the company account as
equity

ABC Limited
Balance Sheet at April 1, 2001

Assets Liabilities
Cash 5,00,000 Equity 5,00,000
Total 5,00,000 Total 5,00,000
 A lathe is bought on cash basis

Owner pays Rs 3 lakhs from the bank acount

Assets Liabilities
Cash 2,00,000 Equity 5,00,000
Plant 3,00,000
Total 5,00,000 Total 5,00,000
 Raw material worth Rs 80,000
bought on a 60 day credit basis
No payment is done so cash position does not change

Assets Liabilities
Cash 2,00,000 Equity 5,00,000
Plant 3,00,000 Account 80,000
Payable
Inventory 80,000
Total 5,80,000 Total 5,80,000
 Raw material worth Rs 40,000 processed and
sold for Rs 50,000 with a 30 day credit
No payment is done so cash position does not change, but
inventory is reduced

Assets Liabilities
Cash 2,00,000 Equity 5,00,000
Plant 3,00,000 Accounts Payable 80,000
Inventory 40,000 Retained 10,000
Earnings
Accounts 50,000
Receivable
Total 5,90,000 Total 5,90,000
 Customer pays up after 20 days

Payment deposited in bank so cash position changes

Assets Liabilities
Cash 2,50,000 Equity 5,00,000
Plant 3,00,000 Accounts 80,000
Payable
Inventory 40,000 Retained 10,000
Earnings
Accounts 00,000
Receivable
Total 5,90,000 Total 5,90,000
 Supplier credit period is over and raw material
is paid for after 60 days
Payment done from bank so cash balance reduces

Assets Liabilities
Cash 1,70,000 Equity 5,00,000
Plant 3,00,000 Accounts 00,000
Payable
Inventory 40,000 Retained 10,000
Earnings
Accounts 00,000
Receivable
Total 5,10,000 Total 5,10,000
Prepare a Balance Sheet from the following information
And provide the missing figures
Particulars Amount in Rs.
Outstanding salaries 43,754
Cash 76,413
Total liabilities ?
Long-term liabilities 9,117
Receivables 17,753
General Reserve 402
Inventory ?
Accounts payable 74,510
Property, plant & 165,822
equipment
Stockholders’ equity 295,805
Other assets 34,015
Bank Borrowing 32,608
Total assets 456,196
Financial Statement Analysis
 Financial Statement Analysis

• Assessment of the firm’s past, present and

future financial conditions
• Done to find firm’s financial strengths and
weaknesses
• Primary Tools:
– Financial Statements
– Comparison of financial ratios to past,
industry, sector and all firms
 Objectives of Ratio Analysis
• Standardize financial information for
comparisons
• Evaluate current operations
• Compare performance with past
performance
• Compare performance against other
firms or industry standards
• Study the efficiency of operations
• Study the risk of operations
 Uses for Ratio Analysis

• Evaluate Bank Loan Applications

• Evaluate Customers’ Creditworthiness
• Assess Potential Merger Candidates
• Analyze Internal Management Control
• Analyze and Compare Investment
Opportunities
 Horizontal, Vertical, & Trend
Analysis
• Horizontal Analysis = calculating the Rupee
change and % change in financial statement
amounts across time
• Vertical Analysis (Common Size Analysis) =
changing all Rupee values for accounts to %
values.
• Trend Analysis = Using the “first” year as a
base year, calculate future year Rupee values as
a ratio.
 Types of Ratio Analysis

• Time Series Analysis or Trend Analysis

– Measures a firm’s performance over time
• Cross Sectional Analysis
– Compares the firm’s ratios with an industry
standard or with its competitor’s ratios.
– Sources:
• U.S. Department of Commerce
• Dun & Bradstreet
• Robert Morris Associates
 Types of Ratios

• Financial Ratios:
– Liquidity Ratios
• Assess ability to cover current obligations
– Leverage Ratios
• Assess ability to cover long term debt obligations
• Operational Ratios:
– Activity (Turnover) Ratios
• Assess amount of activity relative to amount of
resources used
– Profitability Ratios
• Assess profits relative to amount of resources
used
• Valuation Ratios:
• Assess market price relative to assets or earnings
 Liquidity Ratios

• Current Ratio
– Current Assets / Current Liabilities
• Current Assets include Cash, Marketable Securities, Accounts
Receivable and Inventory
• Current Liabilities include Accounts Payable, Debt Due within one
year, and Other Current Liabilities

Current Assets 1870.92

Current Ratio = = = 1.2 : 1
Current Liabilitie s 1555.75
 Liquidity Ratios

• Quick Ratio or Acid Test

– Current Assets minus Inventory / Current Liabilities
– A more precise measure of liquidity, especially if
inventory is not easily converted into cash.

Current Assets - Inventory 720.53

Quick Ratio = = = 0.46 : 1
Current Liabilitie s 1555.75
 Liquidity Ratios

• Cash Ratio
Cash + Marketable Securities 26.08
Cash Ratio = = = 0.17
Current Liabilitie s 1555.75
 Liquidity Ratios

•Interval Measure

–Calculated to assess a firm's ability to meet its regular

cash outgoings

Current Assets − Inventory

Interval Measure =
Average Daily operating expenses
1,870.92 − 1,150.39
= = 77 Days
3,369.94 / 365
 Leverage Ratios
– Leverage ratios measure the extent to which a firm has
been financed by debt.

– Leverage ratios include:

• Debt Ratio
• Debt--Equity Ratio

– Generally, the higher this ratio, the more risky a creditor

will perceive its exposure in your business. Thus, high
leverage ratios make it more difficult to obtain credit
(loans).
 Leverage Ratios Cont.
▪ Leverage ratios also include the Interest-
coverage Ratio, Fixed coverage Ratio etc,.

▪ In contrast to the leverage ratios discussed on

previous slide, the higher the Interest
Coverage Ratio (Times-Interest-Earned Ratio),
the more credit worthy the firm is, and the
easier it will be to obtain credit (loans).
 Total Debt Ratio

– Proportion of interest bearing debt in the

Capital structure.
– In general, the lower the number, the better.

Total Debt
Debt Ratio =
Net Assets
1,229.06
= = 0.646
1901.87
 Debt-Equity Ratio

– The Debt-Equity Ratio indicates the percentage of total

funds provided by creditors versus by owners.

– This ratio indicates the extent to which the business relies

on debt financing (creditor money versus owner’s equity).

Total Debt 1,229.06

Debt − Equity Ratio = = = 1.83
Net Worth 972.81
 Interest Coverage Ratio

– interest coverage ratio indicates the extent to which

earnings can decline without the firm becoming unable
to meet its annual interest costs.
– Also called the Times-Interest-Earned Ratio, this
calculation shows how many times the firm could pay
back (or cover) its annual interest expenses out of
earnings before interest and taxes (EBIT).

EBIT 342.61
Interest Coverage Ratio = = = 2.4
Interest 143.46
 Interest Coverage Ratio

EBITDA 342.61 + 41.59

Interest Coverage Ratio = = = 2.7
Interest 143.46

DA = Depreciation and Amortization expenses

 Fixed Coverage Ratio (OR)
Debt Service Coverage Ratio (DSCR)
– Principal repayments are added to interest payments

•
EBITDA
Fixed Coverage Ratio =
Interest + Loan repayment
1-Tax Rate

EBITDA
Fixed Coverage Ratio = + Pref. Dividend
Interest + Lease rentals + Loan repayment
1-Tax Rate
 Activity Ratios

– Activity ratios measure how effectively a firm is using its

resources, or how efficient a company is in its operations
and use of assets.
– In general, the higher the ratio, the better.
– Activity ratios include:
▪ Inventory turnover
▪ Accounts receivable turnover
▪ Average collection period.
▪ Total assets turnover
▪ Fixed assets turnover
 Inventory Turnover Ratio

– The inventory turnover ratio indicates how fast a firm is

selling its inventories
– This ratio indicates how well inventory is being managed,
which is important because the more times inventory can
be turned (i.e., the higher the turnover rate) in a given
operating cycle, the greater the profit.

Cost of Goods Sold 3,053.66

Inventory Turnover Ratio = = = 8.6
Avg Inventory (244.26 + 7461.81) / 2

365
Days of Inventory Holding = = 42 days
Inventory Turnover
 Inventory Turnover Ratio Cont.
– In the absence of information. Instead of CGS
we can use Sales
– In the case of CGS and Inventory both are
valued at cost. While the sales are valued at
market prices
– Therefore better to use CGS
 Accounts Receivable Turnover

– The accounts receivable turnover ratio, indicates the

average length of time it takes a firm to collect credit sales
(in percentage terms), i.e., how well accounts receivable
are being collected.
– If receivables are excessively slow in being converted to
cash, liquidity could be severely impaired.

Credit Sales
A R Turnover =
Avg AR

Sales 3,717.23
= = = 7.7
Avg AR 483.18
 Average Collection Period

– The average collection period is the average length of

time (in days) it takes a firm to collect on credit sales.

365
ACP = = 47 days
AR Turnover
Accounts Payable Turnover
Days Payable Ratio
 Cash Conversion Cycle
• Cash Conversion Cycle =

• Days Holding Period(Time for converting

Inv into sale) +
• Average Collection Period (Time to
convert sale into cash) –
• Days Payable Period (Time give to make
payments)
• Lower the ratio, better.
 Net Assets Turnover

– The total assets turnover ratio, indicates how efficiently

a firm is using all its assets to generate revenues.
– This ratio helps to signal whether a firm is generating a
sufficient volume of business for the size of its asset
investment

Sales 3,717.23
Net Assets Turnover = = = 1.95 times
Net Assets 1901.87
 Profitability Ratios

– Profitability ratios measure management’s

overall effectiveness as shown by returns
generated on sales and investment.

Profitability ratios include

– Gross profit margin
– Operating profit margin
– Net profit margin
– Return on total assets (ROA)
– Return on stockholders’ equity (ROE)
Gross Profit Margin

– The gross profit margin is the total margin available to cover

operating expenses and yield a profit. This ratio indicates
how efficiently a business is using its labor and materials in
the production process, and shows the percentage of net
sales remaining after subtracting cost of goods sold.
– The higher the ratio, the better. A high gross profit margin
indicates that a firm can make a reasonable profit on sales,
as long as it keeps overhead costs under control.
Gross Profit 663.57
GP Margin = = = 0.179 or 17.9%
Sales 3,717.23
Operating Profit Margin

– The Operating Profit Margin measures profitability without

concern for taxes and interest.
– The higher the ratio, the better. A high operating profit
margin indicates that a firm can make a reasonable profit
on sales, as long as it does good tax planning.

EBIT 342.61
OP Margin = = = 0.092 or 9.2%
Sales 3,717.23
Net Profit Margin

– The net profit margin shows the after-tax profits per rupee of
sales.
– The higher the ratio, the better.

PAT 134.86
NP Margin = = = 0.036 or 3.6%
Sales 3,717.23
 Return on Investment (ROI) OR
Return on Capital Employed (ROCE)
– The return on total assets ratio shows the after-tax
profits per dollar of assets; this is also called return
on investment (ROI).
– The ROI is perhaps the most important ratio of all. It
is the percentage of return on money invested in the
business. The ROI should always be higher than the
rate of return on an alternative, risk-free investment.
– The higher the ratio, the better.
EBIT 342.61
ROI = = = 0.18 or 18%
Capital Employed 1,901.87
Return on Shareholders’ Equity

– The net profit margin shows the after-tax profits per

rupee of sales.
– The higher the ratio, the better.

PAT 134.86
ROE = = = 0.20 or 20%
Net Worth 672.81
 Market Valuation Ratios

– Earnings per share (EPS)

– Price-earnings ratio (P/E).
– Dividend Yield
– Market to Book Ratio
Earnings Per Share (EPS)
– The Profitability of the common shareholders’
Investment.
– The higher the ratio, the better.
– Adjust for the bonus issues

PAT
EPS =
No of common shares outstandin g

134.86
= = Rs. 6.00
22.50
Dividends Per Share (DPS)

– Earnings distributed to the shareholders’ as

cash dividends.
– The higher the ratio, the better.
– .

Dividends Paid to Shareholde rs

DPS =
No of common shares outstandin g

45.00
= = Rs. 2.00
22.50
 Dividend Payout Ratio
&
Retention Ratio
DPS
Payout Ratio =
EPS

2
= = 0.33 or 33%
6

Retention Ratio = 1- Payout Ratio

Growth in Equity = Retention Ratio * ROE

 Market Valuation Measures
• Dividend Yield
– Dividend / Market Value per Share
• payout declared as a percentage of the stock
price
• Earnings Yield
– EPS / Market Value per Share

– Dividend and Earnings yield evaluate the

shareholders’ return in relation to the market
value of the share
 Price-Earnings Ratio
– Measure of optimism or pessimism about firm’s
future.
– High PE Ratio indicates optimism
– Low PE Ratio indicates pessimism

Market Value of the Share

P / E Ratio =
EPS

29.25
= = Rs. 4.88 times
6
 Price to Book Ratio (PB Ratio)

• Market Value to Book Value Ratio

– Stock price / book value per share
• The number of times the market values the stock over its
paid-in capital and retained earnings.
 Dupont Analysis
• ROE is a closely watched number
• It is a strong measure of how well the
management of a company creates value for its
shareholders
• The number can be misleading
• Due to its vulnerability to measures that increase
its value while making the stock risky
• Without a way of breaking down the components
of ROE, investors could be duped into believing
a company is a good investment when it is not.
 Components of ROE

• ROE = (Net profit margin) * (Asset Turnover) * (Equity multiplier)

• Operating Efficiency - Profit margin

• Asset use efficiency – Total asset turnover
• Financial leverage – Equity multiplier
 Dupont Calculation

NetIncome Sales Assets

 
• ROE = Sales Asset Shareholde requity
 Ratio to Predict Insolvency
Ratios Expressed Comments
as
Altman’s Z Score No. 3 or more – Financially sound
Z = 1.2 X1 + 1.4 X2 + 3.3 1.81 to 2.99 – Grey area
X3 + 0.6 X4 + 1.0 X5 Less than 1.8 – Higher chances of
X1 = Working Capital/ financial embarrassment
Total Assets
X2 = Retained Earnings /
Total Assets
X3 = EBIT / Total Assets
X4 = Market Value of
Equity / Book Value of
Total Liabilities
X5 = Sales / Total Assets
 Ratio Analysis Limitations
• Financial ratios are based on accounting data,
and firms differ in their treatment of such items
as depreciation, inventory valuation, research
and development expenditures, pension plan
costs, mergers, and taxes.
• Reflects Book Value
• Does not take size differences of companies into
account
• Identifies problem areas, but not causes
Limitations
▪ Seasonal factors can influence comparative ratios.
▪ A firm’s financial condition depends not only on the
functions of finance, but also on many other factors
such as
▪ Management, marketing, production/operations,
R&D, and MIS decisions
▪ Actions by competitors, suppliers, distributors,
creditors, customers, and shareholders
▪ Economic, social, cultural, demographics,
environmental, political, governmental, legal, and
technological trends.
Accounting Cycle

Exercises
 Type of Accounts
• Personal Accounts :

• Real Accounts

• Nominal Accounts
 Debit and Credit Principle
Conventional Approach

Type of Accounts Debit Credit

Personal Receiver Giver
Real What comes in What goes out
Nominal Expenses/Losses Revenues/Gains
 Debit and Credit Principle
Accounting Equation Approach
Balance Sheet Accounts Debit Credit
Assets Increases (+) Decrease (-)
Liabilities and Owner Equity Decreases (-) Increases (+)
Income Statement Accounts
Expenses and Losses Increases (+) Decrease (-)
(Impact on OE)
Revenues and Gains Decreases (-) Increases (+)
(Impact on OE)
 Classify the accounts as:
Real, Personal or Nominal
• Bank Account
• Furniture Account
• Salary Account
• Cash Account
• Rent Outstanding
• Bank Overdraft
• Capital Account
• Sales
• Accounts Receivables / Sundry Debtors
• Sundry Creditors / Account Payables
The following balances were extracted from the books of Snow White &co. on 31
December, 2011. You are required to arrange them in a Trial Balance
Particulars Amount in Particulars Amount in
(Rs.) (Rs.)

Purchases 11,250,000 Creditors 2,812,500

Capital 9,309,375 Discount allowed 150,000
Inventories 3,750,000 Bank balance (Current Asset) 4,687,500
(1 January 2011)
Sales 16,875,000 General expenses 562,500
Discount earned 84,375 Bad Debts 75,000
Debtors 2,625,000 Furniture 937,500
Freight 22,500 Wages and salaries 1,125,000
Cash in hand 183,750 Repair 187,500
Machinery 1,875,000 Purchase return 187,500
Provision for 562,500 Rent received 225,000
Depreciation
Sales Returns 562,500 Interest earned 187,500
Premises 2,250,000
 Correct the Trial Balance
Particulars Debit Amount Particulars Credit Amount
Machinery 732,089 Capital 1,897,000
Furniture 332,768 Creditors 1,331,800
Bank 303,500 Building 1,700,000
Cash 56,647 Debtors 1,796,950
Loan from Bank 1,265,000 PF deducted from 33,000
salaries
Opening Stock 402,000 Purchases 8,319,200
Sales 10,715,129 Bad Debts 66,560
Sales Returns 399,300 Insurance Premium 74,420
Rent Paid 199,660 Phone Charges 24,657
Salaries 532,600
Interest Charges 66,550
Electricity Expenses 35,368
Commission paid 199,660
TOTAL 15,240,271 TOTAL 15,243,587
 Journalise the following transactions
1. Started business with Rs. 75,000 in bank as capital

2 Bought shop furniture for Rs. 12,000 paying by cheque

3 Bought goods for Rs. 30,000 on credit from Duncans

4 Bought goods for Rs. 8,500 on credit from Brookes

5 Sold goods for cash Rs. 22,800

6 Paid rent in cash Rs. 6,000

7 Paid for stationery expenses Rs. 500 cash
8 Goods worth Rs. 7,000 returned to Duncans
9 Sold goods on credit to Harry for Rs. 20,000

10 Bought a motor van for Rs. 24,000. Paid by cheque

11 Paid by cheque to Brookes Rs. 8,500

12 Harry’s paid us by cheque Rs. 8,000

13 Paid for the month’s salaries in cash Rs. 7,500
 Journalise the following transactions
1. Started business with Rs. 75,000 in bank as capital

2 Bought shop furniture for Rs. 12,000 paying by cheque

3 Bought goods for Rs. 30,000 on credit from Duncans

4 Bought goods for Rs. 8,500 on credit from Brookes

5 Sold goods for cash Rs. 22,800

6 Paid rent in cash Rs. 6,000

7 Paid for stationery expenses Rs. 500 cash
8 Goods worth Rs. 7,000 returned to Duncans
9 Sold goods on credit to Harry for Rs. 20,000

10 Bought a motor van for Rs. 24,000. Paid by cheque

11 Paid by cheque to Brookes Rs. 8,500

12 Harry’s paid us by cheque Rs. 8,000

13 Paid for the month’s salaries in cash Rs. 7,500
 Journalise the following transactions
1. Started business with Rs. 75,000 in bank as capital
1.Bank A/c – Increasing – Asset - Debit
2.Capital A/C – Increasing – Owners Equity – Credit
Bank A/c Dr
To Capital A/c Cr.
2 Bought shop furniture for Rs. 12,000 paying by cheque
1. Furniture A/c – Increasing – Asset - Debit
2. Bank A/c – Decreasing – Asset – Credit
Furniture A/c Dr.
Bank A/c Cr.
3 Bought goods for Rs. 30,000 on credit from Duncans
1. Purchases A/c – Expense – Increasing - Debited
2. Duncans (A/c Payable) – Liability – Increasing – Credited
Purchases A/c Dr.
To Duncans (A/c Payable) Cr.
COGS = [Op. stock + (Purchases – Purchase Returns)– Closing Stock]
4 Bought goods for Rs. 8,500 on credit from Brookes

5 Sold goods for cash Rs. 22,800

1. Cash A/C – Asset – Increasing - Debit
 Journalise the following transactions
1. Started business with Rs. 75,000 in bank as capital (Bank Asset + Capital Liability)

2 Bought shop furniture for Rs. 12,000 paying by cheque

(Furniture Asset Increasing + Bank Asset Decreasing)
3 Bought goods for Rs. 30,000 on credit from Duncans (A/c Payable)
(COGS = Op stock + [Purchases –Purchase Returns]- closing Stock) (10 + 100 – 20) = 90
(Closing Stock = Inventory =B/S)
(Purchases – Expense – reduces OE – Liability – Decreases - Debited)
Duncan – A/C Payable – Liability – Increasing
4 Bought goods for Rs. 8,500 on credit from Brookes

5 Sold goods for cash Rs. 22,800 (refers only 90 units sold)
Revenues – Increase in OE – Credited (Revenue from Sales cr. And Cash Debit)
6 Paid rent in cash Rs. 6,000
7 Paid for stationery expenses Rs. 500 cash
8 Goods worth Rs. 7,000 returned to Duncans
Names of Account :
1 ) Duncans (A/C Payable) – Liability – Reduced – Debited
2) Purchases Returns – Increases OE (Reduction in Expense) - Credited
9 Sold goods on credit to Harry for Rs. 20,000
Journalise the following transactions
7 Paid for stationery expenses Rs. 500 cash
Stationery Expenses A/c dr
Cash A/c cr
8 Goods worth Rs. 7,000 returned to Duncans
1. Duncans (A/c Payable) – Liability – Decreasing- Debited
2. Purchase Returns A/c - Reduction in Expenses – Decreasing – Credited
Duncans A/c Dr.
To Purchase Returns A/c Cr.
9 Sold goods on credit to Harry for Rs. 20,000
A/C Receivable (Harry) Dr.
To Revenue from Sales a/c Cr.
10 Bought a motor van for Rs. 24,000. Paid by cheque

11 Paid by cheque to Brookes Rs. 8,500

Brookes A/C Dr.
To Bank A/c Cr.
12 Harry’s paid us by cheque Rs. 8,000
Bank A/C Dr.
To Harry Cr.
13 Paid for the month’s salaries in cash Rs. 7,500
Introduction to Management
Accounting
Overview of Management Accounting
 Management Accounting encompasses techniques and
processes
 that are intended to provide financial and non-financial
information
 to people within an organization
 to make better decisions and
 thereby achieve organizational control and enhance
organizational effectiveness
Definition of Management Accounting
 A system of collection and presentation of relevant economic
information relating to an enterprise for planning, controlling and
decision making (ICWAI)
 The provision of information required by management for such
purposes as :
- Formulation of policies
- Planning and controlling the activities of the enterprise
- Decision taking on alternative course of action
- Disclosure to those external to the entity
- Disclosure to employees
- Safeguarding assets (CIMA)
Evolution of Accounting subject
between 1775 to 2010
 Bookkeeping (1775 – 1850)
 Financial Auditing (1850 )
 Cost Accounting (1900 )
 Government Accounting, Tax Accounting, Management
Accounting ( 1950)
 Management Auditing, MIS, Accounting for Price Level
Changes, Social Accounting & Reporting ( 1975)
 Strategic Management Accounting, HR Accounting,
Environment Accounting, Creativity Accounting (2000)
Scope of Management Accounting
 Includes Financial Accounting
 Extends to the operation of a system of Cost Accounting and
Financial Management
 It stresses upon the establishment and operation of internal
controls.

 The functions of Management Accounting can be broadly

classified into:
a) Periodic internal accounting reports and
b) Ad hoc analysis of data for decision making
Comparison with cost accounting
Cost Accounting (CA) Management Accounting (MA)
1. Ascertainment, allocation, 1. Concerned more with impact and
distribution and accounting aspects of effect aspects of costs
costs
2. CA data serves as a base to which 2. MA data is derived from both CA
the tools and techniques of MA can be and Financial Accounts
applied
3. Primary emphasis of CA is to deal 3. The main thrust of MA is towards
with collection, analysis, relevance, determining policy and formulating
interpretation and presentation for plans to achieve desired objectives of
various problems of management management. MA makes corporate
planning and strategy effective and
meaningful
 Comparison with Financial Accounting
Nature Financial Accounting Management
Accounting
1.Governed by Company law etc Needs of managers

2. Basic Functions Transaction recording, Decision support,

Publication of external provision of management
financial statements information

3. Users External Internal

4. Availability Publicly available Confidential

5. Time Focus Past and Present Present and Future

6. Period Usually one year As appropriate

 Comparison with Financial Accounting
Nature Financial Accounting Management
Accounting
7. Main emphasis Explanation Planning and Control

8. Speed of Slow but detailed and accurate Fast but approximate

preparation
9. Style and details Standardised Tailored to requirements
and summarised

10. Form of Whole of legal entity Segmented to control

presentation units
11. Criteria Objective, verifiable and Relevant, useful and
consistent understandable
12. Unit of Money Money or physical units
Account
Managerial Functions and Cost
 Planning and control among alternatives and
 Planning optimum utilisation of resources

 Knowledge of costs of each alternative is essential

 Performance of executives and subordinates can be evaluated and controlled

based on cost actually incurred and should have been incurred

 However, there is no one unique concept of cost.

 Different cost concepts exist for different purposes

 The aim is to clarify meanings of various cost concepts and explain their
usefulness
Cost Classification
 Process of Management

Planning Control

Managers need cost information to

perform each of these functions.

Decision
Directing
Making
What Do We Mean By a Cost?

A Cost
is the measure of
resources given
up to achieve a
particular purpose.
 Types of Cost Classification

Traceability Behaviour

Control Relevance

• Historical
Time • Replacement
• Budgeted

Variable
Volume Fixed
Mixed
Step Cost

• Expired
Financial • Unexpired
Statements • Product
• Period

Decision Making • Relevant

• Not Relevant
Types of Cost Classification

Traceability Behaviour

Control Relevance
 Manufacturing Costs

Direct Direct Manufacturing

Labor Material Overhead

The
Product
 Direct Costs

What are direct costs?

Direct costs can be identified specifically
and exclusively with a given cost
objective in an economically
feasible way.
 Indirect Manufacturing Costs...
– or factory overhead, include all costs
associated with the manufacturing process
that cannot be traced to the manufactured
goods in an economically feasible way.
 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs

Materials used to support

the production process.
Examples: lubricants and
cleaning supplies used in an
automobile assembly plant.
 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs

Cost of personnel who

do not work directly on
the product. Examples:
maintenance workers,
janitors and security
guards.
 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs

Examples: depreciation
on plant and equipment,
property taxes,
insurance, utilities,
overtime premium, and
unavoidable idle time.
 Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost
 Direct and Indirect Costs
Direct costs Indirect costs
• Costs that can be • Costs that must be
easily and allocated in order to
conveniently traced to be assigned to a
a product or product or
department. department.
• Example: cost of • Example: cost of
paint in the paint national advertising
department of an for an airline is
automobile assembly indirect to a particular
plant. flight.
 Direct and Indirect Costs
• A cost can be direct to the department, but
indirect to units of product produced in the
department.
– Example: department manager’s salary.

• Tracing costs directly to departments or

products facilitates responsibility
accounting.
Cost Classifications

Cost behavior means

how a cost will react
to changes in the
level of business
activity.
– Total variable costs
change when activity
changes.
– Total fixed costs remain
unchanged when
activity changes.
 Cost Classifications

Cost behavior means

how a cost will react
to changes in the
level of business
Activities that activity.
cause costs to be – Total variable costs
change when activity
incurred are called changes.
cost drivers. – Total fixed costs remain
unchanged when
activity changes.
Cost Drivers
 Identifying Cost Drivers

Cost Driver Examples

Activity Cost Driver
Machining operations Machine hours
Setup Setup hours
Production scheduling Manufacturing orders
Inspection Pieces inspected
Purchasing Purchase orders
Shop order handling Shop orders
Valve assembly support Customer requisitions
 Comparison of
Variable and Fixed Costs

A variable cost is a cost that changes in direct

proportion to changes in the cost driver.

A fixed cost is not immediately affected

by changes in the cost driver.
 Relevant Range

$16,000 –
Fixed Costs

$12,000 –
Relevant Range
$8,000 –

$4,000
–

–
0 500 1,000 1,500 2,000 2,500
Volume in Units
 Rules of Thumb

Think of variable costs on a per-unit basis.

The per-unit variable cost remains
unchanged regardless of changes
in the cost-driver activity.
 Rules of Thumb

Think of fixed costs as a total.

Total fixed costs remain unchanged
regardless of changes in cost-driver activity.
 Cost Classifications

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over
wide ranges of activity.
Total fixed cost remains Fixed cost per unit
Fixed the same even when the goes down as activity
activity level changes. level goes up.
 Controllable and
Uncontrollable Costs
A cost that can be significantly influenced
by a manager is a controllable cost.

Cost item Manager Classificaton

Cost of food used Restaurant Controllable
in a restaurant manager
Cost of national Restaurant Uncontrollable
advertising by a manager
restaurant chain
 Opportunity Cost
The potential benefit that is
given up when one
alternative is selected
over another.
– Example: If you were
not attending college,
you could be earning
$20,000 per year.
Your opportunity cost
of attending college for one
year is $20,000.
 Sunk Costs
All costs incurred in the past that cannot be
changed by any decision made now or in the
future.

Sunk costs should not be considered in

decisions.
– Example: You bought an automobile that cost
$12,000 two years ago. The $12,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $12,000 cost.
 Differential Costs
Costs that differ between alternatives.

Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.

What is your differential cost?

 Differential Costs
Costs that differ between alternatives.

Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.

What is your differential cost?

$300 - $50 = $250
Marginal Costs and Average
Costs

The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.

Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.
 Types of Cost Classification
• Historical
Time • Replacement
• Budgeted

Variable
Volume Fixed
Mixed
Step Cost

• Expired
Financial Statements • Unexpired
• Product
• Period

Decision Making • Relevant

• Not Relevant
 Product Costs...
– are costs identified with goods produced
or purchased for resale.
• Product costs are initially identified as part
of the inventory on hand.
• These costs, inventoriable costs, become
expenses (in the form of cost of goods
sold) only when the inventory is sold.
 Period Costs...
– are costs that are deducted as expenses
during the current period without going
through an inventory stage.
 Other cost concepts
• Out of pocket costs
• Discretionary costs
End of cost classification
C V P Analysis

158
Cost-Profit-Volume Analysis
 What is cost-volume-profit analysis?

It is the study of the effects of output

volume on revenue (sales), expenses
(costs), and net income (net profit).

159
Assumptions in C-V-P Analysis
1. Costs can be accurately separated into
variable and fixed components.
2. Fixed costs remain fixed.
3. Variable costs per unit do not change
over the relevant range.
Questions Addressed by CVP
Analysis
 How much must I sell to earn my
desired income?
 How will income be affected if I
reduce selling prices to increase sales
volume?
 What will happen to profitability if I
expand capacity?

161
CVP Analysis

 Understand how cost behave

in relation to activity levels of
the business

 Apply the cost behavior

approach to CVP analysis

162
Variable Costs
Fixed Costs
Mixed Costs
Cost Estimation Methods

Cost Estimation Methods are frequently

required to separate the fixed and variable
components of a total cost pool. Methods
include:

1. Account Analysis
2. Scattergraph
3. High-Low Method
4. Regression
5. Relevant Range
Scattergraph
High-Low Method

Example: Let total costs at 500 units of

output be $150,000 and at 3,000 units of
output be $400,000. Calculate variable and
fixed costs, respectively.
High-Low Method

Solution: High Low Change

Costs: $400,000 $150,000 $250,000
Units: 3,000 500 2,500
Calculate Variable Cost Per Unit:
$250,000/2,500 = $100
Calculate Total Fixed Costs:
$400,000 – (3,000 x 100) = $100,000
High-Low Method
Regression Analysis
Relevant Range
How Is Cost Behavior
Used By Managers ?

Understanding cost behavior is vital to

the manager’s decision-making role,
because one of the main goals of
management accounting is
controlling costs.

173
Cost-Volume-Profit Analysis
1. The Profit Equation
2. Breakeven Point
3. Margin of Safety
4. Contribution Margin
5. Contribution Margin Ratio
6. What-if Analysis
The Profit Equation
Profit = SP(x) –VC(x) – TFC

X = Quantity of units produced and sold

SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost
Break-Even Point
 The break-even point is the level of
sales at which revenue equals
expenses and net income is zero.

176
Break-Even Point
Break-Even Point
TFC/CM(per unit) = Break-Even (units)

X = Quantity of units produced and sold

SP = Selling price per unit
VC = Variable cost per unit
CM = Contribution margin
TFC = Total fixed cost
Contribution Margin
and Gross Margin

Gross margin (which is also called gross profit)

is the excess of sales over the cost of goods sold.

Contribution margin is the excess of sales over

all variable costs.

179
Contribution Margin (per unit)

SP(u) – VC(u) = CM (u)

SP = Selling price per unit

VC = Variable cost per unit
CM = Contribution margin
u = per unit
Contribution Margin Ratio ( in %)

(SP – VC) / SP = CM%

SP = Selling Price per unit

VC = Variable Cost per unit
CM = Contribution Margin
CVP Scenario

Per Unit Percentage

Selling price $5 100
Variable cost 4 80
Difference $1 20
Total monthly fixed expenses = $8,000
Rent $2,000
Labor $5,500
Other $ 500
182
Equation Technique

Let N = number of units to be sold to break even

$5N – $4N – $8,000 = 0

$1N = $8,000
N = $8,000 ÷ $1
N = 8,000 Units

183
Equation Technique

Let S = sales in dollars needed to break even

S – 0.80S – $8,000 = 0
.20S = $8,000
S = $8,000 ÷ .20
S = $40,000

184
Margin of Safety
 The margin of safety shows how far
sales can fall below the planned level
before losses occur.

185
Target Net Profit

Managers can also use CVP

analysis to determine the
total sales, in units and
dollars, needed to
reach a target
net profit.

186
Target Net Income
and Income Taxes

Revenues (2,535 × $90) $228,150

Variable costs (2,535 × $32) 81,120
Contribution margin: $147,030
Fixed costs: 96,000
Operating income: $ 51,030
Income taxes: ($51,030 × .30) 15,309
Net income $ 35,721

187
Target Net Profit

Contribution Margin Technique

Target sales volume in units =
Fixed expenses + Target net income
Contribution margin per unit

188
Quick Review Question #1

1. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Contribution Margin per unit
is?
a. $65
b. $75
c. $175
d. $30
Quick Review Answer #1

1. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Contribution margin per unit
is?
a. $65
b. $75
c. $175
d. $30
Quick Review Question #2

2. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Break-Even Point is?
a. 1,000 units
b. 1,083 units
c. 2,000 units
d. None of these
Quick Review Answer #2

2. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Break-Even Point is?
a. 1,000 units
b. 1,083 units
c. 2,000 units
d. None of these
Quick Review Question #3

3. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Expected sales are 4,200
units. The Margin of Safety is?
a. $264,000
b. $384,000
c. $143,000
d. $121,000
Quick Review Answer #3

3. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Expected sales are 4,200
units. The Margin of Safety is?
a. $264,000
b. $384,000
c. $143,000
d. $121,000
Quick Review Question #4

4. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Expected sales are 4,200
units. What is profit expected to be?

Answer here: _________________

Quick Review Answer #4

4. At Winford Corp., the selling price per

unit for lawn mowers is $120, variable
cost per unit is $55. Fixed costs are
$130,000. Expected sales are 4,200
units. What is profit expected to be?

Answer here: $143,000

“What If” Analysis
Examples include analyzing changes in:
1. Selling price per unit
2. Variable cost per unit
3. Total fixed cost
Multiproduct Analysis
C-V-P applied to multiple products.

1. Contribution Margin Approach (used for

similar products).
2. Contribution Margin Ratio Approach
(used for substantially different
products).
Contribution Margin Approach
Example: the contribution margin of product
A is $8 and B is $5. Two units of B are sold
for each unit of A. The Weighted Average
Contribution Margin is $6.00.
Contribution Margin Ratio
Approach

Example: the contribution margin ratio of

product A is 20% and B is 50%. Two units
of B are sold for each unit of A. The
Weighted Average Contribution Margin
Ratio is 40%.
Operating Leverage

 Risk arises from different sources

 Broadly classified as Finance and
Business Risk
 Operating Risk is a part of Business
Risk
 Operating Risk arises on account of
higher fixed cost

201
Operating Leverage

 Relationship between fixed and variable

cost helps to measure operating risk
 Degree of Operating Leverage (DOL)
measures how a percentage change in
sales volume from current level will affect
profit
 DOL = Contribution Margin ÷ EBIT
 DOL = % ∆Change in EBIT÷ % ∆ in Sales

202
DOL and DFL
 Firms with low fixed cost will have low
DOL
 Firms with high fixed cost will have
high DOL
 Degree of Financial Leverage (DFL) =
 PBIT ÷ PBT
 Total Leverage = DOL х DFL

203
Operating Leverage
Example of Operating Leverage:
Firm 1 Firm 2
Sales $10,000,000 $10,000,000
VC 5,000,000 7,000,000
CM 5,000,000 3,000,000
FC 3,000,000 1,000,000
Profit $2,000,000 $2,000,000
Which firm has more operating leverage?

DOL = C ÷ PBIT 2.5 1.5

Which firm has more leverage?
If sales decrease by 10%
Firm A Firm B
Sales 9,000,000 Sales 9,000,000
Variable cost 4,500,000 Variable cost 6,300,000
Contribution 4,500,000 Contribution 2,700,000
(C) (C)
Fixed Cost 3,000,000 Fixed Cost 1,000,000
Profit (PBIT) 1,500,000 Profit (PBIT) 1,700,000
Change in PBIT 25% Change in PBIT 15%

Change in 10% Change in 10%

Sales Sales
DOL = 2.5 DOL = 1.5
% ∆ PBIT ÷ % ∆ PBIT ÷
% ∆ Sales % ∆ Sales
Using Relevant Cost for
Decision Making
CVP Analysis Approach
Decision Making
⚫ Define the problem
⚫ Identify the alternatives
⚫ Collect information on alternatives
⚫ Examine irrelevant information
⚫ Make a decision with the remaining
relevant information
How managers make decisions

⚫ Gather and analyse information to

compare alternatives
⚫ Select an alternative
⚫ Implement the decision
⚫ Compare actuals with expectation
⚫ Review and Follow up
Relevant Information
⚫ It has a bearing on the future
⚫ It differs among competing alternatives
Relevant Information
⚫ Focus on costs and revenues that are
relevant to the decisions

⚫ Is expected future data

⚫ Data differs among alternatives

Irrelevant costs
⚫ Costs that do not affect your decision

⚫ Example : Sunk costs

Relevant information for business
decisions

⚫ Opportunity costs

⚫ Out of pocket costs

⚫ Differential costs

⚫ Marginal costs
Relevant Nonfinancial
information
⚫ Closing manufacturing plants
⚫ Laying off employees
⚫ Outsourcing
⚫ Offering discounted prices to select
customer
Keys to making short-term
special decisions
⚫ Focus on relevant revenues, costs and
profits

⚫ Use a contribution margin approach that

separates variable costs from fixed costs
Types of decisions
⚫ 1.Special sales order
⚫ 2. When to drop a product, department
or territory
⚫ 3. Product mix decisions
⚫ 4. Outsourcing decisions (Make/Buy)
⚫ 5. Sell as is or Process further decisions
Special Sales Order
⚫ A special order occurs when a customer
request a one time order at reduced sales
⚫ Considerations:
⚫ i) Do we have excess capacity available to fill
this order?
⚫ ii) Will the reduced sales price be high enough
to cover the incremental costs of filling the
order? (V.C & any additional F.C)
⚫ Will the special order affect regular sales in the
long run?
Decision Rule
⚫ If expected increase in revenues
exceeds expected increase in variable
and fixed costs --- ACCEPT THE
ORDER
⚫ If expected increase in revenues is less
than expected increase in variable and
fixed costs --- REJECT THE ORDER
Drop a Product, Department or
Territory
⚫ Does the product provide a positive
contribution margin?
⚫ Will fixed costs continue to exist even if
we drop the product?
⚫ Are there any direct fixed costs that can
be avoided if we drop the product?
⚫ What could we do with the fixed
capacity?
Decision Rule
⚫ If lost revenues from dropping a
product/department/territory exceeds the
costs savings from dropping – DO NOT
DROP

⚫ If total cost savings exceed revenues

from dropping a product/dept/territory -
DROP
Product Mix Decisions
⚫ When companies do not have unlimited
resources

⚫ Constraints that restrict production or

sale of a product vary from company to
company
Considerations
⚫ What constraint(s) stop us from making
all of the units we can sell?
⚫ Which products offer the highest
contribution margin per unit of the
constraint?
⚫ Would emphasizing one product over
another affect fixed costs?
Constraints
1. A reference to scarce resources.
2. Examples of constraints include
manufacturing space, labor, parts and
materials etc..
3. The focus shifts away from Contribution
Margin and to the scarce resource or
constraint.
Decision Rule

⚫ EMPHASIZE THE PRODUCT WITH

THE HIGHEST CONTRIBUTION PER
UNIT OF THE CONSTRAINT
Outsourcing decisions
(Make/Buy)
⚫ How best to use available resources.
⚫ Considerations:
⚫ i) How do our variable costs compare to
the outsourcing cost?
⚫ ii) Are any fixed cost avoidable if we
outsource?
⚫ iii) What could we do with the fixed
capacity?
Decision Rule
⚫ If incremental costs of making exceed
the incremental costs of outsourcing --
OUTSOURCE

⚫ If incremental costs of making are less

than the incremental costs of
outsourcing --- DO NOT OUTSOURCE
Sell as is or Process further
decisions
⚫ At what point in processing should a
company sell its product?

⚫ Typical of food processing or natural

resource industry
Considerations
⚫ How much revenue will we receive if we
sell the product as is?
⚫ How much revenue will we receive if we
sell the product after processing it
further?
⚫ How much will it cost to process the
product further?
Decision Rule
⚫ If the extra revenue (from processing
further) exceeds extra cost of processing
further --- PROCESS FURTHER

⚫ If extra revenue (from processing further)

is less than extra cost of process further
--- DO NOT PROCESS FURTHER
 Pricing Decisions
Analyzing Customer Profitability
and
Activity Based Pricing
 Pricing Decisions

• Pricing decisions are often the most difficult decisions

that managers face

Objectives of Pricing :
• Increase Market Share
• Expand Profit Margin
• Drive competitor from the marketplace
 Types of Pricing Strategies

• Cost Based Pricing

• Value Based Pricing
• Teaser Pricing
• Strategic Pricing
• Miscellaneous Pricing
 Types of Pricing Strategies

Cost based Value based Teaser Strategic Miscellaneous

Absorption Dynamic Freemium Limit Pricing Psychological

Pricing Pricing

Break Even Premium High-Low Penetration Shadow Pricing

Pricing Pricing

Cost Plus Price Skimming Loss Leader Predatory Transfer Pricing

Pricing Pricing

Marginal Cost Value Pricing Price

Leadership

Time &
Materials
 Pricing Methods

- Profit Maximizing price using economic theory

- Pricing of special orders

- Cost Plus pricing

- Target Costing

- Activity Based Pricing

 The Profit Maximizing Price
Economic theory

• The quantity demanded is a function of the price that is

charged

• Generally, the higher the price, the lower the quantity

demanded

• To calculate profit maximizing price:

- Subtract variable costs from price to obtain the contribution margin
- Multiply by the quantity demanded
- Subtract fixed costs and estimate profits
- Select the price with the highest profit
The Profit Maximizing Price
• Estimates of price and quantity demanded
Price = $6.95, quantity demanded = 20,000
Price = $5.95, quantity demanded = 25,000
Price = $4.95, quantity demanded = 32,000
• Variable cost = $1.50 per unit
• Fixed cost = $80,000
Find the profit maximizing price

(Price - Variable) X Quantity - Fixed Cost = Profit

(6.95 - 1.50) X 20,000 - 80,000 = 29,000
(5.95 - 1.50) X 25,000 - 80,000 = 31,250
(4.95 - 1.50) X 32,000 - 80,000 = 30,400
$5.95 is the profit maximizing price
 Pricing Special Orders
Special orders are for goods and services not considered part
of a company’s normal business

• Price charged will not affect prices charged in normal

course of business

• Price may deviate from what is common

• May charge a price less than full cost
 Pricing Special Orders

• Two alternatives: accept or reject

• Consider incremental revenues and expenses

- Income before special order is the same for both alternatives, not
incremental
- Calculate incremental revenue
- Calculate incremental expenses i.e., materials, labor and variable
overhead
Special Orders – Premier Lens Example

Should Premier Lens accept special order of 20,000

lenses to be sold to Blix Camera for $73 per lens?
Below is the full cost of $75 per lens
Special Orders – Premier Lens Example
• Perform incremental analysis
• Fixed costs are not incremental, they will not
change if the order is accepted
 Cost-Plus Pricing

• Company estimates product cost and adds a markup

to arrive at price which allows for a reasonable profit

• Benefits
- Simple approach
- Guarantees profit if sufficient quantity can be sold at the specified price
 Cost-Plus Pricing
Limitations
• What markup percentage to use?
• Requires considerable judgment and
experimentation
• Inherently circular for manufacturing firms:
- Need to estimate demand to determine
fixed manufacturing costs
- Price affects the quantity demanded
 Exercise 2
• The chief engineer at Future Tech has proposed
production of a portable electronic storage device to be
sold at 30% markup above its full cost. Management
estimates that the fixed costs per year will be $210,000
and the variable cost of the storage device will be $15 per
unit.

• Determine the full cost and price at a level of 60,000 units

• Determine the full cost and price at a level of 40,000 units
• Determine the full cost and price at a level of 30,ooo units
• What do you notice?
 Target Costing

 Once a product is designed it is difficult to

make changes that reduce costs
- 80% of a product’s costs cannot be reduced
once it is designed
- Product features drive costs

 Target costing
- Integrated approach to determine features,
price, costs and design to ensure a profit
Target Costing
 Exercise 3
• A cross functional team at Mazzor Systems is developing
a new product using the target costing methodology.
Product features in comparison to competing products
suggest a price of $2,800 per unit. The company requires
a profit of 25% of selling price.
• What is the target cost per unit?
• Suppose the engineering and cost accounting members
of the team determine that the product cannot be
produced for the cost calculate. What is the next step in
the target costing process?
 Analyzing Customer Profitability

Customer Profitability Measurement System (CPM)

• Indirect costs of servicing customers are assigned to cost pools:

- cost of processing orders
- cost of handling returns

• Costs are allocated to specific customers using cost drivers to

determine customer profitability
Customer Profitability Measurement System
Cost Pools and Cost Drivers to Service
Customers
 Customer Profitability Analysis
Cost Customer 1 Customer 2
Revenue Quantity Amount Quantity Amount
Less COGS 732,600 727,650
Gross margin (666,000) (661,500)
Less indirect costs 66,600 66,150
Internet orders $1.20 /order 165 (198) 0 0
Fax orders $4.50 / order 20 (90) 320 (1,440)
Line items $0.90 / item 2,500 (2,250) 5,100 (4,590)
Miles $0.36 /mile 1,200 (432) 3,300 (1,188)
Weight $0.40 / pound 900 (360) 870 (348)
Items returned $0.80 / item 210 (168) 910 (728)
Profit 63,102 57,856
Profit as a percent of sales 8.61% 7.95%
 Delta products has determined the following costs and drivers
for the Johnson Brand customer:

Calculate the profitability of the Johnson Brands customer.

Cost Johnson
Sales $ 53,800
Cost of sales $ 48,420
Order processing per order $ 5.00 200 orders
Line items per item $ 8.50 120 items
Customer service per call $ 10.00 140 calls
Relationship management per account $ 500.00 4 accounts
• Delta products has determined the profitability of the Johnson
Brand customer:

Johnson
Sales $ 53,800
Cost of sales 48,420
Order processing $5.00 X 200 = 1,000
Line items $8.50 X 120 = 1,020
Customer service $10.00 X 140 = 1,400
Relationship management $500.00 X 4 = 2,000
Loss from customer $ (40)
 Activity-Based Pricing

• Customers are presented with separate prices for

services they request in addition to the cost of goods
purchased
- Customers will carefully consider the services they
request
- May lead them to impose less cost on the supplier
• Also called menu-based pricing
Which of the following are relevant for a special
order?
a. Total company income before the order
b. Fixed costs
c. Incremental revenues and expenses
d. Fixed manufacturing overhead

Answer: c
Incremental revenues and expenses
Cost-plus pricing:
a. Leads to profit maximization
b. Is inherently circular for manufacturing firms
c. Is difficult to perform
d. None of the above are correct

Answer: b
Is inherently circular for mfg firms
Target costing:
a. Requires specification of desired level of profit
b. Adds desired profit to existing costs
c. Is used primarily with products that are already in production
d. Leads to profit maximization

Answer: a
Requires specification of desired profit
 Customer profitability is measured as:

a. Revenue minus cost of goods sold

b. Revenue minus indirect manufacturing costs
c. Revenue minus cost of goods sold minus indirect service costs
d. Revenue minus cost of goods sold minus indirect
manufacturing costs

Answer: c
Revenue minus cost of goods sold minus indirect service costs
With activity-based pricing:
a. Customers face a menu of prices for various services
b. Customers are encouraged to consider the costs they
impose on a supplier
c. Customers may be charged less if they request less
product variety in their orders
d. All of the above are correct

Answer: d
All of the above are correct
Statement of Cash Flows
 What is a Cash flow statement?
• The Statement deals with the provision of
information about the historical changes in
cash and cash equivalents of an enterprise by
means of a cash flow statement which
classifies cash flows during the period from
• operating,
• investing and
• financing activities
 Objective
• Useful in providing users of financial
statements with a basis to assess the ability of
the enterprise to generate cash and cash
equivalents and the needs of the enterprise to
utilise those cash flows.
• Economic decisions that are taken by users
require an evaluation of the ability of an
enterprise to generate cash and cash
equivalents and the timing and certainty of
their generation.
 Objective
• The company’s need for external financing

• Causes and of the change in the amount of

cash and cash equivalents between the
beginning and the end of the accounting
period
 Components of Cash flow

• Operating activities are the principal revenue-producing

activities of the enterprise and other activities that are
not investing or financing activities.

• Investing activities are the acquisition and disposal of

long-term assets and other investments not included in
cash equivalents.

• Financing activities are activities that result in changes in

the size and composition of the owners’ capital (including
preference share capital in the case of a company) and
borrowings of the enterprise
 Operating Activities
•Includes all transactions relating to a company
delivering or producing its goods for sale and
providing its services
 Major Cash Flows:
Operating Activities
• Cash payments for:
• Cash receipts from: – Inventory purchases
– Sale of goods or services – Wages and salaries
– Sale of trading securities – Taxes
– Interest revenue – Interest expense
– Dividend revenue – Other expenses (e.g.,
utilities, rent)
– Purchase of trading
securities
 Implications of Operating Activities
• Ability to decide a strategy that generates
positive cash flow
• Ability to raise cash from financing activities
depends highly on ability to generate cash
from its normal business operations
 Investing Activities
•Includes cash inflows and outflows from
changes in noncurrent assets:
– Productive assets
– Investment securities
– Loans to others
 Major Cash Flows:
Investing Activities

•Cash receipts from: • Cash payments for:

– Sale of plant assets – Purchase plant assets
– Sale of a business segment – Purchase of nontrading
– Sale of nontrading securities
securities – Making loans to other
– Collection of principal on entities
loans
 Financing Activities
•Includes obtaining resources from
– owners and providing them a return on their
investment
– creditors and repaying those borrowings
 Examples of Financing Activities
• cash proceeds from issuing shares or other
similar instruments;

• cash proceeds from issuing debentures, loans,

notes, bonds, and other short or long-term
borrowings; and

• cash repayments of amounts borrowed

 Major Cash Flows:
Financing Activities

•Cash receipts from: •Cash payments for:

– Issuance of stock – Cash dividends
– Borrowing (e.g., bonds, – Repayment of loans
notes, mortgages) – Repurchase of stock
(treasury stock)
 Relationship of the SCF to the
Balance Sheet and Income Statement
Balance Sheet Stmt of Cash Flows
Operating
Current Assets
Investing
Long-term Assets Financing
Net Change in Cash
Current Liabilities Accrual Adjustments
Accts Pay & Accrued Liabil
Short-term Loans Pay Income Statement
Current Portion Long-term
Revenues
Long-term Liabilities
Expenses
Stockholders’ Equity Net Income
 Cash Flow Pattern

Cash flow is typically

Outflow
Cash from... Inflow (positive) (negative)
Operations 
Investing 
Financing  or 
 Cash Flow Pattern
•A company’s cash flow pattern is a general
reflection of where the company is in its life
cycle ...
 Cash Flow Pattern
Start-Up, High Growth Company

Investing

Financing

Operating
 Cash Flow Pattern
Steady-State Company

Investing

Dividends
Financing

Operating
 Cash Flow Pattern
Cash Cow
Investing
Loan Repayment

Share Repurchases
Financing
Dividends

Operating
 Reporting Cash Flows from Operating
Activities
• An enterprise should report cash flows from operating
activities using either:

• the direct method, whereby major classes of gross cash

receipts and gross cash payments are disclosed; or

• the indirect method, whereby net profit or loss is

adjusted for the effects of transactions of a non-cash
nature, any deferrals or accruals of past or future
operating cash receipts or payments, and items of
income or expense associated with investing or
financing cash flows
Reporting Cash Flows from Investing and
Financing Activities

• An enterprise should report separately major

classes of gross cash receipts and gross cash
payments arising from investing and
financing activities