I.

Overview of Managerial Accounting

The Basic Objective of Accounting

 The basic objective of accounting is to provide (stakeholders) with useful information

about a business enterprise in order to help them make rational economic decisions.

 The basic objective of financial accounting is to provide external users with useful
financial information about the financial performance health, and cash flows of a business
enterprise in order to help them make investment and credit decisions.

 The basic objective of management accounting is to provide internal users with financial
and non-financial information about a business enterprise that help them make business
decisions so as to achieve the goals of the organization.

 The study of modern cost accounting yields insights into how managers and accountants
can contribute to successfully running their businesses.

Financial Accounting, Management Accounting, and Cost Accounting

 Accounting systems take economic events and transactions, such as sales and materials
purchases, and process the data into information helpful to managers, sales
representatives, production supervisors, and others.

 Processing any economic transaction means collecting, categorizing, summarizing, and

analyzing.

 Accounting systems provide the information found in the income statement, the balance
sheet, the statement of cash flow, and in performance reports, such as the cost of serving
customers or running an advertising campaign.

 Managers use accounting information to administer the activities, businesses, or

functional areas they oversee and to coordinate those activities, businesses, or functions
within the framework of the organization.

 Individual managers often require the information in an accounting system to be

presented or reported differently.
o E.g. Sales order information: Sales manager → total dollar amount of sales to
determine the commissions to be paid; Distribution manager → sales
order quantities by geographic region and requested delivery dates to ensure
timely delivery; manufacturing manager → quantities of various products and
desired shipping dates in order to develop an effective production schedule.

 Companies create a database—sometimes called a data warehouse or info-barn—

consisting of small, detailed bits of information that can be used for multiple purposes.

 Many companies are building their own Enterprise Resource Planning (ERP) systems →
single databases that collect data and feed it into applications that support the company's
business activities, such as purchasing, production, sales, and distribution
Financial Accounting
 Financial accounting focuses on reporting to external parties and measures and
records business transactions and provides financial statements that are based on
GAAP.
Managerial Accounting
 Management accounting measures, analyzes, and reports financial and non-financial
information that helps managers make decisions to fulfill the goals of an organization.

 It is used to develop, communicate, and implement strategy.

 It is also used to coordinate product design, production, and marketing decisions and
to evaluate performance.

 The information and reports generated do not have to follow set principles or rules.

 The key questions are always:

 How will this information help managers do their jobs better?
 Do the benefits of producing this information exceed the costs? Benefits >
Costs

Comparing Managerial Accounting and Financial Accounting

 Both fields of accounting deal with the economic events of a business and require that
the results of that company's economic events be quantified and communicated to
interested parties.

 Reports such as balance sheets, income statements, and statements of cash flows are
common to both fields of accounting.
Management Accounting Financial Accounting

Purpose of •Help managers make decisions to •Communicate organization’s

Information fulfill an organization' goals financial positions to investors, banks,
regulators and other outside parties
•Special-purpose for a particular
user for a specific •Help external users to make
investment & credit decisions

Primary users Internal users: managers of the External users: investors, banks,
organizations at all levels creditors, regulators, and suppliers

Focus and emphasis Current and Future-oriented Past-oriented (reports on 2010

(budget for 2011 prepared in 2010) performance prepared in 2011)

Rules of Internal measures and reports do Financial statements must follow

measurement and not have to follow GAAP but are GAAP, and be certified and regulated
reporting based on cost-benefit analysis by external, independent auditors

Time span and type of •As frequent as needed Periodic (E.g. annual/quarterly)
reports financial reports, primarily on the
•Varies from hourly information to
company as a whole
15 to 20 years, with financial and
non-financial reports on products,
departments, territories, and
strategies

Behavioural Designed to influence the behaviour Primarily reports economic events

implications of mangers and other employees but also influences behaviour
because manager's compensation
(bonuses) is often based on reported
financial results

Guideline for judging Focus is on relevance Focus is on Reliability

usefulness of
information

Verification process Internal audit Independent-external audit

Cost Accounting
 Cost accounting provides information for managerial accounting and financial
accounting.

 It measures, analyzes, and reports financial and non-financial information relating to

the costs of acquiring or using resources in an organization
o E.g. calculating the cost of a product answers financial accounting's inventory-
valuation needs and managerial accounting's decision-making needs
(such as pricing and promotion).

 Collecting cost information is a function of the management decisions being made.

 Thus, the difference between managerial accounting and cost accounting is no so

distinct, and it is often that both terms are used interchangeably.
Cost management
 Cost management is used to describe the approaches and activities of managers to
use resources to increase value to customers and to achieve organizational goals.

 Decisions include whether to enter new markets, implement new processes, and
change product designs.

 Information from accounting systems help managers to manage costs but are not cost
management.

 Cost management includes decisions to incur additional costs.

Example: To improve customer satisfaction and quality and to develop new products,
with the goal of enhancing revenues and profits.

Strategic Decisions and the Managerial Accountant

 Strategy specifies how an organization matches its own capabilities with the
opportunities in the marketplace to accomplish its objectives.

 Strategy describes how an organization will compete and the opportunities its managers
should seek and pursue.

 Business follows one of two broad strategies:

1. Cost leadership strategy → providing quality products or services at low prices by
judiciously managing their costs.
2. Product differentiation strategy → ability to offer differentiated or unique
products or services that appeal to their customers and are often priced higher
than the less-popular products or services of their competitors.

 Managerial accountants work closely with managers in formulating strategy by providing

information about the sources of competitive advantage.

 Strategic cost management describes cost management that specifically focuses on

strategic issues.

 Managerial accounting information helps managers formulate strategy by answering

questions such as:

 Who are our most important customers, and how can we be competitive and
deliver value to them?
 What substitute product exist in the marketplace, and how do they differ from our
product?
 What is our most critical capability? Technology, production, or marketing? How
can we leverage it for new strategic initiatives
 Will adequate cash be available to fund the strategy, or will additional funds need
to be raised?

 The best-designed strategies and best-developed capabilities are useless unless they are
effectively executed.
Value Chain and Supply Chain Analysis and Key Success Factors
 Customers demand fair price as well as quality products delivered in a timely way.
Value-Chain Analysis

 Value chain is the sequence of business functions in which customer usefulness is

added to the products.

 Six primary business functions:

1. Research and development (R&D): Generating and experimenting with

ideas related to new products, services, or processes.
○HDTV and Blu-ray

2. Design of products and processes: detailed planning, engineering, and

testing of products and processes.
○Flat screen, computer compatible, chip complexity, sizes, controls

3. Production: procuring, transporting, and storing (also called inbound

logistic), coordinating, and assembling (also called operating) resources
to product a product or deliver a service
○Suppliers, make or buy, off-shoring

4. Marketing (sales): promoting and selling products/services to customers or

potential customers.
○Advertising, promotion, pricing, availability

5. Distribution: processing orders and shipping products/services to

customers (aka outbound logistics)
○Packaging, transportation mode, security, channels

6. Customer service: providing after-sales service to customers

○Timing, communication, repair, servicing

 Each of these business functions is essential to companies satisfying their

costumers and keeping them satisfied and loyal over time.

 Companies use the term customer relationship management (CRM) to describe a

strategy that integrate people and technology in all business functions to deepen
relationships with customers, partners, and contributors.
 At different times and in different industries, one or more of these functions is
more critical than others.

 Companies gain (in terms of cost, quality, and the speed of developing new
products) if two or more of the individual business functions work concurrently as
a team.

 Managers track the costs incurred in each value-chain category; their goal is to
reduce costs and improve efficiency.

 Managerial accounting information helps managers make cost-benefit trade offs.

Supply-Chain Analysis
 Supply chain is the parts of the value chain associated with producing and
delivering (production and distribution).
 Supply chain describe the flow of goods, services, and information from the initial
sources of materials and services to the delivery of products to consumers,
regardless of whether those activities occur in the same organizations or other
organizations.

 Cost management emphasizes integrating and coordinating activities across all

companies in the supply chain, to improve performance and reduce costs.
Sample Supply Chain for a Cola Bottling company

Suppliers of Ingredients → Manufacturer of Concentrate → Bottling Company

→ Distribution Company → Retail Company → Final Consumers

Key Success Factors

 Customers want companies to use the value chain and supply chain to deliver improving
levels of performance regarding several (or even all) factors:

1. Cost and efficiency → companies face pressure to reduce cost. Managers must
first understand the tasks and activities that cause costs to arise. They must also
be aware of the price customers are willing to pay. From this target price,
managers subtract the operating income they want to earn to arrive at the
target cost (Price - Cost = Income). Managers strive to achieve the target cost by
eliminating some activities and by reducing the costs of performing activities.

2. Quality → Customers expect high levels of quality. Total quality management

(TQM) aims to improve operations throughout the value chain and to deliver
products and service that exceed customer expectations.

3. Time → New product development time is the time it takes for new products to
be created and brought to market. Customer-response time describe the
speed at which an organization responds to customer requests which
relates to customer satisfaction and loyalty.

4. Innovation → constant flow of innovative products/services is the basis for

ongoing company success.

 Companies are increasingly applying the key success factors of cost and efficiency,
quality, time, and innovation to promote sustainability—the development and
implementation of strategies to achieve long-term financial, social, and environmental
performance.
 Management accountants help managers track performance of competitors on the key
success factors. •Competitive information serves as a benchmark and alerts managers
to market changes.

 Companies are always seeking to continuously improve their operations.

Decision Making, Planning, and Control: The Five-Step Decision-Making Process

 To decide what to, managers work through the five-step decision making process
1. Identify the problem and uncertainties.

2. Obtain information → gathering information before making a decision helps

managers gain a better understand of the uncertainties.

3. Make predictions about the future.

4. Make decisions by choosing among alternatives → When making decisions, strategy

is a vital guidepost; many individuals in different parts of the organization at
different times make decisions. Consistency with strategy binds individuals and
time-lines together and provides a common purpose for disparate decisions.
Aligning decisions with strategy enables an organization to implement its strategy
and achieve its goals. Without this alignment, decisions will be uncoordinated, pull
the organization in different directions, and produce inconsistent results.

 Steps 1 through 4 are collectively referred to as planning. Planning comprises selecting

organization goals and strategies, predicting results under various alternative ways of
achieving those goals, deciding how to attain the desired goals, and communicating the
goals and how to achieve them to the entire organization.

 The most important planning tool when implementing strategy is a budget. A budget is
the quantitative expression of a proposed plan of action by management and is an aid to
coordinating what needs to be done to execute that plan.

5. Implement the decision, evaluate performance, and learn → Management

accountants collect information to follow through on how actual performance
compares to planned or budgeted performance (also referred to as score-
keeping). The comparison of actual performance to budgeted performance is the
control or post-decision role of information. Control comprises taking actions that
implement the planning decisions, deciding how to evaluate performance, and
providing feedback and learning to help future decision making. Measuring actual
performance informs managers how well they and their subunits are doing. Linking
rewards to performance helps motivate managers.
 Learning is examining past performance (the control function) and systematically
exploring alternative ways to make better-informed decisions and plans in the future.
Key Management Accounting Guidelines
 Three guidelines help management accountants provide the most value to their
companies in strategic and operational decision making: Employ a cost-benefit approach,
give full recognition to behavioural and technical considerations, and use different costs
for different purposes.
Cost-Benefit Approach
 Managers continually face resource-allocation decisions, such as whether to purchase a
new software package or hire a new employee.

 They use a cost-benefit approach when making these decisions: Resources should be
spent if the expected benefits to the company exceed the expected costs.

 Managers rely on management accounting information to quantify expected benefits and

expected costs although all benefits and costs are not easy to quantify.

 The cost-benefit approach is a useful guide for making resource-allocation decisions

Behavioural and Technical Considerations
 The technical considerations help managers make wise economic decisions by providing
them with the desired information in an appropriate format and at the preferred
frequency.

 Now consider the human (the behavioural) side of why budgeting is used.

 Budgets induce a different set of decisions within an organization because of better

collaboration, planning, and motivation.

 The behavioural considerations encourage managers and other employees to strive for
achieving the goals of the organization.

 Both managers and management accountants should always remember that

management is not confined exclusively to technical matters.

 Management is primarily a human activity that should focus on how to help individuals
do their jobs better
Different Costs for Different Purposes
 Managers should use alternative ways to compute costs in different decision-making
situations, because there are different costs for different purposes.

 A cost concept used for the external-reporting purpose of accounting may not be an
appropriate concept for internal, routine reporting to managers.
Organization Structure and the Management Accountant
Line and Staff Relationships
 Organizations distinguish between line management and staff management.

 Line management, such as production, marketing, and distribution management, is

directly responsible for attaining the goals of the organization.

 Staff management, such as management accountants and information technology

and human-resources management, provides advice, support, and assistance to line
management.
 A plant manager (a line function) may be responsible for investing in new
equipment.
 A management accountant (a staff function) works as a business partner of
the plant manager by preparing detailed operating cost comparisons of
alternative pieces of equipment.

The Chief Financial Officer and the Controller

 The chief financial officer (CFO)—also called the finance director in many countries—
is the executive responsible for overseeing the financial operations of an organization.

 Their responsibilities include:

 Controllership—includes providing financial information for reports to
managers and shareholders, and overseeing the overall operations of the
accounting system
 Treasury—includes banking and short- and long-term financing, investments,
and cash management
 Risk management—includes managing the financial risk of interest-rate and
exchange-rate changes and derivatives management
 Taxation—includes income taxes, sales taxes, and international tax planning
 Investor relations—includes communicating with, responding to, and
interacting with shareholders
 Internal audit—includes reviewing and analyzing financial and other records
to attest to the integrity of the organization’s financial reports and to
adherence to its policies and procedures

 The controller (also called the chief accounting officer) is the financial executive
primarily responsible for management accounting and financial accounting.

 It should be clear that the successful management accountant must have technical
and analytical competence as well as behavioural and interpersonal skills.

Activity 1. Classify each cost into one of the business functions of value chain, either (1) R&D, (2)
Design, (3) Production, (4) Marketing, (5) Distribution, or (6) Customer Service.

1. Cost of Samples mailed to promote sales of a new product.

2. Labor cost of workers in the manufacturing plant.
3. Bonus paid to person with 90% satisfaction rating in handling customers with complaints.
4. Transportation costs for shipping products to retail outlets.
5. Cost of customer order forms.
6. Cost of paper used in packing cartons to ship books.
7. Cost of paper used in display at national trade show.
8. Depreciation of trucks used to transport books to college bookstores.
9. Cost of wood to manufacture paper.
10. Salary of scientists attempting to find another source of printing ink.
II. Organizational Innovations and Management Accounting

Changes:
1. Increase in global competition
2. Advances in manufacturing technologies
3. Advances in information technologies, the internet, and e-commerce
4. A greater focus on customer
5. New forms of management organization
6. Changes in the social, political and cultural environment of business

CONTEMPORARY MANAGEMENT TECHNIQUES

A. Just-In-Time (JIT)
 The philosophy that activities are undertaken only as needed or demanded.
 A production system also known as pull-it-through approach
 Materials are purchased and units are produced only as needed to meet actual
customer demand.
 In JIT system, inventories are reduced to the minimum and in some cases, zero.

4 Characteristics of JIT
1. Elimination of all activities that do not add value to the product or
service
2. Commitment to a high level of quality
3. Commitment to continuous improvement in the efficiency of an activity
4. Emphasis on simplification and increase visibility to identify activities
that do not add value.

Main Benefits of JIT

1. Working capital position is improved by recovery of funds that were tied
up in inventories
2. Throughput time is reduced, resulting in greater potential production
and quicker response to customers
3. Areas previously used to store inventories are released and are made
available for other more productive uses.
4. Lesser waste and more customer satisfaction are achieved because of
reduction in defect rates.

B. Total Quality Management (TQM)

 Instituted by many companies to ensure that their products are of the highest quality
and that production processes are efficient.
 A technique in which management develops policies and practices to ensure that the
firm’s products and services exceed customers’ expectations.
 Currently, there is no generally agreed upon “perfect” way to institute TQM program.
o listening to the needs of customers
o making products right the first time
o reducing defective products that must be reworked
o encouraging workers to continuously improve their production process.
 Some TQM programs are referred as Continuous Quality Improvement Programs.
 It affects product costing by reducing the need to track the cost of scrap and rework
related to each job.
 It is a formal effort to improve quality throughput an organization’s value chain.
 2 Major Characteristics of TQM
o Focus on serving customers
o Systematic problem-solving using teams made up of front-line workers

C. Process Reengineering
 Reengineering is a process for creating competitive advantage in which a firm
recognized its operating and management functions, often with the result that jobs
are modified, combined, or eliminated.
o Defined as the “fundamental rethinking and radical redesign of business
processes to achieve dramatic improvements in critical, contemporary
measures of performance, such as cost, quality service and speed.”

 Process Reengineering, a more radical approach to improvement than TQM.

o An approach where a business process is diagrammed in detail, questioned
and then completely redesigned in order to eliminate unnecessary steps, to
reduce opportunities for errors and to reduce costs.
o Employee Resistance is one basic recurrent problem

 Business Process is any series steps that are followed in order to carry out some tasks
in a business.

 Main Objective: simplification and elimination of wasted effort and the central idea
is that all activities that do not add value to product or service should be eliminated.

 Steps Used in Process Reengineering

o A business process is diagrammed in detail
o Every step in the business process must be analyzed and justified
o The process is redesigned to include only those steps that the product or
service more valuable

 This process can yield the following anticipated results:

o Process is simplified
o Process is completed in less time
o Costs are reduce
o Opportunities for errors are reduced
D. Benchmarking
 A process by which a firm:
o Determines its critical success factors
o Studies the best practices of other firms for achieving these critical success
factors
o Then implements improvements in the firm’s processes to match or beat the
performance of those competitors.
 Today, benchmarking efforts are facilitated by cooperative networks of
noncompeting firms that exchange benchmarking information

E. Mass Customization
 Is a management technique in which marketing and production processes are
designed to handle the increased variety that results from delivering customized
products and services to customers.
 Growth of mass customization is in effect another indication of the increase attention
given to satisfying the customer.

F. Balance Scorecard
 An accounting report that includes the firm’s critical success factors in 4 areas:
o Financial performance
o Customer satisfaction
o Internal business process
o Innovation and learning

G. Activity-based Costing and Management

 Activity Analysis is used to develop a detailed description of the specific activities
performed in the operation of the firm.
o Provides the basis for activity-based costing and activity-based management.
 Activity-based Costing (ABC) is used to improve the accuracy of cost analysis by
improving the tracing of costs to products or to individual customers.
 Activity-based Management (ABM) uses activity analysis to improve operational
control and management control.
 ABC and ABM are key strategic tools for many firms, especially those with complex
operations, or great diversity of products.

H. Theory of Constraints (TOC)

 A sequential process of identifying and removing constraints in a system.
 Emphasizes the importance of managing the organization’s constraints or barriers
that hinder or impede progress toward an objective.
 Basis Sequential Steps in Applying TOC
o Analyze all the factors of production required in the production chain.
o Identify the weakest link, which is the constraint
o Focus improvement efforts on strengthening the weakest link
o If improvement efforts are successful, eventually the weakest link will improve to
the point where it is no longer the weakest link.
o At this point, a new weakest link must be identified and improvement efforts must
be shifted over that link.
 It is a perfect complement to TQM and Process reengineering
 It focuses improvements efforts where they are likely to be most effective.

I. Life Cycle Costing

 a management technique to identify and monitor the costs of a product throughout
its lifecycle.
 Consists of all steps from product design and purchase of raw material to delivery of
and service of the finished product.
 Steps
 Research and development
 Product design, including prototyping, target costing and testing
 Manufacturing, inspecting, packaging and warehousing
 Marketing, promotion and distribution
 Sales and service
 Management accountants now strategically manage the product’s full life cycle of
costs, including upstream and downstream costs as well as manufacturing costs.

J. Target Costing
 Involves the determination of the designed cost for a product or the basis of a given
competitive price so that the product will earn a desired profit.
 The basic relationship that is observed in this approach is
 Target Cost = Market determined Price - desired profit
 Entity using this must often adopt strict cost-reduction measures to meet the market
price and remain profitable.
 Common strategic approach used by intensely competitive industries where even
small price differences attract consumers to the lower-priced product.

K. Computer-Aided Design and Manufacturing

 Many companies used this to respond to changing consumer tastes more quickly.
 These innovations allow companies to significantly reduce the time necessary to bring
their products from the design process to the distribution stage.
 CAD is the use of computers in product development, analysis, and design
modification to improve the quality and performance of the product.
 CAM is the use of computers to plan, implement, and control production.

L. Automation
 Involves and requires a relatively large investment in computers, computer
programming, machines and equipment.
 2 Integrated Approaches
 Flexible Manufacturing System (FMS)
 A computerized network of automated equipment that produces one or more groups
of parts or variations of a product in a flexible manner.
 It uses robots and computer-controlled materials-handling system to link several
stand-alone, computer-controlled machines in switching from one production run to
another.
 Computer Integrated Manufacturing (CIM)
 Is a manufacturing system that totally integrates all office and factory functions within
a company via a computer-based information network to allow hour-by-hour
manufacturing management.

 Major Characteristics of Modern manufacturing companies adopting FMS and CIM

o Production of high-quality products and services
o Low inventories
o High degrees of automation
o Quick cycle time
o Increased flexibility and
o Advanced information technology

M. E-Commerce

N. The Value Chain

 An analysis tool that firms use to identify the specific steps required to provide a
product or service to the customer.
 Key Idea: firm studies each step in its operation to determine how each activity
contributes to the firm’s competitiveness and profits.
 Analyzing the firm’s value chain helps management discover:
o Which steps or activities are not competitive
o Where costs can be reduced
o Which activity should be outsourced
o How to increase value for the customer as one or more of the steps of the
value chain
 If properly implemented, it can:
o Enhance quality
o Reduce cost
o Increase output
o Eliminate delays in responding to customers

THEMES COMMON TO MANY COMPANIES

1. Customer focus theme
2. Value-chain and supply chain analysis
3. Key success factors
4. Continuous improvement and benchmarking
FOCUS ON THE CUSTOMER
 It means that the management accounting system should produce information about
both realization and sacrifice.
o It should able to measure various attributes of customer value
 To succeed in this era, customer value is key focus that businesses of all types must be
concerned with.
 Cost Information plays an important part in the process called Strategic cost
Management.
o 2 General Strategies
i. Cost leadership
ii. Superior product through differentiation
 Successful pursuit of cost leadership and/or differentiation strategies requires an
understanding of a firm’s value chain (internal) and supply chain (External.)

VALUE CHAIN AND SUPPLY CHAIN ANALYSIS

 Value Chain refers to the sequence of business functions in which usefulness is added to
the products or services of a company.
 Value refers to the increase in the usefulness of the product or service and as a result its
value to the customer.
 Internal Value Chain is the set of activities required to design, develop, produce, market
and deliver products or services to customers.
 To determine product profitability for internal decision-making purposes, some
companies deduct only manufacturing costs from product revenues.

 Selling, General, and Administrative (upstream and downstream costs)

o Can represent half or more of the total costs of an organization.
o If this is omitted in profitability analysis, then the product is UNDERCOSTED and
management may unwittingly develop and maintain products that in the long rum
result in losses rather than profits for the company.

 Industrial Value Chain is the linked set of value-creating activities from basic raw
materials to the disposal of the final product by end-use customers.

 Fundamental to a value-chain framework is the recognition of existing complex linkages

and interrelationships among activities both within and external to the firm.
o 2 types of linkages
a. Internal Linkages – are relationships among activities that are performed
within a firm’s portion of the industrial value chain (the internal value chain).
b. External Linkages – are activity relationships between the firm and firm’s
suppliers and customers.
KEY SUCCESS FACTORS
Cross Functional Teams
o Crucial in managing the time to market.
o Bring together production and operations managers, marketing managers,
purchasing and material-handling specialists, design engineers, quality
management personnel, and managerial accountants to focus their varied
expertise and experience on virtually all management issues.
o Managing the value chain means that a management accountant must
understand many functions of the business, from manufacturing to marketing to
distribution to customer service.

Computer Integrated Manufacturing

o This process is fully automated, with computers controlling the entire production
process.
o In CIM systems, the types of costs incurred by the manufacturer are quite different
from those in traditional manufacturing environments.

 Product Life Cycles and Diversity

 Time-Based Competition
o In a global competitive environment, TIME has become very significant
element in strategies for success.
o Time to Market becomes a critical objective for many companies.
o Response time, Lead time, on time and Downtime are among the many
time-based phrases that crop up in conversations of today’s managers.

 Global Competition
o Caused by:
a. Reductions in tariffs, quotas and other barriers to free trade
b. Improvements in global transportation systems and information
technology
c. Increasing sophistication in international markets.

 Information and Communication Technology Management

 Cost Management System

o Cost Management is widely used today, no uniform definition however
exists.
 It often carried out as an important part of general
management strategies and their implementation.
Continuous Improvement and Competitive Strategy
o Continuous Improvements is the constant effort to eliminate waste, reduce
response time, simplify the design of both products and processes, and improve
quality and customer service.
 Managerial accountants contribute to this program.
o Competitive Strategy involves determination and implementation of a set of
policies, procedures and approaches to business that produces long-term success.

Activity 1. Define Value Adding and Non-Value Adding Activities. Which of the following would
be value added for an automotive manufacturer? Non value added?

1. Painting automobiles
2. Moving auto parts from the warehouse to the plant.
3. Inspection of final product.
4. Assembling the engines.
5. Costs to store finished goods.
6. Costs to store raw materials.
7. Production of bumpers.
8. Production of headlights.
9. Inspection of Intermediate product.
10. Production of spark plugs for automobile.

III. Advanced Concepts for Analyzing and Appraising Financial and Related Information

FINANCIAL RATIO ANALYSIS

It is a process of determining, interpreting and presenting numerical relationships of items and
group of items in the financial statements. Ratios are customarily presented in the following
forms:
I. The first is merely a quotient (Current Liabilities, Proprietors Funds: Total assets etc.)

II. Sometimes ratios are also expressed as rates which refer to ratios over a period of time
(fixed assets turnover ratio, Inventory turnover ratio etc.)

III. Some ratios are presented by per cent. (Gross Profit Ratio, ROI, etc.)

“Ratio analysis is a process of analysis of the ratios in such a manner so that the management can
take actions on off standard performances.” The process of Financial Ratio Analysis can be
segregated into:
a. Working of Ratios
b. Interpretation of Ratios
c. Remedial actions on variances with the objective of improvement in efficiency
CLASSIFICATION:
Ratios may be classified on the following basis leading to somewhat overlapping
categories:
1. Classification according to the statement from which ratios are derived:
a.Balance – Sheet Ratios
b. Revenue Statement Ratios
c. Inter-Statement or combined Ratios

2. Classification according to Importance:

a. Primary Ratios
b. Secondary Ratios

3. Functional Classification:
a. Cash position ratios
b. Liquidity ratios
c. Working Capital ratios
d. Capital Structure ratios
e. Profitability ratios
f. Debt Service coverage ratios
g. Turnover ratios
h. Other ratios

Liquidity Ratios
Also known as Solvency Ratios, and as the name indicates, it focuses on a company’s
current assets and liabilities to assess if it can pay the short-term debts. The three
common liquidity ratios used are current ratio, quick ratio, and burn rate. Among the
three, current ratio comes in handy to analyze the liquidity and solvency of the start-ups.

S. No. RATIOS FORMULAS SIGNIFICANCE

1 Current Ratio Current Assets/Current Primary test of solvency to meet
Liabilities current obligations from current
assets as a going concern;
measure of adequacy of working
capital.
2 Quick Ratio Liquid Assets/Current A more severe test of immediate
Liabilities solvency; test of ability to meet
demands from current assets.

Profitability Ratios
These ratios analyze another key aspect of a company and that is how it uses its assets
and how effectively it generates the profit from the assets and equities. This also then
gives the analyst information on the effectiveness of the use of the company’s operations.
S. No. RATIOS FORMULAS SIGNIFICANCE
1 Gross Profit Gross Profit/Net Sales X 100 Measures profit generated after
Ratio consideration of cost of product
sold.

2 Operating Operating Profit/Net Sales X Measures profit generated after

Profit ratio 100 consideration of operating costs.

3 Net Profit Ratio Net Profit/Net Sales X 100 Measures profit generated after
consideration of all expenses and
revenues.

4 Dividends per Dividends Paid or Declared/ Shows portion of income

Share Ordinary Shares outstanding distributed to shareholders on a
per share basis.
5 Rate of return Net Profit/ Ave. Ordinary Measures rate of return on
on Equity Equity resources provided by owners.

6 Rate of return Net Profit/ Ave. Total Assets Measures overall efficiency of the
on Assets firm in managing assets and
generating profits.

7 Earnings Per Net Profit After Tax & Peso returns on each ordinary
Share Ratio Preference Dividend /No of share. Indicative of ability to pay
Equity Shares dividends.
8 Dividend Pay Dividend Per Equity Shows percentage of earnings
Out Ratio Share/Earning Per Equity paid to shareholders.
Share X 100
9 Earning Per Net Profit after Tax & Peso returns on each ordinary
Equity Share Preference Dividend / No. of share. |Indicative of ability to pay
Equity Share dividends.
10 Dividend Yield Dividend Per Share/ Market Shows the rate earned by
Ratio Value Per Share X 100 shareholders from dividends
relative to current price of stock.

11 Price Earnings Market Price Per Share Equity Measures relationship between
Ratio Share/ Earning Per Share X price or ordinary shares in the
100 open market and profit earned
per share basis.

Working Capital Ratios

Like the Liquidity ratios, it also analyses if the company can pay off the current debts or
liabilities using the current assets. This ratio is crucial for the creditors to establish the
liquidity of a company, and how quickly a company converts its assets to bring in cash for
resolving the debts.
S. No. RATIOS FORMULAS SIGNIFICANCE
1 Trade Net Credit Sales* / Average Velocity of collection of trade
Receivable trade receivable (net) accounts and notes; test of
Turnover efficiency of collection.
*Net Sales if net credit sales is
not available
2 Average 360 days/ Receivable Turnover Evaluates the liquidity of
Collection accounts receivable and the
period/ Or firms’ credit policies.
Number of
Days’ sales Accounts Receivable / (Net
uncollected Sales/ 360)
3 Merchandise Cost of goods sold/ average Measures efficiency of the firm
Inv. Turnover Merchandise Inventory in managing and selling
inventories.
4 Days in Supply 360 days/ Inventory Turnover Measures average number of
Inventory days to sell or consume the
average inventory
5 Working Capital Net Sales/ Ave. Working Indicates adequacy and activity
Turnover Capital of working capital.
6 Investment or Net Sales/ (Ave. Assets or Measures efficiency of the firm
Assets Total Assets) in managing all assets.
Turnover
7 Sales to fixed Net Sales/ Ave. fixed Asset Tests roughly the efficiency of
assets (plant management in keeping plant
turnover) properties employed.
Capital Structure Ratios
Each firm or company has capital or funds to finance its operations. These ratios, i.e., the
Capital Structure Ratios, analyze how structurally a firm uses the capital or funds
S. No. RATIOS FORMULAS SIGNIFICANCE
1 Debt Equity Total Long Term Debts / Shows proportion of all assets
Ratio Shareholders Fund that are financed with debt.

2 Equity Ratio Total Equity/ Total Assets Indicates proportion of assets

provided by owners. Reflects
financial strength and caution to
creditors.

3 Debt to Equity Total Liabilities/ Total Equity Measures debt relative to

Ratio amounts of resources provided
by owners.

4 Book Value per Ordinary SHE/ No. of Measures recoverable amount in

share of outstanding ordinary shares the event of liquidation if assets
ordinary shares are realized at their book values.

5 Times Interest Net Income before Interest Measures how many times
Earned and Taxes/ Annual Interest interest expense is covered by
charge operating profit.

(Comprehensive Illustration):
The Statement of Financial Position as of Dec 31, 2011 and 2010, Income Statement and
Statement of Cash Flows of EBC Enterprise, Inc. for years 2011, 2010, 2009 are given below:

EBC Enterprise Inc.

Statement Of Financial Position at December 31, 2011 and 2010
(In Thousands)
2011 2010
Assets
Current Assets
Cash 2,030.5 1,191.0
Marketable Securities 2,636.0 4,002.0
Accounts Receivable 4,704.0 4,383.5
Allowance for Doubtful Accounts (224.0) (208.5)
Inventories 23,520.5 18,384.5
Prepaid Expenses 256.0 379.5
Total 32,923.0 28,132.0
Non-Current Assets
Land 405.5 405.5
Building and Leasehold Improvements 9,136.5 5,964.0
Equipment 10,761.5 6,884.0
20,303.5 13,253.5
Less: Accumulated Depreciation and Amortization (5,764.0) (3,765.0)
Property plant and equipment, net 14,539.5 9,448.5
Other Assets 186.5 334.0
Total Assets 47,649.0 37,954.5

Liabilities and Equity

Current Liabilities
Accounts Payable 7,147.0 3,795.5
Notes Payable – banks 2.807.0 3,006.0
Current Maturities of long term debt 942.0 758.0
Accrued Liabilities 2,834.5 2,656.5
Total 13,730.5 10,216.0
Deferred Income Taxes 421.5 317.5
Long term Debt 10,529.5 8,487.5
Total Liabilities 24,681.5 19,021.0

Equity
Ordinary shares, par value P1, authorized
10,000 shares; issued 2,297,000 shares
in 2011 and 2,401,500 shares in 2011 2,401.5 2,297.0
Additional paid-in capital 478.5 455.0
Retained Earnings 20,087.5 16,181.5
Total Equity 22,967.5 18,933.5
Total Liabilities and Equity 47,649.0 37,954.5

EBC Enterprise Inc.

Income Statement and Retained Earnings
For the year ended December 31, 2011, 2010 and 2009
(In Thousands)
2011 2010 2009
Net Sales 107,800.0 76,500.0 70,350.0
Cost of Goods Sold 64,682.0 45,939.5 40,803.0
Gross Profit 43,118.0 30,560.5 29,547.0
Selling and Administrative Expenses 16,332.0 13,191.0 12,749.0
Advertising 7,129.0 5,396.0 4,770.5
Depreciation and Amortization 1,999.0 1,492.0 1,250.5
Repairs and Maintenance 1,507.5 1,023.0 1,515.5
Total 33,496.5 24,657.5 23,919.0
Operating Profit 9,621.5 5,903.0 5,628.0
Other Income (Expenses):
Interest Income 211.0 419.0 369.0
Interest Expense (1,292.5) (1,138.5) (637.0)
Earnings Before Income Taxes 8,540.0 5,183.0 5,360.0
Income Taxes 3,843.0 2,228.5 2,412.0
Net Income 4,697.0 2,955.0 2,948.0
Earnings Per Share P2.00 P1.29 P1.33

Statement of Retained Earnings

Retained Earnings, Beginning 16,181.5 14,157.5 12,130.0
Net Income 4,697.0 2,955.0 2,948.0
Cash Dividends (2011-P0.33 per share; 2010-
P0.41 per share) (791.0) (931.0) (920.5)
Retained Earnings at the end of the year P20,087.5 P16,181.5 P14,157.5

EBC Enterprise Inc.

Statement of Cash flows for the years ended December 31, 2011 and 2010
(In Thousands)
2011 2010
Cash Flow From Operating Activities – Direct Method
Cash Received from Customers 107,495.0 74, 830.5
Interest Received 211.0 419.0
Cash paid to supplier for inventory (66,466.5) (49,968.0)
Cash paid to employees (S&A Expenses) (16,332.0) (13,191.0)
Cash paid for other operating expenses (14,864.0) (10,675.0)
Interest Paid (1,292.5) (1,138.5)
Taxes Paid (3,739.0) (2,160.5)
Net Cash Provided (used) by Operating activities 5,012.0 (1,883.5)
Cash Flow From Investing
Addition to Property, Plant and Equipment 7,050.0) (2,386.5)
Other Investing Activities 147.5 0
Net Cash Provided (used) by investing activities ( 6,902.5) (2,386.5)

Cash Flow from Financing Activities

Sales of Ordinary Shares 128.0 91.5
Increase (decrease) in short-term borrowings (15.0) 927.0
(includes current maturities of long term debt)
Addition to long term borrowings 2,800.0 3,941.0
Reductions of long term borrowings (758.0) (796.5)
Dividends paid (791.0) (931.0)
Net cash provided (used) by financing activities 1,364.0 3,232.0
Increase (decrease) in cash & marketable securities (562.5) (1,038.0)

Required:
Use the financial Ratios, evaluate the company’s financial position and operating results for the
years 2011 and 2010.
1. Current Ratio 2011: 32,923 / 13,703.5 = 2.4 times
2010: 28,132 / 10,216 = 2.75 times
Current Ratio is a measure of short-term debt paying ability.
2. Quick or acid test ratio 2011: 9,146.5 / 13, 703.5 = 0.67 times
2010: 9,368 / 10,216 = 0.92 times
Quick Ratio is much more rigorous test of company’s ability to meet its short-term debt.
Again, quick assets do not include inventories and prepayments.
3. Accounts Receivable Turnover
2011: 107,800*/ [(4,480+4,175)/2] = 24.9 times
2010: 76,500 / 4,175** = 18.32 times
Accounts Receivable Turnover measures how many times a company’s accounts
receivable have been turned into cash during the year.
*When net credit sales are not available, use the net sales.
**Assumed Average for 2010 since there’s no 2009 accounts receivable given so the
given in 2010 is assumed to be the average.
4. Ave. Collection Period 2011: 365 / 24.9 = 14.6 or 15 days
2010: 365 / 18.32 = 19.9 or 20 days
Collection Period helps evaluate the liquidity of accounts receivable and the firm’s credit policy.
5. Inventory Turnover 2011: 64,682 / [(23,520.5+18,384.5)/2] = 3.09 times

2010: 45,939.5 / 18,384.5* = 2.5 times

*Assumed Average for 2010.
Inventory turnover measures the efficiency of the firm in managing and selling inventory.
6. Inventory days or period
2011: 365 / 3.09 = 118 days
2010: 365 / 2.5 = 146 days
Inventory period is the number of days to sell the entire inventory one time.
7. Total Asset Turnover 2011: 107,800 / [(47,649+37,954.5)/2] = 2.52 times

2010: 76,500 / 37,954.5* = 2.02 times

*Assumed Average for 2010.
Asset turnover measures the efficiency of management to generate sales and thus earn more
profit for the firm.
8. Debt Ratio 2011: 24,681.5 / 47,649 = 51.8%
2010: 19,021 / 37,954.5 = 50.1%
Debt Ratio measures the proportion of all assets that are financed with debt.
9. Debt to Equity Ratio 2011: 24,681.5 / 22,967.5 = 107.46%
2010: 19,021 / 18,933.5 = 100.46%
Debt to equity ratio measures the riskiness of the firm’s capital structure in terms of relationship
between the funds supplied by creditors (debt) and investors (equity).
10. Times Interest Earned 2011: 9,621.5 / 1.292.5 = 7.44 times
2010: 5,903 / 1,138.5 = 5.18 times
It is the most common measure of the ability of a firm’s operations to provide protection to long-
term creditors.
11. Fixed Charge Coverage
2011: (9,621.5+6,529) / (1,292.5+6,529) = 2.06 times

2010: (5,903 + 3,555.5) / (1,138.5+3,555.5)

= 2 times
It measures the firm’s coverage capability to cover not only interest payments but also the fixed
payment associated with leasing which must be met annually.
12. Gross Profit Margin 2011: 43,118 / 107,800 = 40%
2010: 30,560.5 / 76,500 = 39.95%
It shows the relationship between sales and the cost of products sold, measures the ability of a
company both to control costs and inventories or manufacturing of products and to pass along
price increases through sales to customers.
13. Operating Profit Margin
2011: 9,621.5 / 107,800 = 8.9%
2010: 5,903 / 76,500 = 7.7%
It measures the overall efficiency and incorporates all of the expenses associated with ordinary
or normal business activities.
14. Net Profit Margin 2011: 4,697 / 107,800 = 4.36%
2010: 2,955 / 76,500 = 3.87%
It measures the profitability after considering all revenue and expenses, including interest, taxes,
and non-operating items such as extra-ordinary items, cumulative effect of accounting change,
etc.

15. Return on Investment or Asset

2011: {4,697+[(1,292.5)(1-45%]} / 43,802= 12.35%
2010: {2,955+[(1,138.5)(1-43%]} / 39,955
= 9.02%
16. Return on Equity 2011: 4,697 / [(22,967.5+18,933.5)/2) = 22.42%

2010: 2,955 / 18,933.5 = 15.60%

Return on Assets and Return on Equity are two ratios that measure the overall efficiency of the
firm in managing its total investment in assets and in generating return to shareholders.
*ROE / ROA = Financial Leverage Index

17. EPS 2011: 4,697,000 / [(2,401,500+2,297,000)/2] = P2.00

2010: 2,955,000 / 2,297,000 = P1.29

18. Price/Earnings Ratio 2011: 30 / 2 = 15

2010: 17/1.27 = 13.39
Price-earnings ratio relates the EPS to its Market price at which the stock trades, expressing the
“multiple” which the stock market places on firm’s earnings.

19. Dividend Payout 2011: 0.33 / 2 = 16.5%

2010: 0.41 / 1.29 = 31.78%
20. Dividend Yield 2011: 0.33 / 30 = 1.10%
2010: 0.41 / 17 = 2.41%

 Tip: When the ratio is composed of one income statement account and one balance sheet account, the
balance sheet account must be an average balance.

CASH FLOW ANALYSIS

Funds flow analysis suffers from the major limitation that the liquidity is not fully reflected by
this analysis. The quality of current assets will make the difference, thus, a firm reporting positive
change in funds may still have problems as the current assets are of poor quality. Cash flow
analysis is superior to Funds flow analysis. Also, the cash flows are divided into three major
categories, viz. Operating, investing and financing activities, to have a better understanding of
the liquidity position of the company.
Concept
Cash flow statement indicates the sources and uses of cash flows. The transactions resulting in
cash in-flows are called sources of cash flows; and those transactions that result in cash out-flows
are called uses of cash flows. The information contained in cash flow statement is more reliable
as cash flows are not affected by subjective judgment, estimates and accounting policies. Cash
for the purpose of cash flow includes cash and cash equivalents. Cash consists of cash in hand
and cash at bank. Cash equivalents are short term highly liquid investments that are readily
convertible into known amount of changes in value. These are having short term maturity period
usually not more than three months. The sources and uses of cash are given below:

Sources of cash (Cash in-flows) Uses of Cash (Cash out-flows)

1. Business operations/operating activities 1. Purchase of Fixed Assets

2. Sale of Fixed Assets 2. Purchase of Investments

3. Issue of Equity & Pref. Shares 3. Redemption of Pref. Shares & Debentures
4. Issue of Debentures 4. Repurchase of Equity Shares
5. Long Term Loans raised 5. Repayment of Loans
6. Interest received in Investments 6. Payment of Interest

7. Dividends received in Investment 7. Payment of Div. on Pref. & Eq. Capital

8. Other Items (Specify) 8. Other Items (Specify)
 The cash flows computed are divided into three categories viz. operating; investing and
financing activities. The separate disclosure under these categories helps us to make
proper analysis and have better understanding of the liquidity position of the firm. The
computation of cash flows under each category is discussed below:

Cash flows from operating activities: The cash flow accruing from main operating activities (also
called as revenue producing activities like sale of goods and services) are called cash flows from
operating activities. The net cash flow from operating activities represent the net cash received
from main operations of the business.
The sources of cash or cash in-flows from operating activities are: i) cash receipts from sale of
goods and rendering of services; ii) cash receipts from royalties, fees, commissions, and other
revenues; and iii) refunds of income taxes unless they can be specifically identified with financing
and investing activities.

The sources (cash in-flows) and uses of cash (cash out-flows) from operating activities are:
Sources of Cash (Cash in-flows) Uses of Cash (Cash out-flows)
i) Cash receipts from sale of goods and i) cash payment to suppliers for goods
rendering of services; and services;
ii) Cash receipts from royalties, fees, ii) Cash payment to employees;
commissions, and other revenues; and
iii) Refunds of income taxes unless they iii) cash payments for other expenses
can be specifically identified with related to production, establishment
financing and investing activities. and marketing;
iv) Cash payments of income taxes unless
they can be specifically identified with
financing and investing activities.

Cash flows from investing activities: The cash flows accruing from acquisition and disposal of
fixed assets and investments (not included in cash equivalents) are called cash flows from
investing activities. Given below are the sources and uses of cash from investing activities:
Sources of Cash (Cash in-flows) Uses of Cash (Cash out-flows)

i) Cash receipts from disposal of fixed i) Cash paid for purchase of fixed assets
assets
ii) Cash receipts from sale of investments ii) Cash paid for purchase of investment
iii) Cash receipts towards interest & iii) Cash advances and loans made to 3rd
dividends parties
iv) Cash receipts from repayment of loans
and advances

Cash flows from financing activities: The cash flows from financing the firm and repaying debts
as well as distribution to owners and payment of interest are called cash flows from financing
activities.

Sources of Cash (Cash in-flows) Uses of Cash (Cash out-flows)

i) Cash receipts from issue of Equity i) Buy-back of shares

shares ii) Redemption of Preference shares
ii) Cash receipts from issue of Pref. shares iii) Redemption of debentures
iii) Cash receipts from issue of debentures iv) Repayment of long term loans
iv) Cash receipts from long term loans v) Payment of interest and dividends
raised

Illustration 1. Selected financial information of a company is given below:

Current Assets: July 1, 2017 June 30, 2018
Stock P. 850,000 P. 900,000
Debtors 500,000 600,000
Accrued Revenues 60,000 40,000
Prepaid Expenses 18,000 20,000
Bills Receivable 22,000 18,000
Cash in Hand & at Bank 34,000 59,000
Current Liabilities:
Sundry Creditors 560,000 440,000
Bills Payable 18,000 20,000
Revenues Received in Advance 42,000 56,000

Other Information: Net income for the year was Rs. 2,750,000 after charging depreciation and
interest of P. 580,000 and P. 350,000 respectively. There was a loss of Rs. 52,000 on sale of old
furniture. In the current year deferred revenue expenses of Rs. 30,000 were written off. Ascertain
cash flow from operating activities for the year.

Solution:
Cash Flows from Operating Activities: Pesos Pesos
Net Income 2,750,000
Add:
Depreciation 580,000
Loss on sale of old furniture 52,000
Interest paid on Debentures 350,000
Def. Rev. Expenses written off 30,000
Decrease in Accrued Revenues 20,000
Decrease in Bills Receivables 4,000
Increase in Bills payable 2,000
Increase in Revenues Received in Advance 14,000
Less:
Increase in stock 50,000
Increase in Debtors 100,000
Increase in Prepaid Expenses 2,000
Decrease in Sundry Creditors 120,000 (272,000)
Net Cash In-flow from operating activities 3,530,000

Transactions not affecting Funds:

 If a transaction does not affect any current asset or current liability, it does not affect funds.

 if a transaction affects only current assets (one current asset increases and another current
asset decrease by the same amount) or only current liabilities (one current liability increases
and another current liability decrease by the same amount), then such transaction does not
affect funds.
 When a transaction affects current assets and current liabilities simultaneously increasing or
decreasing both by the same amount, then such a transaction will not affect funds.
Transactions affecting Funds:
 If a transaction affects Current assets and current liabilities by different amounts, and for the
balancing figure some other account (fixed asset, fixed liability or equity) are affected, then
such transaction will affect the funds. The funds will change by the difference in amount
affecting current assets and current liabilities. If current assets have increased by more
amount than the increase in current liabilities or decreased by lesser amount than the
decrease in current liabilities, it will increase funds and is called ‘Source of Funds’. On the
other hand, if current assets have decreased by more amount than decrease in current
liabilities or increased by lesser amount than the increase in current liabilities, it will decrease
funds and is called ‘Use of Funds’.

 If a transaction affects the current assets on the one hand and fixed assets, fixed liabilities or
equity on the other hand, then such transaction will affect funds. If the current assets have
increased, it will increase the funds, and is called ‘Source of Funds’.

 If a transaction affects the current assets on the one hand and fixed assets, fixed liabilities or
equity on the other hand, then such transaction will affect funds. If the current assets have
decreased, it will decrease the funds, and is called ‘Use of funds’.

 If a transaction affects the current liabilities on the one hand and fixed assets, fixed liabilities
or equity on the other hand, then such transaction will affect funds. If the current liabilities
have decreased, it will increase the funds, and is called ‘Source of funds’.

 If a transaction affects the current liabilities on the one hand and fixed assets, fixed liabilities
or equity on the other hand, then such transaction will affect funds. If the current liabilities
have increase, it will decrease the funds, and is called ‘Use of funds’.

Calculating Cash Flows From Operating Activities

1. Direct Method
Income Statement Accounts Adjustments Cash Flow

{ }
Sales Revenue +Decrease in AR
-Increase in AR Collection From
+Increase in Deferred Revenue Customers
-Decrease in Deferred Revenue
{ }
Interest Revenue +Decrease in Interest Receivable
And dividend revenue -Increase in Interest Receivable Interest and
+Amortization of premium on Dividends
Investment in bonds Collected
-amortization of discount on
Investment in bonds

Other Revenues

{ +Increase in Unearned Revenues

-Decrease in other revenue
-Gains on disposal of assets
-investment income(equity method)
}Other Operating
Receipts and
Liabilities

{ }
+increase in Inventory
Cost of Goods Sold -Decrease in Inventory Payments to
+Decrease in Accounts Payable Suppliers
-Increase in accounts payable

{ }
-Depreciation, Depletion and
Selling and Administrative Amortization expense Payments of

Expense +Decrease in Accrued Expense Operating

-Increase in Accrued Expense Expenses

+Increase in Prepaid Expenses

-Decrease in prepaid expenses

{} }
+Decrease in Interest Payable

-Increase in Interest Payable

Interest Expense +Amortization of premium on Payments of Interest

bonds payable

-Amortization of discount on

bonds payable
{ }
Other Expenses -Losses on disposal of

assets and liabilities Other operating

-Investment Loss (equity method) Payments

{}}} }
+Decrease in income tax payable

Income Tax expense -Increase in income tax payable Payment of

+Decrease in deferred income taxes Income

Payable Taxes
-Increase in Income taxes payable

2. Indirect Method
Net Income after Taxes

Plus

Decrease in current assets (except cash, marketable securities and non-trade accounts)
Increase in current liabilities (except financing or non-operating accounts such as bank loan,
current maturities of long-term debt
Depreciation, Depletion and Amortization Expense
Amortization of discount on bonds payable
Amortization of premium on investment in bonds
Increase in deferred income taxes
Loss (net) on disposal of assets and liabilities
Subsidiary loss under equity method
Interest expense*
Income Taxes*

Minus

Increase in current assets (except cash, marketable securities and non-trade accounts)
Decrease in current liabilities (except financing or non-operating accounts such as bank loan,
current maturities of long-term debt
Amortization of premium on bonds payable
Amortization of discount on investment in bonds
Decrease in deferred income taxes
Gain (net) on disposal of assets and liabilities
Subsidiary gain under equity method

Equals

Net Cash Flow From Operations

Minus

Interest paid
Taxes Paid
=
Net Cash From Operating Activities

Comprehensive Illustration I:

Kalikasan Company
Condensed Financial Information
__________________________________________________________________
Statement of Financial Position Information
Balances
Accounts Jan. 1, 2012 Dec. 31, 2012
Cash P 3,500 P 5,500
Accounts Receivable 4,400 3,600
Inventory 5,000 6,600
Land 8,200 12,200
Building and Equipment 35,700 48,700
Accumulated Depreciation (6,000) (8,700)
Total Assets P 50,800 P 67,900

Accounts Payable P 5,100 P 3,200

Salaries Payable 1,400 1,800
Bonds Payable, 10% 7,000 15,000
Ordinary shares, P10 par 8,000 9,000
Additional Paid in Capital 16,000 19,000
Retained Earnings 13,300 19,900
Total Liabilities and Equity P 50,800 P 67,900

Income Statement Information for 2012

Sales Revenue P 80,800
Cost of Goods Sold 48,600
Gross Profit P 31,400
Operating Expenses
Depreciation Expense P 3,400
Other Expenses 15,900 19,300
Operating Income P 12,100
Other Revenues and expenses:
Gain on sale of equipment P 600
Interest Expense 700 100
Income before income taxes P 12,000
Income tax expense 3,600
Net Income P8,400

Retained Earnings Information for 2012

Beginning Retained Earnings P 13,300
Add: Net Income 8,400
Total 21,700
Less: Dividends (1,800)
Ending Retained Earnings P 19,900

Supplementary Information for 2012

Equipment was purchased for cash at a cost of 15,200. Ten –year bonds payable with face value
of 8,000 were used for 8,000 at the end of the year. Land was acquired through the issuance of
100 ordinary shares of P10 par shares when stock was selling at a market price of P40 per share.
Equipment with a cost of 2,200 and a book value of 1,500 was sold for 2,100 cash.

Solution:
Kalikasan Company
Statement of Cash Flows
For the year ended December 31, 2012
Net Cash flows from operating activities
Net Income before interest and taxes P 12,100
Add: Depreciation Expense 3,400
Decrease in Accounts Receivable 800
Increase in Salaries Payable 400
Less: Increase in Inventories 1,600
Decrease in Accounts Payable 1,900
Gain on sale of equipment 600
Interest expense 100
Income tax expense 3,600
Net Cash Provided by Operations 8,900
Cash Flow from Investing Activities
Payment for purchase of equipment P (15,200)
Proceeds from sale of equipment 2,100
Net Cash used for investing activities 13,100
Cash Flow from Financing Activities
Proceeds from issuance of bonds P 8,000
Payment of Dividends (1,800)
Net cash provided by financing activities 6,200
Net Increase in Cash 2,000
Cash Balance, January 1, 2012 3,500
Cash Balance, December 31, 2012 P 5,500

Direct method
Net Cash flow from operating activities:

Cash Flow Operating Activities

Cash Inflows
Collections from customers (80,000 + 800) P 80,800
Cash Outflows
Payment to suppliers (48,600+1,600+1,900) 52,100
Payment of other operating expenses (19,300-3,400-400) 15,500
Payment of Interest expense 700
Payment of Income taxes 3,600
Total P 71,900
Net Cash Flows from Operating Activities P 8,900

Activity 1. True or False (Ratio Analysis)

1. The asset turnover rate multiplied by the rate of net income earned on sales equals the
rate earned on the total assets.
2. If the information were available, financial analysts would be interested in knowing the
sales volume at the break-even point for the business enterprise.
3. If the amount of current assets exceeds the amount of current liabilities, a decrease in
current assets with a corresponding decrease in current liabilities increase the current
ratio.
4. The number of days’ sales in receivable at the end of an accounting period is a better
measure of the quality of receivable than the receivable turnover rate.
5. Window dressing is a violation of generally accepted accounting principles.
6. The dept ration is useful to creditors as well as to stockholders, but each of thes groups
places somewhat different emphasis on it.
7. Short-term creditors generally are more concerned with vertical analysis then with
horizontal analysis.
8. Horizontal analysis is possible for both an income statement and a balance sheet.
9. Common-size financial statements show peso change in specific items form one year to
the next.
10. A company with a 2.0 current ratio will experience a decline in the current ratio when a
short-term liability is paid.

Activity 2. Classification. (Cash Flow Analysis). Identify which operation the activity belongs.
(Operating, Investing or Financing). Determine as well weather it is a Use of Fund or a Source of
fund.
1. Short-term investment securities were purchased.
2. Equipment was purchased.
3. Accounts payable increased.
4. Deferred taxes decreased.
5. Long-term bonds were issued.
6. Ordinary shares were sold.
7. Interest was paid to long term creditors.
8. A long term mortgage was entirely paid off.
9. A cash dividend was declared and paid.
10. Inventories decreased.

Activity 1. Problem Solving

Bryan Corporation
Statement of Financial Position as of December 31, 2011

Assets Liabilities and Owner’s Equity

Cash P50, 000 Accounts Payable P220, 000
Accounts Receivable 280,000 Accrued Taxes 80, 000
Inventory 240,000 Bonds Payable (Long Term) 118, 000
Plant and Equipment 380,000 Common Stock 100, 000
Paid-in Capital 150, 000
Retained Earnings 282, 000
Total Assets P950,000 Total Liabilities and Equity P950, 000
Assume that Total Net Credit Sales is P300, 000 and Cost of Goods Sold is P150, 000.
Required:
a. Compute the Current Ratio e. Receivable Turnover
b. Quick Ratio f. Average Collection Period
c. Debt-to-total-Assets Ratio g. Merchandise Turnover
d. Average Collection Period h. Debt Ratio

Activity 2. Problem Solving

Gray Corporation’s financial statements for the last year are shown below. All figures are in thousands
(P000). The firm paid a P1, 000 dividends to its stockholders during the year. Two million shares of stock
are outstanding. The stock is currently trading at a price of P50. There were no sales of new stock. Lease
payments totaling P400 are included in cost and expense.

Balance Sheet
Assets Liabilities & Equity
Cash P2, 000 Accounts Payable P3, 000
A/R 12, 000 Tax Payable 1, 000
Inventory 14, 000 Long Term Debt 10, 000
Fixed Assets 27, 000 Equity 25, 000
Acc. Depreciation (16,000)
Total Assets P39, 000 Total Liabilities & Equity 39, 000

Income Statement Compute for the following:

1. Current Ratio 12. Return on Assets
Sales P100, 000 2. Quick Ratio 13. Return on Equity
Cost of Sales ( 80, 000) 3. Average Collection Period 14. Price Earnings Ratio
Gross Margin 20, 000 4. Inventory Turnover
Expenses (8, 000) 5. Fixed Asset Turnover
Depreciation (1, 600) 6. Total Asset Turnover
EBIT 10, 400 7. Debt Ratio
Interest ( 800) 8. Debt to Equity Ratio
EBT 9, 600 9. Times Interest Earned
Tax ( 2, 600) 10. Return on Sales
Net Income P 7, 000 11. Return on Sales

Activity 3. Problem Solving

Kerwin Corp.'s transactions for the year ended December 31, 2008 included the following:
 Purchased real estate for P550,000 cash which was borrowed from a bank.
 Sold available-for-sale securities for P500,000.
 Paid dividends of P600,000.
 Issued 500 shares of common stock for P250,000.
 Purchased machinery and equipment for P125,000 cash.
 Paid P450,000 toward a bank loan.
 Reduced accounts receivable by P100,000.
 Increased accounts payable P200,000.

Compute for the following:

a. Cash Flows from Operating Activities
b. Cash Flows from Investing Activities
c. Cash Flows from Financing Activities
IV. Understand the complete components of Feasibility Study

The Importance of Feasibility Studies

 Feasibility studies are important to business development. They can allow a business to
address where and how it will operate. They can also identify potential obstacles that may
impede its operations and recognize the amount of funding it will need to get the business
up and running. Feasibility studies aim for marketing strategies that could help convince
investors or banks that investing in a particular project or business is a wise choice.

Basic Components of a Feasibility Study

EXECUTIVE SUMMARY
The executive summary provides an overview of the content contained in the feasibility
study document. Many people write this section after the rest of the document is
completed. This section is important in that it provides a higher level summary of the
detail contained within the rest of the document.

DESCRIPTION OF PRODUCTS AND SERVICES

This section provides a high level description of the products and/or services which are
being considered as past of the feasibility study. The purpose of this section is to provide
detailed descriptions of exactly what the organization is considering so this information
can be applied to the following sections of the document. It is important that this
description captures the most important aspects of the products and/or services that the
organization is considering as well as how it may benefit customers and the organization.
TECHNOLOGY CONSIDERATIONS
This section should explain any considerations the organization must make with regards
to technology. Many new initiatives rely on technology to manage or monitor various
business functions. New technology may be developed internally or contracted through
a service provider and always result in costs which must be weighed in determining the
path forward.
PRODUCT/SERVICE MARKETPLACE
This section describes the existing marketplace for the products and/or services the
organization is considering. It may describe who the target market consists of for these
products or services, who the competitors are, how products will be distributed, and why
customers might choose to buy our products/services. Most marketplaces are dynamic
environments in which things change constantly. To enter a new marketplace blindly will
usually result in an organization not fully understanding its role and not maximizing its
resulting benefits.
MARKETING STRATEGY
This section provides a high level description of how the organization will market its
product or service. Some topics which should be included are: how does an organization
differentiate itself from its competitors; types of marketing the organization will utilize;
and who the organization will target. Marketing efforts must be focused on the right
target groups in order to yield the greatest return on investment.
ORGANIZATION AND STAFFING
With many new products or services there may be a need for additional staffing or for an
organization to restructure in order to accommodate the change. These are important
considerations as they may result in increased costs or require an organization to change
its practices and processes.
SCHEDULE
This section is intended to provide a high level framework for implementation of the
product or service being considered. This section is not intended to include a detailed
schedule as this would be developed during project planning should this initiative be
approved. This section may include some targeted milestones and timeframes for
completion as a guideline only.
FINANCIAL PROJECTIONS
This section provides a description of the financial projections the new initiative is
expected to yield versus additional costs. Financial projections are one key aspect of new
project selection criteria. There are many ways to present these projections. Net present
value (NPV), cost-benefit calculations, and balance sheets are just some examples of how
financial projections may be illustrated. This section should also provide the assumptions
on which the illustrated financial projections are based.

FINDINGS AND RECOMMENDATIONS

This section should summarize the findings of the feasibility study and explain why this
course of action is or is not recommended. This section may include a description of pros
and cons for the initiative being considered. This section should be brief since most of
the detail is included elsewhere in the document. Additionally, it should capture the
likelihood of success for the business idea being studied.

KEY TAKEAWAYS

 A feasibility study assesses the practicality of a proposed plan or project.

 A company may conduct a feasibility study if it's considering launching a new business or
adopting a new product line.
 It's a good idea to have a contingency plan in case of unforeseeable circumstances, or if
the original project is not feasible.

ECONOMIC ASPECT

Demand and Market Analysis

1. Effective demand represents the total quantity of a specific product purchased at a given price in
a particular market over a given period.
2. The first step in project analysis is a detailed estimate of the size, structure and demand
characteristics of the product to be manufactured.
3. The size of demand during the life span of a proposed project is a function of several variable
factors such as the composition of the market, the competition from other sources of supply of
the same product and substitutes, income and price elasticity of demand, market responses to
socio-economic patterns, distribution o=channels and consumption growth lines.
4. The demand and market study should provide the following basic information:
a) Size and composition of present demand in a market whose geographical limit should be
defined.
b) Market segments identified by end use, consumer groups or geographical division.
c) Demand projection of the overall market and of the segments over a certain period,
preferably 5 to 10 years of the potential life of the project.
d) The market penetration ratio that the project is expected to achieve over the projected
period in the context of developing competition, domestic and global and changing
consumer response.
e) The broad pricing structure on the basis of which projections of growth and market
penetration are made.
f) The conditions of sales promotion and sales organization to be established.

Demand Projection
This is the most significant and certainly the most complex element of market and demand
analysis because it is critical factor for determining both the viability of a project and the
appropriate plant capacity.

Demand Forecasting Techniques

 Trend (extrapolation) Method
This relatively common technique is based on extrapolation of past data and involves
a. The determination of trend, and
b. The identification of its parameters.

 Regression models
Forecast are made on the basis of a relationship estimated between the forecast (or
dependent) variable and the explanatory (or independent) variables.
 Consumption coefficient or End-run method
This method is particularly suitable for assessing intermediate products.

 Consumption level method

This method considers the level of consumption using standard and defined coefficients
and can be usefully adopted when a particular product is directly consumed.

 Market survey
A market survey is an expensive and time-consuming way to forecast demand for a
particular product.

Sensitivity Analysis
It is only by a systematic approach that uncertainly is reduced to a minimum. This approach is
provided by statistical sensitivity analysis by which calculations are made of the degree of
uncertainty. The objectivity of sensitivity is to determine the impact on the size of demand,
aggregate or by segment, if the factors influencing demand turn out to be more or less favorable
than has been assumed.

Sources of Data
Sources of information have to be identified and located in each case. Considerable information may be
available from official published data, including:
(1) Statistical handbooks
(2) Census reports; resources, area or sectoral opportunity studies conducted by governmental and
institutional agencies
(3) Publications of chambers of commerce.

Sales Forecast and Marketing

An analysis of sales and income for sales is essentially an extension of the initial demand analysis
on the basis of which a project is developed. The parameters of market size and anticipated
market penetration, which would be defined in the demand study, should be further refined and
projected in terms of specific sales volume during different periods after a project goes into
production.

Product Pricing
Product pricing has a significant impact on the volume of sales and on the income from such sales.
The base of any pricing should be the production costs and the market structure for a particular
product.

Marketing Strategy
4.7.1. Promotional measures
Sales promotion, the design and creation of a distribution system and the related costs
are important in product marketing. The sales promotion efforts required and the target
for market penetration should be broadly defined.
4.7.2. Distribution system
The sales and distribution organization for marketing a particular product should be
broadly defined and its cost of operation estimated. Details regarding marketing and
distribution have to be worked out during the post implementation stage. The
appropriate marketing structure should be defined in the feasibility study.

Sales Revenue Projection

Projections of sales can only be made according to the market structure, market requirements
and marketing strategies that are followed. Such strategies have to be defined and an assessment
made of the implications in terms of product pricing, production program, promotional efforts
and the sale and distribution mechanism.

V. Apply the concept relevant costs in various types of decision making.

Managers must constantly make decisions and they must estimates how each decision could
affect operating income. Managers often select the course of action that maximizes expected
operating income over the period affected by the decision. To do this, they analyze relevant
information. The management accountant’s role in this process is to supply information on
changes in costs and revenues to facilitate the decision process.

One of the most important roles played by the manager in the organization is decision making
(which means choosing from at least two alternative courses of action). The decision making
process usually starts when a problem is encountered. Alternative courses of action or possible
solutions are then evaluated, and the best alternative is chosen. Throughout this process, the
manager makes use of accounting information and applies analytical techniques or methods to
come up with the best possible solution to the problem under consideration.

Decision making – is the process of studying and evaluating two or more available alternatives
leading to a final choice.

Steps in the decision making process

I. Define strategies: business goals and tactics to achieve them
II. Identify the alternative choices or courses of action
III. Collect and analyze the relevant data on the choices
IV. Choose the best alternative to achieve goals

Factors to be considered in the selection of the best alternative

1) Qualitative factors – are those that cannot be easily and accurately be expressed in terms
of money or any other numerical unit of measure.
2) Quantitative factors – are those that can easily be expressed in terms of money or other
units of measure.
Types of costs used in decision making
1) Relevant costs – are expected future costs that differ under decision alternatives.
2) Differential costs – refer to the increases (increments) or decreases (decrements) in total
costs between two alternatives.
3) Avoidable costs – costs that will be saved or those that will not be incurred if a certain
decision is made. For decision making purposes, this type of costs is usually relevant.
4) Out-of-pocket costs – are costs that require current or near future cash outlays or
incurring of a liability for a decision at hand.
5) Opportunity costs – refer to the income or benefit sacrificed or foregone when an
alternative is chosen. For decision making purposes, these costs are usually considered
relevant.
6) Sunk costs – refer to the non-recoverable costs incurred in the past. For decision making
purposes, these costs are considered irrelevant.
7) Joint costs – are costs incurred in simultaneously processing or manufacturing two or
more products which are difficult to identify individually as separate types of products
until a certain processing stage known as “the point of separation or split off point”. For
decision making purposes, these costs are usually considered irrelevant.

Approaches in solving decision making problems

1) Total approach – is an approach in which the total revenues and costs are determined for
each alternative and the results are compared to serve as bases for making decisions. This
type of analysis is time consuming and requires more effort and cost to prepare, because,
it requires the analysis of all data, whether relevant or irrelevant.

2) Differential analysis – is an area of accounting concerned with the effect of alternative

courses of action on revenues and costs. The relevant revenue and cost data in the
analysis of future possibilities are the differences between the alternative under
consideration. The amount of such difference is differentials.

Types of Decisions
1) Make or Buy
It is a management decision about whether an item should be made internally or
bought from an outside supplier. To put idle capacity to use, firms often consider
manufacturing a part or subassembly they are currently purchasing.

Differential cost analysis is appropriate for shorty run make or buy decisions involving
the construction of plant assets or component parts of the finished product on the
company premises rather than acquiring them outside.

Decision guidelines: The alternative that gives lower relevant costs savings and should
be preferred.

The tabulation of relevant costs in making and buying a part is as follows:

Cost to make Cost to Buy
Purchase price Px
DM, DL, VOH, Material handling costs Px
Avoidable fixed overhead x
Savings if the part is bought (x)
Rental income from released facilities (x)
Contribution margin from a new product
being produced using the released facilities (x)
Rental expense if the part is bought (x)
P XXX P XXX

Sample Problem
R Motors uses production of large diesel engines. The cost to manufacture one unit of T305
is presented below:
DM P 2,000
Materials handling (20% of DM) 400
DL 16,000
Manufacturing overhead ( 150% of DL) 24,000
P 42,000
Materials handling, which is not included in manufacturing overhead , represents the direct
variable costs of receiving department that are applied to direct materials and purchased
components on the basis of their cost. R’s annual manufacturing overhead is one-third
variable and two-thirds fixed. S castings, one of R’s reliable vendors, has offered to supply
T305 at unit price of P 30,000.
Assume R motors is able to rent all the idle capacity for P 50,000 per month. If R decides to
purchase the 10 units from Castings, R’s monthly cost for T305 would be?

Solution:

Cost to make: Cost to buy:

Direct material P 2,000 Purchase price P 30,000
Material handling 400 Material handling 6,000
(2,000*20%) (30,000*20%)
Direct labor 16,000 Total unit cost P36,000
Manufacturing overhead 8,000 Multiply by: number of 10
(24,000*1/3) units
Total unit cost P26,400 Total 360,000
Multiply by: number of 10 Rent income (50,000)
units
Total costs P264,000 Total costs P310,000

Cost to buy: P 310,000

Cost to make: 264,000
P 46,000 increase in cost if purchase outside.

2) Adding or Dropping Products/Services

Some product lines or business segments tend to under-perform compares to others.
In deciding whether to add a new product line or drop an existing one, the
management must consider relevant benefits and costs.

As a rule, product lines or business segments should be evaluated based on traceable

revenues and costs. Allocated fixed costs should be removed from the analysis of
income since the company will incur in the entire amount with or without the product
line or segment.

Decision guidelines: If the direct segment margin is positive and there is no other more
beneficial alternative, then, continue!

 The segment margin maybe determined either under conditions with alternative
use of the capacity or there is no alternative use of the capacity. One determined,
decisions shall be made as follows;
 With no alternative use of capacity
- If the segment margin is positive, continue the division.
 With alternative use of capacity
- Compare the segment margin from the net benefit of the alternative. If
the segment margin is greater then, continue.

Otherwise discontinue the division and undertake the alternative that gives the higher
profit.

Segment margin equals:

CM-Avoidable Fixed expenses = Controllable segment margin

Alternative computation:
CM PX
Controllable direct cost (x)
Controllable margin x
Non controllable Fixed expenses (x)
Segment (direct) margin P XX

Sample Problem

Doyle Company has 3 divisions: R, S, and T. Division R's income statement shows the
following for the year ended December 31:
Sales P1,000,000
Cost of goods sold (800,000)
Gross profit P 200,000
Selling expenses 100,000
Administrative expenses 250,000
Net loss P (150,000)
Cost of goods sold is 75 percent variable and 25 percent fixed. Of the fixed costs, 60 percent
are avoidable if the division is closed. All of the selling expenses relate to the division and
would be eliminated if Division R were eliminated. Of the administrative expenses, 90
percent are applied from corporate costs. If Division R were eliminated, Doyle’s income
would be?

Solution:

Sales P 1,000,000
Variable costs:
COGS (800,000*75%) 600,000
Selling expenses 100,000 (700,000)
Contribution margin 300,000
Avoidable costs:
COGS (800,000*25%*60%) 120,000
Administrative exp. (250,000*10%) 25,000 (145,000)
Controllable segment margin P 155,000
*The overall profit of Doyle will decrease by P155,000 if R Division is eliminated.

1) Sell Now or Process Further

It is a choice of selling a product now or processing it further to earn additional
revenue. This choice is based on an incremental analysis of whether the additional
revenues to gained will exceed the additional costs to be incurred as part of the
additional processing work.

Joint product costs – is used to describe those manufacturing costs that are incurring
is producing the joint products up to split-off point. This cost is irrelevant in decisions
regarding what to do with a product from the split-off point forward because they
have already been incurred and therefore are sunk costs.

Split-off point – is the point in the manufacturing process at which the joint product
can be recognized as separate products.

Separable costs – are costs incurred after the split-off point for the benefit of only one
particular product.

Decision guidelines: If there is a profit from further processing, then process further.

Basic computational guideline is:

Incremental sales P xx
Incremental cost (xx)
Savings from further processing xx
Incremental profit or loss P XX
Sample Problem

India Corporation has P200,000 of joint processing costs and is studying whether to
process J and K beyond the split-off point. Information about J and K follows.
Product J Product K
Tons produced 25,000 15,000
Separable variable processing costs
beyond split-off P64,000 P100,000
Selling price per ton at split-off 15 52
Selling price per ton after additional processing 21 58
If India desires to maximize total company income, what should the firm do with regard
to Products J and K?

Solution:

Product J Product K
Selling price after additional processing P 21 P 58
Less: Selling price at split-off point 15 52
Incremental revenue 6 6
Multiply by: Units produced 25,000 15,000
Total incremental revenue 150,000 90,000
Less: Additional processing costs 64,000 100,000
Incremental Profit (Loss) P 86,000 P (10,000)
Decision Process
Sell now
further

2) Special Sales Pricing/Accept or Reject Special Order

A special order is a one-time order that is not considered part of the company’s
ongoing business. Managers may be asked to consider accepting a special order for
their product at a reduced price to make use of the excess or idle facilities.

Decision guideline: If there is an incremental profit, accept!

In deciding whether to accept or reject a special order, the paramount consideration
is incremental profit, determined as follows:
Incremental sales Px
Incremental costs (x)
Incremental profit or (loss) X
Opportunity costs (benefit) from the alternative use of capacity (x)
Net advantage (disadvantage) of accepting special order P XX

Sample Problem

Sound, Inc., reported the following results from the sale of 24,000 units of IT-54:
Sales P528,000
Variable manufacturing costs 288,000
Fixed manufacturing costs 120,000
Variable selling costs 52,800
Fixed administrative costs 35,200

Rhythm Company has offered to purchase 3,000 IT-54s at P16 each. Sound has available
capacity, and the president is in favor of accepting the order. She feels it would be
profitable because no variable selling costs will be incurred. The plant manager is
opposed because the "full cost" of production is P17. What will be the change in income
if the special order is accepted?

Solution:

Incremental Sales (3,000*P16) P48,000

Incremental Costs (3,000*P12) (36,000)
(288,000/24,000 = 12)
Incremental Profit P12,000
*If the special order is accepted the profit will increase by P12,000.

3) Utilization of Scarce Resources

It is a judgment regarding the best use of scarce resources so as to maximize the total
net income of a business. Scarcity of different resources puts constraints on the
amount of product that can be produced using those resources.

When capacity becomes pressed because of a scarce resources, the firm is said to have
a constraint. Because of the constrained scarce resources, the company cannot fully
satisfy demand, so the manager must decide how the scarce resources should be
used.

Decision guideline: Prioritize the product that gives that gives the highest CM per
limited resource.
To optimize scarce resources, sales and production should be allocated to a product
that gives the highest profit per scarce resource. If the scarce resource is direct labor
hour, then produce the product that gives the highest CM per DL hour , computed as
follows:
CM per hour= UCM/No. Of hours per unit
CM per hour= UCM x no. Units per hour
Sample Problem

Smith Manufacturing has 27,000 labor hours available for producing X and Y. Consider
the following information:
Product X Product Y
Required labor time per unit (hours) 2 3
Maximum demand (units) 6,000 8,000
Contribution margin per unit P5.00 P6.00
Contribution margin per labor hour. P2.50 P2.00

If Smith follows proper managerial accounting practices, what will be the product mix that
the company should set?

Solution:

Based on the contribution margin per labor hour Product X (P2.50 per LH) will be the top
priority for production and followed by Product Y (P2.00 per LH). The decision is based on
the constraint resources which is the labor hours.

Product X
Maximum demand 6,000 units
Multiply by: Require labor time per unit 2 hrs
Total hours need 12,000 hrs.

Product Y
Total labor hours available 27,000 hours
Total hours needed for Product X (12,000 hours)
Excess/idle labor hours 15,000 hours
Divided by: Require labor time per unit 3 hrs.
Total units produced 5,000 units

*The product mix consist of 6,000 units of Product X and 5,000 units of Product Y.

3) Shutdown or Continue Operations

It is a choice that the company make if it is essential for a firm to shut down
temporarily or to continue operations. This type of decision usually arises when a firm
is highly seasonal/cyclical and is expected to experience cyclical lows during
foreseeable periods.

Decision guideline:
 Continue operations; if sales > shutdown point
 Shutdown operations; if sales < shutdown point
Shutdown Point – is a level of operations at which a company experiences no benefit
for continuing operations and therefore decides to shutdown temporarily.
Fixed costs – Shutdown costs
Shutdown point =
Unit Contribution Margin
Shutdown costs – means all costs associated with shutting down or suspending the
business operation. This includes safety and security, re-start-up costs and etc.

Sample Problem

Ben Corporation had been experiencing a slowdown in business activities in August and
September and is considering temporarily shutting down its operations during those
months. The accounting Department has provided the following normal operating data
for considerations.
Unit sales price P 150
Unit variable production costs 60
Unit variable marketing costs 10
Monthly fixed overhead 500,000
Monthly fixed expenses 200,000
Regular sales in units 10,000 per month
Estimated sales in units in Aug and September 5,000 per month

If the company shut down its operations, the following costs are expected to be incurred.

Security and safety P 200,000

Re-start up costs P 100,000
Regular fixed overhead 40% of the total remain
Regular fixed expenses will be reduced by 30%

Which alternative, continuing or discontinuing the operations , is advisable and by how

much is its advantage?

Solution:

Security & safety

P 400,000
(200,000* 2 mons.)
Re-start-up costs 100,000
Fixed overhead
400,000
(500,000*40%*2 mons.)
Fixed expenses
280,000
(200,000*70%*2mons.)
Total shutdown costs P1,180,000

Shutdown point = 1,400,000 – 1,180,000

150 - 70
= 2,750 units

If continue the operation:

Sales (5,000*2mons*P150) P1,500,000
Less: Variable costs (5,000*2mons*P70) 700,000
Contribution margin 800,000
Less: Fixed costs 1,400,000
Net Loss P(600,000)

If shutdown the operation:

Shutdown cost P 1,180,000

Decision: To continue the operation because of an advantage of P580,000 (P1,180,000 –

P600,000).

4) Pricing Products and Services

The pricing decision can be critical because
1) The prices charged for a firm’s products largely determine the quantities
customers are willing to purchases, and
2) The prices should be high enough to cover all the costs of the firm.

Cost-plus Pricing
The most basic approach in pricing decision is that the price of the product or service
should cover all the costs that are traceable to the product and services, variable as
well as fixed.

The formula is expressed as follows:

Target selling price = [ Cost + (Markup percentage * Cost)]

Products however, may be costed in at least two different ways:

1) By the Absorption approach – where the cost base is defined as the cost to
manufacture one unit and therefore excluded all selling, general and
administrative expenses.
2) By the Contribution approach – where cost base consists of all variable cost
associated with a product including variable selling, general and
administrative expenses.

Determining the markup percentage

Under the absorption approach to cost-pus pricing:

Desired return of assets
- SGA expenses
employed
Markup percentage
= Unit
on absorption cost
Volume in units X manufacturing
costs

Under the contribution approach to cost-pus pricing:

Desired return of assets
- Fixed costs
Markup percentage employed
=
on absorption cost Unit variable
Volume in units X
costs

I. True or False:
Write “TRUE” if the statement is true otherwise write “FALSE” if the statements is
incorrect.

1) Future costs that do not differ between the alternatives in a decision are
avoidable costs.
2) The book value of an old machine is always considered a sunk cost in a
decision.
3) In a decision to drop a product, the product should be charged for rent in
proportion to the space it occupies even if the space has no alternative use
and the rental payment is unavoidable.
4) In a special order situation that involves using existing idle capacity,
opportunity costs are zero.
5) In a sell or process further decision, an avoidable fixed production cost
incurred after the split-off point is relevant to the decision.

VI. Understand the technical aspect of the feasibility study.

1. Feasibility Study. Is an analysis that takes all of a project's relevant factors into account—
including economic, technical, legal, and scheduling considerations—to ascertain the
likelihood of completing the project successfully. Project managers use feasibility studies
to discern the pros and cons of undertaking a project before they invest a lot of time and
money into it.
The Technical Aspect of a project feasibility study will cover the following:
I. Production Program
II. Plant Capacity
III. Materials and Inputs
IV. Location and Site
V. Process Engineering

1. Production Program
The following areas will be covered:
1.1. Data and alternatives
1.1.1. Describe the data required to set up a production program
1.1.2. Describe possible alternative production programs
1.2. Selection of production program
1.2.1. State reasons for selection
1.2.2. Describe in detail the production program
1.3. For emissions such as:
1.3.1. wastes and affluent dust, fumes, noise
1.3.2. quantities of emissions
1.3.3. time schedule
1.3.4. means of treatment
1.4. Estimate cost of estimates disposal
1.4.1. Treat
1.4.2. Disposal in dumps and/or sewage system

2. Plant Capacity
Coverage of the study for this part follows:
2.1. Data and alternatives
2.1.1. Describe data for the determination of plant capacity
2.1.2. List possible alternatives on plant capacity
2.2. Determination of feasible normal capacity
2.2.1. Select and describe in detail the feasible normal plant capacity
2.2.2. State reasons for selection
2.2.3. Describe nominal maximum capacity

3. Materials and Inputs

3.1. Data and alternatives
3.1.1. Describe the data for selection of materials and inputs
3.1.2. List all required materials and inputs and show alternatives
3.1.3. Selection and description of materials and inputs
3.2. Supply program
3.2.1. Describe fundamental data for the preparation of the supply program
3.2.2. Prepare supply program, show alternatives

4. Location and Site

This will cover the study of the following issues:
4.1. Location
4.1.1. Data and alternatives
4.1.1.1. Describe the fundamental data and requirements on the locations for
plant operation
4.1.1.2. List possible locations, describe and show them on maps of appropriate
scale
4.2. Site
4.2.1. Data and alternatives
4.2.1.1. Describe the fundamental data and requirements on site for plant
erection and operation
4.2.1.2. List possible locations, describe and show them on maps of appropriate
scale
4.2.2. Site selection
4.2.3. Cost estimate
4.2.3.1. Investment
4.2.3.2. Production costs
4.2.3.3. Local condition
4.2.3.4. Environment impacts

5. Process Engineering
This area of the feasibility study covers the following:
5.1. Project layouts
5.2. Scope of project
5.3. Technology
5.4. Equipment
5.5. Civil engineering works