final copy of accounts prjct

8/8/2019 final copy of accounts prjct

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WORKING

CAPITAL

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ACKNOWLEDGEMENT

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ANY ACCOMPLISHMENT REQUIRES THE EFFORT OF MANY PEOPLE AND THIS

WORK IS NO DIFFERENT.WE WOULD LIKE TO THANK PROF.FATIMA FOR

GIVING US AN OPPURTUNITY FOR DOING THE PRIJECT TOGETHER AND FOR

HELPING AND GUIDING US IN COMPLETION OF THE PROJECT.

WE WOULD ALL THANKS OUR PARENTS AND FRIENDS WHO HAVE

SUPPORTED US AND HELPED US THE PROJECT AND CONSTANTLY MOTIVATED

US IN DOING THE PROJECTT. THIS WAS A NEW LEARNING EXPERIENCE FOR

US AND WILL DEFINILY HELP IN FUTURE.

REGARDLESS OF RHE SOURCE WE WISH TO EXPRESS OUR GRATITUDE TO

TJOSE WHO HAVE CONTRIBUTED TO THIS WORK EVEN THOUGH

ANONYMOUSLY.

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DECLARATION

We the student of royal college of SYBMS 3rd Semesterhereby declare that we have completed this project on

16th Aug in the Academic Year 2010-2011. The

information submitted is true and original to the best

for our knowledge.

PRESENTED BY

NAME OF STUDENTS ROLL NO.

PRIYANKA GAIKWAD 07

RUBY KHOT 13

SABINA MUSA 15

AFSHA RATANSI 19

SHAHISTA SHAIKH 23

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INDEX

SR. NO. TOPICS PG NO.

1 WHAT DOES COST ACCOUNTINGMEAN?

5

2 EMERGENCE OF COST ACCOUNTING 6

3 EXPANDING USES 7

4 BASICS OF COSTING METHODS 8

5 ESTIMATING TOTAL COST 10

6 WORKING CAPITAL DEFINATION 11

7 INTRODUCTION TO WORKING

CAPITAL

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8 IMPORTANCE AND ASPECTS OF

WORKING CAPITAL

14

9 WORKING CAPITAL POLICY 17

10 IMPORTANCE OF WORKING CAPITAL

RATIOS

20

11 WHERE IS WORKING CAPITAL

ANALYSIS MOST CRITICAL

24

12 WORKING CAPITAL CYCLE 25

13 SOURCES AND OTHER REQUIRMENTS

OF WORKING CAPITAL

27

13 OVERVIEW OF CURRENT METHODS 28

15 ACCOUNT ANALYSIS 30

16 FUTURE OF COST ACCOUNTING 33

17 BALANCE SHEET ANALYSIS 36

18 INCOME STATEMENT RATIOANALYSIS

39

19 CONCLUSION 42

20 BIBLOGRAPHY 43

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What Does Cost Accounting Mean?

A type of accounting process that aims to capture a company's costs of

production by assessing the input costs of each step of production as well as

fixed costs such as depreciation of capital equipment. Cost accounting will

first measure and record these costs individually, then compare input results

to output or actual results to aid company management in measuring

financial performance.

HISTORY OF COSTING METHODS

Double-entry bookkeeping,developed in Northern Italy in the

14th and 15th centuries, was the predecessor to modem accounting

methods. Early modem methods were developed in the United States in the

1850s and 1860s by accountants in the railroad industry. These methods

were just one of several innovations originating with the railroads that

marked the transition from traditional to modem business enterprise. Most

important were the developments of J. Edgar Thomson and his cohorts at thePennsylvania Railroad. The work of these and other pioneering accountants

in the railroad industry was the subject of widespread public discussion and

numerous articles in the new financial journals of the day

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EMERGENCE OF COST ACCOUNTING.

Cost accounting was one of three interrelated types of

accounting developed at the time, the others being financial and capital

accounting. Financial accounting addressed issues relating to a firm's daily

financial transactions, as well as overall profitability. For example, railroads

began deriving operating ratios in the late 1850s, which for the first timerelated absolute quantities of profit and loss to business volume. Capital

accounting addressed issues relating to the valuation of a firm's capital

goods. This was particularly important in the railroad industry given the

unprecedented quantities of capital involved and the problem of how to

account for the repair and renewal of capital.

Innovations in cost accounting followed those in financial and capital

accounting. Cost accounting involved the determination and comparison ofcosts among a firm's divisions or operations. Thus the historical development

of cost accounting accommodated the development of the multidivisional

firm towards the end of the 19th century. There was necessarily a

considerable amount of overlap among financial, capital, and cost

accounting. For example, to accurately determine unit costs, it was

necessary to relate overhead costs and capital depreciation to the volume of

production. At the same time, unit costs were typically used to determine

prices, which in turn affected financial accounts. The separation of thesetypes of accounting followed their historical institutional separation. That is,

until the innovations of E.I. Du Pont de Nemours & Co. in the 20th century,

financial, capital, and cost accounting operations were carried out in relative

autonomy within firms.

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Cost accounting was first used by the Louisville & Nashville Railroad in

the late 1860s. This enabled the company to determine such measures as

comparative cost per ton-mile among its branches, and it was by these

measures, rather than earnings or net income,that the company evaluated

the performance of its managers.

EXPANDING USES.

The largest U.S. manufacturing firms in the 1870s were textileproducers. Because these years were a period of hardship for the industry,

textile producers began to devote more attention to the determination and

control of costs. By 1886, Lyman Mills, one of the country's largest textile

producers, began to determine unit costs for its various products, though it

did not use this information to make pricing or investment decisions. The

Standard Oil Trust, formed in 1882, also began to determine the comparative

costs of their different refineries in the 1880s and on this basis opted to

concentrate production in their largest units. However, the enterprise did not

accurately account for overhead or capital depreciation in its determination

of costs.

The firm with the most detailed and sophisticated costing methods in the

1880s was the Carnegie Company, a steel producer. In this case, the

connection between costing methods in the railroad and manufacturing

industries was direct, as Andrew Carnegie patterned the organization of his

firm after the Pennsylvania Railroad, where he had been an executive.

Carnegie's costing method was referred to as the voucher system of

accounting. In this system, each of the company's departments kept track of

the quantity and price of materials and labor for each order. These data were

aggregated into cost sheets that the company's accountants were able to

produce on a daily basis. Though the Carnegie Company made extensive use

of its cost sheets to determine prices, it focused on prime rather than

overhead and depreciation costs.

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THE BASICS OF COSTING METHODS

FIXED COSTS.

One of the key issues in conventional costing methods (i.e., process

costing and job-order costing) is distinguishing among types of costs. A basic

distinction is made between fixed and variable costs. Fixed costs are those

costs that are invariant with respect to changes in output and would accrue

even if no output were produced. Such costs might include interest

payments on the purchase of plant and equipment, rent, property taxes, andexecutive salaries. The notion of fixed costs is restricted within a certain time

frame, since over the long run fixed costs can vary. For example, a

manufacturer may decide to expand capacity in the face of increased

demand for its product, requiring a higher level of expenditure on plant and

equipment.

VARIABLE COSTS.

Variable costs change proportionately to the level of output. For

manufacturers, a key variable cost is the cost of materials. In terms of total

costs at increasing output levels, fixed costs are constant and variable costs

are increasing at a constant rate. In terms of unit costs at increasing output

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levels, fixed costs are declining, and variable costs constant. Manufacturers

are vitally interested in unit costs with respect to changes in output levels,

since this determines profit per unit of output at any given price level. The

characteristics of fixed and variable costs indicates that as output increases,

unit costs will decline, since there is constant variable cost and lesser fixed

cost embodied in each unit. These costing methods thus suggest that it is in

manufacturers' interest to run, within the limits of plant design, at high

capacity levels.

DIRECT COSTS.

Costing methods distinguish between the direct and indirect costs of

any costed object. Direct costs are those costs readily traceable to the

costed object, whereas indirect costs are less-readily traceable. Direct costs

typically include the major components of any manufactured good and the

labor directly required to produce that good.

INDIRECT COSTS.

Indirect costs include plant-wide costs such as those resulting from

the use of energy and fixed capital, but indirect costs may also include thecosts of minor components such as solder or glue. While all costs are

conceivably traceable to a costed object, the determination of whether to do

so depends on the cost-effectiveness with which this can be done. Indirect

costs of all kinds are sometimes referred to as overhead, and in this sense

prime costs can be distinguished from overhead costs.

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WORKING CAPITAL

DEFINITION

Current asset minus current liabilities, Workingcapital measures how much in liquid assets a company has available to buildits business. The number can be positive or negative, depending on howmuch debt the company is carrying. In general, companies that have a lot ofworking capital will be more successful since they can expand and improvetheir operations. Companies with negative working capital may lackthe funds necessary for growth. also called net current assets or currentcapital.

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A recurring theme in this series is the importance of investorsshaping their analytical focus according to companies' business models.Especially when time is limited, it's smart to tailor your emphasis so it's inline with the economic drivers that preoccupy the company's industry. It'stough to get ahead of the "investing pack" if you are reacting to generic

financial results - such as earnings per share (EPS) or revenue growth - afterthey've already been reported. For any given business, there are usuallysome key economic drivers, or leading indicators, that capture and reflectoperational performance and eventually translate into laggingindicators such as EPS. For certain businesses, trends in the working capitalaccounts can be among these key leading indicators of financialperformance.

IntroductionWorking capital may be regarded as the life blood of business. Working

capital is of major importance to internal and external analysis because of itsclose relationship with the current day-to-day operations of a business. Everybusiness needs funds for two purposes.

* Long term funds are required to create production facilities throughpurchase of fixed assets such as plants, machineries, lands, buildings & etc

* Short term funds are required for the purchase of raw materials, paymentof wages, and other day-to-day expenses. . It is other wise known asrevolving or circulating capital

It is nothing but the difference between current assets and currentliabilities. i.e. Working Capital = Current Asset Current Liability.

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Businesses use capital for construction, renovation, furniture, software,equipment, or machinery. It is also commonly used to purchase inventory, orto make payroll. Capital is also used often by businesses to put a downpayment down on a piece of commercial real estate. Working capital isessential for any business to succeed. It is becoming increasingly important

to have access to more working capital when we need it.Working Capital is more a measure of cash flow than a ratio. The result

of this calculation must be a positive number. It is calculated as shownbelow:

Working Capital = Total Current Assets - Total CurrentLiabilities

Bankers look at Net Working Capital over time to determine acompany's ability to weather financial crises. Loans are often tied tominimum working capital requirements.

A general observation about these three Liquidity Ratios is that thehigher they are the better, especially if you are relying to any significantextent on creditor money to finance assets.

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Importance of Adequate WorkingCapital

A business firm must maintain an adequate level of working capital in orderto run its business smoothly. It is worthy to note that both excessive andinadequate working capital positions are harmful. Working capital is just like

the heart of business. If it becomes weak, the business can hardly prosperand survive. No business can run successfully without an adequate amountof working capital.

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DANGER OF INADEQUATE WORKING CAPITAL

When working capital is inadequate, a firm faces the following problems.Fixed Assets cannot efficiently and effectively be utilized on account of lackof sufficient working capital. Low liquidity position may lead to liquidation of

firm. When a firm is unable to meets its debts at maturity, there is anunsound position. Credit worthiness of the firm may be damaged because oflack of liquidity. Thus it will lose its reputation. There by, a firm may not beable to get credit facilities. It may not be able to take advantages of cashdiscount.

CONCEPT OF WORKING CAPITAL

1) Gross Working Capital = Total of Current Asset

2) Net Working Capital = Excess of Current Asset over Current Liability

Current Assets Current Liabilities

Cash in hand / at bankBills ReceivableSundry DebtorsShort term loansInvestors/ stock Temporary investmentPrepaid expensesAccrued incomes

Bills PayableSundry CreditorsOutstanding expensesAccrued expensesBank Over draft

One of the most important areas of finance to monitor is yourcompany's working capital, which is the difference between current assets

and current liabilities. As a small business owner, you must constantly bealert to changes in working capital and their implications; otherwise, youmay miss some warning signs that can lead to business failure. The mostimportant component of working capital is cash, far the most important assetof any business, particularly a small business. Without it, the business will

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fail. So it is of paramount importance for you as the business owner tocontrol all cash transactions.

It is helpful for us, as a business owner, to think of

working capital in terms of five components:

1. Cash and equivalents. This most liquid form of working capital requiresconstant supervision. A good cash budgeting and forecasting systemprovides answers to key questions such as: Is the cash level adequate tomeet current expenses as they come due? What is the timing relationshipbetween cash inflow and outflow? When will peak cash needs occur? Whenand how much bank borrowing will be needed to meet any cash shortfalls?When will repayment be expected and will the cash flow cover it?

2. Accounts receivable. Many businesses extend credit to their customers.If you do, is the amount of accounts receivable reasonable relative to sales?How rapidly are receivables being collected? Which customers are slow topay and what should be done about them?

3. Inventory. Inventory is often as much as 50 percent of a firm's currentassets, so naturally it requires continual scrutiny. Is the inventory levelreasonable compared with sales and the nature of your business? What's therate of inventory turnover compared with other companies in your type ofbusiness?

4. Accounts payable. Financing by suppliers is common in small business;it is one of the major sources of funds for entrepreneurs. Is the amount ofmoney owed suppliers reasonable relative to what you purchase? What isyour firm's payment policy doing to enhance or detract from your creditrating?

5. Accrued expenses and taxes payable. These are obligations of yourcompany at any given time and represent a future outflow of cash.

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Working Capital policy

PRINCIPLES OF RISK VARIATION

* Here risk refers to the inability of a firm to meet its obligation, when theybecome due for payment.* There is a definite inverse relationship between the degree of risk &profitability.* A management prefers to minimize risk by maintaining a higher level ofcurrent assets or working capital.

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PRINCIPLES OF COST OF CAPITAL

* Generally, higher the risk lower is the cost & lowers the risk, higher is thecost.* A sound working capital management should always try to achieve a

proper balance b/w these two.

PRINCIPLES OF EQUITY POSITION

* It is concerned with planning the total investment in Current Asset.* Every rupee invested in the current assets should contribute to the networth of the firm.

The level of Current Asset may be measured with the help of two ratios

Current assets as a % of total assets. Current assets as a % of total sales.

PRINCIPLE OF MATURITY OF PAYMENT

It is concerned with planning the sources of finance for working capital. A firm should make every effort to relate maturities of payment to its

flow of internally generated funds.

Estimation / forecast of working capitalrequirements

"Working capital is the life blood & controlling nerve centre of a business."No business can be successfully run without an adequate amount of workingcapital.

To avoid the shortage of working capital at once, an estimate ofworking capital requirement should be made in advance.

But estimation of working capital requirements is not an easy task & alarge no. of factors has to be considered before starting this.

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Factors requiring consideration while estimatingworking capital.

The average credit period expected to be allowed by suppliers. Total costs incurred on material, wages. The length of time for which raw material are to remain in stores

before they are issued for production. The length of the production cycle (or) work in process. The length of sales cycle during which finished goods are to be kept

waiting for sales. The average period of credit allowed to customers

The amount of cash required to make advance payment

Factors determining working capital requirements

Nature of business Size of business Production policy Manufacturing process Seasonal variations Working capital cycle Rate of stock turn over Credit policy Business cycles Rate of growth of business Price level changes Earning capacity & dividend policy Other factors.

Importance of Working Capital Ratios

Ratio analysis can be used by financial executives to check upon theefficiency with which working capital is being used in the enterprise. The

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following are the important ratios to measure the efficiency of workingcapital. The following, easily calculated, ratios are important measures ofworking capital utilization.

Ratio Formulae Result Interpretation

StockTurnover(in days)

Average Stock* 365/Cost of GoodsSold

= xdays

On average, you turn over the valueof your entire stock every x days.You may need to break this downinto product groups for effectivestock management.Obsolete stock, slow moving lineswill extend overall stock turnoverdays. Faster production, fewerproduct lines, just in time orderingwill reduce average days.

Receivables Ratio(in days)

Debtors * 365/Sales

= xdays

It take you on average x days tocollect monies due to you. If yourofficial credit terms are 45 day and ittakes you 65 days... why ?One or more large or slow debts candrag out the average days. Effectivedebtor management will minimizethe days.

PayablesRatio(in days)

Creditors *365/Cost of Sales

(or Purchases)

= xdays

On average, you pay your suppliersevery x days. If you negotiate bettercredit terms this will increase. If you

pay earlier, say, to get a discountthis will decline. If you simply deferpaying your suppliers (withoutagreement) this will also increase -but your reputation, the quality ofservice and any flexibility providedby your suppliers may suffer.

CurrentRatio

Total CurrentAssets/Total CurrentLiabilities

= xtimes

Current Assets are assets that youcan readily turn in to cash or will doso within 12 months in the course ofbusiness. Current Liabilities are

amount you are due to pay withinthe coming 12 months. For example,1.5 times means that you should beable to lay your hands on $1.50 forevery $1.00 you owe. Less than 1times e.g. 0.75 means that you could

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have liquidity problems and be underpressure to generate sufficient cashto meet oncoming demands.

QuickRatio

(Total CurrentAssets -

Inventory)/Total CurrentLiabilities

= xtimes

Similar to the Current Ratio but takesaccount of the fact that it may take

time to convert inventory into cash.

WorkingCapitalRatio

(Inventory +Receivables -Payables)/Sales

As %Sales

A high percentage means thatworking capital needs are highrelative to your sales.

Other working capital measures include the following:1. Bad debts expressed as a percentage of sales.2. Cost of bank loans, lines of credit, invoice discounting etc.3.Debtor concentration - degree of dependency on a limited number ofcustomers.

Once ratios have been established for our business, it is important totrack them over time and to compare them with ratios for other comparablebusinesses or industry sectors.

A measure of both a company's efficiency and its short-term financial health. The working capital ratio iscalculated as:

Positive working capital means that the company is able to pay off itsshort-term liabilities. Negative working capital means that a companycurrently is unable to meet its short-term liabilities with its current assets(cash, accounts receivable, inventory).Also known as "net working capital".

If a company's current assets do not exceed its current liabilities, thenit may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longertime period could also be a red flag that warrants further analysis. Forexample, it could be that the company's sales volumes are decreasing, andas a result, its accounts receivables number continues to get smaller andsmaller.

Working capital also gives investors an idea of the company's

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underlying operational efficiency. Money that is tied up in inventory ormoney that customers still owe to the company cannot be used to pay offany of the company's obligations. So, if a company is not operating in themost efficient manner (slow collection), it will show up as an increase in theworking capital. This can be seen by comparing the working capital from one

period to another; slow collection may signal an underlying problem in thecompany's operations.

Working Capital Is The DifferenceBetween Current Assets And CurrentLiabilities:

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Where is Working Capital AnalysisMost Critical?

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Working capitalis always significant. This is especially true fromthe lender's or creditor's perspective, where the main concern isdefensiveness: can the company meet its short-term obligations, such aspaying vendor bills?

But from the perspective of equity valuation and the company's growthprospects, working capital is more critical to some businesses than to others.At the risk of oversimplifying, we could say that the models of thesebusinesses are asset or capital intensive rather than service or peopleintensive.

Examples of service intensive companies include H&R Block, whichprovides personal tax services, and Manpower, which provides employmentservices. In asset intensive sectors, firms such astelecom and pharmaceutical companies invest heavilyin fixed assets for the long term, whereas others invest

capital primarily to build and/or buy inventory. It is thelatter type of business - the type that is capital intensivewith a focus on inventory rather than fixed assets - thatdeserves the greatest attention when it comes toworking capital analysis. These businesses tend toinvolve retail, consumer goods and technologyhardware, especially if they are low-cost producers or distributors.

Working Capital Cycle

Cash flows in a cycle into, around and out of a business. It is thebusiness's life blood and every manager's primary task is to help keep itflowing and to use the cash flow to generate profits. If a business isoperating profitably, then it should, in theory, generate cash surpluses. If itdoesn't generate surpluses, the business will eventually run out of cash andexpire. The faster a business expands the more cash it will need for working

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capital and investment. The cheapest and best sources of cash exist asworking capital right within business. Good management of working capitalwill generate cash will help improve profits and reduce risks. Bear in mindthat the cost of providing credit to customers and holding stocks canrepresent a substantial proportion of a firm's total profits.

There are two elements in the business cycle that absorb cash- Inventory (stocks and work-in-progress) and Receivables (debtors owingyou money). The main sources of cash are Payables (your creditors)and Equity and Loans.

Each component of working capital (namely inventory, receivables andpayables) has two dimensions TIME and MONEY. When it comes tomanaging working capital - TIME IS MONEY. If you can get money to move

faster around the cycle (e.g. collect monies due fromdebtors more quickly) or reduce the amount of moneytied up (e.g. reduce inventory levels relative to sales),the business will generate more cash or it will need toborrow less money to fund working capital. As aconsequence, you could reduce the cost of bank

interest or you'll have additional free money availableto support additional sales growth or investment.Similarly, if you can negotiate improved terms withsuppliers e.g. get longer credit or an increased creditlimit, you effectively create free finance to help fundfuture sales.

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Sources of Additional WorkingCapital

Sources of additional working capital include the following:

* Existing cash reserves* Profits (when you secure it as cash)* Payables (credit from suppliers)* New equity or loans from shareholders* Bank overdrafts or lines of credit* Long-term loans

If you have insufficient working capital and try to increase sales,you can easily over-stretch the financial resources of the business. Thisis called overtrading. Early warning signs include:

* Pressure on existing cash* Exceptional cash generating activities e.g. offering high discounts forearly cash payment* Bank overdraft exceeds authorized limit* Seeking greater overdrafts or lines of credit

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* Part-paying suppliers or other creditors* Paying bills in cash to secure additional supplies* Management pre-occupation with surviving rather than managing* Frequent short-term emergency requests to the bank (to help paywages, pending receipt of a cheque).

OVERVIEW OF CURRENT METHODS

PROCESS AND JOB-ORDER COSTING.

There are two conventional costing approaches used in manufacturing.

The first, and more common, is process costing. Used in most mass-

production settings, a process cost system analyzes the net cost of a

manufacturing process, say filling bottles with soda, over a specified period

of time. The unit cost for filling bottles is simply the net costs incurred while

filling all the bottles during the period divided by the number of bottles filled.

Since most manufacturing processes involve more than one step, a similar

calculation is made for each step to arrive at a unit cost average for the

entire production system. By contrast, the second major costing method, job-

order costing, is concerned with tracking all the costs on an individual

product basis. This is useful in settings where each unit of production is

customized or where there are very few units produced, such as in building

pianos, ships, or airplanes. Under job order costing, the exact costs incurred

in the production of a particular unit are recorded and are not necessarily

averaged with those of any other unit, since every unit may be different. Job-

order costing is also widely used outside manufacturing. A single

manufacturer may use both process and job-order costing for different parts

of its operations.

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ACTIVITY-BASED COSTING.

Activity-based costing(ABC) is a secondary and somewhat

complementary (or better, supplementary) method to the two traditional

costing techniques. Whereas traditional methods might classify costs in

generic categories like direct materials, labor, and other overhead, ABC

clusters all the costs associated with a single manufacturing task, regardless

of whether they fall under the headings of labor or materials or something

else. So in the bottling example activity-based costs might include operating

the dispensing machines, performing quality checks, moving pallets of

bottles, and so forth.

Each of these activities may involve human labor, equipment costs,

energy and expendable resources, and materials, but for analytic purposes

the costs are all lumped together under a single activity concept. The

advantage of this approach is that management can then observe which

tasks cost the most versus which add the most value; this analysis may

indicate that a disproportionate amount of money is being spent on low-

value activities, signaling a need for process changes or for outsourcing to a

vendor that can perform the tasks less expensively. Use of this method is

sometimes referred to as activity-based cost management (ABCM) or simply

activity-based management

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ACCOUNT ANALYSIS.

In account analysis, all costs are classified as either strictly fixed or

variable. This has the advantage of ease of computation. However, some

costs may be semi variable costs or step costs. Utility bills are typically semi

variable in that they contain fixed and variable components. Step costs

increase in discrete jumps as the level of output increases. In account

analysis, such costs are typically categorized as either fixed or variable

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depending which element predominates. Thus, the accuracy of account

analysis depends in large part on the proportion of costs that are not strictly

fixed or variable. For many manufacturing firms, account analysis provides a

sufficiently accurate estimation of total costs over a range of output levels.

ENGINEERING APPROACH.

The engineering approach infers costs from the specifications of a

product. The approach works best for determining direct material costs and

less well for direct labor costs and overhead costs. The advantage of the

engineering approach is that it enables manufacturers to estimate what aproduct would cost without having previously produced that product,

whereas the other methods are based on the costs of production that has

already occurred.

HIGH-LOW APPROACH.

In the high-low approach, a firm must know its total costs for

previous high and low levels of output. Graphing total costs against output,

total costs over a range of output are estimated by fitting a straight line

through total cost points at high and low levels of output. If changes in total

costs can be accurately described as a linear function of output, then the

slope of the line indicates changes in variable costs.

The problem with the high-low approach is that the two data points

may not, for whatever reasons, accurately represent the underlying total

cost-output relationship. That is, if additional total cost-output points were

plotted, they might lay significantly wide of the line connecting the two initial

high-low points.

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LINEAR REGRESSION.

Linear regression analysis addresses the shortcomings of the high

low approach by fitting a line through all total cost-output points. The line is

fitted to minimize the sum of squared differences between total cost-output

points and the line itself, in standard linear regression fashion. The drawback

of this approach is that it requires more data points than the other

approaches.

The relation of total costs to output levels is combined in the idea

of standard costs. Standard costs are estimates of unit costs at targeted

output levels, including direct materials costs, direct labor costs, and indirect

costs. Standard costs are used to prepare budgets for planned productionand to assess production that has occurred. The estimation of standard costs

requires the separate estimation of standards for direct materials, direct

labor, and overhead.

DIRECT MATERIALS.

Direct material standards are the easiest to estimate. Costs are

determined from the prices of all necessary material inputs into the product,plus sales tax, shipping, and other related costs. Unanticipated price changes

complicate this otherwise straightforward process. Since standard costs are

a measure of unit costs, it is also necessary to determine the quantity of

materials per unit. This can be done using an engineering approach.

DIRECT LABOR.

Direct labor standards are somewhat more difficult to estimate. Thedetermination of costs must account for wages, though if workers in a

production process are earning different wages, it is necessary to estimate a

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weighted average of wage costs. The cost of benefits, employment related

taxes, and overtime pay must also be accounted for. As with direct material

standards, the quantity of direct labor required to produce a unit of output

can be estimated with an engineering approach. Average set-up time and

downtime must also be included in the estimation. Many union contracts

codify labor time standards, which can make budgeting easier.

OVERHEAD.

Overhead standards are the most difficult to estimate, and they are

typically accounted for in an approximate manner. The problem ofaccounting for overhead costs per unit of output was noted aboveit is often

difficult to trace indirect costs to a particular product. The problem is made

more complicated if these costs are highly centralized within a plant and if

multiple products are produced within a plant. Overhead standards are

typically estimated by taking total overhead costs and relating them to a

more readily-knowable measure, such as direct labor hours, direct labor

costs, or machine hours used. Direct labor hours was traditionally the most

widely-used measure for determining overhead standards, but the growth ofautomated plants resulted in a shift to machine hours used.

FUTURE OF COST ACCOUNTING

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EXPANSION AND INTEGRATION OF ABC.

Widespread corporate interest in activity-based costing (ABC), which

started in the late 1980s and has continued through the late 1990s, has

created dueling cost accounting systems for some companies. Managers

want the analytic power of an ABC system, yet may also require some of the

conventional abilities and rigor of a traditional system like process or job

costing. The failure to integrate these competing needs has caused some

firms to abandon or at least reconsider ABC initiatives, which can be

expensive and time-consuming to implement in a large operation. Some

managers have viewed it as an either-or dilemma, and often ABC is eyed

with some suspicion, as indeed early formulations of it were not effective

substitutes for conventional costing methods. However, many successful

ABC implementations use it as a supplement to, rather than a replacement

for, standard methods. Advocates of ABC have begun to formulate ways in

which ABC can be better integrated with conventional methods so that

companies can enjoy the benefits of both. In 1999 the Institute of

Management Accountants (IMA), the leading professional organization

for managerial accountants, published renewed guidelines for companies

wishing to implement ABC practices, following a series of previous

statements on using ABC dating back to the early 1990s. The IMA's

statements included a number of cautions against potential pitfalls in

establishing an ABC system.

TARGET COSTING.

A related practice that has also enjoyed quite a bit of attention sincethe mid-1990s is target costing, which is a method of engineering a product

and its manufacturing process from the start with a specific cost model in

mind. This approach, which is essentially an elaboration of the engineering

costing approach, attempts to create an optimally efficient process from the

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startwith a profitable yet marketable selling price in mindrather than

waiting until a product is already being manufactured and then setting prices

and looking for cost savings. Some implementations of target costing

actually don't involve accountants as much as they invlolve product

marketing managers, engineers, and others who are part of the actual

design and production processes. IMA guidelines also exist for target costing

systems.

In the world of manufacturingas competition becomes more intenseand customers demand more servicesit is important that management notonly control its overhead but also understand how it is assigned to productsand ultimately reported on the company's financial statements.We view overhead as two types of costs and define them as follows:

1. Manufacturing overhead: - Manufacturing overhead (also referred toas factory overhead, factory burden and manufacturing support costs) refersto indirect factory-related costs that are incurred when a product ismanufactured. Along with costs such as direct material and direct labor, thecost of manufacturing overhead must be assigned to each unit produced sothat Inventory and Cost of Goods Sold are valued and reported accordingto generally accepted accounting principles (GAAP).

Manufacturing overhead includes such things as the electricity used tooperate the factory equipment, depreciation on the factory equipment andbuilding, factory supplies and factory personnel (other than direct labor).

How these costs are assigned to products has an impact on themeasurement of an individual product's profitability.

2. Nonmanufacturing costs: - Non manufacturing cost (sometimesreferred to as administrative overhead) represent a manufacturersexpenses that occur apart from the actual manufacturing function. Inaccounting and financial terminology, the nonmanufacturing costsinclude Selling, General and Administrative (SG&A) expenses, and InterestExpense.

Since accounting principles do not consider these expenses as product

costs, they are not assigned to inventory or to the cost of goods sold.Instead, nonmanufacturing costs are simply reported as expenses on theincome statement at the time they are incurred.Nonmanufacturing costsinclude activities associated with the Selling and General Administrativefunctions. Examples include the compensation of nonmanufacturingpersonnel; occupancy expenses for nonmanufacturing facilities (rent, light,

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heat, property taxes, maintenance, etc.); depreciation of nonmanufacturingequipment; expenses for automobiles and trucks used to sell and deliverproducts; and interest expenses. (Note that factoryadministration expensesare considered part of manufacturing overhead.)

Although nonmanufacturing costs are not assigned to products forpurposes of reporting inventory and the cost of goods sold on a companysfinancial statements, they should always be considered as part of the totalcost of providing a specific product to a specific customer. For a product tobe profitable, its selling price must be greater than the sum of the productcost (direct material, direct labor, and manufacturing overhead) plus thenonmanufacturing costs and expenses.

Ratio Analysis enables the business owner/manager to spot trends in abusiness and to compare its performance and condition with the averageperformance of similar businesses in the same industry. To do this compare

your ratios with the average of businesses similar to yours and compare yourown ratios for several successive years, watching especially for anyunfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your businessproblems before your business is destroyed by them.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (abusiness's ability to pay its bills as they come due) and leverage (the extentto which the business is dependent on creditors' funding). They include thefollowing ratios:

LIQUIDITY RATIOS

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These ratios indicate the ease of turning assets into cash. They includethe Current Ratio, Quick Ratio, and Working Capital.

CURRENT RATIOS

The Current Ratio is one of the best known measures of financialstrength. It is figured as shown below:

Current Ratio = Total Current Assets / Total CurrentLiabilities

The main question this ratio addresses is: "Does your business haveenough current assets to meet the payment schedule of its current debtswith a margin of safety for possible losses in current assets, such asinventory shrinkage or collectable accounts?" A generally acceptable current

ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends onthe nature of the business and thecharacteristics of its current assets andliabilities.The minimum acceptable current ratio is obviously 1:1, but thatrelationship is usually playing it too close for comfort.

If you feel your business's current ratio is too low, you may be able to raise itby:

Paying some debts. Increasing your current assets from loans or other borrowings with a

maturity of more than one year. Converting non-current assets into current assets. Increasing your current assets from new equity contributions. Putting profits back into the business.

QUICK RATIOS

The Quick Ratio is sometimes called the "acid-test" ratio and is one ofthe best measures of liquidity. It is figured as shown below:

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Quick Ratio = Cash + Government Securities + Receivables/ Total Current Liabilities

The Quick Ratio is a much more exacting measure than the CurrentRatio. By excluding inventories, it concentrates on the really liquid assets,

with value that is fairly certain. It helps answer the question: "If all salesrevenues should disappear, could my business meet its current obligationswith the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority ofyour "quick assets" are in accounts receivable, and the pattern of accountsreceivable collection lags behind the schedule for paying current liabilities.

LEVERAGE RATIO

This Debt/Worth or Leverage Ratio indicates the extent to which thebusiness is reliant on debt financing (creditor money versus owner's equity):

Debt/Worth Ratio = Total Liabilities / Net Worth

Generally, the higher this ratio, the more risky a creditor will perceiveits exposure in your business, making it correspondingly harder to obtaincredit.

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INCOME STATEMENT RATIOANALYSIS

The following important state of income ratios measure profitability

GROSS MARGIN RATIOThis ratio is the percentage of sales dollars left after subtracting the

cost of goods sold from net sales. It measures the percentage of sales dollarsremaining (after obtaining or manufacturing the goods sold) available to paythe overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will revealthe relative strengths or weaknesses in your business. The Gross MarginRatio is calculated as follows:

Gross Margin Ratio = Gross Profit / Net Sales

Reminder: Gross Profit = Net Sales - Cost of Goods Sold

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NET PROFIT MARGIN RATIOThis ratio is the percentage of sales dollars left after subtracting the

Cost of Goods sold and all expenses, except income taxes. It provides a goodopportunity to compare your company's "return on sales" with theperformance of other companies in your industry. It is calculated before

income tax because tax rates and tax liabilities vary from company tocompany for a wide variety of reasons, making comparisons after taxesmuch more difficult. The Net Profit Margin Ratio is calculated as follows:

Net Profit Margin Ratio = Net Profit Before Tax / Net Sales

MANAGEMENT RATIOSOther important ratios, often referred to as Management Ratios, are also

derived from Balance Sheet and Statement of Income information.

INVENTORY TURNOVER RATIOThis ratio reveals how well inventory is being managed. It is important

because the more times inventory can be turned in a given operating cycle,the greater the profit. The Inventory Turnover Ratio is calculated as follows:

Inventory Turnover Ratio = Net Sales / Average Inventory at Cost

ACCOUNTS RECEIVABLE TURNOVER RATIOThis ratio indicates how well accounts receivable are being collected.

If receivables are not collected reasonably in accordance with their terms,management should rethink its collection policy. If receivables areexcessively slow in being converted to cash, liquidity could be severelyimpaired. Getting the Accounts Receivable Turnover Ratio is a two step

process and is is calculated as follows:

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Daily Credit Sales = Net Credit Sales Per Year / 365 (Days)

Accounts Receivable Turnover (in days) = Accounts Receivable / DailyCredit Sales

RETURN ON ASSETS RATIOThis measures how efficiently profits are being generated from the

assets employed in the business when compared with the ratios of firms in asimilar business. A low ratio in comparison with industry averages indicatesan inefficient use of business assets. The Return on Assets Ratio is calculatedas follows:

Return On Assets = Net Profit Before Tax / Total Assets

RETURN ON INVESTMENT (ROI) RATIOThe ROI is perhaps the most important ratio of all. It is the percentage

of return on funds invested in the business by its owners. In short, this ratiotells the owner whether or not all the effort put into the business has beenworthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser tosell the company, put the money in such a savings instrument, and avoid thedaily struggles of small business management. The ROI is calculated asfollows:

Return on Investment = Net Profit before Tax / Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allowthe business owner to identify trends in a business and to compare itsprogress with the performance of others through data published by various

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sources. The owner may thus determine the business's relative strengthsand weaknesses.

CONCLUSION

Any change in the working capital will have an effect on a business's

cash flows. A positive change in working capital indicates that the business

has paid out cash, for example in purchasing or converting inventory, payingcreditors etc. Hence, an increase in working capital will have a negative

effect on the business's cash holding. However, a negative change in

working capital indicates lower funds to pay off short term liabilities (current

liabilities), which may have bad repercussions to the future of the company.

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BIBLOGRAPHY

final copy of accounts prjct

Documents