MANAGEMENT ACCOUNTINGFUNDAMENTALS OF ACCOUNTSAn account is a summarised record of relevant transactions at one place relating to a particular head. It records not only the amount of transactions but also their effect and direction.Debit and Credit are simply additions to or subtractions from an account.

Fundamentals of AccountsThe three rules of accounting areDebit the receiver and Credit the giverDebit what comes in and Credit what goes outDebit all expenses and Credit all gains and profits

Classification of AccountsPersonal AccountReal AccountNominal Account

Classification of Accounts (Contd.)

TypeRules for DebitRules for CreditPersonal AccountsDebit the ReceiverCredit the GiverReal AccountsDebit what comes inCredit what goes outNominal AccountsDebit all expenses and lossesCredit all incomes and gains

Classification of Accounts (Contd.)Assets accountsLiabilities accountsCapital accountsRevenue accountsExpenses accountsAssets = liabilities + capital + profits lossesProfits = revenue expensesLosses = expenses - revenue

Rules of Debit and CreditIncrease in assets are debits and decrease are creditsIncrease in liabilities are credits and decrease are debitsIncrease in capital are credits and decrease are debitsIncrease in expenses are debits and decrease are creditsIncrease in revenues are credits and decrease are debits

Financial StatementsFinancial Statements are compilation of accounting information for the external users.They includeProfit and Loss AccountBalance SheetSchedules and Notes forming part of the above

Financial Statements (Contd.)Capital Expenditure is the amount spent by an enterprise on purchase of fixed assets that are used in the business to earn income and not intended for resale.Capital expenditure normally yields benefits over a period extending beyond the accounting period. Revenue expenditure is the amount spent on running of a businessThe benefit of the revenue expenditure is exhausted in the accounting period in which it is incurred.

Distinction between Capital and Revenue Expenditure

PurposeIt is incurred for acquisition of fixed assets for use in businessIt is incurred for running of businessCapacityIt increases the earning capacity of the business It is incurred for earning profitsPeriodIts benefit is extended to more than one yearIts benefit extends to only one accounting yearDepictionIt is shown in the balance sheet It is part of trading or Profit or Loss account

Management AccountingDefinitionManagement accounting is the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information that assists managers in specific decision making within the framework of fulfilling the organizational objectives.

Types of DecisionsThe decisions, managers are concerned with, can be categorized as Planning decisionsControl decisions

Planning DecisionsPlanning Decisions are concerned with the establishment of goals for the organization and the choosing of plans to accomplish these goalsManagement accounting information is needed to take Planning decisions

Control DecisionsControl decisions result from implementing the plans and monitoring the actual results to see if goals are being achievedIf goals are not being achieved, either corrective steps must be taken resulting in goal achievement or goals themselves have to be revised to attainable levelsCost accounting data are needed for taking Control decisions

Financial Accounting vs. Management Accounting Financial Accounting covers the process of book keeping, finalization of accounts, preparation of financial statements, communication of accounting information to users and interpretation thereofManagement Accounting is concerned with accounting information that is useful to management Financial Accounting emphasizes the preparation of reports of an organization for external users whereas Management Accounting emphasizes the preparation of reports for its internal users

Financial Accounting vs. Management AccountingExternal users vs. Internal usersRecord of financial history vs. Emphasis on the futureGAAP vs. Own rulesObjectivity and verifiability vs. FlexibilityEmphasis on accuracy vs.Acceptance of estimatesFocus on company as a whole vs. Focus on segments of a companyBound by conventional accounting systems vs. Use of other disciplines such as Economics, Statistics, OR, OB, etcGoverned by Regulatory Bodies vs. Freedom of choice

Cost Accounting vs. Management AccountingCost Accounting is mainly concerned with the techniques of product costing and deals with only cost and price data. It is limited to product costing procedures and related information processing. It helps management in planning and controlling costs relating to both production and distribution channels. Cost Accounting is a Line functionManagement Accounting is not confined to the area of product costing. The objective is to have a data pool which will include all information that management may need, both costing and financial. Management accounting is a Staff function

Management Accounting Framework

Management Accounting FrameworkData accumulation is done through Financial Accounting and Cost Accounting systems. Financial records are maintained through financial accounting system and cost records are maintained through cost accounting systemsIn Management Accounting system, data support is taken from financial accounting and cost accounting and also data accumulation is carried out from external sources. Accumulated data are reclassified as per the requirements of the management decision making process. Information is built up and then communicated to assist the decision making process

Contents of Management AccountingManagement process is a series of activities involved in planning, implementation and control. Each phase of management process requires decision makingManagement Accounting supports managerial decision making providing the required informationInformation generated in management accounting process includes- - Financial Statement Analysis - Cash flow information - Cost information - Budgets and Standards

Statements of Financial InformationBalance SheetProfit and Loss AccountStatement of changes in financial position - Cash flow statement - Fund flow statement

Contents of Balance SheetThe balance sheet provides information about the financial standing/position of a company at a particular point in time i.e. as March 31, 2006It is a snapshot of the financial status of the companyThe financial position of the company is valid for only one day i.e. the reference day

Contents of Balance SheetThe financial position as disclosed by the balance sheet refers to its resources and obligations and the interests of its owners in the business.The balance sheet contains information regarding assets, liabilities and shareholders equityThe balance sheet can be present in either of the two forms: - the account form - the report form

AssetsAssets are the valuable resources owned by a businessAssets need to satisfy three requirements: - the resources must be valuable i.e. it is cash or convertible into cash or it can provide future benefits to the operations of the firm - the resources must be owned in the legal sense. Mere possession or control would not constitute an asset - the resource must be acquired at a cost

AssetsThe assets in the balance sheet are listed either in the order of liquidity i.e. promptness with which they are expected to be converted into cash or In the reverse order i.e. fixity or listing of the least liquid asset first, followed by others

AssetsAll assets are grouped into categories i.e. assets with similar characteristics are put in one categoryThe standard classification of assets divides them into- - fixed assets / long term assets - current assets - investments - other assets

Fixed assetsThese assets are fixed in the sense that they are acquired to be retained in the business on a long term basis to produce goods and services and not for resaleThey are long term resources and are held for more than one accounting yearThese assets are significant as the future earnings/profits of the company are determined by them

Categories of Fixed AssetsTangibleIntangible

Tangible Fixed AssetsThese assets have a physical existence and generate goods and servicesExamples are land, buildings, plant, machinery, furniture, etcThey are shown in the balance sheet at their cost to the firm at the time of their purchaseThe cost of these assets are allocated over their useful lifeThe yearly allocation is called Depreciation

Tangible Fixed Assets (Contd.)As a result of depreciation, the amount of tangible fixed assets shown in the balance sheet every year declines to the extent of depreciation charged that yearBy the end of the useful life of the asset, value becomes nil or the salvage value, if anySalvage value signifies the amount realizable by the sale of the asset at the end of its useful life

Intangible Fixed AssetsThese assets do not generate goods and services directlyThey reflect the rights of the companyExamples patents, copyrights, trademarks, goodwill, etcThey confer certain exclusive rights on their ownersIntangibles are also written off over a period of time

Current AssetsThe second category of assets in the balance sheet are current assetsIn contrast to the fixed assets, current assets are short term in natureAs short term assets, they refer to assets / resources which are either held in the form of cash or expected to be realized in cash within the accounting period or the normal operating cycle of the businessThe term operating cycle means the time span during which the cash is converted into inventory, inventory into receivables/cash sales and receivables into cash

Current assets (Contd.)Current assets are also known as liquid assetsThey include- - cash - marketable securities - accounts receivables/debtors - bills receivables - inventory

Current Assets (Contd.)CashMost liquid form of current assetCash in hand and at bankTo meet obligations / acquire assets without any delay

Current Assets (Contd.)Marketable SecuritiesShort term investments which are readily marketable and can be converted into cash within a yearOutlet to invest temporarily available surplus/idle fundsDeclared at cost or market value whichever is lower and the other amount is indicated in the financial statement

Current Assets (Contd.)Accounts ReceivableThe amount the customers owe to the firm, arising out of the sale of goods on creditThey are called the sundry debtorsThe unrecoverable portion is termed as bad debts and written off out of the P & L a/c

Current assets (Contd.)Bills ReceivableAmount owed by outsiders for which written acknowledgements of the obligations are availableIOUs are drawn and exchangedTemporary credit can be arranged by discounting these IOUs

Current Assets (Contd.)InventoryIt includesThe goods which are held for sale in the course of business (finished goods)The goods which are in the process of production (work in progress or semi finished goods) The goods which are to be consumed in the process of production (raw materials)

InvestmentsThe third category of assets is investmentsThey represent investment of funds in the securities of another companyThey are long term assets outside the business of the firmThe purpose is to earn a return and/or to control another comapny

Other AssetsIncluded in this category are the Deferred ChargesExample: Advertisement, Preliminary expenses, etc

LiabilitiesLiabilities are defined as the claims of outsiders against the firmThey represent the amount that the firm owes to outsiders other than the ownersThe assets are financed by different sourcesDepending on the periodicity of the funds, liabilities are classified into - Long term and short term sources

Long term LiabilitiesSources of funds included in this category are available for periods exceeding one yearSuch liabilities represent obligations of a firm payable after the accounting periodExample: Debentures, Bonds, Mortgages, Secured loans from FIs and banksThey have to be redeemed/repaid either as a lump sum on maturity or over a period of time in instalments

Current Liabilities or Short term LiabilitiesThese Liabilities are payable to outsiders in a short period, usually within the accounting period or the operating cycle of the firmExample: Accounts payable, Bills payable, Tax payable, Accrued expenses, Short term bank creditAccounts and Bills payable are considered as Trade Credit

Current Liabilities (Contd.)Trade CreditThe claims of outsiders who have sold goods to the firm on credit for a short periodUsually these are unsecuredSuch liabilities extended without any written commitment are Accounts Payable or Sundry CreditorsSuch liabilities extended with formal agreements through IOUs are Bills payable

Current Liabilities (Contd.)Short term Bank CreditLiabilities contracted through banks for a short period for the purpose of running the businessExample: cash credit, overdraft, loans and advances

Current Liabilities (Contd.)Tax Payable refers to the amount payable to the Government as taxesAccrued Expenses represents obligations which are payable and kept outstanding by the firm Example: outstanding wages, salaries, rent, commission, etc

Owners Equity or CapitalThe next main component of the balance sheet is the owners equityIt represents the residual claim of the owners on the assets of the company after settling all the external liabilitiesThe owners of the company are called the shareholdersTwo types of shareholders equity and preference

Preference CapitalThese shareholders are entitled to a stated amount of dividend and return of principal on maturityIn this sense, they are akin to that of a lenderBut, he is entitled to the dividend only if the company has made profits In this sense, they are the owners

Equity CapitalThey are the residual claimants of the profitsAfter all the external liability holders and the preference shareholders have been paid, the balance amount, if any, belongs to the Equity shareholdersComponents: Paid up capital which is the initial investments made by this group and Retained earnings/Reserves and Surplus which is the undistributed part of the residual profits over the years which has been put back in business

Common DoubtsWhy is share capital shown as a liability?Depreciation what is its nature?Accumulated losses treatment?Goodwill what is its nature?What is the significance of the auditors report?

Contents of Profit and Loss AccountRevenues : Turnover Other income Sale of fixed assetsExpensesProfit / Loss

RevenuesRevenue is defined as the income that accrues to the firm by sale of goods and services or through investmentsSales Revenue is the amount earned through sale of goods/servicesGross sales is the total sales, while Net sales is gross sales minus the trade discounts

Revenue (Contd.)Other income is earned through other sources of investments Examples: Interest, dividend, royalty, commission, fee, etcSale of Fixed Assets are the revenues which come into the business when unused / unwanted assets are sold and money recovered by the company

ExpensesThe cost of earning the revenues are the expensesExamples: variable expenses like cost of manufacture, cost of selling, fixed expenses like salaries, administrative expenses

Expenses (Contd.)Cost of goods consumedThis is the value of the inputs used to manufacture the final productIt is calculated as Opening stock + Purchases - Closing Stock

Expenses (Contd.)Manufacturing expensesThese include all expenses related to plant and manufacturing operations like power and fuel, repairs and maintenance, stores consumed, water consumed, etcExcise DutyThis is the amount paid to the Govt. as a tax, before the goods are dispatched from the factory

Expenses (Contd.)Salaries and WagesThese are the cost of labour and other staff and will also include all other employee benefits and amenities. The other benefits include Provident Fund, ESI contributions, medical benefits, LTC, bonus, gratuity, pension, other superannuation benefits, etc

Expenses (Contd.)Administrative ExpensesThese include office expenses, secretarial costs, postage and telephones, directors remuneration and other administrative expensesSelling ExpensesThese include freight, advertising and sales promotion, commissions and discounts and other selling and distribution costs

Expenses (Contd.)InterestThe interest costs consist of interest on long term loans, debentures, bank loans for working capital, interest on public deposits and other loansDepreciationThis represents a non cash expenditure as it is only an accounting provision. This amount is not paid to an outside partyOther expensesThis includes auditors remuneration, petty expenses, donations, etc

Profit / LossThe difference between the revenue and expense is profitWhen expense exceeds the revenue, the company ends up with a loss.PBID: Profit before Interest and DepreciationPBT: Profit before TaxPAT: Profit after Tax

The Profit AppropriationsProfit after Tax (PAT) is available for appropriations for Debenture Redemption ReserveGeneral ReserveDividend on Preference ShareDividend on Equity Share

Profit or Loss carried overAfter appropriating the taxes and dividends, the balance surplus is transferred to Reserves and Surplus in the Balance SheetThe net loss reduces the Reserves and Surplus in the Balance Sheet

Financial Ratio AnalysisFinancial Analysts use the financial ratio analysis to gain critical insights about companiesSeveral ratios are worked out using the financial data drawn from the P&L account and Balance SheetThese ratios are studied and compared to obtain analytical insights

Merits of Ratio AnalysisFinancial ratios are helpful:To bankers for appraising the credit worthinessTo the financial institutions for project appraisalTo investors for taking investment and disinvestment decisionsTo financial analysts for making comparisons and recommending to the investing public

Merits of Ratio AnalysisTo the credit rating agencies (like CRISIL, ICRA, etc) in their credit rating exerciseTo the Government agencies for reviewing a companys overall performanceTo the companys management for making intra-firm and inter-firm comparisons

Limitations of Ratio AnalysisNo uniformity in definitionsNo normsVarying situationsLimitations of published accountsDiversified companiesHistorical costs (replacement cost / market price)Window dressing

Financial Ratio AnalysisRatios on ROIActivity ratiosLiquidity ratiosProfitability ratiosLeverage ratiosCoverage ratiosEquity investors ratio

Ratios on ROIReturn on assets = PAT ---------------- * 100 Total assetsReturn on total capital employed = PBT + Interest -------------------------- * 100Total capital employed(Total cap.employed = total assetscurrent liabilities)

Ratios on ROIReturn on Net worth = Net profit after tax ------------------------ * 100 Net worthNet worth = Share capital + reserves & surplus accumulated losses

Cash Flow AnalysisA cash flow statement depicts change in cash position from one period to another.cash stands for cash and bank balances.Cash flow statement is useful for short term planningIt helps to make reliable cash flow projections for the immediate future.

Difference between CFS and FFSCFSOnly with change in cash positionMere record of cash receipts and paymentsMore for short term useImprovement in cash improves funds position

FFSChange in working capital positionNeeded for short term solvencyLong term useImprovement in funds position need not necessarily improve cash

AdvantagesHelps in efficient cash managementHelps in internal financial managementDiscloses the movement of cashDiscloses success or failure of cash planning

LimitationsCash flow does not reflect net income as it does not consider non cash transactionsCash position can be manipulated by collecting ahead or deferring some paymentsFFS, CFS and Income statement each has its own use and one can not replace the other

CFSSources of CashInternal ExternalApplications of Cash

CFSInternal sourcesCash flow from operating activitiesNet profit +Depreciation +Amortization of non cash expenses +Loss on sale of fixed assets +Gain on sale of fixed assets +Provisions made in the P&L account +Transfer to reserves

CFSAdjustment for changes in current assets and current liabilitiesAdjusted Net profit + Decrease in sundry debtors + Decrease in bills receivables + Decrease in inventories + Decrease in prepaid expenses+ Decrease in accrued income + Increase in sundry creditors+ Increase in bills payable + Increase in outstanding expenses contd..

CFSAdjustment for changes in current assets and current liabilities- Increase in sundry debtors - Increase in bills receivables- Increase in inventories - Increase in prepaid expenses- Increase in accrued income - Decrease in sundry creditors- Decrease in bills payable - Decrease in outstanding expenses

CFSIncrease in cashDecrease in current assetIncrease in current liabilityDecrease in cashIncrease in current assetDecrease in current liability

CFSExternal sourcesIssue of sharesIssue of debenturesRaising of depositsRaising of loans secured and unsecuredRaising of bank borrowingsSale of assets and investments

CFSApplications of cashPurchase of fixed assetsRepayment of loans secured, unsecuredRepayment of bank borrowingsRepayment of depositsRedemption of debenturesRedemption of preference sharesLoss from operationsTax paidDividend paid

Cost ConceptsImportant inputs in managerial decision making is cost dataCost data is classified based on managerial needsManagerial needs are-Income measurementProfit planningCosts controlDecision making

Relating to Income MeasurementProduct cost and Period costAbsorbed cost and Unabsorbed costExpired cost and Unexpired costJoint product cost and Separable cost

Relating to Income MeasurementProduct cost and Period costOnly variable costs are taken as product costs, as they are affected by production volumePeriod costs vary with the passage of time and not with volume of production, viz., fixed costs

Relating to Income MeasurementAbsorbed cost and Unabsorbed costSince fixed costs also contribute to production, they need to be shared by the volume producedSFOR Standard Fixed Overhead RateSFOR = Fixed cost / Units producedAbsorbed costs = units produced * SFORUnabsorbed costs =AFC(Units produced*SFOR)AFC = Actual Fixed costs

Relating to Income MeasurementExpired cost and Unexpired costExpired cost can not contribute to the production of future revenuesUnexpired cost has the capacity to contribute to the production of revenue in the future., example, inventory

Relating to Income MeasurementJoint product cost and Separable costJoint Product costs are the costs of a single process that simultaneously produce multi products and can not be attributed to any one productSeparable costs can be attributed exclusively and wholly to a particular product

Relating to Profit PlanningFixed, Variable, Semi variable / Mixed costFuture cost and Budgeted cost

Relating to Profit PlanningFixed, Variable, Mixed costsFixed costs are associated with those inputs which do not vary with changes in volume of production (Committed and Discretionary)Variable costs which vary with volume of productionMixed cost are partly fixed and partly variable

Relating to Profit PlanningFuture cost and Budgeted costFuture costs are reasonably expected to be incurred at some future date as a result of a current decisionThey are estimated costs based on expectationsWhen an operating plan involving future costs is accepted and incorporated formally in the budget for a specific period, such costs are referred as budgeted costs

Relating to ControlResponsibility costsControllable and Non controllable costsDirect and Indirect costs

Relating to ControlResponsibility costsThis concept applies more as responsibility accountingCosts are classified with the persons / centers responsible for their incurrence

Relating to ControlControllable costs are those which can be controlled / influenced by the responsibility centers/personsNon controllable costs are those which can not be influenced

Relating to ControlDirect costs are those which can be identified in their entirety to a particular product in a responsibility center Indirect costs are common costs which are shared among products / departments

Relating to Decision makingRelevant cost and Irrelevant costIncremental cost and Differential costOut of pocket cost and sunk costOpportunity cost and Imputed cost

Relating to Decision makingRelevant costs are those influenced by a decision and hence are important for decision makers, typically variable costsIrrelevant costs are not affected by the decision taken and hence decision makers do not worry about them, typically committed fixed costs

Relating to Decision makingIncremental costs are additional costs incurred if management chooses a particular course of action as against anotherDifferential costs are difference in costs between any two available alternatives

Relating to Decision makingOut of pocket costs are costs which involve fresh outflow of cash on decision takenSunk costs are those which have already been incurred where current decisions have no impact on.

Relating to Decision makingOpportunity costs represent benefits foregone by not choosing one alternative in favour of another that can be quantifiedImputed costs are the hypothetical costs that must be considered while arriving at the right decision

Marginal CostingMarginal cost is the cost of producing one additional unitVariable cost varies with the level of productionFixed cost remains constant for a range of capacity utilizationTherefore for a given range of capacity utilization, the marginal cost is the variable cost per unit.

Marginal Costing (Contd.)If the level of capacity utilization changes, the fixed cost changes.Then the incremental fixed cost has to be shared by the additional capacity producedThen the Marginal Cost is the sum of variable cost per unit and the incremental fixed cost per unit

Marginal Costing (Contd.)For a given capacity level, the marginal cost is only the variable cost. This is because the fixed cost will not change up to a certain level of productionWhen the fixed cost changes with the change in capacity utilization, the marginal cost is the sum of variable cost per unit and the incremental cost per unit

Marginal Costing (Contd.)Under Absorption costing, all costs, both fixed and variable costs are allocated to the productUnder marginal costing, only variable costs are allocated to the product and the fixed costs are recovered out of the contribution

Break Even AnalysisSalesminusVariable cost=ContributionminusFixed cost=Profit or Loss

Break Even Analysis (Contd.)BEP (in Units) = Fixed cost (in Rs.) ---------------------------------- Contribution per unit (in Rs.)Contribution per unit (in Rs.) = SP(in Rs.)/unit VC(in Rs.)/unit

Break Even Analysis (Contd.)Profit Volume Ratio = Contribution (P/V ratio) ------------------ * 100 Sales

Break Even Analysis (Contd.)BEP (in Rs. = Fixed Coat (in Rs.) ----------------------- P/V ratio

Break Even Analysis (Contd.)Margin of safety = Actual sales BEP salesMargin of safety ratio = Actual sales BEP sales ------------------------------ Actual salesProfit = Margin of safety * P/V ratio

Budgetary ControlBudgeting is tool of planningPlanning involves specification of the basic objectives that the organisation will pursue and the fundamental policies that will guide it

Budgetary Control (Contd.)Steps in Planning:Objectives defined as the broad and long range position of the firmSpecified goal targets in quantitative terms achieved in a specified period of timeStrategies to achieve these goalsBudgets to convert goals and strategies into annual operating plans

Budgetary Control (Contd.)A budget is defined as a comprehensive and coordinated plan, expressed in financial terms, for the operations and resources of an enterprise for some specified period I the future. As a tool, a budget serves as a guide to conduct operations and a basis for evaluating actual results

Budgetary Control (Contd.)The essential elements of a budget are:PlanFinancial termsOperations and ResourcesSpecific future periodComprehensive coverageCoordination

Budgetary Control (Contd.)The main objectives of budgeting are:Explicit statement of expectationsCommunicationCoordinationExpectations as framework for judging performance

Budgetary Control (Contd.)The overall budget is known as the Master budget.Classification Operating budgets and Financial budgetsOperating budgets include cash flows from the operations of the firm viz., sales, collections of receivables, etcFinancial budgets include cash flows from collection and payments of financial nature viz., borrowings, external raising of money, taxes pais and dividend paid, etc

Budgetary Control (Contd.)Operating budgetSales budgetProduction budgetPurchase budgetDirect labour budgetManufacturing expenses budgetAdministrative and Selling expenses budget

Budgetary Control (Contd.)Financial BudgetBudgeted income statementBudgeted statement of retained earningsCash budgetBudgeted balance sheet

Budgetary Control (Contd.)Budgets prepared at a single level of activity, with no prospect of modification in the light of changed circumstances, are referred to as fixed budgetsA flexible budget estimates costs at several levels of activityWhile fixed budget is rigid in nature, flexible budget contains several estimates / plans in different assumes circumstancesIt is a useful tool in real world situations, that is, unpredictable environment

Budgetary Control (Contd.)The framework of flexible budget covers-Measure of volumeCost behaviour with change in volume

Inventory CostingInventories are assets:Held for sale in the ordinary course of business (finished goods)In the process of production for such sale (work in progress)In the form materials or supplies to be consumed in the production process or in the rendering of services (raw materials)Purchased and held for resale

Inventory CostingInventories should be valued at the lower of cost or net realizable valueNet realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make such sale

Inventory CostingThe cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and conditionCost of purchase consists of the purchase price inclusive of the taxes and duties, freight inwards and other acquisition costs directly attributable to the purchase and trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the cost of purchase

Inventory CostingCosts of conversion include costs directly related to production like labor, factory overheads, etc. In this process, if any byproduct, waste or scrap are produced, their net realizable value is removed from the cost of conversionOther costs included in the cost of inventories are only those incurred in bringing the inventories to their present level like design cost, etc.

Inventory SystemsPeriodic System: inventory is determined by a periodic count as of a specific date. As long as the check is frequent enough to avoid negligence, this system is acceptable. The net change between the beginning and ending inventories enters the calculation of cost of goods soldPerpetual System: inventory records are maintained and updated continuously as items are purchased and sold. It has the advantage of providing up to date inventory information on a timely basis, but needs a full fledged record maintenance

Inventory Cost MethodsIn selecting the inventory cost method, the main objective is the selection of the method that clearly reflects its usage and the periodic income. Frequently, the identity of the goods and their specific related costs are lost between the time of acquisition and the time of their use. When similar goods are purchased at different times, it may not be possible to identify and match the specific costs of the item sold. This has resulted in certain accepted costing methods

Inventory Cost MethodsFirst In First Out Method (FIFO)Last In First Out Method (LIFO)Weighted Average Method

Inventory Cost MethodsFIFO: here costs are charged against revenue in the order in which they occur. The inventory remaining on hand is presumed to consist of the most recent costs. In other words, items are converted and sold in the order in which they are purchased.

Inventory Cost MethodsLIFO: this method matches the most recent costs incurred with the current revenue, leaving the first cost incurred to be included as inventories.

Inventory Cost MethodsWeighted Average Method: this method assumes that costs are charged against revenue based on an average of the number of units acquired at each price level. The resulting average price is applied to the ending inventory to find its value. The weighted average is determined by dividing the total cost of the inventory available, including any beginning inventory, by the total number of units.

Inventory Cost Methods

DateUnitsCost per unitTotal costJan 15100005.1051000Mar 20200005.20104000May 10500005.00250000June 8300005.40162000Oct 1250005.3026500Dec 2150005.5027500Total120000621000Op.inv100005.0050000Cl. inv14000

Under FIFODec purchases 5000@5.50 = 27500Oct purchases 5000@5.30 = 26500June purchases 4000@5.40 = 21600Ending inventory 14000 = 75600 (using FIFO)

Under LIFOOpening inventory 10000@5.00 = 50000Jan purchases 4000@5.10 = 20400Ending inventory 14000 = 70400 (using LIFO)

Under Weighted Average MethodWeighted average cost =total cost/total unitsWei. Ave. cost = 671000/130000 = 5.1615Closing inventory 14000@5.1615 = 72261

ComparisonUnder FIFO = 75600Under LIFO = 70400Under WA method = 72261

ComparisonIn periods of inflation, the FIFO method produces the highest ending inventory, resulting in the lowest cost of goods sold and the highest gross profit. LIFO produces the lowest ending inventory resulting in the highest of goods sold and the lowest gross profitThe WA method yields results between those of the above two methods

Emerging ConceptsThe transition from Cost Accounting to Strategic Cost Management (SCM)Cost Analysis is traditionally viewed as the process of assessing the financial impact of alternative managerial decisionsSCM involves usage of cost data to develop superior strategies to gain sustainable competitive advantage

SCMThe process of SCM-Target CostingActivity Based CostingQuality Costing Life Cycle CostingValue Chain Analysis

Target CostingTarget Cost is defined as a market based cost that is calculated using a sales price necessary to capture a predetermined market shareTarget Cost = Sales Price (for the target market share desired profit)Target costing is market driven design methodologyIt estimates the cost for a product and then designs the product to meet the cost

Target CostingIt is Cost Management tool which reduces a products costs over its entire life cycle. It includes actions management must take to-Establish reasonable target costsDevelop methods for achieving those targetsDevelop means to test the cost effectiveness of different cost-cutting scenarios

Activity Based Costing (ABC)Applying overhead costs to each product or service based on the extent to which it is caused by them is the primary objective of overhead costingThis is carried out using a single pre determined overhead rate based on a single activity measureWith ABC, multiple activities are identified in the production process that are associated with costs

Activity Based Costing (ABC)The events within these activities that cause costs are called cost driversThe cost drivers are used to apply overheads to products and services when using ABC

Activity Based Costing (ABC)The following five steps are used in ABC:Choose appropriate activitiesTrace costs to activitiesDetermine cost drivers for each activityEstimate the application rate for each cost driverApply costs to products

Activity Based Costing (ABC)Overhead account Cost driverIndirect labor Man hour costDepreciation-building Sq. feet usedDepreciation-machinery Machine timeElectricity Watts used

Quality CostingA quality costing system monitors and accumulates the costs incurred by a firm in maintaining or improving product qualityThe cost of lowering the tolerance for defective units come from the increased cost of using a better tehnolgyTotal Quality Control (TQC)/ Total Quality Management (TQM) is a management process based on the belief that quality costs are minimized with zero defects

Life Cycle CostingProducts have definite phases of lifeCost, revenue and profits vary in these phasesEach phase has different threats and opportunitiesDifferent functional emphasis comes with each phase

Life Cycle CostingDifferent phases are-IntroductionGrowthMaturitySaturationDecline

Value Chain AnalysisValue chain is the linked set of value creating activities from the basic raw material sources to the end use product delivered into final customerThe primary focus is to create low cost strategy relative to competitors

Value Chain AnalysisIt highlights Linkages with suppliersLinkages with customersProcess linkages within the value chain of a business unitLinkages across business unit value chain within the firm