Introduction
The basic strategic and considerations in managing two individual current assets namely cash and receivables. The third major current asset is inventory. The term inventory refers to the stockpiles of the products a firm is offering for sale and the components that make up the product. In other words, inventory is composed of assets that will be sold in future in the normal curse of business operations. The assets which firms store as inventory in anticipation of need are raw materials, work-in-process and finished goods. The raw material inventory contains items that are purchased by the firm from others ad are converted into finished goods through the manufacturing process. They are an important input of the final goods.
Inventory as a current asset differs from other current assets because only financial managers are not involved. Rather, all the functional areas, finance, marketing, production, and purchasing are involved. The views concerning the appropriate level of inventory would differ among the different functional areas. The job of the financial manager is to reconcile the conflicting viewpoints of the various functional areas regarding the appropriate inventory levels in order to fulfil the overall objective of maximizing the owner’s wealth.
Objectives of inventory management
- The basic responsibility of the financial manager is to make sure the firm’s cash flows are managed efficiently. Efficient management of inventory should ultimately result in the maximization of the owner’s wealth. The objective of inventory management consists of two counterbalancing parts i.e. to minimize investments in inventory and to meet a demand for the product by efficiently organizing the production and sales operations. These two conflicting objectives of inventory management can also be expressed in terms of cost and benefit associated with inventory.
- One operating objective of inventory management is to minimize cost. Excluding the cost of merchandise, the costs associated with inventory fall into two basic categories i.e. ordering or acquisition or set-up costs, and carrying costs.
- Ordering costs is associated with the acquisition or ordering of inventory. Firms have to place orders with suppliers to replenish inventory of raw materials. The expenses involved are referred to as ordering costs. The second broad categories of costs associated with inventory are he carrying costs. They are involved in maintaining or carrying inventory. The cost of holding inventory may be divided into two categories:
- The main components of this category of carrying costs are storage cost, that is, tax, depreciation, insurance, maintenance of the building, utilities, janitorial services and second component is insurance of inventory against fire and theft.
- Opportunity cost of funds consists of expenses in raising funds to finance the acquisition of inventory. If funds were not locked up in inventory, they would have earned a return. This is the opportunity cost of funds or the financial cost component of the cost.
- The second element in the optimum inventory decision deals with the benefits associated with holding inventory. The major benefits of holding inventory are the basic functions of inventory. In other words, inventories perform certain basic functions which are of crucial importance in the firm’s production and marketing strategies.
- The basic function of inventories is to act as a buffer to decouple or uncouple the various activities of a firm so that all do not have to be pursued at exactly the same rate. The key activities are purchasing, production and selling. The term uncoupling means that these interrelated activities of a firm can be carried on independently.
- Inventories permit short term relaxation so that each activity may be pursued efficiently. Stated differently, inventories enable firms in the short run to produce at a rate greater tha purchase of raw materials and vice-versa, or to sell at a rate greater than production and vice-versa
- If the purchasing of raw materials and other goods is not tied to production/sales, i.e. a firm can purchase independently to ensure the most efficient purchase, several advantages would become available.
- Finished goods inventory serves to uncouple production and sale. This enables production at a rate different from that of sales. That is, production can be carried on at a rate higher or lower than the sale rate.
- The inventory of work-in-progress performs two functions. In first place, it is necessary because production processes are not instantaneous. The amount of such inventory depends upon technology and the efficiency of production. The larger the steps involved in the production process, the larger the work-in-process inventory and vice versa
- The maintainance of inventory also helps a firm to enhance its sales efforts. For one thing, if there are no inventories of finished goods, the level of sales will depend upon the level of current production. A firm will not be able to meet demand instantaneously.
- Inventory, thus, ensures a continued patronage of customers
B) Show with appropriate example, how to calculate opportunity cost of capital?
· The idea of the "cost of capital" is fundamental to what managerial finance and accounting professionals do, directly or indirectly, as part of their participation on cross-functional decision teams. They need to understand and apply techniques for estimating the cost of capital for long-term capital budgeting; merger and acquisition analysis; use of Economic Value Added (EVA[R]) as a firm-wide financial performance indicator; incentive systems for financial control, using residual income for evaluating financial performance; equity valuation analyses; and accounting for purchased goodwill.
· Here we offer readers an overview of theoretical and empirical issues involved in estimating a firm's weighted average cost of capital (WACC), and we review and apply several methods for estimating WACC for two widely held U.S. firms: General Electric (GE) and Microsoft. The most difficult to estimate component of a firm's WACC relates to the cost of equity capital ([K.sub.s]), a process complicated in practice by the need to make various assumptions and practical choices. Conventional methods for estimating WACC, therefore, can yield substantially different approximations depending on the assumptions used in estimating [K.sub.s], so good judgment and sensitivity analysis are required when attempting to estimate a firm's cost of capital for applications in accounting and finance.
THEORETICAL FRAMEWORK
Conceptually, a firm's cost of capital is an investor's opportunity cost of investing his or her capital in that firm. An estimate of the firm's WACC is an attempt to quantify the average return expected by all investors in the firm: creditors of short-term and long-term interest-bearing debt, preferred stockholders, and common stockholders. The firm's cost of capital is a weighted average where the weights are determined by the value of the various sources of capital.
In Equation 1 we show the conventional formula for estimating a firm's WACC.
EQUATION 1
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]
where,
[w.sub.i] = the weight of the i-th source of capital (i = 1, ..., N) based on that source's aggregate market value in relation to the firm's total value,
[[summation of].sub.i][w.sub.i] = 1, and
[K.sub.i] = the expected return on the i-th security.
The portion to the right of the equal sign in Equation 1 can be rewritten in a simplified equation when there are only two sources of capital: long-term interest-bearing debt and (common) equity, as shown in Equation 2.
EQUATION 2
WACC = [w.sub.d][K.sub.d](1 - T) = [w.sub.s][K.sub.s]
where,
[K.sub.d] is the expected cost of long-term debt,
T is the firm's marginal income tax rate (combined federal and state),
[K.sub.s] is the expected cost of common stock, and
[w.sub.d] and [w.sub.s] are the weights of long-term debt and common stock in the firm's capital structure. (4) Note that this could be either its target or self-professed optimal capital structure. (5)
When determining the weights of debt and equity, we use their market values rather than book values because market values are more reflective of the true worth of the company.
There are two models that can be used to estimate [K.sub.s]: (1) a single-factor model called the Capital Asset Pricing Model (CAPM) and (2) a multiple-factor model called the Arbitrage Pricing Model (APM). (6) Next, we briefly outline these models below and a third model, the "bond yield plus risk premium model," that financial analysts frequently use.
ESTIMATING THE COST OF EQUITY WITH CAPM
To calculate Equation 2, we need a means of estimating the required returns ([K.sub.i]) for each component of the firm's capital structure. An asset-pricing model such as the CAPM can provide a convenient and theoretically consistent set of return estimates. The standard CAPM method says the required return on a risky asset such as common stock is related linearly to a nondiversifiable risk, otherwise known as "systematic" risk. Systematic risk is the riskiness of the "market portfolio" of all risky marketable assets. This relationship can be summarized concisely, as shown in Equation 3.
EQUATION 3
[K.sub.i] = [K.sub.rf] [[beta].sub.i] ([K.sub.m] - [K.sub.rf])
where,
[K.sub.rf] = the expected return on a riskless security;
[K.sub.m] = the expected return on the systematic risk factor, i.e., the market portfolio's return, which is represented by the return on a large equity portfolio such as the S&P 500; and
[[beta].sub.i] = beta = a measure of the i-th security's sensitivity to the systematic risk factor.
A firm's beta can be estimated from a regression using historical data for the returns on the stock ([K.sub.s]) and a market portfolio proxy ([K.sub.m]). Typically, monthly returns data are used when estimating this regression. This CAPM beta will be biased when estimating a forward-looking cost of equity capital. A forward-looking estimate for [K.sub.s] is important for our analysis because the CAPM (as well as the APM) assumes that investors base their investment decisions on expected returns on all marketable securities. In deriving their published estimates of corporate betas, brokerage and analytical firms such as Merrill Lynch, Bloomberg, and Value Line have used Marshall Blume's idea to reduce the bias in the estimated beta and, in theory, improve one's ability to develop forward-looking return estimates. (7) Value Line's adjustment technique is relatively simple, as shown in Equation 4.
EQUATION 4
[[??].sub.i] = 0.35 0.67 [[beta].sub.i]
where,
[[beta].sub.i] = beta estimated via Equation 3 using historical time-series data and
[[??].sub.i] = an adjusted beta to account for the mean-reversion bias in the estimated beta.
Estimating the other two key components of Equation 3, the risk-free rate ([K.sub.rf]) and the market risk premium ([K.sub.m] - [K.sub.rf]), also requires the analyst's judgment. (8)
Since the advent of the CAPM in the 1960s to explain the pricing of assets, there have been numerous theoretical and empirical developments in asset pricing. In particular, CAPM's single-factor relation described by Equation 3 can be generalized to accommodate multiple systematic risk factors using logic based on the concept of "financial arbitrage." This newer approach, called the Arbitrage Pricing Model (APM), explicitly incorporates risk factors beyond the market portfolio factor, but the APM does not spell out what those extra factors should be, so researchers have been forced to rely on extensive empirical testing of numerous macroeconomic and financial variables to find additional factors that might improve the explanatory power of the CAPM. (9) S. David Young and Stephen F. O'Bryne suggest using growth rates of real GDP and inflation, as well as interest rates, as additional factors in estimating [K.sub.s]. (10)
Other researchers have popularized the use of a three-factor model consisting of: (1) the "excess return," or risk premium, for the market portfolio ([K.sub.m] - [K.sub.rf] from Equation 3); (2) the return on a portfolio that represents the difference between the returns on a group of small capitalization stocks and the returns on a group of large capitalization stocks (referred to as a "Small Minus Big" portfolio, or an "SMB" factor, which is related to the size of the company); and (3) the return on a portfolio that represents the difference between the returns on a group of stocks with high market-to-book equity ratios and the returns on a group of stocks with low market-to-book equity ratios (referred to as a "High Minus Low" portfolio, or an "HML" factor, which is related to the relative valuation of the company). (11)
These two extensions of the CAPM are based on observed empirical relations and do not have a convincing theoretical justification for the additional factors. This has led many practitioners to stay with the more widely accepted and simpler CAPM approach. Yet there are advantages to using the APM, most notably the fact that it usually leads to greater explanatory power of real-world stock returns when compared to the CAPM.
THE "BOND YIELD PLUS RISK PREMIUM" METHOD
The other technique for estimating [K.sub.s] is the "Bond Yield Plus Risk Premium" (BY P). The BY P method is popular among some practitioners (most notably multibillionaire investor Warren Buffett) because of its simplicity and limited number of assumptions. The BY P method is essentially an ad hoc empirical relation with no solid theoretical justification. Yet there appears to be some empirical validity in the notion that the return on a company's stock can be estimated by taking the firm's bond yield-to-maturity (YTM) and adding a fixed risk premium to this yield. So, for example, a firm with a current bond YTM of 7% would lead to an estimated [K.sub.s] of 10% once a fixed 3% risk premium is added to the YTM. (12) Although there is no theoretical reason for adding a 3% premium, it appears that this relation is just as good or better for many stocks than using a formal model such as the CAPM.
Q.2 A) What is time value of money. Explain with example.
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time.
For example, 100 dollars of today's money invested for one year and earning 5 percent interest will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient who assumes 5 percent interest; using time value of money terminology, 100 dollars invested for one year at 5 percent interest has a future value of 105 dollars. This notion dates at least to Martín de Azpilcueta (1491–1586) of the School of Salamanca.
The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum "present value" of the entire income stream.
All of the standard calculations for time value of money derive from the most basic algebraic expression for the present value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sum of PV at present:
PV = FV − r·PV = FV/(1+r).
Some standard calculations based on the time value of money are:
The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they are earnings or obligations.
An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due
It is an infinite and constant stream of identical cash flows
It is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today
· Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.
CALCULATION
· There are several basic equations that represent the equalities listed above. The solutions may be found using (in most cases) the formulas, a financial calculator or a spreadsheet. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT)
· For any of the equations below, the formula may also be rearranged to determine one of the other unknowns. In the case of the standard annuity formula, however, there is no closed-form algebraic solution for the interest rate (although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms).
· These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity - that is, a future payment. The two formulas can be combined to determine the present value of the bond.
· An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate. For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 (see the example below). See compound interest for details on converting between different periodic interest rates.
· The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless.
· For calculations involving annuities, you must decide whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). If you are using a financial calculator or a spreadsheet, you can usually set it for either calculation. The following formulas are for an ordinary annuity. If you want the answer for the Present Value of an annuity due simply multiply the PV of an ordinary annuity by (1 + i).
B) Explain the different types of budgets.
INTRODUCTION
· The purpose of this chapter is to introduce the master budget or financial plan. This topic includes an important set of concepts and techniques that represent the major planning device for an organization, as well as the foundation for a traditional standard cost performance evaluation and control system. The chapter includes seven sections. The first section provides a discussion of the underlying concepts of financial planning and budgeting including the various types of budgets.
· This section also includes a diagram of the master budget that provides an overview of the overall budgeting process. Sections two and three include short, but important discussions of the purposes and benefits of budgeting and the limitations and problems involved in budgeting. The assumptions upon which the budget is based are briefly described in section four. Section five introduces the underlying concept of responsibility accounting and provides a brief discussion of a controversial issue associated with this concept.
· The techniques used to prepare a master budget are discussed and illustrated in section six. This is the longest section and includes a discussion of where the budget director obtains the budget information as well as how the information is used to complete the various schedules and sub-budgets involved. The last section includes a simplified, but fairly comprehensive example.
BUDGETING CONCEPTS
· Budgeting involves planning for the various revenue producing and cost generating activities of an organization. The importance of budgeting is emphasized by an old saying, "Failing to plan, is like planning to fail." Budgeting is essentially financial planning, or planning for financial performance. Consider the conceptual view of financial performance presented in Exhibit 9-1.
· As illustrated in the exhibit, financial performance depends on revenue and cost. Revenue is provided from sales of merchandise by retailers, sales of products, harvested, mined, constructed, formed, processed or assembled by farms, mining companies, construction companies and manufacturers and from sales of various services by firms involved in activities such as banking, insurance, accounting, law, medical care, food distribution, repair and entertainment. In addition to producing revenue, all of these companies generate three types of costs including discretionary, engineered and committed costs.
· Various costs fall into one of these three categories based on the cause and effect relationships involved. Although there are a variety of ways to define costs, categorizing costs in terms of the cause and effect relationships is a prerequisite for understanding the different types of budgets that are introduced in this chapter.
Discretionary Costs
Many activities are viewed as beneficial to an organization, even thought the benefits obtained, or value added by performing the activities cannot be defined precisely, either before or after the activity is completed. The costs of the inputs, or resources required to perform such activities are referred to as discretionary costs. These costs are discretionary in the sense that management must choose the desired level of the activity based on intuition or experience because there is no well defined cause and effect relationship between cost and benefits. Discretionary costs are usually generated by service or support activities. Examples include employee training, advertising, sales promotion, legal advice, preventive maintenance, and research and development. The value added by each of these activities is intangible and difficult, if not impossible to measure, where value added refers to the benefits obtained by either internal or external customers. In terms of cost behavior, discretionary costs may be fixed, variable or mixed.
| TYPE OF COST | CAUSE & EFFECT OR COST BENEFIT RELATIONSHIP | COST BEHAVIOR | EXAMPLES |
| DISCRETIONARY | Relationships are difficult or impossible to define. | Fixed, variable and mixed in the short run. | Cost of administrative and support services such as employee training, advertising, sales promotion, legal advice, preventive maintenance, and research and development. |
| ENGINEERED | Relationships are relatively easy to define. | Variable in the short run. | Direct resources used in production activities such as direct materials and direct labor and many indirect resources such as electric power. |
| COMMITTED | Relationships can be estimated, but not defined precisely. | Fixed in the short run. | Cost of establishing and maintaining the readiness to conduct business, such as the cost associated with plant and equipment. |
Engineered Costs
Engineered costs result from activities with reasonably well defined cause and effect relationships between inputs and outputs and costs and benefits. Direct material costs provide a good example. Engineers can specify precisely how many parts (inputs) are required to generate a specific output such as a microcomputer, a coffee maker, an automobile, or a television set. Direct labor also falls into the engineered cost category as well as indirect resources that vary with product specifications and production volume. Although the cause and effect relationships are not as precise for indirect resources, these relationships can be established using statistical techniques such as regression and correlation analysis. A key difference between discretionary costs and engineered costs is that the value added by the activities associated with engineered costs is relatively easy to measure. Engineered costs are variable in terms of cost behavior.
Committed Costs
Committed costs refers to the costs associated with establishing and maintaining the readiness to conduct business. The benefits obtained from these expenditures are represented by the company's infrastructure. For example, the costs associated with the purchase of a franchise, a patent, drilling rights and plant and equipment create long term obligations that fall into the committed cost category. These costs are mainly fixed in terms of cost behavior and expire to become expenses in the form of amortization and depreciation.
Four Types of Budgets
Four types of budgets are used for planning and controlling the various types of costs discussed above. These four techniques are summarized in Exhibit 9-3.
| TYPE OF BUDGET | CHARACTERISTICS OF THETECHNIQUE | TYPE OF COST OR EXPENDITURE | EXAMPLES |
| APPROPRIATION BUDGET | A maximum amount is established for certain expenditures based on management judgment. | Discretionary costs. | Employee training, advertising, sales promotion and research and development. |
| FLEXIBLE BUDGET | A static amount (a) is established for fixed costs and a variable rate (b) is determined per activity measure for variable costs, i.e., Y = a + bX | The static amount (a) includes both discretionary and committed costs while the flexible part (b) includes engineered costs per X value. | The static part: salaries, depreciation, property taxes and planned maintenance. The flexible part: direct material, direct labor and variable overhead. Also, some costs related to sales reps such as sales commissions and travel. |
| CAPITAL BUDGET | Decisions concerning potential investments are made using discounted cash flow techniques. | Committed costs. | New plant and equipment. |
| MASTER BUDGET | A comprehensive plan is developed for all revenue and expenditures. | Discretionary, engineered and committed costs. | All revenue and expenditures for any company. |
Appropriation Budgets
The oldest type of budget is referred to as an appropriation budget. Appropriation budgets place a maximum limit on certain discretionary expenditures and may be either year's budget amount plus an increment, i.e., small increase. Priority incremental budgets also involve an increase, but require managers to prioritize, or rank discretionary activities in terms of their importance to the organization. The idea is for the manager to indicate which activities would be changed if the budget were increased or decreased. Zero based budgeting was popular for a while around the time of Jimmy Carter's Presidency, but was dropped by most users because it was too expensive and time consuming. The technique is expensive to use because zero based budgets theoretically require justification for the entire budget amount. When it was popular, a more typical approach was to justify the last twenty percent of the budget, i.e., use eighty percent based budgeting.
From a control perspective, appropriation budgets are effective in limiting the amount of an expenditure, but create a behavioral bias to spend to the limit. Establishing a maximum amount for an expenditure encourages spending to the limit because spending below the limit implies that something less than the maximum appropriation was needed. Spending below the limit might result in a budget cut in future periods. Since nearly every manager views a budget reduction in their discretionary costs as undesirable, there are frequently crash efforts at the end of a budget period to spend up to the limit.
Flexible Budgets
The flexible budget was introduced in Chapter 4. Recall that flexible budgets are based on a cost function such as Y = a + bX, where Y represents the budgeted cost, or dependent variable. The constant "a" represents a static amount for fixed costs and the constant "b" represents the rate of change in Y expected for a unit change in the independent variable X. The expression " bX" is the flexible part of the budget cost function. The flexible budget technique is used for planning and monitoring all types of costs. The static amount "a" includes both discretionary and committed costs, while the flexible part "bX" includes various types of engineered costs. The flexible characteristic of the technique enables the flexible budget to play a key role in both financial planning and performance evaluation. The planning dimension is emphasized in this chapter and the performance evaluation aspect is given considerable attention in Chapters 10 and 13.
Capital Budgets
Capital budgets represent the major planning device for new investments. Discounted cash flow techniques such as net present value and the internal rate of return are used to evaluate potential investments. Capital budgets are part of a somewhat more encapsulating concept referred to as investment management. Investment management involves the planning and decision process for the acquisition and utilization of all of the organization's resources, including human resources as well as technology, equipment and facilities. The concept of investment management includes the discounted cash flow methods, but is more comprehensive in that the organization's portfolio of interrelated investments is considered as well as the projected effects of not investing.
Master Budgets
The fourth type of budget is referred to as the master budget or financial plan. The master budget is the primary financial planning mechanism for an organization and also provides the foundation for a traditional financial control system. More specifically, it is a comprehensive integrated financial plan developed for a specific period of time, e.g., for a month, quarter, or year. This is a much broader concept than the first three types of budgeting. The master budget includes many appropriation budgets (typically in the administrative and service areas) as well as flexible budgets, a capital budget and much more. A diagram illustrating the various parts of a master budget is presented in Exhibit 9-4.
The master budget has two major parts including the operating budget and the financial budget (See Exhibit 9-4). The operating budget begins with the sales budget and ends with the budgeted income statement. The financial budget includes the capital budget as well as a cash budget, and a budgeted balance sheet. The main focus of this chapter is on the various parts of the operating budget and the cash budget. The budgeted balance sheet is covered briefly, but not emphasized.
Q.3 A) How does management benefit from standard costing?
· Standard costing is an important subtopic of cost accounting. Standard costs are usually associated with a manufacturing company's costs of direct material, direct labor, and manufacturing overhead.
· Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences between the actual costs and the standard costs, and those differences are known as variances.
· Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes aware that manufacturing costs have differed from the standard (planned, expected) costs.
- If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant the company's actual profit will be less than planned.
- If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit.
· The sooner that the accounting system reports a variance, the sooner that management can direct its attention to the difference from the planned amounts.
· If we assume that a company uses the perpetual inventory system and that it carries all of its inventory accounts at standard cost (including Direct Materials Inventory or Stores), then the standard cost of a finished product is the sum of the standard costs of the inputs are Direct material, Direct labor and Manufacturing overhead in that Variable manufacturing overhead and Fixed manufacturing overhead are included
Benefits of Standard Costing:
The following are the main benefits obtained by use of standard costing system:
· The major goal of alternative forms of cost accounting is to provide the business an realistic view of the cost of merchandise that it sells. Although Standard cost accounting supplies this, it differs because it also focuses on performance measurement and management. standard costing provides a cost objective that Leadership can utilize to gauge the performance of the firm and its’ processes.
· Many companies which use standard cost accounting utilize it to manage by variance. This approach requires thorough variance analysis at all levels. The types of variances which are routinely measured are:
1. Purchase price Variance (PPV): Depending on the system, PPV can have various components. As a rule, it is the difference between the price on the Purchase Order (PO) and the standard cost of the item. The other most common component of PPV is the difference between the invoice from the supplier and the PO.
2. Closed Work Order Variance (CWO): The CWO variance is the difference between the standard cost associated with the item being produced and the actual costs charged to the work order. Depending on the system CWO variances can have various components, as well. Most ERP systems that handle work orders will differentiate between the categories of costs issued to the work order. These are usually Materials, Direct Labor, Factory Burden, and Outside Processing. Within Factory Burden, many systems also differentiate between Variance Burden, Fixed Burden and Material Burden.
3. Direct Labor Application Variance: The Direct Labor variance is the difference between the actual Direct Labor incurred and the Direct Labor charged to work orders.
4. Factory Burden Application Variance: The Factory Burden variance is the difference between the actual Factory Burden incurred and the Factory Burden charged to work orders. In many systems Factory Burden is split up into a number of sub-categories such as variable overhead, fixed overhead and material burden and each of these sub-categories need separate analysis to determine the drivers of the variances.
5. Management by Variance: Management by variance is the method of financial review in which the emphasis of the analysis is on the variances from budget and standard.
· The flow of the review is driven by how the company sees its’ products and markets. Among the most common classifications to go through during the review are product line/family/group, job, or location. For the sake of discussion, we will assume that product line will be the logical group. For every product line, the person doing the anaysis should produce production & sales data related to the specific groups along with variance analysis tables much like those listed in the last section.
· Numbers, on the other hand, are nearly meaningless with no narrative to paint the picture behind the numbers. The person preparing the analysis must not only show the numbers, but explore the drivers of the variances, both positive and negative. This allows this company to plan and carry out modifications to offset ongoing drivers of negative variances or, quite possibly, to further capitalize on operational changes which have shown positive variances by rolling them out into other areas.
· For example, utilizing the illustrations from the prior section, if the decrease from the standard 2 hour to produce a widget to the actual 1.75 hours was because of the purchase of newer, faster machines, then it quantifies the cost savings associated with the improvement that was put in place. On the other hand, the rise in materials usage could be because of training issues associated to employee turnover, or changes in materials to improve yield, quality or cost and is in need or rigorous analysis.
· At the end of the review, all attendees should have a clear view of where the financials stand, what the drivers were (both positive and negative), and know all of the action items to be addressed at a later meeting.
· If you would like more information on Standard Cost or Managing by the Variancescheck out Instant Controller.
B) What are standard costs? Also explain process of standard costing.
· A standard cost is the predetermined cost of manufacturing a single unit or a number of product units during a specific period in the immediate future. It is the planned cost of a product under current and / or anticipated operating conditions.
· A standard is a "benchmark" or "norm" for measuring performance. Standards are found everywhere your doctor, for example, evaluates your weight using standards that have been set for individuals of your age, height and gender. the food we eat in restaurants must be prepared under specified standards of cleanliness. The buildings we live in must conform to standards set in building codes. Standards are also widely used in managerial accounting where they relate to the quantity and cost of inputs used in manufacturing goods and producing services. Engineers and accountants assist managers to set quantity and cost standards for each major input such as raw materials and direct labor time. Quantity standards specify how much of an input should be used to make a product or provide a service. Cost or price standards specify how much should be paid for each unit of input. Actual quantities and actual costs are then compared with these standards. In case of significant deviations managers investigate the discrepancies. The purpose is to find the problem and eliminate it so that it does not recur. This process is called management by exception.
· In our daily lives, we operate in a management by exception mode most of the time. Consider what happens when you sit down in the driver's seat of your car. You put the key in the ignition, your turn the key, and your car starts. Your exception (standard) that the car will start is met; you do not have to open the car hood and check the battery, the connecting cables, the fuel lines, and so on. If you turn the key and the car does not start, then you have a discrepancy (variance). Your exceptions are not met, and you need to investigate why. Note that even if the car is started after a second try, it would be wise to investigate anyway. The fact that exception was not met should be viewed as an opportunity to uncover the cause of the problem rather than as simply an annoyance. If the underlying cause is not discovered and corrected, the problem may recur and become much worse.
· This basic approach to identifying and solving problems is exploited in the variance analysis cycle, The cycle begins with the preparation of standard cost performance reports in the accounting department. These reports highlight the variances, which are the differences between actual results and what should have occurred according to the standards. The variances raise questions. Why did this variance occur? Why is this variance larger than it was last period? The significant variances are investigated to discover their root causes. Corrective actions are taken. And then next period's operations are carried out. The cycle then begins again with the preparation of a new standard cost performance for the latest period. The emphasis should be on flagging problems for attention, finding their root causes, and then taking corrective actions. The goal is to improve operations - not to find blame.
Who Uses Standard Costs?
· Manufacturing, service, food, and not-for-profit organizations all make use of standards to some extent. Auto service centers like Firestone and Sears, for example, often set specific labor time standards for the completion of certain work tasks, such as installing a carburetor or doing a valve job, and then measure actual performance against these standards. Fast-food outlets such as McDonald's have exacting standards for the quantity of meat going a sandwich, as well as standards for the cost of the meat. Hospitals have standards costs (for food, laundry, and other items) for each occupied bed every day, as well as standard time allowances for certain routine activities, such as laboratory tests. In short, you are likely to run into standard costs in virtually any line of business that you enter.
· Manufacturing companies often have highly developed standard costing systems in which standards relating to direct materials, direct labor and overhead are developed in detail for each separate product. These standards are listed on a standard cost card that provides the manager with a great deal of information concerning the inputs that are required to produce a unit and their costs.
Q.4 A) Differentiate between Controllable and Non-Controllable costs.
By Controllability- Costs here may be classified into controllable and uncontrollable
costs.
costs.
- Controllable costs - These are the costs which can be influenced by the action of a
specified member of an undertaking. A business organisation is usually divided into a number of responsibility centres and an executive heads each such centre. Controllable costs incurred in a particular responsibility centre can be influenced by the action of the executive heading that responsibility centre.
For example, Direct costs comprising direct labour, direct material, direct expenses and some of the overheads are generally controllable by the shop level management.
- Uncontrollable costs - Costs which cannot be influenced by the action of a specified member of an undertaking are known as uncontrollable costs.
For example, expenditure incurred by, say, the Tool Room is controllable by the foreman incharge of that section but the share of the tool-room expenditure which is apportioned to a machine shop is not to be controlled by the machine shop foreman
· The distinction between controllable and uncontrollable costs is not very sharp and is sometimes left to individual judgment. In fact no cost is uncontrollable; it is only in relation to a particular individual that we may specify a particular cost to be either controllable or uncontrollable
· Controllable costs are those costs which can be regulated or controlled by specified member of an undertaking. Most of the variable costs are controllable costs. For example, direct material, direct labor and direct expenses are controlled by the lower level of management.
· Where as uncontrollable cost can not be controlled by the specified member of the undertaking. Most of the fixed cost are uncontrollable cost. For example, factory rent manager's salary, Depreciation etc.
· A Controllable cost is "a cost which can be influenced by its budget holder"
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the manager most capable of controlling them. As a system of accounting, it therefore distinguishes between controllable and incontrollable costs.
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the manager most capable of controlling them. As a system of accounting, it therefore distinguishes between controllable and incontrollable costs.
- Most variable costs within a department are thought to be controllable in the short term because manager can influence the efficiency with which resources are used, even if they cannot do anything to rise or lower price levels.
- Many fixed costs are uncontrollable (or committed) in the short term, although some fixed costs may be discretionary.
- Many fixed costs are directly attributable to a department or profit center in that although they are fixed (in the short term) within the relevant range of output, a drastic reduction in the of the department‘s output, or closure of the division entirely, would reduce or remove these costs.
- Assets and liabilities are only controllable to the extent that the investment centers Manager has authority to increase or reduce them.
B) Explain utility of funds flow statement?
1. In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet.[1] As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the International Accounting Standard that deals with cash flow statements.
2. People and groups interested in cash flow statements include:
· Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses
· Potential investors, who need to judge whether the company is financially sound
· Potential employees or contractors, who need to know whether the company will be able to afford compensation
· Shareholders of the business.
PURPOSE
| Statement of Cash Flow - Simple Example for the period 01/01/2006 to 12/31/2006 | |
| Cash flow from operations | Rs.4,000 |
| Cash flow from investing | Rs.(1,000) |
| Cash flow from financing | Rs.(2,000) |
| Net cash flow | Rs.1,000 |
| Parentheses indicate negative values | |
3. The cash flow statement was previously known as the flow of Cash statement. The cash flow statement reflects a firm's liquidity.
4. The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues.
5. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Non-cash activities are usually reported in footnotes.
6. The cash flow statement is intended to:
· It provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances
· It provide additional information for evaluating changes in assets, liabilities and equity
· It improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods
· It indicate the amount, timing and probability of future cash flows
7. The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets
UTILITY OF CASH FLOW STATEMENT
The cash flow statement traces the various sources which bring in cash, such as
operations, sale of current and fixed assets, issuance of share capital and long term
borrowings etc. and the applications which cause outflow of cash, such as, purchase of
current and fixed assets, redemption of debentures, preference shares for cash and so on. This statement is designed for account for the change in cash. The advantage of the cash flow statement is illustrated below
1) Discloses Cash Movement
The primary function carried out by a cash flow statement is to disclose the inward
and outward movement i.e. inflow and outflow of cash. It indicates all possible changes in cash position of a firm in quantitative terms accompanied by the reasons to support such changes. Hence, a cash management can exercise full control over cash movement with the help of cash flow statement.
2) Helps in Financial Planning
It plays a vital role in short-term financial planning. It helps in forecasting cash
requirements, determining the quantity of required cash in advance, the amount that can be generated form internal sources and the volume expected to be acquired from outside sources. Thus, the future course of action related to cash can be planned in the light of cash flow statement.
3) Aids Internal Financial Management
Cash flow statement is of great help to management in formulating policies related to
internal financial management. Since, any information pertaining to the availability of cash from operations can be obtained by means of cash flow statement. Thus, a management can make important decisions involving dividend policy, replacement of assets, repayment of long-term loans etc.
4) Reveals Success or Failure of Cash Planning
It reveals the extent of success or failure of cash planning. As a management may
hold comparison of cash flow of current year with projected cash budget of that period, variations, if any with relevant cause may be detected and necessary remedial actions can be initiated.
5) Adds Efficiency to Cash Management
Cash is the very foundation of all business operations. Therefore, a projected cash
flow statement provides sufficient guidelines to the management for planning and
coordinating financial operations properly, effectively and efficiently.
6) Helps to determine the likely flow of cash.
Projected cash flow statements help the management to determine the likely inflow or
outflow of cash from operations and the amount of cash required to be raised from other sources to meet the future needs of the business.
7) Supplemental to funds flow statement.
Cash flow analysis supplements the analysis provided by funds flow statement, as
cash is a part of the working capital.235
8) Better tool of analysis-
For payment of liabilities, which are likely to be matured in the near future, cash is more important than the working capital. As such, cash flow statement is certainly a better tool of analysis than funds flow statement for short-term analysis.
Q.5 A) Why is Break-even analysis useful to a company.
A company's break-even point is the amount of sales or revenues that it must generate in order to equal its expenses. In other words, it is the point at which the company neither makes a profit nor suffers a loss. Calculating the break-even point (through break-even analysis) can provide a simple, yet powerful quantitative tool for managers. In its simplest form, break-even analysis provides insight into whether or not revenue from a product or service has the ability to cover the relevant costs of production of that product or service. Managers can use this information in making a wide range of business decisions, including setting prices, preparing competitive bids, and applying for loans.
BACKGROUND
· The break-even point has its origins in the economic concept of the "point of indifference." From an economic perspective, this point indicates the quantity of some good at which the decision maker would be indifferent, i.e., would be satisfied, without reason to celebrate or to opine. At this quantity, the costs and benefits are precisely balanced.
· Similarly, the managerial concept of break-even analysis seeks to find the quantity of output that just covers all costs so that no loss is generated. Managers can determine the minimum quantity of sales at which the company would avoid a loss in the production of a given good. If a product cannot cover its own costs, it inherently reduces the profitability of the firm.
MANAGERIAL ANALYSIS
· Typically the scenario is developed and graphed in linear terms. Revenue is assumed to be equal for each unit sold, without the complication of quantity discounts. If no units are sold, there is no total revenue ($0). However, total costs are considered from two perspectives. Variable costs are those that increase with the quantity produced; for example, more materials will be required as more units are produced. Fixed costs, however, are those that will be incurred by the company even if no units are produced.
· In a company that produces a single good or service, this would include all costs necessary to provide the production environment, such as administrative costs, depreciation of equipment, and regulatory fees. In a multi-product company, fixed costs are usually allocations of such costs to a particular product, although some fixed costs (such as a specific supervisor's salary) may be totally attributable to the product.
· Figure 1 displays the standard break-even analysis framework. Units of output are measured on the horizontal axis, whereas total dollars (both revenues and costs) are the vertical units of measure. Total revenues are nonexistent ($0) if no units are sold. However, the fixed costs provide a floor for total costs; above this floor, variable costs are tracked on a per-unit basis. Without the inclusion of fixed costs, all products for which marginal revenue exceeds marginal costs would appear to be profitable.
· In Figure 1, the break-even point illustrates the quantity at which total revenues and total costs are equal; it is the point of intersection for these two totals. Above this quantity, total revenues will be greater than total costs, generating a profit for the company. Below this quantity, total costs will exceed total revenues, creating a loss.
· To find this break-even quantity, the manager uses the standard profit equation, where profit is the difference between total revenues and total costs. Predetermining the profit to be $0, he/she then solves for the quantity that makes this equation true, as follows:
Let TR = Total revenues
TC = Total costs
P = Selling price
F = Fixed costs
V = Variable costs
Q = Quantity of output
TR = P× Q
TC = F + V × Q
TR − TC = profit
Let TR = Total revenues
TC = Total costs
P = Selling price
F = Fixed costs
V = Variable costs
Q = Quantity of output
TR = P× Q
TC = F + V × Q
TR − TC = profit
· Because there is no profit ($0) at the break-even point, TR − TC = 0, and then P× Q − (F + V× Q) = 0. Finally, Q = F(P − V).
· This is typically known as the contribution margin model, as it defines the break-even quantity (Q) as the number of times the company must generate the unit contribution margin (P − V), or selling price minus variable costs, to cover the fixed costs. It is particularly interesting to note that the higher the fixed costs, the higher the break-even point. Thus, companies with large investments in equipment and/or high administrative-line ratios may require greater sales to break even.
· As an example, if fixed costs are $100, price per unit is $10, and variable costs per unit are $6, then the break-even quantity is 25 ($100 ÷ [$10 − $6] = $100 ÷$4). When 25 units are produced and sold, each of these units will not only have covered its own marginal (variable) costs, but will have also have contributed enough in total to have covered all associated fixed costs. Beyond these 25 units, all fixed costs have been paid, and each unit contributes to profits by the excess of price over variable costs, or the contribution margin. If demand is estimated to be at least 25 units, then the company will not experience a loss. Profits will grow with each unit demanded above this 25-unit break-even level.
· While it is useful to know the quantity of sales at which a product will cease to generate losses, it may be even more useful to know the quantity necessary to generate a desired level of profit, sayD.
TR − TC = D
P× Q − (F + V× Q) = D
Then Q = (F + D) ÷ (P − V)
TR − TC = D
P× Q − (F + V× Q) = D
Then Q = (F + D) ÷ (P − V)
· This has the effect of regarding the desired profit as an increase in the fixed costs to be covered by sales of the product. As the decision-making process often requires profits for payback period, internal rate of return, or net present value analysis, this form may be more useful than the basic break-even model.
BASIC ASSUMPTIONS
· There are several assumptions that affect the applicability of break-even analysis. If these assumptions are violated, the analysis may lead to erroneous conclusions.
· It is tempting to the manager to set the contribution margin (and thus the price) by using the sales goal (or certain demand) as the quantity. However, sales goals and market demand are not necessarily equivalent, especially if the customer is price-sensitive. Price-elasticity exists when customers will respond positively to lower prices and negatively to higher prices, and is particularly applicable to nonessential products. A small change in price may affect the sale of skis more than the sale of insulin, an inelastic-demand item due to its inherently essential nature. Therefore, using this method to set a prospective price for a product may be more appropriate for products with inelastic demand. For products with elastic demand, it is wiser to estimate demand based on an established, acceptable market price.
· Typically, total revenues and total costs are modeled as linear values, implying that each unit of output incurs the same per-unit revenue and per-unit variable costs. Volume sales or bulk purchasing may incorporate quantity discounts, but the linear model appears to ignore these options.
· A primary key to detecting the applicability of linearity is determining the relevant range of output. If the forecast of demand suggests that 100 units will be demanded, but quantity discounts on materials are applicable for purchases over 500 units from a single supplier, then linearity is appropriate in the anticipated range of demand (100 units plus or minus some fore-cast error). If, instead, quantity discounts begin at 50 units of materials, then the average cost of materials may be used in the model. A more difficult issue is that of volume sales, when such sales are frequently dependent on the ordering patterns of numerous customers. In this case, historical records of the proportionate quantity-discount sales may be useful in determining average revenues.
· Linearity may not be appropriate due to quantity sales/purchases, as noted, or to the step-function nature of fixed costs. For example, if demand surpasses the capacity of a one-shift production line, then a second shift may be added. The second-shift supervisor's salary is a fixed-cost addition, but only at a sufficient level of output. Modeling the added complexity of nonlinear or step-function costs requires more sophistication, but may be avoided if the manager is willing to accept average costs to use the simpler linear model.
· One obviously important measure in the break-even model is that of fixed costs. In the traditional cost-accounting world, fixed costs may be determined by full costing or by variable costing. Full costing assigns a portion of fixed production overhead charges to each unit of production, treating these as a variable cost. Variable costing, by contrast, treats these fixed production overhead charges as period charges; a portion of these costs may be included in the fixed costs allocated to the product. Thus, full costing reduces the denominator in the break-even model, whereas the variable costing alternative increases the denominator. While both of these methods increase the break-even point, they may not lend themselves to the same conclusion.
· Recognizing the appropriate time horizon may also affect the usefulness of break-even analysis, as prices and costs tend to change over time. For a prospective outlook incorporating generalized inflation, the linear model may perform adequately. Using the earlier example, if all prices and costs double, then the break-even point Q = 200 ÷ (20 − 12) = 200 ÷ 8 = 25 units, as determined with current costs. However, weakened market demand for the product may occur, even as materials costs are rising. In this case, the price may shift downward to $18 to bolster price-elastic demand, while materials costs may rise to $14. In this case, the break-even quantity is 50 (200 ÷ [18 − 14]), rather than 25. Managers should project break-even quantities based on reasonably predictable prices and costs.
· It may defy traditional thinking to determine which costs are variable and which are fixed. Typically, variable costs have been defined primarily as "labor and materials." However, labor may be effectively salaried by contract or by managerial policy that supports a full workweek for employees. In this case, labor should be included in the fixed costs in the model.
· Complicating the analysis further is the concept that all costs are variable in the long run, so that fixed costs and the time horizon are interdependent. Using a make-or-buy analysis, managers may decide to change from in-house production of a product to subcontracting its production; in this case, fixed costs are minimal and almost 100 percent of the costs are variable. Alternatively, they may choose to purchase cutting-edge technology, in which case much of the variable labor cost is eliminated; the bulk of the costs then involve the (fixed) depreciation of the new equipment. Managers should project break-even quantities based on the choice of capital-labor mix to be used in the relevant time horizon.
· Traditionally, fixed costs have been allocated to products based on estimates of production for the fiscal year and on direct labor hours required for production. Technological advances have significantly reduced the proportion of direct labor costs and have increased the indirect costs through computerization and the requisite skilled, salaried staff to support company-wide computer systems. Activity-based costing (ABC) is an allocation system in which managers attempt to identify "cost drivers" which accurately reflect the appropriate usage of fixed costs attributable to production of specific products in a multi-product firm. This ABC system tends to allocate, for example, the CEO's salary to a product based on his/her specific time and attention required by this product, rather than on its proportion of direct labor hours to total direct labor hours.
EXTENSIONS OF BREAK-EVEN ANALYSIS
· Break-even analysis typically compares revenues to costs. However, other models employ similar analysis.
· In the crossover chart, the analyst graphs total-cost lines from two or more options. These choices may include alternative equipment choices or location choices. The only data needed are fixed and variable costs of each option.
· In Figure 2, the total costs (variable and fixed costs) for three options are graphed. Option A has the low-cost advantage when output ranges between zero and X units, whereas Option B is the least-cost alternative between X and X units of output. Above Xunits, Option C will cost less than either A or B. This analysis forces the manager to focus on the relevant range of demand for the product, while allowing for sensitivity analysis. If current demand is slightly less than X Option B would appear to be the best choice. However, if medium-term forecasts indicate that demand will continue to grow, Option C might be the least-cost choice for equipment expected to last several years. To determine the quantity at which Option B wrests the advantage from Option A, the manager sets the total cost of A equal to the total cost of B (FA +VA×Q = FB + VB× Q) and solves for the sole quantity of output (Q) that will make this equation true. Finding the break-even point between Options B and C follows similar logic.
· The Economic Order Quantity (EOQ) model attempts to determine the least-total-cost quantity in the purchase of goods or materials. In this model, the total of ordering and holding costs is minimized at the quantity where the total ordering cost and total holding cost are equal, i.e., the break-even point between these two costs.
· As companies merge, layoffs are common. The newly formed company typically enjoys a stock-price surge, anticipating the leaner and meaner operations of the firm. Obviously, investors are aware that the layoffs reduce the duplication of fixed-cost personnel, leading to a smaller break-even point and thus profits that begin at a lower level of output.
APPLICATIONS IN SERVICE INDUSTRIES
· While many of the examples used have assumed that the producer was a manufacturer (i.e., labor and materials), break-even analysis may be even more important for service industries. The reason for this lies in the basic difference in goods and services: services cannot be placed in inventory for later sale. What is a variable cost in manufacturing may necessarily be a fixed cost in services. For example, in the restaurant industry, unknown demand requires that cooks and table-service personnel be on duty, even when customers are few. In retail sales, clerical and cash register workers must be scheduled. If a barber shop is open, at least one barber must be present. Emergency rooms require round-the-clock staffing. The absence of sufficient service personnel frustrates the customer, who may balk at this visit to the service firm and may find competitors that fulfill the customer's needs.
· The wages for this basic level of personnel must be counted as fixed costs, as they are necessary for the potential production of services, despite the actual demand. However, the wages for on-call workers might be better classified as variable costs, as these wages will vary with units of production. Services, therefore, may be burdened with an extremely large ratio of fixed-to-variable costs.
· Service industries, without the luxury of inventoriable products, have developed a number of ways to provide flexibility in fixed costs. Professionals require appointments, and restaurants take reservations; when the customer flow pattern can be predetermined, excess personnel can be scheduled only when needed, reducing fixed costs. Airlines may shift low-demand flight legs to smaller aircraft, using less fuel and fewer attendants. Hotel and telecommunication managers advertise lower rates on weekends to smooth demand through slow business periods and avoid times when the high-fixed-cost equipment is underutilized. Retailers and banks track customer flow patterns by day and by hour to enhance their short-term scheduling efficiencies. Whatever method is used, the goal of these service industries is the same as that in manufacturing: reduce fixed costs to lower the break-even point.
· Break-even analysis is a simple tool that defines the minimum quantity of sales that will cover both variable and fixed costs. Such analysis gives managers a quantity to compare to the forecast of demand. If the break-even point lies above anticipated demand, implying a loss on the product, the manager can use this information to make a variety of decisions. The product may be discontinued or, by contrast, may receive additional advertising and/or be re-priced to enhance demand. One of the most effective uses of break-even analysis lies in the recognition of the relevant fixed and variable costs. The more flexible the equipment and personnel, the lower the fixed costs, and the lower the break-even point.
· It is difficult to overstate the importance of break-even analysis to sound business management and decision making. Ian Benoliel, CEO of management software developer NumberCruncher.com, said on Entrepreneur.com (2002):
The break-even point may seem like Business 101, yet it remains an enigma to many companies. Any company that ignores the break-even point runs the risk of an early death and at the very least will encounter a lot of unnecessary headaches later on.
B) What are capital investments?
· A capital investment is the acquisition of a fixed asset that is anticipated to have a long life of use before it has to be replaced or repaired. Two of the most easily recognizable examples ofcapital investments are land and buildings. However, a capital investment is made any time that a company purchases goods that will be benefit the operation of the business, but will not be used to cover the operational costs of the business.
· Of course, a capital investment does not have to be an asset that is along the lines of equipment or land. A capital investment can be something as simple as an amount of money that is set aside in some sort of interest bearing account. Since the resource is not being used to cover business expenses, capital assets of this type is free to be used for the purpose of generating additional revenue by accruing interest. Thus, it would be proper to consider an initial amount of money that is used to open a standard savings account as a capital asset, with the fact that a rate of interest will be realized from the principal each year turning the asset into a capital investment.
· Many people think that in order to qualify as identification as a capital investment, the asset must be an item with a great deal of initial worth. In fact, fixed assets may carry any type of inherent worth. The main characteristic of a capital investment is not meeting some basic current value, but the fact that the item is not required for the normal expenses associated with daily living or business operation. Even the component of realizing some sort of interest is not necessarily a qualification for being understood as a capital investment. Money that is kept in a piggy bank or under the mattress would still qualify as a capital investment, since the money (a) is expected to have a long usable life
· Capital investment involves ploughing financial resources into physical resources that will generate wealth for a business over time.
· For example, a financial resource could be a loan or finance raised from shareholders. This finance can then be used to invest in a new factory building or a new automated production line. Utility companies invest vast sums of money in physical capital such as pipelines to pipe gas from the gas fields to where it can easily be distributed to the final consumer in an appropriate form.
· Making an investment involves weighing up the risk against the return. The risk needs to be acceptable to relevant stakeholders such as shareholders, as does the financial return on the capital investment.
· Investment makes it possible to increase productivity i.e. the outputs produced from given quantities of inputs. For example, building a modern pipeline from a high yielding gas field will increase the productivity of capital i.e. output per £ invested, as well as increasing productivity of labour and other resources employed by a company.
· Ideally capital investment should yield greater returns at lower unit costs - enabling what is referred to as economies of scale. Productivity is measured in units of output produced from given units of input, or in terms of revenue per unit of input employed.
· The term capital is used in business both to refer to financial capital - e.g. a business has a sum of capital to invest, and to physical capital i.e. the amount of machinery, equipment, buildings etc that a business has.
· Financial capital can be converted into physical capital, and the output of physical capital is then converted into a financial stream of returns.
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