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2.3.6 DIFFERENCE BETWEEN TRADING A/C AND PROFIT & LOSS A/C
Some of the differences between Trading A/c and Profit & Loss A/c are as follows: Trading account is the account showing the Gross Profit of a business, whereas, the Profit & Loss Account shows the Net Profit of a business. Gross Profit = Sales Turnover - Cost of goods sold (opening stock + purchases + carriage inwards-closing stock) Net Profit = Gross Profit + Revenue (rent received, interest received, discount received) - Expenses All direct expenses/revenues that are directly related to the factory or production are included in a Trading A/c. On the other hand, all Indirect Expenses/revenues that are related to the Administration & Selling are included in a P&L A/c. The gross profit or loss, which is derived from the Trading Account, shows the trend of the business and the Profit & Loss account reflects on the management of the business and the outcomes of the concern.
The Difference Between Cost Accounting and Financial Accounting are as follows: Cost Accounting: The main purpose of cost accounting is to analyse, ascertainment and control of cost. Cost accounting presents cost information at frequent intervals. Cost accounting generally kept voluntarily to meet the requirements of the management. Cost accounting records transactions in a objective manner. It means the purpose for which the cost in incurred. Financial Accounting: The main purpose of financial accounting is to record financial transactions, finding out profit or loss and financial position. Financial accounting presents financial information at the end of the accounting period. Financial accounting is kept compulsory in such a way as to meet the requirement of the Companies Act and income Tax Act. Financial accounting records transactions in a subjective manner. It means according to the nature of expenses.

1. Meaning Cost Accounting : Cost accounting is that part of accounting which is helpful to calculate the cost and
control the cost. In cost accounting, we deeply study the variable cost, fixed cost, overheads and capital cost. Financial Accounting

Financial Accounting is that part of accounting in which we record the

transactions and we make the financial statements. Through making the financial statement, it provide information of profitability and financial position to the interested parties.

2. Objective Cost Accounting : We can not take all decisions on the basis of information which have been
provided by financial accounting. After making the financial statements under financial accounting, we calculate the cost of each unit and use the techniques of cost accounting for better decision making. Financial Accounting : Main objective of financial accounting is to show the financial statement correctly.

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3. Law
Cost Accounting : There is not any restriction on the cost accounts. It can be made according to the need of company but some company must audit their cost accounts under cost audit. Financial Accounting : In financial accounting, there are lots of law restrictions. For example, company accounts and financial statements must be according to the format of company law. It should also follow the rules of IFRS and income tax law.

4. Controlling
Cost Accounting : In cost accounting, we study the techniques of controlling the cost. All the costs are calculated for the purpose of controlling the cost. For example, Company produces product A, B and C. If product C is generating 30% but product A and B is generating just 5%. We will try to control the cost of A and B product through different techniques of cost control. Financial Accounting : In financial accounting, we just record the transactions correctly. We do not care to control the cost.

5. Profit Analysis
Cost Accounting : In cost accounting, to find the profit per job or per batch or per service unit is possible. Financial Accounting : In financial accounting. we make the income statement which shows the net profit or loss or whole organisation not one job or batch.

6. Record
Cost Accounting : In cost accounting, both actual transactions record and estimations are used. For example budgetary control and variance analysis, we set the standard cost which is based on the estimations. These estimations may be differ from actual cost. Financial Accounting : In financial accounting, we use actual transaction for recording purpose. We do not use the estimation for preparing income statements and balance sheet.

7. Valuation of Inventory
Cost Accounting : In cost accounting, inventory's valuation will be on cost. Financial Accounting : In financial accounting, inventory's valuation will be on the cost or market value which will be low.

8. Cycle
Cost Accounting : In cost accounting, we first calculate the raw material cost. Then, we calculate the labour cost. Then, we calculate the direct material cost. After this, we calculate the overhead cost. All these cost are added. A profit margin is added. An estimated sale price is calculated. Its whole controlling cycle will be relating to control the cost of raw material, labour cost and overheads.

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Financial Accounting : In financial accounting, we pass the journal entries. Then, we make the ledger accounts. Then, we prepare the trial balance. Then, we make the final accounts.

What is the current ratio?

The current ratio is a financial ratio that shows the proportion of current assets to current liabilities. The current ratio is used as an indicator of a companys liquidity. In other words, a large amount of current assets in relationship to a small amount of current liabilities provides some assurance that the obligations coming due will be paid. If a companys current assets amount to $600,000 and its current liabilities are $200,000 the current ratio is 3:1. If the current assets are $600,000 and the current liabilities are $500,000 the current ratio is 1.2:1. Obviously a larger current ratio is better than a smaller ratio. Some people feel that a current ratio that is less than 1:1 indicates insolvency. It is wise to compare a companys current ratio to that of other companies in the same industry. You are also wise to look at the trend of the current ratio for a given company over time. Is the current ratio improving over time, or is it deteriorating? The composition of the current assets is also an important factor. If the current assets are predominantly in cash, marketable securities, and collectible accounts receivable, that is more comforting than having the majority of the current assets in slow-moving inventory.

The Current Ratio

One of the first ratios that a lender or supplier reviews when examining a company is its current ratio. The current ratio measures the short-term liquidity of a business; that is, it gives an indication of the ability of a business to pay its bills. A ratio of 2:1 is preferred, with a lower proportion indicating a reduced ability to pay in a timely manner. Since the ratio is current assets divided by current liabilities, the ratio essentially implies that current liabilities can be liquidated to pay for current liabilities. To calculate the current ratio, divide the total of all current assets by the total of all current liabilities. The formula is: Current assets Current liabilities The current ratio can yield misleading results under the following circumstances:

Inventory component. When the current assets figure includes a large proportion of inventory assets, since these assets can be difficult to liquidate. This can be a particular problem if management is using aggressive accounting techniques to apply an unusually large amount of overhead costs to inventory, which further inflates the recorded amount of inventory.

Paying from debt. When a company is drawing upon its line of credit to pay bills as they come due, which means that the cash balance is near zero. In this case, the current ratio could be fairly low, and yet the presence of a line of credit still allows the business to pay in a timely manner. For example, a supplier wants to learn about the financial condition of Lowry Locomotion. The supplier calculates the current ratio of Lowry for the past three years: Year 1 Year 2 Year 3

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Current assets Current liabilities Current ratio $8,000,000 $4,000,000 2:1 $16,400,000 $9,650,000 1.7:1 $23,400,000 $18,000,000 1.3:1

The sudden rise in current assets over the past two years indicates that Lowry has undergone a rapid expansion of its operations. Of particular concern is the increase in accounts payable in Year 3, which indicates a rapidly deteriorating ability to pay suppliers. Based on this information, the supplier elects to restrict the extension of credit to Lowry.

Definition of 'Inventory Turnover'

A ratio showing how many times a company's inventory is sold and replaced over a period. The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days."

Investopedia explains 'Inventory Turnover'

Although the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors. This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall. Things to Remember A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse. Companies selling perishable items have very high turnover. For more accurate inventory turnover figures, the average inventory figure, ((beginning inventory + ending inventory)/2), is used when computing inventory turnover. Average inventory accounts for any seasonality effects on the ratio.

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What is the total asset turnover ratio?

The total asset turnover ratio indicates the relationship of net sales for a specified year to the average amount of total assets during the same 12 months. Lets assume that during a recent year a corporation had net sales of $2,100,000 and its total assets during the same 12 month period averaged $1,400,000. The companys total asset turnover for the year was 1.5 (net sales of $2,100,000 divided by $1,400,000 of average total assets). This ratio will vary by industry, as some industries are more capital intensive than others. Always compare your companys financial ratios to the ratios of other companies in the same industry. Download our Total Assets Turnover Ratio Form and Template. Learn more about Financial Ratios from AccountingCoach.coms free Explanation of Financial Ratios. Take our Financial Ratios Exam.

Operating margin

In business, operating margin also known as operating income margin, operating profit margin and return on sales (ROS) is the ratio of operating income ("operating profit" in the UK) divided by net sales, usually presented in percent.

Net profit measures the profitability of ventures after accounting for all costs.

[1]

Return on sales (ROS) is net profit as a percentage of sales revenue. . . . ROS is an indicator of profitability and is often used to compare the profitability of companies and industries of differing sizes. Significantly, ROS does not account for the capital (investment) used to generate the profit. In a survey of nearly 200 senior marketing [1] managers, 69 percent responded that they found the "return on sales" metric very useful. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a rough measure of operating cash [1] flow, which reduces the effect of accounting, financing, and tax policies on reported profits.

Purpose [edit]
These financial metrics measure levels and rates of profitability. How does a company decide whether it is successful or not? Probably the most common way is to look at the net profits of the business. Given that companies are collections of projects and markets, individual areas can be judged on how successful they are at adding to the corporate net profit. Not all projects are of equal size, however, and one way to adjust for size is to divide the profit by sales revenue. The resulting ratio is return on sales (ROS), the percentage of sales [1] revenue that gets 'returned' to the company as net profits after all the related costs of the activity are deducted.

Construction [edit]
Net profit measures the fundamental profitability of the business. It is the revenues of the activity less the costs of the activity. The main complication is in more complex businesses when overhead needs to be allocated across divisions of the company. . . . Almost by definition, overheads are costs that cannot be directly tied to any [1] specific product or division. The classic example would be the cost of headquarters staff.

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Net profit: To calculate net profit for a unit (such as a company or division), subtract all costs, including a fair [1] share of total corporate overheads, from the gross revenues. Net profit ($) = Sales revenue ($) - Total costs ($) Return on sales (ROS): Net profit as a percentage of sales revenue. Return on sales (%) = Net profit ($) / Sales revenue ($) Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a very popular measure of financial performance. It is used to assess the 'operating' profit of the business. It is a rough way of calculating how much cash the business is generating and is even sometimes called the 'operating cash flow.' It can be useful because it removes factors that change the view of performance depending upon the accounting and financing policies of the business. Supporters argue it reduces management's ability to change the profits they report by their choice of accounting rules and the way they generate financial backing for the company. This metric excludes from consideration expenses related to decisions such as how to finance the business (debt or equity) and over what period they depreciate fixed assets. EBITDA is typically closer to actual cash flow than is NOPAT. . . . EBITDA can be calculated by adding back the costs of interest, depreciation, and amortization charges and any taxes [1] incurred. EBITDA ($) = Net profit ($) + Interest Payments ($) + Taxes Incurred ($) + Depreciation and [1] Amortization Charges ($) Example: The Coca Cola Company
[2] [1]

Consolidated Statements of Income (In millions) Net Operating Revenues Gross Profit Operating Income Income Before Income Taxes Net Income (Relevant figures in italics) $ 20,088 $ 15,924 $ 6,318 $ 6,578 $ 5,080

It is a measurement of what proportion of a company's revenue is left over, before taxes and other indirect costs (such as rent, bonus, interest, etc.), after paying for variable costs of production as wages, raw materials, etc. A good operating margin is needed for a company to be able to pay for its fixed costs, such as interest on debt. A higher operating margin means that the company has less financial risk. Operating margin can be considered total revenue from product sales less all costs before adjustment for taxes, dividends to shareholders, and interest on debt.

What is the operating profit margin?

The basic calculation is: + Revenues

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- Cost of goods sold (such as direct materials, direct labor, and overhead) - Selling and administrative expenses = Operating profit (loss)

The operating profit is then divided by revenues to arrive at the operating profit margin. For example, ABC Company has revenues fo $10 million and an operating profit of $1.5 million. This is an operating profit margin of 15% ($1.5 million operating profit / $10 million revenues). The operating profit margin may be more important than net profit, since it reveals the financial viability of the core business before any extraneous financial or tax-related effects. It is particularly useful to track this item on a historical trend line to see if there are any long-term changes that management should be aware of. You should also track it in comparison to the average figure for the industry in which you operate, and against key competitors, to see if your core business is competitive. The expenses included in the calculation of the operating profit margin are comprised of bothvariable and fixed expenses. This calculation does not necessarily result in a subtotal for acontribution margin (which is derived from revenues minus variable expenses), with fixed costs listed below the contribution margin. Instead, any presentation format can be used. The key point is that non-operating expenses are excluded from the calculation; instead, they are listed as a deduction from the operating profit margin to arrive at the net profit margin. The expenses not included in the calculation of the operating profit margin include:

Income taxes Interest expense Interest income Another definition of the operating profit margin is that it is the same as the gross margin; which is revenues less the cost of goods sold.

Breakeven Point
The breakeven point is the sales volume at which a business earns exactly no money. The breakeven point is useful for the following reasons:

Determine the amount of remaining capacity after the breakeven point is reached, which tells you the maximum amount of profit that can be generated. Determine the impact on profit if automation (a fixed cost) replaces labor (a variable cost) Determine the change in profits if product prices are altered Determine the amount of losses that could be sustained if the business suffers a sales downturn Management should constantly monitor the breakeven point, particularly in regard to the last item noted, in order to reduce the breakeven point whenever possible. Ways to do this include:

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Cost analysis. Continually review all fixed costs, to see if any can be eliminated. Also review variable costs to see if they can be eliminated, since doing so increases margins and reduces the breakeven point. Margin analysis. Pay close attention to product margins, and push sales of the highest-margin items, to reduce the breakeven point. Outsourcing. If an activity involves a fixed cost, consider outsourcing it in order to turn it into a per-unit variable cost, which reduces the breakeven point. Pricing. Reduce or eliminate the use of coupons or other price reductions, since it increases the breakeven point. To calculate the breakeven point, divide total fixed expenses by the contribution margin. Contribution margin is sales minus all variable expenses, divided by sales. The formula is: Total fixed expenses Contribution margin % A more refined approach is to eliminate all non-cash expenses (such as depreciation) from the numerator, so that the calculation focuses on the breakeven cash flow level. Another variation on the formula is to focus instead on the number of units that must be sold in order to break even, rather than the sales level in dollars. This formula is: Total fixed expenses Average contribution margin per unit Breakeven Point Example The management of Ninja Cutlery is interested in buying a competitor that makes ceramic knives. The company's due diligence team wants to know if the competitor's breakeven point is too high to allow for a reasonable profit, and if there are any overhead cost opportunities that may reduce the breakeven point. The following information is available: Before Acquisition Maximum sales capacity Current average sales Gross margin percentage Total operating expenses Breakeven point Operating expense reductions Revised breakeven level Maximum profits with revised breakeven point $5,000,000 4,750,000 35% 1,750,000 $5,000,000 375,000 $3,929,000 $375,000

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The analysis shows that the competitor has an inordinately high breakeven point that allows for little profit, if any. However, there are several operating expense reductions that can trigger a steep decline in the breakeven point. The management of Ninja Cutlery makes an offer to the owners of the competitor, based on the cash flows that can be gained from the reduced breakeven level.

Debt to Equity Ratio

The debt to equity ratio of a business is closely monitored by the lenders and creditors of the company, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations. This is also a funding issue. For example, the owners of a business may not want to contribute any more cash to the company, so they acquire more debt to address the cash shortfall. Or, a company may use debt to buy back shares, thereby increasing the return on investment to the remaining shareholders. Whatever the reason for debt usage, the outcome can be catastrophic, if corporate cash flows are not sufficient to make ongoing debt payments. This is a concern to lenders, whose loans may not be paid back. Suppliers are also concerned about the ratio for the same reason. A lender can protect its interests by imposing collateral requirements or restrictive covenants; suppliers usually offer credit with less restrictive terms, and so can suffer more if a company is unable to meet its payment obligations to them. To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should also include all leases. The formula is: Long-term debt + Short-term debt + Leases Equity For example, New Centurion Corporation has accumulated a significant amount of debt while acquiring several competing providers of Latin text translations. New Centurion's existing debt covenants stipulate that it cannot go beyond a debt to equity ratio of 2:1. Its latest planned acquisition will cost $10 million. New Centurion's current level of equity is $50 million, and its current level of debt is $91 million. Given this information, the proposed acquisition will result in the following debt to equity ratio: $91 Million existing debt + $10 Million proposed debt $50 Million equity = 2.02:1 debt to equity ratio The ratio exceeds the existing covenant, so New Centurion cannot use this form of financing to complete the proposed acquisition.

Net Profit Ratio

Overview

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The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing have been deducted from sales, and income taxes recognized. As such, it is one of the best measures of the overall results of a firm, especially when combined with an evaluation of how well it is using its working capital. The measure is commonly reported on a trend line, to judge performance over time. It is also used to compare the results of a business with its competitors. Net profit is not an indicator of cash flows, since net profit incorporates a number of non-cash expenses, such as accrued expenses, amortization, and depreciation. Issues with the Net Profit Ratio The net profit ratio is really a short-term measurement, because it does not reveal a company's actions to maintain profitability over the long term, as may be indicated by the level of capital investment or expenditures for advertising, training, or research and development. Also, a company may delay a variety of discretionary expenses, such as maintenance, to make its net profit ratio look better than it normally is. Consequently, you should evaluate the net profit ratio alongside a variety of other metrics to gain a full picture of a company's ability to continue as agoing concern. Another issue with the net profit margin is that a company may intentionally keep it low in accordance with a lowpricing strategy that aims to grab market share in exchange for low profitability. In such cases, it may be a mistake to assume that a company is doing poorly, when in fact it may own the bulk of the market share precisely because of its low margins. Conversely, the reverse strategy may result in a very high net profit ratio, but at the cost of only capturing a small market niche. Another strategy that can artificially drive down the ratio is when a company's owners want to minimize taxes, and so accelerate the recognition of taxable income into the current reporting period. This approach is most commonly found in a privately held business, where there is no need to impress outside investors with the results of operations. Similar Terms The net profit ratio is also known as the profit margin.

What is net profit margin?

MONDAY, SEPTEMBER 12, 2011 AT 1:48PM

Net profit margin is the net profits earned by a business, divided by its net sales. The net sales part of the equation is gross sales minus all sales deductions, such as sales allowances. The formula is: This measurement is typically made for a standard reporting period, such as a month, quarter, or year. The net profit margin is intended to be a measure of the overall success of a business. A high net profit margin indicates that a business is pricing its products correctly and is exercising good cost control. It is useful for comparing the results of businesses within the same industry, since they are all subject to the same business environment and customer base, and may have approximately the same cost structures.

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Generally, a net profit margin in excess of 10% is considered excellent, though it depends on the industry and the structure of the business. When used in concert with the gross profit margin, you can analyze the amount of total expenses associated with selling, general, and administrative expenses (which are located on the income statement between the gross margin and the net profit line items). However, the net profit margin is subject to a variety of issues, which include:

Comparability. A low net profit margin in one industry, such as groceries, might be acceptable, because inventory turns over so quickly. Conversely, it may be necessary to earn a high net profit margin in other industries just in order to generate enough cash flow to buy fixed assetsor pay for working capital.

Leveraged situations. A company may prefer to grow with debt, instead of equity funding, in which case it will incur significant interest expenses, which will drive down its net profit margin. Thus, a financing decision impacts the net profit margin.

Accounting compliance. A company may accrue revenue and expense items to be in compliance with various accounting standards, but this may give an incorrect picture of its cash flows. Thus, a large depreciation expense may result in a low net profit margin, even though cash flows are high.

Non-operating items. The net profit margin can be radically skewed by the presence of unusually large nonoperating gains or losses. For example, a large gain on the sale of a division could create a large net profit margin, even though the operating results of the company are poor.

Short-term focus. Company management could deliberately cut back on those expenses that impair the ability of the business to compete over the long term, such as equipment maintenance, research and development, and marketing, in order to increase the net profit margin.

Taxes. If a company can apply a net operating loss carryforward to its before-tax profits, it can record a larger net profit margin. Thus, a specific tax-related scenario can significantly impact the margin. Example of Net Profit Margin ABC International has a net profit of $20,000 in its most recent month of operations. During that time, it had sales of $160,000. Thus, its net profit margin is: ($20,000 net profit / $160,000 net sales) x 100 = 12.5% net profit margin

Activity Based Costing

This technique is been of recent origin and is primarily concerned with appointment of overhead (indirect costs) in an organisation having products that differ in volume and complexity of production. The crux of activity based costing is in accurately assigning the overhead cost to the end product. The traditional costing system does not serve effective purposes of product costing and pricing decisions. Charging overhead to the products on the basis of labour hour rate and machine hour rate may provide faulty data as to costs which should be properly attributed to a product. If the direct labour cost is taken as the base for charging overhead cost, high volume products may tend to get greater share of overhead cost than the low volume complicated products. Every overhead cost does not directly vary with the volume of production. The illegitimate cost attribution would give a distorted picture of the cost information, the result of which shall be arriving at a wrong decision. Activity based costing is a method of cost attribution to cost units on the basis of benefits received from indirect activities. Their performance of particular activities and demands made by these activities on the resources of organisation are linked together so that the cost of product is arrived at as per the quantum of actual activities performed to produce a product or service. The reason for such a basis is that products themselves do not consume resources directly rather several activities

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are required to be performed for them, and these activities consume the resource, of organisation as driven by the cost drivers. Cost centres pay for these resources, depending upon the number of activities required for a product. Thus, the overhead costs of organisation are identified with each activity which is acting as a cost driver i.e. the cost for incurrence of the overhead cost. The number of these activities in an organisation depends upon the complexity of operations. The more complex an organisations operations are, the more cost driven activities it is likely to have. After identifying the overhead cost with each cost centre, the cost per unit of cost driver can be ascertained and cost assigned to jobs on the basis of number of activities required for their accomplishment. Thus, ABC serves as a basis for product costing besides aiming for managing overhead cost.

Activity based costing may be defined as a technique which involves identification of costs with each cost driving activity and making it as the basis for apportionment of costs over different products or jobs.

The Chartered Institute of Management Accountant (CIMA), London, defines it as a technique of cost attribution to cost units on the basis of benefits received from indirect activities e.g. ordering, setting up, and assuring quality. According to Horngreen, ABC is a system that focuses on activities as fundamental cost objects and utilizes cost of these activities as building blocks or compiling the costs of other cost objects. Services: - Activity Based Costing Homework | Activity Based Costing Homework Help | Activity Based Costing Homework Help Services | Live Activity Based Costing Homework Help | Activity Based Costing Homework Tutors | Online Activity Based Costing Homework Help | Activity Based Costing Tutors | Online Activity Based Costing Tutors | Activity Based Costing Homework Services | Activity Based Costing

Problems with Activity Based Costing Many companies initiate ABC projects with the best of intentions, only to see a very high proportion of the projects either fail, or eventually lapse into disuse. There are several reasons for these issues, which are:

Cost pool volume. The advantage of an ABC system is the high quality of information that it produces, but this comes at the cost of using a large number of cost pools and the more cost pools there are, the greater the cost of managing the system. To reduce this cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the resulting information. Doing so should keep the number of cost pools down to manageable proportions.

Installation time. ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install it across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed. Success rates are much higher for smaller, more targeted ABC installations.

Multi-department data sources. An ABC system may require data input from multiple departments, and each of those departments may have greater priorities than the ABC system. Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers.

Project basis. Many ABC projects are authorized on a project basis, so that information is only collected once; the information is useful for a companys current operational situation, and it gradually declines in usefulness as the operational structure gradually changes over time. Management may not authorize funding for additional ABC projects later on, so ABC tends to be done once and then discarded. To mitigate this issue, build as much of the ABC data collection structure into the existing accounting system, so that the cost of these projects is reduced; at a lower cost, it is more likely that additional ABC projects will be authorized in the future.

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Reporting of unused time. When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time. However, there is a large amount of slack time in anyones work day that may involve breaks, administrative meetings, playing games on the Internet, and so forth. Employees usually mask these activities by apportioning more time to other activities. These inflated numbers represent misallocations of costs in the ABC system, sometimes by quite substantial amounts.

Separate data set. An ABC system rarely can be constructed to pull all of the information it needs directly from the general ledger. Instead, it requires a separate database that pulls in information from several sources, only one of which is existing general ledger accounts. It can be quite difficult to maintain this extra database, since it calls for significant extra staff time for which there may not be an adequate budget. The best work-around is to design the system to require the minimum amount of additional information other than that which is already available in the general ledger.

Targeted usage. The benefits of ABC are most apparent when cost accounting information is difficult to discern, due to the presence of multiple product lines, machines being used for the production of many products, numerous machine setups, and so forth in other words, in complex production environments. If a company does not operate in such an environment, then it may spend a great deal of money on an ABC installation, only to find that the resulting information is not overly valuable. The broad range of issues noted here should make it clear that ABC tends to follow a bumpy path in many organizations, with a tendency for its usefulness to decline over time. Of the problem mitigation suggestions noted here, the key point is to construct a highly targeted ABC system that produces the most critical information at a reasonable cost. If that system takes root in your company, then consider a gradual expansion, during which you only expand further if there is a clear and demonstrable benefit in doing so. The worst thing you can do is to install a large and comprehensive ABC system, since it is expensive, meets with the most resistance, and is the most likely to fail over the long term. Similar Terms Activity based costing is also known as abc costing, the abc method, and the abc costing method.

Cost Accounting, Job Costing and Batch Costing

Cost: Cost means the amount of expenditure incurred on a particular thing. CAS-1 (Cost Accounting Standard 1, issued by the ICWA, India) defines Cost as: Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. Costing: Costing means the process of ascertainment of costs. Costing involves the following steps (i) Ascertaining or collecting costs (ii) Analysing or classifying costs into basic elements such as Material, Labour,Expenses etc. and (iii) Allocating total costs to a particular thing i.e. a product, a contract or a process. Thus cost can now be defined as the total expenditure, duly classified into materials, labour, expenses etc. allocated to a particular product or contract or process. Cost Accounting: The Institute of Cost and Management Accountant, England (ICMA) has defined Cost Accounting as the process of accounting for the costs from the point at which expenditure incurred, to the establishment of its ultimate relationship with cost centres and cost units. In its widest sense, it embraces the

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preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of activities carried out or planned. Cost accounting is a term broader than costing. It covers costing plus the reporting and control of costs. Thus Cost Accounting = Costing + Cost Reporting + Cost Control. Cost accounting can be defined as the technique of recording, classification, allocation, reporting and control of costs. Functions of Cost Accountant: The main functions of a cost accountant can be summarized as follows:
1. Determining cost and analyzing income: A cost accountant determines the cost of a job, product or process as the case may be. He analyses and classifies costs according to different cost elements, viz., materials, labour and expenses. Such analysis enables him to tell the management the significance of the different cost elements and fixation of the selling prices of the products manufactured by the business. He advises the management about the profitability or otherwise of each job, product or process. Thus, he helps the management in maximizing business profits. 2. Providing cost data for planning and control: A cost accountant collects, classifies and presents in appropriate form suitable data to the management for planning and controlling the operations of the business. He makes constant endeavour to control and reduce the cost by the following techniques: 1. He submits regular reports to the management regarding wastage of material, idle time, idle capacity, etc. He identifies the causes and suggests suitable controlling measures to prevent or reduce losses on account of these causes. 2. 3. 4. He makes product-wise or process-wise comparisons to identify non-profitable products or processes. He develops cost consciousness in the organization by adoption of budgetary control and standard costing techniques. He maintains an even flow of materials and at the same time prevents unnecessary investment of materials through different material control techniques e.g. ABC analysis, perpetual inventory system, materials turnover ratios, fixation of different levels of materials etc. 5. 3. He organizes various cost reduction programmes with the co-operation and co-ordination of different departmental heads.

Undertaking special cost studies for managerial decision-making: A cost accountant undertakes special cost studies and carries out investigation for collecting and presenting suitably the data to the management for decision-making regarding the following areas: 1. Introduction of new products, replacement of manual labour by machines etc. 2. 3. 4. 5. Make or buy decisions, replacing or repairing old machines, accepting orders below cost, etc. Expansion plans, installation of new capital project, etc. Utilisation of idle capacity and development of a proper information system to provide prompt and correct cost information to the management. Installation of a cost audit system.

All types of manufacturing concerns can broadly be classified into two categories (i) Mass-production concerns, (ii) Special order concerns. Mass production concerns such as chemical plants, flour mills, paper manufacturing, tyre and rubber companies etc., produce uniform standard products and involve generally a continuous production process. The finished products are the result of successive operations. On the other hand, special-order concerns manufacture products in clearly distinguishable lots in accordance with special orders and individual specifications. Printing shops, construction companies, machine tool manufacturing, repair shops, wood-working shops etc., come in this category. In case of mass production concerns the products when

Page 15 of 50
produced are of the same type, and involve the same material and labour and pass through the same set of process. In such industries each process is designated as a separate cost-centre and the cost per unit is calculated by dividing total cost of the process with the total number of units produced by the process. The cost of production of the product is obtained by adding the unit costs of various processes through which the product has passed. This method of costing is known as process costing. Job Costing: In case of special-order concerns products produced or jobs undertaken are of diverse nature. They involve materials and labour in different quantities and entail different amounts of overhead costs. In such concerns it is necessary to keep a separate record of each lot of products or jobs from the time the work on the job or product begins till it is completed. A separate job card or sheet is maintained for each job or product in which all expenses of materials, labour, overheads are entered and cost of completing a job or manufacturing a product is found out. Such a cost system is known as job or terminal or specific costing. Objectives of job costing:
1. 2. It helps in finding out the cost of production of every order and thus helps in ascertaining profit or loss made out on its execution. The management can judge the profitability of each job and decide its future courses of action. It helps management in making more accurate estimates about the costs of similar jobs to be executed in future on the basis of past records. The management can conveniently and accurately determine and quote prices for orders of a similar nature which are in prospect. It enables management to control operational inefficiency by comparing actual costs with the estimated ones.

3.

A system of job costing should be adopted after considering the following two factors.
1. 2. Each order or job should be continuously identifiable from the raw material stage to the stage of completion. The system is very expensive because it requires a lot of clerical work in estimating costs, designing and scheduling of production. It should, therefore, be adopted when absolutely warranted. 1. Materials: The information regarding cost of materials or stores used for a particular job order can be obtained from materials or stores requisition slips. In case of large job orders, materials abstracts can be prepared for finding out the total value of materials issued to different jobs. Labour: The cost of labour incurred on each job can be ascertained with the help of time and job cards. In case of a large number of jobs, preparation of wages abstract may considerably help in computing the amount paid as 3. wages for completion of specific jobs. Wages paid for indirect labour will constitute an item of factory overheads. Overheads: Every job will be charged with amount of overheads determined on the basis of the method selected for allocation of overheads. Normally on the basis of past results an overhead rate is determined and each job is charged for overheads at the pre-determined rate.

2.

Profit or loss on a job can also be found out by preparing a job account. The job account is debited with all expenses incurred on the job and is credited with the job price. The difference of the two sides will be the profit or loss made or suffered on the job.
1. Work-in-process: The account is maintained in the cost ledger and it represents the jobs under production. The account may be maintained in any of the following two ways depending upon the requirements of the business: 1. A composite work-in-process account for the entire factory.

Page 16 of 50
2. A composite work-in-process account for every department. For example, if the factory has three departments A, B and C, a work-in-process for each of these three departments will be opened.

The work-in-process account is periodically debited with all costs direct and indirect incurred in execution of the jobs. At intervals of month or so a summary of completed jobs is prepared and the work-in-process account is credited with the cost of completed jobs. In case work-in-progress account for each department of the factory has been opened, it will be necessary to find out the cost of completed jobs regarding each department. The balance in work-in-process account at any time represents the cost of jobs not yet completed.
1. Job ticket: In order to provide information regarding the progress of each job at each operation, generally a job ticket is issued by the production control department. The ticket contains detachable portions for different operations. The job ticket is useful for both production control and costing departments. On completion of an operation, the relevant portion of ticket is detached and sent to production control department. This enables production control department in keeping production schedule up-to-date. On the basis of detached portion a departmental summary of production can be prepared which is very useful for costing purposes. Moreover, the amount of work-in-process as shown by the cost 2. ledger can be checked by listing the ticket number of jobs in process in any department and valuing this list. Progress advice: The foreman of a department may be required to send periodically a statement regarding the stage of completion of each job to ensure completion of jobs by scheduled dates. Such a note is called progress advice.

Advantages of job costing:

1. 2. 3. 4. 5. 6. 7. 8. Job costing enables the management to identify spoiled and defective work in respect to particular production orders, departments or groups of workers and hence the management can fix up responsibility for inefficiency. Management can determine the trends in costs and compare the operating efficiency of men and machines in each cost centre. It can also determine the completion cost of each job. It enables the preparation of estimates of costs of jobs before production. It enables comparison of estimated costs with actual costs as the costs are analysed on the basis of costs, services and production. It makes available to the management a complete file of production orders which contains valuable statistics on cost. It enables ascertainment of profit or loss on each job immediately after their completion. It enables the management to identify unprofitable jobs. In case of cost plus contracts, job costing enables to provide precise quotations.

9. It helps in production planning. 10. It facilitates fixation of selling price.

Limitations of job costing:

1. 2. 3. 4. 5. 6. Job costing involves a lot of clerical work in identifying materials, labour and overheads with specific jobs and departments. Management cannot evaluate precisely the operating efficiency of men and machines. Since costs ascertained and compiled are historical costs, they are not of much utility to the management. It does not apply budgetary control to important cost elements such as labour, materials and overheads. Job costs over any period of time cannot be compared if major economic changes take place in between. It is expensive to operate and errors are possible due to increased clerical work.

Batch Costing
Nature and use of batch costing Batch costing is a modified form of job costing, while job costing is concerned with where articles are manufactured in definite batches. The articles are usually kept in stock for selling to customers on demand.

The term batch refers to the lot in which the articles are to be manufactured. Whenever a particular product is required, o ne unit of such produced is not produced but a lot of say 500 or 1,000 units of such product is produced. It is therefore also

Page 17 of 50
known as Lot Costing.

This method of costing is used in case of pharmaceutical or drug industries, ready-made garment factories, industries manufacturing component parts of radios, television sets, watches etc. The costing procedure for batch costing is similar to that under job costing except with the different that a batch becomes the cost unit instead of a job. Separate job cost sheets are maintained for each batch of products. Each batch is allotted a number. Material requisitions are prepared batchwise, the direct labour is engaged batchwise and the overheads are also recovered batchwise. Cost per unit is ascertained by dividing the total cost of a batch number of items produced in that batch. Ordinary principles of inventory control are used. Production orders are issued only when the stock of finished goods reaches the ordering level. In of case the batches are repetitive, the costing work is much simplified. quantity

Determination

economic

batch

Since in batch costing, production is done in batches and each batch consists of a number of units, the determination of optimum quantity to constitute an economical batch is all the more important. Such a quantity can be fixed on the basis of same formulae and principles as are applicable to economic ordering quantity of materials. Services: - Batch Costing Homework | Batch Costing Homework Help | Batch Costing Homework Help Services | Live Batch Costing Homework Help | Batch Costing Homework Tutors | Online Batch Costing Homework Help | Batch Costing Tutors | Online Batch Costing Tutors | Batch Costing Homework Services | Batch Costing

Objectives to Cost Accounting

Some angles are averse to cost accounting. They put forward the following arguments against the installation of a costing system in an industrial establishment.

(i) The system is quite expensive because analysis, allocation and apportionment of costs and absorption of overheads require considerable amount of clerical work.

(ii) The results shown by the cost accounts differ materially from those shown by the financial accounts. Preparation of reconciliation statements frequently is necessary to verify their accuracy. This leads to unnecessary increase in work load. (iii) Costing system itself does not control costs or improve efficiency. If the management is alert and efficient it can control costs without the aid of this system. This is, therefore, unnecessary.

Rebuttal of objections: These arguments are untenable. The system will not provide to be expensive if it is introduced after taking into account technical details and advice of technical personnel of the business. Moreover, as stated above, costing helps in minimizing costs by avoiding wastes at all stages. Thus, it will be a profitable investment and it will be wrong to call it expensive. Difference between results shown by cost account and financial account arises on account of over and under absorption of overheads, methods of material pricing used and treatment of other incomes. An integrated system of accounts can help in elimination of these differences. The costing is a must for each manufacturer because each manufacturing process requires use of material, labour etc. in this stage, of competition and globalization, a manufacturer must know the exact cost not only of each article made but also of each process involved in its production so that he may be in a position to avoid waste and minimize its cost. It is possible only when proper costing records are maintained. Hence, it is wrong to say that it is unnecessary. Services: - Objectives to Cost Accounting Homework | Objectives to Cost Accounting Homework Help | Objectives to Cost Accounting Homework Help Services | Live Objectives to Cost Accounting Homework Help | Objectives to Cost Accounting Homework Tutors | Online Objectives to Cost Accounting Homework Help | Objectives to Cost Accounting Tutors | Online Objectives to Cost Accounting Tutors | Objectives to Cost Accounting Homework Services | Objectives to Cost Accounting

Page 18 of 50 Cost Accounting : Cost Accounting may be defined as Accounting for costs classification and analysis of expenditure as will enable the total cost of any particular unit of production to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted. Thus Cost Accounting is classifying, recording an appropriate allocation of expenditure for the determination of the costs of products or services, and for the presentation of suitably arranged data for the purpose of control and guidance of management. Cost Accounting can explained as follows:Cost Accounting is the process of accounting for cost which begins with recording of income and expenditure and ends with the preparation of statistical data. It is the formal mechanism by means of which cost of products or services are ascertained and controlled. Cost Accounting provides analysis and classification of expenditure as will enable the total cost of any particular unit of product / service to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted. For example it is not sufficient to know that the cost of one pen is ` 25/- but the management is also interested to know the cost of material used, the amount of labour and other expenses incurred so as to control and reduce its cost. It establishes budgets and standard costs and actual cost of operations, processes, departments or products and the analysis of variances, profitability and social use of funds. Thus Cost Accounting is a quantitative method that collects, classifies, summarises and interprets information for product costing, operation planning and control and decision making. Costing : Costing is defined as the technique and process of ascertaining costs. The technique in costing consists of the body of principles and rules for ascertaining the costs of products and services. The technique is dynamic and changes with the change of time. The process of costing is the day to day routine of ascertaining costs. It is popularly known as an arithmetic process and daily routine. For example If the cost of producing a product say `200/-, then we have to refer material, labour and expenses accounting and arrive the above cost as follows: Material ` 100 Labour ` 40

Page 19 of 50 Expenses ` 60 Total ` 200 Finding out the breakup of the total cost from the recorded data is a daily process. That is why it is called daily routine. In this process we are classifying the recorded costs and summarizing at each element and total is called technique. Cost Accountancy: Cost Accountancy is defined as the application of Costing and Cost Accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability. It includes the presentation of information derived there from for the purposes of managerial decision making. Thus, Cost Accountancy is the science, art and practice of a Cost Accountant.

COST ACCOUNTING AND FINANCIAL MANAGEMENT

(a) It is science because it is a systematic body of knowledge having certain principles which a cost accountant should possess for proper discharge of his responsibilities. (b) It is an art as it requires the ability and skill with which a Cost Accountant is able to apply the principles of Cost Accountancy to various managerial problems. (c) Practice includes the continuous efforts of a Cost Accountant in the field of Cost Accountancy. Such efforts of a Cost Accountant also include the presentation of information for the purpose of managerial decision making and keeping statistical records. Objectives of Cost Accounting The following are the main objectives of Cost Accounting:(a) To ascertain the Costs under different situations using different techniques and systems of costing (b) To determine the selling prices under different circumstances (c) To determine and control efficiency by setting standards for Materials, Labour and Overheads (d) To determine the value of closing inventory for preparing financial statements of the concern (e) To provide a basis for operating policies which may be determination of Cost Volume relationship, whether to close or operate at a loss, whether to manufacture or buy from market, whether to continue the existing method of production or to replace it by a more improved method of production....etc Scope of Cost Accountancy

Page 20 of 50 The scope of Cost Accountancy is very wide and includes the following:(a) Cost Ascertainment: The main objective of Cost Accounting is to find out the Cost of product / services rendered with reasonable degree of accuracy. (b) Cost Accounting: It is the process of Accounting for Cost which begins with recording of expenditure and ends with preparation of statistical data. (c) Cost Control: It is the process of regulating the action so as to keep the element of cost within the set parameters. (d) Cost Reports: This is the ultimate function of Cost Accounting. These reports are primarily prepared for use by the management at different levels. Cost reports helps in planning and control, performance appraisal and managerial decision making. (e) Cost Audit: Cost Audit is the verification of correctness of Cost Accounts and check on the adherence to the Cost Accounting plan. Its purpose is not only to ensure the arithmetic accuracy of cost records but also to see the principles and rules have been applied correctly. To appreciate fully the objectives and scope of Cost Accounting, it would be useful to examine the position of Cost Accounting in the broader field of general accounting and other sciences. i.e Financial Accounting , Management Accounting, Engineering and Service Industry. Cost Accounting and Financial Accounting: Financial Accounting is primarily concerned with the preparation of financial statements, which summarise the results of operations for selected period of time and show the financial position of the company at particular dates. In other words Financial Accounting reports on the resources available (Balance Sheet) and what has been accomplished with these resources (Profit and Loss Account). Financial Accounting is mainly concerned with requirements of creditors, shareholders, government, prospective investors and persons outside the management. Financial Accounting is mostly concerned with external reporting. Cost Accounting, as the name implies, is primarily concerned with determination of cost of something, which may be a product, service, a process or an operation according to costing objective of management. A Cost Accountant is primarily charged with the responsibility of providing cost data for whatever purposes they may be required for.

Advantages of Cost Accounting

Cost Accounting has manifold advantages, a summary of which is given below. It is not suggested that having installed a system of Cost Accounting, a concern will expect to derive all the benefits stated here. The nature

Page 21 of 50 and the extent of the advantages obtained will depend upon the type, adequacy and efficiency of the cost system installed and the extent to which the various levels of management are prepared to accept and act upon the advice rendered by the cost system. The Cost Accounting System has the following advantages:(i) A cost system reveals unprofitable activities, losses or inefficiencies occurring in any form such as (a) Wastage of man power, idle time and lost time. (b) Wastage of material in the form of spoilage, excessive scrap etc., and (c) Wastage of resources, e.g. inadequate utilization of plant, machinery and other facilities. (ii) Cost Accounting locates the exact causes for decrease or increase in the profit or loss of the business. It identifies the unprofitable products or product lines so that these may be eliminated or alternative measures may be taken. (iii) Cost Accounts furnish suitable data and information to the management to serve as guides in making decisions involving financial considerations. (iv) Cost Accounting is useful for price fixation purposes. Although sale price is generally related more to economic conditions prevailing in the market than to cost, the latter serves as a guide to test the adequacy of selling prices. (v) With the application of Standard Costing and Budgetary Control methods, the optimum level of efficiency is set. (vi) Cost comparison helps in cost control. Comparison may be period to period, of the figures in respect of the same unit or factory or of several units in an industry by employing Uniform Costs and InterFirm Comparison methods. Comparison may be made in respect of cost of jobs, process or cost centres. (vii) A cost system provides ready figures for use by the Government, wage tribunals and boards, and labour and trade unions. (viii) When a concern is not working to full capacity due to various reasons such as shortage of demands or bottlenecks in production, the cost of idle capacity can readily worked out and repealed to the management. (ix) Introduction of a cost reduction programme combined with operations research and value analysis techniques leads to economy. (x) Marginal Costing is employed for suggesting courses of action to be taken. It is a useful tool for the management for making decisions. (xi) Determination of cost centres or responsibility centres to meet the needs of a Cost Accounting system, ensures that the organizational structure of the concern has been properly laid responsibility

Page 22 of 50 can be properly defined and fixed on individuals. (xii) Perpetual inventory system which includes a procedure for continuous stock taking is an essential feature of a cost system. (xiii) The operation of a system of cost audit in the organization prevents manipulation and fraud and assists in furnishing correct and reliable cost data to the management as well as to outside parties like shareholders, the consumers and the Government.

Advantages of Cost Control

The advantages of cost control are mainly as follows (i) Achieving the expected return on capital employed by maximising or optimizing profit (ii) Increase in productivity of the available resources (iii) Reasonable price of the customers (iv) Continued employment and job opportunity for the workers (v) Economic use of limited resources of production (vi) Increased credit worthiness (vii) Prosperity and economic stability of the industry The main differences between Financial and Cost Accounting are as follows:

Page 23 of 50

Page 24 of 50

1.2 COST ACCOUNTING CONCEPTS

Cost: Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. Cost in simple, words, means the total of all expenses. Cost is also defined as the amount of expenditure (actual or notional) incurred on or attributable to a given thing or to ascertain the cost of a given thing. Thus it is that which is given or in sacrificed to obtain something. The cost of an article consists of actual outgoings or ascertained charges incurred in its production and sale. Cost is a generic term and it is always advisable to qualify the word cost to show exactly what it meant, e.g., prime cost, factory cost, etc. Cost is also different from value as cost is measured in terms of money whereas value in terms of usefulness or utility of an article.

Page 25 of 50

1.2 Role of Financial Accounting

Financial accounting generates some key documents, which includes profit and loss account, patterning the method of business traded for a specific period and the balance sheet that provides a statement, showing mode of trade in business for a specific period. It records financial transactions showing both the inflows and outflows of money from sales, wages etc. Financial accounting empowers the managers and aids them in managing more efficiently by preparing standard financial information, which includes monthly management report tracing the costs and profits against budgets, sales and investigations of the cost.

Principles of Financial Accounting

Financial accounting is based on several principles known as Generally Accepted Accounting Principles (GAAP) (Williamson 2007). These include the business entity principle, the objectivity principle, the cost principle and the going-concern principle. Business entity principle: Every business requires to be accounted for separately by the proprietor. Personal and business-related dealings should not be mixed. Objectivity principle: The information contained in financial statements should be treated objectively and not shadowed by personal opinion. Cost principle: The information contained in financial statements requires it to be based on costs incurred in business transactions. Going-concern principle: The business will continue operating and will not close but will realise assets and discharge liabilities in the normal course of operations.

Importance of Financial Accounting

It provides legal information to stakeholders such as financial accounts in the form of trading, profit and loss account and balance sheet. It shows the mode of investment for shareholders. It provides business trade credit for suppliers. It notifies the risks of loan in business for banks and lenders.

Benefits of Financial Accounting

Maintaining systematic records: It is a primary function of accounting to keep a proper and chronological record of transactions and events, which provides a base for further processing and proof for checking and verification purposes. It embraces writing in the original/subsidiary books of entry, posting to ledger, preparation of trial balance and final accounts.

Page 26 of 50 Meeting legal requirements: Accounting helps to comply with the various legal requirements. It is mandatory for joint stock companies to prepare and present their accounts in a prescribed form. Various returns such as income tax, sales tax are prepared with the help of the financial accounts. Protecting and safeguarding business assets: Records serve a dual purpose as evidence in the event of any dispute regarding ownership title of any property or assets of the business. It also helps prevent unwarranted and unjustified use. This function is of paramount importance, for it makes the best use of available resources. Facilitates rational decision-making: Accounting is the key to success for any decisionmaking process. Managerial decisions based on facts and figures take the organisation to heights of success. An effective price policy, satisfied wage structure, collective bargaining decisions, competing with rivals, advertisement and sales promotion policy etc all owe it to well set accounting structure. Accounting provides the necessary database on which a range of alternatives can be considered to make managerial decision-making process a rational one. Communicating and reporting: The individual events and transactions recorded and processed are given a concrete form to convey information to others. This economic information derived from financial statements and various reports is intended to be used by different groups who are directly or indirectly involved or associated with the business enterprise.

Limitations of Financial Accounting

One of the major limitations of financial accounting is that it does not take into account the non-monetary facts of the business like the competition in the market, change in the value for money etc. The following limitations of financial accounting have led to the development of cost accounting: 1. No clear idea of operating efficiency: You will agree that, at times, profits may be more or less, not because of efficiency or inefficiency but because of inflation or trade depression. Financial accounting will not give you a clear picture of operating efficiency when prices are rising or decreasing because of inflation or trade depression. 2. Weakness not spotted out by collective results: Financial accounting discloses only the net result of the collective activities of a business as a whole. It does not indicate profit or loss of each department, job, process or contract. It does not disclose the exact cause of inefficiency i.e. it does not tell where the weakness is because it discloses the net profit of all the activities of a business as a whole. Say, for instance, it can be compared with a reading on a thermometer. A reading of more than 98.4 or less than 98.4o discloses that something is wrong with the human body but the exact disease is not disclosed. Similarly, loss or less profit disclosed by the profit and loss account is a signal of bad performance of the business in whole, but the exact cause of such performance is not identified. 3. Not helpful in price fixation: In financial accounting, costs are not available as an aid in determining prices of the products, services, production order and lines of products. No classification of expenses and accounts: In financial accounting, there is no such system by which accounts are classified so as to give relevant data regarding costs by departments, processes, products in the manufacturing divisions, by units of product lines and sales territories, by departments, services and functions in the administrative division. Further expenses are not attributed as to direct and indirect items. They are not assigned to the products at each stage of production to show the controllable and uncontrollable items of overhead costs. 5. No data for comparison and decision-making: It will not provide you with useful data for comparison with a previous period. It also does not facilitate taking various financial decisions like introduction of new products, replacement of labour by machines, price in normal or special circumstances, producing a part in the factory or sourcing it from the market, production of a product to be continued or given up, priority accorded to different products and whether investment should be made in new products etc. 6. No control on cost: It does not provide for a proper control of materials and supplies, wages, labour and overheads. 7. No standards to assess the performance: In financial accounting, there is no such welldeveloped system of standards, which would enable you to appraise the efficiency of the organisation in using materials, labour and overhead costs. Again, it does not provide you any such information, which would help you to assess the

Page 27 of 50 performance of various persons and departments in order that costs do not exceed a reasonable limit for a given quantum of work of the requisite quality. 8. Provides only historical information: Financial accounting is mainly historical and tells you about the cost already incurred. As financial data is summarised at the end of the accounting period it does not provide dayto-day cost information for making effective plans for the coming year and the period after that. 9. No analysis of losses: It fails to provide complete analysis of losses due to defective material, idle time, idle plant and equipment. In other words, no distinction is made between avoidable and unavoidable wastage. 10. Inadequate information for reports: It does not provide adequate information for reports to outside agencies such as banks, government, insurance companies and trade associations. 11. No answer to certain questions: Financial accounting will not provide you with answers to such questions as: a. Should an attempt be made to sell more products or is the factory operating to its optimum capacity? b. If an order or contract is accepted, is the price obtainable sufficient to show a profit? c. If the manufacture or sales, of product X were discontinued and efforts made to increase the sale of Y, what would be the effect on the net profit? d. Why the annual profit is of a disappointing amount despite the fact that output was increased substantially? e. If a machine is purchased to carry out a job, which at present is done by hand, what effect will this have on the profit line? f. Wage rates having been increased by 50 paisa per hour, should selling price be increased and if so, by how much?

Internal rate of return (IRR )

The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate [1] of return (DCFROR) or the rate of return (ROR). In the context of savings and loans the IRR is also called the effective interest rate. The terminternal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).

Calculation[
Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return. Given the (period, cash flow) pairs ( , ) where is a positive integer, the total number of periods the net present value , the internal rate of return is given by in: , and

The period is usually given in years, but the calculation may be made simpler if is calculated using the period in which the majority of the problem is defined (e.g., using months if most of the cash flows occur at monthly intervals) and converted to a yearly period thereafter. Any fixed time can be used in place of the present (e.g., the end of one interval of an annuity); the value obtained is zero if and only if the NPV is zero. In the case that the cash flows are random variables, such as in the case of a life annuity, the expected values are put into the above formula. Often, the value of cannot be found analytically. In this case, numerical methods or graphical methods must be used.

Page 28 of 50 Numerical solution[edit]

Since the above is a manifestation of the general problem of finding the roots of the equation , there are many numerical methods that can be used to estimate using the secant method, is given by . For example,

where

is considered the

th

approximation of the IRR.

This can be found to an arbitrary degree of accuracy. An accuracy of 0.00001% is provided by Microsoft Excel. The convergence behaviour of the sequence is governed by the following: If the function reproducibly towards has a single real root . , then the sequence will converge

If the function has real roots , then the sequence will converge to one of the roots and changing the values of the initial pairs may change the root to which it converges. If function when . has no real roots, then the sequence will tend towards +. or when may speed up convergence

Having of to

Numerical solution for single outflow and multiple inflows[edit]

Of particular interest is the case where the stream of payments consists of a single outflow, followed by multiple inflows occurring at equal periods. In the above notation, this corresponds to:

In this case the NPV of the payment stream is a convex, strictly decreasing function of interest rate. There is always a single unique solution for IRR. Given two estimates and for IRR, the secant method equation (see above) with will always produce an improved estimate . This is sometimes referred to as the Hit and Trial (or Trial and Error) method. More accurate interpolation formulas can also be obtained: for instance the secant formula with correction

, (which is most accurate when ) has been shown to be almost 10 times more accurate than the secant formula for a wide range of interest rates and initial guesses. For example, using the stream of payments {4000, 1200, 1410, 1875, 1050} and initial guesses and the secant formula with correction gives an IRR estimate of 14.2% (0.7% error) as compared to IRR = 13.2% (7% error) from [2] the secant method. Other improved formulas may be found in If applied iteratively, either the secant method or the improved formula will always converge to the correct solution.

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Both the secant method and the improved formula rely on initial guesses for IRR. The following initial guesses may be used:

where

Decision criterion[edit]
If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

Problems with using internal rate of return[edit]

As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in.

NPV vs discount rate comparison for two mutually exclusive projects. Project 'A' has a higher NPV (for certain discount rates), even though its IRR (= x-axis intercept) is lower than for project 'B' (click to enlarge)

In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project (assuming no capital constraints).

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IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for high IRR projects, since there is frequently not another project available in the interim that can earn the same rate of return as the first project. When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate sometimes very significantly the annual equivalent return from the project. The formula assumes that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows.
[3]

This makes IRR a suitable (and popular) choice for analyzing venture capitaland other private equity investments, as these strategies usually require several cash investments throughout the project, but only see one cash outflow at the end of the project (e.g., via IPO or M&A). Since IRR does not consider cost of capital, it should not be used to compare projects of different duration. Modified Internal Rate of Return (MIRR) does consider cost of capital and provides a better indication of a project's efficiency in contributing to the firm's discounted cash flow. In the case of positive cash flows followed by negative ones and then by positive ones (for example, + + +) the IRR may have multiple values. In this case a discount rate may be used for the borrowing cash flow and the IRR calculated for the investment cash flow. This applies for example when a customer makes a deposit before a specific machine is built. In a series of cash flows like (10, 21, 11), one initially invests money, so a high rate of return is best, but then receives more than one possesses, so then one owes money, so now a low rate of return is best. In this case it is not even clear whether a high or a low IRR is better. There may even be multiple IRRs for a single project, like in the example 0% as well as 10%. Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project. In general, the IRR can be calculated by solving a polynomial equation. Sturm's theorem can be used to determine if that equation has a unique real solution. In general the IRR equation cannot be solved analytically but only iteratively. When a project has multiple IRRs it may be more convenient to compute the IRR of the project with the benefits [3] reinvested. Accordingly, MIRR is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital. It has been shown that with multiple internal rates of return, the IRR approach can still be interpreted in a way that is consistent with the present value approach provided that the underlying investment stream is correctly identified as net investment or net borrowing. See also
[5] [4]

for a way of identifying the relevant value of the IRR from a set of multiple IRR solutions.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over [6] NPV. Apparently, managers find it easier to compare investments of different sizes in terms of percentage rates of return than by dollars of NPV. However, NPV remains the "more accurate" reflection of value to the business. IRR, as a measure of investment efficiency may give better insights in capital constrained situations. However, when comparing mutually exclusive projects, NPV is the appropriate measure.

Mathematics[edit]
Mathematically, the value of the investment is assumed to undergo exponential growth or decay according to some rate of return (any value greater than 100%), with discontinuities for cash flows, and the IRR of a series

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of cash flows is defined as any rate of return that results in a net present value of zero (or equivalently, a rate of return that results in the correct value of zero after the last cash flow). Thus, internal rate(s) of return follow from the net present value as a function of the rate of return. This function is continuous. Towards a rate of return of 100% the net presen t value approaches infinity with the sign of the last cash flow, and towards a rate of return of positive infinity the net present value approaches the first cash flow (the one at the present). Therefore, if the first and last cash flow have a different sign there exists an internal rate of return. Examples of time series without an IRR: Only negative cash flows the NPV is negative for every rate of return. (1, 1, 1), rather small positive cash flow between two negative cash flows; the NPV is a quadrati c function of 1/(1 + r), where r is the rate of return, or put differently, a quadratic function of the discount rate r/(1 + r); the highest NPV is 0.75, for r = 100%.

In the case of a series of exclusively negative cash flows followed by a series of exclusively positive ones, the resulting function of the rate of return is continuous and monotonically decreasing from positive infinity (when the rate of return approaches -100%) to the value of the first cash flow (when the rate of return approaches infinity), so there is a unique rate of return for which it is zero. Hence, the IRR is also unique (and equal). Although the NPV-function itself is not necessarily monotonically decreasing on its whole domain, it is at the IRR. Similarly, in the case of a series of exclusively positive cash flows followed by a series of exclusively negative ones the IRR is also unique. Finally, by Descartes' rule of signs, the number of internal rates of return can never be more than the number of changes in sign of cash flow.

NPV (Net present value)

In finance, the net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values(PVs) of the individual cash flows of the same entity. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting and widely used throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, above the cost of funds. NPV can be described as the difference amount between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) is called the yield and is more widely used in bond trading.
[1]

Formula[edit]

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Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,

where - the time of the cash flow - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital - the net cash flow i.e. cash inflow cash outflow, at time t . For educational purposes, commonly placed to the left of the sum to emphasize its role as (minus) the investment. The result of this formula is multiplied with the Annual Net cash in-flows and reduced by Initial Cash outlay the present value but in cases where the cash flows are not equal in amount, then the previous formula will be used to determine the present value of each cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose, nevertheless the [2] usual initial investments during the first year R0 are summed up a negative cash flow. Given the (period, cash flow) pairs ( , present value is given by: ) where is the total number of periods, the net is

Use in decision making[edit]

NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if is a positive value, the project is in the status of positive cash inflow in the time of t. If is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e., comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. If... NPV >0 It means... the investment would add value to the firm the investment would subtract value from the firm Then...

the project may be accepted

NPV <0

the project should be rejected

NPV =0

the investment would neither gain nor lose value for the firm

We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g., strategic positioning or other factors not explicitly included in the calculation.

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Example
A corporation must decide whether to introduce a new product line. The new product will have start-up expenditures, operational expenditures, and then it will have associated incoming cash receipts (sales) and disbursements (Cash paid for materials, supplies, direct labor, maintenance, repairs, and direct overhead) over 12 years. This project will have an immediate (t=0) cash outflow of 100,000 (which might include all cash paid for the machinery, transportation-in and set-up expenditures, and initial employee training disbursements.) The annual net cash flow (receipts less disbursements) from this new line for years 1-12 is forecast as follows: 54672, -39161, 3054, 7128, 25927, 28838, 46088, 77076, 46726, 76852, 132332, 166047, reflecting two years of running deficits as experience and sales are built up, with net cash receipts forecast positive after that. At the end of the 12 years it's estimated that the entire line becomes obsolete and its scrap value just covers all the removal and disposal expenditures. All values are after-tax, and the required rate of return is given to be 10%. (This also makes the simplifying assumption that the net cash received or paid is lumped into a single transaction occurring on the last day of each year.) The present value (PV) can be calculated for each year: Year Cash flow Present value

T=0

-100,000

T=1

-49701.81818

T=2

-32364.46281

T=3

2294.515402

T=4

4868.51991

T=5

16098.62714

T=6

16278.29919

T=7

23650.43135

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T=8 35956.52284

T=9

19816.38532

T=10

29629.77288

T=11

46381.55871

T=12

52907.69139

The sum of all these present values is the net present value, which equals 65,816.04. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no alternative with a higher NPV. The above strategy (use 10% discount rate for all projects under consideration, and then pick one with the highest positive NPV) comes with some assumptions: 1. Cash flow projection accuracy is expected to be the same across all possible projects (e.g. raw material and labor costs are expected to be about equally stable and able to be reliably forecast over the life of the various competing capital projects.) 2. The investment horizon of all possible projects are equally acceptable (e.g. a 3 year project is not preferable vs. a 20 year project.) 3. The 10% discount rate is the appropriate rate to discount the cash flows from each project. Each project is assumed equally speculative. 4. the shareholders can't get above a 10% return on their money if they were to directly assume an equivalent level of risk. (If the investor could do better elsewhere, no projects should be undertaken by the firm and the money should be given back to the shareholder through dividends and stock repurchases.) More realistic problems would also need to consider other factors, generally including: smaller time buckets, the calculation of taxes (including the cash flow timing), inflation, currency exchange fluctuations, hedged or unhedged commodity costs, risks of technical obsolescence, potential future competitive factors, uneven or unpredictable cash flows, and a more realistic salvage value assumption, as well as many others.

Accounting rate of return(ARR)

This article is about a capital budgeting concept. For other uses, see ARR. Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used [1] in capital budgeting. The ratio does not take into account the concept oftime value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say,

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if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the [2] [3] investment. Over one-half of large firms calculate ARR when appraising projects.

Basic formulae [edit]

where

=Profit/investment equals to ARR. ARR = Incremental Revenue - Incremental Expenses (Including Depreciation)/Initial Investment Average Profit = Profit After Tax/Life of Project

Modified internal rate of return (MIRR)

The Modified Internal Rate of Return (MIRR) is a financial measure of an investment's attractiveness. used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.
Contents
[hide]
[1][2]

It is

1 Problems with the IRR 2 Calculation of the MIRR

2.1 Example

3 Comparing projects of different sizes 4 References

Problems with the IRR [edit]

While there are several problems with the IRR, MIRR resolves two of them. Firstly, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the [3] project that generated them. This is usually an unrealistic scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost of capital. The IRR therefore often gives an unduly optimistic picture of the projects under study. Generally for comparing projects more fairly, the weighted average cost of capital should be used for reinvesting the interim cash flows. Secondly, more than one IRR can be found for projects with alternating positive and negative cash flows, which leads to confusion and ambiguity. MIRR finds only one value.

Calculation of the MIRR [edit]

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MIRR is calculated as follows:

, where n is the number of equal periods at the end of which the cash flows occur (not the number of cash flows), PV is present value (at the beginning of the first period), FV is future value (at the end of the last period). The formula adds up the negative cash flows after discounting them to time zero using the external cost of capital, adds up the positive cash flows including the proceeds of reinvestment at the external reinvestment rate to the final period, and then works out what rate of return would cause the magnitude of the discounted negative cash flows at time zero to be equivalent to the future value of the positive cash flows at the final time period. Spreadsheet applications, such as Microsoft Excel, have inbuilt functions to calculate the MIRR. In Microsoft Excel this function is "=MIRR".

Comparing projects of different sizes [edit]

Like the internal rate of return, the modified internal rate of return cannot be validly used to rank-order projects of different sizes, because a larger project with a smaller modified internal rate of return may have a higher present value. However, there exist variants of the modified internal rate of return which can be used for such [ comparisons.

Payback period
Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because of its ease of use despite the recognized limitations described below. The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, acompact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used. Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing nothing," payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financingor other important considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An

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implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment. Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year. To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net [1] Cash Flow 1{ } It can also be calculated using the formula: Payback Period = (p - n)p + ny (unit:years)

= 1 + ny - np

Where ny= The number of years after the initial investment at which the last negative value of cumulative cash flow occurs. n= The value of cash flow at which the last negative value of cumulative cash flow occurs. p= The value of cash flow at which the first positive value of cumulative cash flow occurs. This formula can only be used to calculate the soonest payback period; that is, the first period after which the investment has paid for itself. If the cumulative cash flow drops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can't be applied. This formula ignores values that arise after the Payback Period has been reached. Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. The modified payback period algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then the cumulative positive cash flows are determined for each period. The modified payback is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow.

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Service Costing:
is cost accounting for services or functions, eg.Canteen, maintenance , personnel. This may referred to as service centre,departments or functions.

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