2014

[STRATEGIC MANAGEMENT
ACCOUNTING]

Contents
PART A ........................................................................................................................................................... 3
Return on Investment: .................................................................................................................................. 3
Advantages of ROI: .................................................................................................................................... 3
Disadvantages of ROI: ............................................................................................................................... 3
ECONOMIC VALUE ADDED: ........................................................................................................................... 4
Pros & Cons: .............................................................................................................................................. 4
EVALUATION: ................................................................................................................................................ 5
OVERCOME MEASURES: ............................................................................................................................... 5
PART B ........................................................................................................................................................... 6
1. Marginal or Variable Costing: ........................................................................................................... 6
Income Statement under Marginal Costing: ............................................................................................. 6
Practical Implication of Marginal Costing: ................................................................................................ 7
Two Managerial Decisions & Justification: ............................................................................................... 7
2. Full or Absorption Costing: ............................................................................................................... 7
Practical Implication of Absorption Costing: ............................................................................................ 8
Two Managerial Decisions & Justification: ............................................................................................... 8
3. ACTIVITY BASED ACCOUNTING: ........................................................................................................ 9
Practical Implication of ABC Accounting: .................................................................................................. 9
Two Managerial Decision & Justification: ................................................................................................. 9
Works Cited ................................................................................................................................................. 10
Bibliography ................................................................................................................................................ 11


PART A
RETURN ON INVESTMENT:
Return on investment is a performance measuring tool which is used by managers to measure the
benefit which they will get from an investment into a business or industry. It is used to evaluate
the efficiency and compare the efficiency of the investments (Investopedia, 2014).
It is calculated by taking profit controllable by the division as a percentage of the investment in
assets which produces that profit. Following is the formula for calculation of ROI:
ROI=



Advantages of ROI:
The basic advantage of utilizing ROI is that it is acceptable in all types of organizations to
measure the performance of the organization by checking its investments in different sectors. It
is easy to understand and anyone can check the benefits of their investments so that they can
make more investments in the future.
The other advantage is that if a company uses decentralized system then the manager of each
department will be responsible for their performance. Therefore, the CEO or managing director
of the company can check the performance level by asking them to generate ROI for their
concerning departments. It also helps them to check their departments sources.
If there is any problem related to the inventories i.e. stock levels are not counted accurately or
the sales level is not at good point then managers can locate the weakness because if sales are
less then the gain on investment will also be less which cause them less ROI and the business
performance will be affected (Roy, 2008).
Disadvantages of ROI:
ROI concentrates on a single department of the company. It does not cover the whole company
but it shows efficiency in terms of departments which makes it not reliable. There are some
circumstances where a company can generate more profit but ROI shows negative or less output
from that investment. For instance, in a service giving company, if they hire new staff for
communicating the services and benefits of the company to the customers then it will show
increase in customers. On the other hand the ROI will shows negative percentage because it will
only consider the expense of the salaries of the staff but it will not consider the benefit from that
staff.
ROI is suitable for short term consideration. It is because in long term evaluation, some
businesses might take years to generate profit while in their beginning years they may only stand
at their break even point therefore, ROI is considered as a best tool for measuring performance
only in short term businesses (Novinson, 2014).
ECONOMIC VALUE ADDED:
Economic value added (EVA) is used by internal management for managing and checking the
performance of the company. It is developed by a consulting organization Stern Stewart in USA
and they have registered the abbreviation EVA as their trademark. Nowadays, EVA is used by
different companies to check that how much profit they can earn on the invested capital in their
company or in any location.
EVA compares the net operating profit and cost of capital of the company which shows that
when cost of capital deducted from the operating profit then how much benefit a company can
get from its investment. Formula for EVA is given below:
EVA= Net operating profit after tax (capital invested x Weighted average cost of capital)
Note: the above three components can easily be found on the companys income statement.
Solving the formula of EVA gives either positive or negative number. Positive number shows
that the company can easily cover the cost of the capital or the company can cover its investment
with profit whereas negative EVA shows that companys cost of profit is more than the operating
profit which results in overall loss in the investment (Investing Answers, 2014).
Pros & Cons:
First of all we will check the benefits of utilizing EVA in the companies. The cost of capital
component encourages the managers to utilize the balance sheet of the business so that they think
about their assets, expenses and other indirect expenses to take decisions about the companys
profit level.
Companies which are based on manufacturing process, it is highly beneficial for them because
managers can know about the current investment i.e. they can evaluate the current investment by
evaluating their tangible assets.
EVA is specifically developed with the sense that shareholders can see their investment in the
companies by checking the numbers because business for shareholders is only true in a sense
when they generate profits (Investing Answers, 2014).
As there are advantages for EVA, limitations are also on the same side. The first limitation is that
the value of operating profit can be manipulated by the managers in order to show that the
investments made by the company are producing higher profits (FPO, 2014).
The other disadvantage is that it is not beneficial for those companies who produce or provide
services because it is difficult for the managers to calculate the cost of the capital (Investing
Answers, 2014).
On the same side the other limitation is that company can neglect its discretionary expenditures,
i.e. company can ignore any training campaigns for their employees which shows less expenses
or less cost of capital in order to show high rate of EVA or this can be neglected by the managers
as a mistake because sometimes its effect is not shown in the financial statements (FPO, 2014).
EVALUATION:
The above critical analyses of both terminologies results in the favor that both can be used in
short term decision making from the managers so that they can measure the performance of the
companies.
The reason behind utilizing these two approaches for short term decision making is as follows:
ROI can be used for the departments of the companies, therefore it cannot be used to
determine the performance of whole of the company. It depicts that managers can only
use it for short term decision making because in long term ROI can shows negative rate
because some businesses can only cover their expenses in the beginning.
ROI can only check for the errors only in the current period of time therefore managers
can use it for the purpose of current period performance indication.
EVA is also used for the current period because if managers select large data then there is
a chance of manipulation of data which shows wrong information about the investment.
EVA can only shows positive and good response for short term analysis because large
amount of calculations will make it complicated. For instance, if the company has
arranged any recreational tour or training program for the employees then their cost of
capital will also change which results in wrong rate of EVA.
OVERCOME MEASURES:
Managers can overcome the use of these two approaches in only short term time period by
following techniques:
If the data provided by the accountants are accurate and reliable so that managers can
calculate EVA for long time period.
The balance sheets and income statements of the company shows true picture of the
investments.
If managers continuously take ROI and EVA of the company and in the end of the
financial year they compare and contrast those ratios so that they can use it for long term
planning and decision making purposes.
For EVA, if managers can correctly have the amounts and costs for the amortization and
intangible assets then they can get the value for EVA for long term decision making for
service sectors as well.
If company makes small amount of investments in different locations or industries then
the managers can easily manage to use both tools for long term decision regarding
performance of the company (Weetman, 2010) (FPO, 2014).
PART B
1. Marginal or Variable Costing:
Marginal costing is that technique of costing in which all the variable costs are included. It is
the sum of direct material cost, direct labor cost, direct expenses and variable production
costs. It is directly related with the variable costs of the production of units therefore it is also
known as variable costing (KAPLAN, 2014).
From the extracts of above findings the definition of marginal costing is as follows:
Marginal costing is an accounting system through which variable costs are charged to the
production and fixed costs are deducted because they are treated as period costs of the period
in which they are incurred (Weetman, 2010)
Variable costs are those costs which change with the output therefore the profit and costs
level in marginal costing also changes when there is any change in output level or inventory.
Following is the income statement under marginal costing:
Income Statement under Marginal Costing:

Sales X
Less: Cost of Sales:
Opening Inventory X
Variable Cost of Production X
Less Closing Inventory (X)
(X)
X
Less Other Variable Costs (X)
Contribution X
Less Fixed Costs (X)
Profit/loss X
From the above statement it is clearly shown that fixed costs are treated as period costs
therefore they are deducted to calculate the profit or loss for the period (Weetman, 2010).
Marginal costing also includes contribution concept which shows that if we deduct variables
costs from sales then we can get contribution which reveals that the firm has some amount
left through which they can pay their fixed costs in order to get their profits.
Practical Implication of Marginal Costing:
Strategic Management Accounting primarily involves decision making which can be done
through marginal costing because it treats fixed costs as period cost. Following are the
practical implications of marginal costing:
In short term decision making, marginal costing is much more beneficial because
managers ignores the fixed costs as period costs and they can plan for short term
objectives.
If a company wants to enter in a new market or target new group of customers then
marginal costing is beneficial because company can forego its profit for short term.
Two Managerial Decisions & Justification:
If a company considers short term planning and the company size is also small then it
will use marginal costing because it will help managers also in case of entering into a
new market of segment. The reason behind this is that in marginal costing fixed cost
is not included in the production cost. If absorption costing is used then it will include
fixed cost which results in low profit level and more production costs through which
customers cannot agree on buying the products. If company uses ABC costing
method then managers find it difficult for small company to take decisions about
entering into new market segments because it will also consider the cost of entering
activity in the new market segment.
Calculation of profit level is not dependent on the stock levels because fixed cost is
not included. If we use ABC method than it will lead towards different costs of
different products because there is no proper method for allocation of costs. In case of
absorption method, when stock level changes profit also changes which will result in
less profit level and managers will not be able to take proper decisions about utilizing
their profits.
2. Full or Absorption Costing:
Absorption costing is defined as the costing technique in which all the overheads are charged
to the products in order to calculate the profits. Absorption costing is also known as full
costing method because of including all the costs i.e. full costs of all the departments and
then deducting those costs from the sales in order to get profit or loss (KAPLAN, 2014)
(Weetman, 2010).
Following is the absorption costing income statement:

Sales X
Less Cost of Sales:
Opening Inventory X
Variable costs of production X
Fixed overhead absorbed X
Less Closing Inventory (X)
(X)
X
(under)/over absorption (X)/X
Gross Profit X
Less Non production costs (X)
Profit/Loss X
Note: Under or over absorption of overheads is necessary because when the budgeted statements
are made there may be any difference in the prices or costs of fixed production overheads which
should be treated.
Practical Implication of Absorption Costing:
Absorption costing is more implemented in organizations than marginal costing due to its nature
of absorbing overheads into the production costs.
It is implemented where a company wants to take decisions for long term planning
because it includes the fixed costs of production which allows the managers take into
consideration every cost and plan for their selling price.
Especially for manufacturing firms, it is used because it also consider about the stock
levels due to which the profits of the firm changes.
It is also used as cost plus pricing strategy because managers know about their costs and
then they can ask customers about more prices for their profits.
Two Managerial Decisions & Justification:
Managers use absorption costing because they want their costs to be recovered from the
sales and in order to do so total cost should be used to set the selling price which can be
only done by absorption costing. In marginal costing it cannot be done because fixed cost
is neglected and selling price cannot be set accurately while deciding about the selling
price of a product whereas in ABC method some variable or fixed cost is also neglected
because it considers only costs of the activities.
If managers wants to decide about cutting their costs in production or reduce their costs
then absorption costing is beneficial because it shows each and every cost incurred in
manufacturing or delivering any product or service. In marginal costing managers cannot
take any decision about cutting their costs because they do not know about their fixed
costs and how to reduce them. Same thing is related with ABC accounting, managers
only focus on the partial costs while using ABC because it is based on the activities and
nature of the activities, if managers want to decide about cost cutting then it will be
lengthy and difficult process.
3. ACTIVITY BASED ACCOUNTING:
Activity based accounting is based on the process of identifying those activities which results
in occurring any costs or become the cause of the cost (Weetman, 2010). Its working
procedure is different i.e. it first assigns the costs to the activities which are required for the
production and then it only assigns those costs to those activities which becomes the real
cause of the production (Averkamp, 2014).
The basic principle for ABC method is that managers should identify the cost pools of the
activities and then charge those costs according to the activities incurred in the production of
the products or delivering services.
Practical Implication of ABC Accounting:
ABC accounting is mostly used in the operations and operational management
because it will help the managers to identify the costs and activities.
It is also used where there is production of more than one product is occurred and it
uses more than one activity. It is because it provides better platform for allocating
costs on the products.
It is better than traditional accounting because it helps the managers to know about
the exact cost of each product due to allocation of costs.
Two Managerial Decision & Justification:
Managers will come to know about the actual production cost of the product because
through ABC managers can allocate costs which are directly related to the production
of any product which help them to cater more customers. For instance, there are two
hostels one with 10 rooms and one with 5 rooms, the cost of providing services to the
hostel will also different because the hostel with 10 rooms will definitely require
more time for cleaning and other services as compared to the small hostel but the
owner offers same costs i.e. rent to the students which is not appropriate therefore
through ABC method total cost can be allocated to the hostels according to the rooms
and services. In case of marginal costing, fixed costs i.e. cleaning, electricity and
other utilities will be neglected because their line rent will not be considered and it
will show less cost level which will make managers ambiguous about their decisions.
If we consider absorption costing then each and every cost will mislead the managers
and make them to consider extra costs as well which they will charge from the
customers and make them unhappy.
Managers can also know about the costs of planning a production schedule and costs
of moving stores which is also included in the production costs which can only be
identified by ABC method. Managers can decide through ABC that whether they
should move their warehouse from one place to another to reduce the cost level or not
because ABC shows the involvement of costs in production and selling of an item. In
marginal costing, these batch related activities are not considered because marginal
costing consider only variable costs and absorption costing technique results in full
costing i.e. all costs are included which mislead the managers because costs which are
not related with the production is also included which make it difficult for the
managers to set the selling price.
WORKS CITED
Averkamp, H., 2014. Accounting Coach. [Online] Available at:
http://www.accountingcoach.com/activity-based-costing/explanation [Accessed 16 July 2014].
CGMA, 2014. CGMA. [Online] Available at: http://www.cgma.org/Resources/Tools/essential-
tools/Pages/activity-based-costing.aspx?TestCookiesEnabled=redirect [Accessed 16 July 2014].
FPO, 2014. Economic Value Added its uses and limitations. [Online] Available at:
http://www.freepatentsonline.com/article/SAM-Advanced-Management-Journal/55015596.html
[Accessed 22 july 2014].
Guzman, O., 2014. Strength & Weakness of Return on Investment. [Online] Available at:
http://smallbusiness.chron.com/strengths-weaknesses-return-investment-3420.html [Accessed 21 July
2014].
Investing Answers, 2014. Economic Value Added EVA. [Online] Available at:
http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/economic-value-
added-eva-2925 [Accessed 21 July 2014].
Investopedia, 2014. Investopedia. [Online] Available at:
http://www.investopedia.com/terms/r/returnoninvestment.asp [Accessed 16 july 2014].
KAPLAN, 2014. Kaplan Financial Knowledge Bank. [Online] Available at:
http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Marginal%20and%20absorption%20costing.
aspx?mode=none [Accessed 15 July 2014].
Novinson, E., 2014. Pros and Cons of ROI. [Online] Available at:
http://www.ehow.com/info_7749114_pros-cons-return-investment.html [Accessed 20 july 2014].
Roy, S., 2008. Advantage and Limitations of ROI. [Online] Available at: http://www.citeman.com/3280-
advantages-and-limitations-of-roi.html [Accessed 18 July 2014].
Weetman, P., 2010. Managment Accounting. 2nd ed. Essex: Pearson Education Limited.

BIBLIOGRAPHY
Averkamp, H., 2014. Accounting Coach. [Online] Available at:
http://www.accountingcoach.com/activity-based-costing/explanation [Accessed 16 July 2014].
CGMA, 2014. CGMA. [Online] Available at: http://www.cgma.org/Resources/Tools/essential-
tools/Pages/activity-based-costing.aspx?TestCookiesEnabled=redirect [Accessed 16 July 2014].
FPO, 2014. Economic Value Added its uses and limitations. [Online] Available at:
http://www.freepatentsonline.com/article/SAM-Advanced-Management-Journal/55015596.html
[Accessed 22 july 2014].
Guzman, O., 2014. Strength & Weakness of Return on Investment. [Online] Available at:
http://smallbusiness.chron.com/strengths-weaknesses-return-investment-3420.html [Accessed 21 July
2014].
Investing Answers, 2014. Economic Value Added EVA. [Online] Available at:
http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/economic-value-
added-eva-2925 [Accessed 21 July 2014].
Investopedia, 2014. Investopedia. [Online] Available at:
http://www.investopedia.com/terms/r/returnoninvestment.asp [Accessed 16 july 2014].
KAPLAN, 2014. Kaplan Financial Knowledge Bank. [Online] Available at:
http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Marginal%20and%20absorption%20costing.
aspx?mode=none [Accessed 15 July 2014].
Novinson, E., 2014. Pros and Cons of ROI. [Online] Available at:
http://www.ehow.com/info_7749114_pros-cons-return-investment.html [Accessed 20 july 2014].
Roy, S., 2008. Advantage and Limitations of ROI. [Online] Available at: http://www.citeman.com/3280-
advantages-and-limitations-of-roi.html [Accessed 18 July 2014].
Weetman, P., 2010. Managment Accounting. 2nd ed. Essex: Pearson Education Limited.