Report on Accounting Process and Cost Volume

Profit Analysis.

Submitted by

Arafat Uddin Khan

Submitted to

Dr. Muhammad Shahin Miah CPA

Submission Date: 12th November, 2018

Table of Contents

1. What is Accounting? ...........................................................................................................1

2. Users of Accounting ............................................................................................................1
3. Functions of Accounting……………………………………………………………………………2

4. Interpretation of Accounting……………………………………………………………………….3

5. Steps in Accounting…………………………………………………………………………………4

6. Difference between theoretical knowledge of Accounting and practical way of

Accounting……………………………………………………………………………………………….5

7. Cost Volume Profit…………………………………………………………………………………...8

8. Uses of cost volume profit in real life…………………………………………………………….9

9. Methods of CVP……………………………………………………………………………………..10

10. Importance of Cost Behavior Analysis………………………………………………………..13

11. Segregation of Mixed Cost into Variable Cost and Fixed Cost……………………...……15

12. Conclusion…………………………………………………………………………………………16

13. Reference…………………………………………………………………………………………...17
1. What is accounting?

“Accounting is the information system that identifies records and communicates the economic
events of an organization to interested users.” (Weygandt, Kimmel & Kieso, 2010, p. 21). There
three activities which can be understood as major activities of accounting which are Identifying,
recording and communicating with the economic events. The beginning of the accounting
process starts with identifying the economic events relevant to its business then recording those
events in order to provide a history of its financial activities. Recording consists of keeping a
systematic, chronological diary of events, measured in dollars and cents or other currencies.
Finally the communications with the collected information to interested users by means of
accounting reports occur. This is a vital element of accounting because it shows the accountant’s
ability to analyze and interpret. (Weygandt, Kimmel & Kieso, 2010).

2. Users of Accounting:

There are tons of financial decisions which are made depending upon the accounting information
and also the financial information depends on the kinds of decision its users make. Weygandt et
al. (2010) inscribed that there are two broad groups of users of accounting: internal users and
external users.

Internal Users of accounting information are the people or executives who plan organize and
run the business. These consist of marketing managers, production supervisors, finance directors
and company officers (Weygandt et al.,2010) There are many details which are recorded by these
users. Accounting information collects all these data and provides internal reports to help users
make decisions about their companies.

External users are individuals and organizations outside a company who want financial
information about the company. The two most common types of external users are investors and
creditors. Investors use accounting information to decide whether to buy, hold or sell ownership
shares of a company. Creditors use accounting information to evaluate the risks of granting
credit or lending money. (Weygandt et al., 2010).

1|Page
3. Functions of Accounting:

In order to talk about the functions of accounting, first of all, it is very important to know about
the role of accounting. The basic role of accounting is to provide relevant financial information
to the businessmen and the stakeholders. Furthermore, facilitating the decision making processes
and keeping them updated. There are two types of functions of accounting, first, historical
functioning and second, managerial functional.

3.1 Historical Functions:

Historical functioning of accounting involves keeping the accurate records of all the past
transactions made in the business. This type of functioning of accounting includes:

1. Recording the financial transactions and maintain a journal to keep them all.

2. It is important to classify and separate the records and the ledger.

3. Preparation of brief summary takes place for the quick reviews.

4. This type of accounting gives the net result other than just keeping the records.

5. Preparation of balance sheet takes place to determine the financial position of the
business.

6. The analyzed data and records are then used for the other purposes.

7. The last step is to communicate the obtained financial information to the interested
sectors, for instance, owners, suppliers, government, researchers etc.

3.2 Managerial Functions:

In an organization, the management committee looks for all kind of the decision making. To
ensure that the decisions are smooth and beneficial for everyone, they do an evaluation of the
past records provided by accounting. These are managerial functions. The five managerial
functions of accounting are:

1. Formation of plans in addition to controlling the financial policies.

2|Page
 2. Besides that, a budget is prepared to estimate the total expenditure for the future
activities.

3. Also, cost control is made possible by comparing the cost with the efficiency of the work.

4. The accounting also provides the necessary information during the evaluation of
employee’s performance.

5. To check for frauds and errors is what the workability of the whole procedure depends.

4. Interpretation of Accounting:

Accounting interpretation is a statement explaining how accounting standard should be solicited.

An interpretation is intended to be an accompaniment to an accounting standard. Accounting
interpretations are issued by accounting standards groups, such as the Financial Accounting
Standards Board (FASB), American Institute of CPAs (AICPA) or International Accounting
Standards Board (IASB), International accounting standards Interpretations are generally not
requirements, but rather outline best practices and give further explanation (Investopedia).

As new transactions occur each day there might some transactions which the accounting
standards did not foreseen before but it has to cope with it. In order to cope with it, accounting
standards might issue new set of standards to deal with such situations and this is how the
accounting interpretation is done to set accounting standards. These standards are call
International Financial Reporting Standards (IFRS) (Weygandt et al., 2010).

5. Steps in Accounting:

According to Walther & Skousen (2009), steps of accounting can be also termed as the
accounting cycle. In this accounting cycle there are some steps which are---

∑ Transactions are recorded in journal

∑ Journal entries are posted to appropriate ledger accounts
∑ A trial balance is constructed
∑ Adjusted entries are prepared and posted
∑ An adjusted trial balance is prepared

3|Page
 ∑ Formal financial statements are produced
∑ The closing process

Now in order to simplify these steps, it can be dived into an eight step accounting cycle as
follows:

1. Transaction
8.Closing
Occures

7.Draft
Financial 2.Journalizing
Statements

6.Closing
3.Posting
Entries

5. Accounting 4.Trial
adjustments Balance

Figure: The Accounting Cycle. Source: (Siddiqui,2015)

4|Page
5.1 Transaction Occurs: The accounting process starts with financial transactions. This step
involves identifying and analyzing business transactions. The transactions are first identified and
are then analyzed in order to determine what accounts are affected as well as the amount to be
recorded. It should be noted that not all transactions and events are entered in the accounting
system. Only those events that involve money or payments, such as, borrowing money,
depositing money into a bank etc. are to be entered in the accounting system. Thus, in order to
measure as a business transaction, an activity or an event must be of financial character (in a
certain amount of money). (Siddiqui,2015).

5.2 Journalizing: Every transaction is listed in the appropriate journal which is maintained in
chronological order. All the transactions are recorded through journal entries that show the
recording date of transactions, account names, Ledger Folio or Reference, brief narration,
amounts, and whether those accounts are to be recorded in debit or credit side of the accounts.
The journals are known as the books of original entry. Journals are used to systematically record
all accounting transactions before they are entered into the general ledger. Thus, the general
journal is a place to first record an entry before it gets posted to the appropriate accounts.
(Siddiqui,2015).

5.3 Posting: The third step in the accounting cycle is to post each journal entry to the appropriate
ledger accounts. Every transaction is posted to the account that it impacts. These accounts are
part of the General Ledger, where you can find a summary of all the business’s accounts. Ledger
posting is the process by which all the transactions are synthesized account-wise, so that the
accumulated balance of each of those accounts can be determined. The process of ledger posting
is vitally important as it helps in ascertaining the net effect of various transactions during a given
period. (Siddiqui,2015).

5.4 Trial Balance: Preparing a trial balance is a key step in the accounting cycle. Depending on
the business practices or when it publishes its financial statements, the trial balance is prepared at
the end of the accounting period. It could be monthly, quarterly or yearly. The information used
in a trial balance comes from the ledgers. Thus, a trial balance is a list of all accounts and their
balances at a point in time. Preparing the trial balance involves the arrangement of all ledger
accounts having been aggregated into debit and credit balances. This activity enables to check
and confirm whether the total of debits is equal to that of credits. (Siddiqui,2015).

5|Page
5.5 Accounting Adjustments: Whether or not it’s tallied trial balance, it does not ensure that all
transactions are free from errors or have been recorded appropriately. There is possibility of
errors in the accounts which cannot be deducted thoroughly or even meticulously sometimes. If
that’s the case, you look for errors and make corrections called adjustments, which are tracked
on a worksheet. This requires making adjustment entries employing worksheet. (Siddiqui,2015).

5.6 Closing Entries: A closing entry is a journal entry made at the end of an accounting period
to transfer the temporary account balances to the permanent accounts. In other words, closing
entries zero out or close temporary accounts and move their balances to permanent accounts to
be carried forward to the next period. (Siddiqui,2015).

5.7 Draft Financial Statements: An adjusted trial balance is a listing of all company accounts
that will appear on the financial statements after year-end adjusting journal entries have been
made. In this way, after having made all the adjustment entries and prepared the final trial
balance, you prepare the balance sheet and income statement using the corrected account
balances. Preparing general purpose financial statements includes the balance sheet, income
statement, statement of retained earnings. (Siddiqui,2015).

5.8 Closing: It’s through this step that the books for the revenue and expense accounts are closed
which leads to begin the entire cycle again with zero balances in the said accounts. At this stage,
it is important to mention that closing all temporary accounts to the retained earnings account is
faster than using the income summary accounts method because it saves a step as well as efforts.
(Siddiqui,2015).

6. Difference between theoretical knowledge of accounting

and practical way of Accounting:

The theory accounting study focused in a set of rules and accounting principles and the
significance of those principles and rules for overcoming social and economic conditions. The
solicitation of accounting theory is a set of concepts and interpretations, principles and standards
regulating professional practice, specifically in the field of presentation and disclosure of this
research came to focus on controversial issues. The tombs of theoretical accounting and its tools
are the interpretations and principles, concepts and definition of accounting, limitations and

6|Page
accounting methods and techniques. Like other science has been accompanied by the
development of accounting practice, development of theory, so this study tried to shed light on
how is the theoretical framework of accounting theory and practical way of accounting different
on the basis of the topic the recording process.

In the recording process the theoretical aspects cover contents like the account, debits and
credits, how debits and credits are used to record business transactions, indicating how a journal
is used in the recording process, how a ledger and posting help in the recording process, how
trial balance is prepared and it is used. In order to compare these theoretical aspects of
accounting and the practical way of accounting, to represent the practical way of accounting
there will be an example of an original company to demonstrate their recording process. The
name of the company is Tote Sack International which is a Non Woven Bag Manufacturing
Company. This is local company based in Dhaka, Bangladesh.

Having a knowledge of theory of accounting is very much imperative for an accountant because
there are theories which enlighten them to the practicality of the recording techniques. For
example, if the accountant of Tote Sack International did not have knowledge of the theoretical
aspects of chart of accounts, debit and credit and how they are used to record business
transactions then it would have been impossible for him to maintain the accounts of the
company. Now to be on the practical side does the accountant really follow each and every word
of what is written in the theory of accounting in terms of recording business transactions? To be
very honest, no, he does not. He knows the concepts of debit and credit but he has his own way
of recording the business transactions of the company. Theory tells the accountant to be very
much elaborated and descriptive and detailed while recording the transactions but for a small
company like this it is really unnecessary to do so and it is also time consuming and labor
consuming too.

According to the (Weygandt et al., 2010) theory, there are three steps in the recording process,

1. Analyze each transaction for its effects on the accounts.

2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger.

7|Page
In this case theory directs to record the transactions in the journals where the transactions are
recorded chronologically and shows effects of transactions. Whereas, when the accounting
operations of Tote Sack International were exposed, especially the recording part, it was slightly
different story. The accountant of this company did not record the transactions in any kind of
journal but he directly recorded the journals into the Ledger book of the company. According to
him it saved a lot of time and documentation for him. It was not difficult to identify all the
business transactions record from the ledger book as well. They had a chart of accounts and
according to those chart of accounts they had their ledger accounts. That is how, when each
transaction occurred they directly posted the transaction in the ledger accounts having all the
documents of proof of transaction, for example, money receipt, vouchers, deposit slip etc.

After posting the transaction to the ledger book theory also says to prepare trial balance, in this
case the accountant of the company indeed prepares trial balance but he directly makes a
worksheet. They do not have any separate trial balance but they have a worksheet and that’s
about it. After one year they prepare the formal income statement, owner’s equity statement and
balance sheet.

This is not only for the case of Tote Sack International but also for many small business where
they are not able to hire ample amount of workforce in the accounts division and mostly this
division is run by one or two people. It is very difficult to process accounting information
according to the theory with this much of a work force for any company practically. Theoretical
knowledge of accounting asks for too much detailing in terms of the recording process. This kind
of system is maintained to the point in many big companies but small and middle range
businesses practically do not really maintain their accounting information as per the theoretical
knowledge accordingly, there are some differences and modifications in practical way.

7. Cost Volume Profit:

Cost volume profit analysis is the study of the effects of changes in costs and volume on a
company’s profits. CVP analysis is important in profit planning. It also is a critical factor in such
management decisions as setting selling prices, determining product mis, and maximizing use of
production facilities. (Weygandt et al., 2010, p.766)

8|Page
Cost Volume profit analysis is used to determine how cost and volume changes affect a
company’s operating income and net income. While performing this analysis, there are several
assumptions are made which are, sales price per unit is constant, variable costs per unit are
constant, total fixed costs are constant, everything produced is sold, costs are only affected
because activity changes, if a company sells more than one product then they are sold in the
same mix.

There are some very important calculation is needed while using CVP analysis, for instant,
contribution margin per unit and contribution margin ratio. The contribution margin represents
the amount of income or profit the company made before deducting its fixed costs. In order to
simplify, it is the amount of sales in current available to cover fixed costs. When calculated as a
ratio, it is the percent of sales dollars available to cover fixed costs. Contribution margin is
needed to figure out the break-even level of the product and contribution margin ration is needed
to figure out the break-even level of the product in currency. The formulas are given below:

Contribution Margin per Unit: (Selling Price-Variable Cost)

Contribution Margin Ratio: (Contribution Margin/Selling price* 100)%

Break-even Point= Fixed Cost/ Contribution Margin per Unit

Break-even point in Dollars= Fixed Cost/ Cost Margin Ratio

8. Uses of cost volume profit in real life:

8.1 Resource allocation:

Contribution margin should play an important role in the allocation of resources to multiple
products. Assuming a company sells one product with a cost margin per unit of $150 where the
selling price $500 and the variable cost is $350. Same company sells another product with a cost
margin per unit of $200 where the selling price $400 and the variable cost is $200.The second
product delivers a higher contribution margin per unit, even though it is sold for a lower price.
Without CVP analysis, many company managers would focus more on product A, because each
unit sold generates more revenue, even though in this example, product B contributes more per
unit for fixed costs and profit.

9|Page
8.2 Expansion / New Product Development:

With the CVP tool, it is relatively easy to calculate a breakeven point, or the point at which total
revenues equal total costs. Break even analysis can be particularly useful if you are considering
an expansion or the introduction of a new product.

8.3 Setting Profit Targets:

Cost Volume Profit analysis can also help setting new profit targets. Suppose the company
wanted profits of $250,000 from the new product next year. Assuming the same expected selling
price and cost structure so what should be the number of units they need to sell? By simply
adding the $250,000 of desired profit to the existing fixed costs of $500,000.

8.4 Pricing Decisions:

The CVP framework can easily accommodate changes in expected selling price. All else being
equal, an increase in selling price will naturally increase contribution margin per unit, resulting
in higher profits.

9. Methods of CVP:

9.1 Contribution Margin Analysis Method:

Contribution margin analysis is a technique that uses contribution margin, a company's sales less
variable costs, to analyze the relationship between cost, volume and profit as these figures
change. This method is often used as a quick and dirty method to answer questions about how
different actions could affect a company's sales volume, cost levels or general profitability
(Fredman, 2018). This technique is definitely very useful but it has some advantages and
disadvantages to its account.

9.1.1 Advantages of Contribution Margin Analysis Method:

9.1.1.1 Ease of Use:

One of the biggest advantages of contribution margin analysis is its ease of use. The contribution
margin is calculated as sales less variable costs and can be converted to a unit-based measure by

10 | P a g e
simply dividing by the number of units sold. This unit measure can be quite useful, because it
tells the manager how much profit she will earn for every unit sold past the point where the
company breaks even. The total contribution margin is useful as well. If the total contribution is
greater than the company's fixed expenses, the company is profitable, if it is less than the
company's fixed expenses, the company will experience a loss. Just by calculating the
contribution margin, the manager is able to quickly determine some of the more critical points
along the spectrum of profitability (Freedman, 2018).

9.1.1.2 Existing Information:

Another advantage of contribution margin analysis is that is conducted with information that
management is already calculating for other purposes. Most companies already calculate sales
figures, and cost information is already being recorded. The only additional work that a small-
business owner needs to do is to classify costs as fixed or variable. Because only a small amount
of additional work is needed, contribution margin analysis can be used in small business without
much additional cost (Freedman, 2018).

9.1.2 Disadvantages of Contribution Margin Analysis Method:

9.1.2.1 Unrealistic Assumptions:

The biggest disadvantage of contribution margin analysis is that it requires some pretty
unrealistic assumptions. First, you assume that the selling price is constant. This means that you
don't offer any discounts for large orders. Second, you assume that costs are linear and can be
cleanly divided into fixed and variable components. Often, this is easier said than done. Third,
multi-product companies are assumed to keep the mix between products constant even as the sale
price changes. Lastly, you assume that manufacturers sell and produce exactly the same number
of units. The extent that these assumptions affect the usefulness of the technique varies from
company to company. However, small-business owners should consider these shortcomings
when interpreting results. For example, if a large portion of your business is discounted sales to
large customers, this technique may not be for you (Fredman, 2018).

11 | P a g e
9.2 High Low method:

The high low method uses the total costs incurred at the high and low levels of activity to
classify mixed costs into fixed and variable components. The difference in costs between the
high and low levels represents variable costs, since only the variable-cost element can change as
activity levels change (Weygandt et al., 2010).

9.2.1Advantages of High-low Method:

9.2.1.1 Informal Analysis:

One advantage of the high-low method is the lack of formality required. The accountant can
analyze these numbers using data from the monthly expenses and the activity level. He does not
need to contact anyone outside of the company to determine the fixed expenses or the variable
rate per unit (McIntosh, 2018).

9.2.1.2 Limited Data:

Another advantage of this method is that it only requires two sets of numbers to calculate the
fixed and variable costs. These include the activity level and the total cost. The accountant
reviews the financial transactions for the account over several months to obtain the total cost
amount. She reviews department records to determine the activity levels for those same months.
After gathering data from these two places, the accountant has all the information she needs to
perform the analysis (McIntosh, 2018).

9.2.2 Disadvantages of High-low Method:

9.2.2.1 Multiple Steps:

One disadvantage of the high-low method is the number of steps necessary to perform this
analysis. The accountant needs to gather monthly data regarding the expense being analyzed and
the unit of activity. The accountant lists each set of data and identifies the high and low values.
She calculates the difference between these sets of values. She divides the difference in dollars
by the difference in activity to calculate the cost per unit of activity, or the variable activity. She
multiplies the variable cost per unit by the number of activities to calculate the total variable

12 | P a g e
cost. She subtracts the total variable cost from the total cost to determine the fixed cost. Each
additional step increases the potential for errors (McIntosh, 2018).

9.2.2.2 Estimate:

Another disadvantage of the high-low method is that the results are estimates, not exact numbers.
An accountant who needs to know the exact dollar amount of fixed expenses each month should
contact a vendor directly (McIntosh, 2018).

10. Importance of cost behavior analysis:

Cost behavior analysis is the study of how specific costs respond to changes in the level of
business activity (Weygandt et al., 2010). AS=s it is expected that some costs change but other
might remain the same. Cost behavior analysis is important because it helps management plan
operations and decides between alternative courses of action (Weygandt et al., 2010).

ÿ Cost behavior analysis is important to management because it is where you can monitor
the financial status of your business.
ÿ The understanding of cost behavior is very important for management's efforts to plan
and control its organization's costs.
ÿ Budgets and variance reports are more effective when they reflect cost behavior patterns.
ÿ Cost behavior analysis helps to prepare a financial forecasting for the company. It also
determines how much profit the new product might make.
ÿ The understanding of cost behavior is also necessary for calculating a company’s break-
even point and for any other cost volume profit analysis.

13 | P a g e
For example,

XYZ Company would like to examine how overhead costs behave with changes in labor hours:

So according to high-low method we need to figure out the variable cost per unit first.

Variable cost per unit= Changes in cost/ changes in activity.

Changes is cost= Cost in highest Activity – Cost in lowest activity

Changes in activity = Highest activity – Lowest activity.

That means, Changes in activity for XYZ company= (4000-1000) Hrs or 3000 Hrs.

Changes in cost for XYZ company= $(80000-55000) or $25000.

So, Variable cost per unit= $(25000/3000) or $8.33.

So Variable cost = $8.33x (x here is the unit of activity)

14 | P a g e
If the Fixed cost is $46000, That means,

The Total Cost Function= 8.33x + Fixed Cost. X here is the labor hour.

This means that for every additional labor hour, total overhead cost will increase by 8.33 dollars.

11. Segregation of Mixed Cost into Variable Cost and Fixed

Cost:

The high-low method is on of the method that segregates Variable cost and Fixed cost from the
mixed cost. The difference in costs between the high and low levels represents variable costs,
since only the Variable cost element can change as activity levels change. The formulas in
computing fixed and variable cost are given in page no. XX of this report. Now in order to
illustrate this method, lets assume that Metro Transit Company has the following maintenance
costs and mileage data for its fleet of buses over a 6-month period.

Month Miles Driven Total Cost

January 20000 $30000
February 40000 48000
March 35000 49000
April 50000 63000
May 30000 42000
June 43000 61000

S0, variable cost per unit = $(63000-30000)/(50000-20000) or $1.10

So the variable cost for January would be $(20000*1.10) or $22000.

That means fixed cost would be $(30000-22000) or $8000.

15 | P a g e
So the variable cost for April would be $(50000*1.10) or $55000.

That means fixed cost would be $(63000-55000) or $8000.

This clarifies that the Fixed cost would be $8000 and we can find out variable cost for each
month with variable cost per unit.

This is how with high-low method Mixed cost can be segregated to Variable cost and Fixed cost.

12. Conclusion:

To conclude, it can be understood that Accounting is also termed as accountancy; it deals with
processing of financial information, measuring and recording of certain financial transaction, it
also includes analyzing of certain economic entities. It is the most important function of any
business. Accounting can also further divided into other branches like management accounting
as well as cost accounting. It is responsible for all the kinds of monetary transactions that help in
taking most of the major management decisions. For any successful business the accounting
team should be highly efficient. The number of members in the accounting team depends entirely
on the size of the business. Also Accounting has two sets of users which are internal and external
users. Accounting also have many functions which are very much needed to perform accounts
related tasks. In above discussion it also clarifies how different accounting could be theoretically
and when performed practical use.

Cost Volume Profit and cost behavior analysis are valuable topics where it is found how it is so
much important for the manger to know about them in terms of taking managerial decision and
profit maximization of a company. There are different methods of CVP which helps mangers to
crack down the numbers and be more specific with their accounting decisions. There are
different methods of segregating variable cost and fixed cost from mixed cost. In the above
discussion high-low method was elaborately discussed with examples and it was showed how
practically fixed cost and variable cost can be differentiated from the mixed cost.

16 | P a g e
13. Reference:

Accounting Interpretation. Investopedia. Retrieved from

https://www.investopedia.com/terms/a/accounting-interpretation.asp

Byrnes, K. (2001). Managerial Accounting- Overview of Cost Behavior. TeachUcomp, INC.

Retrieved from https://www.teachucomp.com/managerial-accounting-overview-of-cost-
behavior/

Freedman, J. (2018). Advantages or Disadvantages of Contribution Margin Analysis.

Retrieved from https://smallbusiness.chron.com/advantages-disadvantages-contribution-margin-
analysis-65329.html

McIntosh, A. K. (2018). What Are the Advantages & Disadvantages of High-Low Method
Accounting? Retrieved from https://smallbusiness.chron.com/advantages-disadvantages-
highlow-method-accounting-24444.html

Siddiqui, F. (February, 2015). 8 Steps of Accounting Cycle for Non-Accounting

Professionals. Linked in. Retrieved from https://www.linkedin.com/pulse/8-steps-accounting-
cycle-non-accounting-professionals-fareed?trk=mp-reader-card

Walther, M. L., & Scousen, J. C. (2009). The Accounting Cycle. Ventus Publishing APS.
PP. 88.

Wegandt, J. J., Kimmel, D. P., Kieso, E. D. (2010). Accounting Principles. Asia: John Wiley
& Sons, INC. PP. 21, 37-54, 759-780.

17 | P a g e