COST ACCOUNTING

Assignment-I

VALUE ADDED ANALYSIS

Submitted To:
Prof. CA Madhura Ranade

By Group 5:
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Abhijeet Patil
Aman Verman Ananya Sarkar Arjun Baburaj Bishruta BanerjeeAditya Chavan -

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Value Added Accounting

There is no free lunch in this world. To generate income or to earn money, one has to sell
some sort of product. A product is a tangible thing or an intangible service having
some utility for the buyer. Hence, the product is a utility or value created over the crude
material.
Value added, therefore, is a created utility in the product of the business. Without creating
value, one cannot sell the product for a profitable price. A firm charges some extra price over
the materials and services used for the value creation over the product. For example, if one
buys some materials and services at $ 100 and sells them at $ 300, then the added value is
$200.
Therefore, Net value = Revenues - The price paid for materials and services.
Value does not come by itself. It needs some changes over the bought-in materials. Change in
the utility of product is brought about by labour, capital, government services etc. Therefore,
the added value is to be distributed to the stakeholders of business in the ratio of the service
rendered by each of the stakeholders. Added value is paid in the form of wages and salaries to
labour, taxes and duties to government, interest and dividends on the capital and residual fund
is retained in the business.
Therefore, the value added is the increase in the market value created by a change in the
form, location or availability of product or service, excluding the cost of bought-in materials
or services used in that product or service.

Definition
Process in which a good or service is stripped down to its essential attributes or benefits.
Those that contribute to the customer appeal are enhanced, the others are reduced or
eliminated. See also value analysis.

Economic Value Added

Economic value added is the incremental difference in the rate of return over a company's
cost of capital. In essence, it is the value generated from funds invested in a business. If the
economic value added measurement turns out to be negative, this means a business is
destroying value on the funds invested in it. It is essential to review all of the components of
this measurement to see which areas of a business can be adjusted to create a higher level of
economic value added. If the total economic value added remains negative, the business
should be shut down.

To calculate economic value added, determine the difference between the actual rate of return
on assets and the cost of capital, and multiply this difference by the net investment in the
business. Additional details regarding the calculation are:

Eliminate any unusual income items from net income that do not relate to ongoing
operational results.

The net investment in the business should be the net book value of all fixed assets,
assuming that straight-line depreciation is used.

The expenses for training and R&D should be considered part of the investment in the
business.

The fair value of leased assets should be included in the investment figure.
If the calculation is being derived for individual business units, the allocation of costs
to each business unit is likely to involve extensive arguing, since the outcome will affect the
calculation for each business unit.
The formula for economic value added is:
(Net investment) x (Actual return on investment Percentage cost of capital)
For example, the president of the Hegemony Toy Company has just returned from a
management seminar in which the benefits of economic value added have been trumpeted.
He wants to know what the calculation would be for Hegemony, and asks his financial
analyst to find out.
The financial analyst knows that the company's cost of capital is 12.5%, having recently
calculated it from the company's mix of debt, preferred stock, and common stock. He then
reconfigures information from the income statement and balance sheet into the following
matrix, where some expense line items are instead treated as investments.
Account Description
Revenue
Cost of goods sold
General & administrative
Sales department
Training department
Research & development
Marketing department
Net income
Fixed assets

Performance
$6,050,000
4,000,000
660,000
505,000

Net Investment

$75,000
230,000
240,000
$645,000
3,100,000

Cost of patent protection

82,000
Cost of trademark protection
145,000
Total net investment
$3,632,000
The return on investment for Hegemony is 17.8%, using the information from the preceding
matrix. The calculation is $645,000 of net income divided by $3,632,000 of net investment.
Finally, he includes the return on investment, cost of capital, and net investment into the
following calculation to derive the economic value added:
($3,632,000 Net investment) x (17.8% Actual return 12.5% Cost of capital)
= $3,632,000 Net investment x 5.3%
= $192,496 Economic value added
Thus, the company is generating a healthy economic value on the funds invested in it.
The measurement has benefited from the marketing efforts of consulting firms that want to
install an economic value added measurement system; whether the metric will have standing
over the long term is difficult to say.