Assignment-1 Accounting and Finance Q.1.

Accounting Information is not an End but a mean to an end for financial

decisions making. Discuss in detail? Answer. Accounting is usually described as the language of business as all kinds of business activities are a result of communicating accounting information. As the major objective of accounting is to provide information that is helpful for decision making purposes. Thus, accounting is not an end but it is a means to an end . The outcome of the accounting information is the decision that resulted due to the use of that information, and the decision may be taken by owners, management, creditors, governmental regulatory bodies, labor unions or by many other groups who have an interest or stake in the financial performance of an enterprise. Most of us think that accounting is a highly technical field required by the professional accountants but in reality everyone requires accounting information. Costs, prices, sales volume, profits and return on investment are all accounting measurements. Investors, creditors, managers and others who have some financial interest in an enterprise require a clear understanding of the accounting concepts to be able to communicate them properly. Financial accounting information has multiple uses in the business environment. Financial accounting prepares the financial transactions of a business into financial statements for the use of internal and external business stakeholders. Internal users are the managers who make decisions to improve the company s profitability and operating environment while external users make use of this information for taking investment decisions for the company. Three main objectives of financial information from general to specific are to provide: y Information that is useful in making investment and credit decisions. y Information useful in assessing the amount, timing and uncertainty of future cash flows.
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y Information about economic resources, changes in resources and claims on them.

The major purpose of most of the companies is to earn profit from different business options. And to earn profit most efficiently and effectively, companies receive their financial information and determine the money costs for the business profitability. Financial accounting information for business decision is often found on the company s income statement, balance sheet and statement of cash flows. The information given on these statements is for a certain point in time and the term results of operations to describe its financial activities during the year. Financial accounting information is designed basically to help investors and creditors to decide where to invest their scarce investment resources as these decisions are useful to society. Financial accounting is also used by managers and in income tax returns. Financial accounting has so many and varied purposes that it is often called general purpose accounting. Financial ratios are used by companies to create a benchmark for analyzing business operations and decision making. A company s financial statement is used to get information to create specific indicators for comparison to other competitors. These ratios often tell about the company s profits, uses of assets for producing goods and services, collect money owed to the company and other kinds of information. Business entities often improve their business operations by using these ratios for making business decisions. Ethics have a very important role in financial accounting and business decision making. The responsibility for maximizing the financial returns of owners managers and employees and other stakeholders comes on the company. Company may use ethics, not only to maximize the company s profit or financial

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return for specific individuals but to increase the livelihood of all the stakeholders concerned with the company operations. Often a company s decision making process is improved by using financial accounting information and ethics. All the past performance of the company and its previous operations are provided to managers with evidence. Financial accounting information helps the companies to evaluate new business opportunities and expand business operations with the use of past performance. Attempting to falsify financial information and to hide the negative accounting information may decrease the company s overall business and decision making process. Managers and employees may see lack of ethics as acceptable in business and consumers may be distinguished and displeased with unethical companies and take their business elsewhere.

Q.2. What is accounting equation? Describe its importance, draw hypothetical accounting equation of a pharmaceutical firm and show the impact of following transactions? Answer. DEFINITION: ASSETS = LIABILITIES + OWNER EQUITY The most fundamental equation of double entry book-keeping system, expresses the relationship between what is owned and what is owed by an entity. The resources controlled by a business are referred to as its assets. For a new business assets originate from two kinds of sources. y Investors who buy ownership in the business. y Creditors who extend loan to the business.
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The accounting equation (assets = liabilities + owners equity) has great importance as the financial standing of a particular time is revealed by this. It is of great importance to the investors who may wish to or have purchased stocks in the business. To, know the financial status of the company is important to the creditors as well, as they wish to loan the business money. To have resources that have no claims in opposition to them is the organizations goal. Transactions Cash+ Bank+ Building+ Office Equipment+ Office Supplies 1 50000+ 50000+ 200000+ 30000+ 10000 5000 2 50000+ 55000+ 200000+ 30000+ 10000 2500 3 50000+ 55000+ 200000+ 32500+ 10000 550 550 4 49450+ 55000+ 200000+ 32500+ 10550 25000+ +10000 5 24450+ 55000+ 300000+ 32500+ 10550 1200 6 25650+ 55000+ 300000+ 32500+ 10550 -950 7 247000+ 55000+ 300000+ 32500+ 10550 -2000 total 245000+ 55000+ 300000+ 32500+ 10550 Accounts Payable+ Loan+ O.E. 80000+ 20000+240000 5000 80000+ 20000+245000 2500 82500+ 20000+245000

82500+ 20000+245000 75000 82500+ 95000+245000 1200 82500+ 95000+247150 -2000 82500+ 95000+247150 -2000 82500+ 95000+ 245150

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Question 4: Develop an appreciation that marginal costing has an edge over absorption costing in managerial decision making? ANS: Marginal costing and absorption costing are two techniques by which cost of goods, products or processes are determined. As absorption method is a traditional technique so according to managerial decision making marginal costing has an edge over it. Managerial Costing & Absorption Costing: Absorption Costing: The Absorption costing technique, as it is a full cost method, is also called traditional or full most method. Both fixed and variable costs are determined by this method. In absorption costing technique, both fixed and variable production overheads are fully absorbed in to the cost of production. These costs include direct material, direct labor, detect expenses and variable production overheads as well as fixed production overheads. 1. Absorption costing has certain advantages as it gives attention to both fixed and variable costs; that are all production costs are considered regardless of whether they are variable or fixed. This aspect is of great importance when it comes to pricing decisions since the manufacturer can have a clear picture of the profit margin to be made on each sale. As all costs have been incorporated into the product cost. 2. It provides realistic periodic profits if company has a natural business cycle; profits are realistic in the sense that all production costs are matched to sales volume as under marginal costing. 3. It is consistent with external reporting requirements; in fact, international accounting standard board recommends the use of absorption casting method over marginal costing, which is considered more useful for internal reporting. These limitations of absorption costing are usually taken as criticism against absorption costing. Its system of costing has a number of disadvantages
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1. It assumes that prices are simply a function of costs and it does not take account of demand. 2. As it included the past costs that may not be relevant to the prolong decision at hand. 3. Information provided does not aid decision- making in a rapidly changing market environment. The technique if absorption costing may lead to rather odd results particularly for seasonal businesses in which the stock levels fluctuate wildly from one period to another. Their profits for the two periods will be influenced by the transfer of overheads in and out of stock, showing falling profit when the sales are high and increasing profits when the sales are low. The technique of absorption costing may also lead to an unprofitable business. On the contrary, marginal costing absorbs only variable production costs into inventory. The method chosen to cost inventory or prepare the profit statement has the potential to affect the pattern of calculated profits, influence employee behavior, and provide management with relevant and useful information for planning and control purposes. Marginal Costing: Marginal costing distinguishes between fixed cost and variable costs as conventionally classified. The marginal cost of a product is its variable cost. This is usually taken as direct labor, direct material, direct expenses and the variable part of overheads. Formal definition of marginal costing is: the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written off in full against the aggregate contribution. Its special value is in decision making (terminology)

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So, in marginal costing technique, only variable production overheads are included into the cost of production or cost of sales. Fixed production overheads are deducted from the contribution margin as period costs to ultimately give the net profit and less figure. The revenue arising from the excess of sales over variable costs is technically known as contribution under marginal costing. Marginal costing also helps in managerial decision making. The theory of the marginal costing can be understood in the following 2 steps: I. If the volume of the output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases- if a factory produces 1000 units at a total cost of Rs.3000 and if by increasing the output by one unit the cost goes up to Rs.3002, the marginal cost of additional output will be Rs.2. If an increase in output is more tan one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit; if for example the output is invreased to 1020 units from 1000 units, the total cost to produce these units is Rs.1045, the average marginal cost per unit is Rs.2.25.

II.

To understand marginal cost properly we have to understand its meaning and that is, the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods. Marginal costing may be defined as the technique of presenting cost data where invariable costs and fixed costs are shown separately for marginal decision making. Marginal costing has some advantages and dis advantages. Advantages of marginal costing s:

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y Distinguishes between fixed and variable costs therefore providing relevant information about costs for decision making processes. It is simple to understand when fixed and variable costs are split, it becomes easier to manage costs as it becomes clearer to management on how costs behave. So by altering the activity level, for instance, management can choose an optimum production level. y Removes the effect of inventory changes on profit and reduces the danger of dysfunctional behavior in employees. Dysfunctional behavior may occur in the case of absorption costing by encouraging managers to produce more inventory than can be sold producing for stock has the effect of absorbing more fixed production overheads, hence reducing the cost of sale. The reduced cost of sale has the effect of improving the level of reported profits. However, it is possible for such stock to tie up capital and even become obsolete. This is dysfunctional. y Avoid capitalization of fixed overheads in unsalable stocks. Under marginal costing, all fixed costs are treated as period costs, meaning that they are all written off in the accounting period to which they relate. So, there is no question of using inventory to defer fixed cost expenses, as might be the case with Absorption costing.

Disadvantages of marginal costing: y We sometimes get mislead results due to the separation of costs into fixed variable costs. y Normal costing system also applies overhead under normal operating volume and this shows that no advantage is gained by marginal costing. y Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs may not be clearly transparent
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y Volume variance in standard costing also discloses the effect of fluctuating output of fixed overhead. Marginal COST DATA BECOMES unrealistic in case of highly fluctuating levels of production e.g. in case of seasonal factories. y Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. y The cost affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also valuable item. A system that ignores fixed cost is less effective since a major portion of fixed cost is not taken care of under marginal costing y In practice, sales price, fixed cost and variable cost per unit may vary .Thus the assumption under laying the theory of marginal costing becomes unrealistic for long term profit planning, absorption costing is the only answer.

Absorption Costing and Marginal Costing Differences: The difference between absorption costing and marginal costing is based on the recovery of fixed overheads. The difference in the valuation of inventory under the three techniques is the result of such treatment. But for the sake of clarity, the difference from both angles is analyzed, i.e recovery of overheads and valuation of stock.

Recovery of overheads : In case of absorption costing both fixed and variable overheads are charged to production, while on the other hand in marginal costing only variable overheads are charged of production while fixed overheads are transferred in full
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to the profit and loss account. Thus, in case of marginal costing, there is underrecovery of overheads since only variable overheads are charged to production.

Valuation of Stocks: In absorption costing stocks of work in progress and finished goods are valued at works cost and total cost of production respectively. The cost of production or work cost is so defined as to include the amount of fixed overheads also.

Absorption costing and marginal costing are two different techniques of accounting while absorption costing is mainly used for cost control purpose. Marginal costing has an edge over absorption costing as for as managerial decision making is concerned.

Q5 a). Examine the role of break-even analysis by elaborating the cost-volume-profit framework? Answer. One of the most common tools used in analyzing the economic
feasibility of a new enterprise or a product is the break-even analysis. The breakeven point is the point at which revenue is exactly equal to the costs. At this point no profit is made and no losses are incurred. The break-even point can be expressed in terms of unit sales. That is, the break-even units indicate the level of sales that are required. Definition: The break-even analysis is used to determine how much sales volume your business needs to start making a profit. The breakeven analysis is especially useful when you are developing a pricing strategy, either as part of a marketing plan or a business plan.

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An understanding of Break0-even analysis is based on the costvolume profit relationship within a business. There are three fundamental relationships. y Revenue varies directly with the number of units sold and the price the sales units are sold at. y Some costs in the business are fixed for a period and do not vary directly with sales levels. These do not automatically increase.

Revenue & Costs Revenue Rs. Costs

Loss

Profit

Break-even point As you can see the revenue line starts from zero i.e. if you don t sell anything you don t generate any revenue while the cost line starts from a point on the Rs. Axis which represents the fixed costs of the business.

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Where the revenue line and the cost line meets the business does not make a profit or loss and is said to be at the break-even point. To the left of the break-even point, the business is making a loss because costs are greater than revenues. While the angle of the revenue line is steeper than the cost line, it takes single sales to pay for the fixed costs. To the right of the break-even point, the business is making a profit because revenue is greater than costs. An alternative way to think about break-even analysis and cost volume profit relationship is sales contributing to meeting and then exceeding the fixed costs. In this approach one doesn t look at total revenue and costs but instead focus on the contribution of every sale which is the difference between your sales price and the variable cost of the sales. So, for example a bookshop may have an average selling price per book of Rs.10 with an average cost price of Rs7. This means that the contribution ( margin) per book is on average Rs3. This changes the break-even graph to look like the one below.

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Contribution and fixed Cost Rs-000 Fixed Costs Contribution

Loss

Break-Even

Profit

Volume

This is the approach whish should be preferred since it helps focus on the three basic profit generating tactics more clearly. The breakeven analysis is a simple but powerful method for understanding the profitability of your business, and the cost volume profit analysis is an important medium through which one can have an insight into effects on profit due to variations in costs, both fixed and variable and sales, both volume and value. This enables us to take appropriate decisions and it helps to understand at this stage the meaning of and the technique of determining the breakeven profit.

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Q5 b). Discuss the applications of cost volume profit relationship in specific decisions? Answer. Cost volume profit analysis is one of the most powerful tools that managers have at their command. It helps them understand the inter-relationship between cost, volume and profit in an organization by focusing on interactions among the following five elements. y y y y y Prices of products Volume or level of activity Per unit variable cost Total fixed cost Misc. of product sold

As cost volume profit (CVP) analysis helps managers understand the interrelationship among cost volume and profit is a vital tool in many business decisions. These decisions include for-example what products to manufacture or sell what pricing policy to follow, what marketing strategy to employ and what type of productive facilities to acquire.

Relevant costs for decision making The costs which should be used for decision making are often referred to as "relevant costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management decisions'. To affect a decision a cost must be: a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we may choose. b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision.

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c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant. Other terms: d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a factory would be incurred whatever products are produced. e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets, development costs already incurred. f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into which cannot be altered. Opportunity cost Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative. Example A company is considering publishing a limited edition book bound in a special leather. It has in stock the leather bought some years ago for PKR1,000. To buy an equivalent quantity now would cost PKR2,000. The company has no plans to use the leather for other purposes, although it has considered the possibilities: a) of using it to cover desk furnishings, in replacement for other material which could cost PKR900 b) of selling it if a buyer could be found (the proceeds are unlikely to exceed PKR800). In calculating the likely profit from the proposed book before deciding to go ahead with the project, the leather would not be costed at PKR1,000. The cost was incurred in the past for some reason which is no longer relevant. The leather
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exists and could be used on the book without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportunities of either disposing of it for PKR800 or of using it to save an outlay of PKR900 on desk furnishings. The better of these alternatives, from the point of view of benefiting from the leather, is the latter. "Lost opportunity" cost of PKR900 will therefore be included in the cost of the book for decision making purposes. The relevant costs for decision purposes will be the sum of: i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is approved, and will be avoided if it is not ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the project). This total is a true representation of 'economic cost'. Relevant costs and opportunity costs Zimglass Industries Ltd. has been approached by a customer who would like a special job to be done for him, and is willing to pay PKR60,000 for it. The job would require the following materials. Material Total units Units Book value of required already in units in stock stock PKR/unit A B C D 1000 1000 1000 200 0 600 700 200 12.00 13.00 14.00 Realisable value PKR/unit 12.50 12.50 16.00 Replacement cost PKR/unit

16.00 15.00 14.00 19.00

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a) Material B is used regularly by Zimglass Industries Ltd, and if units of B are required for this job, they would need to be replaced to meet other production demands. b) Materials C and D are in stock due to previous over-buying, and they have restricted use. No other use could be found for material C, but the units of material D could be used in another job as a substitute for 300 units of material E, which currently costs PKR15 per unit (of which the company has no units in stock at the moment). Calculate the relevant costs of material for deciding whether or not to accept the contract. You must carefully and clearly explain the reasons for your treatment of each material. The assumptions in relevant costing Some of the assumptions made in relevant costing are as follows: a) Cost behavior patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known. b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty. c) The objective of decision making in the short run is to maximise 'satisfaction', which is often known as 'short-term profit'. d) The information on which a decision is based is complete and reliable. Cost-volume-profit (CVP) analysis CVP analysis involves the analysis of how total costs, total revenues and total profits are related to sales volume, and is therefore concerned with predicting the effects of changes in costs and sales volume on profit. It is also known as 'breakeven analysis'. The technique used carefully may be helpful in the following situations:

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a) Budget planning. The volume of sales required to make a profit (breakeven point) and the 'safety margin' for profits in the budget can be measured. b) Pricing and sales volume decisions. c) Sales mix decisions, to determine in what proportions each product should be sold. d) Decisions that will affect the cost structure and production capacity of the company. The basic principles of CVP analysis CVP analysis is based on the assumption of a linear total cost function (constant unit variable cost and constant fixed costs) and so is an application of marginal costing principles. The principles of marginal costing can be summarized as follows: a) Period fixed costs are a constant amount; therefore if one extra unit of product is made and sold, total costs will only rise by the variable cost (the marginal cost) of production and sales for that unit. b) Also, total costs will fall by the variable cost per unit for each reduction by one unit in the level of activity. c) The additional profit earned by making and selling one extra unit is the extra revenue from its sales minus its variable costs, i.e. the contribution per unit. d) As the volume of activity increases, there will be an increase in total profits (or a reduction in losses) equal to the total revenue minus the total extra variable costs. This is the extra contribution from the extra output and sales. e) The total profit in a period is the total revenue minus the total variable cost of goods sold, minus the fixed costs of the period. The cost volume analysis provide a framework within which the impact of volume in the short-run maybe examined on profit. Cost behavior is added as
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the dimension and corresponding changes in profit, break-even, and margin of safety are observed. Cost volume profit analysis is used as a tool of planning. A profit plan has essentially to be based on it. A number of managerial decisions are often premised on this vital tool of analysis.

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ALLAMA IQBAL OPEN UNIVERSITY COL-MBA

ACCOUNTING AND FINANCE CODE: 5566

Submitted by: Humaira Tariq Roll-No: AL-540923

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