Working Capital

WORKING
CAPITAL

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ACKNOWLEDGEMENT

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ANY ACCOMPLISHMENT REQUIRES THE EFFORT OF MANY PEOPLE AND THIS

WORK IS NO DIFFERENT.WE WOULD LIKE TO THANK PROF.FATIMA FOR
GIVING US AN OPPURTUNITY FOR DOING THE PRIJECT TOGETHER AND FOR
HELPING AND GUIDING US IN COMPLETION OF THE PROJECT.

WE WOULD ALL THANKS OUR PARENTS AND FRIENDS WHO HAVE

SUPPORTED US AND HELPED US THE PROJECT AND CONSTANTLY MOTIVATED
US IN DOING THE PROJECTT. THIS WAS A NEW LEARNING EXPERIENCE FOR
US AND WILL DEFINILY HELP IN FUTURE.

REGARDLESS OF RHE SOURCE WE WISH TO EXPRESS OUR GRATITUDE TO

TJOSE WHO HAVE CONTRIBUTED TO THIS WORK EVEN THOUGH
ANONYMOUSLY.

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DECLARATION

We the student of royal college of SYBMS 3rd Semester

hereby declare that we have completed this project on
16th Aug in the Academic Year 2010-2011. The
information submitted is true and original to the best
for our knowledge.

PRESENTED BY
NAME OF STUDENTS ROLL NO.

PRIYANKA GAIKWAD 07

RUBY KHOT 13

SABINA MUSA 15

AFSHA RATANSI 19

SHAHISTA SHAIKH 23

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INDEX
SR. NO. TOPICS PG NO.
1 WHAT DOES COST ACCOUNTING 5
MEAN?
2 EMERGENCE OF COST ACCOUNTING 6
3 EXPANDING USES 7
4 BASICS OF COSTING METHODS 8
5 ESTIMATING TOTAL COST 10
6 WORKING CAPITAL DEFINATION 11
7 INTRODUCTION TO WORKING 12
CAPITAL
8 IMPORTANCE AND ASPECTS OF 14
WORKING CAPITAL
9 WORKING CAPITAL POLICY 17
10 IMPORTANCE OF WORKING CAPITAL 20
RATIOS
11 WHERE IS WORKING CAPITAL 24
ANALYSIS MOST CRITICAL
12 WORKING CAPITAL CYCLE 25
13 SOURCES AND OTHER REQUIRMENTS 27
OF WORKING CAPITAL
13 OVERVIEW OF CURRENT METHODS 28
15 ACCOUNT ANALYSIS 30
16 FUTURE OF COST ACCOUNTING 33
17 BALANCE SHEET ANALYSIS 36
18 INCOME STATEMENT RATIO 39
ANALYSIS
19 CONCLUSION 42
20 BIBLOGRAPHY 43

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What Does Cost Accounting Mean?

A type of accounting process that aims to capture a company's costs of

production by assessing the input costs of each step of production as well as
fixed costs such as depreciation of capital equipment. Cost accounting will
first measure and record these costs individually, then compare input results
to output or actual results to aid company management in measuring
financial performance.

HISTORY OF COSTING METHODS

Double-entry bookkeeping, developed in Northern Italy in the

14th and 15th centuries, was the predecessor to modem accounting
methods. Early modem methods were developed in the United States in the
1850s and 1860s by accountants in the railroad industry. These methods
were just one of several innovations originating with the railroads that
marked the transition from traditional to modem business enterprise. Most
important were the developments of J. Edgar Thomson and his cohorts at the
Pennsylvania Railroad. The work of these and other pioneering accountants
in the railroad industry was the subject of widespread public discussion and
numerous articles in the new financial journals of the day

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EMERGENCE OF COST ACCOUNTING.

Cost accounting was one of three interrelated types of

accounting developed at the time, the others being financial and capital
accounting. Financial accounting addressed issues relating to a firm's daily
financial transactions, as well as overall profitability. For example, railroads
began deriving operating ratios in the late 1850s, which for the first time
related absolute quantities of profit and loss to business volume. Capital
accounting addressed issues relating to the valuation of a firm's capital
goods. This was particularly important in the railroad industry given the
unprecedented quantities of capital involved and the problem of how to
account for the repair and renewal of capital.

Innovations in cost accounting followed those in financial and capital

accounting. Cost accounting involved the determination and comparison of
costs among a firm's divisions or operations. Thus the historical development
of cost accounting accommodated the development of the multidivisional
firm towards the end of the 19th century. There was necessarily a
considerable amount of overlap among financial, capital, and cost
accounting. For example, to accurately determine unit costs, it was
necessary to relate overhead costs and capital depreciation to the volume of
production. At the same time, unit costs were typically used to determine
prices, which in turn affected financial accounts. The separation of these
types of accounting followed their historical institutional separation. That is,
until the innovations of E.I. Du Pont de Nemours & Co. in the 20th century,
financial, capital, and cost accounting operations were carried out in relative
autonomy within firms.

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Cost accounting was first used by the Louisville & Nashville Railroad in
the late 1860s. This enabled the company to determine such measures as
comparative cost per ton-mile among its branches, and it was by these
measures, rather than earnings or net income, that the company evaluated
the performance of its managers.

EXPANDING USES.
The largest U.S. manufacturing firms in the 1870s were textile
producers. Because these years were a period of hardship for the industry,
textile producers began to devote more attention to the determination and
control of costs. By 1886, Lyman Mills, one of the country's largest textile
producers, began to determine unit costs for its various products, though it
did not use this information to make pricing or investment decisions. The
Standard Oil Trust, formed in 1882, also began to determine the comparative
costs of their different refineries in the 1880s and on this basis opted to
concentrate production in their largest units. However, the enterprise did not
accurately account for overhead or capital depreciation in its determination
of costs.

The firm with the most detailed and sophisticated costing methods in the
1880s was the Carnegie Company, a steel producer. In this case, the
connection between costing methods in the railroad and manufacturing
industries was direct, as Andrew Carnegie patterned the organization of his
firm after the Pennsylvania Railroad, where he had been an executive.
Carnegie's costing method was referred to as the voucher system of
accounting. In this system, each of the company's departments kept track of
the quantity and price of materials and labor for each order. These data were
aggregated into cost sheets that the company's accountants were able to
produce on a daily basis. Though the Carnegie Company made extensive use
of its cost sheets to determine prices, it focused on prime rather than
overhead and depreciation costs.

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THE BASICS OF COSTING METHODS

FIXED COSTS.

One of the key issues in conventional costing methods (i.e., process

costing and job-order costing) is distinguishing among types of costs. A basic
distinction is made between fixed and variable costs. Fixed costs are those
costs that are invariant with respect to changes in output and would accrue
even if no output were produced. Such costs might include interest
payments on the purchase of plant and equipment, rent, property taxes, and
executive salaries. The notion of fixed costs is restricted within a certain time
frame, since over the long run fixed costs can vary. For example, a
manufacturer may decide to expand capacity in the face of increased
demand for its product, requiring a higher level of expenditure on plant and
equipment.

VARIABLE COSTS.

Variable costs change proportionately to the level of output. For

manufacturers, a key variable cost is the cost of materials. In terms of total
costs at increasing output levels, fixed costs are constant and variable costs
are increasing at a constant rate. In terms of unit costs at increasing output

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levels, fixed costs are declining, and variable costs constant. Manufacturers
are vitally interested in unit costs with respect to changes in output levels,
since this determines profit per unit of output at any given price level. The
characteristics of fixed and variable costs indicates that as output increases,
unit costs will decline, since there is constant variable cost and lesser fixed
cost embodied in each unit. These costing methods thus suggest that it is in
manufacturers' interest to run, within the limits of plant design, at high
capacity levels.

DIRECT COSTS.

Costing methods distinguish between the direct and indirect costs of

any costed object. Direct costs are those costs readily traceable to the
costed object, whereas indirect costs are less-readily traceable. Direct costs
typically include the major components of any manufactured good and the
labor directly required to produce that good.

INDIRECT COSTS.

Indirect costs include plant-wide costs such as those resulting from

the use of energy and fixed capital, but indirect costs may also include the
costs of minor components such as solder or glue. While all costs are
conceivably traceable to a costed object, the determination of whether to do
so depends on the cost-effectiveness with which this can be done. Indirect
costs of all kinds are sometimes referred to as overhead, and in this sense
prime costs can be distinguished from overhead costs.

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ESTIMATING TOTAL COSTS

Several methods are used in manufacturing to estimate total cost
equations, in which total costs are determined as a function of fixed costs
per time period, variable costs per unit of output, and the level of output.
These methods include account analysis, the engineering approach, the
high-low approach, and linear regression analysis. In all these methods, the
central issue is how total costs change in relation to changes in output.

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WORKING CAPITAL
DEFINITION
Current asset minus current liabilities, Working
capital measures how much in liquid assets a company has available to build
its business. The number can be positive or negative, depending on how
much debt the company is carrying. In general, companies that have a lot of
working capital will be more successful since they can expand and improve
their operations. Companies with negative working capital may lack
the funds necessary for growth. also called net current assets or current
capital.

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A recurring theme in this series is the importance of investors

shaping their analytical focus according to companies' business models.
Especially when time is limited, it's smart to tailor your emphasis so it's in
line with the economic drivers that preoccupy the company's industry. It's
tough to get ahead of the "investing pack" if you are reacting to generic
financial results - such as earnings per share (EPS) or revenue growth - after
they've already been reported. For any given business, there are usually
some key economic drivers, or leading indicators, that capture and reflect
operational performance and eventually translate into lagging
indicators such as EPS. For certain businesses, trends in the working capital
accounts can be among these key leading indicators of financial
performance.

Introduction
Working capital may be regarded as the life blood of business. Working
capital is of major importance to internal and external analysis because of its
close relationship with the current day-to-day operations of a business. Every
business needs funds for two purposes.

* Long term funds are required to create production facilities through

purchase of fixed assets such as plants, machineries, lands, buildings & etc

* Short term funds are required for the purchase of raw materials, payment
of wages, and other day-to-day expenses. . It is other wise known as
revolving or circulating capital

It is nothing but the difference between current assets and current

liabilities. i.e. Working Capital = Current Asset – Current Liability.

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Businesses use capital for construction, renovation, furniture, software,

equipment, or machinery. It is also commonly used to purchase inventory, or
to make payroll. Capital is also used often by businesses to put a down
payment down on a piece of commercial real estate. Working capital is
essential for any business to succeed. It is becoming increasingly important
to have access to more working capital when we need it.

Working Capital is more a measure of cash flow than a ratio. The result
of this calculation must be a positive number. It is calculated as shown
below:

Working Capital = Total Current Assets - Total Current

Liabilities

Bankers look at Net Working Capital over time to determine a

company's ability to weather financial crises. Loans are often tied to
minimum working capital requirements.

A general observation about these three Liquidity Ratios is that the

higher they are the better, especially if you are relying to any significant
extent on creditor money to finance assets.

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Importance of Adequate Working

Capital
A business firm must maintain an adequate level of working capital in order
to run its business smoothly. It is worthy to note that both excessive and
inadequate working capital positions are harmful. Working capital is just like
the heart of business. If it becomes weak, the business can hardly prosper
and survive. No business can run successfully without an adequate amount
of working capital.

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DANGER OF INADEQUATE WORKING CAPITAL

When working capital is inadequate, a firm faces the following problems.

Fixed Assets cannot efficiently and effectively be utilized on account of lack
of sufficient working capital. Low liquidity position may lead to liquidation of
firm. When a firm is unable to meets its debts at maturity, there is an
unsound position. Credit worthiness of the firm may be damaged because of
lack of liquidity. Thus it will lose its reputation. There by, a firm may not be
able to get credit facilities. It may not be able to take advantages of cash
discount.

CONCEPT OF WORKING CAPITAL

1) Gross Working Capital = Total of Current Asset

2) Net Working Capital = Excess of Current Asset over Current Liability

Current Assets Current Liabilities

Cash in hand / at bankBills Payable
Bills ReceivableSundry Creditors
Sundry DebtorsOutstanding expenses
Short term loansAccrued expenses
Investors/ stockBank Over draft
Temporary investment
Prepaid expenses
Accrued incomes

One of the most important areas of finance to monitor is your

company's working capital, which is the difference between current assets
and current liabilities. As a small business owner, you must constantly be
alert to changes in working capital and their implications; otherwise, you
may miss some warning signs that can lead to business failure. The most
important component of working capital is cash, far the most important asset
of any business, particularly a small business. Without it, the business will

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fail. So it is of paramount importance for you as the business owner to

control all cash transactions.

It is helpful for us, as a business owner, to think of

working capital in terms of five components:
1. Cash and equivalents. This most liquid form of working capital requires
constant supervision. A good cash budgeting and forecasting system
provides answers to key questions such as: Is the cash level adequate to
meet current expenses as they come due? What is the timing relationship
between cash inflow and outflow? When will peak cash needs occur? When
and how much bank borrowing will be needed to meet any cash shortfalls?
When will repayment be expected and will the cash flow cover it?

2. Accounts receivable. Many businesses extend credit to their customers.

If you do, is the amount of accounts receivable reasonable relative to sales?
How rapidly are receivables being collected? Which customers are slow to
pay and what should be done about them?

3. Inventory. Inventory is often as much as 50 percent of a firm's current

assets, so naturally it requires continual scrutiny. Is the inventory level
reasonable compared with sales and the nature of your business? What's the
rate of inventory turnover compared with other companies in your type of
business?

4. Accounts payable. Financing by suppliers is common in small business;

it is one of the major sources of funds for entrepreneurs. Is the amount of
money owed suppliers reasonable relative to what you purchase? What is
your firm's payment policy doing to enhance or detract from your credit
rating?

5. Accrued expenses and taxes payable. These are obligations of your

company at any given time and represent a future outflow of cash.

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Working Capital policy

PRINCIPLES OF RISK VARIATION

* Here risk refers to the inability of a firm to meet its obligation, when they
become due for payment.
* There is a definite inverse relationship between the degree of risk &
profitability.
* A management prefers to minimize risk by maintaining a higher level of
current assets or working capital.

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PRINCIPLES OF COST OF CAPITAL

* Generally, higher the risk lower is the cost & lowers the risk, higher is the
cost.
* A sound working capital management should always try to achieve a
proper balance b/w these two.

PRINCIPLES OF EQUITY POSITION

* It is concerned with planning the total investment in Current Asset.

* Every rupee invested in the current assets should contribute to the net
worth of the firm.

The level of Current Asset may be measured with the help of two ratios

• Current assets as a % of total assets.

• Current assets as a % of total sales.
•

PRINCIPLE OF MATURITY OF PAYMENT

• It is concerned with planning the sources of finance for working capital.

• A firm should make every effort to relate maturities of payment to its
flow of internally generated funds.

Estimation / forecast of working capital

requirements

"Working capital is the life blood & controlling nerve centre of a business."
No business can be successfully run without an adequate amount of working
capital.

• To avoid the shortage of working capital at once, an estimate of

working capital requirement should be made in advance.
• But estimation of working capital requirements is not an easy task & a
large no. of factors has to be considered before starting this.

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Factors requiring consideration while estimating

working capital.

• The average credit period expected to be allowed by suppliers.

• Total costs incurred on material, wages.
• The length of time for which raw material are to remain in stores
before they are issued for production.
• The length of the production cycle (or) work in process.
• The length of sales cycle during which finished goods are to be kept
waiting for sales.
• The average period of credit allowed to customers
• The amount of cash required to make advance payment

Factors determining working capital requirements

• Nature of business
• Size of business
• Production policy
• Manufacturing process
• Seasonal variations
• Working capital cycle
• Rate of stock turn over
• Credit policy
• Business cycles
• Rate of growth of business
• Price level changes
• Earning capacity & dividend policy
• Other factors.

Importance of Working Capital Ratios

Ratio analysis can be used by financial executives to check upon the

efficiency with which working capital is being used in the enterprise. The

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following are the important ratios to measure the efficiency of working

capital. The following, easily calculated, ratios are important measures of
working capital utilization.

Ratio Formulae Result Interpretation

Stock Average Stock = x On average, you turn over the value
Turnover * 365/ days of your entire stock every x days.
(in days) Cost of Goods You may need to break this down
Sold into product groups for effective
stock management.
Obsolete stock, slow moving lines
will extend overall stock turnover
days. Faster production, fewer
product lines, just in time ordering
will reduce average days.
Receivable Debtors * 365/ = x It take you on average x days to
s Ratio Sales days collect monies due to you. If your
(in days) official credit terms are 45 day and it
takes you 65 days... why ?
One or more large or slow debts can
drag out the average days. Effective
debtor management will minimize
the days.
Payables Creditors * =x On average, you pay your suppliers
Ratio 365/ days every x days. If you negotiate better
(in days) Cost of Sales credit terms this will increase. If you
(or Purchases) pay earlier, say, to get a discount
this will decline. If you simply defer
paying your suppliers (without
agreement) this will also increase -
but your reputation, the quality of
service and any flexibility provided
by your suppliers may suffer.
Current Total Current = x Current Assets are assets that you
Ratio Assets/ times can readily turn in to cash or will do
Total Current so within 12 months in the course of
Liabilities business. Current Liabilities are
amount you are due to pay within
the coming 12 months. For example,
1.5 times means that you should be
able to lay your hands on $1.50 for
every $1.00 you owe. Less than 1
times e.g. 0.75 means that you could

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have liquidity problems and be under

pressure to generate sufficient cash
to meet oncoming demands.
Quick (Total Current =x Similar to the Current Ratio but takes
Ratio Assets - times account of the fact that it may take
Inventory)/ time to convert inventory into cash.
Total Current
Liabilities
Working (Inventory + As % A high percentage means that
Capital Receivables - Sales working capital needs are high
Ratio Payables)/ relative to your sales.
Sales

Other working capital measures include the following:

1. Bad debts expressed as a percentage of sales.
2. Cost of bank loans, lines of credit, invoice discounting etc.
3.Debtor concentration - degree of dependency on a limited number of
customers.

Once ratios have been established for our business, it is important to

track them over time and to compare them with ratios for other comparable
businesses or industry sectors.

A measure of both a company's efficiency and its short-

term financial health. The working capital ratio is
calculated as:
Positive working capital means that the company is able to pay off its
short-term liabilities. Negative working capital means that a company
currently is unable to meet its short-term liabilities with its current assets
(cash, accounts receivable, inventory).
Also known as "net working capital".

If a company's current assets do not exceed its current liabilities, then

it may run into trouble paying back creditors in the short term. The worst-
case scenario is bankruptcy. A declining working capital ratio over a longer
time period could also be a red flag that warrants further analysis. For
example, it could be that the company's sales volumes are decreasing, and
as a result, its accounts receivables number continues to get smaller and
smaller.
Working capital also gives investors an idea of the company's

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underlying operational efficiency. Money that is tied up in inventory or

money that customers still owe to the company cannot be used to pay off
any of the company's obligations. So, if a company is not operating in the
most efficient manner (slow collection), it will show up as an increase in the
working capital. This can be seen by comparing the working capital from one
period to another; slow collection may signal an underlying problem in the
company's operations.

Working Capital Is The Difference

Between Current Assets And Current
Liabilities:

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Where is Working Capital Analysis

Most Critical?

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Working capital is always significant. This is especially true from

the lender's or creditor's perspective, where the main concern is
defensiveness: can the company meet its short-term obligations, such as
paying vendor bills?

But from the perspective of equity valuation and the company's growth
prospects, working capital is more critical to some businesses than to others.
At the risk of oversimplifying, we could say that the models of these
businesses are asset or capital intensive rather than service or people
intensive.

Examples of service intensive companies include H&R Block, which

provides personal tax services, and Manpower, which provides employment
services. In asset intensive sectors, firms such as
telecom and pharmaceutical companies invest heavily
in fixed assets for the long term, whereas others invest
capital primarily to build and/or buy inventory. It is the
latter type of business - the type that is capital intensive
with a focus on inventory rather than fixed assets - that
deserves the greatest attention when it comes to
working capital analysis. These businesses tend to
involve retail, consumer goods and technology
hardware, especially if they are low-cost producers or distributors.

Working Capital Cycle

Cash flows in a cycle into, around and out of a business. It is the

business's life blood and every manager's primary task is to help keep it
flowing and to use the cash flow to generate profits. If a business is
operating profitably, then it should, in theory, generate cash surpluses. If it
doesn't generate surpluses, the business will eventually run out of cash and
expire. The faster a business expands the more cash it will need for working

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capital and investment. The cheapest and best sources of cash exist as
working capital right within business. Good management of working capital
will generate cash will help improve profits and reduce risks. Bear in mind
that the cost of providing credit to customers and holding stocks can
represent a substantial proportion of a firm's total profits.

There are two elements in the business cycle that absorb cash
- Inventory (stocks and work-in-progress) and Receivables (debtors owing
you money). The main sources of cash are Payables (your creditors)
and Equity and Loans.

Each component of working capital (namely inventory, receivables and

payables) has two dimensions TIME and MONEY. When it comes to
managing working capital - TIME IS MONEY. If you can get money to move
faster around the cycle (e.g. collect monies due from
debtors more quickly) or reduce the amount of money
tied up (e.g. reduce inventory levels relative to sales),
the business will generate more cash or it will need to
borrow less money to fund working capital. As a
consequence, you could reduce the cost of bank
interest or you'll have additional free money available
to support additional sales growth or investment.
Similarly, if you can negotiate improved terms with
suppliers e.g. get longer credit or an increased credit
limit, you effectively create free finance to help fund
future sales.

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Sources of Additional Working

Capital

Sources of additional working capital include the following:

* Existing cash reserves

* Profits (when you secure it as cash)
* Payables (credit from suppliers)
* New equity or loans from shareholders
* Bank overdrafts or lines of credit
* Long-term loans

If you have insufficient working capital and try to increase sales,

you can easily over-stretch the financial resources of the business. This
is called overtrading. Early warning signs include:

* Pressure on existing cash

* Exceptional cash generating activities e.g. offering high discounts for
early cash payment
* Bank overdraft exceeds authorized limit
* Seeking greater overdrafts or lines of credit

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* Part-paying suppliers or other creditors

* Paying bills in cash to secure additional supplies
* Management pre-occupation with surviving rather than managing
* Frequent short-term emergency requests to the bank (to help pay
wages, pending receipt of a cheque).

OVERVIEW OF CURRENT METHODS

PROCESS AND JOB-ORDER COSTING.

There are two conventional costing approaches used in manufacturing.

The first, and more common, is process costing. Used in most mass-
production settings, a process cost system analyzes the net cost of a
manufacturing process, say filling bottles with soda, over a specified period
of time. The unit cost for filling bottles is simply the net costs incurred while
filling all the bottles during the period divided by the number of bottles filled.
Since most manufacturing processes involve more than one step, a similar
calculation is made for each step to arrive at a unit cost average for the
entire production system. By contrast, the second major costing method, job-
order costing, is concerned with tracking all the costs on an individual
product basis. This is useful in settings where each unit of production is
customized or where there are very few units produced, such as in building
pianos, ships, or airplanes. Under job order costing, the exact costs incurred
in the production of a particular unit are recorded and are not necessarily
averaged with those of any other unit, since every unit may be different. Job-
order costing is also widely used outside manufacturing. A single
manufacturer may use both process and job-order costing for different parts
of its operations.

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ACTIVITY-BASED COSTING.

Activity-based costing(ABC) is a secondary and somewhat

complementary (or better, supplementary) method to the two traditional
costing techniques. Whereas traditional methods might classify costs in
generic categories like direct materials, labor, and other overhead, ABC
clusters all the costs associated with a single manufacturing task, regardless
of whether they fall under the headings of labor or materials or something
else. So in the bottling example activity-based costs might include operating
the dispensing machines, performing quality checks, moving pallets of
bottles, and so forth.

Each of these activities may involve human labor, equipment costs,

energy and expendable resources, and materials, but for analytic purposes
the costs are all lumped together under a single activity concept. The
advantage of this approach is that management can then observe which
tasks cost the most versus which add the most value; this analysis may
indicate that a disproportionate amount of money is being spent on low-
value activities, signaling a need for process changes or for outsourcing to a
vendor that can perform the tasks less expensively. Use of this method is
sometimes referred to as activity-based cost management (ABCM) or simply
activity-based management

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ACCOUNT ANALYSIS.

In account analysis, all costs are classified as either strictly fixed or

variable. This has the advantage of ease of computation. However, some
costs may be semi variable costs or step costs. Utility bills are typically semi
variable in that they contain fixed and variable components. Step costs
increase in discrete jumps as the level of output increases. In account
analysis, such costs are typically categorized as either fixed or variable

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depending which element predominates. Thus, the accuracy of account

analysis depends in large part on the proportion of costs that are not strictly
fixed or variable. For many manufacturing firms, account analysis provides a
sufficiently accurate estimation of total costs over a range of output levels.

ENGINEERING APPROACH.

The engineering approach infers costs from the specifications of a

product. The approach works best for determining direct material costs and
less well for direct labor costs and overhead costs. The advantage of the
engineering approach is that it enables manufacturers to estimate what a
product would cost without having previously produced that product,
whereas the other methods are based on the costs of production that has
already occurred.

HIGH-LOW APPROACH.

In the high-low approach, a firm must know its total costs for
previous high and low levels of output. Graphing total costs against output,
total costs over a range of output are estimated by fitting a straight line
through total cost points at high and low levels of output. If changes in total
costs can be accurately described as a linear function of output, then the
slope of the line indicates changes in variable costs.

The problem with the high-low approach is that the two data points
may not, for whatever reasons, accurately represent the underlying total
cost-output relationship. That is, if additional total cost-output points were
plotted, they might lay significantly wide of the line connecting the two initial
high-low points.

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LINEAR REGRESSION.

Linear regression analysis addresses the shortcomings of the high

low approach by fitting a line through all total cost-output points. The line is
fitted to minimize the sum of squared differences between total cost-output
points and the line itself, in standard linear regression fashion. The drawback
of this approach is that it requires more data points than the other
approaches.

The relation of total costs to output levels is combined in the idea

of standard costs. Standard costs are estimates of unit costs at targeted
output levels, including direct materials costs, direct labor costs, and indirect
costs. Standard costs are used to prepare budgets for planned production
and to assess production that has occurred. The estimation of standard costs
requires the separate estimation of standards for direct materials, direct
labor, and overhead.

DIRECT MATERIALS.

Direct material standards are the easiest to estimate. Costs are

determined from the prices of all necessary material inputs into the product,
plus sales tax, shipping, and other related costs. Unanticipated price changes
complicate this otherwise straightforward process. Since standard costs are
a measure of unit costs, it is also necessary to determine the quantity of
materials per unit. This can be done using an engineering approach.

DIRECT LABOR.

Direct labor standards are somewhat more difficult to estimate. The

determination of costs must account for wages, though if workers in a
production process are earning different wages, it is necessary to estimate a

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weighted average of wage costs. The cost of benefits, employment related

taxes, and overtime pay must also be accounted for. As with direct material
standards, the quantity of direct labor required to produce a unit of output
can be estimated with an engineering approach. Average set-up time and
downtime must also be included in the estimation. Many union contracts
codify labor time standards, which can make budgeting easier.

OVERHEAD.

Overhead standards are the most difficult to estimate, and they are
typically accounted for in an approximate manner. The problem of
accounting for overhead costs per unit of output was noted above—it is often
difficult to trace indirect costs to a particular product. The problem is made
more complicated if these costs are highly centralized within a plant and if
multiple products are produced within a plant. Overhead standards are
typically estimated by taking total overhead costs and relating them to a
more readily-knowable measure, such as direct labor hours, direct labor
costs, or machine hours used. Direct labor hours was traditionally the most
widely-used measure for determining overhead standards, but the growth of
automated plants resulted in a shift to machine hours used.

FUTURE OF COST ACCOUNTING

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EXPANSION AND INTEGRATION OF ABC.

Widespread corporate interest in activity-based costing (ABC), which

started in the late 1980s and has continued through the late 1990s, has
created dueling cost accounting systems for some companies. Managers
want the analytic power of an ABC system, yet may also require some of the
conventional abilities and rigor of a traditional system like process or job
costing. The failure to integrate these competing needs has caused some
firms to abandon or at least reconsider ABC initiatives, which can be
expensive and time-consuming to implement in a large operation. Some
managers have viewed it as an either-or dilemma, and often ABC is eyed
with some suspicion, as indeed early formulations of it were not effective
substitutes for conventional costing methods. However, many successful
ABC implementations use it as a supplement to, rather than a replacement
for, standard methods. Advocates of ABC have begun to formulate ways in
which ABC can be better integrated with conventional methods so that
companies can enjoy the benefits of both. In 1999 the Institute of
Management Accountants (IMA), the leading professional organization
for managerial accountants, published renewed guidelines for companies
wishing to implement ABC practices, following a series of previous
statements on using ABC dating back to the early 1990s. The IMA's
statements included a number of cautions against potential pitfalls in
establishing an ABC system.

TARGET COSTING.

A related practice that has also enjoyed quite a bit of attention since
the mid-1990s is target costing, which is a method of engineering a product
and its manufacturing process from the start with a specific cost model in
mind. This approach, which is essentially an elaboration of the engineering
costing approach, attempts to create an optimally efficient process from the

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start—with a profitable yet marketable selling price in mind—rather than

waiting until a product is already being manufactured and then setting prices
and looking for cost savings. Some implementations of target costing
actually don't involve accountants as much as they invlolve product
marketing managers, engineers, and others who are part of the actual
design and production processes. IMA guidelines also exist for target costing
systems.

In the world of manufacturing–as competition becomes more intense

and customers demand more services–it is important that management not
only control its overhead but also understand how it is assigned to products
and ultimately reported on the company's financial statements.
We view overhead as two types of costs and define them as follows:

1. Manufacturing overhead: - Manufacturing overhead (also referred to

as factory overhead, factory burden and manufacturing support costs) refers
to indirect factory-related costs that are incurred when a product is
manufactured. Along with costs such as direct material and direct labor, the
cost of manufacturing overhead must be assigned to each unit produced so
that Inventory and Cost of Goods Sold are valued and reported according
to generally accepted accounting principles (GAAP).
Manufacturing overhead includes such things as the electricity used to
operate the factory equipment, depreciation on the factory equipment and
building, factory supplies and factory personnel (other than direct labor).
How these costs are assigned to products has an impact on the
measurement of an individual product's profitability.

2. Nonmanufacturing costs: - Non manufacturing cost (sometimes

referred to as “administrative overhead”) represent a manufacturer’s
expenses that occur apart from the actual manufacturing function. In
accounting and financial terminology, the nonmanufacturing costs
include Selling, General and Administrative (SG&A) expenses, and Interest
Expense.
Since accounting principles do not consider these expenses as product
costs, they are not assigned to inventory or to the cost of goods sold.
Instead, nonmanufacturing costs are simply reported as expenses on the
income statement at the time they are incurred.Nonmanufacturing costs
include activities associated with the Selling and General Administrative
functions. Examples include the compensation of nonmanufacturing
personnel; occupancy expenses for nonmanufacturing facilities (rent, light,

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heat, property taxes, maintenance, etc.); depreciation of nonmanufacturing

equipment; expenses for automobiles and trucks used to sell and deliver
products; and interest expenses. (Note that factory administration expenses
are considered part of manufacturing overhead.)

Although nonmanufacturing costs are not assigned to products for

purposes of reporting inventory and the cost of goods sold on a company’s
financial statements, they should always be considered as part of the total
cost of providing a specific product to a specific customer. For a product to
be profitable, its selling price must be greater than the sum of the product
cost (direct material, direct labor, and manufacturing overhead) plus the
nonmanufacturing costs and expenses.

Ratio Analysis enables the business owner/manager to spot trends in a

business and to compare its performance and condition with the average
performance of similar businesses in the same industry. To do this compare
your ratios with the average of businesses similar to yours and compare your
own ratios for several successive years, watching especially for any
unfavorable trends that may be starting. Ratio analysis may provide the all-
important early warning indications that allow you to solve your business
problems before your business is destroyed by them.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a
business's ability to pay its bills as they come due) and leverage (the extent
to which the business is dependent on creditors' funding). They include the
following ratios:

LIQUIDITY RATIOS

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These ratios indicate the ease of turning assets into cash. They include
the Current Ratio, Quick Ratio, and Working Capital.

CURRENT RATIOS
The Current Ratio is one of the best known measures of financial
strength. It is figured as shown below:

Current Ratio = Total Current Assets / Total Current

Liabilities
The main question this ratio addresses is: "Does your business have
enough current assets to meet the payment schedule of its current debts
with a margin of safety for possible losses in current assets, such as
inventory shrinkage or collectable accounts?" A generally acceptable current
ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on
the nature of the business and the characteristics of its current assets and
liabilities. The minimum acceptable current ratio is obviously 1:1, but that
relationship is usually playing it too close for comfort.

If you feel your business's current ratio is too low, you may be able to raise it
by:

• Paying some debts.

• Increasing your current assets from loans or other borrowings with a
maturity of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.

QUICK RATIOS
The Quick Ratio is sometimes called the "acid-test" ratio and is one of
the best measures of liquidity. It is figured as shown below:

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Quick Ratio = Cash + Government Securities + Receivables

/ Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current
Ratio. By excluding inventories, it concentrates on the really liquid assets,
with value that is fairly certain. It helps answer the question: "If all sales
revenues should disappear, could my business meet its current obligations
with the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of

your "quick assets" are in accounts receivable, and the pattern of accounts
receivable collection lags behind the schedule for paying current liabilities.

LEVERAGE RATIO

This Debt/Worth or Leverage Ratio indicates the extent to which the

business is reliant on debt financing (creditor money versus owner's equity):

Debt/Worth Ratio = Total Liabilities / Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive
its exposure in your business, making it correspondingly harder to obtain
credit.

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INCOME STATEMENT RATIO

ANALYSIS

The following important state of income ratios measure profitability

GROSS MARGIN RATIO

This ratio is the percentage of sales dollars left after subtracting the
cost of goods sold from net sales. It measures the percentage of sales dollars
remaining (after obtaining or manufacturing the goods sold) available to pay
the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will reveal

the relative strengths or weaknesses in your business. The Gross Margin
Ratio is calculated as follows:

Gross Margin Ratio = Gross Profit / Net Sales

Reminder: Gross Profit = Net Sales - Cost of Goods Sold

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NET PROFIT MARGIN RATIO

This ratio is the percentage of sales dollars left after subtracting the
Cost of Goods sold and all expenses, except income taxes. It provides a good
opportunity to compare your company's "return on sales" with the
performance of other companies in your industry. It is calculated before
income tax because tax rates and tax liabilities vary from company to
company for a wide variety of reasons, making comparisons after taxes
much more difficult. The Net Profit Margin Ratio is calculated as follows:

Net Profit Margin Ratio = Net Profit Before Tax / Net Sales

MANAGEMENT RATIOS
Other important ratios, often referred to as Management Ratios, are also
derived from Balance Sheet and Statement of Income information.

INVENTORY TURNOVER RATIO

This ratio reveals how well inventory is being managed. It is important
because the more times inventory can be turned in a given operating cycle,
the greater the profit. The Inventory Turnover Ratio is calculated as follows:

Inventory Turnover Ratio = Net Sales / Average Inventory at Cost

ACCOUNTS RECEIVABLE TURNOVER RATIO

This ratio indicates how well accounts receivable are being collected.
If receivables are not collected reasonably in accordance with their terms,
management should rethink its collection policy. If receivables are
excessively slow in being converted to cash, liquidity could be severely
impaired. Getting the Accounts Receivable Turnover Ratio is a two step
process and is is calculated as follows:

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Daily Credit Sales = Net Credit Sales Per Year / 365 (Days)

Accounts Receivable Turnover (in days) = Accounts Receivable / Daily

Credit Sales

RETURN ON ASSETS RATIO

This measures how efficiently profits are being generated from the
assets employed in the business when compared with the ratios of firms in a
similar business. A low ratio in comparison with industry averages indicates
an inefficient use of business assets. The Return on Assets Ratio is calculated
as follows:

Return On Assets = Net Profit Before Tax / Total Assets

RETURN ON INVESTMENT (ROI) RATIO

The ROI is perhaps the most important ratio of all. It is the percentage
of return on funds invested in the business by its owners. In short, this ratio
tells the owner whether or not all the effort put into the business has been
worthwhile. If the ROI is less than the rate of return on an alternative, risk-
free investment such as a bank savings account, the owner may be wiser to
sell the company, put the money in such a savings instrument, and avoid the
daily struggles of small business management. The ROI is calculated as
follows:

Return on Investment = Net Profit before Tax / Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow

the business owner to identify trends in a business and to compare its
progress with the performance of others through data published by various

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sources. The owner may thus determine the business's relative strengths
and weaknesses.

CONCLUSION

Any change in the working capital will have an effect on a business's

cash flows. A positive change in working capital indicates that the business
has paid out cash, for example in purchasing or converting inventory, paying
creditors etc. Hence, an increase in working capital will have a negative
effect on the business's cash holding. However, a negative change in
working capital indicates lower funds to pay off short term liabilities (current
liabilities), which may have bad repercussions to the future of the company.

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BIBLOGRAPHY

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