Subject: Industrial Engineering And Management

Topic: Cost Accounting and Financial Management

Difficulty: Medium

Write a short note on:

a. Financial statements.

b. Elements of cost

c. Accounting Rate of Return Method

d. Techniques for adjusting time value of money

e. Balance sheet

Financial statement:

Financial statements (or financial report) are a formal record of the financial activities and position of a business, person, or other entity.

Relevant financial information is presented in a structured manner and in a form easy to understand. They typically include basic financial statements, accompanied by a management discussion and analysis:

A balance sheet or statement of financial position, reports on a company's assets, liabilities, and owners equity at a given point in time.

An income statement or statement of comprehensive income, statement of revenue & expense, P&L or profit and loss report, reports on a company's income, expenses, and profits over a period of time. A profit and loss statement provides information on the operation of the enterprise. These include sales and the various expenses incurred during the stated period.

A Statement of changes in equity or equity statement or statement of retained earnings, reports on the changes in equity of the company during the stated period.

A cash flow statement reports on a company's cash flow activities, particularly its operating, investing and financing activities.

For large corporations, these statements may be complex and may include an extensive set of footnotes to the financial statements and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

Elements of cost:

The cost of a product consists of the following cost components or elements: i)Direct Material ii) Direct Labour iii) Direct Expenses iv) Factory Overhead v)Selling and Distribution and Administrative Overhead

Materials: Material indicates principal substances used in production. Examples are: cotton, jute, iron-ore, and silicon. The cost of material is further divided in to direct and indirect materials.

Direct Material: Direct materials refer to the cost of materials which become a major part of the finished product. They are raw materials that become an integral part of the finished product and are conveniently and economically traceable to specific units of output. Some examples of direct materials are: raw cotton in textiles, crude oil to make diesel, steel to make automobile bodies.

Indirect material: These are materials which are used ancillary to manufacture and cannot be traced in to the finished product. These form a part of manufacturing overhead. Examples are glue, thread, nails, consumable stores, printing and stationary material

LABOUR: Labor is the physical or mental effort expended on the production of an item. It is the active factor of production as against material which is a passive factor. The cost of labor further divided into direct and indirect labor.

Direct Labour: Direct labour is defined as the labour associated with workers who are engaged in the production process. It the labour costs for specific work performed on a product that is conveniently and economically traceable to end products. Direct labour is expended directly up on the materials comprising the finished product. Examples are the labour of machine operators and assemblers

Indirect labor: This includes wages paid for all labour which is not directly engaged in changing the shape or composition of raw materials. It cannot be traced directly to the product. Lick indirect materials, indirect labour forms part of the manufacturing overheads. Examples of indirect labor cost are wages paid to foremen, supervisors, store-keepers, time-keepers, salaries of office executives and the commission payable to sales representatives.

Direct Expenses: Direct expenses include any expenditure other than direct material and direct labor directly incurred on a specific cost unit (product or job). Such special necessary expenses can be identified with cost units and are charged directly to the product as part of the prime cost. Some examples of direct expenses are: (a) Cost of special layout, designing or drawings; (b) Hire of tools or equipment for a particular production or product; (c) Maintenance costs of such equipments.

Indirect expenses: Indirect expenses are those incurred for the business as a whole rather than for a particular order, job or product. Examples of such expenses are rent, lighting, insurance charges.

Overheads: Overheads may be defined as the aggregate of indirect material, indirect labor and indirect expenses. Thus, all indirect costs are overheads. These cannot be associated directly with specific products.

Hence, the amount of overhead has to be allocated and apportioned to products and services on some reasonable basis. The synonymous term is “burden”. Overheads may be subdivided in to following groups: a) Factory overheads. b) Administrative overheads. c) Selling and distribution overheads.

Factory Overhead: Factory overhead also called manufacturing expenses or factory burden may be defined as the cost of indirect materials, indirect labor and indirect expenses. Examples of such items are lubricants, cotton waste, hand tools, works stationery.

Selling and Distribution and Administrative Overhead: Selling and distribution overhead is also known as marketing or selling overhead. Distribution expenses usually begin when the factory costs end. Such expenses are generally incurred when the product is in saleable condition. It covers the cost of making sales and delivering/dispatching products. These costs include advertising, salesmen salaries and commissions, packing, storage, transportation, and sales administrative costs. Administrative overhead includes costs of planning and controlling the general policies and operations of business enterprises.

Fixed cost: Fixed cost is the cost which does not change in total for a given time period despite wide fluctuations in output or volume of activity. Example: Rent, Property taxes, Supervising salaries, depreciation on office facilities, advertising, insurance etc.. Fixed  Committed costcost can be further classified into three types: Managed Discretionary costcost

Variable cost: Variable costs are those costs that vary directly and proportionately with the output. There is a constant ratio between the change in the cost and change in the level of output. Direct materials cost and direct labor costs are the costs which are generally variable costs.

Mixed cost: Mixed costs are made up of fixed and variable elements. They are combination of semi-variable costs and fixed costs.

Accounting rate of return method:

Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money.

ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. More than half of large firms calculate ARR when appraising projects.

The key advantage of ARR is that it is easy to compute and understand. The main disadvantage of ARR is that it disregards the time factor in terms of time value of money or risks for long term investments.

The ARR is built on evaluation of profits and it can be easily manipulated with changes in depreciation methods. The ARR can give misleading information when evaluating investments of different size.

Basic formulas

$ARR=\frac{(Average return during period)}{(Average investment)}$

Where:

$Average Investment=\frac{(Book value at begining of year 1+Book value at the end of useful life)}{(Initial investment)}$

$ARR= \frac{(Incremental revenue-Incremental expenses( including depritiation))}{(Initial investment)}$

$Average profit=\frac{(Profit after tax)}{(Life of investment)}$

Disadvantages:

This technique is based on profits rather than cash flow. It ignores cash flow from investment. Therefore, it can be affected by non-cash items such as bad debts and depreciation when calculating profits. The change of methods for depreciation can be manipulated and lead to higher profits.

This technique does not adjust for the risk to long term forecasts.

ARR doesn't take into account the time value of money.

Techniques for adjusting time value of money:

Time value of money is the value which is earned over a given amount of time in terms of interest. For example if Rs. 200 money will be invested for about 1 year then the earning will be of 5% interest which will be worth 205 after one year. So using this time value of money terminology the future value can be predicted.

The techniques which are used for this is as follows:-

1) Calculation of the present value:- in this the worth of the future sum is given and the specified rate of return is been shown. It has lots of variations in this is that the future cash flow are discounted at the discount rate and it also represents the low present value of future cash flow.

2) Discounted cash flow:- in finance it is the analysis of a method which talks about the value of the project, company and the asset which is being used using the time value of money. In this all estimation has been taken and discounted for the present value as it shows both incoming and outgoing. This kind is used for investment of the finance and used for financial management.

Balance sheet: The balance sheet is a summary statement of what a company owns (or is owed) and what a company owes (or what others own) at a specific point in time. It categorizes all of a company’s resources as assets, liabilities, and owner’s equity.

The basic structure of a balance sheet is shown in Table 2.2. Note, as with the income statement, that these are not the only accounts that may appear on a balance sheet and some balance sheets may utilize slightly different terminology. Some companies offer more detail on their statements than others. Certain accounts that are important for one company may be minor or nonexistent for another company. Nonetheless, these are the major items and delineations that appear on most standard balance sheets and this is the balance sheet structure that we will use throughout the remainder of this section of the book