Management Accounting - Essay Example

? Budget Actual € € Raw material stocks 150,000 186,000 Finished stock 45,000 45,000 Debtors 60,000 90,000 Bank 4,500 -39,000 259,500 303,000 Creditors 66,000 51,000 Working Capital 193,500 252,000 Raw Material Stocks increased by €36,000 (186,000-150,000) this year. This is even though production costs and sales income were the same. If production costs had increased and sales income increased then raw material stocks would not be affected because the production costs and sales income is a factor only of finished goods. The BASE formula helps in determining what caused the actual ending balances of all working capital accounts. Budgeted Balance Additions Subtractions (use to get back to actual balance) Ending Balance (actual) To understand what happened with everything else we must first understand the impact of the Raw Material Stocks. Raw Material Stocks Budgeted Balance 150,000 Additions 36,000 Subtractions 0 Ending Balance (actual) 186,000 By viewing the BASE formula we can see that the Raw Material Stocks balance was greater than the budgeted balance by 36,000 and based on the knowledge that production levels were about the same, this means that the materials would only increase not decrease because the balance was planned to be 150,000 based on production and with a 36,000 increase with the same production. A purchase of Raw Material Stocks equaling 36,000 must have been made. The issue that caused this was probably due to decreased efficiency in using materials. When Raw Materials must be purchased beyond what is budgeted this means there is an unfavorable variance of 36,000. In order to correct this issue the company must come up with a standard of how much Raw Material stocks to use and then if costs allow, use a supervisor to ensure this standard is upheld. Creditors Budgeted Balance 66,000 Additions 36,000 Subtractions 51,000 Ending Balance (actual) 51,000 We can assume based on these numbers that the company added more debt from creditors of about 36,000 since inventory had been bought through creditors the balance increased by the amount of increase in the Raw Material Stock balance. Therefore since the ending balance of creditors was less than the beginning we can see that the company must have paid off creditors in excess of the added debt. That excess is equal to the beginning balance of 66,000 plus added debt of 26,000 minus the ending actual balance of 51,000, which means the company paid toward what was owed creditors, which was 51,000. The issue that may have occurred is that current debts might have become due and therefore these debts had to be satisfied. Thus payment was made to the creditor decreasing working capital. In order to prevent this from happening again debt should be kept to a low amount, paid in a timely manner and cash should be kept in order to satisfy debt. Bank Budgeted Balance 4,500 Additions 7,500 Subtractions 51,000 Ending Balance (actual) (39,000) Due to the fact that the company paid creditors 51,000, that amount must come out of the Bank balance since there is no cash on hand. The beginning balance was only 4,500 and the ending balance was negative 39,000 therefore the company must have added 7,500 to the bank account. Where did that 7,500 come from? The issue is that there is an overdraft of the bank account. This has happened due to the purchases of Raw Material Stocks of 36,000 but the company did not generate enough cash in order to meet its burdens. To prevent this from happening again the company must increase its liquidity by keeping inventory levels low, and the bank/cash balance high. Debtors Budgeted Balance 60,000 Additions 37,500 Subtractions 7,500 Ending Balance (actual) 90000 The debtors actual balance was 30,000 greater than the budgeted balance but what specifically happened was that debtors purchased the same amount of products that was involved in sales but 30,000 of these sales were credit sales. The issue is that there are more creditors that projected. This is a big problem because its likely that some of these debtors will become noncollectable. To prevent this from happening again the company should restrict its credit policy so that payment becomes more likely. Finished goods were the same and this is due to production being the same. There is no problem with this, the budget was adhered to and production ceased when the correct amount of units was made. Control procedures Finished Goods In order to keep finished goods low in terms of working capital, the manager must produce at a level that will prevent Sales from being to low. Sales can be low when the company brings prices to an unacceptable level thus causing customers to be indifferent or lose desire to purchase the product. Therefore the company must keep prices at a reasonable level to keep the product from being left in inventory thus causing a higher working capital. Raw Material Stock This can be controlled by preventing purchasing until an order actually arrives. By doing this the company will avoid having to pay for the raw materials and the inventory will not have to sit in the warehouse. Another way to reduce Raw Materials is to use either just in time inventory or economic order quantity (EOQ). The premise for just-in-time would help a lot as, “ideally, a just-in-time inventory system means that no extra raw materials or inventory of parts for production are stored.” Debtors The best way to decrease debtors is to increase the required credit score and to decrease the allowable pay period. By doing either of these options the company might lose many customers who would not have had the money in order to pay for these products. Bank Obviously to lower the bank balance all the company has to do is withdraw more cash or leave the balance as a negative. To prevent this there must always be cash in the bank. This will be achieved by instructing the bank, not to allow overdraft balances and placing checks only in proper custody. Creditors In order to increase creditors a company would purchase more materials and make arrangements for longer pay periods. By doing this it would be possible to decrease working capital. In order to reduce creditors a company would have to reduce purchasing materials or make arrangements for consignments so that the inventory is not the company's but the vendors. With consignments the company would eliminate creditors and thus increase the working capital. The best thing to do to avoid having unknown debt is to have a vendor file. Working Capital In order for the company to keep working capital on the lower end the company must understand what goes into the working capital formula. Current Assets – Current Liabilities = Working Capital For working capital to be zero or negative the current assets must be equal to or less than the current liabilities. Increasing debt and decreasing cash and inventory would decrease the working capital. On the other hand if the company wanted to increase working capital, increasing assets and decreasing current liabilities for a higher working capital. Four inventory valuation methods There are four methods I would like to discuss: The Cost method is the method of valuing the inventory at the original price of the product. The original price is the invoiced price, which includes freight and insurance, which the buyer paid the seller. The FASB 330-10-30-1 states that “the primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. If using the cost method the company would have to go back to all the prior receipts from vendors in order to record the current inventory value. This would become a tedious task if switching from another valuation such as average cost or FIFO. For example if the invoice was for $15, the inventory cost would be $15. In using this method for this particular type of inventory of a manufacturing company, the company would need to calculate manufacturing overhead, variable costs (raw materials, labor), and fixed costs because based on GAAP, only absorption costing is allowed. There are two types of valuations based on the cost method and these are absorption and variable costing. Absorption costing involves the including of all product costs including fixed and variable manufacturing overhead. Absorption carries all the costs with the inventory and therefore income can be higher than someone else using variable costing when inventory is on hand. Variable costing includes direct labor, direct materials and variable overhead, and the company expenses all Fixed Manufacturing Overhead in the period incurred. Variable Costing Absorption Costing Direct Materials Direct Materials Direct Labor Direct Labor Variable Manufacturing OH Variable Manufacturing OH Fixed Manufacturing OH The other accounts that come into play when using the cost method in a manufacturing company are Work-in-process, where inventory under work is held, manufacturing overhead applied, where the budgeted overhead is estimated. Once the actual overhead is found the company has to transfer direct labor, direct materials, and manufacturing overhead into finished goods which is what is currently being done. The Average Cost Method is the method of valuing the inventory at the average cost of the inventory purchased. “Under the average cost method, the weighted average cost per unit is multiplied by the number of units in ending inventory to produce the cost of ending inventory and by the number of units sold to produce costs of good sold” All invoices for all current inventory is averaged by the number of products in the balance. If using this method the company would still need to know all the original prices as well as using the correct number of products. For example if the company had a $5 cap, $10 hat, and $15 pair of socks, the average cost would be $10, so that when either one of the items is selected the average cost of inventory would decrease by $10. This is method is not extremely accurate especially along the lines of specialty and unique goods because the price is not uniform. The average cost method's balance can be arbitrarily higher due to inflationary forces. If inventory is bought during a rise in prices the inventory's valuation can be raised artificially higher. This is obviously going to make inventory valuation especially in the manufacturing industry where inventory is uniform. First In First Out is the method that values the first product in inventory is the current product being bought. In other words “The FIFO method assumes that a company uses goods in the order in which it purchases them”. This method causes the revenues not to match the revenues with expenses. If revenues do not match expenses then income has the possibility to fluctuate. This inventory method has an advantage during inflationary time because the last can be sold at current prices. The disadvantage of all this recognized profit is that the taxes on the income will be the same and the inventory will now have a higher value because of the lower priced inventory being sold. An example of First in, First out would be when a company has first bought Product A at Price X, and Product B at price Y. If sold, Product A at Price X is what will be recorded. Last in, Last Out is the method that values the last product in inventory as the current product being bought. In other words, “this concept of always taking the newest products first is called last-in, first-out or LIFO”. During inflationary times, this pricing method is actually poor because the product is being sold and priced at inflationary prices. That becomes an advantage in terms of taxes because the income is not realized or recognized. An example of First in, First out would be when a company has first bought Product A at Price X, and Product B at price Y. If sold, Product B at Price Y is what will be recorded. Best costing method The best costing method for the company would be the cost method because as a manufacturing company the inventory is already based on cost. Instead of having the issues that evolve with LIFO, FIFO, and the average cost method of inflationary prices or income being lower or higher than it should be the cost method eliminates those issues. References Average Cost Rich, Jay S., Jefferson P. Jones, Maryanne M. Mowen, and Don R. Hansen., 2009, Cornerstones of Financial Accounting. South-Western, Mason, OH. Just-in-Time inventory Black, Ken, 2008, Business Statistics: Contemporary Decision Making. John Wiley & Sons, Hoboken, NJ. FIFO Kieso, Douglas W., Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield., 2011, Intermediate Accounting. John Wiley & Sons, Hoboken, NJ. LIFO Bragg, Steven M., 2006, The Ultimate Accountants' Reference: including GAAP, IRS & SEC Regulations, Leases, and More. John Wiley & Sons, Hoboken, NJ. Absorption Costing Weygandt, Jerry J., Donald E. Kieso, and Paul D. Kimmel., 1999, Managerial Accounting: Tools for Business Decision Making. Wiley, New York. Read More