Effective Financial Management - Coursework Example

Accounting and Finance Submitted by: XXXXXXXX Number: XXXXXXX of XXXXXXXXX XXXXXXX XXXXXXX XXXXXXXXXX Date of Submission: XX – XX – 2010 Number of Words: 2053 (Excluding Bibliography) 1. Introduction: “Financial management entails planning for the future of a person or a business enterprise to ensure a positive cash flow. It includes the administration and maintenance of financial assets. Besides, financial management covers the process of identifying and managing risks” (Economy Watch 2010). As understood financial management is a mode of right administration of the financial assets of a company. In the case of large companies the amounts of monies spent on the assets is very high. This requires highly effective financial management. The main objectives and requirements of effective financial management can be based on a few tips, i.e. need to have a clear and well planned budget, monitoring the performance and taking action whenever needed, focus should be placed on essential numbers like salaries, materials and also sales. A keen eye on these aspects of the financial management will lead to the better financial management in large companies (Brodie 2010). 2. Absorption Costing: Absorption costing systems is another costing technique that is used irrespective of whether it is variable or fixed costs and the costs that are charges based on the cost units produced. This method is very useful as it unlike the marginal costing. In marginal costing the fixed costs are taken as the period costs. The basic thought process behind the investment decisions revolves around the profit gained by owning a large or small share of a corporation or other businesses. The investment decision is really a two-pronged question: ‘What is the Potential Income?’ and ‘How risky is the venture?’ (Silbiger 1999) High returns are not the only deciding factor for investments. It depends on the risk involved in that investment. Hence the investment decision is dependent on the returns, the risk involved (amount of uncertainty in generating the expected returns) and also the investor’s utility indifference (attitude towards risk and expected returns). In this method the costing system apportions a share of the costs to all of the products and services and this helps ensure that each product makes profits. This is a very effective manner to be used specially in terms of the long run. Here the figures act as a guide and provide an idea of the level of profits that the company can earn. Also using this method helps analyze whether or not the company makes a profit (Garrison, Noreen and Brewer 2009). Likewise a number of subjective assumptions need to be made for the apportionment of many of the costs where some of the costs remain fixed during a period; this is also dependent on the level of activity within the company as well. In this system the costs are classified as per the function. The normal method used here is as follow: Sales – Production costs of sales = Gross Profit or manufacturing profit Gross Profits – Incurred costs or variable expenses = net profit or operating profits In using this method of costing, the factors that influence the profits for manufacturing business are mainly the level of production and the level of sales, the main reason being that the fixed manufacturing costs are absorbed into the in progress and finished goods stock (Dyson 2007). Also in case there is any stock which is available at the end of a financial year, then these costs of stock valuation is transferred to the next financial year. 2.1 Advantages and Disadvantage of Absorption Costing: There are several advantages and disadvantages of the absorption costing. However before moving into the various advantages and disadvantages it is essential to get the definition of absorption costing. Absorption costing has been defined as, “The cost accounting system in which the overheads of an organization are charged to the production by means of the process of absorption. Costs are first apportioned to cost centres, where they are absorbed using absorption rates. Although this method has the advantage of simplicity, it involves an essentially arbitrary allocation of costs; for this reason the system of activity-based costing is now widely preferred” (Encyclopedia 2010). The main advantages of absorption costing is that it allows the company to recognise the importance of fixed costs in the production line and allows the company to analyse the fixed costs to a greater extent. Also this method is beneficial as it is allowed and accepted by the Inland Revenue because the stock is not undervalued in this method and all the costs are based on the real values (Robertson and Mills 2000). The financial statements are prepared based on this method, and the method ensures that all costs are marked at the right prices rather than any undervaluing or over valuing of the costs. This method also ensures that all the fluctuations that are seen in the sales are not shown in the profits very prominently. The method also ensures that the stock valuation is appropriate and no extra or reduced charges are seen on the stock values. The disadvantages of this method however are very few. The method concentrates on both the fixed as well as the variable costs ad this method is hence not very beneficial in the decision making process and the planning and control processes (Garrison, Noreen and Brewer 2009). The process emphases on the total costs and the cost volume profits of the relationship are not considered here. Hence in terms of the decision making process the managers are required to take their intuitive decisions and there is no strong backing for the decision making processes. 3. Marginal Costing: Unlike absorption costing, in this method of costing, only the variable costs or the direct cost are charged on the cost unit of the products. This has been defined as, “Decision making approach in which marginal costs are used as the basis for choosing which product to make or which process to use” (Business Dictionary 2010). This is also referred to as incremental costing. Marginal costing clearly provides a view on the impact on the profits and the changes in the profits with changes in the volume of the type of output. This method also provides a clear way of differentiating between the variable and fixed costs. This technique is also referred to as the direct costing. This method majorly involves the ascertaining of the marginal costs and these are basically the direct costs. Here the fixed costs are never charged to production and instead the fixed costs are treated as period charges. These charges are also written off in the profit and loss account for the accounting year (Dyson 2007). The marginal also allows to easily ascertaining the contribution and contribution is mainly the amount that is excess of the revenues over and above the marginal costs. Marginal costs are generally found from the marginal cost statements. In brief, the marginal costing system is a method that is adopted for recording the costs and also for recording profits (Robertson and Mills 2000). The variable costs are basically charged to the products and are treated as product costs, while the fixed costs are more of period costs and are written off at the end of a financial year. 3.1 Advantages and Disadvantages of Marginal Costing: Marginal costing is simple and straight forward to understand and is mainly based on the fixed versus variable cost concept (Mott 2005). The technique is useful in terms of a short term technique and is helpful and useful in situations specifically that of competitive nature and recessionary periods. This is mainly because in these environments, the orders are only acceptable where the basic marginal costs of the business is met and also any excess over and above the marginal costs is mostly used to contribute towards the overall fixed costs, which thereby allows the losses to be kept at a minimum (Heneghan 2006). Another excellent advantage of this method is that it brings out the relationship between the cost, price and volume of the products and also ensures that there is no over or under absorption in the company. The method also ensures that the stock valuation is not distorted and no confusions occur in terms of the fixed costs. This method is an excellent tool for managerial decision making and helps provide all the information that is necessary for the managers to make their decisions and to ensure better overall performance of the companies (Heneghan 2006). Marginal costing also provides a better control of the company as it differentiates between the fixed and variable costs and also has a clear impact on the production and sales policies of the company. In short this method helps provide a clear and more focused impact on the company and acts as an excellent management tool and decision making tools for the company (Silbiger 1999). Considering the disadvantages of the method, it is important to note that the method uses historical data which can impact the decisions made by the management which relate to the future events. This method also tends to not recognise the long run fixed costs change to become variable (Robertson and Mills 2000). The method also tends to oversimplify the costs into fixed and variable and demarcates them in a not so effective manner. This method is also not too effective in the long run and for pricing as it ignores the fixed costs (Garrison, Noreen and Brewer 2009). It is essential to consider both the fixed as well variable in the long run to make good management decisions (Silbiger 1999). 4. Absorption and Marginal Costing: As has been clearly discussed earlier, marginal cost is a technique which includes only variable manufacturing costs and generally deals with direct materials, direct labor and variable manufacturing overheads while determining and fixing the cost per unit for the products and produces (Mott 2005). Absorption cost on the other hand is a technique which includes all the costs, i.e. manufacturing costs, and also both fixed as well as variable overheads for the determination of the cost per unit of the product. Absorption costing is also referred to as full – cost technique (Robertson and Mills 2000). While dealing with the costing of products and services, it is essential to note that the marginal costing technique bases its costing on the behavioral characteristics of the costs and segregates the cost into fixed and variable elements. This is mainly done to as the variable cost per unit are generally fixed where as the total costs are mostly variable in nature and in most cases the fixed cost are fixed while the fixed cost per unit is variable in nature. Also, the variable costs have a more controllable nature; however the fixed costs are more out of control in nature. Also, as seen in the above discussions, the marginal costs are more useful in terms of short term planning, control and also for decision making in businesses, and the contribution is generally calculated after all elements, i.e. variable costs are deducted from sales value. Also, here in this case the fixed costs tend to be treated as period costs where the costs are deducted from the total contribution to derive the net profits (Kieso, Weygandt and Warfield 2009). Considering the absorption costs in terms of the products and services, here the all the costs of the business are allocated to all the products and services. In this case as discussed earlier, the costs tend to be based on the functions and the gross profits are arrived at by deducting the production costs from sales and further which, the costs that relate to the business functions are then deducted and help arrive at the net profits (Kieso, Weygandt and Warfield 2009). 5. Conclusions Based on the above discussion and after having understood the comparison of the two methods of costing, it is clear that absorption costing gives better view of pricing the products and uses both variable as well as fixed costs in its calculations. However the marginal costs tend to lead to much lower prices and can lead the company to be operating below the capacity. Here the customers tend to still expect low prices because the demand and the capacity increase (Kieso, Weygandt and Warfield 2009). It is also important to consider that there is a clear level of difference in terms of the profits with each of these methods as there is a clear difference in the treatment of the fixed manufacturing overheads (Mott 2005). The marginal costs treats the fixed overheads as period costs while absorption costing absorbs these costs into the cost of the goods produced and is generally charged only when the sale of goods occurs. Hence it is clear that the marginal and absorption costing techniques are not the same and the profits from each of the techniques vary to a great extent (Robertson and Mills 2000). 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Accounting for Non-accountants: A Manual for Managers and Students. 6. Kogan Page Ltd, 2005. Robertson, John, and Roger W. Mills. Accounting Principles for Non-accounting Students. Mars Business Associates Ltd, 2000. Silbiger, S. The 10-Day MBA. Mumbai: Magna Publishers, 1999. Read More