Key Aspects of Management Control and Audit - Coursework Example

Management Control and audit Introduction The various managerial decision making quantitative tools and deterministic evaluation depends, to a very large extent, on the specific requirements of the case study and the planned need for its analysis and interpretation. The determination of recommended selling prices of several products could be done through the process of application of Marginal costing techniques. In a multivariate product scenario, where choices have to be exercised between choosing investments made to different product lines, marginal costing serves to enlighten management regarding the best production or marketing mix to be adopted for optimum profitability. In the problems solved below, the aspects of application of marginal costing techniques and its usage has been carried out, in order to achieve the results depicted in Table below Question 1 Calculate the price and efficiency Variances: Sales – Variable Costs = Contribution, OR Fixed Cost + Profits = Contribution Therefore, we could apply the above formulae to the problem which states, Sales Price – Marginal Costs = Fixed Cost + Profit We shall apply the above formula to the problem of Aspen, Sycamore and Elm and derive: CASE 1: Aspen product: Sale Price – variable costs = fixed costs + profit Or, x – variable costs = fixed cost + profit Or x – 18 = 6.00 + 4.80 (20% of £ 24.00) x -18 = 10.80, or x = 28.80. Therefore it has been solved that selling price of Aspen =£28.80 CASE 2: Sycamore product: Sale Price – variable costs = fixed costs + profit Or, x – variable costs = fixed cost + profit Or x – 13 = 3.00 + 3.20 (20% of £ 16) x -13 = 6.20 , or x = 19.20.Therefore it has been solved that selling price of Sycamore =£19.20 CASE 3: Elm: Sale Price – variable costs = fixed costs + profit Or, x – variable costs = fixed cost + profit Or x – 24.00= 9.00 + 6.60 (20% of £ 33) x -24.00 = 15.60, or x = 39.60.Therefore it has been solved that selling price of Sycamore =£39.60 ***** It is assumed that 20 % margins are arrived after inclusion of fixed costs, too CALCULATION OF PRICING AND EFFICIENCIES PARAMETERS serial Particulars Aspen £ Elm £ Sycamore £ 1 2 3 Selling prices per product Less : Marginal Costs Contribution Less : Fixed costs Profit PV Ratio : Contribution/sales % Comments 28.80 18.00 19.20 13.00 39.60 24.00 10.80 6.00 6.20 3.00 15.60 9.00 4.80 3.20 6.60 3.11 Low 1.20 Very low 6.18 comparatively high Fig. 1: Table showing comparative performance of three product lines Question 2 : The difficulties in controlling the variable variances: When a semi-variable cost is, for the purpose of variance analysis, treated as a variable cost, the charge of overhead is exceeded, since semi-variable costs, unlike variable costs, do not vary with each unit of activity, but change depending upon the level of activity achieved. Therefore, by granting the status of variable costs to semi variable costs, the overheads are hiked and thus profitability is reduced. Similarly, fixed costs remain fixed over period of time, irrespective of levels of activity. By assigning the nature of fixed costs to semi-variable costs, during times of lowered levels, there is a high overhead charge which significantly erodes profitability. (ii)The result of treating a step-fixed costs, for the purpose of variance analysis, as a variable one would be that, if the costs need to be calculated on the shortest time frame, there may not be material variations, but if taken on the long time, the impact of the step fixed costs would not be realized, or in other words, profits may be over stated. For example, the costs of running a single machine for several months would be different from running several machines for a single month. Thus by assigning the nature of variable to a step fixed cost would overstate profits over a period of time. (iii) When an operation entails both fixed and variable costs, taken all costs are variable would wrongly inflate profits and underestimate costs. The element of fixed costs is generic to all cost centers.. In case of high level of activities, by not assigning the rightful fixed costs, profits are inflated; however in the case of taking all overheads as fixed, during lowered levels of activities, costs are higher than booked and this could be disastrous, especially for small companies with low revenue generations. Therefore, it is seen that one of the main difficulties in controlling variances would be first allocating correctly the variables, under the correct headings of fixed, variable and semi variable. Besides, the characteristics of the industry would be a determining factor, since variability may differ from industry to industry. Question 3: Significance of the above Table shown in Figure 1 : It is seen that Elm product has the lowest PV ratio and Sycamore has the highest. Should an eventuality arise in future, for the elimination of product line, Elm would have to be discarded and the spare capacity used for producing Aspen and Sycamore. This would also enhance the future profitability of the group. The utility of Marginal costing analysis lies in its uncanny ability to determine the break even analysis, aids top management whether to take up or drop special order contracts, make or buy decisions or deletion of an unprofitable product.” (Accounting and finance). (B) In the Case of Elm product, it needs to maintain per unit selling price £39.60 in order to maintain a 20% margin on costs. The impact of per unit £30 is as follows: Selling price of 3000 units of Elm = 3000 x £30 = £90,000.00 Less: Marginal Costs: Direct labor: 3000 x £15 = £45,000 Direct materials: 3000 x £6 = £18,000 Assuming that transport costs = NIL *Indirect overhead costs are met by Customer ---------- £63,000.00 Contribution £27,000.00 Less Fixed Costs: £9 x 3000 = £ 27,000 The product would break even when 3000 units are sold £ @ 30, that is, the total costs would be equal to the total revenues. “At the Break even level of output total costs are covered by total revenues so that firm makes neither profit nor loss” (Accounting and Finance, Break even analysis). * It is assumed that total variable costs relate to transport costs which are met by the customer. (C) Selling price of 200units of Aspen = 200 x £20 = £4000.00 Less: Marginal Costs: Direct labor: 200 x £10 = £2000 Direct materials: 200 x £5 = £1000 Other vari. Costs: 200x £3 = £ 600 £3600.00 Contribution £ 400.00 Less Fixed Costs: 200x £6 = £ 1200.00 LOSS £ 800.00 Although a loss has registered, it is seen that the contribution is positive. Therefore this order may be accepted because it may help in the absorption of costs. “The technique of marginal costing also helps the management in determining the optimum levels of activity. …. The level of production can be raised till the marginal cost does not exceed the selling price.” (Gupta & Sharma 2005, p.8.45). The inability to absorb the fixed costs is because of the fixed cost sharing ratio of 2:1:3 among the 3 units for a total perceived demand of 3700 units. For 200 units the share of Aspen would be lower and it may be able to bear its share of fixed costs also. The PV Ratio of Aspen is also good at 10%. It is as per the following: Contribution/Sales % or £400/4000 x 100 = 10% This order may be acceptable because the contribution and PV ratio are positive. The aspect of marginal costing is important because it represents the cost benefit of producing an additional unit. In the case of companies operating in a recessionary market, and therefore not producing up to their full capacity, marginal costing helps to identify whether increased production would entail additional revenue and more significantly profit generation. It is not that value of additional revenue that is considered in marginal costing, but the increasing rate of additional revenue and increasing rate of profits. Marginal costing considers an important aspect of determination of PV Ratio contribution. A Company can take up additional capacity orders if it could absorb its additional costs and contribute towards profitability. Therefore during recessionary times and when the orders are low, marginal costing needs to be depended on, as a fairly accurate indicator of business performance. A Company can go on producing provided it meets its variable costs, and because fixed costs, being fixed in the short period could be shared by all the existing product lines. Therefore, marginal costs would serve the following utilities; it could determine which are the unprofitable product lines which need to be scrapped, it could determine the capacity utilization and it could also determine the selling prices of units below which it may be uneconomical to produce and sell products. “Margin of contribution, P/V ratio and contribution per unit of limiting factor are the main yardsticks for evaluation of managerial decisions in marginal costing.” (Gupta & Sharma 2005, p. 9.3). Wealth creation The main reasons for the working of any enterprise is to generate maximum wealth for the shareholders and to serve the community interests through welfare program. Creation of wealth forms the bedrock for any enterprise, and by the proper performance of assigned duties and responsibilities, the divisional managers, whether relating to finance, accounts and administration, Personnel and HRD, Production etc. ensure the smooth and profitable running of the Company. In order to explain the factors that need to be considered in developing the financial performance measures, it is first of all necessary to know what the financial performance measures actually are. Besides the usual executive compensation packages, paid holidays, bonuses and executive stock options, it has also necessary to measure the EVA, or the Economic value added, which is now “being used by more and more firms to tie executive compensation to stockholder wealth maximization.” (Eugene & Michael. p 21) The main factors that need to be assessed is whether the financial performance measures adds value to the organization and serves in wealth creation process. It is also necessary to know whether this would enhance the image of the company at an international level, since the world has now shrunk into a global village. By creating executive stock options, the company wished to enhance the market value of the company’s stocks and also create opportunities for efforts of divisional heads to substantially increase the bottom line of business endeavors. “Various procedures are used to structure compensation programs, and good programs are relatively complicated. Still, it has been thoroughly established that a well-designed compensation program can do wonders to improve a company’s financial performance.” (Eugene & Michael. p 21). Return on investments: The case of XYZ is taken which has net income of £113.5M and shareholders equity of £896 M. ROI measures the proportion the net profits available for distribution bears to the equity capital. A higher value for ROI denotes a better standing In this case of XYZ Co., the Net income available for common shareholders/common equity = 113.5/896 = 12.7% which is low according to the industry standards of at least 15%, in that out of every 100 of investments made by the equity shareholders, at least 15 must be returned in the form of profits, it shows how well the equity capital is being utilized for wealth maximization of the company. However, ROI may not be a good indicator since wealth maximization could be not only in terms of equity capital but in other ways like preferential dividends, debenture, secured bonds and earned profits maintained as reserves. ROI considers the quantum of investments and not other factors like risk, investment climates and inflationary trends. Several factors go to distort the value of assets including mode of depreciation, stock valuation and valuation of goodwill etc. Therefore, although ROI is a good and traditional indicator of corporate health, it needs to be used with discretion, where the earnings and profits are consistent over a period of time, but in cases where there are wide distortions, it may not serve as a good deterministic tool of economic wealth addition for shareholders. Residual income: If a firm conservatively follows the residual income method than the dividends paid in any given year could be seen as follows Dividends = Net income – retained earnings required to finance new investments = Net income – [(target equity ratio x Total capital budget)] (Eugene & Michael. P. 709). A figurative representation would be as follows. Suppose a Co has a dividend rate of 60% and it also requires £ 50m for capital projects. Thus it would need £50m (0.6) =£30 M for payments for equity shareholders. If the net earnings are £100 M and the capital project of £50m, it could use £30 M of dividends and balance £ 20 M of new debt to fund the capital project of £ 50 Million. The advantages are that, as far as capital projects are concerned, it would serve better to use internal earnings and credit from outside sources in the long run would work out higher than internal fund usage. There are two factors that need to be considered regarding residual income. First, the Company’s efforts must be to increase the stakeholder’s interests and also, the company should refrain from turning the earned incomes for internal usage unless they are confident that the earnings through retained earnings are higher than what the shareholders would receive from outside investments. The flip side is that the dividend income often fluctuates according to the earnings of the Company. In some years the dividends may be high, and yet in other years it may be low, and thus the consistency element is missing which is essential in financial decision making. Therefore, it is necessary that the company needs to chalk out the Dividend plans for the next 5 – 10 years before launching any dividend income programs. Economic value added: It refers to the connection between the executive packages paid to the stockholders maximum wealth generation and is a measure of detecting the true profit potentials of the companies. It is a parameter of managerial effectiveness in a given year. The valuation is: EVA = Net operating profit after taxes – After tax £ cost of operating capital. Where the Pound cost of capital is£198.0 and the net operating profit after taxes (NOPAT) ) is £170.3, hence the EVA is £27.7 ( 198 – 170.3 ) The advantages of the EVA are that, unlike conventional accounting ratios, it is a true test of managerial effectiveness, since it also considered the opportunity cost of capital. Shareholders have the option to invest their monies in outside ventures and that alternative has been financially considered in the determination of EVA. On the flip side, while MVA could be used throughout the organization, EVA has limited usage only in individual divisions or units of the organization., and that also only for a given year, but in the case of MVA, it is for entire corporate lifetime. (Eugene & Michael. P. 50). Conclusion: It is sufficient to say that marginal costing and its applications lie in the areas of price, market mix and demand forecasting, eliminating unproductive product lines, finding out the optimum capacity utilization and ascertaining of optimum production and sales mixes for various products, all fall within the ambit of marginal costing, which could serve useful quantitative data in this areas. Although not strictly conforming to the traditional concept of costing and cost analysis, Marginal costing could be supplemented along with Standard Costing and other cost accounting methods for managerial planning, organizing and decision making in crucial areas of decision making for men, materials, management methods and money. Bibliography Accounting and finance. Contribution. Uses in decision making and planning. [online]. Tutor2U. Last accessed 3 December 2007 at: http://www.tutor2u.net/business/presentations/accounts/contribution/default.html Accounting and finance. Contribution. Break even analysis. [online]. Tutor2U. Last accessed 3 December 2007 at: http://www.tutor2u.net/business/presentations/accounts/contribution/default.html Eugene, Brigham & Michael, Ehrhardt C., 2002. Financial Management: Theory and Practice 10th Edition: Thomson Asia Pvt Ltd: Singapore. Gupta, Shashi K & Sharma R. K., 2005. Management Accounting: Principles and Practice. Marginal Costing and Break-Even Analysis, Cost-Volume-Profit Analysis and Decision Making. Differential cost analysis vs. Marginal Costing. Kalyani Publishers. P 8.45 Gupta, Shashi K & Sharma, R. K., 2005. Management Accounting: Principles and Practice. Marginal Costing and Differential Cost Analysis. Differential cost analysis vs. Marginal Costing. Kalyani Publishers. India. pp.9.3 Read More