Sample Essay on Management Accounting

Introduction

The introduction of a new product into a company is a complex process that requires a comprehensive analysis of the company’s current status. This report serves as a critical analysis report. It contains analysis of the potential risk of the company, the current cash flow statement of the company, the projected cost of the new product and the net present value of the product.

Risk Profile

ABC Company faces a number of risks that are inherent to the company’s activities. The main sources of these risks are the general economic condition and the industry under which it operates. The risk profile below shows the company’s main risks and their sources.

Market Fluctuations

This is mainly caused by the economic cycles and changes in demand by customers. During downturns, the demand level is very low and this in turn leads to increase in inventory levels. Increase in inventory level will mean increase cost and decrease in earnings (Mogielo, 2013). To mitigate this risk, the company should slow production by producing less when downturns are approaching.

Competition

The risk of facing strong and unforeseen competition can lead to a decrease in the amount of sales and this in turn will lead to a reduction in revenue (Mogielo, 2013). To reduce the probability of this risk happening, the company should do a proper search of all the potential competitors in order to understand their strategies. The company should then come up with a better strategy.

Financial Risk

This risk can be caused by changes in interest rates, fraud in the company and poorly projected project budget. Changes in interest rates can increase the interest expenses thereby increasing the cost of the project. Fraud in the company on the other hand can cause the company to have negative cash inflows and hence inadequate funds. Poorly projected budgets can lead to underestimation of the cost of project causing obstacles during the implementation of the project (Ogilvie, 2006). To mitigate this risk, all projected cash inflows and outflows should be discounted and there should be controls that ensure every employee accounts for all the funds they take from the company.

Delay In Project Completion

This risk is mainly caused by natural disaster that the company has got no control over. The probability of such risk occurring is usually very minimal. However the impact is usually very severe and therefore this risk should not be ignored. Keeping some resources for such emergencies would be a good way of dealing with this risk (Mogielo 2013).

Cash flow statements
ABC Company’s
Cash flow Statement as at 31st December, 2012
Indirect Method

Cash flow from operating activities                $ ‘000’                         $ ‘000’

Sales                                                                1200

Add: decrease in accounts receivable             60

Cash received from customers                        1260

Less:

Cost of goods sold                                          800

Add: increase in inventory                              70

Less: increase in accounts payable                  (40)

Cash paid to suppliers                                     (830)

Cash paid for selling and administrative expenses (250)

Income taxes                                                               30

Less: increase in income tax payable                          (30)

Cash paid for income taxes                                         0

Net cash from operating activities                                                                           180

Cash flow from investing activities

Cash paid to purchase equipment                               100

Net cash flow from investing activities                                                                    100

Cash flow from financing activities

Cash used to pay dividends                                        (100)

Net cash flow from financing activities                                                                   (100)

Net increase in cash and cash equivalents                                                                  180

Cash and cash equivalents brought down                                                                  50

Cash and cash equivalents brought forward                                                               230

The net cash inflows from the operating activities are positive. This indicates that the company is able to generate cash internally through sales of products. Even though it is positive, the value is not as high compared to the amount of sales (Esptein, 2011). This is because of the high amount of cash paid to suppliers. The second section of the cash flow statement is the investment section. This section shows how the company uses its income to invest in different activities. From the cash flow statement we can see that the company has invested $ 100,000 to purchase new equipment. The last section of the cash flow statement is the financing section. This section shows the various external sources of funds for the company. From the ABC cash flow statement above it is evident that the company majorly relies on the cash generated internally and it do not have a number of other sources of finance.

To improve its cash flow, the company should look for other sources of finance and stop relying on internal sources. That is the company should increase its financing activities in order to have diversified and reliable sources of finance. ABC Company should also increase its investing activities to ensure increase in earnings.

From the cash flow the net cash inflow is $ 180,000. This cash is mainly internally generated and it is not a large amount. Hence the proposed project cannot be financed by this amount. Therefore there is urgent need to look for other sources of financing this project.

A part from the internally generated finances ABC Company can decide to look for other sources of financing its activities. This can be through debt or equity. I would therefore recommend that the company chose to use debt instead of equity. Corporate debt as a source of finance has less costs compared to the option of using equity (Warren, Reeve & Duchac, 2012). However it is not preferred where a company has cash problems. But as seen from the cash flow statement, ABC company net cash inflow is positive meaning the company does not have cash problem. Hence the appropriate source of fund in this situation would be corporate debt.

Product Cost

In this situation, I chose to use both absorption costing method and variable costing method to compute the cost of the expansion product per unit. Under the absorption method, the product cost is calculated as below.

$

Direct material cost                             (5000 × 5.60)              28000

Direct labour cost                                (5000 × 4.00)              20000

Variable factory overhead                  (5000 × 1.00)              5000

Fixed factory overhead                                                           198000

Total                                                                                        251000

Therefore product cost per unit = 251000/5000 = $ 50.2

Under variable cost, fixed manufacturing cost is not included in the computation of the product. The product cost is calculated as below.

$

Direct material cost                             (5000 × 5.60)              28000

Direct labour cost                                (5000 × 4.00)              20000

Variable factory overhead                  (5000 × 1.00)              5000

Total                                                                                        53000

Therefore the product cost per unit = 53000/5000 = $ 10.6

The introduction of the expansion product helps in absorbing the fixed factory and selling expenses hence making the existing product cheap to product. This can be explained by the calculation below.

Existing product cost before introduction of expansion product:

$

Direct material cost                             (80000 ×1.30 )                        104000

Direct labour cost                                (80000 × 1.28)                        102400

Variable factory overhead                  (40000 × 1.00)                        40000

Fixed factory overhead                                                           198000

Total                                                                                        444400

Therefore existing product cost per unit before introduction of expansion product = 444400/80000 = $ 5.56

Existing product cost after introduction of expansion product

$

Direct material cost                             (80000 ×1.30 )                        104000

Direct labour cost                                (80000 × 1.28)                        102400

Variable factory overhead                  (40000 × 1.00)                        40000

Total                                                                                        246400

Therefore the existing product cost per unit after introduction of expansion product = 246400/80000 = $ 3.08.

Hence the introduction of expansion product makes producing the existing cheaper by ($ 5.56 – $ 3.08) = $ 2.48 per product.

Gross margin of a product is calculated by dividing the gross profits by the revenue (Hansen & Mowen, 2000). Hence if ABC company wants a gross margin of 40%, the following calculation shows the price that the company should sell the new product in order realize the desired 40% gross margin.

Gross margin = gross profit/revenue

Gross profit = revenue – cost of goods sold

Revenue = selling price × units sold.

Let selling price be x and therefore: revenue = 5000 × x = 5000x

Cost of goods sold = 5000 × 50.2 = 251000

Therefore gross profit = 5000x – 251000

Hence, 0.4 = (5000x – 251000)/ (5000x)

0.4 × 5000x = 5000x – 251000

2000x = 5000x – 251000

251000 = 5000x – 2000x

251000 = 3000x

Therefore x = 251000/3000 = 83.67. Hence if the company wants to realize a gross margin of 40%, the expansion product should be sold at $ 83.67

Contribution margin of a product is calculated by subtracting the variable cost from the selling price. After getting the contribution margin, we use this figure to get the break-even points.  Below are the calculations showing the contribution margins and break-even points for the two products.

Current product

Contribution margin = selling price (S.P) – Variable cost

= $ 14.50 – ($ 1.00 + $ 0.20)

= $ 14.50 -1.20 = $ 13.30

Break-even point        = total fixed cost/contribution margin

Total fixed cost           t           = (198000 + 191250) = 389250

Break-even point         = 389250/13.30 = 29267 units

Expansion product

Contribution margin = selling price (S.P) – Variable cost

= $ 83.67 – ($ 1.00 + $ 0.20)

= $ 83.67 -1.20 = $ 82.47

Break-even point        = total fixed cost/contribution margin

Total fixed cost           t           = (198000 + 191250) = 389250

Break-even point         = 389250/82.47 = 4720 units

 

Net present value (NPV)

Where: NPV is the net present value, C is the cash flows, Co is the initial investment cost, n is the number of years and k is the interest rate.

Year Savings PVIF 12% Present Value (PV)
1 $ 15000 0.8929 13393.5
2 $ 13000 0.7972 10363.6
3 $ 10000 0.7118 7118
4 $ 10000 0.6355 6355
5 $6000 0.5674 3404.4
Total PV     40634.5
Less initial investment     (42000)
Net present value (NPV)     $ 1365.5

 

When depreciation is calculated using the straight line method, it is said to be a fixed cost. Hence the depreciation cost will have an impact on the fixed cost of a product (Esptein, 2011). However tis will not mean that every year the fixed cost will keep fluctuating because of the depreciation. This cost will only be calculated once and that is on the first year when the equipment is purchased. Since depreciation cost will increase the fixed cost, and then the implied product cost will also be affected. The depreciation cost will increase the implied cost of the product. However, it will not have any impact on the company’s cash flows. This is because depreciation is considered a non-cash item and therefore does not have any direct influence on the cash flows of the company (Hansen & Mowen, 2000).

The purchase of the new equipment will contribute to a considerable savings for five years. However, these estimates are the current value of the cash flow that the equipment will generate and not the future values. According to the time value of money concept, a shilling today is not the same as a shilling tomorrow (Warren, Reeve & Duchac, 2012). Therefore to find the correct values that can be used to make reliable decision, the cash flow must be discounted using an interest rate. According to the calculations above, the net present value is negative. This means that the equipment should not be bought because in the long run, the equipment will not bring any revenues to the company. Therefore the company should not buy this equipment.

Conclusion

After analysing all the necessary information it is worth noting that the project is likely to be affected by a number of risk mainly financial risks and strategic risks. As seen from the NPV calculated, it is most likely that the project will not deliver the savings predicted and hence financial risk. The purchasing of new equipment whose net present value is negative indicates inappropriate use of the company’s fund and this will bring about strategic risk because the company will not be able to meet other goals if the funds are used inappropriately.

As the management accountant I am face with the responsibility of planning, controlling and ensuring effective communication during the project life cycle. I will be faced with the responsibility of planning what product to sell, where to sell and at what price. Besides planning I as the management accountant will ensure control by providing performance reports and informing stakeholders of any deviation. In addition to planning and controlling, ensuring effective communication maintaining an effective communication system is also part of work.

In conclusion, I would like to make a few recommendations to the company concerning the project. The first one is about the purchase of the new equipment. The company should not purchase the new equipment; instead they should lease the equipment. Secondly the company should look for other sources of funds to finance the project and lastly the company should not sell the new product at a very high selling price. Therefore to ensure the project process is a success, the various risk must be taken into consideration and the company’s cash flow statement, product cost and net present value of the investment must be analysed.

References

Epstein, M. (2011). Advances in management accounting. Bingley, UK: Emerald.

Hansen, D., & Mowen, M. (2000). Management accounting (5th ed.). Cincinnati: South-Western College Pub.

Mogielo, M. (2013). Management Accounting. London: The London School of Economics and Political Science.

Ogilvie, J. (2006). Management accounting – financial strategy. Oxford: CIMA/Elsevier.

Warren, C., Reeve, J., & Duchac, J. (2012. Financial and Management Accounting (11th ed.). South-Western: Cengage Learning.