Introduction to accounting - Essay Example

Introduction to accounting 1. Key assumptions used in the production of key financial data Variable costs such as Direct labor, direct material costs and other manufacturing costs will vary with the level of production Sales revenue varies with the level of production selling and distribution costs will vary with level of production Fixed costs are constant regardless of the level of production Introduction Financial planning entails determining in advance the financial needs in order to allocate resources efficiently. Budgets or forecasts are used as planning tools. Forecasting starts with a detail budgets such as production forecasts, sales forecasts and others. The purpose of this report is convinces investors to consider investing in this company. The new company focuses in producing an energy drink. Therefore, marginal costing is used to aid understanding regarding the costs involved. Break-even analysis will also be discussed in the report as it an application of marginal costing. Marginal costing Marginal costing takes into account variable costs during production while Fixed manufacturing overhead is treated as period costs. It is believed that only the variable costs are relevant to decision-making and that the reason why they are considered in production. Fixed manufacturing overheads will be incurred regardless there is production or not. Marginal costing is useful in making decisions and is widely applied in the break-even Consideration given to fixed cost. Appendix 1 illustrates a cost statement using marginal costing. The contribution margin is positive; therefore the plan of manufacturing an energy drink is a viable one. The fixed costs are not useful in the decision making process that is why contribution margin is used as it excluded fixed costs. Break even analysis Break even analysis is used in showing the relationship between selling prices, sales volume, variable costs, fixed costs and profits at various levels of activity. It is also referred to as cost-volume profit analysis. It used in determining the break-even point. BEP is the level of activity where the total revenue equals the total costs. Therefore, no profits are realized at the BEP. Appendix 2 shows the workings for the break-even point of the energy drink. At the level of production of 4,286 all fixed and variable costs will have been covered by sales revenue. However break even analysis has its limitations. To begin with, breakeven analysis assumes that fixed cost, variable costs and sales revenue behaves are linear. However, this is not the case since some overhead costs may be stepped in nature. As a result, the straight sales revenue line and total cost line tend to curve beyond certain level of production Another limitation of break even analysis is that it assumes that all the stock produced is sold. Therefore, changes in stock levels are not taken into account in the breakeven chart. Finally, breakeven analysis is only suitable in providing information to relatively small companies that produce one type of products. Thus it’s not suitable for companies producing different product. Margin of safety Margin of safety measures the amount by which sales may decrease before a company incurs a loss. Appendix 2 illustrates the margin of safety. Forecasting Forecasting is used in estimating future performance of the business. It is useful in the financial planning process which entails assessing future financial needs. Outsides such as investors use forecasting to value a company and determine its security. Financial forecasting is done by use of pro forma balance sheet and income since items in the balance sheet and income statement vary and grow at different rates. In order to forecast we should have a clear understanding of past financial performance to help us predict future financial performance. In our case, we used competitors as a platform by considering their costs, pricing and other performance indicators. Pro forma statements show forecasts for periods ranging from 1-5 years. In the income statement forecast as shown in appendix 3 we assume: Sales grow at 8% and cost of goods sold grow at the same rate as sales Expenses will be at 6% on sales Tax rate of 30% is to remain constant Interest expense will grow at 5% on debt We stated preparing the forecasted Balance Sheet by determining the retained earnings since they are both linked. The financial forecast of the balance sheet also provided us with an estimate of the external financing is needed to support our estimated sales. In budgeting for the fixed assets, we considered production equipments which will be utilized in generating revenue. The level of external financial has been determined although we will need to revise these amounts in before production starts. In the case of the balance sheet appendix 4 the main assumptions are: Fixed assets remain constant and depreciation in fixed assets will be at a reducing balance basis Inventory and accounts receivables, accruals and payables grow at 5% each year Dividends increase by 8% per annum Debt and equity remains constant The cash budget is an example of short-term financial planning. We have used it in estimating future cash inflows and outflows. Cash budget are only limited to cash making them not widely used as budgeting tool but for decision making purposes by managers. We used previous forecast in preparing the cash budget for example by looking at the income statement we considered material, labor and overhead costs. We looked at the cash flow patterns by considering accounts receivables and payables. We also predicted other payments such as loan and interest payments. In appendix 5 we have assumed that expenses grow at the rate of 2% and the cash inflow at 5%. Summary Having prepared the budgeted financial statements, it is vital to carefully evaluate these financial forecasts with management. For example, our aim is to raise 40,000 capitals as indicated in Exhibit 4. Therefore, questions must be asked before budgeted financial statements are finalized. In addition, forecasts are prepared on an annual basis. Uncertain events can take place during the year and may lead to inaccuracy of our budgets. The only way to improve our financial planning is by simply forecasting on a quarterly basis instead of annual basis. The first step to improving our forecasting is through recognition of certain fundamentals about forecasting. First, it relies on past information and relationships and if such relationships change then our forecast is rendered inaccurate. Uncertainties are to be put in to consideration in order to make our forecasts more accurate and also create different scenarios by assigning probabilities to each scenario. Also, short- term planning should be considered since long period leads to a higher degree of inaccuracy. Other approaches in forecasting Apart from forecasting, other approaches such as the statistical approach can be used in financial planning. A good example is the regression analysis which relies on the average relationships between the dependent variable and independent variable. For example linking advertising costs and sales we can say sales is the dependent variable and advertising is dependent variable. Regression analysis is widely used in forecasting sales. Conclusion From the discussion above, it is recommendable for investors to invest in this company as the income statement reflects a profit. The cash budget also indicates that the cash flow is favorable. In addition, the balance sheet position of that company is good. There are other theoretical factors that may affect returns such as competition, technological changes, tax and inflation. These aspects have not been taken into consideration as the break-even analysis assumes a perfect market exists which is not the case. References Alice C. Lee, John C. Lee, Cheng Few Lee (2009). Financial Analysis, Planning & Forecasting: Theory and Application. World scientific. Birt and Gregory Boland (2010). Accounting: Business Reporting for Decision Making. Wiley and sons publishers. By Cafferky Michael Cafferky, Jon Wentworth (20102).Break Even Analysis: The Definitive Guide to Cost-volume-profit Analysis. Business express. 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