Introduction
Business analysis is the detailed examination of business operations in relation to the environment, in order to explain various aspects of a business. The results of the analysis should therefore, be reflected in a business plan. A business plan is a clear outline of a business’s goal and a course of action to be taken in order to achieve the goals. This work contains a detailed assessment of accounting principles and concepts, analysis of various costs behaviors, analysis and evaluation of the importance of marginal costing, the significance of different sources of funds in management decision- making, detailed performance analysis of John’s enterprise, an analysis of economic tools and theory to practical business decision-making, recommendations and conclusion of the assessment.
Accounting principles and concepts
Accounting practices are guided by international accounting standard and international financial reporting standards. These accounting standards give guidelines on how a particular type of transactions and other events should be reflected in the financial statements of a business. Accounting standards are developed to enhance comparability of financial information between different organizations. International Accounting Standards (IAS’s) and International Financial Reporting Standards (IFRS’s) are meant to be applied in all organizations in the world. The International Accounting Standard Board (IASB) produces IAS’s and IFRS’s (Weygandt 2010). The main objectives of the board are to formulate and publish in the public interest, accounting standards to be observed in the presentation of financial statement. Further, they also promote worldwide acceptance of the standards. Finally, they improve and harmonize regulations, accounting standards, and procedures relating to the presentation of financial statements. Accounting concepts are basic assumptions that underlie the periodic financial account of a business enterprise (McLaney & Atrill 2008). The accounting concepts are discussed below.
The going concern concept implies that a business will continue to be operational in the near future, and that there is no intention to liquidate the business or make drastic cutbacks to the scale of operation. Financial statements should be prepared under the going concern basis unless a business is seeking for liquidation or it has ceased trading. The going concern concept dictates that the assets of a business should not be valued at their break-up value. A break-up value is the amount the assets would sell for if they were sold off (McLaney & Atrill 2008).
The accrual concept, also known as the matching concept, states that revenue and costs must be recognized as they are earned or incurred, but not as payment or receipts is being made. Revenues and costs must be matched so long as their relationships are justifiable and are applicable to the profit and loss account of the period to which they relate (McLaney & Atrill 2008).
Prudence concept concept states that where alternative accounting procedures are to be selected, the choice should be on the one that gives the most cautious presentation of a business’s financial position or results. Therefore, revenues and profits are not anticipated for but are recognized by inclusion in the income statement, only when realized in the form of either cash or other assets. The concepts guards the assets and profits from being overstated by ensuring that a balance is achieved to prevent the material overstatement of liabilities or losses (McLaney & Atrill 2008).
The ‘consistency’ concept states that financial statements should be prepared in a similar way from one period to another. Further, transactions should be treated in a similar way.
The entity concept states that accountants should regard businesses as separate entities, distinct from their owners and managers. The law recognizes only limited or unlimited companies (incorporated companies) as separate entities. Sole proprietorship and partnerships are not regarded as such.
The money-measuring concept the concept states that account will only deal with those items to which monetary value can be attributed. For example, in the statement of financial position of a business, monetary values can be attributed to such assets as machinery and stock of goods. The concept introduces limitations to the subject matter of the accounts. A business may have intangible assets such as brand name or workforce loyalty. These assets may be important to give the business an advantage over other similar businesses without the same, but because they cannot be evaluated in monetary terms, they do not appear anywhere in the accounts (McLaney & Atrill 2008).
Another principle is the the separate valuation principle. The principle states that in determining the amount to be attributed to an asset or liability in the balance sheet, each component item of the asset or liability must be separately determined. After carrying out valuations for each balance sheet item separately, they are added up together to obtain balance sheet totals (McLaney & Atrill 2008).
Under the materiality concept an item is considered material if its omission or inclusion affects the decision making process of the users. Materiality depends on the nature and size of an item. Only items material in amount or in their nature will affect the true and fair view given by a set of accounts (McLaney & Atrill 2008).
In summary, these accounting concepts are important when carrying out business analysis and planning. It is because business analysis looks at the financial statement among other areas. Besides, the standards give a strong foundation for other financial analysis such as marginal costing (McLaney & Atrill 2008).
Management accounting
Budgeting enables an organization to plan for future financial activities. Budgets gives estimates of expected income and expenses of an entity for a given period. They are prepared based on the past financial activities of the entity and the future plans of the organization. In most cases, entities do not carry out their financial activities exactly as planned. There is likelihood of spending more than or less than the budget thus causing variance. Analysis of these variances is vital in an entity. Management accounting is a significant tool for evaluating the viability of a venture (Weygandt, et al. 2010).
Cost Behaviors
Cost is the measure of economic sacrifice made to achieve an organizational goal. For a product, cost represents the monetary measurement of resources such as materials, labor and overheads. For a service, the cost is the monetary sacrifice made to provide a service. Costs are generated by units, that is, the quantitative unit of a product or service in relation to which, costs are ascertained. For example, a unit of production expressed as a relevant quantity (Weygandt, et al. 2010).
Cost behavior refers to the influence on the cost of the change in output level of production. That is, if the output increases, will cost increase, decrease or remain the same? The behavior of costs are variable, fixed, semi-variable, semi-fixed, direct, indirect, controllable, and non-controllable (Weygandt, et al. 2010).
Variable costs are dependent on the number of units produced. They are directly relational to the number of units produced. Semi-variable costs are costs with both fixed and variable components. The fixed components are not pegged on the number of units produced. They are incurred whether production takes place or not. Semi-variable costs are variable within certain activity levels and are fixed within other activity levels. Fixed costs are costs that do not change with the production levels (Weygandt, et al. 2010).
Direct costs consist of costs that can be directly attributed to a specific output. They include direct raw materials and direct labor. On the other hand, indirect costs are those that cannot be directly attributed to a specific product. They are regarded as overheads. Identification of overheads to specific production is done through cost allocation and apportionment. They include supervisors’ salaries, electricity, rent, and depreciation of a building (Weygandt, et al. 2010).
Controllable costs are those that can be influenced by the actions of a person in whom authority for such control is vested. For example, control of labor costs could be influenced by remuneration method and the degree of management control. Non-controllable costs are those that cannot be influenced by a person in whom authority for such control is vested. For example, building depreciation is a non-controllable cost to a manager.
Marginal costing and other related costing
Marginal costing is an accounting system used to assess the profitability of a business. It adopts a different approach to accounting for costs and profit. It rejects the principle of absorbing fixed overhead into unit costs. In marginal costing only variable costs are included in the determination of the production cost (Weygandt, et al. 2010; Collier 2009). This means that fixed costs are treated as period costs.
Marginal costing has a number of advantages over the other methods. The first advantage is that marginal costing is straight forward and easy to calculate. Secondly, in marginal costing there is no apportionment of costs into various components that is, fixed and variable cost. It is because this method of costing is based on variable costs only. It is worth noting that separation of fixed and variable costs cannot be done with accuracy because some costs comprises of both fixed and variable cost elements such as electricity. Further, fixed costs are the same irrespective of the number of output produced. Thus, they are irrelevant in marginal costing analysis. Proponents of marginal costing argue that variable costs are the real costs of producing an extra unit of output thus apportioning fixed costs and charging them to each unit of output is irrelevant and it only increases the unit price of a commodity. Another advantage of marginal costs is that there is no existence of over or under absorption of overheads as is evident in other methods of cost accounting. This implies that values arising from marginal costing are accurate. Further, marginal cost is useful in decision making. Information arising from marginal costing can be used in the decision making process in an organization.
Absorption costing sometimes referred to as full costing is another accounting method used to access profitability of a business. The method values closing stock at full production costs and includes a share of fixed production. It facilitates the ascertainment of the contribution of various products made by a company (Weygandt, et al. 2010).
The importance of using different sources of funds in decision-making
Financing is the heart of every business. Every business needs financing either to start operations or to make profitable investments in projects. The examples of sources of funds are equity capital, debt finance, bills of exchange, lease finance, overdraft finance, debenture finance, and venture capital. The following are some of the importance of using various sources of funds in decision-making.
Cost reduction: different sources of funds have different costs. These costs are variable (increase or decrease). Use of different sources of funds will, on average, lower the cost of funds as compared to the cost of a single source.
Diversify risk: different sources are available under different terms. It might not be possible, to easily get funding from some sources. Therefore, in order to increase the chances of obtaining funds, different sources should be approached.
A business may have many projects in which to invest. Different projects are planned to run for different periods. A short-term project should be funded using short-term funds while long term projects can be financed using both short term and long term funding. Therefore, different sources of funds should be used to obtain appropriate financing methods.
Using revenue reserve as a source of fund helps lower the gearing ratio of a company. The gearing ratio indicates the extent to which a firm has borrowed fixed charge capital to finance the acquisition of assets or other firm’s resources. It reduces the chances of receivership or liquidation.
Performance evaluation of John’s enterprise
This section will carry out an analysis of the proposed venture. It will first analyze the estimated cash flow for five years. Further, capital budgeting decision tools such as net present value approach, payback period, and internal rate of return will be used to evaluate the viability of the project. Also, financial ratio analysis is carried out to determine the profitability of the venture. This analysis is necessary since it helps in establishing whether the owner will obtain adequate returns from his investment. Finally, the section carries out break-even analysis (Bierman & Smidt 2003). Therefore, the performance of the proposed venture will be evaluated using a number of decision making tools.
Annual and monthly cash flow
The estimates used for constructing the monthly and annual cash flow are listed below.
Estimates:
- 1 CHF=$1. 0842
- Transportation cost per kg= 10*1.0842= $10.842 per kg.
- Monthly sales for the first eleven months of year 1= 80kg*$150= $12000.
- Monthly sale for the last month of year 1= 160kg*$150= $24000.
- Monthly sales for the rest of the years= 160kg* $150= $24000.
- Monthly Order level for the first eleven months of year 1=80 kg per month.
- Year 1’s last month order level= 160kg per month.
- Monthly order level for subsequent four years=160kg per month.
- The credit card cost for the first eleven months of year 1= (2%*12000) =$240.
- The credit card cost for the last month of year 1= (2%*24000) = $ 480.
- Discounting rate 5% per annum.
- Purchasing cost per kg= (1.0842*100) = $108.42
- Purchase discount= 40% of total monthly purchases.
- Monthly purchase corresponds to the sales.
Assumptions
The cash flow of the organization is constructed based on the following assumptions.
- John sells his products at $150 per kg.
- During the first eleven months of the year 1, John made 20 sales per month.
- During the last month of the year 1, John made 40 sales per month.
- Salary for the first year was $5,000 and maintained at $6,500 for the next four years.
- The initial investment on chocolate alone was $150,000.
- Business working days are five and four weeks in a month.
Monthly cash flow
The table below summarizes the monthly cash flow of John’s enterprise.
Continuation
The assumptions yield a constant monthly cash flow between February and November. The cash flow for January is negative because of hefty investments made in the first month. The table below shows the trend of monthly cash flow.
Annual Cash flow
Apart from the assumptions and estimates shown above, it will be assumed that sales and expenses will grow at 10% annually from the second year. The table below summarizes the annual cash flow for the four years.
The graph below shows the trend of the earnings for the four years.
From the above estimation and assumptions, it is evident that John’s enterprise is in a position to generate positive cash flows during the five years of forecasting. Besides, the cash flows are increasing over the years.
Tools for evaluation
Project managers should carry out financial analysis on capital investments. This is necessary because capital investments require a large amount of initial capital outlay. Secondly, the benefits from capital investments flow in for a long period. Thirdly, capital investment decisions in most cases deal with an organization’s optimal capital structure that is, in terms sourcing for funds either of debt and equity (Brigham & Joel 2009). Therefore, analysis of the project should be done before requesting for funds because these projects are irreversible. Finally, capital is a limited resource. Organizations and even nations lack adequate resources to invest in all projects. Therefore, it is necessary to appraise all feasible projects. Resources should be dedicated to ventures with high returns (Callan & Thomas 2010).
Net present value
The net present value method will involve selection of a rate acceptable to the management or that equals the cost of finance. If the NPV is positive, the decision should be to invest in the project but if negative, the decision should be to avoid the project. The present value of cash inflows of the project amounts to $160,038.53 and the estimated initial capital is $73,654.08. It is evident that the present value exceeds the initial cost of investment by $86,384.45. This indicates that the owner will obtain positive returns from the project. Thus, based on this approach we can deduce that the business is viable and worth pursuing.
Internal rate of return
IRR is a tool of capital budgeting that give the discount rate that equates the present value of cost to the present value of benefits. Basically, it is the discount rate at which the net present value of the project is zero. Interpolation will be used to estimate the value of IRR. A project is accepted when the internal rate of return is greater that the required rate of return. From the calculations carried out, the internal rate of return for the project is very high, at 37.85%. This can be attributed to low initial investment cost and low required rate of return. The value is greater than the discount rate of 5% thus, the project is viable.
Discounted payback period
The capital decision analysis tool gives the duration of time that the business will take to recover the initial cost of investment. This tool of analysis is significant for ranking of projects or for assessing projects high risk projects. In such projects, the investors require return within a short duration. A project with a shorter payback period is often preferred.
Discounted payback period = Present value of cash inflows / initial investment
= $160,038.53 / $73,654.08
= 2 years and 2 months
Sensitivity analysis
Sensitivity analysis is carried out to ascertain how profitability of the company changes when certain variables such as the price of the commodity, cost of production or operating expenses changes. It is important to find out the key factors that affect profitability of the business. Sensitivity analysis helps in assessing how profitability will change in a worst case and a best case scenario (Haber 2004). In conducting a sensitivity analysis, sales levels can be up-scaled by increasing product prices. To ascertain a desired NPV, prices can be adjusted upward. Marketing strategies should therefore, be formulated to support the ascertainment of the desired NPV level. The sensitivity test conducted assumed that all other items remained constant but the product’s selling price that was increased to $165 per kg. The present value of the project presented a notable increase as compared to its value when products were selling at $160 per kg. Further, the NPV is zero at a discount rate of 37.85%.
Ratio analysis
Financial analysis is an economic tool that involves the use of financial statement items in identifying the company’s financial performance by comparing the items in the balance sheet and profit and loss. Examples of ratios are liquidity ratios, profitability ratios, gearing ratios, efficiency ratios, growth and valuation ratios, and turnover ratios. For example, using turnover ratio, stock holding period measures the number of times stock is turned into sales. In other words, it measures the level of sales in a given period. To reduce the stock holding period (increase sales), suitable promotional activities should be developed (Holmes & Sugden 2008). Return on capital employed will be used to estimate the profitability of the company.
From the table above, it is evident that the profitability of the company is high and increasing over the five year period. Return on capital employed was relatively low in the first year because of the investments. The graph below shows the trend of ROCE over the period.
Apart from return on assets, gross profit margin and operating profit margin can also be used to assess the profitability of the venture (Holmes & Sugden 2008). The table below summarizes the values for gross profit margin and operating profit margin.
From the table above, the gross profit margin is constant at 56.63% for all the five years. The gross profit margin shows the ability of an organization to margin costs of sales so as to generate profit. The gross profit margin ratios also give information on the pricing policy of the organization. Decline in the ratio could indicate increased cost of input or poor pricing. The operating profit margin increased from 1.89% to 20.32%. It shows that the company is able to manage the cost of operation so as to generate profits (Holmes & Sugden 2008). The ratios are fairly constant for all the years because the rate of increase of income and expenses is constant over the years.
Break-even analysis
Break-even analysis is a managerial economic tool used to ascertain the level of production at which the profits earned equals the cost of resources used to create it. It is the point at which total sales revenue covers the cost of the committed resources. This tool also helps to ascertain the level of sales that will generate a targeted level of profit. This economical tool affects the pricing decision in the following way: when variable costs of production increase, product prices should be increased in order to maintain the same break-even level (Vance 2003). The application of the tool goes to the level of determining the sales levels; afterwards, the management uses the information to decide on price changes. For a firm to reach the ascertained target profit as per the break-even analysis, it will have to develop its marketing strategies to facilitate achievement of the target. Appendix one shows the break-even chart for the company. The total fixed cost for the business amounts to $12,107. The total variable cost amounts to $780.62 per unit and the selling price per unit is $150.00. This yield breakeven number of units amounting to The break-even number of units is 19 units. It is less than the current production of the company which is 12 units. This could be an indication that the business is inefficient.
Decision- making under uncertainty
Uncertain events are those whose outcome cannot be predicted with statistical confidence. In such an environment, the states of nature are not known nor are their probability distribution. The decision making process in this situation depends on the risk attitude of the decision maker. Therefore, a number of decision criteria can be used such as maximin, minimax, maximax, and Laplace rationality. Further, probability analysis is often used to estimate returns under uncertainty. Another method that is commonly used is adding a risk premium to the discount rate being used to evaluate these projects (Weygandt, Kieso, & Kimmel 2010).
Recommendation
With detailed analysis of the various economic tools of decision-making, it is appropriate if John uses the net present value (Forecast income) to decide whether to invest in his project or not. The results show a positive NPV. This implies that the project is viable and John should make the investment. Apart from using the NPV approach, the profitability ratios also indicate that the business is profitable and is likely to give owners high return.
Conclusion
In planning for a business operation, the guidelines outlined in the International Accounting standards should be observed. The business management should understand the different cost behaviors to come up with effective cost management methods. A choice should be made on which costing method to use between marginal and absorption costing. It is also advisable for a business to use different sources of funds and employ economic tools in business analysis. The decision should therefore be made concerning various business issues. If John implements these strategies then his business stands a greater chance of success.
List of references
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Brigham, F & Joel, F 2009, Fundamentals of financial management, South-Western Cengage Learning, USA.
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Collier, P 2009, Accounting for managers, John Wiley & Sons Ltd, London.
Haber, R 2004, Accounting dimistified, American Management Association, New York.
Holmes, G & Sugden, A 2008, Interpreting company reports, Financial Times/Prentice Hall, Harlow.
McLaney, E & Atrill, P 2008, Financial accounting for decision makers, Prentice Hall Europe, Harlow.
Vance, D 2003, Financial analysis and decision making: Tools and techniques to solve, McGraw-Hill books, United States.
Weygandt, J, 2010. Accounting principles: Study guide, John Wiley & Sons Ltd, London.
Weygandt, J, Kieso, D & Kimmel, P 2010, Managerial accounting: tools for business decision- making, John Wiley & Sons Ltd, London.