In-Depth Guide to Financial Statement Analysis Methods
Basic Analytical Methods
Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:
1. Horizontal Analysis
Horizontal analysis is the percentage analysis of increases and decreases in related items in comparative financial statements. Each item on the most recent statement is compared with the related item on one or more earlier statements in terms of the following:
- Amount of increase or decrease
- Percent of increase or decrease
When comparing statements, the earlier statement is normally used as the base for computing increases and decreases.
The decrease in accounts receivable could be caused by improved collection policies, which would increase cash. The decrease in inventories could be caused by increased sales.
2. Vertical Analysis
Vertical analysis is the percentage analysis of the relationship of each component in a financial statement to a total within the statement. Although vertical analysis is applied to a single statement, it may be applied on the same statement over time. This enhances the analysis by showing how the percentages of each item have changed over time.
In vertical analysis of the balance sheet, the percentages are computed as follows:
- Each asset item is stated as a percent of the total assets.
- Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity. In a vertical analysis of the income statement, each item is stated as a percent of net sales.
3. Common-Sized Statements
In common-sized statements, all items are expressed as percentages with no dollar amounts shown. Common-sized statements are often useful for comparing one company with another or for comparing a company with industry averages.
Other Analytical Measures
Other relationships may be expressed in ratios and percentages. Often, these relationships are compared within the same statement and thus are a type of vertical analysis. Comparing these items with items from earlier periods is a type of horizontal analysis. Analytical measures are not ends in themselves. They are only guides in evaluating financial and operating data. Many other factors, such as trends in the industry and general economic conditions, should also be considered when analyzing a company.
Liquidity and Solvency Analysis
All users of financial statements are interested in the ability of a company to do the following:
- Maintain liquidity and solvency
- Earn income, called profitability
The ability to convert assets into cash is called liquidity, while the ability of a business to pay its debts is called solvency. Liquidity, solvency, and profitability are interrelated. For example, a company that cannot convert assets into cash may have difficulty taking advantage of profitable courses of action requiring immediate cash outlays. Likewise, a company that cannot pay its debts will have difficulty obtaining credit. The lack of credit will, in turn, limit the company’s ability to purchase merchandise or expand operations, which decreases its profitability.
Liquidity and solvency are normally assessed using the following:
1. Current Position Analysis
Current position analysis is a company’s ability to pay its current liabilities. It is of special interest to short-term creditors and includes the computation and analysis of the following:
- Working Capital is used to evaluate a company’s ability to pay current liabilities. A company’s working capital is often monitored monthly, quarterly, or yearly by creditors and other debtors. However, it is difficult to use working capital to compare companies of different sizes.
Working Capital = Current Assets – Current Liabilities - The current ratio, sometimes called the working capital ratio or bankers’ ratio, is computed as follows:
Current Ratio = Current Assets / Current Liabilities
The current ratio is a more reliable indicator of the ability to pay current liabilities than is working capital. - Quick Ratio (aka acid-test ratio)
One limitation of working capital and the current ratio is that they do not consider the makeup of the current assets. Because of this, two companies may have the same working capital and current ratios, but differ significantly in their ability to pay their current liabilities.
Quick Ratio = Quick Assets / Current Liabilities
Quick assets are cash and other current assets that can be easily converted to cash. Quick assets normally include cash, temporary investments, and receivables.
2. Accounts Receivable Analysis
Accounts receivable analysis is a company’s ability to collect its accounts receivable. It includes the computation and analysis of the following:
- Accounts receivable turnover
- Number of days’ sales in receivables
Collecting accounts receivable as quickly as possible improves a company’s liquidity. In addition, the cash collected from receivables may be used to improve or expand operations. Quick collection of receivables also reduces the risk of uncollectible accounts.
Accounts Receivable Turnover = Net Sales / Average Accounts Receivable
Number of Days’ Sales in Receivables = Average Accounts Receivable / Average Daily Sales
Where Average Daily Sales = Net Sales / 365 days
The number of days’ sales in receivables is an estimate of the time (in days) that the accounts receivable have been outstanding. The number of days’ sales in receivables is often compared with a company’s credit terms to evaluate the efficiency of the collection of receivables.
3. Inventory Analysis
A company’s ability to manage its inventory effectively is evaluated using inventory analysis. It includes the computation and analysis of the following:
- Inventory turnover
- Number of days’ sales in inventory
Excess inventory decreases liquidity by tying up funds (cash) in inventory. In addition, excess inventory increases insurance expense, property taxes, storage costs, and other related expenses. These expenses further reduce funds that could be used elsewhere to improve or expand operations. Excess inventory also increases the risk of losses because of price declines or obsolescence of the inventory. On the other hand, a company should keep enough inventory in stock so that it doesn’t lose sales because of lack of inventory.
Inventory Turnover = Cost of Goods Sold / Average Inventory
What is considered a good inventory turnover varies by type of inventory, companies, and industries.
Number of Days’ Sales in Inventory = Average Inventory / Average Daily Cost of Goods Sold
Where Average Daily Cost of Goods Sold = Cost of Goods Sold / 365 days
The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.
4. Ratio of Fixed Assets to Long-Term Liabilities
The ratio of fixed assets to long-term liabilities provides a measure of whether noteholders or bondholders will be paid since fixed assets are often pledged as security for long-term notes and bonds.
Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets (net) / Long-Term Liabilities
5. Ratio of Liabilities to Stockholders’ Equity
The ratio of liabilities to stockholders’ equity measures how much of the company is financed by debt and equity.
Ratio of Liabilities to Stockholders’ Equity = Total Liabilities / Total Stockholders’ Equity
6. Number of Times Interest Charges Earned
The number of times interest charges are earned, sometimes called the fixed charge coverage ratio, measures the risk that interest payments will not be made if earnings decrease.
Number of Times Interest Charges Are Earned = (Income Before Income Tax + Interest Expense) / Interest Expense
Interest expense is paid before income taxes. In other words, interest expense is deducted in determining taxable income and, thus, income tax. For this reason, income before taxes is used in computing the number of times interest charges are earned. The higher the ratio, the more likely interest payments will be paid if earnings decrease. The number of times interest charges are earned can be adapted for use with dividends on preferred stock. In this case, the number of times preferred dividends are earned.
Number of Times Preferred Dividends Are Earned = Net Income / Preferred Dividends
Since dividends are paid after taxes, net income is used in computing the number of times preferred dividends are earned. The higher the ratio, the more likely preferred dividend payments will be paid if earnings decrease.
Profitability Analysis
Profitability analysis focuses on the ability of a company to earn profits. This ability is reflected in the company’s operating results, as reported in its income statement. The ability to earn profits also depends on the assets the company has available for use in its operations, as reported in its balance sheet. Thus, income statement and balance sheet relationships are often used in evaluating profitability.
Common profitability analyses include the following:
1. Ratio of Net Sales to Assets
The ratio of net sales to assets measures how effectively a company uses its assets.
Ratio of Net Sales to Assets = Net Sales / Average Total Assets (excluding long-term investments)
As shown above, any long-term investments are excluded in computing the ratio of net sales to assets. This is because long-term investments are unrelated to normal operations and net sales.
2. Rate Earned on Total Assets
The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. In other words, this rate is not affected by the portion of assets financed by creditors or stockholders.
Rate Earned on Total Assets = (Net Income + Interest Expense) / Average Total Assets
The rate earned on total assets is computed by adding interest expense to net income. By adding interest expense to net income, the effect of whether the assets are financed by creditors (debt) or stockholders (equity) is eliminated.
Because net income includes any income earned from long-term investments, the average total assets includes long-term investments as well as the net operating assets.
Rate Earned on Operating Assets = Income from Operations / Average Operating Assets
3. Rate Earned on Stockholders’ Equity
The rate earned on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders.
Rate Earned on Stockholders’ Equity = Net Income / Average Total Stockholders’ Equity
Leverage involves using debt to increase the return on an investment. The rate earned on stockholders’ equity is normally higher than the rate earned on total assets. This is because of the effect of leverage.
4. Rate Earned on Common Stockholders’ Equity
The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested by the common stockholders.
Rate Earned on Common Stockholders’ Equity = (Net Income – Preferred Dividends) / Average Common Stockholders’ Equity
Because preferred stockholders rank ahead of the common stockholders in their claim on earnings, any preferred dividends are subtracted from net income in computing the rate earned on common stockholders’ equity.
5. Earnings per Share on Common Stock
Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. Generally accepted accounting principles (GAAP) require the reporting of earnings per share on the income statement. As a result, earnings per share (EPS) is often reported in the financial press.
Earnings per Share (EPS) on Common Stock = (Net Income – Preferred Dividends) / Shares of Common Stock Outstanding
When preferred and common stock are outstanding, preferred dividends are subtracted from net income to determine the income related to the common shares. Many corporations, however, have complex capital structures with various types of equity securities outstanding, such as convertible preferred stock, stock options, and stock warrants. In such cases, the possible effects of such securities on the shares of common stock outstanding are considered in reporting earnings per share. These possible effects are reported separately as earnings per common share assuming dilution or diluted earnings per share.
6. Price-Earnings Ratio
The price-earnings (P/E) ratio on common stock measures a company’s future earnings prospects. It is often quoted in the financial press.
Price-Earnings (P/E) Ratio = Market Price per Share of Common Stock / Earnings per Share on Common Stock
7. Dividends per Share
Dividends per share measure the extent to which earnings are being distributed to common shareholders. It is computed as follows:
Dividends per Share = Dividends / Shares of Common Stock Outstanding
Dividends per share are often reported with earnings per share. Comparing the two per-share amounts indicates the extent to which earnings are being retained for use in operations.
8. Dividend Yield
Dividend yield on common stock measures the rate of return to common stockholders from cash dividends. It is of special interest to investors, whose objective is to earn revenue (dividends) from their investment.
Dividend Yield = Dividends per Share of Common Stock / Market Price per Share of Common Stock
The type of industry and the company’s operations usually affect which measures are used. In many cases, additional measures are used for a specific industry. For example, airlines use revenue per passenger mile and cost per available seat as profitability measures. Likewise, hotels use occupancy rates as a profitability measure. The analytical measures are a useful starting point for analyzing a company’s liquidity, solvency, and profitability. However, they are not a substitute for sound judgment. In addition, any trends and interrelationships among the measures should be carefully studied.
Corporate Annual Reports
Public corporations issue annual reports summarizing their operating activities for the past year and plans for the future. Such annual reports include the financial statements and the accompanying notes. In addition, annual reports normally include the following sections:
1. Management’s Discussion and Analysis (MD&A)
Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the Securities and Exchange Commission. It includes management’s analysis of current operations and its plans for the future. Typical items included in the MD&A include the following:
- Management’s analysis and explanations of any significant changes between the current and prior years’ financial statements.
- Important accounting principles or policies that could affect interpretation of the financial statements, including the effect of changes in accounting principles or the adoption of new accounting principles.
- Management’s assessment of the company’s liquidity and the availability of capital to the company.
- Significant risk exposures that might affect the company.
- Any “off-balance-sheet” arrangements such as leases not included directly in the financial statements. Such arrangements are discussed in advanced accounting courses and textbooks.
2. Report on Internal Control
The Sarbanes-Oxley Act of 2002 requires management to prepare a report on internal control. The report states management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.
Sarbanes-Oxley also requires a public accounting firm to verify management’s conclusions on internal control. Thus, two reports on internal control, one by management and one by a public accounting firm, are included in the annual report. In some situations, these may be combined into a single report on internal control.
3. Report on Fairness of the Financial Statements
All publicly held corporations are required to have an independent audit (examination) of their financial statements. The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the Report of Independent Registered Public Accounting Firm, on the fairness of the statements.
An opinion stating that the financial statements present fairly the financial position, results of operations, and cash flows of the company is said to be an unqualified opinion, sometimes called a clean opinion. Any report other than an unqualified opinion raises a “red flag” for financial statement users and requires further investigation as to its cause.
Unusual Items on the Income Statement
GAAP require that unusual items be reported separately on the income statement. This is because such items do not occur frequently and often are unrelated to current operations. Without separate reporting of these items, users of the financial statements might be misled about current and future operations. Unusual items affecting the current period’s income statement include the following:
1. Discontinued Operations
A company may discontinue a segment of its operations by selling or abandoning the operations. For example, a retailer might decide to sell its product only online and thus discontinue selling its merchandise at its retail outlets (stores). Any gain or loss on discontinued operations is reported on the income statement as a Gain (or loss) from discontinued operations. It is reported immediately following Income from continuing operations. In addition, a note accompanying the income statement should describe the operations sold, including such details as the date operations were discontinued, the assets sold, and the effect (if any) on current and future operations.
2. Extraordinary Items
An extraordinary item is defined as an event or transaction with the following characteristics:
- Unusual in nature
- Infrequent in occurrence
Gains and losses from natural disasters such as floods, earthquakes, and fires are normally reported as extraordinary items, provided that they occur infrequently. Gains or losses from land or buildings taken (condemned) for public use are also reported as extraordinary items. Any gain or loss from extraordinary items is reported on the income statement as Gain (or loss) from extraordinary item. It is reported immediately following Income from continuing operations and any Gain (or loss) on discontinued operations.
Reporting Earnings per Share
Earnings per common share should be reported separately for discontinued operations and extraordinary items. However, only earnings per share for income from continuing operations and net income are required by GAAP. The other per-share amounts may be presented in the notes to the financial statements.
Nature of Manufacturing Businesses
The revenue activities of a service business involve providing services to customers. The revenue activities of a merchandising business involve the buying and selling of merchandise. In contrast, a manufacturing business first produces the products it sells. A manufacturing business converts materials into finished products through the use of machinery and labor. Like merchandising businesses, a manufacturing business reports sales from selling its products. The cost of the products sold is normally reported as the cost of goods sold, whereas a merchandising business reports these costs as the cost of merchandise sold. The subtraction of the cost of goods sold from sales is reported as gross profit. Operating expenses are deducted from gross profit to arrive at net income.
Materials, products in the process of being manufactured, and finished products are reported on the manufacturer’s balance sheet as inventories. Like merchandise inventory, these inventories are reported as current assets.
Manufacturing Cost Terms
Managers rely on managerial accountants to provide useful cost information to support decision-making.
What is a cost? A cost is a payment of cash or its equivalent or the commitment to pay cash in the future for the purpose of generating revenues. A cost provides a benefit that is used immediately or deferred to a future period. If the benefit is used immediately, then the cost is an expense, such as salary expense. If the benefit is deferred, then the cost is an asset, such as equipment. As the asset is used, an expense, such as depreciation expense, is recognized. A manufacturing business converts materials into a finished product through the use of machinery and labor. The cost of a manufactured product includes the cost of materials used in making the product. In addition, the cost of a manufactured product includes the cost of converting the materials into a finished product.
Thus, the cost of the object includes the following:
1. Direct Materials Cost
Manufactured products begin with raw materials that are converted into finished products. The cost of any material that is an integral part of the finished product is classified as a direct materials cost.
To be classified as a direct materials cost, the cost must be both of the following:
- An integral part of the finished product
- A significant portion of the total cost of the product
As noted above, indirect materials costs are included in factory overhead.
Direct Labor Cost
Most manufacturing processes use employees to convert materials into finished products. The cost of employee wages that is an integral part of the finished product is classified as a direct labor cost. Direct labor cost includes the wages of the employees, mechanics’ wages for repairing an automobile, machine operators’ wages for manufacturing tools, and assemblers’ wages for assembling a laptop computer.
Like a direct materials cost, a direct labor cost must be both of the following:
- An integral part of the finished product
- A significant portion of the total cost of the product
Indirect labor costs are included in factory overhead.
Factory Overhead Cost
Costs other than direct materials cost and direct labor cost that are incurred in the manufacturing process are combined and classified as factory overhead cost.
Factory overhead is sometimes called manufacturing overhead or factory burden.
All factory overhead costs are indirect costs of the product. Some factory overhead costs include the following:
- Heating and lighting the factory
- Repairing and maintaining factory equipment
- Property taxes on factory buildings and land
- Insurance on factory buildings
- Depreciation on factory plant and equipment
Factory overhead cost also includes materials and labor costs that do not enter directly into the finished product. Examples include the cost of oil used to lubricate machinery and the wages of janitorial and supervisory employees. Also, if the costs of direct materials or direct labor are not a significant portion of the total product cost, these costs may be classified as factory overhead costs.
Prime Costs and Conversion Costs
Direct materials, direct labor, and factory overhead costs may be grouped together for analysis and reporting. Two such common groupings are as follows:
- Prime costs, which consist of direct materials and direct labor costs
- Conversion costs, which consist of direct labor and factory overhead costs
Conversion costs are the costs of converting the materials into a finished product. Direct labor is both a prime cost and a conversion cost.
Product Costs and Period Costs
For financial reporting purposes, costs are classified as product costs or period costs.
- Product costs consist of manufacturing costs: direct materials, direct labor, and factory overhead.
- Period costs consist of selling and administrative expenses. Selling expenses are incurred in marketing the product and delivering the product to customers.
Administrative expenses are incurred in managing the company and are not directly related to the manufacturing or selling functions.
To facilitate control, selling and administrative expenses may be reported by the level of responsibility. For example, selling expenses may be reported by products, salespersons, departments, divisions, or territories. Likewise, administrative expenses may be reported by areas such as human resources, computer services, legal, accounting, or finance.
As product costs are incurred, they are recorded and reported on the balance sheet as inventory. When the inventory is sold, the cost of the manufactured product sold is reported as the cost of goods sold on the income statement. Period costs are reported as expenses on the income statement in the period in which they are incurred and thus never appear on the balance sheet.
The impact on the financial statements of product and period costs:
Cost Accounting System Overview
Cost accounting systems measure, record, and report product costs. Managers use product costs for setting product prices, controlling operations, and developing financial statements.
The two main types of cost accounting systems for manufacturing operations are:
- A job order cost system provides product costs for each quantity of product that is manufactured. Each quantity of product that is manufactured is called a job. Job order cost systems are often used by companies that manufacture custom products for customers or batches of similar products. Manufacturers that use a job order cost system are sometimes called job shops. An example of a job shop would be an apparel manufacturer, such as Levi Strauss & Co., or a guitar manufacturer such as Washburn Guitars.
- A process cost system provides product costs for each manufacturing department or process. Process cost systems are often used by companies that manufacture units of a product that are indistinguishable from each other and are manufactured using a continuous production process. Examples would be oil refineries, paper producers, chemical processors, and food processors.
Job order and process cost systems are widely used. A company may use a job order cost system for some of its products and a process cost system for other products.
Job Order Cost Systems for Manufacturing Businesses
A job order cost system records and summarizes manufacturing costs by jobs.
The materials inventory, sometimes called raw materials inventory, consists of the costs of the direct and indirect materials that have not yet entered the manufacturing process.
The work-in-process inventory consists of direct materials costs, direct labor costs, and factory overhead costs that have entered the manufacturing process but are associated with products that have not been completed.
Upon sale, a manufacturer records the cost of the sale as the cost of goods sold.
The cost of goods sold for a manufacturer is comparable to the cost of merchandise sold for a merchandising business.
In a job order cost accounting system, perpetual inventory records are maintained for materials, work-in-process, and finished goods inventories.
These subsidiary materials accounts are kept in a ledger, called a subsidiary ledger.
The sum of the subsidiary ledger accounts equals the balance of the materials account, called the controlling account.1
The materials account is a controlling account. A separate account for each type of material is maintained in a subsidiary materials ledger.
A receiving report is prepared when materials that have been ordered are received and inspected. The quantity received and the condition of the materials are entered on the receiving report. When the supplier’s invoice is received, it is compared to the receiving report. If there are no discrepancies, the purchase is recorded.
The storeroom releases materials for use in manufacturing when a materials requisition is received. The materials requisitions for each job serve as the basis for recording materials used. For direct materials, the quantities and amounts from the materials requisitions are recorded on job cost sheets.
Many companies use computerized information processes to record the use of materials. In such cases, storeroom employees electronically record the release of materials, which automatically updates the materials ledger and job cost sheets.
Factory Labor
When employees report for work, they may use clock cards, in-and-out cards, or electronic badges to clock in. When employees work on an individual job, they use time tickets.
As with direct materials, many businesses use computerized information processing to record direct labor. In such cases, employees may log their time directly into computer terminals at their workstations. In other cases, employees may be issued magnetic cards, much like credit cards, to log in and out of work assignments.
Factory Overhead Cost
Factory overhead includes all manufacturing costs except direct materials and direct labor. A summary of factory overhead costs comes from a variety of sources including the following:
- Indirect materials come from a summary of materials requisitions.
- Indirect labor comes from the salaries of production supervisors and the wages of other employees such as janitors.
- Factory power comes from utility bills.
- Factory depreciation comes from Accounting Department computations of depreciation.
Allocating Factory Overhead
Factory overhead is different from direct labor and direct materials in that it is indirectly related to the jobs. That is, factory overhead costs cannot be identified with or traced to specific jobs. For this reason, factory overhead costs are allocated to jobs. The process by which factory overhead or other costs are assigned to a cost object, such as a job, is called cost allocation.
The factory overhead costs are allocated to jobs using a common measure related to each job. This measure is called an activity base, allocation base, or activity driver. The activity base used to allocate overhead should reflect the consumption or use of factory overhead costs. For example, production supervisor salaries could be allocated on the basis of direct labor hours or direct labor cost of each job.
Predetermined Factory Overhead Rate
Factory overhead costs are normally allocated or applied to jobs using a predetermined factory overhead rate. The predetermined factory overhead rate is computed as follows:
Predetermined Factory Overhead Rate = Estimated Total Factory Overhead Costs / Estimated Activity Base
As shown above, the predetermined overhead rate is computed using estimated amounts at the beginning of the period. This is because managers need timely information on the product costs of each job. If a company waited until all overhead costs were known at the end of the period, the allocated factory overhead would be accurate, but not timely. Only through timely reporting can managers adjust manufacturing methods or product pricing.
Many companies are using activity-based costing for accumulating and allocating factory overhead costs. This method uses a different overhead rate for each type of factory overhead activity, such as inspecting, moving, and machining.
Applying Factory Overhead to Work in Process
To summarize, the factory overhead account is:
- Increased for the actual overhead costs incurred
- Decreased for the applied overhead
The actual and applied overhead usually differ because the actual overhead costs are normally different from the estimated overhead costs. Depending on whether actual overhead is greater or less than applied overhead, the factory overhead account will either have a positive or negative ending balance as follows:
- If the applied overhead is less than the actual overhead incurred, the factory overhead account will have a positive balance. This positive balance is called underapplied factory overhead or underabsorbed factory overhead.
- If the applied overhead is more than the actual overhead incurred, the factory overhead account will have a negative balance. This negative balance is called overapplied factory overhead or overabsorbed factory overhead. If the balance of factory overhead (either underapplied or overapplied) becomes large, the balance and related overhead rate should be investigated. For example, a large balance could be caused by changes in manufacturing methods. In this case, the factory overhead rate should be revised.
Disposal of Factory Overhead Balance
During the year, the balance in the factory overhead account is carried forward and reported as a positive or negative amount on the monthly (interim) balance sheets. However, any balance in the factory overhead account should not be carried over to the next year. This is because any such balance applies only to operations of the current year.
If the estimates for computing the predetermined overhead rate are reasonably accurate, the ending balance of Factory Overhead should be relatively small. For this reason, the balance of Factory Overhead at the end of the year is disposed of by transferring it to the cost of goods sold account as follows:
- An ending positive balance (underapplied overhead) in the factory overhead account is disposed of by increasing Cost of Goods Sold and decreasing Factory Overhead.
- An ending negative balance (overapplied overhead) in the factory overhead account is disposed of by increasing Factory Overhead and decreasing Cost of Goods Sold.
Work in Process
During the period, Work in Process is increased for the following:
- Direct materials cost
- Direct labor cost
- Applied factory overhead cost
The finished goods account is a controlling account for the subsidiary finished goods ledger or stock ledger. Each account in the finished goods ledger contains cost data for the units manufactured, units sold, and units on hand.
Sales and Cost of Goods Sold
Sales for a manufacturing business and a merchandising business have the same effect on the accounts and financial statements.
Period Costs
Period costs are used in generating revenue during the current period but are not involved in the manufacturing process. Period costs are recorded as expenses of the current period as either selling or administrative expenses.
Selling expenses are incurred in marketing the product and delivering sold products to customers. Administrative expenses are incurred in managing the company but are not related to the manufacturing or selling functions.
Summary of Cost Flows
- Materials Ledger—the subsidiary ledger for Materials
- Job Cost Sheets—the subsidiary ledger for Work in Process
- Finished Goods Ledger—the subsidiary ledger for Finished Goods
*These 3 are supported by their subsidiary ledgers
Job Order Costing for Decision Making
A job order cost accounting system accumulates and records product costs by jobs. The resulting total and unit product costs can be compared to similar jobs, compared over time, or compared to expected costs. In this way, a job order cost system can be used by managers for cost evaluation and control.
Job Order Cost Systems for Service Businesses
A job order cost accounting system may be used for a professional service business. For example, an advertising agency, an attorney, and a physician provide services to individual customers, clients, or patients. In such cases, the customer, client, or patient can be viewed as a job for which costs are accumulated and reported. The primary product costs for a service business are direct labor and overhead costs. Any materials or supplies used in rendering services are normally insignificant. As a result, materials and supply costs are included as part of the overhead cost.
Like a manufacturing business, direct labor and overhead costs of rendering services to clients are accumulated in a work-in-process account. Work in Process is supported by a cost ledger with a job cost sheet for each client. When a job is completed and the client is billed, the costs are transferred to a cost of services account. Cost of Services is similar to the cost of merchandise sold account for a merchandising business or the cost of goods sold account for a manufacturing business. A finished goods account and related finished goods ledger are not necessary. This is because the revenues for the services are recorded only after the services are provided. In practice, other considerations unique to service businesses may need to be considered. For example, a service business may bill clients on a weekly or monthly basis rather than when a job is completed. In such cases, a portion of the costs related to each billing is transferred from the work-in-process account to the cost of services account. A service business may also bill clients for services in advance, which would be accounted for as deferred revenue until the services are completed.
Just-in-Time Practices
The objective of most manufacturers is to produce products with high quality, low cost, and instant availability. In attempting to achieve this objective, many manufacturers have implemented just-in-time processing. Just-in-time (JIT) processing, sometimes called lean manufacturing, is a philosophy that focuses on reducing time and cost, and eliminating poor quality.
Reducing Inventory
Just-in-time (JIT) manufacturing views inventory as wasteful and unnecessary. As a result, JIT emphasizes reducing or eliminating inventory.
Under traditional manufacturing, inventory often hides underlying production problems. For example, if machine breakdowns occur, work-in-process inventories can be used to keep production running in other departments while the machines are being repaired.
Likewise, inventories can be used to hide problems caused by a shortage of trained employees, unreliable suppliers, or poor quality. In contrast, just-in-time manufacturing attempts to solve and remove production problems. In this way, raw materials, work in process, and finished goods inventories are reduced or eliminated. The role of inventory in manufacturing can be illustrated using a river. Inventory is the water in a river. The rocks at the bottom of the river are production problems. When the water (inventory) is high, the rocks (production problems) at the bottom of the river are hidden. As the water level (inventory) drops, the rocks (production problems) become visible, one by one.
JIT manufacturing reduces the water level (inventory), exposes the rocks (production problems), and removes the rocks so that the river can flow smoothly.
Reducing Lead Times
Lead time, sometimes called throughput time, measures the time between when a product enters production (is started) and when it is completed (finished). In other words, lead time measures how long it takes to manufacture a product.
The lead time can be classified as one of the following: 1. Value-added lead time, which is the time spent in converting raw materials into a finished unit of product 2. Non-value-added lead time, which is the time spent while the unit of product is waiting to enter the next production process or is moved from one process to another. Just-in-time manufacturing reduces or eliminates non-value-added time. In contrast, traditional manufacturing processes may have a value-added ratio as small as 5%.
Reducing Setup Time A setup is the effort spent preparing an operation or process for a production run. If setups are long and costly, the batch size (number of units) for the related production run is normally large. Large batch sizes allow setup costs to be spread over more units and thus reduce the cost per unit. However, large batch sizes increase inventory and lead time.
Emphasizing Product-Oriented Layout Manufacturing processes can be organized around a product, which is called a product-oriented layout (or product cells). Alternatively, manufacturing processes can be organized around a process, which is called a process-oriented layout.
Just-in-time normally organizes manufacturing around products rather than processes. Organizing work around products reduces: 1. Moving materials and products between processes 2. Work-in-process inventory 3. Lead time 4. Production costs In addition, a product-oriented layout improves coordination among operations.
Emphasizing Employee Involvement Employee involvement is a management approach that grants employees the responsibility and authority to make decisions about operations. Employee involvement is often applied in a just-in-time operation by organizing employees into product cells. Within each product cell, employees are organized as teams where the employees are cross-trained to perform any operation within the product cell.
Emphasizing Pull Manufacturing Pull manufacturing (or make-to-order) is an important just-in-time practice. In pull manufacturing, products are manufactured only as they are needed by the customer. Products can be thought of as being pulled through the manufacturing process. In other words, the status of the next operation determines when products are moved or produced. If the next operation is busy, production stops so that work in process does not pile up in front of the busy operation. When the next operation is ready, the product is moved to that operation.
In contrast, the traditional approach to manufacturing is based on estimated customer demand. This principle is called push manufacturing (or make-to-stock) manufacturing. In push manufacturing, products are manufactured according to a production schedule that is based upon estimated sales. The schedule “pushes” product into inventory before customer orders are received. As a result, push manufacturers normally have more inventory than pull manufacturers.
Emphasizing Zero Defects Just-in-time manufacturing attempts to eliminate poor quality. Poor quality creates:1. Scrap 2. Rework, which is fixing product made wrong the first time 3. Disruption in the production process 4. Dissatisfied customers 5. Warranty costs and expenses
One way to improve product quality and manufacturing processes is Six Sigma: was developed by Motorola Corporation and consists of five steps: define, measure, analyze, improve, and control (DMAIC). Since its development, Six Sigma has been adopted by thousands of organizations worldwide.
Emphasizing Supply Chain Management Supply chain management coordinates and controls the flow of materials, services, information, and finances with suppliers, manufacturers, and customers. Supply chain management partners with suppliers using long-term agreements. These agreements ensure that products are delivered with the right quality, at the right cost, at the right time.
To enhance the interchange of information between suppliers and customers, supply chain management often uses: 1. Electronic data interchange (EDI), which uses computers to electronically communicate orders, relay information, and make or receive payments from one organization to another. 2. Radio frequency identification devices (RFID), which are electronic tags (chips) placed on or embedded within products that can be read by radio waves that allow instant monitoring of product location. 3. Enterprise resource planning (ERP) systems, which are used to plan and control internal and supply chain operations.
Activity-Based Costing In today’s complex manufacturing systems, product costs can be distorted if inappropriate factory overhead rates are used. One way to avoid this distortion is by using the activity-based costing (ABC) method. This approach allocates factory overhead more accurately than does the single, plantwide overhead rate.The activity-based costing method uses cost of activities to determine product costs. Under this method, factory overhead costs are initially accounted for in activity cost pools. These cost pools are related to a given activity, such as machine usage, inspections, moving, production setups, and engineering activities.In order to simplify, a service business is used to illustrate the principles of activity-based costing. Like manufacturing businesses, service companies need to determine the cost of services in order to make pricing, promotional, and other decisions. Many service companies find that a single overhead rate can lead to service cost distortions. Thus, many service companies are now using activity based costing for determining the cost of providing services to customers.
Activity Rate= Budgeted Activity Cost
Activity-Base Usage
Cost Behavior is the manner in which a cost changes as a related activity changes.The behavior of costs is useful to managers for a variety of reasons. For example, knowing how costs behave allows managers to predict profits as sales and production volumes change. Knowing how costs behave is also useful for estimating costs, which affects a variety of decisions such as whether to replace a machine.Understanding the behavior of a cost depends on:1. Identifying the activities that cause the cost to change. These activities are called activity bases (or activity drivers).2. Specifying the range of activity over which the changes in the cost are of interest. This range of activity is called the relevant range.Costs are normally classified as variable costs, fixed costs, or mixed costs.
Variable Costs are costs that vary in proportion to changes in the activity base.
When the activity base is units produced, direct materials and direct labor costs are normally classified as variable costs. As shown above, variable costs have the following characteristics: 1. Cost per unit remains the same regardless of changes in the activity base. 2. Total cost changes in proportion to changes in the activity base.
Fixed Costs are costs that remain the same in total dollar amount as the activity base changes. When the activity base is units produced, many factory overhead costs such as straight-line depreciation are classified as fixed costs.
As shown on the preceding page, fixed costs have the following characteristics: 1. Cost per unit changes inversely to changes in the activity base. 2. Total cost remains the same regardless of changes in the activity base.
Mixed Costs are costs that have characteristics of both a variable and a fixed cost.
Mixed costs are sometimes called semivariable or semifixed costs.
For purposes of analysis, mixed costs are usually separated into their fixed and variable components. The high-low method is a cost estimation method that may be used for this purpose. The high-low method uses the highest and lowest activity levels and their related costs to estimate the variable cost per unit and the fixed cost.
Variable Cost per Unit = Difference in Total Cost
Difference in Production
Fixed Cost = Total Cost – (Variable Cost per Unit X Units Produced)
Summary of Cost Behavior Concepts
Mixed costs contain a fixed cost component that is incurred even if nothing is produced. For analysis, the fixed and variable cost components of mixed costs are separated using the high-low method.
Some examples of variable, fixed, and mixed costs for the activity base units produced are as follows:
One method of reporting variable and fixed costs is called variable costing or direct costing. Under variable costing, only the variable manufacturing costs (direct materials, direct labor, and variable factory overhead) are included in the product cost. The fixed factory overhead is treated as an expense of the period in which it is incurred. Variable costing is described and illustrated in advanced accounting courses.
Cost-Volume-Profit Relationships Cost-volume-profit analysis is the examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits. Cost-volume-profit analysis is useful for managerial decision making. Some of the ways cost-volume- profit analysis may be used include:1. Analyzing the effects of changes in selling prices on profits2. Analyzing the effects of changes in costs on profits3. Analyzing the effects of changes in volume on profits4. Setting selling prices5. Selecting the mix of products to sell6. Choosing among marketing strategies
Contribution Margin is especially useful because it provides insight into the profit potential of a company. Contribution margin is the excess of sales over variable costs, as shown below.
Contribution Margin = Sales – Variable Costs
Contribution Margin Ratio The contribution margin can also be expressed as a percentage. The contribution margin ratio, sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide income from operations.
Contribution Margin Ratio= Contribution Margin
Sales
The contribution margin ratio is most useful when the increase or decrease in sales volume is measured in sales dollars. In this case, the change in sales dollars multiplied by the contribution margin ratio equals the change in income from operations, as shown below.
Change in Income from Operations= Change in Sales Dollars X Contribution Margin Ratio.
In the preceding analysis, factors other than sales volume, such as variable cost per unit and sales price, are assumed to remain constant. If such factors change, their effect must also be considered. The contribution margin ratio is also useful in developing business strategies. For example, assume that a company has a high contribution margin ratio and is producing below 100% of capacity. In this case, a large increase in income from operations can be expected from an increase in sales volume. Therefore, the company might consider implementing a special sales campaign to increase sales. In contrast, a company with a small contribution margin ratio will probably want to give more attention to reducing costs before attempting to promote sales.
Unit Contribution Margin is also useful for analyzing the profit potential of proposed decisions. The unit contribution margin is computed as follows:
Unit Contribution Margin = Sales Price per Unit – Variable Cost per Unit
The unit contribution margin is most useful when the increase or decrease in sales volume is measured in sales units (quantities). In this case, the change in sales volume (units) multiplied by the unit contribution margin equals the change in income from operations, as shown below.
Change in Income from Operations = Change in Sales Units X Unit Contribution Margin
Mathematical Approach to Cost-Volume-Profit Analysis uses equations to determine the following:1. Sales necessary to break even2. Sales necessary to make a target or desired profit
Break-Even Point is the level of operations at which a company’s revenues and expenses are equal. At break-even, a company reports neither an income nor a loss from operations.
Break-Even Sales (units)= Fixed Costs
Unit Contribution Margin
Break-Even Sales (dollars)= Fixed Costs
Contribution Margin Ratio
The contribution margin ratio can be computed using the unit contribution margin and unit selling price as follows: Contribution Margin Ratio= Unit Contribution Margin
Unit Selling Price
The break-even point is affected by changes in the fixed costs, unit variable costs, and the unit selling price.
Effect of Changes in Fixed Costs Fixed costs do not change in total with changes in the level of activity. However, fixed costs may change because of other factors such as changes in property tax rates or factory supervisors’ salaries.
Changes in fixed costs affect the break-even point as follows: 1. Increases in fixed costs increase the break-even point. 2. Decreases in fixed costs decrease the break-even point.
Effect of Changes in Unit Variable Costs Unit variable costs do not change with changes in the level of activity. However, unit variable costs may be affected by other factors such as changes in the cost per unit of direct materials.Changes in unit variable costs affect the break-even point as follows:1. Increases in unit variable costs increase the break-even point.2. Decreases in unit variable costs decrease the break-even point.
Effect of Changes in Unit Selling Price Changes in the unit selling price affect the unit contribution margin and thus the break-even point.
Specifically, changes in the unit selling price affect the break-even point as follows: 1. Increases in the unit selling price decrease the break-even point. 2. Decreases in the unit selling price increase the break-even point.
Summary of Effects of Changes on Break-Even Point The break-even point in sales changes in the same direction as changes in the variable cost per unit and fixed costs. In contrast, the break-even point in sales changes in the opposite direction as changes in the unit selling price.
Target Profit At the break-even point, sales and costs are exactly equal. However, the goal of most companies is to make a profit. By modifying the break-even equation, the sales required to earn a target or desired amount of profit may be computed. For this purpose, target profit is added to the break-even equation as shown below. Sales (units)= Fixed Costs + Target Profit Unit
Contribution Margin
Graphic Approach to Cost-Volume-Profit Analysis Cost-volume-profit analysis can be presented graphically as well as in equation form. Many managers prefer the graphic form because the operating profit or loss for different levels of sales can readily be seen.
Cost-Volume-Profit (Break-Even) Chart, sometimes called a break-even chart, graphically shows sales, costs, and the related profit or loss for various levels of units sold.
It assists in understanding the relationship among sales, costs, and operating profit or loss.
The cost-volume-profit chart in Exhibit 5 is constructed using the following steps: Step 1. Volume in units of sales is indicated along the horizontal axis. The range of volume shown is the relevant range in which the company expects to operate. Dollar amounts of total sales and costs are indicated along the vertical axis. Step 2. A sales line is plotted by beginning at zero on the left corner of the graph. A second point is determined by multiplying any units of sales on the horizontal axis by the unit sales price of $50. Step 3. A cost line is plotted by beginning with total fixed costs, $100,000, on the vertical axis. A second point is determined by multiplying any units of sales on the horizontal axis by the unit variable costs and adding the fixed costs. Step 4. The break-even point is the intersection point of the total sales and total cost lines. A vertical dotted line drawn downward at the intersection point indicates the units of sales at the break-even point. A horizontal dotted line drawn to the left at the intersection point indicates the sales dollars and costs at the break-even point. Operating profits will be earned when sales levels are to the right of the break-even point (operating profit area). Operating losses will be incurred when sales levels are to the left of the break-even point (operating loss area). Changes in the unit selling price, total fixed costs, and unit variable costs can be analyzed by using a cost-volume-profit chart. A second point is determined by multiplying any units of sales on the horizontal axis by the unit variable costs and adding the fixed costs.
Profit-Volume Chart Another graphic approach to cost-volume-profit analysis is the profit-volume chart. The profit-volume chart plots only the difference between total sales and total costs (or profits). In this way, the profit-volume chart allows managers to determine the operating profit (or loss) for various levels of units sold.
The profit-volume chart is constructed using the following steps: Step 1. Volume in units of sales is indicated along the horizontal axis. The range of volume shown is the relevant range in which the company expects to operate. Its dollar amounts indicating operating profits and losses are shown along the vertical axis. Step 2. A point representing the maximum operating loss is plotted on the vertical axis at the left. This loss is equal to the total fixed costs at the zero level of sales. Step 3. A point representing the maximum operating profit within the relevant range is plotted on the right. Step 4. A diagonal profit line is drawn connecting the maximum operating loss point with the maximum operating profit point. Step 5. The profit line intersects the horizontal zero operating profit line at the break-even point in units of sales. The area indicating an operating profit is identified to the right of the intersection, and the area indicating an operating loss is identified to the left of the intersection.
Operating profit will be earned when sales levels are to the right of the break-even point (operating profit area). Operating losses will be incurred when sales levels are to the left of the break-even point (operating loss area).
Changes in the unit selling price, total fixed costs, and unit variable costs on profit can be analyzed using a profit-volume chart.
A revised profit-volume chart is constructed by plotting the maximum operating loss and maximum operating profit points and drawing the revised profit line. The operating loss area of the chart has increased, while the operating profit area has decreased.
Use of Computers in Cost-Volume-Profit Analysis With computers, the graphic approach and the mathematical approach to cost-volume-profit analysis are easy to use. Managers can vary assumptions regarding selling prices, costs, and volume and can observe the effects of each change on the break-even point and profit. Such an analysis is called a “what if” analysis or sensitivity analysis.
Assumptions of Cost-Volume-Profit Analysis Cost-volume-profit analysis depends on several assumptions. These assumptions simplify cost-volume-profit analysis. Since they are often valid for the relevant range of operations, cost-volume-profit analysis is useful for decision making.
The primary assumptions of cost-volume-profit analysis are listed below. 1. Total sales and total costs can be represented by straight lines. 2. Within the relevant range of operating activity, the efficiency of operations does not change. 3. Costs can be divided into fixed and variable components. 4. The sales mix is constant. 5. There is no change in the inventory quantities during the period.
Special Cost-Volume-Profit Relationships Cost-volume-profit analysis can also be used when a company sells several products with different costs and prices. In addition, operating leverage and the margin of safety are useful in analyzing cost-volume-profit relationships.
Sales Mix Considerations Many companies sell more than one product at different selling prices. In addition, the products normally have different unit variable costs and thus different unit contribution margins. In such cases, break-even analysis can still be performed by considering the sales mix. The sales mix is the relative distribution of sales among the products sold by a company.
The sales mix could also be expressed as the ratio 80:20. For break-even analysis, it is useful to think of Products A and B as components of one overall enterprise product called E. The unit selling price of E equals the sum of the unit selling prices of each product multiplied by its sales mix percentage. Likewise, the unit variable cost and unit contribution margin of E equal the sum of the unit variable costs and unit contribution margins of each product multiplied by its sales mix percentage. The effects of changes in the sales mix on the break-even point can be determined by assuming a different sales mix. The break-even point of E can then be recomputed.
Operating Leverage The relationship of a company’s contribution margin to income from operations is measured by operating leverage. A company’s operating leverage is computed as follows:
Operating Leverage= Contribution Margin
Income from Operations
The difference between contribution margin and income from operations is fixed costs. Thus, companies with high fixed costs will normally have a high operating leverage. Examples of such companies include airline and automotive companies. Low operating leverage is normal for companies that are labor intensive, such as professional service companies, which have low fixed costs. Operating leverage can be used to measure the impact of changes in sales on income from operations. Using operating leverage, the effect of changes in sales on income from operations is computed as follows: Percent Change in Income from Operations= Percent Change in Sales X Operating Leverage
The impact of a change in sales on income from operations for companies with high and low operating leverage: Operating Leverage HIGH % on Income from Operations from a change in sales LARGE. Operating Leverage LOW % on Income from Operations from a change in sales SMALL
Margin of Safety indicates the possible decrease in sales that may occur before an operating loss results. Thus, if the margin of safety is low, even a small decline in sales revenue may result in an operating loss. The margin of safety may be expressed in the following ways:1. Dollars of sales 2. Units of sales 3. Percent of current salesMargin of Safety= Sales – Sales at Break-Even Point
Sales