The various scholars have developed scientific concepts and techniques of accounting for analysis of financial performance of the business. With the help of these concepts and tools, managers can make effective decisions for their business. They need deep knowledge of the methodology and subject to evaluation and adoption of the methods. This study is presented to provide understanding that how key areas of strategic management accounting are applied in practice. It provides wide knowledge of various financial and accounting aspects such as concept of return on investment, economic value added and costing methods. It gives detail analysis of economical and accounting tools and approaches for different business environment.
Return on investment: It is the concept of an investment of some resource yielding a benefit to the investors. This tool helps in evaluating and analyzing the feasibility and viability of investment option. It is a performance measurement technique to evaluate the efficiency of an investment and companies can compare the effectiveness of a number of different investments options. Investors can calculate return in percentage terms with the help of ROI to make effective decisions of investment (Asteriou and Begiazi, 2013). To calculate ROI, the return on an investment is divided by the cost of the investment which can be explained in the form of formula such as follows.
It is very popular approach because of its simplicity and versatility. A high ROI means the investment gains compare favorably to investment cost. If an investment does not have a positive ROI, then the investors should not undertake the option. They should find out other opportunities with a higher ROI. The return on investment when expressed in percentage terms helps in evaluating and judging capacity of the option to earn profits. It is very simple and easy approach of decision making. It is very useful in selection of the best project from available all options. Projects are priorities on the basis of their ROI and project which has higher ROI will be selected for investment (Brammer and Penning, 2007).
Economic value added: It is the approach which emphasizes on estimation of economic earnings. It is a measurement tool of the company which measures company's financial performance based on the residual wealth computed by deducting cost of capital from its operating profit. It provides a true economic profit of the company to investors. It is a novel term coined in current market as a result of increasing requirements of trade units in earning profits above the needed rate of return. Economic profit means, the value that an enterprise is able to create above a line of required return by the business. This concept is used to find out a profit that is above the cost of capital involved due to this reason; investors are interested in this subject (Brás and Rodrigues, 2007). Following is the formula of calculation of EVA (Economic Value Added).
It is very helpful formula to determine capability of trade to generate profits above the minimum rate of return. It can be used to motivate the investors of the company. With the help of calculation of the EVA, it can be said that the venture which is capable to generate profit higher than cost of capital tends to be profitable in nature. Organizations are responsible in judging capability of investment alternative to create cash inflows (Cafferky, 2010).
The above concepts helps management decision making in short term and emphasizes on feasibility of investment choice for short and medium term. Return on investment approach highlights on evaluation of single investment decision. The managers while making investment decisions have short term viewpoint in mind. It means, they tend to evaluate return which is going to be earned in forthcoming five to six years. ROI is the techniques which emphasizes on identification of short term requirements for making decisions. In this method, performance of business can be evaluated on the basis of return earned on capital employed (Edwards, Boyns and Matthews, 2002). It helps managers in analyzing future investment options also. The investment choice which is able to generate positive ROI in future can be considered to be of profitable in nature. Investors should invest their money in the alternative which has higher and positive ROI. This approach is based on concept that long term objectives can be achieved with the help of short term goals. It helps in identification of immediate return which enterprise is capable in generating through funds investment. Rate of investment is the basic term of formulation of management policies and decisions. They are interested to know the rate of return earned by the unit in near future. The Future course of action of the business is depending on the returns of the trade. Whole strategies of the company are formulated on the basis of investment returns. Management emphasizes on instant result of investment decision it is trough ROI which organization is capable to guide its future course of action (Helgesen and Voldsund, 2009).
Another approach of business is Economic value added which is one of the modern concept developed to overcome the limitation of traditional approaches. It helps to determine value created by the investment choice in true sense. Economic value can be defined as worth of economic resources. It helps in identifying capability of business to reduce or increase overall value or worth of it. Investment decisions should be based on capability to generate profits above the cost of capital. With the help of this approach, businesses are able to pay its cost of capital. The approach since engages managerial decision that is to be supported creation of cash in short time period. It is interested in computation of economic earnings that is also accounted for annual or half or quarter basis. So, it can be said that the concept to ascertain economic value is also based on short term perspective of business (Hill and Clarke, 2013).
Long terms objectives can be achieved by the short term goals of the business. Investors require finding out their short term goals then they can achieve long term objectives with operation excellence. But success of business, it is essential to overcome the short term viewpoint by way of accepting techniques that judges or evaluates long term feasibility or viability of investment decisions. Organization has many other indicators of performance which can be used with ROI and EVA for decision making such as investment appraisal analysis and ratios analysis (Implementing Activity-Based Costing. 2006). These techniques can provide many other hide information of investment options. In the short term ROI and EVA are necessary to measures performance and feasibility of the scheme of investment. However, analyzing trade performance to earn profit in long term is also vital aspect. The organization must foresee its long term goals and objectives. The investment option which can give return for long duration of time should be preferred by the business. They have to find out profitability that is associated with investment option through estimation of cash flow and discounted cash flow of the choice. Companies need to focus on long term objectives to emerge as a successful and leading organization within the industry and market. Finally, it can be said that long term perspective helps in achieving overall objectives of an enterprise (Kinney and Raiborn, 2012).
It is important for the organization to estimate or calculate cost of each unit of products or service. There are various methods of costing available with the business to measure total cost of production and per unit cost of particular good. They can allocate cost to each unit produced by adopting ranges of method or approaches of costing. The different methods of costing are building up as to get better efficiency and effectiveness of improving calculating cost of production within the trade unit. The following three approaches of costing are playing crucial role in the cost calculation (Nsthummar. 2012).
Marginal or variable costing: It refers to additional expenditures which are incurred with production of one extra unit of product. Marginal costing is the variable cost that is associated with manufacturing of goods. According to this approach of costing variable expenses are charged to single unit of production whereas fixed expenditures are charged to the period in which it is going to written off. In simple words, variable costs are involved in production of the product based on particular product. The following diagram shows the allocation of cost as per the marginal or variable costing (Portz and Lere, 2010).
According to above figure, it can be said that majorly there are two types of costs involved in the business such as non manufacturing and manufacturing expenditures. Manufacturing cost is the cost which is directly connected with the production of goods and services. Non manufacturing expenses supports trade operations but are not directly associated with the production process (Vanderbeck, 2012). As per the marginal costing concept all the variable expenses including direct labor, material and overheads are the part of product cost. These products costs are then distributed to whole production as expenditure of products manufactured to determine cost of each unit of good. So it can be said that fixed and overheads expenses are part of period costs. The period costs are the expenses which are estimated tends to be accounted for in gains and losses account. Henceforth, as per the variable costing it can be said that only variable expenses are considered for ascertainment of cost of each unit of product (Vij, 2008).
Full or absorption costing: This method uses the total direct costs and overhead costs associated with manufacturing a product as the cost base. It is also known as full absorption costing. It helps in computation of unit cost of goods and services by including both variable and fixed expenditures as a part of product cost.
It is clear that absorption costing approach takes into concern both fixed and variable expenses of manufacture while calculation unit cost of product. The variable and fixed cost and overheads are allocated to total production of the business. After that, unit cost of production can be calculated by dividing total cost of production from number of total units manufactured by unit. According to this concept, total cost of manufacturing is considered in the income statement as direct costs. Non operating expenses are recorded as indirect expenditures in income statement of business. This method uses both variable and fixed cost as a part of production costs (Asteriou and Begiazi, 2013).
Activity based costing: It is the modern approach developed to overcome disadvantage of traditional concepts of costing. As per this method, costs are segregated on the basis of different activities involved in the business like machining, coloring etc. Thereafter, real cost of unit manufactured is ascertained by finding out various activities involved in its production. Following diagram can explain the ABC clearly (Brammer and Penning, 2007).
It is the scientific and best method of the calculation of per unit costs which helps in ascertainment of unit cost of product in more logical manner. It is helpful tool of cost controlling by dividing manufacturing in the various activities. It is very easy and helpful in assignment of appropriate and accurate expenses to each job of product. This approach is very important in pricing policy making process. With the help of this technique company can clearly distinguishes the product which involves large amount of expenses and efforts from one with involvement of little amount and efforts. They can easily allocate indirect costs to unit cost of good. It is very effective method because it reduces all limitation of classical methods of costing (Brás and Rodrigues, 2007).
Followings are some example of different situations in which different costing methods need to be adopted by the organization.
Marginal costing method can be applicable in the case where enterprise needs to decide the suitable selling price which can be fixed to generate desired profit. For example, the company Royal ltd. incurs Rs. 150,000 as fixed cost and variable cost of Rs. 20 per unit. The business unit has breakeven point of 15000 units. Now, the company wants to earn profit margin of 20% on sale of break even units. It can be possible by application of variable costing method as calculated below (Cafferky, 2010).
As per the computation presented above, the company can charge Rs. 37.50 price to earn profit merging of 20%. It is very good method of deciding future course of action on the basis various costs. In the given case other approaches of costing cannot be applicable due to inclusion of fixed cost in product cost will result in overpricing of goods or services. It is only way to design effective pricing policy in the business to face high competition in the market. In the example there is no activities of production so managers cannot use activity based costing in this case. But they can use variable costing method in calculation expected selling price because marginal profit is given in the case. Decision making regarding pricing can be effective with the help of marginal costing technique. Company can make long term plans also on the basis of these kinds of calculation. There are various situations and scenarios in the business where they can consider marginal costing concept for pricing (Edwards, Boyns and Matthews, 2002).
Suppose the company Suns Ltd. is engaged in production of two type of goods such as product A and Product B. They can produce both products with the help of similar machinery. Manufacturing process involves different phases for producing different types of products. Product A requires less number of machine hours because it passes through first three stage of production only. However, Product B needs more number of machine hours because it requires to pass through five phases of manufacturing process. Now, the organization required to find out cost involved for manufacturing each of its products (Hill and Clarke, 2013).
In the above situation, associate can use activity based costing to find out unit cost of production because production process are divided in many phases. So, different phases can be considered as set of activities involved in manufacturing process. The labors and machine hours invested plus cost of materials needed during each activity should be estimated. It will help in calculation of accurate cost of each unit of goods or services. Marginal costing method and absorption costing tool cannot be applied in this case because they are not suitable for this type of case. This is due to reason that if total cost of production is assigned to both Product B and A; it will result in overpricing of product "A" and lesser cost for Product "B". It will affect the pricing policy of the business. Finally, Company must adopt ABC method in this case (Implementing Activity-Based Costing. 2006).
The above report provides wide knowledge regarding various economic and accounting concepts. The first part of the study deals with concept of Economic value added and Return on Investment concept of investment decision making. It is concluded that both of the approaches take short term opinion into consideration. In the second part kinds of costing tools are presented which can be applied in various business scenarios.