To: The Board
Date: 22 January 2021
Subject: Accounting and Management Issues at NewTech AG.
Several issues are recognized at the NewTech AG. This report will analyze those issues briefly and project a suitable solution for these problems and issues at hand. These issues include the need for the management accounting for the decision making and control, the nature of costs at the firm and the cost-volume-profit analysis, the issue of the opportunity cost of capital and capital budgeting, organizational architecture and responsibility accounting, particularly how to achieve goal congruence, budgeting and the management accounting in Changing environment.
Managerial Accounting: Decision Making & Control And Changing Environment
It seems that the accounting and the reports done at the NewTech AG are only financial accounting-based and there is no management accounting setup in the company. Financial accounting is different from management accounting in the sense that financial accounting is mainly done for the outside users whereas management accounting is done for the internal users to support the decision making. While there are certain legally required formats and requirements for financial reporting, there is no such requirement for management reporting and the reports are generated in the formats required by the management. Financial accounting is backward-looking and reflects history whereas, management accounting is forward-looking and that is why they support the decision making. Moreover, due to being forward-looking and flexible, they can help the management not only in better control of the situation but better decision making, particularly in the rapidly changing environment(Robinson & Robinson, 1986).
As only financial accounting is done at eh NewTech AG to fulfill the auditor’s needs and corporate reporting requirement, the managers are justified in complaining that they are not getting the reports to support the control and decision making and are not forward-looking to help in control and the changing environment. Rather they report what happened in the past(Müller et al., 2020).
The company is urgently required to hire a qualified management accountant as part of the management team so that he or she can prepare reports following the management needs. Moreover, as already described, the company needs a management accountant system following the needs of the management from the other departments. The finance department needs to work following the requirement of the overall management in terms of management accounting. That is what is lacking here in the organization. In this regard, Annett is wrong in launching a standalone system. Rather, the company needs a management accounting system, and it should be developed and implemented following the requirements of the whole management.
The Nature of Costs And Cost-Volume-Profit Analysis
The costs are mainly of two types, variable and fixed. Although costs can be mixed as well, in the case of CVP analysis, a clear distinction between variable and fixed is made. Fixed costs are those that remain fixed despite the change in volume of sales like depreciation, line rent of landline, and so on. On the other hand, variable costs are such that change with the volume of sales like raw material costs, the variable part of electricity bill, and so on. Unfortunately, the data handed over by Annett is suitable is for financial reporting purposes and the report is not that useful for the management accounting purpose as the clear distinction in the variable and fixed costs are not made. However, it is assumed that cost of goods sold is only a variable cost and all the fixed costs are accumulated in the overhead. In this way, it is assumed that the income statement presented is a CVP statement.
The break-even analysis is given below,
It is evident from the above analysis that the sales are fixed but the cost of goods sold, or variable costs are increasing by 2% in each of two previous years. However, even if it is assumed that the cost of goods sold will not increase as a percentage of sales, still the contribution margin will be 34% in 2021, the same as in 2020. It is not clear if the company can increase its sales price by 205 and without impacting the sales level. If it is assumed that the revenue is inelastic and will not be impacted by the increase in sales price by 20%, then a 20% increase in sale price will yield an additional profit of 93,221 (93221 *5*20%) considering the sales will not increase next year. However, if the sales increase at the same rate as in 2020, that is by 202%, then the additional profit would be 187,960 (93221*202%). However, the given profit and loss statements don’t include income tax expense which is perhaps 25% as provided in the capital budgeting analysis. In that case, an increase in profit would be net off by 25%.
The breakeven point is the level of sales at which total revenue is equal to total costs and hence the company makes no profit and no loss. As evident from the above calculation, the company’s breakeven point is increasing year on year and become more than double in 2020 as compared to 2018 due to the increased cost of goods sold per unit. However, the company’s sales are very high and so there is a very high margin of safety to worry about making any loss.
Any pricing decision can only be made after the market survey. Therefore, a market survey is suggested to know if a price increase would result in better profits and not a decline in the profits as expected at the current price. This is because the products sold by the company are not necessities and so a price increase would most likely result in decreasing sales. So final decision should be taken only after input from the marketing team.
There are other ways to increase the profits as well. As the sales are rising, so is the cost of sales. It shows that perhaps the company is not getting the benefits of economy of scales due to bulk purchase and higher production level. A company can negotiate better with the suppliers to ensure better prices. Moreover, the company can also increase automation to save on labor costs and thus increase profits without changing prices.
Opportunity Cost of Capital and Capital Budgeting
Capital budgeting is a lot of complex things rather than just number crunching. Although the expected sales value can be provided through a marketing survey, however, there are other important things as opportunity cost and applicable cost of capital. The opportunity cost of the project is the next best alternative for which those resources can be used(Pierru&Babusiaux, 2000). For example, for the proposed software project, the required 450K. This amount can be used in increasing automation or perhaps upgrading machinery to increase production or saving on the costs. A thorough analysis of the available options needed to be considered.
Then, another very important factor in capital management is the cost of capital. In this case, it is assumed that the cost of capital will be 10%. However, it is not evident whether it is the weighted average cost of capital of the cost of new finance arrangement for the project. The cost of capital should be ideally the actual cost of financing a project. So, if the project is being financed with the current resources, then the weighted average cost of capital will be the best estimate. However, if the new loan is being acquired or new equity is going to be issued, then the relevant cost should be considered(Pierru&Babusiaux, 2000).
the current project has an IRR of 16.5% and an NPV of 112146 which means the project is feasible. However, the project is highly sensitive to several assumptions. It is assumed that the sales will increase by 100% every year for the five years. However, if the sales increased by less than 86%. The project will make a loss.
Then, if the cost of capital, the discount rate increases to 1%, it would result in again a negative NPV and thus a loss for the firm. However, the project is not that much sensitive to the tax rate, and even if the tax rate increases by 45%, the project will still be profitable. Thus before making any decision a marketing survey should be carried out. Moreover, the financial arrangement for the project should also be reviewed for the cost of capital. Moreover, other projects should also be considered.
Organizational Architecture and Responsibility Accounting
The company is so far in the startup mood but growing rapidly. Last year, the revenue grew by over 200% and so as the costs. Some managers seem to be concerned only with their performance. The organization structure needs revamp for success, but the top management needs to focus on goal congruence, that is aligning the goals of the employees with that of the organization. In other words, a win-win situation needs to be created here. In this regard, the organization needs to develop responsibility accounting. The responsibility accounting system is constructed in order to announce and to collect costs by individual levels of responsibility. There are different supervisory areas in an organization and every supervisory area can be given a fixed amount of cost for which that particular manager would be responsible and over which he or she or the whole department can be disciplined.
Responsibility centers can be mainly divided into four main centers that are cost center, revenue center, profit center, and investment center. So that, each department can be given responsibilities according to what is under their control and then, at the period end or even during the period, the actual results can be compared with the standard data to know if the results are favorable or unfavorable. Responsibility accounting can be used to find the causes of such variations and hence tried to improve the performance. The board and the top management can also determine the responsibility of each manager in order to achieve his or her attainable goals in the company. (P.Muthulakshmi, 2012)
The responsibility accounting system must be so designed as to suit the organization. The responsibility accounting system should be in parallel to the organization structure and needs to provide financial information to evaluate the actual results of each individual responsible for a particular function(Roodhooft, 1995).
All organizations are made up of people and resources that are there to accomplish a particular goal, which is economic for the business organizations like the NewTech AG. It is the organizational planning that decides how the different elements of the organization would work together in order to achieve the overall goals of the organization. The lines of the authority are required to be fully defined before the implementation of the responsibility accounting system. When the responsibilities and powers are determined, there would appear a certain level of management structure where each department or responsibility center would make a sphere of responsibility within which concerned individuals would make the decisions for which they would in the end be responsible. Thus a credible organizational structure is highly important in this regard(Roodhooft, 1995).
NewTech has to date done a very limited “top-down” budget every year. This year, in line with the board’s request that the business is “set-up for success”, the Chairman has suggested that a new budget process be launched involving senior & middle managers in the process. This is a very good idea to link performance targets directly to the budget. It will help to achieve the much-needed goal congruence. This is because a budget is a document that defines the performance objectives for each department. If a budget is fair and then linked to the performance targets that are achievable while also linked to the personal success of an individual in the organization, people would try hard to achieve those targets. In this way, all departments will work for mutual success which is highly important as it seems that so far each department is working for itself like sales and finance department where salespeople are concerned with sales only and the finance manager is planning to buy a standalone system that can fulfill the requirements of the finance department only.
NewTech has progressed greatly in the last three years. However, the costs are also rising rapidly. Although overhead cost is still justifiable direct costs should be saved due to economies of scale impact. The company also needs a management accounting system so that managers can get the requirement they needed. A market survey should be done as well as an evaluation of other possible projects before embarking on the 450KIT project. Company employees need budgets and responsibility accounting to become a high performing team.
Müller, W., Kuznetsova, A., Karpachova, О., Khrystoforova, O., &Sulima, M. (2020). ACCOUNTING AND AUDITING ACCORDING TO INTERNATIONAL STANDARDS AS A MANAGMENT FUNCTION. Financial And Credit Activity: Problems Of Theory And Practice, 4(35), 60-68. https://doi.org/10.18371/fcaptp.v4i35.221787
P.MUTHULAKSHMI, P. (2012). Examining The Role of Responsibility Accounting in Organizational Structure. International Journal Of Scientific Research, 3(4), 1-3. https://doi.org/10.15373/22778179/apr2014/209
Pierru, A., &Babusiaux, D. (2000). Capital Budgeting and Cost of Capital: A Unique Formulation of the Main Investment Decision Methods. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.233120
Robinson, L., & Robinson, L. (1986). Increasing Small Business Profit by Use of Managment Accounting Techniques. The Journal Of Cost Analysis, 3(1), 63-71. https://doi.org/10.1080/08823871.1986.10462350
Roodhooft, F. (1995). Responsibility accounting: a dynamic multiple agent approach. European Accounting Review, 4(3), 583-584. https://doi.org/10.1080/09638189500000038
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