Business trends in the corporate world are always changing. Some of the factors that impact on firms include economic decline, change in consumer preferences, and level of competition. To keep up with the changes in the business environment and maintain a competitive advantage, it is important for companies to regularly make fundamental and strategic appraisals of their operations (Smart, Awan & Baxter 2013).
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In this paper, the author will provide a proposal for the management of Central World (WC) Products Plc. (HK). The suggestions will focus on costing systems, profitability analysis, and strategic assessment. The cost accounting system framework will be used to estimate the price of different products for profitability evaluation, inventory appraisal, and expenditure control. Profit analysis will be carried out by looking at the four levels of proceeds margins. The four include gross, operating, pre-tax, and net profit levels. The strategic assessment will be used to provide the management of Central World with analysis and guidance on the best alternatives available to help the company to start trading again.
Proposed Cost System, Profitability Analysis, and Strategic Appraisal
Profitability and Sales Outlets
Differences between strategic and traditional management accounting
Management accounting is the process of preparing executive accounts and reports. The reports provide companies with accurate and timely information required to make both long term and short term decisions. The information can be statistical, financial, or non-financial. Gilkar (2007) is of the opinion that the process is crucial to the implementation of the best organizational strategies. Compared to financial accounting, management entails the creation of monthly reports for the internal stakeholders of a company.
The stakeholders include department managers and chief executive officers. The reports presented to provide information on the sales revenue generated, raw material and inventory, variance analysis, as well as the available cash. Other data shown include states of accounts payable and accounts receivable, trend charts, and the number of orders in hand (Gilkar 2007). According to Bhimani et al. (2015), there are two forms of management accounting. The two are traditional and strategic accounting. The two differ from each other in a number of ways.
Traditional management accounting involves the evaluation of business performance based on long-established systems and standards. The practice is beneficial to companies that offer a narrow range of goods or services. In addition, the approach is used by businesses that do not require custom designs. Warren, Reeve, and Duchac (2011) observe that traditional management accounting focuses on cost reporting and utilization of fixed assets. Some of the primary concerns associated with the practice include ineffective and imprecise performance measurement of organizations carrying out activities in non-conventional means.
On its part, strategic management accounting focuses on merging organizational goals with other relevant business information. The aim is to provide an appropriate model to help company managers to make suitable business decisions (Warren, Reeve & Duchac 2011). The approach also analyses external information on the impact of resources, costs, market share, prices, and cash flow (Horngren, Harrison & Oliver 2008). The evaluation helps managers to determine the best tactical response to given business situations.
Other differences between traditional and strategic management accounting systems are in terms of reporting units, the approach used in cost and profitability analyses, performance appraisal, and ownership. On the basis of the strategy used in cost and performance appraisal, for example, traditional management accounting uses ex-post control. It achieves this through product costing systems, monthly departmental budgets, and period based manufacturing expenditure. In addition, performance appraisal is conducted on a monthly basis. On its part, strategic management accounting uses the ex-ante control-based methodology and life-long outlays to analyze cost (Bhimani et al. 2015). In addition, performance evaluation is carried out on the basis of three or six-monthly multi-dimensional reviews.
Expected profitability: Computations
The calculations used to show the expected profitability of the different types of Central World’s sales outlets for the coming year will be based on activity-based costing (ABC). The reason for using this methodology is that ABC provides companies with important information on cost drivers and activities carried out by the business. In addition, the approach provides vital information on the relationship between clients, markets, costs, and products.
Profitability analysis of CW’s outlets and shops
The table below shows calculations aimed at determining the outlets that make the most profits for CW:
Table 1: Profitability of outlets.
|Profits in departmental stores and own shops|
|Item||Department stores||Own shop||Total|
|Cost of sales||$ 10,000||$150,000||160,000|
CW has a known overhead cost of $200,000. The cost needs to be allocated to all the outlets to get a complete view of the profitability.
The table below shows the calculations for apportioned overheads:
Table 2: Apportioned overheads.
|Item||Department stores||Own Shop||Total|
|Costs of sales||$ 10,000||$150,000||160,000|
|Overheads||$200,000||$ 80,000||$ 120,000||200,000|
|Profit / Loss||-$40,000||$730,000||770,000|
The calculations show that there is a need to allocate overhead costs more fairly to determine the correct expected profits. To ensure proper allocation, CW should determine what makes some outlets costly to deal with compared to others. Some of the factors could be the way the personnel working in these outlets interact with customers and the expenses used in order systems. Such expenses include post, telephone, and internet. For example, if it takes half as many posts, internet, and telephone expected to make orders in department stores outlets, the focus should be on determining how to reduce the costs. In addition, if customers in CW’s shops place more orders compared to those from departmental store outlets, their own shops should get the largest share of the cost of processing orders.
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Calculation of total activity cost
The next step of calculating the expected profitability of the different types of sales outlets for the coming year will involve determining the total activity cost by each task. The duties carried out by CW to effectively serve the clients include making sales calls, processing orders, picking and packing, shipping, and making credit control calls.
The table below shows total cost by activity:
Table 3: Total cost by activity.
|Activity||Total Activity Cost|
|Make sales calls||5850|
|Pick and pack||17,800|
|Make credit control calls||1500|
The company has a total of 15 stores and shops. As a result, the total activity cost by task for the firm is 29150 × 15 = $437250. After getting the cost of each activity performed by CW, the cost of each product and client contribution can be calculated using the second principle of activity-based costing. There are two different types of outlets for CW. As a result, activity costs should be split evenly between all the shops. The measure to be used will be activity drivers.
The final step will entail calculating the expected profitability of the outlets by combining the total activity costs with contribution expenses from table 1. The table below shows the expected profits and loss by outlet:
Table 4: Expected profits and loss by outlet.
|Department Store||Own Shops||Total|
|Cost of sales||$ 10,000||$150,000||160,000|
|Cost to serve||25,000||200,000||225,000|
Comments on the results and figures obtained
A number of findings were made from the calculations of the expected annual earnings in relation to the profitability of CW. In terms of profit margins, for example, the computations show that CW’s total earnings will be $665,000. In addition, the calculations show that CW’s own shops will generate more profits at the end of the coming financial year compared to the departmental stores. In terms of cost allocation, CW’s own shops will require more expenses for processing orders and making deliveries. The reason is that the shops receive more customer orders.
Importance of the Profitability Analysis
Usefulness and limitation of the profitability analysis
Profitability analysis allows business managers to predict the success of a proposal or optimize the gains of an ongoing project (Gilkar 2007). In addition, the evaluation is used to anticipate potential sales and profits specific to given aspects of the business. Such items include geographic regions, customer preferences, and product types (Bhimani et al. 2015).
The information generated through profitability analysis will help Central World (CW) in a number of ways. For example, it will help the management to increase the annual revenues of the organization by attracting more clients. Profitability analysis enables companies to set prices for various products. Amending prices and making them affordable will prompt more clients to seek the firm’s goods and services (Drury 2007). As a result, the sales department will focus on retaining customers who have reasonable demands and value and who are willing to pay for the company’s products.
The profit analysis will also help CW to determine the most and least profitable products. The company provides clients with high-quality gifts and household products. The products generate varying amounts of revenue for the company annually. Through profit analysis, CW will be able to determine that products that are in high demand in the market (McLaney & Atrill 2012). Such items can generate huge profits for the company if sold well. In addition, CW will be in a position to determine the products to be sold and to be bought in large quantities.
The information generated by the profitability analysis will help CW to optimize its responses to changing customer needs. The preferences and wants of the consumers are constantly evolving (Warren, Reeve & Duchac 2011). As a result, it is important for companies to keep track of the changes. Failure to meet the new demands and preferences lead to loss of competitive advantage and reduced revenues. One of the factors associated with the change in needs includes the technological advancement of a current product. Another importance of the profitability analysis information to CW is that it will help the company to evolve its mix of products and maximize its medium and long term earnings
Limitations of profitability analysis
Some of the probable limitations of the profitability analysis include timing, risk, and value problems. The timing concern is brought about by the fact that CW may sacrifice some of its current earnings while anticipating future revenues. The case is evident when a company wishes to introduce a new product that requires high start-up expenditure in the market. Profitability analysis entails calculating Return on Common Equity (ROE). Smart, Awan, and Baxter (2013) note that ROE captures the profits of one year only. As a result, the analysis may fail to provide full information on the effects of long-term decision making.
Another probable limitation of the profitability analysis is the failure to state the risks taken by CW to generate its total ROE. The reason is that, at times, the approach focuses on profits without putting into account risks. As a result, the process can generate inaccurate information on expected financial performance (Drury & Tayles 2006).
Another limitation of the profitability analysis is the misinterpretation of information and future business trends. The issue is linked to the value problem. Profitability evaluation that focuses on ROE analyses return on investment using the information in book value and not market worth (Bhimani et al. 2015). Due to the differences between the two components, a high rate of equity may not lead to increased revenue on investment for stakeholders and the entire company.
Other important information about the company
Additional information about CW is needed to make an informed judgment about the fundamental and strategic appraisal of the business. The factors to be taken into consideration include liquidity, efficiency, profitability, and leverage ratios.
Liquidity cost calculation is an approach used to measure the amount of monetary and easily converted assets that are needed to cover debts and provide a broader picture of the business and its financial situation (McLaney & Atrill 2012). If CW fails to realize enough sales, it may be unable to meet its financial commitments. Liquidity costs can avert this problem through current and quick fraction calculations.
By analyzing CW’s current costs, one is able to determine whether or not the company is capable of generating enough revenue to meet its short term financial obligations. On its part, the quick costs will measure CW’s ability to access money on a timely basis to support the immediate demands aimed at making the company more profitable. The computation of a quick ratio involves dividing the current assets with the liabilities (Gilkar 2007). Based on the trends in the industry within which CW is operating, a ratio of 1.0 or higher will be a sign that the firm is in a good position to meet its demands, make huge profits, and maintain a competitive advantage. As a result, CW must work to ensure that its cash is not underutilized. To avoid underutilization, the company can invest more in other projects.
Efficiency is calculated over a 3 or 5 year period. The computation is used to forecast the performance of specific areas of the business, such as operational results. Drury (2007) notes that the approach uses inventory turnover calculations. The analysis of efficiency ratios will provide information on how long it will take for the company’s products to be sold and replaced in the coming financial year.
The calculation will entail dividing total purchases with the average stock at a given time. Assessing inventory turnover has a number of benefits for a business. In CW’s case, for example, information on supply turnover will help the company to increase its profits each time goods are sold at the right prices and replaced on time. In addition, management will be able to improve the company’s buying practices and stock management. Information on turnover can also help in making informed decisions by determining the inventory networking capital ratio.
The average collection period provides important information about CW and its sales. The data will be needed to make informed choices. The evaluation of collection duration provides companies with the average number of days that clients take to pay for their products (Horngren, Harrison & Oliver 2008). The period will be determined by dividing receivables with total sales and multiplying the result by 365.
Information on the types of customers in all the sales outlets will help in making informed decisions about the fundamental and strategic appraisal of CW. Smart, Awan, and Baxter (2013) note that all customers are not equal. Some clients generate positive net margins compared to others. In addition, some customers are high maintenance. As a result, they are not profitable for the company in any way. Information on clients will help the management make informed choices by focusing on a new customer base and getting rid of those costing the business money. Eliminating such clients will help CW to focus on more profitable customers in its sales outlets. It will also help the company to address the gross margin concerns.
Profitability analysis is important for every organization. The reason is that the evaluation helps companies to identify those business areas that are performing well while finding solutions for those that are failing. The analysis carried out on CW will help the company to develop the appropriate strategies to improve its profitability. It will also make it possible for managers to make informed choices, which are required for the company to continue trading.
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Drury, C & Tayles, M 2006, ‘Profitability analysis in UK organisations: an exploratory study’, The British Accounting Review, vol. 38, pp. 405-425.
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Gilkar, N 2008, Profitability analysis: an exploratory study, Atlantic Publishers & Distributors (P) Ltd., New Delhi.
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McLaney, E & Atrill, P 2012, Accounting: an introduction, 6th edn, Pearson, Harlow, England.
Smart, M, Awan, N & Baxter, R 2013, Principles of accounting, 5th edn, Pearson New Zealand, New Zealand.
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