SBL

Financial Analysis

Tools of financial analysis that can be used to evaluate opportunities and determine whether they are
financially beneficial or not

Knowledge from earlier exams

Advancements in technology mean that accountants are expected to:

Understand and interpret information in a wide range of formats ( published F/S, budget reports, KPIs,
investment appraisals)

Understand the links between different types of information and its impact on the organization

Use management accounting techniques to support decision making (using financial and non- financial

information) SBL: students should be able to analyze numerical and descriptive information and

draw appropriate conclusions

Financial factors to be considered while assessing strategy

Financial Risk: These are the risks which arise from the way a business is financially structured, its management
of working capital and its management of short and long-term debt financing. Cash flow can be strongly
influenced by how much debt to equity a business has, its need to service that debt and the rate at which it
is borrowed. Likewise, the ability of a business to operate on a day-to-day basis depends upon how it
manages its working capital and its ability to control payables, receivables, cash and inventories. Any change
which makes its cash flow situation worse, such as poor collection of receivables, excessive borrowing, increased
borrowing rates, etc., could represent an increased financial risk for the business.

Financial Return: Analysis of returns can be done through approaches like ROCE, NPV analysis, IRR and
payback.

Funding: organizations need to deliver value for money, keeping in mind that risk has to be kept at an
acceptable level. Management will need to decide what the appropriate funding model would be; venture
capital, equity, debt and equity, secured debt etc.

The link between finance objectives and business strategy

The objectives of an organisation

 The role of the strategic business leader is to provide leadership and
guidance on the formulation and execution of an entity’s strategy.
For companies, the main objective is usually stated as maximising the wealth of the company’s
owners, its equity shareholders

For state-owned organisations, the main objective might be stated in terms of providing a
certain standard of public service

For a charity, the main objective might be to provide maximum aid or support for a particular
group of people.

The process can be shown as follows:

Step 1: Identify corporate objective (usually a financial objective)
Step 2: Establish targets for the financial objective
Step 3: Develop business strategies for achieving the
financial objective/targets
Step 4: Convert strategies into action plans
Step 5: Monitor performance

Decision making criteria are strongly linked to the choice of objectives. Thus,
if an objective is to maximise shareholder wealth, decisions should be taken
based on the impact that the decision would have on shareholder wealth.
When the main objective of an organisation is not a financial objective, there
is always a financial constraint on its objective, such as providing the highest
quality of public service with the available finance.

Investment

appraisal Net

present value (NPV)

Net present value (NPV) is the difference between the present value of cash inflows and the present value of
cash outflows over a
period of time. (NPV=PV of inflows-PV of outflows)

Present value describes how much a future sum of money is worth today.
For example, $1000 received three years from now is not worth as much as $1000 received
today. Why is that?
1) Inflation
2) Lost opportunity to invest today to earn return in future
3) Credit risk
Present Value=PV=future Value (1+r)^n
Where r = discount rate (higher the r lower the
PV) n= No of years (higher the n lower the
NPV is used in capital budgeting to analyze the profitability of a projected investment or project. A
positive NPV indicates that the projected earnings generated by a project or investment (in present dollars)
exceeds the anticipated costs (also in present dollars). Typically, if an investment has a positive NPV it will add
value to the company and benefit company shareholders. Decision rule is that projects with “+”ve NPV should
only be taken. For those with NPV=0 non-financial factors should be considered.

It gives net returns in absolute terms (in $ terms) so preferred to other methods of investment appraisals.

Pay Back Period

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered
from the cash inflows generated by the investment. Shorter payback periods are preferable to longer
payback periods. For companies facing liquidity problems, it provides a good ranking of projects that would
return money early. However it does not take into account, the cash flows that occur after the payback period
hence may reject projects with higher total cash flows

Initial Investment
Payback Period = Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use
the following formula for payback period:
B
Payback Period = A +
C
the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A

Decision Rule
Accept the project only if it’s payback period is LESS than the target payback period.

Discounted Pay Back Period

Discounted payback period is more reliable than simple payback period since it accounts for time value of
money. All other advantages and disadvantages are same for both payback periods. It is interesting to note
that if a project has negative net present value it won't pay back the initial investment.
 The rest of the procedure is similar to the calculation of simple payback period except that we have
to use the discounted cash flows as calculated above instead of actual cash flows. The cumulative
cash flow will be replaced by cumulative discounted cash flow.
PV of Initial Investment
Payback Period =
PV of Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then
use the following formula for payback period:
B
Payback Period = A +
C
the above formula,
A is the last period with a negative cumulative Discounted cash flow;
B is the absolute value of cumulative Discounted cash flow at the end of the period A;
C is the total Discounted cash flow during the period after A

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 Decision Rule
Accept the project only if it’s payback period is LESS than the target payback period.

Internal Rate of return

Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a
particular project equal to zero. Corporations use IRR in capital budgeting to compare the profitability of
capital projects in terms of the rate of return. In theory, any project with an IRR greater than its cost of
capital is a profitable one, and thus it is in a company’s interest to undertake such projects

IRR can also be compared against prevailing rates of return in the securities market. If a firm can't find
any projects with IRR greater than the returns that can be generated in the financial markets, it may
simply choose to invest its retained earnings into the market.

The IRR is an indicator of the profitability, efficiency, quality, or yield of an investment. This is a relative
measure (in % form) so easy to understand and use. As a relative measure it ignores absolute returns (more/
less absolute $) and as a result may give inappropriate decision.

o be higher than the Cost of Capital. This is because an investment with an IRR which exceeds the cost of capital has a positive net present value.

Risk and uncertainty

Every decision have some degree of uncertainty and risk including investment decisions.
Risk is measurable uncertainty where probabilities can be assigned to uncertain events based on past
experience.

Uncertainty Risk

A state of having limited knowledge where A subset of uncertainty where a possible outcome
it is have an
impossible to exactly describe the future undesired effect.
outcome
Too little information is available about Some information is available based on past
expected data/experience
future.
Cannot list all possible outcomes Can list all possible outcomes
It results when randomness cannot be Mathematical probabilities can be assigned.
expressed in
Probabilities
Not measurable Measurable
Not all uncertainties are risks. All risks are uncertainties are risks.
Methods to reduce risk and uncertainty
While it is almost impossible to eliminate uncertainty in project management, there are ways to reduce the
elements. When there are only fewer elements to be considered in the estimation, the estimate becomes
more reliable, and uncertainty becomes lower.
Examples to reduce uncertainty and risk could include
● Market research
● Identifying most likely/worst/best possible outcome from a range of outcomes using results of market
research.
● Sensitivity analysis
● Simulation
● Expected value
● Decision Tree

Sensitivity analysis
The technique used to determine how independent variable values (i.e. Sales price/cost) will impact a particular
dependent variable (i.e. Contribution/Profit) under a given set of assumptions is defined as sensitive
analysis.

A Sensitivity Analysis is a "what-if" tool that examines the effect on a company's budgeted Net Income/NPV
(bottom line) when variables (such as sales price & volume ,material / labour costs etc.) are increased or
decreased.

It consider one variable’s uncertainty at a time. It provide a detail insight into which variable is more
sensitive and where most of the monitoring and control efforts are needed.

It measures % change in value of variable to make net income “0”

Numerically: NPV
* 100 Value of
variable

Expected Value
It is essentially an average, based on probabilities.

An expected value is a weighted average of all possible outcomes, and used by risk neutral investor. It
calculates the average return that will be made if a decision is repeated again and again hence used for
longer run and repetitive project. For each decision option it provide a single average return estimate and
by comparing this average return decision become easier. However for one off project it is not suitable as
chances of obtaining returns equal to EV (average return) are minimal.

It is obtained by multiplying the value of each possible outcome (x) by the probability of that outcome
(p), and summing the results.

The formula for the expected value is EV = Σpx

The accuracy of EV is dependent upon accuracy of x and p
Decision Tree
A decision tree is a graphical representation of possible outcomes of an uncertain decision. It's called a decision
tree because it starts with a single box (or root), which then branches off into a number of outcomes, just like
a tree.

Probabilities and Expected Values (EV) can be represented diagrammatically using decision trees. The financial
outcomes and probabilities are shown separately, and the decision tree is 'rolled back' by calculating
expected values and making decisions.

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 Decision trees are helpful, not only because they are graphics that help you 'see' what you are thinking,
but also because making a decision tree requires a systematic, documented thought process. Often, the
biggest limitation of our decision making is that we can only select from the known alternatives. Decision
trees help formalize the brainstorming process so we can identify more potential solutions.

Decision trees should be used where a problem involves a series of decisions being made and several
outcomes arise during the decision-making process. Decision trees force the decision maker to consider the
logical sequence of events. A complex problem is broken down into smaller, easier to handle sections.

omes. Each of those outcomes leads to additional nodes, which branch off into other possibilities. This gives it a treelike shape.

des. A chance node, represented by a circle, shows the probabilities of certain results. A decision node, represented by a square, shows a decision to be

Steps involved in decision making using decision tree:

Step 1: Draw the tree from left to right, showing appropriate decisions and events / outcomes.
Label the tree and relevant cash inflows/outflows and probabilities associated with outcomes.
Step 2: Evaluate the tree from right to left (Rollback analysis) carrying out these two actions:
Calculate an (EV) at each outcome point.
Choose the best option at each decision point.
Step 3: Recommend a course of action to management.
Organization’s performance and position
Most common way to assess performance and position is ratio analysis.

Ratio analysis
The ratio is the numerical relationship between 2 financial items and the relationship can be expressed
as: %, times (i.e. 2 times) or ratio(x: y). Ratio analysis is used to evaluate various aspects of a company’s
operating and financial performance such as its efficiency, liquidity, profitability and solvency.

Ratio analysis can provide an early warning of a potential improvement or deterioration in a company’s
financial situation or
performance.

Ratios are usually only comparable across companies in the same sector, since an acceptable ratio in one
industry may be regarded as too high in another. As ratios are based on financial data which is based on
accounting standards and estimates the result of this analysis should be used with caution. Other non-
financial data should be another aspect of analyzing these ratios.
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Ratios can be divided into following types
Liquidity The ratio between the liquid assets and the liquid liabilities.
Ratios
A liquidity ratio is an indicator of whether a company's current assets will be
sufficient to meet the company's obligations when they become due.
Types
● Current ratio = Current assets
Current liabilities
It signifies a company's ability to meet its short-term liabilities with its short-term assets.
A current ratio greater than or equal to one indicates that current assets should be able to
satisfy near-term obligations.

● Quick/ Liquid Ratio = Current assets – Prepaid expenses – inventories

Current liabilities

The quick ratio is a tougher test of liquidity than the current ratio. It eliminates certain
current assets such as inventory and prepaid expenses that may be more difficult to convert
to cash. Like the current ratio, having a quick ratio above one means a company should have
little problem with liquidity.
Gearing The ratio between the borrowed capital and the shareholder’s capital.
Ratios
Looks at how much capital comes in the form of debt (loans).Also known as “Leverage Ratios”.
The ratios used to determine about the companies' financing methods, or the ability to meet
the obligations. The financial leverage ratios measure the overall debt load of a company
and compare it with the assets or equity.
Types
● Debt equity ratio = Long term debt
Total equity
The debt/equity ratio measures how much of the company is financed by its debt holders
compared with its owners. Assuming everything else is identical, companies with lower
debt/equity ratios are less risky than those with higher such ratios.

● Debt to capital ratio = Long−term debts

Capital employed
It helps in establishing a link between total long-term funds available in the business and
funded debt. Companies with lower debt/capital ratios are less risky than those with higher
such ratios

● Interest Coverage= Operating Income

Interest Expense

It measures a company's ability to meet its interest obligations with income earned from the
firm's primary source of business. Higher interest coverage ratios are typically better, and
 interest coverage close to or less than one means the company has some serious difficulty
paying its interest.
Profitabil The ratio between returns/costs and revenues “And” the ratio between returns and
ity resources.
Ratios
How good is a company at running its business? Does its performance seem to be getting
better or worse? Is it making any money? How profitable is it compared with its competitors?
All of these very important questions can be answered by analyzing profitability ratios.
Examples
● Gross Margin = Gross Profit
Sales
Gross margin shows how much cost is being incurred on a product comparing to products per
dollar of sales. The higher the gross margin, the more of a premium a company charges for
its goods or services. Keep in mind that companies in different industries may have vastly
different gross margins.

● Operating Margin = Operating Income or Loss

Sales

Operating margin captures how much a company makes or loses from its primary business
per dollar of sales. It is a much more complete and accurate indicator of a company's
performance than gross margin, since it accounts for not only the cost of sales but also the
other costs incurred in primary course of business

● Net Margin = Net Income or

Loss Sales
Net margin considers how much of the company's revenue it keeps when all expenses or other
forms of income have been considered, regardless of their nature.

● Return on Assets = Net Income + After tax Interest Expense

Total Assets

Return on assets measures a company's ability to turn assets into profit. The higher the
ratio the more the company is able to generate profits.

● Return on Capital Employed (ROCE)= Profit before interest and tax

Total Capital employed

It is a financial ratio that measures a company's profitability and the efficiency with
which its capital is employed. The higher the ratio the more the company is efficient

● Return on Equity = Net Income

Shareholders'
Equity

Return on equity is a straightforward ratio that measures a company's return on its

investment by shareholders.
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Budgeting and Financial Forecasting
A budget is a quantified expectation for what a business wants to achieve. Conversely, a forecast is an estimate
of what will actually be achieved. Thus, the key difference between a budget and a forecast is that the
budget is a plan for where a business wants to go, while a forecast is the indication of where it is actually
going.

Techniques of Financial Forecasting

Qualitative Techniques of Financial Forecasting

1) Executive Opinions
In this method, the expert opinions of key personnel of various departments, such as production, sales,
purchasing and operations, are gathered to arrive at future predictions.

2) Delphi Technique:
Here, a series of questionnaires are prepared and answered by a group of experts, who are kept separate
from each other. Once the results of the first questionnaire are compiled, a second questionnaire is
prepared based on the results of the first. This second document is again presented to the experts, who
are then asked to reevaluate their responses to the first questionnaire. This process continues until
the researchers have a narrow shortlist of opinions about forecasts

3) Sales Force Polling:

Some companies believe that salespersons have close contact with the consumers and could provide
significant insights regarding customer behavior. In this method of forecasting, the estimates are
derived based on the average of sales force polling.

4) Consumer Surveys:
Businesses often conduct market surveys of consumers. The data is collected via telephonic conversations,
personal interviews or survey questionnaires, and extensive statistical analysis is conducted to
generate forecasts.

5) Scenario Writing:
In this method, the forecaster generates different outcomes based on diverse starting criteria. The
management team decides on the most likely outcome from the numerous scenarios presented.

6) Reference Class Forecasting:

Reference class forecasting or comparison class forecasting is a method of predicting the future by
looking at similar past situations and their outcomes.
 Quantitative Techniques of Financial Forecasting

1) Linear regression Forecasting:

Three major uses for regression analysis are (1) determining the strength of predictors, (2) forecasting an
effect, and (3) trend forecasting.

The center of regression is the relationship between two variables called the dependent and independent
variable. For instance, suppose you want to forecast sales for your company and you've concluded that your
company's sales go up and down depending on changes in GDP.

The sales you are forecasting would be the dependent variable because their value "depends" on the value of
GDP and the GDP would be the independent variable. You would then need to determine the strength of the
relationship between these two variables in order to forecast sales. If GDP increases/decreases by 1%, how
much will your sales increase or decrease?

If one variable increases and the other variable tends to also increase, the covariance (relationship) would be
positive. If one variable goes up and the other tends to go down, then the relationship would be negative.

This strength is measured by Correlation coefficient (often shown as “r”) a statistical measurement which can
range from +1(perfect positive relation) through 0(no relationship) to -1(perfect negative relationship).

The coefficient of determination explains the proportion of change in dependent variable due to
independent variable which is calculated as r^2.

ndent variable when the values of independent variable are known. This is in the form of a straight line which “best fits” the past data available presented

st squares fit" a statistical measurement. The least squares method helps in plotting a straight line that minimizes the distance between the resulting lin

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 Calculation of Linear regression Forecasts:

Linear regression attempts to model the relationship between two variables by fitting a linear equation to observed
data. A linear regression line has an equation of the form Y = a + b(X)

Where X is the independent variable (here GDP) and Y is the dependent variable (here sales). The slope (trend) of
the line is b, and a is the intercept (the value of y when x = 0

The higher the coefficient of determination the stronger the relationship and the more the forecasting accuracy. However it should be
noted that the correlation may be incidental or just because of another variable which can affect accuracy of forecasts.

2) Time-Series Forecasting:

A time series is a series of data recorded or graphed in time order. A time series can be taken on any
variable that changes over time.ie daily closing stock prices, weekly interest rates, national income
etc.

Components of a Time Series: Trend (long term pattern over time)……Cyclical Variation (Rises and Falls
over periods longer than one year)……Seasonal Variation (Patterns of change within a year, typically repeating
themselves)………Residual Variation(irregular but short term variations)

Time series analysis aims to understand patterns evolving over time and use these patterns to predict
future behavior (i.e. monthly sales). Time series are very helpful in study of past behavior of business.
On this basis, we can invest our money in that type of business.

Time series predictions needs large but past data which in itself not a good predictor of future and
may not available in large amount.
In equation form Time series= Y =T +C +S
+R + Where Y= Time series
T= Trend
C= Cyclical Variation(assumed to be Zero)
S= Seasonal Variation
R= Residual Variation(assumed to be Zero)

Trend is calculated using moving averages i.e. 2 moving average(average of 2 values) for 5 years’ time series can be calculated by
averaging year 1 and year 2 values, then year 2 and year 3 values, then year 3 and year 4 values and lastly year 4
and year 5.total 4 averages will be produced in this way.

Trend per time interval= 1st average-last average (where n=number of averages in above case 4)
n-1
Seasonal Variation can be calculated by Subtracting trend values (moving average values) from actual time series values
for each season. it could be + or -.The more these variations the more the time series forecasting is useful.
Seasonal Variation= Time series – trend

Residual Variation= Time series – trend- Seasonal Variation- Cyclical Variation

 The more the residual variation the more the irregularities and the less the chances of accurate forecasts.

Based on above calculations forecasted time series can be

calculated as Y=S+C+R+T

Where S will be for required season and T will be up to forecasted Y(Last moving average + Trend per time
interval*number of time intervals needed after last moving average)

Budgets

Modern formal budgets not only limit expenditures; they also predict income, profits, and returns on
investment a year ahead. They have evolved into tools of control and are also used as a means of
determining such rewards as profit-sharing and bonuses.

Budgets could be prepared by senior management “Top-down” approach or in collaboration with both
senior and operational management “Bottom-up” approach.

Types of Budgets

A business creates a budget when it wants to match its actual future performance to an ideal scenario
that incorporates its best estimates of sales, expenses, asset replacements, cash flows, and other factors.
There are a number of alternative budgeting models available.

The following list summarizes the key aspects of each type of budgeting model:
1) Fixed Budget: A fixed budget is a budget that does not change or flex when sales or some other activity
increases or decreases. Main problem with this budget is that it assume everything will happen as per
plan.
2) Flexible Budget: A flexible budget is a budget for more than one level of expected activity. The
flexible budget is more sophisticated and useful than a fixed/static budget which remains at one amount
regardless of the volume of activity. However actual activity level may not be one of the budgeted
activity level so not a fair basis of managerial performance evaluation.
3) Flexed Budget: Budget reflecting actual activity level by flexing only those items that vary with
output and is used to assess managerial performance.
4) Rolling budget: Method in which a budget established at the beginning of an accounting period is
continually amended to reflect variances that arise due to changing circumstances. By employing a rolling
budget, a business or entity can add an extra degree of flexibility. This may allow them to better react to
changes in costs and revenue. With rolling budgets, performance is assessed against realistic and
rationalized targets.

Example of a Rolling Budget

ABC Company has adopted a 12-month planning horizon, and its initial budget is from January to December.
After a month passes, the January period is complete, so it now added a budget for the following January,
so that it still has a 12-month planning horizon that now extends from February of the current year to
January of the next year.

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Techniques of preparing budget

Budget is a formal way of allocation of available resources. Appropriate basis should be used to allocate
these valuable and perhaps scarce resources to get maximum benefit.

Following techniques can be used as a basis of resource allocation:

1) Incremental budgeting: Resources are allocated based on last year budget or actual figures by adjusting
them for known but future changes only .i.e. inflation, redundancies etc. It is useful for committed costs OR
where environment is relatively stable.
2) Zero-based budgeting: Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must
be justified for each new period. ZBB forces managers to scrutinize all spending and requires justifying
every expense item that should be kept. It allows companies to radically redesign their cost structures
and boost competitiveness.
3) Rolling budget: Rolling budgets repeatedly extend the original budget period. Allocated resources are
reassessed in each period and reallocated to reflect changes in resource requirements as per up to date
knowledge of circumstances.

Standard Costing

An estimated or predetermined cost of performing an operation or producing a good or service, under normal
conditions. Standard costs are used as target costs (or basis for comparison with the actual costs), and
are developed from historical data analysis

The core reason for using standard costs is that there are a number of applications where it is too time-
consuming to collect actual costs, so standard costs are used as a close approximation to actual costs.
Since standard costs are usually slightly different from actual costs, the management periodically calculates
variances that break out differences caused by such factors as labor rate changes and the cost of materials.
Some potential uses of standard costs are: Budgeting, Inventory costing, overhead application, Price
formulation and Cost Control

Variance Analysis

Once the standard/budget has been set actual figures need to be matched with these estimtes to assess
whether any variations have arised and if yes, to what extent. This is called variance analysis.

Some of the factors caused these variances are within the control of managers however some are not. Careful
considerations should be given to both of these types of factors while assessing managerial performance. It
should be noted that some variances are interrelated which need careful interpretations. For example
lower actual prices paid for material will result in favourable material price variance but may affect sales
volume variance negatively as quality of cheaper material purchased and hence the resulting product
may be inferior then budgeted.

Variances can be calculated for each item of budget i.e. Sales price & volume, Labour hours & rate, Material
price & quantity, Fixed & variable overheads ec

Sometimes circumstances changed during budget period outside the control of managers which make
budgetary assumptions inappropriate. A revision to original budget is needed to fairly assess managerial
performance.
There are three types of variances:
1) Basic Variance: Difference between original budget (Standard) and actual figures. This is the total of
planning and operational variance. Assessing performance based on these variances is only appropriate
when management is able to control changed circumstances over budget period (planning variance=0).
2) Planning Variances: Difference between original budget (Standard) and revised budget (Standard).These
variances are fed back to budget planning process to make future planning better and up to date.
3) Operational Variances: Difference between revised budget and actual figures. The aim of separating this
variance is to fairly assess managerial performance based on controllable factors only.

Example: Labour Efficiency(hour) Variance

Basic Variance Per unit =(Original St hrs/unit-Actual hrs/unit)*Rate per hr

Total=Actual units produced * Per unit Variance
Planning Variances Per unit=(Original St hrs/unit-Revised St hrs/unit)*Rate per hr
Total=Actual units produced * Per unit Variance
Operational Variances Per unit =(Revised St hrs/unit-Actual hrs/unit)*Rate per hr
Total=Actual units produced * Per unit Variance
Variance need to be reported in monetary terms that is why above variances are multiplied
by Rate per hr
St hrs/unit=budgeted hr per unit (total budgeted hrs/total budgeted production units)

Managerial Accounting

Managerial accounting is the process of identifying, analyzing, recording and presenting financial information
so internal management can use it for the planning, decision making and control of a company. This is in
contrast to financial accounting, which is the process of preparing and presenting quarterly or yearly financial
information for external use, such as a company's audited financial statements for the public.

Managerial Cost accounting

The recording of all the costs incurred in a business in a way that can be used to improve
its management. Common types of cost accounting are:

Full costing: Full costing is used to determine the complete and entire cost of something including both fixed
and variable costs. It can be used to set sales price based on per unit full cost. However allocation of fixed cost
to each unit may be difficult and time consuming. It can also be used to report inventory valuation
externally.
Allocation of fixed cost can be performed based on:

Absorption costing: Where fixed overheads are absorbed based on total budgeted production or budgeted
machine/labour hours.

Activity-Based-Costing (ABC):It assigns manufacturing overhead costs to products in a more logical manner
than the traditional approach of simply allocating costs on the basis of machine/labour hours. Activity based
costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of
those activities only to the products that are actually demanding the activities.

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Marginal Costing: Marginal cost is the additional (variable) cost incurred in the production of one more
unit of a good or service. Marginal costing is the accounting system in which variable costs are charged to
cost units and fixed costs of the period are written off in full against the aggregate contribution.

The contribution concept lies at the heart of marginal costing. Contribution gives an idea of how much
'money' there is available to 'contribute' towards paying for the overheads of the organisation.

Contribution can be calculated as follows.

Contribution = Sales price - Variable costs

It is principal management tool in decision making as it draws management's attention on additional

contribution from a decision. The more the contribution the more the profit as in theory fixed costs remain
same at whatever level of production.

Relevant Costing: A relevant cost is a cost that only relates to a specific management decision, and which will
change in the future as a result of that decision. The concept of relevant cost is used to eliminate unnecessary
data that could complicate the decision-making process.

It is often important for businesses to distinguish between relevant and irrelevant costs when analyzing
alternatives because erroneously considering irrelevant costs can lead to unsound business decisions. It
assigns future costs and revenues to the decision being made. It includes only those cash flows which will be
affected by the decision.

Typical managerial decision making selects one of two or more alternatives. Costs that remain the same no
matter which alternative the manager chooses are not relevant to the decision. Examples of irrelevant costs
are: Committed costs, sunk costs none cash costs etc. However opportunity costs are considered as relevant.

It can be used in decision such as:

● Make or buy decisions
● Accepting or declining special contracts
● Closure or continuation decisions
● Effective use of scarce resources