That is why sometimes is difficult to evaluate how much of the favorable cost variance is due to lower activity, and how much is due to good cost control?

To answer the question, we must flex the budget to the actual level of activity.

The concept of Budgeting through Flexible Budgets is: if the level of activity for the period is known, there is possible to find out what costs and revenue should have been.

To flex a budget for different activity levels, we must know how costs behave with changes in activity levels.

• Total variable costs change in direct proportion to changes in activity.

• Total fixed costs remain unchanged within the relevant range.

• The result of flexing the budget is the possibility to compare budgeted figures with actual results.

The Flexible Budgets have the following advantages:

• Show revenues and expenses that should have occurred at the actual level of activity.

• May be prepared for any activity level in the relevant range.

• Reveal variances due to good cost control or lack of cost control.

• Improve performance evaluation.

Sales Budget (Step # 1)

Sales can be budgeted taking into consideration the following aspects:

- Sales for previous period

- Production capacities

- Customers’ purchasing power

- Marketing research

- Marketing mix

- Competition

- Seasonal fluctuations

- Product life cycle

* The most precise forecasts can be performed for existent products placed on existent markets.

Inflows will directly depend on Sales Budget. It should also be taken into consideration the collection period of receivables.

Commercial Expenses Budget (Step # 2)

- Normally Commercial Expenses Budget should be correlated with Sales Budget

- It would be hardly possible to have a sales increase while promotional expenses are cut down

- Usually Commercial Expenses are budgeted as a percentage of Sales Budget.

- This percentage will depend on the product life cycle

- Do not forget at this stage about cost related to packing, storage

- The variable and fixed part will be reflected separately

Production Budget (Step # 3)

Production Budget will be elaborated on the Sales Budget basis:

Production Budget = Inventory level at the end of period + Sales for the period -Inventory level at the beginning of period

Inventory Budget (Step # 4)

Inventory Budget contains necessary information for elaborating 2 of the 3 final financial statements:

- Income Statement Pro-Forma, where it influences the cost of the goods sold

- Balance Sheet Pro-Forma, where it determines the Inventory part (materials, work in process and finished products)

Materials Budget (Step # 5)

Materials used in production can be related to direct costs and variable costs as well at the same time.

Materials Budget will be elaborated starting from Production Budget and Sales Budget. The payment period to suppliers should also be taken into consideration because it has direct influence on Cash Flow. Purchases will be calculated using the formula:

Purchases = Production Necessities + Inventory at the end of the period – Inventory at the beginning of the period

Labour Budget (Step # 6)

Labour needs are calculated according to Production Budget, taking into consideration Labour productivity and fees.

Labour expenses can be split into Fixed and Variable part.

Production Indirect Expenses Budget (Step # 7)

As in previous case expenses will be split into Fixed and Variable part.

The fixed part of Production Indirect Expenses will be budgeted for a certain operational level.

The variable part will depend on a chosen cost drive (ex. Production Budget, Direct Labour)

Typical components:

- Equipment and production buildings depreciation

- Rent of equipment and production buildings

- Salary of maintenance personnel

- Auxiliary services costs

Overheads Budget (Step # 8)

Overheads Budget includes expenses that a not directly related to productivity level or sales, but are compulsory for a good functionality of business. Main components are:

- Administrative personnel salary

- Costs related to personnel, law, financial departments, etc.

- Representational expenditures, per diems

- Communication expenditures

- Taxes and interest

- Rent of administrative buildings and transportation means

- The main part of Overheads are fixed costs.

Income Statement (Step # 9)

Income Statement Pro-Forma is the first financial statement elaborated. It contains information on total revenues and expenditures of the 3 activities. For planning purposes the Statement can be more detailed The information for it is produced along the Steps # 1 – 8

It is important that the Steps # 5 – 6 – 7are calculated on the basis of the Budgeted Sales!!!

Balance Sheet (Step # 10)

Balance Sheet is the balance between financial sources and their use. The Balance Sheet projections derive from the necessity of Working Capital (Inventory and Receivables) that are estimated at Steps # 1 and 5, as well as from the principle of Positive Cash Balance.

Current liabilities are calculated at Step # 5 and 6.

At the first stage there will be no modifications in Negative Cash Balance.

The difference between assets and liabilities serves for calculation of cash deficit or surplus.

Modifications in Balance Sheet influence the Cash Flow.

Cash Flow Statement (Step # 11)

The Cash Budget calculation is the most important and the most difficult step at the same time.

The staring point is the Sales Budget.

Payments are determined at Steps #2, 5, 6, 7and 8.

Inflows and payments for Investment and Financial Activities are calculated separately. Depreciation is excluded from all categories of expenditures, when using the direct method of Cash Flow calculation.

Budget a detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a specified period of time.

Purposes of budgeting systems:

- Planning

- Facilitating Communication and Coordination

- Allocating Resources

- Controlling Profit and Operations

- Evaluating Performance and Providing Incentives

Using a budgeting system companies can:

- Improve cash flow;

- Optimize product portfolio;

- Minimize salary adjournment;

- Increase the operational level;

- Eliminate breaks in production process;

- Stabilize debts level;

- Precisely determine the real financing needs.

Types of Budgets

Long-Range Budgets – capital budgets dealing with the acquisition of building and equipment normally cover several years.

Continuous or Rolling Budget – this budget is usually a twelve-month budget that rolls forward one month as the current month is completed.

Operating Budget – the annual operating budget may be divided into quarterly or monthly budgets.

Budgeting comprises 3 obligatory financial statements:

- Income Statement

- Cash Flow Statement

- Balance Sheet

Budgeting comprises 2 components:

Operational Component

- Sales Budget

- Commercial Expenses Budget

- Production Budget

- Inventory Budget

- Materials Budget

- Labour Budget

- Production Indirect Expenses Budget

- Overheads Budget

- Income Statement

Financial Component

- Investment Budget

- Balance Sheet

- Cash Flow Statement

There are some principles to be taken into consideration when developing a Budget. Budgeting is reasonable when:

- There are realistic objectives

- There is a profitable business

- There is a financial diagnosis as base for determining trends

- There is an integrity with Management Informational System

- You can use what-if analysis

Normally it is figured monthly for the first year of activity, quarterly for the second year and annually for the rest of the years.

Setting a price by including a Profit Margin does not guarantee Profit at all. The main flaw of cost-plus pricing is the disregard for the relationship between price and sales volume. A given price does not guarantee sales volume.

The situation becomes dangerous if the price is limiting sales volume. In this case usually, company’s management increases the price to secure profit at the same level and if the market demand is elastic, rising price results in further reduction of the sales volume. At the same time, fixed costs are distributed over a smaller amount of products, and if the company it trying to retain a certain profitability level it looks like it is necessary to increase prices again.

As a conclusion, if a company implements this pricing strategy and is trying to achieve the desired output, planned costs and profitability, it can lead to wrong decisions. There are some other reasons that express the reduced adequacy or even the fact that this method of pricing is a wrong one, such as:

- When setting prices, the allocation of fixed costs per unit of product is a suspect one as the total unit cost calculated on this manner is correct only for particular output volumes. The only case it could be applicable is when the company is producing stable quantities over a long period of time. If there are changes in output the total cost will be different from the one calculated in advance;

- The process of fixed costs allocation per product is significantly influenced by the subjectivism of the entitled persons to perform the assignment as well as by the level of detailed information in respect of a particular fixed costs component. There are many possible ways of how to assign fixed costs to the specific range of products;

- The allocation methods in place can not ever be fully justified;

- Often the Total Unit Costs lead to misunderstandings or wrong interpretation of such information due to the deficiencies of splitting costs into fixed and variable, which again lead to wrong managerial decisions.

Market Oriented Pricing. Cost analysis allows the company to examine consequences of different pricing strategies. With these results, it is much easier to follow the aspects of pricing, which are related to demand elasticity, and the reaction of competitors. The concept of Price Elasticity of Demand is very important in demand analysis: it is percentage change of sales changes as result of a 1% price change. As a rule, price elasticity of demand is negative, which means that price increase results in demand decrease and vice versa. Information regarding the behavior of demand for different products might be gathered through marketing researches or summarization reports developed by specialized bodies.

Microeconomics offers a possibility to set prices which maximize revenues of the company in combination with marketing information. The starting point is the description of the Linear Demand Curve, an example of which is:

If one multiplies Price by Quantity the result is Revenue.

In order to know which price-volume relationship maximizes revenues, it needs to know how total revenue behaves when changing volume by a small amount. Using calculations, this change in revenues can be captured by a derivative of the revenue function. The derivative is called the Marginal Revenue.

The last equation is telling that the marginal revenue curve will have the same intercept with the Y axis as the demand curve, and will cross the X axis half way between the origin and the point where the demand curve meets the X axis. It follows that for the volume-price combination where MR = 0 (where the MR curve intercepts the X axis) revenue is maximized. As a conclusion, the Revenue-Maximizing Price lies in the middle point of the demand curve, and Profits are maximized at the point where marginal revenue equals marginal cost as.

When a company strives for a strong position on the market, price policy becomes a key factor in accomplishing the goal. Price is the tool to stimulate the demand. At the same time, pricing determines the long-term Profitability of a company. For the development of a pricing strategy, it is necessary to consider other profit-related goals such as, sales volume potential and marketing competition. Price determines overall profitability of a company as well as sales volume by implying sales volume at the level above the break-even point for which Cost-Volume-Profit relation is optimal. Price setting directly determines demand level, and consequently, Sales Volume for output with demand elastics. Incorrect pricing (too high or too low) may undermine the position of a given product on the market.

There is a category of businesses that are the only suppliers of a particular product on the market. They face no competition at least in for a visible time span in respect of the particular product or service. The advantage of such a business is the freedom in setting the price and at the same time it is its major danger, expressed by a spoiled image on the market.

These kinds of businesses have to find a balance between the assurance of a sufficient product profitability and simultaneously to not provoke the other companies offering the same “demanded” product through own production or imports.

Another important issue is price setting for the “cannibalized” products, which is the increasing of share of a particular product, implies the shrinkage of the share of other products that is the result of devoting the production capacities to more efficient units from the manufacturer point of view.

There is a practical methodology how to proceed in the establishment of prices for such businesses, which is based on the following steps:

1. Estimation of the satisfactory amount of Profit per annum, deriving from the ROI or from other profitability perspectives. For example the target Income is 3 000 000 MDL/year.

2. Knowing the Fixed Costs of the business, the target Contribution Margin, is calculated by adding up the Income and Fixed Costs. For example the target Contribution Margin is 5 500 000 MDL/year.

3. Deriving from the market research and other possibilities, the approximate product mix for the year is determined in terms of the share of each product in the total product mix.

4. The Productivity and the Contribution Margin per Unit for all products included in the product mix.

5. The Contribution Margin Statement produced, which comprises the following items:

a. Quantity of each product

b. The annual production capacity for each product

c. Unit price per products

d. Contribution margin per unit

e. Total contribution margin per product

6. The Capacity Utilization Ratio for the initial production program is calculated, and based on it, the Target Contribution Margin per 1% of Production Capacity Used.

In order to reach the target Contribution Margin, one must observe the level of production capacities utilization. If the capacity is already used in a high proportion, then the adjustment procedure for prices is required. The prices for those products that have the lowest Contribution Margin per 1% of Production Capacity Used must be increased until 1% of Production Capacity would result in at least 1% of Contribution Margin.

This procedure is followed until the target Contribution Margin (Profit) is reached. If the initial Contribution Margin is already higher than the targeted one, then some price reduction could be applied. The core issue in this context is the actual level of Production Capacity Utilization. It should be appropriately analyzed. The minimum PCU which is acceptable for price setting using this methodology is 75%. At the same time, higher than 95% capacity utilization is not advised. The normal range used for this purposes must fall within 75-90%. In any case, the use of existing output capacities are the second indicator taken into account in the pricing after the demand requirements.

- Determination of the rational composition of the product portfolio;

- Analysis of customers demand for individual products;

- Consideration of limits on production capacity, working capital, and customer demand;

- Choice of optimal prices and production volumes with regard to market demand;

- Cash flow forecast to develop optimal product mix.

Optimal product mix

Often a company may improve its financial condition by changing the composition of its manufactured product mix, even if the current output levels are above the Break-Even Point. This becomes especially critical when a company has limited production capacity and resources. The optimization can be achieved by an increase in sales of products that are most profitable. At the same time, the profitability of one product can not be the only criteria for output increases, since it only reflects the existing structure of production.

The first step in PPO is the determination of the Contribution Margin for each product. An increase in production output must be adjusted to market demand. Contribution Margin provides reliable information for decisions regarding production output increases. The Contribution Margin Ratio (Contribution Margin to Sales) indicates what share of revenue can be used to cover Fixed Costs and Profit. The higher the ratio is, the more preferable it is to produce them.

The second step in PPO is considering the limitation and constrains of the business in respect of Production Capacities, Working Capital, and of market demand for the enterprises products. The importance of the optimization becomes crucial when the company encounters these limitations and it can be attained through the enlargement of the share of more profitable products and reducing the share of the less profitable or even unprofitable ones or even by a total exclusion of those.

The comparison of the product profitability ratio and contribution margin ratio for a company’s products is illustrated. The rating the attractiveness of the particular product based on Product Profitability is different from the one based on the Contribution Margin approach. The first option is the commonly applied one in Moldovan companies, which is not the appropriate one, due to the distortions in the Indirect Costs area, which will be explained further in this section. The calculation of the Product Profitability by products is based on the accounting information which is available in the accounting department, while the calculation of the Contribution Margin Ratio could be performed only by re-categorization of costs in Variable and Fixed, which is a managerial approach. As a conclusion, in order to improve the production plan, products having the highest Contribution Margin Ratio should be favored. This procedure is applicable when the products are produced using different production lines or they are not competitors among them and the market demand has no restrictions in respect of each item produced.

The comparison of the contribution margin ratio and contribution margin ratio per machine hour for a company’s products is illustrated. This is the second step of analysis which is applicable when the products are being produced using the same machines or are competitors among them. As it is seen on the chart, the rating of attractiveness is different for the two ratios presented. In this case the most attractive products are those having the highest Contribution Margin per Machine Hour used. The same comparison is required when analyzing the limitation of Working Capital or Limited Marketing Demand for a particular product.

The process of determining the costs of all units that can be sold, and then allocating these costs between the units sold during the period (cost of goods sold) and the units unsold at the end of the period (inventory) is referred to as Product Costing. Only product costs are use in product costing, not period costs.

Product Costs are costs that are closely associated with units produced by the enterprise or purchased for resale by a retailer or wholesaler. Examples: Cost of materials and labour used in production. Thus, Product Costs are inventory costs when incurred and these costs are assets until the units are sold. At the moment of sale, several things happen:

- The economic benefit, sales revenue, is realized;

- The asset expires;

- No longer recognizing the product cost as an asset, it is now recognized as an expense, cost of goods sold;

- The Cost of Goods Sold is matched with the sales revenue on the Income Statement.

Period Costs are costs that are recognized as expenses as soon as they are incurred. They are not assigned to the product; instead, they are immediately assigned to the Income Statement as an expense of that period. The benefits provided by period costs are realized fully when the costs are incurred and are recognized in the current period. Examples: Administrative salaries, Marketing expenses.

It is important to classify product costs and period costs correctly. If these costs are classified incorrectly, they will be expensed at the wrong time, and the financial statements for the period will be inexact.

There is a third group into which costs can be classified when they occur: Non inventoriable unexpired costs. These costs represent assets when they are incurred, but they are not costs that can be assigned to inventory. Example of such costs: Expenditures for prepaid insurance, prepaid rent, machinery, buildings. Each of these costs is an asset, other than inventory. Many of these assets are used up or consumed as time passes. As they expire over time, the amount expired can then be classified as a product cost or a period cost.

Manufacturers must maintain three different inventory accounts:

- Raw materials inventory. Materials purchased from a supplier;

- Work in progress. The unfinished goods in production – the units that are being worked on;

- Finished goods inventory. The completed product awaiting sale.

Categories of Product Cost used in Moldovan National Accounting System:

- Direct materials. Raw materials that become an integral part of the completed product;

- Direct labour. It is the work that directly converts the raw materials into finished goods;

- Manufacturing overhead. The total costs of production department minus direct costs. Examples: indirect materials, indirect labour, rent, property tax, maintenance and repair, utilities, depreciation, idle time.

The Cost Flow of a retailer goes directly from purchase of goods to sale. The Cost Flow for a manufacturer is much longer:

- Purchase and use of raw materials;

- Use of labour;

- Use of manufacturing overhead;

- Transfer of manufacturing overhead to Work in Progress;

- Completion of production;

- Sale of finished goods.

Overhead Allocation between Product Types

Cost allocation is a process of assigning cost to specific products. It rises the issue of what share of costs need to be assigned to a particular product. The answer to this question has the effect on the viability of the business.

Cost allocation is needed in order to determine product costs, which in turn are needed for (1) reporting to external authorities (Statutory Accounting) and for (2) analyzing product line profitability (Managerial Accounting).

In the process of cost allocation, Direct and Indirect Costs must be assigned to specific products. Direct Costs are easy to allocate because they are linked to particular products, based on the internal standards supported by a normative base. The common Direct Costs are:

- Raw materials;

- Energy;

- Production Labour;

- Subcontracted services.

In order to allocate Direct Costs it is enough to match products made and direct expenses incurred, however, even direct cost allocation sometimes causes difficulties if there are many products made in one place and they use the same machinery an the same materials. In this case direct costs are assigned proportionally to standard norms which are developed by the technological and planning departments. Periodically, standard norms must be compared with actual consumption patterns to make adjustments.

Indirect Costs, often called Overheads, are the hardest to allocate because they are not directly traceable to products. The common Indirect Costs are:

- Top management expenses;

- Social assets;

- Depreciation of buildings;

- Repair and maintenance;

- Interest expenses;

- Rent;

- Security;

- Heating and ventilation.

The Overhead Expenses are allocated in a Two-Stage Process. At the first stage the factory overheads (G&A, Marketing, and other overheads) are assigned to Cost Centers (product line A, product line B) and only then they are assigned to particular products, using specific allocation bases. Identifying Cost Centers is important for accurate cost allocation. A Cost Center is a responsibility center where managers are accountable for the expenses which fall under their control. Normally, cost centers are represented by workshops.

Overhead allocation is a very complex calculation process. All allocation methods are subjective and therefore disputable. The more indirect the cost is, the more subjective its allocation is likely to be. The purpose of the allocation is not to be fully accurate, but simply to spread costs in a fair and efficiency-improving manner.

Allocation bases should be chosen according to the following criteria:

- They should be related to the cost considered, i.e. of the resources effectively used;

- They should be representative of the normal operating conditions;

- If possible, they should be a factor of which decision-makers can have an impact;

- In some cases, they can take the special objectives of cost management into account.

The following are commonly used simple allocation bases:

1. Direct Labour. It is acceptable when manufacturing processes are highly Labour-intensive, overhead a small percentage of total costs and low product diversity. It’s not relevant when Labour costs are low (e.g. 10%) and overhead high (e.g. 30%);

2. Depreciation of machines. It is justified in highly capital-intensive industries. It is also relevant for some types of overhead which are often linked to production facilities (interest expenses, chief engineer. It is not relevant in non capital-intensive industries and for overhead caused by the number of staff;

Sales. This method will be “painless”, as only best-selling products will be penalized. It is not representative in terms of cost generation and it removes part of the incentives to increase sales;

Energy. Only relevant if other bases related to production processes do not apply (e.g. if some departments are grossly overstaffed, or if machines for different products vary widely), as it then becomes the only possible way to assess resources used.

Management should be aware of the consequences to their business when choosing an allocation base. For example, the common Moldovan practice of splitting overhead by a proportion of direct Labour tends to distort the costs of hand-produced products versus those machine-produced products. Choosing “Sales” as an allocation base often penalizes products that are high revenue generators. A good basis on which to allocate overhead in a Moldovan manufacturing company is often a mix of direct Labour and machines.

Changing the itemization and overhead allocation base usually yields different profitability estimates for individual production lines or individual products. The higher the share of overhead costs, the greater the expected changes in profitability estimates for individual products as a result of overhead reallocation. There is no ideal base for overhead allocation but there are more appropriate bases of allocation for each company. Potential benefits from a more detailed allocation of overhead must exceed the related costs.

Incorrect overhead allocation between product types and production divisions can result in (1) inconsistency between the price ratio for individual products and market demand, (2) unjustified reduction of output for some products, (3) incorrect assessment of divisions operations.

The choice of overhead allocation base is determined by company specifics, industry characteristics, as well as by the relative value of certain costs within the overall structure of company costs.

Cost Drivers

The Cost Driver is a factor which affects the level of a particular cost dramatically: it can have a positive or a negative impact. A cost driver is the element of a cost that exerts great influence over its account, such that a change in the cost driver necessarily results in a change in the cost. Knowing the cost driver of products is vital to understand the elements of cost and to make decisions accordingly. Mastering cost drivers allows enterprises to make operational decisions with some degree of certainty as to their cost impact.

Examples of Cost Drivers:

- Labour – Location, efficiency of work;

- Raw materials – Purchasing sale, wastage, delivery costs;

- Financing costs – Interest rates, inflation, location;

- Repairs cost – Number of machines to be repaired, age of machines;

- Energy cost – Volume of buildings to be heated, efficiency of heating system, waste;

- Sales department – Number of invoices issued, number of customers;

- Accounting department – Number of transactions, average transaction processing time;

- Warehousing costs – Average length of storage, number of pallets handled;

- Distribution costs – Complexity of route structure, number of owned vehicles.

Product engineering has a significant effect on the cost of each product. Beyond the basic product engineering, the detailed product specification such as purity, quality, and finish could add further costs. Design specification can often add significant additional cost that customers may not be prepared to pay or may simply not want. The company must analyze whether what is produced is really expected by the customer at the proposed price.

The areas where cost gains can be obtained:

- Input costs can be reduced;

- Switching from one technology to another;

- Labour productivity improvement;

- Efficient organization of the business process;

- Economy of scale;

- Change of location;

- Distribution costs.

The CVP relationships suggest that a useful way of studying the basic profit characteristics of a business is to focus on the Profit per Unit (which is different at every volume), but rather on the Total Fixed Costs and the Contribution Margin.

There are four basic ways in which the profit of a business can be increased:

- Increase in selling price per unit;

- Decrease variable cost per unit;

- Decrease fixed costs;

- Increase volume.

There are 2 approaches to the Cost Accounting in respect of profit analysis:

- Traditional method (cost-plus approach);

- Contribution margin method.

The Contribution Margin is the difference between Sales and Variable Costs and serves to cover Fixed Costs and to bring a certain Profit. In order to maximize Profit volume, it is necessary to maximize the Contribution Margin. Each additional unit of production sold at a given price will directly contribute to the Profit. The Unit Price should not exceed the Variable Unit Costs, otherwise a revision of the Selling Price or discontinuing the manufacturing of the product is required. The uppermost advantage of the Contribution Margin per Unit is that unlike the Profit per Unit it does not varies with the change of the output.

The Cost-Volume-Profit Analysis is based on the following basic assumptions, which are valid only within a certain range of production and sales:

Fixed Costs remain constant within a certain range of output;

Variable Costs per Unit of production do not change with volume of output;

The Sales Price per Unit of production remains fixed for set volume of sales.

The Cost-Volume-Profit Analysis gives answers to the following questions:

At what level of sales is the product profitable?

What will income be at a given sales level?

What could income be if the company operates at maximum capacity?

What will the impact of changes in price, fixed costs, variable costs, and volume be on income?

The basic formula of the Cost-Volume-Profit analysis is:

Another useful indicator of the Cost-Volume-Profit analysis is the Financial Safety Margin (Safety Threshold), which evaluates the sales volume above the Break-Even Point:

It shows how much the actual volume of sales exceeds the Break-Even point in percentage. The higher the margin the larger the profitability corridor of the company.

The Cost Structure effect on Profit is best characterized by the Operating Leverage, which shows the relationship between the change in Profit and change in Sales volume:

The Operating Leverage shows the percent change in Profit with a 1% change in Sales. It is related to the level of company risk. The greater the Operating Leverage, the higher the company risk. The greater the risk, the higher the potential reward. A high Operating Leverage means that there is a high level of fixed costs and a low level of variable costs per unit of production. Operating Leverage becomes higher the closer the sales volume is to the Break-Even point.

The concept of the Contribution Margin is most useful when analyzing one product company. For a company that makes several types of products it is more convenient to use the Contribution Margin Ratio for individual product types, divisions and for the company as a whole. The calculation formula is:

The significance of Contribution Margin is supported by the following:

It is the most important and useful tool of the product profitability analysis or for groups of products measuring changes in monetary terms;

The higher the Contribution Margin Ratio for a particular product the more attractive the manufacturing and selling of this product, from the manufacturer’s point of view, is;

It is the most qualitative and appropriate principle of product portfolio optimization, especially when there is a production capacity limitation.

The Cost-Volume-Profit analysis can also be used to analyze multi-product companies, which is a common situation for most of the businesses. In addition to answering questions covered by the single-product analysis, the modified model also covers the following topics:

Identifying which products are most profitable and vice-versa;

Comparative profitability of products;

How to utilize limited resources more efficiently;

In which product line to invest;

Identifying the optimum product portfolio;

Support for pricing decisions.

- Fixed or Variable – depending on whether the costs change with variations in production volume;

- Direct or Indirect – depending on whether costs are directly related to a certain product.

The purpose of these classifications is:

- Fixed/Variable Costs are used for the Cost-Volume-Profit Analysis and for the optimization of the structure of production;

- Direct/Indirect Costs are used in assessing the allocation of a cost to a particular product or company division.

Fixed Costs do not vary with the quantity produced, no matter what the output is, the amount of fixed costs will be the same. (rent, interest, G&A expenses); Variable Costs vary with the quantity produced. A variation in output will cause a variation in the cost by the same proportion. (raw materials, wages, power energy); Semi-Fixed Costs depend on the quantity produced, but will not vary in direct proportion to the quantity produced. They increase in steps, i.e., they are fixed until a certain level of output is reached at which point they become variable. (shipment for bulk).

Direct Costs are incurred exclusively for one product. They can easily be traced to a specific product. They are generally incurred in the production/marketing process. Dropping the product would eliminate this cost. (raw materials, power energy, wages);

Indirect Costs are incurred for more than one product. They can not be traced for a specific product. Dropping the product would not eliminate this cost. (energy to heat, production supervision Labour).

Classification of costs as Fixed or Variable is necessary for making decisions that affect the volume of output. Managers want to know how such decisions will effect Cost and Revenues, and most importantly – Income.

Cost Management consists of:

- Having a systematic approach to determining what your real costs are;

- Understanding why costs are incurred;

- Taking action based on your analysis and understanding, in order to improve the company’s cost structure (cost reduction, strategic choices);

- Always looking for opportunities to save money.

Advantages of effective Cost Management:

- More cost competitive products, and thus increased sales opportunities;

- Appropriately priced products and flexibility in pricing;

- Availability of qualitative and real information about the cost of certain types of products and their position in the market in comparison with the other competitors’ products;

- Better resources allocation and a better managed business;

- Providing objective data for generating company budgets;

- Capability of evaluating performance of each division in the enterprise from the financial point of view;

While understanding the true costs the company has the opportunity to take better management decisions. The appropriate management of costs will lead to a more competitive enterprise.

The consequences of inefficient Cost Management are:

- Cash is wasted;

- Product prices are set incorrectly;

- Resources are dedicated to “wrong” products, activities or customers;

- Management does not know how the company can reduce its costs;

- Costs rise without being noticed because they are not managed;

- Profitability drops for unknown reasons.

The answer to the question: “How could the production strategy from a cost point of view be optimized in such a way that it would contribute to an appropriate pricing of products and to selling them in a profitable way” could be found through the comparison of the Costing Models.

Full Absorption Costing Model – is based on the calculation of the product cost by applying the total cost incurred for the company or for a particular production line to the total range of products. This model was widely used in countries with controlled economy. It does not provide an accurate or sensitive measurement framework for price computation in competitive markets, and does not provide a basis for determining which products are making profits and which are causing losses. In competitive markets, those companies that can cut their Per Unit Production Costs to a minimum are going to be able to sell their products at a lower price. Those companies that cannot cut their costs will lose market share or suffer losses.

Avoidable Costing Model. It is used by some western companies. It involves selecting of some of the overhead costs and attributing them to a particular product. Avoidable Costs are those overhead costs that would be eliminated if a particular product was completely withdrawn from the production. This method provide a more accurate assessment of the cost of producing a product than the Full Absorption Method, but still does not accurately measures the costs involved for that product.

Variable Costing Model. It is also called the “Marginal Costing Model’, that provides an accurate measure of the costs involved in producing a unit of a particular product. It is the model used most widely in the West, nevertheless in the last years this model is getting more popularity among former SU countries.

Variable Costing Model identifies the costs of producing each additional unit for a given product and focuses on how product costs change when the volume of production changes. It entails identifying which costs are directly attributable to a product (variable costs), e.g., the raw material costs and energy costs. Once these variable per unit costs are known, by subtracting them from the price of the product, one can determine how much of the price is available to cover overhead costs. This amount that contributes to covering fixed costs is called Contribution.

The Accounts Receivable Turnover Ratio indicates how many times, on average, the receivables revolve, that is, are generated and collected during the year. The receivables turnover ratio is computed as follows:

* – the sales figure used in computing the ratio should be that of credit sales only, because cash sales obviously do not generate receivables.

While the turnover figure furnishes a sense of the speed of collections and is valuable for comparison purposes, it is not directly comparable to the terms of trade that the enterprise normally extends. Such comparison is best made by converting the turnover into days of sales tied up in inventories. This measure, also known as Days Sales in Accounts Receivable, measures the number of days it takes, on average, to collect accounts receivable, which is calculated as follows:

These indicators are analyzed:

- In dynamics;

- Are compared to industry averages;

- Are compared to the credit terms granted by the enterprise.

If the company provides a 30 days period of sales on credit, then an average collection period of 60 days reflects either some or all of the following conditions:

A poor collection job (Marketing Department);

Customers in financial difficulty, or an excessive delinquency of 2 – 3 clients;

Introduction of new products (promotion phase);

A desire to make more sales in order to utilize available excess capacity;

Special competitive conditions in the industry.

The further analysis is directed towards the ageing schedule of accounts receivable for each customer.

Inventory Turnover Ratio

In most businesses, a certain level of inventory must be kept in order to generate an adequate level of sales. Inventories are normally considered the least liquid and at the same time the most risky component of the current assets group.

The Inventory Turnover Ratio measures the average rate of speed with which inventories move through and out of the enterprise. The computation of the Average Inventory Turnover is as follows:

Another measure of Inventory Turnover is also useful in assessing purchasing policy is te required number of Days to Sell Inventory. The computation of it is:

These indicators are analyzed:

- In dynamics;

- Are compared to industry averages;

- The further in-depth analysis is directed to the groups of inventories (raw materials, perishable tools, work in progress, finished goods).

A rate of return that is slower than that experienced historically, or that is below that normal in the industry, would lead to the preliminary conclusion that:

Inventories include items that are slow moving because they are obsolete, in weak demand, or otherwise unsalable;

A build-up of inventory in accordance wit a future contractual commitment, or for any number of other reasons that must be probed further;

Anticipation of a price rise;

One should never lose sight of the fact that the total inventory turnover ratio is an aggregate of widely varying turnover rates of individual components. Departmental or divisional turnover rates can similarly lead to more useful conclusions regarding inventory quality.

Accounts Payable Ratio

Not all liabilities represent equally urgent and forceful calls for payment. The nature of current liabilities must be judged in the light of the degree of urgency of payment that attaches to them.

The Accounts Payable Ratio indicates how many times the current liabilities are renewed within a certain period of time and it is expressed through the following formula:

A measure of the degree to which accounts payable represent current rather than overdue obligations can be obtained by calculating the Days Purchases in Accounts Payable Ratio:

The amount of Purchases is calculated based on the following relation:

* – Adjusting of Cost of Goods Sold figure for depreciation and other noncash-requiring charges, as well as for charges in inventories.