Competition Bikes, inc,
Executive Summary Report
Horizontal, Vertical, Trend and Ratio Analysis
The assessments of the financial health of Competition Bikes, Inc. (CB) are derived using
the attached income statements and balance sheets. Focusing on calendar years # 6, 7 and 8 to
gauge the growth and stability of this company.
Between the years # 6 and 7, Competition Bikes, Inc. had a significant growth in new
earnings that was not extended on into year # 8. The net earnings moved from a positive 313.4
% to a dramatic loss of 81.6% .
A.1.a) Horizontal Analysis Results
Horizontal Analysis is a direct comparative analysis of each line item across the same
time frames of a particular company. It is calculated in dollars and percentages. An analysis will
look at how the accounts have fluctuated from one year to the next.
The formula used is:
Dollar change = This Year’s Balance – Last Year’s Balance. Percent change = Dollar Change .
The income statement from year # 6 to year # 7, exhibited a sales increase of 33%.
There was only a 31 percent increase in product costs. This decrease in cost of materials was
offset by sales expense of 33 percent and an increase in general operating espense – totaling 20
percent.. These line expenses both increased from year # 6 through year # 8. These increases
offset the profit from an increase in sales. CB experienced greater gross profits in year # 7 than
year # 6. The balance sheet also shows a growth in assets. Total assets increased by 2.9%.
Liabilities increased to only a slight 1.2% . This is a positive indicator of growth for Competition
A comparative review of the CB income statement from year # 7 to year #8, shows a
decrease in sales by 15 percent. Product costs went down by 14 percent and sales expense
decreased by 15 percent. The general operating expense increased by 1 percent. The decrease in
product cost and sales expense was not significant enough to offset the decrease in sales. The end
result was a dramatic decrease in net income by 82%. The balance sheet shows total assets
decreasing by – 0.1% with liabilities also decreasing by -1.9%. This is a positive sign of
“The horizontal analysis will provide an analysis of the financial performance of
Competition Bikes, Inc. and provides an overview of potential trends of the
company .”(Ashfaq, n.d.).
The years # 7 and 8 utilizing the horizontal analysis further shows that total revenues
decreased by 15.0% . Total expenses decreased by an impressive 69.1%. The result was
earnings before income taxes (EBIT) decreased 313.4% and net earnings reduced 81.6%.
A horizontal analysis of CB is derived utilizing the income statement for Years 8, 7 and 6.
Competition Bikes, Inc.’s financial strength was solely relied on by use of their income
Statements. It revealed a decline in growth in year #8 from year #7 . A 15% decline in
net sales resulted in a 16.3% decline in overall gross profit.
The 15% reduction in sales is an overall operational area of concern. The decline has
been attributed to a decrease in the economy.. It is anticipated that sales trends will remain
steady for the next three years. For CB to recover from a such a steep decrease in sales, new
fiscal policies are necessary to remain a solvent company.
Since sales were down, the products were not manufactured and the cost of goods sold is
aligned with this reduction. The Gross Profit was reduced also because of the lack of sales and
can affect future expansion of CB.
The operational expenses seen a 3.6% decline. This decline was not equal to the decrease
in revenue. Management must keep expenses related to sales income. If they had kept in line the
operational expenses would have declined in lieu of increased.
There are a few areas of concern within this area that must be addressed.
Sales expenses are reduced by 14.9%. This is consistent with the reduced sale. Sales is
remunerated by a percentage.
The reduction in sales paralleled the reduction in total sales expenses. Notably was the
decrease in advertising costs by 16.3 percent. A reduction in advertising can be partially
attributable to the decrease in gross sales.
The Cost of Utilities steadily grew. CB experienced an 11.1% growth. This would not be
suspect except why did utilities needed for production increased when production decreased.
In addition to the utility costs, all other general and administration expenses increased by
7.6 percent. This is of concern, besides utilities, all other costs were either below or even with
year # 7.
Balance Sheets and Total Assets
CB reduced the accounts receivable account by 15 %. The horizontal analysis of the
current assets shows that the assets have grown 16.5% from year 7 to year # 8. The result of
collecting on accounts receivable was an infusion of $ 107,640 dollars. The cash balance rose
Analysis shows that the accumulated depreciation was reduced by $ 230,000 or 50%.
The total assets were reduced by 0.1% or $2, 400.
With a reduction of Accounts Receivable, the cash infusion was apparently partially used
to reduce the total liabilities by $ 38,500 or 1.9 percent. These reductions were in the long term
liabilities column. Reducing Mortgage and other long-term liabilities.
A significant line of concern on the balance sheet is the increased purchase of raw
materials with a decrease in sales. This explains the unexplained increase in current liabilities of
A.1.B ) Vertical Analysis Results
Vertical analysis is a method of analyzing financial statements against net sales of
the company. This analysis will illustrate how one credit or debit can have a positive or
negative effect on the net sales profit.
The income statement of CB, vertical analysis shows the following results.
Gross Profit is the total sales minus the cost of goods sold. Net sales profit is determined
by crediting the fixed general operational expenses to the cost of goods sold. This determines
profit. Gross sales profit is an indicator of the company’s profit on all goods sold. The
significance of this number is maintaining market share and the viability of the product. Gross
sales allow for a cash influx to maintain operations. An analysis identifies weaknesses to discuss
potential remedies needed to increase the gross profit ratio. The gross profit ratio is determined
by the following formula:
Gross Profit Ratio = Gross Profit/ Net Sales
An analysis of the income statement of CB was performed.
Gross Profit for CB is assessed as:
Year 8 Gross Profit - 1,371,400- net Sales Year 8 / 5,083,000 = 27.0%
Year 7 Gross Profit- 1,638,000 - net Sales Year 7 / 5,980,000 = 27.4%
Year 6 Gross Profit - 1,191,000 -net Sales Year 6 / 4,485,000 = 26.6%
The GP is trailing down. This is after a record year in - #7. This creates concern,
particularly when compared to year 6 when the GP was 26.6%. A GP of 27% is considered a
nice reasonable profit. CB needs to pay particular attention to this decrease. A decrease in GP is
a decrease in cash flow, market share and will affect CB’s net earnings. This decrease will
affect the ability to generate cash reserves..
Operating Expenses Ratio (OER) is to determine the cost of normal business operations.
The formula is calculated as follows:
OER = Operating Expenses/Net Sales
Operating Expenses for CB were assessed as:
OE Year 8- 1,273,867 / Net Sales / 5,083,000 = 25.1%
OE Year 7- 1,322,075 / Net Sales / 5,980,000 = 22.1%
OE Year 6- 1,066,895/ Net Sales / 4,485,000 = 23.8%
Year 6 assets represent 24.5 cents out of every dollar and total liabilities are 47.5%.
Year 7 assets were increased to 31.9 cents. This was possible by the accounts
receivable increasing from 6.5% to 16.6%. Liabilities decreased to 46.7%.
The financial statements show that operating expenses are 25.1% of every dollar made by
CB. These expenses include sales expenses, general and administration expenses.
Since year 7, the operating expenses have increased 3%. It is most notable with a reduction in
sales in year 8. Most significant is the sales expenses were not reduced in year 8 consistent with
the major reduction in gross sales. Steadily, the sales expenses stay within 6.7% of gross sales.
Appropriate reductions were not made in sales advertising in year 8 . Sales Commissions were
lower due to the lower sales. This is an indication, CB had established sales commissions
according gross sales. Sales commissions have maintained at 3% of net sales.
General and administration expenses increased steadily. Specifically, there was an
increase in the cost of general and administration expenses from 15.5% to 18.4%. One notable
reason for this increase was that salaries were increased in year 8.
Executive Commissions increased from year 7 to year 8 . Sales income needs to be
directly related to sales profits. This may be an indicator of CB not being in financially good
health in the near future. If their remuneration was directly linked to their net profit, then the
percentage would have stayed more consistent..
The cost of general and administration expenses rose in year 8 by $12,000 or 0.7%. This
Figure is an additional indicator that the financial health of CB is deteriorating.
Executives need to adjust and control expenses.
Net Earnings for CB years 8, 7, 6:
Net Earnings Year 8- 36,100 / 5,083,000 = 0.7%
Net Earnings Year 7- 196,294 / 5,980,000 = 3.3%
Net Earnings Year 6 - 47,479 / 4,485,000 = 1.1%
These ratios should be of major concern to CB. They are breaking even between sales
and expenses. This slim margin is indicative that expenses are too high. The 2.6% reduction in
net earnings is below their prior year 6 net earnings.
In reviewing the Balance Sheet of CB, the following vertical analysis was performed below.
Current Ratio is used to determine whether a company can pay its short-term debt.
Current Assets Ratio is determined by the formula:
Current Ratio = Current Assets/Current Liabilities
Current Ratio for CB was computed by:
Current Assets Year 8/ Current Liabilities-Year 8 1,606,817/ 300,200 = 5.35X
Current Assets Year 7/ Current Liabilities- Year 7 1,379,217/ 233,700 = 5.9X
Current Assets Year 6/ Current Liabilities- Year 6 1,029,303/ 105,080 = 9.7X
Although CB’s year 8 Current Ratio is 5.35X, its current liabilities, the continued
reduction is a concern..
Competition Bikes, Inc's income performance deteriorated between year 7 and 8.
In year 8, for every gross dollar generated, it retained 0.7 cents. In year 7, 3.3 cents was
retained. The overall profitability of the company decreased.
A.1.C ) Trend Analysis
Trend analysis calculates the percent change in an account over two years or more. This
is to illustrate if the company is moving positively or negatively.
The formula is as follows:
(Any year $ / Base Year $) x 100
Year 6 is used as the base year
To evaluate CB net sales profits for years 8, 7, and 6 the following trend analysis was completed:
Net sales- year #8/ 5,083,000 - year # 7/ 5,980,000 - year# 6 / 4,485,000
COG - year #8/ 3,711,600 – year # 7/ 4,324,200 – year # 6/ 3,294,000
Gross Profit- year# 8/ 1,371,400 - year # 7/ 1,638,000- year #6/ 1,191,000
Sales Expense - year # 8/ 338,748- year # 7/ 397,960- year # 6 / 299,220
Total G&A Expenses- year# 8 / 935,119- year # 7 / 924,115- year# 6 / 967,675
Total Operating Expenses- year # 8/ 1,273,867- year 7/ 1,322,075- year #6/ 1,066,895
Operating Income – year# 8 / 97,533- year # 7/ 315,925 – year# 6 / 124,105
EBIT- year # 8/ 48,133- year# 7/ 261,725- year #6/ 63,305
Net Earnings – year # 8/ 36,100- year # 7/ 196,294- year# 6 / 47,479
Net Sales – year # 8/ 113.3%- year #7 / 133.3%- year # 6/ 100.0%
Cost of Goods Sold- year# 8/ 112.7% - year # 7/ 131.3% - year# 6/ 100.0%
Gross Profit – year # 8/ 115.1%- year # 7/ 137.5%- year 6/ 100.0%
Selling Expense – year # 8/ 113.2% - year # 7/ 133.0%- year # 6/ 100.0%
Total G&A Expenses - year # 8 / 96.6%- year # 7 / 95.5%- year 6/ 100.0%
Total Operating Expenses – year# 8 / 119.4%- year 7/ 123.9% - year 6/ 100.0%
Operating Income – year # 8/ 78.6%- year 7/ 254.6%- year 6/ 100.0%
EBIT- year # 8/ 76.0%- year 7/ 413.4%- year 6/ 100.0%
Net Earnings – year #8/ 76.0%- year# 7/ 413.4%- year # 6/ 100.0%
Net Sales decreased in Year 8 in comparison to Year 7. This was calculated by:
Year # 8 Trend : (5,083,000/4,485,000) x 100 = 113.3 %
Year # 7 Trend : (5,980,000/4,485,000) x 100 = 133.3 %
This is a concern since net sales profit was in a decline from Year # 7. However, it did
not fall below year # 6 Net Sales.
Sales should continue to increase annually.. To establish the stability of the company
and the viability of the product.
Cost of Goods Sold for Year # 8 and 7 were evaluated as follows:
Year # 8 Trend : (3,711,600/ 3,294,000) x 100 = 112.7%
Year # 7 Trend : (4,324,200/ 3,294,000) x 100 = 131.3%
In Year # 8, the Cost of Goods decreased compared to Year # 7.
Year # 8 Trend : (5,083,000/4,485,000) x 100 = 113.3 %
Year # 7 Trend : (5,980,000/4,485,000) x 100 = 133.3 %
For Year 8, the trend shows that the cost of goods is reduced but is not in line with the
reduction in sales. The Cost of Goods needs to be evaluated to insure that the proper pricing of
the goods is in line with the sales point of the merchandise..
In EBIT and net earnings, year 7 provided the trend boost with a 413.4% increase in
growth. This was due to the tremendous growth in sales. In year 8, EBIT and Net Earnings
were dramatically reduced even below year 6. This is of major concern. Although sales were
reduced, operating expenses were not reduced to produce a better EBIT and net earnings.
Reduction in expenses should have been made throughout the year as the reduction in sales was
The trend analysis for year # 8, compared to year # 7. Policy change may be needed
when sales are decreasing and expenses are increasing. This simple business fact produces a
strong EBIT and net earnings dividend .
Trend analysis for future years.
Competition Bikes, INC. Year 11- Year 10- Year 9- Year 8
Net Sales year # 11/- 5,083,000-year # 10/ 5,980,000- year # 9/ 4,485,000- year # 8/ 5,083,000
Trend Percentages – year #11/ 111.8- year # 10/ 107.6- year #9/ 103.2- year #8 / 100.0
In base year 6, the trend percentage is 100%. Year 7 trend percentage is 133.3%. The
year 8 trend percentage is 113%. Although lower than year 7, it is still higher than the base year
This trend analysis illustrates sales in year 8 were 13.3% of year 6 sales. This represents
an increase in balance over a three year period. The results are a favorable impact to the
company. The trend is less favorable in the next three years. From year 8 to 11, the trend
analysis is only an 11.8% increase in sales. This is lower than the previous three-year period.
This would still be a favorable impact for CB. The company will recover from its year 8 losses.
They need to be cognizant and pay attention to their operating expenses to insure profitability.
A.1.D) Ratio Analysis
Ratio analysis examines “the financial infrastructure of the firm, its characteristics, and
the impact of management decisions on financial performance” (Skillsoft, n.d.). The ratio
analysis indicates CB’s ability to pay short term liabilities. Ratio analysis has been
reviewed in the summary analysis approach. This concludes all aspects of the companies
financial activities to isolate the following key areas of responsibility:
“Liquidity ratios measure the short-term solvency of a business solvency.” (Skillsoft,
Ratio Analysis) These ratios are used by creditors to evaluate if a company has the
ability to pay back its obligations and liabilities.
The liquidity ratios for CB will also determine how well it is performing financially.
These ratios will determine cash reserves and availability, inventory turnover and the
management of assets and liabilities.
Current Ratio is used to determine whether CB can pay its short-term debt. Current
Assets Ratio formula is:
Current Ratio = Current Assets/Current Liabilities
Current assets year 8/ Current Liabilities Year 8 -1,606,817/ 300,200 = 5.35X
Current assets year 7/ Current Liabilities Year 7 -1,379,217/ 233,700 = 5.9X
Current assets year 6/ Current Liabilities Year 6 -1,029,303/ 105,080 = 9.7X
CB’s Year 8 Current Ratio is 5.35X in current liabilities, the continued reduction is a
point of concern. As the ratio continues to decline, the increase in liabilities must be curtailed
until assets recover.
Quick Ratio determines how well a company can pay back its creditors. It is utilized to
determine their solvency. If their assets outweigh their liabilities. .
The formula is:
Quick Ratio = Liquid Assets / Current Liabilities
Year # 8 Quick Ratio = ( 445,024 + 220,000 + 609,960) / 300,200 = 4.25 %
Year # 7 Quick Ratio = ( 118,550 + 220,000 + 717,600) / 233,700 = 4.52 %
Year # 6 Quick Ratio = ( 261,000 + 198,500 + 271,503) / 105,080 = 6.96 %
The acid test ratio for year 8 is 4.25. This is lower than year # 7, 4.52. Although, it is
higher than its competition, Two Wheel Racing (2WR). Their ratio is slightly lower at 4.2
Competition Bikes Inc., is solvent and can meet its short-term debt obligations 5.35 times
over. From an investors stand point, this company is performing well. From a creditors stand
point, they are credit worthy.
The quick ratio analysis indicates that CB continues to increase its risk in covering its
immediate liabilities. If this ratio continues to decline, this will result in a risk of increased
financial problems or their ability to receive credit lines. Another indicator of the analysis is that
inventory is accumulating. 2WR is excelling CB in most all financial areas. 2WR’s Gross
Profit is 32.10 % compared to CB’s Gross Profit of 27.0%
CB has a weakness in their P/E Ratio of 83.73. 2WR P/E Ratio is 29. Stockholders
may look at this higher P/E Ratio for CB unfavorably. This higher P/E Ratio may be an indicator
that the stock price for CB is overpriced. This possibly could indicate that 2WR’s stock is priced
correctly and allow 2WR possible future growth and strength.
Current Ratio for CB was assessed as:
Current assets Year # 8- 1,606,817 / Current Liabilities - 300, 200 = 5.35X
Current assets Year # 7- 1,379,217 / Current Liabilities - 233,700 = 5.9X
Current assets Year # 6 - 1,029,303 / Current Liabilities - 105,080 = 9.7X
2WR has a lower ability to pay short-term debt than CB . This is a weakness for 2WR.
2WR has a lower average collection period by collecting on accounts faster than CB.
2WR and CB are very competitive with different strengths and weaknesses. If CB
continues to decrease sales and if 2WR increases sales this year – the following year may be the
end of CB.
A.2) Working Capital Analysis
Working Capital is a measure of a company’s financial health in the short-term. It is
required for production and continuous operations. CB’s working capital is invested in
their inventory and accounts receivable. Working capital also provides an indication of whether
current debts can be paid as they are incurred. Working capital is necessary for the company to
continue a growth pattern. Operating expenses like late fees, could be slowly draining CB of
“Positive working capital means that the company is able to pay off its short-term
liabilities.” (Investopedia, Working Capital, n.d.)
A definition of working capital is:
Gross Working Capital- is referred to as Total Current Assets.
Another definition is:
Net Working Capital - is referred to as Current Assets – Current Liabilities.
CB Working Capital is as follows:
Year # 8 - $ 1,306,617
Year # 7 - $ 1,145,517
Year # 6 - $ 1,104,223
CB working capital has increased dramatically in one year. It can pay its short-term
liabilities better than in previous years.
Improving Working Capital.
Working Capital is essential in companies for the day to day operations. For CB to
increase working capital, it must evaluate several areas of its operations to include specifically its
collection policy. The first way to improve working capital is to increase sales. By increasing
sales, cash flow increases.
A notable improvement would be reducing CB’s average collection period from 43.8
days to standard 30 days. This policy action will increase cash flow for CB. In year 8 operating
cycle, revealed 46.9 days conversion from capital to revenue. This included 22.5 day payables
outstanding and 47.7 day sales outstanding. CB should negotiate a 30 day net from suppliers and
a 15 day net from customers. CB should be more diligent in their collection efforts.
Consideration should be made on the increase of interest rates for accounts. To impose penalties
for delinquent accounts. This policy would increase cash flow, reduce potential late fees from
CB’s suppliers and could generate funds to support advertising, R&D and ultimately funds to
the net profit.
To improve the working capital for CB, a review of their supply chain and Just-In- Time
strategy would be prudent. Their current strategy of ordering supplies on a monthly budget
instead of a sales trend is resulting in higher raw materials costs. Purchases should be tied to
sales and a specific strategy and not to budgets.
Working Capital to Increase Profits
With an increase in working capital, CU should invest into a lighter frame to compete
A.3) Internal Controls
“The purchasing department will issue a purchase order to the supplier based on the
monthly budget projections. Purchasing checks with three sources for similar quality
materials and selects the low bidder from the three. The purchase order is sent to the
supplier by the Purchasing Department on the first of the projected month. Upon receipt
of the goods they will be brought to the production line for use during the month. Any
unused parts are sent to the raw materials inventory stores on the last day of the month.
Purchasing sends the suppliers invoice to accounting and accounting writes a check to
pay the invoice (Sarbanes - Oxley Act (SOX).”
Segregation of duties creates a checks and balances system. This greatly reduce the
ability to misappropriate items from the company. The internal controls state that the purchasing
department will issue the purchase order. The expenditure of company funds is under scrutiny by
auditors and is resulting in misinformation about the company’s financial strength. The
prevention of theft and fraud is paramount in an assembly company.
The audit shows the purchase order system as probably the single largest problem in the
company. Many individuals can access the system and generate a payment. The company is
vulnerable to untold losses. Problem, the purchasing department controls the selection of vendors,
purchasing materials and the receiving of materials. This system only pertains to the budgeted
transactions. Purchase agents authorize the purchase and issues the purchase order based on
There is not a solid policy to insure the receipt of goods authorized in the purchase order.
The end result is goods being received that were not ordered or needed..
A.3. A ) Corrective Actions
CB needs to implement the following to be compliant with SOX:
1. Establish processes and policies to an independent or management review of the
three sources who are bidding for the vendor supplier work. To discourage the favoritism of one
of three sources.
2. Establish a separate entity for the physical writing of the purchase order.
3. Implement policies for accurate confirmation of the invoice and the goods. Establish policies
to insure that the goods ordered were delivered. Appropriate payment of the invoice so that the
person ordering and receiving is separate entity.
A.3.B ) Risks
Risks that have been identified:
Financial, the purchasing from a non-qualified resource.
Financial, the receiving of unapproved goods.
The receipt of goods that are not timely delivered causing assembly delays.
The delivery of unnecessary goods in conflict with the Just-In-Time strategy.
A.3.BI ) Risk Mitigation
Area Risk Mitigation
Purchasing from a non-qualified source. The need to implement policy on
review of three bids that include an independent review of the source bids in relation to
2) Independence from resource
Implement management approval and review of all selections of potential sources to
Insure policy compliance and to eliminate the potential for purchases being aligned with internal
Implement policy concerning the receiving of unapproved goods and receipt of all
goods. Compliance of strict adherence to the purchase order specifications for receipt of
Implement policy and process concerning appropriate receipt of goods so that goods are
received according to scheduled purchases.
Fraudulent invoices being paid would be eliminated if the process has several checks and
A.4) Sarbanes-Oxley Compliance
“The Sarbanes-Oxley Act (often abbreviated as SOX) was enacted by the U.S. Congress
in 2002 in the aftermath of several corporate accounting scandals. Accounting problems
at Enron and WorldCom, and other debacles, resulted in a precipitous drop in the
investing public’s confidence in companies published financial statements. SOX was
enacted to bring about reform in companies financial reporting processes, as well as the
internal and external auditing of the financial reporting process. Under SOX, a
company’s top executive, including the CEO (chief executive officer) and the CFO
(chief financial officer), can be held criminally responsible if their financial statements
prove to be fraudulent or materially misstate the firm’s financial condition” (Hilton,
SOX has become the standard of accounting principles since its inception in 2002.
SOX deals with internal controls concerning financial reporting. These controls include polices,
processes and procedures that are used to accurately determine an accurate picture of a
corporation’s financial position.
Specific internal controls include approval cycles of financials to include expense reports
and invoices, as well as authorizations and verifications of the corporation’s operating
performance, assets security and duty separation and can not only cover the executive
officers but also all employees of the corporation (Hilton, 2009).
Corporate Responsibility of Financial Reports (Section 302)
Section 302 outlines corporate officer responsibility to continually evaluate the
company’s financial internal reporting controls. To implement and evaluate controls for financial
A.4A) Noncompliance Actions
The CB financial statement has several material weaknesses.
1. Lack of internal controls in violation of SOX “establishing and maintaining
adequate internal control over financial reporting” (SEC, 2003);
2. With missing inventory, an assessment of its liquidity is overstated. “issued an attestation
report on management's assessment of the company's internal control over financial reporting”
Recommendations for corrective actions for noncompliant with the Sarbanes-Oxley requirement
Sox Section 404 – Contract an independent auditor to evaluate Competition Bikes Inc., internal
Sox Section 906 – Strict requirements of adherence of corporate responsibility for financial
The directive states that “Management is responsible for ensuring the internal control
Processes to prevent material misstatements from being reported in the financial statements”
but does not report on the specific internal controls over the financial reporting nor identify the
framework that was used to insure and evaluate the internal controls.
The letter does not provide details in its assessment that internal controls are effective.
Simply stating that it is effective based on the COSO is not enough since COSO Internal
Control-Integrated Framework states that “material weakness is considered in relation to an
entity’s financial reporting objective…” (COSO, 2011)
In summary of non-compliance corrective actions. A check and balance of all purchase
orders and received goods would alleviate the majority of compliance and profitability issues. A
thorough implementation of Just- In –Time strategy for raw materials would move CB into a
more profitable venture.
~ Robert Hixon
Ashfaq, Qazi. (n.d.) Financial Statement Analysis. Retrieved from
COSO. (2011 Dec). Internal Control – Integrated Framework. Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Retrieved from
Hilton, Ronald. (2009). Managerial Accounting: Creating Value in the Dynamic Business
Environment, 8th Edition, Appendix I. McGraw-Hill Higher Education. (Appendix I).
Investopedia, (n.d.) Working Capital. Retrieved from
Securities and Exchange Commission hereinafter referred to as SEC. (2003, June). Final Rule:
Management’s Report On Internal Control Over Financial Reporting and Certification of
Disclosure in Exchange Act Periodic Reports. 17 CFR PARTS 210, 228, 229, 240, 249, 270 and
274. [RELEASE NOS. 33-8238; 34-47986; IC-26068; File Nos. S7-40-02; S7-06-03]. Retrieved
Skillsoft. (n.d.) Ratio Analysis for Financial Statements. Retrieved from
The Sarbanes-Oxley Act hereinafter referred to as SOX. (n.d.). A Guide to the Sarbanes-Oxley
Act. Retrieved from http://www.soxlaw.com/
Competition Bikes, Inc.
Budget Concerns illustrated in year #9
A 1) Competition Bikes, Inc. ( CB ) budget for year # 9 contains the required schedules. There
are five remaining concerns.
Concern # 1 – Quarterly Budget
My first concern is that the budget should be further divided into quarters. Bicycling is
predominantly a temperate weather activity. Purchasing of raw materials for the onset of a sales
increase in demand should incur a quarter prior to demand. Conversely, the quarter prior to a
historically slower quarter should have a budget with less purchase of raw materials. Reserve
inventory is satisfactory for an unexpected sudden demand for finished product.
Concern # 2 – Sales Projections
According to Hilton,( 2009)
“The sales budget is based on projections that take into account trend information as well
as market, competitor, and other econometric information to provide an accurate forecast
of future sales.”
The projection of 3,510 sold units in year # 9 is not supported by the previous year #8
sales. In year # 8 there was a 15% decrease in units sold than in year # 7. Optimism of a
return of a sales level rivaling year #7 is appreciated. The reality is that if sales do not rival year
#7 , the budget should have a variance allowance in a post historically slow quarter for an
adjustment in material purchases and other production activities.
Based solely on facts provided by the company, year # 8 reduced sales was primarily due
to a downturn in the overall economic situation which affected professional rider’s sponsorship.
CB also stated that this decrease in sponsorship is anticipated to continue though this year and
the following two years. Based on their own statements, there would not be justification for an
optimistic sales forecast.
Concern # 3 – Uncollectable Accounts
CB’s master budget fails to specify in their cash budget line, reference to uncollectable
receivables. With the production of such a high quality specialized product, economic factors
like lack of sponsorship is proven to be a variable factor that could generate delinquent accounts.
Concern # 4 – Raw material levels
CB is budgeting for 140 unproduced bikes including labor. The Just- In – Time principle
states that although it is preferred to have additional parts the risk is that these parts could
become obsolete. It may be prudent to reduce this level of additional parts inventory. A loss of
possible revenue does not justify the possible loss in asset value due to the parts becoming
Concern # 5 – Utilities Expense
The manufacturing overhead schedule of CB, itemizes utilities at a fixed level. It was
evident in year #8 that utilities expenses increased when production went down. This factor is
compounded in complexity when the SG&A schedule has two individual utilities line items.
One is listed as Utilities and the second is Utilities and Services. Both line items are listed
under Facility and General Operations.
A 2 ) Flexible Budget
A flexible budget is a budget with figures that are based on actual output. This number is
then compared to a company's static budget (fixed) to determine variances or differences. The
difference between what level of expense was budgeted and what was actual. A flexible budget
adjusts for changes in the volume of activity. The flexible budget is more sophisticated and than
a static budget. A flexible budget allows for increases in sales and product demand. It allows for
a larger than normal purchase of a raw materials if a tremendous price reduction becomes
available. The budget is used to determine how effectively a company is planning and
performing. Unlike the static budget, the flexible budget provides management with the actual
number, rather than the planned number.
In a budget the fixed cost remains constant. One positive reason the numbers may
change is an increase in projected sales volume. Variable cost can affect a flexible budget in a
positive light because it allows the company an opportunity to adjust to reduce their expenses. If
a company foresees a decrease in demand, they can reduce their labor and material expenses so
cash reserves can be maintained. Because variable cost may vary, the company has the
possibility to spend less than the planned amount which would produce a favorable effect on the
A 2a ) My suggestions for correcting my concerns are as follows:
The master budget should be prepared in quarters and not just an annual budget. This
simple adjustment would allow management the flexibility to adjust expenses based on actual
sales revenue. My concerns would all be addressed as the quarter sales and actual expenses and
revenues are realized.
Sales projections are more difficult to project a year in advance than a few months in
advance. If CB does realize an increase in sales, management can increase production and order
more raw materials. If CB realizes a continued decrease in sales then reductions can be initiated
sooner to prevent an accumulation of antiquated parts and head off unnecessary sales expenses
like advertising. This is an example of variance allowances.
In year # 8, CB was successful in their collection of delinquent accounts. By initiating a
policy early in the year of applying accounts receivable to their budget and being diligent in
changing policies, for example: 30 days net from their suppliers and 15 days net from their own
accounts – the results can be reviewed more often and corrections made sooner. An increase in
delinquency would also be an indicator of a decrease in future orders.
CB had a previous policy to order raw materials based on a static budget. With the
implementation of a flexible budget, CB can adjust their need and supply of materials on a more
regular schedule. Their previous compliance issue concerning purchase orders and deliveries
could be more closely monitored in this quarterly budget. The practice of increasing their assets
with antiquated parts would be curtailed. The decision to assemble bikes from parts in
anticipation of realized sales could be forecasted to increase sales revenue without missing a
potential opportunity. The decision to save labor on assembly could also be forecasted utilizing
In year #8 CB had an increase in utilities expense with a decrease in production. With a
quarterly analysis the utility expenses may indicate a potential unnecessary drain on cash
reserves. If the expense is increasing and production is decreased, an investigation by an outside
firm of the infrastructure may be necessary and warranted. In this instance, variance analysis
would detect a potential waste of natural resources that is happening without managements
knowledge. It is an increase in expense without any explanation.
A 2B ) Management by exception can least best be illustrated by the 4 % annual increase in the
utilities expense. When a projected budget is exceeded. Action by management on any notable
discrepancy in anticipated projections and realized expenses or results is within the role of
management and needs corrective action and further financial analysis.
In this example of a steady increase of utilities expense is not minuscule. It was not a
spike but an increasing large percentage. There is sufficient historical data to determine a budget.
In setting the budget in year seven based on year six of $130,000, then the actual dollar figure of
$135,000 is alarming. Then to set the budget at $135,000 and in year 8, the actual dollar figure is
$140,000. This is an NOT an example of management by exception which necessitates
upper management attention. Subordinate managers can and should be addressing this rising cost.
In a company’s budget variances, management needs to take decisive action. Profit is
made or lost by pennies. Management by exception is illustrated best below:
Dramatic sales or profit decreases in performance and analysis reports are key factors of
management by exception. This is information that the senior management needs to be aware of
to make corrective action. This practice is reserved only for the senior managers that have the
authority and skills to remedy.
Management by exception dictates that a manager's attention should not be directed
towards the parts of the organization where budgets are not being exceeding or that subordinate
managers have the skills to remedy. Time and effort would be wasted by senior management
on areas of the organization with a relatively smooth operation..
If the original plans and budgets are proceeding as planned, the difference between
actual results and initial plans will be minimal. The end expense will fall between standards
If actual results fail to conform to the budget or standards, the performance reporting system
Signals to management of an " exception. The utility expenses are falling out of standards and
Not all variances are worth investigating. Differences between end results and budgeted
or planned results are not always the exact same. Every variance cannot be investigated. It would
be cost prohibitive to trace every insignificant variance. Especially for senior managers.
Our example of the ever increasing utility bill is a justified investigation. When
production is down, the utilities continue to increase. Subordinate managers should be concerned.
Managers should decide to investigate variances based on dollar or percentage changes.
Industry standards and relative weather, personnel, holidays, all play a factor on the variances
seen in manufacturing. Percentage or dollar variances at the exact same time as in previous years
could justify a management investigation in the process causing the variance. The most
dependable strategy is to plot variance data to determine a statistical chart. The idea
behind this chart is that many random variance fluctuations from similar time periods are normal
and expected. These fluctuations are expected even with the best budget and control fluctuations.
~ Robert Hixon
Hill Hilton, Ronald W. ( 2009 ) Managerial Accounting: creating value in a dynamic business
environment – New York ,Mc Graw – Hill
Capital Structure and Budgeting
A 1 ) Competition Bikes, inc. needs to generate a cash infusion for expansion. The options are
bank loans and stock offerings. The focus of this report is to provide analysis as to ultimately
merge or acquire Canadian Biking, inc. by Competition Bikes, inc. This report will
concentrate on the following five key areas and give recommendations on the following:
1) Capital structure approach options
2) Capital structure approach justification
3) Capital budget concerns
4) Working capital for acquisition and expansion
5) Expansion recommendation to either – acquire or merge
“Capital structure is the manner in which a firm’s assets are financed; that is, the right-
hand side of the balance sheet. Capital structure is normally expressed as the percentage
of each type of capital used by the firm debt, preferred stock, and common equity.”
(Capital Structure Decision, 2002)
To be analyzed are the two main components which are debt capital and equity capital.
The decision on the best capital structure is to analyze many factors including but not limited to
gross sales which is an indicator of the demand and viability of the product, assets, growth rate,
current tax liabilities, potential profitability and changing market demands.
The five primary factors to consider in capital structure are as follows;
“1.Tax benefit of Debt: Debt is the cheapest source of long-term finance, when compared
with other source equity, because the interest on debt finance is a tax-deductible expense.
Hence, debt can be accepted as tax sheltered source of finance, which helps in
shareholders’ wealth maximization.
2. Control: Equity shareholders have voting right to elect the directors of the company.
Raising funds by way of issue of new equity shares to the public may lead to loss of
control. If the main objective of management is to maintain control, they will have to
prefer debt and preference shares in additional capital requirements. However the
company earnings should be such that it is able to repay the debt in time.
3. Flexibility: The capital structure should be determined within the debt capacity of the
company, and this capacity should not be exceeded. The debt capacity of a company
depends on its ability to generate future cash flows. It should have enough cash to pay the
debt obligations. The capital structure should be able to adapt its capital structure with a
minimum cost and delay if warranted by a changed situation.
4. Industry Standards: A company needs to examine industry standards of debt-equity
mix while planning its capital structure. For example Electrical Industry tries to maintain
debt-equity ratio of less than 2:1; Chemical Industry has a conservative debt policy; and
in Automobile Industry government permits a debt – equity ratio of 2:1.
5. Company Size: Companies that are very small must rely to a considerable degree on
the owner’s fund for their financing; they find it difficult to obtain long–term debts.
Large companies can make use of different sources of funds. (kkhsou, 2012) “
Debt Capital is a long term debt. Bank loans and bonds are the two primary sources of
loans. Debt Capital is an expensive form of equity but has tax advantages. The return of
investment has a greater return for the investor or lender. Equity Capital or stock holders equity
has the greatest risk for investors.
Capital Structure Options
“The two principal sources of finance for a company are equity and debt. What should be
the proportion of equity and debt in the capital structure of the firm?” (Manage Mentor,
2003). A number of various theories may be utilized to make a determination. These
theories are known as the net income theory (NI), the net operating income theory (NIO),
the traditional theory, and the Modigliani and Miller Theory (MM).
To make an informed decision on the best capital structure approach. It is best to use a
number of elements, operating structure, assets, sales, assets, growth rate, taxes and market
conditions. These capital structure options were reviewed to determine the best approach for the
Canadian Bikes, inc. merger or acquisition to raise the $600,000 and maximize shareholder
· 9% bonds
· 50% preferred (5%, $50 par) and 50% Common Stock
· 20% - 9% bonds and Common Stock
· 40% - 9% bonds and Common Stock
· 60% - 9% bonds and Common Stock
Canadian Bikes, inc. EBIT figures were considered. Utilizing both the low and moderate
projections. The accompanying tables show the EBIT data. Displayed are each year with the
impact of each of the low and moderate EBIT. The earnings per share of common stock show
Capital Structure Recommendation maximizing shareholder return
A capital approach that maximizes shareholder return. I reviewed five options based on
two key factors; earning per common share and net earnings. These two factors were the primary
considerations for key reasons. The result returned $15,000 in preferred stock dividends under
To raise the $600,000 for capital improvements my first concern was the earning per
common share. The EBIT for each of the five years, #9 – #13, considering the low projected
sales and the moderate projected sales were considered. The earnings for both in relation to the
per common share was calculated. The result for the 50% preferred (5%, $50 par) and 50%
common stock option is roughly equal. With exception for year # 9 by 0.01. This was based on
the low projection. In summary, the earning for each common or preferred share of stock is the
best when the 50% preferred (5%, $50 par) and 50% Common Stock option is used.
My second factor analyzed was the net income results for each of the five options. In
every calendar year using the low and the moderate projections, the 50% preferred (5%, $50 par)
and 50% Common Stock options outperform all other options. The net earnings exceed tens of
thousands of dollars each calendar year. In the course of the five year analysis, the net income
variances are dramatic. In both categories the 50% preferred (5%, $50 par) and 50% Common
Stock option is the best.
The final factor analyzed was the annual return of $15,000 in preferred stock dividends
EBIT figures from Canadian Bikes, inc. Budgeted Earnings in US dollars
Year/ Low $/ Moderate $/
9- 74,816 / 109,816
10 - 84,714/ 128,814
11- 94,501/ 148,160
12- 106,872/ 169,568
13- 109,200/ 181,546
Earnings per Common Share Based on Low & Moderate Figures|
Options- Year 9 / Year 10/ Year 11/ Year 12/ Year 13
Low Mod Low Mod Low Mod Low Mod Low Mod
9% bonds 0.016/ 0.043/ 0.024/ 0.058/ 0.031/ 0.072/ 0.041/ 0.089/ 0.042/ 0.098
50% preferred (5%, $50 par) and 50%Commonstock-
0.032 / 0.053/ 0.038/ 0.044 / 0.075 / 0.05/ 0.088/ 0.052 / 0.095
20% - 9% bonds and Common
Stock-0.033 /0.051 /0.038 / 0.061/ 0.043 / 0.071 / 0.050 /0.082 / 0.051/ 0.088
40% - 9% bonds and Common
Stock 0.030 / 0.050/ 0.035 /0.060/ 0.041/ 0.071/ 0.048 / 0.083/ 0.049 / 0.090
60% - 9% bonds and Common
Stock 026/ 0.04/ 0.032 / 0.060/ 0.038/ 0.071/ 0.046 /0.085/ 0.047/ 0.092
Table 2 --
Net Earnings utilizing both Low & Moderate Figures
Five Year Totals Years 9 – 13 Average Earning per Share Based on Low Projection
9% bonds 50% preferred 20% - 9% bonds 40% - 9% bonds 60% - 9% bonds
(5%, $50 par) and Common Stock and Common Stock and Common Stock
50% Common Stock 50%
0.031 0.043 0.043 0.041 0.040
Five Year Totals Years 9 – 13 Average Earning per Share Based on Moderate Projection
0.072 0.075 0.071 0.071 0.071
Five Year Totals Years 9 – 13 Average Net Earning Based on Low Projection
9% bonds 50% preferred 20% - 9% bonds 40% - 9% bonds 60% - 9% bonds
(5%, $50 par) and Common Stock and Common Stock and Common Stock
50% Common Stock 50%
$30,014 $70,516 $62,416 $54,116 $46,216
Five Year Totals Years 9 – 13 Average Net Earning Based on Moderate Projection
$70,186 $110,686 $102,586 $94,486 $86,386
It is my recommendation that CB pursue a combination of approaches to acquire the cash
infusion that is desired. CB should retain 50% preferred stock, offer 50% common stock and
secure debt capital - bank loans or bonds.
A1 a ) While retaining 50% preferred stock the investors with the most to gain and lose will be
insured a guaranteed dividend. The preferred investors will retain control of the company. They
can steer the destiny of the company. They will be undoubtedly become the board of directors
and can decide on dividends to common stock holders in the best interest of the company. The
board of directors can take advantage of tax deductions and pay off debt capital. This strategy
allows the board to incur debt without losing control of the destiny of the company. Retaining
the preferred stock has a dollar value that can be made up with debt capital while retaining
control of the company.
This strategy will result in the highest earnings per share ( EPS ) during the first three
years. During years four and five, securing a 9% bond would generate the second highest EPS.
The option with the greatest return of investment ( ROI ) to the investor is the 50% preferred
stock and 50% common stock.
Internal Rate of Return
The other measure for evaluating the investment is the internal rate of return, IRR. “You
can think of IRR as the rate of growth a project is expected to generate. While the actual
rate of return that a given project ends up generating will often differ from its estimated
IRR rate, a project with a substantially higher IRR value than other available options
would still provide a much better chance of strong growth.” (investopedia, 2012).
A 2 ) Net Present Value: NPV is considered a “sophisticated capital budgeting technique and it
has consideration for the time value of money where as the payback a technique does not. It is
also determined by subtracting the initial cost of the project from the NPV with a discounted rate
that equal to what Competition Bikes cost of capital.” (Gitman, 2008)
NPV compares the dollar value of today to future dollar values. This is adjusted with
consideration of inflation and returns to account.
The formula for NPV is:
NPV = Present value of cash inflow – initial investment
C0 is the initial investment which is a negative cash flow showing that money is going out;
The funds going out is subtracted from the discounted sum of cash flow influx. It is
required that the net present value needs to be a positive number. This factor is crucial in
determining if the decision is a valuable investment.
Criteria for NPV:
NPV greater than $0- then the Competition Bikes, inc. should move forward
NPV less than $0 - then Competition Bikes, inc. should not move forward.
Internal Rate of Return (IRR):
“IRR is more widely used over NPR. The IRR is the discount rate that equates the NPV
of the investment opportunity with the $0. It is compounded annual rate of return that the
company will earn if it invests in the project and receives the given cash inflows.
(Gitman, 2008) “
Criteria for IRR:
IRR is greater than cost of capital -- accept the project
IRR is less than cost of capital-- reject the project
Scenario one with anticipated low demand.
1. Capital improvements of $600,000
2. Ten year depreciation schedule.
The building will be a fixed asset at the end of the ten year term of $200,000.
3. Projected sales projections::
Year 9 – 500 Carbon Lite models
Year s 10- 11 – 1% growth Years 12- 13 – 2% growth
Cost of goods sold will increase proportionately
4. Selling and administrative anticipated expenses for Canadian Bikes, inc. operations:
Year 9 : $250,000 Year 10 : $240,000 Year 11 : $230,000 Year 12 : $220,000
Year 15 : $210,000 Stabilizing after year # 5.
5. Competition Bikes requires a 10% hurdle rate to justify a capital investment.
The IRR, utilizing the worst case scenario with the low demand, is 8.2% IRR. This
factor alone indicates a good project. Acquiring Canadian Bikes, inc. not a certainty but with an
increase in the economy and sponsorships, the return of investment may prove to be a strategic
Moderate demand scenario.
1. Total investment of capital improvements-- $600,000
2. Depreciation tax write offs / credits over the next 10 years.
The acquisition will n asset worth $250,000 at the end of the depreciation schedule. This will be
3. Anticipated sales:
Year 9 – 500 Carbon Lite models Years 10- 11 – 3% growth per year Years 12- 13 – 5%
growth per year .Cost of goods will increase steadily at about 2% per year
4. Budgeted sales and administrative expenses for Canadian Bikes, inc.:
Year 9 : $250,000 Year 10 : $240,000 Year 11 : $230,000 Year 12 : $220,000
Year 15 : $220,000
5. Competition Bikes, inc. is faced with a 10% hurdle rate to first pursue a capital investment.
The strong NPV was the single most significant factor that most influenced my decision
to endorse this acquisition. With just moderate increases in demand, the returns would be
respectable. Illustrated by the NPV formula. The an outcome of an impressive +$8,447. With a
moderate growth rate of only 3% in years ten and eleven. This growth rate is anticipated to
through the next two years at 5 %. Just moderate growth rates through this analysis indicate
Competition Bikes, inc. have a substantial ability to service this amount of debt.
The IRR theory analysis outcome with a moderate demand scenario produces- a 10.4%
IRR. Analysis dictates this project as a great candidate for acquisition.
The following analysis of the calculations for NPV based are figured on the low and
moderate demand. As demonstrated, the data the NPV under the low demand projection is a
negative $39,281 and the moderate demand projection is a positive $8,447.
Low Demand Moderate Demand
Total Present Value $560,710 $608,447
Investment $600,000 $600,000
Net Present Value - $39,281 $ 8,447
The moderate demand is a positive dollar figure. This demonstrates the optimistic nature
of the merger This merger combines desired technologies and new markets. The acquisition also
will acquire a substantial asset – the facilities.
My primary concern is cost of cogs sold. From years #9 -#13 the COGS budget remains
flat which is not realistic.. This negative impact on the EBIT would could be set off by
My second primary concern is the budget decreases in the sales and administrative
expense. There is no indication that these expenses would decrease Competition Bikes has had
increases in administration expenses when sales were down. If sales increase, how can
administration expenses and sales expenses decrease ?
The most conservative approach for Competition Bikes, inc. to obtain their working
capital is to would be to lease the building and pay the licensing fee. Accumulation of assets like
the building and the technology is a tangible value..
“Working capital is how much in liquid assets a company has on hand and available.
Working capital is needed to pay for any monthly expenses and any unexpected expenses
that may arise during such time. Working capital is to meet the short-term obligations of
the business, and to build and grow the business. (Wolfe, 2012)”
My recommendation is for Competition Bikes, inc. to pursue the strategy of selling 50 %
common stock and bonds. This will provide the $600,000 funds for operating cash flow and to
acquire the Canadian Bikes, inc. The purchase the buildings and technology will be collateral to
leverage the stock and bond sale.
“Scholars have found over the years that insufficient capital is one of the main reasons
for small business failure, coupled with lack of experience, poor location, poor inventory
management and over-investment in fixed assets, according to the Small Business
Association.” (Mansueto Ventures LLC, 2011)
A 4) Merger or acquisition is the dilemma for Competition Bikes? The best decision is not only
for the company but for the stock holders. Competition Bikes, Inc. needs to determine if a
merger or an acquisition is the best option.
When Competition Bikes, inc. acquires Canadian Bike, they purchased a large market
share. This will increase their efficiency while capitalizing on the key component of this
acquisition, a new market. They will also acquire Canadian Bikes technology. This acquisition
will be less effective than developing a similar technology. They also acquire a valuable real
Competition Bikes, inc. can tax depreciation and potential bond interest tax savings
resulting in a higher dividend to share holders.
Canadian Bikes estimates a 10% increase in gross sales in the next 5 years. This is an
added benefit to the acquisition for Competition Bikes, inc. These competitive factors makes an
acquisition a more savvy venture than a merger. A merger where Competition Bikes, inc. leases
a building, develops a great market share and pays a licensing agreement is conservative but
within five years Competition Bikes, inc. will be the strongest competitive bicycle manufacturer
in North America.
This acquisition will built company assets. Not spend expend cash to just manufacturer
Capital Structure Decision. (2002). Retrieved January 18, 2011, from Harcourt, Inc:
Krishna Kanta Handiqui State Open University. (2012). Introduction to Capital Structure policies
andDividend decisions.http://www.kkhsou.in/main/EVidya2/management/ capital_structure.html
Jason Van Bergen (2010)
Wolfe, L. (2012). What is working Capital. Retrieved January 24, 2012, from About.com Guide :
Mansueto Ventures LLC. (2011). Retrieved January 24, 2012, from How to Manager Cash Flow:
Gitman, L. (2008). Principles of Managerial Finance 12th edition. Addison Wesley.
Net Present Value. (n.d.). Retrieved January 22, 2011, from Finance Formulas:
Stallman, C. (n.d.). Common Stock vs. Preferred Stock. Retrieved January 18, 2011, from
McClure, B. (2012). Mergers and Acquisitions: Definition. Retrieved from
Activity based costing accounting (ABC) distributes the manufacturing overhead to
products in a more efficient way, than in the traditional way. Activity based costing specifically
allocates the correct percentage of resources to individual products.
ABC is more logical and a more sophisticated method to monitor and allocate company
costs to objects or products than traditional costing. With traditional costing, the overhead costs
may be allocated exclusively on machine hour basis. ABC identifies the many activities for cost
accounting. Taking into consideration all of the resources a company may consume. ABC then
calculates only the activity cost to produce the product. This critical difference is important due
to some products requiring many activities and some products require few activities.
Activity based costing versus Traditional Costing
The primary difference between ABC (Activity Based Costing) and TCA (Traditional
Cost Accounting). ABC assigns all specific activities and TCA may just calculate machine hours
as the total cost ABC is more accurate and complex, encompassing only activities and resources
to produce individual products. Knowing the exact cost to produce separate different products in
one factory. Traditional Cost Accounting is rather simple and less efficient. ABC with
separating expenses can also identify excess raw material and therefore more closely be in line
with a Just-In-Time strategy. This strategy can reduce the accumulation of possibly
obsolete raw materials and help stream line the production line.
Activity Based Costing was initiated in 1981. The methodology is still in the relatively
new stages of accuracy. ABC has a separate overhead and varies by activity and product.
Conversely, Traditional Cost Accounting was initiated in the late 1800’s. The task of calculating
the specific cost of a finished product under the traditional method was less precise. The cost of
goods simply divided by finished products bone activity. The Activity Based Costing method
calculates the exact expenses to produce each individual product using several activities.
With stiff competition, initiating the latest methods of accounting and production, are
necessary to produce a profit. In the case of Competition Bikes, inc, utilizing the Just in time
strategy ( JIT ) and the Activity Based Accounting would improve Competition Bikes return on
Excess inventory would be greatly reduced. During different stages of production,
parts would be ordered to insure that production is continued but excess parts would not
accumulate. Implemented correctly, Just in Time would focus on production improvement. This
would stream line manufacturing, efficiency and quality. To achieve improvement in key areas,
requires employee involvement to improve flow and quality.
Activity Based Costing is a more accurate way of costing finished products. This method
makes Traditional Cost Accounting method obsolete. The Activity Based Costing method is
preferred when overhead is too high and there is an abundance of remaining parts. The accuracy
of product costing is imperative. If the analysis of the final numbers of cost of goods is too low,
it would appear that the company was operating efficiently. Conversely, if in fact there was
many parts remaining, the company lost money.
“If a manufacturer wants to know the true cost to produce specific products for specific
customers, the traditional method of cost accounting is inadequate. Activity based costing
(ABC) was developed to overcome the shortcomings of the traditional method. Instead of
just one cost driver such as machine hours, ABC will use many cost drivers to allocate a
manufacturer’s indirect costs. A few of the cost drivers that would be used under ABC
include the number of machine setups, the pounds of material purchased or used, the
number of engineering change orders, the number of machine hours, and so on
( Averkamp, 2004) .”
The total of all activities gives a more precise cost factor accurate cost factor.
Activity Based Costing is steadily being utilized and implemented due to the increase in
overhead costs and the array of different products being produced. The evidence that Activity
Based Costing has become the standard is that machine hours and direct labor hours accounting
is no longer in practice.
Primary reasons Activity Based Costing should be utilized:
1. Activity based costing provides a more accurate overhead cost position.
2. Activity Based Costing gives valuable information to management on operations that add
value and those that do not. ABC is instrumental in capital investments, pricing, organizational
change and product mix.
3. Activity Based Costing can more easily identify production activities and resources..
4. Activity Based Costing has been proven for being effective in controlling costs, improving
profits and productivity. This is an example of not reinventing the wheel. ABC works.
Concerning directly to Competition Bikes, inc. – utilizing Traditional Cost accounting the
Titanium units cost was $239,020 but utilizing Activity Based Costing, the cost of was $232 340.
The traditional costing method analysis shows the titanium frame cost $713. The ABC
method analyses shows the titanium unit at $656. Utilizing the traditional costing method, the
traditional total cost is $1,460 to produce .Activity Based Costing is $1,359. The ABC method
more accurately puts the cost of production of just the titanium unit by $57. The cost to produce
the Carbon Lite unit decreases by $101.
To summarize and support the implementation of the ABC method to replace the
traditional method for Competition Bikes, inc. is primarily because the traditional method uses
a percentage of the total and ABC method uses details of only the precise activities needed for
Our product line is comprised of primarily the titanium line - 900 or 65 percent of our
product sales and our carbonlite line is 500 of our product sales or 35 percent. The titanium line
is 50.7 percent of our manufacturing overhead and the carbonlite is 49.3 percent. Under the
traditional method the titanium is 48.5 of our total cost and the carbolite is 51.4 percent of our
total cost. Under the ABC method, the titanium is 44.7 percent and the carbonlite is 55.3 percent.
The ABC method is more precise. We see that the Carbonlite is only 35 percent of our sales but
is 55 percent of our total expenses
This change in methodology brings exact activities into consideration. In quality control
for the titanium line we spend only $2, 104 but for the carbonite quality control we spend
$116,896. In engineering services, the titanium line we spend $12,500 and in the carbonlite line
we spend $62,500.
We need to know our exact production cost to accurately figure our breakeven point and
Pricing on each individual product.
Breakeven is the difference between a business making a profit or becoming insolvent.
Determining the breakeven point for a company is critical to either success and growth or failure.
If management is unaware of their financial situation, if they have incorrect or inaccurate
information they may have an incorrect breakeven point thus selling units at a loss to the ultimate
demise of the company.
To determine a company’s breakeven point, I utilized the accompanying Excel spread sheet.:
Fixed Cost / (Unit Price - Variable Unit Cost)
Sales price – variable costs = contribution margin.
The breakeven analysis point has many variables:
· Selling Price per Unit: The set market value for sales of the product.
· Fixed Cost totals: The Activity Based Costing of production per unit. This is fixed.
· Variable Cost total: Projected total production costs including variables.
· Unit Cost variables: Expenses beyond production control that are unexpected.
· Net Profit forecast: Total revenue minus total cost. Production cost is the breakeven point.
When a company offers many different products, an average contribution margin per unit
determines the fixed cost of the product. Then the profit generated above the breakeven point is
the number of units the division must sell for the company to breakeven. This average or
weighted average has a contribution margin. It measures the expenses the company has to invest
to produce and market the products.
Contribution margin and contribution margin ratio
“Key calculations when using CVP analysis are the contribution margin and the
contribution margin ratio. The contribution margin represents the amount of income or
profit the company made before deducting its fixed costs. Said another way, it is the
amount of sales dollars available to cover (or contribute to) fixed costs. When calculated
as a ratio, it is the percent of sales dollars available to cover fixed costs. Once fixed costs
are covered, the next dollar of sales results in the company having income.
The contribution margin is sales revenue minus all variable costs. It may be calculated
using dollars or on a per unit basis ( Cliff Notes, 2012)”
The accompanying Excel spreadsheet was utilized to calculate the breakeven point for
Competition Bikes, inc
Example of the formula:.
The ABC method utilized to figure the breakeven point, must have accurate figures.
Periodically, with an increase in production the breakeven point of a product increases. To
determine the new breakeven point, requires new fixed and variable costs input. into the
spreadsheet that was created. This will provide the new breakeven point.
The individual breakeven point per unit is accomplished by calculating the product mix.
The titanium line divided by the total and the Carbon Lite divided by the total. A weighted
margin is arrived at $181.71. If $ 399, 943 is the fixed cost then divided by breakeven of $181.71
the total sales of units required is 2201 units.
Weighted average with the titanium line of 900 in sales at nearly twice that of the
Carbonlite with 500 sales. The weighted average contribution margin is $181.71. Individual unit
calculations are $ 221 for each titanium sale and $ 111 for each Carbonlite sale.
Net earnings to remain constant would require more sales to break even.
The San Diego plant has a breakeven point utilizing the Cost-Volume-Profit method. The
number of sales for the Titanium line is 1415 units. The breakeven point for the Carbon Lite line
is 786 units. The Titanium line breakeven point in sales revenue is $1,273,500 The Carbon Lite
line breakeven point is $1,175,070 in sales revenue.
BREAKEVEN ANALYSIS CHANGE
It is common knowledge that if a company’s fixed and variable expenses increase then
the end product must increase in price. If the company is forced to increase their fixed costs by
$50,000 and if vendors increase material costs by 10 percent. Competition Bikes, inc. must
increase their per unit sales price to achieve the same breakeven point. This may be avoided if
the company negotiates a decrease in supplies for the purchase of a higher quantity, They must
be careful to not end up with excess inventory at year end.
Cost-volume-profit ( CVP ) is utilized to analyze how an increase in raw materials and
reduced production can negatively affect a company. A CVP analysis must include sales,
administrative costs and manufacturing costs. These expenses should be labeled variable or
Sales price per unit is constant per schedule- fixed.
Variable costs per unit are fixed and constant.
Total fixed costs are fixed an constant.
Assuming everything produced is sold.
The affects of costs are only because of activity changes.
All products produced by a company are sold in the same mix
Example of utilizing the CVP. When the fixed costs are increased by $50,000 and with an
increase of 10 percent in raw materials, the results for Competition Bikes inc., the contribution
profit margin for the Titanium line went from $ 221 to $ 191. The Carbon Lite went from $111
The weighted breakeven was $690 but increased to $871 for Competition Bikes, inc. due
to the $50,000 over head cost and the 10 percent materials increase. With the decrease in
contribution profit sales price, obviously they must increase sales price and / or increase sales
volume. If we increase our over head an additional $50,000 and we have an additional increase
of 10 percent of raw materials our new breakeven point on sales will be 3254 more units. Nearly
a 50 percent increase.
The cost profit tab shows with the increases in the $ 50,000 overhead and 10 percent
product increase, the Titanium sales price goes to $1415 from $900, the variable cost goes to
$709.30 and the contribution margin drops to $191 from $221. The carbonlite price at $1,495,
the variable costs goes to $ 1,451 with only a contribution margin profit of $44 from $111. The
sales weight average contribution margin per unit is $138 from $181.71. We need to sell 2092
titanium models and 1162 carbonlite models.
With the $50, 000 increase and only a weighted average of $138 from $181 – this
requires an additional sale of 362 units.
In summary, with both of these increases, we will have to increase our sales from 2201 to
Harold Averkamp, CPA
CliffsNotes.com. Cost-Volume-Profit Analysis. 30 Sep 2012
Task 5 Notes:
By careful of changing storyline and excel data. The principles and verbage remains.
Custom Snowboards, Inc.
Presentation to CFO
A1) Summary Introduction
Custom Snowboards Inc. is located in Minneapolis, Minnesota, USA. Their current sales
are divided as follows:. Currently, 20 percent in the European market, 5 percent in the Canadian
market and the majority or 75 percent of sales are in the United States market. Currently there
are small warehouse and administrative facilities in both the European and Canadian markets to
service respective customers.
Four years ago the company offered shares of the company on the public Midwest Stock
exchange. Jim Swartz, the founder retained 51 percent of the available shares. Custom
Snowboards Inc. management is evaluating a more aggressive market position in the European
market. Among the strategies for an increase in market share is to acquire an already established
European manufacturer that desires to be acquired. The European Snowfun, Inc. acquisition
would require a loan from a bank, for one million dollars.
A bank is performing due diligence and requires an appropriate presentation before
determining a decision. The terms of the one million dollar loan are: 6.75 percent Apr interest,
60 month term and a $300,000 compensating balance fund. This fund is non-interest bearing, the
bank is trustee for use at their discretion for other endeavors.
The final approval or denial hinges on this presentation.
A company’s financial picture has key points that could affect and impact a loan
officer’s decision. The primary decision is how the debt would be paid back.
A vertical analysis from a submitted financial statement shows the relationship of items
to the base amount. This is the 100 percent figure. The main points from a vertical analysis
considered are : Net sales from year 12 was at its peak, $6,601,000 with gross profit of
$2,009,000. The following year #13 showed an increase to $6,633,200 net sales and a gross
profit of $2,018,800. In year #14 some concern was that sales declined $225,400 but gross
profits only declined $68,600. This was due to management efforts at cutting operating expenses.
Total sales expense in year #12 was $779,000. In year #13 total sales expense was $782,800. In
year #14 sales expense had dropped to $756,200. Current assets in year # 12 was $738,690.
Current assets jumped up in year # 13 to $ 880,950 but in year #14 dropped to $ 740,155 but
still $1,465 above year #12. Net property and equipment asset value is remaining steady. There
was a drop of $100,000 in year #13 but year #14 held at one million as it was in year #12.
Concerning total liabilities and equity: in year #12- $1,738,590, year #13- $1,780,950, Finally in
year #14 it declined to near year #12 or $1,740,155.
The horizontal analysis key points indicates changes from dollar form. We can
concentrate on the profitability. During year #12 and #13 the percentage of change was 0.49
percent for net sales. During year #13 and #14 results shows a variance of -3.40 percent or
$225,400. A key point to a bank loan officer is operating income. This point or factor is
important because it helps determine if the company has the ability to pay back the debt. The
variance in year #12 and #13 was -23.56 percent or $ 63,500. The variance in year #13 and #14
was -52.91 percent or $109,000 . The variance nearly doubled with decreasing net sales. In year
# 12 and #13, net earnings had a variance of -30.91 percent or $43,350. In year #13 and year
#14 a variance of -82.74 percent or $80,175.
A key point in the percentages of the trend analysis occurs between year #12 and year
#17. Trend percentages: year # 12 - 100 percent, year #13 - 100.5 percent, year #14 decline to
- 97.1 percent, year # 15 increase to 103 percent, year # 16 - 102 percent, finally year # 17
increase to - 103.7 percent.
Lenders look for risks in financial statements to find concerns. The simple question is,
can Custom Snowboard, Inc. be capable to repay the loan? Loans are risks to banks. Lenders
require a strong business plan, credit report and financial reports with profitability. The primary
concern for the lender is if the business fails, how may the lender be repaid. If financial
information indicates that repayment is minimal this mitigates the lenders risk.
The capital structure debt to ratio at 100 percent anticipated financing, then EPS is -2.53
percent. Estimated return of 17.2 percent and a estimated share value of -1.47. The capital
structure debt to ratio is positive. With 80 percent financing, the expected EPS is -0.135. The
estimated required rate of return is 14 percent . The estimated share value at -0.96. With only 30
percent financing expected, the EPS is -0.028. The estimated required return is at 11.8. The
estimated share value is -0.23. If the long term debt, which yields 10 percent on the estimated
required return. The capital structure debt to ratio will remain positive.
An expansion into Europe is of major concern and potential risk to the lender. The lender
will need sales forecasts and profitability projections. This is the advantage of acquiring an
established company. In year #15 earnings were $60,118 with a gross profit of $ 310,440. In
Year # 16 earnings were $108, 392 with gross profits of $372,528. In year # 17 earnings further
increased to $166,732 with increased gross profits to $447,034. Earnings continued to escalate in
year #18 to $220,438 with a gross profit of $ 491,737. Earnings and gross profit reached an apex
in year #19. Earnings of $257,665 and gross profits of $ 540,911. The income statements
demonstrate a positive growth pattern. The mitigating factor of the European expansion is less a
factor with such impressive positive growth.
Another risk and concern for the lender is an American company conducting business in
a foreign country. With a changing world, as countries encounter political unrest, economic
downfall and uncertainty, a lender will require collateral for its investment. Mitigating some of
this risk is the North American Free Trade Agreement (NAFTA). This legislation eliminates
most barriers to trade and investment in Canada ,the United States and Mexico. The USDA
(2011) reports that over 70 percent of our exports are high value consumer oriented products
category. The creation of NAFTA created the largest free trade area in the world. This
agreement linked hundreds of millions of people and produced trillions of dollars of goods and
services. This mitigating factor, with regards to a potential trade barrier, actually opened up new
markets, increased economic prospects and prosperity in the United States , Canada and Mexico.
The question of collateral as a risk is minimized by substantial assets held by Custom
Snowboards Inc. headquartered in Minnesota. The land, inventory, equipment, manufacturing
plant, and physical assets could collateralize the loan nicely at the relief of concerns by the
lender. Banks are in the business to make loans. Minimizing concerns and mitigating risks
concerning this expansion to the lender, is recognizing the continued positive growth of earnings
by Custom Snowboards Inc. The collateral and positive growth should secure a loan from the
A3) Ratio Analysis
Custom Snowboards, Inc. main competitor is Winter Sports. Their current ratio is 4.2 as
compared to the higher ratios of Custom Snowboards, inc. In year # 13 - 6.82, in year #14- 5.84.
The higher the ratios, is an indication that a business has sufficient current assets for maintenance
of normal business day to day operations. This ratio indicates that Custom Snowboards, Inc is
most likely than not to satisfy its liabilities in the next 12 month period. This is the primary
strength of the company. This ratio also indicates that Custom Snowboards, inc. has excellent
financial strength for the short term. Ratios higher than 1.5 or 2.0 dictate that a company should
secure funds to further expand the business.
Ratio Analysis: Year Year Year 14
Current Ratio 5.84 6.82 4.2
Acid-Test Ratio 3.64 4.66 3.4
Inventory Turnover 33.33 33.41 30.4
Average Collection Period 11.0 11.0 32.5
Debt Ratio 50.4 51.7 38 percent
Gross Profit Margin 30.4 30.4 32.10 percent
Operating Profit Margin 1.5 3.1 5.20 percent
Net Profit Margin 0.3 1.5 5.14 percent
Earnings per Share 0.02 0.11 0.08
Return on Total Assets 1.0 5.4 4.80 percent
Return on Common Equity 1.9 11.4 8.10 percent
Price / Earnings Ratio 170.52 90.82 29
Times Interest Earned 1.29 2.58 5.1
The quick ratio or acid test determines if a company has adequate short term assets to
manage its immediate liabilities, without having to liquidate its inventory. The higher the quick
ratio or acid test is an indicator of a company’s ability to turn liquidate inventory and current
assets into immediate cash. This insures liquidity of a company. An analysis of Custom
Snowboards in year # 13 is 4.66. In year # 14 it was 3.64. Winter Sports ratios were below 3.4 in
Inventory levels are determined by the turnover rate of a company. A high turnover rate
is an indicator of avoiding accumulation of obsolete parts and a high demand. The turnover rate
was lower for Winter Sports in year #14 – 30.4. The turnover rate of Custom Snowboards, inc.
in year #13 was 33.41 and in year #14 - 33.33.
Winter Sports average collection period in year #14 was 32.5 days, nearly three times the
rate of Custom Snowboards, inc. Their ability to convert receivables to cash reserves was only
11 days, in both years #13 and #14. The higher the turnover ratio determines the rate at which
cash is collected. This indicates that Custom Snowboards, Inc (CS) will benefit by collecting
funds at an impressive rate of 30 days or less. Having assets and adequate capital makes CS a
more efficient company that can operate more efficiently.
Debt ratio for Winter Sports debt ratio in year #14 was 38 percent . Custom
Snowboards was 52.5 percent in year #13 and reduced in year #14 -50.4 percent. Debt ratio
compares a company’s total assets to its total debt. This ratio is the proportion of assets financed
by debt. The higher the debt ratio to assets indicates the leveraged amount. The higher the
leveraged amount, the higher the risk to the lender. The positive mitigating factor for this risk is
in future years. This was evidenced by the decline in year #14. The preferred debt ratio is 30
percent. This would improve a company’s credit rating to decrease the proportion of assets
financed by debt.
Winter Sports Gross Profit Margin in year # 14 was 32.10 percent . Custom Snowboards,
Inc. in both year # 13 and # 14 was 30.4 percent . To determine a company’s manufacturing and
distribution efficiency during the production process, the Gross Profit Margin is utilized. This
margin is necessary to set a value of a product and a sales price . The higher the ratio indicates a
more efficient operating company.
After paying the production costs including wages and materials the profit is the
Operating Profit Margin Ratio. This is an indicator of the efficiency that a company is at
controlling costs and expenses related to business operations. Winter Sports for year # 14 was
5.20 percent but for Custom Snowboards Inc in year #13 was 3.1 percent and in year # 14 was
1.5 percent. The risk for the company in this analysis is that for each dollar invested that it
earns roughly 2 cents from each dollar of sales. To mitigate risks basic variables in forecasting
need to be alternating. By decreasing or increasing production the growth rate can manipulate the
Net Profit Margin is the profit a company makes for every dollar it generates in sales. Net
profit margin is net income divided by sales is the amount of each sales dollar remaining after
ALL expenses have been paid. A higher profit margin is better. Winter Sports has a distinct
advantage with a net profit margin of 5.14 percent in year #14. Custom Snowboards, inc. in year
#13was 1.5 percent and in year # 14 was 0.53 percent. A lower profit margin may indicate a
pricing strategy. A high-volume lower price approach will generate a higher market share. This
still represents that Winter Sports was more efficient and had a greater profit per dollar of sales.
Winter Sports Earnings per share in year #14 was 0.08. Custom Snowboards, inc. in year
#13 was 0.11 and in year #14 it was only 0.02. Earnings per share is the amount of net income
paid or earned for each share of company common stock. Earnings per share is a indicator of the
profitability of a company. To mitigate risks, a company should be diligent at reducing costs and
increasing revenue. Acquiring the European Snowfun, Inc. company may increase earnings per
How profitable a company uses its assets is called return on total assets. Winter Sports in
year #14 was 4.80 percent. Custom Snowboards, Inc. in year # 13 was 5.45 percent but in year
# 14 it was 1.0 percent. The profitability rate is low and the company is in need of
improvements and decisions during an economic slowdown. This is a prime time opportunity to
make some major cost saving decisions. To mitigate risks, the decisions on allocating resources
and the decision to acquire another company needs reevaluated.
Return on Common Equity is the ratio between common stockholder’s equity and net
income. This ratio reveals a corporation’s profitability by measuring the profit a company
generates from the investment from shareholders. The higher the ratio the better the company is
performing. Winter Sports in year #14 was 8.10 percent, Custom Snowboards, Inc. in year #13
was an impressive 11.4 percent. The concern was the dramatic decline in year #14 to 1.9
percent. This was attributed to a total economic slowdown. This analysis presents a low return
on common equity. The company may not be adjusting its spending to compensate for economic
conditions making the company not profitable which is a major weakness. This ratio permits
companies and investors to compare companies profits that their investment earns per dollar. To
mitigate risks, the company might decide to diversify its own investments into several other
assets such as stocks, bonds, or buying other companies like the European Snowfun, inc. This
may prove profitable in the long run.
The ratio of the market price for a share of common stock in relation to a company’s
earnings per share is called the Price/Ratio Earning. The valuation ratio of a company’s per share
earnings and current share price. The higher the P/E is a major indicator of how much th stock is
worth on the market. A low P/E is a weakness and the company stock value is lower with low
investor confidence. Winter Sports, inc. in year # 14 was only 29. Custom Snowboards, inc. in
year # 13 was 90.82 and in year # 14 was an impressive 170.52.
To measure a company’s ability service its debt Times Interest Earned ratio. Higher ratios
are desired. Lower ratios indicate an inability to service debt compared to competitors which is a
weakness. Winter Sports, inc. in year #14 was 5.1, In year # 13 Custom Snowboards, Inc. was
2.91 and in year # 14 it was down to 1.53. Investors find this undesirable and lower earnings
indicate an inability to meet interest payments. In year #13 indicates for ever $1.53 the
organization earns $1.53 worth of income on each dollar of interest expense. To increase the
Times Interest Earned ratio as a mitigating factor is simply to reduce debt. The reduction in
interest expense reduces the debt. This will elevate the Times Interest Earned ratio. This is due to
the income number will be divided by a lower interest expense number. Lower debt and lower
interest expense will have a better debt servicing ability.
The company liabilities during the year is abnormal concerning mortgage payable -
$650,000. The majority of assets are mortgaged. The manufacturing plants, the land, furnishings
net cost is only $900,000 and that was mortgaged. The lender requiring a $300,000 The
company applying for a loan with a stipulation to maintain a $300,000 compensating balance
will further burden the company.
Trend analysis provides economic information concerning the strength of an industry or
an individual business. It dismisses uncertainties in a business concerning slow sales, seasonal
demands and inventory. Trend Analysis is critical to management when making business
decisions with regards to the organizations operations. Historical trend analysis percentages
helps determine future growth in the economic marketplace. Custom Snowboards, Inc. in year
#12 was 100 percent, in year # 13 was 100.5 percent and in year # 14 a slight decline or
weakness at 97.1 percent. The trend analysis forecast in years # 14-17 is more positive. In year
#14 the forecast was 100 percent, in year #15 was 103 percent, in year #16 experienced a
slight decline to 102 percent and in year # 17 experienced an increase to 103.7 percent. The
lender is considering the $1,000,000 loan with terms of 5 year repayment at 6.75 percent interest,
but the catch is a $300,000 compensating balance. The lender will most likely want additional
collateral to mitigate risks. Custom Snowboards, inc. could secure additional properties possibly
from investors. The lender will make its decision on their risks and the mitigating factors
associated with this loan after this presentation.