In the views of Epstein, et al., (2011) an accounting cycle is a collective process of recording and processing the accounting statements of the company. This accounting cycle involves step by step process which is used by organization for classifying and summarizing the economic transactions of a business. This summarizing process of collected financial data is very useful information for the company in evaluating the actual business efficiency and financial data accuracy and reliability. This cycle process helps company to generate useful financial information with the help of different financial statements like income statement, cash flow statement & balance sheet and so on.
In support to this, Romney & Steinbart, (2012) accounting cycle is also consider as a financial process which starting from the recording of the business transactions to the preparation of the financial statements. This process will be proving helpful for the company in regards to keep track of the expenses and revenue. On that basis, company takes their future decisions. The main purpose of the accounting cycle is to convert the recording of information into the meaningful financial statements that is presenting in the form of balances sheet, profit & loss account and income statements etc. on that basis, company and investors measure the performances of the company and investor could able to take the correct investment decision.
Through an accounting cycle, it becomes easy to analyze the financial statements on periodic basis and for which most of the companies’ uses proper accounting software like Tally.erp software which helps in maintain the continuous record of the financial information properly and efficiently (Bierer, et al., 2015). In addition, accounting cycle process usually differs from company to company because every company uses different process to maintain their records like some company’s uses software to record the financial data but there are some company’s which still uses accounting cycle while managing it manually.
An accounting cycle process is used by every organization once in a year while managing the accounting data (Epstein, et al.,2011). This process of accounting cycle starts with the recording of individual transaction and ends with the preparation of final financial statement i.e., Balance sheet.
Accounting Cycle Steps
Accounting cycle includes various types of steps that are also repeated in the same order for every company whether it is small or large firm. The combination of these steps is result into the financial statements (Rosado, et al., 2014). It is also estimated that some companies prepare their financial statements on the basis of quarterly and some on the annually basis. Generally, the large companies prepare the quarterly report while small companies prepare the annually report as the preparation of these reports takes large time of the company. Under this accounting cycle, there are six steps which are to be followed like analyze and measure the transaction, record transaction, posting financial data, prepare unadjusted trial balance, preparing financial statement and closing all temporary accounts (Jiménez & Ongena, 2012). At the same time, the process from booking of transactions to the production of financial statements is unique as there is proper step of which is followed while doing or making record for any transaction.
In the views of Koo (2011) the cycle starts with the business event. The steps include various activities from the booking of transactions to the production of financial statements. Likewise, bookkeepers firstly in the company record the transactions in the form of journal entry. In journal entry, the transactions are mention under the credit and debit account so that reader gets the clear understanding about the transactions. At the same time, the debits and credits from the journals are then posted to the ledger and on that basis, the trail balances are prepared. Furthermore, the accountant and company management evaluates the unadjusted trail balances (Nguyen & Kruse, 2012). They make it adjust through include period adjustment by involving the depreciation expenses and expense accruals etc. these adjustments are then posted into the trail balances and this makes the unadjusted trial balances into the adjusted trail balances.
Now in the end of year, adjustments are made into the trading and profit & loss account, trail balances also matched with the subsidiary accounts and depending upon them the financial statements are prepare and then published in the newspaper, magazines. So that public can measure the performances about the company and able to find that whether this company give them the maximum return of their investments (Warren, et al., 2013). After this, company can close their entry book after the year ending. For that closing entries are made and posted into the closing trial balances. Thus, by practicing these steps, process by the company into the accounting cycle, it is able to prepare its financial statements in a relevant way.
Hence, the above mention steps of the accounting cycle prove to be beneficial for the companies as it helps in making proper analysis (Shanklin & Ehlen, 2011). The accounting departments are able to give attention to each transaction and with every transaction, they get to know whether money is spent or received from the particular transactions. On that basis, the staff could able to take proper and relevant decision in future. Moreover, the steps, process of the accounting cycle also plays a significant role for the company in terms to make future planning. It is because, with the accounting cycle, the accounting departments get to know about the current position of the company. So in that case, accounting cycle allows the company to address all issues related to entries and accounts. This will help the company for related purposes and annual documents reporting. Thus, these actions guide the company to take appropriate decision in future and it reflects that accounting cycle is proving to be crucial for the company.
The operating cycle and cash cycle consider as a metric that shows the time or length within which companies able to convert their raw material like resources inputs into the cash flows. Thus, with the help of this cycle, company could able to estimate that how much time they are taken for translating their resources into the cash inflow/outflow. The main purpose of using the operating cash cycle by the companies is to calculate the amount of time that is associated with each of the process such as production, supplying of goods before it is converted into finished goods for selling to the customers (Wang, et al., 2014). Thus, on that basis, companies have taken their future decision and estimate their total cash inflows of the company. At the same time, this metric also helps in estimating the length and time that how much time is required to sell the products, to receive the cash from customers, to pay the cash to the suppliers. Thus, these assist the company to properly plan their working capital and able to run their business in the smoothly manner.
In addition to this, it is estimated that operating cycle and cash cycle plays a significant role for the companies in regards to determine the time that is taken by the firm from purchasing raw material to translation into the cash. In the operating and cash cycle, the cycle includes the total of inventory holding period and receivables from the customers and payable to suppliers. Hence, all these process are covered into the operating cycle of the firm.
In the views of Dickinson, (2011) the operating cycle and cash operating cycle are differ company to company as small companies has taken less time production but to convert into the cash inflows, it takes huge time. While in case to big & large enterprise, they take large time in the production process due to having high demands, but it has taken less time in the conversion into sale of products or in cash inflows. Thus, the calculation of cash operating cycle is the crucial part for the companies whether it is small or large firms. On the other side, Mishra & Sahab Singh, (2011) identified that the operating cycle and cash operating cycle are differ from small margin but at the same time, it makes huge differences. This means that the minor changes in receivables, payables or holding inventory does not consider as an issue by the reader but in practically, it creates the huge impact on the company profit that does not contribute as an advantage towards the company goodwill in the market. Thus, this indicates that the large requirement of the operating cycle and cash operating cycle estimation by the company.
There are three key elements that are present into the operating cycle and cash operating cycle calculation that is inventory, accounts receivables and accounts payables etc. in order to estimate the companies operating cycle then in that case it includes the estimation of the inventory that company is holding. Besides that, calculate the receivables collection period, creditor’s payment period. Thus, on this basis, company able to decide their working capital (Abuzayed, 2012).
The calculation of operating cycle and cash cycle of the company by using the formula that is mention below:-
Formula for Operating Cycle
OCC:- Inventory Holding Period + Receivables Collection Period.
Operating cycle:- Raw Material Holding period + Work in progress period + Finished goods holding period + Receivables collection period
Formula for cash operating cycle
Cash Operating Cycle = Inventory Holding Period + Receivable Collection Period – Creditor’s Payment Period
Cash Operating Cycle = Raw Material Holding Period + Work-in-process Period
+ Finished Goods Holding Period + Receivable Collection Period – Creditor’s Payment Period.
Thus, in the above mention formula, the inventory holding, receivables collection period and creditor’s payable period are the important tool as on that basis, the company able to estimate their operating cycle as well as their working capital (Teunter et al., 2010).
Inventory holding period:- The inventory holding period indicates the number of days and time period within which company holds the inventory. For calculating the inventory holding period, there is need to divide it by cost of sales and multiple by 365 in case to year or 12 in months.
(Average inventory ÷ Cost of goods sold)* 365
Receivables collection period: The average collection period is defined as a calculation of amount of time within which business receives its all payments from the customers. It is calculated with the following formula:-
Average collection period= Days*Average amount of accounts receivables/ Credit Sales.
Creditor’s payment period= it indicates the days payable outstanding that presents that how long company could take to pay its all invoices from trade creditors like suppliers (Charitou, et al., 2010). At the same time, it also provides guidance to the company regarding company payment of its own bills or account payable. The formula of the average collection period that is as follows:-
Account payable/ (cost of sales/ number of days)
Thus, by calculating the operating cycle/ cash cycle, company able to hold the cash on the longer time and it also get the various potential opportunities of making investment and achieve high returns.
Implications of the Working Capital
The vital implication of the working capital is that with the maintaining of OCC (operating cash cycle), company able to maintain its cash inflows over the longer period of time and they also fulfil their short terms obligations. Besides that, the impact of the measuring the cash cycle has a positive impact on the company as it helps the company to uphold more current assets as compare to current liabilities (Gill et al., 2010). It is also estimated that working capital also assist the company in terms to perform the business activities in a smooth manner and allow the business to further make investment in different portfolios. So this will result in generating cash flow in future. Thus, it can say that working capital at all times proved to be beneficial for the companies in terms to maintain their cash inflows over the longer time in the business for fulfilling their obligations (Kieschnick, et al., 2013).
The contribution margin analysis and break-even point is also known as cost volume profit (CVP) analysis. The cost volume profit analysis is done by the company’s for determining the changes in the cost and volume. It affects the operating income as well as the net income of the company by keeping the sales price, total fixed cost etc constant (Braun et al., 2014). It helps the manager to understand how profit and cost changes with the fluctuation in the volume. In addition, the changes in the factors such as variable and fixed cost, volume, selling price etc assists in examining the effect of these factors on profit margin. It necessary for the manager to study the relationship of cost, sales and net income for making better plans for the organization in future.
The break-even analysis is used to determine the break-even sales for the organization. The break-even point is achieved, when the revenue and cost incurred by the company is equal (Edmonds et al., 2016). It is a point, when the organization does not incur loss and gain profit i.e. ‘no profit no loss’ situation.
Contribution Margin Income Statement
The income statement is known as contribution margin income statement, which helps in organizing the costs by behaviour rather by its functions. The approach of contribution to income determination supports in providing data to the mangers for planning and framing effective decision for the organization (Liu & Santos, 2015). The contribution margin is the difference between the sales and variable cost. On the other hand, for calculating the break-even and contribution margin the difference between the variable and fixed cost must be done for achieving reliable outcomes.
The excess of sales of a product or service over variable cost is known as contribution margin. The amount is used for covering the fixed cost for generating maximum profit margin.
CM ratio = CM/S = [S-VC]/s = 1-[VC/S] or,
CM ratio = Unit CM/p = [p-v]/p = 1-[v/p]
Break-even Point Analysis
The break-even point is the point, which represents the sales revenue is equal to the total variable and fixed cost at a given volume of output for a particular rate (Tsai et al., 2014). In addition, the lower break-even point helps in determining the high profit margin as well as low operating risk and keeping other things equal.
Break-even point in units = Fixed Cost/Unit CM
Break-even point in dollars = Fixed Cost/CM Ratio
Target Income Volume
The break-even and contribution margin analyzes is used by the companies for determining the total sales required in the market to achieve a specific amount of income level or the target net income (Frazier, 2014).
Target Income Volume = [Fixed Cost + Target Income]/Unit CM
Thus, the contribution margin income statement represents the sales and further deducts the amount of variable cost for calculating the contribution margin. It also deducts the fixed cost so that the company arrives at a situation of profit (Edmonds et al., 2016). The variable cost is used because it changes with the changes in the volume of activity, whereas fixed cost is used because it does not change with the changes in the volume of activity. In addition, break-even point is determined by setting the profit to zero with the assistance of profit equation. Moreover, the companies used to calculate the target profit for knowing the total units of products sold for achieving a certain rate of profit.
|Less Variable Expenses||730,000||(45)|
|Net Operating Income||$ 170,000|
The break-even points in units and dollar will be calculated as follows:-
Fixed expenses/Unit contribution margin = $200,000/$25
= 8000 units
(8000 units × $70) = $560,000
The contribution margin at break-even point will be $200,000 at break-even point. It is because the fixed cost will be covered and there will be no profit for the company.
The target profit in terms of units to be sold for earning a profit of $40,000 will be calculated as follows:-
(Fixed expenses + Target profit)/Unit contribution margin = ($200,000 + $40,000)/$25
= 9600 units
Thus, the company must sell 9,600 units of a product in the market for earning a target profit of $40,000.
The contribution margin ratio and expected change in the net operating income will be calculated as follows:-
Contribution margin/Total sales = $370,000/$1,100,000
= 0.33 or 33%
Thus, if the sales increased by $170,000 without any change in the fixed expenses of the company, then the net operating income will be increased by
= $170,000 × CM ratio
= $170,000 × 0.33
Job Order Costing
There are three types of absorption costing system such as job order costing, process costing and ABC costing. Job order costing is also known as job costing, which is a managerial system designed for assigning manufacturing cost to different activities. The manufacturing cost of the individual product or the products involved in the batches are assigned by the company (Zopiatis et al., 2014). The job order costing method is followed by the business, when there is product differentiation and the characteristics are not identical in nature. In addition, job order costing is an accounting system used for tracing the direct cost and assigning indirect cost to the unique and different job irrespective to the specific department.
Features of Job Order Costing
- The characteristics of a job are different from each other and require special treatment under the particular situation
- Each activity in job order costing is treated as a cost unit by the production company
- The cost of each activity is determined after completion of the job and not in the production stage
- There is a changes in the work in progress according to the changes in the jobs or total jobs in hand
Objectives of Job Order Costing
- To maintain separate account for each and every process involved in job for estimating total cost involved for completing the task on time
- To estimate the price of a particular activity by examining the price of previous jobs
- To recognize the profitable and non-profitable activity and eliminating the profitless jobs form the organization (Needles et al., 2013)
- To differentiate the activities of managerial department from one another on the basis of total cost and material required for undertaking the work
Advantages of Job Order Costing
- It is easy to assign cost to different activities separately as well as helps in calculating the profit margin from the individual job. Job order costing is suitable for the companies, whose operations are related with custom orders (Kontis et al., 2014). The accurate profitability can be easily reported on the individual operations at the work place.
- It helps in setting the benchmark for the employee as well as to evaluate the performance of the workforce on the basis of accessibility, productivity, accuracy etc.
- Job order costing facilitates in monitoring the cost of different activity throughout the manufacturing process. The continuous reviewing supports in identifying the potential risk and issues and then taking corrective steps for eliminating such problems in a long run.
Example of Job Order Costing
ABC Limited manufactures various types of sporting products and is planning to sell a batch of 30 special machines (Job 200) to XYZ Limited for $ 109,200. The direct material required is $50,000 and direct manufacturing labor is $15,000. Job 200 used 500 machine hours and total 2,500 machine hours were used by all the jobs in the company. The actual manufacturing overhead costs in the operations were $70,000.
Then, the actual indirect cost rate will be calculated as $70,000/2500 = $28 per machine hour
However, $28 per machine hour* 500 hours = $14,000
Direct Material = $50,000
Direct labor = $15,000
Factory Overhead = $14,000
Total = $79,000
Variable costing is a concept in accounting for managing the cost of different activities, which are involved in manufacturing the product on time. The total manufacturing overhead is calculated during the production cycle of the product (Fakoya & van der Poll, 2013). In addition, when the level of production increases then there is an increment in the income level which raises the issues reacted with absorption costing. The variable cost keeps on changing with the changes in the total production output. The variables costing involves only variable manufacturing cost associated with direct material, direct labor and manufacturing overhead expressed in unit product cost.
Features of Variable Costing
- The manufacturing overheads are differentiating into fixed and variable. The variable cost is referred as product cost.
- The changes in the output with the changes in the average unit cost are not shown by the variable costing.
- Various decisions are made through variable costing as it provides critical information and data.
Difference between Variable Costing and Absorption Costing
In absorption costing system all variable as well as fixed manufacturing cost such as direct material, direct labor and factory overhead is included in the product cost (Osazevbaru, 2014). On the other hand, in variable costing the fixed cost associated with manufacturing and non-manufacturing is not integrated in the product cost.
Advantages of Variable Costing
- The in-depth understanding about the effect of fixed cost on the net profit is evaluated with the support of variable costing because the total fixed cost of a particular year is represented in income statement.
- There is a close relation of variable costing with standard costing system and flexible budgets, which helps in controlling the total cost for the activity.
Example of Variable Costing
Companies produces and sells 6000 units of product Z per year and assume one unit of product Z requires the following costs as outlined below:
Direct materials: $6 per unit
Direct labor: $5 per unit
Variable manufacturing overhead: $1 per unit
Fixed manufacturing overhead: $30,000 per year
The cost of the company for the unit product will be is calculated as:
Absorption Costing: $6 + $5 + $1 + $5 ($30,000 / 6,000) = $17
Variable Costing: $6 + $5 + $1 = $12
Activity-Based Costing is used by the companies for identifying different activities and allocating cost to each and every activity as per the actual consumption of total resources. The objectives of the companies associated with activity based costing are to estimate the total cost element related with the specific product or services (Dong et al., 2014). It is done for examining and eliminating that product from the process, which is unprofitable for the company. In addition, activity based costing helps the business in identifying the product or service, which is ineffective in the long run and eliminating it with the more profitable product that helps in increasing the profit for the company.
Features of Activity-Based Costing
- The total cost in activity based costing is divided into fixed and variable cost that helps in providing information about the cost system.
- The cost behaviour pattern is properly described on the basis of volume, diversity, event and time related.
Difference between Activity-Based Costing and Absorption Costing
The absorption costing is used for assigning the cost to the individual units; whereas activity based costing majorly focus on the activities of the business for determining the total cost (Dong et al., 2015). After this the indirect cost to the units is assigned for accomplish the work on time.
Advantages of Activity-Based Costing
- The cause and effect relationship is studied under activity based costing, which helps in providing accurate and reliable results.
- The decisions about different product lines are made after collecting the information about its long term profitability.
Example of Activity-Based Costing
The activity cost rates are calculated as follows:-
|Activity||Cost Driver||Overhead Cost||Estimated Units||Rate|
|Purchasing Material||Pieces of material||$ 100,000||90,000 pieces||$3 per piece|
|Machine Setups||Machine Setup||700,000||500 setups||1,500 per setup|
|Inspections||Inspection hours||300,000||3,000 inspect. hours||200 per inspect. hour|
Actual Number of cost driver units
|Purchasing Material||5,000 pieces|
|Machine Setups||8 setups|
|Purchasing Material||5,000*3= $15,000|
|Machine Setups||8*1,500= 12,000|
|Total Overhead||$ 57,000|
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