Contribution Margin

what is Contribution margin?

Contribution margin is a product’s price minus all associated variable costs, resulting in the incremental profit earned for each unit sold. The total contribution margin generated by an entity represents the total earnings available to pay for fixed expenses and to generate a profit.In accounting contribution margin is defined as revenues minus variable expenses. In other words, the contribution margin reveals how much of a company's revenues will be contributing (after covering the variable expenses) to the company's fixed expenses and net income. The contribution margin can be presented as:

 1) the total amount for the company,

 2) the amount for each product line, 

3) the amount for a single unit of product, and 

4) as a ratio or percentage of net sales.

The contribution margin concept is useful for deciding whether to allow a lower price in special pricing situations. If the contribution margin at a particular price point is excessively low or negative, it would be unwise to continue selling a product at that price. It is also useful for determining the profits that will arise from various sales levels (see the example). Further, the concept can be used to decide which of several products to sell if they use a common bottleneck resource, so that the product with the highest contribution margin is given preference.

The contribution margin concept can be applied throughout a business, for individual products, product lines, profit centers, subsidiaries, distribution channels, sales by customer, and for an entire business.

To determine the contribution margin, subtract all variable costs of a product from its revenues, and divide by its net revenue. Product variable costs typically include, at a minimum, the costs of direct materials and sales commissions. The calculation is:

              Net product revenue - Product variable costs

                                Product revenue

Contribution Margin Ratio (CM Ratio)

Contribution margin is a product's price minus all associated variable costs, resulting in the incremental profit earned for each unit sold. The total contribution margin generated by an entity represents the total earnings available to pay for fixed expenses and to generate a profit.The contribution margin ratio is the difference between a company's sales and variable expenses, expressed as a percentage. The total margin generated by an entity represents the total earnings available to pay for fixed expenses and generate a profit. When used on an individual unit sale, the ratio expresses the proportion of profit generated on that specific sale.

The contribution margin should be relatively high, since it must be sufficient to also cover fixed costs and administrative overhead. Also, the measure is useful for determining whether to allow a lower price in special pricing situations. If the contribution margin ratio is excessively low or negative, it would be unwise to continue selling a product at that price point, since the company would have considerable difficulty earning a profit over the long term. However, there are cases where it may be acceptable to sell a package of goods and/or services where individual items within the package have a negative contribution margin, as long as the contribution margin for the entire package is positive.

The contribution margin ratio is also useful for determining the profits that will arise from various sales levels (see the example).

The contribution margin is also useful for determining the impact on profits of changes in sales. In particular, it can be used to estimate the decline in profits if sales drop, and so is a standard tool in the formulation of budgets.

To calculate the contribution margin ratio, divide the contribution margin by sales. The contribution margin is calculated by subtracting all variable costs from sales. The formula is:

                         Sales - Variable expenses

                                       Sales

Contribution Margin Income Statement Contribution margin income statement is an income statement that is prepared to show the contribution margin figure in the income statement. A traditional income statements or profit or loss accounts prepared for external parties like govt. agencies, shareholders, auditors show gross profit and net profit and do not show contribution margin figure. A contribution margin income statement is prepared for the use of internal management. In such statements, all variable (manufacturing and non-manufacturing) and fixed (manufacturing and non-manufacturing) expenses are shown separately. When all variable manufacturing expenses are deducted from the sales revenue, the resultant figure is gross contribution margin. And when all non-manufacturing variable expenses are deducted from the gross contribution margin, the resultant figure is contribution margin or net contribution margin.

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Income Statement

What Is an Income Statement?

An income statement, otherwise known as a profit and loss statement, is a summary of a company’s profit or loss during any one given period of time (such as a month, three months, or one year). The income statement records all revenues for a business during this given period, as well as the operating expenses for the business.An income statement is a financial statement that reports a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities.

What Are Income Statements Used for?

You use an income statement to track revenues and expenses, so that you can determine the operating performance of your business over a period of time. Small business owners use these statements to find out which areas of their business are over or under budget.

These statements allow you to pinpoint specific items that are causing unexpected expenditures, such as cell phone use, advertising, or supply expenses. Income statements can also track dramatic increases in product returns or cost of goods sold as a percentage of sales, and can be used to determine income tax liability.Income statements, along with balance sheets, are the most basic elements required by potential lenders, such as banks, investors, and vendors. They will use the financial reporting contained therein to determine credit limits.

How to Prepare an Income Statement?

To prepare an income statement, you need to understand each individual component.

Sales

The sales figure represents the amount of revenue generated by the business. The amount recorded here is the total sales, minus any product returns or sales discounts.

Cost of Goods Sold

This number represents the costs directly associated with making or acquiring your products. Costs include materials purchased from outside suppliers used in the manufacture of your product, as well as any internal expenses directly expended in the manufacturing process.

In a service business where you, as the owner, are the only expense in supplying the service, and you do not pay yourself a salary beyond the company profits, your service expense may be zero. However, in a service business where you pay yourself a salary or have employees, the cost of their labor, including benefits, would be part of your cost of goods sold.

Gross Profit

Gross profit is calculated by subtracting the cost of goods sold from net sales. It does not include any operating expenses or income taxes.

• Sales salaries: These are the salaries plus bonuses and commissions paid to your sales staff.
• Collateral and promotions: Collateral fees are expenses incurred in the creation or purchase of printed sales materials used by your sales staff in marketing and selling your product. Promotion fees include any product samples and giveaways used to promote or sell your product.
• Advertising: These represent all costs involved in creating and placing print or multimedia advertising.
• Other sales costs: These include any other costs associated with selling your product. They may include travel, client meals, sales meetings, equipment rental for presentations, copying, or miscellaneous printing costs.
• Office salaries: These are the salaries of full- and part-time office personnel.
• Rent: This is the fee incurred to rent or lease office or industrial space.
• Utilities: These include costs for heating, air conditioning, electricity, Internet, and phone usage incurred in connection with your business.
• Depreciation: Depreciation is an annual expense that takes into account the loss in value of equipment used in your business. Some examples of equipment that may be subject to depreciation include computers, office furniture, automobiles, and buildings that you own. If you don’t understand depreciation, don’t worry; I will explain it more carefully in a separate section.
• Other overhead costs: Expense items that do not fall into any of the above categories or cannot be clearly associated with a particular product or function are considered to be other overhead costs. These types of expenses may include insurance, office supplies, or cleaning services.

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Public Company Accounting Oversight Board

What is a 'Public Company'

A public company is a company that has issued securities through an initial public offering (IPO) and is traded on at least one stock exchange or the over-the-counter market. Although a small percentage of shares may be initially floated to the public, becoming a public company allows the market to determine the value of the entire company through daily trading.A public, publicly traded, publicly held company, or public corporation is a corporation whose ownership is dispersed among the general public in many shares of stock which are freely traded on a stock exchange or in over the counter markets. In some jurisdictions, public companies over a certain size must be listed on an exchange.

History

The first company to issue shares is generally held to be the Dutch East India Company in 1601, but quasi-corporate entities, often trading or shipping concerns, are known to have existed as far back as Roman times.

Advantages

Publicly traded companies are able to raise funds and capital through the sale (in the primary or secondary market) of shares of stock. This is the reason publicly traded corporations are important; prior to their existence, it was very difficult to obtain large amounts of capital for private enterprises. The profit on stock is gained in form of dividend or capital gain to the holders.

The financial media and analysts will be able to access additional information about the business.

The owners are able to share risks by selling shares to the public. If he holds 100% of the share, he will pay all the debt, however, if he holds 50%, he only needs to pay 50% of the debt. It increases the asset liquidity and the company does not need to depend on fund from the bank. It improves the transparency of company information by releasing annual account report and transaction record. The company may be better known to the public,or increase its popularity. If some shares are given to the managers, the conflicts between managers and shareholders, the principal-agent problem, will be remitted.

Disadvantages

Many stock exchanges require that publicly traded companies have their accounts regularly audited by outside auditors, and then publish the accounts to their shareholders. Besides the cost, this may make useful information available to competitors. Various other annual and quarterly reports are also required by law. In the United States, the Sarbanes–Oxley Act imposes additional requirements. The requirement for audited books is not imposed by the exchange known as OTC Pink.The shares may be maliciously held by outside shareholders and the original founders or owners may lose benefits and control. The principal-agent problem, or the agency problem is a key weakness of public company. The separation of company's ownership and control is especially prevalent in such countries as U.K and U.S.

Public Company Accounting Oversight Board

The Public Company Accounting Oversight Board (PCAOB) is a private-sector, nonprofit corporation created by the Sarbanes–Oxley Act of 2002 to oversee the audits of public companies and other issuers in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports. Since 2010, the PCAOB also oversees the audits of broker-dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection. All PCAOB rules and standards must be approved by the U.S. Securities and Exchange Commission (SEC).

In creating the PCAOB, the Sarbanes-Oxley Act required that auditors of U.S. public companies be subject to external and independent oversight for the first time in history. Previously, the profession was self-regulated.In a public company, accountants are buried with additional reporting requirements, though there is a clear opportunity to raise money through the public markets. In Public Company Accounting and Finance, we explore both of these aspects of a public company. The accountant must learn about earnings per share, segment reporting, and Staff Accounting Bulletins, as well as quarterly and annual reporting to the SEC. Meanwhile, the treasurer can engage in an initial public offering, file registration statements, or sell shares under various SEC exemptions.

PCAOB Powers

Under Section 101 of the Sarbanes-Oxley Act, the PCAOB has the power to:

• register public accounting firms that prepare audit reports for issuers and broker-dealers;
• set auditing, quality control, ethics, independence and other standards relating to the preparation of audit reports of issuers;
• conduct inspections of PCAOB-registered public accounting firms;
• conduct investigations and disciplinary proceedings, and impose sanctions, against registered public accounting firms and associated persons of such firms (including fines of up to $100,000 against individual auditors, and $2 million against audit firms);
• perform such other duties or functions as the Board determines are necessary or appropriate to promote high professional standards among, and improve the quality of audit services offered by, registered public accounting firms and their employees;
• sue and be sued, complain and defend, in its corporate name and through its own counsel, with the approval of the SEC, in any Federal, State or other court;
• conduct its operations, maintain offices, and exercise all of its rights and powers in any part of the United States, without regard to any qualification, licensing or other provision of state or [municipal] law;
• hire staff, accountants, attorneys and other agents as may be necessary or appropriate to the PCAOB's mission (with salaries set at a level comparable to private-sector self-regulatory, accounting, technical, supervisory, or other staff or management positions, as set out by the Sarbanes-Oxley Act to attract the highly skilled and experienced professionals needed to oversee global accounting firms);
• allocate, assess, and collect accounting support fees that fund the Board; and
• enter into contracts, execute instruments, incur liabilities, and do any and all other acts and things necessary, appropriate, or incidental to the conduct of its operations and the exercise of its powers under the Sarbanes-Oxley Act.

Auditors of public companies are prohibited by the Sarbanes-Oxley Act to provide non-audit services, such as consulting, to their audit clients. Congress made certain exceptions for tax services, which are therefore overseen by the PCAOB. This prohibition was made as a result of allegations, in cases such as Enron and WorldCom, that auditors' independence from their clients' managers had been compromised because of the large fees that audit firms were earning from these ancillary services.

In addition, as part of the PCAOB's investigative powers, the Board may require that audit firms, or any person associated with an audit firm, provide testimony or documents in its (or his or her) possession. If the firm or person refuses to provide this testimony or these documents, the PCAOB may suspend or bar that person or entity from the public audit industry. The PCAOB may also seek the SEC's assistance in issuing subpoenas for testimony or documents from individuals or entities not registered with the PCAOB.

The Board's Office of the Chief Auditor advises the Board on the establishment of auditing and related professional practice standards.

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Inventory Accounting

Inventory

Definition: Inventory is an asset that is intended to be sold in the ordinary course of business. Inventory may not be immediately ready for sale. Inventory items can fall into one of the following three categories:

• Held for sale in the ordinary course of business
• That is in the process of being produced for sale

The materials or supplies intended for consumption in the production process.

This asset classification includes items purchased and held for resale. In the case of services, inventory can be the costs of a service for which related revenue has not yet been recognized.

In accounting, inventory is typically broken down into three categories, which are:

• Raw materials. Includes materials intended to be consumed in the production of finished goods.
• Work-in-process. Includes items that are in the midst of the production process, and which are not yet in a state ready for sale to customers.
• Finished goods. Includes goods ready for sale to customers. May be termed merchandise in a retail environment where items are bought from suppliers in a state ready for sale.

What is inventory?

I think of inventory as a company's goods on hand, which is often a significant current asset. Inventory serves as a buffer between a company's sales of goods and its production or purchase of goods. Companies strive to find the proper amount of inventory to avoid lost sales, disruptions in production, high holding costs, etc.

Manufacturers usually have the following categories of inventories: raw materials, work-in-process, finished goods, and manufacturing supplies. The amounts of these categories are usually listed in the notes to its balance sheet.

A company's cost of inventory is related to the company's cost of goods sold that is reported on the company's income statement.

Since the costs of the items purchased or produced are likely to likely to change, companies must elect a cost flow assumption for valuing its inventory and its cost of goods sold. In the U.S. the common cost flow assumptions are FIFO, LIFO, and average.

Sometimes a company's inventory of goods is referred to as its stock of goods, which is held in its stockroom or warehouse.

Accounting Inventory Methods

Inventory includes the raw materials, work-in-process, and finished goods that  a company has on hand for its own production processes or for sale to customers. Inventory is considered an asset, so the accountant must consistently use a valid method for assigning costs to inventory in order to record it as an asset.

The valuation of inventory is not a minor issue, because the accounting method used to create a valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an accounting period, and therefore on the amount of income earned. The basic formula for determining the cost of goods sold in an accounting period is:

Beginning inventory + Purchases - Ending inventory = Cost of goods sold

When you buy inventory from suppliers, the price tends to change over time, so you end up with a group of the same item in stock, but with some units costing more than others. As you sell items from stock, you have to decide on a policy of whether to charge items to the cost of goods sold that were presumably bought first, or bought last, or based on an average of the costs of all items in stock. Your choice of a policy will result in using either the first in first out method (FIFO), the last in first out method (LIFO), or the weighted average method. The following bullet points explain each concept:

• First in, first out method. Under the FIFO method, you are assuming that items bought first are also used or sold first, which also means that the items still in stock are the newest ones. This policy closely matches the actual movement of inventory in most companies, and so is preferable simply from a theoretical perspective. In periods of rising prices (which is most of the time in most economies), assuming that the earliest units bought are the first ones used also means that the least expensive units are charged to the cost of goods sold first. This means that the cost of goods sold tends to be lower, which therefore leads to a higher amount of operating earnings, and more income taxes paid. Also, it means that there tend to be fewer inventory layers than under the LIFO method (see next), since you will continually use up the oldest layers.
• Last in, first out method. Under the LIFO method, you are assuming that items bought last are sold first, which also means that the items still in stock are the oldest ones. This policy does not follow the natural flow of inventory in most companies; in fact, the method is banned under International Financial Reporting Standards. In periods of rising prices, assuming that the last units bought are the first ones used also means that the cost of goods sold tends to be higher, which therefore leads to a lower amount of operating earnings, and fewer income taxes paid. There tend to be more inventory layers than under the FIFO method, since the oldest layers may not be flushed out for years.
• Weighted average method. Under the weighted average method, there is only one inventory layer, since the cost of any new inventory purchases are rolled into the cost of any existing inventory to derive a new weighted average cost, which in turn is adjusted again as more inventory is purchased.

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System Of Accounting For Cost

What is the Accounting Cycle?

The accounting cycle is a series of activities used to identify and record an entity's individual transactions. These transactions are then aggregated at the end of each reporting period into financial statements. The accounting cycle is essentially the core redecoration activity that an accounting department engages in on an ongoing basis, and is the basis upon which the financial statements are constructed. Most accounting controls and procedures relate to the accounting cycle.

The accounting cycle is often described as a process that includes the following steps: identifying, collecting and analyzing documents and transactions, recording the transactions in journals, posting the journalized amounts to accounts in the general and subsidiary ledgers, preparing an unadjusted trial balance, perhaps preparing a worksheet, determining and recording adjusting entries, preparing an adjusted trial balance, preparing the financial statements, recording and posting closing entries, preparing a post-closing trial balance, and perhaps recording reversing entries.

Cycle and steps seem to be a carryover from the days of manual bookkeeping and accounting when transactions were first written into journals. In a separate step the amounts in the journal were posted to accounts. At the end of each month, the remaining steps had to take place in order to get the monthly, manually-prepared financial statements.

Today, most companies use accounting software that processes many of these steps simultaneously. The speed and accuracy of the software reduces the accountant's need for a worksheet containing the unadjusted trial balance, adjusting entries, and the adjusted trial balance. The accountant can enter the adjusting entries into the software and can obtain the complete financial statements by simply selecting the reports from a menu. After reviewing the financial statements, the accountant can make additional adjustments and almost immediately obtain the revised reports. The software will also prepare, record, and post the closing entries.

The following discussion breaks the accounting cycle into the treatment of individual transactions, and then closing the books at the end of the accounting period.

The accounting cycle for individual transactions is:

Identify the event that is causing an accounting transaction. Examples of such events are:

• Buy materials
• Pay wages to employees
• Apply overhead to inventory and the cost of goods sold
• Sell goods to customers
• Provide services to customers
• Receive payment from customers
• Recognize an expense

1. Prepare the business document associated with the accounting transaction, such as a supplier invoice, customer invoice, petty cash voucher, or cash receipt.
2. Identify which accounts are affected by the business document. With a computerized accounting system, there is usually a default account associated with each supplier, so that the system assigns the amount listed on a supplier invoice to the default account (unless you override it). Similarly, there is usually a default account associated with each customer, so that the system assigns billed amounts to a specific revenue account whenever an invoice is created for a customer. There may also be standardized template journal entries in the accounting software for various standard transactions, such as for recording monthly depreciation or accrued wages.
3. Record in the appropriate accounts in the accounting database the amounts noted on the business document. This may involve recording transactions in a specific journal, such as the cash receipts journal, cash disbursements journal, or sales journal, which are later posted to the general ledger. Such transactions may also be posted directly to the general ledger.

The preceding accounting cycle steps were associated with individual transactions. The following accounting cycle steps are only used at the end of the reporting period, and are associated with the aggregate amounts of the preceding transactions:

1. Prepare a preliminary trial balance, which itemizes the debit and credit totals for each account. All debits are listed in the left column, and all credits in the right column. The totals of the two columns should be identical. If not, then there is an error somewhere in the underlying transactions (a one-sided entry) that should be corrected before proceeding. In most accounting software systems, it is impossible to have transactions that do not result in matching debit and credit totals. If the trial balance is being prepared manually, then likely reasons for unbalanced debit and credit totals are:

• Only entering a portion of a transaction
• Entering part of a transaction more than once
• Entering an incorrect amount
• Entering an amount as a debit instead of a credit (or vice versa)

2. Add accrued items, record estimates, and correct errors in the preliminary trial balance with adjusting entries. Examples of such items are:

• Record expenses for supplier invoices that have not yet arrived
• Record revenue for customer invoices that have not yet been billed
• Record errors spotted in the month-end bank reconciliation
• Adjust for transactions that were initially recorded in the wrong account
• Accrue for unpaid wages earned

3. Prepare an adjusted trial balance, which incorporates the preliminary trial balance and all adjusting entries. It may require several iterations before this adjusted trial balance accurately reflects the results of operations and the financial position of the business for which the information is being aggregated.

4. Prepare the financial statements from the adjusted trial balance. The core elements of the financial statements are:

• Balance sheet
• Income statement
• Statement of cash flows
• Statement of retained earnings
• Accompanying disclosures (footnotes)

5. Close the books for the reporting period. This step is handled automatically by an accounting computer system. If you are compiling accounting information manually, then closing the books involves shifting all temporary account balances (e.g., revenue, expenses, gains, and losses) into the income summary account, and shifting the balance from there to the retained earnings account.

6. Prepare and review a post-closing trial balance.This trial balance should contain zero balances for all temporary accounts.

It is also useful to print out the key documents supporting the completed financial statements and store them in a binder. This can include all journals, as well as source documents for major journal entries, such as the depreciation calculations. This information provides backup information for the financial statements, and is of particular use when providing evidentiary matter to auditors.

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Cost Accounting

What is 'Cost Accounting'?

Cost accounting is a type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step of production as well as fixed costs such as depreciation of capital equipment. Cost accounting will first measure and record these costs individually, then compare input results to output or actual results to aid company management in measuring financial performance.

Cost accounting involves the techniques for:

determining the costs of products, processes, projects, etc. in order to report the correct amounts on the financial statements, and

assisting management in making decisions and in the planning and control of an organization.

For example, cost accounting is used to compute the unit cost of a manufacturer's products in order to report the cost of inventory on its balance sheet and the cost of goods sold on its income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of process costing, operations costing, and job-order costing systems.

Cost accounting assists management by providing analysis of cost behavior, cost-volume-profit relationships, operational and capital budgeting, standard costing, variance analyses for costs and revenues, transfer pricing, activity-based costing, and more.

Cost accounting had its roots in manufacturing businesses, but today it extends to service businesses.

Breaking Down Cost Accounting

While cost accounting is often used within a company to aid in decision making, financial accounting is what the outside investor community typically sees. Financial accounting is a different representation of costs and financial performance that includes a company's assets and liabilities. Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost control programs, which can improve net margins for the company in the future.

One key difference between cost accounting and financial accounting is that while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to information needs of the management. Cost accounting, because it is used as an internal tool by management, does not have to meet any specific standard set by the Generally Accepted Accounting Principles and as result varies in use from company to company or from department to department. 

Development of Cost Accounting

Scholars have argued that cost accounting was first developed during the industrial revolution when the emerging economics of industrial supply and demand forced manufacturers to start tracking whether to decrease the price of their overstocked goods or decrease production.

During the early 19th century when David Ricardo and T. R. Malthus were developing the field of economic theory, writers like Charles Babbage were writing the first books designed to guide businesses on how to manage their internal cost accounting.

Types of Cost Accounting

The main aim of every organization is to earn. Maximum profit, which depends on costs incurred by an organisation for different activities.

There are different types of costs that are relevant to business operations and decisions.

It is essential for organizations to have a clear idea about each costs incurred during production.

This is because the price at which an organization is willing to supply depends on the costs of production. The costs are broadly grouped into two categories, namely, accounting cost and analytical cost, which are important for business operations and decisions.

Standard Cost Accounting

This type of cost accounting uses ratios to compare efficient uses of labor and materials to produce goods or services under standard conditions. Assessing these differences is called a variance analysis. Traditional cost accounting essentially allocates cost based on one measure, labor or machine hours. Due to the fact that overhead cost has risen proportionate to labor cost since the genesis of standard cost accounting, allocating overhead cost as an overall cost has ended up producing occasionally misleading insights.

Some of the issues associated with cost accounting is that this type of accounting emphasizes labor efficiency despite the fact that it makes up a comparatively small amount of the costs for modern companies.

Activity Based Costing

The Charter Institute of Management Accountants defines activity based accounting as, "an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs, resources assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs."

Activity based costing accumulates the overheads from each department and assigns them to specific cost objects like services, customers, or products. The way these costs are assigned to cost objects are first decided in an activity analysis, where appropriate output measures are cost drivers. As result, activity based costing tends to be much more accurate and helpful when it comes to helping managers understand the cost and profitability of their company's specific services or products. Accountants using activity based costing will pass out a survey to employees who will then account for the amount of time they spend on different tasks. This gives management a better idea of where their time and money is being spent.

Lean Accounting

Lean accounting is an extension of the philosophy of lean manufacturing and production developed by Japanese companies in the 1980s. Most accounting practices for manufacturing work off the assumption that whatever is being produced is done in a large scale. Instead of using standard costing, activity based costing, cost-plus pricing, or other management accounting systems, when using lean accounting those methods are replaced by value-based pricing and lean-focused performance measurements, for example, using a box score to facilitate decision making and create simplified and digestible financial reports.

Marginal Costing

Considered a simplified model of cost accounting, marginal costing (sometimes called cost-volume-profit analysis) is an analysis of the relationship between a product or service's sales price, the volume of sales, the amount produced, expenses, costs and profits. That specific relationship is called the contribution margin. The contribution margin is calculated by dividing revenue minus variable cost by revenue. This type of analysis can be used by management to gain insight on potential profits as impacted by changing costs, what types of sales prices to establish, and types of marketing campaigns.

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Accounting For A Sole Proprietorship

Sole Proprietorship

A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

A sole proprietorship is a simple type of business structure that is owned and operated by the same person. It does not involve many of the complex filing requirements associated with other types of business structures such as corporations. Sole proprietorships allow persons to report business income and expenses on their individual tax returns.

Sole proprietorships are attractive to small investors because they are relatively easy to start up. Also, the owner is entitled to all the profit that the sole proprietorship collects. On the other hand, sole proprietorships can be risky because there is no separation between the owner and the business. 

In other words, the owner remains personally liable for any losses or debts that the sole proprietorship incurs. They can also be held legally responsible for violations committed by the business or its employees. A sole proprietorship can best be summed up by the phrase, "You are the business.

In addition to the relative simplicity compared to large corporations, opening a sole proprietorship is a low-cost method of entering into the business world. From consultants and free lancers to independent contractors, nearly anyone can create a sole proprietorship.

As the name suggests, "sole proprietorship" refers to a business that is owned by a single owner and should not be confused with a corporation. There are no corporate taxes involved and the sole proprietor pays income tax on the profits generated. The person who organized the business pays personal income taxes on the profits made. This makes the accounting procedure relatively simple for the sole proprietor, who also enjoys complete autonomy in terms of making business decisions.

Setting up a sole proprietorship is easy. One of the main steps is to obtain a local business license (a sales tax permit may also be required). For certain businesses, such as restaurants or legal practices, you may need additional local or state licenses. Legal regulations and licenses aside, there are other major factors to consider when setting up a sole proprietorship. You will have to create a business plan, develop marketing and advertising campaigns, set up a budget, and find ways to fund your business.

Advantages and Disadvantages of a sole proprietorship

Many business owners choose to operate as a sole proprietorship to alleviate the difficult tax procedures that go along with other forms of operation. As a sole proprietor, you would simply have to file an individual income tax return (IRS Form 1040) including your business losses and profits. There are no restrictions on the number of people you can hire, and from the tax and legal perspective there is no distinction between you and your business. You can therefore hire as many people as you want and also recruit independent contractors if need be. Being in complete control of their business, sole proprietors make all the business decisions keeping law in mind.

Some of the Advantages of a Sole Proprietorship

There are many reasons why a person would choose to start their business up using a sole proprietorship structure. Some of the main advantages of sole proprietorships include:

Ease of formation: Starting a sole proprietorship is much less complicated than starting a formal corporation, and also much cheaper. Some states allow sole proprietorship to be formed without the double taxation standards applicable to most corporations. The proprietorship can be named after the owner, or a fictitious name can be used to enhance the business’ marketing.

Tax benefits: The owner of a sole proprietorship is not required to file a separate business tax report. Instead, they will list business information and figures within their individual tax return. This can save additional costs on accounting and tax filing. The business will be taxed at the rates applied to personal income, not corporate tax rates.

Employment: Sole proprietorship can hire employees. This can lead to many of the benefits associated with job creation, such as tax breaks. Also, spouses of the business owner can be employed without having to be formally declared as an employee. Married couples can also start a sole proprietorship, though liability can only assumed by one individual.

Decision making: Control over all business decisions remains in the hands of the owner. The owner can also fully transfer the sole proprietorship at any time as they deem necessary.

 Disadvantages of Sole Proprietorships

Forming a sole proprietorship does involve some risks, mainly to the owner of the business, as legally speaking they are not treated separately from the business. Some disadvantages of sole proprietorships are:

Liability: The business owner will be held directly responsible for any losses, debts, or violations coming from the business. For example if the business must pay any debts, these will be satisfied from the owner’s own personal funds. The owner could be sued for any unlawful acts committed by the employees. This is drastically different from corporations, wherein the members enjoy limited liability (i.e., they cannot be held liable for losses or violations).

Taxes: While there are many tax benefits to sole proprietorship, a main drawback is that the owner must pay self-employment taxes. Also, some tax benefits may not be deductible, such as health insurance premiums for employees.

Lack of “continuity”: The business does not continue if the owner becomes deceased or incapacitated, since they are treated as one and the same. Upon the owner’s death, the business is liquidated and becomes part of the owner’s personal estate, to be distributed to beneficiaries. This can result in heavy tax consequences on beneficiaries due to inheritance taxes and estate taxes.

Difficulty in raising capital: Since the initial funds are usually provided by the owner, it can be difficult to generate capital. Sole proprietorship do not issue stocks or other money-generating investments like corporations do.

So, while sole proprietorship do not necessarily create more liabilities, they do expose the business owner to a risk of being sued. Lawsuits can be filed against the business owner for legal violations, as well as to collect any outstanding debts.

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Accounting principle

Accounting for a sole proprietorship

The accounting for a sole proprietorship does not require a separate set of accounting records, since the owner is considered to be inseparable from the business. Nonetheless, one should maintain records for business activities, in order to judge whether these operations are generating a profit.

A sole proprietorship tends to generate smaller amounts of revenue and incur lower levels of expenses than more complex types of organizations. Consequently, it can make sense to start off with the most minimal accounting record keeping that is based on the cash flows into and out of a bank account. This means maintaining separate cash receipts and cash disbursements journals, and little else. This is considered a single entry accounting system, since it cannot be used to produce a balance sheet, only an income statement.

A single entry system is most suited to a cash basis accounting system, where revenues are recorded as cash is received, and expenses are recorded as payments are made. There is no attempt to track assets or liabilities, so there is no formal tracking of fixed assets, inventory, and so forth in separate journals.

The tax reporting for a sole proprietorship flows through the owner's personal tax return, with a separate form used to itemize the major classes of revenues and expenses incurred by the business. There is no separate tax return for the business, since there is no separate business entity.

The main limitation of this accounting system is that there are insufficient accounting records to be translated into an auditable set of financial statements. If the owner of a sole proprietorship wants to obtain funding for his or her business, the lender will likely require audited financial statements, which will require the following sequence of actions to upgrade the accounting records:

Form a business entity

• Switch to the accrual basis of accounting, using a double entry bookkeeping system
• Have the resulting financial statements audited by a CPA

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