The Application Of Using Financial Modelling Accounting Essay

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This report is to discussing the application of using financial modeling, how the financial modeling is important to the real business Cashmere Wheel Limited and how this model could help the company to forecast and calculate all the financial record. The ABC system are design to help company to do for their planning and to manage their activities and to focus what causes the costs to increase in the cost drivers. The sensitivity analysis is also important because it helps them to forecast the future performance, and to predict any unusual cases happen that could bring big impact to the company. Using the motor industry case study of Cashmere Wheel Limited, there are three scenarios to be chosen from.

2.0 Financial Modeling

Financial modeling is a technique which generally applied in organization and investment situations where the model used to forecast and calculate all the monetary figures. The model somehow can be range from basic straightforward to complicated computer system programs that could require up to several hours in order to operate (Pietersz, 2011). Various people do not have notice that spreadsheets can be applied way more than just creating charts, graphs and tables although the spreadsheets were formerly designed to perform as e-ledgers and worksheets for accounts, but currently, they are using and creating for more complicated mathematical models and applied for analysis.

The fundamental concept regarding the financial models is to determine and analyze the possible of scenarios cases happen and the consequences as many as possible and this could actually helps Cashmere Wheel Limited to have updated information and decisions on which investment is risk-free, and what kind of creative products design is suitable to sell to the public (Tatum, 2011). The company will then draft a variety of several models to take into concern, not just only the current known issues, but as well as the future activities and the impact of politics in the market industry.

2.1 Importance of Financial Modeling

Financial model is important to the big company such as Cashmere Wheel Limited decisions because it is designed to help the company whenever they are considering into a project task, putting in a bid of project, analyzing acquisition, carrying out every month financial planning, conducting capital framework research and so on. It is also important because most of the managing decisions are immediate outcome of financial modeling and they have a direct link with the company's decision making process.

It is a useful method that enables the company choices and risks to be examined in cost effective approach towards the assumptions range, determine the best options in financial returns and have the understanding on the impact of resources limitations to create the most successful organization decisions.

Financial modeling is also able to help the company to prevent over spending on paying out resources on progression, manufacturing and marketing of a products and services that is not able to attract customers. It could also determine what might occur if there is certain changes of movement in consumer choices or economy goes through a recession, and it could take into consideration to the level of risk involved when produce the products. In the case when models show that there is higher possibility that the products and services will never generate enough revenue to offset the expenses costs, the company may decide to focus to another way of direction. Some models contain an extraordinary aspects such as, what would probably happen to the investment when the natural disaster occur, this models will then give the company a better concept of the risk with secure and hold the investment at the specific time period (Tatum, 2011).

2.2 The Advantages and Disadvantages of Financial Modeling

There are many advantages in using financial modeling. One of the advantage is it could be ask in the statement of "what if" without rebuilding a model from scratch each time the test is executed and it also minimize the financial risk, as you know "if you perform this, then is likely to happen" (Teach-ict, 2011). Secondly, model provide consistent outcome, when there is a change in the values in the model, the related formula and values will change automatically too, it gives fast solution and it makes convenient to people. Model has a graphs and charts to help give a better clear result of every department over a period of time and also the values will change automatically when there is value add in. Thirdly, the model is quite simple to use if the company knows the model well and has a very good rules to stick to. Besides, the model can easily share out between one and another regardless who and where they are.

Although financial modeling bring a lot of advantages to user, but it also has its own disadvantages. One of the disadvantage is creating a highly effective model could be frustrated and time-consuming. Secondly, it is impossible to be aware every single changes in the financial model. The bankers may model how much cash an individual might saving or borrowing but they could not determine the impact that the present financial problems will happen on the actual life practice. Thirdly, there are a lot of aspects that should be taken into consideration and sometimes it makes the user to overlook things, this might cause the outcomes inaccurate. The more complex the situation is, the more expensive it will be as it required better software to work on (Teach-ict, 2011).

3.0 Traditional Approach and Activity Based Costing (ABC)

Traditional costing system was created many generations ago at 1900s and currently still broadly applied by everyone nowadays. They depend thoroughly on arbitrary cost allocations. This technique is important as it has to absorb overheads into production units using an appropriate structure and usually it uses volume-based cost driver such as, direct labour hour and machine hour. Every each of the department in Cashmere Wheel Limited is required to calculate the overhead absorption rate. The only activities that are treated as cost centres is production process activities while service and support activities are not recognized as cost centres.

At the late 1980s, ABC system just started to shown up and is an alternative method of the traditional absorption costing (Emblemsvag, 2010). The main objectives of ABC system are to focus attention about what causes costs to increase and also it applies on cause-and-effect cost allocations. ABC required the identification of the cost drivers which make the cost of an organization's main activities. For ABC system, the activities that are treated as cost centres are production process activities and service and support activities.

3.1 The Advantages and Disadvantages of ABC

There are few advantages when the company using ABC system, one of the advantages is the product costs tend to be more accurate because of the more complex analysis and assignment of overhead costs (Accounting for Management, 2011). The overhead costs are assigned on a cause-and-effect instead of using an arbitrary basis. Secondly, cost behavior is way better understood because of the analysis of activities and ABC facilitates a great idea of what drives overhead costs. Thirdly, Cashmere Wheel Limited is able to evaluate the products profitability realistically and bad decisions due to inadequate cost information are much less to happen.

Next are the disadvantages of using ABC system, one of the advantage is it is impossible to allocate all overhead costs to specific activities because some measurement of arbitrary cost apportionment may still be needed at the cost pooling stage for items like rental, rates and building depreciation. Secondly, usually activities and cost pools have more than one cost driver and it is difficult for the company to identify the appropriate cost driver for a cost pool activity. Thirdly, it is very problematic when implementing the ABC, this is due to ABC can be more complicated for understanding compare to traditional costing method.

4.0 Sensitivity Analysis

Sensitivity analysis is known as "what-if" analysis and is a technique used to forecast the outcome of a decision when a scenario happens to be different compared to the key prediction. The company can used to determine how different values of an independent variable will affect a specific dependent variable with a given set of assumptions and is used within specific boundaries that rely on one or more input variables, for example, the effect of the interest rate changes will have on a bond's price. Sensitivity analysis is very beneficial when they trying to determine the consequences of the actual outcome of a specific changing will have if it is different from what was assumed in the past. The analyst can figure out how the changes in one variable can impact the target variable. The below are the three examples of the motor industry scenario cases set up that could be assumed to happen to Cashmere Wheel Limited. There are a few things that could happen whether the cases become better or become worst, and how Cashmere Wheel Limited overcome and behave towards the cases.

4.1 Scenario 1

Under scenario 1, the company chooses to see the best case scenario by assuming that the interest rate for the Ford and Mitsubishi vehicles is reduce by next year from 5% to 2.5%, the productions units for the wheel rims will estimate to increase 3000 units for Huzo, 2300 units for Suzoma and 1800 units for Zara. Due to the increase of production units, shipping cost and inspection cost are also increase accordingly.

By using this method, the company enables to see the demand market for Ford and Mitsubishi will increase as the interest rate is low, consumer will then encourage buying more cars. As the market demand increase, the production of wheel rims to supply to Ford and Mitsubishi will also increase.

4.2 Scenario 2

Under scenario 2, the company chooses to see the worst case scenario by assuming that what if natural disaster such as tsunami and earthquake hit the company factory. This could not be avoiding as it is natural disaster will damage all the factory and warehouse which will make the sales growth drop to 0% or maybe negative profit. The production units for the wheel rims will estimate to decrease 7980 units for Huzo, 5994 units for Suzoma and 2860 units for Zara. Due to the damage of the products, shipping cost and inspection cost at that moment will be cut down.

By using this method, the company enables to see their sales drop sign and the damage cost that bring big effects to them.

4.3 Scenario 3

Under scenario 3, the company chooses to see the scenario case by assuming that what if the cost of input such as material cost and shipping cost increase that could possible affect the company's profit. Material cost for the wheel rims are estimate to be increase in for 25% to every wheel rims products. The new direct material cost per unit will be $1500 for Huzo, $1250 for Suzoma and $1875. Shipping cost is estimated to be increase also for 10% for the air freight from actual shipping cost $31,000 to $34,100.

By using this method, the company able to know what is going to happen and the combination impact that could affect their profits.

5.0 Conclusion

As conclusion, it is important that Cashmere Wheel Limited understand the financial model well as it could helps to improve their financial planning and overcome the impacts that might affect their company profit and loss. The company has predicted out three scenario cases by using the traditional and ABC system, the both system has help the company to clearly see how their business financial flow going up and down if the scenario happens on them. It is important that the company to set up as much as possible scenario case that might happen, because scenario cases could actually help them how to react and decide when things go worst.

References

Books

Ronald, W. H. (2008), Managerial Accounting, 7rd Edition, McGraw-Hill International Edition.

Steve, J., Roby, S. and Greg, J. (2008). Managerial Accounting, 4th Edition, Thomson South-Western.

Ray, H. G., Eric, W. N. and Peter, C. B. (2008). Managerial Accounting, 12th Edition, McGraw-Hill/Irwin.

Drury, C. (2006), Cost and Management Accounting, 6th Edition, Thomson Learning.

Drury, C. (2009), Management Accounting for Business, 4th Edition, Cengage Learning EMEA.

Website

Arixcel Ltd (2011). Best practice of financial modeling. (Online). Available from: http://www.arixcel.com/articles/modelling (Accessed 2 April 2011)

Articlebase (2011). Financial models are a key element in most major business decisions. (Online). Available from: http://www.articlesbase.com/finance-articles/financial-models-are-a-key-element-in-most-major-business-decisions-992694.html (Accessed 2 April 2011)

Leo, J (2010). Why is financial modelling so important? (Online). Available from: http://www.articlealley.com/article_1425557_19.html (Accessed 3 April 2011)

Teach-ict (2011). Advantages of using financial models. (Online). Available from: http://www.teach-ict.com/as_a2_ict_new/ocr/AS_G061/314_spreadsheet_concepts/models/miniweb_financial/pg7.htm (Accessed 3 April 2011)

Teach-ict (2011). Disadvantages of using financial models. (Online). Available from: http://www.teach-ict.com/as_a2_ict_new/ocr/AS_G061/314_spreadsheet_concepts/models/miniweb_financial/pg8.htm (Accessed 3 April 2011)

Alight LLC (2010). Scenario Analysis. (Online). Available from: http://www.alightplanning.com/use-cases/scenario-analysis (Accessed 3 April 2011)

Financial Modeling (2010). Financial modeling: Sensitivity and scenario analysis. (Online). Available from: http://www.finmodelling.com/blog/financial-modeling-sensitivity-and-scenario-analysis/ (Accessed 3 April 2011)

Russ, S (2009). Sensitivity and scenario analyses in financial modeling. (Online). Available from: http://ezinearticles.com/?Sensitivity-and-Scenario-Analyses-in-Financial-Modeling&id=2562105 (Accessed 3 April 2011)

Plum Solutions Pty Ltd (2010). Scenarios, sensitivities, what-if analysis - what's the difference? (Online). Available from: http://www.plumsolutions.com.au/articles/scenarios-sensitivities-what-if-analysis-%E2%80%93-what%E2%80%99s-difference (Accessed 3 April 2011)

Tatum, M (2010). What is financial modeling? (Online). Available from: http://www.wisegeek.com/what-is-financial-modeling.htm (Accessed 2 April 2011)

Accouting For Management (2011). Advantages, Disadvantages and limitations of activity based costing system. (Online). Available from: http://www.accountingformanagement.com/limitations_of_activity_based_costing.htm (Accessed 4 April 2011)

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