In spite of rapid expansion and growth, the management of Magicross Ltd are concerned that although the accounts presented disclose profits being made, the company‟s overdraft has been increasing.

As the Company‟s Cost Accountant, draft a report to management;

  • Detailing factors that can cause an increase in bank overdraft in the face of increasing profitability.
  • Giving options available for improving the company‟s liquidity without seeking external funds.


 To: The Management, Magicross Limited
From:The Cost Accountant, Magicross Limited
Re: Increasing Bank Overdraft in spite of a Reported Profitability:
The following factors could be the cause of increased bank overdraft in spite of the fact that the accounts have reported an increased profitability.
  • Increased debtors: This leads to increased sales, thus increased profits; but the cash available decreases if the debtors are not quickly realized thus making the company borrow.
  • Failure to purchase on Credit: The company pays for supplies in cash thus it depletes the available cash resources.
  • Purchase of fixed assets: The fixed assets usually need heavy initial capital investment thus may greatly reduce the available cash resources of the company, despite the fact that the assets could be used to produce a lot of goods for sale.
  • Prepayments: If the company spends a lot of money prepaying its expenses, the cash resources prepaid will not be available for its use.
  • Non-cash items: Profits reported could increase due to reduction in non-cashflow expenses such as depreciation and losses on disposal of fixed assets. Non cash flow incomes such as reduction in provision for bad and doubtful debts as well as profits on disposal of fixed assets could also increase the reported profit without increasing the cash flow of the company.
b)The company can improve its liquidity without seeking external funds by:
  • Improving debtor’s collection: Ensuring the debtors pay as soon as their credit period lapses.
  • Increase Credit Purchases: Maximize on the use of credit in purchasing supplies in order to preserve the company’s liquidity.
  • Use of Just-in-Time System of Stock: Purchase the stocks only when there is a ready sales order, but do not stock pile.
  • Purchase of EOQ Stocks: The Company can minimize its cash outflows in creditors payments if it purchases the economic order quantity of stocks, as this will minimize its cash payments to creditors. It also minimizes its stock holding costs such as handling costs, insurance costs and stock losses through pilferages, frauds, obsolescence etc
  • Minimize prepayments: Only pay for goods or services when provided or after provision.
  • Investment Policy: Only invest the excess liquidity in short-term investments that have a rate of return acceptable to the firm.
  • Purchase from suppliers with credit: Preferably purchase from those who can offer the longest credit period and can offer acceptable to the firm.
  • Take advantage of discounts: Quality and cash discounts from suppliers should be utilized as far as possible.
  • Dispose redundant Assets: Excess assets should be sold to avoid idle capacities and holding of cash in assets for no reason.
  • Quality Decision Making: The management should make decisions that maximize the company’s net present value



  • What is flexible budgeting?
  • Explain how flexible budgeting may be utilized to control costs.


Flexible Budgeting: This is a budgetary approach that considers the actual level of activities achieved in a given period, and adjusts the budgeted cost (at the budgeted activity level) to the actual activity level. The fixed budget is therefore flexed to the actual performance. The actual performance flexed budget is then used to evaluate the performance of the company.
This method is more equitable as it considers the fact that different levels of activities will inevitably consume levels of resources (costs) different from those budgeted. It would be
more equitable only to evaluate the actual performance from the same basis of output level (flexed level) and not from the budgeted level.

How flexible budgeting may be utilized to control costs:

  • Provides information about actual performance: The management needs to be informed on the performance level achieved and the cost levels expected for that performance level. This will form a good basis of performance level.
  • Business Dynamism: Business environments and activities are never static. Thus, it is illogical to expect the actual activity level to coincide with the budgeted activity level.
    Flexible budgeting enables the static fixed budgets to be useful for purposes of evaluating business performance in a dynamic environment.
  • Provides useful control information: performance with expected (flexed) performance control information. The variances calculated by comparing actual
    performance provides managers with useful


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