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ASSIGNMENT NO. 2
Topic: Analysis and application of various cost concepts for decision making.(1000 words)
Semester: Autumn 2010Course: Cost and Management Accounting Code: 5538 Level: MBA
Submitted to: Sir Waqar Akbar Allama Iqbal Open University Islamabad.
Submitted By: Ishtiaq Ahmed(0333-6824303)
Roll #: AH526270
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In the name of Allah, the most beneficent and the most merciful.
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Acknowledgements
All words of praise and gratitude to the sole Lord of universe, almighty Allah. I am
thank, first and foremost, Allah for having enable me to complete my effort of writing
such an assignment that would not have been possible for me to complete without his
help in all stages of its preparation. I revoke peace for Hazrat Muhammad (S.A.W) for
whom the earth and heaven is created. I am thankful for my parents, teachers, friends
and class fellows for having great courage and help during the report.
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Abstract
The topic assign to me was “Various cost concepts use in Decision Making”. I have
search the whole topic and select “Coca Cola” for practical study and show the
relationship between different costs and Decision making. I have found that the costs
concepts are so much important for an organization for its growth and for the increases
of its profit. “Coca Cola” management uses all the costs concepts for its
daily/weekly/monthly/annually decisions and running the organization in Profit.
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Table of Contents:
Contents Page No
Title page 01
Acknowledgement 03
Abstract 04
Table of contents 05
Introduction to the issue 06
Practical study of organization 13
Data collection methods 25
SWOT analysis 26
Conclusion 28
Recommendations 29
References 30
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Introduction to the issue
What is Decision Making?
”Decision making can be regarded as the mental processes resulting in the selection of
a course of action among several alternative scenarios. Every decision making process
produces a final choice. The output can be an action or an opinion of choice.” Decision
making is central to the management of an enterprise. The manager of a profit making
business has to decide on the manner of implementation of the objectives of the
business, at least one of which may well relate to allocating resources so as to maximize
profit. All organizations, whether in the private or the public sector, take decisions,
which have financial implications. Decisions will be about resources, which may be
people, products, services, or long term and short term investment.
What is Cost?
“Cost is the value of money that has been used up to produce something, and hence is
not available for use anymore”. In economics, a cost is an alternative that is given up as
a result of a decision. Decisions will also be about activities, including whether and how
to undertake them. Where the owners are different persons from the manager (for
example, shareholders of a company as separate persons from the directors), the
managers may face a decision where there is a potential conflict between their own
interests and those of the owners. In such a situation cost considerations may be
evaluated in the wider context of the responsibility of the managers to act in the best
interests of the owners.
Types of Costs:
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Manufacturing costs
Non-manufacturing costs
Fixed costs
Variable cost
Absorption costing
Opportunity costs
Product costs
Period costs
Differential costs
Standard cost
Direct cost & Indirect cost
Mixed cost.
Manufacturing costs:
Most manufacturing companies divide manufacturing cost into three broad categories.
Direct material, direct labor and Manufacturing overhead.
o Direct material:
Direct materials are those materials that become an integral part of the finished
product and that can be physically and conveniently traced to it. For example:
Panasonic use electric motor in it’s CD Players to make the CD spin.
o Direct labor:
The term direct labor is reserved for those labor costs that can be easily traced to
individual product. Direct labor is sometime called touch labor, since direct labor
workers typically touch the product while it is being made. For example the labor
cost of machine operator.
o Manufacturing overhead: 7
Manufacturing overhead the third element of manufacturing cost, includes all
cost of manufacturing except direct material and direct labor. So, we can say that
all costs associated with operating the factory are included in the manufacturing
overhead category. Such as indirect material, indirect labor, maintenance and
repairs on production equipment etc.
Non-manufacturing costs:
Generally non-manufacturing costs are sub-classified into two categories, (1) Selling
costs, (2) Administrative costs
o Selling costs: Selling cost include all costs necessary to secure customer orders
and get the finished product on service into the hand of the customer. This cost is
also known as marketing cost. Example: Advertising, Shipping, Sales travel etc.
o Administrative costs: It includes all executive, organizational and clerical costs
associated with the general management of an organization rather than with
manufacturing and selling. Example: Secretarial, compensation, public relation
and other this types of costs
Fixed costs:
A fixed cost is a cost that remains constant in total, regardless of changes in the level of
activity. As the activity level rises and falls, the fixed cost remains constant in total
amount unless influenced by some outside force, Such as price changes. There are two
types of fixed cost.
o Committed fixed cost: Committed fixed costs relate to the investment in
facilities, equipment and the basic organizational structure of a firm. Example:
Rent.
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o Discretionary fixed cost: Discretionary fixed cost usually arise from annual
decisions by management to spend in certain fixed cost areas. Example:
Advertising.
Variable cost:
A variable cost is a cost that varies in total, in direct proportion to changes in the level of
activity. The activity can be expressed in many ways, such as units produced, units sold,
miles driven, lines of print and so forth. A good example of variable cost is direct
material. It is important to note that when we speak of a cost as being variable, we
mean the total cost rises and falls as the activity level rises and falls. There are two types
of variable cost.
o True variable cost:
Direct material is a true variable cost because the amount used during a period
will vary in direct proportion to the level of production activity.
o Step-variable cost:
A cost that is obtained only in large chunks and that increases or decreases only
in response to fairly wide changes in the activity level is known as step-variable
cost. Maintenance cost is an example of step-variable cost.
Absorption costing:
A costing method that includes all manufacturing costs, direct materials, direct labor
and both variable and fixed overhead as part of the cost of a finished unit of production.
For example in this method the unit cost is as follows:
o Unit cost
Direct material: Rs.03
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Direct labor: Rs .02
Variable MOH: Rs .03
Fixed MOH: Rs .02
Total Rs. 10 per unit
Here fixed and variable MOH both are considered.
Variable costing:
In variable costing, only variable costs of production are allocated to products and the
unsold stock is valued at variable cost of production. Fixed production costs are treated
as a cost of the period in which they are incurred. For example in this method the unit
cost is as follows:
o Unit cost
Direct material: Rs. 03
Direct labor: Rs. 02
Variable MOH: Rs. 03
Total Rs. 08 per unit
Here fixed MOH is not considered.
Opportunity costs:
Opportunity cost is the potential benefit that is given up when one alternative is
selected over another. For example: Suppose I worked in a company and it gives me
20,000 Rs. per month. But suddenly I leave that job and get admitted in North-South
University for M.B.A. Then my salary 20,000 Rs. is my opportunity cost which I sacrificed
for further education.
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Product costs:
Product costs include all the costs that are involved in acquiring or making a product. In
the case of manufacturing goods these costs consist of direct material, direct labor and
manufacturing overhead. Product costs are initially assigned to inventories. So, they are
known as inventor-able costs.
Period costs:
Period costs are all the costs that are not incurred in product costs. These costs are
expensed on the income statement in the period in which they are incurred, using the
usual rules of accrual accounting. Period costs are not included as part of the cost of
either purchase or manufactured goods. Example: Sales commission, Office rent.
Differential costs:
A difference in costs between any two alternatives is known as differential cost. A
differential cost is also known as incremental cost. Technically an incremental cost
should refer only to an increase in cost from one alternative to another. Decreases in
cost should be referred to as decremented costs. So here we see that differential cost is
broader term consist of both incremental cost & decrement cost.
Standard costs:
Standard costs are target costs, which should be attained under specified operating
conditions. They are expressed as a cost per unit. For example: Hospitals have standard
cost (for food, laundry and other items) for each occupied bed per day, as well as
standard time allowance for certain routine activities, such as laboratory
test.
Direct cost:
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A direct cost is a cost that cannot be easily and conveniently traced to the particular cost
object under consideration. The concept of direct cost extends beyond just direct
material and direct labor. Example: Suppose Coca Cola Company is assigning costs to its
various regional and national sales offices. Then the salary of the sales manager in its
Karachi office would be a direct cost of that office.
Indirect cost:
An indirect cost is a cost that cannot be easily and conveniently traced to the particular
cost object under consideration. For example, the Coca Cola Company makes soft drinks
the factory manager’s salary would be an indirect cost of a particular variety such as
Sprite cola.
Mixed cost:
A mixed cost is one that contains both variable and fixed cost elements. Mixed costs are
also known as semi-variable cost. The fixed portion of a mixed cost represents the basic,
minimum cost of just having a service ready and available for use. The variable portion
represents the cost incurred for actual consumption of the service. The account analysis
and the engineering approach is used to estimate the fixed and variable portion of a
mixed cost.
Practical study of the organization
Coca Cola
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Introduction:
Research & Development
Company places great emphasis on Research and Development. For this purpose it has
well equipped and modern laboratory run by qualified staff, which is responsible for the
development of new products and it carries extensive research to improve the quality of
the product. It is also entrusted with the jobs of testing the raw material to enforce the
compliance to standard specifications.
Quality Control:
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Company vigorously pursues the quality in all processes starting from procurement of
the raw material to shipment of finished products to customers.
Basic Products:
o Coca Cola
o Sprite
o Sprite 3G
o Fanta
o Saplaish Orange Juice
o Saplaish Mango Juice
o Other Soft drinks
History of Coca Cola
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(John Pemberton)
In May, 1886, Coca Cola was invented by Doctor John Pemberton a pharmacist from
Atlanta, Georgia. John Pemberton concocted the Coca Cola formula in a three legged
brass kettle in his backyard. The name was a suggestion given by John Pemberton's
bookkeeper Frank Robinson. The soft drink was first sold to the public at the soda
fountain in Jacob's Pharmacy in Atlanta on May 8, 1886. About nine servings of the soft
drink were sold each day. Sales for that first year added up to a total of about $50. The
funny thing was that it cost John Pemberton over $70 in expanses, so the first year of
sales were a loss. Until 1905, the soft drink, marketed as a tonic, contained extracts of
cocaine as well as the caffeine-rich kola nut. In 1887, another Atlanta pharmacist and
businessman, Asa Candler bought the formula for Coca Cola from inventor John
Pemberton for $2,300. By the late 1890s, Coca Cola was one of America's most popular
fountain drinks, largely due to Candler's aggressive marketing of the product. With Asa
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Candler, now at the helm, the Coca Cola Company increased syrup sales by over 4000%
between 1890 and 1900. Advertising was an important factor in John Pemberton and
Asa Candler's success and by the turn of the century, the drink was sold across the
United States and Canada. Around the same time, the company began selling syrup to
independent bottling companies licensed to sell the drink. Even today, the US soft drink
industry is organized on this principle.
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Practical study of the organization with respect to issue
Coca Cola is a manufacturing organization and they use the concept of costs while
decision making. The detail of the cost concepts used in decision making by the Coca
Cola Company are as under:
The Role of Manufacturing costs in Decision Making:
Manufacturing cost is used to determine the inventory valuation on the balance sheet
and cost of goods sold on the income statement of external financial reports. The total
manufacturing cost of one unit is Rs.85, where
Direct material: Rs. 40 Direct labor: Rs. 15 MOH: Rs. 30 Total Rs. 85
Now from this manufacturing cost the company can decide that how much they want to
make profit and set a selling price based on that. Suppose they want to make 20% profit
on manufacturing cost then their selling price will be Rs.102. But after setting selling
price they see that one of their competitor sales their product at Rs. 95. In this situation
the company can justify the manufacturing cost that where the wrong is going on. If
their material price is high then they can buy the raw material from other supplier at
low cost to reduce the access cost. If their labor cost is high, then they can hire labor
from other at low cost or can cut the number of employee to reduce the cost. By taking
this corrective action the company can maintain the manufacturing cost to stay in the
market.
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The Role of Non-manufacturing costs in Decision Making:
Non-manufacturing cost is playing a great role in decision-making. In income statement
we deduct non-manufacturing cost or operating cost from gross margin to get net
profit. Suppose we expect “X” amount of money as net profit. But if the net income falls
below than our expectation, then we must reduce operating cost to gain more profit.
We can give one example to clear this idea. Suppose our net income is less than our
expectation. Now we have to reduce price. We can take advertising cost as a sample. In
case of advertising our first motive is to identify our target consumer then we have to
select the advertising media. Suppose we make one types of product and our target
consumers are fishermen. In this case we must use radio as an advertising media rather
than television and it will cost less. By this way we can save non-manufacturing cost. In
this purpose we can also reduce the cost of shipping, sales travel, compensation, public
relation cost, sales salary etc. to increase net profit.
The Role of Fixed costs in Decision Making:
Usually fixed cost is used to determine break-even point. Suppose our,
Fixed cost = Rs. 20,000
Selling price = Rs. 250
Variable cost = Rs. 150
Then break-even unit = 20,000 (250-150)
= 200 unit
In the break-even point there is no profit as well as no loss at all. We have calculated
break-even point to determine the sales level and using this method we can also
calculate the number of unit to gain our expected profit Reduction of fixed cost is also
very important to increase net income. If we reduce fixed cost per unit then it will
contribute to net income. Suppose our production is not running in our full capacity
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level then we can increase production in order to reduce our fixed cost per unit. For
example
Capacity: 400 UnitsProduction: 300 UnitsFixed cost: Rs.20,000Variable cost: Rs.150Selling price: Rs.250
Current income statement Sales (300 250) = Rs.75,000Less V.Cost (150300) = Rs.45,000 = Rs.30,000 Less Fixed cost = Rs.20,000 Net income = Rs.10,000
Here we see that in the current situation we have a net income of Rs.10,000. Now we get an offer from outside to deliver 100 extra units at Rs.200. In this case our proposed net income as follows:
Sales (300 250+100200) = Rs.95,000 Less V.Cost (150300+150100) = Rs.60,000 = Rs.35,000 Less Fixed cost = Rs.20,000 Net income = Rs.15,000
In this case we will accept the proposal because our proposed net income is greater
than the current net income.
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The Role of Variable cost in Decision Making:
Variable cost plays a great role in decision-making we know that if we increase our
production then our variable cost will also increase. So we have to concentrate on
reduction of total cost and in this case we must consider fixed cost also. If we increase
our production within our capacity, our unit cost of production will decrease. Because as
production increase variable cost will also increase but fixed cost per unit will decrease.
Suppose,
Variable cost = Rs.1 Fixed cost = Rs.10Capacity = 20 unit
Production Variable cost Fixed cost Total cost unit per unit per unit per unit
5 1 2 3 10 1 1 2 15 1 .56 1.56
Here we see that as production increases total cost per unit decrease because fixed cost
per unit continuously decreases. So, in case of reducing total cost we must increase the
production level. And as we know variable cost is constant so we must try to reduce the
total cost from other sector to generate more profit. Thus variable cost has a significant
impact on selling price. Variable cost is also used to calculate cm per unit, cm ratio,
margin of safety, degree of operating leverage and other this types of important things.
The Role of Absorption costing in Decision Making:
Absorption costing is the generally accepted method for preparing mandatory external
financial reports and income tax returns. Absorption costing treats fixed manufacturing
overhead as a product cost. If fixed costs are treated as period costs and there is a low
level of sales activity in a period then a low profit or a loss will be recorded. If there is a
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high level of sales activity there will be relatively high profit. Absorption costing creates
a smoothing of these fluctuations by carrying the fixed costs forward until the goods are
sold. Many firms use the Absorption approach exclusively because of its focus on full
costing of units of product.
The Role of Opportunity costs in Decision Making:
Opportunity cost is a very important item, which is playing an effective role in decision-
making. By considering opportunity cost we can determine the real cost of production.
We can give an example to clear this idea.
Let,Direct material : Rs.3 (Avoidable)Direct Labor : Rs.2 (Avoidable)Supervisor salary : Rs.1 (Avoidable)Factory rent : Rs.1 (Unavoidable)Depreciation : Rs.2 (Unavoidable)Allocated general Expense : Rs.3 (Unavoidable)Total cost per unit : Rs.12
Avoidable cost : (3+2+1) = Rs.6Unavoidable cost : (1+2+3) = Rs.6
Here we see that if we make the material the cost of per unit will be Rs.12. Now we get
an offer from outside at Rs.8 per unit. If we want to buy we have to consider some other
things because there are some unavoidable cost that we can’t ignore. It will add to the
buying cost. Now we see that if we buy it will costs (8+6) = Rs.14 per unit. So we can
easily determine that we will go for making not buying. In this case we have to consider
opportunity cost. Suppose the room, where we will make our production, the rent of
that room is Rs.20,000 and we get an offer for 5,000 unit.
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Make BuyUnit cost Rs.12 Rs.14For 5,000 unit Rs.60,000 Rs.70,000(+) Opportunity cost Rs.20,000 ------Total cost Rs.80,000 Rs.70,000
Here we see that if we go for making it will cost more and if we buy raw material from
outside we can generate Rs.10,000 as a profit. So, in this case we will definitely go for
buy not make.
The Role of Period costs In Decision Making:
Depending on period cost we can also take some corrective action. Normally sales
commission, office rent and other these types of cost are included in period cost.
Suppose our net income is lower than our expectation then we can increase our net
income by reducing period cost. Let’s take office rent. If our office rent is high then we
can reduce the rent by shifting office place. However for many decision-making
purposes the period costs are seen as being non-controllable in the short-term, so that
attention may focus on product cost.
The Role of Product costs in Decision Making:
If an organization wants to minimize their inventory cost they can fallow just in time
process. In this process the cost of inventory is less than the normal process. So, the
product cost is minimized and it will help to generate more profit. If an organization
follows normal process for manufacturing goods, then they must reserve material for
future and it will cost a lot. Such as rent for place, guard salary, maintenance cost. And it
will reduce net income. So, they must follow just in time process to increase the net
income.
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The Role of Differential costs in Decision Making:
Differential cost can be either fixed or variable. To illustrate assume that Coca Cola is
thinking about changing it’s marketing method from distribution through retailer to
distribution by door-to-door direct sale. Present cost and revenues are compared to
projected costs and revenues in the following table:
Retailer Direct sale Differential cost
Distribution Distribution and revenue
Revenue Rs.500,000 Rs.600,000 Rs.100,000
Deduct ======================================
Cost of good sold Rs.150,000 Rs.200,000 Rs.50,000
Advertising Rs.50,000 Rs.25,000 Rs.(25,000)
Commission - 0 - Rs.20,000 Rs.20,000
Depreciation Rs.25,000 Rs.50,000 Rs.25,000
Other expenses Rs.20,000 Rs.20,000 -- 0 --
Total Rs.245,000 Rs.315,000 Rs.70,000
Net income Rs.255,000 Rs.285,000 Rs.30,000
=====================================
According to the analysis the differential revenue is Rs.100,000 and the differential cost
is Rs.70,000 leaving a positive differential net income Rs.30,000 under the proposed
marketing plan. From the given table the company can easily decide that which
marketing plan they should follow. As we see in the above analysis the net income
under door-to-door is Rs.30,000 higher than the previous one. And they can get it
simply focusing on differential cost, revenue and net income. By this way differential
cost helps in decision-making.
The Role of Standard costs in Decision Making:
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Standard cost is used to integrate costs in the planning and pricing and pricing structure
of a business. Once the Standard cost has been decided, the actual cost may be
compared with the standard. If it equals the standard then the actual outcome has
matched expectations. If the actual cost is different from the standard cost allowed,
then there will be variance to be investigated, whether it is favorable or unfavorable.
When the actual cost is less than the standard cost then it is called favorable and when
the actual cost is greater than the standard cost then it is called unfavorable. In case of
favorable term management will accept the proposal and in case of unfavorable term,
they will reject it. Direct cost & Indirect cost.
The Role of Direct and Indirect cost in Decision Making:
Direct cost includes direct material, direct labor; on the other hand indirect cost includes
indirect material and indirect labor. They are playing a great role in decision-making, but
not individually. They have a significant impact on manufacturing cost, because these
costs are included in manufacturing cost. So ultimately they are playing role in setting
selling price.
The Role of Mixed cost in Decision Making:
Mixed costs also have some role in decision-making because this cost is a combined
form of fixed and variable cost. As we know fixed costs are constant but variable cost
differs with the production level. So, by reducing the variable cost we can decrease total
unit cost and it will help to increase net income.
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Data collection methods
The Data is collected by
o Through Company visit
o Mr. Ishfaq Ahmed (Finance Manager Faisalabad Division)
o Online Articles
o Book of Cost Accounting
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SWOT Analysis
The Coca-Cola Company (Coca-Cola) is a leading manufacturer, distributor and marketer
of Non-alcoholic beverage concentrates and syrups, in the world. Coca-Cola has a strong
brand name and brand portfolio. Business-Week and Interbrand, a branding
consultancy, recognize Coca-Cola as one of the leading brands in their top 100 global
brands ranking in 2006. The Business Week-Interbred valued Coca-Cola at $67,000
million in 2006. Coca-Cola ranks well ahead of its close competitor Pepsi which has a
ranking of 22 having a brand value of $12,690 million The Company’s strong brand value
facilitates customer recall and allows Coca-Cola to penetrate markets. However, the
company is threatened by intense competition which could have an adverse impact on
the company’s market share.
Strengths
o Practical use of cost concepts for decision making
o World’s leading brand
o Large scale of operations
o Robust revenue growth in three segment
Weaknesses
o No Use of Differential cost
o Un-satisfacted performance by staff Managers
o Decline in cash from operating activities
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Opportunities
o Can earn more profit through Differential cost
o Growing bottled water market
o Growing Hispanic population in US
Threats
o Intense competition
o Un-satisfacted performance by staff Managers
o Dependence on bottling partners
o Sluggish growth of carbonated beverages
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Conclusion
If any Coca Cola wants to run its company successfully then the management needs to
take proper decision on time. Most decisions will at some stage involve consideration of
financial matters, particularly cost. Decisions may also have an impact on the working
conditions and employment prospects of employees of the organization, so that cost
considerations may, in the final analysis, be weighed against social issues. If the
management can control the cost then the company will generate more profit, on the
other way they will suffer loss. So, by going through this project we can easily
understand how different types of cost play role in decision-making and we can apply
these terms in practical life.
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Recommendations
o The finance manager has to be a enough knowledge about the cost concepts
used for decision making.
o A Fore-cost planning is essential for good results.
o The Company should have to give time to time training to Staff Managers.
o In order to avoid the misallocation of funds financial manager should have to
make the plan before of financial decision.
o To plan for the future the financial manger must assess the firm’s present
financial position and evaluate opportunities in relation to this current position.
o There is need of well-experienced financial manager, because inexperienced
financial manager cannot analyze the financial statement in an effective way.
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References
o Managerial Accounting
Ray H. Garrison
Eric W. Noreen
o Introduction to Management Accounting
Professor Pauline Weetman
Paul Gordon
o Class lecture
o www.the-cocacola-company.com.pk
o www.google.com
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