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ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
Copyright Reserved
2
Editorial Board
Dr. M. Nagarajan
Dean
Faculty of Arts
Annamalai University
Annamalainagar.
Members
Dr. C. Samudhrarajakumar Dr. A. Rajamohan
Professor and Head Professor and Head
Department of Business Administration Management Wing - DDE
Annamalai University Annamalai University
Annamalainagar. Annamalainagar.
Internals
Dr. M.G. Jayaprakash Mr. K. Siva
Assistant Professor Assistant Professor
Management Wing - DDE Management Wing - DDE
Annamalai University Annamalai University
Annamalainagar Annamalainagar
Externals
Dr. V. Balachandran Dr. N. Kannan
Registrar i/c and Professor Professor
Department of Corporate secretary ship Department of Management Studies
Alagappa University Sathya Bama University
Karaikudi Chennai
Lesson Writers
Units : I - III Units : IV - VI
FIRST YEAR
ACCOUNTING FOR MANAGERS
Syllabus
Objectives
The purpose of this course is to acquaint the students with the various
concepts, techniques, methods, process of accounting, data analysis,
interpretation, decision making in the area of various accounting.
Unit–I
Introduction to Accounting – Origin – Concept And Growth – Financial
Accounting-- Purpose – Use and Role – Responsibilities of Financial Manager,
Management Accounting and Cost Accounting – Financial Accounting Rules,
Concepts And Convention – Generally Accepted Accounting Principles – Accounting
Standards - Implications on Accounting System – Process of Accounting, Rules Of
Book Keeping And Books of Accounts – Double Entry- Book Keeping – Journal –
Ledger – Trail Balance – Preparation of Profit and Loss Account And Balance Sheet-
Use Of These Statements By Management – Meaning of Depreciation – Basic
Features of Depreciation – Objectives – Methods – Depreciation Policy.
Unit–II
Analysis Of Financial Statements – Comparative Financial And Operating
Statements – Common Size Statements – Trend Analysis – Ratio And Their Uses –
Types of Ratio and their Meaning – Using Ratio to Understand the Financial Status
and Performance of Organization - Construction of Balance Sheet Using Ratios –
Dupont Analysis – Interpretation of Ratios. Funds Flow Statement – Preparations of
Fund Flow Statement – Cash Flow Statement – Evolution of Funds And Cash Flow
Analysis.
Unit–III
Marginal Costing – Definition – Distinguishing Between Marginal Costing and
Absorption Costing – Break Even Point Analysis – Graphical Representation of
Break Even Analysis – Contribution – P/V Ratio – Margin of Safety – Decision
Making Under Marginal Costing – Key Factor Analysis –Make or Buy Decision –
Export Decision – Sales Man Decision.
Unit–IV
Budget and Budgetary Control – Definition – Objectives – Budgetary Control –
Essentials of A Successful Budgetary Control – Limitations – Master Budget –
Classification of Budget – Flexible Budget – Sales Budget – Production Budget –
Material Budget – Labour Budget – Work Over Head Budget – Administrative Over
Head Budget – Capital Expenditure Budget – Cash Budget – Zero Base Budget –
Organization For Budgetary Control.
ii
Unit–V
Capital Budgeting – Importance – Process – Evolution of Investment Proposal –
Payback Method –Net Present Value Method – Average Rate Of Return Method –
Discounted Flow Method – Time Adjusted Rate of Return Method – Net Terminal
Value Method – Excess Present Value Index Method – Advantages And
Disadvantages Comparison And Contrast – Capital Rationing.
Unit–VI
Cost Accounting – Purpose – Classification of Cost and Their Uses – Allocation
of Cost – Types of Costing – Activity Based Costing – Elements of Cost – Cost Sheet
Preparation – Cost Centre – Standard Costing And Variance Analysis – Advantages
of Cost Accounting – Cost Centre and Cost Unit–Methods Of Costing – Techniques
of Costing
Reporting to Management- Objectives of Reports – Reports for Different Levels
of Management – Preparation of Reports.
Reference Books
1. R.S.N. Pillai, Management Accounting S. Chand, Chennai, 2014.
2. Bagavathi V., Pillai,R.S.N., Cost Accounting, S. Chand, Chennai, 2010.
3. N. P. Srinivasan, M. Sakthivel Murugan, Accounting for Management, S.
Chand, Chennai, 2010.
4. Mani, P.L., N. Vinayaraman, K.L. Nagarajan, Principles of Accountancy,
S. Chand, Chennai, 2014.
5. Jain and Narang, Cost Accounting Principles and Practices Kalayani
Publishers, 2013.
6. Ambrish Gu pta , Financial Accounting for Management: An Analytical
Perspective, 4th Edition, Pearson, 2012.
7. Maheswari S.K., A Textbook of Accounting for Management, 3rd Edition
Vikas Publishing House, 2013.
8. Donna Philbrick, Charles T. Horngren, Introduction to Financial
Accounting 9th Edition, Pearson 2008.
9. William J.Burns, Accounting for Managers: Text & Cases, 2nd Edition
South-Western College, 1998.
10. M.Y Khan and Jain, Management Accounting, Tata McGraw hill, 2006.
11. Ambrish Gu pta, Financial Accounting for Management: An Analytical
Perspective Pearson Education India, 2008
12. Dr. RK Mittal, Management Accounting and Financial Management, FK
Publications, 2012.
13. S. Ramanathan, Accounting for Management, Oxford University Press,
2014.
iii
6 Ratio Analysis 68
LESSON 1
FINANCIAL ACCOUNTING PRINCIPLES AND CONCEPTS
1.1 INTRODUCTION
Accounting is aptly called the language of business. This designation is applied
to accounting because it is the method of communicating business information.
The basic function of any language is to serve as a means of communication.
Accounting duly serves this function. The task of learning accounting is essentially
the game as the task of learning a new language. But the acceleration of change in
business organisation has contributed to increasing the complexities in this
language. Like other languages, it is undergoing continuous change in an attempt
to discover better means of communicating.
1.2 OBJECTIVES
After reading this lesson the student should be able to:
Know the evolution and meaning of accounting,
Understand the nature and role of accounting.
Appreciate the importance of accounting as an information system and
Understand the profession of accounting and its specialized branches.
1.3 CONTENT
1.3.1 Definition of accounting
1.3.2 Evolution of accounting
1.3.3 Objective of accounting
1.3.4 Functions of accounting
1.3.5 Meaning of Management Accounting
1.3.6 Management accounting vs cost accountings
1.3.7 Accounting concepts
1.3.8 Accounting conversion
1.3.9 Accounting standards
1.3.10Financial manager- Role and Duties
1.3.1 DEFINITION OF ACCOUNTING
Before attempting to define accounting, it may be made clear that there is no
unanimity among accountants as to its precise definition. Anyhow, let us examine
three popular definitions on the subject.
American Institute of Certified Public Accountants (AICPA) which defines
accounting as “the art of recording, classifying and summarizing in a significant
manner and in terms of money, transactions and events, which are, in part at least,
of a financial character and interpreting the results thereof”.
American Accounting Association defines accounting as “the process of
identifying, measuring and communicating economic information to permit
informed judgements and decision by users of the information”.
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John Sizer:
"Management Accounting may be defined as the application of accounting
techniques to the provision of information designed to assist all levels of
management in planning and controlling the activities of the firm".
1.3.6 MANAGEMENT ACCOUNTING VS COST ACCOUNTING
Costing has been defined as classifying, recording and appropriate allocation of
expenditure for the determination of the costs of products or services. Cost
accounting will tell the management as to how the busine ss has fared at each stage
of operation. But cost accounting will not tell them anything about the future policy
to be adopted. It is here that management accounting differs from cost accounting.
The aim of management accounting is not to collect information as such but to
utilise the information collected in order to help the management to formulate their
future policy and to make important policy decisions.
Though there is a difference between management accounting and cost
accounting in their objective yet their functions are complementary in nature.
Management accounting depends heavily on cost data and other information
derived from cost records. In one way, management accounting is an expansion of
cost accounting. Like cost accounting, management accounting involves reporting
at frequent intervals rather than at the end of a year or half-year.
Cost accounting deals primarily with cost data. But management accounting
involves the consideration of both costs and revenues. It is a broader concept than
cost accounting. It not only reports costs but also uses them to assist management
in planning possible alternate courses of action.
Conceptually speaking management accounting is a blending together of cost
accounting, financial accounting and all aspects of financial management. It has a
wider scope as a tool of management. But it is not a substitute for other accounting
functions. It is a continuous process of reporting cost and financial data as well as
other relevant information to management.
1.3.7 ACCOUNTING CONCEPTS
The important accounting concepts are discussed here under:
1 Business entity concept: It is generally accepted that the moment a
business enterprise is started it attains a separate entity as distinct from the
persons who own it.
This concept is extremely useful in keeping business affairs, strictly free from
the effect of private affairs of the proprietors. In the absence of this concept the
private affairs and business affairs are mingled together in such a way that the true
profit or loss of the business enterprise cannot be ascertained nor its financial
position. To quote an example if the proprietor has taken Rs.5000/- from the
business for paying house tax for his residence, the amount should be deducted
from the capital contributed by him. Instead if it is added to the other business
expenses then the profit will be reduced by Rs.5000/ and also his capital more by
the same amount. This affects the results of the business and also its financial
5
positions. Not only this since the profi t is lowered, the consequential tax payment
also will be less which is against the provisions of the Income Tax Act.
2 Going Concern Concept: This concept assumes that unless there is valid
evidence to the contrary a business enterprise will continue to operate for a fairly
long period in the future. The significance of this concept is that the accountant
while valuing the assets of the enterprise does not take into account their current
resale values as there is no immediate expectation of selling it. More over,
depreciation on fixed assets is charged on the basis of their expected lives rather
than on their market values.
When there is conclusive evidence that the business enterprise has a limited
life the accounting procedures should be appropriate to the expected terminal date
of the enterprise. In such cases, the financial statements should clearly disclose the
limited life of the enterprise and should be prepared from the quitting concern point
of view rather than from a 'going concern' point of view.
3 Money Measurement Concept: Accounting records only those transactions
which can be expressed in monetary terms. This feature is well emphasized in the
two definitions on accounting as given by the American Institute of Certified Public
Accountants and American Accounting Principles Board. The importance of this
concept is that money provides a common denomination by means of which
heterogeneous facts about a business enterprise can be expressed and measured in
a much better way. For e.g. when it is stated that a business owns Rs. 10,00,000
cash, 500 tons of raw materials, 10 machinery items, 30,000 square metres of land
and building etc., these amounts cannot be added together to produce a meaningful
total of what the business owns. However, by expressing these items in monetary
terms Rs 10,00,000 cash Rs 5,00,000 worth of raw materials, Rs 10,00,000 worth
of machinery items and Rs 30,00,000 worth of land and building - such an addition
is possible.
A serious limitation of this concept is that accounting does not take into
account pertinent non-monetary items which may significantly affect the
enterprise. For instance, accounting does not give information about the poor
health of the President, serious misunderstanding between the production and
sales manager etc., which have serious bearing on the prospects of the enterprise.
Another limitation of this concept is that money is expressed in terms of its value at
the time a transaction is recorded in the accounts. Su bsequent changes in the
purchasing power of money are not taken into account.
4 Cost Concept: This concept is yet another fundamental concept of
accounting which is closely related to the going concern concept. As per this
concept:
i) an asset is ordinarily entered in the accounting records at the pri ce paid to
acquire it i.e., at its cost and ii) this cost is the basis for all subsequent accounting
for the asset.
6
ii) Purchased furniture for Rs. 50,000: The effect of this transaction is that cash
is reduced by Rs. 50,000 and a new asset viz. furniture worth Rs. 50,000 comes in
thereby rendering no change in the total assets of the business. The equation after
this transaction will be:
Capital = Assets
Krishna a Cash + Furniture
300,000 = 250,000 + 50,000
(iii) Borrowed Rs. 200,000 from Mr. Gopal: As a result of this transaction both
the sides of the equation increase by Rs. 200,000 -cash balance is increased and a
liability to Mr. Gopal is created. The equation will appear as follows:
Liabilities + Capital = Assets
Creditors +Krishna = Cash + Furniture
200,000 + 300,000= 450,000 + 50,000
(iv) Purchased goods for cash Rs. 300,000: This transaction does not affect the
liabilities side total nor the asset side total. Only the composition of the total assets
changes i.e. cash is reduced by Rs. 300,000 and a new asset viz. stock worth Rs.
30,000 comes in. The equation after this transaction will be as follows:
Liabilities + Capital = Assets
Creditors +Krishna = Cash + Stock + Furniture
200,000 + 300,000 = 15,000+300,000 + 50,000
(v) Goods worth Rs. 100,000 are sold on credit to Mr. Ganesh for Rs. 120,000.
The result is that stock is reduced by Rs. 10,000 a new asset namely debtor (Mr.
Ganesh) for Rs. 12,000 comes into picture and the capital of Mr.Krishna increases
by Rs. 20,000 as the profit on the sale of goods belongs to the owner. Now the
accounting equation will look as under:
Liabilities + Capital = Assets
Creditors + Krishna = Cash + Debtors + Stock + Furniture
200,000 + 320,000 = 150,000 + 120,000 + 200,000 + 50,000
(vi) Paid electricity charges Rs.3000: This transaction reduces both the cash
balance and Mr.Krishna’s capital by Rs.3000. This is so because the expenditure
reduces the business profit which in turn reduces the owner's equity. The equation
after this will be:
Liabilities + Capital = Assets
Creditors +Krishna = Cash + Debtors + Stock + Furniture
200,000 + 317,000= 147,000 + 120,000 + 200,000 + 50,000
Thus it may be seen that whatever is the nature of transaction, the accounting
equation always tallies and should tally. The system of recording transactions
based on this concept is called double entry system.
8
transactions. It is on account of this convention that the inventory is valued 'at cost
or market price whichever is less', i.e., when the market price of the Inventories has
fallen below its cost price it is shown at market price i.e., the possible loss is
provided and when it is above the cost price it is shown at the cost price i.e., the
anticipated profit is not reduced. It is for the same reason that provision for bad
and doubtful debts, provision for fluctuation in investments, etc., are created. This
concept affects principally the current assets.
The main function of accounting is to provide correct and full information
about the business enterprise. But this is affected by the convention of
conservatism as pointed out by the critics of this convention. They argue that it
encourages the accountant to build secret reserves by resorting to excess provision
for bad and doubtful debts etc. as a result of which not only the Income is affe cted
but also the financial state of affairs of the business. Further it is also against the
convention of full disclosure about which we are going to see right now.
2 Convention of full disclosure: The emergence of joint stock company form
of business organisation resulted in the divorce between ownership and
management. This necessitated the full disclosure of accounting Information about
the enterprise to the owners and various other interested parties. Thus it became
the 'convention of full disclosure' is very important. By this convention it is implied
that accounts must be honestly prepared and all material information must be
adequately disclosed therein. But it does not mean that all information that
someone desires are to be disclosed in the financi al statements. It only implies that
there should be adequate disclosure of information which is of considerable
importance to owners, investors, creditors. Governments, etc. In Sachar Committee
Report (1978) it has been emphasised that openness in Company affairs is the best
way to secure responsible behaviour. It is in accordance with this convention that
Companies Act, Banking Companies Regulation Act, Insurance Act etc., have
prescribed performance of financial statements to enable the concerned companie s
to disclose sufficient information. The practice of appending notes relative to
various facts on items which do not find place in financial statements is also in
pursuance to this convention. The following are some examples:
(a) Contingent liabilities appearing as a note
(b) Market value of investment appearing as a note
(c) Schedule of advances in case of banking companies.
3 Convention of Consistency: According to this concept it is essential that
accounting procedures, practices and methods should remain unchanged from one
accounting period to another. This enables comparison of performance in one
accounting period with that in the past. For e.g. if material Issues are priced on the
basis of FIFO method the same basis should be followed year after year. Similarly, if
depreciation is charged on fixed assets according to diminishing balance method it
should be done in subsequent year also. But consistency never implies inflexibility
as not to permit the Introduction of improved techniques of accounting. However, if
11
b. Cost concept
c. Continuity concept
d. Money measurement concept
Correct Answer: d
2. Which of these are is not a fundamental accounting assumption?
a. Going concern
b. Consistency
c. Conservatism
d. Accrual
Correct Answer: c
3. Fixed assets and current assets are categorized as per concept of:
a. Separate entity
b. Going concern
c. Consistency
d. Time period
Correct Answer: b
1.8 SUPPLEMENTARY MATERIAL
1. www.icai.org
2. www.icmai.org
1.9 ASSIGNMENT
1. Is accounting a staff function or line function? Explain with reasons.
2. Give an account of the various branches of accounting.
3. "Accounting is a service function' Discuss this statement in the context of a
modern manufacturing business.
4. Distinguish between Financial Accounting and Management Accounting.
1.10 SUGGESTED READINGS
1. Antony and Reece: 'Accounting Principles', Richard D. Irwin, Inc. Home
wood, Illinois.
2. Fess/Warren: 'Financial Accounting’, South Western Publishing
Company, Ohio.
3. M.C. Shukla& T.S. Grewal: Advanced Accounts, S. Chand& Company New
Delhi.
1.11 LEARNING ACTIVITIES
1. “There are no externally imosed generally accepted accounting principles
for management accounting .”
2. In the light of the above statement, discuss giving illustration the nature
and scope of management accounting.
1.12 KEYWORDS
Concepts, conventions, accounting standards, business entity, dual aspects,
realisation
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LESSON 2
ACCOUNTING RECORDS AND SYSTEMS
2.1 INTRODUCTION
During the accounting period the accountant records transactions as and when
they occur. At the end of each accounting period the accountant summarises the
Information recorded and prepares the Trial Balance to ensure that the double
entry system has been maintained. This is followed by certain adjusting en tries
which are to be made to account the changes that have taken place since the
transactions were recorded. When the recording aspect has been made as complete
and up to-date as possible, the accountant prepares financial statements reflecting
the financial positions and the results of business operations. Thus the accounting
process consists of three major parts:
i) the recording of business-transactions, during the period;
ii) the summarizing of information at the end of the period and
iii) the reporting and interpreting of the summary information
The success of the accounting process can be judged from the responsiveness
of financial reports to the needs of the users of accounting information.
2.2 OBJECTIVES
After reading this lesson the student should be able to:
understand the rules of debit and credit
apply the rules of debit and credit in journalising the transactions
prepare ledger accounts and balance them
prepare a trial balance
realise the importance of adjustment entries and closing entries
2.3 CONTENT
2.3.1 The account
2.3.2 Debit and credit
2.3.3 Journal
2.3.4 The trial balance
2.3.5 Closing entries
2.3.6 Adjustment entries
2.3.1 THE ACCOUNT
The transactions that take place in a business enterprise during a specific
period may effect increases and decreases in assets, liabilities, capital, revenue and
expense items. To make up to-date information available when needed and to be
able to prepare timely periodic financial statements, it is necessary to maintain a
separate record for each item. For e.g. it is necessary to have a separate record
devoted exclusively to record increases and decreases in cash, another one to
record Increases and decreases in supplies, a third one to machinery, etc. The types
of record that is traditionally used for this purpose is called an account. Thus an
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KINDS OF ACCOUNTS
Accounts are of various types as shown below:
Accounts
Personal Impersonal
(relating to individuals,
firms, companies, banks, etc.)
Real Nominal
(relating to assets like plant, (relating to expenses, losses and
building, cash etc.) incomes like salary paid, rent
received, electricity paid. Interest
received etc.)
decreases, the right side of a liability and capital accounts is to be used to record
increases and the left side to be used for recording decreases. The account balances
when they are totaled, will then conform to the two equations:
1. Assets = Liabilities + Owners equity
2. Debits = Credits
From the above arrangement we can state the rules of debits and credits are as
follows:
Debit signifies Credit signifies
1. Increase in asset accounts 1. Decrease in asset accounts.
2. Decrease in liability accounts 2. Increase in liability accounts
3. Decrease in owners’ equity accounts 3. Increase in owners’ equity accounts
From the rule that credit signifies increase in owners’ equity and debit signifies
decreases in it, the rules of revenue accounts and expense accounts can be derived.
While explaining the dual aspect concept in an earlier lesson we have seen that
revenues increase the owners’ equity as they belong to the owners. Since owners’
equity accounts increases on the credit side, revenue must be credits. So, if the
revenue accounts are to be decreased they must be debited. Similarly, we have seen
that expenses decrease the owners’ equity. As owners’ equity accounts decrease on
the debit side expenses must be debits. Hence to increase the expenses accounts
they must be debited and to decrease it they must be credited. From the above we
can arrive at the rules for revenues and expenses as follows:
Debit signifies Credit signifies
Increase in expenses Decrease in expenses
Decrease in revenues Increase in revenues
The Ledger
A ledger is a set of accounts. It contains all the accounts of a specific business
enterprise. It may be kept in any of the following two forms:
I. Bound ledger and
II. Loose Leaf Ledger
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A bound ledger is kept in the form of book which contains all the accounts.
These days it is common to keep the ledger in the form of loose -leaf cards. This
helps in posting transactions particularly when mechanised system of accounting is
used.
2.3.3 JOURNAL
When a business transaction takes place the first record of it is done in a book
called journal. The journal records all the transactions of a business in the order in
which they occur. The journal may therefore be defin ed as a Chronological records
of accounting transaction. It shows names of accounts that are to be debited or
credited, the amounts of the debits and credits and any additional but useful
information about the transaction. A journal does not replace but precedes the
ledger. A proforma of a journal is given in illustration 1
1.Journalise the following transactions in the books of x &Co.
June
2016 Particulars
Rs.
1 Started business with a capital of 60,000
2 Paid in to bank 30,000
4 Purchased goods from Kamal on credit 10,000
6 Paid to Shriram 4,920
6 Discount allowed by him 80
8 Cash Sales 20,000
12 Sold to Hameed 5,000
15 Purchased Goods form Bharat on Credit 7,500
18 Paid Salaries 4,000
20 Received from Prem 2,480
19
Solution:
been accurate then the debit total and credit total in the Trial Balance must tally
thereby evidencing that an equality of debits and credit has been maintained. It
also serves as a basis for preparing the financial statements. In this connection it is
but proper to caution that mere agreement of the debit and credit totals in the Trial
Balance is not conclusive proof of account recording and posting. There are many
errors which may not affect the agreement of Trial Balance like total omission of a
transaction, posting the right amount on the right side but of a wrong account etc.
The points which we have discussed so far can very well be explained with the
help of the following simple illustration
Illustration 2
January 1 — Started business with Rs.3,00,000
January 2 — Bought goods worth Rs.2,00,000
January 9 — Received order for half of the good from'G'
January 12 — Delivered the goods, G invoiced Rs. 130,000
January 15 — Received order for remaining half of the total goods
purchased.
January 21 — Delivered goods and received cash Rs. 1,20,000
January 30 — G makes payment
January 31 — Paid salaries Rs. 21,000
— Received interest Rs.5,000
Let us now analyse the transactions one by one.
January 1-Started business with Rs.3,00,000
The two accounts Involved are cash and owners’ equity. Cash, an asset
increases and hence it has to be debited. Owners' equity, a liabili ty also increases
and hence it has to be credited.
January 2-Bought goods worth Rs.2,00,000
The two accounts affected by this transaction are cash and goods (purchases).
Cash balance decreases and hence it is credited and goods on hand, an asset.
Increases hence it is to be debited.
January 9 - Received order for half of goods from ‘G'
No entry is required as realisation of revenue will take place only when goods
are delivered (Realisation concept).
January 12 -Delivered the goods, 'G’ invoiced Rs.1,30,000
This transaction affects two Accounts-Goods (Sales) a/c and Receivables a/c.
Since it is a credit transaction receivables increase (asset) and hence is to be
debited. Sales decreases goods on hand and hence Goods (Sales) a/c is to be
credited. Since the term 'goods' is used to mean purchase of goods and sale of
goods, to avoid confusion purchase of goods is simply shown as Purchases a/c and
Sale of goods as Sales a/c.
January 15 -Received order for remaining half of goods.
No entry.
21
Dr Capital a/c Cr
Dr Receivable a/c Cr
Sales a/c 130,000 Cash 130,000
Dr Sales a/c Cr
Balance 2,50,000 Receivable a/c 1,30,000
Cash a/c 1,20,000
2,50,000 2,50,000
Dr Salaries a/c Cr
Cash a/c 21,000 Balance 21,000
Dr Interest a/c Cr
Balance 5,000 Cash a/c 5,000
Trial Balance
Debit Credit
whereas assets, liabilities and owners’ equity accounts, the balances of which are
shown on the balance sheet and are carried forward from year to year are called as
permanent or real accounts.
The principle of framing a closing entry is very simple. If an account is having a
debit balance, then it is credited and the Profit and Loss account is debited.
Similarly, if a particular account is having a credit balance, it is closed by debiting
it and crediting the Profit and Loss account.
In our example Sales account and interest account are revenues and Purchases
account and Salaries account are expenses. Purchases account is an expense
because the entire goods have been sold out in the accounting period itself and
hence they become cost of goods sold out. This aspect would become more clear
when the reader proceeds to the Chapter on Profit and Loss account. The closing
entries would appear as follows:
Now Profit and Loss a/c. Retained Earnings a/c and Balance Sheet can be
prepared which would appear as follows:
Dr Profit and Loss Account Cr
Purchases a/c 2,000 Sales a/c 2,500
Salaries a/c 210 Interest a/c 50
Retained Earnings a/c 340
2,550 2,550
Dr Balance Sheet Cr
Cash 3,340 Capital Retained Earnings 3,000
340
3,340 3,340
make the financial statements complete. These adjustments are needed for
transactions which have not been recorded but which affect the financial position
and operating, results of the business. They may be divided into four kinds: two in
relation to revenues and the other two in relation to expenses. The two in relation to
revenue are:
(i) UNRECORDED REVENUES: i.e. income earned for the period but not
received in cash. For e.g. interest for the last quarter of the accounting period is yet
to be received though fallen due. The adjustments entry to be passed is:
Accrued interest a/c (Dr)
Interest a/c (Cr)
(ii) REVENUES RECEIVED IN ADVANCE: i.e. income relating to next period
received in the current accounting period, e.g. rent received in advance. The
adjustment entry is:
Rent a/c (Dr)
Rent received in advance a/c (Cr)
The two relating to expenses are:
(i) UNRECORDED EXPENSES: i.e. expenses were incurred during the period
but no record of them as yet been made. e.g. Rs.500 wages earned by an employee
during the period remaining to be paid. The adjustment entry would be:
Wages a/c (Dr)
Accrued wages a/c (Cr)
(ii) PREPAID EXPENSES: i.e., expenses relating to the subsequent period paid
in advance in the current accounting period. An example which frequently cited is
insurance paid in advance. The adjustment entry would be:
Prepaid Insurance a/c (Dr)
Insurance a/c (Cr)
In the above four cases unrecorded revenues and prepaid expenses are assets
and hence debited (as debit may signify increase in assets) and revenues received in
advance and unrecorded expenses are liabilities and hence credited (as credit may
signify increase in liabilities).
Besides the above four adjustments, some more are to be done before preparing
the financial statements. They are:
1. Inventory at the end.
2. Provision for Depreciation.
3. Provision for Bad Debts.
4. Provision for Discount on receivables and payables.
5. Interest on capital and Drawings.
2.4 REVISION POINT
Account: It is a statement wherein information relating to an item or a group of
similar items are accumulated.
25
LESSON 3
PREPARATION OF FINANCIAL STATEMENTS: TRADING AND PROFIT
AND LOSS ACCOUNT
3.1 INTRODUCTION
Ascertainment of the periodic income of a business enterprise is perhaps the
foremost objective of the accounting process. This objective is achieved by the
preparation of profit and loss account or the income statement. Profit and loss
account is generally considered to be of greatest interest and importance to end-
users of accounting information. Whereas the balance sheet enables them to know
the financial position of the business enterprise as of a particular date, the profit
and loss account enables them to find out whether the business operations have
been profitable or not during a particular period. The important distinctions which
one needs to make between the balance sheet and the income statement is that the
balance sheet is on a particular date while the profit and loss account is for a
particular period. It is for this reason that the balance sheet is categorised as a
status report (as on a particular date) while the profit and loss account as a flow
report (for a particular period). Usually the profit and loss account is accompanied
by the balance sheet as on the last date of the accounting period for which the
profit and loss account is prepared.
3.2 OBJECTIVES
After reading this lesson the student should be able to:
understand the meaning of income and expense
prepare a Profit and Loss account
appreciate the linkage between Profit and Loss account and Balance
Sheet.
Understand the various methods of inventory valuation
develop an understanding of the various methods of depreciation.
3.3 STRUCTURE
3.3.1 Preparation of trading accounts
3.3.2 Relationship between Balance Sheet and Income Statement.
3.3.3 Concepts underlying Profit and Loss Account
3.3.4 Methods of Inventory Valuation
3.3.5 Depreciation of Fixed Assets
3.3.1 PREPARATION OF TRADING ACCOUNTS
Trading A/c is prepared to ascertain the Gross Profit. Gross Profit is difference
between net sales and cost of goods sold.
A specimen of Trading Account is given below:
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By Closing Stock
XXX
XXX
To Carriage Inwards XXX
XXX
To Wages
To Cross Profit
XXX XXX
3.3.1.1 Cost of Goods sold: When income is increased by the sale value of
goods or services sold, it is also decreased by the cost of these goods or services.
The cost of goods or services sold is called the cost of sales. In manufacturing firms
and retailing business it is often called the cost of goods sold. The complexity of
calculation of cost of goods sold varies depending upon the nature of the business.
In the case of a trading concern which deals in commodities it is very simple to
calculate the cost of goods sold and it is done as follows:
industries, but healthy companies in the same industry tend to have similar gross
profit percentages.
3.3.1.3 Operating Expenses: Expenses which are incurred for running the
business and which are not directly related to the company's production or trading
are collectively called as operating expenses. Usually operating expenses include
administration expenses, finance expenses, depreciation and selling and
distribution expenses. Administration expenses generally include personnel
expenses also.
However sometimes personnel expenses may be shown separately under the
heading 'Establishment Expenses' as is done in the case of Pondicherry Distilleries
under Schedule IX.
Schedule IX: Establishment Expenses
(Rs. in '000)
Salaries and Wages 24,27,000
Bonus and Incentive 4,67,000
P.F. Contribution 1,46,000
Gratuity 1,48,000
Pension 51,000
Employees Welfare Expenses 1,75,000
34,14,000
expense. This item of expense is deducted from income or earnings before interest
and tax. The resultant figure is profit (or) earnings before tax (EBT)
3.3.1.7 Income Tax: The provision for tax is estimated based on the quan tum
of profit before tax. As per the corporate tax laws the amount of tax payable is
determined not on the basis of reported net profit but the net profit arrived at has
to be recomputed and adjusted for determining the tax liability. That is why the
liability is always shown as a provision.
3.3.1.8 Net Profit: This is the amount of profit finally available to the
enterprise for appropriation. Net profit is reported not only in total but also per
share of stock. This per share amount is obtained by dividing the total amount of
net profit by the number of shares outstanding. The net profit is usually referred to
as profit, or earnings after tax. This profit could either be distributed as dividends
to shareholders or retained in the business. Just like gross profit percentage, net
profit percentage on sales can also be calculated which will be of great use for
managerial analysis.
3.3.2 RELATIONSHIP BETWEEN BALANCE SHEET AND INCOME STATEMENT
The amount of net Income reported on the income statement together with the
amount of dividends, explains the change in retained earnings between the two
balance sheets prepared as of the beginning and end of the accounting period. For
e.g. in the balance sheet of Pondicherry Distilleries the retained earnings as on 1st
April stood at Rs.84,03,260 whereas it amounted to Rs. 1,03,81,683 in the balance
sheet as on 31 st March. The reason for this increase is explained in the statement of
retained earnings which is a part of income statement. Thus it can be stated that
there exists a definite and close relationship between balance sheet and income
statement.
3.3. 3 CONCEPTS UNDERLYING PROFIT AND LOSS ACCOUNT
As in the case of balance sheet, many concepts are involved to the preparation
of income statement also. For example, the in come statement is prepared for a
particular accounting period. Here the concept involved is accounting period
concept. Similarly, revenues, are recognised to the period to which goods were sold
to customers or to which services were rendered. This is to ac cordance with
realisation concept. Another concept which has to be followed is the concept of
conservatism. It is because of this concept that provision for bad and doubtful
debts, provisions for fluctuation to investments. etc. are created. It is to accordance
with the concept of consistency that material issues are priced on the basis of the
same method year by year and so is the case with depreciation methods. The
simple equation which is followed to ascertain income is Revenues- Expenses =
Income and this equation is to accordance with yet another important concept
known as concept of periodic matching of costs and revenues.
3.3. 4 METHODS OF INVENTORY VALUATION
Valuation of Inventory is a difficult exercise both for manufacturing concerns
and trading concerns. In the case of manufacturing concerns raw materials
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required for production are purchased at different times and at different prices.
They are issued for production as and when required. It is very difficult to find out
from which specific purchase the issues are made. Hence the valuation of materials
Issued and closing stock of materials becomes difficult. Similarly trading concern
buy stock at different prices and at different times. They go on adding their
purchases to their current stock while at the same time selling them. It would be
impossible to identify the cost price of the commodities sold by pointing out the
time of their purchases and the corresponding purchase price. As a step towards
solving this problem many methods of inventory val uation are developed.
The important among them are:
i) First-in-First-out Method (FIFO)
ii) Last-in-First-out Method (LIFO)
iii) Weighted Average Method
1. First-in-First-out Method: This method is based on the assumption that
costs should be charged against revenue to the order in which they were incurred.
This method assumes that materials issued or goods sold are those which represent
the earliest purchases. This would mean that the materials or goods which remain
in stock, after the issues or sales are those which represent the most recent
purchases. Illustration1 explains the mechanism of this method.:
Illustration 1
Rs.
January 1 Opening Inventory 200 units @Rs.10 2,000
March 31 Purchases 400 units @Rs.11 4,400
June 1 Purchases 500 units @Rs.12 6,000
September 30 purchases 300 units @Rs.l3 3,900
December 1 Purchases 200 units @Rs.l4 2,800
1600 units 19,100
The physical verification on December 31 shows that 250 units are in stock. In
accordance with the assumption that the inventory is composed of the most recent
costs, the cost of 250 units is determined as:
Most recent costs December 1 200 units@Rs.l4 2800
Next most recent costs 50 units@Rs.l3 650
September 30 250 units 3450
recently purchased. It would follow, therefore, that the goods held in stock
represent earlier purchase. Based on data presented in
Illustration 2 the cost of the closing inventory is determined as:
Earliest Costs January 1200 units @ Rs.10 2000
Next earliest costs March 3150 units @ Rs.11 550
250 units 2,550
Deduction of the closing inventory of Rs.2550 from the Rs. 19,100 worth of
materials/goods available for issues/sales gives Rs. 16,550 as the cost of goods
sold.
3 W eighted Average Method: This method is based on the assumption that
costs should be charged against revenue in accordance with the weighted average
unit cost6 of the materials issued or goods sold.
The weighted average unit cost is determined by dividin g the total cost of the
materials or goods by the number of units.
Continuing the data given in Illustration 1 the weighted average cost of 1600
units and the cost of the inventory are determined in the following manner:
Weighted average unit cost Rs. 19,100 = Rs. 11.9375
1,600 units
Cost of inventory 250 units @ Rs. 11.9375 = Rs. 2,984
Deduction of the closing inventory of Rs. 2,984 from the Rs. 19,100 worth of
materials/goods available for issues/sales gives Rs. 16,116 as cost of goods sold
which represents the average of the costs incurred.
The FIFO method and the weighted average method are perhaps the most
extensively used methods. The main argument for FIFO method is that the cost of
the goods issued or sold closely reflects the price trend in the markets. Weighted
average method is preferred because of the 'smoothing of purchase costs achieved
by this method which enables to even out the wide fluctuations in the purchase
prices. The LIFO method is followed by a relatively small number of companies as
the application of this method is not liked by corporation laws in various countries.
Yet many companies use LIFO method for the purpose of internal reporting.
3.3.6 DEPRECIATION ON FIXED ASSETS
With the passage of time, all fixed assets lose their capacity to render services,
the only exception being land. Accordingly, a fraction of the cost of the asset is
chargeable as an expense in each of the accounting periods in which the asset
renders services. The accounting process for thi s gradual conversion of capitalised
cost of fixed assets into expense is called depreciation. Two factors contribute to the
decline in the usefulness of fixed assets: One is deterioration, the other is
obsolescence. Deterioration is the physical process we aring out whereas
obsolescence refers to loss of usefulness due to the development of improved
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equipment or processes, changes in style or other causes not related to the physical
condition of the asset.
The International Accounting Standards Committee defines depreciation as
follows: "Depreciation is the allocation of the depreciable amount of an asset over
the estimated useful life".
The useful life in turn is defined as:
Useful life is the period over which a depreciable asset is expected to be used by
the enterprise."
The depreciable amount is defined as:
"Depreciable amount of a depreciable asset is its historical cost in the financial
statements, less the estimated residual value."
Residual value or salvage value is the expected recovery or sales value of the
asset at the end of its useful life.
Methods of Depreciation: The amount of depreciation of a fixed asset is
determined taking into account the following three factors: its original cost. its
recoverable cost at the time it is retired from service and the length of its life. Out of
these three factors the only factor which is accurately known is the original cost of
the asset. The other two factors cannot be accurately determined until the asset is
retired. They must be estimated at the time the asset is placed in service. The
excess of cost over the estimated residual value is the amount that is to be recorded
as depreciation expense during the asset's lifetime. There are no hard and fast rules
for estimating either the period of usefulness of an asset or its residual value at the
end of such period. Hence these two factors which are inter- related are affected to
a considerable extent by management policies.
Let us consider the following example: A machine is purchased for Rs. 10000
with an estimated life of five years and estimated residual value of zero. The
objective of depreciation accounting is to charge this net cost of Rs. 10,000
(Original cost- residual value) as an expense over the 5-year period. How much
should be charged as an expense each year? To help us in this regard we are
having, the following four frequently used methods of computing depreciation.
i) Straight line method.
ii) Units of production method.
iii) Diminishing balance method.
iv) Sum-of-the-years-digits method.
It is not necessary that an enterprise employ a single method of calculating
depreciation for all classes of its depreciable assets. But in accordance with the
convention of consistency, once a method of depreciation is selected the same
method should be followed throughout.
1. Straight Line Method: Straight line method assumes that the level of
service provided by a fixed asset is even in all the years of its life. Hence this
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method provides for equal annual charges to expense over the estimated life of the
asset. To illustrate let us assume that the cost of a machine is Rs. 11,000, its
estimated residual value is Rs. 1,000 and its estimated life is 5 years. The annual
depreciation is calculated as follows.
Table 1
• In the last year the actual depreciation is Rs. 570 i.e. 40% of Rs. 1,426 and
the book value, therefore, at the year end would have been Rs.856. But since in the
last year the asset should not be depreciated below Its residual value, the
depreciation for the last year should be Rs.426 which is calculated as follows: Rs.
1426 (book value at the beginning of the year) minus Rs. 1000 (estimated residual
value).
4. Sum-of-the-Years-Digits Method: Under this method depreciation for each
year is computed by applying a fraction to the net cost of the asset. The
denominator of the fraction remains constant and it is the, sum of the digits
representing the year of life. To continue our example, the estimated life is 5 years
and hence the denominator would be 5+4+3+2+1 = 15. The numerator of the
fraction is the number of remaining years of life and it changes every year. In our
example the fraction to be applied on the net cost of Rs. 10,000 would be:5/15 in
the first year 4/15 in the second year, 3/15 in the third year, 2/15 in the fourth
year and 1/15 in the last year. The depreciation schedule under this method for
our example would appear as in Table 6-II
Table 2
Year Net Cost Rate Depreciation for the year
It may be seen from the Table that over the life of the asset there is no
difference in the total profit after depreciation. Only there is difference in the
annual profits after depreciation. If the enterprise wants to show hi gher profits in
the initial years, it is better the straight line method of depreciation is followed.
3.4 REVISON POINT
1. Status Report: Position on a particular date
2. Flow Report: Financial position for a particular period
3. Income: Revenues - Expenses
4. Expense: Item of cost applicable to an accounting period
5. Cost of goods sold: Opening stock + Purchase + Freight – Closing stock
6. Gross Profit: Excess of sales revenue over cost of goods sold Operating
Expenses: Expenses incurred for running the business
7. Operating profit: Gross profit - Operating expenses
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Correct Answer: b
2. When depreciation is recorded by charging to Provision for Depreciation
Account , the asset apears
a. at Original Cost
b. at Original Cost less depreciation
c. at market value
d. at realizable value
Correct Answer: a
3. Depreciation is ------
a. a Cash Expenditure like other normal expenses
b. a Cash Operating Expense
c. a Non-Cash Operating Expense
d. a Non-Cash Non-Operating Expense
Correct Answer: c
4. The beginning stock of the current year is overstated by Rs. 500 and
closing stock is overstated by Rs. 1,200.
The Profit of the current Year will be :
a. Rs. 1,700 (overstated)
b. Rs. 1,200 (understated)
c. Rs. 1,700 (understated)
d. Rs. 700 (overstated)
Correct Answer: d
5. The adjustments to be made for prepaid expenses is:
a. Add prepaid expenses to respective expenses and show it as an
asset
b. Deduct prepaid expenses from respective expenses and show it
as an asset
c. Add prepaid expenses to respective expenses and show it as a
liability
d. Deduct prepaid expenses from respective expenses and show it
as a liability
Correct Answer: b
6. If average stock is Rs. 20,000. Closing stock is Rs. 4,000 more than
value of opening stock. Closing stock will be:
a. Rs. 16,000
b. Rs. 18,000
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c. Rs. 20,000
d. Rs. 22,000
Correct Answer: d
3.8 SUPPLEMENTARY MATERIAL
1. www.icai.org
2. www.icmai.org
3.9 ASSIGNMENT
1. 'Depreciation is a process of valuation of fixed assets'- Do you agree with this
statement Discuss
2. Bring out a distinction between:
(1) Straight line method and Diminishing value methods of depreciation.
(2) FIFO and LIFO methods of inventory valuation.
3.10. SUGGESTED READINGS
1. R.L.Gupta and M.Radhaswamy: Advanced Accounts. Vol.I, Sultan Chand
& Sons. New Delhi.
2. M.C.ShukIa&T.S.Grewal: Advanced Accounts. S.Chandand Company. New
Delhi.
3.11 LEARNING ACTIVITIES
Collect the financial information regarding trading organisation and prepare
trading account and profit and loss account. Bring out the efficiency of the
organisation on this basis.
3.12 KEYWORDS
Gross profit, Net profit, Cost of sales, Depreciation
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LESSON – 4
PREPARATION OF BALANCE SHEET
4.1 INTRODUCTION
The basic objective of accounting is to convey information. This is achieved by
different financial statements prepared by a business enterprise. One of the most
Important financial statements is the Balance Sheet. A balance sheet shows the
financial position of a business enterprise as of a specified moment of time. That is
why it is very often called a statement of financial position. It contains a list of the
asset and liabilities and capital of a business entity as of a specified date. Usually
at the close of the last day of a month or a year.
4.2 OBJECTIVES
After reading this lesson the student should be able to:
understand the conceptual basis of a balance sheet
comprehend the form and method of presentation of a balance sheet
classify the different assets and liabilities
prepare a balance sheet from the given balances of accounts of
a business enterprise
4.3 CONTENT
4.3.1 Conceptual basis of a balance sheet
4.3.2 Form and presentation of balance sheet
4.3.3 Accounting concepts underlying the balance sheet
4.3.4 Classification of items in the balance sheet
4.3.1 CONCEPTUAL BASIS OF A BALANCE SHEET
The balance sheet is basically a historical report showing the cumulative effect
of past transactions. It is often described as a detailed expression of the following
fundamental accounting equation which has already been explained in detail in an
earlier chapter:
Assets = Liabilities + Owners' Equity (capital)
Assets are costs which represent expected future economic benefits to the
business enterprise. However, the rights to assets have been acquired by the
enterprise as a result of past transactions. Liabilities also result from past
transactions; they represent obligations which require settlement in the future
either by conveying assets or by performing services. Implicit in these concepts of
the nature of assets and liabilities is the meaning of owners' equity as the resid ual
interest in the assets of the enterprise.
4.3.2 FORM AND PRESENTATION OF A BALANCE SHEET
Two objectives are dominant in presenting information in a balance sheet. One
is clarity and readability; the other is disclosure of significant facts within the
framework of the basic assumptions of accounting. Balance sheet classification,
terminology and the general form of presentation should be studied with these
objectives in mind.
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Order of Permanence
Assets Liabilities
Goodwill Owners equity
Trade Marks Debentures
Patents Mortgage loan
Land and Buildings Provision for Income-tax
Plant and Machinery Income received in advance
Furniture and Fixtures Outstanding expenses
Investments Creditors
Prepaid expenses Bills payable
Inventory
Debtors
Bills receivable
Marketable Securities
Bank
Cash
Whatever is the order, it is always better to follow the same order for both
assets and liabilities. In the illustration the order of liquidity has been followed.
4.3.4 ACCOUNTING CONCEPTS UNDERLYING THE BALANCE SHEET
In the balance sheet of SAU and Sons unde r illustration the amounts are
expressed in money and reflect only those matters that can be measured in
monetary terms. The entity involved SAU and Sons and the balance sheet pertains
to that entity rather than to any of the individuals associated with it. The
statements assume that SA U and Sons is a going concern. The asset amounts
stated are governed by cost concept. The dual aspect concept is evident from the
fact that the assets listed on the left hand side of this balance sheet are equal in
total to the liabilities and owners’ equity listed on the right hand side. Thus in the
balance sheet the following five accounting concepts are involved: business entity
concept, money measurement concept, going concern concept, cost concept and
dual-aspect concept.
4.3.5 CLASSIFICATION OF ITEMS IN THE BALANCE SHEET
Although each individual asset or liability can be listed separately on the
balance sheet, it is more practicable and more informative to summarize and group
related items into categories called as accoun t classifications. The classifications or
group headings will vary considerably depending on the size of the business, the
form of ownership, the nature of its operations and the users of the financial
statements. For e.g. while listing assets, the order of liquidity is generally used by
sole traders, partnership firms and banks whereas joint stock companies by law
follow the order of permanence. As a generalisation which is subject to many
exceptions, the following classification of balance sheet items is suggested as
representative.
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Assets
Current Assets
Investments
Fixed Assets
Intangible Assets
Other Assets
Liabilities:
Current Liabilities
Long term liabilities
Owners’ equity:
Capital
Retained Earnings
4.3.5.1 Classification of Assets
Current Assets: Current assets are those which are reasonably expected to be
realised in cash or sold or consumed during the normal operating cycle of the
business enterprise or within one year, whichever is longer. By operating cycle, we
mean the average period of time between the purchase of goods or raw materials
and the realisation of cash from the sale of goods or the sale of products produced
with the help of raw materials. Current assets generally consist of cash, marketable
securities, bills receivables, debtors, inventory and prepaid expenses. Cash: Cash
consists of funds that are readily available for disbursement. It includes cash kept
in the cash chest of the enterprise as also cash deposited on call or current
accounts with banks.
Marketable securities: These consist of investments that are both readily
marketable and are expected to be converted into cash within a year. These
investments are made with a view to earn some return on cash that otherwise
would be temporarily idle.
Account Receivable: Accounts receivables consist of amounts owed to the
enterprise by its consumers. This represents amounts usually arising out of normal
commercial transactions. These amounts are listed on the balance sheet at the
amount due less a provision for portion that may not be collected. This provision is
called as provision for doubtful debts. Amounts due to the enterprise by someone
other than a customer would appear under the heading other receivables rather
than accounts receivables. If the amounts due are evi denced by written promises to
pay, they are listed as bills receivables. Accounts receivables are expected to be
realised in cash.
Inventory: Inventory consists of: i) goods that are held in stock for sale in the
ordinary course of business, ii) work-in-progress that are to be currently consumed
in the production of goods or services to be available for sale. Inventory is expected
to be sold either for cash or on credit to customers to be converted into cash. It may
be noted in this connection that inventory relates to goods that will be sold in the
ordinary course of business. A van offered for sale by a van dealer is inventory. A
44
van used by the dealer to make service calls is not inventory;' it is an item of
equipment which is a fixed asset.
Prepaid expenses: These items represent expenses which are usually paid in
advance such as rent, taxes, subscriptions and insurance. For e.g., if rent for three
months for the building is paid in advance then the business acquires a right to
occupy the building for three months. This right to occupy is an asset. Since this
right will expire within a fairly short period of time it is a current asset.
Long Term Investments: The distinction between a marketable security
shown under current asset and as an investment is entirely based on time factor.
Those investments like investments in shares, debentures. bonds etc. that will be
retained for more than one year or one operating cycle will appear under this
classification.
Fixed Assets: Tangible assets used in the business that are of a permanent or
relatively fixed nature are called plant assets or fixed assets. Fixed assets include
furniture, equipment, machinery, building and land. Although there is no standard
criterion as to the minimum length of life necessary for classification as fixed
assets, they must be capable of repeated use and are ordinarily expected to last
more than a year. However, the asset need not actually be used continuously or
even frequently. Items of spare equipments held for use in the event of bre akdown
of regular equipment or for use only during peak periods of activity are included in
fixed assets.
With the passage of time, all fixed assets with the exception of land lose their
capacity to render services. Accordingly, the cost of such assets sho uld be
transferred to the related expense amounts in a systematic manner during their
expected useful life. This periodic cost expiration is called depreciation. While
showing the fixed assets in the balance sheet the accumulated depreciation as on
the date of balance sheet is deducted from the respective assets.
Intangible Assets: While tangible assets are concrete items which have
physical existence such as buildings, machinery etc., intangible assets are those
which have no physical existence. They cannot be touched and felt. They derive
their value from the right conferred upon their owner by possession. Examples are:
goodwill patents, copyrights and trademarks.
Fictitious Assets: These items are not at all assets. Still they appear in the
asset side simply because of a debit balance in a particular account not yet written
off e.g. debit balance in current account of partners, profit and loss account etc.
4.3.5.2 Classifications of Liabilities
Current liabilities: When the liabilities of a business enterprise are due within
an accounting period or the operating cycle of the business, they are classified as
current liabilities. Most of current liabilities are incurred in the acquisition of
materials or services forming part of the current assets. These liabilities are
expected to be satisfied either by the use of current assets or by the creation of
other current liabilities. The one-year time interval or current operating cycle
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enterprise for compensation. If the case is decided against the enterprise the
liability arises and in the case of favourable decision, there is no liability at all.
Contingent liabilities are not taken into account for the purpose of totaling of
balance sheet.
4.3.5.3 Capital or Owners Equity
As mentioned earlier in this chapter owners’ equity is the residual interest in
the assets of the enterprise. Therefore, the owners’ equity section of the balance
sheet shows the amount the owners have invested in the entity. However, the
terminology 'owners' equity, varies with different forms of organisations depending
upon whether the enterprise is a joint stock company or sole proprietorship /
partnership concern.
Sole Proprietorship / Partnership Concern: The ownership equity in a sole
proprietorship or partnership Is usually reported on the balance sheet as a single
amount for each owner rather than distinction between the owner's initial
investment and the accumulated earnings retained in the business. For e.g. in a
sole-proprietor's balance sheet for the year 2016, the capi tal account of the owner
may appear as follows.
Rs
Owner's capital as on 1/1/2016 50,000
Add 2016-Proflt 30,000
80,000
Less 2016-Drawlngs 5,000
Owner's capital as on 31/12/2016 75,000
the accumulated amount that has been retained in the business from the beginning
of the Company's existence up to that date. The owners’ equity Increases through
retained earnings and decreases when retained earnings are paid out in the form of
dividends.
Adjusting items for preparing balance sheet.
adjustment Adjusting entry Treatment in balance
sheet
1.Outstanding Expenses a/c. Dr Shown on liabilities side
expenditure To Outstanding esp./c
2.Prepaid expenses Prepaid expenses. a/c Dr Shown on the asset side
To expenses. a/c
3.Closing stock Closing stock a/c Dr Shown on the asset side
To Trading .a/c
4.Accrued income Accrued income. Dr Shown on the asset side
To income a/c
5.Depreciation a. Depreciation a/c Dr Shown by way of
To Asset a/c deducting from respecting
asset of the asset side.
b. Depreciation a/c
To provision for
depreciation a/c
6.Provission for bad Profit &loss a/c Dr Deducting from sundry
debts To provision for bad debtors on the asset side
debts.
7. Provision for Profit &loss a/c Dr Deducting from sundry
discount To provision for discount debtors on the asset side
8.Reserve for Reserve for discount Shown by way of
discount on creditors on creditors a/c Dr deduction from sundry
creditors.
To profit and loss a/c
9.Income received in Income a/c. Shown on liabilities side
Advance To Income received in
Advance a/c
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Illustrations1:
1.on 31.03.2015 the following trial balance was prepared from the books of
Krishna:
Particulars Dr.(Rs) Cr.(Rs)
Sundry debtors 50600 -
Purchases 90000
Capital 70000
Salaries 11000
Wages 14400
Carriage in 750
Reserve 20000
Sales 231700
Particular Rs particular Rs
To purchase 90,000 By sales 2,31,700
Less overcast stock 1,000
To wages 89,000
To Gross profit
750
1,27,550
2,31,700
2,31,700
50
To salaries 11,000
Add O/S 9,000 1,27,550
By Gross profit
20,000
1,000
To carriage out
2215
1,865
Less: old provision 350
1,500
To General charges
3,500
To Interest on Capital
Total 1,27550
1,27550
51
216435.00 216435.00
Illustrations2: From the following trial balance of X and Y. You are required to
prepare Trading and Profit & Loss Account for the year ended 31st March2016 and
Balance sheet as on that date after considering the following adjustments.
TrialBalanceason31stMarch2016
Particulars Rs. Rs.
Opening Stock 17,500 -
Salaries and Wages 4,600 -
Cash in hand 6,000 -
Purchase and Sales 1,12,600 2,65,000
Office Expenses 4,300 -
Productive Wages 7,000 -
Bills Receivable 4,000 -
Legal Expenses 3,300 -
Bad debts 1,900 -
Works Managers Salary 5,600 -
Commission 1,800 2,500
Investments 42,000 -
Debtors 67,500 -
Creditors - 92,000
Bank over draft - 88,000
Pate nts 38,000 -
Loose Tools 28,000 -
Furniture 65,000 -
Goodwill 80,000 -
Interest - 1,600
Land &Building 1,25,000 -
Capital Accounts:
Neela - 1,10,000
52
Sheela - 1,05,000
Drawings:
20,000 -
NeelaSheela 30,000 -
6,64,100 6,64,100
Adjustments:
1. Partners shares Profit and losses equally.
2. The Closing Stock cost Rs. 25,000/-market value Rs. 19,000/-.
3. NeelahaswithdrawngoodsworthRs.800/-for personal use.
4. DepreciateLandandBuildingat10%p.a.andLooseTools15%p.a.
st
TradingAccountfortheyearended31 March2016
Particulars Rs. Particulars Rs.
1,42,100
2,84,800 2,84,800
Profit&LossAccountfortheyearended31stMarch2016
113600
1,46,200 1,46,200
53
4,57,800 4,57,800
Illustration3:From the following Trial balance of Mr. X and Mr. Y. You are
required to prepare Trading and Profit & Loss Account for the year ending31st
Mar.2016 and balance sheet as on that date after consideration the adjustments
given below.
TrialBalanceason31stMarch,2016
Dr. Cr.
Furniture 12,000
Od will 13,000
Building 50,000
4,72,000 4,72,00
0
Adjustments:
1. Partners shares Profit and Losses in the equal ratio.
2. Closing Stock cost price Rs. 40,000/-market value Rs. 45,000/-.
3. Uninsured goods worth Rs. 10,000/-were lost by fire.
4. Un paid Salary and Wages Rs. 2,100/-.
3,80,000 3,80,000
To Salaries 9,200
(+)Outstanding 2,100 11,300
To Uninsured Goods
Lost by fire 10,000
To Net Profit
Mr. X 37,450
1,11,800 1,11,800
55
Equipments 6,000
Creditors 20,000 Closing Stock 40,000
2,07,000 2,07,000
Illustration4:
From the following Trial Balance of Mr. X and Mr. Y, you are required to
prepare a Trading and Profit and Loss Account for they earended 31st March 2010
and the Balance Sheet as on that date, after taking into the consideration the
additional information:
TrialBalanceason31stMarch2010
Particulars Debit(Rs.) Credit(Rs.)
Patents 4,000 -
Loose Tools 3,000 -
Furniture 6,000 -
Goodwill 6,500 -
Interest on Investment - 3,600
Land and Building 25,000 -
Capital Accounts:
Mr.X - 30,000
Mr.Y - 20,000
2,36,000 2,36,000
Adjustments:
1. Partners share Profits and Losses in their capital ratio.
2. The Closing Stock–Cost Rs. 30,000/-Market Value Rs. 22,500/-
3. JaganhaswithdrawngoodsworthRs.600/-for his personal use.
4. Uninsured goods worth Rs. 5,000/-were destroyed by fire.
5. Rs.225/-written off as bad debts from Debtors.
6. OutstandingSalariesandWagesRs.400/-.
7. DepreciationonLandandBuildingat7½%.
Solution:
M/s.X & Y
Trading, Profit & Loss Account for the year ended 31-03-2010
Particulars Rs. Particulars Rs.
To Opening Stock 17,500 By Sales 1,65,000
To Purchases 1,12,600 By Goods with drawn(Jagan) 600
To Productive Wages 7,000 By Goods Lost by Fire 5,000
To Work Manager’s Salary 3,000 By Closing Stock 30,000
To Gross Profit c/d 60,500
2,00,600 2,00,600
1,11,400 1,11,400
4.4 REVISION POINT
1. Asset: Costs which represent expected future economic benefits to the
business enterprise.
2. Liabilities: Represent obligations which require settlement in the future.
3. Current Assets: Assets which are reasonably expected to be realised in
cash or sold or consumed during the normal operating cycle of the
business enterprise or within one year, whichever is longer.
4. Operating cycle: The average period of time between the purchase of goods
or raw materials and the realisation of cash from the sale of goods
5. Fixed Assets: Tangible assets used in the business that are of a permanent
or relatively fixed nature.
6. Intangible Assets: Those assets which have no physical existence.
7. Fictitious Assets: Not assets but appear in the asset side simply because of
a debit balance in a particular account not yet written off.
8. Current liabilities: Liabilities due within an accounting period or the
operating cycle of the business.
9. Long Term Liabilities: Liabilities that become due for payment after one
year.
58
operations of the enterprise. The analysis becomes all the more useful and effective
when a series of balance sheets and profit and loss accounts are studied.
4.7 TERMINAL EXERCISE
1. "Proposed dividends" is shown in the Balance Sheet of a company under
the head:
a. Provisions
b. Reserves and Surplus
c. Current Liabilities
d. Other Liabilities
Correct Answer: a
2. Balance Sheet of a company is prepared in the format prescribed in/by
a. Income Tax Act
b. Schedule VI of the Companies Act,1956
c. By CAG
d. By ICAI
Correct Answer: b
3. Which of the following would not appear on a conventional balance
sheet?
a. income taxes payable
b. funds from operations
c. cash surrender value of life insurance
d. appropriation for contingencies (restriction of retained earnings)
e. patents
ANS: b
4. Tangible assets on the balance sheet should include:
a. equipment
b. taxes payable
c. trademarks
d. bonds payable
e. none of the answers are correct
ANS: a
4.8 SUPPLEMENTARY MATERIAL
1. www.icai.org
2. www.icmai.org
4.9 ASSIGNMENT
1. Give adjustment entries for the following:
(a) income received in advance
(b) prepaid expenses
(c) closing stock
(d) provision for doubtful debts
60
LESSON – 5
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT
5.1 INTRODUCTION
A financial statement is an organized collection of data according to logical and
consistent accounting procedures. Its purpose is to convey an understaning of
some financial aspects of a business firm. It may show a position at a moment of
time as in the case of a balance sheet, or may reveal a series of activities over a
given period of time, as in the case of an income statement.
The term financial statement generally refers to two basic statement.: i. The
income statement and ii. Balance sheet. Of course, a business may also prepare iii.
A statement of retained earnings and iv. A statement of changes in financial
position in addition to the above two statements
5.2 OBJECTIVES
After reading this lesson the student should be able to:
understand the various financial statement like income statement,
Statement of retained earing, statement of changes in financial position.
And types of financial analysis.
5.3 CONTENT
5.3.1 Income statement
5.3.2 Balance sheet
5.3.3 Types of financial analysis
5.3.4 Techniques of financial analysis
5.3.5 Limitations of financial analysis
5.3.1 INCOME STATEMENT
The income statement is generally considered to be the most useful of all
financial statements. It explains what has happened to a business as a result of
operations between two balance sheet dates. For this purpose it matches the
revenues and costs incurred in the process of earn ing revenues and shows the net
profit earned or loss suffered during a particular period.
5.3.2 BALANCE SHEET
It is a statement of financial position of a business at a specified moment of
time. It represents all assets owned by the business at a particul ar moment of time
and the claims of the owners and outsiders against those a sets at that time.
Statement of retained earnings.
The term retained earnings means the accumulated excess of earnings over
losses and dividends. The balance shown by the income statement is transferred to
the balance sheet through this statement, after making necessary appropriations. It
is thus, a connecting link between the balance sheet and the income statement.
Statement of changes in financial position (SCFP)
The balance sheet shows the financial condition of the usiness at a particular
moment of time while the income statement discloses the results of operations of
business over a period of time.
62
for a particular period may be calculated with the sales for the period.
Such analysis is useful in comparing the performance of several
companies in the same group, or divisions or departments in the same
company. Since this analysis depends on the data for one period, this is
not very conducive to a proper anal ysis of company financial position. It
is also called static analysis as it is frequently used for referring to ratios
developed on one date or for one accounting period.
It is to be noted that both analysis – vertical and horizontal – can be done
simultaneously also. For example, the income statement of a company for several
years may be given. Horizontally it may show the cange in different elements of cost
and sales over a number of years. On the other hand, vertically it may show the
percentage of each element of cost to sales.
5.3.4 TECHNIQUES OF FINANCIAL ANALYSIS
A financial analyst can adopt one or more of the following techniques/tools of
financial analysis
Comparative financial statements
Comparative financial statement are those statement which have been designed
in a way so as to provide time perspective to the consideration of various elements
of financial position embodies in such statements. In these statemen t figures for
two or more periods are placed side by side to facilitate comparison.
Both the income statement and balance sheet can be prepared in the form of
comparative financial statements.
Common size financial statement
Common size financial statements are those in which figures reported are
converted into percentages to some common base. In the income statement the sale
figure is assumed to be 100 and all figures are expressed as a percentage of this
total.
Trend percentages
Trend percentages are immensely helpfull in making a comparative study of the
financial statements for several years. The method of calculating trend percentages
involves the calculation of percentage relationship that each item bears to the same
item in the base year.
Funds flow analysis
Funds flow analysis has become an important tool in the analytical kit of
financial analysts, credit grating institutions and financial mangers. This is
because the balance sheet of a business reveals its financial status at a particular
point of time. It does not sharply focus those major financial transactions which
have been behind the balance sheet changes.
Cost volume profit analysis
Cost volume profit analysis is an important tool of profit planning. It studies
the relationship between cost, volume of production, sales and profit. Of course, it
is not strictly a technique used for analysis of financial statements.
64
Ratio analysis
This is the most important tool available to financial analysis for their work. An
accounting ratio shows the relationship in mathematical terms between two
interrelated accounting figures.
5.3.5 LIMITATIONS OF FINANCIAL ANALYSIS
Financial analysis is only a means
Financial analysis is a means to an end and not the end itself. The analysis
should be used as a starting point and the conclusion should be drawn not in
isolation, but keeping in view the overall picture and prevailing economic and
political situation
Ignores price level changes
Financial statements are normally prepared on the concept of historical costs.
They do not reflect values in terms of current costs. Thus, the financial analysis
based on such financial statements or accounting figures would not portray the
effects of price level changes over the period.
Financial statements are essentially interim reports
The profit shown by profit and loss account and the financial position as
depicted by the balance sheet is not exact..
Accounting concepts and conventions
Financial statements are prepared on the basis of certain accounting concepts
and conventions. On account of this reason the financial position as disclosed by
these statements may not be realistic. For example, fixed assets in the balance
sheet are shown on the basis of going concern concepts. This means that value
placed on fixed assets may not be same which may be relaised on their sale. On
account of convention of conservatism the income statement may not disclose true
income of the business since probable losses are considered with probable incomes
are ignores.
Influence of personal judgements
Many items are left to the personal judgement of the accountant. For example,
the method of depreciation, mode of amortization of fixed assets, treatments of
deferred revenue expenditure – all depend on the personal judgement of the
accountant. The soundness of such judgement will necessarily depend upon his
competence and integrity. However, the convention of consistency acts as a
controlling factor on making indiscreet personal judgements
Disclose only monitory of facts
Financial statement do not depict those facts which cannot be expressed in
terms of money. For example, development of a team of loyal and efficient workers,
enlightened management, the reputation and prestige of management with the
public. Are matters which are of considerable importance of 4 th business, but hey
are nowhere depicted by financial statements
65
2. www.icmai.org
5.9 ASSIGNMENT
1. Collect the annual reports of any public limited company for a period of 5
years. Calculate the trend percentages and prepare a report.
5.10 SUGGESTED READINGS
1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.
2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.
5.11 LEARNING ACTIVITY
1. Collect financial information from any pharmaceutical company and apply
different techniques of financial analysis and tabulate the performance of the
company.
5.12 KEYWORDS
Horizontal analysis, Vertical analysis, Rretained earnings
67
LESSON – 6
RATIO ANALYSIS
6.1 INTRODUCTION
Ratio analysis is one of the techniques of financial analysis where ratios are
used as a yard stick for evaluating the financial condition and performance of a
firm. Analysis and interpretation of various accounting ratios gives a skilled and
experienced analyst, a better understanding of the financial condition and
performance of the film than what he could have obtained only through a perusal of
financial statement.
6.2 OBJECTIVES
After reading this lesson the student should be able to:
Understand the different types and classification of ratios.
Understand the objectives, advantages, limitation of ratios
Understand the steps involve the preparation of ratios.
6.3 CONTENT
6.3.1 Meaning of ratios
6.3.2 Classification of ratios
6.3.3 Objectives of Ratio analysis
6.3.4 Advantages
6.3.5 Limitations of ratios
6.3.6 Steps involved in preparation of Ratio analysis
6.3.1 MEANING OF RATIOS
A ratio is a simple arithmetical express of the relationship of the number to
another.
Obviously, no purposes will be served by comparing two sets figures which are
not at all connected with each other. Moreover, absolute figures are unfit for
comparison.
Ratios can be expressed in two ways:
1. Times. When one value is divided by another, the unit used to express the
quotient is termed as “Times’. For example, if out of 100 employee in a
factory, 80 are present, the attendance ratio can be expressed as follows:
=80/100=.8Times
2. Percentage. If the quotient obtained is multiplied by 100, the unit of
expression is termed as” percentage”. For instance, in the above example,
the attendance ratio as a percentage of the total number of the employee is
as follows:
= .8 X 100 =80%
3. Accounting ratios are, therefore, mathematical relationship expressed
between inter-connected accounting figures.
68
Marketpriceequity share
priceearningratio
Earning Per Shares
Cross profit
Gross profitratio 100
Net Sales
1. Fixed interest cover = Income before interest and tax / Interest charges
2. Fixed dividend cover = Net profit after interest and tax / Preference
dividend
3. Debt service coverage ratio = Net profit before interest and tax /
(Principal repayment + Interest expences)
6.3.2.2 Turnover ratios
These ratios indicate the efficiency with which the capital employed is rotated
in the business. Higher the rate of rotation, the greater will be their profitability .the
overall profitability ratio can be classified into
Net operatingProfit
Net Profit ratio 100
Sales
70
Sales
Turnoverratio
Capitalemployed
Net Sales
Fixed assetsturnoverratio
Fixed assets(net)
Net Sales
Working capital turnover ratio
Working capital
Credit Sales
Debtors turnover ratio
Average accounts receivable
Or
Total Sales
Debtors turnover ratio
Accounts receivable
Accounts receivable
Average monthly or daily credit sales
Credit purchases
Creditor's turnover ratio
Average accounts payable
Or
Total purchases
Creditor's turnover ratio
Accounts payable
71
Months(day)in year
Debit payment period ratio
Creditors turnover
Months(day)in year
Average accountspayable
Credit purchasesin the year
Current Assets
Current ratio -
Current Liabilities
Liquid Assets
Quick ratio -
Current Liabilities
Or
Quick assets
Defensiveinterval ratio -
Projected daily cash requirements
Stability ratios
Fixed assets
Fixed assets ratio -
Long term funds
Proprietary ratio
Shareholders
Proprietary ratio
Total tangible assets
73
Calculate the current ratio and acid test ratio for the two years
Solution:
Current assets:
= Stock + Debtors + Cash at Bank
= Rs. 25000 + Rs.10000 + Rs.5000 = Rs.40000 (2006)
= Rs.40000 + Rs.16000 + Rs.4000 = Rs.60000 (2007)
Current liabilities:
= Creditors + bills payable + provision for taxes + overdraft
= Rs.8000 + Rs.2000 + rs.5000 + Rs.5000 = Rs.20000 (2006)
= Rs.15000 + Rs.3000 + Rs.7000 + Rs.15000 = Rs.40000 (2007)
Liquid assets
= Rs.10000 + Rs.5000 = Rs.15000 (2006)
= Rs.16000 + Rs.4000 = Rs.20000 (2007)
Liquid liabilities
= Rs.8000 + Rs.2000 + Rs.5000 = Rs.15000 (2006)
= Rs.15000 + Rs.3000 + Rs.7000 = Rs.25000 (2007)
Currentassets
Currentration =
Currentaliabilities
Rs.40000
2015 = = 2:1
Rs.20000
Rs.60000
2016 = = 1.5:1
Rs.20000
Liquidassets
Acidtestratio = = 2:1
Liquidliabilities
Rs.15000
2015 = = 1:1
Rs.15000
Rs.20000
2016 = = 0.8:1
Rs.25000
76
Illustration 2.
Rs.
Equity share capital 1000000
10% pref. share capital 500000
18 % debentures 800000
Loan at 15 % (long period) 140000
Current liabilities 300000
General reserve 800000
Rs.1440000
=
Rs.1800000
= 0.8
Since the ratio is less than one, it is low geared.
Illustration 3.
Rs.
Preference share capital 300000
Equity share capital 1100000
Capital reserve 500000
Profit & loss account 200000
6% debentures 500000
Sundry creditors 240000
Bills payable 120000
Provision for taxation 180000
Outstanding creditors 160000
77
Rs. 120000
Debt equity ratio =
Rs. 210000
= 0.57 or 4:7
It means that for every four rupees worth of the creditors investment, the
shareholders have invested seven rupees. That is external are equal to 57% of
shareholders fund.
Illustration 4
The following is the balance sheet of a company as on 31 st march
Liabilities Rs. Assets Rs.
Share capital 200000 land and buildings 140000
Profit & loss account 30000 plant and machinery 350000
General reserve 40000 stock 200000
12% debentures 420000 sundry debtors 100000
Sundry creditors 100000 bills receivables 10000
Bills payable 50000 cash at bank 40000
840000 840000
Calculate
1. Current ratio
2. Quick ratio
3. Inventory to working capital
4. Debt to equity ratio
5. Proprietary ratio
6. Capital gearing ratio
7. Current assets to fixed ratio
Solution
Current assets
Current ratio =
Current liabilities
Rs.350000
Current ratio = = 2.33:1
Rs.150000
78
Liquid assets
Quick ratio =
Liquid liabilities
Rs.150000
Quick ratio = = 1:1
Rs.150000
Inventory
Inventory to working capital =
Working capital
Rs.200000
= = 1:1
Rs.200000
Rs.420000
= = 1.56:1
Rs.270000
(Or)
Long term debts
=
Shareholders fund + Long term debts
Rs.420000
= = 0.6 : 1
Rs.270000 + Rs. 420000
= Rs.270000 = 0.32: 1
Rs.840000
Fixed interest bearing securities
Capital gearing ratio =
Equity share capital
79
Rs.420000
= = 2.1: 1
Rs.200000
current assets
Current assets to fixed assets ratio =
Fixed assets
Rs.350000
= = 0.71 : 1
Rs.490000
Illustration 5
From the following balance sheet, compute the following ratios:
1. Current ratio
2. Liquid ratio
3. Absolute liquid ratio
4. Proprietary ratio
5. Assets proprietorship ratio
a. Fixed assets to proprietors equity
b. Current assets to proprietors equity
6. Debt equity ratio
7. Stock to current assets ratio
8. Stock to working capital ratio
9. Current assets to working capital ratio
10. Current assets to liquid assets ratio
11. All long term funds to working capital ratio
12. Tangible assets to working capital ratio
13. Capital gearing ratio
Balance sheet as on 31 st December 2015
1. Current assets :
Rs.
Stock 150000
Debtors 50000
Cash 100000
300000
2. Current liabilities :
Rs.
Creditors 100000
Bank overdraft 50000
150000
3. Liquid assets :
Rs.
Debtors 50000
Cash 100000
150000
4. Liquid liabilities :
Rs.
Creditors 100000
5. Absolute liquid assets :
Rs.
Cash 100000
6. Proprietors equity :
Rs.
Equity share capital 200000
Reserve and surplus 100000
300000
7. Total fixed/tangible assets
Rs.
Plant and machinery 200000
Land and buildings 200000
400000
8. Total debts
Rs.
20% debentures 100000
Loan (long term) 50000
Current liabilities 150000
300000
9. Working capital
Current assets – current liabilities
Rs.300000 – Rs. 150000 = Rs.150000
81
= Rs.265000
Current Liabilities = Rs.60000 + Rs.70000 + Rs.30000 + Rs.5000 = Rs.165000
Current Ratio = Rs.265000 / Rs.165000 = 1.61
Illustration 7
The cost of goods sold of ESP ltd is Rs.500000. the opening stock / inventory is
Rs.40000 and the closing inventory is Rs.60000 (at cost)
Inventory turnover ratio = cost of goods sold / average inventory at cost
= 500000 / (40000 + 60000)/2
= 500000 / 50000
= 10 times
Illustration 8
M/s.X co. supplies you the following information for the year ending 31 stdec 2015:
Credit sales: Rs.150000; cash sales: Rs.250000; Returns inward: Rs.25000;
opening stock: Rs.25000; closing stock: Rs.35000
Find out: inventory turnover when gross profit ratio is 20%
Solution:
Inventory turnover = cost of goods sold / average stock
First of all cost of goods sold will be calculated
Net sales = Rs. 150000 + Rs.250000 – Rs.25000
= Rs.375000
Gross profit on sales = 375000 X 20
100
84
= Rs.75000
Cost of good sold = Net sales – Gross profit
= Rs.375000 – Rs.75000
= Rs.300000
Average stock = (opening stock + closing stock)/ 2
= (Rs.25000 + Rs.35000) / 2
= Rs.30000
Inventory turnover = Rs.300000 / Rs.30000
= 10 times
Illustration 9
Find out a. debtors turnover and b. average collection period from the following
information
31st march 2015 31st march 2016
Rs. Rs.
Annual credit sales 500000 600000
Debtors in the beginning 80000 90000
Debtors at the end 100000 110000
Days to be taken for the year: 360
Solution
Average debtors = (Opening Debtors + Closing Debtors) / 2
Debtors turnover = Net Credit Annual Sales / Average Debtors
Illustration 10
From the following information, calculate average collection period:
Rs.
Total sales 100000
Cash sales 20000
Sales returns 7000
Total debtors at the end of the year 11000
Bills receivables 4000
Bad debts provision 1000
Creditors 10000
Solution:
Average collection period = (Debtors + bill receivable) / net credit sales per day
Net credit sales
Rs.
Total sales 100000
Less cash sales 20000
Solution
Average payment period
= (creditors + bills payable) / net credit purchases per day
86
Illustration 14
The following information is given:
Current ratio: 2.5
fixed assets turnover ratio: 2 times
Liquidity ratio: 1.5
average debt collection periods: 2 months
Working capital: Rs. 300000
Stock turnover ratio: 6 times (Cost of sales / closing stock)
fixed assets: shareholders net worth 1: 1
Gross profit ratio: 20%
reserves: share capital 0.5: 1
Draw up a balance sheet from the above information
Solution
1. Current Liabilities And Current Assets :
Net working capital = current assets – current liabilities
Current ratio = 2.5
Let current liabilities be x to current assets will be 2.5 x
Net working capital = 2.5 x – x
Rs. 300000 = 2.5x – x
Rs. 300000 = 1.5x
X = Rs.300000/1.5 = Rs.200000
When current liabilities are Rs.200000, current assets will be
200000 x 2.5 = Rs.500000
Liquid assets = 200000 x 1.5 = Rs.300000
2. Stock :
Stock = current assets – liquid assets
Stock = Rs.500000 – Rs.300000 = Rs.200000
3. Cost Of Sales
Stock turnover ratio = cost of sales / stock
6 = cost of sales / Rs.200000
Cost of sales = Rs.200000 x 6 = Rs.120000
4. Sales
Cost of sales + gross profit
Gross profit = Rs.1200000 x 20 / 80 = Rs.300000
89
Illustration 15
Fromthefollowinginformation,youarerequiredtoprepareaBalanceSheet.
Particulars Rs.
Working Capital 75,000
Reserves and Surplus 1,00,000
Bank Overdraft 60,000
Current Ratio 1.75
Liquid Ratio 1.75
Fixed assets to proprietors’ Funds .75
Long-term liabilities Nil
Solution:
Balance Sheet
Liabilities Rs. Assets Rs.
Share capital 2,00,000 Fixed Assets 2,25,000
Reserves & Surplus 1,00,000 Stock 60,000
Bank Overdraft 60,000 Debtors and Cash 1,15,000
Creditors 40,000
4,00,000 4,00,000
Workings:
1. Current Assets
Current Ratio=1.75
Working Capital should be=.75
175 175
W orking Capital =Rs.75,000 =Rs.1,75, 000
75 75
2. Liquid Assets(Debtors and Cash)
LiquidRatio–1.15
If current assets are175 liquid assets shouldbe115
175 115
Current Assets =Rs.1,75,000 =Rs.1,15, 000
175 175
3. Stock
Current Assets–Liquid Assets
=Rs.1,75,000–Rs.1,15,000
=Rs.60,000
91
4. Fixed Assets
Share holders’ Equity should be equal to total net assets. Proprietary ratio–7.5
If fixed assets are75 to proprietors’ funds net current assets should be 25 of the
total net assets.
75 75
Net Current Assets =Rs.75,000 =Rs.2,25,000
25 25
5. Share holders’ Funds
Iffixedassetsare75shareholders’fundsshouldbe100
100 100
Fixed Assets =Rs.2,25,000 =Rs.3, 00, 000
75 75
ShareCapital=Shareholder’sFunds–ReservesandSurplusRs.3,00,000–1,00,000 =
Rs.2,00,000
6. Creditors
Currentassets–WorkingCapital–BankOverdraftRs.1,75,000–75,000–60,000=
Rs.40,000
DU PONT ANALYSIS
In ratio analysis, Du-Pont Control Chart shows the relationship of net profit
margin ratio and total investment turnover ratio for calculating return on total
investment ratio (ROI). If company wants to increase return on investment (ROI), it
has to concentrate to increase net profi t margin and total investment turnover
ratio.
92
6.9 ASSIGNMENT
1. What are liquidity ratios? Discuss the importance of current and liquid
ratio.
2. How would you study the Solvency position of the firm?
3. What are various profitability ratios? How are these worked out?
4. The current ratio provides a better me asure of overall liquidity only
when a firm’s inventory cannot easily be converted into cash. If
inventory is liquid, the quick ratio is a preferred measure of overall
liquidity. Explain.
6.10 SUGGESTED READINGS
1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.
2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.
5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
6.11 LEARNING ACTIVITY
From the disclosed financial information from any capital goods company for
the current period collected from website, evaluate the performance through
profitability ratio and turn over ratio.
6.12 KEYWORDS
Liquid assets, proprietary, dept, capital gearing, current assets.
96
LESSON – 7
FUND FLOW STATEMENTS
7.1 INTRODUCTION
The funds statement aims to su pplement the two conventional statements. It
shows information that can only be obtained through analysis and interpretation of
income statements and opening and closing balance sheets. This information
relates to the overall investment and financial activities of the company, showing
the principle sources and application of funds.
7.2 OBJECTIVES
After reading this lesson the student should be able to:
Understand the statement of changes in working capital.
Understand the meaning of fund flow statement.
Understand the preparation of fund flow statement.
7.3 CONTENT
7.3.1 Need for fund flow analysis
7.3.2 Meaning of fund
7.3.3 Meaning of fund flow statement
7.3.4 Importance of fund flow statement
7.3.5 Limitations of fund flow statement
7.3.6 Statement of changes in working capital
7.3.7 Statement of fund flow
7.3.1 NEED FOR FUND FLOW ANALYSIS
The traditional package of financial statements has as such limited role to play
in financial analysis. The balance sheet is a statement of assets and liabilities on a
particular date and portrays the financial position as on that particular date.
Similarly the income statement will show in more detail only the pro fit or loss
arising out of the productive and commercial activities of the enterprise during that
period. However, they fail to throw light on those major financial transactions,
which are behind the balance sheet changes. In order to ascertain such major
financial transactions, or movement of financial resources or funds, a separate
statement is prepared by comparing the balance sheets of two periods. This
statement is variously known as funds flow statement or statement of sources and
uses of funds.
By recording these changes in the financial structure that have resulted from
the companies trading activities, and at the same time indicating the reasons for
those changes, the funds statement serves the dual role of an accounting reports
and an analytical tool. This is so because the funds statement can be used as part
of budgetary process in forecasting the company’s financial requirement for the
future.
97
The fund flow statement is a financial statement which reveals the methods by
which the business has been financed and how it has used its funds between the
opening and closing balance sheet date. Thus a fund flow statement is a report on
movement of funds explaining wherefrom working capital originates and where into
the same goes during an accounting period. This state ment consists of two parts –
1. Sources of funds and 2. Application of funds. The difference between the two
shows the net change in the working capital during the period. It is to be
remembered that only those transactions can find place in this statement which
affect the net working capital of the firm. The fund flow statement is a supplement
to the two principal financial statements. While supplementing the position
statement, it describes the sources from which additional funds were derived and
uses to which these funds were put. The transactions which increase working
capital are sources of funds and the transactions which decrease working capital
are application of funds.
7.3.4 IMPORTANCE OF FUND FLOW STATEMENT
Funds flow statement is a useful tool in the financial manager’s analytical kit.
The basic purpose of this statement is to indicate where funds came from and
where it was used during the certain period. Following are the uses of this which
show its importance
1. Funds flow statement determines the financial consequences of
business operations. It shows how the funds were obtained and used in
the past. Financial manager can take corrective actions
2. The management can formulate its financial policies – dividend, reserve
etc. On the basis of the statement
3. It serves as a control device, when comparing with budgeted figures. The
financial manager can take remedial steps, if there is any deviation
4. It points out the sound and weak financial position of the enterprises
5. It points out the causes for changes in working capital
6. It enables the bankers, creditors or financial institutions in assessing
the degree of risk involved in granting credit to the business
7. The management can rearrange the firms financing more effectively on
the basis of the statement
8. Various uses of funds can be known and after comparing them with the
uses of previous years, improvement or downfall in the firm can be
assessed.
9. The statement compared with the budget concerned will show to what
extent the resources of the firm were used accordin g to plan and what
extend the utilization was unplanned
10. It tells whether sources of funds are increasing or decreasing or
constant.
99
Total (a)
Current liabilities
Outstanding expenses
B/P
Creditors
Total (b)
Working capital (a-b)
Net increase/decrease in
working capital
Illustration 1
From the following information, calculate funds from operation
Profit and loss account
Rs. Rs.
To expenses: By Gross profit b/d 200000
Operation 100000 By Gain on sale of buildings 20000
Depreciation 40000 By Other income 2000
To Loss on Sale of Machinery 10000
To Advertisement Suspense A/C 5000
To Discount of Debtors 500
To Discount on Issue of Shares 500
To Goodwill W/Off 12000
To Preliminary Expenses W/Off 2000
To Net Profit 52000
222000 222000
Solution
Calculation of funds from operation
Rs. Rs.
Reported current profit 52000
Add : items not affecting funds:
Depreciation 40000
loss on sale of machinery 10000
advertisement suspense a/c 5000
discount on issue of shares 500
goodwill w/off 12000
preliminary expenses w/off 2000 69500
121500
Less : non operating income :
Gain on sale of buildings 20000
Other income 2000 22000
Funds from operations 99500
Note: other income Rs.2000 should be shown as a separate source in the funds
flow statement.
102
Illustration: 2
Calculate the funds from operations from the following
Profit and loss account
Rs. Rs.
To Salaries 15000 By Gross Profit 20000
To Rent 15000 By Profit on Sale of Land 5000
To Depreciation 10000 By Net Loss 35000
To Printing Expenses 5000
To Goodwill W/Off 3000
To Provision for Tax 4000
To Loss on Sale of Plant 2000
To Proposed Dividends 6000
60000 60000
Solution
Calculation of funds from operations
Rs. Rs.
Reported net loss (-) 35000
Add: items not affecting funds
Depreciation 10000
Goodwill written off 3000
Provision for taxation 4000
Loss on sale of plant 2000
Proposed dividends 6000 25000
(-)10000
Less: non operating income
Profit on sale of land (-)5000
Funds lost from operation (-)15000
Illustration 3:
From the following particulars prepare a funds flow statement for the year
ended 31 st December 2015.
Rs.
Net profit before writing off goodwill 21500
Depreciation written off on fixed assets 3500
Good will written off from profits 5000
Dividends paid 7000
Shares issued for cash 10000
Purchase of machinery 20000
Increase in working capital 8000
Solution:
Working notes:
Computation of funds from operations
Net profit before writing off goodwill Rs.21500
103
Illustration 4
Following are the comparative balance sheets of accompany for the year 2006
and 2007
Balance sheet
Liabilities 2015 2016 Assets 2015 2016
Rs. Rs. Rs. Rs.
Share capital 70000 74000 Cash 9000 7800
Debentures 12000 6000 Debtors 14900 17700
Creditors 10360 11840 Stock 49200 42700
Profit & loss a/c 10740 11360 Goodwill 10000 5000
land 20000 30000
103100 103200 103100 103200
Additional information
Dividend were paid totaling Rs, 4000
Land was purchased for Rs.15000
You are required to prepare a statement showing changes in working capital
and a funds flow statement
Solution
Statement showing changes in working capital
2015 2016 Effect on working capital
Rs. Rs. Increase Rs. Decrease Rs.
Current assets
Cash 9000 7800 1200
Debtors 14900 17700 2800
Stock 49200 42700 6500
73100 68200
104
Workings
Adjusted P & L a/c
Rs. Rs.
To goodwill written off 5000 By opening balance 10740
To dividend paid 4000 By funds from operations 14620
To depreciation on land 5000 (bal. fig)
To closing balance 11360
25360 25360
Land a/c
Rs. Rs.
To opening balance 20000 By depreciation (bal. fig) 5000
To cash (purchase) 15000 By closing balance 30000
35000 35000
Illustration 5
From the following balance sheets of XYZ for the year ended on 31 st December
2015 and 2016. Prepare a statement showing sources and application of funds and
schedule of changes in working capital
105
Illustration 6
The following are the summarized balance sheets of XYZ ltd as on 31 st
December 2015 and 2016
Capitals & liabilities 2015 2016 Assets 2015 2016
Rs. Rs. Rs. Rs.
Capitals Fixed assets
10% preference shares 100000 110000
Equity shares 220000 250000 Machinery 200000 230000
Share premium 20000 26000 Buildings 150000 176000
Profit & loss 104000 134000 Land 18000 18000
12% debentures 70000 64000 Current assets
Current liabilities Cash 42000 32000
Creditors 38000 46000 Debtors 38000 38000
Bills payable 5000 4000 Bills receivable 42000 62000
Provision for tax 10000 12000 Stock 84000 98000
Dividends payable le 7000 8000
574000 654000 574000 654000
Increase Decrease
Rs. Rs. Rs. Rs.
Current assets
Cash 42000 32000 10000
Debtors 38000 38000
Bills receivables 42000 62000 20000
Stock 84000 98000 14000
Total (A) 206000 230000
Current liabilities
Creditors 38000 46000 8000
Bills payable 5000 4000 1000
Provision for tax 10000 12000 2000
Dividend payable 7000 8000 1000
Total (B) 60000 70000
a. sundry creditors
b. debentures
c. outstanding expenditure
d. bank over draft
ans. B
7.8 SUPPLEMENTARY MATERIAL
www.icai.org
www.icmai.org
7.9 ASSIGNMENT
1. Define fund flow statement. Examine its uses and significances for
management
2. What are the causes for changes in working capital. Explain
3. “ a fund flow statement is better substitute for an income statement”.
Discuss.
4. Suggest some items which may be added back to net profit to get a total
fund provided by profitable operation for fund flow statement. Illustrate your
answer.
5. Is fund flow statement necessary because of the limitations of profit and loss
account and balance sheet. In what respect is the fund statement equally
significant.
6. “ fund flow statement presents a decision view of business”. Comment.
7.10 SUGGESTED READINGS
1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.
2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.
5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
7.11 LEARNING ACTIVITY
Collect the disclosed consecutive two years balance sheet for any one
information sector company from website prepare fund flow statement and evaluate
the performance.
7.12 KEY WORDS
Fund fiow, Working capital, Fund from operation.
110
LESSON – 8
CASH FLOW STATEMENT
8.1 INTRODUCTION
A cash flow statement is a statement depicting change in cash position from
one period to another. When the concept of funds is used to mean ‘cash’ the funds
flow analysis would be called cash flow analysis.
8.2 OBJECTIVES
After reading this lesson the student should be able to:
understand the meaning of cash flow statement.
Understand the difference between the fund flow statement and cash
flow statement.
Understand the steps in preparation of cash flow statement.
8.3 CONTENT
8.3.1 Meaning of cash flow statement
8.3.2 Difference between fund flow statement and cash flow statement
8.3.3 Distinction between cash flow statement and receipts and payments a/c
8.3.4 Limitation of cash flow statement
8.3.5 Managerial uses or advantages of cash flow analysis
8.3.6 Steps in preparation of cash flow analysis
8.3.1 MEANING OF CASH FLOW STATEMENT
It is an analysis based on the movement of cash and bank balance. Such
movements of cash are depicted in a statement called cash flow statement. It is a
statement of changes in financial position prepared on cash basis. While preparing
cash flow statement, two types of cash flows, viz., actual cash flows and notional
cash flows are identified. Actual cash flows refer to the actual movements of cash
into or out of business. Purchase of fixed assets for cash, borrowing from bank or
financial institutions, redemption of debentures etc are a few examples of cash
flows. But notional cash flows result only in the case of incre ase or decrease in
current assets. Notional cash flows result in indirect cash movements into or out of
business. For example, increase in debtors does not result in any actual cash out
flows since it is part of credit sales. But at the same time, cash flo ws out of
business take place in form of material cost, labor cost, and overheads etc incurred
on the goods sold on credit.
8.3.2 DIFFERENCE BETWEEN FUND FLOW STATEMENT AND CASH FLOW STATEMENT
1. The fund flow statement shows the causes of changes in net work ing capital
whereas the cash flow statement shows the causes for the changes in cash.
2. Cash flow statement is started with the opening and closing balances of cash
while there are no opening or closing balances in fund flow statement
3. Cash flow statement deals only with cash whereas fund flow statement deals
with all the components of working capital
111
4. Cash flow statement is useful for short term financing while fund flow
statement is useful for long term financing
5. Cash flow statement is based on cash basis of accounting while the fund
flow statement is based on accrual basis of accounting
6. Cash flow statement depicts only the changes in cash position, while fund
flow statement is concerned with the changes in working capital between
two balance sheet dates
7. Cash is a part of working capital. Improvement in cash position, as indicated
by cash flow statement can be taken as an indicator of improved working
capital position. But the reverse is not true. That is sound fund position may
not necessarily mean sound cash position
8.3.3 DISTINCTION BETWEEN CASH FLOW STATEMENT AND RECEIPTS AND PAYMENTS
A/C
There appears to be many common points in cash flow statement and receipts
and payments accounts. Yet, there are differences between the two
1. The cash flow statement is prepared to disclose the amount of cash
generated from operation and other sources and the amount of outflow,
being cash payments during the period. Receipts and payments account
contains cash receipts and cash payments
2. The cash flow statement can be prepared form the balance sheets of two
dates. The receipts and payments account cannot be prepared so.
8.3.4 LIMITATION OF CASH FLOW STATEMENT
Cash flow statement is a useful tool of financial analysis. However it suffers
from some limitations, which are as follows:
1. Cash flow statement only reveals the inflow and outflow of cash. The cash
balance disclosed by this statement may not depict the true liquid position.
There are controversies over a number of items like cheques, stamps, postal
orders etc. to be included in cash.
2. A cash fund statement cannot be equated with the income statement. An
income statement takes into account both cash and non cash items. Hence
cash fund does not mean net income of the business
3. Working capital being a wider concept of funds, a fu nds flow statement
presents a more complete picture than cash flow statement.
8.3.5 MANAGERIAL USES OR ADVANTAGES OF CASH FLOW ANALYSIS
1. It is very helpful in understanding the cash position of a firm. Since cash is
the basis for carrying on business operations, the cash flow statement is
very useful in evaluating the current cash position
2. it helps management to understand the past behavior of the cash cycle and
to control the uses of cash in future
112
3. The repayment of loans, replacement of assets and other such programs can
be planned on its basis.
4. It throws light on the factors contributing to the reduction of cash balance in
spite of increase in income or vice versa.
5. A comparison of the cash flow statement with the cash budget for the same
period helps in comparing and controlling cash expenditure
6. The cash flow statement is helpful in making short term financial decisions
relating to liquidity, and the ways and means position of the firm.
8.3.6 STEPS IN PREPARATION OF CASH FLOW ANALYSIS
Cash flow statement takes into account only those transactions which result in
immediate inflow and outflow of cash. The preparation of cash flow statement
involves the following stages
1. Calculation of cash from operations
2. Changes in non current liabilities, i.e. Share capital, debentures, loans, and
mortgages.
3. Changes in non current assets i.e. Building, plant, machine and furniture
etc.,
8.3.6.1 Cash from operation
It includes cash received against profit and inflow or outflow of cash due to
change in current assets and current liabilities. Calculation of cash from operation
involves the following
(1) Calculation of operational profit
Excess of current year profit over the previous year profit is assumed to be in
the form of cash, if all transactions are in cash. It should be noted that profit here
means operating net profit. While calculating this operating net profit we have to
take into account only operating income and operating expenses will be added to it
and non operating income are to be deducted. In case of adjustment, it is advisable
to prepare adjusted profit and loss account and calculate profit from operation in
the same way as we do calculate in case of funds flow statement. The following
adjustments are to be made to the net profit.
(2)Non operating expenses: These expenses do not result in outflow of cash
but the net profit is reduced due to the effect of these expenses. In other words,
cash from operation increases in comparison to profit
(3)Depreciation: Depreciation is charged on fixed assets. It appears at the
debit side of profit and loss a/c and thus reduces profit. Depreciation is non cash
item, so it does not reduce cash. In order to ascertain operating profit depreciation
will be added to net profit. When preparing profit and loss account to find out profit
earned during the year, the depreciation account will be written at the debit side of
the profit and loss a/c.
113
(1) Issue of shares or increase in capital : increase in the value of share capital
during the current year in comparison to previous year is supposed to be the issue
of shares, which will undoubtedly bring cash into business and inflow of cash will
take place.
(2)Issue of debentures: If additional debentures have been issued during the
current year, inflow of cash will take place. Increase the balance of debentures
during the current year as compared to the previous year is assumed to be issue of
debentures.
(3)Increase in loan or mortgage: If the balance of loan or mortgage increases
during the current year, it will be assumed that additional loans have been
borrowed and cash flow inside the business has taken place
The change in the value of non current liabilities will result in the outflow of
cash in the following cases:
(4)Redemption of share capital or decrease in share capital : In certain cases
company redeems its redeemable preference shares and thus outflow of cash takes
place. Decrease in the balance of capital during the current year is assumed to be
the redemption
(5)Repayment of debentures: Debentures are the loans taken by the company.
These debentures are redeemed as per the terms of issue. Redemption of
debentures will result in outflow of cash. Decrease in the value of debentures is
assumed to be payment of debentures.
(6)Decrease in loan or mortgage: in case of payment of loan or mortgage, cash
will reduce and outflow of cash will takes place
(7)Payment of tax and dividend: Payment of taxes and dividend is the normal
feature of the company. Whenever taxes and dividends are paid cash goes outside
the business. If the balance of provision of taxation regarding previous and current
years is given, it may be assumed that the previous year’s provision of taxes has
been paid during the current year. In case of adjustment provision for tax account
is prepared to calculate the amount of taxed paid during the year. The same
treatment is accorded to dividend.
8.3.6.3.Changes in non current assets:
Change in non current assets generally fixed assets also results in inflow or
outflow of cash.
Sale or decrease in the value of fixed assets: sometimes the company sells a
part of its land, building, plant, machinery, furniture and vehicles etc. the sale
fetches cash and inflow of cash takes place. Decrease in the value of fixed assets is
assumed to be its sales.
Cash from operations: cash from operations for the purpose of cash flow
statement is the net flow. Funds from operations represent the net flow in a rough
way. Further adjustments as discussed above are required to arrive at the net flow
of cash. This is tabled below:
115
REPORT FORM
CASH FLOW STATEMENT
For the year ended 31 st December ……….
Rs. Rs.
Opening balances
Cash
Bank
Add: sources of cash: ---
Issue of shares ---
Issue of debentures ---
Raising of long term loans ---
Sale of fixed assets ---
Dividends ---
Cash from operations ---
Total of cash inflow (A) ---
116
ACCOUNT FORM
CASH FLOW STATEMENT
For the year ended 31st December….
Inflow Rs. Outflow Rs.
Opening Balances - Redemption of Preference Shares -
Cash - Repayment of Debentures -
Bank - Purchase of Fixed Assets -
Issue of Shares - Repayment of Long Term Loans -
Issue of Debentures - Payment of Taxes -
Long Term Loans - Cash Lost in Operations
Sale of Fixed Assets - -
Dividends - Closing Balance
Cash from Operation - Cash Bank -
Illustration 1. After taking on to consideration the under mentioned items, Jain
Ltd, make a net profit of Rs.100000 for the year ended 31 st ended December 2015
Rs.
Loss on sale of machinery 10000
Depreciation on building 4000
Depreciation on machinery 5000
Preliminary expenses written off 5000
Provision of taxation 10000
Goodwill written off 5000
Gain on sale of buildings 8000
117
Additional information:
1. There were no drawings
2. There was no purchase or sale of either buildings or fixed assets.
Prepare cash flow statement
CASH FLOW STATEMNT
For the year ended 31 st December 2016
Rs. Rs.
Cash balance on 1st Jan 40000 Cash outflows:
Add : Cash inflows Addition to stock 5000
Decrease in debtors 3000 Decrease in accounts payable 4000
118
230000
ACCUMULATED DEPRECIATION A/C
Rs. Rs.
To fixed assets 30000 By balance b/d 60000
To balance c/d 40000 By profit & loss a/c 10000
70000 70000
120
Illustration 4 .
The comparative balance sheets of a company are given below
2015 2016 2015 2016
Rs. Rs. Rs. Rs.
Share capital 35000 37000 Cash 4500 3900
Debentures 6000 3000 Book debts 7450 8850
Creditors 5180 5920 Stocks 24600 21350
Provision for doubtful debts 350 400 Land 10000 15000
Profit and loss 5020 5280 Goodwill 5000 2500
51550 51600 51550 51600
.
121
Workings:
Cash from operations Rs.
Profit for 2015 5280
Profit for 2016 5020
Add: 260
Dividend 1750
Goodwill written off 2500
Decrease in stocks 3250
Increase in provision for doubtful debts 50
Increase in creditors 740
8550
Less: increase in creditors 1440
Cash from operation 7150
Illustration 5 :
From the following particulars prepare cash flow and fund flow statement of XYZ ltd
1st Jan 2015 31st Dec. 2016
Rs. Rs.
Cash 5000 4000
Debtors 40000 45000
Stock 30000 25000
Land 30000 40000
Buildings 50000 55000
Machinery 70000 80000
225000 249000
Current liabilities 35000 40000
Loan from ‘A’ 25000
Bank loan 40000 30000
Capital 150000 154000
225000 249000
During the year, XYZ brought an additional capital of Rs.10000 and his
drawings during the year were Rs.31000
Provision for depreciation on machinery: opening balance Rs.30000 and closing
balance Rs.44000
No depreciation need be provided for other assets
122
Solution
CASH FLOW STATEMENT
For the year ended 31 st December 2016
Rs. Rs.
Opening balance of cash 5000 Purchase of land 10000
Additional capital 10000 Purchase of buildings 5000
Decrease in stocks 5000 Purchase of machinery 20000
Increase in current liabilities 5000 Increase in debtors 5000
Repayment of bank loan 10000
Loan from ‘A’ 25000 Drawings 31000
Cash : operating profit 35000 Closing balance of cash 4000
85000 85000
Workings:
LAND ACCOUNT
Rs. Rs.
To balance b/d 30000 By balance c/d 40000
To cash purchase (balancing figure ) 10000
40000 40000
BUILDINGS ACCOUNT
Rs. Rs.
To balance b/d 50000 By balance c/d 55000
To cash purchase (balancing figure ) 5000
55000 55000
MACHINERY ACCOUNT
Rs. Rs.
To balance b/d 70000 By depreciation 10000
(Rs.40000 – Rs.30000)
To cash purchase (balancing figure ) 20000 By Balance c/d 80000
90000 90000
CAPITAL ACCOUNT
Rs. Rs.
To Cash (drawings ) 31000 By Balance b/d 150000
To balance c/d 154000 By cash (Addition) 10000
By Profit & loss (Profit) 25000
(Balancing figure)
185000 185 000
123
Illustration 6
From the following balance sheets you are required to prepare a cash flow
statement
Liabilities 2015 2016 assets
2015 2016
Rs. Rs. Rs. Rs.
Share capital 200000 250000 Cash 30000 47000
Trade creditors 70000 45000 Debtors 120000 115000
Profit & loss 10000 23000 Stocks 80000 90000
Land 50000 66000
280000 318000 280000 318000
124
Solution
CASH FLOW STATEMENT
For the year 2016
Cash inflow Rs. Cash outflow Rs.
Cash in hand (Jan 2007) 30000 Business operation (A) 17000
Issues of shares 50000 Purchase of land 16000
(Rs.250000 – Rs.200000) (Rs.66000 – Rs.50000)
Cash in hand (Dec. 2007) 47000
80000 80000
Workings:
(A)
Rs.
Profit (December 2016) 23000
Less: Profit (January 2016) 10000
Profit for 2016 13000
Add: decrease in debtors
(Rs.120000 – Rs.115000) 5000
Less: increase in stock 18000
(Rs.90000 – Rs.80000) 10000
Less: decrease in creditors
(Rs.70000 – Rs.45000) 25000 (-) 35000
Outflow of cash by operation 17000
8.4 REVISION POINTS
1. Cash flow statement deals with flow of cash which includes cash
equivalent as well as cash.
2. Cash flow statement is a summary of cash receipts and disbursements
during a certain period. Cash flow statement is prepared as per AS-3
3. There are two methods for preparing cash flow statement : (i) Direc t
method (ii) Indirect method.
4. Cash flow statement shows three categories of cash inflows and outflows
i.e. (i) Operating activities (ii) Investing activities (iii) Financing activities
5. Operating activities are the revenue generating activities of the enterprise.
6. Investing activities constitute the acquisition and disposal of long term
assets and other investments not included in cash and its equivalents.
7. Financing activities are activities that result in change in the size and
composition of the share capital and borrowings of the enterprise.
125
8.9 ASSIGNMENT
1. Describe the operating investing and financing activities of a firm in the
context of cash flow statement
2. Depreciation is a non cash expense. Still it is an integral part of cash
flow. Explain.
3. Describe in brief the procedure of determining cash flow from operating
activities as per indirect method of AS-3. Take an appropriate example
to illustrate your answer.
8.10 SUGGESTED READINGS
1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.
2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.
5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
8.11 LEARNING ACTIVITY
Collect the disclosed consecutive two years balance sheet for any one power
sector company from website prepare cash flow statement and evaluate the
performance.
8.12 KEY WORDS
Cash from operation, Operating activities , Investing activities , Financing
activities.
127
LESSON – 9
MARGINAL COSTING
Marginal costing – definition – distinguishing between marginal costing and
absorption-breakeven point analysis-graphical representation of breakeven
analysis- contribution-p/v ratio-margin of safety -decision making under marginal
costing –key factor analysis-make or buy decision-export decision –sales man
decision
9.1 INTRODUCTION
Marginal costing may be defined as the technique of presenting cost data
wherein variable costs and fixed costs are shown separately for managerial
decision-making. It should be clearly understood that marginal costing is not a
method of costing like process costing or job costing. Rather it is simply a method
or technique of the analysis of cost information for the guidance of management
which tries to find out an effect on profit due to changes in the volume of output.
9.2 OBJECTIVES
To understand the meanings of marginal cost and marginal costing
To distinguish between marginal costing and absorption costing
To ascertain income under both marginal costing and absorption costing
9.3 CONTENT
9.3.1 Need for Marginal Costing
9.3.2 Meaning and definition Marginal costing
9.3.3 Features of Marginal Costing
9.3.4 Advantages of Marginal Costing
9.3.5 Disadvantages of Marginal Costing
9.3.6 Marginal Costing versus Absorption Costing
9.3.1 NEED FOR MARGINAL COSTING
1. Variable cost per unit remains constant; any increase or decrease in
production changes the total cost of output.
2. Total fixed cost remains unchanged up to a certain level of production and
does not vary with increase or decrease in production. It means the fixed
cost remains constant in terms of total cost.
3. Fixed expenses exclude from the total cost in marginal costing technique
and provide us the same cost per unit up to a certain level of production.
9.3.2 MEANING AND DEFINITION MARGINAL COSTING
Marginal costing is formally defined as the accounting system in which variable
costs are charged to cost units and the fixed costs of the period are written-off in
full against the aggregate contribution. Its special value is in decision making.
The term ‘contribution’ mentioned in the formal definition is the term given to
the difference between Sales and Marginal cost. Thus marginal cost = variable cost
ie, direct labour + direct material + direct labour+variable overheads
128
4. Costs are classified on the basis of fixed and variable costs only. Semi-fixed
prices are also converted either as fixed cost or as variable cost.
5. Fixed cost is recovered from contribution and variable cost is charged to
production.
6. Fixed costs which remain constant regardless of the volume of production do
not find place in the product cost determin ation and inventory valuation.
7. Fixed costs are not considered for valuation of closing stock of finished
goods and closing WIP.
8. Marginal or variable costs such as direct material, direct labour and variable
factory overheads are treated as the cost of the product.
9. Under marginal costing, the value of finished goods and work in process is
also comprised only of marginal costs. Variable selling and distributions are
excluded for valuing these inventories.
10. Profitability of various levels of activity is determined by cost volume profit
analysis.
9.3.5 ADVANTAGES OF MARGINAL COSTING
Marginal costing are easy to operate and simple to understand.
Marginal costing is helpful to determine profitability at different level of
production and sale.
Fixed overhead recovery rate is easy
Break even analysis and P/V ratio are useful techniques of marginal costing.
The effects of alternative sales or production policies can be more readily
available and assessed, and decisions taken would yield the maximum return to
business.
Evaluation of different departments is possible through marginal costing
technique.
Marginal costing is useful to various levels of management. It is useful in
decision making about fixation of selling price, export decision and make or buy
decision
As fixed cost is not controllable in short period, it helps to concentrate in
control over variable cost.
9.3.6 DISADVANTAGES
Marginal cost has its limitation since it makes use of historical data
while decisions by management relates to future events.
The separation of costs into fixed and variable is difficult and sometimes
gives misleading results.
It ignores fixed costs to products as if they are not important to
production.
It fails to recognize that in the long run, fixed costs may become
variable.
130
ADD xx
Sales 25,00,000
15,50,000
Contribution 9,50,000
7,50,000
Marginal Costing versus Absorption Costing
After knowing the two techniques of marginal costing and absorption costing,
we have seen that the net profits are not the same because of the following reasons:
1. Over and Under Absorbed Overheads
In absorption costing, fixed overheads can never be absorbed exactly because
of difficulty in forecasting costs and volume of output. If these balances of under or
over absorbed/recovery are not written off to costing profit and loss account, the
actual amount incurred is not shown in it. In marginal costing, however, the actual
fixed overhead incurred is wholly charged against contribution and hence, there
will be some difference in net profits.
2. Difference in Stock Valuation
In marginal costing, work in progress and finished stocks are valued at
marginal cost, but in absorption costing, they are valued at total production cost.
Hence, profit will differ as different amounts of fixed overheads are considered in
two accounts.
The profit difference due to difference in stock valuation is summarized as follows:
a. When there is no opening and closing stocks, there will be no difference in
profit.
b. When opening and closing stocks are same, there will be no difference in
profit, provided the fixed cost element in opening and closing stocks are of
the same amount.
c. When closing stock is more than opening stock, the profit under
absorption costing will be higher as comparatively a greater portion of fixed
cost is included in closing stock and carried over to next period.
133
d. When closing stock is less than opening stock, the profit under absorption
costing will be less as comparatively a higher amount of fixed cost
contained in opening stock is debited during the current period.
The features which distinguish marginal costing from absorption costing are as follows.
The main use of marginal costing are to help with short-term decision-making
in the forms of break-even analysis, margin of safety, target profit, contribution
sales ratio, limiting factors and special order pricing whereas the use of absorption
costing are to calculate profit and to calculate inventory valuation for financial
statements.
In marginal costing costs are classified as either fixed or variable and
contribution to fixed costs is calculated as selling price less variable costs whereas
in absorption costing overheads are charged to output through an overhead
absorption rate, often on the basis of direct labour hours or machine hours
Main focus of Marginal costing is marginal cost and contribution whereas
absorption costing focusses in all overheads charged to output, calculating profit
and calculating inventory values
The usefulness of Marginal costing are concept of contribution is easy to
understand and useful for short-term decision-making, but no consideration of
overheads whereas Absorption costing is acceptable under IAS 2, Inventories
appropriate for traditional industries where overheads are charged to output on the
basis of direct labour hours or machine hours
The limitations of Marginal costing are costs have to be identified as either fixed
or variable, all overheads have to be recovered, otherwise a loss will be made, not
acceptable under IAS 2, Inventories and calculation of selling prices may be less
accurate than other costing methods whereas the limitations of absorption costing
are not as useful in short-term decision-making as marginal costing and may
provide less accurate basis for calculation of selling prices where overheads are
high and complex in nature
Illustration 1
A manufacturing company XYZ produces and sells a product and the following
information is derived from the company. Prepare profit statements using the
marginal costing and absorption costing methods.
number of product manufactured 5,000
number of product sold 4,500
selling price Rs.110 per product
direct materials Rs.30 per product
direct labour Rs.40 per product
fixed production overheads Rs.1,00,000
134
Solution
XYZ Limited
Statement of profit or loss for the year ended 31 December 2015
Marginal costing Absorption costing
Variable costs
3,50,000
3,15,000
4,50,000
9.9 ASSIGNMENT
1.Give a comparative description of absorption costing and marginal costing.
9.10 SUGGESTED READINGS
1. P.Das Gupta: Studies in Cost Accounting, Sultan Chand & Sons, New
Delhi.
2. Jain &Narang: Advanced Cost Accounting, Kalyani Publishers.
3. Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4. S.N.Maheswari: Management Accounting And Financial Control, Sultan
Chand & Sons.
5. V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.
9.11 LEARNING ACTIVITIES
1. From the following particulars, prepare cost statement under
a. Absorption costing
b. Marginal costing
No of units produced 20000
Cost per unit: materialsRs.10
Procutive labour 6
Factory OH 4(50% fixed)
Administrative OH 3(60% fixed)
Selling OH 2 (100% variable on units sold)
No of units sold 19000
Selling price per unit Rs.40
9.12 KEY WORDS
Marginal costing, absorption costing, variable costing, fixed costing.
137
LESSON –10
MARGINAL COSTING – COST VOLUME PROFIT ANALYSIS
10.1 INTRODUCTION
Cost Volume Profit Analysis is used to measure inter relationship between
costs, volume and profit at various level of activity. Cost Volume Profit Analysis (C V
P) is a systematic method of examining the relationship between changes in the
volume of output and changes in total sales revenue, expenses (costs) and net
profit. In other words. it is the analysis of the relationship existing amongst costs,
sales revenues, output and the resultant profit.
10.2 OBJECTIVES
To understand the contribution, profit volume analysis break even point.
This lesson help to solve some problems of cost volume analysis.
10.3 CONTENT
Some solved problems on the topic of P/V ratio, break even point sales etc.,
Illustration 2
Find the profit from the following data
Rs.
Sales 160,000
Marginal cost 120,000
Break- even point 120,000
Solution
P/V ratio = (sales – variable cost)/sales x 100
= (160,000 – 120,000)/160,000 x 100
= 25%
B.E.P = Fixed cost / P/V ratio
60,000 = fixed cost / 25%
139
Illustration 3
From the following particulars calculate the break even point
Rs.
Variable cost per unit 12
Fixed expenses 60,000
Selling price per unit 18
Solution
B.E.P (in units 0 = fixed cost / contribution per unit
(Selling price variable cost = contribution)
(Rs.18 – Rs.12 = 6)
Rs.60,000 / Rs. 6 = 10,000 units
B.E.P sales = 10,000 x Rs.18 = Rs.1,80,000
Illustration 4
A company estimates that next year it will earn a profit of Rs.,100,000. The
budgeted fixed costs and sales are Rs.2,50,000 and 9,93,000 respectively. Find out
the break even point for the company
Solution
B.E.P = F X S / contribution
Contribution = S – V = F + P
F+P = Rs.2,50,000 + Rs.100,000 = Rs.3,50,000
B.E.P sales = 2,5,0,000 x 9,93,000 / 3,50,000
, = Rs.709286
Illustration 5
From the following particulars, find out the selling price per unit if B.E.P is to
be brought down to 9,000 units
Rs.
Solution
Let us assume that the contribution per unit at B.E sales of 9,000 is x.
B.E.P = Fixed cost / contribution per unit
Contribution per unit is not known. Therefore
9000 units = 2,70,000 / x
9000 x = 2,70,000
X = 30
Contribution is Rs.30 per unit, in place of Rs.25. therefore, the selling price
should be Rs.105 i.e Rs.75 + Rs.30
Illustration 6
From the following data, calculate break even point expressed in terms of units
and also the new B.E.P, if selling price is reduced by 10%
Rs.
Fixed expenses
Depreciation 2,00,000
Salaries 2,00,000
Variable expenses
Materials 3 per unit
Labour 2 per unit
Selling price 15 per unit
Solution
B.E.P = Fixed cost / contribution per unit
= 4,00,000 / 10 = 40,000 units.
When the selling price is reduced by 10% selling price becomes Rs.15-1.50 =
Rs.13.50 per unit. So, contribution = Rs.13.50 – Rs.5 = Rs.8.50
B.E.P = Fixed cost / contribution per unit
= 4,00,000 / 8.50 = 47059 units
Illustration 7
From the following information, find out the amount of profit earned during the
year using marginal costing technique
Fixed cost Rs,6,00,000
Variable cost Rs.10 per unit
Selling price Rs.15 per unit
Output level 2,00,000 units
Solution
141
Illustration 8
Fixed overhead Rs.2,40,000
Variable overhead Rs.4,00,000
Direct wages Rs.3,00,000
Direct materials Rs.8,00,000
Sales Rs.20,00,000
Calculate the break even point and P/V ratio
Solution
Statement showing contribution
Rs. Rs.
Sales 20,00,000
Contribution 5,00,000
Solution
P/V ratio = contribution / sales x 100 = (Rs.6000 – Rs.4800)x 100 / Rs.3000
= 40 %
Illustration 10
The sales turnover and profits during two periods are as under:
Period I : sales Rs.20 lakhs; profit Rs.2 lakhs
Period II : sales Rs.30 lakhs; profit Rs.4 lakhs
Calculate P/V ratio
Solution:
P/V ratio = change in profit /change in sales x 100
= (Rs.4,00,000 – Rs.2,00,000 x 100)/ (Rs.30,00,000 -Rs.20,00,000)
= 2,00,000/10,00,000 x 100
= 20%
Illustration 11
The following date are obtained from the records of a company
First year second year
Rs. Rs.
Sales 80,000 100,000
Solution
Contribution per unit = selling price – marginal cost
= Rs.10 – Rs.8 = Rs.2
P/V ratio = contribution / sales x 100
= 2/10 x 100 = 20%
= 40
= Rs.50,000
3. Margin of safety = profit / P/V ratio
= 20,000 / 40%
= 20,000 x 100 / 40
= Rs.50,000
Or
= 1,00,000 – 50,000
= Rs.50,000
144
Illustration 14
The following information was obtained from a company in a certain year
Rs.
Sales 1,00,000
Find the P/V ratio, break even point and margin of safety.
Solution
(profit) as changes occur in the output level, selling price, variable cost per unit,
and/or fixed costs of a product or service. The reliability of the results from CVP
analysis depends on the reasonableness of the assumptions.
10.7 TERMINAL QUESTION
1. Marginal costs is taken as equal to
a) Prime Cost plus all variable overheads
b) Prime Cost minus all variable overheads
c) Variable overheads
d) None of the above
ANSWER: a)
2. If total cost of 100 units is Rs 5000 and those of 101 units is Rs 5030
then increase of Rs 30 in total cost is
a) Marginal cost
b) Prime cost
c) All variable overheads
d) None of the above
ANSWER: a)
3. Marginal cost is computed as
a) Prime cost + All Variable overheads
b) Direct material + Direct labor + Direct Expenses + All variable
overheads
c) Total costs – All fixed overheads
d) All of the above
ANSWER: a)
4. Marginal costing is also known as
a) Direct costing
b) Variable costing
c) Both a and b
d) None of the above
ANSWER: c) Both a and b
5. Which of the following statements are true?
A) Marginal costing is not an independent system of costing.
B) In marginal costing all elements of cost are divided into fixed and
variable components.
C) In marginal costing fixed costs are treated as product cost.
D) Marginal costing is not a technique of cost analysis.
a) A and B
b) B and C
c) A and D
d) B and D
ANSWER: a)
146
3. Cost, volume and profit relationship can be studied, and they are very
useful to the managerial decision making.
4. Inter firm comparison is possible
5. It is useful for forecasting plans and profits.
6. The best products mix can be selected.
7. Total profits can be calculated
8. Profitability of different levels of activity, various products or profits ie.
plans can be known.
9. It is helpful for cost control.
11.3.3 LIMITATIONS OF BREAK EVEN CHART
1. Accurate classification of cost into fixed and variable is not possible.
2. Constant selling price is not true
3. Detailed information cannot be shown in the chart form.
4. No importance is given to opening and closing stocks.
5. Cost, volume and profit relation can be known, capital amount, market
aspects, effect of government policy etc., which are important for decision
making cannot be considered from break even chart.
Illustration 1
You are given the following data for the costing year of a factory
Budget output 200000 units
Fixed expenses Rs.500000
Variable expenses Rs.5 per unit
Selling price Rs.20 per unit
Draw a break even chart showing the break even point. If the selling price is
reduced to Rs.9 per unit, what will be the new break even point
Solution
B.E.P = F.C / S-V
= 500000/5
= 100000 Units
B.E.S = 100000 X Rs.10
= Rs. 1000000
If selling price is reduced to Rs.9, then the contribution will be Rs.4
The new B.E.P = 500000/4
= 125000 units
B.E.S = 125000 X Rs.9
= Rs.1125000
149
20
PROFIT
LE
SA
S
LE
SA
COST AND SALES (IN LAKHS OF RUPEES)
15
T
OS
Rs. 11,25,000
LC
TA
TO
Rs. 10,00,000
VARIABLE COST
10 NEW B.E.P
5
SS
LO
FIXED COST
0 25 50 75 100
Illustration 2
A company budgeted for the year 2016, sales Rs.1000000 (selling price being
Rs.40 per unit), fixed costs Rs.360000 and variable costs Rs.520000. find out break
even point a. taking into consideration the budgeted figure and b. assuming 10%
increase in fixed costs. Also draw a break even chart.
Solution
a. B.E.P (Budgeted figures) = fixed cost x sales / contribution
= 360000 x 1000000 / 480000
= Rs.750000
= Rs. 825000
10
b.BEP (Rs .825000)
9
8 INE
L
ST
COST AND REVENUE (IN LAKHS OF RUPEES)
6 INE
TL
COS
AL
OT
5 a.T b.FIXED COST LINE
0 1 2 3 4 5 6 7 8 9 10
Illustration 3
A company produces 100000 units of an article and sells them at the rate of
Rs.5 each. The marginal cost per unit is 60% of the selling price and total fixed
costs of the concern are Rs.100000.
Draw a break even chart showing a. break even point, b. margin of safety
Solution
Computation of BEP
a. BEP = fixed cost x sales / contribution
= 100000 x 500000 / 200000
5 E
LIN
INE
TL
LE
4 S
SA
CO
TAL
a. TO
3 BEP b.
MARGIN OF SAFETY
2
FIXED COST LINE
1
0 1 2 3 4 5
illustration
The following figures relate to a particular year working at 100% capacity level
in a manufacturing concern
Rs.
fixed overheads 1,20,000
variable overheads 2,00,000
direct wages 1,50,000
direct materials 4,10,000
sales 10,00,000
represent the above figures on the break even chart and determine from the
chart the break even point. Verify your results by calculations
solution :
sales 10,00,000
less : variable cost 7,60,000
contribution 2,40,000
fixed cost 1,20,000
profit 1,20,000
10,00,000
10
E
IN
SL
IT
OF
LE
PR
8
SA
COST AND SALES (IN LAKHS OF RUPEES)
B.E.P E AD
RH
OVE
6 LE
IAB
V AR
DIRECT WAGES
4 DIRECT MATERIAL
FIXED COST
2
0 2 4 6 8 10
Illustration 4
The following are the budgeted data of a company
Rs
Sales 1200000
Variable costs 600000
= 900000
Rs.1080000
12 New Total cost
COST AND REVENUE (IN LAKHS OF RUPEES)
8
i. BEP (Rs.720000)
6
0 2 4 6 8 10 12
2.from the following data ,compute the break even point by means of a break even
chart:
Selling price per unit Rs 2.50
Variable cost per unit Rs 2.00
Total fixed costs Rs 20,000.
11.6 SUMMARY
The cost analysis approach to decision making is used when the decisions
affect costs and revenues and, hence, profit. A break-even chart is a graphical
presentation which indicates the relationship between cost, sales and profit. The
chart depicts fixed costs, variable cost, break-even point, profit or loss, margin of
safety and the angle of incidence. Such a chart not only indicates break-even point
but also shows the estimated cost and estimated profit or loss at various level of
activity. Break-even point is an important stage in the break-even chart which
represents no profit no loss.
11.7 TERMINAL EXERCISE
Fill in the blanks
1. In break even chart , X axis represents _________
Ans: volume of production or sales.
2. In break even chart , Y axis represents _________
Ans: cost and revenue in rupee value.
3.In profit / volume chart, break even point takes place where________ line
and______
155
LESSON – 12
APPLICATION OF MARGINAL COSTING TECHNIQUES
12.1 INTRODUCTION
Marginal costing helps the management in decision making in respect of the
following vital areas:
Selection of a profitable product mix
Profit planning
Make or buy decision
Decision to accept or reject a bulk order
Introduction of a new product
Choice of technique
Key factors
Application of marginal costing techniques with rele vant illustrations
Illustration 1
P/V ratio is 60% and the marginal cost of the product is Rs.50. what will be the
selling price?
Solution
Selling price = variable cost / (100-P/V ratio) = Rs.50/ (100-60%)
= 50 x 100 / 40 = Rs.125
Verification P/V ratio = contribution / sales x 100 = (S-V)/S x 100
= (Rs.125 – 50)/125 x 100 = 75/125 x 100 = 60%
Illustration 2
From the following data, calculate
1. P/V ratio
2. Profit when sales are Rs.30,000
3. New break even point if selling price is reduced by 20%
Fixed expenses Rs.4000
Break even point Rs.10,000
Solution
1. Break even sales = fixed expenses/ P/V ratio
P/V ratio = fixed expenses / break even sales
= 4000 /10000 x 100 = 40%
2. When sales are Rs.20000, the profit is
= sales x P/V ratio – fixed expenses
157
Thus the selling price is reduced by 20%, the volume of sales will have to be increased by
60%
Illustration 4
A company produces and sells 100 units of A per month at Rs,20. Marginal
cost per unit is Rs.12 and fixed costs are Rs.400 per month. It is proposed to
reduce the selling price by 20% . Find the additional sales required to earn the same
profit as before.
Solution
Present profit Rs.
Sale price of 100 units @ Rs.20 2000
Less: marginal cost of 100 units (100 x Rs.12) 1200
Contribution 800
Less : fixed cost 400
Net profit 400
At reduced price, to earn the same amount of profit, the sales required is
= (fixed cost + desired profit) / contribution
= (400 +500) / (16 – 12)
= 225 units
Additional units = 125
12.2 OBJECTIVES
To understand the decision making in respect profit planning, product mix,
make or buy, key factors.
12.3 CONTENT
12.3.1 Product mix
12.3.2 Profit planning
12.3.3 Decision to make or buy
12.3.4 Key factors
12.3.1 PRODUCT MIX
One of the more common decision-making problems is a situation where there
are not enough resources to meet the potentials a lesdemand, and so a decision has
to be made about what mix of products to produce, using what resources there
areas effectively as possible. A limiting factor could be sales if there is a limit to
sales demand but any one of the organization's Resources (labor, materials and
soon) may be insufficient to meet the level of production demanded. It is assumed
in limiting factor accounting that management wishes to maximize profit and that
159
I II III
Total sales (1000 x 20 + (1500x20 + 1500 x15) (2000x20+1000 x 15)
2000 x 15) = 50000 = 52500 = 55000
Less. Marginal cost (1000 x 16 + 2000 x 13) (1500x16+1500 x 13) (2000x16+1000 x 13)
= 42000 = 43500 = 45000
contribution 8000 9000 10000
Less : fixed costs 800 800 800
profit 7200 8200 9200
Therefore , sales mixture III will give the highest profit and as such, mixture III
can be adopted.
12.3.2 PROFIT PLANNING
A business concern exists with the objective of making profits, and profits are
the yardstick of its success. Profit planning is therefore a part of operations
planning. It is the basis of planning cash, capital expenditure, and pricing.
If growth and survival of a business are to be ensured, planning becomes an
absolute necessity. Marginal costing assists profit planning through computation of
contribution ratio.
It enables planning of future operations in such a way as to either maximize
profits or maintain specified levels of profits. Normally, profits are affected by
several factors such as the volume of sales, marginal cost per unit, total fixed costs,
selling price, sales mix, etc. Hence, management can achieve their profit goals by
varying one or more of the above variables.
161
Illustration 7
The Delhi Mixy Co. manufactured and sold 1000 mixies last year at a price of
Rs.800 each, the cost structure of a mixy is as follows
Rs.
Materials 200
Labour 100
Variable cost 50
Marginal cost 350
Factory overhead (fixed ) 200
Total cost 550
Profit 250
Sales price 800
Due to heavy competition, price has to be reduced to Rs.750 for the coming
year. Assuming no change in costs, state the number of mixies that would have to
be sold at the new price to ensure the same amount of total profits as that of the
last year.
Solution
Profit for 1000 mixies = 100 x 250 = rs.250000
Contribution at the price of Rs.750 = 750 – 350 = Rs.400
P/V ratio = contribution per unit / sales price per unit = 400 / 750
Sales required at Rs.750 per mixy to earn a profit of Rs,250000 \
= (fired cost + profit)/ P/V ratio
= (200000 + 250000) / 400/750 = Rs. 843750
= sales in units = 843750 / 750 = 1125 mixies
Or (F.C + profit ) / contribution per unit
= 20000 + 250000 / 400
= 1125 mixies
12.3.3 DECISION TO MAKE OR BUY
The make-or-buy decision is the act of making a strategic choice between
producing an item internally (in-house) or buying it externally (from an outside
supplier). The buy side of the decision also is referred to as outsourcing. Make -or-
buy decisions usually arise when a firm that has developed a product or part—or
significantly modified a product or part—is having trouble with current suppliers,
or has diminishing capacity or changing demand.
Factors that may influence firms to make a product ( suggest these
considerations that favor making a part in -house)
Cost considerations (less expensive to make the part)
Desire to integrate plant operations
Productive use of excess plant capacity to help absorb fixed overhead
(using existing idle capacity)
162
Solution
year Differential Differential loss in Total loss
operating costs scrap value (differential)
Rs. Rs. Rs.
2 20000 50000 70000
3 30000 20000 50000
4 30000 30000 60000
5 40000 20000 60000
The above table shows that in case the machine is replaced at the end of third
year the total loss is minimum at Rs.50000. hence, the machine should be replaced
at the end of the third year.
12.3.4 KEY FACTORS
A key factor is defined as the factor in the activities of an undertaking which, at
a particular point of time or over a period, will limit the volume of output. . If a
factor of production is in short su pply, then the best-paying product becomes that
which yields the highest contribution per unit of limiting factor. Profitability=
Contribution/
Key Factor
Thus, Contribution per unit of key factor may be ascertained & maximized
according to priority (ranking). Some examples of key factors are:
a. Materials-Scarce Raw Material; Restrictions by licenses, etc.
b. Labour-General Shortage; Shortage of a particular type of labour.
c. Plant-Imbalance; Insufficient capacity due to shortage of capital, supply, etc.
d. Management-Shortage of efficient staff; policy decisions.
e. Capital-Shortage of capital; insufficient research activity
f. Sales-Market demand; insufficient advertisement.
12.4 REVISION POINT
Profit planning
Profit planning is the planning of future operations to attain maximum profit.
Under the technique of marginal costing, the contribution ratio, i.e., the ratio of
marginal contribution to sales, indicates the relative profitability of the different
products of the business whenever there is any change in volume of sales, marginal
cost per unit, total fixed costs, selling price, and sales-mix etc.
Hence marginal costing is an useful tool in planning profits as it ensures
sufficient return on capital employed.
Pricing of Products:
Sometimes pricing decisions have to be taken to cater to a recessionary market
or to utilise spare capacity where only marginal cost is recovered. For export
market, sometimes full cost is loaded to the sale price to remain competitive.
Sometimes special prices are to be offered with expansion in mind, fixation of price
below cost can be made on a short-term basis.
164
product mix
The most-profitable product mix can be determined by applying marginal
costing technique. Fixed cost remaining constant, the most profitable product-mix
is determined on the basis of contribution only. That product-mix which gives
maximum contribution is to be considered as best product mix.
Key factor
A key factor is a factor which limits the volume of production and profit of
business. It may be scarcity of any factor of production such as material labour,
capital, plant capacity etc. Usually, when there is no key or limiting factor, the
product is selected on the basis of highest P/V ratio of the product. But with key
factor the selection of product will be on the basis of contribution per unit of
limiting/key factor of production.
Make-or-Buy Decision:
A company may have idle capacity which may be utilised for making a
component or a product, instead of buying them from outside sources. In taking
such ‘make-or-buy’ decision, a comparison should be made between the variable (or
marginal) cost of manufacture of the product and the supplier’s price for it.
12.5 INTEXT QUESTION
1. Mention any four important factors to be considered in Marginal Costing
Decisions.
2. State the non cost factor to be considered in make or buy decision.
12.6 SUMMARY
Resources (labor, materials and so on) may be insufficient to meet the level of
production demanded. It is assumed in limiting factor accounting that management
wishes to maximize profit and that profit will be maximized when contribution is
maximized (given no change in fixed cost expenditure incurred). In other words,
marginal costing ideas are applied. Contribution will be maximized by earning the
biggest possible contribution from each unit of Limiting factor. If growth and
survival of a business are to be ensured, planning becomes an absolute necessity.
Marginal costing assists profit planning through computation of contribution ratio.
The make-or-buy decision is the act of making a strategic choice between producing
an item internally (in-house) or buying it externally (from an outside supplier). The
buy side of the decision also is referred to as outsourcing.
12.7 TERMINAL EXERCISES
1. Make or buy decisions are made by comparing _________________ cost
with outside purchase price
Ans: variable
2. Key factor is taken into consideration to judge the _____________ of
different products whenever there is any shortage.
Ans : profitability
3. The system most useful for making decisions of the make or buy and
similar other ones is called _______________ costing
Ans : marginal
165
solution
profitability statement
product A Product B
(per unit) (per unit)
Rs. Rs.
Selling price 1000 1000
Less: marginal cost
Materials 200 150
Wages 100 200
Variable overhead 150 450 200 550
Contribution 550 450
Less: fixed cost 350 100
Profit 200 350
Total profit (200 x 200) 40000 (100x350) 35000
P/V ratio = contribution per unit / selling price per unit x 100
Contribution per unit and total profit is higher in case of product A though
profit per unit of product B is higher. If output is the key factor, then product A is
better. On the other hand, if there is no limit to output, then product B wou ld be
more profitable.
12.12 KEY WORDS
Product mix, make or buy, key factor,
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LESSON 13
INTRODUCTION TO BUDGET
13.1 INTRODUCTION
To achieve the organizational objectives, an enterprise should be managed
effectively and efficiently. It is facilitated by chalking out the course of action in
advance. Planning, the primary function of management helps to chalk out the
course of actions in advance. But planning has to be followed by continuous
comparison of the actual performance with the planned performance, i. e.,
controlling. One systematic approach in effective follow up process is budgeting.
Different budgets are prepared by the enterprise for different purposes. Thus,
budgeting is an integral part of management.
In the business world, a budget is a statement showing the expected income
and expenditure for a specific future period. Thus, budgeting is required
everywhere in national, domestic and business affairs.
13.2 OBJECTIVES
After completing this Lesson you should be able to Know
Meaning of Budget
Meaning of budgeting
Important elements of Budgeting
13.3 CONTENT
13.3.1 Definition of Budget
13.3.2 Elements of Budgets
13.3.3 Characteristics of a Budget
13.3.4 Budgeting
13.3.5 Elements of Budgeting
13.3.1 DEFINITION OF BUDGET
Budget is a systematic plan for utilization of all types of resources, at its
command. It acts as a barometer of a business as it measures the success from
time to time, against the standard set for achievement.
‘A budget is a comprehensive and coordinated plan, expressed in financial
terms, for the operations and resources of an enterprise for some specific period in
the future’. (Fremgen, James M – Accounting for Managerial Analysis)
‘A budget is a predetermined detailed plan of action developed and distributed
as a guide to current operations and as a partial basis for the subsequent
evaluation of performance’. (Gordon and Shillinglaw)
‘A budget is a financial and/or quantitative statement, prepared prior to a
defined period of time, of the policy to be pursued during the period for the purpose
of attaining a given objective’. (The Chartered Institute of Management
Accountants, London)
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LESSON 14
BUDGETARY CONTROL
14.1 INTRODUCTION
The Budgetary control has now Became an essential e tool of the
management for controlling costs and maximizing profit. Cost can be reduced,
Wastage can be prevented and proper relationship between costs and income can
be established only when the various factors of production are combined in
profitable way. The resources of a Business effectively utilized by efficient conduct
of its operations. This requires careful working out of proper plans in advance, co-
ordination and control of activities on the part of the management.
14.2 OBJECTIVES
After completing this Lesson you should be able to know
Meaning of Budgetary Control
Requirement of sound Budgeting system
Installation of Budgetary control System
14.3 CONTENT
14.3.1 Definition of Budgetary Control
14.3.2 Elements of Budgetary Control
14.3.3 Budget, Budgeting and Budgetary Control
14.3.4 Requirement of Sound Budgetary System
14.3.5 Objectives of Budgetary Control
14.3.6 Installation of Budgetary Control System
14.3.7 Essentials of Effective Budgeting
14.3.8 Standard Costing VS Budgetary Control
14.3.1 DEFINITION OF BUDGETARY CONTROL
Budgetary Control as, “the establishment of the budgets relating to the
responsibility of executives to the requirements of a policy and the continuous
comparison of actual with budgeted result either to secure by individual action the
objectives of that policy or to provide a firm basis for its revision” - CIMA, London
‘Budgetary Control is a planning in advance of the various functions of a
business so that the business as a whole is controlled’. (W heldon)
‘Budgetary Control is a system of controlling costs which includes the
preparation of budgets, coordinating the department and establishing
responsibilities, comprising actual performance with the budgeted and acting upon
results to achieve maximum profitability’. (Brown and Howard)
14.3.2 ELEMENTS OF BUDGETARY CONTROL
1. Establishment of budgets for each function and division of the
organization.
2. Regular comparison of the actual performance with the budget to know
the variations from budget and placing the responsibility of executives to
achieve the desired result as estimated in the budget.
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1.Determination of Objectives
It is very clear that the installation of a budgetary control system presupposes
the determination of objectives sought to be achieved by the organization in clear
terms.
2.Organization for Budgeting
Having determined the objectives clearly, proper organization is essential for
the successful preparation, maintenance and administration of budgets. The
responsibility of each executive must be clearly defined. There should be no
uncertainty regarding the jurisdiction of executives.
3.Budget Centre
It is that part of the organization for which the budget is prepared. It may be a
department or any other part of the department. It is essential for the appraisal of
performance of different departments so as to make them responsible for their
budgets.
4.Budget Officer
A Budget Officer is a convener of the budget committee. He coordinates the
budgets of various departments. The managers of different departments are made
responsible for their department’s performance.
5.Budget Manual
It is a document which defines the objectives of budgetary control system. It
spells out the duties and responsibilities of budget officers regarding the
preparation and execution of budgets. It also specifies the relations among various
functionaries.
6.Budget Committee
The heads of all important departments are made members of this committee.
It is responsible for preparation and execution of budgets. The members of this
committee may sometimes take collective decisions, if necessary. In small concerns,
the accountant is made responsible for the same work.
7.Budget Period
It is the period for which a budget is prepared. It depends upon a number of
factors. It may be different for different concerns/functions.
The following are the factors that may be taken into consideration while
determining budget period:
a. The type of budget,
b. The nature of demand for the products,
c. The availability of finance,
d. The economic situation of the cycle and
e. The length of trade cycle
8.Determination of Key Factor
Generally, the budgets are prepared for all functional areas of the business.
They are inter related and inter dependent. Therefore, a proper coordination is
necessary. There may be many factors that influence the preparation of a budget.
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For example, plant capacity, demand position, availability of raw materials, etc.
Some factors may have an impact on other budgets also. A factor which influences
all other budgets is known as Key factor.
The key factor may not remain the same. Therefore, the organization must pay
due attention on the key factor in the preparation and execution of budgets.
14.3.7 ESSENTIALS OF EFFECTIVE BUDGETING
A budgetary control system can prove successful only when certain
conditions and attitudes exist, absence of which will negate to a large extent the
value of a budget system in any business. Such conditions and attitudes which are
essential for effective budgeting are as follows:
Support of Top Management: If the budget system is to be successful, it must
be fully supported by every member of the management and the impetus and
direction must come from the very top management. No control system can be
effective unless the organisation is convinced that the top management considers
the system to be import.
Participation by Responsible Executives: Those entrusted with the
performance of the budgets should participate in the process of setting the budget
figures. This will ensure proper implementation of budget programmes.
Reasonable Goals: The budget figures should be realistic and represent
reasonably attainable goals. The responsible executives should agree that the
budget goals are reasonable and attainable.
Clearly Defined Organisation: In order to derive maximum benefits from the
budget system, well defined responsibility centers should be built up within the
organization. The controllable costs for each responsibility centers should be
separately shown.
Continuous Budget Education: The best way to ensure the active interest of
the responsible supervisors is continuous budget education in respect of objectives,
potentials & techniques of budgeting. This may be accomplished through written
manuals, meetings etc., whereby preparation of budgets, actual results achieved
etc., may be discussed.
Adequate Accounting System: There is close relationship between budgeting
and accounting. For the preparation of budgets, one has to depend on the
accounting department for reliable historical data which primarily forms the basis
for many estimates. The accounting syste m should be so designed so as to set up
accounts in terms of areas of managerial responsibility. In other words,
responsibility accounting is essential for successful budgetary control.
Constant Vigilance: Reports comparing budget and actual results should be
promptly prepared and special attention focused on significant exceptions i.e.
figures that are significantly different from those expected.
Maximum Profit: The ultimate object of realizing the maximum profit should
always be kept uppermost.
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Cost of the System: The budget system should not cost more than it is worth.
Since it is not practicable to calculate exactly what a budget system is worth, it only
implies a caution against adding expensive refinements unless their value clearly
justifies them.
Integration with Standard Costing System: Where standard costing system
is also used, it should be completely integrated with the budget programme, in
respect of both budget preparation and variance analysis.
14.3.8 STANDARD COSTING VS. BUDGETARY CONTROL
Standard costing and budgetary control have the common objective of cost
control by establishing pre-determined targets. The actual performances are
measured and compared with the pre-determined targets for control purposes. Both
the techniques are of importance in their respective fields and are complementary
to each other.
Points of Similarity:
There are certain basic principles which are common to both standard
costing and budgetary control. These are:
1. The establishment of pre-determined targets of performance
2. The measurement of actual performance
3. The comparison of actual performance with the pre -determined targets.
4. The analysis of variances between the actual and the standard
performance
5. To take corrective measures, where necessary.
Points of Difference:
In spite of so much similarity between standard costing and budgetary
control, there are some important differences between the two, which are as follows:
Standard Costing Budgetary Control
Scope Standard costs are developed Budgets are compiled functions
mainly for the manufacturing of the business such as sales,
function and sometimes also for purchase, production, cash,
making and administration capital expenditure, research &
functions development, etc.,
Intensity Standard costing is intensive in Budgetary control is extensive
application as it calls for in nature and the intensity of
detailed analysis of variances analysis tends to be much less
than that in standard costing.
Relation to In standard costing, variances In budgetary control, variances
accounts are usually revealed through are normally not revealed
accounts through accounts and control is
exercised by statistically putting
budgets and actual side by side.
Usefulness Standard costs represent Budgets usually represent an
realistic yardsticks and, are upper limit on spending without
therefore, more useful for considering the effectiveness of
controlling and reducing costs. the expenditure in terms for
output.
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LESSON 15
TYPES OF BUDGETS
15.1 INTRODUCTION
The budgets are classified according to their nature. The budge ts may be
classified according to function, flexibility, time. Functional budget is one which
relates to a function of the business. Flexible budget is one which is designed to
change in relation to the level of activity attained. On the basis of time, the budget
can be classified as Long term budget, Short term budget ,Current budget ,Rolling
budget .
15.2 OBJECTIVES
After completing this Lesson you should be able to know
Classification of Budgets according to Function, Flexibility and Time
Preparation of different types of Budgets
Advantages and Disadvantages of Budgetary Control
15.3 CONTENT
15.3.1 Types/Classification of Budget
15.3.2 According to Function
15.3.3 Classification according to Flexibility
15.3.4 Classification according to Time
15.3.5 Advantages of Budgetary Control
15.3.6 Limitations of Budgetary Control
15.3.7 Preparation of Budgets
15.3.1 TYPES/CLASSIFICATION OF BUDGETS
Budget can be classified into three categories from different points of view.
They are:
1. According to Function
2. According to Flexibility
3. According to Time
15.3.2 ACCORDING TO FUNCTION
Sales Budget
The budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget.
Production Budget
It estimates quantity of production in terms of items, periods, areas, etc. It is
prepared on the basis of Sales Budget.
Cost of Production Budget
This budget forecasts the cost of production. Separate budgets may also be
prepared for each element of costs such as direct materials bu dgets, direct labour
budget, factory materials budgets, office overheads budget, selling and distribution
overheads budget, etc.
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Purchase Budget
This budget forecasts the quantity and value of purchase required for
production. It gives quantity wise, money wise and period wise particulars about
the materials to be purchased.
Personnel Budget
The budget that anticipates the quantity of personnel required during a
period for production activity is known as Personnel Budget
Research Budget
This budget relates to the research work to be done for improvement in
quality of the products or research for new products.
Capital Expenditure Budget
This budget provides a guidance regarding the amount of capital that may
be required for procurement of capital assets during the budget period.
Cash Budget
This budget is a forecast of the cash position by time period for a specific
duration of time. It states the estimated amount of cash receipts and estimation of
cash payments and the likely balance of cash in hand at the end of different
periods.
Master Budget
It is a summary budget incorporating all functional budgets in a capsule
form. It interprets different functional budgets and covers within its range the
preparation of projected income statement and projected balance sheet.
15.3.3 ACCORDING TO FLEXIBILITY
On the basis of flexibility, budgets can be divided into two categories. They are:
1. Fixed Budget 2. Flexible Budget
1.Fixed Budget
Fixed Budget is one which is prepared on the basis of a standard or a fix ed
level of activity. It does not change with the change in the level of activity.
2.Flexible Budget
A budget prepared to give the budgeted cost of any level of activity is termed as
a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a bu dget
designed to change in accordance with level of activity attained’. It is prepared by
taking into account the fixed and variable elements of cost.
15.3.4 ACCORDING TO TIME
On the basis of time, the budget can be classified as follows:
1. Long term budget 2. Short term budget
2. Current budget 4. Rolling budget
1.Long-Term Budget
A budget prepared for considerably long period of time, viz., 5 to 10 years is
called Long-term Budget. It is concerned with the planning of operations of the
firm. It is generally prepared in terms of physical quantities.
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2.Short-Term Budget
A budget prepared generally for a period not exceeding 5 years is called Short-
term Budget. It is generally prepared in terms of physical quantities and in
monetary units.
3.Current Budget
It is a budget for a very short period, say, a month or a quarter. It is adjusted to
current conditions. Therefore, it is called current budget.
4.Rolling Budget
It is also known as Progressive Budget. Under this method, a budget for a
year in advance is prepared. A new budget is prepared after the end of each
month/quarter for a full year ahead. The figures for the month/quarter which has
rolled down are dropped and the figures for the next month/quarter are added.
This practice continues whenever a month/quarter ends and a new month/quarter
begins.
15.3.5 ADVANTAGES OF BUDGETARY CONTROL
The following are the advantages of budgetary control system.
1.Profit Maximization
The resources are put to best possible use, eliminating wastage. Proper control
is exercised both on revenue and capital expenditure. To achieve this, proper
planning and co-ordination of various functions is undertaken. So, the system
helps in reducing losses and increasing profits.
2.Co-ordination
Co-ordination between the plans, policy and control is established.
The budgets of various departments have a bearing with each other, as
activities are interrelated. As the size of operations increases, co-ordination
amongst the different departments for achieving a common goal assumes more
importance. This is possible through budgetary control system.
As all the personnel in the management team are involved and coordinated,
there is bound to be maximum profits.
Budgetary control system acts as a friend, philosopher and g uide to the
management.
3.Communication
A budget serves as a means of communicating information throughout the
organisation. A sales manager for a district knows what is expected of his
performance. Similarly, production manager knows the amount of material, labour
and other expenses that can be incurred by him to achieve the goal set to him. So,
every department knows the performance expectation and authority for achieving
the same.
4.Tool for Measuring Performance
Budgetary control system provides a tool for measuring the performance of
various departments. The performance of each department is reported to the top
management.
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The system helps the management to set the goals. The current performance
is compared with the pre-planned performance to ascertain deviations so that
corrective measures are taken, well at the right time.
It helps the management to economise costs and maximise profits.
Economy
Planning at each level brings efficiency and economy in the working of the
business enterprise. Resources are put to optimum use. All this leads to
elimination of wastage and achievement of overall efficiency.
Determining Weaknesses
Actual performance is compared with the planned performance, periodically,
and deviations are found out. This shows the variances highlighting the
weaknesses, where concentration for action is needed.
Consciousness
Budgets are prepared in advance. So, every employee knows what is
expected of him and they are made aware of their responsibility. So, they do their
job uninterrupted for achieving, what is set to him to do.
Timely Corrective Action
The deviations are reported to the attention of the top management as well
as functional heads for suitable corrective action, in time. In the absence of
budgetary control, deviations would be known only at the end of the period. There
is no time and opportunity for necessary corrective action.
Motivation
Success is measured by comparing the actual performance with the planned
performance. Suitable recognition and reward system can be introduced to motivate
the employees, at all levels, provided the budgets are prepared with adequate
planning and foresight.
Management by Exception
The management is required to exercise action only when there are deviations.
So long as the plans are achieved, management need not be alerted. This system
enables the introduction of ‘Management by Exception’ for effective delegation and
control.
Overall Efficiency
Everyone in the management is associated with the preparation of budget.
There is involvement from the top functionaries and each one knows how the target
fixed can be achieved. Budgets once, finally, approved by the Budget Committee, it
represents the collective decision of the organisation. With the implementation of
budgetary control, there would be over all alertness and improved working in all the
departments, with better coordination.
Budgetary Control acts like an impersonal policeman to bring all round
efficiency in performance.
Optimum Utilisation of Resources
As there is effective control over production, the resources of the
organisation would be put to optimum utilisation.
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Answer
Sales Budget
Sales estimation
Month Sales(given) based on cash sales ratio given
January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000
On the above basis, the following estimates have been prepared by Sales
Manager:
Raja +10% + 5%
You are required to prepare a budget for sales incorporating the above
estimates.
Answer: Sales Budget
Example
3 The sales of a concern for the next year is estimated at 50,000 units. Each
unit of the product requires 2 units of Material ‘A’ and 3 units of Material ‘B’. The
estimated opening balances at the commencement of the next year are:
Finished Product : 10,000 units
Raw Material ‘A’ : 12,000 units
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W orkings
Additional Information
1. Expected Cash balance on 1 st April, 2006 – 20,000
2. Materials and overheads are to be paid during the month following the
month of supply.
3. Wages are to be paid during the month in which they are incurred.
190
Similarly, the sales collection for the months of May and June may be
calculated
1. Materials and Overheads: These are paid in the following month. That is
March is paid in April, April is paid in May and May is paid in June
2. Sales Commission: It is paid in the following month. Therefore
For April – 5% of March Sales (64,000 x 5 /100) = 3,200
For May – 5% of March Sales (80,000 x 5 /100) = 4,000
For April – 5% of March Sales (84,000 x 5 /100) = 4,200
IV. Flexible Budget
A flexible budget consists of a series of budgets for different level of activity.
Therefore, it varies with the level of activity attained. According to CIMA, London, A
Flexible Budget is, ‘a budget designed to change in accordance with level of activity
attained’. It is prepared by taking into account the fixed and variable elements of
cost. This budget is more suitable when the forecasting of demand is uncertain.
Points to be remembered while preparing a flexible budget
1. Cost has to be classified into fixed and variable cost.
2. Total fixed cost remains constant at any level of activity.
3. Total Variable cost varies in the same proportion at which the level of
activity varies.
4. Fixed and variable portion of Semi-variable cost is to be segregated.
Example
5. The following information at 50% capacity is given. Prepare a flexible budget
and forecast the profit or loss at 60% , 70% and 90% capacity.
Expenses at 50% capacity
Particulars
(`000)
Fixed expenses: Rs.
Salaries 5,000
Rent and taxes 4,000
Depreciation 6,000
Administrative expenses 7,000
Variable expenses:
Materials 20,000
Labour 25,000
Others 4,000
Semi-variable expenses:
Repairs 10,000
Indirect Labour 15,000
Others 9,000
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It is estimated that fixed expenses will remain constant at all capacities. Semi-
variable expenses will not change between 45% and 60% capacity, will rise by 10%
between 60% and 75% capacity, a further increase of 5% when capacity crosses
75% .Estimated sales at various levels of capacity viz.,60% . 70% and 90%
respectively of Rs.1,10,000 1,30,000 and Rs.1,50,000.
Answer
Flexible Budget (Showing Profit & Loss at various capacities)
Capacities
Particulars 50% 60% 70% 90%
Fixed Expenses:
Salaries 5,000 5,000 5,000 5,000
Rent and taxes 4,000 4,000 4,000 4,000
Depreciation 6,000 6,000 6,000 6,000
Administrative expenses 7,000 7,000 7,000 7,000
Variable expenses:
Materials 20,000 24,000 28,000 36,000
Labour 25,000 30,000 35,000 45,000
Others 4,000 4,800 5,600 7,200
Semi-variable expenses:
Repairs 10,000 10,000 11,000 11,500
Indirect Labour 15,000 15,000 16,500 17,250
Others 9,000 9,000 9,900 10,350
Total Cost 1,05,000 1,14,800 1,28,000 1,49,300
Profit (+) or Loss (-) (-) 4,800 (+) 2,000 (+) 700
Estimated Sales 1,10,000 1,30,000 1,50,000
Example
6. The following information relates to a flexible budget at 60% capacity. Find
out the overhead costs at 50% and 70% capacity and also determine the overhead
rates:
Expenses at 60%
Particulars capacity
Variable overheads:
Indirect Labour 10,500
Indirect Materials 8,400
Semi-variable overheads:
Repair and Maintenance(70% fixed; 30% variable) 7,000
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50 % 60% 70%
Capacity Capacity Capacity
Variable overheads:
Indirect Labour 8,750 10,500 12,250
Indirect Materials 7,000 8,400 9,800
Semi-variable overheads:
Repair and Maintenance (1) 6,650 7,000 7,350
Electricity(2) 23,100 25,200 27,300
Fixed overheads:
Office expenses including salaries 70,000 70,000 70,000
Insurance 4,000 4,000 4,000
Depreciation 20,000 20,000 20,000
Total overheads 1,39,500 1,45,100 1,50,700
Estimated direct labour hours 1,00,000 1,20,000 1,50,000
Overhead rate per hour 1.395 1.21 1.077
Workings:
1. The amount of Repairs and maintenance at 60% Capacity is 7,000. Out of
this, 70% (i.e4,900) is fixed and remaining 30% (i.e2,100) is variable. The
fixed portion remains constant at all levels of capacities. Only the variable
portion will change according to change in the level of activity. Therefore,
the total amount of repairs and maintenance for 50% and 70% capacities
are calculated as follows:
which, 5% was variable cost (Rs. 0.50 per unit) and balance 95% was fixed cost,
which works out to Rs. 47,500. Fixed costs Rs. 47,500 are constant, whatever be
the level of activity.
Note 2:
Total Selling Expenses are Rs. 30,000. Out of which, 20% were fixed costs,
which works out Rs. 6,000. Balance amount was variable cost Rs. 24,000, which
works out to Rs. 4.80 per unit.
Note 3:
Total Distribution costs were Rs. 25,000. Out of which 10% were fixed costs,
which works out to Rs. 2,500. Balance amount was variable cost Rs. 22,500, which
works out to Rs. 4.50 per unit.
3. Prepare a Production Budget for each month and summarized Production
Budget for the six months period ending 31st Dec., 1989 from the following of
product X.
(i) The units to be sold for different months are as follows:
Jul-89 1,100
August 1,100
September 1,700
October 1,900
November 2,500
Dec-89 2,300
Jan-90 2,200
Answer:
July Aug Sep Oct Nov Dec
Opening Stock 550 550 850 950 1250 1150
Closing Stock 550 850 950 1250 1150 1100
Production 1100 1400 1800 2200 2400 2250
(All in Rs.)
Month, 2015 Sales Purchases Wages Expenses
January (Actual) 80,000 45,000 20,000 5,000
February (Actual) 80,000 40,000 18,000 6,000
March (Actual) 75,000 42,000 22,000 6,000
April (Budgeted) 90,000 50,000 24,000 7,000
May (Budgeted) 85,000 45,000 20,000 8,000
June (Budgeted) 80,000 35,000 18,000 6,000
You are further informed that:
a. 10% of the purchases and 20% of the sales are for cash;
b. The average collection period of the company ½ month and the credit
purchases are paid off regularly after one month;
c. Wages are paid half monthly, and the rent of Rs. 500 included in
expenses is paid monthly;
d. Cash and Bank Balance as on A pril, was Rs. 15,000 and the company
wants to keep it at the end of every month approximately this figure, the
excess cash being put in fixed deposits in the bank.
6. From the following forecast of income and expenditure, prepare a cash
budget for the months January to April 2016.
(All in Rs.)
Months Sales Purchases Wages Manufacturing Administrative Selling
(Credit) (Credit) Expenses Expenses Expenses
2015, 30,000 15,000 3,000 1,150 1,060 500
Nov
2015, 35,000 20,000 3,200 1,225 1,040 550
Dec
2016, 25,000 15,000 2,500 990 1,100 600
Jan
Feb 30,000 20,000 3,000 1,050 1,150 620
March 35,000 22,500 2,400 1,100 1,220 570
April 40,000 25,000 2,600 1,200 1,180 710
Additional information is as follows:
1. The customers are allowed a credit period of 2 months.
2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant ‘purchased on 15th January for
Rs. 5,000, a Building has been purchased on 1st March and the payments
are to be made in monthly instalments of Rs. 2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st on the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 2016 is Rs. 15,000
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Material 70
Labour 25
Variable Overheads 20
Fixed overheads (Rs.100000) 10
Variable expenses (direct) 5
Selling expenses (10% direct) 13
Distribution expenses (20% fixed) 7
Administration Expenses (Rs.50000) 5
Total 155
Prepare a budget for the purpose of (a)8000 units and (b)6000 units.
Assume that administration expenses are rigid for all levels of production.
5. From the following data, prepare a flexible budget for production of 40000
units and 75000 units, distinctly showing variable cost and fixed cost as
well as total cost. Also indicate element-wise cost per unit. Budgeted
output is 100000 units and budgeted cost per unit is as follows:
Rs.
Direct Material 95
Direct Labour 50
Production overhead (variable) 40
Production overhead (fixed) 5
Administration overhead (fixed) 5
Selling overhead (10% fixed) 10
Distribution overhead (20% fixed) 15
6. Z limited has prepared the budget for the production of 100000 units from
a costing period as under:
Per Unit (Rs.)
Actual production in the period was only 60000 units. Prepare budgets for the
original and revised levels of output.
7. A department of AXY company attains sales of Rs.600000 at 80% of its
normal capacity. Its expenses are given below:
Rs.
Salaries 8% of sales
Travelling expenses 2% of sales
Sales office 1% of sales
General expenses 1% of sales
Distribution Costs:
Wages 15,000
Rent 1% of sales
Other expenses 4% of sales
Draw up Flexible Administration, Selling and Distribution Costs Budget,
operating at 90% , 100% & 110% of normal capacity.
8. A company is expecting to have Rs.25000 cash in hand on 1 st April 2006
and it requires you to prepare cash budget for the three months. A pril to
June 2006. The following information is supplied to you.
Period Sales (Rs.) Purchases (Rs.) W ages (Rs.) Expenses (Rs.)
(2006)
February 70000 40000 8000 6000
March 80000 50000 8000 7000
April 92000 52000 9000 7000
May 100000 60000 10000 8000
June 120000 55000 12000 9000
Other Information:
a. Period of credit allowed by suppliers is two months:
b. 25% of sale is for cash and the period of credit allowed to customers for
credit sale is one month;
c. Delay in payment of wages and expenses one month
d. Income tax Rs.25000 is to be paid din June 2006.
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9. The following data relate to bookshop Ltd: The financial manager has made
the following sales forecasts for the first five months of the coming year,
commencing from 1 st April, 2006:
Month Sales (Rs.)
April 40,000
May 45,000
June 55,000
July 60,000
August 50,000
Other data:
i. Debtor’s and Creditor’s balance at the beginning of the year are
Rs.30000 & Rs.14000 respectively. The balance of other relevant assets
and liabilities are:
Cash Balance Rs. 7,500; StockRs.51,000; Accrued Sales Commission
Rs. 3,500
ii. 40% sales are on cash basis. Credit sales are collected in the month
following the sale .
iii. Cost of sales is 60% on sales
iv. The only other variable cost is a 5% commission to sales agents. The
Sales commission is paid in a month after it is earned.
v. Inventory(stock) is kept equal to sales requirements for the next two
months budgeted sales.
vi. Trade creditors are paid in the following month after purchases.
vii. Fixed costs are Rs.5000 per month including Rs.2000 depreciation.
You are required to prepare a Cash Budget for the months of April, May and
June,2006 respectively.
10. Prepare a Clash Budget for the three months ending 30 th June 2006 from the
information given below:
Period Sales Materials Wages Overheads
(2006) (Rs.) (Rs.) (Rs.) (Rs.)
February 14000 9600 3000 1700
March 15000 9000 3000 1900
April 16000 9200 3200 2000
May 17000 10000 3600 2200
June 18000 10400 4000 2300
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(b). Credit terms are: sales and debtors – 10% sales are on cash, 50% of the
credit sales are collected next month and the balance in the following month.
Creditors – Materials 2 Months
Wages ¼ month
Overheads ½ month
(c). Cash and bank on 1 st April, 2006 is expected to be Rs.6000
(d). Other relevant information are:
i. Plant and machinery will be installed in February 2006 at a cost of
Rs.96000. The monthly instalment of Rs.2000 is payable from April
onwards.
ii. Dividend @ 5% on Preference Share capital of Rs.200000 will be paid on
1st June.
iii. Advance to be received for sale of vehicles Rs.9000 in June.
iv. Dividends from investments amounting to Rs.1000 are expected to be
received in June.
v. Income tax (advance) to be paid in June is Rs.2000
11. The following information relates to Rs. ‘000
7. 10% of the monthly sales are for cash and 90% are sold on credit.
8. A commission of 5% is paid to agents on all the sales on credit but, this
is not paid until the month following the sales to which it relates; this
expense is not included in the overhead figure shown.
9. It is intended to repay a loan of Rs.25000 on 30 th June.
10. Delivery is expected in July of a new maching costing Rs.45000 of which
Rs.15000 will be paid on delivery and Rs.15000 in each of the following
months.
11. Assume that overdraft facilities are available, if required.
You are required to prepare a cash budget for the three months of June, July
and August.
12. With the following data at 60% activity, prepare a budget at 80% and 100%
activity.
Production at 60% capacity 600units
Materials Rs.120 per unit
Labour Rs.50 per unit
Expenses Rs.20 per unit
Factory Expenses Rs.60000 (40% fixed)
Administration Expenses Rs.40000 (60% fixed)
13. For production of 10000 Electrical Irons, the following are budgeted expenses:
Per Unit Rs.
Direct materials 60
Direct labour 30
Variable overhead 25
Fixed overhead (Rs.150000) 15
Variable expenses (direct) 5
Selling expenses (10% fixed) 15
Administration expenses (Rs.50000 rigid of all levels of production) 5
Distribution expenses (20% fixed) 5
Total cost of sales per unit 160
Prepare a budget for production of 6000, 7000 & 8000 irons, showing distinctly
marginal cost and total cost.
204
14. A company produces a standard product. The estimated costs per unit are as
follows:
Raw materials Rs.4; Wages Rs.2; Variable overhead Rs.5
The semi-variable costs are:
Indirect materials Rs.235; Indirect labour Rs.156; Repairs Rs.570
The variable costs per unit included in semi -variable are:
Indirect materials Re.0.05; Labour Re.0.08 and Repai e.0.10.
The fixed costs are Factory Rs.2000; Administration Rs.3000; Selling Rs.2500.
The above cost are 70% of normal capacity production i.e. 700units. The selling
price is Rs.30 per unit. Prepare Flexible Budget for 80% and 100% normal
capacities from the above information.
15. The following data are available in a manufacturing company for a yearly
period:
Fixed Expenses:
Rs. Lakhs
Wages & salaries 9.5
Rent, rates & taxes 6.6
Depreciation 7.4
Sundry administration expenses 6.5
time period for a specific duration of time. It states the estimated amount of cash
receipts and estimation of cash payments and the likely balance of cash in hand at
the end of different periods. Master Budget is a summary budget incorporating all
functional budgets in a capsule form. It interprets different functional budgets and
covers within its range the preparation of projected income statement and projected
balance sheet. Fixed Budget is one which is prepared on the basis of a standard or
a fixed level of activity. It does not change with the chan ge in the level of activity.
Flexible Budget is prepared to give the budgeted cost of any level of activity is
termed as a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a
budget designed to change in accordance with level of activity attained’. It is
prepared by taking into account the fixed and variable elements of cost. Long-Term
Budget is prepared for considerably long period of time, viz., 5 to 10 years is
called Long-term Budget. It is concerned with the planning of operations of the
firm. It is generally prepared in terms of physical quantities. Short-Term Budget is
prepared generally for a period not exceeding 5 years is called Short-term Budget. It
is generally prepared in terms of physical quantities and in monetary units.
Current Budget is a budget for a very short period, say, a month or a
quarter. It is adjusted to current conditions. Therefore, it is called current budget.
Rolling Budget is also known as Progressive Budget. Under this method, a budget
for a year in advance is prepared. A new budget is prepared after the end of each
month/quarter for a full year ahead. The figures for the month/quarter which has
rolled down are dropped and the figures for the next month/quarter are added.
This practice continues whenever a month/quarter ends and a new month /
quarter begins.
15.5 IN TEXT QUESTIONS
1. What do you mean by cash Budget?
2. What do you mean by flexible Budget?
3. What do You mean by Performance Budget?
4. What do you mean by capital Expenditure Budget?
5. What do you mean Rolling Budget?
15.7 TERMINAL EXERCISE
1. ……………………. prepared to give the budgeted cost of any level of
activity is termed as a flexible budget.
2. The budget which estimates total sales in terms of items, quantity,
value, periods, areas, etc is called ……………………………..
3. The budget that anticipates the quantity of personnel required during a
period for production activity is known …………………………….
4. .………………………………., a budget for a year in advance is prepared.
5. …………………..budget relates to the research work to be done for
improvement in quality of the products or research for new products
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LESSON 16
ZERO BASE BUDGETING & MASTER BUDGET
16.1 INTRODUCTION
Zero Base Budgeting is a new management technique aimed at cost reduction
and optimum utilization of resources. This technique was introduced by the U.s
Department of Agriculture in 1961. Petewr. A. Phyrr designed its basic frame work
in 1970 and popularized its wider use in the private sector. In 1979, President
Jimmy Carter issued a mandate asking for the use of ZBB throughout the federal
Government agencies for controlling state expenditure. The technique Become quite
popular in the U.S. A master Budget is the summary budget for the entire
enterprise and embodies the summarized figures for various activities. This budget
is known as summary budget or finalized profit plan. This budget includes the
budgeted position of the profit and loss as well as balance sheet. Master budget is
prepared by committee and becomes target for the compan y.
16.2 OBJECTIVES
After completing this Lesson you should be able to know
Importance of ZBB
Advantages and Disadvantages of ZBB
Objectives of Performance Budgeting
Master Budget and its Importance
16.3 CONTENT
16.3.1 Zero Base
16.3.2 ZBB- Definition
16.3.3 Advantages of ZBB
16.3.4 Limitations of ZBB
16.3.5 Performance Budgeting
16.3.6 Objectives of Performance Budgeting
16.3.7 Master Budget
16.3.1 ZERO BASE BUDGETING (ZBB)
ZBB is starting from scratch. Every year is taken as a new year and previous
year is not taken as the base, in the preparation of budgets. Rather zero is taken as
the base . Something will not be allowed simply because it was allowed in the past.
ZBB proceeds on the assumption that nothing is to be allowed. A manager has to
justify why he wants to spend. The manager proposing an expenditure or activity
has to prove that it is essential and the amounts asked for are reasonable.
16.3.2 ZBB - DEFINITION
“It is a planning and budgeting process which requires each manager to justify
his entire budget request in detail from scratch (Zero Base) and shifts the burden of
proof to each manager to justify why he should spend money at all.
210
proof to each manager to justify why he should spend money at all. The approach
requires that all activities be analyzed in decision packages which are evaluated by
systematic analysis and ranked in the order of importance. A master Budget is the
summary budget for the entire enterprise and embodies the summarized figures for
various activities. This budget is known as summary budget or finalized profit plan.
This budget includes the budgeted position of the profit and loss as well as balance
sheet. Master budget is prepared by committee and becomes target for the
company.
16.7 TERMINAL EXERCISE
1. …………………………………………… is a comprehensive plan which is
prepared from and summarizes the functional budgets
2. …………………………………….technique is the process of analyzing,
identifying, simplifying and crystallizing specific performance objectives of a
job to be achieved over a period of the job.
3. …………………………………… is a new management technique aimed at cost
reduction and optimum utilization of resources.
16.8 SUPPLEMENTARY MATERIAL
1. http://study.com/
2. https://www.efinancemanagement.com
3. http://www.investopedia.com/
4. http://www.bbamantra.com/
5. http://www.accountingtools.com/
6. http://www.csus.edu/
7. http://site.iugaza.edu.ps/
16.9 ASSIGNMENTS
1. Enumerate the importance of ZBB in the present context.
2. Highlight the importance of master Budget in the present scenario.
16.10 SUGGESTED READINGS
1. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot, Jaipur)
2. Khan, Jain — Management Accounting (S. Chand & Sons.)
3. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and
Management Accounting ( Malik and Co.)
16.11 LEARNING ACTIVITIES
You can made attempt to identify which company is following the ZBB
system and know the reason for it.
16.12 KEYWORDS
Zero Base Budgeting, Performance Budgeting, Master Budget.
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LESSON 17
IMPORTANCE OF CAPITAL BUDGETING
17.1 INTRODUCTION
Capital budgeting decisions are of paramount importance in financial
decisions, because efficient allocation of capital resources is one of the most crucial
decisions of financial management. Capital budgeting is budgeting for capital
projects. It is significant because it deals with right kind of evaluation of projects.
The exercise involves ascertaining / estimating cash inflows and outflows, matching
the cash inflows with the outflows appropriately and evaluation of desirability of the
project. It is a managerial technique of meeting capital expenditure with the overall
objectives of the firm. Capital budgeting means planning for capital assets. It is a
complex process as it involves decisions relating to the investment of current funds
for the benefit to be achieved in future. The overall objective of capital budgeting is
to maximize the profitability of the firm / the return on inve stment.
Capital Budgeting is the process of making investment decision in Fixed assets
or Capital expenditure. Capital Budgeting is also known as Investment decision
making, planning of capital acquisition, planning of capital expenditure, analysis of
capital expenditure.
17.2 OBJECTIVES
After completing this Lesson you should be able to know
Meaning of Capital Budgeting
Need and importance of Capital Budgeting
17.3 CONTENT
17.3.1 Capital Expenditure
17.3.2 Capital Budgeting Definition
17.3.3 Need and Importance of Capital Budgeting
17.3.1 CAPITAL EXPENDITURE
A capital expenditure is an expenditure incurred for acquiring or improving the
fixed assets, the benefits of which are expected to be received over a number of
years in future. The following are some of the examples of capital expenditure.
1. Cost of acquisition of permanent assets such as land & buildings, plant
& machinery, goodwill etc.
2. Cost of addition, expansion, improvement or alteration in the fixed
assets.
3. Cost of replacement of permanent assets.
4. Research and development project cost etc.
5. Capital expenditure involves non-flexible long term commitment of
funds.
17.3.2 CAPITAL BUDGETING – DEFINITION
“Capital budgeting” has been formally defined as follows.
“Capital budgeting is long-term planning for making and financing
proposed capital outlay”. - Charles T. Horngreen
214
which must be recovered from the benefit of the same project. If the investment
turns out to be unsuccessful in future or give less profit than expected, the
company will have to bear the extra burden of fixed cost. Such risk can be
minimized through the systematic analysis of projects which is the integral part of
investment decision.
2. Irreversible Decision
Capital investment decision are not easily reversible without much financial
loss to the firm because there may be no market for second-hand plant and
equipment and their conversion to other uses may not be financially viable. Hence,
capital investment decisions are to be carried out and performed carefully and
effectively in order to save the company from such financial loss. The investment
decision which is undertaken carefully and effectively can save the firm from huge
financial loss aroused due to the selection of unfavorable projects.
3. Long-term Commitments of Funds
Capital budgeting decision involves the funds for the long-term. So, it is long-
term investment decision. The long-term commitment of funds leads to the financial
risk. Hence, careful and effective planning is must to reduce the financial risk as
much as possible.
The significance of capital budgeting can also analyzed with the help of
following points.
Capital budgeting involves capital rationing. This is the available funds that
have to be allocated to competing projects in order of project potential.
Normally the individuality of project poses the problem of capital rationing
due to the fact that required funds and available funds may not be the same.
Capital budget becomes a control device when it is employed to control
expenditure. Because manned outlays are limits to actual expenditure, the
concern has to investigate the variation in order to keep expenditure under
control.
A firm contemplating a major capital expenditure programme may need to
arrange funds many years in advance to be sure of having the fun ds when
required.
Capital budgeting provides useful tool with the help of which the
management can reach prudent investment decision.
Capital budgeting is significant because it deals with right mind of
evaluation of projects. A good project must not be rejected and a bad project
must not be selected. Capital projects need to be thoroughly evaluated as to
costs and benefits.
Capital projects involve investment in physical assets such as land, building
plant, machinery etc. for manufacturing a product as against financial
investments which involve investment in financial assets like shares, bonds
or mutual funds. The benefits from the projects last for few to many years.
Capital projects involve huge outlay and last for years.
216
LESSON 18
CAPITAL BUDGETING PROCESS
18.1 INTRODUCTION
Capital budgeting is a complex process as it involves decisions to the
investment of current funds for the benefit to be achieved in future and the future
is always uncertain. A capital Budgeting process may involve a number of steps
depending upon the size of the concern, nature of projects, their numbers,
complexities and diversities etc. That is, capital budgeting decision of a firm has a
pervasive influence on the entire spectrum of entrepreneurial activities. Hence they
require a complex combination and knowledge of various disciplines for their
effective administration, such as economics, finance mathematics, economic
forecasting, projection techniques and techniques of financial control.
18.2 OBJECTIVES
After completing this Lesson you should be able to know
Capital Budgeting Process and Their Kinds
Various factors influencing Capital Investment Decision
18.3 CONTENT
18.3.1 Capital Budgeting Process
18.3.2 Factors Influencing Capital Investment Decisions
18.3.3 Kinds of Capital Budgeting Decisions
18.3.4 Investment Evaluation Criteria
18.3.5 Features Required by Investment Evaluation Criteria
18.3.1 CAPITAL BUDGETING PROCESS
The important steps involved in the capital budgeting process are:
(1) Project generation,
(2) Project evaluation,
(3) Project selection and
(4) Project execution.
1. Project Generation. Investment proposals of various types may originate at
different levels within a firm. Investment proposals may be either proposals to add
new product to the product line or proposals to expand capacity in existing product
lines. Secondly, proposals designed to reduce costs in the output of existing
products without changing the scale of operations. The investment proposals of any
type can originate at any level. In a dynamic and progressive firm there is a
continuous flow of profitable investment proposals.
2. Project evaluation. Project evaluation involves two steps:
i) Estimation of benefits and costs and
ii) Selection of an appropriate criterion to judge the desirability of the projects.
The evaluation of projects should be done by an impartial group. The
criterion selected must be consistent with the firm’s objective of maximizing its
market value.
219
budget also shows the timing of availability of cash flows for alternative investment
proposals, thereby helping the management in selecting the desired project.
7. Return expected from the investment
In most of the cases, investment decisions are made in anticipation of
increased return in future. While evaluating investment proposals, it is therefore
essential for the firm to estimate future returns or benefits accruing from the
investment.
8. Minimum Rate of Return on Investment
Every management expects a minimum rate of return or cut – off rate on
capital investment. It refers to the point of below which a project would not be
accepted.
9. Future earnings
The future earnings may be uniform or Fluctvating. Even though, the company
expects guaranteed future earnings in total which affects the choice of a project.
10. Ranking of the capital investment proposal
Only one profitable project out of many and huge amount is available in the
hards of management there is no need of ranking of capital investment proposal.
Ranking is necessary if there is many profitable projects in hand and limited funds
is available in the hards of management.
18.3.3 KINDS OF CAPITAL BUDGETING DECISIONS
The overall objective of capital budgeting is to maximise the profitability of a
firm or the return on investment. This objective can be achieved either by
increasing the revenues or by reducing costs. Thus, capital budgeting decisions can
be broadly classified into two categories:
1. Those which increase revenue, and
Those which reduce costs
The first category of capital budgeting decisions is expected to increase revenue
of the firm through expansion of the production capacity or size of operations by
adding a new product line. The second category increases the earnings of the firm
by reducing costs and includes decisions relating to replacement of obsolete,
outmoded or worn out assets. In such cases, a firm has to decide whether to
continue with the same asset or replace it. Such a decision is taken by the firm by
evaluating the benefit from replacement of the asset in the form of reduction in
operating costs and the cost/cash outlay needed for replacement of the asset. Both
categories of above decisions involve investment in fixed assets but the basic
difference between the two decisions lies in the fact that increasing revenue
investment decisions are subject to more uncertainty as compared to cost reducing
investment decisions.
Further, in view of the investment proposals under consideration, capital
budgeting decisions may also be classified as.
1. Accept / Reject Decisions
221
3. https://msu.edu
4. http://people.hss.caltech.edu/
5. http://www.investopedia.com/
6. http://umanitoba.ca/
7. http://isites.harvard.edu/
8. wps.prenhall.com/wps
9. https://www.cfainstitute.org
10. www.cengage.com
11. www.hss.caltech.edu
18.9 ASSIGNMENTS
1. Critically examine the various steps involved in capital budgeting process.
2. Outline financial management techniques of evaluation of capital investment
in fixed asset.
18.10 SUGGESTED READINGS
1. Agrawal & Agrawal — Management Accounting (RBD. Jaipur)
2. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot, Jaipur)
3. Khan, Jain — Management Accounting (S. Chand & Sons.)
4. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD, Jaipur)
5. Pandey. I. M. — Management Accounting (S. Chand & Sons.)
18.11 LEARNING ACTIVITIES
Identify a company of your choice and interact with the finance manger
regarding Capital budgeting process, investment evaluation criteria .
18.12 KEYWORDS
Project generation, Project evaluation, Project selection, Project execution,
Accept / Reject Decisions, Mutually Exclusive Project Decisions , Capital
Rationing Decisions.
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LESSON 19
METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSAL
19.1 INTRODUCTION
The capital Budgeting techniques or evaluation of investment proposals have
considerably gained the importance. This is more true in the modern business
environment. After the introduction of New Economic Policy, the environments in
the industry and service sector have considerably changed. Number of mergers,
acquisition, and joint ventures and continues innovation are being experienced in
the markets. Therefore it is very difficult to arrive at decision for financing the
project. It is absolutely essential for every business entity to make use of this scare
resource on the most profitable lines. Following are some of the important methods
used in practice in evaluating the investment proposals.
19.2 OBJECTIVES
After completing this Lesson you should be able to know
Various techniques of investment Appraisal
Discounted and Non-Discounted Cash Flow Methods
Merits and demerits of Various techniques
19.3 CONTENT
19.3.1 Techniques of Investment Appraisal
19.3.2 Non-Discounted Cash Flow Criteria
19.3.3 Discounted Cash Flow Criteria
19.3.4 Discounted Cash Flow Techniques Merits
19.3.5 Discounted Cash Flow Techniques Demerits
19.3.6 Comparison between NPV and IRR
19.3.1 TECHNIQUES OF INVESTMENT APPRAISAL
There are many methods for evaluating or ranking the investment proposals. In
all these methods, the basic approach is to compare the investments in the project
to the benefits derived there from. These methods can be categorized as Follows:
19.3.2 NON-DISCOUNTED CASH FLOW CRITERIA / TRADITIONAL METHODS
Pay-back period
Discounted payback period
Accounting rate of return (ARR)
19.3.3 DISCOUNTED CASH FLOW (DCF) CRITERIA
Net present value (NPV)
Internal rate of return (IRR) / Excess PV Index method/benefit
Profitability index (PI) / Benefit cost ratio
Non-discounted Cash Flow Criteria
Payback period Method
This method is popularly known as pay off, pay-out, recoupment period method
also. It gives the number of years in which the total investment in a particular
225
capital expenditure pays back itself. This method is based on the principle that
every capital expenditure pays itself back over a number of years. It means that it
generates income within a certain period. When the total earnings (or net cash-
inflow] from investment equals the total outlay, that period is the payback period of
the capital investment. An investment project is adopted so long as it pays for itself
within a specified period of time — says 5 years or less. This standard of
recoupment period is settled by the management taking into account a number of
considerations. While there is a comparison between two or more projects, the
lesser the number of payback years, the project will be acceptable.
The formula for the payback period calculation is simple when the cash inflow
is even throughout life of the project/ Machine/ Capital investment. First of all,
net-cash-inflow (Profit after Tax Before Depreciation) is determined. Then we divide
the initial cost (or any value we wish to recover) by the annual cash-inflows and the
resulting quotient is the payback period. As per formula:
5. When the payback period is set at a large “number of years and incomes
streams are uniform each year, the payback criterion is a good
approximation to the reciprocal of the internal rate of discount.
Payback Method – Demerits
This method has its own limitations and disadvantages despite its simplicity
and rapidity. Here are a number of demerits and disadvantages claimed by its
opponents:-
1. It treats each asset individually in isolation with the other assets, while
assets in practice cannot be treated in isolation.
2. The method is delicate and rigid. A slight change in the division of
labour and cost of maintenance will affect the earnings and such may
also affect the payback period.
3. It overplays the importance of liquidity as a goal of the capital
expenditure decisions. While no firm can ignore its liquidity
requirements but there are more direct and less costly means of
safeguarding liquidity levels. The overlooking of profitability and over
stressing the liquidity of funds can in no way be justified.
4. It ignores capital wastage and economic life by restricting consideration
to the projects’ gross earnings.
5. It ignores the earning beyond the payback period while in many cases
these earnings are substantial. This is true particularly in respect of
research and welfare projects.
6. It overlooks the cost of capital which is the main basis of sound
investment decisions.
In perspective, the universality of the pay back criterion as a reliable index of
profitability is questionable. It violates the first principle of rational investor
behaviour-namely that large returns are preferred to smaller ones. However, it can
be applied in assessing the profitability of short and medium term capital
expenditure projects.
Accounting Rate of Return Method
It is also known as Accounting Rate of Return Method / Financial Statement
Method/ Unadjusted Rate of Return Method also. According to this method, capital
projects are ranked in order of earnings. Projects which yield the highest earnings
are selected and others are ruled out. The return on investment method can be
expressed in several ways a follows:
(i) Average Rate of Return Method
Under this method we calculate the average annual profit and then we divide it
by the total outlay of capital project. Thus, this method establishes the ratio
between the average annual profits and total outlay of the projects.
As per formula,
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Thus, the average rate of return method considers whole earnings over the
entire economic life of an asset. Higher the percentage of return, the project will be
acceptable.
(ii) Earnings per unit of Money Invested
As per this method, we find out the total net earnings and then divide it by the
total investment. This gives us the average rate of return per unit of amount (i.e.
per rupee) invested in the project. As per formula:
The higher the earnings per unit, the project deserves to be selected.
(iii) Return on Average Amount of Investment Method
Under this method the percentage return on average amount of investment is
calculated. To calculate the average investment the outlay of the projects is divided
by two. As per formula:
Here:
Average Annual Net Income does not mean average Annual Cash-inflow
Average Investment may be of the following:
OR
OR
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Thus, we see that the rate of return approach can be applied in various ways.
But, however, in our opinion the third approach is more reasonable and consistent.
Accounting Rate of Return Method – Merits
This approach has the following merits of its own:
1. Like payback method it is also simple and easy to understand.
2. It takes into consideration the total earnings from the project during its
entire economic life.
3. This approach gives due weight to the profitability of the project.
4. In investment with extremely long lives, the simple rate of return will be
fairly close to the true rate of return. It is often used by financial
analysis to measure current performance of a firm.
Accounting Rate of Return Method – Demerits
1. One apparent disadvantage of this approach is that its results by different
methods are inconsistent.
2. It is simply an averaging technique which does not take into account the
various impacts of external factors on over-all profits of the firm.
3. This method also ignores the time factor which is very crucial in business
decision.
4. This method does not determine the fair rate of return on investments. It is
left to the discretion of the management.
Discounted Cash flows (DCF) Techniques (or) Time Ad jested Method
Another method of computing expected rates of return is the present value
method. This method involves calculating the present value of the cash benefits
discounted at a rate equal to the firm’s cost of capital. The method is popularly
known as Discounted Cash flow Method. The concept of DCF valuation is based on
the principle that the value of a business or asset is inherently based on its ability
to generate cash flows for the providers of capital. To that extent, the DCF relies
more on the fundamental expectations of the business than on public market
factors or historical precedents, and it is a more theoretical approach relying on
numerous assumptions. A DCF analysis yields the overall value of a business (i.e.
enterprise value), including both debt and equity. In simple the “present value of
an investment is the maximum amount a firm could pay for the o pportunity of
making the investment without being financially worse off.”
Key Components of a DCF:
Free Cash flow (FCF): Cash generated by the assets of all the business (both
tangible and intangible) available for distribution to all providers of capital . FCF is
229
often referred to as unlevered free cash flow, as it represents cash flow available to
all providers of capital and is not affected by the capital structure of the business.
Terminal value (TV): Value at the end of the FCF projection period (Horizon
Period).
Discount rate or Present Value factor (PV) – The rate used to discount the
projected FCFs and terminal value to their present values.
The financial executive compares the present values with the cost of the
proposal. If the present value is greater than the net investment, the proposal
should be accepted. Conversely, if the present value is smaller than the net
investment, the return is less than the cost of financing. Making the investment in
this case will cause a financial loss to the firm. There are four methods to judge the
profitability of different proposals on the basis of this technique
(i) Net Present Value Method
This method is also known as Excess Present Value or Net Gain Method. To
implement this approach, we simply find the present value of the expected net cash
inflows of an investment discounted at the cost of capital and subtract from it the
initial cost outlay of the project. If the net present value is positive, the project
should be accepted: if negative, it should be rejec ted.
NPV = Total Present value of cash inflows – Net Investment
If the two projects are mutually exclusive the one with higher net present value
should be chosen. The following example will illustrate the process:
Assume, the cost of capital after taxes of a firm is 6% . Assume further, that the
net cash-inflow (after taxes) on a Rs. 5,000 investment is forecasted as being
2,800 per annum for 2 years. The present value of this stream of net cash-inflow
discounted at 6% comes to 5,272 (1,813 x 2800).
the internal rate of return. This rate of return is compared to the cost of capital and
the project having higher difference, if they are mutually exclusive, is adopted and
other one is rejected. As the determination of internal rate of return involves a
number of attempts to make the present value of earnings equal to the investment,
this approach is also called the Trial and Error Method,
iii. Profitability Index (PI) Method
This method is otherwise called benefit cost ratio method or Desirability
Factor. One major disadvantage of the present value method is that it is not easy to
rank projects on the basis of net present value particularly when the cost of
projects differs significantly. To compare such projects the present value
profitability index is prepared. The index establishes relationship between cash-
inflows and the amount of investment as per formula given below:
NPV GPV
PI = --------------- x 100 OR -------------------- x 100
Investment Investment
For example, the profitability index of the Rs. 5,000 investment discussed in
Net Present Value Method above would be:
OR
The higher profitability index, the more desirable is the investment. Thus, this
index provides a ready compatibility of investment having various magnitudes. By
computing profitability indices for various projects, the financial manager can rank
them in order of their respective rates of profitability.
(iv) Terminal Value Method
This approach separates the timing of the cash-inflows and outflows more
distinctly. Behind this approach is the assumption that each cash-inflow is re-
invested in other assets at the certain rate of return from the moment, it is received
until the termination of the project. Then the present value of the total compounded
sum is calculated and it is compared with the initial cash-outflow. The decision rule
is that if the present value of the sum total of t he compounded re-invested cash-
inflows is greater than the present value of cash-outflows, the proposed project is
accepted otherwise not. The firm would be different if both the values are equal.
231
ii. The NPV method recognizes the importance of market rate of interest or cost
of capital. It arrives at the amount to be invested in a given project so that
its anticipated earnings would recover the amount invested in the project at
market rate. Contrary to this, the IRR method does not consider the market
rate of interest and seeks to determine the maximum rate of interest at
which funds invested in any project could be repaid with the earnings
generated by the project.
iii. The basic presumption of NPV method is that intermediate cash inflows are
reinvested at the cut off rate, whereas, in the case of IRR method,
intermediate cash flows are presumed to be reinvested at the internal rate of
return.’
iv. The results shown by NPV method are similar to that of IRR method under
certain situations, whereas, the two give contradictory results under some
other circumstances. However, it must be remembered that NPV method
using a predetermined cut-off rate is more reliable than the IRR method for
ranking two or more capital investment proposals.
(a) Similarities of Results under NPV and IRR
Both NPV and IRR methods would show similar results in terms of accept or
reject decisions in the following cases:
1. Independent investment proposals which do not compete with one
another and which may be either accepted or-rejected on the basis of a
minimum required rate of return.
2. Conventional investment proposals which involve cash outflows or
outlays in the initial period followed by a series of cash inflows.
The reason for similarity of results in the above c ases lies on the basis of
decision-making in the two methods. Under NPV method, a proposal is accepted if
its net present value is positive, whereas, under IRR method it is accepted if the
internal rate of return is higher than the cut off rate. The projec ts which have
positive net present value, obviously, also have an internal rate of return higher
than the required rate of return.
(b) Conflict between NPV and IRR Results
In case of mutually exclusive investment proposals, which compete with one
another in such a manner that acceptance of one automatically excludes the
acceptance of the other, the NPV method and IRR method may give contradictory
results. The net present value may suggest acceptance of one proposal whereas, the
internal rate of return may favour another proposal. Such conflict in rankings may
be caused by any one or more of the following problems:
1. Significant difference in the size (amount) of cash outlays of various
proposals under consideration.
2. Problem of difference in the cash flow patterns or timings of the various
proposals and
3. Difference in service life or unequal expected lives of the projects.
233
Exercise:
1) Equipment A has a cost of 75,000 and net cash flow of `20,000 per year for
six years. A substitute equipment B would cost ` 50,000 and generate net cash flow
of ` 14,000 per year for six years. The required rate of return of both equipments is
11 per cent. Calculate the IRR and NPV for the equipments. Which equipment
should be accepted and why?
Solution:
Equipment A
NPV = 20,000 x PVAF 6, 0.11 - 75,000
= 20,000 x 4.231 - 75,000
PVAF 6,0.16
= 3.685
Therefore,
3.784 – 3.75 IRR = r = 0.15 + 0.01
3.784 – 3.685 = 0.15 + 0.0034 = 0.1534 or IRR = 15.34%
Equipment B:
NPV = 14,000 x PVAF6,0.11 - 50,000
= 14,000 x 4.231 - 50,000
59,234 - = Rs
= 50,000 9,234
50,000 /
PVAF6,r = 14,000 = 3.571
234
Therefore,
Equipment A has a higher NPV but lower IRR as compared with equipment B.
Therefore equipment A should be preferred since the wealth of the shareholders will
be maximized.
5) For each of the following projects compute (i) pay -back period, (ii) post pay-
back profitability and (iii) post-back profitability index
a) Initial outlay ` 50,000
= 10,000 (8 – 5) = 30,000
235
b) i) As the case inflows are the equal during the life of the investment
payback period can be calculated as:
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Solution:
Statement of Profitability
Machine E Machine F
Year
PBTAD Tax 50% PATD PBTAD Tax 50% PATD
1 15,000 7,500 7,500 5,000 2,500 2,500
2 20,000 10,000 10,000 15,000 7,500 7,500
3 25,000 12,500 12,500 20,000 10,000 10,000
4 15,000 7,500 7,500 30,000 15,000 15,000
5 10,000 5,000 5,000 20,000 10,000 10,000
Total 85,000 42,500 42,500 90,000 45,000 45,000
Machine E Machine F
Average profit after tax 42,500 x 1/5 = 8,500 45,000 x 1/5 = 9,000
Average investment 60,000 x ½ = 30,000 60,000 x ½ = ` 30,000
Average return on 8,500/30,000 x 9,000/30,000 x
average 100 = 28.33% 100 = 30%
Thus, machine F is more profitable.
Capital Rationing – Meaning
Capital rationing refers to a situation where a firm is not in a position to invest
in all profitable projects due to the constraints on availability of funds. We know
that the resources are always limited and the demand for them far exceeds their
availability, it is for this reason that the firm cannot take up all the projects though
profitable, and has to select the combination of proposals that will yield the greatest
profitability.
Capital rationing is a situation where a firm has more investment proposals
than it can finance. It may be defined as “a situation where a constraint is placed
on the total size of capital investment during a particular period”. In such an event
the firm has to select combination of investment proposals that provide the highest
net present value subject to the budget constraint for the period. Selecting of
projects for this purpose will require the taking of the following steps:
i. Ranking of projects according to profitability index or internal’-rate of return.
Selecting projects in descending order of profitability until the budget figures
are exhausted keeping in view the objective of maximizing the value of the firm.
PRACTICAL PROBLEMS
1. Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the
project is
237
Year X Y
1 5000 1000
2 4000 2000
3 3000 3000
4 1000 4000
5 - 5000
6 - 6000
The company has fixed 3 years pay-back period as the cut-off point, state
which project should be accepted .
Ans: Traditional pay-back period for:
Project X= 2 years &4 Months (2.33 years) Project Y=4 years.
Discounted pay-back period @ 10% Project:
X=2.95 years & project Y=4.79 years
1. KK Ltd has two projects under consideration which are mutually exclusive.
the projects have to be depreciated on straight line basis and the tax rate
may be taken as 50% .
Year Profit before Depreciation
A(Rs.) B(Rs)
1 80,000 20,000
2 60,000 40,000
3 40,000 60,000
4 20,000 80,000
5 10,000 1,00,000
Calculate payback period.
A Ltd. has under consideration the following two projects. their details are as
under:
Project X Project Y
Investment in machinery Rs.10,00,000 15,00,000
Working capital 5,00,000 5,00,000
Life of machinery 4 yrs 6 yrs
Scrap value of machinery 10 % 10 %
Tax rate 50 % 50 %
Income before depreciation and
tax at the end of year
1 8,00,000 15,00,000
2 8,00,000 9,00,000
3 8,00,000 15,00,000
4 8,00,000 8,00,000
5 - 6,00,000
6 - 3,00,000
You are required to calculate the accounting rate of return and suggest which
project is to be preferred.
(Ans: ARR Project X Rs =19.1% ,Project Y Rs = 17.75% )
1. A new capital project costing Rs.140 Lakhs will yield on an average a profit
before tax and depreciation of Rs.50 lakhs .depreciation will be Rs.20 lakhs
per annum and the tax rate is 50% . Work out the pay_back period and
return on investment.
Ans. Pay_back period = 4 years, ARR(on original investment)=10.71% ARR(on
average investment)= 21.43 %
2. A project requires initial investment of Rs 85,000 and is expected to give
cash flows of Rs 18,000, Rs25,000,Rs 10,000,Rs.25,000 and Rs. 30,000 for
5 years respectively. the project has a salvage value of Rs.10,000. The
companys target rate of return is 10% .calculate the profitability of the
projects by using profitability index method. (Ans: P.I = 1.017)
3. A project costs Rs.16,000 and is expected to generate cash inflows of
Rs.4,000 each for 5 years .calculate internal rate of return . (Ans .8%)
4. MM Limited considering a project with an Initial investment of Rs1,80,000,
the life of the project is four years and estimated net annual cash flows are
as follows
240
Year Rs
1 45,000
2 60,000
3 90,000
4 60,000
Calculate internal rate of return [Ans:14.49 %]
Easwar limited company is considering an investment in a project with a
capital outlay of Rs.2,00,000. The estimated annual income after depreciation but
before tax is Rs. 1,00,000; each in the first and second year 80,000; each in the
third and fourth year and Rs.40,000 in the fifth year. Depreciation may be taken
at 20% on original cost and taxation at 50% of net income you are required to
evaluate the project according to each of the following method:
a) Payback period method
b) Rate of return on original investment method
c) Rate of return on average investment method
d) Net present value method discounting in flow at 10%
YEAR 1 2 3 4 5
P.V.F 0.909 0.826 0.751 0.683 0.621
Ans : a)2.25 years b)20 % c) 40 % d) 1,08,130
The expected cash flows of a project are as follows :
Year 0 1 2 3 4 5
Cash 1,00,000 20,000 30,000 40,000 50,000 30,000
flow
The cost of capital is 12% calculate:
a) NPV (b) IRR (c) Payback period and (d) Discounted payback period
Ans: a ) 19,060 b) 20.56% c) 3 years 2 months d) 3 yrs 11 months
Capital rationing
A ltd. has an investment budget of Rs.25 Lakh for next year.it has under
consideration three projects A,B and C(B and C are mutually exclusive )and all of
them can be completed within a year. Further details are given below :
Project Investment required Net present value
A 14 5.6
B 12 7.2
C 10 5.0
Recommend the best policy to utilize budget, supported by proper reasoning
[Ans: A&B is not possible as investment required exceeds Rs.25 lakh.
B&C is not possible as they are mutually exclusive projects:
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0 (5,000) (5,000)
1 2,085 0
2 2,085 0
3 2,085 0
4 2,085 9,677
0 (100) (100)
1 10 70
2 60 50
3 80 20
Both projects have a cost of capital of 10% .
a. Calculate the payback for both projects.
b. Calculate the NPV for both projects.
c. Calculate the IRR for both projects.
d. Calculate the MIRR for both projects.
Answers: a. 2.4 yrs, 1.6 yrs; b. Rs.18.78, Rs.19.98; c. 18.1% , 23.56% ; d.
16.5% , 16.9% ;
3. Expansion Project. A machine has a cost of Rs.180. It will have a life of 3
years, and will be depreciated straight line to zero salvage value. It will result in
sales revenue of Rs.200 per year and cash operating costs of Rs.110 per year. Use
of the machine will require an increase in working capital of Rs.70 for the 3 years,
243
beginning at year 0. The appropriate discount rate is 8% and the firm’s tax rate is
40% .
a. Calculate the initial cash flow at time 0.
b. Calculate the annual operating cash flows (they are identical each year).
c. Calculate the relevant terminal cash flows at the end of year 3.
d. What is the NPV for the machine?
Answers: a. -250; b. 78; c. 70; d. Rs.6.58
4. Inflation adjustment: A project requires an initial investment of Rs.8,000,
has a 4-year life and provides expected cash flows as follows, based on year 1 prices
and costs:
Annual revenue = Rs.5,000
Annual cash operating costs = Rs.2,000
Annual depreciation = Rs.2,000
Terminal cash flow = 0
Cost of capital = 14% and Tax = 30%
a. Calculate the annual operating cash flows without adjusting for inflation.
(Are these cash flows real or nominal?) Calculate the associated NPV.
b. Adjust the cash flows to reflect the effects of inflation, which is expected to
affect sales revenue and cash operating expenses at the rate of 4% annually. (Are
these cash flows real or nominal?) Calculate the associated NPV.
c. Which NPV is the correct one for evaluating the project?
Ans: a. -Rs.133; b. Rs.202
5. Mutually Exclusive Projects with Unequal Lives. Murray’s Coffee House
is trying to choose between two new coffee bean roasters. The required rate of
return for either machine is 10% . Shown below are the after-tax cash flows
associated with each machine:
year CFX CFY
0 (50,000) (30,000)
1 20,000 20,000
2 20,000 20,000
3 20,000
4 20,000
0 -50,000 -100,000
1 20,000 60,000
2 20,000 25,000
3 20,000 25,000
4 20,000 25,000
= 2,00,000
50,000 = 4 Years
(B) When cash inflows are not uniform
It investment in a project Rs.8,00,000 and net cash inflows after tax but before
depreciation are estimated for the next 6 years as Rs.20,000, Rs.25,000,
Rs,20,000, Rs.30,000, Rs.35,000 and Rs.15,000 Respectively, pay back period is
calculated as follows.
Solution
1 Rs.20,000 Rs.20,000
2 Rs.25,000 Rs.45,000
3 Rs.20,000 Rs.65,000
4. Rs.30,000 Rs.95,000
At end of 4 th year the cumulative cash inflow exceeds the investment of
Rs.80,000
Pay back period = 3 Years + 15000
30000
= 3 Years + ½ year
= 3.5 Year
246
(1+r) n
r – Discount rate
n – No of years
For example
(1 + 1) 1 1. 1
(1 + 1) 2 1. 21
247
(1 + 1) 3 1. 33
ARR
X y
Average investment
Aug Invest = org. invest – scrap values + Add net + scrap value working
2 capital
248
= Rs.1,50,000
= Rs.1,50,000
1,50,000
Working notes
Calculation of average annual net earnings
Mac X
5 64,000
Mac Y
5 = 80,000
1 10,000 30,000
2 40,000 50,000
3 30,000 80,000
4 60,000 40,000
5. 90,000 60,000
The company’s targeted rate of return on investment is 12% you are required to
access the projects on the basis of the present values, using, 1)NPV Method 2)
Profitability Index Method.
Present values of Re 1 at 12% interest for five years are given below.
1 year : 0.893 : 2nd Yr : 0.797 ; 3rd year
st
1) NPV Project A B
51,360 83,060
PI = PV of cash inflow
PV of cash outflow
Project A Project B
(Initial invest)
PI = 1,51,360 1,83,060
1,00,000 1,00,000
= 1.5136 1.8306
LESSON 20
INTRODUCTION TO COST ACCOUNTING
20.1 INTRODUCTION
Cost Accounting is a branch of accounting and has been developed due to
limitations of financial accounting. Financial accounting is primarily concerned
with record keeping directed towards the preparation of Profit and Loss Account
and Balance Sheet. It provides information regarding the profit and loss that the
business enterprise is making and also its financial position on a particular date.
The financial accounting reports help the management to control in a general way
the various functions of the business but it fails to give detailed reports on the
efficiency of various divisions.
The limitations of Financial Accounting which led to the development of cost
accounting are as follows.
20.2 OBJECTIVES
After completing this Lesson you should be able to Know
What is cost, costing and cost control?
Objectives and Principles of Cost Accounting
Difference Between Cost Accounting VS Financial Accounting VS
Management Accounting
20.3 CONTENT
20.3.1 Limitation of Financial Accounting
20.3.2 Branches of Accounting
20.3.3 Meaning and Scope of Cost Accounting
20.3.4 Cost Accounting
20.3.5 Costing
20.3.6 Cost Control
20.3.7 Objectives of Cost Accounting
20.3.8 General Principles of Cost Accounting
20.3.9 Difference between Financial Accounting and Cost Accounting
10.3.10 Management VS Cost Accounting
20.3.11 Difference between Management Accounting and Cost Accounting
20.3.1 LIMITATIONS OF FINANCIAL ACCOUNTING
1. No clear idea of operating efficiency: Sometimes profits in an organization
may be less or more because of inflation or trade depression and not due to
efficiency or inefficiency. But financial accounting does not give a clear reason for
profit or loss.
2. W eakness not spotted out by collective results: Financial Accounting
shows the net result of an organization. When the profit and loss account of an
organization, shows less profit or a loss, it does not give the reason for it or it does
not show where the weakness lies.
254
3. Does not help in fixing the price: In Financial Accounting, we get the total
cost of production but it does not aid in determining prices of the products,
services, production order and lines of products.
4. No classification of expenses and accounts: In Financial Accounting, we
don’t get data relating to costs incurred by departments, processes separately or
per unit cost of product lines, or cost incurred in various sales territories. Further
expenses are not classified as direct or indirect, controllable and uncontrollable
overheads and the value added in each process is not reported.
5. No data for comparison and decision making: It does not supply useful
data to management for comparison with previous period and for taking various
financial decisions as introduction of new products, replacement of labour by
machines, price in normal or special circumstances, producing a part in the factory
or buying it from outside market, production of a product to be continued or given
up, priority accorded to different products, investment to be made in new products
or not etc.
6. No control on cost: Financial Accounting does not help to control materials,
supplies, wages, labour and overhead costs.
7. Does not provide standards to assess the performance : Financial
Accounting does not help in developing standards to assess the performance of
various persons or departments. It also does not help in checking that costs do not
exceed a reasonable limit for a given quantum of work of the requisite quality.
8. Provides only historical information: Financial Accounting records only
the historical costs incurred. It does not provide day -to-day cost information to the
management for making effective plans for the future.
9. No analysis of losses: It does not provide complete analysis of losses due to
defective material, idle time, idle plant and equipment etc.. In other words, no
distinction is made between avoidable and unavoidable wastage.
10. Inadequate information for reports: It does not provide adequate
information for reports to outside agencies such as banks, government, insurance
companies and trade associations.
11. No answer for certain questions: Financial Accounting will not help to
answer questions like:-
a. Should an attempt be made to sell more products or is the factory
operating to capacity?
b. if an order or contract is accepted, is the price obtainable sufficient to
show a profit?
c. if the manufacture or sale of product A were discontinued and efforts make
to increase the sale of B, what would be the effect on the net profit? (d)
Why the profit of last year is of such a small amount despite the fact that
output was increased substantially? Etc.
20.3.2 BRANCHES OF ACCOUNTING
Accounting may broadly be classified into Seven categories:-
1. Financial Accounting
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LESSON 21
IMPORTANCE OF COST ACCOUNTING
21.1 INTRODUCTION
Compare with financial accounting, cost accounting is relatively a recent
development. Cost accounting started as a branch of financial accounting, but now
it is regarded as a system in its own right. The vital importance that cost
accounting has acquired in the modern age is because of the growth of complexities
in modern industry. Cost accounting has primarily developed to meet the needs of
management. Cost accounting provides detailed cost information to various levels
of management for efficient performance of their functions.
21.2 OBJECTIVES
After completing this Lesson you should be able to know
Importance of Cost Accounting
Classification and elements of Costs
Components of total cost
21.3 CONTENT
20.3.1 Importance of Cost Accounting
20.3.2 Installation of Cost Accounting System
20.3.3 Classification Of Cost
20.3.4 Elements of Cost
20.3.5 Items Excluded from Cost Accounts
20.3.6 Components of Total Costs
20.3.7 Adjustment for Inventories
20.3.8 Cost Sheet
21.3.1 IMPORTANCE OF COST ACCOUNTING
1. Costing helps in periods of trade depression and trade competition:-
In periods of trade depression the business cannot afford to have leakages
which pass unchecked. The management should know where economies may be
sought, waste eliminated and efficiency increased. The business has to wage a
wax for its survival. The management should know the actual cost of their
products before embarking on any scheme of reducing the prices on giving tenders.
Adequate costing facilitates this.
2. Aids in price fixation:-
Though economic law & supply and demand and activities of the competitors,
to a great extent, determine the price of the article, cost to the producer does play
an important part. The producer can take necessary guidance from his costing
records.
3. Helps in estimate:-
Adequate costing records provide a reliable basis upon which tende rs and
estimates may be prepared. The chances of losing a contract on account of over –
rating or losing in the execution of a contract due to under – rating can be
263
accounting period. Fixed assets come under category of capital expenditure and
maintenance of assets comes under revenue expenditure category.
Based on Association with the Product
There are two categories under this classification:
Product cost - Product cost is identifiable in any product. It includes
direct material, direct labor and direct overheads. Up to sale, these
products are shown and valued as inventory and they form a part of
balance sheet. Any profitability is reflected only when these products are
sold. The Costs of these products are transferred to costs of goods sold
account.
Time/Period base cost - Selling expenditure and Administrative
expenditure, both are time or period based expenditures. For example,
rent of a building, salaries to employees are related to period only.
Profitability and costs are depends on both, product cost and
time/period cost.
Based on Functions
Under this category, the cost is divided by its function as follows:
Production Cost - It represents the total manufacturing or production cost.
Commercial cost - It includes operational expenses of the business and
may be sub-divided into administration cost, and selling and distribution
cost.
Based on Change in Activity or Volume
Under this category, the cost is divided as fixed, variable, and semi-variable
costs:
Fixed cost - It mainly relates to time or period. It remains unchanged
irrespective of volume of production like factory rent, insurance, etc. The
cost per unit fluctuates according to the production. The cost per unit
decreases if production increases an d cost per unit increases if the
production decreases. That is, the cost per unit is inversely proportional to
the production. For example, if the factory rent is Rs 25,000 per month and
the number of units produced in that month is 25,000, then the cost of rent
per unit will be Rs 1 per unit. In case the production increases to 50,000
units, then the cost of rent per unit will be Rs 0.50 per unit.
Variable cost - Variable cost directly associates with unit. It increases or
decreases according to the volume of production. Direct material and direct
labor are the most common examples of variable cost. It means the variable
cost per unit remains constant irrespective of production of units.
Semi-variable cost - A specific portion of these costs remains fixed and the
balance portion is variable, depending on their use. For example, if the
minimum electricity bill per month is Rs 5,000 for 1000 units and excess
266
Indirect labour:- labour employed for the purpose of carrying out tasks
incidental to goods or services provided, is indirect labour such labour does
not alter the construction, composition or condition of the product. It cannot be
practically traced to specific units of output wages of store – keepers, foreman, time
– keepers, directors, fees, salaries of salesmen, etc. are all examples of indirect
labour costs.
Indirect labour may relate to the factory the office or the selling and
distribution division.
c. Expenses: - Expenses may be direct or indirect.
Direct expenses: - These are expenses which can be directly, conveniently and
wholly allocated to specific cost centers or cost units. Examples of such expenses
are: hire of some special machinery required for a particular contract, cost of
defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as “chargeable expenses”.
Indirect expenses:- these are expenses which cannot be directly, conveniently
and wholly allocated to cost centers or cost units.
OVERHEADS:- It is to be noted that the term overheads has a wider meaning
than the term indirect expenses overheads include the cost of indirect material,
indirect labour besides indirect expenses.
Indirect expenses may be classified under the following three categories:-
(a) Manufacturing (works, factory or production) expenses:-
Such indirect expenses which are incurred in the factory and concerned with
the running of the factory or plant are known as manufacturing expenses.
Expenses relating to production management and administration are included
there in. Following are a few items of such expenses:
Rent, rates and insurance of factory premises, power used in factory building,
plant and machinery etc.
(b) Office and Administrative expenses
These expenses are not related to factory but they pertain to the management
and administration of business such expenses are incurred on the direction and
control of an undertaking example are :- office rent, lighting and heating, postage
and telegrams, telephones and other charges; depreciation of office building,
furniture and equipment, bank charges, legal charges, audit fee etc.
(c)Selling and Distribution Expenses:-
Expenses incurred for marketing of a commodity, for securing orde rs for the
articles, dispatching goods sold, and for making efforts to find and retain customers
are called selling and distribution expenses examples are:-
Advertisement expenses cost of preparing tenders, traveling expenses, bad
debts, collection charges etc.
Warehouse charges packing and loading charges, carriage outwards, etc.
268
ELEMENTS OF COST
The above classification of different elements of cost can be presented in the
form of the following chart:
Direct expenses
Works overheads
270
Cost of Production
Administrative overheads
Output……………units
Rs. Rs.
Output…………units
Rs. Rs.
Expenses
xxx
xxx
Xxx -
Xxx -
Practical Problems
273
Illustration 3. Calculate works cost or factory cost from the following details:-
Illustration 5. Prepare cost sheet from the following particular in the book of B.
M. Rehman
Solution:-
Book of B. M. Rehman
Cost sheet
Solution:-
Book of B. M. Rehman
Cost sheet
Particular Details (Rs) Amount (Rs)
Direct material:-
------------- 7,000
Direct wages:-
------------
------------- 275
------------- 550
Indirect depreciation 75
------------ 200
------------- 325
Advertisement 125
------------ 475
------------- 625
Profit 2,500
-----------
Sales 12,500
281
Illustration 8.
Prepare a statement of cost from the following trading and P/L account for the
year ending March 31, 2008
Particular Amount Particular Amount
(Rs) (Rs)
To opening stock material 12,000 By sales 2,00,000
Finished goods 40,000 By closing stock 20,000
material
To purchases 1,20,000 Finished goods 50,000
To cost of moulds 3,000
To salary of factory manger 1,000
To depreciation of machine 800
To gross profit 63,200
------------ -----------
2,70,000 2,70,000
---------- ----------
To office salary 9,000 By Gross profit 63,200
To salesman salary 6,000 By interest from 800
bank
To insurance of office 1,000 By dividend received 200
building
To godown expenses 800 By rent received 900
To directors fees 2,000
To telephone charges 700
To showroom expenses 1,200
To delivery van expenses 1,500
To preliminary expenses 2,000
To interest on deb. 700
To market research exp. 600
To net profit 39,000
-------------- --------------
65,100 65,100
-------------- --------------
282
Solution
Statement of cost
(For the year ending 31 st March 2008)
Particular Details (Rs) Amount (Rs)
Direct material or Raw material purchased 1,20,000
Add:- opening stock of raw materials 12,000
Raw material for consumption 1,32,000
Less:- Closing sock of raw materials 20,000
Raw material consumed 1,12,000
Add:- Direct labour 30,000
Illustration 9.
The following inventory data relate to Nazia Ltd.
Inventories
Opening Closing
Finish goods Rs 1,100 Rs 950
Work in progress Rs 700 Rs 800
Raw materials Rs 900 Rs 950
Additional information:-
Rs Rs
Raw material 33,000 Director’s fees (office) 2,000
Productive wages 35,000 Factory cleaning 500
Direct expenses 3,000 Sundry office expenses 200
Unproductive wages 10,500 Estimating 800
Factory rent and terms 7,500 Factory stationery 750
Factory lighting 2,200 Office stationery 900
Factory heating 1,500 Factory insurance 1,100
Motive power 4,400 Office insurance 500
Haulage 3,000 Legal expenses 400
Director’s fees (works) 1,000 Rent of warehouse 300
Depreciation of Unkeeping of delivery vans 700
- plant and machinery 2,000 Bank charges 50
- office building 1,000 Commission on sales 1,500
- delivery vans 200 Loose tools written off 600
Bad debts 100 Rent and taxes (office) 500
Advertising 300 Water supply 1,200
Sales department 1,500
Salaries
The total output for the period has been 10,000 tones.
(Ans. Prime cost Rs 71,000 works cost Rs 1,08,050 office cost Rs 1,13,600 total
cost Rs 1,18,200 cost per tone Rs 11.82)
2. Prepare a cost sheet to show the total cost of production and cost per unit of
goods manufactured by a company for the month of July 1994. Also find out the
cost of sales.
Rs Rs
Stock of raw materials1-7-94 3,000 Factory rent & rates 3,000
Raw materials purchased 28,000 Office rent 500
Stock of raw materials 31-7-94 4,500 General expenses 400
Manufacturing wages 7,000 Discount on sales 300
Depreciation on plant 1,500 Advertisement 600
Loss on sale of a part of plant 300 Expenses to be charged 2,000
fully income tax paid
The number of units produced during July 1994 was 3,000
The stock of finished goods was 200 and 400 units on 1-7-1994 and 31-7-1994
respectively. The total cost of units on hand on 1-7-1994 was Rs 2,800. All these
had been sold during the month.
287
(Ans. Prime cost Rs 33,500 factory cost Rs 38,000 cost of production Rs 38,900
cost of sales Rs 37416)
3. The following particulars relating to the year 1994 have been taken from the
books of a chemical works manufacturing and selling a chemical mixture:
Rs Rs
Stock on 1st Jan. 1994
Raw materials 2,000 2,000
Finished mixture 500 1,750
Factory stores ------ 7,250
Purchases
Raw materials 1,60,000 1,80,000
Factory stores ------ 24,250
Sales
Finished mixture 1,53,050 9,18,000
Factory scrap ------ 8,170
Factory wages ------ 1,78,650
Power ------ 30,400
Depreciation of machinery ------ 18,000
Salaries
Factory ------ 72,220
Office ------ 37,220
Selling ------ 41,500
Expenses
Direct ------ 18,500
Office ------ 18,200
Selling ------ 18,000
Stock on 31 December 1994
st
4. Calculate
a. Value of raw-materials consumed
b. Total cost of production
c. Cost of goods sold and
d. The amount of profit from the following particulars:
Rs Rs
Opening stock Power 2,000
Raw – materials 5,000 Factory heating and lighting 2,000
Finished goods 4,000 Factory insurance 1,000
Closing stock Experimental Expenses 500
Raw – materials 4,000 Sales of wastage of 200
materials
Finished goods 5,000 Office management salaries 4,000
Raw – materials purchased 50,000 Office printing and 200
stationery
Wages paid to labourers 20,000 Salaries of salesmen 2,000
commission of traveling
agent
Chargeable expenses 2,000
Factory rent, rates & taxes 5,000 Sales 1,00,000
(Ans. (a) Rs 50,800, (b) Rs 87,500, (c) Rs 89,500, (d) Rs 10,500)
[Hint sales of raw-materials wastage of Rs 200 has been deducted from the cost
of raw-materials]
5. The cost of the sale of product ‘X’ is made up as follows:
Rs
Materials used in manufacturing 10,20
Materials used in packing materials 2,500
Materials used in selling the product 350
Materials used in office 75
Materials used in factory 125
Labour required in producing 2,500
Salary paid to works manager and other principal officers of the factory 450
Expenses – indirect office 250
Expenses – direct factory 1,000
Bad debts 300
Packing expenses 150
Lighting and heating charges of the factory 200
Expenses – indirect factory 125
289
Assuming that all the products manufactured are sold, what should be the
selling price to obtain a profit of 20% on cost price?
Illustrate in a chart fork for presentation to your mange, the division of costs of
product ‘X’
[Ans. Prime cost Rs 16,200, works cost Rs 17,100 cost of sales Rs 18,225 sales
Rs 21,870]
6. Calculate the prime cost, factory cost, total cost of production and cost of
sales from the following particulars:
Rs.
Raw materials consumed 12,000
Directly chargeable expenses 500
Wages paid to labourers 2,500
Grease, oil, cotton waste etc. 25
Salary manager and clerks 1,750
Insurance of stock of raw materials 300
Consumable stores 400
Printing and stationery:
Factory 50
Office 200
Sales deptt. 100
----------- 350
[Ans. Prime cost Rs 15,000, factory cost Rs 19225 total cost of production Rs
19,800 cost of sales Rs 21,395]
7. Calculate
1. Value of raw-materials consumed
2. Total cost of production
3. Cost of goods sold and
4. The amount of profit from the following particulars:
Rs
Opening stock:
Raw materials 1,350
Finished goods 2,500
Closing stock:
Raw-materials 750
Finished goods 1,500
Raw materials purchased 20,000
Wages paid to labourers 8,000
Direct expenses 1,250
Experimental expenses 450
Factory printing and stationery 350
Rent :
Factory 250
Office 120
-------- 370
Wages of fireman 1,000
Lighting – office 125
Audit fees 150
Telephone expenses 500
Advertising 1,250
Market research expenses 550
Salary of godown – keepers 175
Traveling expenses 750
Commission of traveling agent 500
Sales 50,000
[Ans. (a) value of raw – materials consumed Rs. 20,600 (b) Total cost of
production Rs 32,795, (c) cost of goods sold Rs 33,795, (d) profit Rs 12,980]
291
8. Prepare a statement of cost from the following trading and profit and loss
account for the year ending 31 st March, 1995.
Particulars Rs Particulars Rs
Opening stock: Sales 1,00,000
Materials 8,000 Closing stock:
Finished goods 25,000 Materials 15,000
Purchase of materials 70,000 Finished goods 30,000
Direct labour 10,000
Grease, oil etc. 500
Salary of storekeeper 700
Power & fuel 800
Gross profit c/d 30,000
------------- -------------
1,45,000 1,45,000
------------- -------------
Lighting: Gross profit b/d 30,000
Office 500 Dividends received 2,000
Sales deptt. 650 Interest on loan 600
Depreciation: Transfer fees 1,450
Office premises 1,000 Received
Delivery vans 750
Fees of office manager 2,000
Bank charges 1,500
Selling expenses 1,500
Sales commission 500
Preliminary expenses 3,000
Packing expenses 1,100
Dividends paid on 1,000
Share capital of company
Discount on debentures 500
Net profit 20,000
------------ -----------
34,000 34,000
292
[Ans. Prime cost Rs 73,000, works cost Rs 75,000, total cost of production Rs
80,000 cost of goods sold Rs 75000 cost of sales Rs 79,000 profit Rs 21,000]
9. The following data relate to the manufacture of standard product during the four
week ending on 28 th Oct. 1994.
Raw materials consumed Rs 20,000
Direct wages Rs 12,000
Machine hr worked 950 (hrs)
Machine hour rate Rs 2.00
Office overhead 15% on works cost
Selling overhead Rs 0.37 per unit
Units produced 20,000
Units sold @ Rs 2.50 each 18,000
Prepare a statement from the above showing:
a. The cost of production per unit, and
b. The profit for the period
[Ans. (a) Rs 1,949 (b) Rs 3,258
10. A firm has purchased a plant to manufacture a new product, the cost data for
which is given below:
Estimated annual sales 24,000 units
Estimated costs:
Material Rs 4.00 per unit
Direct labour Rs 0.60 per unit
Overheads Rs 24,000 per year
Administrative expenses Rs 28,800 per year
Selling expenses 15% of sales
Calculate the selling price if profit per unit is Rs 1.02
[Ans. Rs 9.20]
11. Prepare a cost sheet from the following data to find out profit and cost per unit:
Raw materials consumed Rs 1,60,000
Direct wages Rs 80,000
Factory overheads 20% of direct wages
Office overheads 10% of factory cost
Selling overheads 12,000
Unit produced 4,000
Units sold 3,600
Selling price Rs 100 per unit
[Ans. Prime cost Rs 2,40,000, factory cost Rs 2,56,000, cost of production Rs
2,81,600, cost of sales Rs 2,65,440, profit Rs 94,560]
293
ELEMENTS OF COST: There are three broad elements cost :Material, Labour,
Expenses .Material: - The substance from which the product is made is known as
material. It may be in a raw or a manufactured state. It can be direct as well as
indirect .Labour: - For conversion of materials into finished goods, human effort is
needed such human effort is cal led labour. Labour can be direct as well as
indirect. Expenses: - Expenses may be direct or indirect
OVERHEADS:- It is to be noted that the term overheads has a wider meaning
than the term indirect expenses overheads include the cost of indirect material,
indirect labour besides indirect expenses.
Components of total cost : Prime cost: - It consists of costs of direct material,
direct labour and direct expenses. It is also known as basic, first or flat cost.
Factory cost:- It comprises of prime cost and in addition works of factory
overheads which includes costs of indirect material, indirect labour and indirect
expenses of the factory. The cost is also known as works cost, production or
manufacturing cost. Office cost: - If office and administrative overheads are added to
factory cost office cost is arrived at this is also termed as administrative cost or the
total cost of production. Total cost:- Office cost or total cost of production selling
and distribution overheads are added to the total cost of production to get the total
cost or the cost of sales. Cost of sales or total cost. Cost sheets are prepared for the
use of management and consequently, they must include all the essential details
which will assist the manager in checking the efficiency of production.
21.7 TERMINAL EXERCISE
1. …………………………………..is an analytical statement of expenses relating
to production of an article which informs regarding total cost, per unit cost
and quantity of production.
2. …………….. consists of costs of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost.
3. The substance from which the product is made is known as
……………………..
4. For conversion of materials into finished goods, human effort is needed
such human effort is called ………………………
21.8 SUPPLEMENTARY MATERIAL
1. http://eacharya.inflibnet.ac.in/
2. http://costkiller.net/
3. http://www.icsi.in/
4. http://icmai.in/
5. http://www.newagepublishers.com/
6. https://www.coursehero.com
7. http://imr.ac.in/
295
8. http://www.dphu.org/
9. basiccollegeaccounting.com/
10. http://www.naturalproductsinsider.com/
11. http://www.yourarticlelibrary.com/
12. http://kafco.in/
21.9 ASSIGNMENTS
1. What are the main benefits that may be expected from installation of a
costing system in a manufacturing business.
2. Costing system has become a essential tool in the hands of
management-Comment
3. Money spent on costing installing a costing syste m is not an expenses
but an investment. Give your views.
21.10 SUGGESTED READINGS
1. Arora .M.N Cost Accounting Principles and Practice Vikas publishing
House PVT Ltd
2. Jain and Narang Cost Accounting
3. Pillai R.S.N, Bagavathi Management Accounting S.Chand company
21.11 LEARNING ACTIVITIES
Visit a nearby organization and prepare a report on how the organization had
installed the cost accounting system
21.12 KEYWORDS
Material, Labour, Expenses, Overheads, Cost sheet, Prime cost, factory cost ,
office cost, works cost, total cost,
296
LESSON 22
ESSENTIALS OF GOOD COST ACCOUNTING SYSTEM
22.1 INTRODUCTION
The essentials of good cost accounting system should have stability as well as
specialty designed system. It should have executive support. The cost of installing
and operating system should be justified by results produced. In order to derive
maximum benefits from a costing system, well defined cost centers and
responsibilities centers should be built within the organization. Controllable and
non-controllable costs of each responsibility center should be separately shown.
It should have integration with the financial accounts .Well trained and
educated staff should be employed to operate the system. The cost accounting
department should prepare the accurate reports. Resources should not be wasted
on collecting and compiling cost data not required.
22.2 OBJECTIVES
After completing this Lesson you should be able to know
Essentials of good cost accounting
Importance of cost centre, Profit centre
Techniques of costing
Different types of costing
22.3 CONTENT
22.3.1 Essentials of Good Cost Accounting System
22.3.2 Advantages of Cost Accounting
22.3.3 Limitations of Cost Accounting
22.3.4 Cost Units
22.3.5 Cost Centre
22.3.6 Profit Centre
22.3.7 Methods of Costing
22.3.8 Techniques of Costing
22.3.1 ESSENTIAL OF A GOOD COST ACCOUNTING SYSTEM
A good cost accounting should possess the following essential features:
i. It should be simple, practical and capable of meeting the business
concern requirements.
ii. Accurate data should be used by cost accounting system; otherwise it
may distort the output of the system.
iii. To develop a good system of cost accounting necessary co-operation and
participation of executives from various departments of the business is
needed.
iv. The cost of installing and operating the system should be result oriented
v. It should not sacrifice the utility by introducing unnecessary details.
vi. For the introduction of the system a carefully phased programmed
should be prepared by using network analysis.
297
Cost centre is the smallest organizational sub- unit for which separate cost
collection is attempted. Thus cost centre refers to one of the convenient unit into
which the whole factory organization has been appropriately divided for costing
purposes. Each such unit consists of a department or a sub-department or item of
equipment or , machinery or a person or a group of persons.
For example, although an assembly department may be supervised by one
foreman, it may contain several assembly lines. Some times each assembly line is
regarded as a separate cost centre with its own assistant foreman.
The selection of suitable cost centres or cost units for which costs are to be
ascertained in an undertaking depends upon a number of factors which are listed
as follows.
1. Organization of the factory
2. Conditions of incidence of cost
3. Requirements of the costing system i.e. Suitability of the units or centres
for cost purposes.
4. Availability of information
5. Management policy regarding making a particular choice from several
alternatives
22.3.6 PROFIT CENTRE
A profit centre is that segment of activity of a business which is responsible
for both revenue and expenses and discloses the profit of a particular segment of
activity. Profit centres are created to delegate responsibility to individuals and
measure their performance.
22.3.7 METHODS OF COSTING:
Depending upon the nature of the business and the types of its products,
numbers of methods of cost ascertainment are used in practice. The methods of
costing are as follows:
a) Job Costing: In this system the cost of each job is ascertained separately
which is suitable in all cases where work is undertaken on receiving a customer’s
order. Like a printing press, motor work shop etc.
b) Batch Costing: It is considered as the extension of job costing. It represents
a number of small orders passed through the factory in batch. Each batch here is
treated as a separate unit of cost.
c) Contract Costing: It is suitable for the firms which are engaged in the work
of construction of bridges, roads, buildings etc.
d) Single or Output Costing: It is used in the business where a standard
production is turned out and it is desired to find the cost of a basic unit of
production.
e) Process Costing: It is a method of costing used to asce rtain the cost of a
product which may passes through various processes before completion.
300
LESSON 23
STANDARD COSTING AND VARIANCE ANALYSIS
23.1 INTRODUCTION
The word "Standard" means a "Yardstick" or "Bench Mark." The term "Standard
Costs" refers to Pre-determined costs. Brown and Howard define Standard Cost as a
Pre-determined Cost which determines what each product or service should cost
under given circumstances. This definition states that standard costs represent
planned cost of a product.
Standard Cost as defined by the Institute of Cost and Management
Accountant, London "is the Predetermined Cost based on technical estimate for
materials, labour and overhead for a selected period of time and for a prescribed set
of working conditions.",
Standard costs are the basis of the system of standard costing. They are the
pre- determined costs of manufacturing a single unit or a number of product units
during a specific period in the immediate future. They are the planned costs of a
product under current and/or anticipated operating conditions. Here is a definition
of the term standard cost:
The standard cost is a pre-determined cost which is calculated from
management’s standards of efficient operation and the relevant necessary
expenditure. Thus, it is clear from these definitions that standard costs represent
the costs that should have been incurred under the expected circumstances.
In a standard cost system, each unit of product has a standard material cost, a
standard labour cost, a standard overhead cost for each product centre. The total
standard cost for the period under consideration is obtained by multiplying these
standard unit costs by the number of units flowing through the cost centre in that
period.
23.2 OBJECTIVES
After completing this Lesson you should be able to know
The purpose and importance of Standard costing
Variance analysis and its importance
Different types of variances
23.3 CONTENT
23.3.1 Purpose of Standard Costing
23.3.2 Historical or Actual Cost
23.3.3 Difference between Standard Costing and Historical Cost
23.3.4 Importance of Standard Cost
23.3.5 Standard Costing
23.3.6 Standard Cost VS Budgetary Control
23.3.7 Limitation of Standard Costing
305
The nature of both of these techniques is forward looking. However, they differ
in the following respects:
The scope of budgetary control is wider. It is an integrated plan of action a
co-ordinated plan in respect of all functions of an enterprise. The scope of
standard costing is limited to the operating level. Here too it is further
linked to costs. Budgetary control is extensive whereas standard costing is
intensive in its application. The budgets embrace revenues as well as costs
and all functions and activities - sales, purchase, finance, capital
expenditure, personnel etc. in addition to production whereas the coverage
of standard costing is limited to costs only.
Budgetary control requires functional co-ordination whereas standard
costing does not require such co-ordination since it is possible -to think
even of one aspect of cost.
It is possible to introduce the standard costing into the accounting routine
itself. In such a case, the variances are given out by the accounting system
itself. Budgetary control cannot be introduced into the accounting system.
In standard costing standards are based on technical assessment whereas
budgetary targets are based on past actuals adjusted to future trends. The
standards set up under standard costing are attainable level of
performance whereas the actual expenditure should not normally exceed.
Thus, they differ in approach.
Budgets are projection of final accounts while standard costs are
projection of only cost accounts.
By nature, budgetary control emphasizes the forecasting aspect of the
future operations while the scope and utility of standard costing is limited
to only operating level of the concern.
In standard costing, variances are analysed in details according to their
originating causes and are revealed through different accounts whereas in
budgetary control, the degree of variance analysis tends to be much less
and variances are not revealed through the accounts but are revealed in
total. Thus standard costing and budgetary control are two different
aspects of the process of managerial control. But they both are
complementary to each other and should be used simultaneously in order
to achieve maximum efficiency and economy.
It is often emphasized that budgetary control and standard costing cannot
function independently. This opinion is supported by the fact that both methods
use pre-determined costs for the coming period. Strictly speaking, this is not true
but it is a fact that both function better in conjunction with each other. When
standard costs have been determined, it is relatively easy to compute budgets for
production costs and sales. With the use of standard costs, a budget becomes a
summary of standards for all items of revenue and costs. On the other hand, in
308
determining standard costs it is essential to ascertain the level of output for the
period and this is much easier when budgeted level has been formulated
23.3.7 APART FROM THE ABOVE THE STANDARD COSTING HAS THE FOLLOWING
LIMITATIONS:
1. Standard costing is expensive and a small concern may not meet the cost.
2. Due to lack of technical aspects, it is difficult to establish standards.
3. Standard costing cannot be applied in the case of a- concern where non-
standardized products are produced.
4. Fixing of responsibility is difficult. Responsibility cannot be fixed in the case
of uncontrollable variances.
5. Frequent revision is required while insufficient staff is incapable of operating
this system.
6. Adverse psychological effects and frequent technological changes will not be
suitable for standard costing system.
23.3.8 ADVANTAGES OF STANDARD COSTING
The following are the important advantages of standard costing:
1. It guides the management to evaluate the production performance.
2. It helps the management in fixing standards.
3. Standard costing is useful in formulating production planning and price
policies.
4. It guides as a measuring rod for determination of variances.
5. It facilitates eliminating inefficiencies by taking corrective measures.
6. It acts as an effective tool of cost control.
7. It helps the management in taking important decisions.
8. It facilitates the principle of "Management by Excepti on."
9. Effective cost reporting system is possible.
23.3.9 VARIANCE ANALYSIS
Standard Costing guides as a measuring rod to the management for
determination of "Variances" in order to evaluate the production performance. The
term "Variances" may be defined as the difference between Standard Cost and
actual cost for each element of cost incurred during a particular period. The term
"Variance Analysis" may be defined as the process of analyzing variance by
subdividing the total variance in such a way that management can assign
responsibility for off-Standard Performance.
The variance may be favourable variance or unfavourable variance. When the
actual performance is better than the Standard, it presents "Favourable Variance."
Similarly, where actual performance is below the standard it is called as
"Unfavourable Variance."
309
Where
AQ = Actual quantity
AP = Actual price
SQ = Standard quantity for the actual output
SP = Standard price
Material Usage Variance:
The material quantity or usage variance results when actual quantities of
raw materials used in production differ from standard quantities that should have
been used to produce the output achieved. It is that portion of the direct materials
cost variance which is due to the difference between the actual quantity used and
standard quantity specified.
As a formula, this variance is shown as:
Materials quantity variance = (Actual Quantity – Standard Quantity) x Standard
Price
A material usage variance is favourable when the total actual quantity of
direct materials used is less than the total standard quantity allowed for the actual
output.
Various reasons for occurrence of Material usage variance:
Material usage variance may be caused by:
Solution:
Material usage variance = (Actual Quantity – Standard Quantity) x Standard
Price
Material A = (2,050 – 2,000) x Rs. 10 = Rs. 500 (unfavourable)
Material B = (2980 – 3000) x Rs. 20 = Rs. 400 (favourable)
Total = Rs. 100 (unfavourable)
It should be noted that the standard rather than the actual price is used in
computing the usage variance. Use of an actual price would have introduced a price
factor into a quantity variance. Because different departments are responsible,
these two factors must be kept separate.
(a) Material Mix Variance:
The materials usage or quantity variance can be separated into mix variance
and yield variance.
For certain products and processing operations, material mix is an important
operating variable, specific grades of materials and quantity are determined before
production begins. A mix variance will result when materials are not actually placed
into production in the same ratio as the standard formula. For instance, if a
product is produced by adding 100 kg of raw material A and 200 kg of raw material
B, the standard material mix ratio is 1: 2.
Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix
variance will be found. Material mix variance is usually found in industries, such
as textiles, rubber and chemicals, etc. A mix variance may arise because of
attempts to achieve cost savings, effective resources utilisation and when the
needed raw materials quantities may not be available at the required time.
Materials mix variance is that portion of the materials quantity variance which
is due to the difference between the actual composition of a mixture and the
standard mixture.
It can be computed by using the following formula:
Material mix variance = (Standard cost of actual quantity of the actual mixture
– Standard cost of actual quantity of the standard mixture)
Or
Materials mix variance = (Actual mix – Revised standard mix of actual input) x
Standard price
Revised standard mix or proportion is calculated as follows:
Standard mix of a particular material/Total standard quantity x Actual input
Example:2
A product is made from two raw materials, material A and material B. One unit
of finished product requires 10 kg of material.
312
During a period one unit of product was produced at the following costs:
Material A 8kg @ `20 = `40
Material B 4kg @ `12.5 = `50
12kg @ `17.5 = `80
materials yield variance equals the total materials quantity variance. Accordingly,
mix and yield variances explain distinct parts of the total materials usage variance
and are additive.
The formula for computing yield variance is as follows:
Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per unit
Example:3
Standard input = 100 kg, standard yield = 90 kg, standard cost per kg of
output = ` 200
Actual input 200 kg, actual yield 182 kg. Compute the yield variance.
Solution :
Standard yield for the actual input = 90/100 x 200 = 180 kg
Yield variance = (Actual yield – Standard yield for the actual input) x
Standard cost per unit (per kg)
= 182 – 180 x ` 200
= 2 x 200 = ` 400(favourable)
The above yield variance can be computed by using another formula also, e.g.,
Yield variance = (Actual Loss – Standard Loss on Actual Input) x Standard Cost
per unit
= 182-180 x `200
= 2 x 200 = ` 400 (favourable)
In this example, there is no mix variance and therefore, the materials usage
variance will be equal to the materials yield variance.
The above formula uses output or loss as the basis of computing the yield
variance. Yield variance can also be computed on the basis of input factors only.
The fact is that loss in inputs equals loss in output. A lower yield simply means
that a higher quantity of inputs has been used and the anticipated or standard
output (based on actual inputs) has not been achieved.
Yield, in such a case, is known as sub-usage variance (or revised usage
variance) which can be computed by using the following formula:
Sub-usage or revised usage variance = (Revised Standard Proportion of Actual
Input – Standard quantity) x Standard Cost per unit of input
314
Example:4
Standard material and standard price for manufacturing one unit of a product
is given below:
Materials yield variance always equal sub-usage variance. The difference lies
only in terms of calculation. The former considers the output or loss in output and
the latter considers standard inputs and actual input used for the actual output.
Mix and yield variance both provide useful information for production control,
performance evaluation and review of operating efficiency.
Materials Price Variance:
A materials price variance occurs when raw materials are purchased at a
price different from standard price. It is that portion of the direct materials which is
due to the difference between actual price paid and standard price specified and
cost variance multiplied by the actual quantity. Expressed as a formula,
315
Labour cost variance denotes the difference between the actual direct wages
paid and the standard direct wages specified for the output achieved.
This variance is calculated by using the following formula:
Labour cost variance = (AH x AR) – (SH x SR)
Where:
AH = Actual hours
AR = Actual rate
SH = Standard hours
SR = Standard rate
Example:6
Standard labour hour per unit = 5 hr
Standard labour rate per hour = Rs 30
Units completed = 1,000
Labour cost recorded = 5,050 hrs @ Rs 35
Labour efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavourable)
It may be noted that the standard labour hour rate and not the actual rate is
used in computing labour efficiency variance. If quantity variances are calculated,
changes in prices/rates are excluded, and when price variances are calculated,
standard quantities are ignored.
(i) Labour Mix Variance:
Labour mix variance is computed in the same manner as materials mix
variance. Manufacturing or completing a job requires different types or grades of
workers and production will be complete if labour is mixed according to standard
proportion. Standard labour mix may not be adhered to under some circumstances
and substitution will have to be made. There may be changes in the wage rates of
some workers; there may be a need to use more skilled or expensive types of
labour, e.g., employment of men instead of women; sometimes workers and
operators may be absent.
These lead to the emergence of a labour mix variance which is calculated by using the
following formula:
Labour mix variance = (Actual labour mix – Revised standard labour mix in
terms of actual total hours) x Standard rate per hour
Example:7
Class Proportion
A 50% 3 hours @ `40 =`120
B 50% 3 hours @ `20 =` 60
100% 6 hours `30 =`180
3
Class B 8 4 hours
6
Applying the formula
Class A = (6-4) x `40 = `80 (unfavourable)
Class B = (2-4) x `20 = `40 (favourable)
Total labour mix variance = `40 (favourable)
(ii) Labour Yield Variance:
The final product cost contains not only material cost but also labour cost.
Therefore, gain or loss (higher or lower output than the standard output) should
take into account labour yield variance also. A lower output simply means that final
output does not correspond with the production units that should have been
produced from the hours expended on the inputs.
It can be computed by applying the following formula:
Labour yield variance = (Actual output – Standard output based on actual
hours) x Av. Std. Labour Rate per unit of output.
Or
Labour yield variance = (Actual loss – Standard loss on actual hours) x Average
standard labour rate per unit of output
Labour yield variance is also known as labour efficiency sub-variance which
is computed in terms of inputs, i.e., standard labour hours and revised labour
hours mix (in terms of actual hours).
Labour efficiency sub-variance is computed by using the following formula:
Labour efficiency sub-variance = (Revised standard mix – standard mix) x
Standard rate
2. Labour Rate Variance:
Labour rate variance is computed in the same manner as materials price
variance. When actual direct labour hour rates differ from standard rates, the
result is a labour rate variance. It is that portion of the direct wages variance which
is due to the difference between actual rate paid and standard rate of pay specified.
The formula for its calculation is:
Labour rate variance = (Actual rate – Standard rate) x Actual hours
Using data from the example given above, the labour rate variance is Rs
25,250, i.e.,
Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250
(unfavourable)
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The number of actual hours worked is used in place of the number of the
standard hours specified because the objective is to know the cost difference due to
change in labour hour rates, and not hours worked. Favourable rate variances arise
whenever actual rates are less than standard rates; unfavourable variances occur
when actual rates exceed standard rates.
3. Idle Time Variance:
Idle time variance occurs when workers are not able to do the work due to
some reason during the hours for which they are paid. Idle time can be divided
according to causes responsible for creating idle time, e.g., idle time due to
breakdown, lack of materials or power failures. Idle time variance will be equivalent
to the standard labour cost of the hours during which no work has been done but
for which workers have been paid for unproductive time.
Suppose, in a factory 2,000 workers were idle because of a power failure. As
a result of this, a loss of production of 4,000 units of product A and 8,000 units of
product B occurred. Each employee was paid his normal wage (a rate of? 20 per
hour).
A single standard hour is needed to manufacture four units of product A
and eight units of product B.
Idle time variance will be computed in the following manner:
Standard hours lost:
Product A = 4, 000/ 4 = 1,000 hr. Product B = 8, 000 / 8 = 1,000 hr.
Total hours lost = 2,000 hr. Idle time variance (power failure)
2,000 hours @ Rs 20 per hour = Rs 40,000 (Adverse)
III. Overhead Variances:
The analysis of factory overhead variances is more complex than variance
analysis for direct materials and direct labour. There is no standardisation of the
terms or methods used for calculating overhead variances. For this reason, it is
necessary to be familiar with the different approaches which can be applied in
overhead variances.
Generally, the computation of the following overhead variances are
suggested:
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Problem 2:
From the following data, calculate overhead variances:
Budgeted Actual
Output 15,000 units 16,000 units
No. of working days 25 27
Fixed overheads ` 3,00,000 ` 3,50,000
Variable overheads ` 4,50,000 ` 4,70,000
There was an increase of 5% in capacity
Solution:
1. Total Overhead Cost Variance:
Actual overhead cost – (Actual units x Std. Rate)
(Rs 3,05,000 + 4,70,000) – (16,000 x Rs 50)
Rs 7,75,000 – Rs 8,00,000 = Rs 25,000 (favourable)
Standard rate = Standard Overhead /Standard Output
2. Variable Overheads Variance:
Actual variable cost – (Actual units x Std. Rate)
4,70,000 – (16,000 x Rs 30)
Rs 4,70,000 – Rs 4,80,000 = Rs 10,000 (favourable)
3. Fixed Overhead Variance:
Actual fixed overhead cost – (Actual units x Std. Rate of fixed overhead)
3,05,000-(16,000 x 20)
3,05,000 – 3,20,000 = Rs 15,000 (favourable)
4. Volume Variance:
(Actual units x St. rate) – Budgeted fixed overheads
(16,000 x Rs 20) – Rs 3,00,000 = Rs 20,000 (favourable)
5. Expenditure Variance:
Actual fixed overheads – Budgeted fixed overheads
Rs 3,05,000 – Rs 3,00,000 = Rs 5,000 (unfavourable)
6. Capacity Variance:
Std. Rate x (Revised budget units – Budgeted units)
Revised budgeted units = Budgeted units + Increase in capacity
= 15,000 + 5/100 x 15,000= 15,750 units 100
= Capacity variance
= Rs 20 (15,750 units – 15,000 units)
= Rs 20 x 750 = Rs 15,000 (favourable)
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7. Calendar Variance:
Increase or decrease in production due to more or less working days x Std. rate
per unit within 25 days, standard production with increased capacity = 15,750
units within 2 days (27 – 25),
production will be increased by = (15, 750 x 2)/25 = 1,260 units
Calendar variance = 1,260 units x Rs 20
= Rs 25,200 (favourable)
8. Efficiency Variance:
Std. rate x (Actual production – Std. production)
Standard production:
Budgeted production = 15,000 units
Production increased due to increase in capacity 5% = 750 units
Now budgeted production = 15,000 + 750 = 15,750 units
Production increased due to 2 more working days
Units for 2 days = (15, 750 x 2)/25 days = 1,260 units
Total units = 15,750 + 1,260
= 17,010 units
Efficiency Variance = Rs 20 (16,000 units – 17,010 units)
Rs 20 (- 1,010 units) = Rs 20,200 (unfavourable)
Problem 3:
In department A the following data is submitted for the week ending 31st October:
Standard output for 40 hours per week 1,400 units
Standard fixed overhead `1,40,000
Actual output 1,200 units
Actual hours worked 32 hrs
Actual fixed overhead `1,50,000
Standard output
1. S tan dard production per standard hours
Standard hours
1,400
35 units
40
Standard fixed overhead
2. S tan dard fixed overhead rate per units
Standard hours
Rs.1,40,000
Rs.100
1,400
Rs.1,40,000
Rs.3,500
40
Statement of fixed overhead variances of department A:
A. Expenditure variance:
(Actual overhead – Budgeted overhead)
Rs 1,50,000 – Rs 1,40,000 = Rs 10,000 (Adverse)
B. Volume variance:
Std. fixed overhead rate per unit x (Actual output – Budgeted output)
Rs 100 (1,200 – 1,400) = Rs 20,000 (Adverse)
C. Total overhead cost variance:
(Actual overhead – Overhead recovered by actual output)
Rs 1,50,000 – Rs 1,20,000 = Rs 30,000 (Adverse)
(a) Efficiency variance:
Std. fixed overhead rate per unit x (Actual production – Std. production for
actual hours)
Rs 100 (1200 – 32 x 35) = Rs 8000 (Favourable)
(b) Capacity variance:
Std. fixed overhead rate per hour (Actual hours – Standard hours)
Rs 3,500 (32 – 40) = Rs 28,000 (Adverse)
Problem 4:
A Cost Accountant of a company was given the following information regarding the
overheads for February, 2012:
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Or
(ii) (9,96,000 hrs x Rs 125) – (Rs 3,10,00,000 + Rs 10,08,00,000)
= Rs 12,45,00,000-Rs 13,18,00,000
= Rs 73,00,000 Adverse
Verification:
Total overhead cost variance = Fixed overhead cost variance + Variable
overhead cost variance
Rs 73,00,000 A = Rs 61,00,000 A + Rs 12,00,000 A
Rs 73,00,000 A = Rs 73,00,000 A
Problem 6:
The following information has been extracted from the books of Goru Enterprises which is
using standard costing system:
Actual output = 9,000 units
Direct wages paid = 1,10,000 hours at Rs 22 per hour, of which 5,000 hour,
being idle time, were not recorded in production
Standard hours = 10 hours per unit
Labour efficiency variance = Rs 3,75,000 (A)
Standard variable Overhead = Rs 150 per unit
Actual variable Overhead = Rs 16,00,000
You are required to calculate:
(i) Idle time variance
(ii) Total variable overhead variance
(iii) Variable overhead expenditure variance
(iv) Variable overhead efficiency variance.
Solution:
Actual output = 9,000 units
Idle time = 5,000 hours
Production time (Actual) = 1,05,000 hours
Standard hours for actual production = 10 hours/unit x 9,000 units = 90,000
hours.
Labour efficiency variance = Rs 3,75,000 (A)
i.e. Standard rate x (Standard Production time – Actual production time) = Rs
3,75,000 (A).
SR (90,000 – 1,05,000) = – 3,75,000
SR = -3,75,000/-15,000 = Rs 25
(i) Idle time variance = 5,000 hours x 25 Rs hour = Rs 1,25,000. (A)
(ii) Standard Variable Overhead = Rs 150/unit
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b. Variances
i Material Price Variance = (AP-SP) × AQ
= (`390 – 400) × 560
= `5600 (F)
ii Material Usage Variance = (AQ-SQ) × SP
= (`560 – 550) × `400
= `4,000 (A)
iii Labour rate Variance = (AR-SR) × AH
=(`105–100) × `3,100
= `15,500 (A)
iv Labour efficiency Variance = (AH-SH) × SR
=(`3,100–3,300) × `100
= `20,000 (F)
60.00
Other overheads may be ignored.
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Solution
Jumbo Food Products Ltd.
i Actual Output
Actual Direct Wage Cost ` 16324
Less : Adverse Labour Efficiency Variance (Adv) ` 360
` 15964
Add: Labour Rate Variance (Fav) ` 636
Total Standard direct wage cost ` 16624
Output = Total standard direct wages cost ÷ Standard direct wages
per unit = 16600 ÷ 20 = 830 units
Alternatively
Actual direct materials ` 12870
Less : Adverse material price variance ` 1170
` 11700
Add: Favourable material usage variance ` 750
Total standard material cost ` 12450
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ii Actual Profit
Actual Sales ` 59760
Less : Direct Material `(12870)
Direct Wages `(16324)
Production Overhead(830 x 25) 20750 ` 636
Less : Favourable O.H. Variances
Expenditure (400)
Volume (750) ` 19600
Actual Profit ` 10966
iii The Actual Price per kg of Material
Direct materials ` 12870
Less : Adverse price variance ` 1170
Total Standard Material Cost ` 11700
Total standard material cost ÷ Standard price kg = 11700 ÷ 1.50 =
7800 kg
` 19600
Illustration:9
Rush Ltd. has furnished you the following data:
Budget Actual Dec.2011
Illustration:10
RSV Ltd. has furnished you the following information for the month of August
2011.
Budget Actual
Output (Units) 30000 32500
Hours 30000 33000
Fixed Overhead N 45000 N 50000
Variable Overhead N 60000 N 68000
= 45000/30000
= N 1.50
the cost from materials, labour and overheads. In addition, it is essential to analyse
the difference between actual sales and the targeted sales because this difference
will have a direct impact on the profit and sales. Therefore the analsysis of sales
variances is important to study profit variances.
Sales Variances can be calculated by Two methods:
I. Sales Value Method and
II. Sales Margin or Profit Method.
I.Sales Value Method
The method of computing sales variance is used to denote variances arising
due to change in sales price, sales volume or the sales value.
The sales variances may be classified as follows:
(a) Sales Value Variance
(b) Sales Price Variance
(c) Sales Volume Variance
(d) Sales Mix Variance
(e) Sales Quantity Variance
II. Sales Margin or Profit Method
Under this method of variance analysis, variances may be computed to show
the effect on profit.
The sales variance according to this method can be classified as follows:
(1) Sales Margin Value Variance
(2) Sales Margin Volume or Quantity Variance
(3) Sales Margin Price Variance
(4) Sales Margin Mix Variance
Sales variance is the difference between the actual value of sales achieved in
a given period and budgeted value of sales. There are many reasons for the
difference in actual sales and budgeted sales such as selling price, sales volume,
sales mix.
Sales variance can be calculated by using any of the following two methods:
A. Sales variance based on turnover
B. Sales variances based on margin (i.e.,contribution margin or profit)
The first approach i.e., sales variance based on turnover, accounts for
difference in actual sales and budgeted sales. The sales variances using margin
approach accounts for difference in actual profit and budgeted profit. In the margin
method, it is assumed that cost of production is constant, i.e., no difference is
assumed between actual cost of production and standard cost of production.
The reason for this assumption is that cost variances are calculated separately
to analyse the difference between actual cost and standard cost of production.
346
Therefore, cost side of the sales variance is assumed constant under the margin
method.
Sales variances computed under these two methods show different amounts of
variance.
The different sales variances under these two approaches and their formula are
given below:
A. Sales Variances Based on Turnover:
If actual selling price is less than the budgeted selling price, variance is
favourable and if actual selling price is more than the budgeted selling price, there
will be unfavourable sales price variance.
(iii) Sales Volume Variance:
Sales volume variance arises when the actual quantity sold is different from the
budgeted quantity. If actual sales quantity exceeds the budgeted sales quantity,
there is a favourable sales volume variance and if actual quantity sold is less than
the budgeted quantity, the variance is unfavourable .
If actual margin per unit is more than the budgeted margin per unit, favourable
variance will be found and if actual margin is less than the budgeted margin,
variance will be unfavourable.
(iii) Sales Margin Volume Variance:
This variance shows the difference between actual sales units and budgeted
sales units.
The formula is:
Sales Margin Volume Variance = (Actual quantity – Budgeted quantity) x
Budgeted Margin per unit.
If actual sales units are more than the budgeted sales units, variance will be
favourable and if actual sales units are less than the budgeted sales units,
unfavourable variance will arise.
Sales margin volume variance can be calculated using another formula which is:
Sales margin volume variance = (Standard profit on actual quantity of sales –
Budgeted profit)
If standard profit exceeds budgeted profit, variance will be favourable and if
standard profit is less than the budgeted profit, unfavourable variance will emerge.
Sales margin volume variance consists of:
(i) Sales margin mix variance and
(ii) Sales margin quantity variance.
(i) Sales Margin Mix Variance:
This variance shows the difference between actual mix of goods and budgeted
(standard) mix of goods sold.
The formula is:
Sales Margin Mix Variance = (Actual sales mix – Standard proportion of actual
sales mix) x Budgeted margin per unit.
If budgeted margin per unit on actual sales mix is more than the budgeted
margin per unit on budgeted mix, variance will be favourable. In the reverse
situation, unfavourable variance will arise.
(ii) Sales Margin Quantity Variance:
This variance will be found when the total actual sales quantity in standard
proportion is different from the total budgeted sales quantity.
The formula is:
Sales Margin Quantity Variance = (Actual sales in standard proportion –
Budgeted sales) x Budgeted margin per unit on budgeted mix
If actual sales (in standard proportion) are more than the budgeted sales,
variance will be favourable and if actual sales are less than the budgeted sales,
unfavourable variance will arise.
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LESSON – 24
REPORTING TO MANAGEMENT
24.1 INTRODUCTION
The success or otherwise of any busine ss undertaking depends primarily on
earning revenue that would generate sufficient resources for sound growth. To
achieve this objective, the management should discharge its functions efficiently
and effectively. The reporting systems are highly useful to the management for
effective planning and control. A regular system of reporting is considered as a
better guidance for prompt decision making. Hence, it is necessary to have a good
management reporting system.
24.2 OBJECTIVES
After completing this Lesson you should be able to know
The meaning of management reporting
Objectives of management reporting
Different types of management reporting
24.3 CONTENT
24.3.1 Definition of Management Reporting
24.3.2 Objectives of Management Reporting
24.3.3 Essentials of Good Reporting System
24.3.4 Classification of Management Report
24.3.1 DEFINITION OF MANAGEMENT REPORTING
According to Kohler reporting refers to "A body of information organized for
presentation or transmission to others. It often includes interpretations,
recommendations and findings with supporting evidence in the form of other
reports."
'Management Reporting' may be defined as "A system of communication,
normally in the written form, of facts which should be brought to the attention of
various levels of management who use them to take suitable action." In other words
the process of providing information to the management is known as Management
Reporting. The word "Information" refers to the data processed or evaluated for a
specific purpose.
Dr. Maheshwari has also defined Management reporting system as "an
organized method of providing each manager with all the data and only those data
which he needs for his decisions, when he needs them and in a form which aids his
understanding and stimulates his action."
24.3.2 OBJECTIVES OF MANAGEMENT REPORTING
1. To obtain the required information relating to the business to discharge its
managerial functions of planning. organizing, controlling. directing, and
decision making etc. efficiently and effectively.
2. To ensure the operational efficiency of the concern.
354
10. Cost-Benefit Analysis: Cost-Benefit Analysis should be made and the cost
of reporting should commensurate with the expenditure involved.
11. Principle of Exception: Since the time and effort of managerial personel
are precious, the principle of management by exception has become the
rule of the day instead of exception. It is necessary therefore to draw the
attention of management, through reports, only towards exceptional
matters.
12. Controllability: It is necessary that every report should be addressed to a
responsibility centre and analysed the factors into controllable and
uncontrollable separately. So that the head of the responsibility centre can
be held responsible only for controllable variance but not for variances
which are beyond his control.
Further, in order to assist the management to imitate remedial measures,
probable reasons for the factors of uncontrollable should also be incorporated in
the reports.
24.3.4 CLASSIFICATION OF MANAGEMENT REPORTING
Basically, there are two ways to report to the management. They are :
Oral Report and
Written Report.
The Written Reports may be classified into number of ways. The following are
the important types:
I According to Objects:
a. External Reports
b. Internal Reports
i. Reports Meant for Top Management
ii. Reports Meant for Middle Level Management
iii. Reports Meant for Junior Level Management
II According to Period:
1. Routine Reports
2. Special Reports
III According to Functions:
a. Operating Reports
(1) Control Reports
(2) Information Reports
(3) Venture Measurement Reports
b. Financial Reports
(1) Static Reports
(2) Dynamic Reports
According to Object or Purposes
356
(A) External Reports: These reports prepared for persons outside the business
such as Government. shareholders. bankers. investors and financial institutions
etc. External Reports usually represent published annual reports. Annual Reports
of Trading. Profit and Loss Accounts and Balance Sheet of the Indian Companies
are to be prepared in terms of Schedule VI of the Indian Companies Act of 1956.
(B) Internal Reports : Internal Reports are those which are prepared for internal
uses of different level of management. It is also called as Management Reports.
These reports are not meant for disclosure to those who are outsiders to the
business. They do not have to comply with any statutory requirements. From the
managerial point of view the reports can be classified into the following categories :
(1) Report Meant for the Top Level of Management
(2) Report Meant for the Middle Level of Management
(3) Report Meant for the Junior Level of Management
(1) Report Meant for the Top Level of Management
Top Level Management is concerned with the formulating policies planning
and setting goals and objectives. This level of management consisting of the Board
of Directors including Chairman. Managing Directors. General Manager or any
other chief executive as the case may be. The report to this level of management
should be specifically summarized with all aspects of operating performance
together with a comparison of actuals with budgeted performance. The usual
reports sent to this level of management are:
(a) Reports on budgeted and actual profit
(b) Reports on sales and production
(c) Capital budget
(d) Master budget
(e) Periodical financial reports
(f) Plant utilization report
(g) Machine and labour utilization report
(h) Reports on research and development activities
(i) Project evaluation report
(j) Report on stock of raw materials, work in progress and finished goods
(k) Overhead cost absorption and efficiency reports
(l) Reports on selling and distribution overhead.
(2) Reports Meant for Middle Level Ma nagement
The Middle Management is constituted of the heads of all departments such as
production department headed by production manager. marketing department
headed by marketing manager and so on. This level of management is concerned
with the functioning and control of their departments. They act mainly as
coordinating executives to administer policies directly through operating
supervisors and evaluate their performance. Hence, they may require more detailed
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