Finiii Ma
Finiii Ma
Finiii Ma
MANAGEMENT ACCOUNTING
INTRODUCTION:
A business enterprise must keep a systematic record of what happens from day-
tot-day events so that it can know its position clearly. Most of the business
enterprises are run by the corporate sector. These business houses are required
by law to prepare periodical statements in proper form showing the state of
financial affairs. The systematic record of the daily events of a business leading
to presentation of a complete financial picture is known as accounting. Thus,
Accounting is the language of business. A business enterprise speaks through
accounting. It reveals the position, especially the financial position through the
language called accounting.
MEANING OF ACCOUNTING:
Financial Accounting
Cost Accounting, and
Management Accounting
FINANCIAL ACCOUNTING:
Accounting as a process deals only with those transactions which are measurable
in terms of money. Anything which cannot be expressed in monetary terms does
not form part of financial accounting however significant it is.
2. Recording of information:
3. Classification of Data:
4. Making Summaries:
The classified information of the trial balance is used to prepare profit and loss
account and balance sheet in a manner useful to the users of accounting
information. The final accounts are prepared to find out operational efficiency
and financial strength of the business.
5. Analyzing:
It is the process of establishing the relationship between the items of the profit
and loss account and the balance sheet. The purpose is to identify the financial
strength and weakness of the business. It also provides a basis for interpretation.
The profitability and financial position of the business as interpreted above are
communicated to the interested parties at regular intervals so as to assist them to
make their own conclusions.
It records only the historical cost. The impact of future uncertainties has no
place in financial accounting.
Cost figures are not known in advance. Therefore, it is not possible to fix the
price in advance. It does not provide information to increase or reduce
the selling price.
2 It does not reveal which departments are performing well? Which ones are
incurring losses and how much is the loss in each case?
5 Can the expenses be reduced which results in the reduction of product cost
and if so, to what extent and how? No answer to these questions.
COST ACCOUNTING:
The Institute of Cost and Works Accountants, London defines costing as, “the
process of accounting for cost from the point at which expenditure is incurred or
committed to the establishment of its ultimate relationship with cost centres and
cost units. In its wider usage it embraces the preparation of statistical data, the
application of cost control methods and the ascertainment of the profitability of
activities carried out or planned”.
The Institute of Cost and Works Accountants, India defines cost accounting as,
“the technique and process of ascertainment of costs. Cost accounting is the
process of accounting for costs, which begins with recording of expenses or the
bases on which they are calculated and ends with preparation of statistical data”.
To put it simply, when the accounting process is applied for the elements of
costs (i.e., Materials, Labour and Other expenses), it becomes Cost Accounting.
1 Cost Control
2 Cost Reduction
0 Cost Ascertainment:
The main objective of cost accounting is to find out the cost of product, process,
job, contract, service or any unit of production. It is done through various
methods and techniques.
2. Cost Control:
3. Cost Reduction:
Cost reduction refers to the real and permanent reduction in the unit cost of
goods manufactured or services rendered without affecting the use intended. It
can be done with the help of techniques called budgetary control, standard
costing, material control, labour control and overheads control.
The price of any product consists of total cost and the margin required. Cost data
are useful in the determination of selling price or quotations. It provides detailed
information regarding various components of cost. It also provides information
in terms of fixed cost and variable costs, so that the extent of price reduction can
be decided.
ᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ0 It is based
on estimation: as cost accounting relies heavily on
predetermined data, it is not reliable.
ᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ1 No uniform
procedure in cost accounting: as there is no uniform procedure,
with the same information different results may be arrived by
different cost accounts.
ᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ2 Large
number of conventions and estimate: There are number of
conventions and estimates in preparing cost records such as
materials are issued on an average (or) standard price, overheads
are charged on percentage basis, Therefore, the profits arrived
from the cost records are not true.
ᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ3 Formalities
are more: Many formalities are to be observed to obtain the
benefit of cost accounting. Therefore, it is not applicable to small
and medium firms.
ᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ4 Expensive:
Cost accounting is expensive and requires reconciliation with
financial records.
0 It is unnecessary: Cost accounting is of recent origin and an
enterprise can survive even without cost accounting.
MANAGEMENT ACCOUNTING
Definition:
From these definitions, it is very clear that financial data is recorded, analyzed
and presented to the management in such a way that it becomes useful and
helpful in planning and running business operations more systematically.
4. Controlling:
5. Reporting:
Management accounting keeps the management fully informed about the latest
position of the concern through reporting. It helps management to take proper
and quick decisions. The performance of various departments is regularly
reported to the top management.
6. Facilitates Organizing:
The role of financial accounting is limited to find out the ultimate result, i.e.,
profit and loss; management accounting goes a step further. Management
accounting discusses the cause and effect relationship. The reasons for the loss
are probed and the factors directly influencing the profitability are also studied.
Profits are compared to sales, different expenditures, current assets, interest
payables, share capital, etc.
3. Use of special techniques and concepts.
It supplies necessary information to the management which may be useful for its
decisions. The historical data is studied to see its possible impact on future
decisions. The implications of various decisions are also taken into account.
5. Achieving of objectives.
6. No fixed norms.
7. Increase in efficiency.
Management accountant is only to guide and not to supply decisions. The data is
to be used by the management for taking various decisions. „How is the data to
be utilized‟ will depend upon the caliber and efficiency of the management.
2. It is only a Tool:
4. Personal Bias:
5. Psychological Resistance:
6. Evolutionary stage:
Management accounting provides data and not decisions. It only informs, not
prescribes. This limitation should also be kept in mind while using the
techniques of management accounting.
8. Broad-based Scope:
The scope of management accounting is wide and this creates many difficulties
in the implementations process. Management requires information from both
accounting as well as non-accounting sources. It leads to inexactness and
subjectivity in the conclusion obtained through it.
MANAGEMENT ACCOUNTANT
5 The assured fiscal protection for the assets of the business through
adequate internal; control and proper insurance coverage.
6 The preparation and filing of tax returns and to the supervision of all
matters relating to taxes.
0 The preparation and interpretation of all statistical records and reports of
the corporation.
RESPONSIBILITY ACCOUNTING
RESPONSIBILITY CENTRES
2 Investment centres.
Cost Centres
When the manager is held accountable only for costs incurred in a responsibility
centre, it is called a cost centre. It is the inputs and not outputs that are measured
in terms of money. In a cost centre records only costs incurred by the
centre/unit/division, but the revenues earned (output) are excluded form its
purview. It means that a cost centre is a segment whose financial performance is
measured in terms of cost without taking into consideration its attainments in
terms of “output”. The costs are the planning and control data in cost canters.
The performance of the managers is evaluated by comparing the costs incurred
with the budgeted costs. The management focuses on the cost variances for
ensuring proper control.
A cost centre does not serve the purpose of measuring the performance of the
responsibility centre, since it ignores the output (revenues) measured in terms of
money. For example, common feature of production department is that there are
usually multiple product units. There must be some common basis to aggregate
the dissimilar products to arrive at the overall output of the responsibility centre.
If this is not done, the efficiency and effectiveness of the responsibility centre
cannot be measure.
Profit Centres
When the manager is held responsible for both Costs (inputs) and Revenues
(output) it is called a profit centre. In a profit centre, both inputs and outputs are
measured in terms of money. The difference between revenues and costs
represents profit. The term “revenue” is used in a different sense altogether.
According to generally accepted principles of accounting, revenues are
recognized only when sales are made to external customers. For evaluating the
performance of a profit centre, the revenue represents a monetary measure of
output arising from a profit centre during a given period, irrespective of whether
the revenue is realized or not.
A profit centre must maintain additional record keeping to measure inputs and
outputs in monetary terms. When a responsibility centre renders only services to
other departments, e.g., internal audit, it cannot be made a profit centre. A profit
centre will gain more meaning and significance only when the divisional
managers of responsibility centres have empowered adequately in their decision
making relating to quality and quantity of outputs and also their relation to costs.
If the output of a division is fairly homogeneous (e.g., cement), a profit centre
will not prove to be more beneficial than a cost centre.
Due to intense competition prevailing among different profit centres, there will
be continuous friction among the centres arresting the growth and expansion of
the whole organization. A profit centre will generate too much of interest in the
short-run profit to the detriment of long-term results.
Investment Centres
When the manager is held responsible for costs and revenues as well as for the
investment in assets, it is called an Investment Centre. In an investment centre,
the performance is measured not by profits alone, but is related to investments
effected. The manager of an investment centre is always interested to earn a
satisfactory return. The return on investment is usually referred to as ROI, serves
as a criterion for the performance evaluation of the manager of an investment
centre. Investment centres may be considered as separate entities where the
manager are entrusted with the overall responsibility of inputs, outputs and
investment.
TRANSFER PRICING
When profit centres are to be used, transfer prices become necessary in order to
determine the separate performances of both the „buying profit centres.
Thus, transfer pricing is the process of determining the price at which goods are
transferred from one profit centre to another profit centre within the same
company.
If transfer prices are set too high, the selling centre will be favored whereas if set
too low the buying centre exercise which does not effect the overall profitability
of the firm. However, in certain circumstances, transfer pricing may have an
indirect effect on overall company profitability by influencing the decisions
made at divisional level.
The fixation of appropriate transfer price is another problem faced by the profit
centres. The transfer price forms revenue for the selling division and an element
of cost of the buying division. Since the transfer price has a bearing on the
revenues, costs and profits or responsibility canters, the need for determination
of transfer prices becomes all the more important. But the transfer price
determination involves choosing one among the various alternatives available
for the purpose.
These are three objectives that should be considered for setting-out a transfer
price.
Autonomy of the Division. The prices should seek to maintain the maximum
divisional autonomy so that the benefits, of decentralization (motivation,
better decision making, initiative etc.) are maintained. The profits of one
division should not be dependent on the actions of other divisions,
Market based transfer pricing: Where a market exists outside the firm for
the intermediate product and where the market is competitive
(i.e., the firm is a price taker) then the use of market price as the
transfer price between divisions will generally lead to optimal
decision-making.
Cost based pricing: Cost based transfer pricing systems are commonly used
because the conditions for setting ideal market prices frequently do
not exist; for example, there may be no intermediate market which
does exist may be imperfect. Providing that the required information
is available, a rule which would lead to optimal decision for the firm
as a whole would be to transfer at marginal cost up to the point of
transfer, plus any opportunity cost to the firm as whole. The two
main cost derived methods are those based on full cost and variable
cost.
Full cost transfer pricing: this method, and the variant which is full costs
plus a profit mark-up, has the disadvantage that suboptimal decision-
making may occur particularly when there is idle capacity within the
firm. The full cost (or cost plus) is likely to be treated by the buying
division as an input variable cost so that external selling price
decisions, may not be set at levels which are optimal as far as the
firm as a whole is concerned.
Variable cost transfer pricing: Under this system transfers would be made
at the variable costs up to the point of transfer. Assuming
that the variable cost is a good approximation of economic marginal
cost then this system would enable decisions to be made which
would be in the interests of the firm as a whole. However, variable
cost based prices will result in a loss for the setting division so
performance appraisal becomes meaningless and motivation will be
reduced.
Relevant points
CONCLUSION
Transfer price policies represent the selection of suitable methods relating to the
computation of transfer prices under various circumstances. More precisely,
transfer pricing should be closely related to management performance
assessment and decision optimization. But the problem of choosing an
appropriate transfer pricing for the two functions of management-performance
measurement and decision optimization –does not hold any simple solution.
There is no single measure of transfer price that can be adopted under all
circumstances.
ACTIVITIES:
Bring out the differences between the Financial Accounting and Cost
Accounting
Find out the differences between the Cost Accounting and Management
Accounting
State the limitations of financial accounting and point out how management
accounting helps in overcoming them.
i. Cost Centre
ii. Profit Centre
iii. Investment Centre
iv. Market based transfer pricing
v. Cost based transfer pricing
vi. Full cost transfer pricing
vii. Negotiated transfer pricing
viii. Variable cost transfer pricing
UNIT - II
Introduction:
Definition of Budget:
Elements of Budget:
Budgeting:
„The entire process of preparing the budgets is known as Budgeting‟ (J. Batty)
„Budgeting may be said to be the act of building budgets‟ (Rowland & Harr)
Elements of Budgeting:
CIMA, London defines 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”
Regular comparison of the actual performance with the budget to know the
variations from budget and placing the responsibility of executives to
achieve the desire result as estimated in the budget.
1. Planning:
2. Co-ordination:
There are certain steps necessary to install a good budgetary control system
in an organization. They are as follows:
2 Budget Centre
3 Budget Officer
4 Budget Manual
5 Budget Committee
6 Budget Period
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.
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:
5. Budget Manual:
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:
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.
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.
Types of Budgeting:
Budget can be classified into three categories from different points of view.
They are:
According to Function
According to Flexibility
According to Time
I. According to Function:
The budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget.
This budget forecasts the cost of production. Separate budgets may also be
prepared for each element of costs such as direct materials budgets, direct labour
budget, factory materials budgets, office overheads budget, selling and
distribution overheads budget, etc.
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.
The budget that anticipates the quantity of personnel required during a period
for production activity is known as Personnel Budget.
The budget relates to the research work to be done for improvement in quality of
the products or research for new products.
(g) Capital Expenditure Budget:
The budget provides a guidance regarding the amount of capital that may be
required for procurement of capital assets during the budget period.
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.
On the basis of flexibility, budgets can be divided into two categories. They are:
0 Fixed Budget
1 Flexible Budget
Fixed Budget:
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 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 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.
III. According to Time:
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:
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
.
PREPARATION OF BUDGETS:
I. SALES BUDGET:
Sales budget is the basis for the preparation of other budgets. It is the forecast of
sales to be achieved in a budget period. The sales manager is directly responsible
for the preparation of this budget. The following factors taken into
consideration:
Example
1. The Royal Industries has prepared its annual sales forecast, expecting to
achieve sales of Rs.30,00,000 next year. The Controller is uncertain about the
pattern of sales to be expected by month and asks you to prepare a monthly
budget of sales. The following sales data pertained to the year, which is
considered to be representative of a normal year:
Answer:
Sales Budget
Month Sales (given) Sales estimation based on cash sales ratio given
January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000
February 1,15,000 (1,15,000/25,00,000) x 30,00,000 = 1,38,000
March 1,00,000 (1,00,000/25,00,000) x 30,00,000 = 1,20,000
April 1,40,000 (1,40,000/25,00,000) x 30,00,000 = 1,68,000
May 1,80,000 (1,80,000/25,00,000) x 30,00,000 = 2,16,000
June 2,25,000 (2,25,000/25,00,000) x 30,00,000 = 2,70,000
July 2,60,000 (2,60,000/25,00,000) x 30,00,000 = 3,12,000
August 3,30,000 (3,30,000/25,00,000) x 30,00,000 = 3,96,000
September 3,40,000 (3,40,000/25,00,000) x 30,00,000 = 4,08,000
October 3,50,000 (3,50,000/25,00,000) x 30,00,000 = 4,20,000
November 2,00,000 (2,00,000/25,00,000) x 30,00,000 = 2,40,000
December 1,50,000 (1,50,000/25,00,000) x 30,00,000 = 1,80,000
Total 25,00,000 30,00,000
Note: Sales budget is prepared based on last year‟s month-wise sales ratio.
Example:
Market studies reveal that Raja is popular as it is under priced. It is observed that
if its price is increased by Re.1 it will find a readymade market. On the other
hand, Rani is over priced and market could absorb more sales if its price is
reduced to Rs.20. The management has agreed to give effect to the above price
changes.
On the above basis, the following estimates have been prepared by Sales
Manager:
You are required to prepare a budget for sales incorporating the above estimates.
Answer:
Sales Budget
Raja Rani
Units Units
Budgeted Sales 400 300
Add: Increase (10%) 40 (20%) 60
440 360
Increase due to advertisement 60 40
Total 500 400
2. Budgeted sales for Mumbai:
Raja Rani
Units Units
Budgeted Sales 600 500
Add: Increase (5%) 30 (10%) 50
630 550
Increase due to advertisement 70 50
Total 700 600
II. PRODUCTION BUDGET:
Production Budget
First take into account the opening cash balance, if any, for the
beginning of the period for which the cash budget is to be prepared.
Then Cash receipts from various sources are estimated. It may be from
cash sales, cash collections from debtors/bills receivables, dividends,
interest on investments, sale of assets, etc.
The Cash payments for various disbursements are also estimated. It may
be for cash purchases, payment to creditors/bills payables, payment
to revenue and capital expenditure, creditors for expenses, etc.
The estimated cash receipts are added to the opening cash balance, if
any.
The estimated cash payments are deducted from the above proceeds.
The balance, if any, is the closing cash balance of the month concerned.
The closing cash balance is taken as the opening cash balance of the
following month.
Example:
Materials and overheads are to be paid during the month following the
month of supply.
Wages are to be paid during the month in which they are incurred.
The terms of credits are payment by the end of the month following the
month of sales: Half of credit sales are paid when due the other half to be
paid within the month following actual sales.
st
Preference Dividends for Rs. 30,000 is to be paid on 1 May.
st st
Share call money of Rs. 25,000 is due on 1 April and 1 June.
Answer:
1. Sales Collection:
Payment is due at the month following the sales. Half is paid on due and other
half is paid during the next month. Therefore, February sales Rs. 50,000 is due
at the end of March. Half is given at the end of March and other half is given in
the next month i.e., in the month of April. Hence, the sales collection for the
month of April will be as follows:
Similarly, the sales collection for the months of May and June may be
calculated.
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.
3. Sales Commission:
Semi-variable expenses:
Repairs 10,000
Indirect Labour 15,000
Others 9,000
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%.
FLEXIBLE BUDGET
Capacities
Particulars 50% 60% 70% 90%
Rs. Rs. Rs. Rs.
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:
FLEXIBLE BUDGET
The amount of Repairs and maintenance at 60% Capacity is Rs. 7,000. Out
of this, 70% (i.e Rs. 4,900) is fixed and remaining 30% (i.e Rs. 2,100) 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:
Repairs and maintenance 50% 60% 70%
Fixed (70%) 4,900 4,900 4,900
Variable (30%) 1,750 2,100 2,450
6,650 7,000 7,350
Total
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. The
approach requires that all activities be analyzed in decision packages, which are
evaluated by systematic analysis and ranked in the order of importance”. – Peter
A. Phyrr.
It implies that-
Every budget starts with a zero base
No previous figure is to be taken as a base for adjustments
Every activity is to be carefully examined afresh
Advantages of ZBB:
Controls inefficiencies
PERFORMANCE BUDGETING:
Definition:
The responsibility for preparing the performance budget of each department lies
on the respective departmental head. It requires preparation of performance
reports. This report compares budget and actual data and shows any existing
variances. To facilitate the preparation the departmental head is supplied with
the copy of the master budget appropriate to his function.
MASTER BUDGET:
1. From the following particulars, prepare production cost budget for June,2006.
(Answer: Raw Material „A‟ – Rs. 2,35,200; Raw Material „B‟ – Rs. 3,97,500)
Particulars A B C D
Estimated Opening Stock 16,000 6,000 24,000 2,000
Estimated Closing Stock 20,000 8,000 28,000 4,000
Estimated Consumption 1,20,000 44,000 1,32,000 36,000
Standard Price per unit 0.25 p 0.05 p 0.15 p 0.10 p
(Answer: Material „A‟ – Rs. 31,000; Material „B‟ – Rs. 2,300; Material „C‟
– Rs.20,400 and Material „D‟ – Rs. 3,800)
3. Parker Ltd. manufactures two brands of pen Hero and Zero. The sales
department of the company has three departments in different areas of the
country.
The sales budget for the year ending 31st December 1999 were:
Hero – Department I 3,00,000; Department II 5,62500; Department III 1,80,000
and Zero – Department I 4,00,000; Department II 6,00,000; Department III
20,000. Sales prices are Rs. 3 and Rs.1.20 in all departments.
4. Bajaj Co. wishes to arrange overdraft facilities with its bankers during the
period from April to June 2006 when it will be manufacturing mostly for stock.
Prepare a Cash Budget for the above period from the following data, indicating
the extent of the band overdraft facilities the company will require at the end of
each month.
(a)
Answer: Closing balance for April – Rs. 26,500; May Rs. (25,500) and June Rs.
(83,000)
5. Draw up a Cash Budget for January to March 2006 from the following
information:
st
(a). Cash and bank balance on 1 January, 2006 – Rs. 2,00,000.
A building has been purchased on 1st March and the payments are to be
made in monthly instalments of Rs. 2,000 each.
(Answer: Closing balance for January – Rs. 18,985; February Rs. 28,795;
March Rs. 30,975 and April Rs. 23,685)
7. From the following budget date, forecast the cash position at the end of April,
May and June 2006.
Months Sales (Rs.) Purchases (Rs.) Wages (Rs.) Mis. Expenses (Rs.)
February 1,20,000 84,000 10,000 7,000
March 1,30,000 1,00,000 12,000 8,000
April 80,000 1,04,000 8,000 6,000
May 1,16,000 1,06,000 10,000 12,000
June 88,000 80,000 8,000 6,000
Additional information:
Sales: 20% realized in the month of sale; discount allowed 2%. Balance
realized equally in two subsequent months.
Purchases: These are paid in the month following the month of supply.
Income Tax : First instalment of advance tax Rs. 25,000 due on or before
15th June.
Income from investments: Rs. 5,000 received quarterly in April, July, etc.
(Answer: April – Rs. 5,680; May – Rs. (-) 7,084 and June – Rs. (-) 62,936
8. The Expenses for the production of 5,000 units in a factory are given as
follows:
(Answer Total cost of sales Rs. 7,69,000; Total cost of sales per unit Rs. 109.94)
9. Draw up a flexible budget for the overhead expenses on the basis of the
following data and determine the overhead rate at 70%, 80% and 90% plant
capacity.
10. The cost of an article at a capacity level of 5,000 units is given under „A‟
below. For a variation of 25% in capacity above or below this level, the
individual expenses as indicated under „B‟ below:
Cost per unit Rs. 12.55. Find out the cost per unit and total cost for production
levels of 4,000 units and 6,000 units. Also show the total cost and unit cost for
5,000 units
Particulars „A‟ „B”
Rs. Rs.
Material cost 25,000 (100% varying)
Labour cost 15,000 (100% varying )
Power 1,250 (80% varying)
(Answer: Cost per unit at 16,000 units – Rs.318.85; at 12,000 units – Rs.333.60)
Both standard costing and budgetary control aim at maximum efficiency and
managerial control. Budgetary control and standard costing have the common
objective of controlling business operations by establishing pre-determined
targets, measuring the actual performance and comparing it with the targets, for
the purposes of having better efficiency and of reducing costs. The two systems
are said to be interrelated but they are not inter-dependent. The budgetary
control system can function effectively even without the system of standard
costing in operation but the vice-versa is not possible.
Standard Costing provides a stable basis for comparison of actual with standard
costs. It brings out the impact of external factors and internal causes on the cost
and performance of the concern. Thus, it helps to take remedial action.
3. Cost Consciousness
An effective budget can be formulated for the future by once knowing the
deviations of actual costs from standard costs. Data are available at an early
stage and the capacity to anticipate about changing conditions is developed.
Men, machines and materials are more effectively utilized and thus benefits of
economies can be reaped in business together with increased productivity.
The net profit is analyzed and responsibility can be placed on the person in
charge for any variations from the standards. It discloses adverse variations and
particular cost centre can be held accountable. Thus, delegation of authority can
be made by management to control the affairs in different departments.
7. Management by ‘Exception’
While setting standard cost for operations, process or products, the following
preliminaries must be gone through:
Establish Standard Committee comprising Purchase Manager, Personnel
Manager, and Production Manager. The Cost Accountant coordinates the
functions.
Study the existing costing system, cost records and forms in use.
Take necessary action to ensure that adverse variances are not repeated.
2 Types of standards
Establishment of cost centre. For fixing responsibility and defining the lines of
authority, cost centre is necessary. “A cost centre is a location, person or
item of equipment (or group of these) for which costs may be
ascertained and used of the purpose of cost control”. With the help of cost
centre, the standards are prepared and the variances are analyzed.
Basic standard. It is a fixed and unaltered for an indefinite period for forward
planning. According to I.C.M.A London, it is “an underlying standard
from which a current standard can be developed”. From this basic
standard, changes in current standard and actual standard can be
measured.
Ideal standard. I.C.M.A. defines it as “the standard which can be attained under
the most favorable condition possible”. It is fixed and
needs a high degree of efficiency, best possible conditions of
management and performance. Existing conditions and conditions
capable of achievement should be taken into consideration. It is difficult
to attain this ideal standard.
Direct Material cost. Standard material cost is equal to the standard quantity
multiplied by the standard price. The setting of standard costs for direct
materials involves
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Trade and cash discounts received
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Future prices based upon statistical data
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Material price already contracted
Setting standard for Direct Labour. The standard labour cost is equal to
the standard time for each operation multiplied by the standard
wage rate. Setting of standard cost of direct labour involves:
REVISION OF STANDARDS
Standard cost may be established for an indefinite period. There are no definite
rules for the selection for a particular period. If the standards are fixed for a short
period, it is expensive and frequent revision of standards will impair the utility
and purpose for which standard is set.
At the same, if the standard is set for a longer period, it may not be useful
particularly in the days of high inflation and large fluctuations of rates in case of
materials and labour.
Apart from the above, basic standards are revised in the course of time under the
following circumstances, when:
The systems of budgetary control and standard costing have the common
objective of controlling business operations by establishing pre-determined
targets, measuring the actual performance and comparing it with the targets, for
the purposes of having better efficiency and of reducing costs. The tow systems
are said to be interrelated but they are not inter-dependent. The budgetary
control system can function effectively even without the system of standard
costing in operation but the vice-versa is not true. Usually, the two are used in
conjunction with each other to have most fruitful results. The distinction
between the two systems is mainly on account of the field or scope and
technique of operation.
Budgeting Standard costing
Favorable variance: When the actual cost incurred is less than the standard cost,
the deviation is known as favorable variance. The effect of the favorable
variance increases the profit. It is also known as positive or credit variance.
Unfavorable variance: When the actual cost incurred is more than the standard
cost, the variance is known as unfavorable or adverse variance. It refers to
deviation to the loss of the business. It is also known as negative or debit
variance.
Uses
The variance analysis are important tools of cost control and cost reduction and
they generate and atmosphere of cost consciousness in the organization.
Computation of variances
The causes of variance are necessary to find remedial measures; and therefore a
detailed study of variance analysis is essential. Variances can be found out with
respect to all the elements of cost, i.e., direct material, direct labour and
overheads. The following are the common variances, which are calculated by the
management. Sub-divisions of variances really give detailed information to the
management in order to control the cost.
Material variances
Labour variances
Material variance:
(or)
(or)
MPV= AQ (SP-AP)
Thus material usage variance is “that portion of the direct materials cost variance
which is the difference between the standard quantity specified for the
production achieved, whether completed or not, and the actual quantity used,
both valued at standard prices”.
Material Usage or Quantity Variance:
MUV = SR (SQ-AQ)
d) Material Mix Variance (MMV). When two or more materials are used in
the manufacture of a product, the difference between the standard composition
and the actual composition of material mix is the material mix variance. The
variance arises due to the change in the ratio of material and the standard ratio.
The formula is:
After finding out this revised standard mix it is multiplied by the revised
standard cost of standard mix and then the standard cost of actual mix is
subtracted form the result.
Example:1
Answer:
= Rs.16 - Rs.30
= Rs. 14 (Adverse)
= Rs. 10 (Adverse)
= Rs. 4 (Adverse)
Example:2
Answer:
Rs 12 x10
Rs. 120(A)
Rs. 15 x 10
Rs 150 (F)
0 Rs. 30 (F)
Material Yield Variance: It is that portion of the direct material usage variance
which is due to the difference between the standard yield specified and the
actual yield obtained. The variance arises due to abnormal contingencies like
spoilage, chemical reaction etc. Since the variance is a measure of the waste or
loss in the production, it known as material loss or waste variance.
When actual mix and standard mix are the same, the formula is:
Labour Variances
Labour Variances arise because of (I) Difference in Actual Rates and Standard
Rates of Labour and (Ii) The variation in Actual Time taken y workers and the
Standard Time allotted to them for performing a job. These are computed on the
same pattern as that of Material Variances. For Labour Variances by simply
putting the word “Time” in place of “Quantity” in the formula meant for
Material Variances. The various Labour Variances can be analysed as follows:
This variance represents the difference between the Standard Labour Costs and
the Actual Labour Costs for the production achieved. If the Standard Cost is
higher, the variation is favourable and vice versa. It is calculated as follows:
It is the difference between the Standard Rate of pay specified and the Actual
Rate Paid. According to ICMA, London, the variance is “the difference between
the standard and the actual direct Labour Rate per hour for the total hours
worked. If the standard rate is higher, the variance is Favourable and vice versa.
Labour Rate Variance = Actual Time (Standard Wage Rate x Actual Wage Rate)
V
=AT (SR-AR)
It is the difference between the Standard Hours for the actual production
achieved and the hours actually worked, valued at the Standard Labour Rate.
When the workers finish the specific job in less than the Standard Time, the
variance is Favourable. If the workers take more time than the allotted time, the
variance is Adverse.
d) Idle Time Variance: It arises because of the time during which the Labour
remains idle due to abnormal reasons, i.e. power failure, strikes, machine
breakdown, shortage of materials, etc. It is always an Adverse variance
Labour Idle Time Variance = Actual Idle Time x Standard Hourly Rate
It is the difference between the standard composition of workers and the actual
gang of workers. It is a part of labour efficiency variance. It corresponds to
material mix variance. It enables the management to study the labour cost
variance occurred because of the changes in the composition of labour force.
(i) When the total hours i.e. time of the standard composition and actual
composition of workers does not differ the formula is:
(ii) When the total hours i.e. time of the standard composition and actual
composition of workers differs, the formula is:
It is just like Material Yield Variance. It is the difference between the standard
labour output and actual output of yield. It is calculated as below:
OVERHEAD VARIANCE
It is the difference between standard overheads for actual output i.e. Recovered
Overheads and Actual Overheads. It is the total of both fixed and variable
overhead variances. The variable overheads are those costs which tend to vary
directly in proportion to changes in the volume of production. Fixed overheads
consist of costs which are not subject to change with the change in the volume of
production. The variances under overheads are analysed in two heads, viz
Variable Overheads and Fixed Overheads:
The term overhead includes indirect material, indirect labour and indirect
expenses and the variances relate to factory, office or selling and distribution
overheads. Overhead variances are divided into two broad categories: (i)
Variable overhead variances and (ii) Fixed overhead variances. To compute
overhead variances, the following terms must be understood:
a) Standard overhead rate per unit
Budgeted overheads
0 ……………………
Budgeted output
Standard overheads = Standard rate per unit x Standard output for actual time
Variable cost varies in proportion to the level of output, while the cost is
fixed per unit. As such the standard cost per unit of these overheads remains the
same irrespective of the level of output attained. As the volume does not affect
the variable cost per unit or per hour, the only factors leading to difference is
price. It results due to the change in the expenditure incurred.
Standard Overhead Rate= (Standard Time for Actual output- Actual Time)
Fixed overhead variance depends on (a) fixed expenses incurred and (b) the
volume of production obtained. The volume of production depends upon (i)
efficiency (ii) the days for which the factory runs in a week (calendar variance)
(iii) capacity of plant for production.
(b) Fixed Overhead Volume Variance. This variance is the difference between
the standard cost of overhead absorbed in actual output and the standard
allowance for that output. This variance measures the over of under recovery of
fixed overheads due to deviation of actual output form the budgeted output level.
OR
Calculate:-
Material Usage Variance (b) Material Price Variance (c) Material Cost
Variance
Answer:
Standard quantity:
For 70kg standard output
Standard quantity of material = 100 kg
2,10,000 kg of finished products
2,10,000 x 100
= …………………………………….. =3,00,000 kg
70
2. Actual Price per kg
2,52,000
=……………… = Re. 0.90
2,80,000
(a) Material Usage or Quantity Variance
=SP (SQ-AQ)
=Re.1 (3,00,000-2,80,000)
=Re.1 * 20,000
= Rs.20,000 (Favourable)
Material Price Variance
0 AQ (SP - AP)
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ᜀĀᜀĀᜀĀᜀĀᜀĀᜀ0 (SQ x SP) - (AQ x
AP)
Example: 4
Calculate
0 AQ (SP - AP)
Material Mix Variance = Standard Rate x (Revised std. Quantity - Actual qty.)
MVV for material „A‟= 5(90-80) =50 (Adverse)
MVV=50-100=-50=Rs.540 (Adverse)
Example: 5
Vinak Ltd. produces an article by blending two basic raw materials. It operates a
standard costing system and the following standards have been set for new
materials.
During April 1994 the company produced 1700 kgs of finished output. The
position of stocks and purchases for the month of April 1994 is as under:
6,800
Standard Yield Rate =………= Rs. 4 per kg
1,700
Actual Costs:
A - 35+800-5 = 830kgs. consumed 35 x 4 (assumed) = Rs. 140.00 795
x 4.25 (purchase price) = Rs. 3,378.75
…………….
Rs. 3,518.75
A = 4 (800-830) =120(A)
B= 3 (1,200-1,190) =30(F)
……….
Rs. 90(A)
Material Yield Variance = SYR* (AY-SY)
=4(1,700-1,717)=68(A)
If SY For 2,000 kgs. input SY=1,700
Then, For 2,020 kgs. input SY = ?
2,020
=…………. x 1,700=1,717 kgs }
2,000
Material Mix Variance = SP (RSQ-AQ)
2.020
For „A‟ = 800 x ………… = 808
2,000
2,020
For „B‟= 1,200 x …………..=1,212
2,000
Example: 6
Standard labour hours and rate for production of Article A are given
below:
(b) Labour Rate Variance = Actual Time (Standard Rate x Actual Rate)
Skilled worker = 4500 (1.50 - 2) = Rs.2250 (A)
Unskilled worker = Rs.4,200 (0.75 – 0.75) = Nil
Semi skilled worker = 1,000 (0.50 - 0.45) = Rs.500 (F)
Total Labour Rate Variance = Rs.1,750 (A)
(c) Labour mix variance: = SR (Revised std. Mix of Actual hours worked) –
Actual Mix
Revised std. Mix of Actual hours worked
Std Mix
=……………………… x Total Actual Hrs.
Total Std. Hours
5,000
Skilled worker = …………… x 18,700 = 5,500 Hrs
17,000
8,000
Unskilled worker =………… x 18,700 = 8,800 Hrs.
17,000
4,000
Semi skilled worker =………… x 18,700 = 4,400 Hrs
17,000
(d) Labour Efficiency Variance = SR (ST for Actual output – Revised Std.
Hrs)
Skilled worker = 1.50 (5,000 - 5,500) = Rs.750 (A)
Unskilled worker = 0.50 (8,000 - 8,800) = Rs.400 (A)
Semi skilled worker = 0.75 (4,000 - 4,400) = Rs.300 (A)
Total Labour Efficiency Variance = Rs. ,450 (A)
Overhead Variance:
Example: 9
S.V. Ltd has furnished you the following data:
Budget Actual July 1994
No. of working days 25 27
Production in units 20,000 22,000
Fixed overheads Rs.30,000 Rs.31,000
Budgeted fixed overhead rate is Re. 1 per hour. In July 1994, the actual hours
worked were 31,500.
Calculate the following variance: (i) Efficiency Variance (ii) Capacity variance (iii)
Volume variance (iv) Expenditure variance and (v) Total overhead variance.
Answer:
Budgeted overhead
Recovered overhead =…………………… x Actual output
Budgeted output
30,000
=……….. x 22,000
20,000
2 33,000
Efficiency Variance = Standard Rate per hour (Standard hours for actual
production – Actual hours)
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ĀᜀĀᜀĀᜀ0 Re. 1 x (33,000 – 31,500)
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ĀᜀĀᜀĀᜀ1 Rs.1,500 (F)
(ii) Capacity Variance = Standard Rate per hour x (Actual hours - Budgeted
hours)
1 Standard overheads - Budgeted overheads
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ᜀĀᜀĀᜀĀᜀĀᜀ0 Re. 1 x (31,500 –
30,000)
2 Rs.1500 (F)
Volume variance = Recovered overhead – Budgeted overheads
0 Rs. 33,000 – Rs. 30,000
1 Rs. 3,000 (F)
Expenditure variance = Budgeted overheads – Actual overheads
\ = Rs.30,000 – Rs.31,000
0 Rs.1,000 (A)
Total overhead variance = Recovered overhead – Actual overheads
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ᜀĀᜀĀᜀĀᜀĀᜀ0 Rs.33,000 – Rs.31,000
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ᜀĀᜀĀᜀĀᜀĀᜀ1 Rs.2,000 (F)
Example: 10
Vinak Ltd.has furnished you the following for the month of August 1994.
Budget Actual
Output (Units) 30,000 32,500
Hours 30,000 33,000
Fixed hours Rs. 45,000 50,000
Variable overhead Rs. 60,000 68,000
Working days 25 26
Calculate the variances.
Answer:
30,000
…………= 1 hours
30,000
Total standard overhead rate per hour
Budgeted overheads
=……………………..
Budgeted hours
1,05,000
= …………. = Rs.3.50 per hour
30,000
45,000
= ………. = Rs.1.50
30,000
Standard variable overhead rate per hour
Budgeted variable overheads
=……………………………….
Budgeted hours
60,000
= ……….. = Rs.2
30,000
Overhead cost variance = Recovered overheads – Actual overheads
= Rs.4,250 (A)
Rs.3,000 (A)
48,750 – 50,000
=Rs.1,250 (A)
Rs.45,000 – Rs.50,000
Rs.5000 (A)
Volume variance = Recovered overheads- Budgeted overheads
48,750 – 45,000
Rs.3,750 (F)
OR
Rs.750 (A)
Or
Rs.4,500 (F)
30,000
= ……….. = 1,200
25
=1,200 x 1.50 = Rs.1,800 (F)
Note:
Disposal of Variances:
Exercises:
Material Cost Variance, Material Price Variance and Material usage variance.
The standard quantity of materials required for producing one ton of output is 40
units. The standard price per unit of materials is Rs. 3. During a particular period
90 tons of output was undertaken. The materials required for actual production
were 4,000 units. An amount of Rs. 14,000 units. An amount of Rs.14, 000 was
spent on purchasing the materials.
(MCV:Rs.3,200(A), MPV: Rs.2,000 (A), MUV Rs.1,200 (A)
The standard materials required for producing 100 units is 120 kgs. A standard
price of 0.50 paise per kg is fixed 2,40,000 units were produced during the
period. Actual materials purchased were 3,00,000 kgs. at a cost of Rs. 1,65,000.
Calculate Materials Variance. ( MCV - 21,000)
From the data given below, calculate: Material Cost Variance, Material Price
Variance and Material Usage Variance
Standard Actual
Materials Quantity Price per unit Quantity Price per unit
(units) Rs. (units)
Rs.
A 40 10 50 12
B 60 5 50 8
(Materials Mix Variance: Rs.50 (A)
5 Calculate material mix variance form the data given as such:
Standard Actual
Materials Quantity Price per unit Quantity Price per unit
(units) Rs. (units)
Rs.
A 50 2.00 60 2.25
B 100 1.20 90 1.75
Due to the shortage of material A, the use of material „A‟ was reduced by 10%
and that of „B‟ increased by 5% Ans: (Material Mix Variance = -12 (A)
Standard Actual
Materials Quantity Price per unit Quantity Price per unit
(units)
(units) Rs. Rs.
A 80 8.00 90 7.50
B 70 3.00 80 4.00
(MCV; Rs.145 (A), MPV: Rs.35 (A), MUV: Rs.110 (A), MMV: Rs.3.3 (F)
Standard Actual
Materials Quantity Price per unit Quantity Price per unit
(units) Rs. (units)
Rs.
A 80 5 60 4.50
B 70 9 90 8.00
…… …..
150 150
There is a standard loss of 10%. Actual yield is 125 units. (MYV: Rs.76.3 (A)
……. ……..
240 Rs. 50
Ten units of finished product should be obtained from the above mentioned mix.
During the month of January, 1978, ten mixes were completed and the
consumption was as follows:
……. ……..
2,440 Rs.524
……. ………
(MCV: Rs.74 (A), MPV: Rs.26 (A), MUV: Rs.48 (A), MMV: Rs.0.35 (F)
A
B
The standard loss in processing is 15%. During April, 1980, the company
produced 1,700 kg of finished output. The position of stock and purchase for the
month of April, 1980 are as under:
(MCV: Rs.286 (F), Material Price Variance: Rs. 376.75 Favourable, Material
Usage Variance. Rs.90 unfavoruable, Material Mix Variance: Rs. 22 Adverse)
10. In a manufacturing concern, the standard time fixed for a month is 8,000
hours. A standard wage rate of Rs. 2.25 P. per hour has been fixed. During one
month, 50 workers were employed and average working days in a month are 25.
A worker works for 7 hours in a day. Total wage bill of the factory for the month
amounts to Rs. 21,875. There was a stoppage of work due to power failure (idle
time) for 100 hours. Calculate various labour variances.
(LCV: Rs.3875 (A), Rate of pay variance: Rs. 2187.50 (A), LEV: Rs.1462.50
(A)
11. The information regarding the composition and the weekly wage rates of
labour force engaged on a job scheduled to be completed in 30 weeks are as
follows:
Standard Actual
Category of No. of Weekly wage No. of Weekly wage
wokers workers rate per workers rate per
worker worker
Rs. Rs.
Skilled 75 60 70 70
Semi skilled 45 40 30 50
Unskilled 60 20 80 20
The work was completed in 32 weeks. Calculate various labour
variances.
12. The following data is taken out from the books of a manufacturing concern.
Calculate: (i) Labour Cost Variance, (ii) Labour Rate Variance, (iii) Labour
Efficency Variance, (iv) Labour Mix Variance.
Ans:(Labour Cost Variance: Rs. 35 Adverse, Labour Rate Variacne Rs. 212.50
Adverse, LEV:Rs.177.50 Favourable and LMV: Rs.24.38 unfavourable)
Calculate labour variances from the following data:
Standard Actual
Out put in units 2,000 2,500
Number of workers employed 50 60
Number of working days in a month 20 22
Average wage per man per month (Rs.) 280 330
Ans: LCV Rs.2300 (A), LRV Rs. 1320 (A), LEV Rs 980 (A)
1 Expenditure Variance
2 Volume Variance
3 Capacity Variance
4 Efficiency Variance
Budget Actual
Ans: Fixed Overhead Variance: Rs. 300 (A), Expenditure Variance: Rs. 400 (A),
Volume Variance: Rs. 100 (F), Capacity Variance: Rs. 800 (F), Efficiency
Variance: Rs. 700 (A)
From the following information, calculate various overhead variances:
Budget` Actual
Output in units 12,000 14,000
Number of working days 20 22
Fixed Overheads 36,000 49,000
Variable Overheads 24,000 35,000
There was an increase of 5% in Capacity.
(Total Overhead cost Variance: Rs.14,000 (A), Variable Overhead Variance: Rs.
7,000 (A), Fixed Overhead Variance: Rs.7000 (A),Expenditure Variance: Rs.
13,000 (A), Volume Variance: Rs.6000 (F), Capacity Variance: Rs.1,800 (F),
Calendar Variance: Rs.32,780 (F), Efficiency Variance: Rs.420 (F)
Unit III
Lesson I
Introduction
Definition
Differential Costing
Marginal Cost
Contribution:
Angle of incidence:
Profit goal:
Operating leverage
On completion of this lesson, you should be able to define and explain the
following concepts:
Marginal Costing
Differential Costing
Marginal Cost
Fixed Cost
Variable Cost
Contribution
P / V ratio
Margin of Safety
Angle of Incidence
Introduction
Marginal costing is a study where the effect on profit of changes in the volume
and type of output is analysed. It is not a method of cost ascertainment like job
costing or contract costing. It is a technique of costing oriented towards
managerial decision making and control.
Batty defined Marginal Costing as, “a technique of cost accounting which pays
special attention to the behaviour of costs with changes in the volume of output”
The method of charging all the costs to production is called absorption costing.
Kohler‟s dictionary for Accountants defines it as “the process of allocating all
or a portion of fixed and variable production costs to work – in – process, cost
of sales and inventory”. The net profits ascertained under this system will be
different from that under marginal costing because of
Direct costing is defined as the process of assigning costs as they are incurred
to products and services
Fixed and variable costs are kept separate at every stage. Semi –
Variable costs are also separated into fixed and variable.
As fixed costs are period costs, they are excluded from product cost or cost of
production or cost of sales. Only variable costs are considered as the cost
of the product.
As fixed cost is period cost, they are charged to profit and loss account during
the period in which they incurred. They are not carried forward to the next
year‟s income.
The difference between the contribution and fixed costs is the net profit or loss.
Sales price and variable cost per unit remains the same.
The selling price per unit remains unchanged at all levels of activity.
Variable cost per unit remains constant irrespective of level of output and
fluctuates directly in proportion to changes in the volume of output.
Fixed costs remain unchanged or constant for the entire volume of production.
Segregation of cost into fixed and variable elements: In marginal costing, all
costs are segregated into fixed and variable elements.
Marginal cost as product cost: Only marginal (variable) costs are charged to
products.
Fixed costs are period costs: Fixed cost are treated as period costs and are
charged to costing profit and loss account of the period in which they are
incurred.
Contribution is the difference between sales and marginal cost: The relative
profitability of the products or departments is based on a study of
“contribution” made by each of the products or departments.
Simplicity
Stock valuation cab be easily done and understood as it includes only the
variable cost.
Meaningful Reporting
The fixed costs are treated as period costs and are charged to Profit and Loss
Account directly. Thus, they have practically no effect on decision making.
5. Profit Planning
7. Pricing Policy
Classification of Cost
Break up of cost into fixed and variable portion is a difficult problem. More
over clear cost division of semi – variable or semi – fixed cost is complicated
and cannot be accurate.
Since fixed cost is not included in total cost, full cost is not available to
outsiders to judge the efficiency.
Marginal costing is most suitable for decision making in a short term. It assumes
that costs are classified into fixed and variable. In the long term all the cost are
variable. Therefore it ignores time element and is not suitable for long term
decisions.
Under marginal costing only variable costs are considered and the output as well
as stock are undervalued and profit is distorted. When there is loss of stock the
insurance cover will not meet the total cost.
Automation
Marginal costing lays too much emphasis on selling function and as such
production aspect has been considered to be less significant. But from the
business point of view, both the functions are equally important.
In contract type and job order type of businesses, full cost of the job or the
contract is to be charged. Therefore it is difficult to apply marginal costing in all
these types of businesses.
Misleading Picture
Each product is shown at variable cost alone, thus giving a misleading picture
about its cost.
Since cost, volume, and profits are interlinked in price determination, which can
be changed constantly, development of long term pricing policy is not possible.
Absorption costing charges all the costs i.e., both the fixed and variable fixed to
the products, jobs, processes, and operations. Marginal costing technique
charges variable cost. Absorption is not any specific method of costing. It is
common name for all the methods where the total cost is charged to the output.
Absorption Costing is defined by I.C.M.A, England as “the practice of charging all
costs, both fixed and variable to operations, processes, or products”
From this definition it is inferred that absorption costing is full costing. The full
cost includes prime cost, factory overheads, administration overheads, selling
and distribution overheads.
The difference between marginal costing and absorption costing is shown with
the help of the following examples.
Illustration No: 1 Cost of Production
(10000 units)
Per Unit Total
(Rs. P) (Rs)
Variable cost 1.50 15000
Fixed Cost 0.25 2500
---------
Total cost 17500
---------
Sales 5000 units at Rs. 2.50 per unit Rs. 125000
Closing stock 5000 units at Rs. 1.75 Rs. 8750
Solution:
Rs.
Sales 12500
Closing stock 8750
-----------
21250
Less: Total cost 17500
-----------
Profit 3750
----------
Under marginal costing method, the profit will be calculated as follows:
Sales
Less: Marginal
Cos
t of
Profit
Rs.
12500
7500
-----------
5000
2500
-----------
2500
----------
Closing stock will be valued at Rs.7500 only at marginal cost.
Illustration No: 2
The monthly cost figures for production in a manufacturing company are as
under:
Rs.
Variable cost 120000
Fixed cost 35000
-------------
Total cost 155000
-------------
Normal monthly sales is Rs. 200000/-. Actual sales figures for the three separate
months are:
Prepare two tabulations side by side to summarize these results for each of the
three months basing one tabulation on marginal costing theory and the other
tabulation along side on absorption cost theory.
Solution:
Note: Stocks at marginal cost is based on variable portion of the monthly total
cost given as follows:
120000
Marginal cost in Rs.108500 = 108500 X ------------- = Rs. 84000
155000
120000
Marginal costs in Rs. 135625 = 135625 X -----------= Rs. 105000
155000
Differential Costing
In the illustration given below, differential cost at levels of activity has been
shown:
Both the differential cost analysis and marginal cost analysis are based on the
classification of cost into fixed and variable. When fixed costs do not
change, both differential and marginal costs are same.
Both are the techniques of cost analysis and presentation and are used by the
management in formulating policies and decision making.
Dissimilarities
Entire fixed cost are excluded from costing where as some of the relevant fixed
costs may be included in the differential cost analysis.
(iii)In marginal costing, contribution and p/v ratio are the main yardstick for
evaluating performance and decision making. In differential cost analysis
emphasis is made between differential cost and incremental or decremental
revenue for making policy decisions.
Marginal Cost
Marginal cost is the cost of producing one additional unit of output. It is the
amount by which total cost increases when one extra unit is produced or the
amount of cost which can be avoided by producing one unit less.
The ICMA, England defines marginal cost as, “the amount of any given volume
of output by which the aggregate cost are charged if the volume of output is
increased or decreased by one unit”.
In practice, this is measured by the total cost attributable to one unit. In this
context, a unit may be single article, a batch of articles, an order, a stage of
production, a process etc., often managerial costs, variable costs are used to
mean the same.
For convenience the element of cost statement can be written in the form of an
equation as given below:
Or
In order to make profit, contribution must be more than fixed cost and to avoid
loss, contribution should be equal to fixed cost.
Products
--------------------------------------------
X Y Z
(Rs) (Rs) (Rs)
Direct Materials 2500 10000 1000
Direct Labour 3000 3000 500
Variable Overheads 2000 5000 2500
Sales 10000 20000 5000
Solution:
Marginal Cost Statement
Products
----------------------------------------------------------
X Y Z Total
(Rs) (Rs) (Rs) (Rs)
Sales (A) 10000 20000 5000 35000
------------------------------------------------------------
Direct materials 2500 10000 1000 13500
Direct Labour 3000 3000 500 6500
Variable Overheads 2000 5000 2500 9500
------------------------------------------------------------
Marginal Cost (B) 7500 18000 4000 29500
------------------------------------------------------------
Marginal Contribution
(A – B) 2500 2000 1000 5500
Less:FixedCost 3000
--------
NetProfit 2500
--------
Contribution:
Contribution is the difference between selling price and variable cost of one
unit. The greater contribution from the selling unit indicates that the variable
cost is less compared to selling price. Total contribution is the number of units
multiplied by contribution per unit. Contribution will be equal to the total fixed
costs at break even point where profit is zero.
Illustration No.4:
Solution:
When profits and sales for two consecutive periods are given, the following
formula can be applied: Change in Profit
--------------------
Change in Sales
Margin of safety:
The excess of actual or budgeted sales over the break-even sales is known as the
margin of safety.
(Or)
Profit
----------
P/V Ratio
When margin of safety is not satisfactory, the following steps may be taken into
account:
Angle of incidence:
This is obtained from the graphical representation of sales and cost. When sales
and output in units are plotted against cost and revenue the angle formed
between the total sales line and the total cost line at the break-even point is
called the angle of incidence.
Large angle indicates a high rate of profit while a narrow angle would show a
relatively low rate of profit.
Profit goal:
To earn a desired amount of profit i.e., a profit goal can be reached by the
formula given below
Change in EBIT
-------------
EBIT
Degree of Leverage DOL= --------------------------------------
Change in sales
------------
Sales
Test Yourself:
The selling price of a particular product is Rs.100 and the marginal cost is
Rs.65. During the month of April, 800 units produced of which 500 were sold.
There was no opening at the commencement of the month. Fixed costs
amounted to Rs. 18000. Provide a statement using a) Marginal costing and b)
Absorption costing, showing the closing stock valuation and the profit earned
under each principle.
Rs.
Sales 1000000
Variable cost 600000
Fixed cost 150000
Rs.
Sales 300000
Variable cost 200000
Profit 50000
4. Determine the amount of variable cost from the following.
Rs.
Sales 500000
Fixed cost 100000
Profit 100000
References
Lesson II
Introduction
Define BEP
Explain CVP Analysis with example
Introduction
Break-even analysis is the form of CVP analysis. It indicates the level of sales at
which revenues equal costs. This equilibrium point is called the break even
point. It is the level of activity where total revenue equals total cost. It is
alternatively called as CVP analysis also. But it is said that the study up to the
state of equilibrium is called as break even analysis and beyond that point we
term it as CVP analysis.
Cost – Volume Profit analysis helps the management in profit planning. Profits
are affected by several internal and external factors which influence sales
revenues and costs.
Units sold.
Machine hours.
Selling price
Sales volume
Sales mix
These depict the interplay of three elements viz., cost, volume, and profits. The
charts are graphs which at a glance provide information of fixed costs, variable
costs, production / sales achieved profits etc., and also the trends in each one of
them. The conventional graph is as follows:
This is a simple break even chart. The procedure for drawing the chart is as
follows:
Depict the X - axis as the volume of sales or capacity or production.
Having known the „0‟ level of activity the same fixed cost is incurred, the fixed
cost line is depicted as being parallel to the X – axis.
At „0‟ level of activity, the total cost is equal to fixed cost. Therefore the total
cost line starts from the point where the fixed cost line meets the Y – axis.
The meeting point of the sales and the total cost line is the Break Even Point.
It is also called Break Even Point because at that point there is no profit and loss
either.
The costs are just recovery by sales. If a perpendicular line is drawn to the X-
axis from the BEP, the meeting point of the perpendicular and X- axis will show
the break even volume in units. If a perpendicular line is drawn to meet the Y-
axis from the BEP, the meeting point shows the break even volume in money
terms.
Angle of Incidence
This is the angle of intersection between the sales line and the total cost line.
The larger the angle the greater is the profit or loss, as the case may be.
Margin of Safety
This is the difference between the actual sales level and the break even sales. It
represents the “cushion” for the company. The larger the distance between the
break even sales volume and the actual sales volume, the company can afford to
allow the fall in sales without the danger of incurring losses. If the margin of
safety is low i.e., if the distance between the actual sales line and the break even
sales line is too short, even a small fall in the sales volume will drive the
company into the loss area.
The position of break even point should be ideally closer to the y – axis. This
will mean that even a small increase in sales will immediately make the
company break even. I t should be noted that beyond the break even point all
contribution (Sales – Marginal Cost) will directly increase the profits.
Scale of sale is selected on horizontal axis and that for profit or loss are selected
on vertical axis. The area below the horizontal axis is the loss area and that
above it is the profit area.
Points of profits of corresponding sales are plotted and joined. The resultant line
is profit / loss line
Illustration No. 1
Draw up a profit – volume of the following:
Sales Rs. 4 Lakhs
Variable cost Rs. 2 Lakhs
Fixed cost Rs. 1 Lakhs
Profit Rs. 1 Lakhs
Solution
2.The variable costs vary with volume and the fixed costs remain constant.
The relationship between cost volume and profit are well defined in CVP
analysis. With the given example we can elaborately see the relationship
= 20 - 12 = Rs.8/-
Since the profit = total contribution - fixed cost, we get nil profit. 160000-
160000=0
This is the break even point where the total cost is equal to the total revenue and
the company has no profit and no loss.
If the fixed cost is Rs. 120000, then the company may earn a profit of Rs.
(160000-120000) = 40000. If the fixed cost is Rs.200000, then it may end in a
loss of Rs (200000-160000) = 40000
If the variable cost per unit is increased, say to Rs. 15 in the existing condition,
then the contribution will come to Rs (20000 x (20-15) = 100000 and that will
result in a loss of Rs. 160000-100000 =40000. If the variable cost per unit is
decreased say to Rs.10 then the contribution will come to Rs.20000x (20-10) =
200000. Then the profit will be 200000-160000=40000
The above proves that the variation in the costs varies the profitability of the
firm.
Now we can see how the change in volume alters the profitability. If the sales
volume is 10000 instead of 20000 as above and the all the other conditions
being the same, the result will be (10000x8) - 160000 = 80000 loss. Likewise if
the volume is increased to 30000 it will result in a profit of Rs 30000x8 -
160000 = 80000. This shows that the profit increases with the increase in
volume when other conditions are unchanged.
The unit selling price is constant. This implies that the total revenue of the firm
is a linear function of output. For firms which have a strong market for their
products, this assumption is quite valid. For other firms, however, it may not be
so. Price reduction might be necessary to achieve a higher level of sales. On the
whole, however, this is a reasonable assumption and not unrealistic enough to
impair the validity of the cost-volume- profit model, particularly in the relevant
range of output.
Inventory changes are nil. A final assumption underlying the conventional cost-
volume-profit model is that the volume of sales is equal to the volume of
production during an accounting period. Put differently, inventory changes are
assumed to be nil. This is required because in cost-volume-profit analysis we
match total costs and total revenues for a particular period.
3.It provides the basic information for further profit improvement studies.
4.It is useful in decision making and it helps in considering the risk implications
of alternative actions.
5.It helps in finding out the effect of changes in the price, volume, or cost.
6.It helps in make or buy decisions also and helpful in the critical circumstances
to find out the minimum profitability the firm can maintain.
1.The basis assumptions are at times base less. For example, we can say that the
fixed costs cannot remain unchanged all the time. And the constant selling price
and unit variable cost concept are also not acceptable.
2.It is difficult to segregate the cost components as fixed and variable costs.
5.It is a static tool since it gives the relationship between cost, volume and profit
at a given point of time and
Illustration No. 2
Calculation of Profit
Profit = Contribution – Fixed cost
Illustration No. 3
From the following data, calculate the break-even point of sales in rupees:
Manufacturing Rs.10
Selling Rs.5
Overhead (fixed):
Solution:
Manufacturing: Rs. 10
Selling: Rs.5
Rs.15
--------
Contribution per unit Rs. 5
Contribution ratio = Rs.5 / Rs.20 =25%
Selling- Rs.200000
--------------
Rs.700000
Rs.700000/25%
Rs.2800000
Rs. 700000/Rs.5
140000 units
Illustration No. 4
The following data have been obtained from the records of a company
I Year II Year
Rs. Rs.
Sales 80000 90000
Profit 10000 14000
Calculate the break-even point.
Solution:
Changes in profit
Changes in sales
= 14000 – 10000
90000- 80000
Contribution = Sales x P/V Ratio = 90000 x 40% = Rs.36000
To find the break-even point, we should first find out the fixed cost because
{This can be cross checked by using the first year‟s figures (80000 x 40%) –
10000}
Illustration No. 5
A.G. Ltd., furnished you the following related to the year 1996.
First half of the year (Rs.) Second half of the year (Rs.)
Assuming that there is no change in prices and variable cost and that the fixed
expenses are incurred equally in the 2 half year periods, calculate for the year
1996:
(a) The profit volume ratio (b) Fixed expenses (c) Break even sales and (d) % of
margin of safety.
Solution:
c) Break even sales=Fixed cost / P/V Ratio for the year1996=26000 / 40% =
Rs.65000
Note: (1) Since fixed expenses are incurred equally in the 2 half years,
Rs.13000 is multiplied with 2 to get fixed cost of the full year.
st nd
(2)Sales of both 1 and 2 half years are added and are taken as actual sales
i.e., Rs.95000 to calculated margin of safety.
Illustration No.6
From the following information relating to Palani Bros. Ltd., you are required to
find out:
P/V Ratio (b) Break even point (c) Profit (d) Margin of safety (e) Volume of
sales to earn profit of Rs.6000.
Total
Sales
15000
Solution:
Amount
(Rs.)
Sales 15000
Less:Variablecost 7500
--------
Contribution 7500
Less: Fixed cost 4500
--------
Profit 3000
(a)P/V ratio =Contribution / Sales x 100
= 7500 / 15000 x 100 = 50%
(b)Break even sales = Fixed expenses / P/V Ratio
Illustration No. 7
The sales turnover and profit during two years were as follows:
Calculate:
(a) P/V Ratio (b) Break-even point (c) Sales required to earn a profit of
Rs.40000
(d) Fixed expenses and (e) Profit when sales are Rs.120000
Solution:
When sales and profit or sales and cost of two periods are given, the P/V ratio is
obtained by using the „Change formula‟
Fixed cost can be found by ascertaining the contribution of one of the periods
given by multiplying sales with P/V Ratio. Then, contribution – Profit can
reveal the fixed cost.
Ascertaining P/V ratio using the change formula and finding cost are the
essential requirements in these types of problems.
a) P/V ratio
Note: The same fixed cost can be obtained using 1992 sales also.
=120000 x 25/100=Rs.30000
Illustration No. 8
Number of units that must be sold to earn a profit of Rs.60000 per year.
Number of units that must be sold to earn a net income of 10% on sales
Fixed cost-Rs.79200
Solution:
Contribution per unit = Sales price per unit – Variable cost per unit
=20 – 14 = 6.
79200 / 30%
Rs.264000
Rs.464000
----------
Contribution = 118000
----------
Profit = 39600
----------
Illustration No. 9
You are given the following data for the year 1986 for a
Solution:
Margin Cost and contribution statement for the year 1986
Particulars Rs.
8,00,000
Less : 4,00,000
4,00,000
Less : 2,00,000
2,00,000
New variable cost = Rs.12 (given New fixed cost=200000 + (200000 x 10%)
=Rs.1260000
The P/V Ratio of a firm dealing in precision instruments is 50% and margin of
safety is 40%. You are required to work-out break even point and the net profit
if the sales volume is Rs.5000000. If 25% of variable cost is labour cost, what
will be the effect on BEP and profit when labour efficiency decreases by 5%.
Solution:
= 5000,000 – 2000000
= Rs.3000000
(2)Calculation of profit
= 2467105 – 1500000=Rs.967105
Note: If for 100 units labour cost is Rs.100, 5% decrease in efficiency makes the
labour to produce only 95 units in the same time.
Original labour cost has to be multiplied with 100 / 95 to get new labour cost.
Illustration No. 11
P Q R
4. Contribution (1-2) 50 40 30
10% + 15% +
30% = 55%
Illustration No. 12
Raviraj Ltd. Manufactures and sells four types of products under the brand
names of A, B, C and D. The sales mix in value comprises 33 1/3%, 41 2/3%,
16 2/3% and 8 1/3% of products A, B, C and D respectively. The total budgeted
sales (100%) are Rs. 60,000 per month.
Calculate the break even point for the products on an overall basis and also the
B.E. Sales of individual products. Show the proof for your answer.
Solution:
A = 40 %( 100-60)
= 32 %( 100-68)
= 20 %( 100-80)
= 60 %( 100-40)
Calculation of Composite P/V Ratio
P/V Ratio
fractions)
Composite P / V Ratio
Rs. 14,700
35%
Profit/Loss Nil
Test yourself
Problems
2. A Ltd. has two factories X and Y producing same article whose selling price
is Rs. 150 per unit. Other details are:
X Y
Determine the BEP for the two factories assuming constant sales mix also
composite BEP.
b. If sales are 10% and 15% above the break even sales volume determine the
net profit.
References
Introduction
Profit planning
Explain managerial decisions which are taken with the help of marginal costing
decisions in different situations.
Introduction
The following are some of the managerial decisions which are taken with the
help of marginal costing decisions:
Key factor:
Profit planning
One of the main purposes of cost accounting is the ascertainment of cost for
fixation of selling price. Price fixation is one of the fundamental problems
which the management has to face. Although prices are determined by market
conditions and other factors, marginal costing technique assists the management
in the fixation of selling prices under various circumstances which is as follows.
Out of the three products, product II gives the highest contribution per unit.
Therefore, if no other factors no others factors intervene, the production
capacity will be utilized to the maximum possible extent for the manufacture of
that product. Product I ranks second and so, after meeting the requirement of
Product II, the capacity will be utilized for product I. What ever capacity is
available thereafter may be utilized for Product III.
Key Factor
When there is no limiting factor, the production can be on the basis of the
highest P / V ratio. When two or more limiting factors are in operation, they will
be seriously considered to determine the profitability.
Contribution
Profitability = -------------------------
Key factor (Materials, Labour, or Capital)
Profit planning is the planning of the future operations to attain maximum profit
or to maintain level of profit. Whenever there is a change in sale price, variable
costs and product mix, the required volume of sales for maintaining or attaining
a desired amount of profit may be ascertained with the help of P / V ratio.
When a firm is operating for loss sometime, the management has to decide upon
its shut down.
Complete shut down: The firm may be permanently closed any intention to
revive it. Such a decision is warranted.
When the selling price does not even cover the variable cost: or
The demand for the output is very low and the future prospects are bleak.
Complete shut down saves the management from the fixed of running the
factory or division or firm.
b) Partial or temporary shut down: Here the intention is to close down for
sometime and reopen the firm when circumstances favour it. Some fixed cost
will continue in the form of irreducible minimum, like Skelton staff to maintain
the factory, some managerial remuneration, salaries, irreplaceable technical
experts, etc. The saving from the partial shut down should be compared with the
position if the firm continues. If there is substantial savings, shut down may be
preferable. Minor savings in expenditure does not warrant shut down because
reviving a firm is a cumbersome process.
Decision to Make or Buy
Illustration No. 1
An automobile manufacturing company finds that the cost of making Part No.
208 in its own workshop is Rs.6. The same part is available in the market at
Rs.5.60 with an assurance of continuous supply. The cost data to make the part
are:
Material Rs.2.00
Direct labour Rs.2.50
Other variable cost Rs.0.50
Fixed cost allocated Rs.1.00
----------
Rs.6.00
----------
Should be part be made or brought?
Will your answer be different if the market price is Rs.4.60? Show your
calculations clearly.
Solution:
To take a decision on whether to „make or buy‟ the part, fixed cost being
irrelevant is to be ignored. The additional costs being variable costs are to be
considered.
Materials Rs.2.00
Direct labour Rs.2.50
Other variable cost Rs.0.50
---------
Total variable cost Rs.5.00
----------
The company should continue „to Make‟ the part if its market price is Rs.5.60
„Making‟ results in saving of Rs.0.60 (5.60 – 5.00) per unit.
(b)The company should „Buy‟ the part from the market and stop its production
facilities which become „Idle‟ if the production of the part is discontinued
cannot be used to derive some income.
Note: The above conclusion is on the assumption that the production facilities
which become „Idle‟ if the production of the part is discontinued cannot be used
to derive some income.
However, if the „Idle facilities‟ can be leased out or can be used to produce
some other product or part which can result in some amount of „contribution‟,
that should also be considered while taking the „Make or buy decision‟.
Key Factor
Illustration No. 2
Two businesses S.V.P. Ltd., and T.R.R. Ltd., sell the same type of product in
the same type of market. Their budgeted Profit and Loss Accounts for the
coming year are as follows:
S.V.P. Ltd. T.R.R. Ltd.
Rs. Rs.
Sales 150000 150000
Less: Variable cost 120000 100000
Fixed cost 15000 35000
------------ ------------
Budgeted Net Profit 15000 15000
------------ ------------
You are required to:
Calculate the sales volume at which each business will earn Rs.5000/- profit.
Solution:
(2) In conditions of low demand, a concern with lower break even point is likely
to earn more profits because it will start making profits at lower level of sales.
Therefore in case of low demand SVP Ltd., will make profits when its sales
reach Rs.75000, whereas TRR Ltd., will start making profits only when its sales
reach the level of Rs.105000.
Illustration No. 3
Product A Product B
Sales (per unit) Rs.100 Rs.120
Consumption of material 2 Kg. 3 Kg.
Material cost Rs.10 Rs.15
Direct wages cost 15 10
Direct expenses 5 6
Machine hours used 3 2
Overhead expenses :
Fixed 5 10
Variable 15 20
Direct wages per hour is Rs.5. Comment on the profitability of each product
(both use the same raw materials) when:
Solution:
Statement showing key-factor contribution
When total sales potential in units is limited, product „B‟ will be more profitable
compared to „A‟ as its „Contribution per unit is more by Rs.14 (69 – 55).
When production capacity in terms of machine hours is the limiting factor, product
„B‟ is more profitable as its „contribution per hour‟ is more by Rs.16.17
(34.5 – 18.33)
When raw material is in short supply product „A‟ is more profitable as its
„contribution per kg‟ is higher by Rs.4.5 (27.5 – 23)
When sales potential in value is the limiting factor product „B‟ is better as its
P/V Ratio is higher than that of product „A‟.
Note: Contribution per unit can be divided with any given „Key Factor‟ or
„Limiting factor‟ to obtain „Key-factor contribution‟ (K.F.C.). The Product
which gives higher contribution in terms of key-factor is decided to be better
and more profitable
Illustration No. 4
S & Co. Ltd., has three divisions, each of which makes a different product.
The budgeted data for the next year is as follows:
Costs :
Direct Material 14,000 7,000 14,000
Direct Labour 5,600 7,000 22,400
Variable overhead 14,000 7,000 28,000
Solution:
Problems
Present the following information to management:
The managerial product cost and the contribution per unit and ii. The total
contribution and profits resulting from each of the sales mixes:
Product per unit
Rs.
Direct materials A 10
Direct materials B 9
Direct wages A 3
Direct wages B 2
Fixed expenses - Rs. 800
(Variable expenses are allotted to products 100% of direct wages)
Sales Price - A Rs. 20
Sales Price - B Rs. 15
Sales mix:
100 units of product A and 200 of B
150 units of product B and 150 of B
200 unit of product A and 100 of B
Recommend which of the sales mixes should be adopted.
Pondicherry Trading Corporation is running its plant at 50% capacity. The
management has supplied you the following details:
Cost of Production
Per Unit (Rs)
Direct materials 4
Direct labour 2
Variable overheads 6
Fixed overheads (Fully absorbed) 4
------
16
Production per month 40000 units
Total cost of production
40000 X Rs. 16 640000
Sales price 40000 X Rs. 14 560000
---------------
Rs. 80000
----------------
An exporter offers to purchase 10000 units per month at Rs. 13 per unit and the
company is hesitating in accepting the offer due to the fear that it will increase
its already large operating losses.
Advise whether the company should accept or decline this offer.
References
UNIT – IV
SECTION – A
Objectives: In this section, we will introduce you to the meaning and types of
financial statements; analysis and interpretation of financial statements; types of
financial statements; steps involves in financial statements analysis; techniques
of financial analysis; limitations of financial analysis; ratio analysis and cash
flow analysis. This section is theory cum practical problems of financial
statements analysis. After you workout this section, you should be able to:
Thus, the term 'financial statements' generally refers to two basic statements: (i)
the Income Statement and (ii) the Balance Sheet. 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.
Income Statement
The Income statement (also termed as Profit and Loss Account) is generally
considered to be the most useful of all financial statements. It explains what has
Financial Statements
The nature of the 'Income' which is the focus of the Income Statement can be
well understood if a business is taken as an organization that uses 'inputs' to
'produce' output. The outputs are the goods and services that the business
provides to its customers. The values of these outputs are the amounts paid by
the customers for them. These amounts are called 'revenues' in accounting. The
inputs are the economic resources used by the business in providing these goods
and services. These are termed as 'expenses' in accounting.
2. Balance Sheet
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. It is fundamentally a display of things that have caused the
beginning of the period retained earnings balance to be changed into the one
shown in the end- of the period balance sheet. The statement is also termed as
Profit and Loss Appropriation Account in case of companies.
The Balance Sheet shows the financial condition of the business at a particular
moment of time while the Income Statement discloses the results of operations
of business over a period of time. However, for a better understanding of the
affairs of the business, it is essential to identify the movement of working capital
or cash in and out of the business. This information is available in the statement
of changes in financial position of the business. The statement may emphasize
any of the following aspects relating to change in financial position of the
business:
Profitability, and
Financial soundness
A distinction here can be made between the two terms - 'Analysis' and
„interpretation‟. The term' Analysis' means methodical classification of the data
given in the financial statements. The figures given in the financial statements
will not help one unless they are put in a simplified form. For example, all items
relating to 'Current It Assets' are put at one place while all items relating to
'Current Liabilities' are put at another place. The term 'Interpretation' means
explaining the meaning and significance of the data so simplified. However,
both' Analysis' and 'Interpretation' are complementary to each other.
Interpretation requires Analysis, while Analysis is useless without Interpretation.
Most of the authors have used the term' Analysis' only to cover the meanings of
both analysis and interpretation, since analysis involves interpretation.
According to Myres, "Financial statement analysis is largely a study of the
relationship among the various financial factors in a business as disclosed by a
single set of statements and a study of the trend of these factors as shown in a
series of statements." For the sake of convenience, we have also used the term
'Financial Statement Analysis' throughout the chapter to cover both analysis and
interpretation. '
Financial Analysis can be classified into different categories depending upon (i)
the material used, and (ii) the modus operandi of analysis.
External Analysis. This analysis is done by those who are outsiders for the
business. The term outsiders include investors, credit agencies, government
agencies and other creditors who have no access to the internal records of the
company. These persons mainly depend upon the published financial statements.
Their analysis serves only a limited purpose. The position of, these analysts has
improved in recent times on account of increased governmental control over
companies and governmental regulations requiring more detailed disclosure of
information by the companies in their financial statements.
Internal Analysis. This analysis is done by persons who have access to the
books of account and other information related to the business. Such an analysis
can, therefore, be done by executives and employees of the organization or by
officers appointed for this purpose by the Government or the Court under
powers vested in them. The analysis is done depending upon the objective to be
achieved through this analysis.
(i) Horizontal Analysis. In case of this type of analysis, financial statements for
a number of years are reviewed and analyzed. The current year's figures are
compared with the standard or base year. The analysis statement usually
contains figures for two or more years and the changes are shown regarding each
item from the base year usually in the fom1 of percentage. Such an analysis
gives the management considerable insight into levels and areas of strength and
weakness. Since this type of analysis is based on the data from year to year
rather than on one date, it is also tern as 'Dynamic Analysis'.
(iii) Vertical Analysis. In case of this type of analysis a study is made of the
quantitative relationship of the various items in the financial Statements on a
particular date. For example, the ratios of different items of costs for a particular
period may be calculated with the sales for that period. Such an analysis is
useful in comparing the performance of several companies in the same group', or
divisions or department in the same company. Since this analysis depends on the
data for one period, this is not very conducive to a proper analysis of the
company's 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.
Each of the above steps has been explained in the following pages.
Methodical Classification
Both the Income Statement and Balance Sheet can be prepared in the form of
Comparative Financial Statements.
Comparative Income Statement. The Income Statement discloses Net Profit or
Net Loss on account of operations. A Comparative Income Statement will show
the absolute figures for two or more periods, the absolute change from one
period to another and, if desired, the change in terms of percentages. Since the
figures for two or more periods are shown side by side, the reader can quickly
ascertain whether sales have increased or decreased, whether cost of sales has
increased or decreased, etc. Thus, only a reading of data included in
Comparative Income Statements will be helpful in deriving meaningful
conclusions.
Example (i): From the following Profit and Loss Account and the Balance Sheet
of Swadeshi Polytex Ltd. for the year ended 31st December, 1997 and 1998, you
are required to prepare a Comparative Income Statement and a Comparative
Balance Sheet.
Profit and Loss Account (In LAkhs of Rs.)
BALANCE SHEET
for the years ended 31st december 1997 and 1998 (In Lakhs of Rs.)
Absolute
Percentage
increase or increase or
Particulars decrease decrease
in in
1997 1998 1998 1998
Net Sales 800 1,000 +200 +25
Cost of Goods Sold .600 750 -150 +25
Gross Profit 200 250 +50 +25
Operating Expenses: - - -
Administration Expenses 20 20 - -
Selling Expenses 30 40 +10 +33.33
Total Operating Expenses 50 60 10 +20
Operating Profit 150 190 +40 +26.67
Swadeshi Polytex Limited
COMPARATIVE BALANCE SHEET
Absolute
Percentage
increase
increase(+)
or
Assets 1997 1998 or decrease
decrease
(-) during
during
1998
1998
Current Assets:
Cash 100 140 40 +40
Debtors 200 300 100 +50
Stock 200 300 100 +50
Total Current Assets 500 740 240 +50
Fixed Assets:
Land 100 100 - -
Building 300 270 -30 -10
Plant 300 270 -30 -10
Furniture 100 140 +40 +40
Total Fixed Assets 800 780 -20 -2.5
Total Assets 1,300 1,520 220 +17
Liabilities & Capital:
Current Liabilities
Bills Payable 50 75 +25 +50
Sundry Creditors 150 200 +50 +33.33
Tax Payable 100 150 +50 +50
Total Current Liabilities 300 425 +125 41.66
Long term Liabilities
6% Debentures 100 150 +50 +50
Total Liabilities 400 575 +175 +43.75
Capital & Reserves
6% Pref. Capital 300 300 - -
Equity Capital 400 400 - -
Reserves 200 245 45 22.5
Total Shareholders' Funds 900 945 45 5
Total Liabilities and Capital 1,300 1,520 220 17
Comparative Financial Statements can be prepared for more than two periods or
more than two dates. However, it becomes very cumbersome to study the trend
with more than two period‟s data. Trend percentages are more useful in such
cases.
The American Institute of Certified Public Accountants has explained the utility
of repairing the Comparative Financial Statements as follows:
The utility of preparing the Comparative Financial Statements has also been
realized in our country. The Companies Act, 1956, provides that companies
should give figures for different items for the previous period, together with
current period figures in their Profit and loss Account and Balance Sheet.
Example (ii): On the basis of data given in example (i), prepare a Common-size
Income statement and Common Size Balance Sheet of Swadeshi Polytex Ltd.,
st
for the years ended 31 March, 1997 and 1998.
Gross Profit 25 25
Opening Expenses:
Trend Percentages
The base year should be carefully selected. It should be a normal year and be
representative of the items shown in the statement.
Trend percentages should be studied after considering the absolute figures on which
they are based; otherwise, they may give misleading results. For example, one
expense .may increase from Rs. 100 to Rs. 200 while the other expense may
increase from Rs. 10,000 to Rs. 15,000. In the first case trend percentage will
show 100% increase while in the second case it will show 50% increase. This is
misleading because in the first case the change though 100% is not at all
significant in real terms as compared to the other. Similarly, unnecessary doubts
may be created when the trend percentages show 100% increase in debt while
only 50% increase in equity. This doubt can be removed if absolute figures are
seen, e.g., the amount of debt may increase from Rs. 20,000 to Rs. 40,000 while
that of equity from Rs. 1,00,000 to Rs. 1,50,000. .
The figures for the current year should also be adjusted in the light of price level
changes as compared to the base year, before calculating the trend percentages.
In case this is not done, the trend percentages may make the whole comparison
meaningless. For example, if prices in the year 1998 have increased by 100% as
compared to 1997, the increase in sales in 1998 by 60% as compared to 1997
will give misleading results. Figures of 1998 must be adjusted on account of rise
in prices before calculating the trend percentages.
Example (iii): From the following data relating to the assets side of the Balance
Sheet of Kamdhenu Ltd., for the period 31st Dec., 1995 to 31st December, 1998,
you are required to calculate the trend percentage taking 1995 as the base year.
(Rupees in thousands)
Fixed Assets
Land 400 500 500 500 100 125 125 125
Building 800 1,000 1,200 1,500 100 125 150 175
Plant 1,000 1,000 1,200 1,500 100 100 120 150
Total Fixed 2,200 2,500 2,900 3,500 100 114 132 159
Assets
4. Funds Flow Analysis
Funds flow analysis has become an important tool in the analytical kit of
financial analysts, credit granting institutions and financial managers. 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. For example, if a loan of Rs.2,
00,000 was raised and pail during the accounting year, the balance sheet will not
depict this transaction However, a financial analyst must know the purpose for
which the loan was utilized and the source from which it was obtained. This will
help him in making a better estimate about the company's financial position and
policies.
Funds flow analysis reveals the changes in working capital position. It tells
about the sources from which the working capital was obtained and the purposes
for which is used. It brings out in open the changes which have taken place
behind the Ice Sheet. Working capital being the life-blood of the business, such
an analysis is extremely useful. The technique and the procedure involved in
funds flow analysis has been discussed in detail later in the book.
Cost-Volume-Profit Analysis
Ratio Analysis
This is the most important tool available to financial analysts for their work. An
accounting ratio shows the relationship in mathematical terms between two
interrelated accounting figures. The figures have to be interrelated (e.g., Gross
Profit and Sales, Current Assets and Current Liabilities), because no useful
purpose will be served if ratios are calculated between two figures which are not
at all related to each other, e.g., sales and discount on issue of debentures.
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 view the overall picture and the prevailing economic and
political situation.
The profit shown by Profit and Loss Account and the financial position as
depicted by the Balance Sheet is not exact. The exact position can be known
only when the business is closed down. Again, the existence of contingent
liabilities and deferred revenue expenditure make them more imprecise.
Financial statements are prepared on the basis of certain accounting concept and
conventions. On account of this reason the financial position as disclosed by
statements may not be realistic. For' example, fixed assets in the balance sheet,
shown on the basis of going concern concept. This means that value placed on&
assets may not be the same which may be realized on their sale. On account
convention of conservatism the income statement may not disclose true income
of the business since probable losses are considered while probable incomes are
ignored.
Many items are left to the personal judgment of the accountant. For example, the
method of depreciation, mode of amortization of fixed assets, treatment of
deferred revenue expenditure - all depend on the personal judgment of the
accountant. The soundness of such judgment will necessarily depend upon his
competence and integrity. However convention of consistency acts as a
controlling factor on making indiscreet personal judgments.
RATIO ANALYSIS
Meaning of Ratio
Since, we are using the term 'ratio' in relation to financial statement analysis; it
may properly mean 'An Accounting Ratio' or 'Financial Ratio'. It may be defined
as the mathematical expression of the relationship between two accounting
figures. But these figures must be related to each other (i.e., these figures must
have a mutual cause and effect relationship) to produce a meaningful and useful
ratio. For example, the figure of turnover cannot be said to be significantly
related to the figure of share premium. It indicates a quantitative relationship
which the analyst may use to make a qualitative judgment about the various
aspects of the financial position and performance of a concern. It may be
expressed as a percentage or as a rate (i.e., in 'x' number of times) or as a pure
ratio, e.g., if gross profit on sales of Rs. 1,00,000 is Rs. 20,000, the ratio of gross
Rs.20,000
profit to sales is 20%. ie. 100
Rs.1,00,000
Liquidity Ratios
These ratios measure the concern's ability to meet short-term obligations as and
when they become due. These ratios show the short-term financial solvency of
the concern. Usually the following two ratios are calculated for this purpose:
Objective: The objective of computing this ratio is to measure the ability of the
firm to meet its short-term obligations and to reflect the short-term financial
strength / solvency of a firm. In other words, the objective is to measure the
safety margin available for short-term creditors.
Components: There are two components of this ratio which are a under:
Current Assets which mean the assets which are held for their conversion into
cash within a year and include the following:
. Current Assets
Current Ratio =
Current Liabilities
(e) Interpretation: It indicates rupees of current assets available for each rupee
of current liability, Higher the ratio, greater the margin of safety for short-term
creditors and vice-versa. However, too high / too low ratio calls for further
investigation since the too high ratio may indicate the presence of idle funds
with the firm or the absence of investment opportunities with the firm and too
low ratio may indicate the over trading/under capitalization if the capital
turnover ratio is high.
However, the traditional standard of 2: I should not be used blindly since there may be
firms having current ratio of less than 2, which are working efficiently and meeting
their short-term obligations as and when they become due while the other firms having
current ratio of more than 2, may not be able to meet their current obligations in time.
This is so because the current ratio measures the quantity of current assets and not their
quality. Current assets may consist of doubtful and slow paying debtors and slow
moving and obsolete stock of goods. That is why, it can be said that current ratio is no
doubt a quick measurement of a firm's liquidity but it is crude as well.
(f) Precaution: While computing and using the current ratio, it must be ensured
(a) that the quality of both receivables (debtors and bills receivable) and
inventory has been carefully assessed and (b) that all current assets and current
liabilities have been properly valued.
= Rs. 95,000 + Rs. 3,40,000 - Rs. 30,000 + Rs. 10,000 + Rs. 10,000 + Rs.
10,000 + Rs. 5,000 = Rs. 4,40,000
Current Liabilities= Trade Creditors + B/P + O/s Exp + Bank O/D + Provision
for Tax = Rs. 40,000 + Rs. 30,000 + Rs. 20,000 + Rs. 10,000 + Rs. 2,40,000
= Rs. 3,40,000
2. Quick Ratio
Meaning: This ratio establishes a: relationship between quick assets and current
liabilities.
Objective: The objective of computing this ratio is to measure the ability of the
firm to meet its short-term obligations as and when due without relying upon the
realization of stock.
Components There are two components of this ratio which are as under:
Quick assets: which mean those current assets which can be converted into
cash immediately or at a short notice without a loss of value and include
the following:
Quick Assts
Quick Ratio =
Current Liabilities
Interpretation: It indicates rupees of quick assets available for each rupee of
current liability. Traditionally, a quick ratio of 1:1 is considered to be a
satisfactory ratio. However, this traditional rule should not be used blindly since
a firm having a quick ratio of more than 1, may not be meeting its short-term
obligations in time if its current assets consist of doubtful and slow paying
debtors while a firm having a quick ratio of less than 1, may be meeting its
short-term obligations in time because of its very efficient inventory
management.
Precaution: While computing and using the quick ratio, it must be ensured,
that the quality of the receivables (debtors and bills receivable) has been
carefully assessed and (b) that all quick assets and current liabilities have been
properly valued.
These ratios show the long-term financial solvency and measure the enterprise's
ability to pay the interest regularly and to repay the principal (i.e. capital
amount) on maturity or in pre-determined installments at due dates. Usually, the
following ratios are calculated to judge the long-term financial solvency of the
concern.
Debt-Equity Ratio
Components: There are two components of this ratio, which are as under:
Debt-Equity Ratio =
Shareholders 'Funds
Example (vi): Capital Employed Rs. 24,00,000, Long-term Debt Rs. 16,00,000
Calculate the Debt-Equity Ratio.
Debt-Equity Ratio = = = 2 :1
This ratio is a variation of the debt-equity ratio and gives the similar indications
as the debt-equity ratio. In this ratio, the outside long-term liabilities are related
to the total capitalization of the firm and not merely to the shareholders' funds.
This ratio is computed by dividing the long-term debt by the capital employed.
In the form of a formula, this ratio may be expressed as under:
Long-term Debt
Capital Employed
Where, the Capital Employed comprises the long-term debt and the
shareholders' funds.
Components: There are two components of this ratio which are as under:
Computation: This ratio is computed by dividing the net profits before interest
and taxes by interest on long-term debt. This ratio is usually expressed as 'x'
number of times. In the form of a formula, this ratio may be expressed as under:
(e) Interpretation: Interest coverage ratio shows the number of times the
interest charges are covered by the profits out of which they will be paid. It
indicates the limit beyond which the ability of the firm to service its debt would
be adversely affected. For instance, an interest coverage of five times would
imply that even if the firm's net profits before interest and tax were to decline to
20% of the present level, the firm will still be able to pay interest out of profits.
Higher the ratio, greater the firm's ability to pay interest but very high ratio may
imply lesser use of debt and/or very efficient operations.
Example (viii): Net Profit before Interest and Tax Rs. 3,20,000, Interest on long
term debt Rs. 40,000. Calculate Interest Coverage Ratio.
Solution:
Rs.3,20,000
= = 8 Times
Rs.40,000 8 Times
ACTIVITY RATIOS
These ratios measure the effectiveness with which a firm uses its available
resources. These ratios are also called 'Turnover Ratios' since they indicate the
speed with which the resources are being turned (or converted) into sales.
Usually the following turnover ratios are calculated:
III. Net Working Capital Turnover Ratio IV. Stock Turnover Ratio
Meaning: This ratio establishes a relationship between net sales and capital
employed.
Components: There are two components of this ratio which are as under:
0 Net Sales which mean gross sales minus sales returns; and
Computation: This ratio is computed by dividing the net sales by the capital
employed. This ratio is usually expressed as 'x' number of times. In the form of a
formula this ratio may be expressed as under:
Net Sales
Capital Employed
(e) Interpretation: It indicates the firm's ability to generate sales per rupee of
capital employed. In general, the higher the ratio the more efficient the
management and utilization of capital employed. A too high ratio may indicate
the situation of an over-trading (or under. capitalization) if current ratio is lower
than that required reasonably and vice versa.
Meaning: This ratio establishes a relationship between net sales and fixed
assets.
Components: There are two components of this ratio which are as under:
ĀĀĀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀЀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ0 Net
Sales which means gross sales minus sales returns;
ĀĀĀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀЀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ1 Net
Fixed (operating) Assets which mean gross fixed assets minus
depreciation thereon.
1 Computation This ratio is computed by dividing the net sales by the net
fixed assets. This ratio is usually expressed as 'x' number of times. In the form of
a formula, this ratio may be expressed as under:
Net Sales
(e) Interpretation: It indicates the firm's ability to generate sales per rupee of
investment in fixed assets. In general, higher the ratio, the more efficient the
management and utilization of fixed assets, and vice versa. It may be noted that
there is no direct relationship between sales and fixed assets since the sales are
influenced by other factors as well (e.g., quality of product, delivery terms,
credit terms, after sales service, advertisement and publicities.)
Example (ix): Fixed Assets (at cost) Rs. 7,00,000, Accumulated Depreciation
till date Rs. 1,00,000, Credit Sales Rs. 17,00,000, Cash Sales Rs., 1,50,000,
Sales Returns Rs. 50,000. Calculate Fixed Assets Turnover Ratio.
Example (x): Capital Employed Rs. 2,00,000, Working Capital Rs. 40,000,
Cost of goods sold Rs. 6,40,000, Gross Profit Rs. 1,60,000. Calculate Fixed
Assets Turnover Ratio.
Meaning: This ratio establishes a relationship between net sales and working
capital.
Components: There are two components of this ratio which are as under:
0 Net Sales which mean gross sales minus sales returns; and
Net Sales
Working Capital
(e) Interpretation: It indicates the firm's ability to generate sales per rupee of
working capital. In general, higher the ratio, the more efficient the management
and utilization of, working capital and vice versa.
Example (xi): Current Assets Rs. 6,00,000, Current Liabilities Rs. 1,20,000,
Credit Sales Rs. 12,00,000, Cash Sales Rs. 2,60,000, Sales Returns Rs. 20,000.
Calculate Working Capital Turnover Ratio.
Solution:
(a) Meaning: This ratio establishes a relationship between costs of goods sold
and aver age inventory.
Objective: The objective of computing this ratio is to determine the efficiency
with which the inventory is utilized.
Components: There are two components of this ratio which are as under:
(d) Computation: This ratio is computed by dividing the cost of goods sold by
the average inventory. This ratio is usually expressed as 'x' number of times. In
the form of a formula, this ratio may be expressed as under: -
Average Inventory
(e) Interpretation: It indicates the speed with which the inventory is converted
into sales. In general, a high ratio indicates efficient performance since an
improvement in the ratio shows that either the same volume of sales has been
maintained with a lower investment in stocks, or the volume of sales has
increased without any increase in the amount of stocks. However, too high ratio
and too low ratio calls for further investigation. A too high ratio may be the
result of a very low inventory levels which may result in frequent stock-outs and
thus the firm may incur high stock-out costs. On the other hand, a too low ratio
may be the result of excessive inventory levels, slow-moving or obsolete
inventory and thus, the firm may incur high carrying costs. Thus, a firm should
have neither a very high nor a very low stock turnover ratio, it should have a
satisfactory level. To judge whether the ratio is satisfactory or not, it should be
compared with its own past ratios or with the ratio of similar firms in the same
industry or with industry average.
(f) Stock Velocity- This velocity indicates the period for which sales can be
generated with the help of an average stock maintained and is usually expressed
in days. This velocity may be calculated as follows:
Average stock
Or __________________________________
The term "Cash" here stands for cash and bank balances. In a narrower sense,
funds are also used to denote cash. In such a case, the term "Funds" will exclude
from its purview all other current assets and current liabilities and the terms
"Funds Flow Statement" and "Cash Flow Statement" will have synonymous
meanings. However, for the purpose of this study we are calling this part of
study Cash Flow Analysis and not Funds Flow analysis.
Cash Flow Statement can be prepared on the same pattern on which a Funds
Flow Statement is prepared. The change in the cash position from one period to
another is computed by taking into account "Sources" and" Applications" of
cash.
Sources of Cash
Internal Sources- Cash from operations is the main internal source. The Net
Profit shown by the Profit and Loss Account will have to be adjusted for non-
cash items for finding out cash from operations. Some of these items are as
follows:
iii) Loss on Sale of Fixed Assets. It does not result in outflow of cash and,
therefore, should be added back to profits.
Gains from Sale of Fixed Assets. Since sale of fixed assets is taken as a separate
source of cash, it should be deducted from net profits.
Creation of Reserves. If profit for the year has been arrived at after charging
transfers to reserves, such transfers should be added back to profits. In case
operations show a net loss, such net loss after making adjustments for non-cash
items will be shown as an application of cash.
For the sake of convenience computation of cash from operations can be studied
by taking two different situations:
The computation of cash from operations will be very simple in this case. The
net profit as shown by the Profit and Loss Account will be taken as the amount
of cash from operations as shown in the following example:
Example (xii):
PROFIT AND LOSS ACCOUNT (for the year ended 31st Dec.1998)
Dr. Cr.
Rs. Rs.
To Purchases 15,000 50,000
To Wages 10,000 By Sales
To Rent 500
To Stationery 2,500
To Net Profit 22,000
50,000 50,000
In the example given above, if all transactions are cash transactions, i.e., all
purchases' and expenses have been paid for in cash and all sales have been
realized in cash, the cash from operations will be Rs. 22,000. i.e., the net profit
shown in the Profit and Loss Account. Thus, in case of all transactions being
cash transactions, the equation for computing cash from operations can be made
out as follows:
When all Transactions are not Cash Transactions:
In the example given above, we have computed cash from operations on the
basis that all transactions are cash transactions. It does not really happen in
actual practice. The business sells goods on credit. It purchases goods on credit.
Certain expenses are always outstanding and some of the incomes are not
immediately realized. Under such circumstances, the net profit made by a firm
cannot generate equivalent amount of cash. The computation of cash from
operations in such a situation can be done conveniently if it is done in two
stages:
Dr. Cr.
To Wages 5,000
30,000 30,000
10,000 10,000
Solution:
Rs. Rs.
Depreciation 1,000
In the illustration given above, the cash from operations has been computed on
the same pattern on which funds from operations are computed. As a matter of
fact, the fund from operations is equivalent to cash from operations in. this case.
This is because of the presumption that all are cash transactions and all goods
have been sold. However, there may be credit purchases, credit sales,
outstanding and prepaid expenses, etc. In such a case, adjustments will have to
be made for each of these items in order to find out cash from operations. This
has been explained in the following pages:
Effect of Credit Sales. In business, there are both cash sales and credit sales.
In case, the total sales are Rs. 30,000 out of which the credit sales are
Rs. 10,000, it means sales have contributed only to the extent of Rs.
20,000 in providing cash from operations. Thus, while computing
cash from operations, it will be necessary that suitable adjustments
for outstanding debtors are also made.
Effect of Credit Purchases. Whatever has been stated regarding credit sales
is also applicable to credit purchases. The only difference will be that
decrease in creditors from one period to another will
result in decrease of cash from operations because it means more
cash payments have been made to the creditors which will result in
outflow of cash. On the other hand, increase in creditors from one
period to another will result in increase of cash from operations
because less payment has been made to the creditors for goods
supplied which will result in increase of cash balance at the disposal
of the business.
15,000
Example (xiv):
Rs.
Gross Profit 30,000
The expenses paid include Rs. 1,000 paid for the next year. While interest of Rs.
500 has become due during the year, but it has not been received so far. The net
profit for the year will be computed as follows:
PROFIT AND LOSS ACCOUNT
32,500 32,500
Rs.
External Sources
Issue of New Shares. In case shares have been issued for cash, the net cash
received (i.e., after deducting expenses on issue of shares or discount on
issue of shares) will be taken as a source of cash.
Decrease in various current assets and increase in various current liabilities may
be taken as external sources of cash, if they are not adjusted while computing
cash from operations.
Applications of Cash
Purchase of Fixed Assets. Cash may be utilized for additional fixed assets or
renewals or replacement of existing fixed assets.
Payment of Tax. Payment of tax will result in decrease of cash and hence it
is an application of cash.
Payment of Dividend. This decreases the cash available for business and
hence it is an application of cash.
Balance as on 1.1.19..
Balance …….....
Issue of Shares
Cash balance
Bank balance
* These totals should tally with the balance as shown by (1) - (2).
Following are the points of difference between a Cash Flow Analysis and a
Funds Flow Analysis:
(1) A Cash Flow Statement is concerned only with the change in cash
position while a Funds Flow Analysis is concerned with change in
working capital position between two balance sheet dates. Cash is only one
of the constituents of working capital besides several other constituents
such, as inventories, accounts receivable, prepaid expenses.
Another distinction between a cash flow analysis and a funds flow analysis can
be made on the basis of the techniques of their preparation. An increase
in a current liability or decrease in a current asset results in decrease in
working capital and vice versa. While an increase in a current liability or
decrease in current asset (other than cash) will result in increase in cash
and vice versa,
Some people, as stated earlier, use term 'Funds' in a very narrow sense of cash
only. In such an event the two terms 'Funds' and 'Cash' will have synonymous in
meanings.
Cash flow analysis helps in evaluating financial policies and cash position. Cash
is the basis for all operations and hence a projected cash flow statement will
enable ill management to plan and co-ordinate the financial operations properly.
The management can know how much cash is needed, from which source it will
be derived, how much can be generated internally and how much could be
obtained from outside.
Cash flow analysis provides information about funds which will be available
from operations. This will help the management in determining policies
regarding internal financial management, e.g., possibility of repayment of long-
term debt, dividend policies, planning replacement of plant and machinery, etc.
Cash flow statement discloses the complete story of cash movement. The
increase in or decrease of, cash and the reason therefore can be known. It
discloses the reasons for low cash balance in spite of heavy operating profits or
for heavy cash balance in spite of low profits. However, comparison of original
forecast with the actual results highlights the trends of movement of cash which
may otherwise go undetected.
The extent of success or failure of cash planning can be known by comparing the
projected cash flow statement with the actual cash flow statement and necessary
remedial measures can be taken.
LIMITATIONS OF CASH FLOW ANALYSIS
Cash flow analysis is a useful tool of financial analysis. However, it has its own
limitations. These limitations are as under:
1 The cash balance as disclosed by the cash flow statement may not
represent the real liquid position of the business since it can be easily
influenced by postponing purchases and other payments.
Cash flow statement cannot replace the Income Statement or the Funds Flow
Statement. Each of them has a separate function to perform.
In spite of these limitations, it can be said that cash flow statement is a useful
supplementary instrument. It discloses the volume as well as the speed at which
the cash flows in the different segments of the business. This helps the
management in knowing the amount of capital tied up in a particular segment of
the business. The technique of cash flow analysis, when used in conjunction
with ratio analysis, serves as a barometer in measuring the profitability and
financial position of the business.
The concept and technique of preparing a Cash Flow Statement will be clear
with the help of the following illustration.
From the following balances, you are required to calculate cash from operations:
December 31
1997 1998
Rs. Rs.
Solutions:
December 31st
1997 1998
Rs. Rs.
1,38,300
Less:
SECTION – B
In this section, we will introduce you to Value chain analysis; Activity based
costing; Quality costing; the concept, phases and benefits of Target costing;
Life-cycle costing (Production and Project). After you workout this section, you
should be able to:
Value chain is the linked set of value-creating activities from the basic raw
material sources for suppliers to the ultimate end-use product delivered into the
final customers' hands. No individual firm is likely to span the entire value
chain. Each firm must be understood in the context of the overall value chain of
value-creating activities. Note that the value chain requires an external focus,
unlike conventional management accounting in which the focus is internal to the
firm. According to Michael Porter, a business unit can develop a sustainable
competitive advantage based on cost or on differentiation or on both, as shown
in the following diagram.
Differentiation
Differentiation
with Cost
Advantage
Superior Advantage
Relative
Stuck-in-the Low Cost
Differentiation
Middle Advantage
Position
Inferior
Whether or not a firm can develop and sustain differentiation or cost advantage
or differentiation with cost advantage depends on how well the firm manages its
value chain relative to the value chain of its competitors. Value chain analysis is
essential to determine exactly where in the chain customer value can be
enhanced or costs lowered.
Note that no single firm spans the entire value chain in which it operates.
Typically, a firm is only apart of the larger set of activities in the value delivery
system. The value chain concept highlights four profit improvement areas:
The following five steps are used to apply costs to products under an ABC
system:
Each of these activities is composed 'of transactions that result in costs. More
than one cost pool can be established for each activity. A cost pool is an account
to record the costs of an activity with a specific cost driver.
Once the activities have been chosen, costs must be traced to the cost pools for
different activities. To facilitate this tracing, cost drivers are chosen to act as
vehicles for distributing costs. These cost drivers are often called resource
drivers. A pre-determined rate is estimated for each resource driver.
Consumption of the resource driver in combination with the pre-determined rate
determines the distribution of the resource costs to the activities.
Cost drivers for activities are sometimes called activity drivers. Activity drivers
represent the event that causes costs within an activity. For example, activity
drivers for the purchasing activity include negotiations with vendors, ordering
materials, scheduling' their arrival, and perhaps inspection. Each of these activity
drivers represents costly procedures that are performed in the purchasing
activity. An activity driver is chosen for each cost pool. If two cost pools use the
same cost driver, then the cost pools could be combined for product-costing
purposes.
Cooper has developed several criteria for choosing activity drivers. First, the
data on the cost driver must be easy to obtain. Second, the consumption of the
activity implied by the activity driver should be highly correlated with the actual
consumption of the activity. The third criterion to consider is the behavioral
effects induced by the choice of the activity driver. Activity drivers determine
the application of costs, which in turn can affect individual performance
measures.
The judicious use of more activity drivers increases the accuracy of product
costs. Ostrenga concludes that there is a preferred sequence for accurate product
costs. Direct costs are the most accurate in applying costs to products. The
application of overhead costs through cost drivers is the next most accurate
process. Any remaining overhead costs must be allocated in a somewhat
arbitrary manner, which is less accurate.
Modison Motors Inc. produces electric motors. The company makes a standard
electric-starter motor for a major auto manufacturer and also produces electric
motors that are specially ordered. The company has four essential activities:
design, ordering, machinery, and marketing. Modison Motors incurs the
following costs during the month of, January:
Overhead:
Utilities Rs.
10,00,000
Rs.
60,00,000
Traditional cost accounting would apply the overhead costs based on a single
measure of activity. If direct labor dollars were used, then the overhead rate
would be Rs.60, 00,000 / (Rs.10, 00,000 + Rs.2, 00,000), or Rs.5, per direct-
labor dollar. Hence: Overhead to standard motors
Rs. 50,00,000
Designin Orderin
Machining Marketing Totals
g g
10,00,00
Labor Dollars 20,000 1,00,000 1,30,000 3,50,000
0
Sq.ft of
50,000 30,000 1,00,000 20,000 2,00,000
building
The resource driver application rates are calculated by dividing overhead costs
by total resource driver usage:
Overhead Resource Cost of Total Driver Application
Account Driver Overhead Usage Rate
Depreciation 50.000
Machine time 10,00,000 Rs.20/hr.
of machinery hrs.
20,00,000
Utilities Amps used 10.00.000 0.50/amp
amps
By multiplying the application rate times the resource usage of each activity,
overhead costs can be allocated to the different activities. For example, the cost
of the indirect labor allocated to the designing activity is Rs. 10/labor dollar
times Rs. 10,000 in labor, or Rs. 100,000.
Depreciation
50,000 30,000 1,00.000 20,000 2,00,000
of building
Depreciation
10,00,000 10,00,000
of equipment
Once the overhead costs have been distributed to the activity cost pools, activity
drivers must be chosen to apply the costs to the .products. Suppose the following
activity drivers are chosen:
Modison Motors uses actual costs and activity levels to determine the
application rates shown below:
The application rates are then multiplied by the cost driver usage for each
product to determine the costs applied to each product.
The ABC method applied a much higher amount of the overhead cost to the
special-order electric motors than when all overhead was applied by direct-labor
dollar (Rs.330, 000 versus Rs.100, 000). The reason for the greater overhead
application to the special-order electric motors is the greater usage of the
activities that enhance the manufacturing of the electric motors during their
production. Use of direct-labor dollars to allocate overhead does not recognize
the extra overhead requirements of the special-order electric motors.
Misapplication of overhead could lead to inappropriate product line decisions.
First, ABC is based on historical costs. For planning decisions, future costs are
generally the relevant costs. Second, ABC does not partition variable and fixed
costs. For many short run decisions, it is important to identify variable costs.
Third, ABC is only as accurate as the quality of the cost drivers. The distribution
and application of costs becomes an arbitrary allocation process when the cost
drivers are not associated with the factors that are causing costs. And finally,
ABC tends to be more costly than the more traditional methods of applying costs
to products.
QUALITY COSTING
The benefits from increased product quality come in lower costs for reworking
discovered defective units and from more satisfied customers who find fewer
defective units. The cost of lowering the tolerance for defective units results
from the increased costs of using a better production technology. These costs
could be due to using more highly skilled and experienced workers, from using a
better grade of materials, or from acquiring updated production equipment.
The quality costs discussed here deal with costs associated with quality of
conformance as opposed to costs associated with quality of design. Quality of
design refers to variations in products that have the same functional use.
Quality of Conformance refers to the degree with which the final product meets
its specifications. In other words, quality of conformance refers to the product's
fitness for use. If products are sold and they do not meet the consumers'
expectations, the company will incur costs because the consumer is unhappy
with the product's performance. These costs are one kind of quality costs that
will be reduced if higher-quality products are produced. Thus higher quality may
mean lower total costs when quality of conformance is considered.
The costs associated with quality of conformance generally can be classified into
four types: prevention costs, appraisal costs, internal failure costs, and external
failure costs. The prevention and appraisal costs occur because a lack of quality
of conformance can exist. The internal and external failure costs occur because a
lack of quality of conformance does exist.
Prevention Costs are the costs incurred to reduce the number of defective units
produced or the incidence of poor-quality service. Prevention costs begin with
the designing and engineering of the product or service. Designers and engineers
should work together to develop a product that is easy to assemble with a
minimal number of mistakes.
Appraisal Costs are the costs incurred to ensure that materials, products, and
services meet quality standards. Appraisal costs begin with the inspection of raw
materials and part from vendors. Further inspection costs are incurred
throughout the production process. Quality audits and reliability tests are
performed on products and services to determine if they meet quality standards.
Appraisal costs also occur through field inspections at the customer site before
the final release of the product.
Internal Failure Costs are the costs associated with materials and products that
fail to meet quality standards and result in manufacturing losses. These defects
are identified before they are shipped to customers. Scrap and the costs of
spoiled units that cannot be salvaged are internal failure costs. The cost of
analyzing, investigating and reworking defects is also internal failure costs.
Defects create additional costs because they lead to down time in the production
process.
External Failure Costs are the costs incurred when inferior-quality products or
services are sold to customers. These costs begin with customer complaints and
usually lead to warranty repairs, replacement, or product recall.
The problem management faces is choosing the desired level of product quality.
If all the costs can be measured accurately, then the desired level of product
quality occurs when the sum of prevention, appraisal, and failure costs is
minimized. Quality costs are minimized at a specific percentage of planned
defects.
The magnitude of quality costs has prompted many companies to install quality-
costing systems to monitor and help reduce the costs of achieving high-quality
production. Several examples follow.
Although the concepts of quality costing are easy to understand, the cost
measurement of many quality efforts is difficult. Many of the costs are not
isolated in a traditional cost accounting system, and some costs are opportunity
costs that are not part of a historical cost accounting system.
Quality cost reports provide management with only a partial picture of the costs
of quality. Management would also like to know the potential trade-off among
the different types of quality costs relating to new technologies. Cost trade-offs
are not part of a historical cost accounting system, and estimates of these cost
trade-offs must be made.
Prevention costs:
Appraisal costs:
Out-of-warranty repairs
6.000 3.9
and replacement
Total quality control (TQC) is a management process based on the belief that
quality costs are minimized with zero defects. The phrase quality is free is
commonly advocated by proponents of TQC, who argue that the reduction of
failure costs due to improved quality outweigh additional prevention and
appraisal costs.
It is not surprising, then, that U.S. Auto Manufacturers have recently become
leaders in advocating TQC.
TQC begins with the design and engineering of the product. Designing a product
to be resistant to workmanship defects may not be incrementally more costly
than the present design process, but the reduction in other quality costs can be
substantial.
TQC is often associated with just-in-time (JIT) manufacturing. Under JIT each
worker is trained to be a quality inspector. Therefore teams specializing in
quality inspection become unnecessary. With suppliers delivering high-quality
parts and materials, a company can substantially reduce if not eliminate
appraisal costs.
TARGET COSTING
Introduction
Target cost = Sales price (for the target market share) - Desired profit
Sony's Walkman was a classic example of how a company uses the "PROFITS
= SALES - COSTS" equation to full advantage: First set the price at which the
customer will buy, then bring down your costs so you can make profits. "I
dictated the selling price (of the Walkman) to suit a young person's pocketbook,
even before we made the first machine," wrote Sony Corp. Chairman Akio
Morita in his book Made In Japan. "I said I wanted the first models ... to retail
for no more than Yen 30,000. The accountants protested but I persisted. I told
them I was confident we would be making our new product in very large
numbers and our cost would come down as volume climbed."
It is a cost management tool which reduces a product's costs over its entire life
cycle. Target costing includes actions management must take to: establish
reasonable target costs, develop methods for achieving those targets, and
develop means by which to test the cost effectiveness of different cost-cutting
scenarios.
Based upon its strategic business plans, a company must first establish what type
of product it wishes to manufacture.
Traditionally (before target costing), once the type of product was determined,
its development was assigned to the product design department. Then the
produced product was sent to the costing department, which assessed the cost of
the design and frequently found it more expensive to produce than the market
would tolerate.
The design was then returned to the design department with instructions to
reduce its costs, usually by promising its quality. The product design was sent
back and forth between the two departments until consensus was reached. The
product was then sent to the manufacturing department, which often concluded
that it was impossible to manufacture it in its proposed e. It was then sent back
to the design department, so on. Much time, money and effort were spent [ore
the product reached the production stage. As a result, profit suffered.
Under target costing, a product's design begins at the opposite end. It first
establishes a price at which the product can be competitive and then assigns a
team to develop cost scenarios and search for ways to design d manufacture the
product to meet those cost constraints. Several steps must be taken in order to
establish a reasonable target cost.
Development Phase
The company must find ways to attain the target cost. is involves a number of
steps.
First, an in-depth study of the most competitive product on the market must be
conducted. This study will show what materials were used and what
features are provided, and it will give an indication of the manufacturing
process needed to complete the product.
After trying to identify the cost structure of the competitor, the company should
develop estimates for the internal cost structure of its own products. This
is most effectively done by analyzing internal costs' of similar products
already being produced by the company and should take into account the
different needs of the new product in assessing these costs.
After preliminary analysis of the cost structures of both the competition and
itself, the company should further define these cost structures in terms of
cost drivers. Focusing on cost drivers can help reduce waste, improve
quality, minimize non-value-added activities, and identify ineffective
product design. The use of multiple drivers‟ leads both to a better
understanding of the inputs and resources required to produce products,
and a better cost analysis through more detailed cost information.
When enough cost information is available, the product development team is
able to generate cost estimates under different scenarios. After this, the
designers, manufacturers, marketers, and engineers on the team should conduct a
session of brainstorming to generate ideas on how to substantially reduce costs
(by smoothing the process, using different materials, and so on) or add a number
of different features to the product without increasing target costs. In these
brainstorming sessions, no idea is rejected, and the best ideas are integrated into
the development of the product.
Production Phase
In these stages, target costing becomes a tool for reducing costs of existing
products. It is highly unlikely that the design, manufacturing, and engineering
groups will develop the optimal, cost-efficient process at the beginning of
production. The search for better, less expensive products should continue in the
framework of continuous improvement.
The ABC technique can be useful as a tool for target costing of existing
products. ABC assists in identifying non value-added activities and can
be used to develop scenarios on how to minimize them. Target costing at
the activity level makes opportunities for cost reduction highly visible.
Target costing also provides incentives to move toward less expensive means of
production, as well as production techniques that provide a more even
flow of goods. JIT provides an environment where there is
better monitoring of costs and product quality as well as access to ideas
for continues improvement and better production strategies.
The process of target costing provides detailed information on the costs involved
in producing a new product, as well as a better way of testing different
cost scenarios through the use of ABC.
Target costing reduces the development cycle of a product. Costs can be targeted
at the same time the product is being designed, bringing in the resources
of the manufacturing and finance departments to ensure that all avenues
of cost reduction are being explored and that the product is designed for
manufacturability at an early stage of development.
The internal costing model, using ABC, can provide an excellent understanding
of the dynamics of production costs and can detail ways to eliminate
waste, reduce non-value-added activities, improve quality, simplify the
process, and attack the root causes of costs (cost drivers). It can also be
used for measuring different cost scenarios to ensure that the best ideas
available are incorporated from the outset into the production design.
Target costing is also used to forecast future costs and to provide motivation to
meet future cost goals.
There is one major drawback to target costing. It is difficult to use with complex
products that require many subassemblies, such as automobiles. This is
because tracking costs becomes too complicated and tedious, and cost
analysis must be performed at so many levels.
CAM-l defines life-cycle costing as "the accumulation of costs for activities that
occur over the entire life cycle of a product, from inception to abandonment by
the manufacturer and the customer," Life-cycle analysis provides a framework
for managing the cost and performance of a product over the duration of its life.
The life-cycle commences with the initial identification of a consumer need and
extends through planning, research, design, development, production, and
evaluation, and use, logistics support in operation, retirement, and disposal. Life-
cycle is important to cost control because of the interdependencies of activities
in different time periods. For example, the output of the design activity has a
significant impact on the cost and performance of subsequent activities.
Cost systems have focused primarily on the cost of physical production, without
accumulating costs over the entire design, manufacture, market, and support
cycle of a product. Resources committed to the development of products and the
manufacturing process represents a sizeable investment of capital. The benefits
accrue over many years, and under conventional accounting, are not directly
identified with the product being developed. They are treated instead as a period
expense and allocated to all products. Even companies which use life-cycle
models for planning and budgeting new products do not integrate these models
into cost systems. It is important to provide feedback on planning effectiveness
and the impact of design decisions on operational and support costs. Period
reporting hinders management's understanding of product-line profitability and
the potential cost impact of long-term decisions such as engineering design
changes. Life-cycle costing and reporting provide management with a better
picture of product profitability and help managers to gauge their planning
activities.
The cycle begins with the identification of new consumer need and the invention
of a new product and is often followed by patent protection and further
development to make it saleable. This is usually followed by a rapid expansion
in its sales as the product gains market acceptance. Then competitors enter the
field with imitation and rival products and the distinctiveness of the new product
starts diminishing. The speed of degeneration differs from product to product.
The innovation of a new product and its degeneration into a common product is
termed as the 'life cycle of a product'.
Characteristics
The products have finite lives and pass through the cycle of development,
introduction, growth, maturity, decline and deletion at varying speeds.
Product cost, revenue and profit patterns tend to follow predictable courses
through the product life cycle. Profits first appear during the growth
phase and after stabilizing during the maturity phase, decline thereafter
to the point of deletion.
Profit per unit varies as products move through their life cycles.
Typically the life cycle of a manufactured product will consist of the following
activities:
Decommissioning or Replacement.
There are five distinct phases in the life cycle of a product as shown.
Despite little competition profits are negative or low. This owns to high unit
costs resulting from low output rates, and heavy promotional investments
incurred to stimulate growth. The introductory stage may last from a few months
to a year for consumer goods and generally longer for industrial products.
Growth phase: In the growth phase product penetration into the market and
sales will increase because of the cumulative effects of introductory promotion,
distribution. Since costs will be lower than in the earlier phase, the product will
start to make a profit contribution. Following the consumer acceptance in the
launch phase it now becomes vital to secure wholesaler/retailer support. But to
sustain growth, consumer satisfaction must be ensured at this stage. If the
product is successful, growth usually accelerates at some point, often catching
the innovator by surprise.
Profit margins peak during this stage as 'experience curve' affects lower unit
costs and promotion costs are spread over a larger volume.
Maturity phase: This stage begins after sales cease to rise exponentially. The
causes of the declining percentage growth rate the market saturation eventually
most potential customers have tried the product and sales settle at a rate
governed by population growth and the replacement rate of satisfied buyers. In
addition there are no new distribution channels to fill. This is usually the longest
stage in the cycle, and most existing products are in this stage. The period over
which sales are maintained depends upon the firm's ability to stretch, the cycle
by means of market segmentation and finding new uses for it.
Decline phase: Eventually most products and brands enter a period of declining
sales. This may be caused by the following factors:
The average length of the product life cycle is tending to shorten as a result
of economic, technological and social change.
Market saturation
0 Is the growth rate of sales volume declining?
1 What is the current level of ownership compared to potential?
2 Are first time buyers a declining proportion of total sales?
Nature of competition
0 How many competitors have entered or plan to enter?
1 Is long-term over capacity emerging?
2 Are prices and profit margins being cut?
0 Are new products being created in this industry or others which may
meet consumer needs more effectively?
The term 'project life cycle cost' has been defined as follows: 'It includes the
costs associated with acquiring, using, caring for and disposing of physical
assets, including the feasibility studies, research, design, development,
production, maintenance, replacement and disposal, as well as support, training
an operating costs generated by the acquisition, use, maintenance and
replacement of permanent physical assets'.
Product life cycle costs are incurred for products and services from their design
stage through development to market launch, production and sales, and their
eventual withdrawal from the market. In contract project life cycle costs are
incurred for fixed assets, i.e. for capital equipment and so on. The component
elements of a project's cost over its life cycle could include the following:
Operations costs, i.e. the costs incurred in operations, such as energy costs,
and various facility and other utility costs.
Retirement and disposal costs at the end of life or the capital equipment life.
Project life-cycle costing is a new concept which places new demands upon the
Management Accountant. The development of realistic project life cycle costing
models will require the accountant to develop an effective working relationship
with the operational researcher and the systems analyst, as well as with those
involved in the terrotechnological system, particularly engineers. Engineers
require a greater contribution from accountants in terms of effort and interest
throughout the life of a physical asset. A key question for many accountants will
be whether the costs of developing realistic life cycle costs will outweigh the
benefits to be derived from their availability. Lifecycle costing in the
management of Physical Assets, much value can be obtained by thinking in life-
cycle costing concepts whenever a decision affecting the design and operation of
a physical asset is to be made.
The concept project life cycle costing has become more widely accepted in
recent years. The philosophy of it is quite simple. It involved accounting for all
costs over the life of the decision which is influenced directly by the decision.
Terrotechnology is concerned with pursuit of economic life cycle costs. This is
quite simply means trying to ensure that the assets produce the highest possible
benefit for least cost. To do this, it is necessary to record the cost of designing,
buying, installing, operating, and maintaining the asset, together with a record of
the benefits produced. Most organizations keep a record of the initial capital
costs, if only for asset accounting purposes.
What significant inferences are brought out by the statement of cash flow?
What are the limitations of cash flow statements?
What are the categories under which the various ratios are grouped?
Reference:
CA Study Material.
Unit V
Reporting to Management
Contents Design:
0Introduction.
ĀĀĀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀЀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ0
Objectives of Reporting.
ĀĀĀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀЀĀȀ⸀ĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀĀᜀ1
Principles of Reporting.
1Importance of Reporting.
Types of Reports.
Forms of Report.
Summary.
References.
0 INTRODUCTION
financed? What was achieved? What are the liabilities arising from their
Reports are an important instrument for planning and policy formulation. For
this purpose, they should provide information on ongoing programs and the
main objectives of government departments. Reports can also be used for public
relations and be a source of facts and figures. They give an organization the
opportunity to present a statement of its achievements, and to provide
information for a wide variety of purposes.
Reporting must take into account the needs of different groups of users
including:
(i) the Cabinet, core ministries, line ministries, agencies, and program managers;
According to surveys carried out in several developed countries,2 all users need
comprehensive and timely information on the budget. The executive branch of
government needs periodic information about the status of budgetary resources
to ensure efficient budget implementation and to assess the comparative the
costs of different programs. Citizens and the legislature need information on
costs and performance of programs that affect them or concern their
constituency. Financial markets need cash based information, etc.
Reports prepared by the government for internal and external use are governed
1. Completeness. The measures, in the aggregate, should cover all aspects of the
reporting entity's mission.
6. Consistency. Consistency is required not only internally, but also over time,
that is, once an accounting or reporting method is adopted, it should be used for
all similar transactions unless there is good cause to change it. If methods or the
coverage of reports have changed or if the financial reporting entity has
changed, the effect of the change should be shown in the reports.
Usefulness. Agency reports, to be useful both inside and outside the agency,
reports should contribute to an understanding of the current and future activities
of the agency, its sources and uses of funds, and the diligence shown in the use
of funds.
5.4 IMPORTANCE
In cost accounting, there are three important divisions, viz., cost ascertainment,
cost presentation, and cost control. Cost presentation serves as a link between
cost ascertainment and cost control. The management of every organisation is
interested in maximisation of profit through minimisation of wastages, losses,
and ultimately cost. So management will have to be furnished with frequent
reports on all functional areas of business to achieve these objectives.
The draft of the report should be reviewed for an appropriate number of times so
that the errors are completely avoided. While reviewing the draft, certain
guidelines are to be followed, as indicated below:
Because the readers are with different profiles, the style and presentation of the
text of the report should suit the profile of the targeted group of readers;
otherwise, the purpose of the report will be lost.
The content of the report should fully reveal the scope of the research in logical
sequence without omitting any item and at the same time it should be
crisp and clear.
There should be continuity between chapters and also between sections as well
subsections.
The abstract at the beginning should reveal the essence of the entire report
which gives the overview of the report.
A reading of abstract and conclusion of a report should give the clear picture
of the report content to the readers.
The presentation of the text should be lucid so that every reader is able to
understand and comprehend the report content without any difficulty.
The report should have appropriate length. The research report can be from
300 to 400 pages, but the technical reports should be restricted to 50 to
75 pages.
A good report should satisfy the following requisites in order to enable the
receiver of report to understand and get interested in the report.
(a) Title: This contains the subject-matter of the report. It should be brief but
not vague. Where a lengthy report is to be prepared the subject-matter is to be
presented in various ,
Date: The date on which the report is presented is to be mentioned. This helps
receiver of the report to know what changes must have occurred during the time lag
of period covered under the report and date of presentation of report.
Name: The report must contain the name of the person by whom a report is
prepared, the name of person to whom it is meant and the names of those for
whom copies are sent.
Standard: The reports prepared must meet the standard expected by its
receiver. Use of highly technical words may not be readily understood by lower
level management.
(m) Simplicity: The report should be brief, clear and simple to understand.
The form of report should be designed to suit different levels of management.
Where it is inevitable to prepare a lengthy report, a brief synopsis should
precede the report.
(n) Controllability: Where variances are incorporated it is essential to stress
on controllable aspects and to drop out uncontrollable element. But this depends
upon the circumstance under which the report is prepared.
5.6.TYPES OF REPORTS
Reports are classified into different types according to different bases. This is
shown in the following chart:
TYPES OF REPORT
On the basis of purpose, reports can be classified into two types, viz., (a)
External report, and (b) Internal report.
External report: External report is prepared for meeting the requirements of
persons outside the business, such as shareholders, creditors, bankers,
government, stock exchange and so on. An example of external report is the
published accounts, viz., profit and loss account and balance sheet. External
report is brief in size as compared to internal report and they are prepared as per
the statutory requirements.
Internal report: Internal report is meant for different levels of management. This
can again be classified into three types: (a) Report meant for top level
management, (b) Report meant for middle level management, and (c) Report
meant for lower level management. Report to top level management should be in
summary form giving an overall view of the performance of the business.
Whereas external reports are prepared annually, internal reports are prepared
frequently to serve the needs of management. Internal report need not conform
to any standard form as it is not statutorily required to be prepared.
According to this basis. reports can be classified into two types, viz., (I) Routine
reports, and (2) Special reports.
Special reports: Special reports are prepared to cover specific or special matters
concerning the business. Most of the special reports are prepared after
investigation or survey. There is no standard form used for submitting this
report. Some of the matters which are covered by special reports are: causes for
production delays, labour disputes, effects of machine breakdown, problems
involved in capital expenditure, make or buy problems, purchase or hire of fixed
assets, price fixation problems, closing down or continuation of certain
departments, cost reduction schemes, etc.
According to the purpose served by the reports, it can be classified into two
types, viz., -(a) operating report, and (b) financial report.
Operating report: These reports are prepared to reveal the various functional
results. These reports can again be classified into three types, viz., (a) Control
reports, which are prepared to exercise control over various operation of the
business, (b) Information report, which are prepared for facilitating planning and
policy formulation in a business, (c) Venture measurement report which is
prepared to show the result of a specific venture undertaken as for example a
new product line introduced.
Process reports explain how products are produced, tests are completed, or
devices operate by describing the details of procedures used to perform a series
of operations. Process reports may be general or detailed. General process
reports are addressed to persons not directly involved in performing the process.
Detailed process reports are designed to give the readers all the necessary
information needed to complete the process.
3.Analytical Report
4.Examination Report
5.Laboratory Report
7. Design Portfolio
8. Detail Report
Detail Report: Prints a text report outlining each audit question as well as the
scoring criteria and responses entered for each question. Compliance level is
calculated as a percentage at the end of the report.
Summary Report
A report allowing users to summarize responses based on the selection from four
fields.
Management Reporting
Establishment objectives
The main body of the report for the survey-based research contains the
following:
i. Problem definition
Data analysis
Conclusions.
There are problems, viz., production scheduling, JIT, supply chain management,
line balancing, layout design, portfolio management, etc., exist in reality. The
solution for each of the above problems can be obtained through algorithms. So,
the researchers should come out with newer algorithms or improved algorithms
for such problems. For a combinatorial problem, the researcher should attempt
to develop an efficient heuristic. The algorithmic research report can be
classified into the following categories:
The main body of this type of research report will contain the following:
Problem identification
Literature review
Objectives of the research
Case study
Conclusions.
In this type of research, the results of the algorithm will be compared with the
optimal results of the mathematical model as well as with the results of the best
existing algorithm to check its solution accuracy through a carefully designed
experiment
The main body of this type of research report will contain the following:
Problem identification
Literature review
Experimentation arid comparison of the exact algorithm with the best existing
exact algorithm in terms of computational time
Case study
Conclusions.
1. Oral Report
An oral report is not very popular as it does not serve any evidence and cannot
be referred to in future. Oral report may take the form of a meeting with
individuals or a conference.
2. Descriptive Reports
These are written in narrative style. They are frequently supported by tables and
charts to illustrate certain points covered in the report. One important point that
must be considered in drafting this form of report is the language. The language
used must be simple, easy to understand and lucid. Where the report is very
long, it must be suitably divided into paragraphs with headings. They must cover
all the principles of .good report discussed earlier.
3. Comparative Statement
This form of report is used for preparing the routine report. Under this method
the particulars of information are shown in a comparative form, i.e., the actual
results an compared with planned results and the deviations between the two arc
indicated. The various tools used to prepare this form of report arc comparative
financial statements, ratio analysis, fund flow analysis and so on.
This is more popular form of preparing reports. They occupy lesser space and
gives at a glance the whole picture about a particular aspect of study. They also
facilitate in comparative study and shows the trend over a period of time. This
form of report can b used where a report contains presentation of statistical
numbers and other facts and figures It overcomes the language barrier and is
very easily understood by everyone. Of course when large numbers are
involved, it is to be reduced by selecting a convenient scale Diagrammatic
representation involves the following forms:
(a) Bar diagram: They make use of horizontal and vertical axes to show the
magnitude of values, quantity and period. Bar diagrams are of the following
types.
Simple bar diagram: These are most popularly used in preparing reports. The
consider only length but not the width to indicate the change. In formation
relating to volume of production, cost of production sales, etc. for different years
can be shown under this form.
Multiple bar diagram: This type of diagram is used to report related matters
such as production and sales, sales and profit, advertisement and sales and so on.
Sub-divided bar diagram: This form of diagram is used to report matters
which involved different component parts as for example, the cmponents of total
cost of production such as prime cost, factory cost, office cost, cost ,of sales.
(b) Pre-diagram: They take the form of circles instead of bars. They facilitate
comparison besides depicting the actual information under review.
5. Break-even Chart
This type of chart is prepared to show the relationship between variable and
fixed cost and sales. It shows the point of no-profit and no-loss or where total
cost equals total revenue received.
6. Gantt Chart
This chart was first introduced by Heny L. Gantn. It is a special type of bar
diagram under which bars are drawn horizontally. This chart shows the bars of
planned schedule and attained performance. They are largely used to denote
utilisation of machine capacity.
Master budget which covers all functional budgets for taking remedial actions
where there are significant deviations from budgeted figures.
Capital expenditure budget and cash budget to know the extent of variances for
taking remedial measures.
Reports relating to production and sales, which shows the trend of the
performance of business.
Report covering important ratios such as stock turnover ratio, fixed assets
turnover ratio, liquidity ratio, solvency ratio, profitability ratios, etc. to know the
improvement in business.
Reports relating to actual sales and budgeted sales and actual selling and
distribution expenses and budgeted selling and distribution expenses.
The lower level management include supervisors, foremen and inspectors who
are concerned with the operations of the factory. They are interested in
increasing the efficiency of the production departments. The reports that are to
be sent to them are variances relating to planned and actual performance. The
report must also emphasise cost control aspects.
(a) General.
This report shows the planned rate of progress payment billings and billings for
accepted supplies under each major task for the remainder of the subcontract
performance period. For each task, the planned billings are to be projected in
monthly increments for each of the twelve months of the current or succeeding
fiscal year, and in fiscal year increments thereafter for the remainder of the
subcontract. (Projected billings should be directly related to the activities
scheduled to be performed during each billing period, as reflected on the
Milestone Schedule and Status Report.) or schedule. Each time it is necessary to
alter the plan, a new plan and narrative explanation for the change will be
provided to the Company.
(B) As a monthly report, this document provides a comparison of the planned
billings with the actual billings for work performed as of the cut-off period for
the report. Variances from the plan are computed, and explanations for variances
exceeding + 10% will be provided by the Seller in the Narrative Highlights
Report. In addition, upon the occurrence of a variance exceeding + 10%, the
Seller must reevaluate the estimated billings for the balance of the current fiscal
year and to the completion of the subcontract. Narrative explanations must be
provided for significant changes to these estimated billings.
As a status report, it measures status or progress against the baseline plan. It will
reflect planned and accomplished events, milestones, slippages, and changes in
schedule.
The mechanical format of a report consists of three parts: the preliminaries, the
text, and the reference materials. The length of any of these three parts is
conditional on the extent of the study.
The Preliminaries
0 Title page
2 Table of contents
3 List of tables
2. The Text
Main body of the report (usually divided into chapters! and sections)
Conclusion
3. The Reference Material
THE PRELIMINARIES
1. TITLE PAGE
Most universities and colleges prescribe their own form of title page for theses,
dissertations and research papers and these should be complied with in all
matters of content and spacing. Generally, the following information is required:
Written Report
PREFACE
The preface (often used synonymously with foreword) may included: the
writer's purpose in conducting the study, a brief resume of the background,
scope, purpose, general nature of the research upon which the report is being
based and acknowledgments.
3. TABLE OF CONTENTS
The table of contents includes the major divisions of the report: the introduction,
the chapters with their subsections, and the bibliography and appendix. Page
numbers for each of these. divisions are given. Care should be exercised that
titles of chapters and captions of subdivisions within chapters correspond exactly
with those included in the body of the report. In some cases, sub-headings within
chapters are not included in the table of contents. It is optional
whether the title page, acknowledgments, list of tables and list of Figures are
entered in the table of contents. The purpose of a table of contents is to provide
an analytical overview of the material included in the study or report together
with the sequence of presentation. To this end, the relationship between major
divisions and minor subdivisions needs to be shown by an appropriate use of
capitalisation and indentation or by the use of a numeric system.
A table of contents is necessary only in those papers where the text has been
divided into chapters or several subheadings. Most short written assignments do
not require a table of contents. The basic criterion for the inclusion of
subheadings under major chapter division is whether the procedure facilitates the
reading of a report and especially the location of specific sections within a
report.
4. LIST OF TABLES
After the table of contents, the writer needs to prepare a list of tables. The
heading LIST OF TABLES, should be centered on a separate page by itself.
The list of Figures appears in the same form as the list of tables. The page is
headed LIST OF FIGURES, without terminal punctuation, and the numbers of
the Figures are listed at the left of the page under the heading Figure.
6. INTRODUCTION
An introduction should be written with considerable care: with two major aims
in view: introducing the problem in a suitable context, and arousing and
stimulating the reader's interest. If introductions are dull, aimless, confused,
rambling, and lacking in precision, direction and specificity; there is little
incentive for the reader to continue reading. The reader begins to expect an
overall dullness and aimlessness in the whole paper. The length of an
introduction varies according to the nature of the research project.
Be accurate in documentation.
8.CONCLUSION
The conclusion serves 'the important function of tying together the whole thesis
or assignment. In summary form, the developments of the previous chapters
should be succinctly restated, important findings discussed and conclusions
drawn from the whole study. In addition, the writer may list unanswered
questions that have occurred in the course of the study and which require further
research beyond the limits of the project being reported. The conclusion should
leave the reader with the impression of completeness and of positive gain.
9. BIBLIOGRAPHY
The bibliography follows the main body of the text and is a separate but integral
part of a thesis, preceded by a division sheet or introduced by a centered
capitalized heading BIBLOGRAPHY. Pagination is continuous and follows the
page numbers in the text. In a written assignment, the word bibliography may be
a little pretentious and the heading REFERENCES may be an adequate
alternative.
10. APPENDIX
11. INDEX
The length of the abstract may be specified, for example, 200 words. Usually an
abstract is short.
From the outset, the aim is, at the production of a piece of work of high quality.
The text should be free of errors and untidy corrections. Paper of standard size
(usually quarto) and good quality should be used.
5.11.SELF ASSESMENT QUESTIONS
What are the items under the text of a research report? Explain them in brief.
research report.
Assume a research topic of your choice and give the complete format of its
research report.
0 Distinguish between routine and special reports. State the various matters
which are sent to management under routine and special reports.
Explain different types of reports submitted to the management of an
organisation.
0 REFERENCES: