SELF LEARNING MATERIAL

COMMERCE
COURSE : COM - 103

(1st Semester)

COST AND MANAGEMENT

ACCOUNTING

BLOCK : 1,2,3, 4 & 5

Directorate of Open & Distance Learning

DIBRUGARH UNIVERSITY
DIBRUGARH-786004
 COMMERCE
COURSE : COM - 103
COST AND MANAGEMENT
ACCOUNTING

Contributor :
Prof. ARM Rehman
Department of Commerce
Dibrugarh University

Editor :
Dr. Ajanta B. Rajkonwar
Department of Commerce
Dibrugarh University

© Copy right by Directorate of Open and Distance Learning, Dibrugarh

University. All rights reserved. No part of this publication may be reproduced, stored in
a retrieval system or transmitted, in any form of by any means, electronic, mechanical,
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Published on behalf of the Directorate of Open and Distance Learning, Dibrugarh

University by the Director, DODL, D.U. and printed at SUNPRINT, Dibrugarh University
Market Complex, Dibrugarh-786004.

Acknowledgement

The Directorate of Open and Distance Learning, Dibrugarh University duely

acknowledges the financial assistance from the Distance Education Council,
IGNOU, New Delhi for preparation of this Self Learning Material.
 COMMERCE
COURSE : COM - 103

COST AND MANAGEMENT

ACCOUNTING

CONTENTS

Pages
Block -1 : Cost Accountancy, Activity Based
Costing and Cost Reduction 1-38
Unit -1 : Cost Accountancy 1 - 15

Unit -2 : Activity Based Costing 16 - 26

Unit -3 : Cost Reduction 27 - 38

Block -2 : Operating Costing, Process Costing

and Reconciliation of Cost and
Financial Accounts 39-102
Unit -1 : Operating Costing 39 -57

Unit -2 : Process Costing 58 - 83

Unit -3 : Reconciliation of Cost and Financial Accounts 84 - 102

Block -3 : Analysis and interpretation of accounts;
Study of Financial Statement; Techniques
of Financial Statement analysis
103 - 125
Unit -1 : Analysis and interpretation of Accounts 103 - 109

Unit -2 : Study of Financial Statements, Techniques of

Financial Statement Analysis 110- 125

Block -4 : Analysis and Interpretation of Financial

Data Ratio Analysis 126 - 170
Unit -1 : Analysis and Interpretation of Financial Data 126 - 132

Unit -2 : Ration Analysis 133 - 170

Block -5: Working Capital : Concept and Management;

Projection of Working Capital Requirement
171 - 205
Unit -1 : Working Capital - Concept and Management 171 - 184

Unit -2 : Projection of Working Capital Requirement,

in case of Trading Organisation - in case of

Manufacturing Organisation 185 - 205

 COST AND MANAGEMENT ACCOUNTING

BLOCK - 1
COST ACCOUNTANCY : INTRODUCTION
ACTIVITY BASED COSTING - COST REDUCTION
This block comprises three units.

UNIT- 1 : EVOLUTION OF COST ACCOUNTANCY,

CONCEPTS AND CONVENTIONS OF
COST ACCOUNTANCY, ESSENTIALS OF
COST ACCOUNTING SYSTEM
Structure
1.0 Objectives.
1.1 Introduction.
1.2 Definitions of Cost, Costing and Cost Accounting.
1.3 Nature of Cost Accounting.
1.4 Objectives of Cost Accounting.
1.5 Importance of Cost Accounting.
1.6 Evolution of Cost Accounting System.
1.7 Essentials of Cost Accounting.
1.8 Cost Concepts.
1.9 Points to Remember
1.10 Key Words
1.11 Self- assessment Questions (Assignments)
1.12 Further Readings
1.0 Objectives

After going through this unit, you should be able to :

• Explain the definition of Cost Accounting.
• Discuss the nature and objectives of Cost Accounting.
• Narrate the importance of Cost Accounting.
• Trace the evolution of Cost Accounting.
• Define clearly the important cost concepts.
2

1.1 INTRODUCTION
In fact, costs play a significant role in the context of
"matching concept". Truly speaking cost determination and
its application is not only useful to accountants but it is also
used as a technique of managerial decision-making, business
strategy and industrial control. Therefore, it is appropriate to
introduce you with the basic foundation and idea about the
mechanism of cost accounting principles so as to enable you
to understand its applicability to Management Accounting.

1.2 DEFINITIONS OF COST, COSTING AND COST

ACCOUNTING
Cost
Cost may be defined as one which is sacrificed or is given
in order to obtain something. The cost of an item represents
actual outgoings or ascertained charges incurred in its
production and sale. This term means the cost to produce and
sell, but because of different meaning, it is advisable to qualify
the term 'cost' to express exactly what it means e.g. prime cost,
works cost, total cost etc.

Costing
Costing is a term which denotes the 'technique' or
'process' of ascertaining cost.
" It is the technique and process of ascertaining costs". -
I.C.M.A., London
It expresses the actual cost of any particular unit of
production and also discloses how such total cost is
constituted. According to Wheldon, it is "the classifying,
recording and appropriate allocation of expenditure for the
determination of the costs of products or services; the relation
of these costs to sales volumes and the ascertainment of
profitability."
 3
Cost Accounting
Cost Accounting is the art and science of computing and
determining the cost of production. The Institute of Costs and
Works Accountants of London defined cost accountancy as
"the application of costing and cost accounting principles,
methods and techniques to the science, art and practice of cost
control and the ascertainment of profitability. It includes the
presentation of information derived therefrom for the purpose
of managerial decision making."
According to Kohler-cost accounting includes the
presentation and interpretation of cost data as an important
decision-making tool to management, in controlling current
and future operations. He has defined cost accounting as :
"…….. that branch of accounting dealing with the
classification, recording, allocation, summarization and
reporting of current and prospective costs. Included in the
field of cost accreting are the design of operation of cost
systems and procedures; the determination of costs byu
departments, functions, responsibilities, activities, products,
territories, periods and other units of forecasted future costs
and standard or desired costs, as well as historical costs; the
comparison of costs of different periods, of actual with
estimated or standard costs, and of alternative costs; the
presentation and interpretation of cost data s an aid to
management in controlling current and future operations."
Other important definitions of cost accounting are also
presented here.
According to Sickele - Cost accounting is the science of
recording and presenting business transactions pertaining to
the production of goods and services, whereby these records
become a method of measurement and a means of control.
Morse has defined it as - Cost accounting is the
processing and evaluation of monetary and non-monetary data
to provide information for external reporting, internal
planning and control of business operations and special
analysis and decisions.
4

All these definitions thus reveal three different

interpretations of cost accounting :
(i) Cost record keeping aspect,
(ii) Cost finding aspect and
(iii) Decision Making aspect.

1.3 NATURE OF COST ACCOUNTANCY

The nature of Cost Accounting may be explained as :
1. Ascertainment of cost : Cost Accounting is concerned
with ascertainment of cost of each product, process or
operation and ensuring that all the expenses have been absorbed
in the cost of products. For this purpose, the Cost Accountant
has to introduce a system of recording costs. Suitable records
should be maintained for materials, labour and overheads. The
cost data gives a basis for the determination of selling price. Again
matching of costs with revenue helps in assessing the profitability
of each product or service.
2. Cost control : Cost accounting is also concerned with
improving efficiency by controlling and reducing cost. This aspect
is becoming increasingly important due to growing competition.
This is achieved by using budgets and standards set up for the
guidance of management. Deviations are ascertained by
comparing actual with standards.
Accordingly remedial measures are taken. A check is also
exercised over the stocks of raw materials, work-in-process, and
finished gods so that wastage is avoided and least amount of
capital is locked up in these stocks.
3. Determination of prices : Cost Accounting provides
detailed information about the cost of product. It provides
adequate cost data for fixation of selling prices and submitting
quotations. It also guides management is fixing prices during
the time of depression or incurrence of loss.
4. Managerial decision : Cost Accounting provides suitable
data and information to management on different decisional
 5
problems, such as : 9i) whether to make or buy ; (ii) whether to
accept an order below cost; (iii) whether to introduce a new
product; (iv) what should be the priority accorded to a product
and (v) future expansion policies and capital outlays.

1.4 OBJECTIVES OF COST ACCOUTING

The objects of cost accounting can be grouped under these
two heads:
A. Primary objectives and
B. Secondary objectives.
A. Primary Objectives
i) To ascertain the cost of producing an article or job.
ii) To ascertain the performance of an activity or
operation as well as services rendered.
iii) To exercise control and regulate selling price and
to see that cost of production of an article or articles
are recovered in selling price.
iv) To prepare tender estimate and quotation and
minimize the risks of losses while preparing or
estimating prices for quotations.
v) To point out and to obviate waste and leakages or
loopholes in elements of cost.
vi) To raise 'productivity' of an organization.
B. Secondary Objectives
i) To generate reliable cost information with a view
to help the management to have a comparison
between workers' efficiency and machine and also
tracing leakage in material and labour, maintain
control over inventory etc.
ii) To aid management in taking managerial decision
on projects plan.
iii) To aid in exercising social control of business.
6

1.5 IMPORTANCE OF COST ACCOUNTING

Cost accounting is of immense importance to
management, employees, creditors, Government and society
in general. These are explained under the following heads:
Benefits to Management
Cost accounting aids management is carrying out its
functions effectively and efficiently.
Planning : Cost accounting compiles up-to-date cost
data, analysed by operations, products, elements, functions
and departments and presents them in a suitable form. On
the basis of such data, management can plan is future
operations in a more efficient manner.
Budgeting : Cost accounting does not merely record
actual costs incurred but also works out estimated and
standard costs for exercising control. It prepares budgets for
future activities based on past experience and anticipated
changes in future. It helps management to make an objective
assessment of organizational strengths, weaknesses,
opportunities and threats (SWOT analysis) before
implementing a project.
Decision making : Cost accounting enables management
to arrive at decisions based on cost data. With the help of
valuable cost data, management decides issues such as make
or buy, expand or contract business activities, putting scarce
inputs to effective use, evaluating the profitability of various
alternatives, selling below cost price etc.
Pricing : Cost accounting provides useful data for
quoting appropriate prices for inland as well as foreign
markets by applying the techniques such as marginal costing,
budgetary control well before undertaking production
schedule. Cost accounting data enables management to fix
minimum prices during depression, by segregating expenses
into fixed and variable components.
Controlling : Cost accounting serves as a means of control
in the following manner:
 7
• An efficient system of inventory control in the form of
buying, receiving, inspection, storage, issue of materials,
prevents wastage, under-and-over stocking of materials
at various levels. The fixation of stock levels and
inventory control ensures regular and adequate supply
of materials of proper quality and quantity whenever
required.
• An appropriate system of control over labour cost by job
and time records helps management avoid idle time,
defective work etc. and utilize human resources in most
optimal way.
• It provides systematic and meaningful records to
management, facilitating the introduction of corrective
measures at the appropriate time.
Effective utilization of resources : The standards for
measuring efficiencfy are set annually. Deviations are checked
quickly, weak points are identified and remedial steps are
taken up at the right time. The reasons for profit or loss during
a period are examined thoroughly for future guidance.
Attempts are made to put resources to the best possible use.
Costs and revenues of two products, two periods, two
departments etc. are compared from time to time with a view
to improve efficiency on a continuous basis.
Benefits to Employees
Cost accounting provides a number of benefits to
employees which are explained below:
• It facilitates the introduction of different incentive
schemes and bonus plans and, thus, provides adequate
rewards for sincere and efficient workers.
• Appraisal of employee performance is done scientifically
by setting standards of efficiency and measuring it
through time and motion studies. Job and time cards
help management in identifying people who are regular,
productive, and, thus, deserve promotions from time to
time.
8
Benefits to Creditors
Creditors, bankers, debentureholders study the data
provided by cost accountants in order to ascertain the
solvency, profitability and future prosperity of an enterprise
before they lend. The reports of cost accountants immensely
help them take right decisions.
Benefits to the Government
The techniques of cost accounting are useful in
formulating national plans aimed at achieving economic
progress. In order to take decisions relating to price ceiling,
import and export policies, granting of quotas and subsidies,
taxation, the Government requires cost data of various
industries, Cost audit, to a large extent, helps in ensuring that
corporate funds are not squandered away in uneconomical
activities.
Benefits to the Society :
Costing provides immense benefits to the society in the
following ways :
• It minimizes all kinds of waste, facilities are used to their
maximum potential, and therefore, ultimate consumers
get quality products at an economical price.
• It brings stability by improving operating and
managerial efficiency.
• Cost reduction and cost saving efforts carried out by
various firms helps in curbing inflationary tendencies
in the economy of the country.

1.6 EVOLUTION OF COST ACCOUNTING

Though financial accounting had its beginning early
during the modern civilization, development of cost
accounting has been rather slow and late The beginning of
cost accounting may be first traced to Robert Loder's "Farm
Accounts" for 1610-20. Attempts were made by many
industrialists in Great Britain and in the United States to install
factory cost systems as early as in 1805. However, such efforts
were sporadic.
 9
According to Lawrence and Humphreys, some good
starting point was 1875 with the writings of John Walker, a
practical foundryman, when he published in Liverpool,
"Prime Cost Keeping for Engineers, Iron founders, Boiler and
Bridge Makers et cetera." Although his book was entitled
Prime Cost Keeping, chapter V described 'the manner in which
the percentage for general expenses is arrived at.' He stated
the basic data of costing and indicated how they should be
recorded. He described how average costs of material and
labour over fixed periods of time should be computed, the
period of such average being quarter of a year.

Serious studies in cost accounting started in 1890's with

the writings of Henry Metcalfe "The Cost of Manufactures",
Emile Garcke and John Manger Fells "Factory Accounts : Their
Principles and Practice", George P. Norton "Textile
Manufacturers" Book-Keeping", J. Slater Lewis "The
Commercial Organisation of Factories" and later with
Alexander H. Church "The Proper Distrubiton of
Establishment Charges", Engineering Magazine, 1901; J. Lee
Nicholson "Cost Accounting : Theory and Practices" and J.
Maurice Clark "Studies in the Economics of Overhead Costs."
The development of cost accounting in this period was also
slow due to the following two reasons.
• Firstly, cost accounting tried to adopt itself within the
framework of financial accounting.
• Secondly, the accountants had a tendency not to disclose
the cost accounting methods they had developed within
their own firms.
The First World War brought in "cost plus contract" in
the field of cost accounting. With a view to avoid delays in
estimating for urgent contracts, contracts were placed for war
work on the basis that they would reimburse the cost, plus a
percentage to cover the administration and other overhead
expenses incurred by the contractee. The demand for persons
adequately qualified to price such contracts caused a great
influx to the profession of cost accounting. In 1919 the Institute
of Cost and Works Accountants (presently known as the
10
Chartered Institute of Management Accountants) came into
being in Great Britain. At about the same time, the National
Association of Cost Accountants (now known as the National
Association of Accountants) was established in New York.
These two institutions have contributed significantly to the
progress of cost accounting profession.
The advancement of cost accounting during this period
was influenced by the growth of 'scientific management' and
a shift of emphasis from cost ascertainment to cost control. In
1920's the 'standard costs' were developed in the USA and the
leading cost accountants in Great Britain recognized it as a
remarkable and progressive addition to their costing
techniques. Budgetary control also followed subsequently.
Cost accounting was integrated within the general accounts
and standard costs were initiated to measure performance.
Thus, the gradual evolution of cost accounting upto mid
1950's can be traced to the following stages:
Stage - I : Cost accounting was developed for cost
ascertainment (including inventory valuation) and profit
measurement.
Stage - II : The emphasis was on cost control.
Stage - III : Cost analysis stage.
In India the necessity of qualified cost accountants was
felt particularly during the Second World War. The number
of these accountants at that time was not many. They acquired
their professional education and training from the Institute of
Cost and Management Accountants of England. They were
mainly employed in Indian Defence Factories where historical
costing and budgetary control had been in vogue for a number
of years.
It was felt that the profession of Cost Accounting be
formally organized in India. In 1959, the Cost and Works
Accountants Act of India was enacted by the Government of
India and the Institute of Cost and Works Accountants of India
which initially was a company limited by guarantee, started
functioning as a body corporate.
Thereafter the Government of India have been taking
important steps to improve the profession. The concept of cost
audit is an example on the point. The financial audit (Sec. 224-
227 of the Companies Act, 1956) at the end of the year was
 11
perhaps considered by the Government to be inadequate to
assess the real efficiency of working of manufacturing
establishments. Accordingly the Government of India have
framed Cost Accounting Record Rules for maintenance of cost
statements for various industries (upto 31st March, 1986, 34
industries have been brought under the purview of the Cost
Accounting Record Rules). As a secondary step, the
Government of India from time to time issues order under
Section 233-B for cost audit in the selected industries falling
under the purview of the record rules. The Sachar Committee
have recommended for 'continuous audit' in certain
industries. The Institute of Cost and Works Accountants of
India has also been making efforts for development of the
profession. A separate Directorate has been functioning
exclusively for promoting professional development.

1.7 ESSENTIALS OF COST ACCOUNTING

An ideal and well-structured system of cost accounting
is essential for ascertaining and controlling costs. To meet the
management requirements of cost identification and control
in organization, a sound cost recording system must be
established. The following are some of the essentials of a good
costing system:
1. Suitable : The cost accounting system must be suitable.
It must be developed according to the nature, conditions, size
and requirements of the organisation.
2. Simple : It must be simple and easy to understand
and implement. Simple record and clear form of control is the
foremost requirement.
3. Flexible : The costing system must be flexible enough
so that it can be adapted to the changes that may take place in
the organization.
4. Comparable : The costing system should be
implemented in such a way that the management must be able
to make a comparison of facts with the past figures, figures of
other concerns or other departments of the same unit.
5. Uniform : All forms and proforma etc. used in the
costing system should be uniform in size and quality of
contents.
12
6. Cost-effective : The system should be cost effective to
ensure that the benefits must outweigh the costs.
7. Labour-saving : The cost accounting system must
involve minimum clerical work so that employees of the
organization should feel it easy while implementing the
system.
8. Control : It must provide for an effective system of
control over materials, labour and overhead costs.
9. Reconciliation: The cost accounting system must be
so devised that financial as well as cost records are capable of
easy reconciliation.

1.8 COST CONCEPTS FOR MANAGERIAL DECISIONS

For managerial decision purposes, costs may be classified
into the following types:
Differential costs : Differential cost is the increase or
decrease in total cost that results from an alternative course
of action. It is determined by subtracting the cost of one
alternative from the cost of another alternative. The alternative
choice may arise because of change in the method of
production, change in the volume of sales, make or buy
decisions, accept or refuse decisions etc.
Opportunity costs : It is the measurable advantage
scarified as a result of the rejection of alternative uses of
resources, whether of materials, labour or facilities. For
example, if an owned building is proposed to be used for a
project, the likely rent of the building is the opportunity cost
which should be taken into consideration for evaluating the
profitability of the project.
Imputed costs : These are the costs that do not involve at
any time actual cash outlay and, as a consequence, which do
not appear in the financial records. However such costs
involve foregoing on the part of the person or persons for
whom costs are being calculated. In fact, these are hypothetical
costs which are computed only for the purpose of decision
making. For instance, rent on own building, interest on capital
etc. are imputed costs.
Replacement cost : This is the cost at which an identical
asset could be purchased so that the identical old asset is being
 13
replaced. In other words replacement cost is the current market
cost of replacing an asset. When the management
contemplates the replacement of an asset, it has to keep in
mind its replacement cost and not the cost at which it was
purchased earlier.
Out-of-pocket costs : Out-of-pocket costs represent cash
payments to be incurred (such as wages, rent) as against costs
which do not require cash outlay( viz depreciation). It is
widely used by business concerns as an aid in making decision
pertaining to price fixation during depression, make or buy
decisions etc.
Sunk costs : These costs were incurred in the past and
are not recoverable in a given condition. Sunk costs may not
be relevant for a particular decision-making. For example, a
machine costing Rs.25,000 has a present book value of Rs,5,000.
If the machine were scrapped and replaced, the loss would
be Rs.5,000.This undepreciated book value of the machine is
a sunk cost and is not relevant to decision regarding the
replacement of this machine.
Conversion cost : This cost denotes the sum of direct
labour and overhead costs in the manufacture of a product. It
represents the total cost of 'converting' a raw material into
finished product. Appropriate use of this cost can be made in
certain managerial decision.
Future costs : Since no decision can change historical
costs, decisions made now can affect only what will happen
in the future. Hence the only relevant costs for decision-making
are pre-determined or future costs. At the same time, it is the
historical costs which generally provide a basis for
computation of future cost. Besides this, anticipated changing
relationships in the future are also important for estimating
future costs.

1.9 POINTS TO REMEMBER

Cost Accounting is concerned with recording,
classification, ascertainment, allocation, summarization and
reporting of current and prospective costs.
The primary objectives of cost accounting are :
(i) To ascertain the cost of product.
14
(ii) To ascertain the performance of an activity or
operation.
(iii) To exercise control and regulate selling prices.
(iv) To raise the productivity of an organistion.
Cost Accounting is of immense importance to
management, employees, creditors, Government and society
in general. It aids management in carrying out the managerial
functions effectively and efficiently in the areas of planning,
budgeting, decision-making, controlling and optimal
utilization of resources.
The following are some of the essential of a good costing
system:
(i) Suitable, (ii) Simple, (iii) Flexible, (iv) Comparable, (v)
Uniform (vi) Cost-effective, (viii) Labour-saving, (viii) Control
and (ix) Reconciliation.

1.10 KEY WORDS

Cost : The cost of an item means actual outgoings or
ascertained charges incurred in its
manufacture and sale.
Costing : It is a term which indicates the technique and
process of ascertaining costs.
Differential : Differential cost represents the increase or cost
cost decrease in the total cost that results from an
alternative course of action.
Opportunity : It is the measurable advantage sacrificed as a
cost result of rejection of alternative uses of resources,
whether of materials, labour or facilities.
Imputed costs : These are the costs that do not involve at any
time actual cash outlay and as a consequence,
do not appear in the financial records.
Out-of-pocket : Out-of-pocket costs represent cash payments
costs to be incurred (such as wages, rent) as against
costs which do not require cash outlay (viz.
depreciation).
 15
Sunk costs: These costs were incurred in the past and are
not recoverable in a given condition.
Conversion cost : It represents the total cost of converting a
raw material into finished product.

1.11. SELF-ASSESSMENT QUESTIONS OR ASSIGNMENTS

1. What is cost accounting? Discuss the objectives of cost

accounting.
2. Explain the importance of cost accounting as a
managerial tool.
3. How does cost accounting help in the planning and
control of operations of a business enterprise?
4. " A sound costing system must place the same emphasis
on cost control as on cost ascertainment." Comment on
the statement.
5. Describe the definitions of cost, costing and cost
accounting. Discuss the nature of cost accounting.
6. Give a brief account of the evolution of cost accounting.
7. "While financial accounting is external, cost accounting
is internal to the business". Comment.
8. Discuss the essentials of cost accounting.
9. Explain the different cost concepts for managerial
decisions.
10. Narrate the following cost concepts :
(a) Differential cost.
(b) Opportunity cost
(c) Imputed cost
(d) Sunk cost
(e) Out-of-pocket cost
(f) Future cost

1.12 FURTHER READINGS

Arora, M.N., "Cost Accounting" Vikas Publishing House Pvt.
Ltd., New Delhi.
Jain, S.P. and Narang, K.L., "Cost Accounting" Kalyani
Publishers, New Delhi.
Khan, M.Y. and Jain, P.K., "Cost Accounting" Tata McGraw-
Hill Publishing Company Ltd., New Delhi.
16
Block - 1
UNIT - 2 : ACTIVITY BASED COSTING
Structure
2.0 Objectives
2.1 Weaknesses of Conventional Costing.
2.2 Meaning of Activity Based Costing
2.3 Stages and flow of costs in Activity Based Costing
2.4 Cost analysis under Activity Based Costing
2.5 Differences between Activity Based Costing and
Conventional Costing.
2.6 Scope of Activity Based Costing.
2.7 Benefits and limitations of Activity Based Costing.
2.8 Installation of Activity Based Costing
2.9 Points to Remember
2.10 Key Words
2.11 Self-assessment Questions (Assignments)
2.12 Further Readings.

2.0 Objectives
After studying this unit, you should be able to :
• Explain the meaning of Activity Based Costing.
• State the classification of activities.
• Define Cost Drivers.
• Make a comparison of Activity Based Costing with
Conventional Costing System.
• Discuss the impact of Activity Based Costing in
terms of its benefits and limitations.

2.1 WEAKNESSES OF CONVENTIONAL COSTING

Conventional costing suffers from some inherent
weaknesses. Conventional costing may lead to overcosting or
undercosting of products or services. Overcosting happens
when a product or service consumes a relatively low level of
 17
resources but is allocated a relatively high cost. Undercosting
occurs when a product or service consumes a relatively high
level of resources but is allocated a relatively low cost. Over-
or undercosting of products leads to distorted cost
information. Substandard cost information causes
management to make wrong decisions for product emphasis,
pricing, make or buy etc. Subsequently the objectives of costing
system remain far from having been achieved.
Traditional costing leads to under or overcosting of
products or services mainly due to following reasons. In
traditional costing, overhead or indirect costs are recovered
on the basis of volume only e.g., labour hour rate, machine
hour rate etc.
Under the traditional method of allocation, costs are
averaged or spread over products / services equally
irrespective of activities or demands on resources. This is
because of the fundamental assumption in the allocation of
cost that the higher the volume the greater the share of indirect
costs to a product or service and vice versa. In fact, this
assumption is not based on reality.

2.2 MEANING OF ACTIVITY-BASED COSTING

An activity is a process or procedure that causes work.
Activity-Based Costing gives emphasis on activities as the
fundamental cost objects. In the context of ABC by acivities
we only mean the activities of the support or service
departments viz. machine set-up, material handling,
engineering charge, quality testing, inspection etc. It is thus
apparent that ABC differs from the traditional costing system
only in respect of allocation of overhead or indirect costs.
Direct costs are identified with the cost object, in the same
way as done in case of traditional costing system. Overhead
costs are attached to the cost objects based on activities.

Activities drive costs. Therefore, costs are allocated

based on appropriate cost drivers. Consequently cost drivers
are the factors that are significant determinants of costs. For
18
instance, costs of warehousing depend on the number of items
in stock, costs of purchase department depend on the number
of orders placed etc. A few examples of activities and the
relevant cost drivers are given below :
Activity Cost driver
Purchasing materials ... No. of orders placed
Warehousing ... Items in stock
Material handling …. No. of parts
Inspection …. Inspection per item
Quality testing …. Hours of test time
Packing …. No. of packing orders
Distribution …. No. of depots
Customer Service …. No. of orders
Receiving materials …. No. of receiving orders
Communications …. No. of phone calls
Activity-Based Costing is not an alternative costing
system. It is an approach to develop more logically and
accurately the cost numbers used in the existing costing
systems. It then facilitates various strategic exercises such as
value chain analysis, benchmarking, target costing etc. for
overall operational improvement.

2.3. STAGES AND FLOW OF COSTS IN ACTIVITY-

BASED COSTING
There are two primary stages in Activity-Based costing.
Firstly, tracing costs to activities and secondly, tracing
activities to products.
First, activities are identified and thereafter classified
into different categories that have relationship with the
different parts of the production process. Direct labour related
activities, machine related activities (machine cost centers),
and support activities such as ordering, receiving, materials
handling, production scheduling, packing and despatching
are examples of such activities.
 19
Secondly, factory overhead costs of the activities are
identified and classified into homogeneous cost pools. A
homogendes cost pool is a collection of overhead costs that
are logically related to the tasks being performed. A cost pool
should be established for each activity. Cost pool is like a cost
centre or activity centre around which costs are accumulated.
Third, the factors that affect the cost of a particular activity
should be identified. They ate called cost drivers. Direct costs
do not need cost drivers as they can be linked directly to a
product. Direct costs are themselves cost drivers. But all other
works or manufacturing costs need cost drivers. Cost drivers
are the forces, factors that determine the cost of activities. Cost
drivers can link a pool of costs in an activity centre to the product.
The basic assumption in Activity-Based Costing is that cost
behaviour is influenced by cost drivers. Thus, in order to trace
overhead costs to products, appropriate cost drivers should be
identified.

2.4. COST ANALYSIS UNDER ACTIVITY BASED

COSTING
Activities are identified and classified into different
categories or segments of the production process. The
grouping of activities is done using the different levels at
which activities are performed. Activities are broadly
classified into one of the four activity categories :
1. Unit level Activities
2. Batch level Activities
3. Product level Activities
4. Facility level Activities
Unit level activities are those activities that are
performed each time a unit is produced. These are repetitive
activities. For instance, direct labour hours, machine hours,
power are used each time a unit is produced. Direct meterials
and direct labour activities are also unit level activities,
although these are not overhead costs. Costs of unit level
activities vary with the number of unit produced.
20
Batch level activities are those activities which are
performed each time a batch of goods is produced. The cost
of batch level activities varies with the number of batches but
are fixed with regard to the number of units in each batch.
Material handling, machine setups, inspections, production
scheduling are examples of batch level activities which are
related to batches rather than to individual products.
Product level activities are performed to support the
production of each different type of product. Maintenance of
equipment, maintaining bills of materials, handling materials,
testing routines are some examples of product-level activities.
Facility-level activities are those which are necessary
for sustaining a factory's general manufacturing process. These
activities are common to a variety of products and are very
difficult to link to product-specific activities. Factory
management, maintenance, plant depreciation, security are
examples of facility-level activities.
In Activity-Based Costing, facility-level activities and
costs are treated as periodic cost. The costs associated with
unit level, batch level and product level - are assigned to
products, using cost drivers that express the cause and effect
relationship between activity consumption and cost.

2.5. DIFFERENCES BETWEEN ACTIVITY-BASED

COSTING AND CONVENTIONAL COSTING
1. The real change Activity-Based Costing implements in
the cost structure of the organisation lies in the treatment
of allocation of overheads while the conventional system
allocates costs between products on the basis of machine-
hours or labour-hours.
2. Traditionally companies distribute their overhead,
between different products in the same ratio as the
respective costs of direct labour in these products. Hence
if a unit of the product A consumes twice as many labour-
hours as a unit of product B, the total overhead cost per
unit is also distributed between product A and product
B in the same ratio. As such, the manufacturer of the two
 21
products uses the overheads, in a production that bears
no relationship with labour costs.
But the Activity-Based Costing allocates the total
overhead costs to different activities on the basis of cost
drivers so as to distribute the total costs accurately
between them.
3. The result of using Actively-Based costing is found to
be a dramatic one. The respective costs of different
products are often found to be as much as 50% higher or
lower than those computed under the conventional
costing system.

2.6. SCOPE OF ACTIVITY-BASED COSTING

The Activity-Based Costing may be effectively used in the
following situations where :
1. The ratio of indirect cost to total cost is rising
rapidly.
2. The company is confused about the optimum
product-mix and pricing.
3. The company seems to be competitive in one line,
but not in others.
4. The Turnover is rising without any corresponding
growth in profits.
5. Labour operation are being replaced by automated
ones. Different operations require varying number
of operators.
6. Quality management costs are rising, but not
customer-satisfaction.

2.7. BENEFITS AND LIMITATIONS OF ACTIVITY-

BASED COSTING
The benefits of Activity-Based Costing are :
1. In Activity-Based Costing, managers emphasize on
activities rather than products because activities in
various departments may be combined and costs of
22
similar activities ascertained, e.g. handling of materials,
repairs of machines, quality control etc. Since detailed
costs are kept by activities, the total company costs for
each activity can be ascertained, analysed, planned and
controlled.
2. Since costs are identified with activities and then
allocated to products or services, based on appropriate
cost drivers, product/service costs ascertained are more
accurate. Moreover, since overhead or indirect costs
constitute a sizable portion of the total costs of the firm,
the overall impact of allocation of indirect costs to
product/services more accurately is significant.
3. Managers manage activities rather than products.
Changes in activities result into changes in costs.
Therefore if activities are undertaken efficiently, costs
will decrease and products will be more competitive.
4. To manage activities in a better way and to make rational
economic decisions, managers need to identify the
relationships of causes (activities) and effects (costs) in a
more detailed and accurate manner. Activity-Based
Costing gives emphasis on this aspect.
5. If management realizes that a large number of its
products may be breakeven or unprofitable, the Activity-
Based Costing system is useful in setting priorities for
managerial decision and action.
The limitations of Activity-Based Costing are :
1. Activity-Based Costing does not encourage managers to
think about changing work processes to make business
more competitive.
2. In some areas, Activity-Based Costing does not conform
to generally accepted accounting principles. For
example, Activity-Based Costing encourages allocation
of non-product costs like research and development to
products while committed product costs like factory
depreciation are not allocated to products.
3. Activity-Based Costing does not encourage identification
and removal of constraints causing delays. An overemphasis
 23
on cost reduction without regard to constraints, does not
create an environment conducive for understanding the
problems and their solution.

2.8. INSTALLATION OF ACTIVITY-BASED COSTING

In India, at present, firms have to operate in a competitive
environment and there is no scope for inefficiency and cost
relating to the same. Although full-fledged implementation of
Activity-Based Costing in India is limited, yet many large Indian
companies which are using conventional costing leading to
allocation of overhead costs need to switch over to the Activity-
Based Costing system.
The factors which justify the implementation of Activity-
Based Costing are :
(a) Relatively high ratio of overhead costs to total cost;
(b) Product complexity ; and
(c) Diversity of volume.
The steps involved in installation of Activity-Based
Costing are :
(a) Primary steps : These are feasibility studies,
establishing IT infrastructure, convincing the line-employees
and value chain analysis.
(b) Operational steps : These include identification
of activities, costs and cost drivers, computation of absorption
rates and allocation of overhead costs based on the activities/
transactions.
The aforesaid steps are now explained in brief as follows.
1. Feasibility Study : Installation of Activity-Based
Costing needs considerable efforts and costs. The types of costs
needed are :
(a) Cost of development of the system and
(development cost).
(b) Cost of running the system. (operational cost)
The expected benefits are :
(i) more accurate cost information for product pricing;
24
(ii) more accurate profit analysis by product, process,
customer and department ;
(iii) improved measures of performance ; and
(iv) improved insight into cost causation.
The anticipated benefits should overweigh the costs in
order to justify the installation of Activity-Based Costing.
2. IT infrastructure : In practice, a lot of information is
required to be generated for Activity-Based Costing. The
rationale for Activity-Based Costing depends on the analysis
of each and every activity/resource deployed and incurrence
of cost. Therefore, creation of a database is a must for
successful operation of Activity-Based Costing. Hence, IT
infrastructure should be built up to provide necessary back up.
3. Selling the concept to the line-employees : The
difficulty in selling the concept to the line-employees was one
of the problems faced by many Canadian firms in
implementing Activity-Based Costing. Often employees offer
resistance to new system. Training programmes, case study,
demonstration, group discussion etc. help considerably to sell
the concept to the employees.
4. Strategy and value chain analysis : The Activity-
Based Costing system must fulfill two basic strategic
requirements :
(i) Providing information and analytical support, and
(ii) Providing impetus for development of new and
revised strategy.
Value chain analysis emphasizes on the strategic
aspects of various activities within the firm. The purpose of
value chain analysis is to determine where managers can
lower costs from production to distribution in the company's
segment of the chain. It, thus encourages operational efficiency
and rationalization of cost structure with activities.
5. Inventorisation and screening of activities : The
salient feature of Activity-Based Costing is its emphasis on
activities as the fundamental cost objects. The whole process
of a firm's operations from product design to marketing - are
represented by several important activities. Hence, the success
of Activities-Based Costing depends on a comprehensive
inventorisation of all activities and their screening.
 25
6. Identification of costs and cost drivers : Resources
employed, or costs incurred, for undertaking the activities should
be identified, Identification of costs vis-à-vis activities may not
be easy.
For identification of costs and cost drivers, the following
three approaches may be adopted :
(i) Personal observation and measurement by each
line-manager in respect of activity under his control ;
(ii) Analysis of cost and operating records ; and
(iii) Feedback about the experience of other
organizations.
A cost driver is the cost allocation base. When there are a
number of cost drivers for any particular cost pool, costs should
be allocated based on the primary cost driver.

2.9. POINTS TO REMEMBER

Traditional costing leads to under or overcastting of
products or services since indirect costs are recovered on the
basis volume only e.g., labour-hour rate, machine hour rate etc.
Activity-Based Costing is an approach to develop more
logically and accurately the cost numbers used in the existing
costing systems.
Activity-Based Costing allocates the total overhead costs
to different activities on the basis of cost drivers so as to distribute
the total costs accurately between them.

2.10. KEY WORDS

Cost Driver : Cost drivers are the factors or
transactions that are significant
determinants of costs. Costs are,
therefore, allocated based on
appropriate cost drivers.
Cost Pool : A cost pool represents a grouping of
individual cost items. For indirect or
support department costs which
need allocation to products or
services, such pools need to be
26
formed. It comprises costs that have
the same or similar cause and effect
relationship with the cost allocation
base.

2.11. SELF ASSESSMENT QUESTIONS

1. Explain briefly the limitations of traditional costing
where overhead costs are allocated based on volume.
2. What do you mean by Activity-Based Costing ? How
product costs are determined in Activity-Based Costing?
3. How Should costs be allocated in Activity-Based Costing?
Illustrate your answer with imaginary figures.
4. Discuss the stages and flow of costs in Activity-Based
Costing .
5. Explain, in brief, cost analysis under Activity-Based
Costing.
6. Narrate the scope of Activity-Based Costing. Describe the
differences between Activity-Based Costing and
Conventional Costing.
7. Describe the benefits and limitations of Activity-Based
Costing.
8. What are the factors than determine the suitability of
application of Activity-Based Costing ? Explain them in
brief.
9. Why do managers prefer Activity-Based Costing system
to traditional costing system ? Explain the broad
classifications of activities in Activity-Based Costing.
10. Write short notes on :
a. Cost Driver ;
b. Cost pool ; and
c. Traditional costing system.

2.12. FURTHER READINGS

Banerjee, B. "Cost Accounting",
The World Press Private Ltd., Kolkata.
Lal, Jawahar, " Managerial Accounting Himalaya
Publshing House, Mumbai.
 27
BLOCK - 1
UNIT - 3 : COST REDUCTION
Structure
3.0 Objectives
3.1. Meaning of Cost Reduction
3.2 Cost control and Cost reduction
3.3 Objectives of Cost Reduction
3.4 Principles of Cost Reduction and Control
3.5 Scope and Areas of Cost Reduction
3.6 Distinction between Cost Control and Cost Reduction
3.7 Techniques to Control and Reduce Costs
3.8 Advantages of Cost Reduction
3.9 Dangers of Cost Reduction Efforts
3.10 Cost Reduction its organisation
3.11 Points to Remember
3.12 Key Words
3.13 Self-Assessment Questions
3.14 Further Readings

3.0 Objectives
After studying this unit, you should be able to :
• Explain the meaning of Cost Reduction.
• State the objectives and scope of Cost Reduction.
• Identity the areas of Cost Reduction.
• Describe the differences between Cost Reduction
and Cost Control.
• Discuss the principles of Cot Reduction and control.
• Narrate the techniques to control and reduce Costs.

3.1. MEANING OF COST REDUCTION

Cost control attempts to bring the actuals in harmony

with the predetermined targets. If this materialises assuming
no increase or decrease in costs, the profit margin becomes
28
more or less stable at a particular level of sales. Of course,
this is easier said than done. In reality, prices may fluctuate.
Alternatively, sales may decrease due to different reasons. But
in all these situations, the business must aim at maximizing
profits at the same level of sales by reducing costs.
Cost reduction aims to achieve a permanent reduction
in cost, without jeopardizing the quality of the product. It is
a systematically planned way of improving efficiency of
business operations.
According to the C.I.M.A., London "Cost reduction is
to be understood as the achievement of real and permanent
reductions in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use
intended."
It has three important characteristics :
1. The reduction must be real. It must arise within the
organisation as a result of improved efficiency.
2. The reduction must be a permanent one.
3. The reduction should not be at the cost of essential
characteristics and quality of the products or
services rendered.

3.2. COST CONTROL AND COST REDUCTION :

Cost control and Cost Reduction may both be
considered to be the two sides of the same coin,
Cost control aims at reducing inefficiencies and wastes
and setting up targets and in achieving them. According to
Eric L. Kohler, cost control is the employment of management
devices in the performance of any necessary operation so that
pre-determined objectives of quality, quantity and time may
be achieved at the lowest possible outlay for goods and
services. In brief, it is the regulation by executive advice of
the costs of operating an undertaking. The first requirement
of cost control is to fix the reasonable targets for all important
activities, in consultation with employees who are responsible
for achieving them. Secondly, the actual performance should
be compared with the targets at periodic intervals. Important
 29
deriations must be identified, analysed and brought to the
notice of those responsible for results. Cost reduction aims to
achieve a permanent reduction in costs, without impairing the
quality of the product.

3.3 OBJECTIVES OF COST REDUCTION :

The objectives of cost reduction programmes are :
1. Developing cost consciousness among employees.
2. Avoiding wasteful expenditure.
3. Developing efficient operating procedures.
4. Improving the overall efficiency of organisatised
work.
For the purpose of achieving these objectives the cost
reduction programmes must be undertaken systematically.
Employees of the organisation should be motivated to
participate in the programmes actively. Priorities should be
pre-determined so as to decide the sequence in which cost
reduction efforts must be implemented in different areas.

3.4 PRINCIPLES OF COST REDUCTION AND

CONTROL :
Cost reduction and control is a total task and an all-
performing job that must affect every phase of the business
from inquiry to invoice. Therefore the successful programme
is applied with equal weightage to every unit, section,
department and division. Further, it is developed keeping
with certain basic principles. The violation of any one of these
principles reduces the probability of any permanent impact.
The "principles'' of cost reduction and control are almost
comparable to the principles of sound management.
1. It must be based on a sound management
organisation.
2. The programme must be based on a management
cycle.
3. It must be planned job, coupled with all other
company activities.
30
4. The programme is a continuous line responsibility.
Therefore, every employee must be held
consistently accountable.
5. Responsibility for cost control must be delegated
accompanied by corresponding authority.
6. The programme must be assessed, redesigned and
revaluated in a continuous process of follow-up.

3.5 SCOPE AND AREAS OF COST REDUCTION

The scope of cost reduction is very vast. Every segment
of an organisation is involved in this programme. Cost
reduction may be implemented in the following areas :
1. Design : Product design has the maximum scope
for offering cost reduction with hamparing quality of the
products. It may be achieved by a change in improvement in
the following areas :
(a) Design of methods of production;
(b) Design of machinery, tools and equipments;
(c) Standardisation of methods;
(d) Layout of building, machinery, transport
equipment etc.
2. Factory organization and production methods:
The scope of cost reduction in this area is also very high.
For instance, the area of control for cost reduction programme
includes:
(a) Material purchase, receiving, inspection, storage,
handling stock etc;
(b) Recruitment, training, promotion, methods of
remuneration to labour;
(c) Overhead;
(d) Production planning and control;
(e) Tools storage, maintenance and control;
(f) Maintenance of transport equipment;
(g) System analysis;
(h) Suitable working conditions.
 31

3. Administration : Since cost reduction is a top

management matter, there is enormous scope of cost reduction
in this area. This includes the following:

(a) Reorganising the office, assessing the effectiveness

of existing staff;

(b) Rationale of certain expenses, e.g. overtime wages,

traveling, use of company car etc.;

(c) Ckecking possible misuse by appointing Vigilance

Inspectors.

4. Marketing : By rationale thinking and joint

efforts much economy can be achieved in this area also.
Market research, advertisement, sales office, warehousing,
packing, distribution, after-sale service etc. are the areas where
cost reduction programme can be undertaken.

5. Finance : Cost reduction may be extended to the

use of finance by better utilization of fixed assets and working
capital. Savings in capital may be achieved in :

(a) Better utilization of fixed assets employed;

(b) Disposal of uneconomical fixed assets and

reinvestment of the said fund in profitable channel;

(c) Non-acquisition of fixed assets where chances of

obsolescence are high;

(d) Better inventory control;

(e) Better credit control;

(f) Increased productivity by raising the level of

capacity utilization.
32

3.6 DISTINCTION BETWEEN COST CONTROL AND

COST REDUCTION
Cost Control Cost Reduction
1. Aims at achieving pre-determined 1. Aims at achieving a real and
targets. The goal is to attain targets. permanent reduction is cost. The
goal is to improve the standards.
2. The process of cost control is to
2. It is not concerned with
set target, ascertain actual
maintenance of performance
performance, and compare it with according to standards. It challenges
target, investigate the variances and standards.
minimize them. 3. Emphasis is on present and future.
3. Emphasis is on present and past. 4. Recognises no conditions as
4. Seeks to attain lowest cost possible permanent, since a change will result
in a lower-cost.
under existing conditions.
5. Applied to every section of the
5. Usually limited to items which have
business.
standards.
6. It is a continuous process
6. It tends to set up a conservative searching for alternatives all the
procedure and lacks dynamism. times and is innovative.
7. It is a preventive function; costs 7. It is a contractive function and
are optimised before they are does operate even when a cost
control system exists.
incurred.
8. It adds thinking to doing at all levels
8. It is management by directive
of management.
dictating how to do a thing.
9. It represents achievement in
9. It represents efforts made towards reduction of costs in all efforts to
achieving a target or goal. reach the goal.

3.7 TECHNIQUE TO CONTROL AND REDUCE COSTS

Different management techniques are used to facilitate
the work of cost control and reduction. Some are formal
techniques while others are based only on careful observations
of physical conditions during daily operations. Others are
more refined and formal- results of accounting and statistical
analyses or engineering analyses. None of these techniques is
considered as the only control and reduction device. In fact,
combined techniques are used to complement each other to
appropriate cost problem. The important techniques which
are utilized to control cost are explained below:
 33
1. Budgetary Control : The budget is the
fundamental model of accounting for cost control. By setting
goals in advance, it assigns these goals to the operating
managers. Some functional budgets are established relating
to the responsibilities of executives and an overall master
budget too. The actual performance is continuously compared
with the budgeted plan or targets expressed in money terms.
By adopting the concept of flexible or variable budgeting, the
control machinery is made more effective.
2. Standard Costing : Standard Costing develops
standards with regard to the three major elements of cost-
materials, direct labor and overheads, and then computes
variances by measuring the actual performance against the
predetermined standards. The fundamental of standard
costing is measurement and analysis of variances.
3. Control Ratios : For the purpose cost control, it
is often useful to ascertain ratios from accounting data. These
provide management with information necessary for their
control work. These ratios facilitate intra-firm and inter-firm
comparisons and thus locate areas where a certain firm's
performance is below the ordinary level, as also the average
level attained earlier by itself. Some of the important control
ratios are:
Actual hours worked
(i) Capacity ratio = x100
Budgeted hours
Allowed hours
(ii) Activity ratio = x100
Budgeted hours
Allowed hours
(iii) Efficiency ratio = × 100
Actual hours hours

4. Value Analysis : The Value Analysis has emerged as a

powerful technique to reduce costs. It has also been recognized
as the most appropriate, effective and organized
methodologies to ensure better cost effectiveness in
organization. By analysing the value of goods and services
purchased in relation to their use, an attempt is made to
substitute designs, components, and materials of lower cost.
34
The main idea is to examine the functions which are preferred
in the manufacture of a product with a view to improve the
value. The knowledge of value, functions and cost factors
serves to control costs and wastes. The relationship may be
expressed as :
Function
Value =
Cost
Two general conceptual tools are basic in the operation
of a Value Analysis Programme.
(i) Design analysis of the required material;
(ii) Cost analysis of the required material.
Therefore value may be equivalent to function/ cost or
worth/ price. Value can be improved by :
(i) improving function, while the cost remains same.
(ii) Reducing costs while the functions remain same or
(iii) Improving functions and reducing costs
simultaneously.

3.8 ADVANTAGES OF COST REDUCTION

The following are the advantages or benefits on cost
reduction:
1. To the Business Concern
(i) Cost reduction raises profit and provides a basis
for higher dividends to the shareholders, more
bonus to staff and more retention of profit.
(ii) Management may spend more for better amenities
to labor. This will create an improved relation
between management and staff and thus reduce
labor turnover.
(iii) Because of above two benefits, it creates greater
confidence and goodwill.
2. To the industry
Reduced cost is an important indicator or of
productivity and thus efficiency. Hence members of the
industry may gain from the experience of the more efficient
firm and in this manner the entire industry may be benefited.
 35
3. To the nation
(i) Higher profit will result into more revenue to the
Government by way of taxation.
(ii) Higher revenue may result in more spending on
development programmes of the country.
(iii) As a consequence of reduction in cost, export prices
may be reduced which may lead to higher and
higher exports.

3.9 DANGERS OF COST REDUCTION EFFORTS

Cost reduction is a useful and effective device to reduce
costs in a real way. The ultimate benefits are quite attractive,
in the form of reduced expenditure, better cost consciousness
among employees, and higher profits for further growth and
development. But on the other hand, some dangers need to
looked into carefully.
1. Sacrificing overall goals : It may so happen that a
department may resort to certain measures which might be
beneficial from its own viewpoint, but not from the organizational
point of view.
2. Sacrificing quality : In efforts to reduce costs, there
is every possibility of the product quality might be sacrificed.
3. Sacrificing employee morale : At the beginning,
employees may start to look at cost reduction programmes with
scepticism. It may be termed as another attempt to utilize them
to increase the profits of the organization without any personal
payoffs.
4. Crash programme, Panic : The pgorammes may
be taken up by management hurriedly. It might be put into
motion as a last resort viz. when there is a serious cash crunch or
when losses mount up seriously. Such panic measures do not
yield the desired results.
Such dangers can be timely avoided if the cost reduction
programme is implemented systematically. It should not be put
into operation as an emergency measure when things go out of
hand.
All employees must actively participate and they must
have the confidence that the payoffs are going to be substantial.
36

3.10 COST REDUCTIION - ITS ORGANISATION

The areas and scope of cost reduction are so vast that
there should be a systematic and co-ordinated approach to
the problem. Generally, in a big concern Cost Reduction
Committee is constituted with departmental heads and top
executives for designing and administration of cost reduction
programme.
In other concerns, one of the executives may be assigned
the responsibility or a Cost Reduction Officer may be
appointed. But irrespective of the type of machinery, an all-
round co-operation from the sections of the organsiation is
essential. Moreover it must be planned and followed up by
an authorized machinery.
The drive for a cost reduction programme may be
initiated by :
1. Top management : Generally the programme is
initiated by the top management. But although the policy is
announced from the top level, its execution and realization
should be materialized in the interest of the organization.
2. Large firms : Sometimes smaller companies
might be compelled to be more efficient to supply components
at the prices laid down by large firms. The components might
be the entire output of the company. After securing details of
relative cost, pressure may be put by the customer firm for
cost reduction.
3. Outside Agencies like Government Trade
Association etc.

3.11 PINTS TO REMEMBER

Cost control attempts to bring the actuals in harmony
with pre-determined targets. If it materializes assuming no
increase or decrease in costs the profit margin becomes more
or less stable at a particular level of sales.
 37
Cost reduction aims to achieve a permanent reduction
in costs, without impairing the quality of the product.

Cost reduction and control is a total task and an all-

performing job that must affect every phase of the business
from inquiry to invoice. Therefore, the successful programme
is applied with equal weightage to every unit, section,
department and division.
The scope of cost reduction is very vast. Every segment
of an organisation is involved in this programme. Cost
reduction may be implemented in the areas like design, factory
organisation and production methods, administration,
marketing and finance.
Important techniques which are utilized to control and
reduce costs are budgetary control, standard costing, control
ratios and value analysis.

3.12. KEY WORDS

Value Analysis : It is recognized as a powerful technique
to reduce costs. By analyzing the value
of goods and service purchased in
relation to their use, an attempt is made
to substitute designs, components and
materials of lower cost.
Budgetary Control : It is the process of exercising control
through establishment of flexible
budgets, continuous comparison of
actual performance with the budgeted
plan or targets expressed in money terms
and taking recourse to remedial
measures.

3.13 SELF-ASSESSMENT QUESTIONS

1. Explain the meaning of cost reduction and cost control.
What are the objectives of cost reduction?
38
2. Discuss about the scope of cost reduction. What are the
major areas in which cost reduction is usually possible?
3. "Cost control does not necessarily aim at a reduction in
cost. Its object is more to ensure the maximum utility of
the costs incurred". Discuss to what extent you agree with
this statement.
4. Differentiate between cost reduction and cost control.
5. Describe the principles of cost reduction and control.
6. Narrate the different techniques of controlling and
reducing costs.
7. Explain the concept of value analysis as a technique of
cost reduction.
8. Analyze the advantages that are derived by various
parties because of implementation of cost reduction in
business or industrial concerns.
9. State the difficulties which are generally encountered by
management in implementing cost reduction programme
in their organizations.
10. Write short notes on :
(a) Value Analysis;
(b) Budgetary Control; and
(c) Control Ratios.

3.14 FURTHER READING

Rao, V.S.P., "Cost Accounting",
Vrinda Publications (P) Ltd., Delhi.
 39

BLOCK - 2
OPERATING COSTING
PROCESS COSTING
RECONCILIATION OF COST
AND
FINANCIAL ACCOUNTS
This Block comprises three units.

UNIT -1 : CONCEPT OF OPERATING COSTING,

OPERATING CONSTING IN TRANSPORT
AND POWER HOUSE.

Structure
1.0 Objectives
1.1. Concept of Operating Costing
1.2. Transport Costing - Objectives
1.3. Composition of Costs
1.4. Collection of Costs
1.5. Ascertainment of Costs
1.6. Illustrations 1 to 5
1.7. Power House Costing-Main Heads of Expenditure
1.8. Power House Cost Sheet
1.9. Illustrations 1 to 2
1.10. Points to Rembmer
1.11. Key Words
1.12. Self-Assessment Questions
1.13. Further Readings

1.0 Objectives
After studying this unit, you should be able to :
• Explain the definition of Operating Costing.
• Describe the objectives of Transport Costing.
40
• Narrate the compositions of costs in Transport
Costing.
• Prepare Operating Cost sheet of Transport
Undertakings.
• Discuss the concept of Power House Costing.
• Prepare Power House Cost Sheet.

1.1 CONCEPT OF OPERATING COSTING

Operating cost means the cost of rendering a service.
The term "operating" indicates the cost procedure applied for
determining the cost per unit of service rendered. Opearting
costing is thus also known as service costing. Operating
costing is practised by those business and industries which
render service to consumers: for instance, transport services,
utility services like canteens, hospitals etc. and distribution
service like supply of electricity, gas etc.
According to Wheldon - operating costing is unit
costing as applied to the costing of services. The method of
ascertaining operating cost is quite simple and easy. The
expenses of providing a service during a particular period
are classified under suitable headings like fixed, semi-fixed
and variable expenses and then their total amount is divided
by the number of service units for the same period. This would
resultantly give the cost per unit of service.
Cost Unit : The selection of cost unit in operating costing
is complicated. This may be simple cost unit or composite
cost unit, the unit for example is per km, per bed, per mea etc.
In composite cost unit, more than one unit would be combined
as shown below:
Undertaking Cost unit
Passenger transport Per passenger km.
Goods transport Per quintal- km. Or
Per tonne-km.
Electricity Per Kilowatt - hour
Hospital Per patient bed or
Per patient day / week
Water Supply Per 1,000 gallons
Canteen Per meal
 41

Cinema / Theatre Per man show

Gas works Per 1,000 cubic feet produced
Boiler House Per thousand Kg. of steam

1.2 TRANSPORT COSTING - OBJECTIVES

Transport services are performed by roadways,
railways, goods carriers, steamers etc. Such business concerns
use operating costing in order to find out the total cost of each
vehicle and then applying it to the unit cost. The cost
information helps in charging for the services against
departments and customers. It also aids in comparing among
the vehicles and then applying it to the cost unit.
It further helps in making comparison of alternative
modes of transport. Of course, the service rendered by the
transport carrier depends upon:
(a) the scientific routing of vehicles,
(b) the use of vehicles of proper type and capacity,
(c) the supervision of the time taken for journeys of
known mileage, and
(d) the possibility of return loads so as to minimize
empty return journeys.

OBJECTIVES
The objectives of transport costing are :
1. Controlling the operating and running costs and
avoiding wastage of all types.
2. Quoting hire charges for clients who require the transport
service.
3. Making comparison of the cost of running a vehicle with
similar vehicles.
4. Ascertaining the cost of services rendered to other
departments.
5. Calculating the cost of idle vehicles.

1.3. COMPOSITION OF COSTS

The total costs in respect of transport costing may be
divided into the following three heads:
42
1. Standing or Fixed charges : Standing charges have
to be incurred whether the vehicle operates or not. These are
more or less fixed in nature. The vehicle may be idle, but even
then its expenses have to be incurred. The following are the
examples of these expenses:
(i) License fees
(ii) Road tax
(iii) Insurance premium
(iv) Garage rent
(v) Apportionment of supervision cost
(vi) Interest on capital
(vii) Depreciation (if based on time)
2.. Operating and Running Cost : The expenses which are
incurred on the actual running of the vehicles, are
called operating and running cost. These expenses
vary from time to time and even come to zero when
the vehicles are off the road. These are variable in
nature. The following are the examples of these
expenses:
(i) Petrol and fuel
(ii) Oil
(iii) Grease
(iv) Wages of driver, conductor, attendant
(v) Depreciation (if allocated on the basis of
mileage run)
3. Maintenance charges : These expenses are incurred on the
repairs and maintenance of vehicles. These are
semi-variable in nature and the examples thereof
are :
(i) Wear and tear of tyres
(ii) Repairs and renewals
(iii) Tyres and tubes
(iv) Garage expenses
(v) Overhaul
(vi) Cleaning
(vii) Painting
(viii) Hire of spare vehicles when the firm's own
vehicles are under repair.
 43

1.4 COLLECTION OF COSTS

The procedure followed for this purpose is almost like
Job or Contract Costing. Each vehicle is allotted a distinct
number and all the basic documents will have the assigned
number of respective vehicles. A separate Daily Log Sheet for
each vehicle is kept by the concerned driver. It records the
details regarding the operation of a vehicle during a given
period. For calculating the cost of services, it is necessary to
know the capital maintenance and running charges, Oil and
fuel used, trips made, time spent by employees at various
levels, delay etc. These data help management in improving
the operational efficiency, in respect of different vehicles under
its control.

1.5 ASCERTAINMENT OF COSTS

Total fixed costs, maintenance costs and running costs
are collected and allocated under the respective heads and
then divided by total units e.g. ton km. Or passengers carried,
to arrive at the per unit average cost. A specimen proforma of
cost sheet for ascertainment of costs is given here.
TRANSPORT COMPANY
Cost Sheet
For the month of ………..
Vehicle No. 7068 245 Total
Capacity (Quintals)
Expenses
A. Standing Charges :
Insurance
Rod Tax
Licence fees
General supervision
Interest on Capital
Total
Vehicle No. 7068 245 Total
Capacity (Quintals)
Expenses
44
B. Maintenance Charges:
Tyres and tubes
Garage rent
Repairs
Paintings
Overheauls
Total
C. Running Charges :
Petrol
Engine oil
Lubricating oil
Grease etc.
Depreciation (on mileage basis)
Total
Grand Total (A+B+C)
D. Quintals - kms. Run
E. Cost per Quintal - km.

1.6 ILLUSTRATIONS
Illustration - 1
From the following data relating to a tempo compute the cost per running
km.
Kms. Run (annual) --- 20,000
Kms. Run per litre --- 25
Estimated life in Kms. --- 1,20,000
Cost of vehicle --- Rs. 30,000
Road Licence (annual) --- Rs.1,000
Insurance (annual) --- Rs.800
Garage rent (annual) --- Rs.500
Supervision (annual) --- Rs.1,500
Driver's wages per hour --- Rs.5
Cost of petrol per litre --- Rs.2
Repairs and maintenance per km. --- Rs.1.50
Tyre allocation per km. --- Rs.0.75
 45
You are to charge interest on the cost of vehicle at 5%
per annum. The vehicle runs 25 kms. Per hour on an average.
Solution:
Statement of cost per running km.
A. Fixed cost (per annum) : Rs
Road license --- 1,000
Insurance --- 800
Garage Rent --- 500
Supervision --- 1,500
Interest @ 5% --- 1,500
Fixed costs per annum --- 5,300
Kms. Run per annum --- 20,000
Fixed cost per km. (A) --- 0.265
B. Variable cost per km. : Rs.
Driver's wages (Rs. 5 per hour for 25 kms.) --- 0.200
Cost of petrol per km. (2/25) --- 0.080
Repairs and maintenance --- 1.500
Tyre allocation --- 0.750
Depreciation (Rs.30,000/1,20,000 km) --- 0.250
Variable cost per km. (B) --- 2.780
Running cost per km. (A+B) --- 3.045
Illustration - 2
The Popular Transport Company provides the
following details in respect of a truck of 5 tonne capacity:
Cost of truck --- Rs. 90,000
Estimated life --- 10 years
Diesel, oil, grease --- Rs. 15 per trip each way
Repairs and maintenance --- Rs. 500 per month
Driver's wages --- Rs. 500 per month
Cleaner's wages --- Rs. 250 per month
Insurance --- Rs. 4,800 per year
Tax --- Rs. 2,400 per year
General supervision charges--- Rs. 4,800 per year
46
The truck carries goods to and from city covering a
distance of 50 kms. each way.
On outward trip freight is available to the extent of full
capacity and on return 20% of capacity.
Assuming that the truck runs on an average 25 days a
month, work out :
(a) Operating cost per tonne-km.
(b) Rate per tonne per trip that the company should
charge if a profit of 50% on freight is to be earned.
Solution :
Popular Transport Co.
Statement of operating costs per truck (Tonnes-kms. 7,500)
Costs
Per month Per tonne-km.
Rs. Rs. Rs.
Fixed costs :
Driver's wages --- 500
Cleaner's wages --- 250
Insurance --- 400
Taxes --- 200
General supervision --- 400
1,750 0,233
Variable running costs :
Diesel, oil, grease --- 750
Depreciation --- 750
Repairs & maintenance --- 500
2,000 0.267
(a) Operating Cost : --- 3,750 Re. 0.500
(b) Freight rate :
Cost per tonne-km. Re. 0.50
Profit per tonne-km. 0.50
Re.1.00
 47
Freight per trip-both ways 300 tonne-kms. @ Re.1.00--- Rs. 300
(Truck makes only one trip a day, tonne-kms. Covered
in a trip would be 7,500/25)

Working Notes:
1. Tonne-Kms. Per month
6 tonnes x 50 kms. X 25 days = 7,500 tonne-Kms.
5 tonnes on outward trip and one tonne on return trip
Outward trip tonne-Kms. 5 x 50 x 25 = 6,250
Inward trip tonne-Kms. 1 x 50 x 25 = 1,250
Total --- 7,500
2. It is assumed that the truck makes only one trip per day.
3. The scrapvalue of the truck is assumed to be nil. Hence
the total amount to be depreciated in a year is Rs.90,000/10 =
Rs.9,000
Illustration - 3
The Kaziranga Transport Company is running four
buses between two towns which are fifty Kilometers apart.
Seating capacity of each bus is 40 passengers.
The following particulars were obtained from their
books for a particular month of a year:
Rs.
Salaries of office and supervisory staff --- 20,000
Wages of drivers, conductors and clearners --- 30,000
Diesel oil and other oils --- 10,000
Repairs and Maintenance --- 3,000
Taxation, Insurance etc. --- 2,500
Depreciation (on Kms. Basis) --- 4,000
Interest and other charges --- 3,500
Actual passengers carried were 75% of the seating
capacity. All the four buses run 30 days in the month, each
bus made one round trip per day.
48
Prepare on Operating Cost Sheet for the month showing
the cost per passenger - km.
Solution : The Kaziranga Transport Co.
Operating Cost Sheet
For the moth of …………………
Rs.
A. Standing Charges :
Taxation, Insurance etc. --- 2,500
Interest and other charges --- 3,500
Total --- 6,000
B. Maintenance Charges :
Salaries of office and supervisory staff 20,000
Repairs and Maintenance 3,000
Total --- 23,000
C. Running Charges : Rs.
Diesel oil and other oils --- 10,000
Wages of drivers, conductors
and cleaners --- 30,000
Depreciation (on Kms. Basis) --- 4,000
Total --- 44,000
Operating Cost (A+B+C) --- 73,000

73,000
Cost per Passenger - Km = ------------------- = Re. 0.2027
3,60,000
Working Notes :
Passenger = No. of Trips per day x No. of days in a month x
percentage of capacity x Km. per tirp.
= 4 x 1 x 30 (75% of 40) x (50 x2)
= 4 x 1 x 30 x 30 x 100
= 3,60,000 passenger - Kms.
Illustration - 4
Sri A.K. Choudhury owns a fleet of taxis and the following
information is available from the records maintained by him :
 49
Number of each taxi --- 10
Cost of each taxi --- Rs. 3,00,000
Salary of manager --- Rs. 5,000 p.m.
Salary of accountant --- Rs. 3,000 p.m.
Salary of mechanic --- Rs. 2,000 p.m.
Salary of cleaner --- Rs. 1,000 p.m.
Garage rent --- Rs. 1,000 p.m.
Insurance Premium --- 5 % per annum
Annual tax --- Rs. 2,400 per taxi
Driver's salary --- Rs. 2,000 p.m. per taxi
Annual repair --- Rs. 2,000 per taxi.
Total life of a taxi is about 2,00,000 kms. A taxi runs in
all 3,000 km. in a month of which 30% it runs empty. Petrol
consumption is one litre for 10 km @ Rs. 50 per litre. Oil and
other sundries are Rs. 50 per 100 km. Calculate the cost of
running a taxi per km.
Solution :
Operating Cost Sheet for the period……………………
Per Km Rs.
Rs.
Rs.
Fixed cost per month (for 10 taxis)
Manager's salary --- 5,000
Accountant's salary --- 3,000
Salary of cleaner --- 1,000
Salary of mechanic --- 2,000
Garage Rent --- 1,000
Total Fixed Cost --- 12,000
Fixed cost per taxi (Rs. 12,000 ÷10) 1,200
Insurance premium (3,000,000 x 5/100 x ½) 1,250
Taxes (Rs. 2,400 ÷ 12) --- 200
Driver's salary --- 2,000
4,650
Fixed cost per taxi per km. (Rs. 4,650 ÷ 2,100) 2.20
Variable cost per km. :
(a) Depreciation (per effective km.)
[3,00,000 ÷ 2,00,000 x 70/100] 1.05
50
(b) Petrol per month [50/10 x 3,000] = Rs. 15,000
15,000
Per effective Km. = ----------------- = Rs. 7.14 7.14
2,100

2,000 1
(c) Repair (---------------- x -------- ) 0.08
2,100 12
(d) Oil and other sundries (1,500 ÷ 2,100) 0.71
Cost per km. per taxi --- 11.18
* Note : A taxi runs 30% empty and thus its effective run is
only 70%. All costs have been calculated taking into
consideration its effective km.

Illustration - 5

Prepare a Cost Sheet for the unit cost per passenger --- km for
a fleet of passenger buses run by a Transport Company from
the following figures extracted from its books :

5 passenger buses costing Rs. 50,000 : Rs. 1,20,000; Rs.

45,000; Rs. 55,000 and Rs. 80,00 respectively. Yearly
depreciation of vehicles 20A% of the cost.

Annual repair, maintenance and spare parts - 80% of

depreciation.

Wages of 10 drivers @ Rs. 100 each per month

Wages of 20 cleaners @ Rs. 50 each per month
Yearly rate of interest @ 4% on capital
Rent of six garages @ Rs. 50 each per month
Director's fees @ Rs. 400 per month
Office establishment @ Rs. 1,000 per month
Licence and taxes @ Rs. 1,000 every six months.
Relisation by sale of
old tyres and tubes @ Rs. 3,200 every six month
900 passengers were carried over 1,600 Kms. during the year.
 51
Solution :
Cost of buses = (Rs. 50,000 + 1,20,000 + 45,000 + 55,000 + 80,000)
= Rs. 3,50,000
Yearly depreciation (20% of cost) = Rs. 70,000
Yearly repairs (80% of depreciation) = Rs. 56,000
Operating Cost Sheet for the year……………………
Rs. Rs.
A. Standing Charges :
Wages of drivers (10 x 100 x 12) --- 12,000
Wages of cleaners (20 x 50 x12) --- 12,000
24,000
Interest (4% on Capital) --- 14,000
Director's fees (400 x 12) --- 4,800
Office Establishment (1,000 x 12) --- 12,000
Licence and Taxes (1,000 x 2) --- 2,000
Total 56,800

Rs.
B. Maintenance Charges :
Garage Rent (6 x 50 x 12) --- 3,600
Repairs, Spare parts etc. 56,000
Less : Sale proceeds of old tyres, tubes 6,400
49,600
53,200
C. Operating Charges :
Depreciation 70,000
D. Grand Total (A + B + C) --- 1,80,000
E. Passenger - Kms. carried (900 x 1,600) --- 14,40,000
F. Cost per Passenger - Km. (1,80,000 ÷ 14,40,000) 0.125

1.7 POWER HOUSES COSTING

Power houses also adopt operating costing. Their
objective is to ascertain the total cost and per unit cost of
52
generating steam or electricity for fixing departmental charges
and outside tariffs. The details of constituent elements of cost
are furnished by the cost office whereas technical data viz.,
steam pressure, meter-reading, evaporation, factory heating,
turbines, losses etc. are supplied by the engineering
department. But the important point is that costs need to be
built up and analysed are not only meant for cost finding, but
also equally important for controlling them. Standards of
expenditure should be established under each major head on
the basis of detailed studies.
The main heads of expenditure for an undertaking like
power house are as under :
(i) Water-cost of supply, purification and softening.
(ii) Fuel-coal or oil, including its cartage, handling and
storage.
(iii) Indirect materials - service materials, and small
tools.
(iv) Labour - wage of coal handlers, stockers and ash
removers.
(v) Overhead costs - rent, rates, depreciation, insurance
and interest on capital.
(vi) Supervision - Wages of foremen and salary of the
works manager.
(vii) Maintenance - furnace repairs, renewal of fire bars,
replacement of fire iron etc.

1.8 POWER HOUSE COST SHEET

Boiler House Cost Sheet
Month Total Consumption
Total Steam Produced Cost per Total
Particulars 1000 Ib. cost
1 2 3
A. Fixed Overheads :
Rent, Rates etc.
Depreciation of Plant
Depreciation of Building
Insurance
 53
1 2 3

B. Maintenance Charges :
Meters
Furnace
Service materials
Tools and accessories
C. Labour Charges :
Coal handlers
Ash removers
D. Fuel :
Fuel
Power
E. Water Charges :
Water purchased
Water softening
F. Supervision and other charges :
Engineers
Foremen
General labour
Cleaners
Total

1.9 ILLUSTRATIONS
Illustration - 1

From the following data pertaining to a certain year,

prepare an Operating Cost Sheet showing the cost of electricity
generated per Kwh. By the Popular Thermal Power Station :

Total units generated --- 10,00,000 Kwh.

Operating labour --- Rs. 50,000

Repairs and maintenance --- Rs. 50,000

Lubricants, spares and stores --- Rs. 40,000

Plant supervision --- Rs. 30,000

54
Administrative overheads --- Rs. 20,000
Coal consumed per Kwh. for the year 2.5 kg. @ Re0.05 per kg.
Charge depreciation @ 10% on capital cost of Rs. 2,00,000.
Solution : [Units generated :
Operating Cost Sheet 10,00,000 Kwh.]
Total Per Kwh.
Rs. Rs.
Fixed Expenses :
Plant supervision --- 30,000
Administrative overhead --- 20,000
50,000 0.05
Variable Expenses :
Operating labour --- 50,000 0.05
Repairs & maintenance --- 50,000 0.05
Lubricants, spares, stores --- 40,000 0.04
Coal consumed --- 0.05
Depreciation --- 0.02
Cost per Kwh. 0.26
Illustration - 2
The following cost data pertaining to a year have been
collected from the books of the Amrit Power Co. Ltd. Prepare
a Cost Sheet showing the cost of generation of power per unit
of Kwts.
Total units generated --- 15,00,000 Kwts.
Rs.
Capital cost --- 1,50,000
Operating labour --- 16,500
Plant supervision --- 5,250
Lubricant and supplies --- 10,500
Repairs and Maintenance --- 21,000
Administration overhead --- 9,000
 55
Coal consumed per Kwt. is 1.5 lbs and cost of coal
delivered to the Power Station is Rs. 33.06 per metric tonne.
Depreciation rate chargeable is 4% p.a. and interest on capital
is to be taken at 7%.
Solution : Power House Cost Sheet
Particulars Cost Per Kwts.
1 2 3
Fixed Charges : Rs. Rs Rs.
Plant supervision --- 5,250
Administration overhead --- 9,000
Interest @ 7% --- 10,500
24,750 0.0165
Variable costs :
1.5 lbs x 15,00,000 x 33.06
Coal : ------------------------------------------------------------ = 33,750 2.25
2205

Depreciation : (4% on Rs.1,50,000) 6,000 0.40

Operating Labour = 16,500 1.10
Lubricant supplies = 10,500 0.70
Repairs & Maintenance = 21,000
87,750 0.0585
Total --- 1,12,500 0.0750

1.10 POINTS TO REMEMBER

Operating costing refers to the cost procedure applied
for determining the cost per unit of service rendered by
transport services, utility services like hospitals, electricity,
Gas supply, canteens etc.
The objectives of transport costing are - controlling
operating and running costs, quoting hire charges for clients
seeking transport service, making comparison of the cost of
running a vehicle with similar other vehicles and ascertaining
the cost of services rendered to other departments.
56
A separate Daily Log Sheet for each vehicle is kept wherein
various details regarding the operation of a vehicle during a
specified period are recorded. Costs are collected on the basis
of the details of each vehicle as contained in the Daily Log
Sheet.
The main heads of expenditure for a power house are : water,
fuel, indirect materials, labour, overhead costs, supervision
and maintenance.

1.11 KEY WORDS

Cost Unit : It is a quantitative unit of product or service
in relation to which costs are ascertained. For
ascertainment of costs, they are expressed in
terms of physical measurement like number,
weight, volume, area, length or any other
convenient units.
Composite cost unit : When a single type unit does not serve
the desired purpose, composite units may be
used for cost measurement. For instance, in
transport costing-pasenger - miles or ton-miles
are better measures than only passengers or
tons.

1.12 SELF ASSESSMENT QUESTIONS

1. What is operating costing? To what industries is this
method applicable?
2. What is Operating Cost? Prepare a statement with
imaginary figures for working out the running cost per
kilometer of a taxi.
3. Explain the objectives of Transport Costing.
4. Discuss, in detail, the composition of costs in case of
transport costing.
5. How collection of costs is done in transport costing?
6. Prepare a proforma of Daily Log Sheet.
7. Explain what do you understand by cost unit and
composite cost unit.
 57
8. Prepare a Power House Cost Sheet with imaginary
figures.
9. A transport company is running two buses between two
places 100 km apart. Seating capacity of each bus is 50
passengers. The following information have been
obtained from their books for a month.
Rs.
Salary of supervisor and office staff --- 15,000
Wages of drivers, conductors and cleaners --- 30,000
Diesel, Oil etc. --- 20,000
Repairs and maintenance --- 4,000
Taxation and insurance --- 2,000
Depreciation --- 3,000
Interest and other charges --- 3,000
Actual passengers traveled were 80% of the capacity.
The buses ran on all the days. Each bus made a to and fro trip.
Find out the cost per passenger - Kilometer.
10. from the following data pertaining to a year, prepare a
Cost Sheet showing the cost of electricity generated per
unit of Kwh. by the Asom Valley Thermal Power Station.
Total Units generated --- 20,00,000 Kwts.
Plant supervision --- Rs. 30,000
Operating labour --- Rs.50,000
Lubricants, Spares and stores --- Rs. 40,000
Administration overheads --- Rs.20,000
Repairs and Maintenance --- Rs.50,000
Coal consumed per Kwh. for the year is 2.5 kg. @ Rs.4.00 per kg.
Depreciation charge @ 5% on Capital Cost of Rs.20,00,000.

1.14 FURTHER READINGS

Banerjee, B. "cost Accounting",
The World Press Private Ltd., Kolkata.
Lal Nigam, B.M. "Theory and Techniques of Cost Accounting",
& Himalaya Publishing House, Mumbai.
Sharma , G.L.,
58
BLOCK - 2
UNIT - 2 : PROCESS COSTING, INTER-PROCESS
PROFITS, BY-PRODUCT AND JOINT
PRODUCTS
Structure
2.0 Objectives
2.1 Process Costing : Introduction
2.2 Applicability of Process Costing.
2.3 Essential Characteristics of Process Costing.
2.4 Distinction between Job Costing and Process Costing.
2.5 General Principles of Process Costing.
2.6 Illustration - 1
2.7 Normal Process Loss
2.8 Illustration - 2
2.9 Abnormal Process Loss
2.10 Illustration - 3
2.11 Abnormal Gain / Effectiveness
2. 12 Illustration - 4
2. 13 Inter-Process Profits
2. 14 Illustration -5
2.15 By-Product and its accounting treatment.
2.16 Illustration - 6
2.17 Joint Products and their accounting treatment
2.18 Illustration - 7
2.19 Points to Remember
2.20 Key words
2.21 Self-Assessment Questions.
2.22 Further Readings.

2.0 Objectives
After studying this unit you should be able to :
• Define the meaning of Process Costing.
• State the features and applicability of Process
Costing.
 59
• Distinguish between Job Costing and Process
Costing.
• Explain the principles of Process Costing.
• Describe the normal wastage and abnormal wastage
and their accounting treatment.
• Identify the Inter-Process Profits, Joint Products and
By- Products and their accounting treatment.

2.1 PROCESS COSTING : INTRODUCTION

Process costing is a method of costing applied to
industries in which the material has to pass through two or
more processes before being converted into a finished
product. The different processes are in a sequential order so
that the output of the earlier stage becomes the input of the
succeeding stage, and then the out put of the final stage
becomes the finished product.
In such industries output consists of like units, each unit
being processed in the identical manner. Hence it is assumed
that the same amount of raw materials, labour and overhead is
chargeable to each unit that has been processed. The record of
units produced is known and costs are accumulated process-
wise. The cost of a unit at the end of a manufacturing process is
ascertained viz., dividing the total cost of a process by the number
of units produced in that process.

2.2 APPLICABILITY OF PROCESS COSTING

Process costing is applied in the following categories
of industries:
1. Manufacturing industries : Cement, iron and steel,
automobile plants, paper, rubber ceramics, ice, paints
industries etc.
2. Mining: Mineral oil, coal, iron, gold, sulphur, zinc, gas
etc.
3. Chemical industries : Oil, chemicals, medicines, soap,
perfumery etc.
4. Public Utility Works : Water supply, gas supply,
generation and distribution of electricity.

2.3 ESSENTIAL CHARACTERISTICS OF PROCESS

COSTING
The essential characteristics of process costing are as
follows:
60
1. The production is continuous and the end product is the
result of a sequence of processes.
2. The products are homogeneous and standardized.
3. The sequence of operation for processing the product is
specific and pre-determined.
4. The products are not distinguishable in processing stage.
5. The finished product of each but last process becomes
the raw material for the next process and that of the last
process is transferred to the stock of finished goods.
6. Some loss of materials in processes is unavoidable due
to evaporation, chemical action etc.
7. Costs are accumulated process-wise.
8. The cost per unit produced is the average cost and is
calculated by dividing the total process cost by the
number of units produced.

2.4 DISTINCTION BETWEEN JOB COSTING AND

PROCES COSTING
The main points of difference between job costing and
process costing are as under:
Job Costing Process Costing
1. Production is against specific 1. Production is continuous and the
orders. products are homogeneous.
2. Each job is separate and 2. Since production is continuous,
independent of others. products lose their individual
3. Costs for each job are determined identity.
separately 3. Costs are compiled for each
4. Job may or may not have opening process for a period.
or closing work in progress. 4. Since production is continuous,
5. Costs are completed when a job there is always work in progress.
is completed. 5. Costs are claculated at the end of
6. There are usually no transfers the cost period.
from one job to another unless 6. Transfer of costs from one process
there is excess production to another is made, as the product
7. Each job is dissimilar as moves from one process to another.
production is against specific 7. Since the production process is
individual orders. standardised, products are uniform
8. Cost control is more or less and similar.
difficult as each product unit is 8. Cost control is comparatively easier,
different and the production is not as the production is standardised
continuous. and is more stable.
 61

2.5 GENERAL PRINCIPLES OF PROCESS COSTING

The general principles followed in cost determination
under process costing are stated as follows :
1. In process costing, a separate account is kept for each
process. The account is debited with the value of
materials, labour and overheads relating to the process.
2. Direct and indirect costs are accumulated by process or
departments at regular intervals. For this purpose,
sometimes Process Cost Sheets are used for cost
computation.
3. The quantity or physical units of output in each process
or departments are recorded in the respective process
accounts.
4. The total cost of each process is divided by the total
volume of production at the end of each period and
consequently the cost per unit of output is determined.
5. The cost of one process is transferred to the next process
and charged at an initial cost. The cumulative costs of
different departments determine the ultimate total cost
and cost per unit of output at the final stage.
6. If there is work in process at the end of a period, the stage
of completion of the incomplete work is determined, and
the ascertainment of inventory is made in terms of
completed units e.g., if twenty units are one half
complete, they are taken as equivalent to 10 completed
units. The total cost is then divided by the total number
of units and the unit cost obtained for the process.
7. In case of loss or spoilage in any process the units
produced in the process bear the loss and the average
cost per unit of that department is increased.

2.6 ILLUSTRATION - 1
A product passes through three distinct processes to
completion. These processes are numbered respectively as I,
II and III. During the week ended 15th January, 500 units are
produced. The following information have been obtained:
62
Process I Process II Process III
Rs. Rs. Rs.
Materials 3,000 1,500 1,000
Labour 2,500 2,000 2,500
Direct Expenses 500 100 500
The indirect expenses for the period were Rs.1,400
apportinoed to the processes on the basis of wages.
No work-in-progress or process stocks existed at the
beginning or at the end of the week.
Assuming that an order for 100 units included in the
output for the week, also prepare the appropriate Production
Order.
Solution: Process - I Account
Week ended 15th Jan. (output : 500 units)
Cost Total Cost Total
Particulars per cost Particulars per cost
unit unit
Rs. Rs. Rs. Rs.
To materials 6 3,000 By Process - II A/c 13 6,500
To labour 5 2,500 (out put
To Direct Expenses 1 500 transferred)
To Indirect Expenses 1 500
(25 / 70 x Rs. 1,400)
13 6,500 13 6,500
Process - II Account
Cost Total Cost Total
Particulars per unit cost Particulars per unit cost
Rs. Rs. Rs. Rs.
To Process - I A/c 13.00 6,500 By Process-III A/c
To Materials 3.00 1,500 (output transferred) 21.00 10,500
To Labour 4.00 2,000
To Direct Expenses 0.20 100
To Indirect Expenses 0.80 400
(20/70 x Rs.1,400)
21.00 10,500 21.00 10,500
 63
Process - III Account
Cost Total Cost Total
Particulars per cost Particulars per cost
unit unit
Rs. Rs. Rs. Rs.
To Process -II A/c 21.00 10,500 By Finished Stock
To Materials 2.00 1,000 A/c 30.00 15,000
To Labour 5.00 2,500 (output
To Direct Expenses 1.00 500 transferred)
To Indirect Expenses 1.00 500
(25/70 x Rs.1,400)
30.00 15,000 30.00 15,000

Production Order for 100 units

Process - I Process - II Pricess - III Total
Cost Total Cost Total Cost Total Cost Total
Particulars Per Cost Per Cost Per Cost Per Cost
Unit Unit Unit Unit
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
To Materials 6.00 600 3.00 300 2.00 200 11.00 1,100
To Labour 5.00 500 4.00 400 5.00 500 14.00 1,400
To Direct 1.00 100 0.20 20 1.00 100 2.80 280
Expenses
To Indirect 1.00 100 0.80 80 1.00 100 2.80 280
Expenses
Total Cost 13.00 1,300 8.00 800 9.00 900 30.00 3,000

2.7 NORMAL PROCESS LOSS

It is the loss which is unavoidable on account of inherent
nature of material. This is called normal loss. Such loss can be
estimated in advance on the basis of past experience or chemical
data. The percentage of such losses is also anticipated from past
experience. Normal loss should be absorbed by good units
arising out of the process. In this manner, the cost of spoiled or
lost units is absorbed as an additional cost of good units
produced in the process. Normal process losses may included
scrap and / or waste. Where scrap possesses some value as a
waste product, the value thereof is credited to the Process
Account. This resultantly reduces the cost of normal process loss
shared by usable good units.
64

2.8 ILLUSTRATION - 2
The following information is extracted from the Cost
Accounts of a Factory producing a commodity in the
manufacture of which three processes are involved. Prepare
Process Cost Accounts showing the cost of the output and the
cost per unit at each stage of manufacture.
(a) The operations in each separate process are completed
daily.
(b) The value at which units are to be charged to Processes
B and C is the cost per unit of Processes A, A plus B
respectively.
Processes
A B C
Rs. Rs. Rs.
Direct Wages --- 640 1,200 2,025
Machine Expenses --- 360 300 360
Factory Overhead --- 200 225 240
Raw Materials consumed --- 2,400
Units Units Units
Production (Gross) 37,000
Wastage --- 1,000 1,500 500
Opening Stock --- --- 4,000 16,500
Closing Stock --- --- 1,000 5,500
Solution :
Process A Account
Particulars Units Rs. Particulars Units Rs.

To Direct Materials 37,000 2,400 By Normal 1,000 -

To Direct Wages 640 Wastage

To Machine Expenses 360 By Process B A/c 36,000 3,600

Factory Overhead 200 (Re 0.10 per unit)

37,000 3,600 37,000 3,600

 65
Process B Account
Particulars Units Rs. Particulars Units Rs.
To Opening Stock* 4,000 400 By Normal 1,500 -
(@ Re.0.10 per unit) Wastage
To Process A A/c Closing Stock 1,000 100
(output received) 36,000 3,600 (Re. 0.10 per unit)
To Direct Wages 1,200
To Machine Expenses 300 By Process C A/c 37,500 5,625
(output transferred)
To Factory Overhead 225 @ Re.0.15 cost
per unit)
40,000 5,725 40,000 5,725
Process C Account
Particulars Units Rs. Particulars Units Rs.
To Opening Stock* 16,500 2,475 By Normal 500 -
(@ Re.0.15 per unit) Wastage*
To Process A A/c Closing Stock
(output received) 36,000 3,600 (Re. 0.10 per unit) 5,500 825
To Direct Wages 2,925
To Machine Expenses 360 By Finished Stock 48,100 10,000
(Final output)
To Factory Overhead 240 (@ Re.0.225 cost
per unit)
54,000 11,625 54,000 10,825
* Opening stock and closing stocks consists of raw materials. Therefore
these are valued at the same rate at which output from the preceding
process has bee obtained.

2.9 ABNORMAL PROCESS LOSS

Loss caused bys abonormal or unexpected conditions like
accident, carelessness, substandard materials etc. or loss in excess
of the anticipated normal process loss is regarded as abnormal
process loss. Abnormal loss should not afect the normal cost of
production. So, abnormal loss is valued like good units and
tranferred to a separate account called Abnormal Loss Account.
66
The valuation of abnormal loss should be done with the help of
the following formula:
Total Cost - Scrap Realized
------------------------------------------------------------------- x No. of Abnormal Units.
Normal Production
In this way, these losses are segregated from process costs
and investigated in order to prevent such occurence in future.
The cost of abnormal spoilage is transferred from the process
account to the Abnormal Loss Account. A separate account is
kept for abnormal losses to which the cost of material, labour
and overhead incurred by the wastage is debited; the
corresponding credit being given to the process account in which
such loss occurs. The abnormal loss account is closed by writing
it off to the Costing Profit and Loss Account. In case, abnormal
loss is treated as production cost, the cost of production and
hence of the products would fluctuate from time to time and
would provide a misleading picture to management.

2.10 ILLUSTRATION - 3
In the manufacture of the product "A" 1,000 kgs. of material
at Rs.7 per kg. was supplied to the first process. Labour cost
amounted to Rs.3,000 and production overhead was Rs.1,000.
The normal loss has been estimated at 10% which could be sold
at Rs.4 per kg. The actual production of the process was 800 kgs.
Prepare Process - I Account.
Solution :
Process - I, Account
Particulars Qty. Per Amount Particulars Qty. Per Amount
kg kg kg kg.
Rs. Rs. Rs. Rs.
Direct Materials 1,000 7 7,000 100 4 400
Direct Labour 3,000 Transferred to
Process II 800 11.73 9427
Production 1,000 Abnormal Loss 100 11.73 1,173
Ovehead

1,000 11,000 1,000 11,000

 67
Working :
1. Abnormal Loss is calculated as follows:
Normal Production : Abnormal Loss : Kg.
Quantity : 900 Kgs. Normal Production 900
Cost : Rs. 10,600 Actual Production 800
Actual Production : Abnormal loss 100
Quantity = 800 kg 10,600
Cost = ( ----------------------x 100 )
900
10,600 = Rs. 1,173
Cost = ( -------------------- x 800)
900
= Rs. 9,427

2.11. ABNORMAL GAIN OR EFFECTIVENESS

If the actual process loss or wastage is less than the
determined percentage of normal loss or wastage, the difference
is called abnormal gain or effetiveness.
Like abnormal loss, abnormal gain also should not affect
the cost of normal production. The abnormal gain is valued in
the same manner as abnormal loss and credited to Abnormal
Gain Account.

2.12. ILLUSTRATION - 1
In Process B, 100 units of a commodity were transferred
from Process-A at a cost of Rs. 1,500. The additional expenses
incurred by the process were Rs. 200. 20% of the units entered
are normally loss and sold at Rs.5 each. The output of the process
was 90 units.
Prepare Process - B Account.
Solution :
Process B Account
Particulars Units Amount Rs. Particulars Units Amount Rs.
To Process A A/c 100 1,500 By Normal Loss 20 100
(20 units sold
@ Rs.5)
To Additional * 200 By Process-C A/c 90 1,800
Expenses (output)
To Abnormal gain A/C 10 * 200 Cost per unit :
100 1,900 100 1,900
68
* Normal output : Units entered - Normal Loss.
= (100 - 200)
= 80 units
Actual output = 90 units
Abnormal gain = 10 units.
Valuation of Abnormal Gain :
Normal Cost of Normal output
= ------------------------------------------------- x Units of Abnormal Gain
Normal output
1,600
= ---------------------- x 10
80
= Rs. 200
Abnormal Gain Account
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Normal Loss A/c 10 50 By Process B A/c 10 200
(Loss of income)
To costing Profit & 150
Loss-A/C 10 200 10 200

2.13. INTER-PROCESS PROFITS

In case of some process industries, the output of one
process is transferred to the next process not at cost but at market
value or plus a percentage of profit. The excess of transfer price
over cost is known as inter-process profit. The purpose of this
practice is : (i) to show whether cost of production competes with
market prices, (ii) to show whether cost of production competes
with market prices, (ii) to make each process stand on its own
efficiency and economies, i.e., the tranferor process receives the
benefit of economies effected by it. The limitation of this practice
about this profit included in closing stock of every process. Since
the goods are not sold, this profit is unrealized. Therefore it
becomes necessary to find out the profit (unrealised) included
in closing stock of processes and in the finished stock.
For computing the profit element i closing inventoris and
to get the net relised profit for a period, there columns, have
 69
been shown on each side of process accounts. Closing stock hs
been deducted from the debit side of process accounts instead
of showing it on the credit side. Cost of closing stock can be easily
obtained by comparing the accumulated cost and total in any
process. The cost of stock can be found by the following formula:
Cost column
( = --------------------------- x Stock )
Total column
The profit on closing stock can then be obtained by
deducting the cost of stock thus ascertained from the value of
stock.
Accounting Adjustments for Inter-Process Profit
For the units sold, the Prift & Loss Account absorbs the
difference between the cost and sales value and hence there is
no problem. But the problem arises in respect of stock unsold
which contains an element of unrealised profit. Therefore,
necessary adjustments are made in the value of closing stock by
means of a provision of reserve.

2.14 ILLUSTRATION - 5
A product passes through there distinct processes before
it is completed. The out put of each process is charged to the
next process at a price calculated to give a profit of 20% on
transfer price. The output pf Process III is charged to the finished
stock account on a similar basis. There was no work-in-progress
at the beginning of the year and overheads have been ignored.
Stocks in each process have been valued at the price cost of the
process. The following data have been obtained at the end of
31st December, 2005.
Process I Process - II Process - III Finished Stock
Rs. Rs. Rs. Rs.
Direct Materials 4,000 6,000 2,000 -
Direct Wages 6,000 4,000 8,000
Stock (31.12.05) 2,000 4,000 6,000
Sales during 2005 - - - -
70
From the above information prepare :
(a) Process Cost Accounts showing the profit element at
each stage;
(b) Actual realised profit ; and
(c) Stock valuation as would appear in the Balance Sheet.
Solution :
Process - I Account
Particulars Total Cost Profit Particulars Total Cost Profit
Rs. Rs. Rs. Rs. Rs. Rs.
Material Wages 4,000 4,000 - Process - II A/C 10,000 8,000 2,000
wages 6,000 6,000 (Transfer)
Total 10,000 10,000 -
Less : Closing
Stock c/d. 2,000 2*,000 -
Prime Cost 8,000 8,000
Gross Profit
(25% on cost) 2,000 - 2,000
10,000 8,000 2,000 10,000 8,000 2,000

10,000 x 2,000
( ------------------------------------------ = Rs. *2,000)
10,000
Process - II Account
Particulars Total Cost Profit Particulars Total Cost Profit
Rs. Rs. Rs. Rs. Rs. Rs.
Process - I A/c 10,000 8,000 2,000 Process - III A/C 20,000 14,400 5,600
(Transfer) (Transfer)
Material 6,000 6,000 -
wages 4,000 4,000
Total 20,000 18,000 2,000
Less : Closing
Stock c/d. 4,000 3*,600 400
Prime Cost 16,000 14,400 1,600
Gross Profit
(25% on cost) 4,000 - 4,000
20,000 14,400 5,600 20,000 14,400 5,600

18,000 x 14,400
( --------------------------------------- = Rs. *3,600)
20,000
 71
Process - III Account
Particulars Total Cost Profit Particulars Total Cost Profit
Rs. Rs. Rs. Rs. Rs. Rs.
Process - II A/c 20,000 14,000 5,600 Finished stock A/C 30,000 19,520 10,480
(Transfer) (Transfer)
Material 2,000 2,000 -
wages 8,000 8,000
Total 30,000 24,400 5,600
Less : Closing
Stock c/d. 6,000 4,880 1,120
Prime Cost 24,000 19,520 4,480
Gross Profit
(25% on cost) 6,000 - 6,000
30,000 19,520 10,480 30,000 19,520 10,480

Finished Stock Account

Particulars Total Cost Profit Particulars Total Cost Profit
Rs. Rs. Rs. Rs. Rs. Rs.
Process - III A/c 30,000 19,520 10,480 Sales 36,000 17,568 18,432
(Transfer)
Less : Closing
Stock A/c. 3,000 *1,952 1,048
27,000 17,568 9,432
Gross Profit 9,000 -- 9,000
36,000 17,568 18,432 36,000 17,568 18,432

19,520 x 3,000 *
( --------------------------------------------= Rs. 1,952)
30,000
(b) Calculation of Actual realised profit :
Particulars Apparent Profit Unrealized Profit Actual Profit
of Process in closing stock
Rs. Rs. Rs.
Process - I 2,000 --- 2,000
Process - II 4,000 400 3,600
Process - III 6,000 1,120 4,880
Finished stock 9,000 1,048 7,952
Total 21,000 2,568 18,432
72
(c) Stock Valuation for Balance Check :
Sheet Purpose : Total cost incurred in Rs.
Cost of closing stock all Processes ---- 30,000
Rs.
Process - I --- 2,000 Less : Cost of goods sold 17,568
Process - II -- 3,600 Cost of closing stock 12,432
Process - III --- 4880
Finished stock --- 1,952
Total --- 12,432

2.15 BY-PRODUCT AND ITS ACCOUNTING TREATMENT

In some industries, the production of the main product is
accompanised by production of one or more secondary products.
for instance, production of sugar is accompanied by bagasse and
molasses. Similarly, in oil refinery, processing of crude petroleum
yields not only refined oil i.e., the main product, but also some minor
products like sulphur, bitumen, chemical, fertilizers etc. These minor,
or secondary products are known as "By-products". As such, by
product are products of comparatively small value that are produced
incidental to then main product.

Valuation of By-product
By-products are produced jointly with other major products
and remain inseparable upto the point of split-off. Accordingly, the
processing costs upto the split-off point relate to the main product as
well as the by-product . Therefore, complicacy arises in the valuation
of by-product at the point of split-off.
Valuation of by-products is based on two important
considerations:
(i) A by-product is relatively less important than the joint
products.
(ii) It has a faily steady market value.
The methods used for valuing by-products may be
categorised under :
(i) Non-cost Methods or Sales Value Methods
(ii) Cost Methods.
 73
Non-cost-Methods or Sales Value Methods :
Only the sales value of the by-product is taken into
account unde these methods. Therefore, these are known as non-
cost methods. The non-cost methods are :
(a) Other income method.
(b) Crediting sales value to total cost.
(c) Crediting sales value less selling and distribution
expenses.
(d) Crediting sales value less the cost incurred on by-
product after split-off.
(e) Crediting sales valueless profit or reverse cost
method.
Cost - Methods :
Under these methods, attempts are made to approtion the
joint costs incurred upt the split-off point to the by-products as
fairly and accurately as possibe. The cost methods are :
(a) Opportunity or replacement cost method.
(b) Standard cost method
(c) Joint cost method or Apportionment on a suitable
basis.

2.16 ILLUSTRATION - 6
In manufacturing the main product, a company processes
the incidental waste into two by-products A and B. From the
following data relating to the Products, you are required to
prepare a comparative profit and loss statement showing the
individual costs and other details. The total costs up to separation
period was Rs. 3,10,400.
Main By-product By-product
Product A B
Rs. Rs. Rs.
Sales -- 8,00,000 64,000 96,000
Costs after separation 80,000 12,800 14,400
Estimated Net Profit
Percentage to sales value -- 20% 20%
Estimated selling
expenses as percentage
of sales value 20% 20% 20%
74
Reverse cost method should be followed for separation of joint
costs.

Solution
Comparative Profit & Loss Statement
Main By-product By-product
Product A B
Rs. Rs. Rs.
Joint cost upto separation point 3,10,400 * **
* **
Less : Cost allocated to By products 80,000 32,000 48,000
2,30,400
Cost after separation 80,000 12,800 14,400
Selling Expenses 1,60,000 6,400 14,400
Total Cost --- 4,70,400 51,200 76,800
Net Profit --- 3,29,600 12,800 19,200
Sales --- 8,00,000 64,000 96,000

Cost allocated to By-products calculated as under

A B Total
Rs. Rs. Rs.
Sales --- 64,000 96,000
Less : Estimated
Net profit --- 12,800 19,200
Estimated
selling
Expenses 6,400 14,400
Cost after
Separation 12,800 32,000 14,400 48,000
Cost before Separation * 32,000 ** 48,000 80,000

2.17. JOINT PRODUCTS AND THEIR ACCOUNTING

TREATMENT
Meaning
In some industries, two or more products of equal
importance are simultaneously produced. These products are
 75
regarded as joint products. As such, "joint products represent
two or more products separated in the course of same processing
operations usually requiring further processing, each product
being in such proportion that no single product can be designated
as a major product." Joint products have the following
characterstics:
1. They are produced from the same basic raw materials.
2. They are produced simulataneously by a common
process.
3. They are comparatively of equal importance.
4. They may require further processing after the point
of separation.
For instance, in an oil industry - gasoline, fuel oil,
lubricants, coal tar, asphalt and Kerosene are all produced from
crude petroleum. All of these are joint products.
Accounting for Joint Product
The joint costs should be properly and reasonably
apportioned to various joint products. Otherwise the costs of
joint products will vary considerably. Consequently this will
affect.
(a) Valuation of closing inventory,
(b) Pricing of products and
(c) Profit or loss on sale of various products.
Even through there are no scientific methods of
apportionment of joint costs, the following methods are widely
used in apportioning total process costs upto the point of
separation.
1. Average Unit Cost Method : This is by far the most simple
method. The total costs are assessed, yielding an average unit
cost with one net profit for the entire operation. The total process
costs upto the point of split-off are divided by the total units or
weight produced to arrive at the average cost per unit of
production. The process losses are borne by the joint products
in the ratio of their output units / weight. This method can be
used where the joint products can be measured in terms of
common unit viz., Kg., litre, gallon, lb. etc. Where the end
products can not be expressed in common unit, this method is
not applicable.
76
Illustration
From the following information, find out the cost of joint
products, A, B and C under Average Unit Cost Method.
(a) Pre-separation point costs -- Rs. 40,000
(b) Other production data :
Product Units produced Raw materials used
(Units)
A 1,000 8,000
B 600 4,000
C 400 8,000
Total 2,000 20,000
Solution
40,000
Cost per unit = ---------------------- = Rs. 20
2,000
Cost of Production
Produts Units produced Cost per unit Total
Rs. Rs.
A 1,000 20 20,000
B 600 20 12,000
C 400 20 8,000
Total 2,000 40,000
2. Physical Unit Method : A physical base viz., raw materials, is
the proportion used to apportion pre-separation point costs to
joint products. The physical volume of materials found in joint
products at the point of separation is found out and on that basis
the cost is apportioned. Process loss is borne by joint products
in the ratio of their output-weight. This method can be applied
when physical units of output are similar or identical. This
method may not be useful where costs hae no relationship to the
output-weight of individual products.
Illustration:
An oil processing company produces two main products
A and B . During the month of February of a particular year the
company produced. A 2,000 gallons and produced B 1,000
gallons. The joint cost upto split-off point was Rs. 1,000. Apportion
the joint cost by using relative weight of output method.
 77
Solution
Split-off point cost Rs. 1,000 for 3,000 gallons. Therefore,
the product cost on the physical quantity basis comes to Rs. 0.33
per gallon. Cost are assigned as follows:
Production Weighting Cost Assigned

A. 2,000 gallons 2,000 Rs. 660

-----------x 1,000
3,000
B. 1,000 gallons 1,000 Rs. 340
----------- x 1,000
3,000 Rs.1,000
3. Survey Method : Under the method, all important factors viz.,
volume, selling price, marketing process, technical aspects etc.
affecting costs are ascertained by means of an extensive survey.
Percentages or point values are given to individual products as
per their relative importance and cost are aportioned on the basis
of total points. These ratios should be revised from time to time
depending upon the factors affecting production and sales.
4. Market Value Method : This is very popular method because
it makes use of a realistic basis for apportioning joint costs.
Products are made to bear a proportion of the joint cost on the
basis of their ability to absorb the same. Under this method, joint
costs are apportioned after ascertaining "What the traffic can
bear". Market value represents the weighted market value i.e.,
units produced multiplied by the price of a unit of joint product.

2.18 ILLUSTRATION - 7
From the following information, ascertain the profit made
by each product, apportioning the joint costs on a sales value basis:
A B
Rs. Rs.
Sales --- 76,000 84,000
Selling costs --- 10,000 40,000
Materials Rs. 62,400
Process costs Rs. 27,600
78
Solution
Joint costs be apportioned:
Rs. 62,400 + Rs.27,600 = Rs. 90,000
Product Product
A B
Rs. Rs.
Sales --- 76,000 84,000
Selling costs --- 10,000 40,000
Effective sales value 66,000 44,000
Joint cost apportionment
(ratio 3 : 2 ) 54,000 36,000
Profit 12,000 8,000

2.19. POINTS TO REMBMER

Process costing is a method of costing applied to
industries in which the material has to pass through two or more
processes before being converted into a finised product. The
different processes are in a sequential order so that the output of
the earlier stage becomes the input of succeeding stage, and then
the output of the final stage becomes the finished product.
Process costing is applied in manufacturing industries like
cement, paper, rubber; chemical industries like oil, chemicals,
mining industries viz., mineral oil, coal, iron; and public utility
works like water supply, gas supply, generation and distribution
of electricity.
In case of some industries, the output of one process is
transferred to the next process not at cost but at market value or
plus a percentage of profit. The excess of transfer price over cost
is known as inter-process profit. The purpose of this practice is
to : (i) show whether cost of production competes with market
prices, and (ii) make each process stand on its own efficiency
and economy.
The methods used for valuing by-products may be
categorised as :
 79
(i) Non-cost methods or Sales Value Methods.
(ii) Cost Methods.
The methods used for apportionment of joint costs in case
of joint products are :
(i) Average Unit Cost Method
(ii) Physical Unit Method.
(iii) Survey Method
(iv) Market Value Method
Abnormal Loss is ascertained as :

Normal Cost of Normal Output

---------------------------------------------------------------x Abnormal loss (units)
Normal Output (units)
Abnormal Gain is calculated as :

Abnormal Cost of Normal Output

-------------------------------------------------------------- x Abnormal Gain (units)
Normal Output (units)

2.20 KEY WORDS

Normal Process Loss : It is the loss which is unavoidable on
account of inherent nature of material or
due to other technical reasons.
Abnormal Process Loss : Loss caused by abnormal or unexpected
conditions like accident, carelessness,
substandard materials etc. or loss in excess
of the anticipated normal process loss is
regarded as abnormal process Loss.
Abnormal Gain : If the actual process loss or wastage is less
than the determined percentage of normal
loss or wastage, the difference is called
abnormal gain or effectiveness.
Scrap : It is the descarded material which has
some recovery value and which is usually
either disposed of without further
treatment (other than reclamation and
handling), or reintroduced into the
production process in place of raw
material.
80
By-product : In some industries, the production of the
main product is accompanised by
production of one or more secondary
products. These minor or secondary
products are known as "By-products". By -
products are products of comparatively
small value that are produced incidental
to the main product.
Joint product : Joint products represent two or more
products separated in the course of same
processing operations usually requiring
further processing, each product being in
such proportion that no single product can
be designated as a major product.

2.21. SELF ASSESSMENT QUESTIONS

1. Describe the characteristics of Process Costing. Name eight
industries where Process Costing can be applied.
2. Explain the factors which should be considered by a cost
accountant in deciding whether to apply a process or job
costing system. In what type of industries is process costing
generally applied?
3. Narate the points of distinction between job costing and
process costing.
4. What do you understand by normal wastage and abnormal
wastage of materials during the manufacturing process?
Stage how each of these two are treated in cost accounts.
5. How will you deal with the following in cost accounts?
(a) Normal wastage, (b) Abnormal wastage,
(c) Abnormal effectiveness.
6. What do you understand by joint products? Discuss, in
brief, the methods which may be applied in the costing of
joint-products.
7. Distinguish between joint product and by-product with
reference to the :
(a) Method of accounting and
(b) Method of valuation.
 81
8. What is a by-product? Explain how would you suggest for
accounting for by-product?
9. What is inter-process profit? Explain how would you
compute the reserve for unrealised profits.
10. Explain the distinctive features of by-product and joint
product.
Normal and Abnormal Losses and Abnormal Gains:
11. A product passes through three processes - A, B and C .
The normal wastage of each process is as follows:
Process A - 3% B-5% C-8%
Wastage of Process A was sold at Rs. 0.35 per unit, that of
B at Re.0.50 per unit and that of C at Re.1 per unit. 10,000 units
were introduced to Process A at Re.1 per unit. The other expenses
were as follows:
Process
A B C
Rs. Rs. Rs.
Sundry Materials 1,000 1,500 500
Labour 5,000 8,000 6,500
Direct Expenses 1,000 1,100 2,000
Actual output 9,500 units 9,100 units 8,100 units
(in units)
Prepare Process Accounts, assuming that there were no
opening or closing stocks.
Inter-Process Profit :
12. From the following information of a Manufacturing Company
which manufactures a product, you are required to prepare
Process Accounts.
Process A Process B Process C
Rs. Rs. Rs.
Material 30,000 7,500 7,500
Direct wages 22,500 15,000 15,000
Closing stock 7,500 8,750 21,300
82
Finished goods sold for Rs. 1,30,000 value of closing stock
of finished goods Rs. 5,612. It is the policy of the company to
charge 20% on tranfer price (25% of cost price) while transferring
goods from Process-A to B and 20% on cost price from B to C
and from C to the finished stock.

Joint Product

13. From the following information, ascertain the profit made

by each product, apportioning joint costs on a sales value
basis:
Product
A B
Rs. Rs.
Sales --- 4,00,000 6,00,000
Selling costs --- 50,000 2,00,000
Joint costs:
Materials Rs.3,00,000
Process costs Rs.1,00,000

By-Product:

14. The product A yields by-products B and C. The joint expenses

of manufacture are :

Materials Rs. 5,000; Labour Rs.4,000;

Overhead Rs.4,500; the subsequent expenses are as

follows:
A B C
Rs. Rs. Rs.
Materials 1,000 800 900
Labour 1,200 700 850
Overhead 1,300 500 750
3,500 2,000 2,500
Selling Price 21,000 10,000 9,000
Profit on sales 50% 50% 331/3%
 83
Show how would you apportion the joint expenses of
manufacture and prepare the necessary cost accounts.

2.22. FURTHER READINGS

Arora, M.N. "Cost Accounting"
Vikash Publishing House Pvt. Ltd.
Lall Nigam, B.M. "Theory and Techniques of Cost Accounting",
& Himalaya Publishing House, Mumbai
Sharma, G.L.
84

BLOCK - 2
UNIT - 3 RECONCILIATION OF COST AND
FINANCIAL ACCOUNTS

Structure :
3.0 Objectives
3.1 Introduction
3.2 Objectives of Reconciliation.
3.3 Need for Reconciliation.
3.4 Reasons for Disagreement between cost accounts and
financial accounts.
3.5 Differing treatment of items.
3.6 Effect of various items on profit.
3.7 Procedure of Reconciliation.
3.8 Illustrations - 1 to 5
3.9 Points to Remember.
3.10 Key Words.
3.11 Self-Assessment Questions.
3.12 Further Readings.

3.0 Objectives :
After studying this unit of the block, you should be able to:
• Explain the need for reconciliation of cost and financial
accounts.
• State the objectives of reconciliation of cost and
financial accounts.
• Trace the reasons for disagreement between cost
accounts and financial accounts.
• Exercise the procedure of reconciling between cost
accounts and financial accounts.
 85

3.1 INTRODUCTION
In business and industrial enterprises where cost
accounting and financial accounting systems are maintained
separately, the difference between the profits shown by the two
systems is bound to arise. Even if the cost accountant maintains
his own ledger on double entry principle, customarily his profit
differs from the one shown by the financial accounts.
There are two systems of keeping cost accounts - integral
accounting system and non-integral accounting system. In
integral accounting system, only one set of accounts is
maintained which contains both financial and cost accounts. In
this system, obviously there is no need for any reconciliation
between cost and financial accounts.
But in non-integral accounting where separate financial
accounts and cost accounts are kept, the profit or less shown by
the two sets of accounts may be different. In such cases, it is
necessary to reconcile cost and financial accounts. In the absence
of reconciliation, the two sets of accounts may provide
contradictory information on the basis of which management may
take wrong decisions.

3.2 OBJECTIVES OF RECONCILIATION

Reconciliation is resorted to fulfil these two objectives :
1. Locate the reasons for the difference in the profit or loss in
cost books and financial set of books.
2. Check and verify the reliability of cost as well as financial
data and arithmetical accuracy.

3.3. NEED FOR RECONCILIATION

The need for reconciliation arises due to the following reasons :
1. Reconciliation is necessary to find out the reasons for
the difference and to ensure than no income or
expenditure item has been omitted and that there is
no under or over-recovery of overheads.
86
2. Cost ascertainment and cost control depend on the
accuracy of cost analysis, distribution and allocation.
If the total expense which is classified and distributed
in cost accounts is not correct, cost allocation and
ascertainment would be rendered inaccurate and
misleading. Therefore, it is necessary that costing
figures in total should agree with the financial records
to ensure the accuracy of costing data. Reconciliation
also enables to test the reliability of cost accounts.

3.4 REASONS FOR DISAGREEMENT BETWEEN COST

ACCOUNTS AND FINANCIAL ACCOUNTS
The reasons for disagreement in the profit or loss shown
by the two sets of accounts may be attributed to the following
categories.
1. Items shown only in financial accounts :
There are a number of items which are shown in financial
accounts and not in cost accounts. These items are classified into
three categories as under:
(a) Purely financial charges :
(i) Losses on investments.
(ii) Losses on sale of capital assets.
(iii) Discounts on bonds, debentures etc.
(iv) Interest on bank loans and mortgages etc.
(v) Fines and penalties.
(vi) Damages payable under law.
(b) Purely financial incomes :
(i) Rents receivable.
(ii) Dividends and interest received on investments.
(iii) Interest received on bank deposits.
(iv) Transfer fees received.
(v) Profits arising from sale of capital assets.
 87
(c) Appropriation of profit :
(i) Dividing paid.
(ii) Transfer to reserves.
(iii) Charitable donations.
(iv) Income-tax.
(v) Amounts written off goodwill, preliminary
expenses etc.
(vi) Any other items which appear in Profit and Loss
Appropriation Account.
2. Items shown only in cost accounts : There are
certain items which are included in cost accounts but not in
financial accounts. These items are :
(i) Charges in lieu of rent where premises are owned.
(ii) Interest on capital employed in production but upon
which no interest is actually paid.
3. Under-absorption or over-absorption of overheads
In cost accounts, overheads are recovered at a pre-
determined rate whereas in financial accounts these are recorded
at actual cost. This may cause a difference between overheads
absorbed in cost and actual overhead cost incurred. Such
differences should be written off to an Overhead Adjustment
Account. As a result, the actual amounts in financial account will
agree with those shown in cost accounts.
However, when under or over-absorbed overhead are not
written off to an Adjustment Account and carried forward to the
next accounting year, the difference in the two sets of accounts
will exist. In such a case, it becomes necessary to take into account
while reconciling the two accounts.
4. Different bases of stock valuation
In cost accounts stocks are valued according to the system
adopted in Stores Account e.g., FIFO, LIFO etc. But valuation of
stock in financial accounts is invariably based on the principle
of cost or market price whichever is less. This results into some
difference in profit or loss shown by the two sets of account books.
88
5. Different bases of depreciation
The rates and methods of charging depreciation may be
different in two sets of accounts. Foe example, in the financial
accounts straight line or diminishing balance method may be
used, whereas in cost accounts machine-hour rate or replacement
value method may be used.

3.5 DIFFERENT TRATMENT OF ACCOUNTS

Some of the items in financial accounts are treated
differently from those in cost accounts. Such instances are :
(i) Abnormal losses and savings : In financial accounts,
the abnormal items are merged with their normal
headings. Abnormal losses of material or time, for
instance, will be added to the debits for materials and
wages. In cost accounts, on the other hand, abnormal
wastages, losses or savings are kept outside the
manufacturing costs. Losses as a result of
obsolescence, overhauling of the plant etc., are not
entered in the cost accounts, but are kept separate.
(ii) Depreciation : In financial accounts, depreciation is
treated as a period cost which varies with the lapse of
time. By way of prudence, it is customary these days
to charge extra depreciation on some accelerated
methods. Cost accounts do not allow for such extra
charge. Besides, in cost ledger depreciation is treated
as a variable cost.
(iii) Inventory valuation : In cost accounts, finished stock
and work-in-progress are generally valued at factory
cost. But the basis of valuing factory cost could be
LIFO, FIFO, base stock, weighted average, standard
or replacement cost. But in financial accounts, the
conventional principle of cost or market price,
whichever is lower, is adopted. Resultantly the
difference emerges.
(iv) Overhead charged : Various methods have been
employed to recover overhead costs. The aim is to
make a fair and logical charge in respect of the
overheads. But all these methods are based upon
estimate and hence, will recover a little more or less
 89
from the total amount of indirect expenses. Hence
under or over-absorption of overheads causes
difference in two sets of accounts. In addition certain
overheads e.g., selling and distribution costs might
have been totally ignored in cost accounts.

3.6 EFFECT OF VARIOUS ITEMS ON PROFIT

The effect of various items, already discussed, on the profit
reflected by cost accounts and financial accounts is analysed as
under.
Reasons for Differences Effect on Effect on
Profit as per Profit as per
Cost Accounts Fin. Accounts
More Less More Less
1. Pure financial charges ü ü
2. Items shown in Cost A/c only ü ü
3. Incomes and gains credited ü ü
to financial accounts only
4. Expenses or Losses included ü ü
in financial accounts only.
5. Over-recovery of overheads in Cost A/c. ü ü
6. Under-recovery of overheads in Cost A/c.s. ü ü
7. Methods of deprecidation :
Excess depreciation cost books
when compared to financial books ü ü
Excess depreciation in financial books. ü ü
8. Valuation of stock :
Higher value of opening stock and / or lower ü ü
value inclosing stock in cost books.
Lower value of opening stock and / or higher ü ü
value of closing stock in cost book

3.7 PROCEDURE OF RECONCILIATION

The cost and financial accounts are reconciled by
preparing a Reconciliation Statement or a Memorandum
Reconciliation Account. The following procedure is
recommended for preparing a Reconciliation Statement :
90
1. Ascertain the points of difference between cost accounts
and financial accounts.
2. Start with the point as per cost accounts.
3. (a) Regarding items of expenses and losses
Add : Items overcharged in cost accounts.
Deduct : Items undercharged in cost accounts.
For example, depreciation in cost accounts is Rs. 5,500
and that in financial accounts is Rs. 6,000. This will
add to costing profit by Rs. 500. Then in order to
reconcile, Rs. 500 will be deducted from costing profit.
(b) Regarding items of incomes and grains
Add : Items under-recorded or not recorded in cost
accounts.
Deduct : Items over-recorded in cost accounts.
For example, interest in investments received amounting
to Rs. 2,000 is not recorded in cost accounts. This will have
the effect of reducing profit as per cost books. Thus in order
to reconcile, this amount of Rs. 2,000 for interest should be
added to the costing profit.
(c) Regarding valuation of stock
(i) Opening stock : Add : Amount of over-valuation
in cost accounts.
Deduct :Amount of under-
valuation in cost accounts
(ii) Closing stock : Add : Amount of under-
valuation in cost accounts.
Deduct: Amount of over-
valuation in cost accounts.
4. After making all the above additions and deductions in
costing profit, the resulting figure shall be the profits as
per financial books.
5. The above treatment of items will be reversed when the
staring point in the Reconciliation Statement is the profit
as per financial accounts or loss as per cost accounts.
 91

3.8 ILLUSTRATION - 1
From the following figures, prepare a Reconciliation
Statement :
Rs.
Net profit as per financial records …… 1,28,755
Net profit as per costing records ……. 1,72,400
Works overhead under-recovered
in costing ….. 3,120
Administrative overhead recovered
In excess …… 1,700
Depreciation charged in financial records 11,200
Depreciation recovered in costing ……….. 12,500
Interest received but not included in costing 8,000
Obsolescence loss charged in financial
Records …… 5,700
Income-tax provided in financial books …… 40,300
Bank interest credited in financial books ….. 750
Stores adjustments (credit in financial books). 475
Depreciation of stock charged in financial
Books ….. 6,750
Solution :
Reconciliation Statement
Particulars Amount Amount
Rs. Rs.
Net Profit as percosting records 1,72,400
Add : Excess Depreciation charged
(Rs. 12,500 - 11,200) 1,300
Excess Administrative Overhead 1,700
Interest received but not included 8,000
Bank interest ….. 750
Stores adjustment … 475
12,225
1,84,625
Less : Works overhead under-charged 3,120
obsolescence loss not charged 5,700
Income-Tax not provided 40,300
Depreciation in stock value 6,750
55,870
Net Profit as per financial records 1,28,755
92

Illustration - 2
The following are the figures taken from the cost Ledger
of a firm :
(a) Inventory : Rs.
(i) Opening Balance ……… 10,000
(ii) Net Debits ……… 90,000
(iii) Net Credits ………. 80,000
(iv) Drawals for maintenance
Included in net credits above …. 10,000
(b) Work-in-Progress : Rs.
(i) Opening Balance …… 15,000
(ii) Debits for material as per
Inventory Account … … . 70,000
Debit for Labour …….. 20,000
Debits for Overhead …….. 80,000
(iii) Credits-Finished goods ……. 1,75,000
(c) Finished products :
(i) Opening Balance ……. 20,000
(ii) Debits …….. 1,75,000
(iii) Credits from cost of sales … … . 1,86,000
Further data from financial books :
Sales ……. … … 2,10,000
Wages …… …… 25,000
Other expenses … … ….. 85,000
You are required to prepare a Costing Profit of loss
Account leading upto the profit as per financial account. Also
reconcile the two profit figures.
 93
Solution :
Costing Profit and loss Account
Rs. Rs.
To Materials consumed By Sales ... 2,10,000
(Rs. 80,000 - 10,000) 70,000
To Wages 20,000
Prime Cost 90,000
To Overhead 80,000
1,70,000
Add : Work-in-Progress
(Opening Balance) 15,000
1,85,000
Less : WIP -*closing Balance 10,000
Cost of production 1,75,000
Add : Finished stocks(opening) 20,000
1,95,000
Less : *Finished stocks-(closing) 9,000
cost of sales 1,86,000
Profit … 24,000
2,10,000 2,10,000
* These figures have been found out by preparing these accounts.
Financial Profit and Loss Account
To Opening stock : Rs. Rs. Rs.
Inventory 10,000 By Sales 2,10,000
WIP 15,000 By Closing stock :
Finished Goods 20,000 Inventory 20,000
45,000 WIP 10,000
To Purchases 90,000 Finished Goods 9,000
To Wages 25,000
To Other Expenses 85,000 39,000
To Net Profit 4,000
2,49,000 2,49,000
94
Reconciliation Statement
Rs. Rs.
Profit as per Cost Account 24,000
Len : maintenance materials not charged in costing 10,000
Wages under-charged in costing 5,000
(Rs. 25,000-20,000)
Under-absorbed overhead 5,000
(Rs. 85,000-80,000)

20,000
Profit as per financial accounts . . .. 4,000

Illustration - 3
The Blue Ltd. Made a profit of Rs. 20,000 during a
particular year as per their costing system, whereas their Final
Accounts disclose a profit of Rs. 15,000. From the following Profit
and Loss Account for the year ended 31st December as per the
financial books, you are required to prepare a Reconciliation
Statement showing the causes for this difference :
Trading and Profit & Loss Account
Rs. Rs.
To Opening Stock 1,00,000 By Sales 1,75,000
" Purchases 80,000 By Closing Stock 80,000
" Direct wages 20,000
" Factory expenses 15,000
" Gron Profit c/d 40,000
2,55,000 2,55,000
To AdministrativeExpenses 10,000 By Gross Profit C/d 40,000
" Selling Expenses 15,000
" Net Profit 15,000
40,000 40,000
 95
Costing records show the following : Rs.
(a) Stock Ledger closing balance ……….. 89,000
(b) Direct Labour ……….. 23,000
(c) Factory Overheads ………. 13,000
(d) Administrative overheads and selling expenses expenses
calculated at 8% of the selling price.

Solution :
Reconciliation Statement
Rs. Rs.
Profit as per Cost Accounts …… 20,000
Add : Over-recovery of -
Direct Labour (Rs. 23,000-20,000) 3,000
Administrative
Overhead (Rs. 14,000 -10,000) 4,000 7,000
27,000
Less : Under-recovery of -
Factory Overhead (Rs. 15,000-13,000) 2,000
Selling Expenses (Rs. 15,000-14,000) 1,000
Over-valuation of closing stock
in cost Accounts (Rs. 89,000-80,000) 9,000 12,000
Profit as per financial accounts 15,000

Illustration - 4

During a certain year, the auditors certified the financial

accounts showing a profit of Rs. 1,68,000 ; whereas the same as
per costing books was coming out to be Rs. 2,40,000. Given the
following information, you are required to prepare a
reconciliation statement showing clearly the reasons for the
difference.
96
Trading and Profit & Loss Account
Rs. Rs.
To Opening stock 8,20,000 By Sales 34,65,000
" Purchases 24,72,000 By Closing stock 7,50,000
" Direct wages 2,30,000
" Factory overheads 2,10,000
" Gron Profit c/d 4,83,000
42,15,000 42,15,000
To Administrative Expenses 95,000 By Gross Profit c/d 4,83,000
To Selling Expenses 2,25,000 By Sundry income 5,000
* Net Profit 1,68,000
4,88,000 4,88,000

The costing records show :

(a) Book value of closing stock Rs. 7,80,000.
(b) Factory overheads have been absorbed to the extent
of Rs. 1,89,800.
(c) Sundry income is not considered.
(d) Administrative expenses are recovered at 3% of selling
price.
(e) Total absorption of direct wages Rs. 2,46,000.
(f) Selling prices include 5% for selling expenses.
Solution :
Reconciliation Statement
Rs. Rs.
Profit as per Cost Accounts 2,40,000
Add : Sundry income not considered
in cost books … 5,000
Add : Administrative expenses
over-recovered in cost books …… 8,950
Add : Over-absorption of direct wages 16,000 29,950
Less : Over-valuation of stock in 2,69,950
cost books ……. 30,000
Less : Factory overheads under -absorbed
overhead in cost books ….. 20,200
Less : Selling overhead under-absorbed
in cost book …. 51,750
1,01,950
Profi as per Financial Accounts 1,68,000
 97

Illustration - 5
The net profit of the X co. Ltd. Appeared at Rs. 60,652
as per financial records for a particular year ending 31st March
of the year. The Cost Books, however, showed a net profit of
Rs. 86,200 for the same period. A scrutiny of the figures from
both the sets of accounts revealed the following facts :

Rs.
Works overhead under-recovered in costs ……. 1,560
Administrative overhead over-recovered in costs ….. 850
Depreciation charged in financial accounts ……….. 5,600
Depreciation recovered in costs……………… 6,250
Interest on investments not included in costs ………. 4,000
Loss due to obsolescence charged in financial account … 2,850
Income-Tax provided in financial accounts …….. 20,150
Bank Interest and transfer fee in financial books …….. 375
Stores Adjustment (credit in financial books) 237
Value of opening stock in :
Cost Accounts ................... 24,800
Financial A/cs. .................. 26,300
Value of closing stock in :
Cost Accounts …………. 25,000
Financial A/cs ………… 23,000
Interest charged in accounts ………………… 2,000
Good will written off ……………….. 5,000
Loss on sale of furniture ………………. 600

Prepare a statement showing the reconciliation between

the figures of net profit as per Cost Accounts and the figures of
net profits as shown in the Financial Books.
98
Solution :
Reconciliation Statement
Rs. Rs.
Profit as per Cost Accounts …….
Add : (a) Administrative overheads
over-recovered in Cost A/cs. …… 8500
(b) Depreciation overcharged in
Cost Accounts :
Cost Books ……. 6,250
Financial Books … 5,600 650
(c) Receipts and grains credited in
Financial Books but not shown in
Cost Books :
(i) Interest on investment ……. 4,000
(ii) Bank interest and transfer fees 375
(iii) Stores Adjustment ….. 237
(d) Interest charged in Cost Accounts …. 2,000 8,112
94,312
Less : (a) Works overhead under-recovered
in cost Books ….. 1,560
(b) Expenses and losses debited in
Financial Books but ignored in cost Books :
(i) Income Tax 20,150
(ii) Loss due to obsolescence .. 2,850
(iii) Goodwill written off …. 5,000
(c) Under-valuation of opening stock in
Cost Accounts …. 1,500
(d) Over-valuation of closing stock
in Cost Accounts …. 2,000
(e) Loss on sale of furniture …… 600 33,660
Profit as per Financial Accounts 60,652

3.9 POINTS TO REMEMBER

The objectives of reconciliation are :

(i) to ascertain the reasons for the difference in the profit or
loss as per cost books and financial set of books.
(ii) To check and verify the reliability and accuracy o both the
cost data and those of the financial set of books.
 99
Some of the items in financial accounts are treated
differently from those in cost accounts. As a consequence,
difference arises between the profits or loss as per the costing
books and the financial set of books. Such items are the following :
(i) Abnormal losses and savings,
(ii) Depreciation.
(iii) Inventory valuation
(iv) Overhead charged.
The procedure of reconciliation of profits & losses as per
cost accounts and those of financial accounts involves the
following steps :
(i) Regarding items of expenses and losses - add items
overcharged and deduct items undercharged.
(ii) Regarding items of incomes and gains - add items
under recorded or not recorded and deduct items
over recorded.
(iii) Regarding Valuation of opening stock - add amount
of over-valuation and deduct amount of under-
valuation.
(iv) Regarding valuation of closing stock - add amount of
under-valuation and deduct amount of over-
valuation.

3.10. KEY WORDS

Over-absorption : Overhead costs are charged to cost units
at some pre-determined rates. Hence the
amount of overhead costs absorbed in
excess of actual overhead costs is called
over-absorption of overheads.
Under-absorption : Overhead costs charged to cost units (at
predetermined rates) less than the actual
overhead costs are known as under-
absorption of overhead.
Reconciliation : Reconciling the differences between
costing set of books and financial set of
books of accounts.
100

3.11. SELF-ASSESSMENT QUESTIONS

1. What are the reasons for difference in the profits revealed
by financial and cost accounts? How would you reconcile
the two profits?
2. How would you account for difference in the results shown
by financial books and costing records?
3. Name and six items which are included in financial accounts
but they are not included in cost accounts and state the effect
on the profits of cost accounts.
4. Why is reconciliation of cost and financial accounts
necessary? Under what circumstances, a reconciliation
statement can be avoided?
5. "It has been stated that an efficient costing system will not
necessarily produce accounts which in their result will agree
with the financial accounts." Comment on this statement.
6. What purposes are served by the preparation of
Reconciliation Statement? Explain each of them in detail.
7. Indicate with reasons how you would consider the following
while reconciling the financial profits with the profits as
shown by the cost accounts:
(a) Under-absorption of factory overhead.
(b) Over-valuation of closing stock in cost accounts.
(c) Income-tax provided in financial accounts
8. Describe briefly the procedure for preparing a statement
reconciling the profits as per cost accounts and as per financial
accounts.
9. A firm whose financial year ends on 31st March shows that
according to financial books profit amounts to Rs. 2,57,500.
Profits as per Cost Accounts are Rs.3,44,800. While
reconciling the two profits, following differences have been
noticed.
 101
Rs.
Under-absorption of Factory Overhead 6,240
Over-absorption of office Overheads 3,400
Depreciation charge in Financial Accounts 22,400
Depreciation charge in Cost Accounts 25,000
Interest on investment not included in Cost Accounts -- 16,000
Loss included in Financial Account 11,400
Income-Tax --- 8,600
Interest and dividenol received --- 2,450
Loss due to depreciation in stock value in Financial set of books-- 13,500
You are required to reconcile the two profits and prepare Reconciliation
Statement.
10. From the following figures prepare a Reconciliation Statement:
Rs.
Net Loss as per financial records --- 2,08,045
Net Loss as per costing records --- 1,72,400
Works overhead under-recovered in costing -- 3,120
Administrative overhead recovered in excess --- 1,700
Depreciation charged in Financial records 11,200
Depreciation recovered in costing --- 12,500
Interest received not included in costing --- 8,000
Obsolescence loss charged in financial records 5,700
Income-tax provided in financial books --- 40,300
Bank interest credited in financial books --- 750
Stores adjustments (credit-in financial books) --- 475
Value of opening stock in : Cost accounts --- 52,600
Financial accounts --- --- --- 4,000
Value of closing stock in : Cost accounts --- 52,000
Financial A/cs -- --- --- 49,600
Interest charged in cost accounts but not in financial accounts --- 6,000
Preliminary expenses written off in financial accounts --- 800
Provision for doubtful debts in financial accounts -- 150
102

3.12 FURTHER READINGS

Arora, M.N., "Cost Accounting", Vikas Publishing House Pvt.
Ltd, New Delhi.
Rao, V.S.P., "Cost Accounting", Vrinda Publications (P) Ltd.,
Delhi - 91.
 BLOCK - 3

ANALYSIS AND INTERPRETATIN OF ACCOUNTS

ANALYSIS AND INTERPRETATIN OF ACCOUNTS -

STUDY OF FINANCIAL STATEMENTS ; VERTICAL
FORMS-RELATIONSHIP BETWEEN ITEMS IN
BALANCE SHEET AND PROFIT & LOSS ACCOUNT;
TREND ANALYSIS; COMPARATIVE STATEMENTS;
COMMON SIZE STATEMENTS

Block - 3 consists of two units.

Unit - 1 Discusses the meaning and objectives of financial
statement analysis.
Unit -2 Explains the techniques of financial statement analysis.
It discusses the techniques like horizontal analysis,
vertical analysis, trend analysis and ratio analysis.

UNIT - I ANALYSIS AND INTERPRETATION OF

ACCOUNTS

Structure
1.0. Objectives
1.1 Meaning of financial statement analysis.
1.2 Objectives of financial statement analysis.
1.3 Interpretation of financial statements.
1.4 Parties interested in financial statements.
1.5 Limitations of financial statement analysis
1.6 Procedure for Interpretation
1.7 Points to Remember
1.8 Key Words
1.9 Self-Assessment Questions
1.10 Further Readings
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1.0 Objectives
After going through this unit, you should be able to :
• Define the meaning of financial statement analysis.
• Explain the objectives of financial statement analysis.
• Narrate the parties interested in financial statements.
• State the procedure for interpretation.

1.1 MEANING OF FINANCIAL STATEMENT ANALYSIS

The financial statements prepared in an absolute manner
are not more than a group of accounting figures and convey
nothing to a layman. Of late, corporate managers are becoming
increasingly interested in the information presented to them by
accounts and are beginning to question the need for and use of
such statements prepared by the finance and accounts division.
But it is a challenge to those who are presenting, and also to
those who are being presented with such information. Therefore,
it becomes necessary on the part of the Finance Manager to
regroup, analyse and present the financial figures in a more
meaningful manner for the use of all non-financial executives.
Financial Statement Analysis is an analysis which highlights
important relationships in the financial statements. It emphasizes
on evaluation of past operations as revealed by the analysis of
basic statements. Financial Statement Analysis includes the
methods used in assessing and interpreting the results of past
performance and present financial position as these relate to
specific factors of interest in investment decisions. It is an important
way of assessing past performance and in planning and forecasting
future performance. According to Baruch Lev:
"Financial Statement Analysis is an information
processing system designed to provide data for
decision making models, such as the portfolio
selection model, bank lending decision models,
and corporate financial management models."
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1.2 OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

The main objectives of financial statement analysis is to
provide information about a business enterprise to decision
makers. The decision makers are interested in evaluating the
economic situation of the firm and predicting its future course.
Financial statement analysis can be utilized by the different
users and decision makers to achieve the following objectives:
1. Evaluation of Past Performance and Current Position:
Past performance is an indicator of future performance.
Therefore, for an investor or creditor, it is necessary to know the
trend of past sales, expenses, net income, cash flow and return
on investment. By studying these trends, one can judge
management's past performance and can also use these as
possible indicator of future performance. The analysis of current
position also indicates about current state of the business. This
will show the types of assets owned by a business and also the
liabilities due against the business concern. This will also reflect
the cash position, relation of debt to equity and the levels of
inventories and receivables.
2. Prediction of Net Income and Prospects of Growth: The
financial statement analysis is useful in predicting the earning
prospects and growth in the earnings which are used by investors
for comparison of investment alternatives. Financial statements
which contain information on past performances are analysed
and interpreted as a basic for forecasting future rates of return
and risks. Such prediction tends to improve the financial
decisions of the investors.
3. Prediction of Bankruptcy and Failure: Financial statement
analysis is an important tool in predicting the bankruptcy and
probability of failure of business enterprises. Financial statement
analysis performs this through the assessment of solvency
position. After getting such prediction, managers and investors
both can take preventive steps to avoid or minimize losses.
4. Loan decision by Financial Institutions and Banks: All
lenders are primarily concerned with repayment of loan and
payment of interest on the due dates. This requires
comprehensive investigation and analysis of the financial
statements submitted by the borrowers. Financial statement
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analysis is useful in determining credit risk, deciding terms and
conditions of loan, interest rate, date of maturity etc.

1.3 INTERPRETATION OF FINANCIAL STATEMENTS

The first step in the interpretation of financial statements
is analysis. Analysis has no value without interpretation and
interpretation is not at all possible without analysis. Different
account balances appear in the financial statements. These
account balances do not reflect homogeneous data, hence it is
not easy to interpret them and draw some conclusions. Therefore
interpretation requires an analysis of data in the financial
statements so as to bring some homogeneity in the amounts
shown in the financial statements. Analysis means splitting of
the total amount contained in the statements into their component
parts. It is largely a study of relationship among the various
financial factors in a business.
The second step in the interpretation of financial
statements is comparison. Just an examination of the components
of a statement can not lead to a definite conclusion in relation to
the financial status of a business. In order to interpret the position
of an enterprise, it is necessary not only to separate the total given
in the financial statements into their components but also to make
comparison of the various components and to examine their
content. Thus, interpretation requires analysis and comparison.

1.4 PARTIES INTERESTED IN FINANCIAL STATEMENTS

Different parties are interested in the study of published
financial statements of companies and their outlook often differs
very widely.
The main interested parties and their purposes of
interpretation are as follows:
(i) Management: To review the progress, position and
prospects of the company and to decide upon the course of action
to be taken in future.
(ii) Shareholders: To judge the prospects of their investments
and to elect to sell or continue ownership.
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(iii) Debentureholders: To know the adequacy of the
provisions for replacement of fixed assets, ensuring security of
their investment to satisfy their claims.
(iv) Creditors and Bankers : To ascertain whether there will
be adequate surplus of liquid assets to satisfy their claims against
the company.
(v) Trade Union/ Employees: To decide the ability of the
company to pay higher wages, bonus etc.
(vi) Security analysis: To learn and advise their clients whether
it is time to buy, to hold or to sell the securities of the company.
(vii) Auditors : Internal Auditor to report to the management
and external auditor to report to the shareholders.
(viii) Government: To protect the interests of the shareholders
and public revenue to the treasury.
(ix) Stock Exchange: To protect the investors' interests in listed
companies or to act as a "Watchdog" of corporate investors.
(x) Researchers: Economists; the Company Law Board;
Public Accounts Committee and the Estimates Committee in
respect of Government Companies for wide and varied reasons.

1.5 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

Any person using the techniques of analysis of financial

statement should keep in kind the very limitations of financial
statements themselves. The basic nature of financial statements
is historic and essentially they are interim reports. The figures
taken from one year statements have limited utility. Any charge
in the method or procedure of accounting hampers the utility of
such analysis. An analyst should also be cautious from window-
dressing in the accounts. Many items are influenced by personal
judgment. The soundness of the judgment necessarily depends
on the competence and integrity of those who make them.

1.6 PROCEDURE FOR INTERPRETATION

When a Finance Manager is called upon to interpret the
financial statements of such companies, he should take the
following steps :
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(i) Ascertain the purpose and the extent of the analysis and
interpretation ;
(ii) Study all available data contained in the financial
statements to gain an insight into the meaning and
significance of the financial figures ;
(iii) Obtain such additional information as is considered
necessary for the work ;
(iv) Tabulate the data in a logical manner ;
(v) Analyse the data by preparation of comparative statements,
ratio analysis, trend analysis etc.
(vi) Interpret the facts revealed by the analysis ;
(vii) Present the findings in the form of a report, supplemented
by charts, diagrams etc. where necessary.

1.7 POINTS TO REMEMBER

Financial Statement Analysis is an analysis which
highlights important relationships in the financial statements. It
emphasizes on evaluation of past operations as revealed by the
analysis of basic statements. Analysis includes assessing the
results of past performance and present financial position as
these relate to specific factors of interest in investment decisions.
The main objectives of financial statement analysis are -
(i) Evaluation of Past Performance and current position.
(ii) Prediction of net income and prospects of growth.
(iii) Prediction of bankruptcy and failure.
(iv) Loan decisions by banks and financial institutions.
The first step in the interpretation of financial statements
is analysis which involves splitting of the total amount contained
in the statements into their component parts. It is largely a study
of relationship among the various financial factors in a business.
The second step in the interpretation of financial
statements is comparison of the various components and to
examine their contents.
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1.8 KEY WORDS
Financial statement analysis :
This is an information processing system designed
to provide data for decision0making models, such
as the portfolio selection model, bank lending
decision model and corporate financial
management models.
Interpretation :
Interpretation of financial statements means
splitting the data according to their components in
order to ascertain the significance of relationship
between the related data or groups of data ;
comparison of past and present performance and
subsequently make future prediction relating to
the business enterprise.

1.9 SELF ASSESSMENT QUESTIONS

1. Explain the meaning of financial statement analysis. State
the main objectives of such analysis.
2. What do you understand by interpretation of financial
statements ? What are the components of interpretation ?
3. Discuss about the different parties and their outlook for
which they are interested in financial statements.
4. Narrate the procedure of interpretation of financial
statements.
5. Describe the limitations of financial statement analysis.

1.9 FURTHER READING

Banerjee, B., "Financial Policy and Management Accounting"
The World Press Private Ltd., Kolkata.
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BLOCK - 3
UNIT - 2 STUDY OF FINANCIAL STATEMENTS,
VERTICAL FORMS-RELATIONSHIP BETWEEN ITEMS IN
BALANCE SHEET AND PROFIT & LOSS ACCOUNT; TREND
ANALYSIS ; COMPARATIVE STATEMENTS' COMMON-
SIZE STATEMENTS

Structure
2.0 Objectives
2.1 Techniques of financial Statement Analysis :
Horizontal Analysis -
Vertical Analysis -
Trend Analysis -
Ratio Analysis -
2.2 Comparative Financial Statements -
2.3 Common-Size Statements -
2.4 Points to Remember -
2.5 Key Words -
2.6 Self -Assessment Questions -
2.7 Further Readings.

2.0 Objectives
After going through this unit, you should be able to :
• Explain the different techniques of analysis of financial
statement.
• Utilise the Horizontal Analysis and Vertical Analysis.
• Prepare and explain the Comparative Statements as well
as the Common-Size Statements.
• Make Trend Analysis.
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2.1 TECHNIQUES OF FINANCIAL STATEMENT

ANALYSIS

Different techniques are used in the analysis of financial

statements to emphasize the comparative and relative
significance of data presented and to assess the position of the
firm. These techniques of financial analysis are aimed at showing
the relationships and changes. Among the widely used of these
techniques are the following :

1. Horizontal Analysis

2. Vertical Analysis

3. Trend Analysis

4. Ratio Analysis

1. Horizontal Analysis

The analysis of percentage increase and decrease in

corresponding item in comparative financial statement is called
horizontal analysis. Such analysis involves the computation of
amount changes and percentage changes from the previous to
the current year. The amount of each item in the latest statement
is compared with the corresponding item in one more earlier
statement. The increase or decrease in the amount of the item is
then listed together with the percent of increase or decrease.
When the comparison is made between two statements, the
earlier statement is used as the base. In case, horizontal analysis
includes more than two statements, there are two or even more
alternative in the selection of the base. Firstly, the earliest period
may be used as the basis for comparing all later periods ; or
secondly, each statement may be compared with the immediately
preceding statement.
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Illustration - 1

Comparative Balance Sheet with Horizontal Analysis

XYZ Co. Ltd.

Balance Sheet

As at 31.12.2004 and 31.12.2005

(in lakhs) Incease / Decrease

Particulars 2004 2005 Amount Percentage

Rs. Rs. Rs.

Assets

Current Assect :

Cash . . . 100 180 80 80

Marketable Securities 600 660 60 10

Receivables . . . 2,500 2,750 250 10

Inventories . . . 2,000 2,200 200 10

Prepaid Expenses . . 50 100 50 100

Total Current Assets 5,250 5,890 640 12

Properties :

Land, Buildings,

Machinery and

Equipment less

Accumulated

Depreciation 5,000 6,000 1,000 20

Other Non-current Assets 200 250 50 25

10,450 12,140 1,690 16

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Particulars (in lakhs) Increase/ Decrease

2004 2005 Amount PC
Rs. Rs. Rs.

Litabilities

Current Liabilities :

Payables 2,200 2,300 100 4.5

Taxes payable 300 400 100 33

Dividends payable 100 100 - -

Total Current Liabilities 2,600 2,800 200 7.6

Long-term Liabilities :

Long-term Debentures 2,750 2,750 - -

Other long-term liabilities 600 140 (-) 460 76

Deferred income tax liabilities 400 450 50 13

Total Liabilities 6,350 6,140 (-) 210 3

Ownership :

Equity Capital 2,500 4,000 1,500 60

Preference Capital 1,600 2,000 400 25

Total ownership 4,100 6,000 1,900 46

Total Liabilities and

Ownership 10,450 12,140 1,690 16

The comparative Balance Sheet presents the amount of

increase or decrease and percentage changes. The percentage
change is calculated as follows :
Amount of Change
Percentage charge = ------------------------------------------------------ x 100
Previous year amount
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Illustration - 2
XYZ Co. Ltd
Comparative Income Statement with Horizonal Analysis For
the years ended 31.12.04 and 31.12.05
(Rs. In lakhs) Increase/Decrease
Particulars 2004 2005 Amount P.C.
Sales …. 10,000 10,800 800 8.0
Cost and Expenses :
Cost of goods sold 6,800 7,100 300 4.4
Selling and Administration
Expenses 2,100 2,200 100 4.7
Total Costs and Expenses 8,900 9,300 400 4.5
Earnings from Operations 1,100 1,500 400 36.3
Unusual Charges - (500) (500) NA
Other income and expenses
Including interest
Expenses of Rs. 180 and
Rs. 110 80 (30) (110) (137.5)
Earning Before Income Tax 1,180 970 (210) (17.8)
Provision for Income Taxes 450 390 (60) (13.3)
Net Earnings 730 580 (150) (20.5)
Appropriate care should be exercised while analyzing
percentage change. For example, while analysing the changes in
the components of total assets in the Comparative Balance Sheet,
one may notice 10% increase in both receivables and inventories
while the corresponding increase in cash is not adequate.
In the Income Statement, there is 8% growth in sales
compared to 137.5% decrease in other income and consequently
net earnings in 2005 decreased by 20.5%. This aspect needs
immediate attention.
2. Vertical Analysis
Vertical Analysis applies percentages to indicate the
relationship of the different parts to the total in a single statement.
Vertical analysis sets a total figure in the statement equal to 100
percent and computes the percentage of each component of that
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figure. The figure to be used as 100 percent will obviously be
total assets or equity capital and total liabilities in the case of
Balance Sheet whereas revenue or sales in the case of the profit
and loss account.
The following is an example of vertical analysis using
Profit and Loss Account and showing each item as a percentage
of the sales figure.

Illustration - 3
XYZ Co. Ltd.
Income Statement with Vertical Analysis for the year ended
31.12.2005 (in Thousands of Rs.)
Amount Percent
Net sales ... 5,00,000 100%
Cost of goods sold ... 3,00,000 60%
Gross Profit . . . 2,00,000 40%
Operating Expenses :
Administrative Expenses . . . 45,000 9%
Selling Expenses ... 40,000 8%
Total Operating Expenses . . . 85,000 17%
Operating Income ... 40,000 8%
Interest Expenses ... 4,000 0.8%
Income before Income Tax . . . 36,000 7.2%
Income Tax ... 15,000 3.0%
Net Income ... 21,000 4.2%

3. Trend Analysis
Trend Analysis or Trend Percentage also plays a
significant role in the interpretation of horizontal financial
statements. An analysis of the trend of certain business facts is
extremely helpful in budgeting, forecasting etc.
In trend analysis, percentage changes are calculated for
several successive years instead of between two years. Trend
analysis is important because of its long-run view. It may indicate
changes in the nature of the business. By looking at a trend in a
particular ratio, one may observe whether that ratio is rising,
falling or remaining relatively constant. From this observation,
a problem is detected or the symptom of a good management is
found.
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Trend analysis applies an index number over a period of

time. For the use of index numbers, the base year is equal to 100
percent. All the other years are measured in relation to that
amount. For instance, one may be interested in the trends of sales
and earnings for the past five years. For this purpose, data of
sales and earnings data of a company are supplied to prepare
further the trend analysis or percentages.

Illustration - 4

XYZ Co. Ltd.

Annual Performance (In lakhs of Rupees)

Year I Year 2 Year 3 Year 4 Year 5

Sales . . . 220 280 350 450 600

Net Earnings 10 15 25 40 50

The above data reveal a fairly healthy growth pattern. But

the pattern of change from year to year can be ascertained more
precisely by calculating trend percentages. To achieve this, a base
year is selected and thereafter the data are divided for each of
the other years by the base year data. The resultant figures are
the indexes of the changes that have been occuring throughout
the entire period. If the year 1 is chosen as the base year, all data
for the year 2 through 5 will be related to the year 1, which is
represented as 100%.

To devise the following table, each year sales is divided

from year 2 through years 5 by Rs. 220, the year 1 sales in lakhs
of Rupees. Likewise the net earning for year 2 through 5 were
divided by Rs. 10, the year 1 net earnings in lakhs of Rupees.
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Illustration - 5
Annual Performance (Percentage of Base Year)
Years 1 Year 2 Year 3 Year 4 Year 5
Sales . . . 100 127 159 204 272
Net
Earnings 100 150 250 400 500
The trend percentages reveal that the growth in net
earnings exceeded the growth in sales in all the years from year
2 upto the year - 5. The growth ratio of net earnings in years 3, 4
and 5 were remarkably high being 2.5 times, 4 times and 5 times
respectively as compared to the base year.

Illustration - 6
Modern Textile Co. Ltd.
Comparative Balance Sheet : Trend Percentages
(2001 to 2005) (Rs. 000)
Base data 2001 = 100%
Assets Trend Percentage
2001 2002 2003 2004 2005 2002 2003 2004 2005
1. Fixed Assets 154 182 221 270 309 117 143 175 200
2. Current Assets 524 482 591 631 689 92 113 120 131
3. Investments 12 13 15 48 53 108 125 400 441
Total Assets 690 677 827 949 1,051 98 119 137 152
Liabilities and
Owners Equity :
1. Share capital 100 100 135 135 170 100 135 135 170
2. Reserves 73 78 125 125 96 107 170 170 131
3. Long term
liabilities 304 316 332 425 478 104 109 140 157
4. Current liabilities 213 183 235 264 307 86 110 124 144
Total liabilities, 690 677 827 949 1,051 98 119 137 152
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Taking 2001 as the base year, the total assets and
particularly current assets have been reduced during 2002. There
is a steady rise in all the assets for all the subsequent years. If
these changes were shown in absolute rupees, they would not
have expressed themselves as clearly as the percentages do.
Moreover, the changes are expressed in relation to the base year
so that a clear picture of increase or decrease emerges.
On going through the data relating to resources, it is
noticed that twice during this period fresh capital is introduced.
It appears that during 2005 part of the increased capital might
have been financed out of reserves by issue of bonus shares.
There is a steady rise in long-term as well as current
liabilities. This indicates the growing business.
Trend percentages are calculated only for some important
items which can be logically connected with each other. While
setting out trends of revenues, the trend of costs and expenses
should be connected with them. The changes in these items and
percentage changes would indicate the factors affecting the profits
favorably or unfavorably. Similarly, trend percentages may be
calculated to show how much of the total investment is blocked
in fixed assets, and in the currents and whether changes in the
pattern is suitable.
4. Ratio Analysis
Ratios are simply a means of highlighting in arithmetical
terms the relationship between figures drawn from various
financial statements. Robert Anthony defines a ratio as simply
one number expressed in terms of another. A good number of
ratios can be computed from the basic financial statements viz.
Profit and Loss Account and Balance Sheet.
In other words, the relationship of one item to another
expressed in a simple mathematical form is known as ratio. This
relationship may be expressed in different modes of expressing
ratios :
(i) Percentages, for instance, cost of goods sold is 65% of the
net sales, or
(ii) As a quotient, for instance, current assets are 1.6 times the
current liabilities.
The relationship or ratio between current assets and current
liabilities is determined by dividing the amount of current assets by
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current liabilities. Suppose, current assets are Rs. 1,00,000 and
current liabilities Rs. 50,000 ; then Rs. 1,00,000 should be divided
by Rs. 50,000 to establish the relationship between the two.
Current assets Rs. 1,00,000
---------------------------------= ---------------------------------------- = 2
Current liabilities Rs. 50,000
This relationship or ratio is expressed as under :
(i) Current assets are twice the current liabilities.
(ii) There are Rs. 2 of current assets to meet liabilities of every
Re.1.
(iii) That the current assets are 200% of the current liabilities.
(iv) That the ratio of current assets to current liabilities is 2:1.
In whatever way the ratios are expressed they convey
deep meaning to the financial data and facilitate its interpretation.
Ratio analysis involves three steps. First, the financial manager
selects from the statements those sets of data which are relevant
to his objective of analysis and calculates appropriate ratios for
the firm. The second step calls for a comparison either with the
industry standards or with the ratios of the same firm relating to
past. After such comparison, the conclusions may be drawn and
presented in the shape of report.
Ratio analysis may be made for an internal purpose i.e.
for the purpose of management. For this, varied and detailed
data would be available within the organization. However, the
analysis made by outsiders are generally based upon published
statements. The ratios discussed here are mainly on the basis
that such analysis is undertaken for the purpose required by the
management.
Ratios are guides that are useful in assessing the financial
position and operations of a company and in comparing them to
previous years or to other companies. The main purpose of ratios
is to point out areas for further investigation. They should be
utilized in connection with a general understanding of the
company and its environment.
Financial ratios are classified in various groups. Indeed
their actual classification depends upon the objects of analysis,
nature of party interested in calculation and on the quality of the
data available. Generally, ratios are divided into two main
groups :
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Ratios

Statement classification Purpose or Functional

-Balance Sheet Ratios Classification
-Profit & Loss A/c or -Liquidity Ratios
Revenue Ratios -Debt Ratios
-Composite or -Profitability Ratios
Mixed Ratios -Activity Ratios

2.2 COMPARATIVE FINANCIAL STATEMENTS

Comparative financial statements are the statements of the
financial position of a business so designed as to provide time
perspective to the consideration of various components of
financial position contained in such statements. In any
comparative statement columns for more than one year's position
or working can be drawn and figures may be provided. The
annual data can be compared with similar data for previous
years. Comparative statements may be made to show (i) absolute
data (in Rupees) ; (ii) increase or decrease in Rupee values, (iii)
increase or decrease in absolute data in terms of percentages or
(iv) Common-size statements. The important comparative
statements are :
(i) Comparative Balance Sheet, (ii) Comparative Income
Statement, (iii) Comparative Statement of Working Capital and
(iv) Comparative Statement of Manufacturing Costs.
Illustration - 7
VICCO Ltd.
Balance Sheet (Rs. In lakhs)
Liabilities 2004 2005 Assets 2004 2005

Share Capital 70 70 Fixed Assets 100 120

Reserves 70 120 Current Assets :
Secured Loans 25 20 Stocks 60 80
Unsecured Loans 15 10 Debtors 30 40
Current Liabilities 20 30 Cash 10 10
200 250 200 250
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Solution :
Comparative Balance Sheets
Particulars (Rs. In lakhs) Increase/Decrease
2004 2005 Amount P.C. Ratio

Capital & Liabilities

Share Capital 70 70 - - 1.00
Reserves 70 120 +50 +71 1.71
Secured Loans 25 20 -5 -20 0.80
Unsecured Loans 15 10 -5 -33 0.67
Current Liabilities 20 30 +10 +50 1.50
Total Liabilities &
Capital 200 250 +50 +25 1.25
Assets
Fixed Assets 100 120 +20 +20 1.20

Current Assets
Stock 60 80 +20 +33 1.33
Debtors 30 40 +10 +33 1.33
Cash 10 10 - - 1.00
Total Assets 200 250 +50 +25 1.25

Recognising the importance of comparative figures for two

years, the Companies Act, 1956 has made it mandatory that in
the Balance Sheet of a company the figures for the previous year
should also be given to facilitate the comparison. However, for
the purpose of interpretation of financial statements the figures
of only one previous year may not be adequate.

2.3 COMMON-SIZE STATEMENT

Financial statements expressed in absolute rupee figures

are not easily comprehensible. It is therefore, necessary that the
absolute figures reported in these statements should be converted
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into percentages to some common base. Such a statement gives
only vertical percentages or ratios for financial data without
giving rupee values is known as 'Common-Size Statement.' The
common-size statements are also known as "Component
Percentage" "Or 100% Statements". This is mainly because each
statement is reduced to 100 and each individual item is stated as
percentage of the total 100.
Total assets, liabilities and total net sales are stated as
100%. The ratio of each statement item to the statement total is
found by dividing individual rupee amounts by total amount
in the statement.

Illustration - 8
Using the same data, as given in the Illustration 7, the
Common-Size Balance Sheets can be prepared as shown below :
VICC Ltd.
Common-Size Balance Sheets (Percentages)
Liabilities 2004 2005 Assets 2004 2005
Share Capital 35 28 Fixed Assets 50 48
Reserves 35 48 Current Assets :
Secured Loans 12.5 8 Stocks 30 32
Unsecured Loans 7.5 4 Debtors 15 16
Current Liabilities 10 12 Cash 5 4
100 100 100 100
Similarly, Common-Size Income Statement can be
prepared by assuming total net sales to be equal to 100 and all
other figures are expressed as a percentage of sales.

Illustration - 9
It shows operating profit or loss relating to a Transport
Corporation and which has been prepared in a Common-size
statement.
This data may be analysed to find the percentage of
operating costs and gross margin to revenue.
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Common-size Statement showing Percentage operating
Expenses and Gross Revenue to Total Revenue Earned
Items 2003 2004 2005
Revenue Earned . . . 100% 100% 100%
Total Operating Expenses . . 111% 97% 93%
Gross Revenue - 11% +3% +7%

Illustration - 10
However, when it is desired to study the percentage of
each item of operating expenses to the total expenditure, in
relation to the data presented in Illustration - 9, the Common-
Size Statement may be prepared as under:
. . . . . . Sate Transport Corporation
Statement showing Percentage of Operating Costs to Total Operating Cost
2003 2004 2005
Items 100% 100% 100%
Running Costs . . . 50% 55% 49%
Fuel ... 25% 30% 34%
Maintenance . . . 25% 15% 17%
100 100 100

2.4 POINTS TO REMEMBER

Financial statement analysis in an information processing
system aimed at providing data for decision making. It is also
an important way of assessing past performance and in planning
and forecasting future performance.
Different techniques are used in the analysis of financial
statements to emphasize the comparative and relative
significance of data presented and to assess the position of the
firm.
Among the widely used of the techniques of financial
analysis are comparative balance sheet, comparative income
statement, trend analysis, common-size statement and ratio
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analysis. Comparative financial statements are the statements of
the financial position of a business so designed as to provide
time perspective to the consideration of various components of
financial position contained in such statements.

2.5 KEY WORDS :

Horizontal Analysis : The analysis of percentage increase and
decrease in corresponding item in
comparative financial statement is called
horizontal analysis. It involves the
computation of amount changes and
percentage changes from the previous to
the current year.
Vertical Analysis : Vertical analysis applies percentages to
indicate the relationship of the different
parts to the total in a single statement.
Such analysis sets a total figure in the
statement equal to 100% and computes
the percentage of each component of that
figure.
Common-size statement : Comparative statements that give only
the vertical percentages or ratios for
financial data without giving absolute
rupee values, are known as Common-
Size Statements'.

2.6 SELF ASSESSMENT QUESTIONS :

1. What do you mean by financial statement analysis ? What
are its purposes ?
2. State the limitations of financial statements and show how
analysis of these statements increases their utility.
3. Explain the different techniques of analysis and
interpretation of financial statements.
4. "The conventional financial statements themselves are
static but the life and speech is provided by their analysis
and interpretation." Comment on this tatement.
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5. What is horizontal analysis ? Discuss about the utility of
such analysis. Explain giving suitable examples.
6. What is vertical analysis ? Narrate its utility and give
suitable examples.
7. What do you understand by vertical and horizontal
analysis? Distinguish between the two.
8. The position of inventory stock at the end of different
accounting years was as follows :
Year 2000 2001 2002 2003 2004
Inventory (Rs.) 25,000 30,000 22,000 21,000 23,000
Prepare a statement showing the trend percentages.
9. The following are the Balance Sheets of the Primer Co.
Ltd. for the years 2004 and 2005.
BALANCE SHEETS (Rs. In lakh)
Liabilities 2004 2005 Assets 2004 2005
Share Capital 150 150 Fixed Assets 250 300
Reserves 190 240 Current Assets :
Secured Loans 30 40 Stocks 90 100
Unsecured
Loans 20 30 Debtors 50 60
Current
Liabilities 20 25 Cash 20 25
410 485 410 485
Prepare Comparative Balance Sheets of the Company.
10. Using the same data, as given in the question no. 9, prepare
Common- Size Balance Sheets of the Company for the years
2004 and 2005.

2.7 FURTHER READINGS :

Lal, Jawahar, "Mangerial Accounting", Himalaya Publishing
House, Mumbai.
126

BLOCK 4
ACCOUNTING RATIOS

ANALYSIS AND INTERPRETATION OF FINANCIAL

DATA-DIFFERENT MODES OF EXPRESSING RATIOS;
ANALYSIS AND INTERPRETATION OF DIFFERENT
RATIOS ACCORDING TO CONVENTIONAL AND
FUNCTIONAL CLASSIFICATIONS
Block - 4 comprises two units.
Unit - 1 : Discusses the meaning, purpose and need for analysis
of ratios. This unit also explains the advantages and
limitations of ratio analysis.
Unit - 2 : Explains the different modes of expressing ratios. This
unit discusses the classifications of ratios.

UNIT - 1 : ANALYSIS AND INTERPRETATION OF

FINANCIAL DATA
Structure
1.0 Objective
1.1 Meaning, purposes and need for Ratio Analysis
1.2 Advantages of Ratio Analysis
1.3 Limitations of Ratio Analysis
1.4 Points to Remember
1.5 Key Words
1.6 Self-Assessment Questions
1.7 Further Readings.

1.0 OBJECTIVES
After going through this unit, you should be able to :
• Explain the meaning of ratio analysis, purpose of ratio
analysis, need for analysis of ratio and use of ratios.
• Narrate the advantages and limitations of ratio analysis.
 127

1.1 MEANING, PURPOSES AND NEED FOR RATIO

ANALYSIS

Ratio analysis is an important means of expressing the

relationship between two numbers. A ratio can be ascertained
from any pair of figures. A ratio must represent a meaningful
relationship to achieve its objectives, but the use of ratios can
not substitute studying the underlying data.

It is not easy to arrive at any concrete conclusion from a

large number of figures with varying degrees, whether a business
is progressing or not. The following situation will make this
point clear.
Situation Capital Employed Profit Earned
Rs. Rs.
No.1 60,000 12,000
No.2 48,000 12,000
No.3 50,000 10,000
From the situations mentioned here, it is very difficult
to recommend any situation as being the best of the three
situations. Persons without knowledge of accountancy and
arithmetics may perhaps recommend situation No.1 which
indicates highest profit. They may also be in a dialemma
which one of these situations is by far the best. To overcome
such problem the only solution is to bring a relationship
between the two figures appearing therein and express them
in terms of percentage.
Situation Relationship Result (Percentage)

12,000
No.1 --------------------- x 100 20%
60,000
12,000
No.2 --------------------- x 100 25%
48,000
10,000
No.3 --------------------- x 100 20%
50,000
128
From the situations shown above, it is quite clear that the
situation no.2 is by far the best of all the situations. Therefore,
ratio analysis is the process of determining and interpreting
numerical relationships based on financial statements.
Presentation of these ratios enables the user to understand
financial statements in a better way than by simply looking at
the absolute rupee amounts alone.
Ratios are guides or indicators that are useful in
evaluating the financial position and operations of a company
and in comparing them to previous years or to other companies.
The main purpose of ratios is to pinpoint the areas for further
investigation. They should be used in connection with a general
understanding of the business enterprise and it environment.
The outsiders are also benefited by the study of accounting
rations. They are mainly interested in:
(i) The solvency or liquidity position (short-term and / or
long-term).
(ii) The profitability or the earning capacity.
For example, a temporary lender of money will be
interested in the liquidity position of the firm and analysis of
solvency position will help him to determine the desirability of
granting loan. Likewise, a mortgage will be interested mainly in
his security, an intending investor, in the earning capacity and
so on.

1.2 ADVANTAGES OF RATIO ANALYSIS

Ratio analysis is useful to management in pointing out
specific areas that reflect improvement or deterioration as well
as detect any point of trouble area that may hamper the
attainment of objectives. The related parties carry out frequent
examination of these three areas to evaluate management's ability
to maintain a satisfactory balance among them, and to appraise
the efficiency and effectiveness with which management directs
the firm's operations. In this way, the purpose of ratio analysis is
to help the reader of financial statements understand the
information shown by focusing a number of key relationships.
However the following are the principal advantages of ratio
analysis:
 129
1. Accounting ratios are most commonly used for
management control purpose, by comparing its own
performance with the performance with the performances
of other similar types of business. It permits the data to
measured against yard -sticks. Of performance or of sound
financial condition.
2. Accounting ratios play a significant role in cost accounting,
financial accounting, budgetary control and auditing.
3. It guides management in formulating future financial plans
and policies.
4. Accounting ratios provide greater clarity, meaning to the
data and it brings out information not otherwise apparent.
5. Accounting ratios measure profitability and solvency of a
business concern.
6. It facilitates monetary figures of many digits to be condensed
into two or three digits, which enhance the managerial
efficiency.
7. From ratio analysis, it is possible without any difficulty, to
have a general impression of the past performance of the
business and is possible to have a forecast about the
uncertain future.
8. Accounting ratios are one of the factor which accelerates
the development of the art in the field of financial
management.

1.3 LIMITATIONS OF RATIO ANALYIS

Accounting ratios are not free from some limitations. These are :
1. Rather than the actual ratios and percentages, the trend of
the result is more important. Structural relationships,
ascertained from the financial statements of a single year
only, are of limited value. The trends of these structural
relationships ascertained from statements of a series of years
may be more useful than absolute ratios.
2. Standard ratios, predictive analysis and budgeting are often
more useful to management than ratios obtained by the
analysis of past results. But in analyzing financial
statements, the accountant is bound to use historical
financial statements.
130
3. It is also important fact that one specific ratio used without
reference to other ratios may be misleading. In arriving at a
correct diagnosis, the combined effect of the various ratios
must be considered which will be of assistance in
appropriate interpretation. Each ratio has its own role in
this interpretation.
4. Unless and unit the accounts have been prepared on
uniform basis, inter-firm comparison through accounting
ratios becomes misleading. Similarly unless the accounts
have been prepared on consistent basis over the periods,
even in the same unit same ratios over a number of periods
may not carry the same meaning.
5. It must be admitted that ratios are only a preliminary step
in interpretation and must be supplemented by deeper
investigation before some conclusions can be drawn from
them. They may be useful in attracting attention to the
aspect (s) of the business which require further analysis and
investigation.
6. From the above points, it can be stated that ratio analysis
can be regarded "only as an aid to making, judgement and
not a substitute to judgement."

1.4 POINTS TO REMBMER

Ratio analysis is an important means of expressing the
relationship between two numbers. A ratio can be ascertained
from any pair of figures. A ratio must represent a meaningful
relationship to achieve its objectives, but the use of ratios can
not substitute studying the underlying data.
Ratios are guides or indicators that are useful in
evaluating the financial position and operations of a company
and in comparing them to previous years or to other companies.
The main purpose of ratios is to pinpoint the areas for further
investigation. They should be used in connection with a general
understanding of the business enterprise and its environment.
To outsiders are also benefited by the study a accounting
ratios. They can judge the position of business enterprise
particularly with regard to the following aspects in which they
are mainly interested:
 131
(i) Short-term or long-term solvency of the business as well as
its liquidity position.
(ii) The profitability or the earning capacity of the business.
Ratio analysis is useful to management in pointing out
specific areas that reflect improvement or deterioration as well
as detect any point of trouble area that may hamper the
attainment of objectives.
Accounting ratios are not free from some limitations.
Therefore, ratio analysis can be regarded 'only as an aid to
making judgement and not a substitute to judgement.'

1.5 KEY WORDS

Ratio Analysis : Ratio analysis is one of the popular tools of
financial statement analysis. Ratio is the quotient formed
when one magnitude is divided by another measured in
the same unit. A ratio is defined as "the indicated quotient
of two mathematical expressions " and as "the relationship
between two or more things". Usually the ratio is stated
as a percentage.
Solvency : This indicates the ability of a business enterprise to
repay its debts in time to creditors. A satisfactory solvency
position ensures safety to both long-term and short-term
debts due to creditors or bankers.
Liquidity : Liquidity refers to the status of convertibility of
assets (namely, current assets) into cash. If a company
has insufficient current assets in relation to its current
liabilities, it might be unable to meet its commitments,
and be forced into liquidation.

1.6 SELF ASSESSMENT QUESTIONS

1. What do you understand by "Accounting Ratios"? State

their significance in the analysis of financial statements.
132
2. Discuss the purposes of accounting ratios. Also explain the
need for the study of accounting ratios.
3. "A device for making financial data more meaningful is to
reduce them to ratios." Elucidate the statement.
4. Describe the advantages that are derived from ratio analysis.
5. State the main limitations of ratio analysis.
6. "Ratios are mechanical and incomplete." Explain this
statement.

1.7 FURTHER READING

Safah, M.A., "Management Accounting : Principles and Practice",
Ashish Publishing House, New Delhi - 26.
 133
Block 4
Unit 2 : DIFFERENT MODES OF EXPRESSING RATIOS ;
ANALYSIS AND INTERPRETATION OF
DIFFERENT RATIOS ACCORDING TO
CONVENTIONAL AND FUNCTIONAL
CLASSIFICATION

Structure :
2.0 Objectives
2.1 Different Modes of Expressing Ratios
2.2 Conventional or Structural of Statement Classification of
ratios
(a) Balance Sheet Ratios
(i) Balance Sheet Ratios
(ii) Liquid Ratio
(iii) Proprietary Ratio
(iv) Debt-Equity Ratio
(v) Capital Gearing Ratio
(vi) Stock to working capital ratio.
(b) Revenue Statement Ratios
(i) Gross Profit Ratio
(ii) Net Profit Ratio
(iii) Expense Ratio
(iv) Operating Ratio
(v) Stock Turnover Ratio
(c) Composite Ratios
(i) Ratio of Return on Proprietor's Equity
(ii) Ratio of Return on Ordinary Share Capital
(iii) Ratio of Return on Capital Employed, or Ratio
of Return on Total Resources
(iv) Ratio of Turnover of Debtors
(v) Ratio of Turnover of Fixed Assets
(vi) Ratio of Turnover of Total Assets
(vii) Ratio of Turnover of Capital Employed.
134
2.3 Functional or Purpose Classification of Ratios
(a) Liquidity Ratios
(i) Current Ratio
(ii) Acid Test Ratio
(iii) Receivables Turnover Ratio
(iv) Inventory Turnover Ratio
(b) Leverage Ratios
(i) Debt-Equity Ratio
(ii) Equity Ratio / Proprietary Ratio
(iii) Ratio of External Equities to Total Assets
(iv) Fixed Assets to Net Worth Ratio
(v) Current Assets to Net Worth Ratio
(vi) Interest Coverage Ratio
(c) Profitability Ratio
(i) Gross Profit Margin Ratio
(ii) Net Profit Margin Ratio
(iii) Ratio of Return on Assets / Capital Employed
(iv) Ratio of Return on Owner's Equity
(v) Ratio of Return on Equity Capital
(vi) Earnings Per Share (EPS)
(d) Activity Ratios
(i) Fixed Assets Turnover Ratio
(ii) Total Assets Turnover Ratio
(iii) Inventory Turnover Ratio
(iv) Average Collection Period
2.4 Points to Remember
2.5 Key Words
2.6 Self Assessment Questions
2.7 Further Readings

2.0 Objectives
After going through this unit you should be able to :
• Describe the different modes of expressing ratios.
 135
• Identify the different ratios according to conventional
classification.
• State the different ratios according to functional
classification.
• Make analysis and interpretation of different ratios
according to conventional and functional classification.

2.1 DIFFERENT MODES OF FEXPRESSING RATIOS

Ratio analysis is the process of determining and
interpreting numerical relationship between two figures taken
from the financial statements. In other words the relationship of
one item to another expressed in a simple arithmetical form is
called a ratio. This relationship may be expressed in different
modes of expressing ratios.
(i) Percentages, for example, cost of goods sold is 60%
of the net sales or
(ii) As a quotient, for instance, current assets are 1.80 times
the current liabilities.
This relationship or ratio between current assets and current
liabilities is determined by dividing the amounts of current
liabilities. Suppose, current assets are Rs.20,00,000 and current
liabilities Rs.10,00,000; then Rs.20,00,000 should be divided by
Rs.10,00,000 to establish the relationship between the two.

Current Assets Rs. 20,00,000

-----------------------------------= -----------------------------------= 2
Current Liabilities Rs. 10,00,000

This relationship or ratio are twice the current liabilities.

1. Current assets are twice the current liabilities.
2. There are Rs. 2 of current assets to meet every Re.1 of current
liabilities.
3. That the current assets are 200% of the current liabilities.
4. That the ratio of current assets to current liabilities is 2 : 1.
In whatever way the ratios are expressed they give deep
meaning to the financial data and facilitate its interpretation.
136
Analysis may be made for an internal purpose, i.e. for the
purpose of management. For this purpose varied and detailed
data would be available within the organization. However, the
analysis made by outsiders are generally based upon published
statements. The ratios discussed here are mainly on the basis
that such analysis is undertaken for the purpose required by the
management.
The management will be interested in evolving analytical
tools which will help in measuring costs, efficiency, liquidity
and profitability.

2.2 CONVENTIONAL OR STRUCTURAL OR

STATEMENT CLASSIFICATION OF RATIOS
(A) BALANCE SHEET RATIOS
(i) Current Ratio (Solvency Ratio) : This ratio is also known
as working capital ratio. It is ascertained by dividing the amount
of current assets by the amount of current liabilities. Suppose
current assets are Rs.5,00,000 and current liabilities Rs.2,50,000,
then the current ratio will be :

Current Assets Rs. 5,00,000

-----------------------------------= -----------------------------------= 2 to 1 or 200%
Current Liabilities Rs. 2,50,000

It means that for payment of current liability of Re.1 current

assets to the tune of Rs. 2 are available. In other words, for
payment of current liability of Rs.100 current assets worth Rs.200
are available.
The current ratio is considered as a test of solvency of the
business enterprise. It shows the short-tem financial strength. It
indicates the extent of protection of the current creditors of the
business entity.
It is contended that for the industrial or commercial
concerns the desirable current ratio should be 2:1. In other words,
the current assets should be twice the current liabilities so as to
ensure that the financial position of the business is should and
that it will be able to meet its commitments. In fact 1 : 1 should
be sufficient in the sense that the enterprise has as much amount
of current assets as are current liabilities. However, in practice it
is noticed that recovery from these assets gets delayed and the
 137
commitments have to be discharged in time to keep the credit of
the business. Therefore it is suggested that there should be safe
margin between current assets and current liabilities. The margin
of 2:1 i.e., current assets being twice the current liabilities, in the
ordinary course of business, provide a safe margin so that even
though current assets are reduced to half the business will still
be able to meet its Commitments.

Illustration :
The following are the relevant figures from the Balance
Sheet of the ABC Ltd. As on 31st December, 2005. Find out the
Current Ratio and give your comments.
Liabilities Rs. Assets Rs.
Bills Payable 15,000 Stock-in-trade… 95,000
Trade Creditor 78,000 Sundry Debtros… 63,000
Bank Overdarft… 28,000 Cash and Marketable
Securities … 50,000
Loans and Advances 36,000
1,21,000 2,44,000

Solution :

Current Assets Rs. 2,44,000

-----------------------------------= -----------------------------= 2.01 : 1
Current Liabilities Rs. 1,21,000
Comment :
If 2 : 1 is accepted as a proper solvency ratio, this ratio
suggests that the company would be able to discharge its
commitments easily. This ratio indicates sound working capital
position and also indicates efficient working capital
management.
(ii) Liquid Ratio : The liquid ratio is designed to show the
amount of cash available for meeting immediate payments. This
ratio which measures solvency or liquidity is also called "acid
test" or "quick assets" ratio.
It is ascertained by relating quick assets to quick liabilities.
Quick assets mean total current assets less stock-in-trade
and pre payments. Stocks are not included as quick assets
138
because of the time required for manufacturing and selling them.
Debtors are included in quick assets. It may be remembered that
all the debtors may not be readily reliable where necessary stock
up debtors may be deducted from total debtors. Quick liabilities
are current liabilities les bank overdraft. Bank overdraft is
excluded from quick liabilities because it is considered that bank
overdraft is not likely to be called back immediately.
The term liquidity refers to the conversion of assets into
the cash during the normal course of business.
This ratio provides more stringent test of the solvency of the
business enterprise. It is, therefore, sometimes termed as a
"solvency ratio".

Liquid Assets
Liquid Ratio = ----------------------------------------------------------------------------------
Current Liabilities - Bank Overdraft

Cash + Marketable Investment + Sundry Debtors

Or = ------------------------------------------------------------------------------------------------
Current Liabilities - Bank Overdraft

Illustration :

The following are the relevant extract from the Balance

Sheet of XYZ Ltd. As on 31st December, 2005. Ascertain the Acid
Test Ratio and given your comments.

Liabilities Rs. Assets Rs.

Bills Payable... 16,000 Stock-in-trade... 1,05,000
Sundry Creditors... 56,500 Sundry Debtors... 98,500
Bank Overdraft... 28,500 Cash and Bank
Balances.... 7,500
Loans and Advances
(short-term)... 2,23,000
1,01,000 2,23,000

Solution:
Cash & Bank Balance + Debtors, Loans & Advances
Acid Test Ratio = ----------------------------------------------------------------------------------------------------------------------------------------------------------
Current Liabilities - Bank Overdraft
 139

1,18,000
= ---------------------------------------------------------
72,500
= 1.62 : 1
Comment :

The Acid Test Ratio shows that the immediate solvency

(liquidity) position of the enterprise is should which is 1.62.1 as
against the standard Acid Test Ratio of 1:1.

(iii) Proprietory Ratio : Proprietory ratio represents the

proportion of Proprietors' Equity to Total Assets.

Proprietor's Equity
Proprietory Ratio = -----------------------------------------------------------------------
Total Assets

The most convenient way of expressing this ratio is in

percentages. This ratio suggests the extent of proprietors'
investment in the total investment of the business enterprise. The
ratio can not exceed 100%. If the ratio is 100%, i.e. if entire
investment in total assets is made by proprietors only, it would
mean that there are no outside liabilities and the financial
condition of the business is very good. Proprietory ratio is a test
of capitalization. High proprietory ratio is an indication of sound
financial position but in such a case the return will normally be
low. High ratio would also mean inefficient use is being made
of external finance. In fact, successful financial management
requires a balanced use of internal and external resources to
maximize the profit and rate of return.
Higher proprietory ratio is views with favour from the
creditors as they get larger protection.

Illustration :
The relevant extracts from the Balance Sheet of the ABC
Ltd. As on 31st December are presented here. Ascertain the
Proprietory Ratio and give your comment.
140
Liabilities Rs. Assets Rs.
Equity Share of Fixed Assets 1,85,000
Rs. 100 each fully (Net Block)
Paid-up 8,000 Current Assets :
Preference Share Debtors ... 85,000
of Rs. 100 each Inventory ... 90,000
fully paid-up. 1,50,000 Bills Receivable 20,000
Capital Reserve... 26,000
Revenue Reserve... 54,000
Debentures... 18,000
Creditors... 52,000
3,80,000 3,80,000
Solution :
Shareholder's Funds Rs. 3,10,000
Proprietory Ratio = --------------------------------------------------------------------------= ----------------------------------------------------
Total Assets Rs.3,80,000
= 0.812 or
= 81.2%
Comment :
It mean that 81.2% of the total value of the assets are
finance out of the proprietors' funds consisting of own
contribution and accumulated profits. This is a good position in
as much as most of the investment is finance by the proprietors.
However, such a high ratio would indicate insufficient use of
outside resources.
iv) Debt-Equity Ratio:
Debt-equity ratio establishes the relationship between
owned fund and the borrowed funds. It reflects the extent to
which borrowed capital is used in place of equity capital.
Business firms acquire assets both with owners' and creditors'
funds. The larger the portion of funds provided by owners, the
less risk is assumed by creditors. The debt-equity ratio is
ascertained as :
Total Debt
Debt-Equity Ratio = --------------------------------------------
Total Owner's Equity
 141
This ratio represents the proportion of external equity to
internal equity in the capital structure of the firm. The external
equity implies the amount of debt / liabilities to outsiders. It
includes both short-term and long-term liabilities. On the other
hand owner's equity includes all such liabilities that belong to
the shareholders, viz. share capital, reserves and surpluses. But
at the same time, the accumulated losses and deferred expenses
are to be deducted from the owner's equity in the calculation of
debt-equity ratio.
Too high or too low a ratio may be disadvantageous. Too
high ratio implies that management is not taking the
opportunities of maximizing profits through borrowing. Too low
ratio suggests undue exposure to risks of bankruptey and to a
fixed burden of interest expense in the event of relatively low
profit.
As a rule, debt-equity ratio of less than 1.00 is considered
as acceptable although this is not based on any scientific analysis.
As the ratio increases, the amount of risk assumed by creditors
increases, because the ratio signifies decreasing solvency. In reality
the acceptable level of ratio will vary from firm to firm. For instance
financial institutions will have much high debt-equity ratio as
compared to trading or manufacturing concerns.

Illustration:
From the following Balance Sheet you are required to
calculate the Debt-Equity Ratio. Also give your comments.
Balance Sheet
Liabilities Rs. Assets Rs.
3,000 Equity Buildings ... 2,50,000
Share @ Rs.100 Furniture... 40,000
each .... 3,00,000 Machinary... 2,10,000
7% Debentures... 1,50,000 Stock... 60,000
Reserves and
Surplus ... 80,000 Debtors... 30,000
Sundry Creditors... 30,000 Cash Balances... 20,000
Bills Payable... 50,000
6,10,000 6,10,000
142
Solution:
Total Debt
Liquid Ratio = -----------------------------------------------------------
Total Owner's Equity
Rs. 2,30,000
= ------------------------------
Rs.3,80,000
= 0.61 (approx)
Comment :
The proportion of total debt to total owner's equity is 61%
which implies that external debts (both short-term and long-term)
are adequately secured. If profitability is high enough to meet
the interest commitments on external debts, it will
simultaneously lead to increased return to Equity Shareholders.
(v) Capital Gearing Ratio:
This ratio indicates the relation which a capital entitled to
a fixed rate of dividend bears to the ordinary capital. In other
words, this ratio indicates the relationship of proportion between
equity capital which is entitled to unlimited rate of return to
preference capital plus debentures which are entitled to fixed
rate of return. Where capital carrying a fixed rate of dividend is
greater in proportion to the ordinary share capital then the capital
structure of the company is said to be highly geared. On the other
hand, if equity capital is higher than the preference capital and
debentures, the capital is said to be low geared.
Since dividend on equity capital can not be paid until
provision has been made for debenture interest and preference
dividend, if the capital is highly geared the equity shareholders
would bet less return.
However, if the capital is low geared, the equity
shareholders would receive more benefit. If the rate of profit
earned on total paid up capital is higher than that of the rate of
preference dividend and debenture interest ordinary
shareholders benefit and the company is said to be "Trading on
the Equity"
Preference Capital (Paid up) + Debentures
Capital Gearing Ratio = ---------------------------------------------------------------------------------------------------------
Equity Share Capital (Paid up) + Reserve & surplus
 143
Illustration :

The following are the relevant extracts from the Balance

Sheet of the Pioneer Toys. Ltd. As on 30th June, 2006. Find out
the Capital Gearing Ratio.
Liabilities Rs.
800 Equity Shares of Rs.100 each fully paid … 80,000
1,600 7% Preference Shares of Rs.100 each fully paid … 1,60,000
Debentures … … … 40,000
Capital Reserve… … … 16,000
Solution:
Preference Capital Rs.1,60,000
Capital Gearing Ratio = ------------------------------------------------------------------- = ----------------------------------------------------
Equity Share Capital Rs.96,000

=2

Preference Share Capital + Debentures Rs.1,60,000

------------------------------------------------------------------------------------------------------------------------- = ----------------------------------------------------
Equity Share Capital + Reserve Rs.80,000

= 2.08
Comments :

Here, capital is highly geared. Equity shareholders will

receive dividend only after large amount is paid to the preference
shareholders by way of dividends. But if the profitability of the
company is very high the balance of profit will be distributed
among small number of Equity holders who will get larger rate
of return.

(vi) Stock to Working Capital Ratio:

This ratio is ascertained by dividing the inventory value

by the cost of working capital. This ratio which is related to quick
assets ratio or acid test ratio, is used to draw attention to possible
reduction in working capital that may result from a fall in
inventory values.
144

Illustration:
The following are the relevant extracts from the Balance
Sheet of the Prime Wood Ltd. As on 31st December, 2005.
Calculate the Stock to Working Capital Ratio and give your
comment.
Liabilities Rs. Assets Rs.
Sundry Creditors ... 1,70,000 Inventory 1,75,000
Bills Payable ... 10,000 Cash in hand
and Bank
Unclaimed Dividend... 800 Balance... 8,500
Provision for Taxation... 15,200 Sundry Debtors...1,85,000
Bills Receivables... 21,500
Solution:

Stock to Net Working Inventory Rs. 1,75,000

Capital Ratio = ----------------------------------------- = ------------------------------------
Net Working Capital Rs. 1,94,000

= 0.902 to 1
Comment:
The inventory is almost equal to the net working capital.
If the inventory is sufficiently liquid, i.e., if it is readily reliable
this ratio should be considered satisfactory. This rate is related
to acid test ratio which draws attention to a possible reduction
in working capital. This ratio should, however, be studied
alongwith the sales to cost of sales ratio and sales to inventory
ratio.
(B) REVENUE STATEMENT RATIOS
An indepth analysis of the various items set out in the
income statement is of great significance because success of the
business ultimately depends upon the profitability of the
enterprise. Management would be interested in knowing the
factors responsible for earning profit and those which are drawn
on the revenues. For instance, management might have set the
goal that all the operating expenses should not exceed 20% of
 145
net sales and the total commission paid should not exceed 5% of
the net sales. In order to see whether the goal is achieved it would
be necessary to determine the ratio and find out whether the goal
is achieved or not. The following are the important revenue ratios.
(i) Gross Profit Ratio
(ii) Net Profit Ratio
(iii) Expense Ratio
(iv) Operating Ratio
(v) Stock Turnover Ratio
(i) Gross Profit Ratio:
This ratio is known as Gross Profit Ratio, Turnover Ratio
or Gross Profit to Turnover Ratio. It is ascertained as under:
Gross Profit
This ratio is known as Gross Profit Ratio, Turnover Ratio
or Gross Profit to Turnover Ratio. It is ascertained as under:

Gross Profit Gross Profit

Gross Profit Ratio = --------------------------or --------------------------------
Net Sales Turnover

This ratio may be expressed in pcercentages

Gross Profit
Gross Profit Ratio = --------------------------x 100
Turnover
This ratio is of immense significance is measuring the
business results. The Gross Profit should absorb all the expenses
leaving profit for the owners. Whether this is possible or not can
be judged by testing this ratio. High gross profit ratio would
normally suggest high rate of profit and the low ratio would
suggest low rate of profit. However, before coming to the
conclusions analyst must make proper inquiry into the causes
of high or low ratio.
Illustration :
The following are the relevant extracts from the Trading,
Profit & Loss Account of the Peacock Co. Ltd. For the year ended
31st December, 2005. Calculate the Gross Profit Ratio. Also give
your comment.
146
Trading Account
Rs. Rs.
To opening Stock 16,000 By Sales 2,58,500
To Purchases 2,12,500 Less Returns 8,500
2,50,000
To Gross Profit 40,000 By Closing Stock 18,500
2,68,500 2,68,500
Comment :
The Gross Profit Ratio is 16% . This ratio is not the final
test of the profitability of the concern. This ratio should be cross
checked by net profit ratio and operating ratio.
(ii) Net Profit Ratio:
This ratio is ascertained by making a comparison of net
profit and net sales. It indicates the relationship between the net
profit and net sales in terms of percentages.
This ratio of net profit to net sales indicates the portion of
profit which is left for the proprietors after all the expenses are
met. When compared with the desired ratio, this ratio reveals
whether the return to the proprietors is adequate and whether it
is commensurate with the desired rate of return.
High net profit ratio is obviously a welcome symptom as
against low net profit ratio. However the ratio may be high for a
temporary period due to boom in the market or specially
favourable market conditions.
It may be due to external forces, too. Before relying upon
this ratio, causes of changes in the ratio must be properly
analysed. However, consistently high ratio reflects the efficiency
of the business operations.
Illustration:
The following are the relevant figures taken from the
Trading and Profit & Loss Account to the XY Co. Ltd. For the
year ended 31st December, 2005. Ascertain the Net Profit Ratio.
Net Sales ... Rs.5,00,000
Net Profit ... Rs. 1,00,000
Solution:
Net Profit 1,00,000
Net Profit Ratio = -------------------------- x 100 = ---------------------- x 100
Net Sales 5,00,000
= 20%
 147
(iii) Expense Ratio :
This ratio expresses the percentage of each item of
expenditure or a group of items of expenditure in relation to
Net Sales.
This ratio is valuable for the purpose of ascertaining
whether and to what extent individual expenses vary with
different trading periods. In other words, the ratio reveals the
behaviour of each item of expenditure(or group of items) to net
sales at different periods.
Illustration:
The following are the relevant extracts from the Trading
and Profit & Loss Account of the S.Co. Ltd. for the year ended
31st December 2005. Calculate various expense ratios.
Rs. Rs.
To Opening stock 31,000 By Sales ... 3,00,000
To Purchases 1,60,000 By Closing Stock ... 47,500
To Gross Profit 1,56,500
3,47,500 3,47,500
To Administrative By Gross Profit b/d 1,56,500
Expenses ... 47,800
To Finance Expenses 3,500
To Selling and
Distribution expenses 12,000
To Net Profit ... 93,200
1,56,500 1,56,500
Solution:
1. Ratio of selling & Distribution Expenses to Net Sales :
Selling and
Distribution Expenses Rs.12,000
= ---------------------------------------------- x 100 = ------------------------------ x 100 = 4%
Net Sales Rs. 3,00,000
2. Ratio of Administrative Expenses to Net Sales :

Administrative Expenses Rs.47,800

= ---------------------------------------------- x 100 = -------------------------- x 100 = 15.9%
Net Sales Rs. 3,00,000
148
3. Ratio of Finance Expenses to Net Sales :
Finance Expenses Rs.3,500
= ------------------------------------------- x 100 = ------------------------------ x 100 = 1.16%
Net Sales Rs. 3,00,000
4. Operating Ratio :
This ratio shows the relationship between operating
expense i.e. cost of goods sold plus other operating expenses to
Net Sales.
The main function of this ratio is to ascertain the efficiency
of the management as regards business operations.
The term operating expenses include all expenses i.e. cost
of goods sold, administrative, selling, distrubiton expenses,
interests, general charges and depreciation. Financial charges e.g.,
interest should not be considered while calculating this ratio.
This ratio is ascertained as under:

Cost of goods sold + Operating Expenses

Operationg Ratio = -------------------------------------------------------------------------
Net Sales
This ratio is usually expressed in percentages.

Illustration :
The following are the relevant extracts from the Trading
and Profit & Loss Account of a company for the year ended 31st
December, 2005. Calculate the operating Ratio and give your
comments.
Rs. Rs.
To opening stock ... 62,000 By Sales ... 6,00,000
To Purchases ... 3,20,000 By Closing
To Gross Profit c/d ... 3,13,000 Stock 95,000
6,95,000 6,95,000
To Administrative Expenses 85,500 By Gross Profit b/d 3,13,000
To Interest ... 6,500
To Selling and Distribution
Expenses 23,000
To Net Profit c/d 1,98,000
3,13,000 3,13,000
 149
Solution :
Operating Expenses:
(i) Cost of goods sold :
Rs. Rs.
Opening stock ... 62,000
Purchases ... 3,20,000
3,82,000
Less : Closing stock ... 95,000
(ii) Other operating Expenses 2,87,000
Administrative Expenses... 85,500
Interest ... 6,500
Selling & Distribution
Expenses 23,000
1,15,000
Total 4,02,000

Cost of goods sold + Operating Expenses

Operationg Ratio = -------------------------------------------------------------------------
Net Sales
Rs. 4,02,000
= ---------------------------
Rs. 6,00,000
= 0.67 or 67%
Comment :
Operating ratio indicates the cost of operations. Its
purpose is to ascertain the efficiency of the management as
regards operations. Higher the operational cost lesser the net
profit margin. The ratio is 67% leaving 33% for the proprietors of
the business. This indicates the efficiency of the management.
However, in interpreting the operating ratio full
recognition should be given to the variations in individual items
of expenses from year to year, particularly those changes which
are due to to changes in accounting procedures and management
policies.
(v) Stock Turnover Ratio :
This ratio relates to number of items the stock is turned
over on an average during the accounting period. It suggests the
period within which stocks are to be replaced.
150
This ratio is ascertained by dividing the cost of goods sold
by the average stock held.
Thus, if the cost of goods sold is Rs.2,15,000 and the
average stocks held are Rs.64,000 then the ratio would be :
Cost of goods sold Rs. 2,25,000
------------------------------------ = ------------------------------ = 3.5
Average stock held Rs. 64,000

52 weeks
It means the stocks in this case turn 3.5 times a year i.e. -------------------- = 15 i.e.
3.5
every 15 weeks.

Often difficulty is experienced in finding out average

stocks held. Where monthly stock records are available it would
be possible to find out average stocks from these records. But
often it is experienced that opening and closing stock figures
only are available. In such a case, average stock held will be found
by averaging these stock values.
Rs.
Opening stock .... 84,000
Closing stock .... 1,26,000
Total .... 2,10,000
Average stock held .... 1,05,000
Normally higher frequency of stock turnover means larger
sales and more profitable business. But it the stock turnover is
comparatively lower and if it is falling, it is a danger signal.
Illustration:
The following is the Trading Account of the M.Co. Ltd. as
on 31st December, 2005. Calculate the Stock Turnover Ratio and
give your comment.

Rs. Rs. Rs.

To Opening stock 40,500 By Sales 1,80,000
To Purchases 1,11,500 Less : Returns 15,000
1,65,000
To Freight 3,850 By Closing stock 39,500
To Gross Profit 48,600
2,04,500 2,04,500
 151
Solution :
Cost of Goods sold :
Rs.
Opening stock ... 40,500
Purchases ... 1,11,550
Freight .... 3,850
1,55,900
Less : Closing stock .... 39,500
1,16,400
Average Stock :
Opening Stock ... 40,500
Add : Closing stock .... 39,500
80,000
Rs.80,000
Average Stock (
------------------------
2
) ... 40,000

Cost of goods sold

Stock Turnover Ratio = -----------------------------------
Average Stock

Rs.1,16,400
= --------------------------
Rs. 40,000
= 2.91 Times
Comment :
It means stock turns ove 2.91 times a year. Therefore, within
how many weeks the stocks turnover on an average, can be found by
52
= -------- = 17.86 weeks
2.91

(c) COMPOSITE RATIOS

Composite ratio establishes a relationship between the
two figures, one appearing in Balance Sheet and the other in
Profit and Loss Account. Composite ratios consist of the
following:
(i) Ratio of Return on Proprietors' Equity
(ii) Ratio of Return on Ordinary Share Capital
(iii) Ratio of Return on Capital Employed, or
Ratio of Return on Total Resources
152
(iv) Ratio of Turnover of Debtors.
(v) Ratio of Turnover of Fixed Assets.
(vi) Ratio of Turnover of Total Assets.
(vii) Ratio of Turnover of Capital Employed.
(i) Ratio of Return on Proprietors' Equity:
The ratio of return on Proprietors' equity represents the
earning power of the funds invested in the business by the
proprietors. This ratio enables the shareholders to know the
percentage of profit earned on the amount invested by them in
the business. In other words, this ratio measures the return on
investment by the proprietors, in the form of profit. Hence, this
ratio is also known as "Return on Priprietors' Funds" or "Earning
Proprietory Ratio".
This ratio is ascertained as under:
Net Profit
Ratio of Return on Proprietors' Equity = -----------------------------------
Proprietors' Equity
This ratio is of very practical interest to proprietors and
to those who wish to invest funds in the business enterprise.
This ratio enables them to gauge earning capability of the
business and enable them to make a comparison with similar
business in the same industry. This ratio give idea whether
adequate return is being achieved at given risks.
Illustration:
The following are the relevant extracts from the Profit &
Loss Account and Balance Sheet of the C.S. Co. Ltd. and on 31st
December, 2005.
Profit & Loss Account
For the year ended 31.12.2005
Rs. Rs.
To Administrative By Gross Profit ... 2,00,000
Expenses ... 80,000
To Selling & Distribution
Expenses... 27,000
To Finance Expenses 13,000
To Net Profit c/d 80,000
2,00,000 2,00,000
 153
Balance Sheet
------------------------------------------------------
As at 31st December, 2005
Rs. Rs.
Share Capital :
600 7% Preference
Share of Rs. 100
each fully paid ... 60,000
1,500 Equity Shares
of Rs. 100 each
paid... 1,50,000
2,10,000
Reserves :
General Reserve 40,000
Capital Redemption
Reserve ... 30,000
Dividend Equalisation
Fund ... 20,000
90,000
Rs. 3,00,000
Solution :
Ratio Return on
Net Profit
Proprietors' Equity = ------------------------------------
Shareholders' Fund
Rs. 80,000
Proprietors' Equity = ------------------------------------
Rs. 3,00,000
= 0.266 or 26.6%
Comment :
This ratio is quite satisfactory. High ratio is a symptom of
business efficiency. This ratio would attract both the classes of
people, i.e. investors and creditors and would as well help the
business external finance. However, before relying upon this
154
ratio comparison should be made with the similar ratio of other
enterprises in the same class of industry.
(ii) Ratio of Return on Ordinary Share Capital:
This ratio helps in measuring the return available on the
funds supplied by the ordinary shareholders, to the exclusion
of the preference shareholders. This ratio relates the net profit
(less the amount necessary for paying the dividend to preference
shareholders) or the ordinary capital. This ratio is designed to
show what percentage of the net profit for the period bears to
the amount of capital invested by the ordinary shareholders.

Ratio of Return on Net Profit (less Preference dividend)

Ordinary capital = ------------------------------------------------------------------ x 100
Ordinary Capital
If the perference shares are Participating, Preference Share
then in that case the furthe amount required to be paid to them
must be deducted from net profit before this ratio is worked out.

Illustration:
The following are the extracts from the Profit and Loss
Appropriation Account and Balance Sheet of the BS Co. Ltd. as
on 31.12.2005.
Balance Sheet
------------------------------------
(As at 31.12.2005) Rs.
600, 7% Preference Shares of
Rs. 100 each fully paid ... 60,000
1,500 Equity Shares of Rs.100
each fully paid .... 1,50,000

Profit & Loss Appropriation Account

--------------------------------------------------------------------------
(For the year ended 31.12.2005)
Rs. Rs.
To Proposed Dividends : By Net Profit b/d 40,000
Preference 4,800
Equity 15,000
19,800
To Provision for Taxation 15,000
To Balance c/d. 5,200
40,000 40,000
 155
Solution :
Ratio of Return on Ordinary Capital :
Rs.
Net Profit ... 40,000
Less : Dividend
Preference Shareholders 4,800
35,200
Net Profit Rs. 35,000
------------------------------------ = ------------------------------ x 100
Ordinary Capital Rs. 1,50,000

= 23.46%
(iii) Ratio of Return on Capital Employed or Ratio of Return
on Total Resources :

This ratio is determined by ascertaining the relationship

between net profit and the total resources employed in the
business.
Net Profit may be total net profit as stated in Profit &
Loss Account or operating net profit which is arrived at by
excluding the items of incomes and expenses of non-recurring
and exceptional nature.
This ratio is an indicator of the earning power of the
business. It reveals how profitably the management has
employed resources at its disposal. Obviously higher ratio will
indicate better management performance.

Net Profit
Ratio of Net Profit to Total Assets = ----------------------------
Total Assets

Ratio of Operating Operating Net Profit

Net Profit to Total Assets = -------------------------------------------
Total Assets

Illustration :

The following are the relevant extracts from the Trading,

Profit & Loss Account and Balance Sheet of the K.S. Ltd., as on
31st December, 2005.
156
Balance Sheet
( As at 31st December, 2005)
Assets Rs. Rs.
Fixed Assets ... 1,82,000
Current Assets :
Debtors ... 62,000
Stock in trade ... 12,000
Bills Receivable... 4,500
Cash in Bank ... 16,500
95,000
Rs. 2,77,000
Trading and Profit & Loss Account
(For the year ended 31st December, 2005)
Rs. Rs.
To Opening Stock ... 18,000 By Sales 4,38,000
To Purchases ... 3,60,000 Less :
3,78,000 Return 12,000
4,26,000
Less : Closing stock 26,000
Cost of Sales.... 3,52,000
To Gross Profit c/d 74,000
4,26,000 4,26,000
To Establishment Expenses 4,000 By Gross Profit b/d 74,000
To Administrative Expenses 32,000
To Selling & Distribution
Expenses 4,000
To Finance Expenses ... 1,000
To Net Profit c/d 3,000
Total Rs. 74,000 Total Rs. 74,000

Solution :
Ratio of Return on Total Resources :
Operating Net Profit to Total Assets :
Operating Net Profit Rs. 33,000
------------------------------------ = ------------------------------ = 0.119 or 11.9%
Total Assets Rs. 2,77,000
 157
(iv) Ratio of Turnover of Debtors :
This ratio shows the time lag between the sales and the
collection from debtors. It shows the normal period for which
sundry debtors are outstanding. This ratio indicates the level of
efficiency of the credit policies and working of the collection
departments.
The amount of total credit sales is divided by 365 to find
out average daily credit sales. The total debtors and bills
receivables should then be divided by the daily average credit
sale to find this ratio.
Rs.
Total Sales ... 6,30,000
Less : Cash Sales ... 30,000
Credit Sales ... 6,00,000
Total Debtors ... 80,000
Bills Receivables ... 70,000
Total Receivables ... 1,50,000

Rs. 6,00,000
Average Daily Credit Sales = --------------------------------- = Rs.1,644
365

Total Receivables Rs. 6,00,000

------------------------------------------------------- = -------------------------------------- = 91 days
Average Daily Credit Sales Rs.1,644

Thus the debtors turn over within 91 days. If the policy of

the enterprise is to allow 90 days' this ratio confirms that the
policy is properly followed. But suppose, the credit period is 60
days and this ratio shows that the credits period has been unduly
extended and the management must find the causes for the same.
It is likely that some debtors are stuck up or there may be dispute
relating to prices, quality or goods with major debtors.

The ratio also suggests the period for which money

remains blocked with debtors. Management might test the
advisability of investing the funds with the debtors.
158

Illustration:
The following are the relevant extracts from the Trading
Account and Balance Sheet of B.C. Ltd. as on 31st December, 2005.
Calculate the ratio of turnover of debtors.
Balance Sheet
(As at 31st December, 2005)
Current Assets, Loans and Advances:
Rs. Rs.
Sundry Debtors ... 64,000
Stock-in-trade ... 41,800
Bills Receivable ... 6,000
Cash in Bank ... 12,560
1,24,360
Trading Account
(For the year ended 31st December, 2005)
Rs. Rs.
By Sales ... ... 3,16,400
Less : Returns ... ... 4,400
3,12,000
Solution :
Turnover of Debtors

Rs. 3,12,000
Average Daily Sales = --------------------------------- = Rs.854.79
365 or
= Rs.855

Total Receivable
No. of days' credit = -------------------------------------------
Average Daily sales

Rs. 70,000
= -----------------------------
855

= 81.8 or 82 days.
 159
(v) Ratio of Turnover of Fixed Assets:
This ratio measures the efficiency in the utilisation of fixed
assets. The ratio of sales of fixed assets measures the turnover of
the plant and machinery and is expressed as under:
Sales
Ratio of Turnover of Fixed Assets= --------------------------------------
Net Fixed Assets
For example : Sales Rs. 2,60,000 and Fixed
Assets Rs. 2,00,000

Rs.2,60,000
Ratio of Turnover of Fixed Assets= ------------------------------
Rs. 2,00,000
= 1:3:1
It means that for every investment of Re.1 in fixed assets
of the business, Rs.1.30 is the worth of sales. This ratio, thus,
indicates the level of operational efficiency.
(vi) Ratio of Turnover of Total Assets :
This ratio measures the overall performance and activity
of the business organisation. It is computed by dividing sales
by total assets. The following formula is applied to compute this
ratio.
Sales
Ratio of Turnover of Total Assets = ------------------------------
Total Assets

Illustration :
Compute the Ratio of Turnover of Total Assets from the
following particulars:
Rs.
Sales ... ... 5,60,000
Less : Returns 60,000
Assets :
Fixed 1,50,000
Current 1,00,000
Rs. 2,50,000
160

Solution :
Sales
Ratio of Turnover of Total Assets = ------------------------------
Total Assets

Rs. 5,00,000
= -----------------------------
Rs.2,50,000
= 2:1
Comment :
It means that for every investment of Re.1 in total assets
of the business, Rs.2 is the worth of sales. This ratio thus indicates
that the total assets investments have been very gainfully utilised
in the business.
(vii) Ratio of Turnover of Capital Employed:
This ratio indicates how many capital turned over during
a given period. High turnover rate reflects higher profitability
of business. This ratio is an indicator of managerial efficiency.
In other words, this ratio shows the extent to which capital
employed contributes towards sales and is measured by :

Sales
= --------------------------------------
Capital Employed
This ratio is expressed in terms of TIMES.
For example, sales Rs.10,00,000 ; capital
employed Rs. 2,50,000
Then the ratio of Turnover of Capital Employed would
be as follows:
Sales Rs.10,00,000
= -------------------------------------- = ------------------------------ = 4 times.
Capital Employed Rs.2,50,00
The ratio, thus computed, implies that capital employed
turns over 4 times during during the year. In othe words, capital
employed turns over once in 3 months.

Illustration:
Compute the Ratio of Turnover of Capital Employed from
the following particulars. Also give your comments.
 161
2004 2005
Rs. Rs.
Sales ... ... 6,00,000 7,50,000
Capital Employed ... 2,00,000 3,00,000
Solution :
Ratio of Turnover of Sales
Capital Employed = --------------------------------
Capital Employed
2004 2005

Rs. 6,00,000 Rs.7,50,000

= -------------------------------- = --------------------------------
Rs.2,00,000 Rs.3,00,000
= 3 times = 2.5 times

Comments :
The velocity of turnover of capital employed has
decreased from 3 times in 2004 to 2.5 times in the year 2005. This
might be due to the following reasons:
(i) Unscientific adoption of loan capital without proper
diagnosis in the sales area.
(ii) Operational performance of the business appears to be
unsatisfactory.
It should be noted that higher is the capital turnover ratio,
better is the operational performace.

2.3 FUNCTIONAL OF PURPOSE CLASSIFICATION OF

RATIOS
(a) LIQUIDITY RATIOS
(i) Current Ratio
(ii) Acid Test Ratio
(iii) Receivables (Debtors) Turnover Ratio
(iv) Inventory (Stock) Turnover Ratio
These ratios have been discussed in the conventional
classification of ratios.
162
(b) LEVERAGE RATIOS
(i) Debt-Equity Ratio
(ii) Equity Ratio / Proprietory Ratio
These ratios have been discussed under the Balance Sheet
ratios within the conventional classification.
(iii) Ratio of External Equities to Total Assets:
(Solvency Ratio)
This ratio measures the proportion of the firm's assets that
are financed by creditors. The ratio of external equity to total
assets is a variant of the proprietory ratio. To the creditor, a low
ratio would ensure greater security for extending credit to the
firm. However, a low too low ratio suggests that management is
not using its credit most advantagenosly. This ratio is expressed
as under.
External Equities
Solvency Ratio = -------------------------------------
Total Assets
The term external equities represent all debts both long-
term as well as short term. On the other hand, total assets refer to
total resources of the concern.
(iv) Fixed Assets to Net Worth Ratio (Ratio of fixed assets to
proprietor's funds)
This ratio indicates the percentage contributed by owners
to the value of the fixed assets. This ratio can be worked out as
follows:
Fixed Assets
Fixed Assets to Net Worth = ------------------------------
Net Worth
Fixed asset implies the cost of acquisition of fixed assets
less the amount of depreciation thereon upto the period. The
net worth means the amount due to the shareholders, i.e. share
capital, reserves and surpluses. The financial experts contend
that in manufactring concerns, the investment in plant should be
made out of borrowed capital. Therefore a ratio of at least 1:1 is
considered desirable. While a lower ratio suggests an undue
burdern of debt on the enterprise tht tends to increase the internal
rate at which an enterprise can borrow.
 163

(v) Current Assets to Net Worth Ratio :

The ratio of current assets to net worth establishes the

relationship between the current assets and net worth. In other
words, it is a correlation between current assets and net worth.
This ratio is expressed as :
Current Assets
Current Assets to Net Worth Ratio = ------------------------------
Net Worth

The ratio means the extent to which shareholders' funds

have gone into the financing of the current assets. It is useful to
study the ratio of current assets to net worth with the ratio of
fixed assets to net worth.
(vi) Interest Coverage Ratio:
A company is solvent if its revenue is more than its interest
and other expenses. Likewise a company having sufficient
revenue to meet only expenses and leaving nothing as net income
is considered less solvent. Against the background, one of the
aproaches to test the solvency of the company is interest coverage
ratio.
This ratio measures how many times a company could
pay its interest expenses which is calculated by dividing interest
expenses into earning available for payment of interest expense.
This ratio can be ascertained as:
Net Profit before interest and tax
Interest coverage Ratio = -----------------------------------------------------------------
Fixed Interest charges

Interest Coverage Ratio measures the ability of a firm to protect

the interests of long-term creditors. It is often stated that in order
to ensure an adequate protection to the long-term creditors this
ratio should be 2 or more.

Illustration:

From the following Balance Sheet you are required to

calculate the ratios mentioned below the Balance Sheet.
164

Balance Sheet

Liabilities Rs. Assets Rs.

6,000 Equity Shares Buildings ... 5,00,000
@ Rs. 100 each ... 6,00,000 Machinery... 4,20,000
7% Debentures 3,00,000 Farniture ... 80,000
Reserves & Surplus 1,60,000 Stock... 1,20,000
Sundry Creditors 60,000 Debtors 60,000
Bills Payable 1,00,000 Cash Balance 40,000
12,20,000 12,20,000
(i) External Equities to Total Assets Ratio.
(ii) Fixed Assets to Net Worth Ratio.
(iii) Current Assets to Net Worth Ratio.
Solution:

(i) External Equities to External Equities

Total Assets Ratio = ---------------------------------------------
Total Assets

Rs. 4,60,000
= ----------------------------
Rs.12,20,000
= 0. 377
Fixed Assets
(ii) Fixed Assets to Net Worth Ratio = --------------------------------
Net Worth
Rs. 10,00,000
= -----------------------------
Rs.7,60,000
= 1.315

Current Assets
(iiI) Current Assets to Net Worth Ratio= --------------------------------
Net Worth
Rs. 2,20,000
= -----------------------------
Rs.7,60,000
= 0.289
 165

(c) PROFITABILITY RATIOS

(i) Gross Profit Margin Ratio
(ii) Net Profit Margin Ratio
(iii) Ratio of Return on Assets / Capital Employed
(iv) Ratio of Return on Owners' Equity
(v) Ratio of Return on Equity Capital
All these ratios have been explained earlier.
(vi) Earnings Per Share (EPS) :
This ratio is very popular and widely used indicator of
profitability because it can be easily compared to the previous
EPS and to the EPS of the companies. The earnings per share
indicates average amount of net income earned by each equity
share. This ratio is calculated with the help of the following
formula:
Net Profit after tax - Preference dividend
(ii) EPS = ---------------------------------------------------------------------------------
No. of Equity shares

Illustration:
From the data given below, you are required to calculate
the ratio of Earnings Per Share:
Capital :
5,000 7% Preference Shares
@ Rs. 100 each fully paid;
15,000 Equity Shares @ 100 each fully paid;
Assets:
Rs.
1 - 4 - 2005 ... 5,50,000
31-3-2006 ... 7,00,000
Net Profit for the year
(after tax) ... 1,75,000
Solution:
Net Profit after tax - Prof. Divid.
Earnings Per Share (EPS) = ----------------------------------------------------------------
No. of Equity Shares

Rs. 1,75,000 - Rs. 35,000

= -------------------------------------------------
15,000
= Rs. 9.33
166

(d) ACTIVITY RATIOS

(i) Fixed Assets Turnover Ratio
(ii) Total Assets turnover Ratio
(iii) Inventory Turnover Ratio
(iv) Average Collection Period.
The first two ratios have been discussed under the
composite ratios. The last two ratios have been disscussed under
the liquidity ratios.

2.4 POINTS TO REMEMBER

Current Assets
Current Ratio = ---------------------------------------
Current Liabilities
Liquid Assets
Acid Test Ratio= --------------------------------------------------------------------------------------------------------------------
Liquid Liabilities ( Current Liabilities - Bank Overdraft )
Proprietor's Equity
Proprietory Ratio = ------------------------------------------------
Total Asset
Total Debt
Debt - Equity Ratio = ------------------------------------------------
Total Owner's Equity
Cost of goods sold + Operating Expenses
Operating Ratio = -------------------------------------------------------------------------------------------------------
Net Sales
Cost of goods sold
Stock Turnover Ratio = -------------------------------------------------------
Average stock held
Ratio of Return on Net Profit
Capital Employed = --------------------------------
Total Assets

Ratio of Turnover Total Receivables

of Debtors = --------------------------------------------------------------
Average Daily Credit Sales

Net Profit before interest and tax

Interest Coverage Ratio = ---------------------------------------------------------------------------
Fixed Interest Charges
 167

Net Profit after tax - Preference Dividend

Earnings Per Share (EPS)= ------------------------------------------------------------------------------------------
No. of Equity Shares

2.5 KEY WORDS

Liquidity : This indicates the liquidity position of the

company. In other words, it refers to the
immediate liquid assets like cash and assets
which are immediately convertible into cash.

Leverage : Leverage is an indication of the use of company

makes of borrowed funds to increase the return
on owner's equity. Leverage measures the
contribution of financing by owners compared
with the financing provided by the firm's
creditors.

Solvency : Solvency refers to the ability of the company to

repay its debts. If it is unable to do so, then the
company is insolvent. On the contrary, if it has
the ability to repay its debts then it is solvent.

2.6 SELF ASSESSMENT QUESTIONS

1. Discuss the different modes of expressing accounting
ratios.
2. Describe the different ratios as per the conventional
classification.
3. Narrate the various ratios under the functional
classification of ratios.
4. What do you understand by liquidity ratios, leverage
ratios, profitability ratios and activity ratios?
5. Following are the accounting information obtained from
the books of a limited company.
168
Rs.
Sales ... ... 22,50,000
Cost of Goods sold ... 12,50,000
10,00,000
Administrative Expenses 3,50,000
6,50,000
Taxes... 4,00,000
Net Profits ... 2,50,000
Balance Sheet
Liabilities Rs. Assets Rs.
Equity share Capital 7,50,000 Building 15,00,000
7% Preference Share Capital 15,00,000 Machinery 12,50,000
Reserves 2,50,000 Debtors 1,50,000
6% Debntures 4,00,000 Stock 1,50,000
Current Liabilities 2,50,000 Cash 1,00,000
31,50,000 31,50,000
Opening stock was Rs.1,50,000 You may assume 360 days in a year.
Ascertain the following ratios:
(i) Current Ratio
(ii) Debt-Equity Ratio
(iii) Gross Profit Ratio
(iv) Net Profit Ratio
6. The following is the Balance Sheet of the A.K. Ltd. and
on 31st December, 2005 :
Liabilities Rs. Assets Rs.
Share Capital 4,00,000 Buildings 4,00,000
General Reserve 1,00,000 Machinery 3,00,000
Profit & Loss 61,000 Inventory 2,00,000
Bank Loan 1,40,000 Debtors 1,20,000
Sundry Creditors 3,00,000 Cash in hand 41,000
Provision for tax 60,000
10,61,000 10,61,000
 169
You are required to comment on the liquidity position of
the company.

7. The following is the Balance Sheet of the B.C. Ltd. for the
year ended 31st December, 2005.
Balance Sheet
Liabilities Rs. Assets Rs.
10,000 Equity shares Fixed Assets 4,00,000
of Rs. 20 each 2,00,000 Stock 60,000
Reserves 40,000 Debtors 60,000
Profit & Loss A/C 60,000 Cash Balances 80,000
6% Debentures 1,60,000
Trade Creditors 1,00,000
Bills Payable 40,000

6,00,000 6,00,000

You are required to calculate:

(i) Debt-Equity Ratio

(ii) External Equities to Total Assets Ratio

(iii) Fixed Assets to Net Worth Ratio

(iv) Proprietory Ratio

8. Calculate the Average Collection Period from the

information given below:

Total Sales ... Rs.6,00,000

Cash Sales ... 20% of Net Sales
Sales Returns ... Rs. 50,000
Total Debtors at the end of the year Rs. 60,000
Bills Receivable at the end of the year Rs.20,000
Provision for Bad Debts ... Rs. 6,000
170
9. The following are the information taken from the financial
statements of company:
(i) Capital :
a) 7% 4,000 Preference Shares @ Rs.100 each fully paid
b) 8,000 Equity Shares @ Rs.100 each fully paid
(ii) Profit before tax Rs. 15,00,000
(iii) Rate of Tax 40%
(iv) Depreciation Rs.1,60,000
(v) Market price of Equity Share Rs.500
(vi) Proposed dividend 25%
You are required to calculate the Earnings Per Share (EPS).

2.7 FURTHER READING

Sahaf, M.A., : "Management Accounting : Principles and
Practice", Ashish Publishing House, New
Delhi - 26.
 171

BLOCK - 5
WORKING CAPITAL
WORKING CAPITAL - CONCEPT AND MANAGEMENT -
PROJECTION OF WORKING CAPITAL REQUIREMENTS -
(1) IN CASE OF TRADING ORGANISATION
(2) IN CASE OF MANUFACTURING ORGANISATION
Block - 5 : comprises two unit
Unit 1 Discusses the meaning, concepts and importance of
working capital. It also explains the factors affecting
the amount of working capital.
Unit 2 Describes how to estimate the working capital
requirements in case of trading organisation and
manufacturing organisation.

UNIT - 1 WORKING CAPITAL - CONCEPT AND MANAGEMENT

Structure
1.0 Objectives
1.1 Meaning of Working Capital
1.2 Concepts of Working Capital
1.3 Importance of Working Capital
1.4 Factors affecting the amount of Working Capital.
1.5 Classification of Working Capital
1.6 Working Capital Cycle
1.7 Points to Remember
1.8 Key Words
1.9 Self-Assessment Questions.
1.10 Further Readings.

1.0 OBJECTIVES
After going thorugh this unit, you should be able to :
• Explain the meaning, concepts and importance of
working capital.
• Analyse the factors affecting the amount of working
capital.
• Classify working capital and describe the working
capital cycle.
172

1.1 MEANING OF WORKING CAPITAL

Working capital indicates the investment by a company in
short-term assets such as cash, marketable securities, accounts
receivable and inventories. Net working capital or net current
assets refers to the current assets less current liabilities.
Management of working capital, therefore, includes management
of all current assets and current liabilities.
The apparatus, which the businessman uses in carrying on
his business, has two main and distinct wings. One of the wings
consists of establishment such as land, building, plant,
equipments, accessories, tools, production processes etc.
popularly known as fixed assets. The other and equally
important wing is to "funds" with which day-to-day business
operations are carried out. Sophisticated machinery and state of
the art techniques might be made available by the businessman
for manufacturing the product, but it is the amount of "funds"
which are employed in day-to-day carrying on the business and
the efficiency with which these are employed, determine to a
great extent the financial results of the business enterprise.
Funds are utilised in day-to-day business in the form of
debtors, stocks, bills receivables, cash and bank balances and
readily realiable investments etc. These are popularly called
"current assets". It is with these funds that the day-to-day working
of the business is carried on. These assets are, therefore, known
as "Working Capital".
Thus working capital refers to the investment by a business
in its short-term assets like inventories, accounts receivable,
marketable securities. Net current assets or net working capital
represents the current assets less current liabilities. Hence,
management of working capital involves management of all
current assets and current liabilities.

1.2 CONCEPTS OF WORKING CAPITAL

There are two concepts regarding the meaning of working
capital. According to one School of thought (supported by
distinguished authorities like Lincoln, Doris, Stevens and Saliers),
Working capital is the excess of current assets over current
liabilities, as reflected in the following equation:
Working Capital = Current Assets - Current Liabilities.
 173
Net Working Capital refers to the difference between the
current assets and current liabilities, i.e. the excess of current
assets over current liabilities. The importance of this net working
capital concept lies in that the business has to determine the
amount and nature of the current assets to be used for meeting
the commitment to current liabilities, as and when they become
due for payment. Further, the amount needed in the business
for operational purposes is the amount of current assets that
remain after payment of liabilities.
According to the other School of thought (supported by
authorities like Mead, Baker, Mallot and Field), Working Capital
represents only the current capital assets or gross working
capital. There is basis for both these contentions. To understand
them, current conception of current assets and liabilities is
essential. Current Assets are those assets that in the ordinary
course of business can be or will be turned into cash within a
short period(note exceeding one year, normally) without
undergoing diminution of value and without disrupting the
organisation. Examples of current assets are : (i) Cash in hand
and at bank; (ii) Accounts receivable from customers (les
reserve); (iii) Notes receivable from customers (les reserves); (iv)
Inventories such as (a) Merchandise Inventory (of merchants), or
(b) Raw Marketable work in progress, Finished goods (of
manufacture); (vii) Marketable securities held as temporary
investment; (viii) Accured income.
Current liabilities are those liabilities intended at their
inception to be paid in ordinary course of business within a
reasonable short time (normally within a year) out of the current
assets or the income of the business. These are : (i) Accounts
payable to creditors; (ii) Notes or Bills payable ; (iii) Accrued
expenses such as accrued taxes, salaries and interest; (iv) Liability
reserves of the nature of accrued expenses, such as a reserve for
income taxes; (v) Bonds to be paid within one year, (vi) Dividends
payable.
The arguments of the first School of thought with regard to
working capital as the excess of current assets over current
liabilities ae : (i) It is an established definition of working capital
which is in use since long, (ii) This concept of working capital
enables the shareholders to judge the financial soundness of the
concern and the extent of protection afforded to them. It is
because with an increase in short-term borrowings the working
174
capital does not increase. (iii) Any concern with an excess over
current liabilities can successfully tide ove periods of emergency
e.g. depression (iv) Further there is no obligation on the part of
the company to return the amount invested by the shareholders
or creditors. (v) Such a definition is of great practical value in
ascertaining the true financial position of companies having
current assets of similar amount.

1.3 IMPORTANCE OF WORKING CAPITAL

Proper and efficient management of working capital is very
important for the success of an enterprise. It aims at protecting
the purchasing power of assets and maximising the return on
investment. The manager of administration of current assets to a
very large extent determines the success of operations of a firm.
Constant management is required to maintain appropriae levels
in the various working capital accounts. Cash and financial
bodget aid in establishing proper proportions. Sales expansion,
dividend declaration, plant expansion, new product line,
increased salaries and wages, rising price levels etc. put added
burdern on working capital maintenance. Failure of business is
undoubtedly due to poor management and absence of
management skill. Shortage of working capital, so often
advanced as the main cause of failure of industrial concerns, is
nothing but the clearest evidence of mismanagement which is
so common.
In fact the major portion of the financial manager's time is
spent in the management of working capital. Current assets
account for a very large portion of the total investment of a firm.
In some of the industries, current assets on an average represents
over three fourths of the total assets. In the case of trading
concerns, these account for about 80% of the total investment.
The relationship between sales growth and current assets
is close and direct. A firm may, sometimes, be able to reduce the
investment in fixed assets by renting or leasing plant and
machinery. But it can not avoid investment in cash, accounts
receivable and inventory. The management of working capital
also helps the management in evaluating various existing or
proposed financial constraints and financial offerings. All these
factors clearly indicate the importance of working capital
management in a firm.
 175

1.4 FACTORS AFFECTING THE AMOUNT OF WORKING

CAPITAL
The Level of working capital requirement is influenced by
a number of factors which are discussed below:
(i) General nature and type of business.
(ii) Size of business,
(iii) Production cycle and cost of product,
(iv) Volume of sales,
(v) Terms of purchase and sales
(vi) Turnover of inventories,
(vii) Turnover of debtors
(viii) Period required to cover a business cycle,
(ix) Market conditions,
(x) Uniform and seasonal nature of sales,
(xi) Credit rating of the company.
The concept of working capital as current assets les current
liabilities does not indicate the magnitude of working capital of
a particular industrial or trading concern. As mentioned above,
the working capital requirements depend upon a variety of
factors. For instance, if the turnover of company A which
manufactures machinery is Rs.30,00,000 per annum, it might
require working capital of say Rs.10,00,000 while company B,
which carries on business as a wholesale distributor of milk
powder, may require Rs.2,00,000 as working capital for the same
turnover of Rs.30,00,000. Therefore a discussion of the factors
affecting the size of working capital should be appropriate at
this point.
(i) General nature and type of business
The working capital requirements of a manufacturing
company are relatively larger than those of a retail trader or
reseller. Industrial unit manufacturing capital goods will require
more working capital than the one producing consumer goods
since the cycle of a business manufacturing capital goods is
longer than that of consumer goods industry. But at the same
time, capital goods industry which can secure the sizeable amount
176
as advance against order for the product might need less working
capital than the consumer goods industry which has to supply
goods at any three or months' credit.
Working capital requirements of seasonal business vary
considerably with peak season requirements being larger than
those for a lean season. In case of a business dealing in perishable
goods it is difficult to carry large stocks, and hence working
capital required would be comparatively small.
Working capital requirements thus depend upon the nature
of the business.
(ii) Size of business:
The size of business also affects its working capital
requirements. The larger the scale of operations the greater is
the amount of working capital.
(iii) Production cycle and cost of product:
The time taken to convert raw materials into finished stock
is known as the production cycle. The longer the production cycle
and the greater the cost of product the larger is the inventory
tied up in its manufacture. A company engaged in turning out a
product which involves any aging process like a distillery, must
make a particularly heavy investment in inventory. On the other
hand, one engaged in bakery sells the bulk of its output daily
and therefore, it is turned over far more rapidly.
(iv) Volume of Sales :
Volume of sales is directly related to working capital
requirements. An industrial unit producing and selling 30 TV
sets in a day will require more working capital than the one
producing and selling only 10 TV sets in a day, obviously
because of larger working capital in financing the raw materials
and operating costs. Although to some extent the requirements
of working capital may be reduced by more efficient bulk buying
getting more discounts on purchases, yet by and large, working
capital requirements vary directly with the volume of sales.
(v) Terms of purchases and sales :
Working capital requirements are affected by the terms of
purchase and sale. Sometimes purchases may be self-financing.
Businessman may purchase goods on credit, say 50 or 80 days'
credit. It assumed that the operating cycle is of 40 days' duration.
 177
The finished goods produced may be sold on cash basis. Under
such circumstances, working capital requirements for purchases
would be quite small.
But when goods are bought on cash payment, larger amount
will be necessary to finance the inventory. Sometimes, supply of
materials is irregular and this necessitates making purchases as
and when materials are available, even on unfavorable terms.
Such a situation involves larger outlay of working capital.
(vi) Turnover of inventories:
The ratio of annual sales to working capital or any
component thereof determines the number of times current assets
are converted back into cash during a year. The higher the rate
of turnover, larger is the volume of business transactions which
can be conducted with a given amount of such current assets.
For inventories, the higher the rate of turnover the lesser the risk
of loss due to changes in demand, style changes and price
declines.
(vii) Turnover of debtors:
If a businessman has a monthly turnover of Rs. 2 lakhs and
allows 60 days' credit facilities, he would need investment of
Rs. 4 lakhs to finance the debtors. If he allows 90 days' credit he
would require Rs.6 lakhs of finance the debtors. The longer the
credit terms, the larger would be the finance the required. Thus,
the working capital requirements depend upon the span of time
necessary to collect receivables into cash. The shorter the time
required to collect receivables, the lower is the amount of
necessary working capital High inventory turnover alongwith
efficient collection from debtors will keep the working capital
requirements to the minimum.
(viii) Period required to cover a business cycle:
Business cycles affect the working capital requirements. In
the periods of prosperity, business activity expands. Such
expansion leads to purchasing goods in advance of current needs
to secure the advantages of lower prices and to meet the possible
increases in demand. This requires larger capital outplays. On
the other hand, I periods of depression when business activity is
reduced, there is a tendency to buy less and use the stocks already
178
accumulated and to recover the receivables. However actual
requirements of working capital is largely influenced by the
period required to cover a business cycle.
(ix) Market conditions:
The quantity of stocks to be maintained is also determined
by the availability of materials and the time taken to make the
goods available. Fluctuation in market prices discourage the
businessman to keep large inventories due to the risk of possible
loss. However, in the case of very risky business, large amount
of cash is sometimes kept by way of temporary investments to
meet the possible loss and to save the company's credit.
(x) Uniform and seasonal nature of sales:
When sales are steady and uniform almost the same amount
of working capital would be needed throughout the year.
However, if the sales are seasonal, large working capital would
be required during peak season and small one during the lean
period.
(xi) Credit Rating of the Company:
The sizes of the working capital maintained by a company
in the form of cash depends also upon the cash policy of the
company while framing such a policy the time within which
Debtors turnover and the practice of taking advantages of cash
discount should be kept in mind.
Similarly, a company having a high credit rating enjoys the
benefit of higher credit purchases. Consequently it requires a
proportionately lesser amount of working capital and vice versa.

1.5 CLASSIFICATION OF WORKING CAPITAL

Generally speaking, the amount of funds required for
operating needs varies from time to time in every business. But
a certain amount of assets in the form of working capital are
always required, if a business has to carry out its functions
efficiently and without a break. These two types of requirements
- permanent and variable are the basis for a convenient
classification of working capital as follows:
 179
Working Capital

Permanent or Fixed Temporary or Variable

Regular Reserve margin Seasonal Special

or Cushion
(i) Permanent of fixed working capital : It is that part of the
capital which is permanently locked up in the circulation of
current asset and in keeping it moving. For instance, every
manufacturing concern has to maintain stock of raw materials,
work-in-progress, finished products, loose tools and equipment.
It also requires money for the payment of wages and salaries
throughout the year.
The permanent or fixed working capital can again be sub-
divided into (a) Regular Working Capital and (b) Reserve margin
or cushion working capital. Regular Working Capital is the
minimum amount of liquid capital needed to keep up the
circulation of the capital from cash to inventories, to receivables
and back again to cash.
This would include a sufficient cash balance in the bank to
discount all bills, maintain an adequate supply of raw materials
for processing, carry a sufficient stock of finished goods to give
prompt delivery and effect the lowest manufacturing costs, and
enough cash to carry the necessary accounts receivables for the
type of business engaged in.
Reserve margin or cushion working capital is the excess
over the need for regular working capital that should be provided
for contingencies that arise at unstated periods. The contingencies
comprise (a) rising prices, which may make it necessary to have
more money to carry inventories and receivables, or may make
it advisable to increase inventories; (b) business depressions,
which may raise the amount of cash required to ride out usually
stagnant periods; (c) strikes, fires and unexpectedly severe
competition, which use up extra supplies of cash; and (d) special
operations, such as experiments with products or with method
of distribution, war contracts, contracts to supply new businesses,
and the like which can be undertaken only if sufficient funds are
available, and which in many cases mean the survival of a
business.
180
(ii) Variable working capital : The variable working capital
changes with the volume of business. It may be sub-divided into
(a) seasonal and (b) special working capital. In may lines of
business (e.g. Gur or Khandsari making and Fur industry
operations are highly seasonal and, as a result, working capital
requirements vary significantly during the year.
The capital required to meet the seasonal needs of industry
is termed as Seasonal Working Capital. On the other hand,
Special Working Capital is that part of the variable working
capital which is required for financing special operations, such
as the launching of extensive marketing campaigns experiments
with products or with methods of distribution, carrying out of
special jobs and similar other operations that are outside the
usual business of buying, fabricating and selling.
This distinction between permanent and variable working
capital is of great significance particularly in arranging the finance
for an enterprise. Regular of fixed working capital should be
raised in the same way as fixed capital is procured, through a
permanent investment of the owner or through long-term
borrowing. As business expands, this regular capital will
necessarily expand. If the cash returning from sales includes a large
enough profit to take care of expanding operations and growing
inventories, the necessary additional working capital may be
provided by the earned surplus of the business. Variable needs
can, however, be financed out of short-term borrowings from the
Bank or from public in the form of deposit.

1.6 WORKING CAPITAL CYCLE

The working capital cycle refers to the period that a business
enterprise takes in converting cash back into cash. For example,
a manufacturing firm uses cash to acquire inventory of raw
materials that is converted into semi finished goods or work-in-
progress and then into finished goods. When finished goods are
disposed of to customers on credit, account receivable are
generated. When cash is collected from customers, they again
have cash. At this stage one operating cycle is completed. Thus
a circle from cash back to cash is called the "working capital cycle".
The following diagram will illustrate the several current assets
forming the working capital cycle.
 181

Debtors g Cash g Raw

Material

g
Working
Sales Capital Work
Cycle in
g
Progress

g
g Finished g
Goods

Thus a working capital cycle, generally, has the following

four distinct stages:
(i) The raw materials and stores inventory stage;
(ii) The semi-finished goods or work-in-progress stage;
(iii) The finished goods inventory stage; and
(iv) The accounts receivable or book debts stage.
Each of the above working capital cycle stage is expressed
in terms of number of days of relevant activity and requires a
level of investment to support it . The sum total of these stage-
wise investments will be the total amount of working capital of
the firm.
The following formula may be used to express the
framework of the operating or working capital cycle:
T = ( r - c) + w + F + b
Where, 't' stands for the total period of the working capital cycle
in number of days;
'r' stands for the number of days of raw material and
stores consumption requirements held in raw
materials and stores inventory;
'c' the number of days of purchase in trade creditors'
'w' the number of days of cost of production held in work-
in-progress;
'f' the number of days of cost of sales held in finished
goods inventory; and
'b' the number of days of sales in book debts.
182
The computations may be made as under:
Average inventory of raw materials and stores
'r' = ------------------------------------------------------------------------------------------------
Average per day consumption of raw materials stores

Average trade creditors

'c' = ---------------------------------------------------------------------
Average credit purchases per day

Average work-in-progress
'w' = -------------------------------------------------------------------------------
Average cost of production per day

Average inventory of finished goods

'f' = -----------------------------------------------------------------------
Average cost of sales per day

Average book debts

'b' = ----------------------------------------------------------
Average sales per day
The average inventory, trade creditors, work-in-progress,
finished goods and book debts can be computed by adding the
opening and closing balances at the end of the year in the
respective accounts and dividing the same by two. The average
per day figures can be obtained by dividing the concerned annual
figures by 365 or the number of days in the given period.

1.7 POINTS TO REMEMBER

Working capital indicates the investment by a company in

short-term assets such as cash, marketable securities, accounts
receivable and inventories.
Working capital is the excess of current assets over current
liabilities, as reflected in the following equation:
Working capital = Current Assets - Current liabilities.
Proper and efficient management of working capital is very
important for the success of an enterprise. It aims at protecting
the purchasing power of assets and maximizing the return on
 183
investment. Constant management is required to maintain
appropriate levels in the various working capital accounts.
Permanent or fixed working capital is that part of the capital
which is permanently locked up in the circulation of current
assets and in keeping it moving.
The variable working capital changes with the volume of
business. It may be sub divided into (a) seasonal working capital
and (b) special working capital.
The following formula may be used to express the
framework of the operating cycle or working capital cycle :
T = (r - e) + w + f + b
The working capital cycle, generally, has the following four
distinct stages:
(i) The raw materials and stores inventory stage;
(ii) The semi-finished goods or work-in-progress stage.
(iii) The finished goods inventory stage; and
(iv) The accounts receivable or book debts stage.

1.8 KEY WORDS

Gross Working Capital :
The term Gross Working Capital represents only
the current assets and refers to the total amount of
investments made in the current capital assets by
a business unit.
Net Working Capital :
This term refers to the difference between the
current assets and current liabilities, i.e. the excess
of current assets over current liabilities. In other
words, the term net working capital represents the
total investments made in the current assets
through finance provided by the proprietors
owners and long-term borrowings.
Working Capital Cycle :
The term working capital cycle refers to the period that a
business enterprise takes in converting cash back into cash after
184
completing one production cycle. Thus a circle from introducing
cash back to cash is called the working capital cycle.

1.9 SELF ASSESSMENT QUESTIONS

1. What do you understand by working capital? How is
working capital determined in cash of a business
enterprise?
2. Explain the concept of working capital. Discuss the
importance of working capital in a business or industrial
concern.
3. Narrate the different factors that affect the amount of
working capital.
4. Describe the different determinants of the amount of
working capital requirement in cash of an industrial
enterprise.
5. Elucidate the terms "Gross Working Capital" and "Net
Working Capital". Differentiate between the two.
6. What are the advantages of having adequate working
capital?
7. Discuss about the classification of working capital.
Distinguish between permanent working capital and
temporary working capital.
8. What is "Working capital cycle"? Is it feasible to minimize
the working capital requirement of a firm by minimizing
the period of the cycle? If so, describe how this can be done?

1.10 FURTHER READING

Banerjee, B., "Financial Policy and Management Accounting",
The World Press Private Ltd. Kolkata.
 185

Block - 5
Unit - 2
PROJECTION OF WORKING CAPITAL
REQUIREMENTS - IN CASE OF TRADING
ORGANISATION - IN CASE OF MANUFACTURING
ORGANISATION

Structure
2.0 Objective

2.1 Estimating Working Capital Requirement : Trading

Organisation.
2.2 Illustrations - Trading concern.
2.3 Estimating Working Capital Requirement :
Manufacturing Organisation.
2.4 Illustrations - Manufacturing concern.
2.5 Points to Remember
2.6 Key Words
2.7 Self-Assessment Questions

2.8 Further Readings.

2.0 OBJECTIVES

After going through this unit, you should be able to :

• Estimate the working capital requirements in case of

trading concerns.

• Estimate the working capital requirements in case of

manufacturing concerns.
186

2.1 ESTIMATING WORKING CAPITAL REQUIREMENT:

TRADING ORGANISATION

In case of trading concern, if the Balance Sheet of the

previous accounting year is available and the volume of business
for the budget period can be estimated, then the estimated
working capital requirement can be determined easily. Here the
efforts that have to be made is to adjust the items of current assets
and liabilities in relation to the volume of business and deduct
the aggregate value of adjusted current liabilities from the
aggregate value of the adjusted current assets.

If the figures of current assets and current liabilities relating

to the previous accounting period are not available for any reason
viz. in sufficient information, new concern etc. then the
preparation of working capital budget becomes comparatively
difficult. In such a case, the items of current assets and liabilities
for current or budget period should be determined first on the
basis of a given volume, the difference between current assets
and current liabilities would then give the estimated working
capital requirement.

2.2 ILLUSTRATIONS -- TRADING CONCERN

Illustration - 1 :

The following is the Balance Sheet of the ABC Ltd., as on

31.12.2005. The company seeks to expand its activities. It has
estimated that would be able to increase the sales by 25%. You
are required to forcast the working capital required after the
expansion.
 187
BALANCE SHEET
As at 31st December, 2005
Rs. Rs.
Fixed Assets (at cost) … 2,68,00
Less : Depreciation … 48,000
2,20,000
Current Assets :
Stock in trade … 4,08,000
Sundry Debtors … 4,80,000
Bank Balance … 16,000
9,04,000
Less : Current Liabilities:
Trade Creditors … 3,68,000
Bank Overdraft … 2,20,000
Taxation … 80,000
Outstanding Expenses … 36,000
7,04,000
2,00,000
Total Assets 4,20,000
Represented by :
Equity Share Capital … 3,00,000
Reserves … 1,20,000
4,20,000
The following further information is furnished:
1. It is decided to limit the Bank Overdraft to Rs.1,60,000.
2. Increase in creditors, stocks and debtors is expected to be
proportionate.,
3. Rates of taxation will remain the same. The profit is expected
to be Rs.4,00,000 as against Rs.2,00,000 prior to expansion.
4. It is decided to maintain minimum banks balance of
Rs.30,000.
Solution:
Statement of Estimated Working Capital Required
Rs. Rs.
Current Assets :
Stock-in-trade (Note 1) 5,10,000
Sundry Debtors (Note 2) 6,00,000
Bank Balance (Note 3) 30,000
11,40,000
188
Less : Current Liabilities:
Trade Creditors (Note 4) 4,60,000
Bank Overdraft (Note 5) 1,60,000
Taxation (Note 6) 1,60,000
Outstanding Expenses (Note 7) 45,000
8,25,000
Net Working Capital Forcast … 3,15,000
Present Working Capital … 2,00,000
Additional Working Capital Required 1,15,000

Working Note
Note 1 : Rs.
Stock as on 31.12.05 4,08,000
25% increase 1,02,000
5,10,000
Note 2 :
Sundry Debtors as an 31.12.2005 4,80,000
25% increase 1,20,000
6,00,000
Note 3:
Minimum Bank Balance required
to be maintained 30,000
Note 4 :
Trade Creditors as on 31.12.05 3,68,000
25% increase 92,000
4,60,000
Note 5:
Bank Overdraft limited to Rs.1,60,000
Note 6:
Taxation will be twice the previous amount
as the profit will increase by 100%
Note 7:
Outstanding Expenses as on 31.12.05 36,000
25% increase 9,000
45,000
Illustrtion - 2 :
The Wonderful Industries Ltd. are engaged in large-scale
retailing. From the following information, you are required to
forcast their working capital requirements.
 189
Projected annual sales ... Rs.65,00,000
Percentage of Net Profit on cost of sales 25%
Average credit period allowed to Debtors 10 weeks
Average stock carrying (in terms of sale requirements) 8 weeks
Average credit period allowed by Creditors 4 weeks
Add 10% to computed figures to allows for contingencies
Solution : Rs.
Projected Annual sales ... 65,00,000
Net Profit @20% on sales or 25% on cost of
sales 13,00,000
Cost of sales per annum ... 52,00,000
Cost of sales per week ... 1,00,000
(Rs. 52,00,000)
-------------------------
52 weeks
Statement of Working Capital Requirement
Selling Price Cost Price
Basis Basis
(Rs. in lakhs) (Rs. in lakhs)
Current Assets :
Stock (Rs.1,00,000 x 8) .. 8.00 8.00
Debtors:
At cost equivalent
Rs.1,00,000 x 10 = 10.00 10.00
13 lakhs
Profit : --------------------------- x 10 = 2.50 12.50
52 weeks weeks 20.50 18.00
Less : Current Liabilities:
Creditors (Rs.1 lakhs x 4) 4.00 4.00
Working Capital computed 16.50 14.00
Add : 10% for contingencies 1.65 1.40
Net Working Capital Required 18.15 15.40

Note : It has assumed that the creditors include those for both goods and
expenses and that all such creditors allow one month credit on an
average.
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Interpretation of Results:

The amount of Rs.15.4 lakhs (Rs.18.15 lakhs) found above

is to be interpreted as the amount to be blocked in inventory,
debtors (minus creditors) at any time during the year in quesiton,
in order that the anticipated activity (Primarily sales) can go on
smoothly.
The amount is not for a period of time but at any point of
time. It represents the maximum or the highest quantum of
locking up at any time during the period.
Illustration - 3 :
The following working capital statement as on 31.03.2006
is submitted to you:
Statement of Net Working Capital
( As on 31.03.2006)

Current Assets : Rs. Rs.

Stock in Trade:
Item A ... 36,000
Item B ... 84,000
Item C ... 42,000
1,62,000
Sundry Debtors:
More than 6 months old 24,000
Others ... 68,000
92,000
Cash and Bank Balance 22,000
2,76,000
Current Liabilities :
Bank Overdraft (Stocks) ... 97,200
Bank Overdraft (Debtors) ... 50,400
Sundry Creditors ... 40,000
Provision for Taxation ... 35,000
2,22,600
Net Working Capital ... 53,400
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The following additional information are also furnished.
1. The company has decided to improve the business. This
will increase the sales by 20%.
2. Stocks re likely to increase by 20% over the proportionate
increase resulting from expanded activity. It is estimated
that stock of items of A, B and C will be in the ratio of 1:2:1.
3. There will be a change in credit policy resulting in average
reduction of debtors by 15%. It is estimated that 30% of
debtors will remain outstanding for more than 6 months.
4. Liabilities will increase in proportion to increase in business
activity.
5. Rate of taxation will remain the same but surcharge of 10%
of the tax payable is levied.
6. Due to increased activity, the profit is likely to go up by
20%.
7. Bank has sanctioned overdraft facilities as under:
(a) Against Stock ... 80% of cost item - A
60% of cost of item - B
40% of cost of item - C
(b) Against Debtors ... 40% against Debtors of
more than 6 months old.
60% against other Debtors.
8. Bank Balance to remain at Rs.15,000.
Solution:
Working Notes
Current Assets Requirements:
1. Stock-in-trade : 2. Sundry Debtors:
Rs. Rs.
Present Stock 1,62,000 More than 6 months old 24,000
20% increase due
to increased activity 32,400 Other 68,000
1,94,400 Add: 20 % for increased 92,000
Further 20% increase Activity 18,400
due to change in 1,10,400
stock policy 38,880 Less : 15% reduction due
Total stock Required 2,33,280 to change in credit policy 16,560
Debtors 93,840
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3. Sundry Creditors:
Present Balance ... 40,000
Add : 20% increase ... 8,000
48,000
4. Provision for Taxation:
Present Provision ... 35,000
Profits would rise by 20% hence taxation
would also be increase by 20% 7,000
42,000
Add : New Levy of 10% Surcharge 4,200
46,200
5. Bank Overdraft:
(a) Stock estimated at Rs.2,33,280.
Proportionate Bank Overdraft (stock)
stock of each item. Rs. Rs.
Item A .. 58,320 80% ... 46,656
B ... 1,16,640 60% ... 69,984
C ... 58,320 40% ... 23,328
2,33,280 1,39,968
(b) Debtors : Bank Overdraft (Debtors)
More than 6 Rs. P.C. Rs.
months old :
30% of Rs.93,840 28,152 40% 11,260
Others :
70% of Rs.93,840 65,688 60% 39,413
93,840 50,673
Statement of Working Capital forecast
Current Assets :
Stock-in-trade Rs. Rs. Rs.
Item A ... 58,320
Item B ... 1,16,640
Item C ... 58,320
2,33,280
 193
Sundry Debtors
More than 6 months old ... 28,152
Others 65,688
93,840
Bank Balance ... 15,000
Total Current Assets 3,42,120
Less : Current Liabilities:
Bank Overdraft (stock) ... 1,39,968
Bank Overdraft (Debtors) ... 50,673
1,90,641
Creditors ... 48,000
Provision for Taxation 46,200
2,84,841
Net Working Capital 57,279
Less : Present Working Capital 53,400
Additional Working Capital required 3,879

2.3 ESTIMATING WORKING CAPITAL REQUIREMENT :

MANUFACTURING CONCERN
The steps involved in estimating the working capital
requirement of a manufacturing concern can be explained as
follows:
1. Determine the average production in terms of days, week
or month as the case may be.
2. Ascertain the average cost (daily, weekly or monthly as
required) of each element of cost viz. material, labour and
overheads.
3. Determine the "Operating Cycle" or the "net block period"
for each element of cost (For example, materials may be
purchased in week1, paid in week 3, stored until week 4,
included in a product in the process of production in week
5, stored again before sales in week 6, despatched to
customers in week 7 and paid for by the customer in week
10. The net block period here is 10 - 3 = 7 weeks (i.e. the
period during which cash remains blocked).
194
4. Multiply (2) by (3) to determine the working capital
requirement for each element of cost. For example, if the
average weekly cost of raw mateials is Rs.10,000 and the
'net block period' for the element is, say, 4 weeks, the
average working capital requirement for materials is
Rs.10,000 x 4 = Rs.40,000.
5. Add together all the amount obtained in (4) plus cash float,
if any, that it is deemed desirable to hold. This gives the
total amount required to finance the working capital.
Very often another amount is allowed to meet the
contingencies e.g. 5% of 10% of the total amount involved
may be added to cover the contingencies. This is expected
to over uncertainties or contingencies.
It emerges from the ealier discussion that the following
information are necessary for preparation of a Working Capital
Forcast to sustain a given volume of activity.
1. The expected annual production.
2. The cost of raw materials, wages and overheads per unit of
the product.
3. The period within which raw materials will remain in store
before issue to production shops.
4. The processing or conversion time.
5. The period of storage of finished goods before sale.
6. The terms of credit to debtors, credit from suppliers of
materials and supplies, time-lag in wage payment etc.

2.4 ILLUSTRATIONS : MANUFACTURING CONCERN

Illustration - 1

M/S B. & Co. requests you to prepare a statement showing

the working capital requirements. They estimate to produce 4,800
units in a year. The following information have been furnished
for you.
 195
Elements of cost Cost per unit
Rs.
Raw Materials ... 8
Direct Labour ... 2
Overheads ... 6
Total Cost 16
Profit ... 4
Selling Price ... 20
Raw materials are in stock on an average period of one
month. Materials remain in process on an average period of half
a month. Finished goods are in stock on an average period of
one and a half months. Customers enjoy one month's credit while
suppliers allow one month's credit.
Cash in hand expected in Rs.2,500.
You are further informed that production is carried out
uniformly during the year and wages & overheads accrue evenly.
Solution: Rs.
Annual sales ... 4,800 units : 96,000
Monthly Sales ... 400 units : 8,000
Monthly cost of 400 units : Rs.
Raw Materials ( 400 x 8) .. 3,200
Direct Labour (400 x 2) .. 800
Overheads (400 x 6) .. 2,400

Total 6,400
Statement showing Estimate of Working Capital
A. Current Assets :
(a) Stock-in-trade Rs.
(i) Raw material (one month's stock) 3,200
(ii) Work-in-progress:
One month's expenditure Rs.6,400
Half month's expenditure 3,200
196

(iii) Finished Goods:

One and half month's stock
Cost per month ... Rs.6,400
1
Cost for 1 /2 months 9,600
16,000
(b) Debtors :
1 month's sales remains outstanding
Units x Selling Price (400 x 2) ... 8,000
(c) Cash in hand ... 2,500
26,500
B. Less : Current Liabilities:
As the business enjoys one month's
Credit from suppliers, amount equal to the cost of one month's
consumption of Raw Materials remains payable to suppliers 3,200
Estimated Working Capital ... 23,300
Illustration - 2:
A manufacturing concern undertakes the manufacture of
toys. The following are the cost data per unit of toys.
Elements of cost Cost per Unit
Rs.
Materials ... 4
Direct Labour ... 2
Overheads ... 2
Total Cost ... 8
Profit 2
Selling Price ... 10

The manufacturing concern has budgeted a sale of

Rs.2,60,000 per annum. The following additional data have also
been furnished.
1. The production process takes 3 (three) weeks.
2. The concern carries stock of raw materials equal to 3 weeks'
consumption and finished goods equal to 2 weeks'
production.
 197
3. The enterprise allows credit for 5 weeks to customers and
receives credit of 4 weeks from suppliers.

4. It is assumed that the production and overheads accure

uniformly throughout the year.

5. The enterprise maintains Bank Balance at Rs.5,000.

You are required to estimate the working capital

requirement of the manufacturing concern, from the information
provided.

Solution:
Budgeted Sales ... ... Rs. 2,60,000
Selling Price per unit ... Rs. 10
Therefore production per annum 26,000 units
Production per week ... 500 units
(26,000
------------------
52
1. Stock-in-trade:
A. Raw Materials :
(Units per week x Cost per unit x No. of weeks stock) or (500 x 4 x 3)
.... Rs. 6,000
B. Work-in-progress:
Production process takes 3 weeks
(i) Raw Materials for 3 weeks 6,000

(ii) Labour for 3 weeks :

(Units per week x labour charge per unit x Time lag
during production) or (500 x 2 x 3) 3,000
(iii) Overheads:
(Units per week x cost of overhead per unit x Time
lag during production) or (500 x 2 x 3) 3,000
12,000
198
C. Finished Goods :
Cost per unit ... Rs.8
Finished Goods in stock = 2 weeks' production
(weekly production x No. of weeks production in stock x cost per unit)
or (500 x 2 x 8) ... 8,000
2. Debtors :
Sales price per week = (Units sold x Sale price per unit) or
(500 x 10) = 5,000
Debtors = (Credit period x Sales per week) or (5 x 5,000) ... 25,000
3. Creditors:
Value of Supplies per week (Raw Materials in units x Unit cost of Raw Materials)
or (500 x 4) .... Rs. 2,000
Value of Supplies for 4 weeks' credit period ( 2,000 x 4) Rs. 8,000
Statement of Estimated Working Capital
Rs. Rs. Rs.
Current Assets :
Stock-in-trade:
Raw Materials 6,000
work-in-progress 12,000
Finished goods 8,000
26,000
Debtors 25,000
Bank Balance ... ... 5,000
56,000
Less : Current Liabilities:
Creditors ... 8,000
Estimated Working Capital Required 48,000
Illustration - 3
The Modern Engineering Works which manufactures
watches, furnishes you with the following data with the request
to you to give the estimate of the working capital required by
the concern:
 199
1. The monthly production is 200 watches.
2. The sale price is Rs. 500 per watch.
3. The break-up of cost of a watch is as under:
(i) Raw Materials .. 50% of the selling price.
(ii) Labour 15% of the selling price.
(iii) Overheads 25% of the selling price.
On studying the production process, it is found that :
(i) Each watch remains in process for about one month.
(ii) Raw materials are fed immediately at a time.
(iii) Labour and overheads are paid evenly during the
month.
(iv) One month's raw materials remain in stock.
(v) The firm carries three month's production as the
finished goods stock.
(vi) The debtors are allowed credit for one month and
suppliers allow credit for two months.
There is a regular production and sales cycle. The company
normally keeps the cash at Rs.20,000.
Solution:
1. Raw Materials:
Monthly production = 200 units
Sales price of 200 unit
@ Rs. 500 each = Rs.1,00,000
Raw Materials cost,
50% of sale price = Rs.50,000
2. Work-in-Progress:
(one month's cost is taken as value of work-in-progress
because production cycle takes one month) Rs.
(i) Raw Materials cost of one month ... 50,000
(ii) Labour
(Cost of 1 month is 15% of selling price,
i.e. 15% of Rs.1,00,000 As this cost is evenly
200
incurred throughout the month, 1 month's cost
is Rs.15,000) ... 15,000
(iii) Overheads
(Cost of 1 month is 25% of selling price = Rs.25,000)... 25,000
90,000
3. Finished Goods :
As the firm carries finished goods inventory of 3 months'
production, the cost of finished goods inventory:
Production cost per month : Rs.
Raw Materials ... 50,000
Labour ... 15,000
Overheads 25,000
90,000
∴ 3 months' cost (3x 90,000) 2,70,000
4. Stock-in-trade:
Raw Materials ... 50,000
Work-in-progress ... 90,000
Finished Goods ... 2,70,000
... 4,10,000
5. Debtors:
As the credit period allowed to Debtors is one months,
sale equal to 1 month (Rs.500 x 200 units) ... 1,00,000
6. Bank Balance (as given) 20,000
7. Liabilities:
Creditors for goods:
2 month's credit is allowed by
suppliers. Therefore, 2 months' Raw Materials
cost would remain unpaid ( 2 x 40,000) ... 1,00,000
 201
Statement showing Estimate of Working Capital
Current Assets : Rs. Rs.
Stock-in-trade:
Raw Materials ... 50,000
Work-in-progress ... 90,000
Finished Goods ... 2,70,000
4,10,000
Debtors .. .. 1,00,000
Bank Balance ... ... 20,000
5,30,000
Less : Current Liabilities:
Creditors 1,00,000
Estimated Working Capital ... 4,30,000

2.5 POINTS TO REMBMER

The steps involved in estimating the working capital
requirement of a manufacturing concern are as follows:
1. Determine the daily / weekly / monthly average
production.
2. Determine the daily / weekly / monthly average cost of
each element of cost viz. material, labour and overheads.
3. Ascertain the 'operating cycle' or the 'net block period' for
each element of cost.
4. Multiply (2) by (3) to determine the working capital
requirement for each element of cost.
5. Add together all the amounts obtained in (4) plus cash float,
if any, that it is deemed desirable to hold. This gives the
total amount required to finance the working capital.
Thereafter very often another amount is allowed to
meet the contingencies e.g. 5% or 10% of the total amount
involved may be added to cover the contingencies. This is
expected to cover uncertainties or contingencies.
202

2.6 KEY WORDS

Adjusted Current Assets : All the figures of each current assets
are revised according to anticipated
changes that may take place in terms
of volume, cost etc. Finally the
revised figure of the current asset is
obtained. This is called adjusted
current asset.
Adjusted Current Liabilities: All the figures of each current
liability are revised according to the
anticipated changes that are likely to
happen in terms of volume, cost, time
etc. Accordingly, the revised figure of
each current liability is determined.
This revised current liability is known
as adjusted current liability.
Operating Cycle: It is also known as 'net block period'. It refers
to the period that a business
enterprise takes in converting cash
back into cash after completing one
production cycle.

2.7 SELF-ASSESSMENT QUESTIONS

1. Describe the procedure of estimating working capital
requirement in case of trading organisation.
2. Explain the steps that are involved in estimating the
working capital requirement in case of a manufacturing
concern.
3. Discuss about the information which are necessary for
preparation of a statement of working capital forcast.
4. Write short notes on the following:
(a) Adjusted Current Assets;
(b) Adjusted Current Liabilities; and
(c) Operating Cycle.
 203
5. The following is the Balance Sheet of the Z. Co. Ltd. as on
31.12.2005. The company plans to expand its activities. It
has also estimated that it will be able to increase the sales
by 25%. You are required to forecast the working capital
required after the expansion.
Balance Sheet
( As at 31.12.2006)
Rs. Rs.
Fixed Assets (at cost) 10,50,000
Less : Depreciation 50,000
10,00,000
Current Assets :
Stock-in-trade ... 4,00,000
Sundary Debtors ... 3,00,000
Bank Balance ... 50,000
7,50,000
Less : Current Liabilities:
Trade Creditors ... 2,00,000
Bank Overdraft ... 1,00,000
Taxation ... 50,000
Outstanding Expenses... 10,000
3,60,000
Net Current Assets 3,90,000
Total Assets 13,90,000
Represented by :
Equity Share Capital ... 10,00,000
Reserves ... 3,90,000
13,90,000
The following additional information have been furnished:
1. It is decided to limit the bank overdraft to Rs.50,000
2. Increase in creditors, stocks and debtors is expected to be
proportionate.
3. Rates of taxation will remain the same. The profit is expected
to be Rs.50,00,000 as against Rs.2,50,000 prior to expansion.
204
4. It has decided to maintain minimum bank balance of
Rs. 30,000.
5. B. Co. Ltd., is to manufacture a new product designed to
sell at Rs.100 each. The annual output is estimated to be
8,000 units and no fluctuations in production are
anticipated. The unit cost are as follows:
Rs.
Materials ... 50
Labour ... 20
Overheads ... 10
80
Materials are bought on one month's credit and stores
equivalent to three months' issues will normally be on hand. The
manufacturing cycle is two months and finished goods are in
stock on an average for a further month. Customers are allowed
two months for payment.
Assuming that there is no lag in payment of wages, that
both wages and overheads, accrue evenly and that a cash float of
Rs.10,000 will normally be held, ascertain the amount of working
capital requirement.
7. You are required to prepare a statement showing the
working capital needed to finance a level of activity of 6,00,000
units of output for the year. The cost structure for the company's
product for the abovementioned activity level is detailed below:
Elements of cost Cost per unit
Rs.
Raw Materials ... 20
Direct Labour ... 10
Overheads ... 20
Total cost ... 50
Profit ... 10
Selling price ... 60
Raw materials are held in stock on an average period for
two months. Work-in-progress will approximate to half-a-month's
production. Finished goods remain in store on an average, for a
month.
 205
Suppliers of materials extend one month's credit. Two
months' credit is normally allowed to debtors. A minimum cash
balance of Rs.30,000 is expected to be maintained. The production
pattern is assumed to be even during the year.
8. The capacity of an organisation is to produce 50,000 units
of a product per annum. Due to frequent power cut, the
organisation can operate at 60% of the capacity level. You are
required to ascertain the working capital requirement at the
current level of operations. The following information on the cost
structure of the product, at the current level of production, is
available;
Elements of cost Per Unit
Rs.
Raw Materials ... 12
Direct Labour ... 6
Overheads ... 8
Total cost ... 26
Profit 4
Selling Price 30
Raw materials are in stock, on an average, for 2 months.
The duration of the production process is half-a-month. Finished
goods are in stock, on an average, for 1 month. Credit allowed to
customers is 3 months and that obtained from suppliers of raw
materials is one and a half month. Lag in payment of wages is
half a month. There is usually, no lag in payment of overheads.

2.8 FURTHER READING

Banerjee, B., "Financial Policy and Management
Accounting" The World Press Private Ltd.,
Kolkata.

****