193E140 MGMT Acctg PDF

(i)
M.COM. COMPUTER APPLICATIONS

FIRST YEAR
COURSE – IV : MANAGEMENT ACCOUNTING
SYLLABUS
Definition – Scope – Objective – Advantages and limitations of management

accounting – Distinction s between financial accounting and management
accounting – Analysis and interpretation of financial statements – Comparative
financial statements – Accounting ratios – Their significance and
Find How analysis – Cash flow statements – Forecasting of fund requirements

– Budgets and Budgetary control – Objectives and advantages – Limitations – Sales
budget – Production cost budget – Cash budget – Flexible budget.
Marginal costing – Variance analysis – Capital budgeting – Financial

evaluation of projects – Inventory control – Accounting for inflation - Depreciation
policy.
LIST OF BOOKS
1. R.N. Anthony - Management Accounting Principles.
2. J. Batty - Management Accountancy.
3. Hongren - Management Accounting
4. Brown and Howard - Principles and Practice Management
Accountancy
5. Dr. Manmohan and S.N. Goyal - Principles of Management Accounting
6. Hingaroni, Grewal & Ramanathan - Management Accounting
7. S. Nagarathnam - A guide to Management Accounting
and Hold Company Accounts
8. A.H. Taylor and H. Shearing - Financial and Cost Account for
Management
ANNAMALAI UNIVERSITY
9. J. Batty - Cost and Management Accountancy
for students
10. H. Bierman an A.R. Drebin - Managerial Accounting
11. Dr. B.K. Basu - Lectures on Management Accountancy.
12. N. Sarker - Management Accountancy
13. S.C. Kuchal - Financial Management
14. S.B. Chowdhry - Management Accountancy.
(ii)

FIRST YEAR
CONTENTS
Lesson Title Page No.
1. Introduction of the Subject – Management Account 1
2. Distinctions Between Management Accounting and
Financial Accounting 14
3. Analysis and Interpretation of Financial Statement 20
4. Accounting Ratios - I 51
5. Accounting Ratios - II 76
6. Fund Flow Analysis 93
7. Fund Flow Analysis (continued) Some Practical Hints 106
8. Cash Flow Statement 121
9. Cash Flow Statements (continued) 133
10. Forecasting of Fund Requirements 152
11. Budget and Budgetary Control 163
12. Sales Budget 172
13. Cash Budget 180
14. Flexible Budget 187
15. Production Cost Budget Etc. 198
16. Marginal Costing 211
17. Break-Even Point 228
18. Profit Volume Ratio 242
19. Differential Costs Analysis 251
20. Standard Costing 258
21. Variance Analysis 269
22.
23. & 24
Capital Budgeting
Capital Budgeting (contd.) Financial Evaluation of Projects
287
293
25. Inventory Control 318
26. Accounting for Inflation 331
27. Depreciation Policy 343
28. Miscellaneous Reporting for Management 352
(iii)

FIRST YEAR
COURSE INTRODUCTION
Dear Students,
We extend to you a warm welcome and take this opportunity to wish you a
happy and prosperous year of post-graduation in Annamalai University.
This first dispatch contains the following
1. Syllabus on Management Accounting
2. List of prescribed text-books.
3. List of lessons in Management Accounting to be dispatched to you.
We sincerely try our best to provide all felicities through correspondence to you
with our enriched experience. Of course, you are going to study in different
environments. The lessons are self-explanatory. We advise you to be regular and
systematic in your pursuit of studies and in the preparation for the university
examinations since the time at you disposal is limited. Success in the examination
depends on you sincere and methodical efforts.
Management Accounting is a wide and diverse subject. It is the blending
together with a coherent whole, financial accounting, cost accounting and all
aspects of financial management. It emphasises the common denominator of the
functions of both management and accounting – the making of an effective decision
based on appropriate information.
So a sound and deep knowledge of Management Accounting is essential for a
commerce student not only to obtain a degree but also to have good prospects in
his life.
The lessons have been written in a simple language. The illustrations and
problems have been so selected, explained and solved that a student like you will
be able to acuire and develop knowledge in the subject without any difficulty.
Please go through the syllabus and model question papers which will help you
to make effective preparation from the examination point of view.
We wish you all astounding success in the University Examination.
Yours Sincerely,
STAFF.
1
LESSON - 1
INTRODUCTION OF THE SUBJECT
– MANAGEMENT ACCOUNT
OBJECTIVES
After studying this lesson the student should be able to
 Know the importance of Management Accounting in an organisation.
 Release the Scope of Management Accounting
 Understand the functions of a Management Accounted
 Know the limitations of management Accounting.
STRUCTURE
1.1. Introduction
1.2. Evoluvation of management Accounting
1.3. Definition
1.4. Scope of Management Accounting
1.5. Objective of Management Accounting
1.6. Advantages of Management Accounting
1.7. Functions of Management Accounting
1.8. Importance of Management Accounting
1.1. INTRODUCTION
The increasing complexities of modern and commercial life have necessitated
that accounting presentation should play a dynamic role in modern management.
The very aim of traditional accounting is to report operational results ie., profit or
loss of the organisation. But this does not cater to the needs of decision-makers.
Moreover the accounting system does not aid management adequately; this does
not mean that the system is defective, but it is due to the inefficiency on the part of
those who handle it. The processes of management are directing co-ordinating
control and motivation which fault o achieves their objectives if they are not
supported by appropriate plan, fact and control. No doubt accounting system
contributes much to all these processes. If the accounting systems are to be
utilised for the benefit of the managerial needs, it should be so designed as to meet
the changing conditions of the business as well as the society.
The whole accounting system can be classified as 1) Financial Accounting 2)

cost Accounting and 3) Management Accounting. Financial Accounting attempts to
2
report the operating result during a year as well as the position of assets and
liabilities on a particular date. This system helps the shareholders only and not the
management.
Cost accounting was introduced to avoid the shortcomings of financial

accounting. This is only to avoid the possible losses arising from the mishandling
of the financial data and not to boost up the performance strategy of the business.
It also attempts to assist the management by reporting the operating result at
regular intervals and at different levels of activities. Lastly, cost accounting is
meant to measure the responsibility of the actual performance against planned
performance.
It is also true that “many important data for managerial use are beyond the
ability of accountancy to supply – for example, market demand, state of competition
general business conditions, engineering design, personnel information, legal
regulations and limitations”. So management accounting has been originated to
fulfill managerial needs by providing the said important data which normal
accounting fails to supply. Hence, it evaluates alternative courses of action such as
Planning of profit, product pricing, inventory control etc. The term ‘management
accounting’ for the benefit of management needs. The question of management will
arise only when there some problem. The improvement and smooth running of the
existing system to avoid the possible problems may call for management analysis.
1.2. EVOLUTION OF MANAGEMENT ACCOUNTING

There are five stages in the evolution of management accounting and they are:
1) Financial recording: 2) Cost ascertainment; 3) Integration of cost and financial
accounting: 4) Business forecasting. Budgeting and standard costing: and
5) Budgetary control.
As already stated, in olden days the role of the accountant was merely to
record the transactions as and when they took place, analyse and summarise the
records, and present periodically the financial position of a concern in the form of
final accounts ie., Profit and Loss Account and Balance Sheet. Now, the systematic
recording of financial transactions reveals correct profit or loss derived during a
particular period and the particulars of assets and liabilities of a concern.
Cost Accounting
The systematic recording of the financial transactions seldom help the
management, because the accounts were prepared from the view point of
arithmetical accuracy. But with the advent of factory system of production,
ascertainment of the cost of production of several lines of product and services
became necessary and complex. Hence a new discipline in the sphere of
accounting viz. cost accounting was enunciated by great authors like F.W. Tylor,
Gantt, Emerson etc. Under cost accounting certain methods were followed to
control expenditure and to avoid waste. Financial accounts could not exercise such
3
control of expenditure. Cost accounting began to play a vital role in maintaining

cost records and in supplying the actual cost figures to the management to help
them to gave competitive pricing policies and to keep systematic cost account.
Hence cost accounting is the second stage in the development of accountancy.
Reconciliation of cost and financial accounts

Later on it was found that mere ascertainment of the cost of production would
not be of much use unless the cost data are reconciled with those of financial
accounts. Hence, the concept of integration of cost and financial accounts was
originated. The source of collecting data for both is the same. Similarly the cost of
production and value of sales were easily available from the financial records hence
the reconciliation of these two accounts was treated as the basis on which financial
accounting structure was built up.
Business forecasting, budgeting and standard costing

For a long time the principles of accountancy were found useful to deliver only
the historical figures about costing and financial transactions. Then after
introducing new methods and extending the scope of accountancy, it was used by
the management to exercise operational control and to obtain logical forecasting of
the activities. Thereafter the concept of accounting went through radical charges:
Various authors and accountants improved the system of accounting so as to reveal
various significant figures of the operations ‘as they should be’ (forecasting) instead
of simply furnishing the figures ‘as they were’. This gave rise to the system of
budgeting to estimate the financial surplus or deficit which is practiced in
government department. But never before the system was used to control the
financial cost operations.
The introduction of Standard Costing is a landmark in the development of cost
accounting. The principles of standard costing are based on the concept of
budgeting. The various differences between standard cost data and actual cost
data i.e. variances help the management to ensure cost control. Moreover, further
development in cost accounting such as Marginal Costing. Cost-Profit-Volume
Theory motivated cost to derive maximum utilisation of the minimum inputs. This
is the fourth stage of development in the accounting field which gave rise to
management accounting.
Budgetary control
To-day economic activities are complex and diverse. The market is wide and
competition becomes cut-throat. Hence the mere ascertainment of cost is of little
use. Besides the modern management is interested in not only knowing the cost of
production but also in controlling the costs. It is possible only if the management
is in a position to determine financial cots, managerial performance, planning etc.,
and this gave birth to ‘Management Accounting’. Hence, new techniques were
invented to present the accounts periodically (not necessarily at the end of the year)
4
before the management. Such accounts should be prepared in such a manner that
the results could be easily compared with the budgeted data and efforts be made to
exercise control. Such new techniques were termed as ‘Management Accounting’
for the first time in 2950. Thus accounting has developed as an internal
administrative aid to business management and this use of accounting has to be
viewed as something quite different from the conventional system of recording and
classifying the business transactions called double entry system of accounting.
1.3. DEFINITIONS OF MANAGEMENT ACCOUNTING

There is no unanimity among the management accountants to define this
subject. There are various definitions on the concept given by different scholars,
experts and professional bodies of the world. They are as follows:
“Any form of accounting which enables a business to be conducted more
efficiently can be regarded as Management Accounting” – The Institute of Chartered
Accountant of England and Wales.
“Management Accountancy is the presentation of accounting information is
such a way as to assist management in the creation of policy and in the day-to-day
operations of an undertaking” – The Anglo American Council on Productivity
Report.
“Management Accounting includes the methods and concepts necessary for
effective planning, for choosing among alternative business performances” – The
American Accounting Association.
“The application of accounting and statistical techniques to the specified
purpose of producing the interpreting information design to assist management in
the function of promoting maximum efficiency and in envisaging, formulating and
co-ordinating their execution” – Association of Certified and Corporate Accountant.
“Management Accounting is the term used to describe the accounting methods,
system and techniques which coupled with special knowledge and ability, assist
management in its task of maximising profit and minimising losses”.
Dr. J. Batty
“The essential aim of management accountancy should be to assist
management in decision-making and control”.
- Brown and Howard
‘Management Accounting is concerned with accounting information that is
useful to management’.
Rober N. Anthony
‘Management Accountancy is the adoption and analysis of accounting
information, audits diagnosis and explanation in such a way as to assist
management.
T.G. Rose
5
“Management Accountancy is the adoption and analysis of accounting

information, audits diagnosis and explanation in such a way as to assist
management.
- T.G. Rose
“Management Accounting for profit control includes income accounting, cost
accounting and budgetary planning and control.
- Keller
“Management Accounting functions largely through operating reports based
upon standard costs and budgets compared with actual expenditure, through
internal auditing, and through special duties and reports pertaining to the probable
plans programmes”
- Crossman
“Forward Accounting include standard costs; budgeted costs and revenues,
estimates of cash requirements break-even charts and projected financial
statements and the various studies required for estimation also the internal
controls regulating and safeguarding future operations”
- Kohler.
From the above definitions we learn that Management Accountancy is the art
and science of directing accounting information to the person concerned in order to
release the business philosophy ie., presenting the accounting information in a
manner which aids the Management in taking management decisions. All the
definitions of Management Accounting bring out its mechanical concept but not the
spirit of the system. However, we can come to a conclusion that all accounting
operations which are oriented towards increasing the productivity of human,
material and other productivity of human, material and other productivity
resources of the enterprise constitute Management Accounting. Hence, all
accounting which directly or indirectly, by provide, effective tools to managers in
enterprises and government animations lead to increase in productivity is
Management Accounting.
The term “Management Accounting” is composed of two word management and
Accounting. A clear grasp of these two words is essential to understand
“Management Accounting’. Management is mainly a task of planning” co-
ordinating and controlling the efforts of others towards a particular objective. Its
main aim is to achieve greatest efficiency in the utilisation of available material,
man-power, machines and skill. To-day scientific management is the substitute for
gusess-work or-hit or-miss-method. The objects of scientific management are to
study the operating problems on the basis of face and to work out the best use and
application of human and material resources. Hence, we may call Management
Accounting as a science which will achieve these objectives.
6
The other word ‘Accounting’ is art of analysis and interpreting the transactions
in terms of time, quantity and money. As already discussed accounting systems
are of three kinds 1) Financial Accounting 2) Cost Accounting and 3) Management
Accounting.
Management Accounting is of recent origin. It was first coined by the British
Team of Accountants which visited the U.S.A. under the sponsorship of Anglo-
American Productivity council in 1950. Its main aim was to highlight the utility of
accounting as an effective management tool. It is used to explain the modern
concept of accounts as a tool of management in contrast to the conventional
accounts prepared mainly for information of proprietors. Now, the purview of
management accounting includes all techniques and controls such as financial
control, budgetary control, efficiency in operation through standard costing, cost-
volume-profit analysis, etc. It also includes planning for future variances between
the actuals and standards, reporting to top management, formulation of policy etc.
Lastly, accounting information should be presented in such a way as to assist the
management to conduct day-to-day business most efficiently. Moreover the
published account of business concerns do not provide any information in a form
that suggests the line on which management policies and actions should proceed.
In short, all the requirements of modern management should be written in
management language. Management accounting is otherwise known as Managerial
Accounting, Control Accounting, Responsibility Accounting, Decision Accounting,
forward Accounting or Management Accountancy.
1.4. SCOPE OF MANAGEMENT ACCOUNTING

The scope of Management Accounting is very wide and broad-based. Within its
fold it encompasses a searching analysis of all the aspects and branches of
business operations. Anyhow the areas included within the ambit of Management
Accounting may be listed as follows:
1. General Accounting (Financial Accounting)
2. Cost Accounting
3. Budgeting and forecasting
4. Cost control procedure
5. Cost and Statistics
6.
7.
Taxation
Methods and procedures
8. Audit
9. Office services
10. Legal provisions
7
1. General or financial accounting

This include recording of external transactions covering receipts and payments
of cash, recording of inventory and sales and recognition of liabilities and setting up
of receivables. It also covers the preparation of regular financial statements which
are made up from ledger balances. Management cannot obtain full control and co-
ordination without proper system of accounting
2. Cost Accounting
It is concerned with the application of cost to job, product, process and
operation. It acts as a supplement to financial accounting. it also helps in
sharpening the internal aspects of financial accounting. It plays a vital role in
assting the management in the creation of policy and operation of business
concerns.
3. Budgeting and forecasting

These envisage the preparation of fixed and flexible budgets, cash budgets,
profit and loss forecasts etc., in co-operation with operating and other departments.
They help the management a great-deal.
4. Cost control procedures

They are concerned with the establishment and operation of internal control
and the preparation of internal reports in order to convert the budget into operating
services, Management is assisted by them by measuring actual results against
budgetary standard of performance.
5. Cost and statistics

These are concerned with the provision of statistical and analytical information
in the form of graphs, charts, diagram etc., to the various departments of the
business.
6. Taxation
This is concerned with the computation of income, filing of returns and making
of tax payments, in accordance with the provisions of the Income Tax Act.
7. Methods and procedures

These deal with reducing the cost and improving the efficiency of accounting as
also of office operations, including the preparation and issuance of accounting and
other manuals, where these will prove useful.
8. Audit
It needs devising system of internal control by establishing internal audit
coverage of all operating units.
8
9. Office services
These are concerned with the maintenance of data processing and other office
management services like communication, duplicator, printing, mailing, etc.
10. Legal provision

Several management decisions depend upon the provisions of various laws and
statutory provisions prevailing in the country. For example the decision to make a
fresh issue of shares depends upon the permission of controller of capital issues.
Like-wise the form of published accounts, the external audit, the authority to float
loans, sales, pay roll, income etc, depend upon various rules and regulations
passed from time to time.
It is very clear that management Accounting has a close relation with all those
areas explained above to have its scope wide and broad based.
1.5. OBJECTIVES OF MANAGEMENT ACCOUNTING

1. To assist the management in promoting efficiency, which includes best possible
service to its customers, investors and employees.
2. To formulate policy and planning, management accountant should provide the
management information to that it could formulate a plan for the future. He
should assist the management by furnishing statements of past results and
also future probabilities and the benefits that would accrue by following the
policies formulated. There should be proper allocation of responsibilities to the
personnel and there should be well designed organisation for varying out the
plan.
3. The actual work done should be compared with the standards to enable the
management to control the performance effectively.
4. Preparation of budgets covering all aspects of a business, e.g production,
selling, distribution and finance.
5. Analysis of financial and physical transactions to enable effective comparisons
to be made between the forecast and actual performance.
6. Presenting to the management at regular intervals operating statements and
short-term financial statements.
7. Interpretation of financial statements to enable to management formulate
future policies and operations.
Thus the basic objectives of Management Accounting is to assist the
management in performing its duties efficiently. In order to achieve these
objectives Management Accounting should employ three principal devices, viz., 1)
Forward Locking Principle, 2) Target Setting Principle and 3) The Principle of
Exception. The first principle is based on the past and all other available data,
forecasting the future and recommending wherever appropriate the course of action
9
for the future. The second principle is the fixation of an optimum target which is
known as standard, budget etc., and through continuous review ensuring that the
target is achieved or exceeded. Under the their principle, Manager Accounting,
instead of concentrating on voluminous date, concentrates on deviations from
targets (usually called variances) and continuous and prompt analysis of the causes
of these variances on which management can initiate necessary follow-up.
1.6. ADVANTAGES OF MANAGEMENT ACCOUNTING

1. It increases efficiency in business operation
2. The activities of a business are well regulated by installation of an efficient
system of planning and budgeting
3. It enables the actual performance be measured by means of comparison with
the pre-determined budget
4. It enables the business to get the maximum return on capital employed
5. It enables the management to improve its service to its customers.
6. It creates harmony in the relationship between the management and labour.
1.7. FUNCTIONS OF MANAGEMENT ACCOUNTING

These include all activities connected with collecting processing, interpreting
and presenting information to management. Management Accounting satisfies the
various needs of management for taking appropriate business decisions which may
be described as follows:
1. Modification of data
2 Analysis and Interpretation of data.
3. Facilitating Management Control
4. Formulation of Business Budgets.
5. Use of qualitative Information
6. Satisfaction of Informational Needs of Levels of various management
1. Modification of Data
Management Accounting supplies accounting data required for decision
making purposes through a process of classification and combination which
enables to retain similarities of details without eliminating the dissimilarities e.g.
combination of purchases for different months and their break-up according to the
class of product, type of suppliers, days of purchase, territories etc.
2. Analysis and Interpretation of Data

The data collected becomes more significant and meaningful only with analysis
and interpretation. For example, when the data or final accounts are analysed by
means of comparative statements, ratios and percentages, cash flow statements
10
and fund flow statements, it will facilitate new directions for its use by
management.
3. Facilitating Management Control

Management Accounting enables all accounting efforts to be directed towards
control of a business concern. The important features in any system of control are
the standard for performance and measure of deviation therefrom. This is made
possible through budgetary control and standard costing which are an integral part
of Management Accounting.
4. Formulation of Business Budgets

One of the primary functions of management is planning, which is
accomplished by Management Accounting through the process of budgeting. It
involves the setting up of objectives and the selection of the most appropriate
strategies by comparing them with reference to some discriminating criteria
Forecasting, probability and trends are some of the techniques used for this
purpose.
5. Use of Qualitiative Information

Management Accounting draws upon sources, other than accounting for such
information as it is not capable of being readily convertible into monetary terms.
Statistical accompilations, engineering records and minutes of meeting ar a few
such sources of information.
6. Satisfaction of Information Needs or Levels of Management

This serves management as a whole according to its requirements. This serves
top. middle and lower level managerial needs to subserve their respective needs.
For instance, it has a system of processing accounting data in a way that yields
concise information to cover the entire field of business activities at long intervals
for the top management technical data for specialised personnel regularly and
detailed figures relating to a particular sphere of activity at short intervals for those
at the lower rungs in the organisational set-up.
In short the list of Management Accounting is a profit of overall managerial
activity (not something grafted on to it from outside) guiding and serving
management as a body to derive the best return from its resources, both for itself
and for the supr system in which it functions.
LIMITATIONS OF MANAGEMENT ACCOUNTING
Though Management Accounting has several advantages, as a new discipline,
it has to face conditions which limit the effectiveness of management through
accounting. Such conditions are
1. Lack of knowledge and understanding
2. Persistence of Intuitive Decision-making
11
3. Wide scope
4. Top-Heavy Structure
5. Evolutionay Stage
6. Psychological Resistance
1. Lack of Knowledge and Understaning

The mergence of Management Accounting has resulted in the combination of a
number of subjects like accounting, management theory, economics, engineering,
statistics, etc. Hence an inadequate grounding on the part of management in any
one or more of these subjects is bound to have an unfavorable effect on the
consideration and solution of problem in connection with management
performance.
2. Persistence of Intuitive Decision Making

The main subjective of Management Accounting is the elimination of intuitive
management. But there is always a temptation to take an easy course of arriving at
decisions based on intuition rather than taking the tortuous path of scientific-
decision-making.
3. Wide Scope
The wide scope and ambitious nature of the objectives of Management
Accounting create many difficulties. That is, it is one thing to record, interpret and
evaluate an objective historical event converted into money figures while it is
something quire different to perform the same functions in respect of past
possibilities, future opportunities and unquantifiable situations.
4. Top-Heavy Structure
The installation of a system of Management Accounting requires very elaborate
organisation and a large number of rules and regulations. Hence, the entire
proposition becomes very costly and only very big concerns can adopt it.
5. Evolutinoary Stage
When compared to other systems, Management, Accounting is a new discipline
and is still inn a state of evolution. It is quire natural that it has the same
impediments as a relatively new discipline has to face like sharpening of analytical
tools, improvement of techniques etc.
6. Psychological Resistance
When a good system of Management Accounting is adopted, it brings about a
radical change in the established pattern of the activity of management personnel,
which calls for a rearrangement of personnel as well as their activities. There will
be certainly some opposition from some quarters for this change.
12
1.8. IMPORTANCE OF MANAGEMENT ACCOUNTING

If we compare the advantages of management Accounting with its limitations,
certainly the former outweighs the latter. The importance of Management
Accounting is over emphaised due to the following.
1. The function of Management Accounting is a managerial activity and it puts its
finger in every pie without itself making them. It aids and guides the setting of
objective, planning, co-ordinating, controlling etc. But it does not itself perform
these function.
2. It serves management as a whole (top, middle and lower level) according to its
requirement. But while doing so, it never fails in keeping in focus the macro
approach to the business as a whole.
3. It brings in its fold the concept of Cost-Benefit analysis. The basis approach of
Cost-Benefit analysis is of two groups ie., measurable and non-measurable. It
is easy to deal with measurable costs which are expressed in terms of money.
But there are many ventures such as office canteens where the cost-benefit
may not be monetarily measurable.
4. It lays grant emphasis on the future and examines this future in the light of the
past and the present e.g., the use of budgets.
5. It involves a process of selective and discriminating reporting of data ** to
magnify some points out of the mass of figures to help the management to
concentrate more on such points rather than wasting time in reviewing any
normal situation. Thus, it facilitates prompt decision making by the
management e.g., costs which are useful in short-term decision making.
6. It lays emphais on the behaviour of cost elements rather than on its
accumulation. For example, when the question arises as to whether a
component part should be purchased instead of being manufactures of a by-
product should be processed beyond the split off point or sold without
processing etc. The division of costs into fixed semifixed and variable is very
important in all matters of managerial decision.
7. It goes deep in establishing the relationship between cause and effect of any
significant activity in the business rather than merely pointing out. For
example, while the financial accounting merely points out that gross profit has
narrowed or widened in relation to sales Management Accounting lays
emphasis on the causes of such behaviour because remedy can be taken by
the management only through such knowledge.
From the foregoing discussions we can come to a conclusion that Management
Accounting is the blending of all processes connected with financial and cost
accounting and is also concerned with the establishment and operation of internal
controls. Its significance has increased very rapidly in modern times due to the
13
improvement in analytical and problem solving techniques and the availability of

more data processing equipment’s. It, with the help of these techniques and
apparatus, satisfies the management’s informational needs for assessing the cost
implications of making and buying a component whether it would be profitable to
process a by product or to sell it without further processing, whether output should
be expanded beyond the existing level for assessing the causes and effects of cost
and revenue changes and other similar matters.
Last but not the least, we should know the following different stages involved
in Management Accounting.
1. Re arrangement 2. Adoption 3. Analysis 4. Diagnois 5. Explanation and 6.
mental Revolution by which they mean classifying the financial data. Processing of
financial data, interpreting the financial statement, the result of the financial
statement the result of analysis and diagnosis and concept of human psychology
regarding the introduction of Management Accounting respectively.
MODEL QUESTIONS
1. Define “Management Accountant” what are its scope and object?
2. What are the functions of Management Accounting?
3. What are the advantages and limitations of Management Accounting?
4. Give and outline of the evolution of Management Accounting?
5. On what areas does Management Accounting lay emphasis?

14
LESSON - 2
DISTINCTIONS BETWEEN MANAGEMENT ACCOUNTING
AND FINANCIAL ACCOUNTING
OBJECTIVES
 Know the differences between cost Accounting and Management
Accounting
 Identify the tools and techniques of Management accounting
 Understand the role of management Accounting
STRUCTURE
2.1. Introduction
2.2. Cost Accounting and Management Accounting
2.3. Tools and techniques of management accounting
2.4. Importance of Management accounting in the Indian context
2.5. Tools and techniques of Management Accounting
2.6. Role of Management Accounting
2.1. INTRODUCTION
One may question the necessity to have Management Accounting when
Financial Accounting is in force. It co-exists for the following reasons.
Management Accounting is a dynamic process. We have to rearrange the data
furnished by the Financial Accounting for the modern busy management of large
scale business concerns. Hence it is different from the Financial Accounting. The
differences between the two is based partly on the use of accounting, data. partly
on the degree of information supplied, partly on the emphasis for which data are
supplied, and parley on methodology through which the data are collected.
On the other hand, Financial Accounting gives the story of how a business has
fared financially during a given period of treading or how its affairs stand at a
particular point of time. The Profit and Loss Account conveys the first information
and the Balance Sheet the second information. The information thus obtained is of
great importance to the top management. They supply to the management valuable
information about the final result of the trading operations of the business but they
never tell them how the business has fared at every stage of operation or as to why
or where any operation has failed to achieve its object. They do not tell them what
should be the future policy of the management or the target set to produce even
better results. Thus, Financial Accounting cannot cope with the varied results.
Thus, Financial Accounting cannot cope with the varied business problems.
Moreover it is said to be static. Hence, Management Accounting has been put in
use in order to overcome these defects.
15
In this connection we may refer to Robert Anthony, who comments that the
terms ‘Management Accounting’ and ‘Financial Accounting’ are not precise
descriptions of the activities they comprise. All accounting is financial in the sense
that all accounting are in mone lay terms and management of course, is
responsible for the content of Financial Accounting reports. In spite of this close-
relation, there are some basic differences between the tow and they are discussed
below.
1. Financial Accounting is confined to the prepartion of financial statements for
the use of outsiders like debenture holders, creditors and bans and also for
the information shareholders to show the manner in which the business
**ations are conducted during a specified-period. But management containing
information for management.
2. Financial Accounting has as one of its objects, the furnishing of information to
outsiders who have a right to sell the same under certain well-defined and
accepted principles and rules. Management Accounting, on the other hand,
need not conform to the standards or rules laid down for the use of outsiders.
For Management Accounting, the management can follow its own rules and
principles for the efficient achieving of its objectives.
3. Financial Accounting, generally, deals with the whole of the business. While
Management Accounting deals with the several divisions of the business.
4. Financial Accounting, is absolutely compulsory but Management Accounting is
only optional.
5. Financial Accounting is mainly concerned with historical information i.e. what
has happened? But Management Accounting is concerned not only with the
past information but also with information about the future.
6. In Financial Accounting there is the recording of business transactions in
which the values of the assets and liabilities are ascertained on a specified date
by the preparation of a Balance Sheet, expenses adn incomes are summed up
in the Profit and Loss Account for a specified period and the result of trading is
ascertained. In Management Accounting the two main terms are planning and
budgeting with the help of which the management will be a position to forecast
the future possibilities.
7. Financial Accounting will not reveal whether the plans formulated and the
decision arrived at by the management are being followed rigidly and, if not,
what part of them are not followed, but Management Accounting will reveal
them entirely.
8. In Financial Accounting, records are maintained in the form of personal, real
and nominal accounts. But in Management Accounting costs and revenues are
mostly separated by responsibility centers or profit centers.
16
9. The Financial Accounting Statements are prepared on some generally accepted

accounting principles and conventions. But Management Accounting does not
have such accounting principles and conventions. Information outside the
debit-credit structure is often as valuable as others.
10. In Financial Accounting reports made for outsiders, do not specify any
alternative courses and their financial implications. But in Management
Accounting reports made for internal management, furnished data for
evaluating the alternatives open to them in making decision by making
significant comparisons of monetary consequences of those alternatives.
2.2. COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Cost, in a broad sense is the vital factor to take business decisions. In costing
we had the earliest application of accounting information to the problem of internal
managerial control. Cost accounting was developed in the late 10th century to fulfil
the need to evaluate inventories in annual accounts. Prior to the advent of
Management Accounting most of business concerns directed their costing activities
towards the calculation of costs by organisational responsibilities for a prided In
short, Cost Accounting will tell the management as to how the business had faced
at each stage of operation. But it will never tell them anything about the future
policy to be adopted.
On the other hand the main aim of Management Accounting is not to collect
information as such but to utilise the information so collected in order to help the
management to formulate their future policy and to make important policy decision.
Hence, Management Accounting is a system of accounting which is concerned with
internal reporting of factual information to management for planning and
controlling current operations, decision making on special matters and formulating
long-range plans. Management Accounting also refers to the methods and
techniques which assist management in achieving organisational objectives.
Cost Accounting deals with cost finding, control, cost reduction and cost
reconciliation. So cost accounting is a necessary adjunct of Management
Accounting which draws heavily on cost data and other information derived from
cost records. hence, Management Accounting is extension at Cost Accounting.
Like Cost Accounting it involves reporting at frequent intervals rather than at the
end of a year or half-year. It is also concerned with units and segments of activity
rather than the business as a whole. It reports both historical data and estimates
for the future. Hence, the functions of these two accounting systems are
complementary in nature. In the absence of Cost Accounting system, details of cost
information will not be available. But cost data cannot be effectively used for
management purpose without systematic reporting in a meaningful form.
Management Accounting involves the consideration of both costs and revenues
whereas Cost Accounting deals mainly with cost data. It is also concerned with
17
production, purchasing, storing and sales in the physical sense. It cuts across
such areas as cost accounting, budgeting, internal control etc. Hence, the concept
of Management Accounting is broader than the of Cost Accounting. It not only
reports costs but also uses them as well as data from various economic and
statistical sources to assist management in planning possible alternate courses of
action. Thus Management Accounting includes all accounting functions which
report financial data and interpretation of such data regarding relevant information.
Management Accounting conceptually speaking is a blending together of Cost
Accounting. Financial Accounting and all its aspects. As a tool of management. It
has wider scope. But it is not considered to be a substitute for other accounting
functions. It is a continuous process of reporting cost and financial data as well as
other releant information to management.
2.3. TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING

Modern management is not satisfied with mere postmortem examination of
accounts and records. It seeks guidance from accounts in its management
functions. It is not an easy job to arrive at concrete management decisions unless
it is accentuated on some aids or media. hence, some tools are necessary to reach
the target. management Accounting employs tools and techniques in order to
discharge its duty of helping management in planning. Co-ordination, control and
appraisal of activities. Such techniques and tools are as follows:
1. Analysis of Financial statements
2. Ratio Analysis
3. Cash Flow and Fund Flow Analysis
4. Statistical and Graphical Techniques.
5. Costing Techniques.
6. Standard Costing and Variance Analysis
7. Budgetary Control
8. Inventory Management
9. Financial Planning and Control
10. Evaluation of Capital Projects and Returns on investment
11. Communications and Reporting
12. Total and Marginal Cost Analysis including Even Charts and Profit-Volume
Analysis
The above analysis may show areas where immediate management action is
necessary and serve as the basis for formulation of regular plans for the future.
Fund flow Analysis may disclose important features on the basis on which working
capital requirements, stock holding. Cash requirements and cash position, etc.
18
may be modified and revised. Ratio Analysis may throw up data for action spheres
of profitability and solvency of the business. Marginal lost Analysis assists in policy
decisions in respect of utilisation of material sales mix, cost control, spare capacity,
etc. Other data from the above analysis may be used for drawing budgets and
standard costs for future periods.
2.4. IMPORTANCE OF MANAGEMENT ACCOUNTING THE INDIAN CONTEXT

Some experts are of the opinion that Management Accounting can wait in India
since business has not helped the stage which can afford that luxury. But
Management Accounting is not a luxury. Instead, it is a necessity for a growing
business and it will not cost more that any good accounting system. Hence, we can
introduce it where business has reached its peak of growth.
In our country there has been a phenomenal change in the business methods
and systems due to increasing industrial growth and product development.
Management of large and medium cad industries has become increasingly more
comples difficult may be partly due to the necessity of tackling multifarious
problems in the operational and finical grounds. Due to rapid growth of the public
sector, the importance of Management Accounting in India can hardly be
emphasied. In recent years the Management Accounting services have become
more important as an aid to management and it is recognised as a well
differentiated profession in our country.
The significance of Management Accounting cannot be over emphasied in the
present context of management in India. The shareholders raise their voice against
low divided and demand a higher share in property. Workers command more and
more wages and bonus and fight for ** in the hours of work and acceleration in
welfare amentias. The consumers, as well as the government stares on improving
quality of goods and price-reduction. Under these circumstances we can boldly say
that Management Accounting alone can successfully guide the management and
help in satisfying shareholders, laborers, consumers and the government.
Management Accounting Serves as array to Achieve Greater, Cheaper and Better
Production
Despite the numerous technological development, scientific management and
nationalisation that a management has today, it cannot solve certain problems.
Here Management Accounting comes to play an important role in relieving
management from a number of problems and assist them in achieving greater,
cheaper and better results. A case for Management Accounting must be made in
order to save our industries and their management, because it represents the art
science and profession of planning, controlling and improving efficiency.
2.5. MANAGEMENT ACCOUNTING IS A TECHNIQUE TO KEEP ALL ALERT

No doubt, Management Accounting can be described as an automatic
technique which keeps all the organs of the industry ever alert and stimulates them
19
to achieve greater efficiency. It is supposed to notice all danger signals and to

prescribe remedial measure or the cure even before the onset of disease.
Management Accounting serves as a tool for Decision Making

Figures provided by the management accountant assist the management in
arriving at decisions and to know how to curtail manufacturing expenses, how to
reduce wastage and leakage and how to improve the quality of the goods produced.
Mangement Accounting is a ‘Must’ for Managerial Planning

To-day, file has become complex both for individuals and for industrial
organisations. In the past, management could take decisions by “hit or miss
methods” or by ‘mere guess’. If any management does not plan is present as well
as future operations on a systematic basis, it will, be branded as, ‘inefficient’ by the
harsh and cold logic of failing profits. Hence, modern management for its vital
takes of planning should rely more and more on Management Accounting.
2.6. MANAGEMENT ACCOUNTING RAISES THE GENERAL STANDARD OF

LIVING
In order to raise the general standard of living it is necessary to increase
general level of consumption, which is possible only when better and cheap
commodities are available in plenty. Consumption depends upon production which
requires utilisation of material, labour and skill. The management must know the
detailed particulars about financial cost, operational performances and the
deviations from the standards. Techniques of Management Accounting alone can
fulfil this requirement of management.
In this manner, Management Accounting introduces the concept of promise
and performance. It also throws a number of aids to management to adopt a
forward looking approach instead of a merely backward facing philosophy. Further,
it shows the way to highest efficiency, productivity and cost reduction. The
emphasis must be shifted from ‘how much more’ one can produce to how efficiently
** from ‘knowing costs one can product to ‘controlling costs’.
MODEL QUESTIONS
1. What are the points of distinction between Management Accounting and
Financial Accounting?
2. What are the tools and techniques of Management Accounting.
3. ANNAMALAI UNIVERSITY
How are Management Accounting and Cost Accounting interrelated?
4. Discuss the importance of Management Accounting in the context of the Indian
economic development.

20
LESSON - 3
ANALYSIS AND INTERPRETATION OF
FINANCIAL STATEMENT
OBJECTIVES
 Release the limitations of financial statements
 Identify the financial troubles that a business might meet
 Understand the nature and types of financial analysis
 Apply the various tools of financial analysis
STRUCTURE
3.1. Concept of financial statements
3.2. Nature of financial statements
3.3. Limitations of financial statements
3.4. Types of financial analysis
3.5. Methods and Devices used in analysing financial statements
3.6. Financial troubles
3.1. CONCEPT OF FINANCIAL STATEMENTS

Financial statements or reports are account balances arranged in effective and
meaningful order so that the facts and concepts they portray may a be readily
interpreted and used as bases for decisions by all those interested in the affairs of a
business concern. Management on the basis of information given by these reports,
may review the company’s progress to date and decide upon the courses of action
to be taken in future, creditors may choose to extend or maintain or restrict credit.
Shareholders may judge prospects for their investment and elect to sell or to
continue the ownership, laborers may judge the ability of the company to pay more
wages; and the customers may appraise the effectiveness of the economic unit from
which they buy goods or services.
The term ‘financial statement’ refers to two statements-the Balance sheet or
statement of financial position reflecting the assets, liabilities and capital on a
particular data and income statement or Profit and Loss Account, showing the
operational results during a certain period. Usually they are prepared at the end of
a given period for a business concern in the case of limited companies these include
Profit and Loss Appropriation Account. In big companies they have a third
statement which is called ‘package of financial statements’ and it includes schedule
relating to land, buildings, equipment, inventories, long term investments, accrued
21
liabilities, long-term debt, cost of goods manufactured, selling expenses, etc. These
schedules constitute the first step towards the analysis of certain data in the
Balance sheet and Income Statement. when adequate information cannot be given
merely by listing of financial statement items, explanatory footnotes are to be given
as an integral part of financial statements.
3.2. NATURE OF FINANCIAL STATEMENTS

Financial statements are plain statements of informed opinion
uncompromising in their truthfulness. It is meant that within the limits of
accepted accounting principles and of the very human abilities of the persons
preparing them they are to rely on judgements and estimates divorced of fancy and
prejudice. The American Institute of Accountants says that ‘they reflect a
combination of recorded facts, accounting conventions and personal judgements
and the judgements and judgements and conventions applied affect them
materially’.
Recorded facts represent the data contained in the statements as found in

accounting records and they consist of such data as cash on hand and in the bank,
the amount due from customers the cost of fixed assets, the amount due to
creditors etc. As the price level (cost) of fixed assets on the date of acquisition is
stated as a rule in the accounts rather than the replacement cost, the balance sheet
does not show the financial position of a business in terms of current economic
conditions. Of course, in some cases, appraised values might be substituted for
cost. Certain factors, which affect the financial position of a business, appear as
footnoted to the Balance sheet. Generally they are unexecuted orders, purchases
and sale contract and commitments claims for tax refunds, judgements,
endorsements and guarantees.
3.3. LIMITATIONS OF FINANCIAL STATEMENTS

1. Financial Statements are essentially interim reports and hence, cannot be final
because the actual gain or loss of a business can be determined only after it
has put down it shutters.
2. They tend to give an appearance of finality and accuracy, because they are
expressed in exact money amount. Any value to the amounts presented in the
statement depends upon the value standards of the person dealing with them.
3. The Balance Sheet loses its function as an index of current economic realities
due to the fact that financial statements are compiled on the basis of historical
costs while there is a marked decline in the value of the monetary unit and the
resultant rise in prices. The problem has become more important especially
during the war and the post war period.
22
4. They do not give effect to many factors which have a bearing on financial
conditions and operating results because they cannot be stated in terms of
money and are qualitative in nature. Such factors are the reputation and
prestige of the business with the public, its credit rating the efficiency and
loyalty of its employees and integrity of management. Due to these limitations
it is said that financial statements do not show the financial condition of a
business rather they show the position of financial accounting for a business.
PARTIES INTERESTED IN FINANCIAL STATEMENTS

Now-a-days the ownership of capital of many public companies has become
truly broads based due to digperal of shareholding. Hence the public in general
evince interest in the financial statements. Apart from the shareholders there are
other persons and bodies who are also interested in financial results disclosed by
the annual reports or companies. As, already mentioned, such persons and bodies
include.
1. Potential investors;
2. Creditors, potential suppliers or others doing business with the companies;
3. Debenture holders’
4. Credit institutions like banks;
5. Employees-and Trade Union;
6. Important customers who wish to make a long-standing contract with the
company;
7. Economic and investment analysis;
8. Members of Parliament, the Public Accounts Committee in respect of
Government Companies;
9. Taxation Authorities;
10. Company Law Board;
11. Other departments dealing with the industry in which the company is engaged.
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Analysis and interpretation of financial statements an attempts to determine
the significance and meaning of the financial statement data so that a forecast can
be made of the prospects for future earnings ability to pay interest, debt maturities
(current and long-term) and probability of a sound dividend policy. To quote Myers
“Financial statement analysis is largely study of the relationship among the various
financial factors in a business as disclosed by a single set of statements and study
of the trend of these factors as shown in a series of statements. So financial
analysis’ main function is the pinpointing of the strengths and weaknesses of a
23
business concern by regrouping and analysis of figures contained in financial

statements by making comparison of various components and by examining their
content. The financial manager uses this as the basis to plain future financial
requirements by means of forecasting and budgeting procedures.
The analysis and interpretation of financial statements represents the last of

the four major steps of accounting viz.
1. Analysis of each transaction to determine the accounts to debited and credited

and the measurement and valuation of each transaction to determine the
amounts involved.
2. Recording of the information in the journals, summarisation in ledgers and
preparation of a work sheet.
3. Preparation of financial statements.
4. Analysis and interpretation of financial statements results in the presentation
of information that assists business managers, creditors and investors. They
require a clear understanding of monetary valuation of the items.
The analyst must group what represents sound and unsound relationships
reflected by the financial statements. He should fully realise that financial,
administrative and operating policies of management or the absence of such
policies can be detected by studying the statements. Moreover, the process of
analysing financial statements involves the compilation and study of financial and
operating data and the preparation and on of measuring devices such as ratios,
trends and percentages. Thus, the date is more meaningful and it is placed in
better perspective when it is provided by means of measurement, its relationship
with other date was established and it is ranked in terms of its relative significance.
One can achieve this by comparisons made between related item in the same
statement for a given data or in period of time of statements for a series of years.
That as why the financial and operating data of one company should be compared
with statistics prepared for the industry.
Analysis and interpretation are interconnected because interpretation is

impossible without analysis and short or interpretation, analysis is useless.
Interpretation requires proper analysis. It is difficult to interpret financial
statements figures which consist not only of account balances, which usually are
the results of a number of debit and credit entries for a variety of transaction, but
also combinations of account balances, because the figures do not represent
homogeneous data. So this needs in analysis of the totals in statements into their
components so as to restore some sort of homogeneity to the statement data. For
example, through current liabilities, in a company’s balance sheet, are shown
24
separately from other liabilities it would be better from the point of view of the
financial manager to have information regarding debts due within a month or six
months or for long periods. This information has to be obtained by aging the
accounts as it is not available in statements. Interpretation further requires
comparison. The Financial statement has to be dissected into its constituents in
order to measure the relative magnitudes of the various entities. For example, if
current liabilities on a particular date are at a certain figure and if it is desired to
know whether business would be in a position to meet these obligations, the value
of liabilities will be compared with that of assets such as cash, readily convertible
assets, etc., which are available to pay off liabilities.
Unlike in the earlier days, now accountants play a vital role in the analysis and
interpretation of financial and operating data due to the pressing demand for
analytical information by business executives, bankers and others. Now-a-day a
the work of an accountant is incomplete if he has not analysed and interpreted the
data presented in the statements.
3.4. TYPES OF FINANCIAL ANALYSIS

1. External Analysis
2. Internal Analysis
3. Horizontal Analysis
4. Vertical Analysis
1. External Analysis
This is made by those who do not have access to the detailed records of the
company. This group includes credit agencies, investors and governmental
agencies regulating a business in a nominal way. They depend almost entirely on
published financial statements. Now their position has been improved due to
governmental information regulations requiring business undertakings to make
available detailed information schedules and explanatory footnotes to the public
through audited accounts.
2. Internal Analysis
This is accomplished by those who have access to the books of accounts and
all other information related to business. The internal analyst analyses for
managerial purposes. It is the internal analysis and it is conducted by executives
and employees of the enterprise as well as governmental and court agencies which
may have major regulatory and other jurisdiction over the business.
25
3. Horizontal Analysis
When financial statements for a number of years are reviewed and analysed,
the analysis is called ‘horizontal analysis’. This is also known as ‘Dynamic
Analysis’ as it is based on data from year to year rather than one data or period of
time as a whole.
4. Vertical Analysis
It is often used for referring to ratios developed on one date or for one
accounting period. It is also called ‘Static Analysis’. This is not very helpful for a
proper analysis of the firm’s financial position and its interpretation as it does not
enable to study the data in perspective. But this can be provided by a study
conducted over a number of years, so that comparisons can be effected. Hence this
is not very useful.
External Analysis and Internal Analysis are differentiated according to material

used and Horizontal Analysis and Vertical Analysis are according to Modus
Operandi of analysis.
PROFIT AND LOSS ACCOUNT

It is also known as profit and loss statement or income statement. This is a
very important financial statement, because any business is conducted primarily to
earn profit. The main feature of accounting is the determination of net profit of
business concern. This statement matches revenues (sales) and costs incurred in
the process of earning revenues (ie. cost of goods sold, administrative, selling,
distribution and other general expenses).
For the proper analysis of financial statements, the following terms are
essential.
1. Sales and other operating revenues must be compared with the cost of goods
sold and in case of excess of the former over the latter there will be gross profit.
2. When cost of goods sold exceeds the sales and other operating revenues, there
will be gross loss.
3. Operating expenses such as administrative, selling and distributive expenses
are deducted from the gross profit in order to get Operating profit.
4. Non-operating income such a interest, rent etc. are added to the operating
profit and therefrom other non-operating expenses are deducted to derive net
profit before tax.
26
5. When provision for tax is deducted from Net Profit before tax, we get Net Profit
after tax.
MULTIPLE-STEP INCOME STATEMENT

Generally Profit and Loss Account is prepared in horizontal form. But this
form has become out of date steadily. So the presentation of Profit and Loss
Account in vertical form and multiple steps as under:
Multiple Step
Profit and Loss Account
For the year ended 31 st December 1982
Rs.
Net Sales 36,140

Less: Cost of gods sold 16,461
Gross Profit 19,679
27
Gross Profit
General and Administrative Expenses
Office Salaries 2,000

Insurance 300
Taxes 1,500
Depreciation 1,300
5,100
Selling Expenses,
Advertising 3,000
Depreciation 1,000
Travelling expenses 1,000 5,000
Total operating expenses 10,100
ii) Operating profit 9,679
Add: Interest earned 1,000
Less: Interest Expense 100 900
iii) Net Profit before Income-Tax 10,479
Less: Provision for Income-Tax 5,200
iv) Net Profit after Income – Tax 5,279
Add: Gain on sale of Investment net of Income Tax on the
gain of Rs.1,000 1,000
Net Profit 6,279
Single Step Statement
As multiple-step income statement is confusing. Business concerns now a-
days adopt single-step income statement. Under this method all kinds of incomes
operating or non-operating are collected at one place. All deduction will be made at
one place. The difference will be either net profit or net loss. The following is an
example is an example for the signal step income statement in Vertical order
Single step Income Statement

For the year ended 31st December, 1982
Rs.
Income:ANNAMALAI UNIVERSITY
Sales 48,000
Interest on securities 2,000
Miscellaneous 500 50,500
28
Deductions
Cost of goods sold 37,500

Selling expenses 1,400
Administrative expenses 500
Interest on Debenture 100
Loss on sale of asset 300
Provision for tax 5, 000 44,800
Net Income for the year 5,700
Illustration-1
During the year, 1982, a company made a gross profit 33 1/3% on sales of
Rs.30,000 and a net profit of 15% on turnover. Calculate 1) cost of goods sold and
2) expenses.
Solution
Rs.
Sales 30,000
Gross Profit at 33½ on sales 30,000 × 331/3 10,000
100
Net Profit at 15% on turnover 30,000 × 15 4,500
100
1. Cost of goods sold = Sales — Gross Profit
30,000 — 10,000 = 20,000
2. Expenses = Gross Profit — Net Profit
10,000 — 4,5000 = 5,500
Note
Gross Profit = Sales — Cost of goods sold
Sales = Cost of goods sold + Gross profit
Cost of goods sold = Sales — Gross Profit
Purchases = Cost of goods sold + Closing stock — Operating Stock
ILLUSTRATION - 2
From the following, compute the purchases and sales for the year 1982.
Opening Stock Rs.15,000
Closing Stock Rs.12,500
Cost of goods sold Rs.1,00,000
Gross Profit on sales 20%
29
SOLUTION
Purchases = Cost of goods sold + Closing stock - Opening stock
= 1,00,000 + 12,500 - 15,000
= 97,500
Sales = Cost of goods sold + Gross profit
(But it is 25% on cost) i.e.
20 20

100  20 80
1,00,000  20
G.P. = = 25,000
80
Sales = 1,00,000 + 25,000 = 1,25,000
PROFIT AND LOSS APPROPRIATION ACCOUNT

This account shows the utilisation of net profit earned by a business concern.
Dividends declared, the amount transferred to general reserve or any other reserve
are shown in this account. The balance in transferred to the Balance Sheet. The
horizontal form of P & L (APP) a/c is given below:
Profit and Loss Appropriation Account
For year ended 31st March, 1982.
Rs. Rs.
To Interim Dividend 24,000 By Balance b/d 40,000
” Proposed final Dividend 10% ” Net Profit for the
on Rs.1,00,000 10,000 current year 60,000
” Transfer to S.F. 2,000
” Balance carried to
Balance Sheet 64,000
1,00,000 1,00,000
BALANCE SHEET
A Balance Sheet, strictly speaking, discloses the names of all such accounts
which show balances. Purchases A/c, Sales A/c, Wages A/c Salaries A/c etc. are
transferred to Trading and Profit and Loss A/c and to not appear in the Balance
Sheet. But accounts such as Building A/c, Machinery A/c, Debtors A/c, Creditors
A/c etc, are not transferred to P & L A/c and are shown in the Balance Sheet.
Similarly, preliminary expenses, discount on shares and debentures are not
transferred in full to P & L A/c but they are shown in the Balance Sheet until they
are written off. Hence, we can remark that Balance Sheet is a list of balances.
30
Balance Sheet is a statement of assets and liabilities. It is divided into two

equal parts. On the left side liabilities are show on and on the right side assets are
shown. Assets of the Joint Stock Company are written in the order or permanence
nor in the order of liquidity.
The uses of total capital ie, land, building, machinery, stock etc, are shown on
the assets side and the sources of capital ie., ownder, loan etc, are shown on the
liabilities side. As sources of capital in a business must be equal to the uses of
capital, the totals of the two sides of a balance sheet, must be equal. This only
emphasises that the Balance Sheet is not and does not purport to be a statement of
value. In short the Balance Sheet may be described as the listing of the sources
and uses of capital.
Classification of Assets and Liabilities

Generally assets are classified into two kinds ie., Fixed assets and Current
Assets. Fixed Assets are further classified into Tangible Assets and Intangible
Assets. Tangible Assets are Building. Plant and Machinery. Furniture etc,
whereas intangible Assets are Goodwill, Patents, Trade marks. Fixed Assets are not
held for resale but they are held for the services that they yield in the production of
other goods and services.
Current Assets are: Cash, Bank Balance, Temporary Investments, Bills
Receivable, Debtors, Stock-in-Trade (Inventories). Current assets are those assets
which are reasonably expected to be realised in cash or sold or consumed during
the normal operating cycle of the business.
Liabilities are also classified as Fixed and Current Liabilities. They are the
claims of creditors against the concern. Fixed Liabilities are those liabilities which
do not become due for payment immediately and which do not require current
assets for their payment. They are otherwise called Long term Liabilities. Current
liabilities, are those obligations which are paid out of current assets or by creating
current liabilities. The following are the Current liabilities:
1. Creditors
2. Bills Payable
3. Outstanding Creditors for expenses
4. Proposed dividends
Bank O.,D. (Sometimes)
6. Provision for taxation
If current liabilities are deducted from current assets the resultant difference is
termed as Working Capital.
Balance Sheet also can be presented in tow ways viz, 1. Horizontal
presentation 2. Vertical presentation. Under the former assets and liabilities are
31
shown side by side. Assists are shown on the right hand side and Liabilities on the
left-hand side. The following is the example horizontal presentation of the Balance
Sheet of an individual proprietor.
Balance Sheet of Mr. Murugan

As on 31st December, 1982
Liabilities Rs. Assets Rs.

Current Liabilities Current Assets
Sundry Creditors 000 Cash in hand 000
Outstanding expenses 000 Cash at bank 000
Bills Payable 000 Bills Receivable 000
Bank over Draft 000 Debtors
000
Income received in advance 000 Stock-in trade
000
Investments
Fixed Liabilities
Fixed Assets
Loan 000
000
Mortgage 000 Furniture
000
Capital (Murugan) 000 Machinery
000
Building
000
Land
Total 000 Total 000
Following is the example of Vertical presentation of the Balance Sheet of a

Joint Stock Company
Balance Sheet of M/S Chidamabaram Company Ltd.

As at 31st December 1982
Fixed Assets
Net
Cost Depreciation
Rs.
Land 40,000 - 40,000
Building 80,000 8,000 72,000
Machinery
Furniture
24,000
20,000
4,800
2,400
19,200
17,600
1,48,800
32
Current Assets
Stock in Trade 24,000

Sundry Debtors 16,000
Bills receivable 8,000
Cash at Bank 16,000
Cash in hand 2,000
66,000
LESS: Current Liabilities
Sundry Creditors 12,000
Bills payable 11,200
Outstanding expenses 4,800
28,000 38,000
Total Net Assets 1,86,800
Capital Employed
Share Capital 1,66,500

Reserve 20,300
1,86,800
ILLUSTRATION - 3
From the following Balance Sheet of Lakshmanan Co. Ltd., given in
conventional form you are required to prepare Balance Sheet in Vertical form
suitable for comparison purposes showing the working capital and percentage to
proprietor’s funds.
Lakshmanan Co. Ltd.

Balance Sheet as at 31st December, 1980

Equity Share Capital 75,000 Fixed Assets 1,20,000
Preference Share Capital 30,000 Current Assets 90,000
Reserves 37,500
Profit & Loss A/c 7,500
Current Liabilities 60,000
2,10,000 2,10,000
33
SOLUTION
Balance Sheet of M/S Lakshmanan Co. Ltd.,
as at 31st December, 1980
(Vertical form)
Amount Percentage of
Proprietor’s
Rs.
funds%
Proprietor’s Funds
Equity share Capital 75,000 50
Preference share Capital 30,000 20
Reserves 37,500 25
Profit & Loss A/c 7,500 5
1,50,000 100
Current Assets 90,000 60
Less: Current Liabilities 60,000 40
Working Capital 30,000 20
Add: Fixed Assets 1,20,000 80
1,50,000 100
3.5. METHODS AND DEVICES USED IN ANALYSING FINANCIAL
STATEMENTS
Analytical Methods and devices used in analysing financial statements are as
follows
1. Comparative financial and operating statement
2. Statement of change in net working capital
3. Trend Ratios
4. Common size percentages
5. Individual Ratios
Two years figures of a concern can be easily compared. Under the Companies
Act, companies must show the corresponding figures of the previous year in their
Profit and Loss Accountant and Balance Sheet. We can observe by this comparison
the increase or decrease in the various assets and liabilities and the proprietary
equity or capital. Similarly we can observe the progress of a business by the
comparison of income statements for two periods. It is more welcome to work out
the items in terms of percentage and enter these also in the statements as
comparison of absolute figures has no significance or sometimes in misleading.
Sometimes Financial statements when read with absolute figures are not easily
understandable. Hence, it is essential that figures reported in these statements
34
should be converted into percentage to some common base. The statements must
be prepared as common size statements. For example in a Balance Sheet the total
assets and liabilities is taken as 100 and all the figures are expressed as percentage
of total. Similarly, in a Profit and Loss Account sales figure is assumed to be equal
to 100 and all other figures are expressed as a percentage of the total. The
statements thus prepared are called common size statements.
In preparing an analysis of Company Accounts we have to take three steps,
namely:
1. Preparing synopsis of Profit and Loss Account and Balance Sheet.
2. Computation of significant financial ratios.
3. Writing a review of the analysis.
The following points must be noted from this analytical summary in order to
measures the progress of a concern.
1. Percentage of gross profit and net profit on sales.
2. Percentage of net profit on capital employed.
3. Provision for depreciation and expenditure.
4. Trend of sales, stocks and expenditure.
5. Retention of profits in the form of reserves and surplus.
6. Dividend record.
We can obtain a lot of information from an examination of a series of Balance
Sheets. The following are such useful conclusions:
1. A weak financial position is indicated if share or loan capital is frequently
increased without a corresponding increase in turnover.
2. If bank loans are retained for long unduly periods it is meant that revenue
earning capacity of the company is not adequate to justify an increase of share
capital.
3. If profits are comparatively stable over a period of years it is also meant that
profit shall not be affected provided normal conditions are maintained.
4. Greater productive efficiency and improvement in the selling prices are
indicated if profits are gradually increased without corresponding increase in
floating assets.
5. Steady and satisfactory progress is sure and certain if dividends are
maintained and regular transfers are made to reserves and the working capital
remains stable.
6. If creditors are gradually exceeding debtors without corresponding increase in
stock, overriding is indicated where profits are maintained.
35
7. An increased turnover is indicated if profits are gradually increased with a

corresponding increase in debts, stock etc.
8. Inadequate provision for depreciation and overvaluation of fixed assets are
indicated if they are increasing in value without a corresponding increase in
profits.
The above conclusions cannot be applied without modification to any
individual concern for the obvious reason that consideration must be given to those
circumstances peculiar to the business under review.
Trend Analysis: It is essential to have statements for a number of years for
analysing the trend of data shown in the financial statements. it also involves the
calculation of percentage relationship that each statement item bears to the same
item in the base year. Trend percentages disclose changes in the financial and
operating data between specific period and make it possible for the analyst to form
an opinion as to whether unfavorable or unfavorable tendencies are reflected by the
data.
Comparative Income Statement

An Income statement shows the net profit or net loss of a business for a
particular period. A comparative income statement shows the operating results for
a number of accounting periods in order to state the changes in absolute data from
one period to another in terms of money and percentages. It provides information
regarding the account balances and decreases in money amounts and if desired,
the percentage of increase or decrease as given below.
ILLUSTRATION - 4
Tamii Nadu Automobiles Limited
Comparative Statement of Income
(For the year ended 31st December 1979 and 1980 in Thousand Rupees)
Amount of Amount of Percentage of

increase or increase or
1979 1980 Decrease during decrease during

1980 1980
1 2 3 4 5
ANNAMALAI UNIVERSITY Rs. Rs. Rs. %

Net Sales 833 935 102 12
Less: Cost of goods sold 510 582 72 14
Gross profit on sales 323 353 30 9
36
Operating Expenses
Selling expenses
Advertising expenses 10 20 10 100
delivery expenses 20 18 –2 –10
Salesman Salaries 126 128 2 1.6
Sales supplies expenses 14 15 1 7
Miscellaneous selling expenses 20 23 3 15
Total of selling expenses 190 204 14 7
Administrative and General Expenses Rs. Rs. Rs. %
Doubtful debt 3 4 1 33
Office salaries 30 34 4 13
Office expenses 2 4 2 100
Officer’s Salaries 28 25 –3 –11
Stationery & Postage 1 2 1 –100
Telephone & Telegraph 2 1 –1 –50
Miscellaneous General expenses 3 5 2 67
Total 69 75 6 9
Rs. Rs. Rs. %
Total operating expenses 259 279 20 8
323 359
259 279
Operating Profit 64 74 10 16
Add: Other Income
Interest Income 2 2 - -
Rent Income 2 2 2 100
Purchases Discounts 4 6 2 50
Total other Income 8 12 4 50
Total of operating profit and other
Income 72 86
Less: Other Expenses
Interest expenses 26 17 –9 –35
Sales Discount 8 7 –1 –12
Total Other expenses 34 24 10 -29
Income for the year before
Income tax 38 62 24 63
Income tax 10 13
Income after Income tax 28 49 -1 75
37
Rs. Rs.
Loss on sale of long term Investments — 22
Net Income transferred to appropriation account 28 27
Balance of appropriation Account on January 224 222
252 249
Appropriations
Rs. Rs.
Reserve fund 10 10
Dividends Declared 20 30
Total Appropriations 30 40
Rs. Rs.
Balance of Appropriations 31st December 252 249
(—) 30 40
222 209
The above comparatives income statement shows that net sales are increased
by Rs.1,02,000 whereas cost of goods sold by Rs.30,000 gross profit on sales also
increased by Rs.30,000 but it declined as a percentage of net sales. The favorable
point is that the increase in gross profit is adequate to cover the increase of
Rs.20,000 in operating expenses and to leave Rs.10,000 increase in operating
profit. We learn that selling expenses increased by a larger amount than general
and administrative expenses but this only natural since the former bears a direct
relationship to sales. however, as a percentage of net sales, selling expenses have
declined.
Comparative Balance Sheet

Increase or Decreases, in various assets and liabilities including capital can be
observed by a comparison of the balance sheet at the beginning and end of the
period. Such observation yields a lot of information to know the enterprise. In
order to facilitate comparison, a simple device known as the comparative balance
sheet is used.
38
Tamilnadu Automobile Limited
Comparative Balance Sheet at on 31 s t December 1979 and 1980

(In Thousand Rupees)
December Increase or
Decrease Amount
1979 1980
%
CURRENT ASSETS Rs. Rs. Rs.
Cash 118 10 —108 —92
Sundry Debtors 213 195 —18 —9

(—) Provision for Doubtful debts 4 5 1 25
Net Sundry Debtors 209 190 —19 —9
Trading stock 160 130 130 —19
Prepaid expenses 3 3 —— —
Other current assets 29 10 —19 —66
Total current assets 519 343 —176 —34
INVESTMENTS:
Real Estate 200 100 —100 —50
Subsidiary A 70 70 — —
Total Investment 270 170 —100 —37
FIXED ASSETS
Furniture & Fixtures 10 20 10 100
Less: Allowance for Depreciation 1 2 1 100
Net Furniture & Fixtures 9 18 9 100
Buildings and Equipment’s 360 841
Less: Allowance for Depreciation 50 55
310 786 476 154
Land 20 30
Other Fixed Assets 10 15
Total Fixed Assets
Other assets
349
46
849
59
500
13
143
28
Total assets 1,184 1,421 237 20
39
LIABILITIES AND CAPITAL

Current Liabilities:
Sundry creditors 255 117 —138 —54
Other current liabilities 7 10 3 43
Total current liabilities 262 127 —135 —52
Fixed Liabilities
Debentures 50 100 50 100
Mortgage Debentures 150 225 75 50
200 325 125 150
Total liabilities 462 452 —10 —
Capital — — 110
Equity share capital 400 600 200 50
Capital Reserve 60 10 50 83
General Resersve 222 209 —13 —6
Sinking Fund 40 50 10 25
Total Surplus 322 369 47 15
Total Capital 722 969 247 34
Total Liabilities and capital 1,184 1,421 237 20
CONCLUSIONS
1. Total Fixed assets were increased by Rs.5,00,000. This new investment in
fixed operating assets was financed primarily by the use of a portion of net
working capital amounting to Rs.41,000 (1,76,000-1,35,000), by the issue of
two categories of debentures to the tune of Rs.1,25,000, by the issue of equity
shares for the value or Rs.2,00,000 by an increase of Rs.50,000 in capital
reserve and by liquidating real estate investments for Rs.78,000 (1,00,000-
22,000 as shown in the income statement). Although the analysis of the
financing of fixed assets is over-simplified, it helps to illustrate broadly the
basic approach. The expansion of fixed assets has resulted in increased plant
capacity, increased productivity of existing plant or decreased unit cot of
2.
operation.
The relationship between total current assets for Rs.3,43,000 and total current
liabilities of Rs.1,27,000 appears to be satisfactory from the point of view of the
capacity of the business to pay off its current liabilities but it appears that the
cash balances have been drawn upon to an extent as to reduce it to only
Rs.10,000 which is inadequate for the regular operations of a company of this
size.
40
3. Increase in Capital Reserve of the order Rs.50,000 is the result of appreciation

of fixed assets consequent upon their revaluation. The ratios are determined
by dividing the rupee amount for the current year, by the rupee amount for the
preceding year or base year if any. The use of ratios avoids the necessity of
showing decrease signs. if a ratio is less than one it is meant that the amount
for the current year is less than the amount for the base year.
The following is an example of trend analysis of the Asset side (Current Assets)
of the Balance of Madras Co Ltd.
Madras Company Limited

Comparative Balance Sheet as on 31st December 1975 —1980
(Rupees in Thousand)
Trend Percentage Base Date

ASSETS December 31
31.12.1975 100
1975 1976 1977 1978 1979 1980 1976 1977 1978 1979 1980
Current Assets
Rs. Rs. Rs. Rs. Rs. Rs. % % % % %
Cash 30.8 36.4 32.0 28.6 29.0 23.6 118 104 93 94 77
Marketable
Securities 14.4 11.0 8.8 11.2 13.8 5.4 76 61 78 96 37
66.0 59.4 57.6 50.2 59.8 59.4 98 95 83 99 98
Debtors
78.8 74.8 71.8 72.4 85.2 83.6 95 91 92 108 106
Stock (FIFO)
Other Current 3.6 1.0 6.8 8.8 5.2 1.2 — — — — —
Assets
Total Current
assets 193.6 182.6 177.0 171.2 193.0 173.2 97 94 91 103 Z92
Trend percentage may be calculated only for some important items which are
logically ‘connected with each other. If accounting practices reflected in accounts
have not been consistently followed year after year they become uncomparable.
They should not be read without considering the absolute data on which they are
based. For example the trend percentage may reflect 100% increase in two
expenses. One expense might have increased from Rs.200 to Rs.400 and another
from Rs.20,000 to Rs.40,000. The increase in the first case is not significant
whereas the increase in the second case is significant if we consider the actual
figures also,, Moreover a change in price level makes comparison out of tune.
When prices in 1989 have increased by 75% over the price 1975 then increase in
sales by 50% will give a misleading picture.
41
COMMON SIZE STATEMENT

Illustration 5
B.Ltd.
Income Statement for the year ended 31 s t December
1980 1979 1978

Rs. Rs. Rs.
Net sales 16,00,000 11,00,000 7,00,000
Less: Cost of goods sold 11,36,000 7,59,000 5,11,000
Gross Margin 4,64,000 3,41,000 1,89,000
Less: Operating expenses 3,04,000 1,98,000 1,12,000
Net Operating income 1,60,000 1,43,000 77,000
Less: Interest expenses 16,000 8,000 700
Net Income before Income Tax 1,44,000 1,34,200 76,300
Less: Provision for Taxation 64,000 57,200 34,300
80,000 77,000 42,000
Prepare a Commen size Statement and Cumment briefly
B.Ltd.
Income Statement for the year ended 31 s t December
1980 1979 1978

Rs. Rs. Rs.
Net sales 100 100 100
Less: Cost of goods sold 71 69 73
Gross Margin 29 31 27
Less: Operating expenses 19 18 16
Net Operating income 10 13 11
Less: Interest expenses 1 0.8 0.1
Net Income before Income Tax 9 12.2 10.9
Less: Provision for Taxation 4 5.20 4.9
Net Income after tax
COMMENT
5 7 6
The figures of Sales, cost of goods sold and Gross profit all have continuously
increased since 1978. The coming size statement discloses that cost of goods sold
in relation to sales decreased in 1979 and again increased in 1980. With the result
rate of gross profit in 1979 over 1978 increased but in 1980 over 1979 decreased.
Similarly Net Profit after tax in absolute figures show increasing trend since 1978
42
but the rate of Net Profit on sales in 1980 is 5% in contrast to 1% in 1979 and 6%
in 1978.
COMMON - SIZE BALANCE SHEET

Illustration - 6
From the following balance sheets of Ganapathy Co Ltd., prepare a common
size Balance Sheet for three years to the nearest tenth of one percent using 31st
December 1978 as the base year (100%)
1. Accounts Receivables
2. Current Assets
3. Total Non-current Assets,
4. Current liabilities and
5. Capital
Liabilities Assets
1980 1979 1978 1980 1979 1978
Accounts payable 40 45.0 35.0 Cash 12 9 7

Accrued expenses 9 7.5 4.5 Accounts receivable 60 65 64
Taxes payable 16 10.0 15.5 Inventories 23 16 19
Total current Total current
liabilities 65 62.5 55.0 assets 95 90 90
Share Capital 55 50.0 50 Fixed assets
Retained Earnings 30 22.6 20 (Net after Depreciation) 51 42.5 30
Other Non–current
Assets 4 2.5 5
Total Capital 85 72.5 70 Total Non–current
Assets 55 45 35
Total liabilities and 150 135 125 Total current and 150 135 125
capital Non–current Assets
WORKINGS
1. Liabilities — (total capital and 2. Assets — (Total current and Non–
liabilities to each item) current assets to each item)
43
1980 1980
70 12
× 100 = 26.7 × 100 = 8.0
150 150
9 60
× 100 = 6.0 × 100 = 40.0
150 150
16 23
× 100 = 10.7 × 100 = 15.3
150 150
55 51
× 100 = 36.6 × 100 = 34.0
150 150
30 4
× 100 = 20.0 × 100 = 2.7
150 150
100.0 100.0
1979 1979
45 9
× 100 = 33.3 × 100 = 6.7
135 135
7 .5 65
× 100 = 5.6 × 100 = 48.2
135 135
10 16
× 100 = 7.4 × 100 = 11.9
135 135
50 42.5
× 100 = 37.0 × 100 = 31.4
135 135
22.5 2 .5
× 100 = 16.7 × 100 = 1.8
135 135
100.0 100.0
1978 1978
35 7
× 100 = 28.0 × 100 = 5.6
125 125
4 .5
× 100 = 3.6
64
× 100 = 51.2
125 125
15.5 19
× 100 = 12.4 × 100 = 15.2
125 125
50 30
× 100 = 40.0 × 100 = 24.0
125 125
44
20 5
× 100 = 16.0 × 100 = 4.0
125 125
100.0 100.0
Common Size Balance Sheet of Ganapathy Co. Ltd.
As on 31 st December 1978 — 1980
Liabilities Assets
1980 1979 1978 1980 1979 1978

% % % % % %
Accounts payable 26.7 33.3 28.0 Cash 8.0 6.7 5.6

Accrued expenses 6.0 5.6 3.6 Accounts receivable 40.0 48.1 51.2
Taxes payable 10.7 7.4 12.4 Inventories 15.3 11.9 15.2
Total current Total current
liabilities 43.3 46.3 44.0 assets 63.3. 66.7 72.0
Shaper Capital 36.6 37.0 40.0 Fixed assets
Retained Earnings 20.0 16.7 16.0 (Net after
Depreciation) 34.0 31.4 24.0
Other Non–current
Assets 2.7 1.9 4.0
Total liabilities & Total Non–current
Capital 56.6 53.7 56.0 Assets 36.7 33.3 28.0
100 100 100 Current Assets 100 100 100
ILLUSTRATION: 7
You are required to compute the trend percentage from the above Illustration
using 31st December 1978 as the base year (100%)
Workings: BASE YEAR 1978
Assets — Receivable 65
= × 100 = 101.5
64
60
= × 100 = 93.7
64
Current Assets
=
90
90
× 100 = 100
95
= × 100 = 105.5
90
Non—current Assets 45
= × 100 = 128.5
35
45
55
= × 100 = 157.1
35
Liabilities — current 62.5
= × 100 = 113.6
55
65
= × 100 = 118.2
55
Capital 72.5
= × 100 = 103.5
70
85
= × 100 = 121.4
70
TREND ANALYSIS
Comparative Balance Sheet of Ganapathy Co. Limited

As on 31st December 1978 to 1980
Trend Percentage Base

December 31
Date: 31.12.1978
Assets
1978 1979 1980 *1978 1979 1980
Rs. Rs. Rs. % % %
Receivable 64 65 60 100 102 94
Total Current Assets 90 90 95 100 100 106
Total Non–current Assets 35 45 55 100 129 157
Liabilities
Current Liabilities 56 62.5 65 100 114 118
Capital 70 72.5 85 100 104 121
*As it represents base data; all the percentages are 100
3.6. FINANCIAL TROUBLES

The following are the chief financial troubles that a business concern might
meet
Failure to make a profit
2. Running out of money
3. Overtrading
4. Under Trading
5. Over Capitalisation
46
6. Under Capitalisation
7. Capital Gearing
8. Earning Capacity
1. Failure to make out a profit

As we know, profit is the excess of sales revenue over expenditure. Any failure
to make a profit may be due to something wrong either in sales or expenditure.
Selling prices may not be too low but good selling lines may not be profitable while
other lines have priced themselves, because the profit margin on them is higher
then what is necessary. On the other hand, the expenditure may not be too high.
It may be that the total level of expenditure is right but the money might have been
spent on wrong things.
2. Running out of Money

Profit alone is not everything. Inspite of excellent profit records some business
units had to close when all their money was locked up in stock which they could
not realise. Hence, they were not able to pay their creditors in time. That is why it
is said that control of stocks and Work-in-progress in a matter of sound production
control combined with proper control of materials through their records. Moreover
the profit earned on the capital employed can be increased by increasing the rate at
which the stock is turned over.
When a business does not keep its bank balance under control, it will find
itself without sufficient funds to meet the demands of creditors. Everything will go
on smooth as long as the cash coming from customers meets the demands made by
cash, a serious shortage of working capital can be developed.
The normal cash receipts from customers are assessed together with any
anticipated receipts on capital account and from other sources. The running bank
balance month by month is the differences between the above-said receipts and
outgoings. We can forecast for the coming months of the probable drawings on the
bank. From this calculation if it is seen that there is going to be a temporary
shortage of working capital at any period, them there is a lot of time to take
necessary steps to provide the required funds.
The following action must be taken if funds are going to be consistently short:
1. The concern should reduce the level of stocks carried.
It should shorten the terms of credit extended to its customers.
3. It should press the customers to pay their dues promptly by allowing additional
cash discount.
4. It must arrange for overdraft facilities from the bank when the position is only
temporary.
47
5. Lastly, it should arrange for a further supply permanent capital.
3. Over Trading
When the business accepts excessive orders it faces over trading because the
decision of accepting excessive orders compels the management to make credit
purchases and to make overtime payment to the workers engaged in order to fulfil
the works. The increase of cash balance is necessary much more than the usual
demand in order to make payments to trade creditors from whom purchases are
made. At the same time realisation of cash is delayed because of the long time
taken in converting raw materials into finished product and then selling them in
the market. It is meant that the business has accepted havy orders, commitments
and responsibilities beyond its overall means. This situation is called overriding.
Due to this overriding business is faced with the need for borrowing at high rates of
interest to deliver goods according to the schedule and thereby avoid loss good of
will and status which will have serious impact on the concern’s future.
The following are the symptoms of over-trading
1. Piling up of stock
2. Increasing trend of total creditors.
3. Sales are too high in comparison working capital
4. Sales are too high in relation to capital
5. lack of funds and borrowings at high rates of interest
6. Reduction in turnover and delay in execution of order resulting in loss of
goodwill.
7. More than the normal credit period allowed indicates an Index of poor cash
position and consequently over-trading.
Apart from above drawbacks, overriding weakens the morale of workers and
staff. It cuts down all valuable activities such as training, research, modernisation,
development etc. This will affect the long-term efficiency, stability and growth
potential of the concern. Thus over trading is very harmful to the prospects and
profitability of a business concern.
4. Under Trading
This is a condition just the reverse of overtrading. Generally it indicates the
inadequate volume of business. This may be due to under employment of assets of
the business leading to the fall in sales and result in financial crisis. This makes
the business unable to meet its commitments, Ultimately this leads to forced
liquidation.
48
5. Over Capitalisation
A business concern is said to be over capitalised when its earnings are not
sufficient to justify a fair return on the amount of share capital and debentures
Moreover, it is said to be over capitalised when the total of owned and borrowed
capital exceeds its fixed and current assets. Accumulated losses are shown on the
asset side.
6. Under Capitalisation
There is a sign of under-capitalisation when both equity and preferential
(owned) capital of the business is much less than the borrowed capital including
trade creditors. It means that the business depends upon borrowed money and
trade creditors. This is the result of overtrading. It also results in the payment of
excessive interest on borrowed capital, use of out-dated equipment’s because of
inability to buy new ones and high cost of production due to the use of old
machines and high cost of purchase of extra credit demanded on purchase, etc.
7. Capital Gearing
‘Capital Gearing’ or ‘Gearing ratio’ is the relationship between the Equity Share
Capital and the preference Share Capital and also loan charges. It is also defined
as the ratio between the fixed amount payable to preference shareholders in the
form of preference dividend and debenture holders in the forms of debenture
interest and the profits available to the quity shareholders.
When the preference share capital and debentures issued are proportionately
then higher to the Equity Share Capital there is said to be ‘High Gearing’. On the
other hand if they are proportionately less as compared to Equally Share Capital, it
is to be ‘Low Gearing’. If the gearing is high, dividend to be received by the Equity
Shareholders fluctuates accouring to the increase in profits. If the capital structure
gearing is very high, then further loans or preference share capital is out of
question and in that case equity shares are speculative. The heavy fixed interest
and the preference dividend can be paid, when there are substantial profits leaving
the balances as payment of dividend on equity shares. If a company’ a capital
structure is highly geared it is said to be ‘Trading on Equity’. But the preference
share capital, debentures and long term loans are proportionately higher than the
equity share capital and reserve.
High gearing is not good for a business where the prospects of the future
profits are not high or for a business which is comparatively new, since it cannot
afford to pay fixed amount of interest with the limited income. If the business can
foresee with certainty the profit to be made in future and can be sure of minimum
amount of profits, high gearing is, better, because this leaves more amount for the
equity shareholders and also for plouhing back of profits.
49
8. Earning Capacity
Earning capacity means the trend of profits made by a company during the
current year and in the past years. One can judge the progress of a company by its
earning capacity. For this purpose it is essential to study the Profit and Loss
Account.
The following information will be disclosed by a comparative study of the Profit
and Loss A/c for a new years.
1. The amount of the profits and the trend there of i.e whether progressive,
regressive of stationary.
2. The percentage of the profits on the capital employed in the business can be
compared with the percentage earned by other firms in the same industry.
3. The profits allocated to reserves and carried forward and whether these
indicate the pursuit of a prudent policy on part of the management.
4. The amounts and rates of dividend paid on the share capital.
5. Large functuations would point out the speculative nature of the business.
6. Whether the provision made for the depreciation on the fixed assets appears to
be adequate having regard to the book value of such assets.
QUESTIONS
1. What do you understand by Financial statement analysis? What are the uses
2. What are the different methods used for analysis of financial statements
3. Explain the following with examples:
a. Comparative financial statement
b. Common-size financial statement
4. What are the various types of financial statements.
5. On the basis of the data given in problem prepare a common size income
statement of Kannan industries Ltd. for the year ended 31.32.20o01 and 2002.
Profit & Loss A/c (in Lakhs)
2001 2002 2001 2002
To Cost of goods sold
To Operating exps:
600 750 By Net Sales 800 1000
Administration 20 20
Selling 30 40
To Net Profit 150 190
800 1000 800 1000
50
6. From the following information show the results of operations of a

manufacturing using trend percentages using 2002 as the base year
(Amount in thousand rupees)
1999 2000 2001 2002
Sales 1300 1200 950 1000

Cost of Goods Sold 728 696 589 600
Gross Profit 572 504 361 400
Total selling expenses 120 110 97 100
Net operating Profit 452 394 264 300

51
LESSON — 4
ACCOUNTING RATIOS - I
OBJECTIVES
 Know the importance of preparing ratios
 Provide a broad classifications of ratios
 Identify the limitations of ratios
Structure
4.1. Introduction
4.2. Definition
4.3. Advantages
4.4. Limitations
4.5. Kinds of ratios
4.1. INTRODUCTION
As commerce graduates you all know the methods of recording business
transactions in the books of accounts and the preparation of Profit and Loss
Account and Balance Sheet. It is also necessary to examine the art of
interpretation of accounts. It requires skill an judgement to know the meaning and
relative importance of figures: which are visible to all. Here we are goin to see how
business enterprises measure their turnover, Profitability, liquidity and leverage.
With the use of ratios we can measure a business concern’s performance. Ratios
found in final accounts of a company may reveal much about its financial position
to its shareholders, creditors and management.
The shareholders, investors, creditors, financial institutions and financial
journalists are very much interested to read the accounting data. Most of the
people in the case of limited companies, who read the accounting data, are not
intimately connected in any way with the day to day running of the company. It is
very important to know how to read the accounts properly and to extract maximum
information from them. Hence, the principles to be examined by the interpreter are
1. Profitability, 2. Ownership, 3. Solvency, 4. Trend, 5. Gearing and 6. Financial
strength. Any person reading and interpreting the accounts will place a different
emphasis on each of the above principles. The technique that is followed by
accountants to facilitate the discussion of the above principles is Accounting Ratio
or Ratio Analysis. This technique is highly developed in America. In 1919
Alexander Wall presented this elaborate system of Ratio Analysis. He pointed out
that in order to get a complete picture it is essential to consider the relationships in
financial statements other than that of current assets to current liabilities-
relationship that might be measured quantitatively and used as checks on current
52
ratio. Since then, comprehensive analysis by means of calculation of a series of

ratios rapidly became “all the rage”.
4.2. DEFINITION
A ratio is a number expressed in terms of another number. It is a statistical
yardstick-a measure of the relationship between two figures. It is an expression
spelt out by dividing one figure with the other. For example, a business has
current assets of Rs.5,14,000 and current liabilities of Rs.2,00,000 on a particular
date. Then the resulting ratio would be 5,14,000/2,00,000 = 2.57. There are
different ways of expression of the ratios.
1. They are stated as Pure Ratios ie. 2:1 (Current assets are double the current
liabilities).
2. In some cases, they are expressed as so many times, ie., stock turnover being 5
times a year.
3. In other case; they are expressed as percentages i.e, 25% gross profit on sales.
Hence a ratio is simply the quotient of two numbers. It is almost meaningless
by itself. An accounting ratio must be interpreted against some standard to input
meaning. We can compare a present ratio with the past as well as expected future
ratio for the same company. The second methods of comparison involved
comparing the ratio of one Company with those of similar companies at the same
point of lime.
4.3. ADVANTAGES OF ACCOUNTING RATIOS

1. Accounting ratios are most commonly used for management control purposes
by comparing its oven performance with the performance of other similar
concerns.
2. It is one of the media to link the past and future.
3. They can play a significant role in cost accounting, financial accounting,
budgetary control and auditing.
4. Apart from management, it assists the general public to understand the
financial trend and financial health of the business. It is possible, from ratio
analysis, to have a general impression of the past performances of the business
and is possible to have a forces about the uncertain future without any
difficulty.
5.
Identification of financial responsibility is possible from critical ratio analysis.
6. Ratio analysis is one of the factors which curb the development of institution in
financial management.
However, it is questioned whether accounting ratios will render valuable
services to all concerned. It all depends on the person who handles it.
53
4.4. LIMITATIONS
Accounting ratios have the following limitations
1. The ratios thus drawn are based on the historical figures appearing in the
Balance sheet. Hence the performance of one enterprise based on the
historical data gives a wrong direction to the approach.
2. Assets and liabilities are not grouped under money value and real value items
in preparing different ratios.
3. One particular ratio is not sufficient to review the operation of the business. It
should be considered along with other related ratios.
4. Accounting and financial ratios will tend to interpret wrong direction, if based
on unauthentic data.
5. Accounting ratios, in practice are useful to understand the trend of a particular
unit not particular type of business as a whole. This can be done by
comparing the past results with that of the present Management and financial
policies which differ widely from concern to concern. But in practice it is
difficult to compare the performance of one Company with the other. The
study of ratio analysis gives us some guideline, because, a ratio which is
satisfactory for one particular enterprise may be reverse in the case of another.
6. From the points discussed above it can be stated that ratio analysis can be
regarded ‘only as an aid to making judgement and not a substitute to
judgement’.
Need for the Accounting

The need for the accounting ratios arises because absolute figures are often
misleading. No doubt, they are certainly valuable but their value increases
manifold if they are studied with other ratios. They enable the meass of data to be
summarised and simplified for presentation to management for studying trends and
making comparative statement, of performance and stability of business. For
example, if sales have been increased from Rs.10 lakhs to Rs.10.5 lakhs; it may not
be as favorable as it appears as it the same might have been on account of
disproportionate rise in expenses or due to increase in selling price. Hence as
overall appraisal of the company’s business depends upon the different accounting
ratios drawn on the basis of various records.
It is clear that ratio analysis is an instrument for diagnosis of the financial
health of an enterprise. It is an invaluable aid to management in the discharge of
its bais functions of forecasting, planning, co-ordination control and
communication Ratio analysis helps in predicting and projecting the future by
analytical study of the past performance of the business.
54
4.5. KINDS OF RATIOS

Accounting ratios may be broadly classified as follows
1. Balance Sheet Ratios
2. Revenue Statement ratios of P & L Account Ratios
3. Balance Sheet and Revenue Statement Ratios.
They may also be classified either according to Structural point of view of the
Functional point of view. Under the structural point of view we have.
2. P & L Account Ratios
3. Composite Ratios
When a ratio is between two balance sheet item it is called Balance Sheet Ratio
or Financial Ratio’. When a ratio is between two P & L Account items it is called
‘Profit and Loss Account Ratio or Operating Ratio’ and when a ratio is between
Balance Sheet item and a Profit and Loss Account item, it is called ‘Composite
Ratio’.

1. Current or 2 to 1 Ratio
2. Acid Test or Quick Ratio or Liquid Ratio
3. Proprietary Ratio
4. Assets-Proprietorship Ratio
5. Debt-Equity Ratio
6. Capital Gearing Ratio
Revenue Statement or P& L Account or Profit ability ratios

1. Gross Profit Ratio
2. Net Profit Ratio
3. Expenses Ratio
4. Operating Ratio
5. Stock Turnover Ratio
3. Composite Ratios
1. Return on proprietors’ Fund
2. Return on proprietors’ Equity
3. Return on Equity share capital
4. Return on capital employed
55
5. Return on Total Assets

6. Turnover of Fixed Assets
7. Turnover of Total Assets
8. Turnover of Working capital
9. Turnover of Debtors
10. Creditors velocity
From the functional or working point of view the accounting ratios may be
classified as
1. Solvency ratio
2. Profitability ratio and
3. Performance and efficiency ratio
BALANCE SHEET RATIOS

1. Current Ratio
It is also know as ‘Working Capital Ratio’ solvency Ratio and ‘2 to 1 ratio’. It
expresses the relation between current assets and current liabilities. Current
assets include cash, stock, debtors, bills of exchange and investments which are
held by the business for the purpose of immediate conversion into cash. Normally
asset which will be converted within a year ie., within the two dates of balance
sheets may be regarded as current assets. In the cycle of business operation, these
assets change their form during the period covered from the last balance sheet. For
example just before acquisition of materials there is cash but after acquisition cash
is converted into stock and when cash sales are effected, stock is convered into
cash.
Current liabilities include sundry creditors, bills payable, provision for
taxation, outstanding expenses etc.
CURRENT RATIO is obtained by dividing the total current assets by the total
current liabilities. It is calculated as
Current assets
Current liabilities
Example: Current Assets 10,00,000
Current Liabilities 5,00,000
Working capital 5,00,000
56
10,00,000
Current Ratio is =2:1
5,00,000
SIGNIFICANCE
Current Ratio measures the company’s ability to meet its short tem
obligations. As current assets are almost double the current liabilities, current
ratio is reasonably good. In this example, standard ratio is 2 : 1 which is desirable.
Since it indicates that current assets are twice the current liabilities. But in actual
practice 1 : 1 ratio is considered more suitable than 2 : 1, because high ratio may
be due to poor investment policies, excessive stock etc. On the other hand low ratio
(0.5 : 1) may signify that a shortage of working capital. High ratios indicate both
under-trading and over-capitalisation whereas low ratios indicate over-trading and
under-capitalisation of business. Current ratio varies from industry to industry
and within industry form company to company and within the same company from
time to time.
WINDOW DRESSING
Window Dressing is an artificial practice to show current ratio position as
favorable. That is to say current ratio, after window-dressing does not show the
real current financial position. It is a malpractice by which the honest and
innocent investors are being deprived of the real facts. It may be done in the
following ways.
1. Deferring purchases,
2. Manipulating the value of inventory
3. Treading borrowed capital as long term loan capital.
4. Recording in advance in the current year the cash receipt of the next year.
5. Extensive drive is made for the collection of debts inn order to keep the bank
balance in a favorable position.
MECHANISM
Originally, current ratio is 2: 1 i.e.,
Currents Assets = 10,00,000

=2:1
Current liabilities = 5,00,000
If the needed credit purchase of stock of Rs.3 lakhs could not be deferred (i.e.
after purchasing goods worth 3 lakhs on credit basis) the current ratio will be
(13,00,000 / 80,000) = 1.6 : 1
Hence, the ratio has declined. An equal increase in both current assets and
current liabilities would decrease current ratio. Similarly equal decrease in current
assets and current liabilities would increase current ratio. The dual purposes of
57
current ratio are to serve as an Index of solvency and to measure the strength of
working capital. This ratio is of primary importance to the short term creditors The
main purpose is to test the normal solvency of the business.
2. Liquid Ratio
It is also known as “Quick Ratio” or “Acid Test Ratio” or “Near Money Ratio”. It
brings a relationship between liquid assets and liquid liabilities. It gives accurate
guide to liquidity. It is being calculated as
Liquid Assets
Liquid Liability
Liquid assets include cash, debtors, bills receivable and temporary investment
which can be realized without difficulty. They also refer to current assets minus
inventories. Prepaid expenses are not included in this list because they are not
expected to be converted into cash. In the case of debtors, if there are bad debts,
necessary provision should be made for meeting the same. Stock is not a liquid
asset in as much as it cannot be immediately converted into cash. Liquid liabilities
include sundry creditors, bills payable, accrued expenses, and outstanding
creditors. They do not refer to Bank O.D. since the same normally represents a
permanent arrangement like a fixed liabilities except when the business is called
upo9n to pay immediately. In short we can note that Liquid assets = Current
assets - Inventories. Liquid liabilities = Current liabilities - Bank O.D.
The main purpose of the Liquid ratio is to test the immediare solvency of the
business.
SIGNIFICANCE
Example: Liquid assets Rs, 7,20,000
Liquid liabilities 6,00,000
7,20,000
Acid Test Ratio = 7.2 : 6 = 1.2 : 1
6,00,000
The standard ratio is 1 : 1. If the liquid ratio is 1 : 2 : 1 the position is
satisfactory. Here it is meant that for every Re.1 worth of liquid liabilities, there are
liquid assets worth Rs.1.2.
As already seen, the current ratio includes asset which, requests the
company’s operations to continue in order to get covered on can. This asset is
‘Inventories’. The liquid ratio removes this least liquid of current assets, i.e.,
inventories to indicate how liquid the company would be if operations were to halt
suddenly. As only cash and quick selling assets are included in the list of liquid
assets, the loss on realization is less, for the obvious reason that stocks are less
liquid and are also subject to wide market fluctuations.
58
Liquid ratio assists in the study of the immediate cash position of a company.
It is a supplementary measure of liquidity and places more emphasis on immediate
conversion of assets into cash then does the current ratio. When used with the
current ratio, it gives a better picture of the company’s ability to meet its short-term
liabilities out of short term assets. It also serves as a more rigorous test of liquidity
than the current ratio.
A reasonable standard for the liquid ratio like current ratio, various from
season to season in a company and from company to company in an industry. This
ratio is certainly an improvement over the current ratio. It is very useful for the
banks and financial institutions. This ratio may fall in times of prosperity in some
manufacturing concerns, because increased activity may lead to larger stocks and
less cash. On the otherhand, when the trade is slowing down, the reverse will
happen and the ratio will rise.
3. Proprietory Ratio
It is the ratio of the proprietors’ funds to the total assets. It is otherwise
known as ‘Capital Ratio’, Equity Ratio’ and ‘Worth Debt Ratio’. It indicates how
much of the total assets is owned by the proprieties. It is calculated as
PROPRITORS FUND
TOTAL ASSETS
The term equity comprises the long term and short term and the owner’s
equity or share capita otherwise called external equities and internal equities. In
the case of external equities great importance is attached for the reason that if the
debenture holders and creditors are not paid promptly the company can be brought
to liquidation by them. On the other hand there is not much risk attached to
liabilities to the shareholders. The proprietors’ funds include not only equity
capital but also preference capital plus General Reserve and P&L A/c (Cr) Balance.
Total assets include goodwill also. Some may exclude goodwill. But it is necessary
to indicate whether goodwill is taken for calculation or not.
SIGNIFICANCE:
If the proprietors’ funds are Ls. 20,00,000 and the total assets are Rs.
25,00,000 the capital ratio is
20,00,000 20
ANNAMALAI UNIVERSITY 25,00,000
=
25
= 0.8 : 1
It is clear that out of every Rupee employed in the business, proprietors

contribution is 80 paise while the creditors have contributed the remaining 20
paise.
This ratio helps to ‘test the soundness of capital structure. When this ratio is
below what is normal in the industry in which the company is engaged, the
59
company’s condition may be criticised as top heavy with debt. Lastly, the main
purpose of this ratio is to indicate the long term or future solvency position of the
business.
4. Assets proprietorship Ratio

This ratio is further analysed into
1. Ratio of Fixed Assets to proprietors’ funds
2. Ratio of Current Assets to proprietors’ funds
3. Ratio of Fixed Assets to Current Assets.
The proprietor should provide the Fixed Assets and contribute some part of the
working capital if the business has been adequately financed in relation to its
capital structure. The main object of determining the ratio of fixed assets to
proprietors’ funds is to find out the extent to which his funds are sunk into the
assets with low turnover. When his funds are less than the fixed assets, creditor’s
obligation may be used to finance a part of the fixed assets.
This ratio is being calculated by dividing the depreciated book value of the
fixed assets by the amount of proprietors’ fund. The formula is
Fixed Assets
× 100
Proprietor’s Fund
Example: Proprietors’ fund Rs. 20,00,000

Fixed Assets Rs. 15,00,000
The ratio expressed as percentage would be
15,00,000
× 100 = 75%
20,00,000
Similarly the ratio of current assets to proprietors’ fund is obtained by dividing the
value of current assets by the amount of proprietors’ fund. For Example, if the
value of current assets is Rs.20,00,000 and the proprietors’ funds are Rs.
40,00,000 the ratio expressed in percentage.
Current Assets
× 100
Proprietor’s Fund
20,00,000
Would be: × 100 = 50%
40,00,000
In the same manner the ratio of fixed assets to current assents can be ascertained
as follows:
60
Fixed Assets
Proprietor’s Fund
For example, if a company has fixed assets worth Rs, 15,00,000 and current assets
worth Rs. 10,00,000/- the ratio would be (15/10) = 1.5 : 1
5. Debt Equity Ratio

This ratio relates to all recorded creditors’ claim on assets to the owners. It is
also known as External-Internal Equity ratio. It measures the Company’s
obligations to creditors in relation to fund provided by the owners.
It is calculated as 1. Debt.
Equity
2. (Debt)
Equity + Debt
The second method is better one. Debt includes both long term and short term
loans in the form of Bills Payable mortgages, debentures, creditors, outstanding
and accrued expenses. Equity includes equity share capital preference share
capital, capital reserve etc. In short, it is proprietors funds.
SIGNIFICANCE
Suppose the liabilities to outsiders are Rs. 5,00,000 and the proprietors’ funds
are Rs. 20,00,000 then Debt Equity Ratio would be:
Debt 5,00,000 5
= = =1:5
Debt + Equity 5,00,000 + 20,00,000 25
This means that the value of assets could shrink 80 percent before creditors
prospects of repayment would in any way be impaired. Here the interpretation
depends entirely on the financial and business policy of the company.
The purpose tests ratios is to have an idea of the amount of capital subscribed
to the company by the share holders and the assets cushion’ available to creditors
on liquidation.
6. Capital Gearing Ratio

The term ‘Capital Gearing’ is used to denote the proportion between Equity
share capital on the one hand and Preference share capital and other kinds of fixed
interest bearing loans on the other. It is as significant and helpful for the smooth
and successful running of a business as the use of speed gears for a motor car or a
machine. Such relationship indicates whether capital structure is high geared or
low geared. or low geared.
Capital gearing ratio is calculated as
61
Equity capital
Fixed Interest Bearing Securities
As already seen Equity capital includes all reserves and undistributed profits which
belong to the shareholders. Fixed interest bearing securities include preference
shares, redeemable preference shares, debentures, public debts etc.
SIGNIFICANCE
It capital carrying fixed rate of interest is more than the equity share capital;
gearing is said to be ‘high’. For example the equity share capital of a company Rs.
10,00,000. General Reserves Rs. 2,00,000 the preference share capital Rs.
4,00,000 and Debentures.
12,00,000
Rs. 22,000,000 ratio being 12: 6 = 2 : 1. Here
6,00,000
gearing is low because capital carry fixed ratio of interest is less than equity capital.
Suppose if Equity Capital is Rs. 2,00,000 and reserves Rs. 4,00,000 add preference
share capital and debentures amount to Rs. 12,00,000 the gearing is said to be
high as follows:
6,00,000 6
= = 6:12 = 1 :2
12,00,000 12
From the above illustrations it is clear that low gearing means High Equity
capital and high gearing means low Equity Capital. When the company earns good
profit, shareholders stand to gain with high capital gearing, because the debt
capital is paid fixed interest and the balance of profits is available to the equity
share holders. On the other hand when a company has low profit, the payment of
fixed interest may absorb all the profits leaving nothing for the equity holders.
Hence, gearing ratio affects distribution policies, the building up of reserves,
stable dividend policy etc. It must be carefully planned as it affects the company’s
capacity to maintain an even distribution policy during the difficult trading periods.
The purpose of this ratio is for the analysis of the capital structure of a
company. It is important both for the company and the prospective in vestors.
7. This ratio is set up for comparison of the gross profit with net sales. This is
also called ‘Turnover Ratio’. This is invariably expressed as a percentage. This will
reveal the extent to which the business is managed profitably. This also serves as
an effective check on stock control. This ratio serves as a guide to the efficiency of
the production department. This ratio may be compared with the ratios in the
previous year and in similar business. It is calculated as under.
Gross Profit
× 100
Net Sales
62
Net sales Rs. 10,00,000

Gross profit Rs. 2,00,000
2,00,000
Percentage of gross profit on sale is × 100 = 20%
10,00,000
SIGNIFICANCE
This indicates the margin of profit on sale effected and whether the average
percentage of mark-up on the goods is maintained,
1. Variation in the item of goods sold to the change in cost.
2. Variation in the item of cost of goods sold due to changes in commodity
volume.
3. Variation in the item of sales due to changes in commodity volume
4. Variation in the item of sales due to change in selling prices. Similarly a drop
in gross profit ratio may be due to the following factors.
1. Closing stock may have been undervalued.
2. Selling prices may have fallen without similar fall in the prices of goods
purchased.
3. Sales may have been omitted.
4. Purchases may have been inflated.
5. The cost of purchases may have been risen without a corresponding rise in
selling prices.
Evaluation is a proper norm for judging the gross profit ratio. It must be
adequate enough to cover the operating expenses and to provide for fixed charges;
dividends and building up of reserves.
8. Operating Ratio
This is accertained by comparing the cost of goods sold and other operating
expenses with net sales. The ratio is calculated as,
Cost of goods sold + Manufacturing Administrative, Selling
and Financial expenses × 100
Net Sales
A rise in the operating ratio indicates a decline in the efficiency
Net Profit Ratio + Operating Ratio = 100
Example: Cost of goods sold Rs. 10,40,000
Operating expenses Rs. 3, 60,000
14,00,000
63
Net sales 16,00,000

14,00,000
Operating ratio = = 0.88 : 1
16,00,000
SIGNIFICANCE
This is a test of under-efficiency of the management in their business
operations. It is a means of ascertaining operating efficiency. The operating ratio,
under normal conditions, should be low enough so as to leave a portion of the sales
sufficient to give a fair return to the investors. When more capital is needed; the
operating ratio should be lower.
9. Net Profit Ratio

It is the ratio of operating profit to net sales. Higher the net profit ratio the
better it is for any concern. It is ascertained by finding out the ratio between the
net profit to net sales.
Net profit Rs.1,00,000
Net sales Rs.16,00,000
1,00,000
N.P. Ratio = × 100 = 6.25 %. Thus, it is calculated
16,00,000
Net Operating Pr ofit
by using the formula × 100
Net Sales
SIGNIFICANCE
This is an effective measure of profitability of a business. This is an indication
of the company’s performance and its sales promotion. This shows what portions
of sales is left over after deduction of all expenses.
19. Expense Ratios

Many expense ratios exist. It is useful to examine each of the individual
expense items as a percentage on sales. By doing so we can find out specific areas
of improvement or deterioration. Here Administrative expenses, selling expenses
material consumed etc., may be compared in relation to the turnover. Such
comparison with corresponding ratios of the previous year will afford valuable
information to effect economy. Expense ratio are calculated as follows.
Materials consumed
Sales
× 100
Finance exp enses

2. × 100
Sales
Selling exp enses
3. × 100
Sales
64
Ad min istrative exp enses

4. × 100
Sales
Non  operating exp enses
5. × 100
Sales
18. Stock Turnover Ratio
It is also known as ‘Inventory Ratio’ and it is prepared to ascertain the number
of times the stock is tuned during the period under review. It is the relationship
between inventory and cost of goods sold. As sales figures are at selling price and
the inventory at cost, the ratio is computed by dividing the cost of goods sold by the
average inventory. Average inventory means opening stock plus closing stock
divided by 2 and cost of sale; means opening stock plus purchases minus closing
stock. The stock turnover ratio is calculated as:
Cost of goods sold

Average Stock
Example Cost of goods sold Rs. 10,40,000

Opening Stock Rs. 3,00,000
Closing Stock Rs. 4,00,000
Average Stock Rs. 7,00,000
= Rs.3,50,000
2
Inventory Turnover Ratio
10,40,000
= = 3 times (Approximately)
3,50,000
SIGNIFICANCE
The ratio is an indicator of the velocity of the movement of goods during the
year. If sales decrease, the ratio will also decrease. This services as a check on the
control of stock in a business. This ratio will reveal the excess of stock and
accumulation of obsolete or damaged stock. This must also be compared with the
ratio of stock to working capital. The ratio of net sales to stock is a satisfactory
relationship, if the stock is more than three fourths of the net working capital.
This ratio affords useful information where capital is being locked up in slow
moving stocks or whether gross profit may be increased by reducing prices in order
65
to include a rapid rate of turnover. Lastly, the ratio shows whether the business is
indulging in over-trading or under-trading.
12. Return on Proprietors’ Equity

This ratio is also known as Return on Shareholders’ Equity. This ratio is the
ratio of net profit to Proprietors’ Equity. It also indicates the profitably of the
business. It is usually expressed as a percentage. It measure the business success
and managerial efficiency.
Net Profit (after taxes & preference
dividend)
× 100
Proprietors’ Equity
13. Return on Shareholders’ Investment

It is otherwise known as Return on proprietors’ fund. It brings out the
relationship between the Proprietors’. Fund and Net Profit. This ratio measures
the profitability of the business. In other-words it indicates the rate of return
earned on the investment of owners funds. For the calculation of this ratio we
should take the simple average of such shareholders’ investment as on the date of
commencement of the figures at the beginning and end of the year. This ratio is
being calculated as follows:
Net Profit (after interest and taxes)
× 100
Proprietors’ Fund
SIGNIFICANCE
Net profit is Rs.30,000 and proprietors’ funds are Rs.2,00,000 Return on
Shareholders’ Investment Ratio.
Net Profit
× 100
Proprietors’ Equity
30,000
× 100 = 7.5%
4,00,000
This means that the return on proprietors’ funds is 7.5% or 7# paise for a rupee.
14. Return of Equity Share Capital
This is also known as Rate of Return on Equity Capital. This is considered in
the analysis of overall profitability. It brings out the relationship between the
Equity Share Capital and Net Profit after paying dividend to the preference
shareholders. It is usually expressed as a n percentage. This ratio is calculated as
follows.
66
Net Profit (after taxes and preference

dividend) × 100
Equity Share Capital
This shows what percentage of the earned profit of the period bears to the
amount of capital invested by equity shareholders for the risk borne by them.
Example. Net Profit Rs.7,00,000
Equity Share Capital Rs.40,00,000
Return on equity 7,00,000

= × 100 = 17.5%
Share capital 40,00,000
The purpose of this ratio is to ascertain the return to the shareholders on the
shares held by them.
TRADING ON EQUITY
In connection with return on equity capital a term ofter used is ‘Trading on
Equity’. It occurs when capital others than that of residual owners or equity
shareholders is employed in the undertaking, thereby meaning the use of both long
and short term debt as well as all classes of preference share capital. The essential
feature of trading on equity is the use of these funds at an explicit (definite) return
in excess of such cost. This point that the company should be able to meet the
obligations in respect of interest and dividend on equity shares is very important.
In short when capital other than these of equity shareholders is employee ‘trading
on equity’ occurs. Hence all concerns may be said to be ‘Trading on Equity’.
15. Return of Total Assets

It is otherwise known as Return on Gross capital employed or Total capital
employed. There is a relationship between the total assets and net profit before
charging preference divided as interest expenses. Total assets are contributed by
both preference shareholders and creditors. This ratio measures profitability of
total capital committed to the business. It also helps the management to find out
its success in enhancing the income of the shareholders through the use of
borrowed find. It is calculated as follows: Return on total Assets
Net profit (before Preference
dividend and Interest expenses) × 100
=
Total Assets
For example, the rate of return on total assets is 20% and the rate of interest
on borrowed capital is 10%. The management has made a saving of 10% (20-10)
through the use of borrowed capital and thus benefited the equity holders.
67
16. Turnover to Fixed Assets

It is also called as Sales to Fixed Assets or Fixed Assets Turnover or Net Sales
to Fixed Ratio. It shows whether fixed assets are fully utilised. This ratio shows
any excess investment in fixed assets and the ratio of cost of goods manufactured
to fixed assets. A high ratio shows better use of fixed asset. It may be calculated
as
Net sales
Fixed Assets
17. Turnover to Total Assets

It is also called total assets turnover Ratio. It is calculated by dividing the net
sales by total assets. The standard of this ratio is two times. A high ratio indicates
utilization over trading of fixed assets whereas a low ratio indicates excessive
investments ie., a symptom of idle capacity. Some authors take cost of goods old
instead of sales. The turnover total assets ratio is arrived at as under:
Net sales
Total Assets
18. Return on Capital Employed

It is otherwise known as Return on Investment or simply ROI. The proprietors
invest money in a business to obtain a satisfactory return on their capital. The
ultimate test of success of a business is its earning power. The return on capital
employed is considered to be the most significant from the view point of
management. This will indicate the earning capacity of the business and will
enable comparisons to be made with other periods and other business.
This ratio includes (1 Capital base (2) Shareholders, Equity Capital (3)
Proprietress’ Equity which can be arrived at by deducting current liabilities, long
term bestowing and other outside funds from total assets and 94) Proprietors’
equity plus long term borrowing and debentures ie., total capital employed. The
measure of met profit to be used will depend upon the capital base employed.
Generally this ratio is determined by dividing the net profit by the shareholders
funds plus long term liabilities. The ratio may be expressed as follows:
Profits
1.
Return on capital employed =
Capital employed
× 100
Profits Sales
2. Return on capital employed = × × 100
Sales Capital employed
68
The First ratio reveals the efficiency of trading operation of the business. It is a
profitability ratio. The second ratio reveals the degree of success in the utilisation
of empital employed in the business. It is a capital investment ratio.
Advantages
1. It allows external comparison to be made.
2. It may be used as an instrument of control for making internal comparison like
the profitability of different produces.
3. It gives suitable ideas for analysis and decisions, to bring about effective
changes in the financial policies.
4. It is a good tool for making capital budgeting decisions, the relative profitability
of future courses of action such as expansion and introduction of new product.
5. Return on capital employed is the only measure which can be said to show
satisfactorily the benefits being obtained for the sacrifice involved.
6. It throws on the comparative statistics of the earnings capacity of the business
as compared with likely return on the alternative employment of the same
capital elsewhere.
19. Turnover on Working Capital

It is otherwise known as sales to working capital or working capital turnover
ratio. It is calculated by dividing the net working capital by net sales. Whether
working capital is effectively used or not will be shown by the working capital
turnover Raito. It is calculated as
Net working capital
Net sales
It shows whether the business is being operated on a small or large amount of
working capital in relation to sales. It helps us to test the efficiency with which the
working capital is utilised. A high ratio shows higher efficiency and low ratio
indicates inefficiency. Sales in respect of working capital should be normal. A low
turnover of working capital may be the outcome of an excess working capital, slow
turnover of inventories and a large cash balance. On the other hand, a high
working capital turnover may be the result of favorable turnover of stock and
receivables or may reflect an inadequate working capital.
SALES TO NET WORTH
Sometimes total net worth or sales to share capital ratio is also calculated.
Generally share capital includes equity capital and in some cases preference share
capital. It is called Net Worth. When sales are compared with net worth, it
indicates the utilisation of capital and reflects the profit earning capacity of the
69
business. It should be remembered that too much sales in relation to capital leads
to over trading.
20. Turnover of Debtors

It is also called ‘Debtors Turnover’ or ‘Debtors Turnover Period’. It indicates
the rate at which the money is being collected on account of credit sales. In other
words, the average collection period can be ascertained. This ratio is calculated in
the following two ways.
Average Credit sales Per day =
Credit sales
365
Number of days sales Debtors + B/R

outstanding = Credit Sales Per day
Debtors + B/R
Credit Sales
Debtors’ velocity =
365
Debtors + B/R
= × 365
Credit sales
This is mainly prepared to find how many days’ credit is outstanding by

debtors
EXAMPLE
Net sales Rs. 10,00,000
Total Debts Rs. 2,40,000
Bills receivable Rs. 80,000 Rs.3,20,000
Sales 10,00,000
Average daily sales = = Rs.2,740
ANNAMALAI UNIVERSITY 365
=
365
Debtors + Bills Receivable
No. of days of credit =
Average Daily Sales
3,20,000
= = 117 days (Approx
2,740
70
SIGNIFICANCE
There should be a relationship between the debtors’ turnover ratio and the
period of credit allowed by the business. if the period of credit allowed to a debtor
is 30 days, the normal ratio is 12 to 1. ie., 365/30. If the credit sales for the year is
R.10,00,000 and the outstanding figure is Rs.3,20,000 and if the period of credit
allowed is 30 days the outstanding debtors figure represents 117 days and the
indication is that credit collection system is faulty.
Of course, this is subject to variations from month to month owing to seasonal
sales. This serves as a check on collection of outstanding debts. If the average
dept is high, immediate steps should be taken to collect the outstanding. The
debtors’ balances should be examined and if there are bad debts they should be
written off. As the policy of management is to earn real profits, prompt action in
the collection policy is essential. Some leading accountants are of the opinion that
the average collection period should be more than one third higher than the net
selling terms.
AGING OF ACCOUNTS
This is another method of analysing the liquidity of receivables. This involves
classifying the amount due in each account according to the period for which it is
outstanding. For example such a classification of debors on 31st December may
reveal that 65% of the amounts outstanding are not more than a month old 255
may be outstanding for more than a month but less than 2 months and the balance
of 10% may be outstanding for more than 2 months but less than 3 months. The
accounts with outstanding dues which are long overdue need to be investigated and
written of0f, if they become uncorrectable. hence, with the help of information on
aging of accounts we can get an accurate picture of the investment in receivables
and changes in the basic composition of the investment overtime.
21. Creditors, velocity

It indicates the turnover of payables in the credit purchases. It is calculated
by divined sundry creditors and Bills payable by credit purchases. The formula is
as follows.
Sundry Creditors + B/P

× 350
ANNAMALAI UNIVERSITY Credit purchases
Example: A Company’s Credit purchase is Rs.14,00,000 The total Sundry creditors
and Bills payable are Rs.2,00,000
2,00,000
Now creditors’ velocity is 365 = 52 days.
14,00,000
71
This ratio should be tend with normal credit received as also with actual
debtors’ turnover Ratio.
22. Ratio of Security

This ratio is nothing but Fixed Assets offered as security to Fixed Liabilities
which are in the form of mortgage doeds or debenture bonds secured by a charge
on all the fixed assets. It that case, it is better to obtain the market values of the
fixed assets at the date of calculation. Otherwise the fixed assets minus
depreciation may be taken over. if the total fixed assets are Rs.25,00,000 to total
fixed liabilities of Rs.14,00,000 it would reveal 1,79:3. It means that the creditors
will remain completely satisfied and the management need not apprehend trouble
from them.
23. Solvency Ratio

This ratio is calculated by dividing the total liabilities by total assets. Here
total liabilities include fixed liabilities and current liabilities and total assets include
fixed assets and current assets. The man purpose of this ratio is to show whether a
company is able to meet its total outside liabilities form total assets. If it is done,
the company is said to be solvent.
EXAMPLE
Balance Sheet of A co, Ltd., as at 31st December. 1980
Liabilities Assets
Rs. Rs.
Share capital 2,50,000 Fixed Assets 3,50,000
Fixed liabilities 1,00,000 Current Assets 1,50,000
Current liabilities 1,50,000
5,00,000 5,00,000
Calculate Solvency Ratio
The company is solvent because its total liabilities are only 50% of total assets.
Total liabilitie s
SOLUTION: Salvency ratio =
Total Assets
1,00,000  1,50,000 2,50,000
ANNAMALAI UNIVERSITY =
3,50,000  1,50,000
=
5,00,000
× 100
= 50%
The company is solvent because its total liabilities are only 50% of total assets.
72
24. Analysis from equity shareholders poit of view

It is quite natural that equity shareholders are interested in the capital
appreciation of their investment and dividend per share. Of course, both these
factors are influenced by the earnings of the company. From their point of view,
the following ratios must be calculated.
1. Earnings per share (EPS)
This is calculated by dividing the profit (minus preference dividend) by the
number of Equity shares. The gives the income earned for each equity share.
Net P rofti – P referenceDividend
The formula is EPS =
Number of Equity shares
For example X Co, is having 5,000 equity shares and the net profit after paying
preference dividend is Rs.50,000
50,000
They EPS = = Rs.10
5,000
2. Price Earning Ratio (PER)
This is calculated as follows
Market Pr ice per Equity Share
Price Earning Ratio =
E.P.S.
Example: Y Company’s share is priced at Rs.80 and EPS is Rs.10
PER = 80/10 = 8
3. Pay Out Ratio (POR)
It is also known as Dividend Pay out Ratio and it is the ratio of dividends per
share to EPS. It shows what portion of EPS has been used for paying dividend and
what has been retained for polishing back. It is calculated as follows
Dividend per Equity Share
Pay Out Ratio =
E.P.S.
For example, X Co, distributes Rs.20 by way of dividend per equity share, than pay
out ratio is 20/10 = 2.
4. Dividend Yield Ratio indicates the effective return on investment. Which
prospective investors may hope to earn. It is calculated as follows.
Dividend per share
× 100
Market price of equity share
73
For example, X Co., declares 20% dividend on its share of Rs.100 each Rs.80
paid out of which the market price is Rs.160, the dividend yield ratio will be
calculated as under.
20
Dividend per share × 80 = Rs.16
100
16
Yield × 100 = 10%
160
5. Cover for Preference and equity dividends
The first is arrived at by dividing the net profit after tax by preference dividend.
The second is arrived at by dividing the net profit after tax minus preference divided
by equity divided. They are calculated as follows
1. Cover for preference dividend =
Net Profit after tax
Preference Dividend
2. Cover for equity dividend =
Net profit after tax — preference dividend
Equity dividend
Example:
9% 40,000 preference shares of Rs.10
Each 1,20,000 equity shares of Rs.10 each
Profit, after tax at 50% Rs.3,60,000 Equity dividend paid at 20%.
SOLUTION
4,00,000  9
1. Dividend of preference shares : = = Rs.36,000
100
1,20,000  20
2. Dividend of Equity Shares = = Rs.24,000
100
3,60,000
3. Cover for preference dividend = = 10 times
36,000
56,00,000  36,000
Cover for Equity Dividend
24,000
= 13½ times
QUESTIONS
1. Discuss the significance of any three of the following ratios to financial analyst.
a. Current ratio
b. Liquidity ratio
74
c. Net profit ratio

d. Debt equity ratio
2. Give any three limitations of ratio analysis
3. What is meant by Ratio analysis? Explain its significance of ratio analysis
4. Explain the importance of Ratio analysis in making comparisons between
firms.
5. From the following information find out (i) current Assets (ii) current Liabilities
(iii) stocks (iv) fixed assets
a. Current ratio 2.5
b. Liquid ratios 1.5
c. Fixed assets proprietary funds 0.75
d. Working capital Rs.60000
e. Reserve of surplus Rs.40000
f. Bank overdraft Rs.10000
g. There is no long term loan or fichus asset.
6. The following are the summarised Profit and Loss account of Murugan
Products Ltd, for the year ending 31.12.91 of B/s as on
Profit & Loss A/c
To Opening Stock 9950 By Sales 85000

To Purchase 54525 By Closing Stock 14900
To Incidental exps. 1425
To G/p 3400
99000 99000
To Operating exps By G/P 34000
Selling & Distr. 3000 By Non–ope. Income
Admn. 15000 Interest 300
Finance 1500 19500 Profit on sale
of shares 600 900
To Non-Ope. Exps.
To N/P
Loss on sale of assets 400
15000
34900 34900
75
Balance Sheet
Liabilities Assets
Issued Capital Land & Building 15000
200 E.S. of 10 20000 Plant & Machinery 8000
Reserve 9000 Stock–in–trade 14900
Current Liabilities 13000 Sundry debtors 7100
Profit & Loss A/c 6000 Cash at Bank 30000
48000 48000
You are required to calculate

a. Current ratio
b. Operating ratio
c. Stock turnover ratio
d. Return on total resources
e. Turnover of fixed assets

76
LESSON - 5
ACCOUNTING RATIOS - II
OBJECTIVES
 Understand the calculation of various kinds of ratios to test short term
solvency, long term solvency and profit earning capacity
 Interest the calculated ratios
 Release the significance of Accounting ratios.
STRUCTURE
5.1. Introduction
5.2. Current ratio
5.3. Operation ratio
5.4. Stock turnover ratio
5.5. Return on total resources
5.6. Turnover of fixed assets
5.7. Long term solvency ratio
5.8. Short term solvency ratio
5.1. INTRODUCTION
A comparative study of the relationship, which may be expressed as pure
ratios or percentage of functions, reveals liquidity, solvency, profitability and overall
financial position of an enterprise. These ratios are meaningless if they are not
compared to some appropriate standards. Following are four common standards
used in this connection.
1. Historical Standards
2. Absolute Standards
3. Budgeted Standards
4. Horizontal Standards
Historical standards refer to comparing a company’s own past performance as
a standard for the present and future. It simply indicates whether current period is
better or worse than the past.
Absolute Standards: are those which are recognised as being desirable
regardless of the type of company. They are neither desirable nor can they be
achieved in all cases.
77
Budgeted Standards: are arrived at after preparing the budget for a period.
These are set by the management as goals. They are very useful since they are
evolved after taking into account the prevailing conditions.
Horizontal Standards: compare one company with another company or
companies of the same nature. Variations in accounting methods lead to
significant differences in ratios too.
The following table gives various which are calculated as test for various
purposes.
Test for Ratios used Purpose

I. Short—term 1. Current Ratio Adequacy of working capital
Solvency or
2. Liquid Ratio Ability to meet current liability
liquidity
II. Long—term 1. Shareholders Equities Adequacy of Shareholder’s
Solvency or to Total Equities Ratio contribution
Leverage Ratios
2. Net Income to Debt Ability to meet long—term
Service Ratio liabilities
3. Cash to Debt Service Availability of cash resources
Ratio to meet long term liabilities
III. Profit Earning 1. SALES RATIO Ability to make sufficient sales
capacity a. Sales to fixed Assets
b. Sales to working
capital
2. EXPENSE RATIOS Availability to bring down
a. Factory cost to sales expenses
b. Administrative cost to
sales
c. Any other expenses to
sales
3. PROFIT RATIOS Ability to earn Sufficient profit
a. Gross Profit Ratio
b. Return on proprietors’
Fund
c. Return on Equity
Share Capital
78
VI. Financial Trend 1. Current Ratio Ability to avoid trading

2. Proprietary Ratio Ability to avoid over
capaitalisation
3. Turnover of Debtors Ability to keep credit policies.
4. Stock Turnover Ratio Ability to keep minimum
investment.
5. Net profit to Ability to earn sufficient
proprietors’ Fund profits.
PROBLEM 1. The following are the summarised Profit and Loss Account of
Sindu Products Limited for year ending 31st December, 1982 and the Balance
Sheet as on that date:
Profit and Loss Account
Rs. Rs.
To Opening Stock 99,500 By Sales 8,50,000
“ Purchases 5,45,250 “ Closing Stock 1,49,000
“ Incidental expenses 14,250
“ Gross Profit 3,40,000
9,09,000 9,99,000
Rs. Rs.
To Operating expenses By Gross Profit 3,40,000
Selling and “ Non–Operating Income:
Distribution 30,000 Interest 3,000
Administration 1,50,000 Profit on sale of
Finance 15,000 1,95,000 shares 6,000 9,000
“ Non–Operating expenses
Loss on sale of assets 4,000
Net Profit 1,50,000
3,49,000 3,49,000
ANNAMALAI UNIVERSITY Balance Sheet
Rs. Rs.
Issued Capital 2000 Land & Building 1,50,000
Equity shares of Rs.100 Plant & Machinery 80,000
each 2,00,000 Stock in Trade 1,49,000
79
Reserve 90,000 Sundry Debtors 71,000

Current liabilities 1,30,000 Cash and Bank balances 30,000
Profits & Loss Account 60,000
4,80,000 4,80,000
From the above statement you are required to calculate the following ratios
and state the purpose they serve:
1. Current Ratio
2. Operating Ratio
3. Stock Turnover
4. Retune on Total Reserves
5. Turnover of Fixed Assets
SOLUTION
Current Assets
1. Current Ratio =
Current Liabilitie s
Rs.1,49,000  71,000  30,000 2,50,000
= =
Rs. 1,30,000 1,30,000
= 1.923:1 Dr. 1.92:1
Here current assets include cash, bank balance, debtors and stock in trade.
Though the ratio is very near the standard of 2.1 very large part of current assets
consists of stock which is the least liquid of current assets. Hence current ratio is
not at all favorable and the purpose of this ratio is to test the normal solvency o the
business.
5.2. OPERATING RATIO
Cost of goods sold  Operatingexpenses

=
Net Sales
Rs. 5,10,00  1,95,000
= = 0.83 : 1
Rs. 8,50,000
cost of goods is calculated by adding opening stock purchases and incidental

expenses and deduction these from closing # 99,500 +{ 5,45,250 + 14,250 =
6,59,000 - 1,49,000 = 5,10,000. It is ment that our or every Rs. I worth of sales 83
paise constitute the cost of goods sold and operating expense. The purpose is to
ascertain the operational efficiency of the management.
80
5.4. STOCK TURNOVER RATIO

Cost of goods sold
=
Averagestock
Openingstock  Closing stock
Average stock =
2
Rs.99,500  1,49,000 2,48,500
= = 1,24,250
2 2
5,10,000
Stock Turnover Ratio = = 4.1:1
1,24,250
It means that stock is turned over slightly more that 4 times on an average during
the current year. The purpose of this ratio is to indicate the marketing efficiency of
the business.
5.5. RETURN ON TOTAL RESOURCES

Net P r ofit Rs.1,50,000
× 100 = × 100 = 31
T otal Re sources Rs.4,80,000
It is meant that Rs.31 are earned on every Rs.100 worth of total assets. In other
words, the business has given a return of 31% on total resources during the
current year.
Sometimes the return on total resources is the ratio of operating net profit to
total assets which may be calculated as follows:
Net Profit Rs.1,50,000

ADD: Non—operating expense written back 4,000
1,54,000
LESS: Non—operating Income exclude 9,000
1,45,000
1,45,000
Return on Total Resources × 100 = 30.2%
4,80,000
The object of this ratio is to test the profitability of the business and assets the
efficiency of the operation of the business.
5.6. TURNOVER OF FIXED ASSETS
N et sales
=
8,50,000
= 3.7:1
Fixed assets 2,30,000
Here fixed assets represent land and building Rs.1.50,000 and Plant and Machinery
Rs.80,000 = 2,30,000. This means that for every rupee worth of fixed assets, net
sales amount to Rs.3.7. The purpose of this ratio is to measure the productivity of
fixed assets.
81
We may also calculate this ratio by dividing assets into cost of goods sold.
Cost of goods sold
Now Turnover of Fixed Assets =
Fixed Assets
5,10,000
= = 2.22:1
2,30,000
This means that for every one rupee invested in fixed assets, goods costing Rs.2.22
have been sold. The purpose of this ratio is to indicate the proportion of goods sold
in relation to investment in fixed assets.
PROBLEM 2
The following figures relate to the trading activities of Tamil Nadu Traders
Limited for the year ended 30th June 1982.
Rs.
Sales 5,20,000
Purchases 3,22,250
Opening Stock 76,250
Closing stock 98,500
Sale Returns 20,000
SELLING AND DISTRIBUTION EXPENSES Rs.
Salaries 15,300
Advertising 4,700
Travelling 2,000
ADMINISTRATIVE EXPENSES
Salaries 27,000
Rent 2,700
Stationery, Postage 2,500
Depreciation 9,300
Other Charges 16,500
Provision for Taxation 40,000
NON—OPERATING INCOME
Dividend on shares
Profit on sale of shares
9,000
3,000
NON—OPERATING EXPENSES
Loss on sale of assets 4,000
You are required to
1. Arrange the above figures in a from suitable for analysis and
82
2. Show separately the following ratios:

a. Gross Profit Ratio
Operating Ratio
SOLUTION
Tamilnadu Traders Limited
Revenue Statement
(For the year ended 30th June, 1982)
Rs. Rs. Rs.
Sales less returns 5,00,000

Less: Cost of goods sold
Stock on 1st July 1979 76,250
Purchases 3,22,250 3,98,500
Less: Stock on 30th June, 1980 98,500 3,00,000
Gross Profit 2,00,000
OPERATING EXPENSES
Selling and distribution Expenses
Salaries 15,300
Advertising 4,700
Travelling 2,000 22,000
ADMINISTRATIVE EXPENSES
Salaries 27,000
Rent 2,700
Stationery, Postage 2,500
Depreciation 9,300
Other charges 16,500
Provision for Taxation 40,000 98,000 1,20,000
Operating Net Profit 80,000
NON—OPERATING INCOME
Dividend on shares 9,000
Profit on sale of share
NON—OPERATING EXPENSES
3,000 12,000
Loss on sale of assets 4,000 8,000

Net Profit 88,000
83
Ratios
Gross Pr ofit
1. Gross Profit Ratio = × 100
Net Sales
Rs. 2,00,000
= × 100 = 48%
Rs. 5,00,000
Operating exp enses
2. Operating Ratio = × 100
Net Sales
3,00,000  1,20,000
= × 100 = 84%
5,00,000
Cost of goods sold
3. Stock Turnover Ratio =
Average Stock at cos t
3,00,000
= = 3.4 (App.)
* 87,375
* Average Stock includes opening stock of Rs.76,250 and closing Stock of
Rs.98,500 divided by 2.
PROBLEM 3
Following is the Balance Sheet of A company Ltd as a 31st March, 1982.

6% Preference Capital 1,00,000 Cash in hand 2,000
Equity Share Capital 1,00,000 Cash at Bank 10,000
7% Debentures 40,000 Bills Receivable 30,000
8% Public Debt 20,000 Investments 20,000
Bank O.D. 3,000 Debtors 70,000
Creditors 96,000 Stock 40,000
Outstanding Creditors 7,000 Furniture 30,000
Proposed Dividend 10,000 Machinery 1,00,000
Reserves 1,51,000 Land and Building 2,20,000
Provision of taxation 20,000 Good will 35,000
Profit and Loss A/c 20,000 Preliminary Expenses 10,000
5,67,000 5,67,000
During the year, Provision for taxation was Rs.20,000 Debentures are
repayable in 1982 and Public Debt in 1982 Sales during the year were Rs.3,00,000,
Proposed dividend was Rs.10,000. Profits carried forward from the last year
Rs.15,000.
84
You are required to calculate

a. Long-term Solvency Ratio
b. Short-term Solvency Ratio
c. Sales Ratio
5.7. LONG-TERM SOLVENCY RATIO

Normally they include 1. Shareholders’. Equities to Total Equities Ratio 2. Net
Income Debt Service Ratio 3. Cash to Debt Service Ratio.
I. Shareholders’ Equities to Total Equities
Pr oprietors' Funds
=
Total Equities
1,00,000  1,00,000  1,51,000  20,000
=
5,67,000
3,71,000
= 371:567 = 8.63:1
5,67,.000
Here shareholder’s contribution is only 65 paise out of every investment of
Rs.1 in the company. In other words, it is meant that the cushion against fall in
price of assets in the case of liquidation of the company is only 35 paise. This
margin may not be a satisfactory one.
2. Net Income to Debt Service Ratio
Net Income before ch arg ing Interestand income T ax
=
P eriodicIntereston long term Debt
35,000  4,400 39,400 394
=   times (app.)
4,400 4,400 44
NET INCOME IS CALCULATED AS FOLLOWS

Rs.
Profit as per Balance Sheet 2,000
+ Transfer to proposed Dividend 10,000
+ Provision for taxation 20,000
50,000
— Carried forward from last year 15,000
35,000
Periodic Interest
7% Debentures Rs. 40,000 2,000
8% Public Debt Rs. 20,000 1,600
4,400
85
Note: From this angle earning of the company is very found.

3. Cash to Debt Service Ratio
Cash available Cash in hand + cast at bank

= =
Periodic cash Pay-ment Debentures P ublic Debt
+ + Interest on then
of principal + Interest 10 5
200  10000 120000
 
40000  20000  4400 4000  4000  4400
10 5
12000 30
=   0.97 : 1
12400 31
Note: Here the position is not satisfactory.
5.8. SHORT-TERM SOLVENCY RATIOS

Usually they include i) Current Ratio and ii) Acid Test Ratio
Current Assets
i. Current Ratio =
Current Liabilities
Rs. 2,000  10,000  30,000  20,000  70,000  40,000
=
Rs. 3,000  96,000  7,000  10,000  20,000
1,72,000
= = 17:2136 = 1.26 : 1
1,36,000
It is to be noted that the company has now Rs.1.26 current assets as against
Rs.1 current liabilities. there is a very small margin of safety against fall in price.
Hence the current ratio is not a favorable one. IN short, the financial position is
not sound.
Liqauid Assets
ii) Acid Text ratio =
Liquid Liabilitie s
Liquid Assets = Current Assets — Stock
Liquid Liabilities = Current liabilities — Bank O/D
Rs. 2,000  10,000  30,000  20,000  70,000
=
Rs. 96,000  7,000  10,000  20,000
1,32,000
= = 132:133 = 0.99:1
1,33,000
It is clear that company’s immediate resources for meeting current liabilities

are little less than their obligaitons. Hence its financial position cannot be said to
be very strong. This fact was supported by current ratio also.
C. Sales Ratios: They includes i. Sales to fixed Assets and

i. Sales to working capital
86
ii. Sales to Fixed Assets or Turnover to Fixed Assets
Net Sales 3,00,000

= = 0.78 : 1
Fixed Assets 3,85,000
Fixed Assets include Furniture, machinery, Land and Buildings as well as good
will. Whether this ratio is satisfactory or not will be determined by comparing it
either with standard ratio or with some ratio prevalent in that industry.
ii. Sales to working capital or working capital Turnover =
Net w orkingcapital
Net Sales
Working capital = Current Assets — Current Liabilities
= 1,72,000 — 1,36,000 = 36,000
36,000
= = 0.2
3,00,000
Any comment of this ratio can be made only after comparing the ratio with
some standard ratio.
PROBLEM - 4
From the following information you are required to prepare a Balance Sheet
1. Current Ratio - 1.75
2. Liquid Ratio - 1.25
3. Stock Turnover Ratio (Closing stock) - 9
4. Gross Profit Ratio - 25%
5. Debt collection period - 1½ months
6. Reserves and surplus to capital - 0.2
7. Turnover to Fixed Assets - 1.2
8. Capital Gearing Ratio - 0.6
9. Fixed Assets to Net worth - 1.25
10. Sales for the year - Rs. 12,00,000
SOLUTION
Balance Sheet

Share capital 5,00,000 Fixed Assets 7,50,000
Reserves and Surplus 1,00,000 Stock 1,00,000
Long-term loans 3,00,000 Debtors 1,50,000
Current Liabilities 2,00,000 Cash and Bank Balances 1,00,000
11,00,000 11,00,000
87
Workings
1. Cost Sales Rs.
Sales 12,00,000
Less: G.P. at 25% on sales 3,00,000
9,00,0000
Cost of Sales
2. Stock Turnover Ratio =9
Average Stock
Cost of Sales 9,00,000
Average Stock = =
9 9
= Rs. 1,00,000
3. Fixed Assets
Cost of Sales
Turnover to Fixed Assets = = 1.2
Fixed Assets
10 9,00,000  10
Cost of sales × = = Rs.7,50,000
12 12
4. Debt Collection Period = 1½ months
1½ 3
Debtors = Sales × = 12,00,000 × = 1,50,000
12 24
5. Current Assets
Quick Assets - 1.25
Current Assets - 1.75
Stock should be - 0.50
175 175
Stock × = 1,00,000 + = 3,50,000
50 50
6. Quick Assets (Debtors and Cash)

Quick Assets = Current Assets — Stock
3,50,000 — 1,00,000 = 2,50,000
7. Cash
Quick Assets – Debtors
2.50,000 — 1,50,000 = 1,00,000
8. Current Liabilities
Current Assets - 1.75
100 100
Current Assets + = 3,50,000 + — 2,00,000
175 175
88
9. Net Worth
Fixed Assets to net work — 1.25
100 100
Fixed Assets × = 7,50,000 × Rs.2,00,000
125 125
10. Reserves and Surplus
Reserves and Surplus to Capital — 0.2
Shareholders’ Funds Capital Reserves and Surplus
If Reserve is 2, Shareholders’ funds should be 12,00,000
2 2
Shareholders Funds × = 6,00,000 × = 1,00,000
12 12
11. Share Capital
Shareholders, Funds — Reserves and surplus
= Rs, 6,00,000 — 1,00,000 = Rs. 5,00,000
12. Long Term Liabilities

Capital gearing - 0.6
6 6
Share scapital × = 5,00,000 × = Rs.300000
10 10
PROBLEM 5
The following ratios and other data pertain to the Financial statement of Palani
Limited for the year ended 31st December, 1982.
Working capital ratio 1.75 to 1
Acid Test Ratio 1.27 to 1
Working capital Rs.33,000
Fixed assets to shareholders, equity ratio 0.625 to 1
Inventory Turnover (based on cost of closing inventory 4 times
Gross profit percentage 40%
Earning per Share Rs. 0.50
Average age of outstanding accounts receivable (based on calendar year of 365
days) 73 days.
Share capital Number of shares 20,000
Earning for the year as a percentage of share capital 25%
The company had no prepaid expenses, deferred revenue expenditure
intangible assets or long term liabilities.
Reconstruct in as much detail as possible Palani Ltd’s Balance Sheet and Profit
and Loss Account for the year ended 31st December, 1982. Show your workings
SOLUTION
89
Profit and Loss Account for the year ended 31st December 1982.
To Cost of Sales 84,480 By Sales 1,40,800

Gross Profit C/d 56,320
1,40,800 1,40,800
To Expenses 46,320 By Gross Profit 56,320

Net Profit C/d 10,000 B/d
56,320 56,320
Balance Sheet as at 31st December 1982

Share Capital 20,000 shares 40,000 Fixed Assets 55,000
of Rs.2 each Current Assets
Reserves and Surplus Cash 27,720
Profit-Balance B/F 38,000 A/cs Receivable 28,160
Profit for the year 10,000 48,0000 Stock 21,120 77,000
Current Liabilities 44,000
1,32,000 1,32,000
Working
1. Current Assets: Working Capital Rs.33,0000
Working Capital Ratio 1.75 to 1
Working Capital 1.75 — 1 = 0.75
33,000  175
= Rs.77,000
75
2. Current liabilities: Rs.
Current assets 77,000
Working capital 33,000
44,000
3. Stock: Working capital 1.75

Liquid assets 1.27
Stock 0.48
77,000  48
= = 21,120
175
4. Shareholders’ Funds
90
Fixed Assets 0.625 of Shareholders’ Funds

Net current assets should be 0.375
If Net current assets are 0.375
Shareholders’ Funds should be 1
33,000  1,000
= Rs.88,000
375
5. Fixed Assets
If Net current assets are 0.375
Fixed assets should be 0.625
If Net current assets are Rs.33,000
Fixed assets should be
33,000  625
= Rs.55,000
375
6. Cost of Goods Sold: Inventory Turnovers 4 times
Stock = 21,120 × 4 = 84,480
7. Sales
Cost of goods sold Rs. 84,480
Add: 66% on cost 56,320
1,40,800
8. Net Profit
Earning Per Share Rs.0.50
Earning on 20,0000 Shares Rs. 10,0000
9. Expenses
Gross Profit Rs. 56,320
Less: Net Profit 10,000
46,320
10. Debtors
Debt collection Period 73 days
Sales .. Rs.1,40,800
1,40,800  73
365
= Rs. 28,160
91
11. Share Capital

Net Profit 25% of Share Capital
Net Profit Rs.10,000
10,000  100
= Rs. 40,000
25
12. Reserves And Surplus

Share holders’ Funds 88,000
Less: Share Capital 40,000
48,000
PROBLEM 6
Rajaram company sales goods on cash as well as credit (though not on
deferred installment terms.) The following particulars are extracted from their
books of accounts for the calendar year 1980:
Rs.
Total Gross sales 1,00,000
Cash sales (included in the above) 20,900
Sales Returns 7,000
Total Debtors for sales as on 31.12.1980 9,000
Bills Receivable on 31.12.1980 2,000
Provision for Doubtful Debts on 31.12.1980 1,000
Total creditors on 31.12.1980 10,000
Calculate the average collection period
SOLUTION
Calculation of net credit Sales for 1980
Total Gross Sales 1,00,000

—Cash sales 20,000
80,000
—Sales return 7,000
73,000
Average collection period

=
Debtors  BillsRe ceivable
Net cdreditfor the year
× 360
Rs. 11,000
= × 360
Rs. 73,000
= 0.1506 × 360 = 54 days (App)

92
Explanation. Information regarding Reserve for doubtful debts and total creditors is
irrelevant in the calculation of average collection period.
Note: It has been assumed that the number of working days in year is 360.
Questions
1. Define liquidity. How do you analysis the liquidity position of a firm using
ratio analysis.
2. Write a short note on significance of financial ratios.
3. Define and distinguish between operating Ratio and Net Profit Ratio.
4. What are the classifications of ratios? Explain it.
5. Calculate the following ratios:
6. (a) Gross profit ratio (b) Operating ratio (c) Stock turnover ratio (d) E.P.S.
Profit & Loss A/c
To Open Stock 20000 By Sales 40000
To Purchase 240000 By Closing Stock 30000
To Wages 60000 By Profit on Sale or
Investment 4000
To Carriage inward 10000 By Interest on investment 6000
To Salaries 40000
To Deb. Interest 10000
To Loss on sale of
Machinery 5000
To Net Profit 55000
440000 440000
Share capital: 2000 shares of Rs.10 per share.
7. From the following data, prepare balance sheet
Sales Rs.3200000
Sales to net worth 2.3 times
Current debt to net worth 42%
Total debt to net worth 75%
Current ratio 2.9 times
Net sales to inventory 4.7 times
Average collection period (Assume 360 days) 64 days
Fixed assets to net worth 53.2%

93
LESSON - 6
FUND FLOW ANALYSIS
OBJECTIVES
 Understand the concept of funds and flow of funds
 Evaluate the changes in working capital in an organisation and
 Know the limitations of fund flow statement
 Identify the sources and uses from a given financial statement
STRUCTURE
6.1. Meaning
6.2. Impact of fund flow
6.3. Advantages of fund flow
6.4. Preparation of fund flow analysis
6.5. Preparation of fund flow statement
6.1. MEANING
Fund Flow statement or Flow of Funds is a statement of sources and
applications of funds. In other words, it is a statement of sources and uses of
funds. Professor Anthony has explained the fund flow by way of “where got, where
gone statement”. The meaning is
Where Got = Sources of Fund
Where Gone = Applications of Fund
1. Statement of sources and application of Funds
2. Statement of derivation and disposition of the means of operation.
3. Statement of sources and utilisation of Funds
4. Statement of financial charges in position.
5. Statement of sources and uses of Funds.
6. Where-got and where-gone statement.
6.2. IMPACT OF FUND FLOW
The effects of fund flow are indicated by increase or decrease in assets and
liabilities or equities. That is to say increase in equities and decrease in assets will
always be represented by increase in assets and decrease in equities or liabilities.
Sources of funds should always be represented by the application of funds. But no
such guarantee is there. The difference in the statement indicates either increase
or decrease release in working capital. This can be explained in the following way.
94
Source > Application = Increase in working capital

Sources < Application = Decrease/release in working capital
Hence, the increase and release/decrease in working capital may be revealed
from a statement called “Statement of changes in working capital” which is
prepared by comparing the Balance Sheets of different periods. The result can be
arrived at by deducting the working capital of the current year from the working
capital of the previous year. Working capital means current assets minus current
liabilities. If current year’s working capital is greater than the previous year’s
working capital. It indicates increase in working capital. If the current year’s
working capital is less than that of the previous year it indicates decrease/release
in working capital of the business.
Current years Previous year’s working Increase in working

> =
working capital capital
Current year’s Previous year’s working Decrease/Release in
< =
working capital capital working capital
Anyhow, increase and decrease or release in working capital can be found out
by the effect (+/—) of each transaction, on its working capital. Once again, it may
be revised that increase assets and decrease in liabilities have favorable effect (+) on
the working capital. On the other hand, decrease in assets and increase in
liabilities have unfavorable effect (+) on the working capital. On the other had,
decrease in assets and increase in liabilities have unfavorable or adverse effect (—)
on the working capital of the business. Hence, the balance of the “statement of
changes in working capital” should always be equal to the balance of “Fund Flow
Statement” or “the statement of sources and uses Funds’.
The whole thing may be explained follows
Sources > Application Previous year = Increase in W.C.

Current year’s W.C. < W.C. = Increase in W.C.
Sources < Application = Decrease in W.C.
Current years W.C. < Previous year’s W.C. = Decrease in W.C.
Components of Fund Flow
1) Sources - Applications
Sources
Increase in profit
Applications
Payment of share capital
Increase in share capital Payment of Dividends
Issue of shares Purchase of Addition to fixed assets
Share premium Purchase of Investment
Issue of debentures Redemption of Debentures
95
Sale of fixed assets Repayment of Institutional loans

Bank loan Advantages of Fund Flow Statement
Depreciation
Sale of investment etc.
6.3. ADVANTAGES OF FUND FLOW STATEMENT
Everybody knows that funds of working capital is the life blood of any
business. The availability of the correct amount of funds and its proper use in a
business can hardly be emphasized. The statement is one of the tools for managing
favourably this working capital. It also reveals the comparative position of working
capital. It also reveals the comparative position of working capital on the two
balance sheet dates. It also reflects changes in capital structure and asset
expansion. The management, from this report, can recommend appropriate
measures for improving the position of working capital. Thus, the statement is able
to present the information which is not either available or readily apparent from an
analysis of other financial statements. That is why Perry Mason has sated that the
Fund Flow Statement shall be treated as a major financial statement and it should
be presented in all annual reports of the corporations.
Drawbacks of the Funds Flow Statement

Funds Flow Statement does not reveal shifts among the items making up of
current liabilities. It would not tell whether any loss of working capital has unduly
impaired the financial position. Only an examination of the balance sheet at the
end of the period will show the resultant effects of these changes. This statement
cannot replace the usual financial statements. In fact, the statement is intended to
supplement and not to supplant, the convential financial statements either in whole
or part.
Anyhow, if compared with Ratio Analysis, the Funds Flow Analysis Provides a
rich source of information’s regarding possible managerial issues.
Meaning of Fund
The term fund may mean the following
1. As cash is the easiest form of expressing economic value and is readily
convertible into goods and services we think of funds as cash. It business were
operated strictly on cash basis, it would be very easy to trace the kwy
commitments and recovery over a period of time.
2. It is quite certain that all resources are not obtained on the basis of cash
transaction. Management has discretion to obtain credit. For example, if a
business obtained trade credit from a supplier, someone else’s funds will be
employed until repayment is made. If credit is similarly granted to customers,
its funds are in effect used by someone else. By these management decisions
the economics’ values have been shifted. Hence, the concept of funds should
96
be interpreted to denote the changed in current assets and current liabilities,

ie., working capital.
3. All financial aspects of all important transactions between the business and
outsiders, whether they affect cash or working capital will be interpreted as
fund.
Concept of Flow
As already stated, use of funds will always reduce the net working capital and
similarly an inflow of funds will always increase the net working capital. The flow
of fund can be said to have taken place only when the net working capital is
affected, as the term “funds” has been used in a special sense to mean net working
capital. Moreover, the flow of funds in a business may be visualised as a
continuous process. For every use of funds, there must be an offsetting source., In
a broad sense, the assets of a business represent the net uses of funds, its
liabilities and net worth represents net assets.
6.4. PREPARATION OF FUNDS ANALYSIS

The Funds Flow Analysis involves preparation of
1. Schedule of changes in working capital and
2. Statement of Sources and Application of Funds
Schedule of changes in working capital: - It is necessary to prepare this
schedule. It is prepared with the help of only current assets and current liabilities.
Here, we should compare each current asset in the previous year with that in
the current year. Similarly, we should compare each current liability in the
previous year with that in the current year. The difference is recorded for every
current asset and liability. We should repeat this until all accounts in respect of
current assets and current liabilities in the two balance sheets are gone through
and differences are properly recorded. The two column showing the changes in
current assets and current liabilities are balanced. The balancing figure represents
either an increase or decrease in the working capital. We should also remember
that schedule of changes in working capital is prepared only from accounts
declared in the Balance sheets. There is no effect of additional information given in
the problem because such additional information will affect the statement of
sources and application of funds.
Proforma
Statement showing changes in the working capital for the year ended 19
97
Previous Current Effects

Year Year Increase (+) Decrease (—)
Rs. Rs. Rs. Rs.
CURRENT ASSETS
Cash in hand … …
Debtors … …
Inventory … …
Bills Receivable … …
Total (A) … …
CURRENT LIABILITIES
Trade Creditors … …
Bills payable … …
Total (B) … …
Working capital or Net
working capital (A — B) … …
Increase / Decrease in W.C. … …
Total … …
Statement of Flow of Funds for the year ended 19 ……
Sources Rs. Uses/Applications Rs.

1. Increase in share capital 1. Reademption of Redeemable
2. Issue of Debentures Preference Share Capital
3. Loan from Bank 2. Redemption of Debentures
4. Sale of Investments 3. Repayment of Institutional
Loans
5. Sale of fixed assets
4. Purchase of assets
6. Depreciation
5. Purchase of Investment
7. Trading profit
6. Payment of Dividend
8. Other receipts
(Interm also)
(Non Trading)d
Total
ANNAMALAI UNIVERSITY 7. Other payments (Non-Trading)
Total
(either) (or)
Decrease in working capital Increase in working capital
98
6.5. PREPARATION ON FUND FLOW STATEMENT

Usually, the period covered by Fund Flow statement is one year though it may
also be two or more years. The data for the preparation of this statement is
obtained from two balance sheets, supplemented by such other information from
the accounts as may be needed. This is prepared only with the help of non-current
assets and non-current liabilities.
Problem 1
From the following condensed Balance Sheet as aat 31st December 1981 and
1982 prepare in fund flow statement.
1982 1983
Assets
Rs. Rs.
Cash in hand 25,000 15,000
Cash at Bank 22,000 15,000
Debtors 1,00,000 1,00,000
Stock 45,000 50,000
Bills receivable 15,000 20,000
Work-in-progress 45,000 30,000
Land & Buildings 30,000 25,000
Plant & machinery 36,000 25,000
3,18,000 2,80,000
LIABILITIES Rs. Rs.

Share capital 2,50,000 2,00,000
Creditors 20,000 35,000
Bills payable 25,000 35,000
P & L a/c 23,000 10,000
3,18,000 2,80,000
Statement showing changes in the working capital for the year ended 31st Dec,
1982.
1981 1982 Effects of each transaction
Current Assets
Rs. Rs. Increase (+) Decrease (–)
Cash 15,000 25,000 10,000
Bank 15,000 22,000 7,000
Debtors 1,00,000 1,00,000 -
Bills Receivable 20,000 15,000 5,000
99
Stock 50,000 45,000 5,000

Work-in-progress 30,000 45,000 15,500
Total (A) 2,30,000 2,52,000
Current Liabilities
Creditors 35,000 20,000 15,000
Bills Payable 35,000 25,000 10,000
Total (B) 70,000 45,000
Working capital (A—B) 70,000

(2,30,000—70,000) 1,60,000
(2,52,000—45,000) 2,07,000
Working capital increase in W.C. 47,000
Total 2,07,000 2,07,000 57,000 57,000
Statement showing Sources and Applications for Funds for the year ended
December 1982.
Sources Rs. Applications Rs.

Issue of shares 50,000 Purchase / Addition of land 5,000
Increase in profit 13,000 Purchase/Addition of P & M 11,000
Increase in W.C. 47,000
63,000 63,000
There is a relationship between source and application of fund. If the sources
are greater than application, it indicates increase in working capital. In the above
case, source is 63,000 and application is Rs.16,000. Hence, the increase in
working capital is 47,000 which is indicated in the statement.
Current Assets include the following items

1. Cash-in-hand
2. Cash-at-Bank
3. Temporary Investments
4. Bills payable
5.
6.
Debtors
Stock-in-Trade
7. Prepaid expenses
Current Liabilities include the following items

1. Outstanding creditors for services rendered
3. Trade creditors for goods supplied
100
3. Bills payable
4. Bank O, D (temporary)
Non current assets include the following items

1. Goodwill 2. Land 3. Building 4. Plant & Machinery 5. Furniture & Fixtures
6. Long-term Investments 7. Trade Marks & Patent rights 8. preliminary expense 9.
Discount on issue of shares 10. Deferred Revenue expenditure 11. P & L A/c (Dr.)
Balance.
Non-current liabilities include the following items

1. Equity share capital 2. Preference share capital 3. Redeemable Preference
share capital 4. Debentures 5. Long-term loans 6. Share Premium A/C 7. Share
forfeited A/C 8. P & L A/C (Cr.) Balance. 9. Provision for Depreciation 10 Capital
Reserve 11. Appropriation of profit.
Depreciation is ‘retention of profit. Out of the profits of the business a portion
is set aside of the replacement of the said machine in the year of replacement.
Sometimes depreciation expense is added back to net income to determine the flow
of funds from operation. Instead of showing two items, such as (i) profit of the
business and (ii) depreciation, one item can be shown as ‘Income from operations’
Problem 2
The following figures are given
31.12.81 31.12.82
Rs. Rs.
Cash 1,30,000 40,000
Debtors 1,00,000 1,60,000
Stock 2,35,000 2,55,000
Land 5,40,000 10,20,000
Plant 28,04,000 35,44,000
Furniture 2,10,000 2,10,000
40,19,000 52,29,000
Creditors 3,19,000 3,65,000
Provision for Dividend - 2,00,000
Debentures - 5,35,000
Equity capital 36,00,000 40,00,000

1,00,000 1,29,000
Profit and Loss A/c
40,19,000 52,29,000
101
Prepare Statement of Sources and Application of Fund and a statement

showing the movement of working capital.
Solution
Statement showing the Movement of working capital
Current Assets
Movement in working
1981 1982 capital
Rs. Rs. + —
Rs. Rs.
Cash 1,30,000 40,000 - 90,000
Debtors 1,00,00 1,60,000 60,000
Stock 2,35,000 2,55,000 20,000
Total of Current Assets (A) 4,65,000 4,55,000
Current Liabilities
Movement in working
1981 1982 capital
Rs. Rs. + —
Rs. Rs.
Creditors 3,19,000 3,65,000 46,000
Total of Current Liabilities(B) 3,19,000 3,65,000
Working capital (A—B) 1,46,00 90,000
Decrease or Release in
working capital 56,000 56,000
1,46,000 1,46,000 1,36,000 1,36,000
Material A (900 × 2) — (1,000 × 1,90) Rs,1,800 — 1,900 = 100(A)
Material B (800 × 4) — (850 × 4.2) Rs. 3,200 — 3,570 = 370 (A)
Material C (500 × 6) — (450 × 6.50) Rs. 3,000 — 2,925 = 75 (F)
Total material cost variance 395 (A)
This can also be calculated as follows
Total Standard Cost of Standard input Total actual cost of

—
for actual out put input for actual output
102
2. Material Price Variance
Formula: (SP — AP) × AQ Rs.

Material A(2 — 2.10) × 1000 = 0.10 × 1000 = 100 (F)
Material B(4 — 4.20) × 850 = 0.20 × 860 = 170 (A)
Material C(6 — 6.50) × 450 = 0.50 × 450 = 225 (A)
Total Material Price Variance Rs.295 (A)
3. Material Mix Variance
Here, it is necessary to calculate revised standard proportion of actual input
S tan dard Mix
Formula × Total actual Input
T otal S tan dard Input
1980 1981
Assets
Rs. Rs. Rs. Rs.
Building at cost 1,50,000 20,000
P & M at cost 2,60,000 3,20,000
—Depreciation 85,000 1,75000 95,000 2,25,000
Shares in subsidiary company 20,000 20,000
Stock 45,000 49,000
Sundry Debtors 15,000 18,000
Bank 25,000 48,000
4,30,000 5,90,000
During the year 1981 plant costing Rs.15,000 (accumulated depreciation
thereon Rs.8000) was sold for Rs.5000, the loss on sale being charged to P 7 L a/c
Solution
Statement showing Source and Application of Funds during the year ended
31st December 1981.
Funds Provided by
Rs. Rs.
Profit for the year (2) 50,000
Add Non-cash item-Depreciation 18,000 75,000
Share issue proceeds 1,00,000
Share premium 10,000 1,10,000
Sale of plant 1 5,000
1,90,000
103
Funds Applied By
Rs. Rs.
Purchase of Building (3) 80,000
Purchase of Plant (4) 75,000
Debentures repaid (1,00,000— 24,000 1,79,000
76,000)
Dividends paid 10,000
Increase in working capital 1,000
1,90,000
1. Statement showing change in working capital
1980 1981 + —
Rs. Rs. Rs. Rs.
Stock 45,000 49,000 4,000
Debtors 15,000 18,000 3,000
Bank 27,000 48,000 23,000
Creditors 60,000 1,04,000 44,000
Provision for taxation 20,000 5,000 15,000
80,000 1,09,000
Working capital 5,000 6,000 1,000
Increase 1000 -
6,000 6,000 45,000 45,000
2. Profit for the year 1981
Rs.
Net Profit as per Balance sheet 45,000
Add loss on sale of plant 2,000
47,000
Add proposed dividend 10,000
57,000
3.
104
Buildings Account
Rs. Rs.
To balance b/f 1,50,000 By balance c/d 2,30,000
To Purchase 80,000
2,30,000 2,30,000
4. Plan A/c
Rs. Rs.
To balance b/f 2,60,000 By Sale 5,000
To Purchase 75,000 By Dep. Provision 8,000
By Loss on sale 2,000
By Balance c/d 3,20,000
3,350000 3,35,000
5. Provision for Depreciation on plant A/c
Rs. Rs.
To plant a/c 8,000 By balance b/f 85,000
To balance c/d 95,000 By Depreciation 18,000
1,03,000 1,03,000
QUESTION
1. What is a funds flow statement? Examine its managerial use.
2. Distinguish between Fund flow statement and Balance sheet.
3. Explain the items of sources and application of funds.
4. Explain the procedure for the preparation of fund flow statement.
5. From the following summarised Balance sheet of B Ltd., for two years on
31.3.2002 and 31.3.03.
i. Explain how the increase in Fixed Assets was financed.
ii. Find out the working capital for each of the two years and comment on the
significance of the changes.
2002 2003
Share capital
Share premium
10,00,000
1,00,000
15,00,000
1,50,000
Profit & Loss A/C 4,00,000 7,00,000
Trade Creditors 2,50,000 3,00,000
Bank overdraft — 1,00,000
Proposed Dividend 50,000 50,000
18,00,000 2800,000
105
2002 2003
Land & Building 5,00,000 50,000
Plant & Machinery 7,00,000 1,60,000
Stock 1,75,000 30,000
Debtors 2,25,000 3,50,000
Cash 2,00,000 50,000
18,00,000 28,00,000
Sales 18,00,000 35,00,000
6. Calculate the Funds from operations from the following Profit & Loss
Appropriation A/C
Profit & Loss A/C
To Salaries 5,000 By G/P 50000

To Rent 3,000 By Profit on sale of Building
To Depn. On plant 5,000 Book value 10000 5000
To printing & stationery 3,000 Sold for 15000
To preliminary exps.
Written off 2,000
To Goodwill written off 3,000
To Prov. For tax 4,000
To proposed Dividends 6,000
To N/P 24,000
55000 55000
106
LESSON - 7
FUND FLOW ANALYSIS (CONTINUED)
SOME PRACTICAL HINTS
OBJECTIVES
 Identify the items which require special treatment while preparing fund
flow statement
 Prepare fund flow statement
STRUCTURE
7.1. Changes in Current Assets and Current Liabilities
7.2. Changes in Non-current items
7.3. Provision for doubtful debts
7.4. Investments
7.5. Proposed Dividend
7.1. CHANGES IN CURRENT ASSETS AND CURRENT LIABILITIES

All changes in current assets and current liabilities between the dates of two
balance sheets are taken care of through the schedule of changes in working
capital. Hence, these changes need not be dealt with separately in the Statement of
Sources and Application of Funds.
7.2. CHANGES IN NON-CURRENT ASSETS AND NON-CURRENT LIABILITIES

The only changes in non current assets and non-current liabilities which are
offset by changes in working capital must be shown in the statement of Sources
and Application of Funds, For example, if shares were issued for Rs.1,00,000 in
exchange for machinery worth Rs.60,000 plus cash for Rs.40,000 the issue of share
capital would be shown as a source only as R.40,000. Similarly the purchase of
machinery would be shown as an application only at Rs.40,000.
Difference in the values of Fixed Assets between the dates of two balance
sheets would represent either sale or purchase thereof. The figures of purchase
should be treated as an application of funds and the actual sale proceeds should be
taken as a source of funds. Similarly, difference in the values of fixed liabilities
between the dates of two balance sheets would represent either additional issuance
or repayment hereof. The same will be shown in the Funds Flow Statement.
7.3. PROVISION FOR DOUBTFUL DEBTS

This provision is created to guard against future losses on Debtors. This may
be treated as Non-Current liability like internal reserve. A separate account must
be prepared for it. The balancing amount would be transferred to Adjusted Profit
and Loss Account and it may be added back to or deducted from the net profit to
107
find out funds from trading operations. Some experts treat the provision for
doubtful debts as a current liability. The debtors, in that case, must be shown at
gross figure under current assets and the provision under current assets and the
provision under current liabilities. Any change in these accounts will be
automatically adjusted in the schedule of changes in working capital. Treatment
for provision for loss of stock or allowance for inventory loss is similar.
7.4. INVESTMENT
When surplus funds are temporarily invested in marketable securities they will
be treated as current assets. Any change will be automatically adjusted through
the schedule of changes in working capital. Hence no separate treatment is
required in the statement of sources and application of funds. If investments are of
a permanent nature they should be treated as fixed assets. Any change may
represent either purchase or sale on investments. Without considering profit or
sale of investment, actual sale proceeds should be taken as a source of funds and
the purchase price as an application of funds.
7.5. PROPOSED DIVIDEND

1) This may be treated as current liability. Then it will not be used for
adjusting the net profit made during the year for calculating the income
from operations.
2) It may also be treated as non-current liability. If it is the case dividend paid
during the year is shown as an application of funds.
It should be noted that only the payment of dividend reduces the working
capital, while the declaration of the dividend does not affect the working capital,
because the latter is a mere appropriation of funds. Such proposed dividend must
be added back to the Net Profit in order to know the income operations.
7.6. PROVISION FOR TAXATION

There are two alternative methods of dealing with this item.
1. Provision for taxation may be treated as current liability. If this is the
treatment, then provision for taxation made during the year is not used for
adjusting the profit made during the year for calculating the income from
operations.
2. This may also be treated as internal appropriation ie. non current liability’.
Then it will be used for adjusting the Net Profit made during the year and tax
paid is treated as an application of funds Uetermination of Sources of Fund
from operations or the Trading Profit
Some special items are to be added back to Net Profit.
When we determine the sources of funds from operation, certain items, which
have already been debited to P & L a/c are added back to the figure of Net profit.
108
We should also determine those items already debited to P & L a/c for the current
year to be added back.
For this purpose, we should ask the following two questions. Does the item
taken by itself.
i. result in a change in any current asset or liability?
ii. constitute a current operating change on cost?
If the answer to the question is in the affirmative the item should not be added
back. On the otherhand if the answer is in the negative the following items should
be added back.
1. Salary
2. Depreciation
3. Preliminary expenses
4. Goodwill
5. Transfer to General Reserve, Dividend Equalisation Reserve, Sinking Fund or
any other Reserve
6. Loss or gain on sale of Non-current Assets
7. Dividends Received or Receivable
8. Re-transfer of Excess provision for Taxation
9. Outstanding salary
10. Salary adjusted against earlier advance
Hidden Information
Sometimes we are unable to locate easily transactions taking place in the
business. For example, it balance sheets on two different dates show Machinery
Account at Rs.2,00,000 and Rs.2,20,000 respectively and as information if it is
given that Depreciation on Machinery has been provided for Rs.40,000 then, hidden
information can be revealed by preparing Machinery Account as under.
Machinery A/C
To opening Balance 2,00,000 By Depreciation 40,000

” Cash purchase of By closing Balance 2,20,000
machinery (*Balance figure) 60,000
2,60,000 2,60,000
*Application of funds
It is understood from the above account that there is a purchase of Machinery
of Rs.60,000 (not Rs.20,000) Hence, there is an application of funds of Rs.60,000.
109
If we assume, in the above example, the opening balance as Rs.3,20,000 the

Machinery account would appear as follows.
Machinery A/C
Rs. Rs.
To Opening balance 3,20,000 By depreciation 40,000
By closing balance 2,20,000
By cash (Sale of Machinery
— balance Figure) 60,000
3,20,000 3,20,000
The Following Technique is given for the construction of the

Funds Flow Statement
1. Prepare a Schedule of changes in working capita(prepare also hidden
information in ledger a/c)
Funds from Trading Operations Rs.

Net profit xxx
Add
1. Depreciation of Fixed Assets xxx
2. Depreciation of wasting Assets xxx
3. Amortisaion of Intangible Assets xxx
4. Deferred Revenue Expenses charged to Revenue xxx
5. Loss on sale of Non-current Assets xxx
Less
1. Gain on sale of Non-current Assets xxx
Funds from Trading Operations xxx
Total xxx
Funds from other than trading Operations Rs.

1. Sale of Non-current assets xxx
2. Issue of Long-term loans like Debentures
3. Issue of share capital
xxx
xxx
4. Application of Funds
1. Purchase of Non current Assets xxx
2. Redemption of Debentures; prefernce shares etc. xxx
3. Payemtn of cash Dividend xxx
110
4. Payment of Tax xxx

5. Write off Net loss xxx
5. Record the Increase or Decrease in working capital as per schedule of changes
in working capital
Proforma of Adjusted Profit & Loss A/c
Rs. Rs.
To Depreciation written off xxx By Opening balance xxx
” Preliminery expenses written of xxx ” Dividend already credited to
” Good will written of xxx P & L a/c xxx
” Discount on issue of shares xxx ” Over provision for taxation
written back xxx
” Deferred Revenue expenses
already charged xxx ” Gain on sale of Fixed Assets xxx
” Transfer to general reserve xxx ” Funds from Trading operations
(Balancing figure) xxx
” Transfer Sinking Fund xxx
” Loss on sale of fixed assets
written of xxx
” Closing balance xxx
xxx xxx
Proforma of Statement of Sources and Uses of Funds
Statement of Sources and uses of Funds for the year ended
Sources Rs. Uses Rs.

1. Funds from Trading xxx 1. Redemption of Redeemable
operations preference shares xxx
2. Issue of shares xxx 2. Repayment of debentures xxx
3. Issue of Debentures xxx 3. Redemption of loan xxx
4. Loans obtained xxx 4. Purchase on Investment and
5. Sale of Investment and other other fixed assets xxx
fixed assets xxx 5. Payment of Dividend xxx
6. Non-trading income xxx 6. Non-Trading expenses xxx
ANNAMALAI UNIVERSITY 7. Increase in working capital xxx
N.B.
1. Decrease or Release in working capital will be shown under the heading
sources.
2. Funds lost from Trading operations will be shown under the heading ‘uses’.
111
Problem 1
1. From the following Balance Sheet of Ashok Ltd., make out (1) Statement of
changes in working capital and (2) Fund Flow Statement.
2. A machine has been sold for Rs.10,000. The written down value of the
machine was Rs.12,000. Depreciation of Rs.100,000 is charged on plant
account in 1980.
3. The investments are trade investment, Rs.3,000 by way of dividend is received
including Rs.1000 from pre-acquisition profit which has been credited to
investment Account.
4. An interim dividend of Rs.20,000 has been paid in 1980.
Solution
Ashok Limited
Statement of changes in the working capital
1979 1980 + —
Current Assets
Rs. Rs. Rs. Rs.
Stock 77,000 1,09,000 32,000
Sundry Debtors 1,40,000 1,70,000 30,000
Bills Receivable 20,000 30,000 10,000
Cash-in-hand 15,000 10,000 5,000
Cash-at-Bank 10,000 8,0000 2,000
A Rs. 2,62,000 3,27,000
Current Liabilities
Sundry creditors 25,000 47,000 22,000
Bills payable 20,000 16,000 4,000
Libaility for expenses 30,000 36,000 6,000
B Rs. 75,000 99,000
Working capital (A—B) 1,87,000 2,28,000
Increase in W.C. 41,000 41,000
2,28,000 2,28,000 76,000 76,000
112
Balance Sheets of Ashok, Ltd., as at 31st December
1979 1980 1979 1980

Rs. Rs. Rs. Rs.
Equity share capital 3,00,000 4,00,000 Goodwill 1,00,000 80,000

8% Redeemable Land and Building 2,00,000 1,70,000
Preference share Plant 80,000 2,00,000
capital 1,50,000 1,00,000
Investments 20,000 30,000
Capital Reserve - 20,000
Sundry Debtors 1,40,000 1,70,000
General Reserve 40,000 50,000
Stock 77,000 1,09,000
P & L a/c 30,000 48,000
Proposed Dividend 42,000 50,000 Bills receivable 20,000 30,000
Sundry creditors 25,000 40,000 Cash-in-hand 15,000 10,000
Bills payable 20,000 16,000 Cash-at-bank 10,000 8,000

Liability for expenses 30,000 36,000 Preliminary expenses 15,000 10,000
Provision for taxation 40,000 50,000
6,77,000 8,17,000 6,77,000 8,17,000
Notes: 1. A piece of land had been sold out in 1980 and the profit on sale has been
credited to capital Reserve.

(For the year 1980)
Source Rs. Application Rs.

1. Issue of Equity capital 1,00,000 1. Redemtion of preference
2. Sale of land 50,000 share capital 50,000
3. Sale of Machine 10,000 2. Interim Dividend paid 20,000
4. Divident Received 3. Purchase of plant 1,42,000
3,000
5. Trading Profit for the year 4. Investment purchased 11,000
1,43,000
5. Payment of proposed
Dividend for 1979
42,000
2,65,000
Increase in W.C. 41,000
ANNAMALAI UNIVERSITY 3,06,000 3,06,000
Workings
Plant A/c
Rs. Rs.
To Opening balance 80,000 By Adjusted P & L a/c
113
To cash purchase (Balancing 1,42,000 (Depreciation) 10,000

figure) By cash 10,000
Adjusted P & L a/c
(Loss on sale) 2,000
By closing Balance 2,00,000
2,22,000 2,22,000
Land and Building A/c
Rs. Rs.
To Opening balance 2,00,000 By Cash
To capital Reserve 20,000 (Balancing figure) 50,000
Closing balance 1,70,000
2,20,000 2,20,000
Note: It has been assumed that no depreciation has been written off in respect of
Land Building during the year 1980 and land costing Rs.30,000 was sold for
Rs.50,000.
Investment A/c
Rs. Rs.
To Opening balance 20,000 By Dividend A/c 1,000
To Cash (Balance figure) 11,000 ” Closing balance 30,000
31,000 31,000
Goodwill A/c
Rs. Rs.
To Opening balance 1,00,000 By Adjusted P/L
(Balance figure) 20,000
” Closing balance 80,000
1,00,000 1,00,000
General Reserve A/c
Rs. Rs.
To Closing balance 50,000 By Opening balance 40,000
” Adjusted P & L A/c
(Balancing figure) 10,000
50,000 50,000
114
Provision for Taxation
Rs. Rs.
To Closing balance 50,000 By Opening Balance 40,000
Adjusted P & L A/c
50,000 50,000
Proposed Dividend A/c
Rs. Rs.
To Cash 42,000 By Opening balance 42,000
To closing balance 50,000 By Adjusted P & L A/c
92,000 92,000
Note: Assumed that the proposed dividend for 1979 was paid during the year 1980
Preliminary Expenses A/c
Rs. Rs.
To Opening balance 15,000 By Adjusted P/L
(Balance figure) 5,000
15,000 15,000
Adjusted P & L A/c
Rs. Rs.
To General Reserve 10,000 By opening balance 30,000
” Proposed Dividend 50,000 ” Dividend 2,000
” Interim Dividend 20,000 ” Trading profit
” Provision for taxation 10,000 (Balancing figure) 1,43,000
” Goodwill 20,000
” Plant A/c (Depreciation) 10,000
” Plant A/c (loss on sale)
” Preliminary Expenses
2,000
5,000
” closing balance 48,000
1,75,000 1,75,000
115
Problem 2
The following are the summaries of the Balance Sheets of Time and Talent
Limited as at 31st December, 1979 and 31st December 1980.
1979 1980
Rs. Rs.
Sundry Creditors 39,500 41,135
Bills Payable 33,780 11,525
Bank O.D. 59,510 -
Provision for taxation 40,000 5,000
Reserve 50,000 56,000
P & L A/c 39,690 41,220
Share capital 2,00,000 2,60,000
4,62,480 4,53,880
1979 1980
Rs. Rs.
Cash 2,500 2,700
Sundry Debtors 85,175 72,625
Sundry Advances 2,315 735
Stock 1,11,040 97,370
Land and Building 1,48,500 1,44,250
Plant and Machiner 1,12,950 1,16,200
Good will – 20,000
4,62,480 4,53,880
The following additional information is obtained from the general ledger
1. During the year ended 31st December 1980 as interim dividend of Rs.26,000
was paid.
2. The assets of another company was purchased for Rs.60,000 payable in fully
paid shares of the company. These assets consisted of stock Rs.21,640,
machinery Rs.18,360 and goodwill Rs.20,000. In addition, sundry purchases
of plant were made totaling Rs.5,650.
3. Income-tax paid during the year amounted to Rs.25,000
4. The net profit for the year before tax was Rs.62,530.
You are required to prepare a statement showing the sources and application
of funds for the year 1980 and a schedule setting out changes in working capital.
116
Solution
Time and Talent Limited
Schedule of changes in working capital
1979 1980 Increase Decrease

Rs. Rs. Rs. Rs.
CURRENT ASSETS
Cash 2,500 2,700 200 –––
Debtors 85,175 72,625 ––– 12,550
Advances 2,315 735 ––– 1,580
Stocks 1,11,040 97,370 ––– 13,670
Total Current Assets 2,01,030 1,73,430

Rs. Rs. Rs. Rs.
CURRENT LIABILITIES
Creditors 39,500 41,135 – 1,6345
Bills payable 33,700 11,525 22,255 –
Bank O.D. 59,510 – 59,510 –
Provision for taxation 40,000 50,000 10,000
Total Current Liabilities 1,72,790 1,02,660
Working capital 278,240 70,770
Increase in working capital 42,530 42,530
70,770 70,770 81,965 81,965
Statement of Sources and Application of Funds
(For the year ending 31 s t December, 1980)
Sources Rs. Applications Rs.

1. Profit for the year before tax 52,540 1. Purchase of Machinery 5,650
2. Increase in share capital 2. Payment of Interim
(Only so much as is
represented by current asset
Dividend
Increase in working capital
26,000
42,530
bought i.e. Stock worth Rs.
21,640) 21,640
74,180 74,180
117
Working
Adjusted P & L A/c
Rs. Rs.
To Land and Buildings By Opening Balance 39,690
(Depreciation) 4,250 ” Trading Profit before tax
” Plant & Mechinery (Balancing figure) 52,540
(Depreciation) 20,760
” Dividend Paid 26,000
92,230 92,230
Share Capital A/c
Rs. Rs.
To closing balance 2,60,000 By Opening balance 2,00,000
” Stock (Source of Funds) 21,640
” Goodwill 20,000
” Machinery 18,360
2,60,000 2,60,000
Land and Building A/c
Rs. Rs.
To closing balance 1,48,500 By adjusted P&L A/c
(Balancing figure-
Depreciation) 4,250
” Closing Balance 1,44,250
1,48,500 1,48500
Plant and Machinery A/c
Rs. Rs.
To closing balance 1,12,950 By Adjusted P&L A/c
To Share capital 18,360 (Balancing figure-
To CashANNAMALAI UNIVERSITY 5,650
Depreciation)
By Closing Balance
20,760
1,16,200
1,36,960 1,36,960
Notes:
1. Interim Dividend paid Rs.26,000 must have been debited to P & L A/c, because
it does not appear in the Balance Sheet.
118
2. Source of fund on account of increase in share capital may be taken to be

Rs.60,000 (Rs. 2,60,000-2,00,000), but in that case goodwill Rs.20,000 and
further machinery Rs.18,360 would appear as applications.
Problem 3
The following Funds, Statement and information pertain to the operation of
Material Company during the year ended 31st December 1980.
Statement of Sources and Application of Funds

Sources Rs.
Funds provided by operations 60,000
Funds from issue of Debentures 1,00,000
Funds from issue of Equity Shares 2,00,000
3,60,000
Uses
For acquisition of plant and Equipment 1,80,000
For payment of Dividend 20,000 2,00,000
Net Increase in working capital 1,60,000

Additional Information
1. The Material Company was incorporated on January 2, 1980.
2. Plant was purchased on the same date and plant to the value of
Rs.10,000 was destroyed by fire on January 2, 1980.
3. Expected life of the plant is 10 years. The company has decided to use the
Straight Line Method for providing depreciation. You are required to prepare a
Balance Sheet as at 31 December, 1980.
Solution
Before preparing the Balance Sheet, we have to determine the Net profit from
the given Funds from Trading operations
Profit and Loss A/c
To Dividend
Rs.
20,000 By Funds from Trading
Rs.
60,000
To Depreciation operation
Cash Rs. 1,80,000
Minus destroyed Rs. 10,000
Divided by 10 years i.e.,
119
1,70,000 17,000
To Loss of Plant 10,000
To Net profit 13,000
60,000 60,000
Material Company Balance Sheet as at 31 s t December 1980

Share Capital 2,00,000 Plant & Equipment 1,80,000
Debenture 1,00,000 Less Deprecation 10,000
P & L A/c 13,000 1,70,000
Less Depreciation 17,000
1,53,000
Current Assets
(Balance Figure) 1,60,000
3,13,000 3,13,000
QUESTIONS
1. Define fund flow statement. What are its objectives
2. Explain the factors which influence working capital needs of a business.
3. What are the needs for fund flow statement?
4. What do you mean by the term fund. Explain the concept of flow of funds
5. From the following details calculate funds from operation
Salaries 5000 Dis. On issue of debn. 2000

Rent 3000 Prov. For bad debts 1000
Refund of tax 3000 Transfer to general reserve 1000
Profit on sale of building 5000 Preliminary exps. Written off 3000
Depn. On plant 5000 G/w written off 2000
Prov. For tax 4000 Proposed dividend 6000
Loss on sale of plant 2000 Dividend recd. 5000
Clos. Balance of P&L a/c 6000
Ope. Balance of P & L a/c 25000
6. From the following balance sheets prepare

a. a schedule of changes in working capital
b. a funds flow statement
120
Balance Sheet
Share capital 10000 15000 Cash 5000 8000

Profit & Loss A/C 5000 8000 Debtors 10000 15000
General Reserve 4000 6000 Stock 10000 12000
Sundry creditors 8000 12000 Machinery 3000 5000
Bills payable 5000 3000 Land 4000 4000
32000 44000 32000 44000
Given below are some matters which require special attention while preparing
a statement of sources and applications of funds.


121
LESSON - 8
CASH FLOW STATEMENT
OBJECTIVES
 Know the meaning of cash flow statement
 release the merits of cash flow analysis
 list the limitations of cash flow analysis
 understand the principles related to preparation of cash flow statement
 distinguish cash and non-cash items
STRUCTURES
8.1. Cash flow statement
8.2. Cash flow
8.3. Simplified view of business operations
8.4. Advantages
8.5. Limitations
8.6. Preparation of cash flow statement
8.1. CASH FLOW STATEMENT

Cash Flow statement is only a summarised statement containing actual
receipts and payment during the period. This statement will commence with the
opening cash and bank balances and to this are added the amounts of cash
received such as issue of shares, issue of debentures, receipts from debtors and
sale of assets. From the total, the following items are deducted representing
payments to creditors, payment of liabilities, payment of expenses, purchases of
assets and payment of taxation and dividends. The balance will represent the
closing cash and bank balances if the figures of purchases sales and creditors are
not available, it is usual in prepare the statement in the same way as the Sources
and Application of Funds. Individual increase or decrease in each of the current
assets and current liabilities is shown in the statement. Moreover, the movement of
various assets and liabilities are shown in this statement.
The term “Funds” has a variety of meanings, including cash,working capital
and all financial resources. Here the term “Funds” is to be used in its narrowest
concept of cash:
8.2. CASH FLOW

A business concern gets cash from the following sources
1. Capital raised
2. Borrowings
122
3. Cash collections from customers

4. Income from investments, sale of fixed assets etc.
Similarly a business concern makes the following payments

1. Fixed Assets purchased
2. Materials supplied wages, overheads paid
3. Income Tax and Dividend paid
4. Repayment of loan etc.
The cash on hand and at bank are considered as reservoirs of cash into which
flow of additional cash comes from owners, lenders and customers. Profits are
represented by a part of the cash inflows on account of sales of inventory and
collections from customers. Though the entire profits are not paid out to the
owners immediately, a potion the profits is retained.
Cash outflows take place from the reservoir intermittently on account of
payments made to outsiders and suppliers and repayment of other loans. It should
be noted that if an accounting year ends with more cash in the reservoir than at the
beginning, this excess does not mean profits for the year, because accounts are
maintained on accrual basis rather than on Cash basis. By meansd of examples
this can be explained.
8.3. SIMPLIFIED VIEW OF A BUSINESS OPERATIONS

We assume that all transactions during the year were carried on cash. All
purchases and sales and all expenses were for cash and completed within a year
itself. besides, expenses were incurred according to the limit applicable for the year
ie. no more and no less. During the year no loan repayment was made. Under this
unrealistic assumption. It is clear that the amount of profit will increase the sum
of cash.
Example
Rs.
Sales 1,00,000
Less: Purchase 40,000
Wages 10,000
Other expenses
Net Profit
5,000 55,000
45,000
Thus the net profit from operation or the net cash flow or cash operation is
Rs.45,000.
As cash sales of Rs.1,00,000 must have resulted in an inflow of cash of
Rs.1,00,000 and payments must have resulted in an outflow of cash Rs.55,000
123
leaving a net cash balance of Rs.45,000. In this case the net profit has generated
an equivalent amount of cash resources.
Complexities of real Operation

Now we can see a generalised cash flow model. Sales and purchases may be
both for cash and credit. Expenses may partly remain unpaid or paid in advance
and so on. Under such circumstances the net profit made by a business concern
cannot generate equivalent amount of cash.
Example 2
Taking example 1, It is assumed that out of sales Rs.1,00,000 Rs.25,000 are
locked up with customers on account of credit sales. That is the amount due from
debtors at the end is Rs.25,000. Out of sales of Rs.1,00,000 it must have resulted
in an inflow of cash of Rs.75,000 (Rs.1,00,000 - Rs.25,0000). The net cash flow is
worked out as follows.
Rs.
Cash inflow from sales 75,000
Less: Purchase 40,000
Wages 10,000
Other expenses 5,000 55,000
Cash from operation 20,000
But the net profit remains the same Rs.45,000 and the cash generated from
the operation is reduced from Rs.45,000 to Rs.20,000. From this it is obvious that
the profit need not generate an equivalent of cash.
Example 3
Determine the Net Cash Flow from the following data:
Rs.
Net profit made during 1980 1,00,000
Debtors on 1.1.1980 25,000
Debtors on 31.12.1980 15,000
Solution
Net Profit
Rs.
1,00,000
Add: Debtors on 1.1.1980 25,000
1,25,000
Less: Debtors on 31.12.1980 15,000
Cash from operations 1,10,000
124
Example 4
Rs.
Net profit made during the year 40,000
Creditors on 1.1.1980 7,5000
Creditors on 31.12.1980 5,000
Calculate the Cash generated
Solution
Rs.
Net Profit 40,000
+ Creditors on 31.12.1980 5,000
45,000
— Creditors on 1.1.1980 7,500
Cash from operation 37,500
Example 5
Calculate cash generated from operation
Trading and Profit and Loss Account
Rs. Rs.
To Opening Stock 20,000 By Sales (cash) 3,00,000
” Purchase (cash) 1,60,000 ” Cl. Stock 30,000
” Profit 1,5000
3,30,000 3,30,000
Solution
Rs.
Cash inflow from sales 3,00,000
Less cash outflow for purchase 1,60,000
Cash from operation 1,40,000
ANNAMALAI UNIVERSITY Rs.

Profit made during the year 1,50,000
Add: Opening stock 20,000
1,70,000
Less: Closing Stock 30,000
1,40,000
125
Sources and Uses of Cash

Source of cash Use of Cash
1. Issue of capital 1. Purchase of Fixed Assets
2. Issue of long-term loans like 2. Payment of Dividends, Taxes etc.
debentures 3. Repayment of loans Redeemable
3. Sale of Fixed Assets etc. preference shares, Debenture etc.
Cash Flow From Operation

Added to Net Profit Dedected from Net Profit
1. Decrease in Debts, B/R, Stock, 1. Increase in Debtors, B/P, Stock,
Prepaid expenses, Accrued Income Prepaid expenses, Accrued Income
etc. etc.
2. Increase in Creditors, B/P, 2. Decrease in Creditors, B/P,
Outstanding expenses, Income Outstanding expenses, Income
Received in Advanced Received in Advance etc.
3. Non-cash expenses 3. Decrease in Deferred creditors.
Non-Cash Items
A few expenses do no result in outflow of cash and they should be added back
to the profit.
1. Depreciation of Fixed assets.
2. Amortisation of Deferred Expenses (e.g) Preliminary expenses Discount on
issue of shares and Debentures.
3. Amortisation of Intangible Assets (e.g) Goodwill, Trade marks Patent rights.
4. Reserves
5. Provision for Doubtful Debts, Provision for Discounts on Debtors etc.
6. Loss on sale of fixed Assets (gain on sale of fixed assets is deducted from the
profit)
8.4. ADVANTAGES OF CASH FLOW ANALYSIS

1. Thoug ‘all financial resources’ concept and ‘working capital concept, are more
commonly used, the cash concept is useful in evaluating financial policies and
current cash position. It will enable the management to plan and co-ordinate
the financial operations properly. From this, ‘management will know how
much cash is needed how much can be generated internally and for how much
it should arrange from outside. Thus it is especially useful in preparing cash
budgets.
126
2. As it gives the amount of cash inflow from operations it may be useful to

internal financial management in considering the possibility of retiring long-
term debt, in planning replacement of plant facilities and formulating dividend
policies.
3. A comparison of the Cash Flow Statement for the previous year with the budget
for that year would indicate to what extent the resources of the enterprise were
raised and applied according to the plan.
4. It enables the financial manager to account for a situation when the business
has made a profit and yet run out of money or when it has suffered a loss and
still has plenty of money at the bank.
5. As the day-to-day transactions of a business are carried on with cash, that part
of funds flow analysis which relates to cash is of greater value to the
management.
8.5. LIMITATIONS
1. As the enterprise shifts from strictly cash basis, enters with credit transactions
as well and takes into account prepaid and accrued items; the net income, no
doubt, would generally present an increase in working capital. yet equating
net income to cash flow for such enterprise would be inaccurate and
misleading since a number of ‘non-cash’ items would affect the net income of
the enterprise.
2. In addition to current assets, most of the business concerns have a number of
fixed assets. These assets involve cash payments in years past and charges
against operating income of current year effected through depreciation entries.
Thus net income moves even further away from being a net cash flow.
3. The cash balance is too easily influenced by postponing purchases and other
payments.
Though the Cash Flow statement cannot replace the usual financial
statements, yet it serves as a very useful supplementary statement. When it is
used with ratio Analysis, it provides a barometer for measuring any change in the
speed with which cash is flowing through the different parts of the business and its
impact on the profitability of the business.
8.6. PREPARATION OF CASH FLOW STATEMENT

First Step
Calculate operating Profit made during the year, after
a. Adding back non-cash expenses such as depreciation of fixed assets.
b. Adding back the amortised portion of intangible assets (e.g) Goodwill written
off, preliminary expenses written off to apparent profit made during the year,
127
Second Step
Prepare a Statement of Cash Flow
a. Take opening Cash/Bank balance, b. Add to it sources of cash c. Deduct
there from uses of cash; and d. the amount left is the closing Cash/Bank balance.
Problem: 1
Following are the comparative Balance Sheets of western system Ltd.
Liabilities 31.12.80 1.1.80 Assets 31.12.80 1.1.80
Rs. Rs. Rs. Rs.

Share Capital 38,000 36,000 Cash 8,000 12,000
Trade creditors and Trade Debtors 38,000 31,000
Bills Payable 15,200 12,800 Land and Building 12,400 10,000
P&L Patent Rights 1,800 1,600
(Appropriation A/c. 6,800 5,800
60,000 54,600 60,200 54,600
You are required to prepare Cash Flow statement
Solution
1. Calculation of operating profit (7,000 — 5,800) = Rs. 1,200. (In the absence of
any other information an increase in the P & L (app) a/c may be taken as
operating profit made during the year)
Western System Limited

Cash Flow Statement
For the year ended 31st December 1980
Rs. Rs.
Cash Balance as on 1.1.1980 12,000 Cash outflows
Add cash inflow 1. Increase in Trade Debtors 7,000
1. Increase in Trade creditors 2. Purchase of Land and
& B/P 2,400 Buildings 2,400
2. Issue of shares 2,000 3. Purchase of Patent Rights 200
3. Opening Profit 1,200 9,600
ANNAMALAI UNIVERSITY Cash balance as on
31.12.1980 8,000
17,600 17,600
128
Alternatively It may be shown as follows

Rs.
Opening Profit 1,200
Add increase in Trade creditors and 2,400
B/P
Total cash available for use 3,600
Less increase in Trade Debtors 7,000
Use of cash on account of operation 3,400
Cash Flow Statement

Rs.
Cash Balance as on 1.1.1980 12,000
Add: Source
Issue of shares 2,000
Total cash available for use 14,000
Less: Uses Rs.
On account of operating 3,400
Purcahase of Land Building 2,400
Purchase of Patent Rights 200 6,000
Cash Balance as on 31.12.1980 8,000
Problem 2
The Profit and Loss Account of an enterprise for the year ended 31.12.1980
stood as follows:
Rs. Rs.
By cost of Materials By Sales 13,00,000
consumed 4,00,000 ” Dividend received 10,000
” Manufacturing wages ” Commission accrued 15,000
paid 2,00,000
” Net Loss 25,000
Add outstanding 50,000 2,50,000
” Salaries paid 1,00,000

” Add outstanding 40,000
1,400,000
” Office expenses paid 1,10,000
129
” Selling and distribution

expenses paid 1,50,000
” Depreciation 2,00,000
” Preliminary expenses
written off 25,000
” Goodwill written off 75,000
13,50,000 13,50,000
From the above Profit and Loss Account, it is clear that no cash payment was
made in respect of outstanding wages, salaries, depreciation preliminary expenses
written off and Goodwill written off. Similarly dividend received should not be
regarded as inflow of cash from trading operations because it represses income
derived from an outside source.
The Net flow of cash from trading during the year may be calculated as follows:
Rs. Rs.
Cash received in respect of sales
(all sales assumed to be cash sales) 13,00,000
Less: Trading Chares paid:
Materials 4,00,000
Manufacturing wages 2,00,000
Salaries 1,00,000
Office expenses 1,10,000
Selling and distribution expenses 1,50,000 9,60,000
Inflow of cash from Trading Operations 3,40,000
Alternatively
Rs. Rs.
Net Loss as per P & L a/c (—) 25,000
Add Non-cash charges debited to P & L a/c
Outstanding wages 50,000
Outstanding salaries 40,000
Depreciation
Preliminary expenses written off
2,00,000
25,000
Goodwill written off 75,000 (+) 3,90,000
3,65,000
130
Less: Non-Trading receipts

Dividend
Non-cash income Commission accrued 10,000
15,000 25,000
Cash inflow from Trading Operations 3,40,000
The same result can be obtained by preparing and Adjusted Profit and Loss
Account.
Adjusted P & L a/c
Rs. Rs.
To outstanding wages 50,000 By closing balance (Net loss) 25,000
” Outstanding Salareis 40,000 ” Dividend 10,000
” Depreciaton 2,00,000 ” Commission accured 15,000
” Preliminary expenses ” Cash Trading Profit
written off 25,000 (Balance figure) 3,40,000
Good will written off 75,000
3,90,000 3,90,000
Problem 3
Statements of Financial possition of Mr. X are given below.
1.1.1980 31.12.1980 1.1.1980 31.12.1980

Rs. Rs. Rs. Rs.
Account payable 29,000 Cash 40,000 30,000
Capital 7,39,000 25,000 Debtors 20,000 17,000
6,15,000 Stock 8,000 13,000
Building 1,00,000 80,000
Other Fixed
Assets 6,00,000 5,00,000
7,68,000 6,40,000 7,68,000 6,40,000
Additional Information:
There were no drawings
2. There were no purchase or sale of either building or other fixed assets.
Prepare a statement of cash. Flow
131
Solution
Statement of Cash Flow
(For the year ended 31.12.1980
Rs. Rs.
Cash balance on 1.1.1980 40,000 1. Addition to stock 5,000
Add cash in flows 2. Decrease in Accounts
1. Decrease in Debtors 3,000 Payable 4,000
3. Funds lost in trading
Operations 4,000
43,000 43,000
Workings
1. Net Loss for the year 1980
Rs.
Capital at end 6,15,000
Capital at beginning 7,39,000
1,24,000
3. Funds (cash) lost in operation/trading
Rs.
Net Loss for 1980 1,24,000
Less: Non-cash charges
Depreciation on Building
(Rs.1,00,000—80,000) 20,000
Depreciation on other Fixed Assets
(Rs.6,00,000—5,000) 1,50,000 1,20,000
4,000
QUESTIONS
1. Explain the meaning of a cash flow statement. Discuss its utility and
significance
2. How cash flow statement differs from funds flow statement
3.
What are the limitations of cash flow statement?
4. What purpose does the cash flow statement serve
5. Balance sheets of Harsha Ltd, as on 1.1.01 to 31.12.01 were as follows
132
1.1.01 31.12.01 1.1.01 31.12.01

Bills Payable 10,000 5,000 Cash 30,000 22,000
Creditors 1,40,000 1,44,000 Debtors 30,000 80,000
Bank loan 65,000 50,000 Stock 45,000 35,000
Capital 1,25,000 1,53,000 Machinery 80,000 65,000
Land 90,000 80,000
Buildings 65,000 70,000
3,40,000 3,52,000 3,40,000 3,52,000
During the year, a machine costing Rs.12,000 accumulated depn. Rs.4000)
was sold for Rs.7000. Balance of Prov for depn against machinery as 1.1.01
was 35000 & 31.1.201 Rs.50000. NP for the year 01 amount Rs.55000. You
are required to prepare cash flow statement.
6. The foll are the summarised balance sheets of a company as on 31.12.01 & 02.
1.1.01 31.12.01 1.1.01 31.12.01

Sh. Capital 70,000 74,000 Bank Bal. 9,000 7,800
Bonds 12,000 6,000 A/c receivable 14,900 17,700
Accounts 10,360 11,840 Inventories 49,200 42,700
Payable 700 800 Land 20,000 30,000
Prov. For D/D 10,040 10,560 G/w 10,000 5,000
Reserve &
surplus
1,03,100 1,03,200 1,03,100 1,03,200
Additional information:
a. Dividends amounting to Rs.35000 were paid during the year 2001
b. Land was purchased for Rs.10000
c. Rs.5000 were written off on Goodwill during the year
d. Bonds of Rs.6000 were paid during the course of the year.
You are required to prepare cash flow statement.

133
LESSON - 9
CASH FLOW STATEMENTS
(CONTINUED)
OBJECTIVES
 Familiarize with the principles of cash flow statement
 Find cash from operations
 Prepare cash flow statement
STRUCTURE
Illustrations
Problem 1
Balance Sheets of M/s Black and White as on 1.1.1980 and 31.1.2.1982 were
as follows
Balance Sheet
1.1.82 31.12.82 1.1.82 31.12.82

Liabilities Assets
Rs. Rs. Rs. Rs.
Creditors 40,000 44,000 Cash 10,000 7,000
Mrs. White’s Loan 25,000 – Debtors 30,000 50,000
Loan from Stock 35,000 25,000
P.N. Bank 40,000 50,000 Machinery 80,000 55,000
Capital 1,25,000 1,53,000 Land 40,000 50,000
Buildings 35,000 68,000
2,30,000 2,47,000 2,30,000 2,47,000
During the year a machine costing Rs.10,000 (Accumulated depreciation
Rs.3000) was sold for Rs.5,000. The provision for depreciation against machinery
as on 1.1.1982 was Rs.25,000 and on 31.1.21982, Rs.40,000. Net profit for the
year 1982 amounted to Rs.45,000. you are required to prepare 1. Cash Flow
Statement 2. Fund (working capital) Flow statement.
134
Solution 1
Cash Flow Statement
(For the year ended 31.11.1982)
Rs. Rs.
Cash Balance on 1.1.1982 10,000
Add cash inflows Cash Outflows
1. Decrease in stock 18,000 1. Increase in Debtors 20,000
2. Sale of machinery 5,000 2. Purchase of land 10,000
3. Increase in creditors 4,000 3. Purchase of Building 25,000
4. Loan from P.N. Bank 10,000 4. Mrs. White’s loan repaid 25,000
5. Drawings 17,000
5. Operating Profit 65,000
97,000
Cash Balance on 31.12.1982 7,000
10,04,000 1,04,000
Workings
Capital A/c
Rs. Rs.
To Closing Balance 1,53,000 By Opening balance 1,25,000
” Cash (Drawings Balance ” Net Profit 45,000
figure 17,000
1,70,000 1,70,000
Alternatively
Rs.
Capital in the beginning 1,25,000
Add Net Profit 45,000
1,70,000
Less capital at end 1,53,000
Drawings 17,000
ANNAMALAI UNIVERSITYProvision for Depreciation A/c
Rs. Rs.
To Machinery A/c 3,000 By Opening balance 25,000
” Closing balance 40,000 ” P & L a/c (Depreciation for
1982 Balancing figure) 18,000
43,000 43,000
135
Alternatively
Machinery at cost on 1.1.1982 (80,000 + 25,000) 1,05,000
Less cost of Machine sold Rs.
Cash 5,000
Accumulated depreciation 3,000
Loss on sale 2,000 10,000
Machinery at cost on 31.12.82 (55,000 + 40,000) 95,000

CASH INFLOW OPERATISNG PROFITS
Rs.
Nonprofit 45,000
AddNet-funds terms already debited to P & L A/c
Loss on sale of machine 2,000
Provision for depreciation 18,000 20,000
65,000
Solution 2
Schedule of Changes in working capital
Current Assets
1.1.1982 31.12.1982 Increase Decrease
Rs. Rs. Rs. Rs.
Cash 10,000 7,000 - 3,000
Debtors 30,000 50,000 2,000 -
Stock 35,000 35,000 - 10,000
75,000 82,000
Current Liabilities
Rs. Rs. Rs. Rs.
Creditors 40,000 44,000 4,000 -
40,000 44,000
Working capital
Increase in
35,000 38,000 3,000
working capital 3,000

38,000 38,000 20,000 20,000
136

Sources Rs. Application Rs.

1. Sale of Machine 5,000 1. Purchase of land 10,000
2. Loan from P.N. ;Bank 10,000 2. Purchase of Building 25,000
3. Funds from Operations 65,000 3. Repayment of Mrs. White’s
Loan 25,000
4. Drawing by partners 17,000
77,000
80,000 80,000
Problem 2
A Ltd. has submitted the following condensed Balance Sheets (as on
31.12.1979 and 31.12.1980) add the Statement of Income and Reconciliation of
Retained Earnings for the year ended 31.12.1980.
Balance Sheets
31.12.1979 31.12.1980 31.12.1979 31.12.1980

Rs. Rs. Rs. Rs.
Share capital 5,00,000 6,00,000 Fixed Assets 12,00,000 13,50,000

General Reserve 1,00,000 1,30,000 Less Accumulated
Retained Earnings 70,000 90,000 Repetition 4,00,0000 4,50,000
6% Debentures 4,00,000 8,00,000 9,00,000

Loan against 3,00,000
Stock 2,50,000 3,50,000
Mortgage of Book Debts. 2,00,000 1,70,000
Building — 50,000
Cash in Hand &
Creditors for goods 2,18,000 1,44,000 Bank 1,00,000 30,000
Wages outstanding 4,000 600 Prepaid expenses 2,000 5,000
Provision for Preliminary
Income-Tax 80,000 1,50,000 expenses 20,000 15,000
13,72,000 14,70,000 13,72,000 14,70,000
137
Statement of Income and Reconciliation of Retained Earnings. (For the year

ended 31.1.21980)
Rs. Rs.
Sales 20,00,000
Less: Cost of goods sold stock on 31.12.1979 2,50,000
Add: Purchases 15,00,000
17,50,000
Less: Stock on 31.12.1980 3,00,000 14,50,000
5,50,000
Less: Wages 48,000
Gross Income 5,02,000
Less: Sundry expenses 1,47,000
Preliminary expenses written off 5,000
Depreciation 50,000 2,02,000
Net Income 3,00,000
Less: Provision for Income tax 1,50,000
Less: Transfer to General reserve 30,000 1,50,000
Dividend Paid 1,00,000 1,30,000
Net Income for the year retained 20,000
Add: Retained Earnings on 31.12.1980 70,000
90,000
During 1980, the company purchased a building for Rs.1,50,000 out of which
Rs.1,00,000 were paid in cash and for the rest the building was mortgaged to the
seller. You are required to prepare.
1. Cash Flow Statement and
2. Fund (working capital) Statement
138
Solution
Cash Flow Statement
Rs. Rs.
Cash at Bank on 1.1.80 1,00,000 Out flow of cash
Add Cash in flows 1. Redemption of
1. Issue of share 1,00,000 Debentures 1,00,000
2. Decrease in Creditors 74,000
2. Increase in Debtors 30,000
3. Payment of Income tax 80,000
3. Operating profit 3,63,000
4. Purchase of Building 1,00,000
5. Addition of Stock 1,00,000
6. Payment of Dividend 1,00,000
7. Wages outstanding on
31.12.1979 paid 4,000
8. Sundry Expenses paid
on Advance 5,000
5,63,000
Cash at Bank on
31.12.1980 30,000
5,93,000 5,93,000
Workings
1. Fixed Assets A/c
Rs. Rs.
To Opening balance at By Closing balance at cost 13,50,000
cost 12,00,000
” Cash 1,00,000
” Mortgage Loan 50,000
13,50,000 13,50,000
Alternatively
Balance of Fixed Assets at cost on 31.12.1980
Rs.
13,50,000
Less Balance of Fixed Assets at cost on 31.12.1979 12,00,000
Fixed Assets bouth during 1980 1,50,000
Less: Financed by Mortgage Loan 50,000
Bought for cash 1,00,000
139
2. Wages Outstanding A/c
Rs. Rs.
To cash (assumed) 4,000 By Opening balance 4,000
” Closing balance 6,000 ” Adj. P/L. (non-cash item
debited to P/L a/c) 6,000
10,000 10,000
Alternatively
Rs.
Wages as per Income Statement 48,000
Add: Outstanding Wages on 31.12.1980 4,000
52,000
Less: Outstanding wages on 31.12.1980 6,000
Wages paid in cash during 1980 46,000
Less: paid for 1979 4,000
Wages paid in cash during 1979 for 1980 42,000
Wages debited in income statement 48,000
Non-cash wages to be added back 6,000
3. Prepaid Expenses A/c
Rs. Rs.
To Opening balance 2,000 By Closing balance 5,000
” Cash (Balance figure)O 5,000 ” Adjr. P/L (debited in P/L
a/c but not paid during 1980 2,000
7,0000 7,000
Alternatively
Rs.
Sundry Expenses as per Income statement 1,47,000
Add: Prepaid Expenses on 31.12.1980 5,000
1,52,000
Less: Prepaid Expenses on 31.12.1979 2,000
Expenses paid in cash during 1980 1,50,000
Less: Prepaid on 31.12.1980 5,000
Expenses paid in cash during 1979 for 1980 1,45,000
Expenses depited in Income statement 1,47,000
Non Cash Expenses to be added back 2,000
140
4. Provision for Income Tax A/c
Rs. Rs.
To cash (Balancing figure 80,000 By Opening Balancing 80,000
” Closing balance 1,50,000 ” Adj. P/L 1,50,000
2,30,000 2,30,000
Alternatively
Rs.
Provision for Income on 31.12.1979 80,000
Add Transfer from P/L during the year 1980 1,50,000
2,30,000
Less: Balance on 31.12.1980 1,50,000
Income-tax paid during the year 80,000
5. Cash Inflow from Operating Trading Profit
Adjusted P/L A/c
Rs. Rs.
To Depreciation provision By Opening balance 70,000
(Rs.450,000—4,00,000) 50,000 Operating / Trading Profit 36,000
” Preliminary Expenses (Balancing figure
written/off (Rs.20,000—
15,000) 5,000
” Wages outstanding
(non-cash item) 6,000
” General Reserve
(Rs.1,30,000—1,00,000) 30,000
” Provision for income tax 1,50,000
” Dividend paid 1,00,000
” Sundry Expenses
Prepaid (non-cash-item) 2,000
ANNAMALAI UNIVERSITY 4,33,000 4,33,000
141
Solution (2)
Statement of Changes in Working Capital

Rs. Rs. Rs. Rs.
Current Assets
Cash at Bank 1,00,000 30,000 70,000
Stock 2,50,000 3,50,000 1,00,000
Book Debts 2,00,000 1,70,000 30,000
Prepaid Expenses 2,000 5,000 3,000
5,52,000 5,55,000
Current Liabilities
Creditors 2,18,000 1,44,000 74,000
Provision for Income tax 80,000 1,50,000 70,000
Outstanding wages 4,000 6,000 2,000
3,02,000 3,00,000
Working capital 2,50,000 2,55,000
5000
2,55,000 2,55,000 1,77,000 1,77,000
Funds Flow Analysis
(for the year ended 31 s t December 1980)
Source Rs. Applications Rs.

1. Issue of shares 1,00,000 1. Purchase of Fixed Assets 1,00,000
2. Funds from operating 2,05,000 [Rs.13,50,000—
Profit (12,00,0o00+50,000)]
2. Redemption of Debentures 1,00,000
3. Dividend paid 1,00,000
3,00,000
ANNAMALAI UNIVERSITY 3,50,000

3,50,000
142
Working
Adjusted P/L A/c
Rs. Rs.
To Provision for By opening Balance 70,000
depreciation 50,000 ” Funds from operating
” Preliminary expenses 5,000 profit (Balancing figure) 2,05,000
written off 30,000
” General Reserve 1,00,000
” Dividend Paid 90,000
” Closing Balance
27,50,000 2,75,000
Alternatively
Rs.
Net income for the year (less provision for Income tax because the
same has been treated as a current liability (Rs.3,00,000—
1,50,000) 1,50,000
Add Non-funds items
Provision for Depreciation 50,000
Preliminary expenses written off 5,000 55,000
Funds from Operating / Trading Profit 2,05,000
Problem 3
A Company finds on 1st January, 1980 that it is short of funds with which to
implement its programme of expansion. On 1st January 1979 it had a credit
balance of Rs.1,80,000. From the following information prepare a statement for the
Board of Directors to show how the overdraft of Rs.68,750 as at 31st December
1979 has arisen.
Figure as per Balance Sheet

(As at 31 s t December)
1978 1979
Fixed Assets
Rs.
7,50,000
Rs.
11,20,000
Stock and stores 1,90,000 3,30,000
Debtors 3,80,000 3,35.000
Bank Balance 1,80,000 (Cr) 68,750 (O.D)
Trade Creditors 2,70,000 3,50,000
143
Share Capital (in shares of Rs.10 each) 2,25,000 3,00,000

Bills Receivable 87,500 95,000
The profit for the year ended 31st December, 1979 before charging.
Depreciation amounted to Rs.2,40,000
5,000 shares were issued on 1st January 1979 at a premium of Rs.5 per share,
Rs.1,37,500 were paid in March 1979 byway of income tax. Dividend was paid as
follows:
1978 (final on the capital on 3.12.1978 at 10 per cent less tax at 25 per cent)
1979 (interim) 5 per cent free of tax.
Solution
Cash Flow Statement
Rs. Rs.
Bank Balance on 1.1.1979 1,80,000
Cash Outflows Cash Inflows
1. Issue of shares 50,000 1. Purchase of Fixed Assets 3,70,000
2. Share Premium 25,000 2. Increase in Stock and
3. Decrease in Debtors 45,000 Stores 1,40,000
4. Increase in Creditors 80,000 3. Income tax paid 1,37,500
5. Operating Profit 2,40,000 4. Increase in Bills
Receivable 7,500
5. Final Dividend for 1978 18,750
6. Interim Dividend for 1979 15,000
6,88,750 6,88,750
Workings
2,50,000  10
1. Final Dividend works out to Rs. = Rs.25,000. Since Income-tax
100
is to be deducted at source @ 25% the net payment is Rs.25,000 — 6,250 =
Rs.18,750.
2. Interim Dividend has been calculated @ 5% on Rs.3,00,000.
Interim Dividend is free of tax and hence nothing is deductible from Rs.15,000
15,000  25
on account of income-tax. In addition, Rs.5,000 ie. is payable to
75
the government on account of income-tax.
4. It is assumed that the figure of income-tax paid ie., Rs.1,37,500 includes
11,250 (Rs.6,250 +Rs.5,000) in respect of final and interim dividend.
144
5. It is assumed that fixed assets are appearing at cost.

6. It is obvious that the profit for the year 1979 Rs.2,40,00 is before charging
Final and Interim Dividend.
Problem 4
The Balance sheet of jai Limited as on December 31, 1979 was as follows.

Share Capital Land and Buildings 1,50,000
7% Redeemable Preference Plant and Machinery 3,00,000
share Capital: 1,000 shares Patents 60,000
of Rs.100 each Rs.90 per
Trade Investments 1,90,000
share called and paid 90,000
Stock-in-Trade 86,000
Equity share capital in fully
Book debts 1,00,000
paid shares of Rs.10 each) 3,00,000
Less: Provision 5,000 95,000
Capital Redemption
Reserve 50,000 Cash and Bank 65,000
General Reserve 2,50,000 Advance income-tax paid for
1971 84,000
6% Debentures (secured by
a floating charge) 1,00,000 Preliminary expenses 10,000
Creditors 60,000
Outstanding Expenses 59,000
Provision for income-tax 1,10,000
Proposed Equity Dividend 1,30,000
10,40,000 10,40,000
The following is the condensed projected P &L A/c of company for the year
2972.
Rs. Rs.
To Opening Stock 86,000 By Sales 13,50,000
” Purchases 8,40,000 ” Closing Stock 80,000
” Wages 1,20,000 ” Income from Trade
” Salaries 96,000 Investment 10,500
” Other Expenses 24,000 ” Saving in provision for
Income-tax for 1971 10,000
” Debenture interested paid 6,000
” Profit on sales of
” Provision for Depreciation 55,000
Machinery 5,000
” Provision for Income tax 1,00,000
” Pref. Dividend paid 6,300
145
” Proposed Equity Dividend 33,000

” Provision for Doubtful
Debts 1,000
” Preliminary Expenses
Written off 5,000
” Patents written off 20,000
” Balance of profit 63,200
14,55,500 14,55,500
Additional Information given
(i) (a) Provision for Depreciation as on 31.12.1971 Plant & Machinery Rs.1,00,000;
land & Buildings Rs.15,000.
(b) Depreciation for 1972 Plant & Machinery Rs.51,250: Land & Buildings
Rs.3,750.
(ii) New Machinery costing Rs.80,000 will be bought towards the end of 1972 a
Machinery costing Rs.18,000 (accumulated depreciation upto 31.12.1971 being
Rs.12,000) will be sold in the beginning of 1972.
iii. At the end of 1972, Redeemable Preference Shares are to be redeemed out of
profits.
iv. The company allows 1# months credit to its customers and receives 2 months
credit from its suppliers. Wages, Salaries & other expenses are paid one month
in arrears.
v. Proposed Equity Dividend for 1971 will remain unclaimed to the extend of
Rs.3,000 by 31.12.1972.
iv. Amount of Income-tax paid in advance during 1982 is likely to be Rs.90,000.
Prepare
1. B/S of the company as it is likely to be on 31.12.1972.
2. Cash Flow Statement
4. Fund (working capital) Flow Statement.
146
Solution 1
Balance Sheet
(As on 31st December 1972)

Share Capital Fixed Assets Land &
30,000 Equity shares of Building at cost 1,65,000
Rs.10 each fully paid 3,00,000 Less Depreciation
Reserves and Surplus upto 31.2.1971 15,000
Capital Redemption 1,50,000
Reserve 1,50,000 Loss Depreciation
General Reserve 1,50,000 for 1972 3,750 1,46,250
Profit & Loss A/c 63,200 Plant & Machinery
at cost 4,00,000
Secured Loans
Add: New Machine
6% Debentures (secured
bought 80,000
by a floating charges on
the undertakings of the 4,80,000
company) 1,00,000 Less cost of
Current Liabilities machinery sold 18,000
Creditors 1,40,000 4,62,000
Outstanding Expenses 2,000 Less Depreciation
up to 31.12.1971 88,000
Outstanding Wages 10,000
3,74,000
Outstanding Salaries 8,000
Less: Depreciation
Unclaimed Divided for
for 1972 51,250 3,22,750
1971 2,000
Provision
Patents 60,000
Proposed Equity Dividend 33,000
Less Write off 20,000 40,000
Provision for Income-tax 1,00,000
Investment:
Trade investments 1,90,000
Current Assets:
ANNAMALAI UNIVERSITY Loans and Advance

Stock
80,000
Book Debts 1,68,750

Less Provision 6,000 1,62,750
Cast at Bank 21,450
147
Advance payment of Income

tax Misc. Expenditure &
Losses 90,000
Preliminary Exp. 10,000
Less Written of 5,000 5,000
10,58,2000 10,58,200
Working
8,40,000  2
1. Creditors = Rs. = Rs. 1,40,000
12
24,000
2. Outstanding Expenses = Rs. = Rs. 2,000
12
1,20,000
3. Outstanding wages = Rs. = Rs. 10,000
12
96,000
4. Outstanding Salaries = Rs. = Rs. 8,000
12
Note: Cash & Balance Rs. 21,450 is as per Cash Flow Statement
Solution 2
Cash Flow Statement
(For the year ended 31 st Dec. 1972)
Rs. Rs.
Opening balance of cash 65,5000 Cash Outflows:
and Bank 1. Redemption of Pref.
Add Cash Inflow from Shares 1,00,000
1. Sale of Machine 11,000 2. Outstanding exposes on
2. Income from 31.12.71 paid 50,000
Investments 10,5000 3. Income-tax for 1971
3. Operations Rs.10,000—
2,78,000
(10,000+84,000) 16,000
4. Final call on Redeemable
Pref. Shareholders 4. Income-tax for 1972 90,000
10,000
5. Decrease in stock 6,000 5. Proposed Equity Dividend
6,000
6. Increase in creditors
80,000
for 1971 paid
6. Purchase of Machinery
28,000
80,000
3,95,500
7. Increase in Debtors 68,750
8. Pref. Dividend Paid 7,300
148
4,39,050
Closing balance of Cash
Bank (Balancing figure) 21,450
4,60,500 4,60,000
Workings
Rs.
Cash from operations
Net profit for the year (given) 63,200
Add: Non Cash and/or Non-Trading charges already
debited to P/L Ac/
Wages outstanding 10,000
Salaries outstanding 8,000
Expenses outstanding 2,000
Depreciation 55,000
Provision for Income-tax 1,00,000
Proposed Equity Dividend for 1972 33,000
Provision for doubtful Debts 1,000
Preliminary Expenses Written off 5,000
Patents Written off 20,000
Pref. Dividend paid 7,300 2,40,300
3,03,500
Less: Non-cash and / or trading incomes already
credited to P/L Ac/
Income from Trade Investment 10,5000
Saving in provision for Income-tax for 1971 10,000
Profit on Sale of machinery 5,000 25,500
Cash from operations 2,78,.000
Note: It has been assumed that final call of rS.10 per share would be made prior
to redemption of redeemable preference shares as otherwise they cannot be
redeemed in accordance with the provisions of the Companies Act.
149
Solution
Statement of changes in working Capital

Rs. Rs. Rs. Rs.
CURRENT ASSETS
Stock 86,000 80,000 6,000
Debtors 95,000 1,62,750 67,750
Cash and bank 65,000 21,450 43,350
Advance Payment of Income tax 84,000 90,000 6,000
3,30,000 3,54,200
CURRENT LIABILITIES
Outstanding Expenses 50,000 20,000
Proposed for Income-tax 10,000 1,00,000 30,000
Proposed Equity Dividend 30,000 33,000 10,000
Unclaimed Equity Dividend - 2,000 3,000
Creditors 60,000 1,40,000 2,000
2,50,000 2,95,000 80,000
Working capital 80,000 59,200
Decrease in working Capital 29,800
20,800
80,000 80,000 1,34,550 1,34,550
(For the year ended 31 s t December 1972)
Source Rs. Applications Rs.

1. Final call on Redeemable 1. Purchase of Machinery 80,000
Pref. Shareholders 10,000 2. Redemption of Machinery
2. Sale of Machine 11,000 shares 1,00,000
3. Income from Trade 3. Pref. Dividend paid 6,300
Investments 10,500
4. From Operations 1,34,000
1,65,500
Decrease in working capital 20,800
1,86,300 1,86,300
150
Workings
Adjusted Profit and Loss A/c
Rs. Rs.
To Depreciation 55,000 By Opening balance Nill
” Preliminary Expenses 5,000 ” Income from Investment 10,000
”Patterns written off 20,000 ” Profit on sale of Machine 5,000
” Pref. Dividend paid 6,300 ” Funds from operations
” Closing balance 63,200 (Balancing figures) 1,34000
1,49,500 1,49,500
Rs.
Cost of machine sold (given) 18,000
Less: Accumulated dep. (-) 12,000
Written-down value 6,000
Add Profit on sale (given) 5,000
11,000
Note: It has been assumed that final call of Rs. 10 per share would be made prior to
redemption of redeemable preference shares as otherwise they cannot be
redeemed in accordance with the provisions of the Compaines Act.
QUESTIONS
1. What are the internal sources of cash flow statement?
2. Difference between cash flow statement and Fund flow statement
3. Explain the procedures for the preparation of cash flow statement
4. What are the uses of cash flow statement?
5. From the following prepare cash flow statement for the year ended 31.1.202
1.1.02 31.12.02 1.1.02 31.12.02

A/c payable 29,000 25,000 Cash 4,000 30,000
Capital
7,39,000 6,15,000 Debtors
Stock
2,000
8,000
17,000
13,000
Building 1,00,000 80,000
Other fixed assets 6,00,000 50,000
7,68,000 6,40,000 7,68,000 6,40,000
151
Addn Information
i. There were no drawings
ii. There were no purchase or sale of either building or other fixed assets.
6. From the foll B/S as on 31.12.02 & 31.12.03 you are required to prepare cash
flow statement.
Share Cap. 1,00,000 1,50,000 Fixed assets 1,00,000 1,50,000

P & L a/c 50,000 80,000 Goodwill 50,000 40,000
General Reserve 30,000 40,000 Inventories 50,000 80,000
12% Bonds 50,000 60,000 Debtors 50,000 80,000
Sundry as. 30,000 40,000 Bills receivable 10,000 20,000
O/s Exps. 10,000 15,000 Bank 10,000 15,000
2,70,000 3,85,000 2,70,000 3,85,000

152
LESSON - 10
FORECASTING OF FUND REQUIREMENTS
OBJECTIVES
 understand the concept of working capital
 trace the determinants of working capital
 explain the causes for changes in working capital
 assess the sources of working capital evaluate the forecasting technique of
working capital
STRUCTURE
10.1. Introduction
10.2. Definition
10.3. Determinants of working capital
10.4. Sources of working capital
10.5. Working capital budget
10.6. Forecasting techniques of working capital
10.1. WORKING CAPTAL

In addition to the amount of fixed capital, every business requires working
capital. In other works: working capital is that portion of a business concern’s total
capital which is employed in short term operation. Fixed capital would be idle and
ineffectual without working capital.
10.2. DEFINITION
Working capital represents the excess of Current assets Over Current
Liabilities, ie., Working capital = current Assets current liabilities.
In flow Cash Gutflow
Sale of P urchase
finished goods Raw materials
Workin g
ANNAMALAI UNIVERSITY Capital
Cycle
Finished
Wages
goods Stock
Ex pen ses
153
From the above figure the basic flow of working capital can understood Cash is
converted into raw-materials, which are out into production process. Wages are
paid to workers. Expenses are incurred for continuous production Finished goods
are sold both for cash and credit. Business will have debtors as a result of credit
sales and creditors as a result of credit purchases. Cash is received from debtors
and cash is paid to creditors. The process goes on like this. Thus, the working
capital is repeatedly invested, recovered and reinvested as long as the business is
goind on. This can be compared to river which is there from day to day, but the
water in the river constantly changing. hence, working capital is described as
circulating capital or Revoling capital.
The cycle in a manufacturing concern, will run as follows:
Cash  Materials  Wages  Expenses  Finished  good  Sales Debtors 
Cash
The cycle, in a purely retailing concern is shortened like this
Cash  Merchandise  Sales Debtors  Cash
In a purely financing concern, the cycle is further shortened as follows:

Cash  Debtors  Cash
It is clear that amount of working capital required and if level at any particular
time will be governed directly by the speed with which this case cycle can be
sustained. The faster the cycle, the less the investment in working capital needs to
be.
10.3. DETERMINANTS OF WORKING CAPITAL

The important factors which influence the amount of working capital of a
concern are 1. Nature of Business 2. Supply of Raw-materials 3. Span of
Manufacture 4. Stock and Debtors Turnover 5. Terms of purchases and sales. 6.
Clearanse of commitments and payments of bills as and when they arise. 7. Levels
of capacity utilistion 8. Seasonal and cyclicar fluctuation 9. Cash inflow
(depreciation and retained earnings) 10. Factors affecting the size of current assets
or current liabilities.
Importance of Adequate working capital

Maintaining an ample working capital fund in a concern 1. enhances the
technial and commercial solvency and credit worthiness of concern 2. makes it
possible to avail cash discount facilities offered to it be the suppliers 3. improves
morale of the executive and their efficiency and 4. enables to maintain a sound
bank and trade relations.
154
10.4. SOURCES OF WORKING CAPITAL

The following are the sources of working capital
W orki ng Cap i tal
Lon g T erm Medium an d Sh ort

Sources T erm Sources
1. Sale of Shares
2. Sale of Deben tures In tern al Extern al
3. Retain ed Earnings
1. Depreciation 1. T rade credit
4. Sale of Idle Fix ed Assets
2. Rserves and 2. Bank credit
P rovision s 3. P ublic deposit
4. Customer's Advan ce
5. Factoring
Causes for changes in Working Capital
The following are the main causes for charges in the working of a concern:
1. Increase in current assets, resulting in increase in working capital.
2. Increasing current liabilities with the effect of decrease in working capital.
3. Decrease in Current assets, resulting in decrease in working capital.
4. Decrease in current liabilities resulting in increase in working capital.
10.5. WORKING CAPITAL BUDGET

This is important aspect of over all financial budgeting it forecasts is the future
requirements of working capital and the formulation of plans for meeting them.
This budget determines the behavior of working capital with the volume of sales or
cost of sales.
There are three methods available for forecasting working capital requirement;
1. Cash Forecasting Method 2. Balance Sheet and 3. Profit and Loss Adjustment
Method. The cash forecasting method indicates the position of cash at the end of
period after considering the receipts and payments to be made during that period.
A forecast recast is made of the various assets and liabilities in the Balance Sheet
method of Forecasting. Then the difference between the two is taken as either cash
surplus or cash deficiency as the case may be Under the Profit and Loss Method,
the forecasted Profits and adjusted after adding the cash flows and deducting the
cash outflows.
155
10.6. FORECASTING TECHNIQUE OF WORKING CAPITAL

An important problem that is generally faced by a business is the
determination of the amount of working capital required to finance a particular
level of business operations.
The technique of working capital forecasts involves careful study of every
aspect of activity as well as contingencies. The following items are generally
considered while preparing an estimate of working capital requirements.
1. Costs to be incurred on materials, wages and over heads obtained from cost
records.
2. Length of time during which raw materials to remain in stock before they are
issued for productive purposes. The longer the period of time, more would be
the working capital requirements.
3. Length of the production cycle so that, longer the length of the cycle, larger will
be the working capital requirements.
4. Length of sale cycle denoting the period of time finished products have to stay
in godown before sale. This factor is closely related to the problem of
seasonally and the working capital requirements are bound to be large during
slack season and would necessitate special steps to meet such requirements.
5. Period of credit availed of from creditors. This is bound to reduce working
capital requirements.
7. Time-lag involved in the payment of wages and overhead expenses,
8. Extent of percentage by way of provision for contingencies and this would be
added to the amount calculated by taking the above factors into consideration.
PROBLEM 1
Mr. Murugan industries Ltd., are engaged in large scale customs retailing.
From the following information, you are required to forecast their working capital
requirements,
Projected annual sales Rs.32,00,000
Percentage of Net profit on cost of sales 15%
Average credit allowed to Debtors 10 weeks.
Average credit allowed by creditors 4 weeks.
Average stock carrying
(in terms of sales requirements) 8 weeks
Add 10% to computed figures to allow for contingencies.
156
SOLUTION
Projected Annual Sales Rs.32,50,000 p.a.
Net Profit (20% on sales) Rs.6,50,000 p.a.
Cost of Sales (32,50,000 — 6,50,000) Rs.26,00,000 p.a.
Cost of Sales per week Rs.50,000 p.a.
26,00,000
Rs. = 50,000
52
Statement of Working Capital Requirement

Rs.
CURRENT ASSETS
Stock (Rs. 50,000 × 8) 4,00,000
DEBTORS
At cost equivalent (Rs. 50,000 × 10) 5,00,000
Profit
6,50,000  10 1,25,000 6,25,000
52
10,25,000
Less: CURRENT LIABILITIES:
Creditors (Rs. 50,000 × 4) 2,00,000
Working capital computed 8,25,000
Add. 10% for contingencies 82,500
Net Working Capital Required 9,07,500
PROBLEM
From the following information prepare a statement showing 1. the estimated
working capital requirements 2. as regards cash of the constituent part of working
capital.
Budgeted sales Rs.2,60,000 per annum. Analysis of cost of each unit.
Rs.
Raw Material 3
Labour 4
Overheads 2
Profit 1
Selling price 10
It is Estimated That
1. Pending use, raw materials are carried in stock for three weeks and finished
goods for two weeks.
157
2. Factory processing will take three weeks.

3. Suppliers will give five weeks credit and customers require eight weeks credit.
It may be assumed that production and overheads accrue evenly throughout
the year.
SOLUTION
Annual sales Rs.2,60,00, weekly sales Rs.5,000 or 500 unit of Rs.10 each.
Rs. Rs.
Raw Materials 3 or 30% 1,500

Labour 3 or 40% 2,000 Per week
Over heads 2 or 20% 1,000 Rs.5000
Profit 1 or 10% 500
10 or 100% 5000
Working Capital Requirement
Rs. Rs.
STOCK
Raw Materials (Rs.1500 × 2 weeks) 3,000
Labour (Rs.2000 × 2 weeks) 4,000
Overheads (Rs.1000 × 2 weeks) 2,000 9,000
WORK IN PROGRESS
Raw Materials (Rs.1500 × 3 weeks) 4,500
Labour (Rs. 200 × 3 weeks) 6,000
Overheads (Rs. 1000 × 3 weeks) 3,000 13,500
RAW-MATERIALS
(Rs. 1500 × 3 weeks) 4500
SUNDRY DEBTORS
Raw Materials (Rs. 1500 × 8) 12,000
Labour (Rs. 2000 × 8) 16,000
Overheads (Rs. 1000 × 8)
Total current assets
8,000 36,000
63,000
Less: credit from suppliers of Materials (Rs. 1500 × 5) 7,5000
Total working capital Required 55,500
158
Problem 3
You are required to prepare for the Board of Directors of Ashok Lever Ltd, a
statement showing the working capital needed to finance a level of activity of
5,2000 units for 188-.
You are given the Following Information

Elements of cost Amount per unit
Rs.
Raw Material 8
Wages 2
Overheads 6
Total cost 16
Profit 4
Selling price 20
1. Raw Materials in stock, on an average one month.
2. Materials in process, on an average, half a month.
3. Finished goods in stock, on an average, six weeks.
4. Credit allowed to Debtors is two months.
5. Credit allowed by Creditors is one month.
6. Lag in payment of wages is 1# weeks.
7. Cash on hand and at Bank is expected to be Rs.7,300
8. Production is carried on evenly during the year and wages and over heads
accrue evenly.
Solution
Working Capital Requirement Forecast
Work in Finished
Items Period Total R.M. progress goods Debtors Creditors
weeks Rs. Rs. Rs. Rs. Rs. Rs.
1.Materials
a. Stock
b. Work in progress
4
2
—
—
3,200
— 1,600
— —
—
—
—
—
—
c. Credit to Debtors 6 — — — 4,800 — —
d. Credit to Debtors 8 — — — — 6,400
20
e. Credit from Creditors 4 — — — — — 3,200
159
Total 16 12,800
2.Wages
a. Work-in-progress 1 — — 200 — — —
b. Finished goods 6 — — — 1,200 — —

c. Credit to Debtors 8 — — — — 1,600 —
15
d. Credit from employees 1½ — — — — 300
Total 13½ 2,700
3.Overheads
a. Work-in-progress 1 — 600 — — —
b. Finished goods 6 — — 3,600 — —
c. Credit to Debtors 8 — — — 4,800 —
Total 15 9,000
4.Profit
Credit to Debtors 8 3,200 — — — —
27,700 3,200 2,400 9,600 16,000 3,500

Total Working capital is arrived as follows
Working capital required (as shown in statement) Rs. 27,700
Cash on hand and at Bank, expected 7,300
39,000
Working Notes
2000  8
a. Material cost is Rs. = Rs.800 per week
20
2000  2
b. Wage cost is Rs. = Rs.200 per week
20
c. Sales are 5,000 units @ Rs.20 per unit = Rs.1,04,000 ie. Rs.2000 per week.
d. Assumed that wages accrue evenly during the time manufacture is in progress.
Process time is two weeks and it is assumed that labour is evenly carried on
during production, so that on an average, the total cost of labour is
e.
outstanding for only half the time.
Lag in payment of wages of 1½ weeks is considered as follows: The employee
earns wages from the beginning of the week and they increase daily until the
end of the week. Thus, on average, the employer owes half the week’s wages.
If this is not paid the following week end, in effect the employee owes 1½ weeks
wages in arrears.
160
f. Realised profit on cash sales for full year and credit sales for 44 weeks have
been taken into consideration.
Problem 4
The following is the Balance Sheet of M/s Gopalakrishnan & Co. on 31st
March 1980.
Rs. Rs.
Capital 10,00,000 Fixed Assets 4,00,000
Creditors (Trade) 1,40,000 Stock 3,00,000
Profit and Loss A/c 60,000 Debtors 1,50,000
Cash and Bank 3,50,000
12,00,000 12,00,000
The Management estimates the purchases and sales for the year ended 31 st
March, 1981 as under.
Upto 28.2.1981 March 1981

Rs. Rs.
Purchase 14,10,000 1,00,000
Sales 19,20,000 2,00,000
It was decided to invest Rs. 1,00,000 in purchases of fixed assets which are
depreciated @ 10% on cost.
The time-lag for payment to trade creditors for purchases and receipts from
sale is one month. The business earns a gross profit of 30% on turnover. The
expenses against gross profit amount to 10% of the turnover. The amount of
depreciation is not included in these expenses.
Draft a Balance sheet as at 31st March, 1981 assuming that creditors are all
trade creditors for purchases and debtors for sales and there is no other item of
current assets and liabilities apart from stock.
Solution
Projected Trading and Profit and Loss Accout for the year ending 31 st March,
1981.
To Opening Stock
Rs.
3,00,000 By Sales
Rs.
21,00,000
” Purchase 15,20,000 ” Closing stock
” Gross Profit C/d (Balancing figure) 3,36,000
(30% on sales) 6,36,000
24,56,000 24,56,000
161
Rs. Rs.
To Sundry Expenses (10% By Gross Profit b/d 6,36,000
on sale) 2,12,000
” Depreciation 50,000
” Net Profit 3,74,000
6,36,000 6,36,000
Projected Balance Sheet of M/s. Gopalakrishnan & Co. (As on 31st March
1981)

Capital 10,000 Fixed Assets 4,00,000
P & L A/c Balance + Addition 1,00,000
on 1.4.1980 60,000 5,00,000
Profit for the — Depreciation 50,000 4,50,000
year 3,74,000 4,34,000
Stock 3,36,000
Sundry creditors 1,10,000
Sundry Debtors 2,00,000
Cash and Bank 5,58,000
15,44,000 15,44,000
Working
Cash and Bank A/c
Rs. Rs.
To Balance on 1.4.80 3,50,000 By Sundry creditors
” Sundry Debtors (Rs.1,40,000 + 14,10,000) 15,50,000
(Rs.1,50,000+19,2000) 20,70,000 ” By Expenses 2,12,000
” Fixed Assets 1,00,000
” Balance on 31.3.81 5,58,000
24,20,000 24,20,000
QUESTION
1.
2.
Explain the need for or objects of working capital
Discuss the advantage of working capital for a manufacturing concern
3. What is meant by working capital and its concepts?
4. Explain the dangers of
a. Excess working capital
b. Inadequate working capital
162
5. 3 Ltd. is engaged in customer retailing you are required to forecast their

working capital requirements from the foll. information
Projected annual sales Rs.650000 % of N.P. to cost of sales 25%
Average credit allowed to drs. to weeks
Average credit allowed to crs. 4 weeks
Average stock carrying 8 weeks
Add 20% to allow for contingencies
6. From the foll details calculate the average requirements working capital of K
ltd.
Average Period of Estimated for first

Credit year (Rs.)
Purchase of Materials 6 month 2600000
Wages 1½ weeks 1950000
Overheads 6 months 100000
Rent, rates etc. 1 month 800000
Salaries 2 month 750000
Other overheads 2 month 200000
Cash sales 6000000
Credit sales 400000
Average amt. Of stock & W.i.p 300000
Average amt. Of undrown profits
Assume that all exps. and income were made at an even rate for the year.
163
ALESSON — 11
BUDGET AND BUDGETARY CONTROL
Objectives
 The objective of this unit are to familiarize you with.
 The basic aspects of financial planning statement, role of budgeting
 Various types of budgets
 Difference between forecast and budgeting
 Some new ideas and developments in the area of budgeting.
STRUCTURE
11.1. Budget and Budgeting
11.2. Definition of budget
11.3 Budgetary control
11.4. Objectives
11.5. Steps in budgetary control
11.6. Organization for budgetary control
11.7. Budget committee
11.8. Preparation of Budget manual
11.9. Classification of Budget
11.10. Forecast and budget
11.1. BUDGET AND BUDGETING

The most important factor in Management Accounting is the formulating of
policy and its successful implementation. For the effective functioning of the
management, it is essential that it should be appraised of the fact that how far the
forecases made by them in the past have been achieved and to what extent their
policies have been implemented and on the basis of which future forecases may be
made. Hence it is absolutely necessary that the management should be supplied
with al the information in the form of statements, reports and charts. No planning
could be made uniess a policy is formulated. Hence a policy comprises the various
objects of the management and the principles followed in the attainment of those
objects. As no budget can be prepared without a policy, it is the keynote of the
budget. Hence, the purpose of budgeting is to assess the extent of success of the
management in their planning and the corrective actions to be taken in case of
variation.
164
11.2. DEFINITION OF BUDGET

1. C.M. Arther of England defines a budget as “a financial and/or quantitative
statement prepared prior to a defined period of time, of the policy to be pursued
during that period for the purpose of attaining a given objective”. According to this
definition, the essential features of budget are:
1. Budget is a projected plan of financial statement or quantitative statement
(without financial figures)
2. It is prepared for a specific future period.
3. It is plan of a policy to be pursed during the budget period.
4. The purpose of the budge is to attain a given object.
5. In short, it is a blue print of the projected plan of action expressed in monetary
and/or physical units for a specific period of time. It is both a plan as a control
tool in the hands of the management.
Budgeting
It refers to formulation of plans for future activity which lays down carefully
determined objective and programmes of activity and provide yard sticks by which
deviations from planned targets can be measured. It is the preparation in advance
of the quantitative as well as financial statements to indicate the intention of the
management in respect of the various aspects of the business. It also refers to the
process of preparing the budget.
11.3. BUDGETARY CONTROL

It refers to the principles, procedures and practices of achieving given
objectives through budgets and budget reports. It has been defined as “the
establishment of departmental budgets relating to the responsibilities of executives
to the requirements of a policy and the continuous comparison of actual with
budgeted results, either to secure by individual action, the objective of their policy
or to provide a basis for its revision”. According to this definition of I.C.W.A.
England, the budgetary control contains the following.
1. Establishment of budgets.
2. Measurement of actual performance.
3. Continuos comparison of actual performance with budgeted performance.
Analysis of the cause of variations and reporting to management for corrective
actions.
5. Revision of budgets in the light of changed circumstances, if necessary.
It is the system of controlling cost which includes the Preparation of budget,
co-ordinating the departments and establishing responsibilities comparing the
actual performance with that budgeted and acting upon the results to achieve the
165
objectives. In short, a budget is a means and budgetary control is the end result.
Budgeting is the art of planning; budgetary control is the art of executing that plan.
11.4. OBJECTIVES
1. To provide a detailed plan of the work to be carried out by a business during a
specified period.
2. To provide a means of assessment of responsibilities for the deviations from the
plan and to take the necessary action by the supply of information.
3. To provide co–ordination of the activities of the business to enable the
management to get the maximum benefit.
4. It serves as a measure of performance.
5. It provides the management with summarised picture of the results to be
achieved from the plan of operations.
Advantages:
The following are the advantages derived from a budget:
1. Co-ordination between the plans, policy and control is established.
2. As every person in the management is connected with the preparation of the
budget, he can very well know that the targets fixed could be reached.
3. Performance like production, expenditure and sales are subject to serve control
measurements.
4. As there is effective control over the cost, there is the possibility in their
reduction as well as elimination of wastage in man power and material.
5. Since there is an effective control over the production, resources can be put to
the proper and fuller use.
6. A budgetary control system indicates where the management policy goes wrong
and why and form the basis for a change or modification in policy.
7. As the personnel will try to achieve the target by co-ordinated efforts there is
bound to be the maximum profits.
8. Since every aspect of the business is thoroughly reviewed, the top management
gains control of the various activities.
9.
The liquid capital is put to better utilisation and the surpluses which are not
inverted can be avoided.
10. It serves as an effective control over stores and stocks.
11. The responsibilities of the executive and personnel for the achievement of a
policy are well defined.
166
12. A well organised budget control system is bound to give maximum utilisation of
recources and the maximum profits of the business can be reaped.
13. This enables constant comparison of the actual output and expenses with the
budgeted figures.
Limitations:
1. Budget is a plan on estimates and chances of erring on estimates are always
there:
2. Changing circumstances may cause hurdles in the way of budgetary control.
3. Lack of co-ordination and participation may be there.
4. Budgetary control is only a tool in hands of the management and does not take
place of the management.
5. The cost of the budgetary control sometimes may outweigh the benefits derived
out of it.
11.5. STEPS IN BUDGETARY CONTROL

1. Establish a plan or target of performance which co-ordinates all the activities of
business.
2. Record the actual performance.
3. Compare the actual performance with the planned target.
4. Calculate the difference or variance and analyse the reasons for them.
5. Act immediately to remedy the situation.
11.6. ORGANIZATION FOR BUDGETARY CONTROL

There should be an effective organisation for successful budgetary control.
Such organisation requires.
1. The creation of budget centre.
2. The introduction of adequate accounting records.
3. The general instruction in technique.
4. The preparation of an organisation chart.
5. The establishment of budge committee.
6.
7.
The preparation of budget manual.
The fixation of budget period.
8. The determination of the key factor.
9. The determination of the level of the activity.
167
11.7. BUDGET COMMITTEE

A budget committee is an advisory committee established to frame a budget
and exercising overall control there out. The committee is composed of the Chief
Executive, Budget Officer and Head of the Department. The main function are:
1. To provide data for planning.
2. To receive and-scrutinise budgets.
3. To define management policies
4. To receive, review and revise budgets
5. To approve budges
6. To analyse variances
7. To take remedial action
Budge Period
A budget period is a period of time for which the budget is prepared and
employed. Budget periods vary between short-term and long-term. The budget
period is usually determined by taking into account the nature of the product and
the need for control, Short-term budget is always costly to prepare and operate.
Long-term budget is always costly to prepare and operate. Long-term budget may
be affected by unforeseen contingencies.
11.8. PREPARATION OF BUDGET MANNUAL

The budgetary system becomes essential to systematize the procedure for the
preparation of various budgets. Generally the practice is to arrange this by means
of a judgement manual which has been described by I.C.W.A. London as “a
document which sets out the responsibilities of persons engaged in the routine or
and the forms, and records required for budgetary control”.
Budget manual is prepared and maintained usually in loose leaf form to
facilitate alterations as and when required. Such a manual would include the
following matters.
1. An outline of the function of various individuals who are responsible for any
portion of the preparation of any budget.
2. A statement of the steps in the preparation of the sales budget including its
3.
submission, review, approval and final adoption.
The various matters connected with the preparation of the production budget
as well as the materials and purchase budgets.
4. The preparation of budgetary function in relation to such matters as labour,
materials and expenses.
5. The preparation of departmental expense budgets.
168
6. The preparation and development of the plant and equipment budget.

7. The formulation and through examination of the financial budget.
8. The preparation of final statements together with the procedures to be followed
in their submission, review and approval.
9. Accounts code in use.
Key Factor
The Key factor is otherwise known as “limiting” or “governing” or “principal
budget” factor. The influence of Key factor is to be first assessed for effective
planning and budgetary control and the same determines the priorities in preparing
the financial budgets.
The following is the detailed list of key factors.
1. SALES: i.e. Market demand, efficiency of salesman and Adverting effect.
2. MATERIALS: i.e. Supply of materials, Restriction, control etc.
3. LABOUR: i.e. Supply and demand.
4. PLANT: i.e. Machine capacity Finance availability powercut etc.
11.9. CLASSIFICATION OF BUDGETS

A Classification according to Time Factor
In terms of time fact, budgets are broadly classified into the following three
types.
1. LONG-TERM BUDGETS: They are concerned with planning the operations of a
firm over a prospective five to ten years, They are usually in the form of
physical quantities.
2. SHORT-TERM BUDGETS: They are usually for a period of one year or two and
are in the form of production plan in monetary term.
3. CURRENT BUDGETS: They cover a period of a month or so and are the short-
term budgets adjusted to current conditions or prevailing circumstances.
B. Functional Classification
According to this classification, budgets correspond and are co-terminus, with
a particular function and are integrated with the master budget of the business.
They are called ‘functional budgets’ whose number depends on the size and nature
of the business. The following are the business. The following are the function
budgets:
1. SALES BUDGET: This is a forecast of total sales classified according to groups
of products, salesman and geographical locations.
2. SELLING AND DISTRIBUTION COST BUDGET: It is concerned with an
estimate of the cost of selling and distribution of goods.
169
3. PRODUCTION BUDGET: It is a forecast based on sales, productive capacity

and requirements of inventories etc.
4. PRODUCTION COST BUDGET: This is related to the cost of production,

including direct material cost. Direct labour cost and expense fixed, variable
and semi-variable.
5. PURCHASES BUDGET: Correlated with sales forecast and production

planning, it deals with purchases required for planned production. Purchases
would include both direct materials and goods.
6. PERSONNEL BUDGET: This has reference to the utilization of man power and
would include labour employed in productive. This would be split up between
direct and indirect labour.
7. RESEARCH BUDGET: It relates to improvement in the quality of the products

of research for new products.
8. MASTER BUDGET: The ultimate integration of separate budgets by the

accountant provides the Master Budget which includes estimate profit and loss
account for the future period and an estimated Balance Sheet at the end
thereof.
9. CAPITAL BUDGET: It is a forecast of outlay on fixed assets as also of the

sources of capital required. The budget period in the case of capital budget
may differ from that of other budgets, as such expenditure is frequently
planned a number of years in advance.
10. OFFICE AND ADMINISTRATION BUDGET: This budget represents cost of all
administrative expense, such as managing director’s salary, staff salaries and
expenses of office management like lighting and clearing.
11. PLANT UTILISATION BUDGET: This is intended to cover the plant and
machinery requirements to the budgeted production during the period.
Schedules will be produced showing the available load in each department
expressed in standard hours or units.
12. CASH BUDGET: It is a sum total of the requirements of cash in respect of
various functions budgets as well as of anticipated cash receipts.
C. Classification According to Flexibility:

1. SALES BUDGET: It is a budget in which targets are rigidly fixed. Such
budgets are usually prepared from on to three months in advance of the fiscal
year to which they are applicable. Thus twelve months or more may elapse
170
before figures forecast for the December budget are used to measure actual
performance. Though a fixed budget can be revised wherever necessity arises,
it smacks of rigidity and artificiality so for as control over and expenses are
concerned. Thus it remains unchanged in spite of change in the volume of
output or level of activity.
2. FLEXIBLE BUDGET: The figures used in this form of cost and expense budget
are made adaptable to any given set of operating conditions in any month of a
fiscal year. The figures range from lowest to the highest probable percentages
of operating activity in relation to standard performance. So a flexible budget
can be used for the entire fiscal year of as long as there is no need of material
changes in the standards. It possesses a distinct advantage over the fixed
budget particularly where it is difficult to forecast sales, costs and expenses
with any great degree of accuracy.
Flexible budget is defined as “A budget which is design of change in
accordance with the level of activity attained”. For this purpose all the items of cost
are classified into fixed and variable cost. It is more elastic, useful and practical.
11.10. FORECAST AND BUDGET

Forecasting lead to budgeting and budgeting leads to budgetary control . A
forecast is not a budget itself. Forecasting refers to a systematic analysis of past
and present circumstances with the aims of drawing conclusions about the future
course of events. It is only a tentative estimate and can be revised as soon as more
recent data are available. But a budget remains unchanged for the whole of the
budget period, except for change in the level of activity when budget allowances are
called for. A budget is always used for evaluating efficiency of performance while a
forecast is not used for this purpose. A budget is a planned result that an
enterprise aims to attain while a forecast is a prediction of what will, happen under
given set of circumstances. Lastly budgetary control aims at control of costs
through comparison while forecast do not have any such aims of procedures.
QUESTIONS
1. What is budgetary control? State the main object of budgetary control.
2. Explain how Flexible budgeting is considered to be superior to fixed budgeting
3. Explain the role of budgeting in financial control.
4.
5.
What are the various types of budget Explain it.
Prepare a production budget for three months ending Mar 31, 02 for a factory
producing four products, on the basis of the following information.
171
Estimated stock on Estimated sales Desired closing

Type of Product Jan.1 2002 Jan—Mar. 02 stock Mar.31, 2002
units units units
A 2000 10000 5000
B 3000 15000 4000
C 4000 13000 3000
D 5000 12000 2000
M Ltd plans to sell 11000 units of a certain product line in the first fiscal
quarter, 120000 units of a certain product line in the first fiscal quarter, 120000
units in the second quarter, 130000 units in the third quarter and 150000 units in
the fourth quarter and 140000 units in the first quarter of the following year. At
the beginning of the first quarter of the current year, there are 14000 units of
product in stock. At the end of each quarter, the company plans to have on
inventory equal to one-fifth of the sales for the next fiscal quarter.
How many units must be man unfactured in each quarter of the current year?

172
LESSON – 12
SALES BUDGET
OBJECTIVES
 Know the role sales budget in an organisation.
 Identify the factors to be considered while preparing sales budget
 Find the limitations of sales budgeting
 Prepare sales budget
STRUCTURE
12 .1. Introduction
12.2. Limitations
12.3. Preparation of sales budget.
12.1. INTRODUCTION
The sales budget represents the revenue side of the profit plan. Both sales
quantities and sales revenues are considered in formulating a sales budget. It
must be noted that “the purpose of sales budgeting is not to attempt to estimate
what actual sales will be, but rather to develop a plan with clearly defined
objectives towards which the operation effort is directed”.
Sales estimates must be made both for long and short periods. While long run
sales budget, prepared for five year or more, emphasis the position that the firm
wants to achieve in industry and the ultimate objective towards which the firm
should be heading, the short term sales budget usually covers one year and focuses
on the current portion of the long range sales projection.
Generally speaking preparation of the sales budget is the responsibility of the

Sales Manager, who in turn shall ask the divisional or regional sales manager to
project sales for their division or regions. The divisional sales managers shall ask
the local salesmen or agents to submit estimated sales for the forthcoming period.
The individual salesmen shall prepare sales estimates that they expect to cover. By
adding together the amount of sales that various salesmen estimate to achieve, the
divisional sales projections are established. The sales manager shall consider all
the divisional sales estimates and make adjustments to the estimates according to
his own forecast and understating of future market conditions and shall prepare
the Sales Budget of rate firm, for a particular period.
The following information is considered while developing a sales budget:

1. A forecast of the future general and specific conditions of the whole economy
and marketing area.
173
2. General conditions prevailing in the economy affect business to a large extent.

3. Price situation shall be analysed to find out how the how the firm’s prices
compare with competitor’s prices.
4. The probable effects of a change in product prices shall be analysed to see at
what price the products can be maximised.
The primary objective in sales planning should be to maximise profits in the

long run rather that in the short run. Keeping this objective in mind, the long run
sales planning should include plans about the new products to be introduced in
future and old products that get dropped. That part of the long run sales plan
which concerns changes to be introduced during the budget period should be
brought into shaper focus.
An analysis of the past sales performance of a firm for interim periods (over the
past 3 to 5 years) by products, sales territories, customers, size of orders, salesmen
etc., will be done. This will indicate to some extent what the firm will realistically
be able to achieve in the near future.
Thus sales budget is a statement of planned sale sin terms of quantity and
value. In forecasting the following factors are to be considered.
1. Past sales should be analysed to present the long term trends and seasonal
movements to enable the management to assess the accurate sales prospects.
2. Comparisons to be made with the conditions prevailing in the same business
as well as those of similar nature.
3. Market research to be conducted to employee the potentialities of the products
to be marketed. If new and the extent to which the products will continue to
have good market.
4. Assessment by the sale department as regards the targets to be reached by
fixing responsibility with the executives concerned.
While preparing the sales budget it is advisable to prepare the estimated sales
as a result of market research. Market research will enable the management to
know whether the demand for their products are local or foreign and how far their
merchandise will have popularity. Hence, the sales budget is prepared to cover the
sales of the products only under competitive conditions in various areas and the
popularity their merchandise command in that area as compared with the other
areas. If the above factors are taken into consideration, it is possible to establish
the probable sales in the future and the net probability of sales for the period.
Factors such as seasonal, stable and unstable sales should also be considered.
Past sales can serve as a guide for a future sales. A change in fashion may also
affect the demand for a particular type of product. It may be prepared under
various heads suitable to the requirements of the business. It should contian only
174
realistic figures and should be prepared on the basis of past experience looking into
the future trends and taking into account the economic, concentions, market
research and competition.
12.2. LIMITATION
Limitations of the firm should be given due consideration in developing a sales
budget. They are
1. Limited plant capacity, or
2. Non-availability of supervisory personnel and highly skilled workers or
3. Limited availability of stores capacity. Etc.
Illustration – 1
12.3. PREPARATION OF SALES BUDGET
How a sales budget is prepared for the product X in sales division North,
South, East and West by comparing the actual sales with the budgeted sales or the
corresponding period of the previous year is shown by way of an illustrations with
imaginary figures.
illustration – 2
(In the same line budget is prepared for three products A, B and C)
Popular Engineering Co. Ltd., operates three sales divisions – North, South and
West – selling three branded products A, B and C. Sales budget for the next year
has to be prepared by the Budget Committee.
For this purpose the following information has been made available.
Budgeted sales for the current year
Product North South West

A 4,000 units at Rs.10 6,000 units at Rs.10 6,000 units at Rs.10
B 3,000 units at Rs.20 8,000 units at Rs.20 4,000 units at Rs.20
C 2,000 units at Rs.40 12,000 units at Rs.40 5,000 units at Rs.40
Actual Sales for Current year
(Based on actual sales to date and estimate sales for remainder of the year)
Product
A
North
5,000 units at Rs.10
South
West
B 2,000 units at Rs.20 10,000 units at Rs.20 5,000 units at Rs.20
C 1,000 units at Rs.40 10,000 units at Rs.40 5,000 units at Rs.40
Suggestions and estimates emerging as a result of consultations with divisional
sales managers are:
175
i. Product A is selling at a higher rate than expected Market surveys have

revealed that it is popular and possibly underpriced. It is anticipated that,
even if the price was increased to Rs.11 per unit, the product would find a
ready market.
ii. Product C is not selling at the expected rate. Market surveys have revealed
that customers feel it to be over-priced and the market can absorb more if the
price is reduced by Rs. 2 per unit.
The management has agreed to principle that the price changes should be
through. Accordingly, estimate based on price changes and on reports from
salesmen have been prepared by divisional sales managers and are as follows:
Increase/Decrease on previous Budget (In Percentage)
Product North South West

A + 30 +20 +10
B — 10 +50 —10
C +10 +30 +20
The company follows the practice of preparing sales budget which highlights,
apart from the budgetary figures for the next period, the budgeted sales and the
actual sales for the current period.
Solution: (For Illustration – 1)

Quarterly Sales Budget for Product X
(For the quarter ending 31 s t March 1980)
Sales relating to corresponding quarter of last year Budgeted for the year
Area Budgeted sales Actual sales Quantity Price Budgeted
Reasons (Units) Rs. Revenue

Quantity Price Amount Quantity Price Amount
sales
(units) Rs. Rs. (Units) Rs. Rs.
Competi-
N 5,000 10 50,000 4,000 8 32,000 tion 4,000 8 32,000
Inexperien
S 25,000 10 2,50,000 20,000 10 2,00,000 23,000 10 2,30,000
ced
E 20,000 10 2,00, 000 19,500 10 1,95,000 salemen 21,000 10 2,10,000
-
W 15,000 10 1,50,000 25,000 10 2,50,000 Heavy 30,000 10 3,00,000
6,50,000 6,77,000
demand
7,72,000
176
Solution: (Illustration – 2)
Sales Budget
Actual Sales for the Current

Division Budget for Next Year Budget for the Current Period
period
and
Quantity Price Value Quantity Price Value Quantity Price Value
Product
(units) (Rs.) (Rs.) (units) (Rs.) (Rs.) (units) (Rs.) (Rs.)
North A 5,2000 11 57,200 4,000 10 40,000 5,000 10 50,000
B 2,700 20 54,000 3,000 20 60,000 2,000 20 40,000
C 2,200 38 83,600 2,000 20 80,000 1,000 40 40,000
Total 10,000 1,94,800 9,000 1,80,000 8,000 1,30,000
South A 7,200 11 79,200 6,000 10 60,000 8,000 10 80,000
B 12,000 20 2,40,000 8,000 20 1,60,000 10,000 20 2,00,000
C 15,600 38 5,92,800 12,000 40 4,80,000 10,000 40o 4,00,000
Total 34,800 9,12,000 26,000 7,00,000 28,000 6,80,000
West A 6,600 11 72,600 6,000 11 60,000 7,000 10 70,000
B 3,600 20 70,000 4,000 20 80,000 5,000 20 1,00,000
C 6,000 38 2,28,000 5,000 40 2,00,000 5,000 40 2,00,000
Total 16,200 3,72,000 15,000 3,40,000 17,000 3,70,000
Total A 19,000 11 2,09,000 16,000 10 1,60,000 20,000 10 2,00,000
B 18,300 20 3,66,000 15,000 20 3,00,000 17,000 20 3,40,000
C 23,800 38 9,04,400 19,000 40 7,60,000 16,000 40 6,40,000
Total 61,100 14,79,400 50,000 12,20,000 53,000 11,80,000
Illustration – 3
You are required to prepare a Selling overhead Budget from the estimates given
below:
Rs.
Advertisement of Sales Department 1,000

Salaries to Sales Department 1,000
Expenses of Sales Department (fixed) 750
Salaries and Dearness Allowance 3,000
The sales during the period were estimated as follows:
Rs.
Rs. 80,000 including Agents’ Sales 8,000

Rs. 90,000 including Agents’ Sales 10,000
Rs. 1,00,000 including Agents Sales 10,500
177
Commission at 1% on sales,
Carriage outwards: Estimate as 5% on sales
Agent’s Commission: 60% on Sales.
Solution
Selling Overhead Budget for the Period
Rs. Rs. Rs.

80,000 90,000 1,00,000
FIXED OVERHEADS
Advertisement 1,000 1,000 1,000
Salaries of Sales Dept. 1,000 1,000 1,000
Expenses of Sales Dept. (Fixed) 750 750 750
Salesmen’s Remuneration, Salaries 3,000 3,000 3,000
and D.A.
5,750 5,750 5,750
VARIABLE OVERHEADS
Salesmen’s Commission 1% on
72,0o00, 80,000 and 89,500 720 800 890.00
Carriage Outwards 5% on Sales 4,000 4,500 5,000.00
5230 650 682.50
Agent’s Commission
10,990 11,700 12,327.50
Illustration – 4
Chandramohan Bors. Sells two products which are manufactured in one plant.
During the year 1980 it plans to sell the following quantities of each product.
Sales Budget (units)
Second Fourth
First quarter Third quarter Total
quarter quarter
Product I 90,000 2,30,000 3,00,000 80,000 7,00,000
Product II 85,000 75,000 55,000 85,000 3,00,000
Each or these two products is sold on a season basis. Product I tends to sell
better in summer months, and product II sells better during the winter.
Chandramohan Bros. Plan to sell product I throughout the year at a price of Rs. 10
a units and product II at a price of Rs. 20 a unit.
178
A study of the past experience reveals that they have lost about 3% of its billed
revenue each year because of returns (constituted 2% of loss of revenue) allowance,
and debts (1% loss)
Prepare a budget incorporating the given information.
Chandramohan Bros.
Sales Budget
First Second Third Fourth Total

quarter quarter quarter quarter
Rs. Rs. Rs. Rs. Rs.
Product I 9,00,000 23.00,000 30,00,000 8,00,000 70,00,000

Product II 17,00,000 15,00,000 11,00,000 17,00,000 60,00,000
Total 26,00,000 38,00,000 41,00,000 25,00,000 1,30,000
Returns 52,000 76,000 82,000 50,000 2,60,000

Allowances and
Bad debts. 26,000 38,000 41,000 25,000 1,30,000
Total deductions 78,000 1,14,000 1,23,000 75,000 3,90,000
Net Sales 25,22,000 36,86,000 39,77,000 24,25,000 1,26,10,000
QUESTION
1. What is meant by sales budget.
2. Explain the factors to be considered while preparing the sales budget
3. Dinesh & Company Ltd. Produces two products, Alpha and Beta. There are
two Sales divisions, North and South. Budgeted Sales for the year ended 31 st
December 2002 were as follows:
Price per unit

Division Products Units
Rs.
Alpha 25,000 10
North
Beta 15,000 5
South
Alpha
Beta
24,000
30,000
10
5
179
Actual sales for the said period were:
Product North South

Alpha 28,000 units @ Rs.10 each 25,000 units @ Rs. 10 each
Beta 18,000 units @ Rs. 5 each 33,000 units @ Rs. 5 each
On the basis of assessments of the salesmen the following are the observation
of sales division for the year ending 31st December, 2003.
North zone Alpha Budgeted increase of 40% on 2002 budget

Beta Budgeted increase of 10% on 2002 budget
South zone Alpha Budgeted increase of 12% on 2002 budget
Beta Budgeted increase of 15% on 2002 budget.
It was further decided that because of the increased sales comparing in North
an additional sales of 5000 units of product will result.

180
LESSON – 13
CASH BUDGET
OBJECTIVES
 Realise the role of cash budget in an organisation.
 Describe the roles related to cash budget
 Prepare cash budget.
STRUCTURE
13.1. Introduction
13.2. Illustrations 1
13.3. Test
13.1. INTRODUCTION
A cash budget is a detailed estimate for a stipulated future period of time of
cash inflows for all sources, cash disbursement for all purposes and the resultant
cash balances.
The period of cash budget must synchronize with the periods for which other
budgets, particularly the master budget, are prepared cause such budget is largely
dependent on information continued in other budgets. A breakdown in terms of
weeks, 10 months and other time period is provided within the broad frame work of
the budget period.
Cash budget plays a very important role in the financial management of a
modern business undertaking; particularly those conducting business operations
on a large scale.
Cash budget is always a valuable adjuct to other budgetary statements. It is
useful to the borrower in as much as it enables him to ascertain his cash position
to ensure prompt payments of debts on maturity dates without adversely affecting
cash resources for trading purposes. It enables to determined the quantum and
the timing of, and the period for which, surplus funds can be loaned out or invested
in some other way or used for expansion. A good cash budgeting can help in
increasing the volume of business without any corresponding increase in working
capital by facilitating the flow of cash.
A cash budget is very useful as a planning tool ie., planning for new
borrowings or replacement of existing debt, for dividend payments for cash outlays,
capital expenditure, for any cash flow, etc.
Thus, cash budget is a cash forecast based upon the operating budget and the
statement of financial position at the beginning of the budget period. This is a
statement of estimated sources and uses of cash. Usually the company’s receipts
for sales and the estimated cash payments are taken into account. These forecasts
181
are made generally on a monthly basis to ensure a safe cash balance maintained at
all times. A company must be aware of its cash resources during a budgeted period
to enable the same to arrive at decisions as regards capital expenditure, working
expenses of the business, investment of surplus, etc.
The cash budget will commence with the opening balance of cash in hand and
at bank. To this will be added, the cash receipts for sale and from debtors and
other income items. Against these will be noted the payments of cash both capital
and revenue. The balance will represent the available or required cash. If there is
no adequate cash then it may be necessary to curtail the operations. If there is too
much cash the company is not wise in using the same. Hence, cash budget is
extremely important to ensure that there is just the required amount of cash
available.
13.2. ILLUSTRATION 1
From the following particulars of A B C company Ltd., construct a Cash Budget for
the period of four months commencing from January to April of 1982.
Expected Sales Expected Purchases

Rs. Rs.
January 1,20,000 96,000
February 80,000 1,60,000
March 90,000 1,62,000
April 80,000 1,80,000
Wages to be paid to workers Rs.10,000 every month.
Balance at Bank of 1st January Rs.16,000
Cash Budget
Solution
Period: Four month ending 30th April, 1982
January February March April

Particulars
Rs. Rs. Rs. Rs.
Balance b/d 16,000 30,000 - -
RECEIPTS:
Sales 1,20000 80,000 90,000 80,000
Total 1,36,000 1,10,000 80,000 80,000
Deficit b/d - - 60,000 1,42,000
PAYMENTS
Purchases 96,000 1,50,000 1,62,000 1,80,000
182
Wages 10,000 10,000 10,000 10,000

Total 1,06,000 1,70,000 2,32,000 3,32,000
Total receipts 1,36,000 1,10,000 90,000 80,000
Less: Total 1,06,000 1,70,000 2,32,000 3,32,000
payments
Cash available 30,000 - - -

e) Balance Deficit - 60,000 1,42,000 2,52,000
Illustration 2
A Co., Ltd. Wishes to arrange overdraft facilities with its banker during
October/December 1982 when it would be manufacturing moistly of stock.
Indicate with the help of a cash budget the extent of bank facilities the company
would require for each month of the period.
Sales Purchases Wages

Month
Rs. Rs. Rs.
August 90,000 62,400 6,000
September 96,000 72,000 7,000
October 54,000 1,21,500 5,500
November 87,000 1,23,000 5,500
December 63,000 1,34,000 7,500
Fifty Percent of credit sales would be realised in the month following the sales
and the remaining fifty percent in the second month following. Creditors would be
paid in the following of purchase; interest Rs. 2,000 is payable in the month of
November and income Tax Rs. 12,000 is payable in December.
Cash at bank on 1st October 1982 was estimated at Rs.12,500.
Solution:
CASH BUDGET 1982
October November December

Rs. Rs. Rs.
a. RECEIPTS FROM SALES
First month
Second month
45,000
48,000
48,000
27,000
27,000
43,000
93,000 75,000 70,000
b. PAYMENT
Creditors 72,000 1,21,500 1,23,000
Wages 5,000 5,000 7,500
183
Interest - - -
Income tax - - 12,000
77,500 1,28,500 1,42,500
c. BALANCE (A-B) 15,500 -53,500 -72,000
Opening Balance 1st October 1982 12,500 28,000 -25,500
Overdraft require 28,000 -25,000
Cumulative Overdraft -97,500
Illustration 3
Summarrised below are the Income and Expenditure – forecasts for the
months March to August, 1979.
Credit Credit Manufacturi Office Selling

Month Wages
Sales Purchases ng expense expense expenses
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,5000 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500
You are given the following further information
1. Plant costing Rs. 16,000 is due for delivery in July payable 10% on delivery
and the balance after 3 months.
2. Advance Tax of Rs. 8000 is payable in March and June each.
3. Period of credit allowed i) by suppliers 2 months and ii) to customers 1 month.
4. Lag in payment of manufacturing expenses ½ months
5. Lag in payment of all other expenses 1 month. You are required to prepare a
each budget for 3 months starting on 1st May 1979 when there was cash
balance of Rs. 8,000.
Solution
Cash Budget
(For the quarter ended 31 s t July 1979)
May June July

Rs. Rs. Rs.
RECEIPTS
Opening Balance 8,000 15,750 12,750
184
Sales 62,000 64,000 58,000

Total 70,000 79,750 70,950
PAYMENTS
Purchases 36,000 38,000 33,000
Wages 8,000 10,000 8,500
Manufacturing Expenses 3,750 4,000 3,750
Office Expenses 1,500 2,500 2,000
Selling Expenses 5,000 4,500 3,500
Advance Tax - 8,000 -
Delivery of plant
(with 105 Payment of delivery) - - 1,600
Total 54,250 67,000 52,350
Cash available (closing Balance) 15,750 12,750 18,400
Notes:
1. As customers are given one month credit, the amount of credit sales realised
during a month is the amount of such sales of the previous month.
2. In view of the fact that the period of credit allowed by suppliers is two months,
payments made for credit purchases in a month is the amount of such
purchases of months back.
3. Owing to the one month lag in the payment of all expenses, wages as well as
office and selling expenses paid during a month are those of the previous
month.
4. Manufacturing expenses paid during the month have been adjusted by
bringing forward one-half of these expenses of the proceeding month and
carrying over one-half of such expenses of the current month to the next
month.
Illustration 4
Kamaraj and Co. closes its books on 31st March each year. On 1st January
1980, it wants to prepare a each forecast for the first quarter of the ensuring year.
The following information is available. Sales (as per sales budget).
March, 1980 Rs. 50,00,000; April 1980 Rs. 60,00,000
May, 1980 Rs. 55,00,000; June 1980 Rs. 70,00,000
Details of cost of sales for the month of March:
Materials Rs. 22,50,000; Variable overheads Rs. 50,00,000
Wages Rs. 7,50,000; Fixed overheads Rs. 7,50,000
Fixed overheads include an amount of Rs. 2,00,000 for depreciation on plant
and machinery. One fifth of the sales are for cash and the rest on credit.
185
Customers are allowed a credit period of one month which happens to be the credit
period allowed by the suppliers also.
Wages and variable overheads are paid in the month which follows that in
which they are incurred. Material and Labour costs are strictly variable. Fixed
overheads are to be paid in the same month. During June 1980, income tax of Rs.
6,00,000 is to be paid. The staff is to be paid a bonus of Rs. 3,00,000 in may. A
uniform gross profit on variable cost is maintained by the company. The cash
balance in hand 1st April is expected to be Rs. 2,50,000.
Prepare a cash forecast for the 3 months and also suggest how the short fall or
excess can be filled up or utilised as the case may be. Assume that each month’s
production is sold in full.
SOLUTION
Cash Forecast for the period
1 st April to 10 t h June 1980
Particulars April May June

Rs. Rs. Rs.
Balance b/d 2,50,000 14,00,000 22,50,000
RECEIPTS:
Cash Sales 12,00,000 11,00,000 14,00,000
Collection from Debtors 40,00,000 48,00,000 48,00,000
Total 54,50,000 73,00,000 84,50,000
PAYMENTS
Materials supplied 22,50,000 27,00,000 24,75,000
Wages 7,50,000 9,00,000 8,25,000
Variable overheads 5,00,000 6,00,000 5,50,000
Fixed Overheads 5,50,000 5,50,000 5,50,000
Staff bonus - - -
Income Tax - - 6,00,000
Balance c/d 14,00,000 22,50,000 30,50,000
Total 54,50,000 70,00,000 80,50,000
WORKING
Ratio of gross profit to sales i.e., sales: Variable cost in the month of March.
ANNAMALAI UNIVERSITY Rs.
Sales 50,00,000
Variable cost 35,00,000
Gross profit 15,00,000
Percentage of gross profit on sales = 30%
Variable cost = 70%
186
Out of this:
Materials Cost = 45%
Labour Cost = 15%
Variable Cost = 10%
April May June

Rs. Rs. Rs.
Variable Cost 42,00,000 38,50,000 40,00,000
Material Cost 27,00,000 24,75,000 31,50,000
Labour Cost 9,00,000 8,25,000 10,50,000
Variable Overheads cost 6,00,000 5,50,000 7,00,000
The above cash forecast shows that there is a surplus cash of Rs.14,00,000 in
April, which increases by 8,50,000 is May and another Rs.8,00,00 in June. If
more cash is not required in the future quarters, these can be invested temporarily.
The amount to be invested should be after leaving a safe minimum cash balance of
Rs.2,50,000. So in April Rs.11,50,000 could be invested, in May another
Rs.8,50,000 and in June further Rs.8,00,000. However, if excess funds are not
required for some years to come, the money can either be invested in long term
securities of better used to pay off any of the long term liabilities.
QUESTIONS
1. Summarised below are the income and expenditure forecasts of Kannan Ltd.
For the month of March to August, 2003.
Sales (all Purchase Manufacturing Office Selling

Month Wages
credit) (all credit) expenses Expenses expenses
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500
You are given the following further information
a. Plant costing Rs,16,000 is due for delivery in July payable 10% on delivery and
b. ANNAMALAI UNIVERSITY
the balance after three months.
Advance Tax of Rs. 8,000 is payable in March and June each.
c. Period of Credit allowed, by suppliers 2 months and (ii) to customer 1 month
d. Long in Payment of manufacturing expenses ½ ;months.
You are required to prepare a cash budget for three months starting on 1 st May
2003 when there was a cash balance of Rs. 8,000
(Ans. July closing Balance 18,4000)
187
LESSON – 14
FLEXIBLE BUDGET
OBJECTIVES
After reading into this lesson you are able to
 Know the need for preparing flexible budgeting
 Explain different methods of preparing flexible budget.
 Prepare flexible budget.
STRUCTURE
14.1. Introduction
14.2. Multi-activity method
14.3. Formula method (or) Budget Cost allowance method
14.4. Graph method
14.1. INTRODUCTION
Budget may be discussed under two broad classifications – 1. Fixed Budget

and 2. Flexible Budget.
Fixed Budget is a budget which would remain unchanged inspite of changes in
the volume of output or level of activity. The institute of Cost and Management
Account (U.K) has defined a fixed budget as “a budget which is designed to remain
unchanged irrespective of the level of activity actually attained”. It is prepared for
the defined level of activity in quantitative as well as financial terms.
Flexible Budget is defined as “a budget which is designed in change in
accordance with the level of activity attained”. For this purpose all the items of cost
are classified into fixed and variable cost. A series of Budgets for different levels of
activity are prepared, by tacking into account the behaviour classification of cost.
It is the most important tool in the hands of management for effective cost control.
It is more elastic, useful and practical.
The comparison of budget figures with actual result is the kernel point of
budgetary control. In fixed budgetary control the figures are prepared on the basis
of one estimated volume output. If the actual volume output differs considerably
from the budgeted one a meaningful comparison can be made only if budget figures
are adjusted for changes in the volume of output. In other words, the objective of
flexible budgetary control is to change the budget figures progressively to
correspond with the actual output achieved.
It is otherwise known as variable or sliding budget, It is prepared when it is not
possible to determine budgeted costs for any level of activity. Moreover it is
188
prepared by a business for which it is not possible to make a forecast for the future
with certainty. This is due to following causes.
1. Circumstances beyond the control of management
2. Absence of comparisons of the actual results and a budget
3. Where it is not possible to assess the demand for the products in future on
account of political of social condition, flexible budge is prepared.
4. Where it is not possible to judge the public reaction in the case of a new
venture.
5. Where violent fluctuations are expected on account of variation in season or
weather.
In such cases it is possible only to prepare budget taking into consideration
the probable levels of activities. Sometimes fixed budget is prepared and later it is
split into short term flexible budgets. Some times circumstances give rise to
various discrepancies on comparison of the results with the actual. Hence, a
flexible budget is prepared to avoid possible discrepancies. The technique of
flexible budget follows a definite pattern. Different volume of operations of a
business or a factory is expressed as a percentage. To each volume of operation the
related expenses, split into flex variable and Semi-Variable in nature are worked
out along with the anticipated sales. Then the management chooses that volume of
operation which yields the maximum profits.
There are three methods of development a flexible budget and they are (1)
Multi-activity method (2) Formula method; and (3) Graph method:
14.2. MULTI-ACTIVITY METHOD

Under this method a flexible budget is prepared for varying levels of output. It
is essentially a production cost budget though it relates to sales, cash etc. The
budgeted cost has to be changed to correspond with the actual volume of
production. An accurate classification of expenses between fixed, variable and
semi-variable is essential in order to compile correct flexible budget. According to
I.C.W.A. fixed Cost a cost which tends to be unaffected by variation, in volume of
outputs Semi-variable cost-a cost which is part fixed and partly variable. Variable
cost-a cost which tends to vary directly with the volume of output.
The production cost budget for different volumes of output is prepared at the
time of budgeting itself. If original target is made for 10,000 units (100%)
production, simultaneously cost figures for 9000 units (90%) 8000 units (80%)
11,000 units (11%) and 12,000 units (120%) will also be ascertained. It the
concern is following fixed budgetary control, it will prepare the budget figures on
the basis of production target of 10,000 units alone. When the volume of output is
only 800 units, there is no doubt that there will be large variation between the
budget figures and actual figures. It is due to the variance in the volume of the
189
output itself. Hence the variance will not reveal the efficiency or inefficiency of the
different functions.
Assume that the actual output is 8,000 units at the end of a period and actual
costs are:
Rs.
Fixed cost 40,000
Semi-variable cost 54,000
Variable cost 80,000
If the company is following fixed budgeting system, it may have already
prepared budget figures for 10,000 units. Then the variance will be:
In a fixed budgeting
Budget figures Actual figures

Type of cost Variance
(for 10,000 units) (for 8,000 units
Rs. Rs. Rs.
Fixed Cost 40,000 40,000 -
Semi-variable cost 60,000 54,000 6,000
Variable cost 1,00,000 80,000 20,000
2,00,000 1,74,000 26,000
It is clear that the actual costs are less than budget costs. It is due to
reduction in the volume of output if the same company follows flexible budgeting
system the real variance between targeted figures and real figures can be found out:
In a flexible Budgeting
Budget figures for various levels of activity
80% 90% 100% 110% 100%

Type of cost (for 8,000 9,000 (for For 10,000 For 11,000 For 12,000
units units units units units
Rs. Rs. Rs. Rs. Rs.

Fixed cost 40,000 40,000 40,000 40,000 40,000
Semi-variable cost 52,000 56,000 60,000 64,000 68,000
Variable cost 84,000 92,000 1,00,000 1,00,000 1,16,000
1,76,000 1,88,000 2,00,000 2,04,000 2,24,000
Budget Variance is calculated as follows:

190
Budget
Actual figures Variance
Type of cost figures (for
(for 8,000 units) F.A.
8,000 units)
Rs. Rs. Rs. Rs.

Fixed cost 40,000 40,000 - -
Semi-variable cost 52,000 54,000 - 2,000
Variable cost 84,000 80,000 4,000 -
1,76,000 1,74,000 4,000 2,000

14.3. FORMULA METHOD OR BUDGET COST ALLOWANCE METHOD:
Under the method, a budget is prepared for the anticipated normal level of
activity and later on, an allowance will be made for variable cost for the number of
units by which the actual output differs from the budgeted output. For example,
let us assume that the production cost budget is prepared at Rs. 8,000 on the basis
of normal production level which is 80%d of capacity and the budget cost consists
to fixed cost Rs. 31,200 and variable cost Rs, 4,800. Then variable cost per 1%
production is Rs. 60 (4,800/80). If the actual production attained is 85% the
variable cost allowed will be Rs. 5,100 (Rs. 60 × 85). This variable cost plust fied
cost (ie 5100 + 3200) Rs. 8,300 will be cost allowed by the budget for the actual
production level. Hence, the formula for calculating production cost budget allowed
is stated as follows:
Expenses Budget allowed = Fixed cost + (Actual Units of activity × Variable cost
per unit of activity)
14.4. GRPAH METHOD

The total expenses for any given level of output can be obtained by plotting on
a graph points which show the total actual past expenses of varying levels of
output.
Among these methods, the firs method is the easiest to apply and will give
results for a limited range of range of activity level. If the output fluctuates heavily
the second or third method would be better ones to apply.
Problem 1
Prepare a flexible budget for production at 80 percent and 100 percent activity
on the basis of the following information. Production at 50% capacity … 5,000
units.
Raw materials Rs. 80 per unit.
Direct labour Rs. 50 per unit
Expenses Rs. 15 per unit
Factory expenses Rs. 50,000 (50% Fixed)
Administration expenses Rs. 60,000 (60% Variable)
191
Solution
Flexible Budget
Capacity output 50% 80% 100% Nature of

Units (5,000) (8,000) (10,000) cost
Rs. Rs. Rs.

Materials 4,00,000 6,40,000 8,00,000 Variable
Direct labour 2,50,000 40,00,000 50,00,000 ”
Expenses 75,000 12,00,000 15,00,000 ”
Factory expenses:
Variable (50%) 25,000 40,000 50,000 ”
Fixed (50%) 25,000 25,000 25,000 Fixed
Administration Expenses
Variable (60) 36,000 57,600 72,000 Variable
Fixed (40%) 24,000 24,000 24,000 Fixed
Total 8,35,000 1,30,60,000 16,21,000
Problem 2
The expenses budgeted for production of 10,000 units in a factory are
furnished below:
Per Unit
Rs.
Materials 70
Labour 25
Fixed over heads (Rs.1,00,000 10
Variable overheads 20
Variable expenses (Direct) 5
Selling expenses (10% fixed) 13
Distribution expenses (20% fixed) 7
Administrative expenses (Rs. 50,000) 5
Total cost of sales per units (to make and sell) 155
Prepare a Budget for production of
a) 8,000 units and
b) 6,000 Units
Assume that administration expenses are rigid for all levels of production.
192
Solution:
Flexible Budget
10,000 units 8,000 units 6,000 units

Per Amount Unit Per Amount Unit Per Amount Unit
Cost Particle Rs.
Rs. Rs. Rs. Rs. Rs. Rs.
PRODUCTION EXPENSES
Materials 70 7,70,000 70 5,60,000 70 4,20,000
Labour 25 2,50,000 25 2,00,000 25 1,50,000
Overheads 20 2,00,000 20 1,60,000 20 1,20,000
Direct variable Expenses 5 50,000 5 40,000 5 30,000

Fixed Overheads 10 1,00,000 12.50 1,00,000 16.67 1,00,000
DISTRIBUTION
EXPENSES
Fixed 1.40 14,000 1.75 14,000 2.33 13,980
Variable 5.60 56,000 5.60 44,880 5.60 33,600
SELLING EXPENSES
Fixed 1.30 13,000 1.63 13,000 2.17 13,020
Variable 11.70 1,17,000 11.70 93,600 11.70 70,200
ADMINISTGRATION
EXPENES 5.00 50,000 6.25 50,000 8.33 49,980
Total cost to make

and sell 155.00 15,50,000 159.43 12,75,400 166.80 10,00,800
Problem 3
The cost of an article at capacity level of 5,000 units is given under ‘A’ below:
For a variation of 25% in capacity above or below this level, the individual expenses
vary as indicated under ‘B’ below:
A (Rs.) B (Rs.)
Material cost 25,000 (100% variable)
Labour cost 15,000 (100% variable)
Power 1,250 (80% variable)
Repairs and maintenance 2,000 (75% variable)
Stores 1,000 (100% variable)
Inspection 500 (20% variable)
Depreciation 10,000 (100% Fixed)
193
Administrative overheads 5,000 (25% variable)

Selling Overheads 3,000 (50% variable)
62,750
Cost per unit Rs. 12.55
Find the unit cost of the product under each individual expenses at production
levels of 4,000 units and 6,000 units.
SOLUTION:
Flexible Budget
4,000 units 5,000 units 6,000 units

Per Amount Per Amount Per Amount Nature of
Particulars Unit Unit Unit cost
Material cost 5.00 20,000 5,00 25,000 5.00 30,000 Variable
Labour cost 3.00 12,000 3.00 15,000 3.00 18,000 ”
Prime Cost C/F 8.00 32,000 8.00 40,000 8.00 48,000

Power 0.26 1,050 0.25 1,350 0.24 1,450 Semi-
Repair and variable
Maintenance 0.43 1,709 0.40 2,000 0.38 23,000 ”
Stores 0.20 800 0.20 1,000 0.20 1,200 Variable
Inspection 0.12 480 0.10 500 0.09 520 Semi-fixed
Depreciation 2.50 10,00 2.00 10,000 1.67 10,000 Fixed
Cost of
Production 00.51 46.030 10.95 24,750 10.58 63,570
Administration
Overheads 1.19 4,750 0.00 5,000 0.87 5,250 Semi fixed
Selling Overheads 0.67 2,700 0.60 3,000 0.55 3,300 ”
Total cost 13.37 53,4880 12,550 62,750 12.00 72,020

Variability of an item of expense is found out as follows.
4,000 or 6,000
Fixed portion + Variable portion ×
5,000
For example 80% of power is variable and 20% is fixed.

The power expense for 4,000 units will be calculated as:
4,000
= 250 + 1000 × = 250 + 800 = 1.050
5,000
194
Note:
1. Semi-Variable or semi-fixed means the same but where 5% or more is varying,
it has been termed as Semi-Variable as in the case of powered repair etc., and
where less than 50% is varying, it has been termed as Sefimied as in the case
of Inspection and Administrative Overheads.
2. Calculation of per unit cost per item for different capacities has been made
after ascertaining Variable and Fixed cost.
Problem 4
A flexible budget at 60%, 80% and 100% production capacity is to be prepared
from the following information relating to the productive activities of Venkateswara
Engineering Company Limited for the three months ended 31st December, 1980.
Rs.
FIXED EXPENSES
Management salaries 42,000
Rent and Taxes 28,000
Depreciation of Machinery 35,000
Sundry office cost 44,500
1,49,500
SEMI-VARIABLE EXPENSES AT 50% CAPACITY
Plant Maintenance 1,500
Indirect Labour 49,500
Salesmen’s Salaries and Expenses 14,500
Sundry Expenses 13,000
78,500
VARIABLE EXPENSES AT 50% CAPACITY
Materials 1,20,000
Labour 1,28,000
Salesmen’s Commission 19,000
2,67,000
Semi Variable expenses remain constant between 40% and 0% capacity
increase by 10% of the above figures between 70% and 85% capacity and increase
by 15% of the above figures between 85% and 100% capacity. Fixed expenses
remain constant whatever be the level of activity. Sales at 60% capacity are Rs.
5,10,00, at 80% capacity Rs. 6,80,000 and at 100% capacity Rs. 8,50,000, it is to
be assumed that all items produced are sold.
195
Flexible Budget
(For the three months ended 31 s t December 1980)
Level of Activity
60% 80% 100%

Rs. Rs. Rs.
VARIABLE EXPENSES
Materials 1,44,000 1,92,000 2,40,000
Labour 1,53,600 2,04,800 2,56,000
Salemen’s Commission 22,800 30,400 38,000
3,20,400 4,27,200 5,34,000
SEMI VARIABLE EXPENSES

Plant Materials 12,500 13,750 14,375
Indirect Labour 49,500 54,450 56,925
Salesmen’s Salaries & expenses 14,500 15,950 16,675
Sundry expenses 13,000 14,300 14,990
89,500 98,450 1,02,965
FIXED EXPENSES
Management Salaries 42,000 42,000 42,000
Rent and Taxes 28,000 28,000 28,000
Dep. Of Machinery 35,000 35,000 35,000
Sundry office costs 44,500 44,500 44,500
1,49,500 1,49,500 1,49,500
Total costs 5,59,400 6,75,150 7,86,425

Sales 5,10,000 6,80,000 8,50,000
Profit / Loss -49,400 4,850 63,575
Problem 5
Prepare a flexible budget for direct machine hours – worked at 80%, 90%, and
100% activity on the basis of the following information.
Machine hours at 60% capacity – 2,40,000 hours.
Foremen Salaries 24,000
Indirect Labour 21,000
Other expenses 35,000
196
Calculate the budget allowance for 3,70,000 machine hours and for 5,50,000
machine hours.
Solution
Flexible Budget
Machine hours 2,40,000 2,80,000 3,20,000 3,60,000 4,00,000
Percent 60 70 80 90 100
Pressmen 24,000 24,000 24,000 24,000 24,000
Salaries 21,000 22,000 23,000 25,000 27,00
Indirect Labour 35,000 37,000 40,500 44,000 47,000
Other expenses
80,000 83,000 89,000 93,000 98,000
Budget allowance for 3,70,000 machine hours:

One method is to use budget allowance that is nearest to the desired volume.
Here allowance at 3,60,000 machine hours would be used. Second method is to
use straight line interpolation.
Forewent salaries will remain constant 24,000
Indirect labour Rs, 25,000 + (27,000 — 25,000)
 3,70,000  3,50,000 
×  
 4,00,000  3,60,000  25,000
Other expenses Rs. 44,000 + (47,000 — 44,000)
 3,70,000  3,60,000 
×  
44,750
 4,00,000  3,60,000 
94,250
QUESTIONS
1. What do you understand by Flexible budget allowance?
2. Difference between Flexible Budgeting and Static Budgeting
3. Explain salient features of flexible budget.
4.
Discuss the various steps involve in flexible budgeting.
5. Draw up a flexible budget for overhead expenses on the basis of the following
data and determine the overhead rates at 70% & 90% plant capacity
197
Capital levels
Variable Overheads: Indirect labours 12000
Stores including spares 4000
Semi-variable overheads: Power (30% fixed) 20000
Repairs & maintenance (40% variable) 2000
Fixed overheads: Depn. 11000
Insurance 3000
Salaries 10000
Total over heads 62000
Estimated labour hours: 124000


198
LESSON – 15
PRODUCTION COST BUDGET ETC
OBJECTIVES
 Understand the need for preparing production and cost budget
 Know different kinds of cost budgets
 Prepare production budget and cost budgets
STRUCTURE
15.1. Production Budget
15.2. Production cost Budget
15.3. Direct materials Budget
15.4. Purchase Budget
15.5. Direct Labour Budget
15.6. Factory overhead Budget
15.7. Selling & Distribution expenses Budgeting
15.8. Master Budget
15.9. Administrative overhead Budget
15.10. Research and Development Cost Budget
15.11. Capital Budget
15.1. PRODUCTIUON BUDGET

It is prepared by the works manager. The manufacturing process is analysed
in several stages of production in different departments. The maximum capacity of
each department is to be considered and this should be compared with the sales as
production is based on anticipated sales. This may be prepared for a year or for a
month and for each department and for each type of machine. This will cover the
anticipated outlay both in quantity and value for the purchase of raw materials,
labour cost and factory over head charges. This will enable the management to
minimise the cost of production by maintaining the maximum output. This forms
the most important part of the budgetary control system. It should aim at co-
ordinated production with the sales estimate to harmonise each and every stage of
production.
Problem
The Golden company plans to sell 1,08,000 units of a certain product line in
the first fiscal quarter 1,20,000 units in the second quarter, 1,32,000 units in the
third quarter and 1,56,000 units in the fourth quarter and 1,38,000 units in the
199
first quarter of the following year. At the beginning of the first quarter of the
current year, there are 18,000 units of product in the stock. At the end of each
quarter the company plans to have an inventory equal to one sixth of the sale for
the next fiscal quarter.
How many units must be manufactured in each quarter of the current year?
Solution
The Golden Company Production Budget
First Second Third Fourth

quarter quarter quarter quarter
units units units units
Sales Budget 1,08,000 1,20,000 1,32,000 1,56,000
Add: Stock required at the end of
the period 20,0000 22,000 26,000 23,000
Total 1,28,000 1,42,000 1,58,000 1,79,000
Less Stock in the beginning 18,000 22,000 22,000 26,000
Estimated production 1,10,000 1,32,000 1,36,000 1,53,000
15.2. PRODUCTION COST BUDGET
This budget indicates the details given in the production budget in terms of
cost. It includes the cost of three elements normally incurred in the process of
production material, direct labour and overhead Separate budgets for these three
element also will be prepared. Costs will be analysed by departments and/or
products.
Problem
Production costs of a factory for a year are as follows:
Rs. Rs.
Direct Labour cost 75,000
Direct material cost 1,20,000
Product Overhead-Fixed 45,000
variable 70,000 1,15,000
The production manager anticipates the following changes in the forthcoming
year. ANNAMALAI UNIVERSITY
1. The average rate for direct labour will fall from Rs.4 per hour to Rs. 3 per hour.
2. Production efficiency will decrease by 4/-
3. Direct labour hours increase by 10/-
200
4. The purchase price per unit of direct materials and of the other materials and
of the other materials and service included among overhead will remain
unchanged.
Draw up a budget and compute a factory overhead rate, the overheads being
absorbed on a direct wages basis.
Solution
Production Cost Budget
Original Budget Revised Budget

Rs. Rs.
Direct Labour Costs 75,000 64,350
Direct Material costs 1,10,000 1,32,000
Prime Cost 1,85,000 1,96,350
Production Overhead
Fixed 55,000 45,000
Variable 70,000 77,000
Total Cost 3,10,000 3,18,3507
1. The labour hours will increase by 10%. Also there will be increase in labour
hours as production has decreased by 4%. So increased total labour hours will
be
75,000 110 104
= 18,750 × × = 21.450
4 100 100
Rate is decreased to Rs. 3. So direct labour cost will be 21,450 × 3 = Rs. 64,350.
2. As labour hours will increase by 10% it has been assumed the reduction will
increase by 10%
15.3. DIRECT MATERIALS BUDGETS

It is by-product of production budget. It will be in terms of quantities to be
issued for production during the period, from stores. Direct materials to be utilised
for production of finished goods are to be included in this budget. This may also
contain information about prices and stock levels of raw materials. They will
ensure that the materials of right quality and quantity are purchased. Anticipated
variations in prices are adjusted by the use of standard costs. Estimates of the
quantities of raw materials required for production should be made.
Problem
The sales director of manufacturing company reports that next year he expects
to sell 54,000 units of a certain product.
201
The production manager consults the stock keeper and casts his figures as
follows:
The kinds of raw materials A and B are required for manufacturing the
product. Each unit of the product required 2 units of A and 3 units of B. The
estimated opening balance at the commencement of the next year are:
Finished product 10,000 units, A – 12,000 units B – 12,000 units.
The desirable closing balances at the end of the next year are: Finished
product – 14,000 units, A – 13,000 units, B – 16,000 units.
Draw up a quantitative chart showing the Material Purchase Budget for the
next year.
Solution
Material Purchase Budget (Quantitative)
Finished Material B
A (Units)
Product Units (Units)
Production Budget 54,000 1,08,000 1.62,000
Add Opening Balance 10,000 12,000 15,000
64,000 1,20,000 1,77,000
Less Closing Balance 14,000 13,000 16,000
Estimated sales of Product 50,000 1,07,000 1,61,000
materials
15.4. PURCHASES BUDGET
Purchase Budget, arising from material budget, represents the starting point of
the purchase programme in as much as it sets the dimensions of such a
programme which also involves initiation of action to accomplish the same.
After determining the quantities of different types of raw materials requird,
preparation of budget entails further adjustments arising from raw material stock
policies and contracts already placed. In this way where the stock of raw materials
are to be reduced the quantities to be purchased will be less than quantities of
materials required by the production budget while opposite will be the case if stocks
are to be increased. Further, the possibility of procuring materials requirements
from internal sources, as in the case of spares, has also to considered.
Problem
Following information regarding the stocks of materials required for the
production programme of Indian Limited is available
202
Estimated Stocks
(in Kgs) Estimated
Materials consumption for the
On 1St July On 30th June period price (Kg)
1979 1980
IC 20,000 17,000 9,03,000 Re 1
B 10,000 20,000 6,90,000 50 P
ND 30,000 33,000 5,47,000 40 P
Collating the details given above prepare Purchases Budget of Indian Limited.
Solution
Indian Limited
Purchase Budget
Particulars IC BL ND
Kg Kg Kg
Estimated Consumption 9,30,000 6,90,000 5,47,000
Add Stock Required on 30.6.80 71,000 20,000 33,000
Total Requirement 9,20,000 7,10,000 5,80,000
Less Estimated Stock on 1.7.79 20,000 10,000 30,000
Quantity to be purchased 9,00.000 7,00,000 5,50,000
Price per Kg. Estimated Rs 1 50P 50P
Estimated Cost of purchase of 9,00,00,000 3,50,.000 2,20,000
Materials Rs.
15.5. DIRECT LABOUR BUDGET
It covers the estimated of Labour costs of employing workmen. For the
purpose of recruiting labour at the proper time, the number of employees of various
skills required should be estimated. The budgeter should be prepared
incorporating therein the estimates of remuneration payable to workers on the
basis of which they are employed whether on price system or on time basis. The
standard time required for production by the operatives are estimated. Therefore,
the number of each grade and the standard wage rates of 1 hour are to be
considered.
Problem
1. A firm produces three products viz. X Y and Z. Each of this product consists of
three operations, namely, moulding, fabrication and finishing. Time taken in
theses operations for various products are as follows:
203
Moulding Fabrication Finishing

Product
Minutes Minutes Minutes
X 30 15 15
Y 15 10 5
Z 15 15 6
2. On the basis of time a consumed in individual oper1ations, the total machine
hours to be worked for achieving production quota to be calculated as follows:
Machine Time Budget
Units to be Moulding Fabrication Finishing

Product
Predicted Hours Hours Hours
X 78,000 39,000 19,500 19,500
Y 30,000 7,500 5,000 2,500
Z 50,000 12,500 12,500 5,000
Total 59,000 37,000 27,000
3. Labour cost for various operations can be found by converting machine-hours
into equivalent labour hours and multiplying these labour hours by wage-rates.
This is shown below
Direct Labour Budget
For the quarter ending 31st March 1982
Wage Product X Product Y Product Z
Operation Rate Equivalent Labour Equivalent Labour Equivalent Labour

Labour cost Labour cost Labour cost
Rs Hours Rs Hours Rs Hours Rs

Moulding 2 13,000 26,000 2,500 5,000 4,167 8,334
Fabrication 3 9,750 29.250 2,500 7,500 6,250 18,750
Finishing 1 19,500 19,500 2,500 2,000 5,000 5,000
74,750 15,000 37,000 32,084

Note: It is assumed that in the moulding department one worker can control three
machines at a time. So machine hours have been divided by three and equivalent
labour hours have been found. Similarly in fabrication department one worker can
control two machines and in finishing department one machine at a time.
15.6. FACTORY OVERHEAD BUDGETS

This will cover all indirect costs to be incurred in the factory. While preparing
this budget, fixed, variable and semi-variable expenses should be carefully divided.
204
Fixed overhead charges being constant, it is easy to determine. This is based upon
the figures available from the previous budget. It is also important to allocate each
item of expenditure incurred to the service department of the factory. Proper
allocation then, should be made to the production departments.
Problem
The following variable and fixed factory expenses are expected to be incurred
during the quarter ending 31st March 1982.
Expenses Total Moulding Department Finishing

s
fabrication
Variable 73,630 35,400 22,040 16,130
Fixed 48,000 20,000 12,000 16,000
Total 1,21,630 55,460 34,040 32,130
Budgeted machines hours: Moulding = 59,000 hrs
Fabrication = 37,000 hrs
Finishing = 27,000 hrs
Machine hour-rate: Moulding = 55,400 hrs Re.0.94
59,000 per hr.
Fabrication = 34,400 Re.0.92
37,000 per hr.
Finishing = 32,130 Re.1.19
27,000 per hr.
Prepare Factory Overhead Budget
Solution
Factory Overheads Distribution Budget
Overheads Product X Product Y Product
Operations Amount of Amount Amount

Machine Machine Machine
Rate Rs. Factory of Factory of factory
ANNAMALAI UNIVERSITY Hours

expenses
Hours
expenses
Hours
expenses
Building 0.94 39,000 36,660 7,500 7,050 12,500 11,750

Fabrication 0.92 19,500 17,940 5,000 4,600 12,500 11,500
Finishing 1.19 19,500 23.205 2,500 2,975 5,000 5,950
77,805 14,625 29,200
15.7. SELLING AND DISTRIBUTION EXPENSES BUDGET
205
The selling and Distribution Expenses Budget shows the cost of promoting,
selling and distributing the products that are expected to be incurred in the budget
period to achieve the ales target. These expenses should be clearly distinguished
and separate budgets, if possible, prepared for them also and they should also be
classified under variable and fixed expenses. The method of budgeting, selling and
distribution expenses is the same as that for manufacturing overhead expenses.
Past experience about the behaviour of these cost is analysed and adjustments are
made for likely changes in future.
Problem
The sales department of Sankar Tubes Limited is divided into three divisions
and each division is further sub-divided into Four areas. North, South, East and
West. Division II Sells Product B only which is sold at Rs. 50 per unit. For the
budget period ended 31st March, 1978 the aggregated budgeted sales of the
salesmen in each area are:
North – Nil
South - 5,000 units
East - 3,000 units
West - 2000 units
After a budget showing these sales had been prepared, the sales manager
decided to try to sell product B in North area; sales manager forecasts 3,000 units
for that area in the budget Period.
The actual expenditure in respect of selling expenses of Divisions II in the last
budget period ended 31st March, 1977 was as thus Description of Expenditure.
Area
East West South Total

Rs. Rs. Rs. Rs.
DIRECT SELLING EXPENSES
Representative’ salaries and
commission 8,000 8,000 14,000 30,000
Representatives’ expenses 5,000 4,000 8,000 17,000
DISTRIBUTION EXPENSES
Carriage Outwards 2,500 3,500 2,000 8,000
Warehousing wages 8000 6,000 16,000 30,000
Warehousing General 3,000 1,000 5,000 9,000
SALES OFFICE
Salaries 4,000 4,000 10,000 18,000
206
Rent and Rates 1,500 1,000 4,500 7,000

Miscellaneous expenses 300 200 1,000 1,500
PUBLICITY
Advertising Contracts 7,000 13,000 10,000 30,000
Total 39,000 40,700 70,500 1,50,500
During the next budget period ending on 31 st March, 1978, the changes to be
provided for are as follows.
1. As a result of increased turnover, the representatives’ commission in each area
is to be increased by Rs.1,000.
2. On the formation of a new North area, the transfer of an experienced
representative from South area will result in a transfer of Rs. 3,600 in respect
of his salary and commission. The employment in the North area of further
representatives will cost Rs. 14,400.
3. Representatives’ expenses in the North area will be Rs.10,000.
4. On a variation in the patter of sales, the expenditure for carriage outward will
rise Rs.200 in the East area, Rs. 200 in the West area and Rs. 400 in the South
area. The total cost in the North Area in anticipated at 5,000.
5. Sales office salaries will increase by 10 percent in East, South and West areas
which the amount to be charged to North Area will be Rs. 3,000.
6. In respect of rent and rates of sales office of Rs. 500 is to be transferred from
the South to North area;
7. Miscellaneous expenses in East, west and South areas will increase by Rs. 100
in area;
8. Advertising attracts will cost an additional Rs. 4,000 in the South area.
9. Apart from the item listed in 2, 3, 4 and 5 above, the following expenditure is
chargeable to the North area:
Rs.
Warehouse wages 10,000
Advertising contracts 15,000
5,000
Warehouse General expenses
Miscellaneous expenses 500
Prepare the selling expenses budget for the next budget period ending 31 st March,
1978.
207
Solution
Sales Expenses Budget
(For the period 31 s t March, 1978)
Area
East West South Total

Rs. Rs. Rs. Rs.
DIRECT SELLING EXPENSES
Representative’ salaries and
commission 9,000 11,400 9,000 8,000
Representatives’ expenses 5,000 8,000 4,000 10,000
DISTRIBUTION EXPENSES
Carriage Outwards 2,700 2,400 3,700 5,000
Warehousing wages 8,000 16,00 6,000 10,000
Warehousing General 3,000 5,000 1,000 5,000
SALES OFFICE
Salaries 4,400 11,000 4,400 3,000
Rent and Rates 1,500 4,400 1,000 500
Miscellaneous expenses 400 1,100 300 500
PUBLICITY
Advertising Contracts 7,000 14,000 13,000 15,000
Total 41,000 72,900 42,900 67,000
15.8. MASTER BUDGET
It is an integration of the various budgets showing the estimated profit or loss
for the future period and a Balance Sheet at the end of the period. Usually a
budget committee will be formed consisting of the various departmental managers.
Summarised figures will be shown at each item in the budget. These figures will be
referenced to the particular budget in which detailed figures will be available. This
will be supplied to the top management. This will portray the overall plan for the
budget period.
It contains information as regards sales, production, direct and indirect costs,
profit accounting ratios and appropriation of profits. In a Master Budget only
summarised figures will be shown as each item and will give reference to the
particular budget in which the detailed result will be shown. It is a summary of all
other principal budgets.
208
Problem
Glass manufacturing company requires you to calculate and present the
budget for the next year from the following information’s,
SALES
Toughened glass1 Rs. 3,00,000
Bent toughened glass Rs. 5,00,000
Direct Material cost 6% of sales.
Direct wages 20 workers at Rs. 150 pm.
FACTORY OVERHEADS
Indirect Labour
Works Manager Rs. 500 per month
Foreman Rs. 400 per month
Stores and Spares 2½ on sales
Depreciation for March Rs. 12,600
Light and Power Rs. 5,000
Repairs etc. Rs. 8,0000
Other Sundries 10% on daily wages.
Administration, selling and distribution expenses Rs. 14,000 per annum.
Solution
Master Budget for or the year ended …
Rs.
6. (I) SALES BUDGET:

Toughened glass (Quantity) 3,00,000
Bent Toughened glass (”) 5,00,000
8,00,000
(ii) Less Administrative, selling and distribution expenditure 14,400
7,86,000
ANNAMALAI UNIVERSITY Production Cost Budget
Direct Materials 60% of sales (quantity) 4,80,000

Direct wages – (20 × 150 × 12) 36,000
Prime cost 5,16,000
Variable stores and spares 2½ on sales 20,000
209
Light and Power 5,000

Repair 8,000 33,000
5,49,000
FIXED
Indirect labour:
Works manager 6,000
Foreman 4,800
Depreciation 12,600
Sundries 3,600 27,000
5,76,000
Work Cost
C. Expected profit = 7,86,000 — 5,76,000 = 2,10,000
15.9. ADMINISTRATISVE OVERHEADS BUDGET

The administrative overheads, like factory overheads, should also be divided
into variable and fixed expenses. But in practice most of the administrative
overheads tend to be fixed nature. The preparation of his budget is the
responsibility of the chief accountant, who besides considering past experience,
shall also consider the likely changes that are expected to occur during the
forthcoming period, In short, the method of preparing this budget is the same as
that of factory overheads.
15.10. RESEARCH AND DEVLEOPMENT COST BUDGET

The aim of this budget is to develop new products or new processes for
producing existing products. Generally the development of a new product or new
process requires a great deal of investment in facilities. It gives those research
specialists and indication of the resources at their disposal. Usually it is prepared
in two parts. (1) Fixed expenses necessary to maintain research and development
work at the irreducible level and (2) Cost to be incurred on completing the projects
on hand it on those to be taken up.
15.11. CAPITAL BUDGET

Capital expenditure may be incurred for the replacement of work out plant or
obsolescent plant, acquisition of new machinery for the manufacture of new
products or new process. This involves the preparation of a budget on a long term
basis planning the amount to be spent on each of the major projects and the
consideration of the sources of the required funds.
Capital budget will cover the acquisition of new plant and machinery, building
tools, furniture and fittings and requirements of working capital. When capital
expenditure has been agreed, a budget is prepared setting out the plants containing
210
the estimated expenditure the period during which it will be incurred, the financing
of the expenditure and the expected returns on the same.
QUESTIONS
1. Your Company manufactured two products A and B. A forecast of the number
of units to be sold in first seven months of the year is given below.
Product A Product B
January 1,000 2,800
February 1,200 2,800
March 1,600 2 400
April 2,000 2,000
May 2,400 1,600
June 2,400 1,600
July 2000 1,800
It is anticipated that (I) there will be no work in-pogress at the end of any
month (ii) finished units equal to half the sales for the next month will be in stock
at the end of each month (including the previous December)
Budgeted production and production cost for the whole year are as follows:
Product A Product B
Production
(Units) 22,000 24,000
Rs. Rs.
Per unit: Direct material 10.00 15.00
Direct labour 5.00 10.00
Prepare for the six months ending 30th June, a production budget for each
month and summarised production cost budget.

211
LESSON – 16
MARGINAL COSTING
OBJECTIVES
After reading this lesson you will be
 Familiarize with technique of marginal costing
 Distinguish between marginal costing absorption costing
 Realise the role of Marginal costing technique in Managerial decision
making.
 Know the limitations of Marginal costing.
STRUCTURE
16.1 Definition
16.2. Requisites for Marginal costing
16.3. Uses of Marginal costing
16.4. Limitations of Marginal costing
16.5. Difference between Marginal costing absorption costing
16.6. Make / Buy Decision
16.7. Profit Planning
16.8. Level of Activity planning
16.1. DEFINITION
Marginal costing is not a method of costing like job costing or process costing.
It is a specials technique very useful in the process of decision – making for the
management.
The Institute of Cost and Works Accountant of England has defined marginal
costing as “the ascertainment by differentiating between fixed costs and variable
cost of marginal cost and of the effect upon the profit of changes in the volume type
of output” Thus, the technique of marginal costing are:
1. differentiation between fixed costs and variable costs;
2. ascertainment of marginal cost and
finding out the effect on profit due to changes in volume or type of output.
Similarly ‘marginal cost’ is defined as “the amount of any given volume of
output, by which aggregate costs are changed, if the volume of output is increased
or decreased by one unit”. For example if the total costs of any two units produced
is Rs. 200 and a third is produced and if the total these three units is Rs. 250/-
212
then the marginal cost of the third unit is Rs. 50/- Hence marginal cost is the
additional cost of producing one additional unit.
16.2. REQUISITES FOR MARGINAL COSTING

It necessitates the analysis of costs into fixed and variable. The variable cost
varies directly in proportion to change in the volume of output, whereas fixed cost
remains fixed at the same level regardless of changes in the volume of output and
varies per unit inversely with the changes in the level of output. Hence fixed cost is
known as period cost because it accrues with the passage of time irrespective of the
volume of output. Variable cost is also known as product cost as it is related to
volume of output. Semi variable cost is one which is partly fixed and partly
variable.
Hence, marginal costing is equal to total costs less fixed costs i.e., direct
materials, direct labour, direct expenses and variable overhead. Thus, marginal
cost is variable cost (which forms part of product costs and does not include fixed
costs). Fixed cost are not included in the cost of production because they bear
relation to certain period of time and also vary per unit of production. In short the
whole marginal costing is built on the foundation of this classification of overheads
into fixed and variable expenses. Let us take a factory which manufactures 100
products and want to make an additional 101st product. The figure will be as
under.
For 101 For 101st

products product
Rs. Paise
Direct material 30 30
Direct labour 20 20
Variable overhead 10 10
Fixed overhead 40 -
Total cost 100 60
Profit 20 20
Selling 120 80
To produce the additional 101st product, direct material direct labour and
variable overheads alone are required. We need not employ additional
administrative staff, hire additional building, buy additional equipment, etc. All the
fixed expenses are taken care of already by the 100 products and the 101st product,
can be made without any additional fixed expenses. The 101st product is the
marginal product and the marginal cost. Thus, the marginal cost is defined as the
“Prime cost plus the variable cost”.
213
In the above example the cost of 101st product is only 60 paise as compared to
Re.1, the cost of the 100 products. Also it can be sold cheaper than the 100
products, getting the same quantum of profit. This show that the cost of additional
activity, in their limits is always less than the cost of the original activity and it is
always profitable to undertake extra activity, within limits. This is the principle
and purpose of marginal costing.
Marginal cost is otherwise known as incremental cost, extra cost, differential
cost, variable cost, or direct cost.
Characteristics of Marginal costing-A full fledged system of marginal costing is
characterized by the following features:
1. A technique, not a system of costing: marginal ;costing is a technique of
analysis and presentation of cost rather than a system of costing. It can be
applied with any existing method of costing.
2. Fixed costs are treated as period cost; Fixed costs do not form part of cost of
production. They are written off during the period in which they are incurred.
3. Profitability judged by contribution: The relative profitability of a product or
department is judged by the marginal contribution.
4. Separation of costs into fixed and variable components-All costs are classified
into fixed and variable costs in computing the cost of production.
5. Valuation of Stock: the stock of finished goods and work-in progress are valued
at variable costs excluding selling and distribution variable costs.
6. Cost-Volume-profit relationship: Break even technique is fully employed to
reveal the state of profitability at various level of activity.
7. Basis for price fixation: price are based on marginal costs plust profits.
Contribution is the excess of selling price over the marginal costs of sales.
8. Method of reporting and recording: Marginal costs are not incorporated in
accounting reports. They are incorporated in flexible budgets so that after the
expiry of budget period, estimated costs at the beginning may be compared
with the actual costs incurred at the end.
9. Instrument of control and decision making: marginal costs are used as an
instrument of control and decision making by management, for improving the
efficiency of the concern.
16.3. USES OF MARGINAL COSTING

1. Simplicity: The system of marginal costing is very simple and easy to
understand by all managers.
214
2. Profit planning: Marginal costing helps ;profit planning by focussing attention

of contribution, which represent the difference between sales value and
variable costs.
3. Cost control: The marginal cost technique officers a fundamental basis for the
effective control of costs by presenting a vivied picture of the entire variable
costs. The classification of costs into fixed and variable enables to prepare
flexible budgets and control the costs effectively through responsibility
identification.
4. Production planning: Marginal costs remain the same per unit of production
irrespective of the value of production. Hence, it helps the management in
future production.
5. Stock valuation: Marginal costing facilitates stock valuation very much since
no portion of fixed costs is carried forward to the next accounting period.
6. Simplification of overhead treatment: The system of marginal costing simplifies
the overhead recovery system. It does away with the need for allocation,
appointment and absorption of fixed overheads. Hence, under over-absorption
of overheads cannot arise at all.
7. Decision making: The technique of marginal costing is a valuable aid to
management for decision making in many key area such as:
a. the price at which a product should be sold.
b. Utification of surplus capacity.
c. Submission of quotation and tenders.
d. Dermination of volume of output.
e. Make or buy a component.
f. Replacement of machinery
g. Determining optimum product or sales mix.
h. Operate the plant or shut it down etc.
i. Acceptance of export orders.
j. Suspension or permanent closure of a business.
8. Performance appraisal: When there are several profit generating divisions in a
company, marginal costing helps to ascertain the contribution of each division
to the total profit of the company income and expenditure can easily be
matched.
215
16.4. LIMITATIONS OF MAGINAL COSTING

1. Difficulty in analysis: Considerable difficulty is always experienced analysing
overheads into their fixed and variable component, and no variable cost is
completely variable nor is a fixed cost completely fixed.
2. Lopsided emphasis: Marginal costing has a tendency to attach more
importance to the selling function, which has the effect of relegating the
production function to a comparatively unimportant position.
3. Difficulty in Application: The technique of marginal costing cannot be
adequately applied kin the case of industries in which large stocks have to
carried by way of work-in-progress.
4. Limited scope: As marginal costing distinguishes between the treatment of
fixed and variable components as parts of fixed costs, it is difficult to adopt the
technique in capital intensive industries where fixed are very high.
5. In appropriate basics for princing-Selling price cannot reasonably be fixed on
the basis of contribution alone, since there is a danger of too many sales being
effect at marginal costing resulting either in loss to the business or inadequate
profit.
6. As fixed costs are due to increasing automation the costing system cannot be
effective and dependable.
7. As marginal costing is suitable only for taking short-term decisions it is not
useful in the long-run.
8. The exclusion of fixed overhead from the inventories affects the profit and loss
account and products unrealistic and conservative Balance Sheet.
9. As marginal costing does not provide any standard for the evaluation of
performance it does not ensure effective control than a system of budgetary
control and stand costing.
Marginal Cost Equation: We know that sales = Total cost + Profit. But Total
cost = Direct material + Direct labour + Variable overhead + Fixed overhead.
Therefore, Sales = Direct material + Direct labour + Variable overhead + Fixed
overhead + Profit.
But Direct material + Direct labour + Variable overhead – Marginal Cost and
Fixed overhead + Profit Contribution.
So Sales = Marginal cost + contribution = (1)
This is known as Marginal Cost Education and is very useful in working out
problem. This equation can also be expressed in the following ways:
Contribution = Sales — Marginal cost (2)
Marginal Cost = Sales — Contribution (3)
216
The concept of Contribution: In a business, one has to incur the fixed expenses
whether there is production or not. Any return from that business should not only
yield him a profit but also fully cover his fixed expenses. The sale of the product
contribute towards profit as fixed expenses. Thus, profit plus fixed overheads is
known as Contribution or Contributory Profit or Contributory Margin or Gross
Margin or Marginal Contribution.
Contribution is the difference between selling price and variable cost. It is
expressed as follows:
Contribution = Fixed cost + Profit
Contribution = Sales — Variable Cost
Profit = Contribution — Fixed cost
Role of Contribution:
1. It can be used to determine ‘break even point’ and profit at different levels of
sales and vice versa.
2. In the selection of a procut Mix, products which give the maximum
contribution are to be retained and their production pushed up.
3. Contribution marginal is of considerable help while considering the acceptance
or rejection of any order.
While choosing from the alternative methods of production, the method which
yields the greatest contribution is to be adopted, keeping various other key factors
in view.
Illustration – 1
Rs.
Direct materials 2,00,000
Direct wages 1,60,000
Overheads:
Fixed 60,000
Variable 80,000
Sales 2700 units at Rs. 220 Closing stock
300d units
Draw up a cost and profit statement under marginal costing.
217
Solution:
Statement of Cost and Profit
Direct materials 2,00,000
Direct wages 1,60,000
Variable overheads 80,000
Marginal cost 4,40,000
4,40,000  300 44,000
Less: closing stock =
3,000
Marginal cost of goods sold 3,98,000
Sales of 27,000 units at Rs.220 5,04,000
Contribution (5,94,000 — 3,96,000) 1,98,000

Less: Fixed costs 60,000
Profit earned 1,38,000
16.5. DIFFERENCE BETWEEN MARIGNAL COSTING AND ABSORPTION
COSTING:
Absorption costing is the practice of charging all costs, both variable and fixed,
to operations, processes or products it is otherwise known as total costing,
conventional costing, traditional costing, historical costing or full costing.
A comparison of absorption costing and marginal costing is made as follows:
1. Decision-making: Marginal costing is highly suitable for decision making but
absorption costing is not so. The contribution is the guiding factor for decision
– making under marginal costing but under absorption costing managerial
decisions are guided by the profit.
2. Profit or loss: The calculation of profit or loss under the absorption costing is
not the same as that of the marginal costing. If the closing stock, is more than
the opening stock [i.e. production is more then the sales] there would be higher
profit in absorption costing. If sales are more than the production there would
be higher profit in marginal costing.
3. Variable overhead: Factory overhead is taken as a direct cost under marginal
costing whereas it is an indirect cost under absorption costing.
4. Stock Valuation: Stocks of finished goods and work-in progress are valued at
marginal cost under marginal costing while they are valued at cost of
production which includes fixed costs under absorption costing.
5. Fixed overhead absorption: Under absorption costing method, there cannot be
cent percent absorption of fixed overheads because of the difficulty in
forecasting costs and volume of output. There will be either over-absorption or
under absorption. As the fixed over-head under marginal costing, is wholly
218
charged to profit and loss account there is no problem of over recovery or

under-recovery of overheads.
X Y Co. Ltd.
Date of selling price and costs of a product
Fixed costs for the year 1980: Rs.

Manufacturing fixes costs 1,00,000
Selling and administration Fixed costs 10,00
Variable costs per unit:
Manufacturing 4 per unit
Selling and administration 2 per unit
Selling price 25 per unit
During 1980, X Y Z company product and sold 10,000 units of the product
and there was no beginning inventory on 1st January 1980. The income statement
for the firm, on the basis of absorption costing and marginal costing is shown
below:
X Y Z Co. Ltd.
Statement of income for the year 1980
Absorption Costing Variable

Costing
Rs. Rs.
Units of the product sold 10,000 10,000
Sales revenue (10,000 units at the rates of Rs.25) 2,50,000 2,50,000
Cost of goods sold
Variable manufacturing costs
(10,000 units at the rate of Rs.4) 40,000 40,000
Fixed manufacturing 1,00,000 -
Total manufacturing cost 1,40,000 40,000
Cross Profit (2,50,000 — 1,40,000) 1,40,000
Contribution margin (Gross) (2,50,000 — 40,000) 2,10,000
Less Selling and administrative Expenses
Variable selling and administrative expenses
(10,000 units at Rs.2) 20,000 20,000
Fixed selling and administrative expenses 10,000 -
30,000 20,000
219
Net profit before taxes (1,10,000 — 30,000 80,000

Contribution margin (Net) (2,10,000 — 20,000) 1,90,900
Less: fixed Cost of year:
Fixed manufacturing costs 1,00,000
Fixed selling and administrative costs 10,000
1,10,000
Total period costs Net Income before taxes
(1,90,000 — 1,10,000) 80,000
Less: Taxes at the rate of 50% 40,000 40,000
Net Income after taxes 40,000 40,000
Notes:
1. There were no beginning and ending inventory since production during the
year amounted to 10,000 units and the firm was able to sell out it.
2. Under absorption costing the cost product is Rs. 14 (ie) Variable cost Rs.4 and
fixed cost Rs. 10 per unit and the cost of product under marginal costing is Rs.
4 per unit.
3. Under both the methods, the profit figure is the same but the method of
calculation differs from one another.
The effect of changing prices on profits

A concern cannot hope to produce and sell any number of units at the
prevailing price. When the supply increases, naturally the price. When the supply
increases, naturally the price must be reduced to sell the entire stock. This has got
a definite impact on direct relationship with the profits.
If the output is to be increased, price has to be decreased. Otherwise market
may not absorb the entire stock and the competitors may encroach the field. Such
a limiting factor which prevents an enterprise from earning profits indefinitely, is
called the ‘key factor”. The most common key factor is the market for sales. When
management plans to expand output, normally the cost per unit will be reduced,
enabling a price reduction. The selling price may be reduced to attach a wider
market. Therefore, the management is willing to know the effect of such a price
change on the profits.
Ranga Ltd., is planning to expand its production of electrical iron boxes.
Though it has got an installed capacity to produce 1,00,000 boxes, it is operating
only at 60% of its capacity. Now it process to increase its production upto 90,000
units without incurring any additional fixed expenses. However, the market
research shows that a reduction of 5% must be made in the present selling price to
sell the entire stock of 90,000 units, Management wishes to know the effect of
220
changes in price and volume on the present amount of profits. Below are given the
details of cost of production and the selling price available now.
Level of activity …
Rs. 60%
Per Unit
Selling price: 100
Direct materials 32
Direct wages 18
Variable overheads 7
Marginal costs 57
Contribution 43
Less: Fixed costs 23
Profit … 20
Estimate the profit at the proposed level of activity at the reduced price.
Solution
Profit Statement
Rs.
Sales proceeds (90,000 × 95) 85,50,000
Marginal cost (90,000 × 57) 51,30,000
Contribution (90,000 × 38) 34,20,000
Less: Fixed cost (60,000 × 23) 13,80,000
20,40,000
Estimate profit for 90,000 units 20,40,000
Present profit for 60,000 units at the rate of Rs.20 each 12,00,000
Increase in profit estimated 8,40,000
This increase in profit at reduced price is due to the increase in the
contribution resulting from additional units sold:
Verification Rs.
Contribution by 90,000 units at the rate of Rs.38
Contribution by 60,000 units at the rate of Rs.43
34,20,000
25,80,000
Increase in contribution at decreased price 8,40,000
Production Mix or sales Mix
A business concern may deal in a variety of goods and it may produce more
than one product. In such cases the present capacity is used proportionately in the
221
production of the selected mix of the products. Then the question may arise as to
which product mix is profitable i.e., which product must be produced and in what
quantity. However, the limiting factor (key factor) is the demand for each product
in the mix or the production capacity.
Illustration 4
Following information has been made available from the cost records of
Chidambaram Automobiles Limited manufacturing spare parts.
Per unit
Direct materials
X Rs.8
Y Rs.6
Direct wages
X 24 Hours at 25 p.per hour
Y 16 Hours at 25 p.per hour
Variable overheads 15% of wages
Fixed overheads Rs.750
Selling price
X Rs.25
Y Rs.20
The director wants to be acquainted with the desirability of adopting any one of
the following alternative sales mixes in the budget for the next period:
a. 250 units of X and 250 units of Y
b. 400 units of Y only
c. 400 units of X and 100 units of Y
d. 150 units of X and 350 units of Y
State which of the alternative sales mixes you would recommend to
management.
Solution
Marginal Cost Statement
(Per unit)
Product X Product Y
Rs. Rs.
Direct materials 8 6
Direct Wages 6 4
222
Variable overheads 9 6
Marginal cost 23 16
Contribution 2 4
Selling price 25 20
Selection of Sales Alternative
X Y Total
Rs. Rs. Rs.

a) 250 units of X and 250 units of Y
Contribution 500 1,000 1,500
At Rs.2 and 4 respectively Less Fixed
overheads 750
Profit 750
b) 400 units of Y only: — 1,600 1,600
Contribution at Rs.4 Less fixed overheads 750
Profit 850
c) 400 units of X and 100 units of Y:
Contribution at Rs.2 and 4 respectively 800 400 1,200
Less: Fixed overhead 750
Profit 450
150 units of X and 50 units of Y:
Contribution at Rs.2 and 4 respectively 300 1,400 1,700
Less: Fixed overhead 750
Profit 950
Note:
As the fourth alternative of manufacturing 150 units of X and 350 units of Y
yield the maximum profit, it is the best sales alternative and it is recommended
for adoption.
16.6. MAKE OR BUY DECISION

A manufacturing concern sometimes has to make a decision regarding the
manufacture of a particular component. To decide whether or not to manufacture
the component, marginal costing technique can be used. The company has to
compare the price of the component purchased from outside and the marginal cost
of producing the same internally.
If the marginal cost of production is lower than the purchase price it is
profitable to produce the part rather than purchasing from outside. But in practice
223
other complications may arise. For example, the concern may not have a surplus
capacity to produce that component in which case the production of some other
items, can be stopped and that capacity can be utilised to produce the component.
Under the circumstances the loss of contribution made by these items should be
considered as part of the marginal cost of product of the component. Sometimes
the manufacture of the component may involve some new items of fixed expense
which should also be included in the marginal cost of the component. Making due
allowance for these key factors a decision can be taken on this issue with the help
of marginal costing technique.
Illustration 5
A manufacturing company produces a single product utilising its full capacity
for 10 hours daily. The contribution of this product is Rs.60 per unit. A
component of this product is now bough outside at Rs.35. However, if this part is
also produced in the company itself 4 hours daily have to be spared for that
purpose. Also it is estimated that the marginal cost of production of this part will
come to Rs.20. Is it desirable to make this part in the company itself by restricting
the volume of production?
Solution
Report on the desirability of making the parts
Rs.
Contribution of the product for 10 hours = 60
For one hour = 60
=6
10
Loss of contribution of this product if the part is
produced (4 hours) 4 × = 6 = 24
 Marginal cost of production of the part 20 + 24 = 44
The purchase price of the part is only Rs. 35; Therefore it is economical to buy
the part in the market.
16.7. PROFIT PLANNING

Through the calculation of contribution ratio, marginal costing enables the
planning of future operations in such a way as to attain either maximum profit or
to maintain a specified level of profit. Thus it is helpful in profit planning.
Illustration 6
A toy manufacture earns an average net profit Rs.3 per price in a selling price
of Rs. 15 by producing and selling 6,000 pieces at 60^ of the total potential
capacity. Composition of this cost of sales is:
224
Rs.
Direct material 4.00
Direct wages 1.00
Works overhead 6.00 (50% fixed)
Sales overhead 1.00 (25% varying)
During the current year, he intends to produce the same number but
anticipates that:
a. his fixed charges will go up by 10%
b. rates of direct labour will increase by 20%
c. rates of direct material will increase by 5%
d. Selling price cannot be increased.
Under these circumstances he obtains an order for a further 20% of his
capacity. What minimum price will you recommend for accepting the order to
ensure the manufacturer an overall profit of Rs.1,80,500?
Solution
Marginal cost statement for current year.
(Price to acceptance of 20% excess order)
Per Piece Total Amount

Rs. Rs.
Variable Cost
Direct material 4.20
Direct labour 1.20
Variable works overhead 3.00
Variable sales overhead 0.25
8.65 5.19,000
Sales value 15.00 9,00,000
Contribution 6.35 3,81,000
Fixed Cost
Works Overhead
Rs.
1,80,000
Rs. Rs.
Add 10% 18,000 1,98,000

Sales overhead 45,000
Add% 4,500 49,500 2,47,500
Profit … … 1,33,500
225
Planned Profit = Rs.1,80,500

Increase in profit = Rs.1,80,500 — 1,33,500 = 47,000
The minimum price for 60,000 toys (order for 20% capacity) can be worked out
as under,
Rs.
Variable cost at Rs. 8.55 1,73,000
Add increase in profit 47,000
2.20,000
2,20,000
Minimum Sale Price per unit = Rs.11
20,000
16.8. LEVEL OF ACTIVITY PLANNING
One of the very common problem confronting a business is regarding the level
of activity for which it should have plans in hand. Such plans may envisage an
expansion or contraction of productive activities depending upon the quantitative
conditions in the market. The expansion or contraction has to be arranged before
the events overtake the business. In this context, management would like to have
an idea of the contribution at different levels of activities and marginal costing
proves very useful from this point of view.
Illustration 7
Following is the cost structure of Discs Electronic Corporation.
Level of Activity
Output (in units) 50% 70% 90%
10,000 14,000 18,000
Costs Rs. Rs. Rs.

Materials 1,00,000 1,40,000 1,80,000
Labour 30,000 42,000 54,000
Factory overhead 50,000 60,000 70,000
Factory cost 1,80,000 2,42,000 3,04,000
In view of the fact that there will be no increase in fixed costs and import
license for the scarce material required in the manufacture of its product has been
obtained, the corporation is considering an increase in production to its full
installed capacity.
226
Solution
Marginal cost statement
(At 100% level of activity with 20,000 units)
Total cost Cost per unit

Rs. Rs.
Materials 2,00,000 10.00
Labour 60,000 3.00
Variable factory overheads 50,000 2.50
Marginal factory 3,10,000 15.50
Fixed factory overheads 25,000 1.25
Total factory cost 3,35,000 16.75
Thus the marginal factory cost per unit is Rs.15.50 and the total production
cost per unit is Rs.16.75.
Workings
i. Calculation of Variable Factory Overheads per unit.
Rs.60,000 — 50,000
= Rs.250
4,000 units
ii. Calculation of Fixed Factory Overheads:

Factory Overheads — (No. of units at certain level of
activity × variable factory overheads per unit)
Rs. 50,000 — (10,000 units × units Rs.2.50) 50,000 — 25,000 Rs. 25,000
The amount can be verified by making calculations at any other level of
activity.
iii. Variable factory overheads at 100% level of activity, 2,000 units × Rs.250, Rs.
50,000.
QUESTIONS
1. Distinguish between absorption costing and marginal costing.
2. Define Marginal cot and marginal costing? What are its features?
3. What is Break-even analysis? Discuss its assumptions and uses.
4.
Explain the technique of marginal costing and state its importance in decision
making.
5. Calculate Break-even point from the following particulars.
Fixed Expenses 1,50,000
Variable cost per unit 10
Selling Price per unit 15
227
6. From the following data calculate:

i. Break-even point expressed in amount sales in rupees.
ii. Number of units the must be sold to earn a profit of Rs.60,000 per
year.
iii. How many units must be sold to earn a net income of 10% of sales?
Selling price Rs.20 per unit
Variable manufacturing costs 11 per unit
Variable selling costs 3 per unit
Fixed factory overheads 540000 per year
Fixed selling costs 252000 per year.
The particulars of two plants producing an identical product with the selling
price are as under.
Plant Plant B
Capacity utilisation 70% 60%
(Rs. Lakhs) (Rs. Lakhs)
Sales 150 90
Variables costs 105 75
Fixed costs 30 20
It has been decided to merge plant ‘B’ with plant ‘A’. The additional fixed
expenses involved in the merger amount to Rs. 2 laks. Required
i) Find out the break-even point plant ‘A’ and plant ‘B’ before merger and
the break-even point of the merged plant.
ii) Find the capacity utilisation of the integrated plant required to earn a
profit of Rs.18 lakhs.

228
LESSON – 17
BREAK-EVEN POINT
OBJECTIVES
The aim of the lesson is to
 Understand the concept of breakeven analysis
 Know how the cost sheet Break-even chart.
 Evaluate the merits & Demerits of break even anlysis.
 Find break-even points angle of incidence
STRUCTURE
17.1. Introduction
17.2. Break even analysis
17.3. Break even chart
17.4. Features of break even chart
17.5. Construction of Break even chart
17.6. Position of Break even chart
17.7. Margin of safety
17.8. Angle of incidence
17.9. Advantage
17.10. Limitations
17.11. Calculation of break even chart.
17.1. INTRODUCTION
When the selling price exceeds the cost, we are making profit: when the selling
price is below cost,. There is loss. If the product is sold at cost, ie., if cost = sales,
no profit is made; no loss is made, it breaks even. This is known as the Break-even
point. Hence it maybe described on a specific level of activity or volume of sales
which breaks the revenue and costs evenly., income just balance with expenses.
Hence at the break-even point cost = sales, profit = 0, loss = 0.
Fixedexpenses ContributionatBEP
Contributionperunit

Contribution per unit
BEP units × selling price per unit BEP = Sales.

There will be contribution even when loss is made when loss is incurred,
contribution and fixed expenses can be converted by a return contribution to the
business is made.
229
17.2. BREAK-EVEN ANALYSIS

Break-even analysis indicates the level at which costs and revenue are in
equilibrium. Broadly speaking, break-even analysis means an analytical technique
that can be used to determine the probable profit at any level of production. It is
basically an extension of marginal costing. Breakeven analysis may be performed
both graphically as well as algebraically. It establishes the relationship among cost
(fixed and variable cost) or production volumes of production and the profit hence.
This analysis is also called a cost-volume profit (CVP) analysis’.
17.3. BREAK-EVEN CHART

When the break-even analysise is performed graphically it is known is a break
even char (BEC). It is a geographical chart, which shows the profitability or
otherwise of an undertaking at various levels of activity and as a result indicates
the point at which neither profit nor loss is made. In short, the break-even chart is
a device that facilitates the graphic presentation of the cost volume — profit
relationship.
17.4. FEATURES A BREAK EVEN CHART

The following are the chief features of a break even chart.
1. Cost: The total costs, fixed costs and variable costs can be directly read off the
chart for any chosen level of activity.
2. Sales Revenue: Like cost, sales revenue can also be directly noted for any
specified level of activity.
3. Profit or loss: The gap between the total cost line and the income line at any
level of activity measures the profit or loss at that level.
4. Break even points: When the income line intersects the total cost line, income
and total costs are equal then neither a profit nor a loss is made, the firm
breaks even. This point is called break even point and is usually measured in
terms of activity.
5. Margin of safety: This is merely the difference between the break-even point
and any activity selected for consideration.
6. Angle of incidence: It is an angle at which sale line cost the total cost line.
17.5. CONSTRUCTION OF BREAK-EVEN CHART
There are two methods of drawing the chart. In both the methods sales and
cost are represented by Y axis while X axis represents output or capacity. In the
first method, the fixed cost line, the total cost line and the sales line are drawn. In
the second method, the variable cost line, the total cost line and the sales line are
drawn. In both the cases the point of sales line and the total cost line is the
Breakeven point.
230
The fixed cost line is a line parallel to the X axis as the distance between two
parallel lines is constant representing the expenses that the fixed at no production
or different volumes of production.
The total cost line will not pass through the origin as at zero output the sales is
zero.
In the second method the variable cost line is drawn instead of the fixed cost
line and it passes through Origin as at zero production, the variable cost is zero. In
this case, the total cost line is a line parallel to the variable cost line as the total
cost is arrived at by adding a constant figure, ie., fixed cost to variable cost.
Analysis
The B E P is the intersecting point between sales line and the total cost line.
The difference between the sales line and the fixed cost line represents profit above
B E P and loss below B E P. At B E P profit = 0; loss = 0.
In the second method, the difference between the sales Line and the variable
Cost Line denotes contribution, which
Method I
5000
Sales and cost in Rupees
4000
e
lin
s
le
Sa
3000
st line
tal co
2000 To
Fixed cost line

1000
100 200 300 400 500

Output
231
Method II
5000
Sales and cost in Rupees
4000
e
lin
s
le
Sa
3000
e
os t lin
al c
2000 Tot
t line
1000 le cos
iab
Var
100 200 300 400 500

Output
includes profit above B E P, as B E P is just fixed cost and below B E P contains

losses. The angle of incidence is the angle between the sales line and the total cost
line. If the angle is large profits are being made at a high rate. If the angle is small,
profits are made with difficulty.
In the above Breakeven chart (3) Total production/Sales Rs.100 lakhs; Fixed
costs Rs.30 lakhs; Total costs Rs.70 lakhs; Break even point Rs.50 lakhs.
17.6. POSITION OF BREAK EVEN POINT

The position of the break – even point on the chart is important. If it is very
much to the right of the chart, it may be either due to high fixed costs or low
contribution. If the point is very much to the left of the chart, there is scope for
increased production and sales.
232
Cost and Revenue (in lakhs of Rupees)

100
e
90
lin
s
le
ea
80
Sa
Ar
Angle of
fit
70 Incidence
o
Pr
60 ine
B.E.P. co st l
50 To tal
40 Variable cost
Fixed cost line
ea
30
Ar
Margin
ss
20
Lo
of
10 safety
0
10 20 30 40 50 60 70 80 90 100
Output and Sales (in lakhs of Rupees)
17.7. MARGIN OF SAFETY

Margin of safety is the difference between the actual sales and the sales at the
break even point. In terms of production also, it is the excess of production ovary
the break even output. Margin of safety may be expressed either in volume or in
percentage But, the percentage is generally used. The formula for the calculation of
the margin of safety is as follows:
P rofit  Contribution 
MS =  P / V ratio  
P / Vration  Sales 
The Margin of safety is on indicator of the strength of a business. In the above

it is the distance between the BEP and the present sales or production. If the
distance is long, there will be profit and it is short, there will be loss. The margin
of safety at break-even is nil because actual sales volume is just equal to the
expenses.
17.8. ANGLE OF INCIDENCE

This is the angle formed at break-even point at which the sales line cuts the
total cost line. This angle is an indicator of profit-earning capacity over the break-
even point. If the angle is large it indicates that the profits are being made very
satisfactorily at a high rate. If the angle is small it indicates that the profits are
being earned at a relatively low rate of return revealing that variable cost form a
large part of costs of sales. Anyhow if the Angle of Incidence and Margin of Safety
are considered together, they will be more informative.
233
For example, a large angle of incidence with a high margin of safety will
indicate the most favourable conditions of a business or even the existence of
monopoly. Similarly if the contribution margin is higher, the angle of incidence
also will be higher, the angle of incidence can be improved by raising the selling
price and/or by reducing the variable cost. More over it is not affected by the fixed
costs, even though the break-even point is affected by the fixed costs.
17.9. ADVANTAGES OF BREAK-EVEN ANALYSIS

Break-even analysis helps management in many ways. Its advantages are
given below:
1. Profit planning: deciding the quantum of profits to be earned based on the
projections regarding the level of activity.
2. Product planning: adding a new product line to the existing product line.
3. Activity planning: expansion or reduction of capacity
4. Lease Decisions: whether to lease or purchase capital assets like ownership or
hire etc.
5. Make or Buy decisions
6. Capital profit decisions: studying the effect of installing an equipment initially
or replacing it with a new one when it become obsolete.
7. Distribution channel decisions a producer can make a choice between
exclusive distribution and selective distribution.
8. Price decision: if the demand schedule and cost pattern are known, it is
helpful for determining the best price so as to in yield maximum profit.
9. Choosing promotion: Mix: determining the best promotion mix which consists
of personal selling, advertising and sales promotion.
10. Decision regarding profitability of products or department: the decision
whether a department should continue or a particular product should be
eliminated rests on the contribution made or the loss incurred by the product
or department.
17.10. LIMITATIONS OF BREAK EVEN ANALYSIS

1. When break-even analysis is based on accounting data it may suffer from
many limitations of data such as neglect of imputed cost, arbitrary depreciation
estimates and inappropriate allocation of overhead costs.
2. It is static in character – Prices and costs are subject to constant change from
unit to unit and from product to product.
3. Selling costs: are specially difficult to handle in break-even analysis.
234
4. Costs: in a particular period may not be caused entirely by the output in that
period.
5. A basic assumption in break even analysis is that the cost revenue volume
relationship is linear. This is realistic only over narrow ranges of output.
6. It is not an effective tool for long range used but only for short range use.
7. The straight line total revenue curve presumes that any quantity might be sold
at that one price. Perfect competition is rare in the real world.
8. The area included in the break-even analysis should be limited, if too many
products, too many departments or too many plants are combined together and
graphed on a single break-even chart, both good and bad performances can
easily be buried in the total picture of the group.
9. It assumes that profits are a function of output ignoring the fact that they are
also caused by other factors such as technological changes, improved
management, change in the scale of fixed factors of production and so on.
17.11. CALCULATION OF BREAK EVEN POINT

Break-even point can be calculated and understood by (1) Equation method
and (2) Contribution Margin method.
Example for Equation Method

Sales 2,000 units at Rs.20
Fixed cost Rs.15,000
Variable cost Rs.10 per unit
The quantity to be sold at the break-even point x.
Equation is Sales – (Fixed cost + Variable cost_ = 0
Or Sale – (Fixed cost = Variable cost) = 0
20x – (15,000 + 10x) = 0
or 20x – 15,000 – 10x = 0
or 50x – 10x = 15,000
or 10x = 15,000
15,000
or x= = 1,500 Units
ANNAMALAI UNIVERSITY10
Example for Contribution Method

FixedCost of a P eriod
Number of units at the BEP =
Contribution M arg in P erUnit
Selling price Rs.20 Per Unit

Variable cost Rs.10 Per Unit
235
Fixed cost Rs.15,000

15,000
Number of units of the BEP = = 1,500 Units
10
Here, Contribution margin is Rs.10 (Rs.20-10). Contribution margin can also
be expressed as a percentage on the sales revenue.
Example
Rs. %
Selling price 20 100
Less variable 10 50
Contribution Margin 10 50
FixedCost
Sales revenue at the BEP =
Contribution m arg in as a percentage
15,00 15,000  100
= ie
50% 50
= 30,000
A sales revenue of Rs.30,000 should be earned to break-even.
Illustration
500 1,000 1,500 2,000
Units Sold
Rs. Rs. Rs. Rs.
Sales revenue (@ Rs. 20 each) 10,000 20,000 30,000 40,000
Cost:
Variable cost (@ Rs.10 per unit) 5,000 10,000 15,000 20,000
Fixed cost 15,000 15,000 15,000 15,000
Total cost 20,000 25,000 30,000 35,000
Draw a break even chart showing fixed cost, variable cost, and total cost at
various levels of out-put.
Fig.1 is a graph, prepared on the horizontal axis showing various levels of
output and on vertical axis showing various levels of output and on vertical axis
showing cost and sales revenue in thousands of rupees. Then sales revenue line is
drawn by joining point of sales revenue at various levels of output. Now we may
draw the fixed cost line, variable cost and the total cost line on the graph. The
behaviour of these cost and their presentation has been shown in the figures 2, 3
and 4 shows the total cost line by combining fixed cost and variable cost at each
level of output.
236
Fig.
50
Sales Revenue and Cost
(Rupees in Thousands)
40
ue
en
v
30
Re
s
le
20 Sa
10
0
500 1000 1500 2000 2500
Units of Product
e
in
os
t tl
Cost
s
Cost
lc
Cost
o
ta lc
To ta
Fixed Cost To
Volume Volume Volume
Fig.2 Fig.3 Fig.4

It we draw both the total cost line and the sales revenue line on single graph,
the point where the total cost line interests the sales revenue line represents the
break-even point. Figure 5 shoes such a combined graph. Now the –even chart
clearly shows the relationship between cost, volume and profit. In figure 5 we see
that 500 units level represents the break-even of Rs.30,000 must be earned to
avoid losses. It also emphasis that the firm will earn higher and higher profits as
the firm’s sales increase above the 1,500 units level.
The following cost date relating to a business is available:
1. Fixed costs are Rs.50,000
2. Variable costs are Rs.75,000
3. Sale price per Unit is Rs.2
237
4. Number of Units produced and sold 1,00,000

The management wants to effect a reduction of 10% in the sale price. Show
the above information by means of a break-even graph. In this chart, break-even
points are thus: Present BEP – 40,000 units and Rs.80,000. BEP on 10%
reduction in the selling price – 47,619 units approximately and Rs.85,714
approximately.
200000
Revenue and costs (in Rupees)
e
lin
st
es
co
a of
al
Are
ts
150000
en
ec
Pr
line
l cost
a
100000 Tot
Preset B.E.P
B.EP. with 10%
Reduction in
sales price
50000
Fixed Cost
0
20000 40000 60000 100000
Output (in units
Illustration 3
The following information is available in respect of X Ltd. For the budget
period.
Sales 20,000 units at Rs.10 per Unit
Variable costs Rs.4 per Unit
Fixed cost Rs.50,000 including depreciation of Rs.10,000
Preference dividend to be paid Rs.20,000
Takes to be paid Rs.30,000
238
It may be assumed that there are no lags in payment. Prepare Cash a Break-
Even Chart.
200000
Profit unpaid
fixed cost
160000 Preference
dividend
Taxation
120000
80000 Variable costs

requring cash
40000
Fixed Cost
Requiring Cash
0
4000 8000 12000 16000 20000
The cash break-even point –point would be 6,675 approximately in terms of

units sold.
Algebraic Representation
We have seen some graphic representation by drawing break-even chart. But
it is not necessary to draw a chart for calculating the break-even point which also
can be calculated by using the following algebraic formula;
FixedCost
1. Break-even point =
Variable cos t
1
Corresponding sale
or
Fixedcos t
2. Break even point =
RatioofVariable incometo sales
Or
Fixedcos t X Sales
3. Break even point =
ANNAMALAI UNIVERSITY Sales  Variable cos t
Examples
Fixed cost Rs.6,000
Variable cost will rise from zero to Rs.6,000
Selling price Rs.600 per ton
239
The tonnage produced and sold is 30 tons.

6,000 6,000 6,000
1. Break-even point = Rs.
6,000 1 2
1 or 1  or
18,000 3 3
6,000  3
= Rs. = Rs.9,000
2
6,000 6,000
2. Break-even point = Rs. or
12,000 : 18,000 2.3
6,000 6,000  3
= Rs. or = Rs.9,000
2 /3 2
6,000  18,000 1,08,00
3. Break-even point = Rs. 
18,000  6,600 12
= Rs.9,000
Illustration – 4
From the following information find out (a) Contribution per unit (b) Break
even point (c) Margin of safety and (d) Profit.
Rs.
Total fixed costs 90,000
Total variable costs 1,50,000
Total sales 3,00,000
Unit sold 1,00,00 unit
How many units should be sold to earn a profit of Rs.1,20,000
Solution
a. Contribution – Selling price per unit – Variable cost per unit
C = Rs.3.150 Rs.1.50
FixedExpenses
b. Break-even point =
Contribution per Unit
60,000
= Rs. = 60,000 units
1.50
B.E.P. (in value) = 60,00 Units × Rs.3 = Rs.1,80,000
c. Margin of safety = Actual sale – B.E. sales
= Rs.3,00,00 – 1,80,000 = 1,20,00
or = 10,00,00 units – 60,000 units
= 40,000 units
240
40,000
or =  100  40 %
10,00,00
d. Profit = Units sold × contribution – Fixed costs

= Rs.10,00,000 — 1.50 × 90,000
= Rs.1,50,000 — 90,000 = Rs. 60,000
Volume of sales required to earn a profit of Rs. 1,20,000
Fixedcos t  DesiredP rofit
=
Contribution per unit
Rs. 90,000  1,20,000 2,10,000
= = = 1,40,000 units
Rs. 1.50 1.50
2,10,000
or × 100 — Rs.4,20,000
50
Illustration 5
A Calculate the break even point from the following data.
1. Sale price per unit Rs. 10
2. Variable cost per unit, Rs.6
3. Fixed cost Rs. 20,000
B. Calculate the revised break-even points if
1. Sales price is increased to Rs. 11 per unit.
2. Sale price is reduced to Rs. 9 per unit
3. Variable cost increases to Rs. 7 per unit
4. Variable cost reduces to Rs. 5 per unit
5. Fixed overheads rise to Rs. 25,000
6. Fixed overheads fall to Rs. 15,000
Solution
20,000 20,000
A.B.E.P =  = 5,000 units
10  6 4
20,000 20,000
B.1.B.E.P =  = 4,000 units
11  6
20,000
5
20,000
2 B.E.P. =  = 6,667 units
96 3
20,000 20,000
3. B.E.P =  6,667 units
10  7 3
20,000 20,000
4. B.E.P. =  = 4,000 units
10  5 5
241
25,000 25,000
5. B.E.P. =  = 6,250 units
10  6 4
15,000 15,000
6. B.E.P. =  3,750 Units
10  6 4
QUESTIONS
1. Enumerate the merits and demerits of break-even point
2. State four different methods of finding out the break-even point graphically
The following information relating to a company is given to you
Rs.
Sales 4,00,000
Fixed costd 1,80,000
Variable Cost 2,50,000
Ascertain how much the value of sales must be increased for the company to break-
even.
3. Raj Corp. Ltd. Has prepared the following budget estimate for the year 1979-
80.
Sales units 15,000

Fixed expenses Rs.34,000
Sales Rs.1,50,000
Variable costs Rs. 6 per unit
You are required to
i. Find the P/V Ratio, break-even point and margin of safety
ii. Calculate the revised P/V ratio break-even point and margin of safely an
each of the following cases.
a. Decrease of 10% in selling price
b. Increase of 10% variable costs
c. Increase of sales volume by 2000 units
d. Increase of Rs.6000 in fixed costs.
5.
What are the chief advantages of break-even analysis?
assumptions behind this analysis.
Outline the
6. Give a brief account of practical application of marginal costing which you

consider sound from a policy point of view.
242
LESSON - 18
PROFIT VOLUME RATIO
OBJECTIVES
After reading this lesson you are able to
 Understand the meaning of profit volume ratio
 Apply profit volume ratio while taking decisions.
 Construct profit volume graph.
STRUCTURE
18.1. Introduction
18.2. Profit volume ratio
18.3. Significance
18.4. Practical applications of P/V ratio
18.5. Profit volume Graph
18.1. INTRODUCTION
All business concerns consider the profit-maximisation as their ultimate
objective. Hence every organisation tries to bring under its control all those factors
which influence the profits of its business. The amount of profit is determined by
the factors such as.
1. Price of the product.
2. Volume of sales;
3. Cost of production – Fixed and variable
4. Sales mix of the product.
Each of these factors will influence the amount of profit that can be earned by
the business concern. It follows that a change in any of these factors can affect the
profit volume. That is why it is said, “profit is the resultant of the interplay of cots,.
And volume”. Therefore profit-planning is based on these vital factors and cost –
volume – profit analysis is an attempt at systematic study of the relationship
existing among these variable factors. It analyses the effect of changes in these
factors on the profits. Thus, it is an integral in these factors on the profits. Thus,
it is an integral part of profit planning. In short, management is told what may
happen in terms of profit. If,
1. the price is reduced or increased
2. the volume of sales is larger or smaller
3. costs are reduced or increased
243
This study is otherwise called the Break-even analysis which tells the
management new much sales in units should be effected to avoid a loss at least.
We have seen Break-even analysis in detail in are last lesson. Now we will see the
profit/volume ratio which is another method to determine the cost-volume-profit-
relationship.
18.2. PROFIT VOLUME RATIO

The profit/volume ratio; popularity known as the P/V ratio, express the
relation between contribution and sales and makes the changes in the percentage
of contribution in relation to changes in the volume of sales. Here profit means the
contribution and volume means the sales value. It is one of the most important
ratios for studying the profitability of operation of a business. This ratio explains
the rate at which sales are contributing towards the recovery of fixed costs and
profits. A big radio means that the break-even point is achieved sooner after which
profit is break-even point is achieved sooner after which profit is earned at a higher
rate and a low ratio implies the opposite.
The Profit/Volume ratio is otherwise known as the Marginal Incomes Ratio or
Contribution-Sales Ratio or Variable-Profit Ratio. The formula for calculating P/V
ratio is expressed in symbols as follow.
Contribution C
P/V Ratio = I, e,
Sales S
Fixedexpenses  P rofit FP
or = i.e.,
Sales S
Sales — Variable cos ts S—V
or = i.e.,
Sales S
Changein Contribution Changein P rofit or less
P/V Ratio = 
Changein Sales Changein Sales
18.3. SIGINFICANCE
The real significance of P/V ratiolies in its use for appraising profitability of
different operations, product lines, sales area, method of sales, classes of
customers, etc., A higher ratio indicates greater profitability and a lower ratio
indicates lesser profitability.
The ratio is useful for determination of the break-even point, level output or
sales to earn a desired amount of Profit, calculation of variable cost and profit for
any volume of sales.
1. BEP =
2. Sales required to earn a desired amount profit.
3. Variable cost = Sales (1 — P/V Ratio)
4. Profit = P/V Ratio × Margin or safety
244
5. Fixed costs = Sales of B.E.P. × P/V Ratio

6. Contribution = Sales × P/V Ratio.
18.4. PRACTICAL APPLICATION OF P/V RATIO

Management may expect an accountant to furnish it with information
regarding a wide of problems which call for the use of Profit-Volume ratio in a wide
scale. A few of such problems are as follows.
1. Ascertainment of profit at a particular level of sales volume.
2. Determination of BEP.
3. Calculation of sale required to earn a particular level of profit.
4. Estimation of the volume of sales required to maintain the present level of the
profit in costs selling prices are to be reduced by a stipulated margin.
5. Comparison to be made in respect of product lines, sales area, method of sale,
separate companies and individual business.
The P/V Raito, together will profit-graphs, can be used to give clues to answer
on such problems. Normally it is expressed din percentage by multiplying it by
100. It is improved if contribution is increased and this can be done by any one of
the following ways:
a. By increasing the selling price.
b. By reducing variable cost.
c. By increasing the production of such products whose P/V ratios are favorable.
d. By altering the sales mixture ie., products having low P/V ratio will be
substituted by a product with a higher ratio.
However, it should be noted that P/V ratio is not affected by any decrease in
fixed costs, although this decrease would increase the total profit.
18.5. THE PROFIT VOLUME GRAPH

The break-even chart is a helpful device to show the relationship between cost,
volume and profit. But it does not show directly the relationship between profits
and volume. If we want to know the profits expected to be earned at any level of
activity, we have to compare the total cost line and the sales volume at that level of
activity: So the P/V graph can be prepared to show directly the relationship
between profits and volume. To prepare such a graph, profit and losses are shown
on the vertical axis and number units of product or sale volume in (rupees) is
shown on horizontal axis. Sales line, variable cost and fixed cost line are not a
shown on this graph; rather only the amount of profit or losses at various levels of
volume is shown. A line joining the points showing profits or losses at various
levels of activity is drawn which is known as profit line. A horizontal line is drawn
245
on the graph to distinguish between profits and losses. The point where the profit
line intersects this horizontal line will show the break-even point.
Illustration 1
The XYS Ltd, sells its products at Rs. 10 per unit and the variable cost is Rs.6
per unit. The fixed cost of the firm amounts to Rs. 2,000 per month.
Prepare a Profit/Volume graph and show the profits, that the firm shall earn if
it sells 200, 400, 600, or 1,000 units.
Solutions
First we should calculate the net profit that the firm should earn at various
levels of sales.
Units sold 0 200 400 600 800 1000

Sales (@ Rs.10 each) 0 2,000 4,000 6,000 8,000 10,000
Cost of sales:
Variable cost 0 1,200 2,400 3,600 4,800 6,000
Fixed Cost 2,000 2,000 2,000 2,000 2,000 2,000
Total cost 2,000 3,200 4,400 5,600 6,800 8,000
Profit or loss (2,000)–) (1,200)(–) (400) 400 1,200 2,000
By taking the amounts of profits and losses at various levels of sale volume we
can prepare the following P/V graph.
2000
1500
(in rupees)
Profit
e
lin
1000
it
of
Pr
500
B.E.P.
0
(in Rupees)
2000 4000 6000 8000 10000

500
Sales Revenue (in Rupees)
Loss
1500
2000
200 400 600 800 1000

Units of Product
246
1. The above graph clearly shows that (i) if the firm does not produce and sell any
thing, even the fixed cost of Rs.2,000 will be incurred. Since at this level of
activity (of sales) no revenue is earned, the total losses of the firm will amount
to Rs. 2,000. At any level of activity below a sales revenue of Rs. 5,000, losses
will be incurred. Hence, at a sales revenue of Rs. 4,000 loss will amount to Rs.
400.
2. at a sales revenue of Rs. 5,000, the firm shall break-even.
3. at any level of sales above Rs.5,000 profits will be earned. Hence, if 1,000 units
are sold, total re venue will be Rs.10,000 and profits of Rs. 2,000 will be
earned.
Illustration 2
With a view of increase the volume of sales, Arumugam Enterprises has in
mind a proposal to reduce the price of its product by 20%. No change in total fixed
costs and variable costs per unit is estimated. The directs, however, desire the
present level of profit to be maintained. The following information has been
provided.
Rs.
Sales — 50,000 Units 5,00,000
Variable Cost — Rs. 5 per units Fixed costs 50,000
Advice management on the basis of various calculations made from the data
given.
Solution
Rs.
Sales 5,00,000
Less: variable costs 2,50,000
Contribution 2,50,000
Profit 2,00,000
Sales — Variable Costs
P/V Ratio =
Sales
× 100
Rs. 5,00,000 — 2,50,000

= × 100
Rs. 5,00,000
2,50,000
= × 100
5,00,000
= 50%
247
1. When the selling price is reduced without any corresponding increase in sales
volume.
4,00,000 — 2,50,000
P/V Radio = × 100
4,00,000
1,50,000
= × 100
4,00,000
= 37.5%
2. When the directors want to maintain the same level of profit after reduction in
selling price as before and fixed cost will not change sale volume required to
meet such a situation would be
Fixedcos t  profit
P / V Ratio
50,000  2,00,000 2,50,000 200
= Rs. = 
37,5% 75
= Rs. 6,66,667 or 83,333 Units.

Thus a reduction of 20% in selling price requires an increase of above d66% in
the sales volume.
Hence the management, with the help of above information, has to decide
between two alternatives to reduce or not to reduce the selling price taking Units
consideration whether it would be able to measure up to the takes of increasing the
sales volume by 66%
Verification
Rs.
Sales 6,66,667
Less: Variable Cost (83,333 Units Rs. 5 each) 4,16,665
Contribution 2,50,002
Profit 2,00,002
Note: The difference of Rs.2 in profit is negligible due to approximate calculation.
Sales Mix
A business concern may produce and market more than one product. Each
product may contribute (towards fixed costs and profit) in different ratios. The
commutative effect of the contribution made by all of them determine the profit.
One product may contribute more than the other product. Favorable product alone
cannot be produced by eliminating the other, because there may be limiting factors
248
like the restricted marker for the product, necessity of utilising the scrap on the
production of by-products and like.
Anyhow the mix of the product could be so altered as to give the maximum
possible profit in their limitations imposed by these products. It is not sufficient to
provide the management with the information of overall profit earned by all the
products together. It most also be informed of the individual contribution of the
product and of the effect of any changes in the mix on the profit earned. For this
purpose, the P/V chart can also be used to show the analysis of the product mix.
The P/V graph will show the cumulative effect of the product mix on the profit of
the organisation and also the over-all profit-volume ratio of the business.
Illustration-2
The Following is the statement of Sri Ram Company for the month of
November.
Products
L M
Total
Rs. Rs.
Sales 60,000 60,000 1,20,000
Less variable costs 42,000 30,000 72,000
Contribution 18,000 30,000 48,000
Fixed costs 36,000
Net profit 12,000
You are required to Compute the P/V ratio for each product and then compute
the P/V ratio break-even point and one profit for the company under each of the
following assumptions:
1. Sales revenue divided 60% to product L and 40% to product M
2. Sales revenue dividend 40% to product L and 60% to product M. Also
construct a profit-volume chart showing the profits estimated on sale upto
Rs.1,80,000 per month for each of the sales mix provided above.
Contribution
a. P/V ratio =  100
Sales X
L
Products
M Company
30 50% 40%
18,000  100 30,000 48,000
× 100 × 100
60,000 60,000 1,20,00
249
60% 40%
Sales mix
Rs. Rs. Rs.
Sales 72,000 48,000 1,20,000
Variable costs 50,400 24,000 74,400
Contribution 21,600 24,000 45,000
Less: Fixed Costs 36,000
Net Profit 9,600
P/V ratio 30% 50% 38%

F
B/E Sales  S Rs. 94,737
C
L M Company
Rs. Rs. Rs.
Sales mix 40% 60%
Sales 48,000 72,000 1,20,000
Less: Variable costs 33,000 36,000 69,000
Contribution 14,000 36,000 50,000
Net Profit 14,400
P/V Ratio 30% 50% 42%
B/E Sales Rs.85,714
It is clear from the above calculations that second type of sales mix is
advantageous for the company.
250
(L 40% Rs.60% )
e
lin
200 it
r of
P (L 60% Rs.40% )
80
B.E. at
40 6,35,714
0
Break-Even Line
40 B.E.
Rs.94,737
80
120
40 80 120 160 200 240 280
Profit at the sales of Rs. 1,80,000

i) Sale mix: L 60% M 40%
Rs.
Sale 1,80,000
Less: variable cost (L. Rs. 75,600 + M. Rs.36,000) 1,11,600
68,400
Less Fixed costs 36,000
Net Profit 32,400
ii. Sales Mix: L 40% M 60%
Rs.
Sale 1,80,000
Less: variable cost (L. Rs. 50,400 + M. Rs.54,000) 1,04,400
Contribution 75,600
Less Fixed costs 36,000
Net Profit 39,600
1.
QUESTIONS
What is meant by cost volume profit analysis. State the objectives (Advantages)
of such analysis.
2. What is “cost and profit planning”? Bring out its importance.
3. Write short notes on profit volume ratio.

251
LESSON – 19
DIFFERENTIAL COSTS ANALYSIS
OBJECTIVES
After carefully reading this lesson you are able to
 Understand the concept differential costs
 Evaluate the characteristics of differential costing.
 Realise the role of differential costing in policy decision.
 Acquire the skill of applying differential costing techniques.
STRUCTURE
19.1. Meaning differential cost
19.2. Characteristics
19.3. Problems
19.1. DIFFERENTIAL COSTS

It is the difference in the total costs that will arise from the selection of one
alternative instead of another. The alternative choice may arise on account of
changes in the method of production, sales volume, product mix, price, selection of
an additional sale channel, make or buy, take or refuse decisions etc.
19.2. CHARACTERISTICS
(1) In order to ascertain the differential costs, only total costs is needed and not
cost per unit (2) Existing level is taken to be base for the comparison with some
future of forecast level. (3) Differential cost is the economist’s concept of marginal
cost. (4); It may be referred to as incremental cost when the difference in cost is
due to increase in the level of production and decremental costs when difference in
cost is due to decrease in the level of production (5) It does not form part of the
accounting records;, but may be incorporated in budgets. (6) It is not necessary to
adopt marginal cost technique for differential cost analysis because it can be
worked out on the method of Absorption costing or the Standard costing. (7) What
is said of the differential cost above, applies to differential revenue also.
The Differential costing is the Marginal costing, because both involve
incremental costs. When fixed costs do not change, both are the some Both
systems are techniques of cost analysis and presentation and are applied for
formulating policies and for making managerial decisions. Lastly they are based on
the classification of cost units as fixed and variable.
(1) Differential cost includes relevant fixed cost, if additional volume involves
additional fixed cost outlay. But Marginal cost is composed of variable cost only. (2)
In Differential cost analysis, comparison is made between differential cost and
252
incremental or decremental revenue for many policy decisions. But in Marginal

costing, contribution, P/V ratio and limiting factors are taken as yard sticks for
evaluating performance and management decisions. (3) It is applied to a fixed
additional quality of output, whereas Marginal cost is applied to any additional
unit. (4) Unlike Marginal costing it does not from part of accounting records but
may be used both in absorption costing and standard costing and not to Marginal
costing only.
While Marginal costing technique is applied for the problems, the solutions of
which are known as technical decisions, the differential cost analysis is a
managerial too both for factual and strategic decision. The differential cost analysis
is useful in making many policy decisions such as:
1. The introduction of a new plant.
2. Make or buy decisions
3. Lease or buy decisions
4. Discontinuing a product, suspending or closing down a segment of the
business.
5. The profitability of a change in product mix.
6. Acceptance of an offer at a lower selling price.
7. Change in the methods of production.
8. The determination of the most profitable levels of production and price.
9. Submitting tenders.
10. The determination of price at which raw materials can be purchased.
11. Equipment replacement decisions.
12. The profitability or otherwise of further processing.
13. The opening of a new sales area of territory.
19.3. PROBLEMS
The components of an item are manufactured by another unit under the same
management. The unit at present manufactures, 1,00,000 units (the present
requirement of the main factory) at the following costs:
Materials
Rs.
5,00,000
Labour 2,50,000
Overheads 2,00,000
9,50,000
253
Labour is paid @ Rs.2 per unit, the fixed D.A. and other allowance monthly.
The components required by the main factory are to be increased by 20 percent.
The component factory can increase production upto 25 percent without any
additional labour force. Overheads are variable to the extend of 25 percent of the
present amount.
The additional equipment may be purchased from the market at Rs.8.50 per
unit. Suggest which will be better.
Differential cost of 20,000 units:

Materials @ Rs. 5 per unit Rs.1,00,000
Labour:
Variable Rs.2 per 40,000
Fixed Nil
Overheads:
Variable @ 50 paise per unit 10,000
Fixed Nill
If purchased from outside:
20,000 units @ Rs. 8.50 per unit 1,70,000. Since the Purchase cost is more
than the differential cost of producing 20,000 additional units, it is better to make
than to buy.
Problem 2
(Determination of the most Profitable level of production and price)
A company’s flexible budget reveals the following market conditions and costs:
Selling price Total semi Total Variable Total fixed

Output in units per unit fixed costs costs costs
Rs. Rs. Rs. Rs.
60,000 12 1,50,000 4,18,000 1,42,000
1,20,000 11 1,50,000 8,18,000 1,42,000
1,80,000 10 1,70,000 12,72,000 1,42,000
2,40,000 9 1,70,000 15,79,000 1,42,000
3,00,000 8 2,00,000 17,78,000 1,42,000
a.
3,60,000 7 2,00,000 10,02,000 1,42,000
Prepare a schedule showing total differential costs and incremental revenue.
b. At what level should the company set its level of production.
c. What selling price should be established in order to obtain the most profitable
operations for the year.
d. Schedule of total differential costs and incremental revenue.
254
Incremental Differential
Output Revenue Total cost
revenue cost
Rs. Rs. Rs. Rs.

60,000 7,20,000 - 7,10,000 -
1,20,000 13,20,000 6,00,000 11,10,000 4,00,000
1,80,000 18,00,000 4,80,000 15,90,000 4,80,000
2,40,000 21,60,000 3,60,000 18,90,000 3,00,000
3,00,000 24,00,000 2,40,000 21,20,000 2,30,000
3,60,000 25,20,000 1,20,000 22,44,000 1,24,000
b. It is profitable to increase the level of output as long as the incremental
revenue is more than the differential costs. The increase will not be
advantageous at the point at which the incremental revenue becomes equal
to the differential costs. We can see from the above schedule at an output
level of 3,60,000, the differential costs are more than the incremental
revenue. Hence, the most profitable level of output is 3,00,000 units.
c. The selling price to be set is obviously Rs.8 per unit at the decided level of
3,00,000 units.
Problem 3 (Suitable Product Mix)

Two products A and B are at present manufactured in a mix of 70,00 units of
the product A and 3,000 units of product B. For product A costs of materials,
labour, and variable overheads per unit are respectively Rs. 5, Rs. 4 and Rs. 8. For
the product B these costs are respectively, Rs. 8, Rs. 3 and Rs.3. The selling price
per unit are respectively Rs. 20 and Rs. 19.
You are required to examine if a proposal for mixing 3,000 unit of A and 7,000
units of B should be made. There will be an additional inspection cost of Rs. 500
and an additional selling and distribution overheads of Rs. 800 if the volume of B is
to be boosted to 7,000 units.
Solutions
Mix. 1 Mix. 2
7,000 units 3,000 units 3,000 units 7,000 units
ANNAMALAI UNIVERSITY A
Rs.
B
Rs.
A
Rs.
B
Rs.
Materials 35,000 24,000 15,000 56,000
Labour 28,000 9,000 12,000 21,000
Variable overhead 56,0000 9,000 24,000 21,000
Inspection cost - - 500 5,000
255
Selling and Distribution

overhead - - 800 800
1,19,000 42,000 52,300 99,300
Sale valued 1,40,000 57,000 60,000 1,33,00
21,000 15,000 7,700 33,700
Total 36,000 41,400
The mix 2, with 3,000 units of A and 7,000 units of B gives a differential profit
of Rs. (41,400 — 36,000) Rs. 5, 400 and is therefore preferable.
Problem 4 (To drop a Product Line)

Three different product lines are sold by Mohan Mills. Product A contribution
20% of its revenue of fixed costs and profits, product B contribution 10% and
product C contributes 60%
The product sell for the following prices:
Production A Rs. 8 per unit
Product B Rs. 2 per unit
Product C Rs. 3 per unit
The company earned a net profit of Rs.50,000 before income taxes, last year by
selling 50,000 units of product A, 1,50,000 units of product B and 60,000 units of
product C.
Rajendra, ‘the sales manager, believes that the profit picture can be improved
by eliminating product B and concentrating the sale effort on product A and C. He
seeks an opportunity to increase the sales of product A to 70,000 units but admits
that product C will probably sell at the same amount next year.
Prepare a projected statement using Rajendra’s assumption. Do you agree
with him? Explain, what would cause the profit to increase or decrease as the case
might be.
Solution
A B C Total
Sale (in Units)
50,000 1,50,000 60,000 2,60,000
Sales proceeds
Rs.
4,00,000
Rs.
3,00,000
Rs.
1,80,000
Rs.
8,80,000
Less variable cost 3,20,000 2,70,000 72,000 6,62,000
Contribution 80,000 30,000 1,08,000 2,18,000
Less: Fixed costs 1,68,000
Profit 50,000
256
Marginal cost Statements
(On the basis of Rajendra’s assumptions)
Sale in Units A C Total

70,000 60,000 1,30,000
Sales Proceeds 5,60,000 1,80,000 7,40,000
Less variable costs 4,48,000 72,000 5,20,000
Contribution 1,12,000 1,08,000 2,20,000
Less: Fixed cost 1,68,000
Profit 52,000
Conclusion
In case the business can reasonably expect to push up sales of product A by
20,000 Units, Rajendra’s assumption is quite reasonable and the manufacture of
product B can be dropped.
In accordance with Rajdendra’s assumption, profit would increase by Rs. 2,000
because the contribution margin of product B now being discontinued was very
small and the same has been more than made good by increase in the contribution
of product A resulting from 20,000 units increase in sales.
Problem – 5(Depth of processing)

A manufacturer produces a product X of which the selling price is Rs. 5 per
Unit. He manufactures another product Y by combining X with other direct
materials and employing further labour and overhead for additional processing.
The selling price of Y is Rs. 12 per unit. The additional cost per unit required for
converting X into Y in material Rs.2, labour Rs. 1.50 ;and the increase in the
manufacturing overhead cost is estimated from the following flexible budget totals:
Total Labour Hours 6,000 6,500 7,000 7,500 8,000

Total factory overhead 6,000 7,000 8,5000 10,000 12,000
The manufacturer estimates that he can sell 1,500 additional units of the
product Y with no increase in selling and administrative cost but at a reduction of
1,500 units in the sale of product X. The factory is now operating at 6,500 labour
hours, and if 1,500 additional units of Y are produced, the labour hours required
would be 7,000. Advice on the desirability or otherwise or producing 1,500
additional units of Y.
257
Solution
Rs. Rs.
Increment Revenue 18,000

1,500 units of Y Rs. 12 per unit
Less Loss of revenue from the reduced
7,500 10,500
sale of 1,500 units of × @ Rs.4
Differential costs
Materials
1,500 units @ Rs. 2 per unit 3,000
1,500 units at Rs.1.50 per unit 2,250
Overhead
Manufacturing Overhead
For 7,000 labour hours 8,500
For 6,000 labour hours 7,000 1,500 6,750
Incremental gain 3,750
As the incremental revenue is more than the differential costs by Rs. 3,750, a
further processing of the product X to products and sell 1,500 additional units of Y
is recommended.
QUESTIONS
1. Define differential cost analysis.
2. What is cost analysis? What are the characteristics.

258
LESSON – 20
STANDARD COSTING
OBJECTIVES
 Know the meaning of standard costing
 Identify merits & demerits of standard costing
 Distinguish between standard costing & budgeting control
 Find the determinations of standards.
 Realise the importance of variance analysis.
STRUCTURE
20.1. Standard costing
20.2. Objectives
20.3. Establishment of a standard costing system
20.4. Applicability
20.5. Types of standards
20.6. Standard costing & budgeting control.
20.7. Advantages
20.8. Limitations
20.9. Determination of standards
20.10. Determination of standard
20.11. Preparation of standard cost low and cost sheet.
20.1. STANDARD COSTING

Standard costing is one of the tools of cost control. It is an extension of
budgetary control. It is not a substitute to cost control but regarded as
complementary to the ordinary costing system. Standard costs form the basis of
the system of standard costing.
Definition
I.C.M.A., England ahs defined Standard costs as “a predetermined cost which
is calculated from management’s standard of efficient operation and the relevant
necessary expenditure”.
It also has defined Standard costing as “the preparation and use of standard
costs their comparison with actual costs and the analysis of variances to their
causes and points of incidence”.
From the above definitions it is clear the Standard costs represent the
scientifically planned or predetermined costs based on technical estimate of
259
material, labour and overhead for a selected period of time and for a prescribed set
of working conditions. These standards can be established in respect of qualities
like material and labour. Moreover these standards should be accepted by the
people who use it and they should be relatively permanent. The technique of
standard costing involves.
1. The ascertainment of standard costs.
2. The used of standard costs.
3. Their comparison of it with the actual and the measurement of variances.
4. The location of responsibility for the variance and the corrective action to be
taken.
5. The analysis of variance for ascertaining the reasons for the same.
20.2. OBJECTIVES
The objectives of standard costing are:
1. The control of all factors affecting production.
2. The disclosure of the effect of temporary increase of decrease in the volume and
sales on revenues.
3. The supply of prompt reports to the management showing the progress of
production and low expenditure to date. Compares the estimates so that
corrective actions may be taken in time.
20.3. ESTABLISHMENT OF A STANDARD COSTING SYSTEM

The installation of standard costing system in a manufacturing concern
involves the following steps.
1. Setting of standard costs
2. Setting up of standards
3. Classification of accounts
4. Establishment of costs centers
5. Standardisation of functions
20.4. APPLICABILITY
The technique of standard costing can be applied to any class of production or
service. Anyhow it is appropriate in those cases where service or production is of a
repetitive character. It is implied that this technique is of maximum value when it
is used with a process costing system in process industries like bricks, cement,
fertilizer, paper, sugar, biscuits etc.
260
20.5. TYPES OF STANDARDS

The following are four types of standards which may be used in an
organisation.
1. Ideal Standard
2. Basic standard
3. Normal Standard
4. Expected Standard
1. Ideal Standard
Manufacturing concerns may try to reach this level of attainment which will
result only from ideal condition like maximum sales, low cost of labour and
materials etc. But ideal conditions exist rarely. So they are not realistic. They
discourage the employees with adverse variance.
2. Basic Standard
Here standards are fixed with reference to base year. For example, if the year
1980 is taken as the base year, than the standards costs fixed for that year will be
compared with the actual costs of the year under consideratio9n. The main
difference between the current standard and the basic standard is in the period of
time for which the standards are set for a short term, the basic fixed for quite a
long period requiring periodic revisions.
3. Normal Standards
Some times an average level of attainment is set as the target. This would iron
out the wide functuations that may be caused by the seasonal and cyclical changes
in business.
4. Expected Standard
Business organisation hopes to attain some maximum possible efficiency
under the actual conditions which are prevailing in the business. Standards are
set for budget period on the basis of this expected level attainment. As they are
based on current conditions, they are fixed for a short term and revised frequently
whenever changes take place in the working conditions. Hence they are also called
‘current standard costs’
20.6. STANDARD COSTING AND BUDGETORY CONTROL
Nature of cost: The standards are ‘ought to be’ costs while the budgets are
‘should be’ costs.
2. Basis: Standard costs are scientifically planned on technical assessment under
a set of working conditions. But budgets are based on estimated cost and past
actual and adjusted to the future needs.
261
3. Projection: Standard costs are projection of cost account, whereas budgets are
projection of financial accounts.
4. Indices: Standards are pointers to further possible improvements. But budgets
are indices, adherence to which keeps a business out of difficulties.
5. Cost plan: Standard costs are criteria for operative efficiency. But budgets are
plans of action for a definite period.
6. Applicability: Standard costing cannot fully be adopted in job-order industries
and contracts. But budgeting can be adopted in any industry or business.
7. Scope: Standard costing relates only to the function of production and the
related manufacturing cost. But budgets are formed for all activities and
functions such as production, purchases selling and distribution, research and
development, capital expenditure etc. Moreover standards include only
expenditure whereas budgets include both income and expenditure. Lastly,
standard costing is intensive whereas budgetary control is extensive.
Similarities
Both standard costing and Budgetary control have the following common
principles:
1. The establishment of predetermined target performance.
2. The measurement of actual performance
3. The analysis of variances between actual and standard performance
4. Taking of corrective measures, wherever necessary.
5. The comparison of actual performance with the predetermined targets.
Both standard costing and Budgetary control are important in their respective
fields and complementary to each other. Usually they are used to conjunction with
each other to obtain most fruitful results.
20.7. ADVANTAGES
1. Standard costs help the management in fixation of prices and in laying down
production policies.
2. They help in readily showing up and than elimination of avoidable wastage and
losses.
They provide constant and uniform bases for management on the operational
efficiency of workers and other members of the staff.
4. Management, through the study of variances, needs to concentrate only areas
and problems which call for its attention ie, the system of “management by
exception” be precrised.
262
5. Delegation of authority becomes effective as the concerned men know that they
have to achieve and by what standard they will be judged.
6. The whole concern is injected with a dynamic forward looking mentality.
7. Performance of employees at all levels can be judged objectively. This enables
the concern to promote and reward the right person.
8. Standards function as a ‘yardstick’ to measure the actual performance and the
efficiency of labour and other factors.
9. Valuation of closing stock is faciliated by the standard cost of production.
10. As standards are set for every element of cost, the costing procedures are
simplified.
20.8. LIMITATIONS
1. Setting the standards itself is a difficult task as it involves technical skill.
2. The fixation of inaccurate standards, especially those that are incapable of
achievement, adversely effects the morale of the employees and act as
hindrance to increased efficiency.
3. The system is not suitable for the jobbing type of industries producing articles
according to customer’s specifications. Even if it is installed, the fixation of
standard for each type of job becomes difficult and expensive.
4. It is necessary to distinguish between controllable and uncontrollable variances
in order to locate deviations and fix responsibilities.
5. The system may not be suitable even in the case of industries that are liable to
frequent technological changes affecting the conditions of production. Even if
it is installed, a constant revision of standards becomes necessary.
6. Small concerns cannot afford this system due to higher cost associated with
standard costing.
7. There is not unanimity regarding the circumstances to be taken as the basis
for setting standard costs. Even if there is unanimity, a revision of standard is
essential to suit to the changing circumstances. The revision of standard
becomes expensive. If they are not revised, they become outmoded. Just as
inaccurate standards are not reliable and harmful, so are outmoded standards
disadvantageous.
20.9. DETERMINATION OF STANDARDS
For any given product or unit the following standards must be determined.
1. Standard material cost
2. Standard labour costs
3. Standard direct costs
263
4. Standard variable overhead costs

5. Standard fixed overhead costs
6. Standard selling price and profit.
The Standard Direct Material costs is found by multiplying he quantity of
materials to be purchased with the rate of price at which they are available.
Determination of Standard Labour costs involves fixation of (a) standard
labour grease (b) standard labour times i.e., standard hours through “Time Motion
and Fatigue Study” with the help of work study engineers and (c) standard wages
rates based on time rate, piece rate and premium plans.
Standard Direct (expenses) costs is any expenditure other than direct material
and direct labour which is directly to be accrued on a specific cost unit. It is
charged directly to the particular cost standard (account) concerned.
Standard Overhead costs are classified as manufacturing, administration,
selling and distribution overhead. They are also classified as fixed, variable and
semi-variable so that correct estimate for each class may be prepared for the budget
period. Standard overhead rate in determined on the basis of the past records and
the future trends.
20.10. DETERMINATIONOF STANDARD HOUR

Time factor is common to all the operations. In standard costing ‘standard
hour’ is applied to the quantity of work or output which should be performed in one
hour. A standard hour may be defined as an hour which measures the amount of
work that should be performed in one hour under standard conditions. It has a
practical advantage in the measurement of ‘Efficiency Ratio and Activity Ratio’.
Efficiency ratio is the number of standard house equivalent to the work
produced, expressed as a percentages of the actual hours spent in producing that
work.
S tan dard hours for actual production
Efficiency Ratio =  100
Actual hours for actual production
Activity Ratio is the number of standard hours equivalent to the work

produced, expressed as a percentage of budgeted standard hours,
S tan dard hours for actual P roduction
Activity Ratio =  100
S tan dard hours for budgeted production
20.11. PREPARATION OF STANDARD COST CARD OR COST SHEET

Standards are recorded in standard cost cards or standard cost sheets after
they7have been computed for material, labour and over-heads. These cards give
the standard limit cost of a product. A card will be prepared for each product to
show the quantity and prices of each class of material required, the time and rate of
264
each grade of labour, the overhead rate and the total of each element of cost for
each operation or product. Standard cost card is similar to a job card.
Problem – 1
Three materials are mixed into a compound as follows:
Material X 40% Rs.30 per kg.
Out of the total mixture 5% invisible weaste 9due to loss in weight) and
wasters 5% which realise Rs.10per kg. Are provided in the standard. Find out the
cost of output per kg.
Solution
Rate Per Total cost per
Material Kg.
Kg 100 Kg Rs.
X 40 30 1,200
Y 30 25 750
Z 30 20 600
100 2,550
Less Invisible waste 5
95
Less Wastes 5 10 50
90 2,500
2,500
Cost per kg = = Rs.27.78
90
Problem – 2
Calculate Standard Labour Time for Machine part No.2300 from the following
data
Standard barch size 100 pieces
Set up time 64 minutes
Operating time 64 minutes
Operating time (each piece)
Fixing job on machine 2 minutes
Cutting time 10 minutes
Removing the job from machine 3 minutes
265
Allow 10% on total operation time for inspection during process and allow
further 5% on total time for fatigue.
Solution
Calculation of Standard Labour Time
Total operating time for each piece = 2 + 10 + 3 = 15 minutes

Operatings time for 100 pieces = 15 × 100 = 1,500 minutes
Time of inspection (10% on 1,500 minutes) = 150 minutes
Set-up time 64 minutes
1,714 minutes
Fatigue time (5% on total time) 86 minutes
Standard time for 100 piece 1,800 minutes
1,800
Thus, standard time for 1 piece = = 18 minutes
100
Problem – 3
The works Manager of a Cement manufacturing company supplies you the
following information:
Output (Units) 20,000 30,000 40,000

Overheads costs Rs. Rs. Rs.
Fixed 1,50,000 1,50,000 1,50,000
Variable 1,00,000 4,50,000 6,00,000
Calculate fixed and variable overhead costs per unit.
Solution:
Standard Variable Overheads Rate
standard Variable Overheadsfor the budget period
Budgeted productionin units or Budgeted hours for the budgeted period.
Standard Fixed Overhead Rate

S tan dard FixedOverheadsfor the budgeted period
Budgeted productionin Unitesof Budgeted hours for the budgeted period
Total and Unit Overhead at different levels of output

Output in Units
20,000
Rs.
30,000
Rs.
40,000
Rs.
Overhead costs per unit
Fixed 7.50 5.00 3.75
Variable 15.00 15.00 15.00
Total Rs. 22.50 20.00 18.75
266
Problem 4
Product X takes 5 hours to make and Y requires 10 hours. In a month of 25
effective days of 8 hours a day, 1.000 units of X, and 600 units of Y were produced.
The company employs 50 workers in the production department. The budget hours
are 1,02,000 for the year. Calculate capacity ratio, activity ratio and efficiency
ratio.
Solution
Standard hours produced X: 1,000 units @ 5 hours
= 5000 hours
Y 600: units @ 11 hours
= 6000 hours
= 5000 + 6000 = 11,000 hours.
1,02,000
Standard hours per month = = 8,500 hours
12
Actual hour recorded
Capacity Ratio = × 100
S tan dard hours budgeted
10,000  100
= = 118
8,500
Problem 5
A product passes through three process X, Y and Z. In the process the mixture
consists of
60 percent material A 700 per tonne
15 percent material B 1,200 per tonne
25 percent of the same mixtures from the forming proposes.
In the X process no material is lost. In the Y process 25% of the input does not
make satisfactory output and is returned to the process where it is quite
satisfactory as material.
In the Z process 20% input becomes scrap and is completely valueless. Direct
wages and overhead cost per tonne of input of each stage are as follows.
ANNAMALAI UNIVERSITY X
Rs.
Y
Rs.
Z
Rs.
Direct wages 200 300 100
Overheads 300 400 700
Compile standard costs showing the cost per tonne of output at each stage
267
Cost Statement of product
Solution
Tonnes Amount
X Process
Rs. Rs.
Material A 60 42,000
Material B 15 18,000
Mix of A and B (4 : 1) 25 20.000
Total 100 80,000
Wages for 100 tonnes Rs.200 20,000
Overheads for 100 100 tonnes Rs.300 30,000
Cost of X Process 1,30,000
Amount
Y Process Tonnes
Rs.
Input from X process 100 1,30,000
Wages 30,000
Overheads 40,000
Total 2,00,000
Less transfer to X process 25 20,000
Cost of Z Process 75 1,80,000

Z Process:
Input from Y Process 75 1,80,000
Wages 7,500
Overheads 52,500
Less Scrap 15 -
60 2,40,000
Cost per tonne:
1,30,000
X Process = Rs.1,300
100
X Process
1,80,000
= Rs.2,400
75
2,40,000
X Process = Rs.4,000
60
268
QUESTIONS
1. Define standard costing and explain its advantages and limitations.
2. Write show notes on
a. Standard productive hour and
b. Standard cost sheet
3. Define ‘standard costing’. Distinguish it from ‘Budgetary control’
4. What is standard costing? Discuss its advantages from the management point
of view.
5. The standard material and standard cost per Kg of material required for the
production of one unit of product ‘A’ is as follows:
Material 5 Kgs. standard price Rs.5 per kg. The actual production and related
material data are as follows.
400 units of product A
Material used 2200 Kgs.
Price of material Rs.4.50 Per kg.
Calculate
1. Material cost variance
2. Material usage variance
3. Material price variance
6. From the following information of product No.777 calculate
(1) Material cost variance. (2) Material price variance (3) Material usage
variance (4) Material mix variance (5) Material sub-usage variance.
Standard Actual
Material quality Sp. Quantity Ap.
Kg. Rs. Kg. Rs.
X 20 5 24 4.00
Y 16 4 14 4.50
Z 12 3 10 3.25

269
LESSON – 21
VARIANCE ANALYSIS
OBJECTIVES
After carefully reading into this lesson you may be able to
 Understand different kinds of variances.
 Know the procedures to be followed to prepare variances
 Acquire skill regarding variances
 Prepare different variances
STRUCTURES
21.1. Introduction
21.2. Material cost variance
21.3. Labour cost variance
21.4. Overhead variance
21.5. Sales variances
21.6. Profit/Loss variances
21.1. INTRODUCTION
The main aim of the Standard Costing is the control of the cost Management is
provided with information about the situation wherein the actual results are not as
they were planned to be. Hence, management is informed of only the deviations or
variances from the original plans, their favourable or unfaourable nature and the
causes of such deviations. In this context, standard costing subscribes to the
principle of “management by exception”.
270
Variance is the difference between the standard cost and the actual cost. It is
expressed by a simple formula as follows.
Vari ances
Cost/Variances Sales Varian ces
Material Labour Overhead Price Volume

Cost Vairance Cost Vairance Cost Vairance Variance Variance
Price Volume Rate Efficiency Idle Time

Variance Variance Variacne Variance Variance
Mix Yield Variable O.H. Fixed O.H.

Variance Variance Variance Variance
Expenditure Volume
Variance Variance
Efficiency Capacity Calendar

Variacne Variance Variance
Variance = actual cost – standard cost. Variance analysis is therefore; the

process of analysing variances by dividing the total variance in such a way that
management can assign responsibility for off standard performance. If variance is
to increase the profit or is said to be favourable and it is own as (F). It would result
when the actual costs are lower than the standard costs. It is also known as
positive or credit variance and viewed only as savings: If variance is not to increase
the profit, it is adverse or unfavourable audit is shown as (A). It would result when
actual costs exceed the standard cost. It is also known as negative debit variance
and viewed as additional costs or losses.
The diagram in page 2 shows the inter-relationships the various variances and
the sub-variances.
21.2. MATERIAL COST VARIANCE (MCV)
This is the difference between the standard cost of material specified for the
output achieved and the standard cost of direct materials used.
Material Cost Variance = Total Standard Cost – Total Actual Cost
MCV = (SQ X SP) – (AQ X AP) where as
271
SQ = Standard Quantity
SP = Standard Price
AQ = Actual Quantity
AP = Actual Price
a. Material Price Variance

This is the difference between the standard price specified and the actual price
paid.
MPV = AQ (SP – AP)

b. Material Usage Variance
This is the difference between the standard quantity specified and the actual
quantity used.
MUV = SP (SQ – AQ)

Material Mix variance is sub divided into (I) Material Mix variance and (ii)
Material yield or scrap variance
c. Material Mix Variance

This is that portion of the direct material usage variance which is due to the
difference between the standard and the actual composition of a mixture.
a. When the ratio of mix is different but the total quantities of standard mix
and the total quantities of actual mix are the same.
MMV = SP (SQ – AQ)

b. When the total actual quantity and total standard quantity and the ratio of
mix are different, then the standard quantity of each material will be
revised MMV = (RQ – AQ) X SP where RQ denotes Revised Standard
Quantity, which is equal to
T otal w eight of actual mix
 s tan dardquantity
T otal w eight of s tan dard mix
i. Material yield or scrap variance

This is that portion of the direct material usage variance which is due to the
difference between standard yield specified and actual yield obtained.
MYV = SP X Abnormal Loss/gain
MYV = SR (SY – AY)
The difference between standard yield and actual yield is called abnormal loss
or gain. If the standard yield is less than the actual yield, the difference is called
abnormal gain and if it is reverse, it is abnormal loss.
272
21.3. LABOUR COST VARIANCE (LCV)

It is difference between standard direct wages specified for the activity achieved
and the actual direct wages paid.
LCV = SLC – ALC (Standard Labour Cost – Actus Labour Cost)

Labour cost variance is sub0divided into
1. Rate of pay variance and
2. Efficiency variance, which is further subdivided into a. Idle time Variance b.
Calendar Variance; c. Mix Variance; and d. Yield Variance,
1. Labour Rate of pay Variance (LRV)

This is that portion of Labour cost variance which is due to the difference
between the standard rate of pay specified and the actual rate paid.
LRV = AT (SR – AR)

= Actual Time (Standard Rate – Actual Rate)
2. Labour Efficiency variance (LEV)
This is also that portion of labour cost variance, which is due to the difference
between the standard labour hours specified for the output achieved and the actual
labour hours expended. This is otherwise known as Labour Time Variance Labour
Quantity Variance, Labour Usage Variance and Labour Spending Variance.
LEV = SR (ST – AT)

a) Labour Idle Time Variance (LITV)
This is that portion of Labour cost variance, which is due to the abnormal idle
time of workers on account of failure of power supply, machine breakdown, storage
of materials etc.
LITV = IH X ST
(Idle Hours X Standard Rate Per Hour)
b) Labour Calendar Variance (LCV)
This arises only when workers are paid for the days for which they have not
worked and for which no provision was made while determining standard. This will
happen only when some special public holidays are declared.
LCV = SR X Holidays
c) Labour Mix Variance (LMV)
It is due to the differences in the standard composition of labour and the
actual composition of labour.
LMV = Standard cost of standard mix – Standard cost of actual mix

273
d) Labour yield variance (LYV)

It is due to the difference in the standard output specified and actual output
obtained.
LYV = Standard Labour cost per unit (Actual output Standard output)
21.4. OVERHEAD VARIANCES
Overhead variances are classified into 1. Fixed Overhead Variances and 2.
Variable Overhead Variances. Fixed Overhead Variance is sub-divided into
Expenditure Variance and volume Variance, which can be further sub-divided into
Efficiency Variances, Capacity Variances and Calendar Variances.
Similarly Variable Overhead Variances can be subdivided into Expenditure
Variance and Efficiency Variance.
1) Fixed Overhead Cost Variance (FOCV)

It is that portion of overhead variance which is due to the difference between
fixed overhead recovered and the actual fixed overhead cost incurred.
FOCV = (Actual output × Standard fixed overhead Rate) — Actual overhead.

Budgeted Fixed Overhead
Standard Fixed Overhead Rate =
Budgeted Output (Units)
a) Fixed Overhead Expenditure Variance (FOEV)

This is the difference between actual overhead expenditure and the budgeted
expenditure.
FOEV = Budgeted Fixed Overhead — Actual Fixed Overhead

Or
FOEV = (Standard Recovery Rate × Budgeted Production) — Actual.
Fixed Overheads
b) Fixed Overhead Volume Variance (FOVV)
It is the difference between the standard cost overhead absorbed in actual
output and the standard allowance allowed for that output. This variance is
caused due tot the difference between the budget output and the actual output.
FOVV = Standard Fixed Overhead Rate (Actual) Quantity — Budgeted
Quantity)
= Standard Fixed Overhead — Budgeted Fixed Overhead.
This variance can further be analysed as under
i) Fixed Overhead Efficiency Variance (FOEV)

This is that portion of volume variance which is due to the difference between
too budgeted efficiency and the actual efficiency achieved.
274
FOEV = Standard Overhead Rate per unit (Actual Quantity — Standard

Quantity)
Ii) Fixed overhead Capacity Variance (FOCV)

This is that portion of Volume Variance which arises due to working higher or
lower capacity usage than Standard.
Capacity Variance = Standard Overhead Rate per Unit (in terms of
output) Standard Quantity — Budgeted Quantity)
capacity variance
(In terms of hours) = Fixed Overhead Standard Rate per Hour
(Standard hours for the period — Actual Hours
for the period)
Iii) Fixed Overhead Calendar Variance (FOCV)

This is the difference between the number of working days anticipated in the
budgeted period and the actual working days in the budgeted period.
Calendar Variance (In Hous) = Standard Rate per hour
(Actual Hours — Budgeted Hours)
Calendar Variances (In Days) = Standard Cost of Fixed Overheads per day
(Actual Days — Budgeted Days)
In all these cases if the actuals exceed the standard or budgeted items, the
Variance is favorable and vice versa.
2) Variable Overhead Variance (VOV)

These are caused by difference between the actual variable overhead
expenditure incurred and the standard allowed.
VOV = SC — AC
= (Actual Output × Standard Overhead Rate)
Actual Overhead.
Budgeted Variable Overhead
Standard overhead Rate =
Budgeted Output in Units
a) Variable Overhead Expenditure Variance (VOEV)

This is the difference between the Standard overhead allowed and the actual
overhead incurred, for the actual time worked.
VOEV = (AT × SVR) — AVO
= Actual time worked × Standard Variable Overhead Rate — Actual
Variable overhead Rate for the period.
275
Or
= Budgeted cost — actual Cost
b) Variance Overhead Efficiency Variance (VOEV)

This is the difference between Standard Variable overhead allowance of actual
output, and the standard Variable overhead of actual time.
VOEV = Standard Overhead Rate (Actual time Standard time
for actual production)
Variable Overhead
Total Variance = Expenditure Variance + Efficiency variance.
21.5. SALES VARIANCES

So far we have explained the cost variance which ultimately affects profit
favorably of adversely. But budgeted profit may be affected due to increase or
decrease in the selling price and in the quantum of sales.
There are two methods of computing sales variances viz 1. Sales Value Method
and 2. Sales Profit Method.
Sales Value Method

a) Sales value variances
This is the difference between standard or budgeted sales and the actual sales.
Sales value Variance = Standard Sales — Actual Sales.
Where a Standard sales = Standard price × Actual quantities of sales.
b) Sales Price Variance

This is that portion of the sales value variance which is due to the difference
between standard prices specified and the actual price charged.
Sales price variance = Actual Quantity Sold (Standard price — Actual price)
c) Sales volume variance

It is difference between budgeted sales and the standard value of the actual
mix of sales.
Sales volume variance = Standard Price (Actual Quantity —
ANNAMALAI UNIVERSITY Standard Quantity)

Or = Budgeted Sales — Standard Sales
Sales volume variance: This can be further sub-divided into I) Mix variance
and ii) Quantity variance.
276
i) Mix Variance: This is the portion of the sales value variance which is due
to the difference between the standard and the actual inter-relationship of the
qualities of each product or product group of which sales are composed.
Mix Variance =
T otal Quantity of Actual Mix
 S tan dard cos t of S tan dard Mix
T otal Quantity of S tan dard Mix
Budgeted Sales of a P roduct
or =  S tan dard Sales
T otal Budgeted Sales
or = Standard Value of Actual Quantity at standard Mix —

Standard Value of Actual Mix
(ii) Quantity Variance: It is the difference between the sales volume variance
and the sales mix variance, arising purely due to difference in the quantity sold.
Quantity Variance = (Total Standard Quantity — Total Actual Quantity) ×
Total Standard price Rate.
2. Sales Profit or Margin Method

It is the difference between the actual margin from sales (cost of sales) at
standard and Budgeted margin.
Margin Value Variance = Budgeted profit — Actual profit
a) Sales Margin Price Variance

This is that portion of total margin variance which is due to the difference
between the standard price of the quantity of the sales effected and the actual price
of those sales.
Margin Price Variance = (Actual Quantity of sales × Standard price) — Actual
Quantity of sales × Actual price
Or
Standard profit — Actual profit
b) Sales margin volume Variance (SMVV)

between the budgeted quantity and the actual quantity of sales. Margin Volume
Variance
SMVV = Standard Margin per unit (Budgeted units —
Actual units sold)
As already stated volume variance can be further subdivided into (I) Mix
variance and (ii) Quantity variance.
277
Sales Margin Mix Variance

It is that portion of the sales margin variance which is due to the difference
between the actual and budgeted quantities of each product of which the sale
mixture is composed, valuing sales at the standard not selling prices and cost of
sales at standard.
Sales Margin Mix Variance = Standard Margin (Standard Proportion of

Mix — Actual Mix)
Sales Margin Quantity Variance
It is the difference between sales margin volume variance and sales margin mix
variance.
Margin Quantity Variance = Total standard Margin Rate (Total Standard
Quantity — Total Actual Quantity)
Sales Margin Variance Due to Sales Allowance

between the budgeted rebates, discounts etc., and those allowed on those sales.
21.6. PROFIT OR LOSS VARIANCE

This is the difference between the budgeted profit or loss and the actual profit
or loss and the actual profit or loss
Illustration - I
Kg Rs.
45 of material A at Rs. 2 per Kg. 90.00
40 of material B at Rs. 4 per kg. 160.00
25 of material C at Rs. 6 per kg. 150.00
110 400.00
Less standard loss 10
100
Actual production 2,000 units of chemical No. 550 and actual material usage
is as follows.
Rs. Rs.
Material A
Material B
1,000
850
Rs. 1.90 per Kg
Rs. 42.0 per Kg.
1,900
3,570
Material C 450 Rs. 650 per Kg. 2,925
2,300 8,395
Calculate
1. Material Cost Variance
278
2. Material Price Variance

3. Material Mixture Variance
4. Material Yield variance
5 .Material Usage variance.
Solution
Working Notes
a. Standard percentage of output derived from input
100
× 100 = 90.9%
100
Normal Loss = 90.1%
Since the actual output is 2,000 Kg. The standard date has to be converted
into input required for the purpose of production of 2,000 Kg.
Standard input = 45 × 20 = 900 Kg. Of material A

40 × 20 = 800 Kg. Of material B
25 × 20 = 500 Kg. Of material C
Total 2,200
Less Normal loss 9% 200
Output 2,000 Kg.
b. Standard loss on actual input:

If 110 units are input then loss is 10 kg.
10
2,300 units are input the loss is = × 2300
110
2300
= Kg.
11
c. Average Standard Price

T otal cos t 400
= — Rs. 4 per kg
T otal S tan dard Output 100
d. Material cost variance

Formula: SQ × SP — AQ × AP.
Material A (900 × 2) — (1.00 × 1.90) Rs. 1,800 — 1,00 = 100 (A)
Material B (800 × 4) — (850 × 4.20) Rs. 3,200 — 3,570 = 370 (A)
Material C (500 × 6) — (450 × 6.50) Rs. 3,000 — 2,.925 = 75 (F)
Total Material cost variance = 395 (A)
This can also be calculated as follows:
279
Total Standard Cost of Standard (Total actozi cost of input for

—
input for actual output) actazi output
Rs. 8,000 — 8,395 = Rs. 395 (A)
(2) Material Price Variance
Formula: (SP × AP) × AQ
Rs.
Material A (2–2.10) × 1000 0.10 × 1000 = 100 (F)
Material B (4–4.20) × 850 0.20 × 860 = 170 (A)
Material C (6–6.50) × 450 0.50 × 450 = 225 (A)
Total Material Price Variance – Rs. 295 (A)
3. Material Mix Variance:
Here, it is necessary to calculate revised stanord propoyclon of actual input.
S tan dard Mix
Formula: × Total Actual Input
T otal S tan dard Input
Kg.
900 10,350
Material A × 2,300 =
2,000 11
800 9,200
Material B × 2,300 =
2,200 11
500 5,750
Material C × 2,300 =
2,200 11
Formula for Material Mix Variance
Revised Standard Proportion on the

— Actual Proportion × Sp.
Basis of Total Actual input
 10,350  1,300
Material A   100 × 2 = = 118.19 (A)
 11  11
 9,200
Material B 

 850 × 4 =
600
= 54.55 (A)
 11  11
 5,750  4,800
Material C   450 × 6 = = 436.57 (F)
 11  11
Total Material Mix Variance Rs. = 263.63 (F)
280
4. Material yielded Variance

Standard loss to Actual Loss on Average
— ×
terms of actual input Actual Input Standard Price
2,300 — 300 = 4 = — = RTTs.363.63 (A)

11
5. Material usage variance

Formula
Material Mix Variance — Material yield variance = Material usage variance
Rs.263.63 (F) — Rs.363.63(A) = Rs.100 (A)
Check:
Material Mix Variance — Material yield variance = Material usage variance
Rs.395(A) = Rs.295(A) + Rs.100(A)
Illustration 2:
Standard labour hours and rate for production of Article A is given below
Rate Total
Hrs.
Rs. Rs.
Skilled worker 5 1.50 per hour 7.50
Unskilled worker 8 0.50 per hour 4.00
Semi-skilled worker 4 0.75 per hour 3.00
14.50
Actual data Rate per hour Total

Articles produced 1,000 units
Skilled worker 4,500 hours 2.00 9,000
Unskilled worker 10,000 hours 0.45 4,500
Semi-skilled worker 4,200 hours 0.75 3,150
16,650
Calculate:
a. Labour cost variance
b. Labour rate variance
c. Labour efficiency variance
d. Labour mix variance
281
Solution
a) Labour cost variance
Formula
(Standard hours for actual Production × SR) — (AH × AR)
Rs.
Skilled worker (5,000 × 1.50) – (45,000 × 2) 7,500 – 9,000 = 1,500 (A)
Unskilled worker (8,000 × 0.50) – (10,000 × 0.45) 4,000 – 4,500 = 500 (A)
Semi-Skilled worker (4,000 × 0.75) – (4,200 × 0.75) 3,000 – 3,150 = 150 (A)
Total labour cost variance 2,150(A)
b) Labour price variance
(SR — AR) × AH Rs.
Skilled worker (1.50 — 2) × 4,500 2.250(A)
Semi-skilled Worker (0.75 — 0.75) × 4,200 Nil
Unskilled Worker (0.50 — 0.45) × 10,000 500.00 (F)
Total Rs. 2,750.00(A)
Labour Mix variance
For calculation of labour mix variance we will have to calculate revised
standard hours in terms of total actual hours worked.
Formula
S tan dard mix
× Total actual hours
T otal s tan dard hours
Hrs.
5,000 93,500 = 5,500
Skilled worker  18,700 
17,000 17
8,000 1,49,600 = 8,800
Unskilled worker  18,700 
17,000 17
Semi-skilled worker
4,000
17,000
 18,700 
74,800
17
= 4,400
Formula of labour mix variance

(Revised standard mix of actual hours worked — Actual mix) × Standard cost
282
Rs.
Skilled workers (5,500 — 4,500) × 1.50 1,500 (F)
Unskilled Workers (10,000 — 8,800) × 0.50 600 (A)
Semi-skilled workers (4,00 — 4,200) + 0.75 150 (F)
Total labour mix variance 1.050 (F)
D. Labour efficiency variance
(S.Hours for actual Production — Revised S.Hours) × S.R.
Rs.
Skilled worker  93,500  750 (A)
 5,000 —   1.50 =
 17 
Unskilled worker  1,49,600  400 (A)

 8,500 —   0.50 =
 17 
Semi-skilled worker  74,800  300 (A)

 4,000 —   0.75 =
 17 
Total labour efficiency variance 1.450 (A)
Working Notes
Standard hours for actual Production
Units Standards Hours
Actual units 1,000 × 5 5,000 skilled
1,000 × 8 8,000 unskilled
1,000 × 4 4,000 semiskilled
Illustration 3
A manufacturing company operates a costing system and showed the following
data in respect of the month of November
Actual No. of working days 22

Actual man hours worked during the month 4,300
Number of products produced 425
Actual overhead incurred (Rs.) 1,800
Relevant information from the company’s budget and standard cost date is as
follows
Budgeted number for working days per month 20
Budgeted man hours per month 4,000
Standard man hours per product 10
Standard overhead rate per man hour 15p
283
You are required to calculate for the month of November

a. The overhead variance
b. The calendar variance
c. The volume variance
Solution
4. Overhead cost variance
Standard overhead cost of actual production-Actual overhead cost
Rs.2,125 — Rs.1,800 = Rs.325 (F)
5. Overhead calendar variance

6. Where standard overhead rate per unit is given
Revised budgeted quantity i.e. Quantity of actual Standard rate
— ×
Budgeted quantity on the basis no. of working days unit
(440 — 4000) × 5
(40 × 5 = Rs.200 (F))
Ii. Where standard rate per hour is given

(possible number of hours — Budgeted hours) × Standard overhead rate per hour
(4,400 — 4,000) × 0.50
400 × 0.50 = Rs.200 (F)
7. Overhead volume variance

Where standard rate per unit as given
(Actual production — Budgeted production) × Standard overhead rate per unit
(425 — 400) × Rs.5
25 × Rs.5 = Rs.125 (F)
Ii. Where standard rate per hour is given

(Standard hours for Actual
× Standard overhead rate per unit
production — Budgeted hours)
(4,250 — 4,000) × 50 P
250 × 50 = Rs.125 (F)
Working Notes
8. Standard cost per unit
50 p × 10 hrs = Rs.5 per unit
9. Standard overhead cost of actual production
284
425 units × Rs.5 per unit = Rs.2,125

10. Revised budgeted quantity
If 20 are the working days standard production 400 units
400
If 22 are the working days standard production  22 = 440 units
20
11. Possible Hours
In 20 working days the standard hours are 4,000
4,000
 in 22 working days the standard hours are  22 = 4,400 hours
20
12. Standard hours for actual production
Actual production × Standard hours per unit 425 × 10 = 4,250 hrs
Illustration 4
Standard Actual
Sale price Sale Price
Quantity Total Quantity Total
Rs Rs.
Rs. Rs.
Produce X 500 5 2,500 500 5.00 2,500
Produce Y 400 6 2,400 600 6.25 3,750
Produce Z 300 7 2,100 400 6.75 2,700
1,200 7,000 1,500 8,950
Calculate (1) Sales Value Variance (2) Sales Price Variance (3) Sales mix
Variance (4) Sales Sub Volume Variance.
Solution
1. Sales value variance
Formula : Actual quantity × (AP) — (SQ × SP)
Rs
Product X (500 Nil
Product Y (600 (F)
Product Z 600 (F)
Total Sales Value Variance 1,950 (F)
2. 2. Sales price variance

Formula (AP — SP) × Actual quantity
285
Product X Rs.(5.5) × 500 Nil

Product Y Rs.(6.25.6) × 600 150 (F)
Product Z Rs.(6.75.7) × 400 100 (A)
Total Sales Price Variance 50 (F)
3. Sales mix variance

Formula: (Actual proportion = Revised standard mix of actual total sale) × SP
Product X (500 — 625) × 5 625 (A)

Product Y (600 — 500) × 6 600 (F)
Product Z (400 — 375) × 7 175 (F)
Total Sales mix Variance Rs. 150 (F)
4. Sales sub-volume variance

Formula: (Revised standard mix- standard mix) × SP
Product X (625 — 500) × 5 625 (A)

Product Y (500 — 400) × 6 600 (F)
Product Z (375 — 300) × 7 525 (F)
Total Sale sub-volume Variance Rs. 1,750 (F)
Check:
Sale Price variance + sale mix variance + sale sub usage = sale value variance
Rs.59 (F) + Rs. 150 (F) + Rs.1,750 (F) = Rs.1,950 (F)
Working Notes
Revised standard mix
If 1,200 units are total sale, product A sold = 500
S tan dard units or product
Product A If 1,500 =  AQ
T otal s tan dard units
ANNAMALAI UNIVERSITY =
500
1,200
 1,500 = 625 units
400
Product B =  1,500 = 500 units
1,200
300
Production C =  1,500 = 375 units
1,200
286
QUESTIONS
1. Define Material cost variance state its advantages
2. Explain the classification of direct material cost variance unit different
categories with suitable examples.
3. Explain the term ‘variance’ under standard costing and discuss its significance.
4. What are the different types of Labour variance? How are they calculated and
dealt with?
5. Give that the cost standard for materials consumption are 40Kg. @ Rs.10 per
kg. Compute the variance when actuals are
43 Kg at Rs.10 per kg
36 Kg for a total cost of Rs.360.
6. Mixers Ltd, is engaged in producing a ‘standard mix’ using 60 kg of chemical X
and 400 Kg of Chemical ‘Y’. The standard loss of production is 30% The
standard price of X is Rs.5 per kg and of ‘Y’ is Rs.10 per kg.
The actual mixture and yield were as follows
X 80 Kg @ Rs.4.50 per kg and
X 70 Kg @ Rs.8.00 per kg

287
LESSON – 22
CAPITAL BUDGETING
OBJECTIVES
 Understand the importance of capital budgeting
 Identify the objectives of capital budgeting
 Know the limitations of capital budgeting
 Evaluate feasibility study
STRUCTURE
22.1. Capital expenditure control
22.2. Capital expenditure planning
22.3. Capital budget
22.4. Capital budgeting
22.5. Objectives of capital budgeting
22.6. Limitations of capital budgeting
22.7. Classification of capital expenditure budget
22.8. Project report
22.9. Financing source mix
22.10. Feasibility
22.1. CAPITAL EXPENDITURE CONTROL

The forecasting and budgeting of capital expenditure are important factors in
the management of a business. The expansion of the existing plant and equipment
and the introduction of technological improvements represent major factors in
economic growth and contribute to increased productivity. As business expands, it
becomes necessary to invest in fixed assets so as to increase the volume of
production. Investments in fixed assets for new project or for replacements
necessarily have to be justified by the expected yield there form. It is quite natural
that every business would expect a return adequate to the capital invested.
Capital expenditure Includes the following

1.
2.
For additions or extensions to the existing plant to Increase production.
For replacing worn-out machinery to increase the capacity of the existing
facilities.
3. For addition of new line of production or developing a new product.
4. For replacing machinery to achieve cost saving or for reducing costs through
technical improvement in machinery.
288
5. Installation of a new plant.
22.2. CAPITAL EXPENDITURE PLANNING

Capital expenditure programmes are carefully planned based upon well-
thought-out forecasts. Factors like economic trends, demands, sales and other
connected influences are considered. Before it takes a final shape, it is subjected to
strict scrutiny and evaluation. Points dealing with installation of cost saving
machines, cheaper and efficient way of carring out the projects are discussed and
analysed by the departmental heads.
Generally approval of authority for appropriating funds is granted by the Board
of Directors. Before they are authorised, it is the practice to submit the
appropriating request to the management for approval. This request will usually
contains information relating to the description of the project, purposes and
reasons for the same, estimated total cost, date of commencement and date of
completion of the project, and other financial implications. The estimated income
from the project is also ascertained. Authorisation of capital expenditure involves a
formal capital budget and the authority for the appropriation. Most of the concerns
have standard forms which contain the details such as 1. Description and purpose
of proposal 2. Estimated cost of the project and 3 effect on operating cost and
profits.
Capital
The term capital, in business variance, refers to fixed assets used in
production while a budget is a plan detailing project inflows and outflows during
some future period.
22.3. CAPITAL BUDGET

Capital Budget outlines the planned expenditure on fixed assets. Anthony
defines it “as a list of what management believes to be worth while projects for the
acquisition of new capital assets together with the estimated cost of each project”.
22.4. CAPITAL BUDGETING

According to Harold Bierman it, and Thomas K. Dyckkan “capital budgeting is
the process of deciding whether or not commit resources to projects whose costs
and benefits are spread over several time period”.
In the words of Prof. S. Kuchal “capital budgeting process involves planning
the availability and controlling the allocation and expenditure of long term
investment funds”.
Hence, capital budgeting involves the following three steps.
1. Estimation of the available funds for investment.
2. Preparation of a list of alternative investment
289
3. Evaluation of various projects by means number of techniques and

selection of the most profit ones.
In short, capital budgeting means planning for capital assets or fixed assets.
But to speak broadly, it is a many sided activity that includes reaching for new and
more profitable investment proposals, investigating engineering and marketing
considerations to predict the consequences of accepting the investment and making
economic analysis to determine the profit potential of each investment proposal.
The decision of capital invalids a financial analysis of the various proposals
regarding capital expenditure to evaluate their impact on financial condition of the
company and to choose the best out of the various alternatives.
22.5. OBJECTIVES OF CAPITAL BUDGETING

The first and foremost objective of budgeting is to spread the available invisible
funds over the capital projects in an optimum combination so as to maximise the
total profits accruing from all the investments put together.
It has other objectives such as employment generation, employee
compensation and satisfaction, provision for research and development and the
like.
It also aims at controlling capital expenditure. ie., it helps controlling
expenditure by forecasting the long-term financial requirements and thus enables
to plan in advance to raise funds at the most appropriate time.
It determines the total amount of money to be invested on long term project so
that it may be controlled in line with the company’s financial policies.
Lastly, it tries to compromise between the availability of funds and
requirements of the capital projects.
22.6. LIMITATIONS OF CAPITAL BUDGETING

The different methods of ranking investment proposals represents a
continuous attempt at systematic analysis of available alternative proposals as well
as Improvement of procedure of evaluation. This sophistication and retirement of
procedure itself cannot ensure the best possible choice. If the data are wrong.
Moreover, capital budgeting technique involves an entire range of data relating to
the projections of expectations involving revenue, costs, equipment, life. Human
and material performance, etc. Lastly there are some factors which cannot be
quantified. For instance, an investment may have a direct or indirect effect on
employee morale or on relations with the community which could cause irreparable
harm, if not carefully judged. Skilful managerial judgement is imperative under
such conditions.
22.7. CLASSIFICATION OF CAPITAL EXPENDITURE BUDGET

The following are the classification of capital expenditure budget
290
1. Initial Capital Expenditure Budget

2. Capital Budget for Replacement and Expansion
3. Annual Capital Budget.
Initial capital Expenditure Budget is prepared for new project on the basis of
estimates for civil works, electrical works, cost of plants, machinery, euipments and
tools, preliminary expenses etc.
Under Budget for Replacement and Expansion, expenditure necessary to
replace worn out or damaged equipment are included in this group. Replacement
may be undertaken for either maintenance of business or cost reduction or both.
Expansion may be on existing products/markets or into new products/markets.
Every year there is some amount of capital expenditure for purchase of office
equipment, vehicles, extension of building, furniture, machine, accessories and the
like. This is called Annual capital Budget.
Similarly Capital Expenditure projects may also be classified into 1. Profit
Earning Projects and 2. Non-Profit projects. Profit Earning Projects are taken up
with a view to increasing or maintaining profits such as investment in a plant
which is expected to improve the quality of products or to improve facilities of
increased productivity or to expand the productive capacity to reduce the cost.
Sometimes capital investments are undertaken for meeting some contractual
obligations such as labour agreements or statutoty requirements or the orders of
government or Local Authorities such as safety measures for employees. Research
and development projects etc. Prestige value projects are also undertaken in order
to create a favourable image in the minds of public e.g. investments on guess
houses, community hall, traffic umbrellas, parking lots etc. These are all Non-
profit projects.
22.8. Project Report

The first stage in the development of a project is the preparation of Project
Report. The main factors affecting the capital investment decision and incorporated
in the project report are give below:
1. The amount of the investible funds available during the project period.
2. The project cost and the production life of the investment
3. The phasing of the expenditure under the project
4. The amount of earning
5. Opportunity or alternative cost
6. Interest cost of the capital to be invested
7. Additional working capital requirements
291
22.9. FINANCING SOURCE MIX

This is another consideration in project evaluation ie., to examine the various
methods of financing in project and their effects on profitability of the project.
Whether capital expenditure takes the form of additional equipment or equipment
replacement, it requires liquid cash to execute the project and in turn when
production increases this requires additional working capital also. This additional
finance must be obtained either form outside sources or from within the business.
Then it should be decided whether the capital expenditure is to be financed by
internal sources.
FEASIBILITY
The following are five major areas with reference to which the feasibility of a
capital project must be evaluated
1. Technical
2. Commercial
3. Financial
4. Managerial and
5. Economic feasibility
Here, the main aim is to explain the financial feasibility of a project through
profitability statements, other areas are left untouched. Here is also assumed that
in deciding whether or not to in that in fixed assets the sole criterion is the profit
expected for the investment. Hence, it is the responsibility of the management
accountant to see that the management is presented with the most useful
information about each project, and so decisions are based not on a guess work but
on reasoned calculations.
Methods: In capital budgeting time factor is very important. Planning and
execution are two important factors. There are two main methods of capital
budgeting i.e., 1. long-range Budget and 2. Short-Range Budget.
long-range Budget: Usually this extends to a period of three to five years. It
covers arras of future expenditure instead of particular proposals. It contains
objectives only in general terms. It comprises of a forecost of the business future
and estimates of the future capital requirements prepared by the various heads of
the department and compiled into a budget.
Short-Range Budget: This is prepared to cover a short period of not more
than a year. It covers an estimate of funds that are available for capital
expenditure and proposal for the project submitted by the various heads of the
department to be included in the coming budget.
QUESTIONS
1. What is capital expenditure budget? Why is it necessary.
292
2. Write short notes on

a. capital rationing
b. pay-back reciprocal
3. What are the distinct categories of investment decision? Discuss the basic
factors on which investment decisions adopted.
4. Outline the financial management technique of capital investment in fixed
assets.
5. A company has to choose the of the following two multvaley exclusive projects.
Both the projects have to be depreciated on straight line basis. The tax rate is
50%
Cash Inflows
Year
Project A (Rs.) Project B (Rs.)
0 15000 15000
1 4200 4200
2 4800 4500
3 7000 4000
4 8000 5000
5 2000 10000
6. A project cost Rs.500000 and yields annually a profit of Rs.80000 after
depreciation at 12% p.a. But before tax 50%. Calculate pay-back period.

293
LESSON — 23 & 24
CAPITAL BUDGETING (CONTINUED) FINANCIAL
EVALUATION OF PROJECTS
OBJECTIVES
 Elaborate the basic capital budgeting techniques
 To know the factors should be used to assess profitability of capital
expenditure on projects
STRUCTRUE
1. Methods used to evaluate the profitability of the proposed projects
1. Payback method
2. Return on investment method
3. Discounted cash flow method
4. Internal rate of return method
5. Net present value method
6. Financial Evaluation of projects
Methods used to Evaluate the profitability of the proposed projects:

There are several methods employed in assessing the profitability of capital
expenditure on projects. The principal methods are
1. Payback period
2. Accounting Rate of Return
3. Net present value
4. Internal Rate of Return Discounted cash Flow
1. Pay-Back method
This is also known as “pay-off” method. It is employed to determine the
number of years in which capital expenditure incurred is expected ‘to pay for itself’.
This deals with the comparison of the capital expenditure with the flow of income
generated therefrom. “The pay-back” period is the number of years during which
the income is expected. The amount of annual sales of the products of the plant is
taken and the cost of production deducted therefrom. Depreciation is not included
in the costs. The main idea is to assess the cash generated. Here, the net amount
represents the annual income. The principle is that investment represents a sum
of cash spent at a point of time, the net income generated runs over a period of
time.
294
If the sum total of the cash income so generated which runs over a period of
years, is more than the investment, there is justification for one to so invest. This
is one of the most commonly used methods for determining the profitability of
capital investments. The criterion here is that the average income from a proposed
investment be sufficient to cover the investment within a period of time.
Calculation of pay-back period

This is calculated by dividing the investment by the amount of return per
annum after charging taxation but before charging depreciation.
Original cos t of Investment
Pay-back period =
Annual Net Cash Inflow sor Savings
I I I
P  or or
S C E
where P = Payback period C = Annual Cash inflows
I = Initial Investment E = Earnings per year
S = Saving per year
Example: If a project consist Rs.5,00,000 and it has an estimated life of 10 years,
the amount of profits or fund inflows from the same are as follows
Rs. Rs.
I year 50,000 VI year 1,00,000
II year 1,00,000 VII year 1,00,000
III year 1,00,000 VIII year 1,00,000
IV year 1,00,000 IX year 1,00,000
V year 1,00,000 X year 1,00,000
It will be found that the investment of Rs.5,00,000 will be recovered before the
end of the 6th year. Therefore the pay back period is six years. Strictly speaking
this method measure only the liquidity and not the profitability of a project. It is
only a yardstick used to measure the number of years for the earnings of a project
to return the capital.
Advantages
1. The method is useful considering the present day development of
technology.
2. The main advantage is its simplicity to understand and the case of
calculation
3. As the pay-back period is usually a short period, it is very easy to work out
the costs and the sales.
295
Disadvantages
1. As the earnings for the period beyond the period of return of investment are
considered, it does not measure true profitability.
2. Since this method is concerned with the recovery of costs only during the
pay-back period the true profitability of the investments cannot be correctly
assessed.
3. As the period under this method is limited to a short period only, the
serviceable life of an asset is ignored. Hence, the real return on investment
cannot be correctly assessed in the absence of consideration of the full
serviceable life of an asset. An asset with a long life, may fail to meet the
pay-back period requirement but may yield a greater return during its life.
4. It provides no measure to compare with the costs of investments or the
current rate of return on investments.
5. Under this method the time factor is ignored. In order to make correct
comparisons of different investments, it is necessary to discount the future
income to the present value.
6. Since this method attempts to shorten the period by adoption of pay back
period, too much importance is attached for recovery of income quickly.
Return on Investment Method

This is an accounting method and takes into consideration the rate of return
likely to be obtained from the project. This is defined as the ratio of profit (after
depreciation and taxes) to initial capital outlay. The figure thus obtained is
compared to the cost of capital projects which did not give the desired minimum
rate of return i.e., cut off rates are rejected. Acceptable projects are ranked
according to the respective rates of return and the one which yields the highest rate
of return is selected.
This method is otherwise known as “Accounting Method” “Interest Rates of
Return Method” “Unadjusted Rate of Return Method”. “Average Rate of Return
Method”. “Financial statement Method”.etc, The return on investment should be
calculated on the basis of data available and whenever possible both total and
average investment methods should be applied.
i. Total income method

Under this method total earnings are ascertained and then it is divided by the
total investment. This gives the rate of return per rupee invested in the project.
The higher the earnings per rupee or the higher the percentages the project
deserves to be selected.
T otal Earning
Earnings per Unit of Investment =
P roject Outlay
296
This can also be expressed as the total expected income from a project as a
percentage of its capital cost.
Example
Cost of the project Rs.16,00,000
Depreciation 20%
Life of the asset 5 years
Annual Income before depreciation
Year 1 1,60,000
Year 2 2,00,000
Year 3 2,00,000
Year 4 2,40,000
Year 5 2,40,000
Total expected income 10,40,000

Total forecast income 10,40,000
Less Depreciation 5 years i.e. 20% 6,00,000
Net Income after depreciation 4,40,000
Total return on original investment

4,400,00
=  100  73%
6,00,000
Earnings per unit of money invested

4,40,000
= = 0.73 = 73 paise for every rupee invested.
6,00,000
ii. Average Rate of Return on Investment

Here all the earnings after taxes and depreciation are added and then, it is
divided by the project’s effective economic life. This gives the figure of average
earnings over the period which is again divided by original investment. The project
which gives the highest rate of return is normally selected.
Formula:
Net P rofit after depreciation and taxes  100
=
Life of asset  Capital outlay
297
III. Additional Earnings on Investment Method

Additional profit is the excess of profit of one asset over the other. To calculate
the additional profit, the profit or earnings for two alternatives under consideration
should be calculated as under.
Average additional profit per annum
=  100
Average amount invested
Merits
1. Unlike pay back method, this considers the earnings of the whole working
like of a project.
2. This method really attempts to find out the profitability of the investment
project. Under pay back method, it is concerned only with the recovery of
the original investment, but this method embodies the concept of net
earnings after allowing for depreciation as it is of vital importance in the
appraisal of a proposal.
3. This technique is easy to understand and simple to calculate.
4. This technique functions as a yardstick of computing the relative
profitability.
Drawbacks
1. This method ignores the time element of the earnings. Hence, it may prove
sometimes to be unreliable or inaccurate.
2. Not all the accountants agree with the usage of the concept of average
investment.
3. The sum total of the earnings of the entire working life of the asset is
averaged and a common rate of return is calculated. This method ignores
the fact that profits accurate an uneven rate.
4. There is no reasonable rate of return on investments. Some stipulate a
minimum rate so that if investments do not show this rate they are
summarily excluded from considerations.
Discounted Cash Flow Method

As money has a time-value time factor in investment is fundamental for the
purpose of evaluating investments. Cash flows received in different years should
not be treated to have uniform value. The nominal value of rupee received to-day is
more valuable than a rupee to be received a year later. The Discounted Cash Flow
(D.C.F) method takes the time factor of income into consideration while the
foregoing members do not take it into account.
This technique has nothing to do with inflation reducing the value of money,
but a person who foregoes a pending money immediately expects to receive a regard
298
for his action. This reward takes the form of interest. Discounting is just the
opposite of compounding. At compound rate of interest, the future value of the
present money is ascertained whereas in discounting the present value of the
future money is calculated.
Example
Consider an investment made to-day of Rs.100 at 10% p.a. compound interest
will grow as indicated below.
Rs.
) year 100
I year 100 + 10 = 110
II year 110 + 11 = 121
III year 121 + 12.10 = 133.10
IV year 133.10 + 13.31 = 146.41
V year 146.41 + 14.64 = 161.05
The following formula is used to calculate the future value.
Future value = Principal + (1 + I)n where ‘I’ is the rate of interest per period and
‘n’ is the number of periods. Similarly the following formula is useful is calculate
the present value of the future sum.
Future sum 100
Present Value =   0.909
(1  i)n 100
Where ‘I’ is the of interest per period and ‘n’ is the rate of interest per period
and ‘n’ is the number of periods. Similarly the following formula is useful to
calculate the present value of the future sum.
Where ‘I’ is the rate of interest per period and ‘n is the number of periods. Now
we can calculate the present value of future money for the above example.
At the end of Amount Discounted factor Present Value

Rs. (A) for 10% (B) (A × B)
Ist year 111.00 .909 100
IInd year 121.00 .826 100
IIIrd year 133.00 .751 100
IVth year 146.41 .683 100
Vth year 161.05 .621 100
This technique considers the net cash flow as representing the recovery of
original investments plus return on capital invested. The analysis under this
method could be made in two ways.
299
1. Internal Rate or Return Technique

2. Net Present Value Method
Internal Rate of Return Technique

This is defined as the interest rate that equates the Present value of the
expected future receipts (Net profit plus depreciation) to the cost of the investment
outlay. It is the time adjusted rate of return as well as the maximum rate of
interest that could be paid for the capital employed over the life an investment
without loss on the projects. In other words, ikt is the discount rate that equates or
breaks evenly the present value of initial outlay with present value of the expected
net cash flows of reduces the net present value to zero.
This is otherwise known as the “trial and error” method because it involves
making a series of trial calculations in an attempt to compute the correct interest
which discounts the cash flow to zero. This rate is also known as “solution” or
“yield” rate of interest.
Internal Rate of Return is mathematically represented by that rate ‘r’ such that
E1 E2 En
C=   where
1  r 
1
1  r 
2
1  r n
‘C’ is the required capital outlay, ‘B’ is the earnings and ‘r’ is the rate of return.
Calculation of Internal Rate or Return

a) Establishing the First Trial Rate
This rate is found by trial and error from the present value tables. Where the
earnings are equal or even for all years, to select a trial rate first of all divide the
initial capital outlay by net cash flow per annum ie.,
Investment
Earnings per annum
On the other band, when the net cash flow is not too uneven, the trail rate may
be selected with the following formula
Average excess cash flow ovr capial cos t
=  100
Average Investment
where Average excess cash flow
ANNAMALAI UNIVERSITY T otal NCF less capital cos t

project life
b) The second Trials Rate

This rate is selected by considering whether cash inflow is greater or less than
the cash outflow. If the inflow is less that the outflow the second trial rate will be
less than the first trial rate. On the other hand, if the inflow exceeds the outflow,
300
the second trial rate will be higher than the first trail rate. Thus, an area can be
located where an exact discount rate lies and this can be approximated by simple
interpolation.
c) Comparison of Internal Rate of Return with cut -off Rate

While comparing these two rates, if the former is not less than the latter,
project is financially profitable. Here the project with maximum rate should be
selected as the most profitable one.
Example
Calculate the internal rates of return for projects X and Y from the following
data
X Y
Initial Investment Rs.15,000 Rs. 15,000
Effective Life
(No Salvage value) 4 yrs. 4 yrs.
Rs. Rs.
Cash inflows: I 6,000 -
II 6,000 -
III 6,000 -
IV 6,000 30,000
Solutions
Project ‘X’
There is an annuity of Rs.6,000 per year for 4 years for project X. Hence, for
calculating the internal rate of return one can use the Annuity Table.
The proportion of Annuity of Rs.6,000 and initial Investment of Rs.15,000 is
6,000: 15,000 or 1 : 2 × 5. In the Annuity Table, one will read the discount rate
that will reduce an annuity of Rs. One for 4 years to a present value of 2.5. The
Annuity Table shows that 2.5 factor lies between the 21% and 22% discount rates.
The approximate internal rate between 21% and 22% shall be determined by
extrapolation as under:
1 2 3 1×3
Annuity Discount Rate Discount factor Present Value
6,000 21 % 2.5404 15.242
22% 2.4936 14.961
1% 281
301
15,242 — 15,000
Internal Rate of Return = 21 +  
15,242 — 14,961
242
= 21 +
281
= 21.86%
Protect ‘Y’
For project ‘y’ there is a lumps sum of Rs.30,000 that will be received after the
end of 4th year. For calculating the internal rate or return, we can use liable that
gives the present value of a rupee due at the end of ‘n’ years. The proportion
between the amount of cash inflow and the initial investment is 30,000: 15,000 or
1:05. In the table we can read the discount rate that will reduce a rupee receivable
after the end of 4th year to a present value factor of 0.5. The Annuity Table shows
that 0.5 factor lies between 18% and 19% discount rates. The approximate internal
rate between 19% shall be determined by extrapolation as under:
1 2 3 1×3
Annuity Discount Rate Discount factor Present Value
30,000 18 % 0.5157 15.471
19% 0.4986 14.958
1% 513
15,471 — 15,000
Internal Rate of Return = 18 +  
15,471 — 14,958
471
= 18 ×
513
= 18.92%
Merits
1. There is no need for specifying a required rate of return.
2. It takes into account the magnitude as well as timing of cash inflows and
outflows over the total effective life of the asset.
3. As it is a relative measures, it allows ranking of investments according to their
internal rates of return.
It is also useful when the cost of investment and the annual cash inflows are
know while the unknown rate of return is to be calculated.
Limitations
1. It is very difficult to select an appropriate rate to interest. Due to frequent
economic changes, the structure of interest also is subject to change. Moreover
it is linked with Bank Rate.
302
2. The selection of cash inflow is based on sales forecasts which is in itself an

indeterminable element.
3. It also involves a good amount of calculation with which businessmen are not
familiar.
4. Net present Value Method

This is another D.C.F. method used in capital budgeting i.e. the Net Present
Value or Excess present value or simply the present value method. To quote Hariod
Bierman “the present value of an investment may be defined as the maximum
amount a firm could pay for the opportunity of marking the investment without
being financially worse off”.
The discount rate is assumed under this method. Usually this assumed
discount, should be equal to be company’s weighted average cost of capital. Unless
a capital project is expected to yield at least as much as the cost of capital, the
project should not be accepted. Otherwise by getting into such on economical
project, the company runs the risk of lowering its profits and the earnings per share
in the long-run.
The net cash inflows, under this method, are discounted to the present value.
This is the Gross Present Value of the net cash inflows. From, this, the present
value of the cost of the project is subtracted. The resulting surplus is the net
present value of the investment.
Under this technique, the best project out of severs alternatives is that which
has the highest net present value. But when there are no alternative investments,
a project can be taken up if the present value of various cash inflows equals to or
exceeds the present value of the capital outlay. If the two projects are mutually
exclusive, the project with higher net present value should be accepted.
Present value profitability Index may be calculated as follows.
P resent value of Net Cash inf low s

Profitability Index =
Initial cash Outlay
Some accountants prefer to use the net or excess present value of cash inflows
instead of the gross present value, as used above. Hence
N P V
Profitability Index =  100
Example
ANNAMALAI UNIVERSITY I
Initial capital outlay is Rs.3,00,000

The present value of net cash inflows at 10% is Rs.3,86,900
3,86,900
Profitability Index = = 1.29
3,00,000
303
86,900
0r  100 = 29%
3,00,000
Merits
1. This method is superior to other methods as it takes into account both the
magnitude and the timing of cash flows over the effective life of the asset.
2. It reduces the different capital projects to a common denominator of the
present worth of successive returns from the project.
3. According to this method, the capital project which is quick earning and gives
the returns during early years is considered better than the capital project with
the same total of returns but with longer gestation periods.
Limitation
1. It is difficult to use and understand for an ordinary business men.
2. It is not possible to have a uniform rate of discount or rate of interest for
application during the long service period of a capital project.
Illustration – 1
The management of X Ltd, decided to purchase machine ‘A’ or ‘B’ . The
following information is available.
Machine A Machine B
Cost of Machine Rs.42,000 Rs.15,000
Estimated life 6 years 7 years
Sales per year Rs.30,000 Rs.30,000
Cost per annum Rs. Rs.
Labour 2,000 10,000
Materials 12,000 12,000
Overheads 4,000 3,000
Advise the management regarding the selection of machine on the basis of Pay-
back period and profitability.
Solution
Machine A Machine B
Cost of Machine Rs.42,000 Rs.15,000
Estimated life 6 years 7 years
1. Sales: Rs.30,000 Rs.30,000
2. Costs: Rs. Rs.
Labour 2,000 10,000
Materials 12,000 12,000
304
Overheads 4,000 18,000 3,000 25,000

3. Net cast Flow (Marginal Profit 12,000 5,000
4. Pay Back Period 3½ years 3 years
5. Pay Back Profitability 30,000 20,000
Note: Depreciation and taxation have been ignored
Working
1 42,000 1
Pay back period =   3 years
E 12,000 3
15,000
= = years
5,000
Pay back profitability = Net cash flow × (Life of project pay back period)
A B
= 12,000 × 
6 — 3½ 500 7 — 3
= Rs.12,000 × 2½ yrs.
5000
= 30,000 =  4yrs.
20,000
If we consider the payback period alone, Machine B having a slightly shorter

pay off period should be recommended. In the long run, on pay back profitability
criterion, the Machine A which yields a profit of Rs.30,000 in 6 years would be
advisable to the Machine B which gives surplus of Rs.10,000 in 7 years.
The difference in the results points out one of the limitations of the payback
period method viz, it is ignores the return obtained after the payback period is over.
Illustration – 2
M/s Bharat Industries Ltd. Purchased a machine five years age. A proposal is
under consideration to replance it by a new machine. The life of the machine is
estimated to be 10 years. The existing machine can be sold at its written down
value. As the management Accountant of the company you are required to submit
your recommendations based on the following information.
Particulars Existing Machine New Machine

Rs. Rs.
Initial Cost 25,000 50,000
Machine hours P.a 2,000 hrs. 2,000 hrs.
Wages per running hour 1.25 1.25
Power per hour 0.50 2.50
Indirect materials per annum 3,0000 5,000
305
Other expenses per annum 12,000 15,000

Cost of material Per unit 1 1
No. or units produced 12 units 18 units
Selling price per unit 2 2
Interest to be paid at 10% on fresh capital invested
Solution
Comparative Profitability Statement
Items Existing Machine New Machine

1. Units produced per annum 24,000 units 36 units
2. Selling price (per unit) Rs.2 Rs.2
3. Cost per annum
Wages 2,500 2,500
Power 1,000 4,750
Indirect Materials 3,000 5,000
Other expenses 12,000 15,000
Cost of materials 24,000 36,000
Depreciation 2,500 5,000
Interest - 3,000
45,000 71,250
4. Cost per unit 1,87 1,98
Profit per unit 0.13 0.02
As the profit per unit as will as the total profit will diminish with the
introduction of new machine it is not advisable to replace the existing machine by
the new one.
Fresh capital introduced is Rs.50,000 — 12,500 — Rs.37,500 assuming the
machine can be sold immediately.
Note
80,000
1. Depreciation of old machine has been tacked as Rs. = Rs.8,000 p.a
10
Depreciation of old machine may be based on present value of old machine ie.,
20,000
= 5,000 (Assuming the machine will continue for 4 years as usual).
4
3. Some accountants favour addition of the loss on sale of old machine to new
machine for calculating depreciation. Loss on old machine — Book value less
306
realised value is i.e. 32,00 — 20,000 = 12,000. So depreciation of new machine

is Rs.12,000 + Rs.1,200 = Rs.13,200 p.a.
Illustration
The Alpha Company Ltd. Is considering the purpose of a new machine. Two
alternative machine (X and Y) have been suggested, each costing Rs.4,00,000.
Earnings after taxation are expected to be as follows:
Cash Flow
Year Machine X Machine Y

RS. Rs.
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
The company has a target rate or return on capital at 10 percent and on this
basis you are required to compare the profitability of the machine and state which
alternative you consider financially preferable.
Note: The present values of Rs.1 at 10% are as follows:
I year 0.91
II year 0.83
III year 0.75
IV year 0.68
V year 0.62
Solution
Statement of Net Present Value of Machine X
Year Cash inflow P.V.F. at 10%` Present value

1 40,000 .91 36,400
2 1,20,000 .83 99,600
3
4
1.60,000
2,40,000
.75
.68
1,20,000
1,63,000
5 1,60,000 .62 99,000
7,20,000 5,18,400
Net present value = Rs.5,18,400 — 4,00,000
= Rs.1,18,400
307
Statement of New Present value of Machine Y
Year Cash inflow P.V.F. at 10% Present value

1 1,20,00 .91 1,09,200
2 1,60,00 .83 1,32,800
3 2,00,00 .75 1,50,000
4 1,20,00 .68 81,600
5 80,000 .62 49,600
6,80,000 5,23,200
Net present value = Rs.5,23,200 — 4,00,000 = 1,23,200
Recommendation:
Machine ‘Y’ is financially preferable. Though the total cash inflow is greater for
machine X than for machine Y (Rs.7,20,000 as against Rs.6,80,000) yet the present
value the cash inflow of machine Y is greater than that of machine X (Rs.1,23,200
as against RS.1.18 400). Hence, it will be more profitable to purchase machine Y
than machine X in view of their respective net present values.
Illustration 4
Kannan Confectionery Ltd. Is contemplating the purchase of machine. Two
machine A and B are available each costing Rs.5,00,000. In comparing the
profitability of the machines, a discount rate of 10% is to be used. Earnings after
taxation are expected to be as under.
Cash flow
Year Machine A Machine B

1 1,50,00 50,000
2 2.50,000 1,50,000
3 2,50,000 2,00,000
4 1,50,000 3,00,000
5 1,00,000 2,00,000
Indicate which machine would be more profitable investment using the
various methods of ranking Investment proposals.
308
Solutions
1. Payback Period Method
Machine A Machine B
1st year 1,50,000 1st year 1,50,000
2nd year 2,00,000 2nd year 1,50,000 Machine A
3rd year (3/5) 1,50,000 3rd year 2,00,000 better
4th year 1/3 1,00,000
5,00,000 5,00,000
3 1
Pay back period = 3 3 year
5 3
ii. Post payback (Profitability) Return:
Machine A Machine B
III year 2/5 1.00.000 -
Machine B is
IV year 2/3 1,50,000 2,00,000
better
V year 1,00,000 2,00,000
3,50,000 4,00,000
iii. ROI Method
Total Profit 8,50,000 9,00,000
8,50,000 9,00,000
Average Annual Profit = 1,70,000 = 1,80,000
5 5
Depreciation p.a = 1,00,000
Profit after Depreciation = 70,000 A; 80,000 B
70,000 80,000
A=  100 = 28% B=  100 = 32%
2,50,000 2,50,000
Machine B is better.
iv. Net P.V. Method: Machine A is better
Year Dis Factor 10% Machine A Machine B

ANNAMALAI UNIVERSITY Cash Flow P.V Cash Flow P.V
1 .909 1,50,000 1,96,390 50,000 47,450
2 .826 2,00,000 1,65,200 1,50,000 1,23,900
3 .751 2,50,000 1,87,750 2,00,000 1,50,200
4 .683 1,50,000 1,02,450 3,00,000 2,04,900
309
5 .621 1,00,000 62,100 2,00,000 1,24,200

8,50,005 6,53,850 9,00,0000 6,48,650
Last Cash flow 5,00,000 5,00,000
Net present value 1,53,850 1,48,650
(i.e. excess of DCF over capital cost) Machine A is more profitable
Comparison of Results of Different Methods

Machine A Machine B
3 1
2 year 3
1. Payback period 5 3
2. Post Payback profits 3,50,000 4,00,000
3. Return on Investment 28% 32%
4. Net present value 1,53,950 1,48,650
It will be observed from the above table that machine A would be preferred
under the payback period method and the net present value method, while Machine
B would be preferred under the post payback profitability method and the ROI
method. The reasons for this inconsistency is the Machine A gives a high return in
the early part of its life end a favourable result with the payback period and not
present value methods, with the Machine B does not yield a good return until late
in its working life so that the post payback, profitability and ROI methods show
more favourable results. Therefore they do not consider when the yiels is obtained.
Merely the extend of the yield is considered.
Financial Evaluation of Projects

Project planning or capital e4xpenditure involves long-term implication. As a
large amount of capital is invested, it affects subsequent years position. In the case
of capital acquisition planning, the important question is whether expenditure is
worthwhile or in other words the expected returns would exceed the investment.
Hence, the question will be considered only when the return is favorable.
The following factors should be taken into account to assets to profitability of
capital expenditure on projects
1. The amount of investment in the proposed project
2. The anticipated life of the asset
3.
The duration of investment in case it extends over a number of years.
4. The amount of working capital required for the operation of the project.
5. The extent to which the profitability of existing assets will be affected.
6. The replacement costs of the proposed project at the end of life of the asset
7. The return of capital expenditure and the duration or period of the same.
310
Table A— I
Present value of one Rupee Due at the End of ‘n’ Years at %
n 11% 12% 13% 14% 15%

01 0.90090 0.89286 0.88496 0.87719 0.86957
02 0.81192 0.79719 0.78315 0.76947 0.75614
03 0.73119 0.71178 0.06935 0.67497 0.65752
04 0.65873 0.63552 0.61332 0.59208 0.57175
05 0.59345 0.56743 0.54276 0.51937 0.49718
06 053464 0.50663 0.48042 0.45559 0.43233
07 0.48166 0.45235 0.42506 0.39964 0.37594
08 0.43393 0.40388 0.37616 0.35856 0.32696
09 0.9092 0.36061 0.33288 0.30751 0.28426
10 0.35218 0.32197 0.29459 0.26974 0.24718
11 0.31728 0.28748 0.26070 0.23662 0.21494
12 0.28584 0.25667 0.23071 0.20756 0.18691
13 0.25871 0.22917 0.20416 0.18207 0.16253
14 0.23190 0.20162 0.18068 0.15971 0.14136
15 0.20900 0.18270 0.15979 0.14010 0.12286
16 0.18829 0.16312 0.14150 0.12289 0.10689
17 0.16963 0.14564 0.15222 0.10780 0.9293
18 0.15282 0.13001 0.11081 0.09456 0.8083
19 0.13768 0.11611 0.09806 0.08295 0.7320
20 0.12403 0.10361 0.08677 0.06727 0.6110
21 0.11741 0.9256 0.07688 0.06384 0.5313
22 0.10067 0.88264 0.06796 0.05599 0.1620
23
0.09069 0.7379 0.06014 0.04911 0.4017
24 0.08670 0.6588 0.05322 0.04308 0.3493
25 0.7361 0.5882 0.04710 0.03779 0.3030

311
16% 17% 18% 19% 20% n

0.86027 0.85470 0.84746 0.84034 0.83333 01
0.74316 0.73051 0.71818 0.70616 0.69444 02
0.64066 0.62437 0.60863 0.59342 0.57870 03
0.55229 0.53365 0.52579 0.49867 0.48225 04
0.47611 0.45611 0.43711 0.41905 0.40188 05
0.41644 0.38984 0.37043 0.35214 0.33490 06
0.35383 0.3320 0.31392 0.29592 0.27908 07
0.30503 0.28478 0.26604 0.24867 0.23757 08
0.26295 0.24340 0.22546 0.20897 0.19381 09
0.22668 0.20804 0.19106 0.17560 0.16151 10
0.19542 0.17781 0.16192 0.14756 0.13459 11
0.16846 0.15197 0.13722 0.12400 0.11216 12
0.14523 0.12689 0.11629 0.10420 0.09346 13
0.12520 0.1102 0.09855 0.08757 0.07789 14
0.10793 0.09489 0.08352 0.07359 0.06491 15
0.9304 0.08110 0.07078 0.6184 0.05409 16
0.8021 0.06932 0.05998 0.05196 0.04507 17
0.6914 0.05925 0.05083 0.04367 0.03756 18
0.5961 0.05064 0.04308 0.03669 0.03130 19
0.5139 0.04328 0.03651 0.04367 0.02608 20
0.4430 0.02699 0.03094 0.02591 0.02174 21
0.3819 0.03162 0.02622 0.02178 0.01811 22
0.3292 0.02703 0.02222 0.01830 0.01539 23
0.2838
0.2447
0.02310
0.01974
0.01883
0.01596
0.01536
0.01293
0.01258
0.01048
24
25
312
Table A — 1
Present Value of One Rupee Due at the End of ‘n’ Years at %
N 21% 22% 23% 24% 25%

01 0.82645 0.81967 0.71301 0.80645 0.80000
02 0.68301 0.67186 0.66098 0.65036 0.64000
03 0.56447 0.55071 0.53738 0.52449 0.51260
04 0.46651 0.45140 0.43690 0.42297 0.40960
05 0.38554 0.37000 0.35520 0.34111 0.32768
06 0.31863 0.30328 0.28878 0.27500 0.26214
07 0.26333 0.24859 0.19088 0.21184 0.20972
08 0.21763 0.20376 0.15519 0.17891 0.16777
09 0.17986 0.16702 0.12617 0.14428 0.13422
10 0.14864 0.13690 0.10258 0.11635 0.10737
11 0.12285 0.11221 0.08339 0.09383 0.08590
12 0.10153 0.09198 0.06780 0.07567 0.06872
13 0.08391 0.07539 0.05512 0.06103 0.05497
14 0.06934 0.06180 0.04431 0.04911 0.04398
15 0.05731 0.05065 0.03642 0.3969 0.03518
16 0.04336 0.04152 0.02962 0.03201 0.02812
17 0.0914 0.03403 0.02408 0.02581 0.01252
18 0.03235 0.02789 0.01958 0.52082 0.01801
19 0.02673 0.02286 0.01592 0.01679 0.01441
20 0.02209 0.01874 0.01294 0.01354 0.01153
21 0.01826 0.01536 0.01052 0.01092 0.00922
22 0.01509 0.01259 0.00855 0.00800 0.00738

23 0.01247 0.01032 0.00693 0.00710 0.00590
24 0.01031 0.00846 0.00695 0.00579 0.00472
25 0.00852 0.00693 0.00565 0.00462 0.00378

313
26% 27% 28% 29% 30% n

0.79365 0.78740 0.78125 0.77519 0.76923 01
0.62998 0.62000 0.61035 0.60093 0.59172 02
0.49991 0.48816 0.47684 0.46583 0.45517 03
0.29675 0.38440 0.37253 0.36111 0.35013 04
0.31488 0.30268 0.29104 0.27993 0.27933 05
0.24991 0.23833 0.22737 0.21700 0.20718 06
0.19834 0.18766 0.17764 0.16822 0.15937 07
0.15741 0.14776 0.13878 0.13040 0.12259 08
0.12493 0.11635 0.10842 0.10106 0.09430 09
0.09915 0.0916 0.87470 0.07836 0.07154 10
0.00869 0.07214 0.6617 0.06075 0.05580 11
0.06245 0.05690 0.05170 0.04009 0.04292 12
0.04957 0.04472 0.04039 0.03650 0.0302 13
0.03934 0.03522 0.03155 0.02830 0.02540 14
0.03122 0.02773 0.02465 0.02194 0.01954 15
0.02478 0.02183 0.01926 0.01700 0.01503 16
0.01967 0.01719 0.01505 0.1318 0.01156 17
0.01561 0.01354 0.01175 0.01022 0.00889 18
0.01239 0.01066 0.00918 0.00792 0.0084 19
0.00983 0.00839 0.00717 0.00614 0.00526 20
0.00780 0.00661 0.00561 0.00476 0.00526 21
0.00619 0.00520 0.00438 0.00369 0.00311 22
0.00591 0.00410 0.00342 0.00286 0.00239 23
0.00390
0.00310
0.00323
0.00254
0.00267
0.00209
0.00222
0.00172
0.00184
0.00142
24
25
314
Table B
Present value of one Rupee per year ‘n’ Years at %
n 11% 12% 13% 14% 15%

01 0.9009 0.8929 0.8850 0.8772 7.7986
02 1.7125 1.6901 1.6681 1.6467 1.6256
03 2.4437 2.4018 2.3612 2.3296 2.2832
04 3.1024 3.0373 2.9745 2.9137 2.8550
05 3.6969 3.6048 2.5172 3.4334 3.3525
06 4.2305 4.1114 3.9676 3.8887 3.7845
07 4.7122 4.5638 4.4226 4.2883 4.1604
08 5.1461 4.9676 3.7988 4.6389 4.4573
09 5.5370 5.3282 5.1317 4.9454 4.7716
10 5.8892 5.6502 5.4562 5.2161 5.0188
11 6.2065 0.9377 5.6869 5.4527 5.2337
12 6.4924 6.1944 5.9176 5.6603 5.4206
13 5.7499 6.4235 6.1218 5.8424 5.5831
14 6.9819 6.6282 6.3025 6.0021 5.7245
15 7.1909 6.8109 6.4624 6.1422 5.8474
16 9.3792 6.9740 6.6039 6.2651 6.9542
17 7.5488 7.1196 6.7261 6.3729 6.0472
18 7.7016 7.2494 6.8399 6.4674 6.1280
19 7.8393 7.3658 6.9380 6.554 6.1982
20 7.9633 7.4694 7.0248 6.6231 6.2593
21 8.0751 7.5920 7.1016 6.6870 6.3125
22 7.1757 7.6446 7.1695 6.7429 6.3587
23
8.2664 7.7184 7.2297 6.7921 6.3988
24 8.3481 7.7843 7.2826 6.8351 6.4338
25 8.4217 7.8431 8.3300 6.8729 6.4641

315
16% 17% 18% 19% 20% n

0.8321 0.8547 0.8485 0.8403 0.8333 01
1.6052 1.5852 1.5656 1.5465 1.5278 02
2.2454 2.2096 2.1743 2.1699 2.1065 03
2.7982 2.7432 2.6901 2.6386 2.5887 04
3.2743 3.1993 3.1272 3.0576 2.9906 05
3.6847 3.5892 3.4976 3.4099 3.3255 06
4.0386 3.9224 3.8115 3.7057 3.6046 07
4.3438 2.2072 4.0776 3.9544 3.8272 08
4.6065 4.4506 4.3030 4.1633 4.0310 09
4.8332 4.6586 4.4941 4.3319 4.1925 10
5.0285 4.8364 4.6560 4.4863 4.3271 11
5.1971 4.9884 4.7962 2.6105 4.4392 12
5.3423 5.1183 4.9095 4.7147 4.5327 13
6.4975 5.2293 5.0081 4.8023 4.6106 14
5.5755 5.3242 5.0916 4.8759 4.6755 15
5.6685 5.4053 5.1624 4.9377 4.7296 16
5.7487 5.4746 5.2223 4.98987 4.7746 17
5.8178 5.5339 5.2732 5.0333 4.8122 18
5.8775 5.5845 5.3162 5.0700 4.8435 19
5.9288 5.6278 5.3527 5.1009 4.8696 20
5.9731 5.6648 5.3837 5.1268 4.8913 21
6.0113 5.6964 5.4099 5.1486 4.9094 22
6.0422 5.7234 3.4321 5.1668 4.9245 23
6.0726
5.0971
5.7465
5.7465
5.4509
5.4669
5.1822
5.1951
4.9371
4.9475
24
25
316
Table B
Present Value of One Rupee per year ‘n’ Years at %
N 21% 22% 23% 24% 25%

01 0.8264 0.8197 0.8139 0.8065 0.8000
02 1.5095 1.4915 1.4740 1.4568 1.4400
03 2.0739 2.0422 2.0114 1.9813 1.9520
04 2.5404 2.4936 2.4483 2.4043 2.3516
05 2.9260 2.8536 2.8035 2.7454 2.6893
06 3.2446 3.1669 2.0923 4.0205 2.9514
07 3.5079 3.4155 3.3270 3.2423 3.1611
08 3.7256 3.6193 3.5179 3.4212 3.3289
09 3.9054 3.7863 3.6731 3.5655 3.4631
10 4.0541 3.9232 3.7993 3.6819 3.5705
11 4.1769 4.0354 3.9018 3.7757 3.6564
12 4.2785 4.1274 3.9852 3.8514 3.6564
13 4.3624 4.2028 4.0550 3.9124 3.7801
14 4.4317 4.2646 4.1082 3.9616 3.8241
15 4.4890 4.3152 4.1530 4.0013 3.8593
16 4.5364 4.3567 4.1894 4.0333 3.8874
17 4.7555 4.3908 4.2190 4.0591 3.9099
18 4.6079 4.4187 4.2431 4.0799 3.9279
19 4.6346 4.4415 4.2627 4.0967 3.9423
20 4.6567 4.x603 4.2786 4.1103 3.9339
21 6.6750 4.x755 4.2916 4.1212 3.9631
22 4.6900 4.x882 4.3921 4.1300 3.9705

23 4.7025 4.4980 4.3105 4.1371 3.9764
24 4.7128 4.5070 4.3176 4.1428 3.9811
25 4.7213 4.5139 3.3232 4.1474 3.9849

317
26% 27% 28% 29% 30% N

0.7937 0.7874 0.7813 0.7752 0.7692 01
1.4235 1.4074 1.3916 1.3761 1.3500 02
1.9234 1.8956 1.8684 1.8420 1.8161 03
2.3202 2.2800 2.2410 2.2031 2.1662 04
2.6351 2.5827 2.5320 2.4830 2.4356 05
2.8850 2.8210 2.7594 2.7000 2.6427 06
3.0833 3.0087 2.9370 2.8682 2.8021 07
3.2407 3.1564 3.0748 2.9986 2.9247 08
3.3657 3.2728 3.1842 3.0997 3090 09
3.4648 3.3644 3.2680 3.1781 3.0916 10
3.5435 3.4365 3.3351 3.2388 3.1473 11
3.6060 3.4933 3.3868 3.2859 3.1903 12
3.6555 3.6381 3.4272 3.3224 3.2233 13
3.6949 3.5733 3.4587 3.3507 3.2487 14
3.7261 3.6010 3.4834 3.3726 3.2682 15
3.7509 3.8228 3.5026 3.3896 3.2832 16
3.7703 3.6400 3.5177 3.4028 3.2948 17
3.7861 3.6536 3.5294 3.4130 3.3047 18
3.7985 3.6642 3.5386 3.4210 3.3105 19
3.8083 3.6xx6 3.5458 3.4271 3.3158 20
3.8161 3.6792 3.5514 3.4319 3.3198 21
3.8223 3.6844 3.5558 3.4356 3.3230 22
3.8223 3.6885 3.5592 3.4384 3.3254 23
3.8312
3.8242
3.6918
3.6943
3.5619
3.6640
3.4406
3.4423
3.3272
3.3286
24
25



318
LESSON – 25
INVENTORY CONTROL
Objectives
You should be able to
 Define the term inventory control and list sits importants and objectives.
 Assess cost involved in building inventaries.
 Evaluate the various technique of inventory control.
 Calculate economic ordering quantity
 Define perpetual inventory system and its advantages.
 Various methods of inventary valuation methods.
STRUCTURE
25.1. Definition
25.2. Importance
25.3. Essentials
25.4. Objectives
25.5. Inventary control system
25.6. Inventary level
25.7. Conditions for effective physical control
25.8. Inventory control technique
25.9. Inventory valuation
25.10. Market Price interpretation
25.1. DEFINITONS
The term ‘inventory’ is used to denote the stock on hand at a particular time
comprising raw-materials, goods in the process of manufacture and finished
products. It also means “the aggregate of those items of tangible personal property
which (I) are held for sale in the ordinary course of business (ii) are in the process of
production for such sales of (iii) are to be currently consumed in the production of
goods or services to be available for sales”.
According to this definition, inventories can be classified as follows:
1. Raw-Materials
2. Work-in-Progress
3. Finished goods
4. Consumable and spare Parts
319
5. Maintenance materials and tools and

6. Packing materials
25.2. IMPORTANCE
It has a primary significance in accounting sphere to ascertain the correct
income for a particular period. Both the quantity of inventory and the value have
great financial significance as the income arises in a continuos process which
involve in the goods being acquired and then sold and then in future goods being
acquired for additional sales. The main objective is the ’matching of appropriate
costs against revenues’ so that there may be correct assessment of income. At a
particular date, the inventory represents the balance of costs applicable to the
goods on hand remaining after matching of absorbed cost with current revenue.
Further the question of optimum quantity of the various items of the inventory
required in carrying on the business is of vital importance as regards its
profitability.
Inventory requires the closet attention at all times. A constant review of stock
must be maintained. It is –odivisable to periodically review the relationship
between the quantity of each type of materials of significance in the inventity with
its utilisation. Inventory plays a very important part in the determination of the
profits of a business. The amount of earnings will be less if the quantity of goods
held by a business is not at the most economic level. The profits will be affected
considerably if a business were to invest additional capital for carrying on the
business if improper inventories are kept in addition to incurring of unnecessary
expenses for the same. If the inventories are not kept at the required level result of
deterioration, absolescence and other allied factors, the possibility of loss will be
greated if larger quantities of stock are carried. Therefore, it is essential that the
management should take a decision as to when the quantities are to be ordered
according to the requirements and the number of units to be kept on hand.
25.3. ESSENTIALS OF AN INVENTORY CONTROL SYSTEM

If the inventory control system is to be effective the following considerations are
to be taken into account.
1. Maintenance of proper records with regard to the units and the values of
various items of the inventories.
2. Materials should be properly identified and proper storage facilities should be
made available for location of the same.
3. To ensure proper control over the receipts and issue of the materials.
4. There sould be proper co-ordination of the Inventory control system with the
other departments of business such as sales, purchases and production
departments.
320
5. There should be well-trained and capable persons who should be entrusted

with the responsibility of the implementation of the system to enable them to
perform their duties efficiently.
25.4. THE OBJECTIVIES OF INVENTORY CONTROL SYSTEM ARE:

1. To ensure that supplies are on hand when needed.
2. To avoid excess consumption of supplies and wastage.
3. To avoid excess inventory and minimise deterioration and obsolescence, and
4. To avoid improper conversion of supplies.
25.5. INVENTORY CONTROL SYSTEM

In order to establish and a develop a sound inventory control system, it is
essential to consider the following factors:
1. The type of the business.
2. Thee result to be achieved by the system The extent to which the system will be
implemented.
4. To minimise as far as possible the expenses, connected with carrying the
stocks and with ordering the goods.
5. To maintain stock according to the level of sales.
25.6. INVENTORY LEVEL

The question of determining the level of the inventors to be maintained is a
business is the most important factor in management accounting. It is necessary
that proper control should be exercised on the level of the inventory to be
maintained. Efficient management of inventories demands that both over and
under investment in stock be avoided. If there is no proper control, there is the risk
of accumulation of inventory with increasing costs. The normal level to be
maintained depends upon the nature of the business and the type of the innovatory
held. It should be remembered that, in both cases of excessive inventory and
insufficient inventory there are risks the of unnecessary cost incurred there are
risks the of unnecessary cost incurred thereon. To much capital tied up in
inventories results in the lower rate of return and the possibility of substantial loss
from decline in market value. Too small a quantity is likely to reduce the value of
the business and hinder proper servicing of customers.
The following factors are to be considered for establishing the stock level to be
maintained in a business for effectiveness of the system of control.
1. On the basis of the previous records pertaining to sales and production, the
demand for the inventory should be determined. It is essential to make
allowance for fluctuations. In the case of business with seasonal sales, a
321
change in the inventory level is necessary by periodical review of the inventory,

the destred level should be maintained.
2. Present position regarding supplies of materials and labour and their
availability.
3. The next factor is the time that elapses between the time requisitioning of the
items and the time of the receipt of the same. This is called ‘lead time’. Due
allowance should be made for the variability in the lead time.
4. Quantities of stocks on hand and required at the end of the period.
5. The effectiveness of the system depends upon the storage facilities available.
Inventory level will be affected, if theories lack of storage facilities.
6. In carrying stocks at higher levels there is the danger of expenses of storage
involved.
7. The most important is the price factor. Low value items may be purchased in
large quantities to take advantage of the price position while higher value items
may be purchased frequently in small quantities.
8. Capital to be invested in stock.
9. If higher levels of inventories are maintained, stock level will be affected by
obsolescence, change in fashion and improvements in technicalities.
25.7. CONDITIONS FOR EFFECTIVE PHYSICAL CONTROL

1. Area of Responsibility
It is necessary that be organisation of the stores department should provide for
well-defined areas of responsibility and to centralise the authority for controlling
inventories.
2. Accounting Records
Physical control is facilitated by the provision of dependable set of accounting
records, which should include the quantities received, issued and in hand at each
of the store room.
3. Storage Facilities
There should be adequate storage facilities. Storage facilities for bulkier items
may require large are to. Access should be restricted to an entrance at one point at
which the person incharge can exercise control. The storage arrangement should
be systematic to facilitate taking physical inventory easily.
4. Codes
It is desirable to assign a code or symbol to each item of the goods stored. The
use of symbol facilitrages accuracy in identification of the materials. This
contributes much to the efficient handling of and accounting for stores.
322
Classification and coding are the essential steps in establishing and maintaining
strict controller stores.
5. Identification
Each item of material handled should have a definite name and should always
be dealt with under that name. In addition to the identification of the goods
themselves, their should be a plan of identification carried out in all parts of the
store room.
Casts Involved in Building Inventories

In order to keep sufficient quantity of materials and other stocks, we have to
incur following expenses.
1. Capital is locked up in the-forms of materials, semi-finished and finished
goods. The cost of capital invested in the inventories must be considered as
the cost of maintenance of inventories.
2. Depreciation, wastage in warehousing, leakage and normal loss of weight due
to the inherent quality of the goods cannot be avoided. Again due to
obsolescence and efflux of time the value of the stock may be reduced. Such
costs are to be recovered from the remaining units of the stock.
3. Storage expenses of goods should also be considered as an associate cost. For
example, warehouse rent, maintenance expenses, premium paid for insurance
of the goods, go down rent etc are such expenses which increase the cost value
of the stock.
There are the major items of expenditure costs incurred on the inventories and
they are often called “Inventory carrying costs”
25.8. INVENTORY CONTROL TECHNIQUE

1. Perpetual Inventory and continuous stock taking.
2. A B C Aanlysis
3. Input-output Ratio Analysis
4. Inventory Turn over Ratio
5. Determination of stock levels.
6. Economic order quantity
1. Perpetual Inventory System
According go the institute of Costs and Management Accountants, England, it
is defined as ‘a system’ of records maintained by the controlling department which
reflects the physical movements of stocks and their current balance”. It is a
method of ascertaining balance after every receipt and issue of materials through
stock records to facilitate regular checking and to avoid closing down for stock-
taking. In order to ensure accuracy of perpetual inventory record. It is desirable to
323
check the physical stocks by a programme of continuos stoke-taking. Any

discrepancy noted between physical stock and stock records can be investigate and
rectified, then and there.
2. A B C Control Method
This method is useful in business organisations which are dealing in a number
of items of goods. Under this method, inventories are grouped under three
categories A, B and C. ‘A’ is allotted for the high value items, ‘B’ for medium-value
items and ‘C’ for low-value items. Values of the items are converted into
percentages, each item being stated at a percent of the total value of all the items.
Usually items which account for 70% to 80% of the value are grouped under item
‘A’. Those which account for 10% to 20% of the values are grouped under item ‘B’.
The remaining items are grouped under category ‘C’. High value items should be
reviewed frequently and accurately and low value items may be reviewed frequently
and accurately and low value items may be reviewed at long periods. In the case of
medium-value items, the control should be more than the low-value items and less
than the high value items. More-over in this case reviews need not be made as
frequently as in the case of high value items.
3. It pur Output Ratio Analysis

This ratio is the ratio of the raw-materials put into manufacturing and the
standard raw material content of the actual output. A standard ratio of input of
material and output of material should be determined and the actual ratio should
be compared with the standard ratio. If the actual ratio is higher than the standard
ratio, the performance will be considered to be below that the standard ratio, the
percentage of losses that have occurred at each stage. It also measures the
productivity of capital. This method is also useful to ascertain the raw material
cost of finished output by multiplying the raw material cost per unit by this ratio.
4. Inventory Turnover Ratio

This ratio is another method of exercising control. It is essential to compare
the turnover of different kings of materials to find out the items: which are slow
moving thus helping the management to avoid keeping capital locked up in such
items. A low ratio is an indicator of slow moving stock, accumulation of obsolete
stock, carrying of too much stock. It will lead to the disadvantages arising out of
over-stocking. But a high turnover ratio is an indication of fast moving stock and
investment in stock. If this ratio for a particular item is zero. It means that the
item had not been used at all during the period and should be immediately
disposed of, otherwise the quality of the item may get deteristory.
5. Stock Levels
The demand and supply method of stock control technique determines
different stock levels viz, Maximum Level, Minimum Level, Recorder Level, Danger
Level and Average Level.
324
Maximum Stock Level

It represents the quantity above which inventory should no be allowed to be
kept. To fix the maximum level of stock, the stock controller must consider the
following factors giving due allowance for the special circumstances if any.
1. Amount of capital available and required for purchase.
2. Storage facilities and storage cost.
3. Rate of consumption of the material.
4. Possibilities of price fluctuations.
5. Seasonal nature of supply of materials.
6. Possibility of loss due to fire, evaporation, moisture etc.
7. Insurance cost
8. Changes in fashions and habits which will outdate the products.
9. Restrictions imposed by Government or Local. Authority or Trade Association
in regard to materials in which there are inherent risks, or fire and explosion or
restriction as to imports or procurement.
Minimum Stock Level

It represents the quantity below which stock should not be allowed to fall.
This is known as safety or buffer stock. The main purpose of this level is to ensure
that production is not held up due to shortage of any material. This level is fixed
after considering average rate of consumption of materials and lead time.
Re-coreder or Order level

This is the point at which the store keeper should initiate the purchase
requisition for fresh supplies as and when materials in store approach that level.
This level is fixed between maximum and minimum stock levels in such a way that
the difference of quantity of the materials between the re-order level and the
minimum level will be sufficient to meet the requirements of production of the time
the fresh supply of the material is received.
Danger Level
It means a point at which instead of the material are stopped and issues are
made only under specific instructions. This level is generally fixed below the
minimum stock level when stock of materials reaches the danger level, the
purchase officer should make special arrangements to get the materials at any cost.
9. Economic Order Quantity

This is the optimum or the most favourable quantity which should be ordered
as and when the purchases are to be made. This is one where the cost carrying is
equal to or almost equal to the cost of not carrying. This is otherwise known as
325
Recorder Quantity or Standard Order Quantity, and it depends upon two factors
viz, cost of carrying and cost of ordering and receiving per order. The following
formula is useful to calculate Economic order quantity
2CO
E.O.Q. 
I
where C is Annual consumption. O’ is ordering and receiving cost per order and ‘I’
is interest payment per unit per year.
Example
A unit of material X cost Rs.50 and the annual consumption is 2,00,000 units.
The cost of placing an order and receiving material is Rs.200 and the interest
including variable cost of storage per unit per year is 10% Calculate E.O.Q.
2CO
E.O.Q. 
I
2  2,00,000  200
=
5
= 1,60,00,000 = 4,000 units
25.9. INVENSTORY VALUATION

Materials are issued to different jobs or work order from the stores. They
changed with the value of materials issued to them. Following are the important
methods or valuign material issues.
A. Based on Cost Price

1. The First in First Out (FIFO) Method
2. The Last in First Out (LIFO) Method
3. The Highest in First Out (HIFO) Method
4. The Next in First Out (NIFO) Method
5. The Base stock Method
6. The Specific Actual Price Method
7. The Inflated Price Method
8. The Fixed Cost Method
9. Average Cost method
a. Simple average price method
b. Periodic simple average price method
c. Weighted average price method
326
d. Periodic weighted average price method

e. Moving simple average price method
f. Moving weighted average price method
B. Based on Market Price Method

10. Realisable Value Method
11. Replacement Value Method
C. Based on Standard Price Method

12. Current Standard Price
13. Basic Standard Price
All these method cannot be appropriate under all circumstances. The selection
of a proper method of pricing issues depends on the following factors.
1. The nature of the business and types of production
2. The method of costing method
3. The nature of materials
4. The extend of price fluctuations
5. The frequency of purchases and issues
6. The necessity for maintaining uniformity within an industry.
7. Length of inventory turnover period and quantity of material to be handled.
8. The policy of management
Illustration
From the following information calculate the Maximum Stock Level, Minimum
Stock Level, Re-ordering Level Average Stock Level and Danger Level.
Normal Consumption 300 units per day

Maximum Consumption 450 units per day
Minimum Consumption 240 units per day
Re-order quantity 3,600 Units
Re-order period 10 to 15 days
Normal re-order period
Time required for emergency purchase
12 days
4 days
Solution
Re-ordering Level = Maximum consumption × Maximum
re-order period
= 450 × 15 = 6,750
327
Maximum Stock Level = Reordering Level + Re-order quantity —

(Minimum consumption × minimum
re-order period)
= 6,300 + 3,600 – (240 × 2,400) 2,400 =
Minimum Stock Level = 7.500 units
Re-ordering Level — (Normal Consumption ×
Normal-reorder period)
Average Stock Level = = 6300 — (300 × 12) = 2,700 units
½ (Minimum stock level + Maximum Stock
Level
Danger Level = = ½ (2,700 + 7,500) = 5,100 units
Minimum consumption per day × Time for
emergency purchase
= 240 = 960 units
Illustration — 2
Calculate the material turnover ratio for the year 1980 from the following
information and determine which the two materials is most fast moving
. Material A Material B
Material on hand on 1.1.1980 2,00,000 8.75,000
Material on hand on 31.12.1980 1,50,000 6,25,000
Material purchased during 1980 10,00,000 12,50,000
Solution
Cost of Materials consumed
Material A Material B
Rs. Rs.
Opening Stock 2,50,000 8,75,000
Add purchases 19,00,000 12,50,000
21,50,000 21,25,000
Less closing stock 1,50,000 6,25,000
20,00,000 15,00,000
Average Stock
2,50,000  1,50,000
Material A = = Rs.2,00,000
2
8,75,000  6,25,000
Material B = = Rs.7,50,000
2
328
Cost of Material Consumed

Material Turnover Ratio =
Cost of Average stock
20,00,000
Material Turnover Ratio of A = = 10 times
2,00,000
1,50,000
Material Turnover Ratio of B = = 2 times
75,000
Days during the year
Material Turnover in days =
material T urnover Ratio
365
Material Turnover of A (in days) = = 182.5 days
2
A turnover ratio of 36.5 days shows that an average stock is being held for
36.5 days. On the otherhand a turnover of 182.5 days shows that an average stock
is being held for 182.5 days. So material B is very slow moving while material A is
for moving.
Illustration 3
Find out the input-output ratio and cost of finished output from the following
information’s.
Standard Actual
Input of groundnut-oil seeds 100 kg. 1000 k.g
Output of groundnut-oil seeds 10 k.g 90 k.g
Cost per kilo is Rs.120
Solution
100 10
Standard input-output ratio = 
10 1
1000 10
Actual input-output ratio = 
90 9
Raw material cost of finished output per k.g

10
Standard =  1.20 = Rs.12.00
1
10
Actual —  1.20 = Rs.13.33
0.9
As the actual ratio is higher than the standard ratio the performance is below
the standard.
329
Market Price Interpretation

When stock is valued according to the principle “Cost or market price
whichever is lower” then the term “market price” is subject to the following
interpretations
1. It may be used in the sense of expected selling price
2. It may be used in the sense of replacement price.
For example if an article costs Rs.10 and if it will fetch only Rs.9 everybody will
value it as Rs.9. Normally this article costs Rs.10 can be sold for Rs.12 but now it
is available for Rs.9. Then the market price will get adjusted to Rs.10.80 (Rs.12
minus 10 percent of Rs.12)
Now cost price is Rs.10 Market or selling price is Rs.12 and Replacement of
market buying price is Rs.9. If we take the market price as expected selling price,
stock should be valued at Rs.10 because it is clear than even after the fall in price
ie. Rs.10.80 is more than the original cost of Rs.10. On the otherhand if we take
the market price as the replacement cost then the stock should be valued at Rs.9.
Illustration — 4
Radha confectionery works Ltd. Uses large quantities of sweetening materials
for its products. The following figures relate to this material during the calendar
year 1980.
Quarter ended Purchase Invoice cost Consumption.
Per Tonne
Tonnes Rs. Tonnes

March 31 2,000 1.240 1,200
June 30 4,200 1.260 2,400
September 30 1,400 1.280 3,000
December 31 2,400 1.240 2,700
10,000 9,300
The stock of materials on 31st December 1979 was 2,000 tonnes purchased at
Rs.1,200 a tonne. You are required to compute the value of stock on 31 st
December, 1980 applying 1. LIEO 2. FIFO and 3. Market replacement cost
assuming that the stock of materials on December 31, 1980 was 2,700 tonnes
valued at Rs.1,320 a tonne by way of Market Replacement cost.
330
Solution
1. Stock valuation under ‘FIFO’ method
Tonnes
Stock on 31st December 1979 2,000
Add: purchases during the year 1980 10,000
12,000
Less: Consumption during the year 1980 9,300
Closing stock on 31st December 1980 2,700
Value of stock on 31.12.1980
The earliest lots are exhausted first and so the closing stock is valued
accordingly.
2,000 Tonnes at Rs.1,2000 24,00,000

700 Tonnes at Rs.1,240 8,68,000
2,700 32,68,000
2. LIFO Method
The latest lots are exhausted first and hence, the closing stock valued
accordingly
2,400 Tonnes at Rs.1,340 32,16,000

300 Tonnes at Rs.1,280 3,84,000
2,700 36,00,000
3. Market Replacement Cost Method
Rs
Stock on 31.12.1980 35,61,000
2,700 tonnes at 1,320
Hence, valuation of closing stock of 2,700 tonnes as on 31.12.1980 are:
Rs.
FIFO Basis 32,68,000
LIFO Basis 36,00,000
Market Replacement cost Basis 35,64,000
QUESTIONS
1. Define Inventory Control
2. What is meant by Inventory valuation? What are the essential of Inventory
evaluation.
3. What are the conditions for effective Physical control
331
LESSON – 26
ACCOUNTING FOR INFLATION
Objectives
 Explain the concept of inflation
 Distinguish between Historical cost and current replacement cost
 Develop skill to find profit under inflation accounting
 Prepare P & L a/c and B/s under inflation accounting
Structure
26.1. Meaning
26.2. Difference between cost and value
26.3. Monetary value and real value of assets & liabilities
26.1. MEANING
Accounting for inflation is otherwise is known as “Revaluation Accounting”.
“the Replacement Value Theory” and “Stabilised Accounting”. The method of
accounting, which takes into account the recorded book value to be adjusted owing
to change in prices, is known as accounting for inflation. That is to say, the system
of accounting, which pays due regard to the money value and real value of assets
and liabilities, is known as accounting’ for inflation.
Problems
The problem of replacement of fixed assets:
As depreciation is made on historical cost method, it accounts more for cost
than for values. Cost means sacrifices made in the acquisition of an item and value
implies benefits accruing on its acquisition. Only on the date of purchase the cost
or value of an item would be same. Subsequently cost remains the same but the
value changes.
26.2. DIFFERENCE BETWEEN COST AND VALUE

If depreciation is charged on historical cost method, the plugging back of profit
due to charging of depreciation would be less than what it would have been if it was
made on current values. So there is less retention of profit. Moreover, the total
fund arising out of the depreciation does not permit the company to replace the
assets such as machines at current values. Hence the replacement becomes more
and acute during the period of inflation. The alternative in this case is to introduct
further capital into the business.
332
Example
A machine was purchased in 1968
Its cost price Rs.12,000

Its sorap values Rs.2,000
Estimated life 10 years
IT is clear from the above example, the year of replacement of the existing
machine is 1978 when the market price of similar type of machine was Rs.20,000.
Cost of machine Rs.12,000

Less: Scrap value Rs.2,000
Rs. 10,000
As this value of Rs.10,000 will be spread over for 10 years.
10,000
The depreciation that should be charged is Rs.1,000 ie.
10
This provision for deprecation for the replacement of machine is known as
plugging back of profit.
At the end of 10th year Rs.10,000 will be ploughed back out of the revenue of
the years.
X1 + X2 + … … = E X. The cost plus scrap value of asset will be the total
amount to be used for replacement purpose. Moreover this Rs.12,000 (10,000 +
2,00) will not be sufficient to replace similar type of machine. When the price of
such machine had gone up, say Rs.20,000.
From all these points it is clear that the replacement of assets is one of the
most important problems during the period of inflation.
2. Problem of Inventory Valuation

Conventional method of valuation of stock is either at cost price or market
price whichever is less. But trading usually takes the valuation at latest purchase
which is higher that the previous purchases. Hence profit is inflated. This will be
clear from the two examples given below, assuming market price to replace the cost
of goods sold: Rs.18,000
Exhibit — I
Assuming stock valuation at latest purchase Trading A/c
Rs. Rs.
To Opening stock 20,000 By Sales 60,000
To Purchase 20,000 By Closing 30,000
To Gross profit 50,000
90,000 90,000
333
Exhibit — 2
Assuming stock valuation either at cost price or market price whichever is
lower.
Trading A/c
Rs. Rs.
To Opening stock 20,000 By Sales 60,000
To Purchase 20,000 By Closing 20,000
80,000 80,000
Analysis of Exhibits
Cost of goods sold Opening stock + Purchase — closing stock sales = Cost of
goods sold + Profit
Exhibit No.1
Rs.
Purchases 20,000
40,0000
Closing Stock 30,000
Cost of goods sold 10,000
Sales = Cost of goods sold + Profit
Rs.60,000 = Rs.10,000 + Rs.50,000
Exhibit No.2
Rs.
Purchases 20,000
40,000
Closing Stock
Cost of goods sold
20,000
20,000
Sales = Cost of goods sold + Profit
Rs.60,000 = Rs.20,000 + Rs.40,000

334
From the above examples we can understand the retnetion of profit is higher in
the case where closing stock take the valuation either at cost price or market price
whichever is lower. On the other hand it is lower in the case where closing stock
takes the valuation of latest purchase. Now the market price of the ‘cost of goods
sold as indicated earlier Rs.18,000 Retention of profit in the first case will not help
the management to replace similar type of goods sold whereas the retention of profit
tin the second case in sufficient to meet the situation arising from inflation. Hence
replacement of stock is another problem to be observed during the period of
inflation.
3. Problem of proper interpretation of Financial Statement
Changes in the purchasing power of money will definitely affect accounting for
real value. Value may be of two types – 1, (Real value and 2) Money value. The
assets and liabilities which are reassessed owing to rise in price level are known as
real value items and which do not permit reassessment under similar
circumstances are formed as money value items. Examples of real value assets and
liabilities are land machinery, building, capital, reserve etc. This indicates the
items of tangible assets and get worth of the business. Examples of money value
assets and liabilities are cash, debtors, bills receivable, bills paybale etc. It is a fact
that appropriate technique for the new method of accounting for inflation has not
been arrived at any uniformity. The presentation of corporate accounts is the
subject matter of research for the Institute of Charted Accountants of India. The 1st
of analysis can be summed up as follows.
a. The Balance Sheet does not show a ‘true and fair’ view of the state of affairs of
the business.
b. Trading and profit and loss Account shows a ‘distorted’ Picture of the business
operation. If the depreciation was charged at current value, the reported profit
would have come down. Such statement of the operation of the business
‘understate assets and overstate profit’ . This will be clear from the examples
given below.
A
P & L A/c.
Rs.
To Depreciation 2,000
” Net Profit 8,000
B
P & L A/c.
Rs.
To Depreciation 4,000
” Net Profit 6,000
335
It is clear that in the case of A, the reported profit is higher because

depreciation was charged at historical cost method. In case of B the reported profit
is lower to the extent of Rs..2,000 if the same is compared with A. This indicates
greater retention of profit. This is possible because the deprecation was charged at
current replacement value.
4. Erosion of Real Capital

Eroasion of real capital is the greatest curse of inflation. Owing to inadequate
provision for depreciation and improper valuation of closing stock the profit of the
business, is inflated. This give rise to some industrial problem as to distribution of
dividend, payment of bonus etc. The owner of the business, overdraws revenue
resources and what is left indicates high money value in terms of less commodity.
It is fact that as revenue is not matched with proper cost a part of the “real capital
of the business in concerned”.
1. Problem of Disparity of the Rate of Dividend

Preference share holders, the holders of fixed interest bearing securities and
providers of long-term loan, suffer during the period of inflation, because their
capital and income both depreciate in terms of purchasing power of money.
2. Problem of proper Managerial Decision.

Management needs accurate meaningful report on a day-to-day, week-to-week,
month-to-month and even hourly basis, for taking its decision in a right
perspective. Therefore the financial ratio computed from unadjusted balance sheet
would provide misleading information. The adjusted rate of return ratio would be
very helpful to take correct management decision. Management policies can be
formulated following the experience of the past, condition of the present and
institution about the future. The efficiency of the management will be tested from
the ratio mentioned below.
Net P rofit
Earning Ratio =
Equity capital/capital employed
Earning Ratio — X (Depending on the past experience)
Earning Ratio — Y (Depending on the present experience)
Earning Ratio — Z (Depending on the intuition about the future)
Hence, the function of top management should be it make reconciliation
among the past present and uncertain future.
7. Problem of Distribution of Divided and payment of Taxation for Profit

It is clear that the under-statement of assets and overstatement of profit brings
may problems in accounting literature. This result in payment of higher divided
and taxation.
336
26.3. MONEY VALUE AND REAL VALUE ASSETS AND LIABILITIES

Sometimes assets are classified as real value and money value items, Value of
real assets such as machinery, equipment, buildings land etc., rises with rise in
price level, whereas that of money value assets such as cash, debtors etc. remains
constant. At the time of rise in price level, book value of real value assets are only
subject to revision.
It is difficult to suggest that what category, real value or money value, good will
belong to. If it is treated simply as an annulty of some periodical receipts of money
in future, it is reasonably considered a money asset. As such its value will not rise
with the rise in prices. Goodwill is considered as a real value asset, if such money
receipt is likely to rise with the rise of price level. But a rise in the value of goodwill
will not possibly be recorded, because the said rise will not be represented by any
cost.
Illustration — 1
The following is the Trial Balance of a company at the end of 31 st December,
1980 (where accounting was done on orthodox principles)
Dr. Dr.
Opening Stock 2,000
Purchases 10,000
Sales 1,500
Expenses 2,000
Depreciation 400
Fixed Asset at cost 4,000
Provision for depreciation 1,600
Sundry Debtors 3,000
Bank 1,700
Capital 6,000
Reserve 500
Sundry creditors 1,500
23,100 23,100
1.
The following information is supplied
Closing stock which was purchased at the beginning of all four quarters is
valued at cost price at Rs.2,300
2. The accounts relate to the first year of inflation after a period of stable prices.
During this year, the general ‘Index of inflation’ rose steadily from 100 to 140,
the price of the commodity in which the company dealt also increased steadily,
337
but only by 20 present while the prices of its fixed assets increased by 50
percent.
Prepare the final account, in such a way which according to you will be best
under such inflationary, conditions. (Ignore Income Tax)
Trial Balance
Accounts, Orthodex system Converted to present Day Currency
(Revaluation system)
Dr. Cr. Dr. Cr.

Profit and Loss items From To
Rs. Rs. Rs. Rs.
Opening stock 2,000 - 100 120 2,400 -
Purchases 10,000 - 120 120 10,000 -
Expenses 2,000 - 120 120 2,000 -
Depreciation 400 - 100 120 480 -
Sales - 13,500 120 120 - 13,500
Closing stock - 2,300 130 120 - 2,123
Balance Sheet Items
Fixed Asset at cost - 100 140 5,600 -
Closing stock 4,000 - 130 140 2,477 -
Sundry Debtors 2,300 - 140 140 3,000 -
Bank 3,000 - 140 140 1,700 -
Provision for Depreciation 1,700 1,600 100 140 - 2,240
Capital - 600 - 6,000
Reserve - 500 100 140 - 3,100
Sundry creditors - 1,500 140 140 1,500
25,400 25,400 27,657 28,463

Loss on inflation 806
28,463 28,463
Trading and Profit and Loss Account
To opening stock
Rs.
2,400 By sales
Rs.
13,500
To Purchases 10,000
338
12,400
Less closing stock 2,123
To Cost of goods sold 10,277
13,500 13,500
To expenses 2,000 By Gross Profit 3,232
To Depreciation 480
To Net trading profit 743
3,223 3,223
P & L Appropriation A/c
To Loss on Inflation 806 By Net trading Profit 743

By Loss on appropriation a/c 63
806 806
B/S as at

Capital 6,000 Fixed Assets at cost 5,600
Reserve 3,100 Less: provision for
Depreciation 2,240 3,360
9,100 Closing Stock 2,477
Less Loss on Sundry Debtors 3,000
Appropriation A/c 63 Books 1,700
10,537 10,537
Illustration – II
The following is the Trial Balance of X Co. Ltd., as at 30 th June 1980. You are
required to prepare the trading and Profit and Loss Account for the year ended and
the Balance Sheet as at that date both on Orthodox and the Replacement system of
accounting assuming that
1. The year in question is the first year of inflation
During this year the general index number of prices one by 40 percent, the
prices of commodity in which the company dealt rose by 20 percent and the
prices of its fixed assets by 50 percent.
3. The quality and quantity of the closing stock is the same as those of the
opening stock.
339
Trial Balance
Rs. Rs.
Opening Stock 37,000 Share capital 75,000
Plant and Machinery Provision for depreciation 20,000
(at cost) 50,000 Sundry creditors 15,650
Sundry debtors 48,000 Sales 1,72,000
Purchases 1,14,000 Provision for taxation 8,000
Closing stock 42,550 Closing Stock 42,550
Cash in hand 2,250 General Reserve 10,000
Cash at Bank 14,600
Postage and stationery 3,000
Salary 8,000
Wages 6,000
General Expenses 4,200
Bad debt 600
Taxation 8,000
Deprecation 5,000
3,43,200 3,43,200
Trading and Profit and Loss Account for the year ending June, 1980
Orthodox Replacement Orthodox Replacement

Particulars Particulars
Rs. Rs. Rs. Rs.
To Opening Stock 37,000 37,000 By Sales 1,72,000 1,72,000

” Purchases 1,14,000 1,14,000
1,51,000 1,51,000
Less: Closing 42,550 (A)37,700
Stock
1,08,450 1,14,000
To Wages 6,000 6,000
” Gross profit c/d 57,550 52,000
1,72,000 1,72,000 1,72,000 1,72,000
To Postage and By Gross Profit 57,550 52,000
Stationery 3,000 3,000
” Salary 8,000 8,000
” General
Expenses 4,200 4,200
340
” Bad debts 600 600

” Depreciation 5,000 (B) 7,500
Net trading Profit 36,750 28,700
57,550 52,000 57,550 52,000
Profit and Loss Appropriation Account

Rs. Rs. Rs. Rs.
To Taxation 8,000 8,000 By New trading

” Arrear Profit b/d 36,750 28,700
depreciation (G) 7,500
” Net profit
transferred to
Reserve 28,750 13,200
36,750 28,700 36,750 28,700
Balance Sheet as at 30.6.1980

Rs. Rs. Rs. Rs.
Share Capital 75,000 75,000 Plant and 50,000 50,000

General Reserve 10,000 10,000 Machinery 20,000 (B)
Appropriation A/c 28,750 13,200 Less: Depreciation 30,000
Sundry Creditors 15,650 15,650 30,000 20,000
Provision for 8,000 Sundry Debtors 48,000 48,000

taxation 8,000 Closing stock 42,550 37,000
Cash in hand 2,250 2,250
Cast at Bank 14,600 14,600
1,37,400 1,21,850 1,37,400 1,21,850
Working
(A) Closing Stock as per information supplied, Closing stock is the same as
opening stock.
(B) Deprecation
150
5,000 × = Rs. 7,500
100
150
20,000 × = Rs.30,000
100
(C) Arrears depreciation
341
In this problem, under orthodox depreciation, provided upto 30 th June

amounted to Rs.15,000
So arrears depreciation will be like this
Rs. 30,00 — (Rs. 15,000 + Rs. 7,500 being current years debt)
Rs. 30,000 — 22,500 = 7,500
Illustration – III
Radha, Geetha and Seetha Company, a dealer of varieties of articles adopted a
LIFO Method of inventory valuation as on January 1977, at which time FIFO
inventory balances amounted to Rs. 2,00,000. No attempt was made to keep
separate inventory balances for each of the Company’s merchandise items A rupee
value method was adopted.
You are given the following information for the years 1977-1980.
1. The company’s inventory had following LIFO valuation on December 31,1979.
Rs.
Lifo base (1.1.77 price) 2,00,000
1979 layer 35,000
1979 10,500
Total 2,54,500
2. All increments to the Lifo inventory are priced at beginning-of-year prices. (For
this purpose, it is assumed that beginning-of-year prices are the same as the
prices prevailing at the end of the previous year)
3. Year ending inventories were as follows:
End-of year Beinning-of year

Price Prices
December 31, 1979 3,33,000 3,02,727
December 31, 1980 3,12,000 3,00,000
4. Merchandise purchases during 19o80 amounted to Rs.25,00,000
5. The ratios of end of year prices to beginning of year price were*
1977 1.10
ANNAMALAI UNIVERSITY 1978 1.05
1979 1.10
1980 1.04
(*Note that these index numbers have not been ‘chained’)
(a) Compute the cost of goods sold for 1980 and the December 32, 1980 inventory
valuation
342
(b) What was the price level gain or loss reflected in the 1980 income statement?
(Assume that adequate Supplies of merchandise could have been bough at year
ends to keep inventories constant)
(c) What was the price level gain or loss or eliminated rom reported Income of the
years 1977 through 1980 by the adoption of the Lifo method?
Solution
a) Cost of good sold: Rs. 25,29,500 Lifo inventory
Base Rs.2,00,000
1978 layer Rs. 25,000
2,25,000
Computation: 1980 decrement
Decrement = Rs. 3,33,000 —Rs. 3,30,000
= Rs. 33,000 at 1.1.80 prices
= 33,000/1. 1 = Rs.30,000 at 1.1.179 prices
But only Rs. 19,500 in 1979 layer (at 1.1.79 Prices) leaving Rs. 10,500
This is equivalent to Rs. 10,500/1.05 = Rs. 10,000 at 1.1.78 prices.
Therefore, the decrement is Rs. 19,500 + Rs. 10,000 + Rs. 29,500
b) Price level gain = Rs. 33,000 × 1.04 × 1.04 = Rs. 29,500
= Rs. 4,820
The 1.04 factor is necessary to get decrement in end-of-year prices to calculate
the effect of not re-building inventory at year-end.
Cumulative gain eliminated from income by use of Lifo = Rs. 3,12,000 — Rs.
2,25,00 = Rs.87,000
Questions
3. What is meant by inflation accounting?
4. What are the limitations of historical accounting in period of inflation
5. What are the objections against inflation accounting.
Explain current cost Accounting
343
LESSON - 27
DEPRECIATION POLICY
OBJECTIVES
 Know the reason for providing depreciation
 Define depreciation
 Evaluate the different methods of calculating depressions
STRUCTURE
27.1. Introduction
27.2. Definition
27.3. Causes of depreciation
27.4. Methods of depreciation
27.5. Income tax & Depreciation
27.6. Depreciation accounting
27.7. Managerial significance of depreciation accounting.
27.8. Depreciating policy & price level changes
27.1. INTRODUCTION
General fixed assets, except land, such as Plant and Machinery Furniture,
Buildings and Equipment have short period of useful life. As these assets are
permanently used in the business, they necessarily go down in value in course of
time. Depreciation is thus, diminution in the value of a fixed asset due to use
and/or the lapse of time.
The term depreciation is derived from the Latin words ‘do’ (meaning down) and
‘premium’ (meaning price) in business, it is used to denote loss or value which arise
through wear and tear or some other form of material deterioration or the effluxion
of time.
Definitions
“Depreciation represent that part of the cost of a fixed asset to its owner, which
is not recoverable when the asset is finally put-out of use by him. Provision against
this loss of capital is an integral cost of conducting the business during the effective
commercial life of the asset and is not dependent upon the amount of profit
cleared?
The Institute of Charted Accountants of Australia

“Depreciation is the allocation of the entire cost of depreciable assets to the
operating expenses of a series of fiscal period”.
344
Mr. Montogmery
“Depreciation is the process of spreading the value of a fixed asset over the
accounting periods comprising its service life”
Third international Congress on Accounting

“Depreciation accounting is a system of accounting which aims to distribute
the cost or other basic values of tangible capital assets, less salvage value (if any)
over the estimated useful life of the Unit (which may be a group of assets) in a
systemic and rational manner. It is a process of allocation and not of valuation.
Depreciation for the year is the portion of the total charges under such as system
that is allocated to the year. Although the allocation may properly take into
account occurrences during the year, it is intended to the measurement of the
effect of all such occurrences”.
It is clear the because of constant use in running the business, the value of
fixed assets is diminishing. Depreciation is just like an expense incurred for the
business purpose. It is proper that deprecation should be provided for, before
calculating the profit. Hence the amount equivalent to decrease in the value of
fixed assets occurred during a particular accounting period must be debited to
Profit and Loss Account. Then only we can ascertain true profit or loss.
Provision for depreciation also serves the purpose of showing the fixed assets
at their real value. The value of the assets will be exaggerated in the Balance Sheet
if depreciation is not provided for. Moreover the Balance Sheet will not represent a
true and fair state of affairs of the business.
Lastly when the profit and Loss account is charged with depreciation over the
years, the fund accumulated out of this process can be utilized by the firm to buy a
new asset when the life of the old one comes to an end. The following are the main
purposes of charging depreciation to the Profit and Loss Account.
1. To ascertain the true profit
2. To show the true value of the fixed assets and
3. T accumulate funds to replace the asset at the end of its useful life.
Other advantages of providing depreciation are:
1. To compute tax liability
2.
3.
To decide for how much to buy or sell the asset in the second-hand market.
To decide what part of the gross profit to distribute to the owners of the
business and
4. To decide how much to charge the consumers of the product.
Causes of Depreciation
The main causes of depreciation are:
345
1. Wear and tear due to actual use

2. Effect of time-mere passage of time will cause a fall in the value of an asset,
even if it is not used.
3. Obsolescence a new invention or a permanent change in demand may render
the asset useless.
4. Accidents and
5. Fall in market price.
The Basic Factors

For calculating depreciation the basic factors are:
1. Cost of the asset
2. Probable working life of the asset.
3. Scrap value of the asset.
4. Possible annual charge for repairs
5. Selecting the appropriate method of charging deprecation.
Methods of Depreciation
1. Straight-line Method
As this method is very simple and easy to understand, it is widely used. This
is otherwise know as “Fixed Installment method” or “Original Cost System”. Under
this method a fixed amount is to be charged as deprecation for each year of
expected use of the asset. The annual charge is computed by dividing the
depreciable cost, total cost minus salvage value by the estimated working life
expressed in years. Suppose an asset is purchased for Rs. 80,000. and its residual
value at the end of its tenth year of life is Rs. 8,000 the balance of Rs. 72,000 is to
be written off during the course of 10 years at the rate of Rs. 7,200 per year. It is
suitable for use in connection with patents, lessholds and machinery etc, as
depreciation is connection with patents leaseholds and similar assets having a
definite life and it is not suitable for plant and machinery etc. as depreciation is
constant while the repairs will be havey din later years. This method is generally
followed regarding ocean going ships etc.
2. Service - Hours Method

This method takes into consideration the “running time” of the asset for the
purpose of calculating the amount of depreciation. For example, in the case of air-
craft the estimated useful life may be calculated in terms of “flying hours”. The
formula is, depreciation is written off on the basis of the balance in the account of
the asset.
The main advantage of this method is that the decreasing depreciation charges
in the later years of an asset’s life fund to compensate the increasing cost of
346
maintenance and repairs as the asset grows older and thus help to make the total
cost of using the asset more or less constant. Hence, this method is suitable for a
assets like plant and machinery boiler, lorry motor car and buildings.
5. Sum of the years Digit Method

Depreciation rate, under this method is expressed a fractions. For getting the
fraction, one has to add the numbers representing the period of life, use the sum
thus obtained as a denominator and use as numberator, the same numbers take in
reverse order and finally multiply the net asset value by the fractions thus
produced. For examples a fixed asset costing Rs. 50,000/- (Rs. 10,000/- residual
value) with estimate useful life of 5 years, the denominator of the fraction for each
would be 15 (1+2+3+4+5) years The allowable depreciation, for the first year is 5/15
of cost, for second year 4/15 of the cost and so on.
6. Double Declining Balancing Method

Under this method the depreciation is charged on the reducing balance method
but the rate of deprecation is determined by multiplying the straight line rate by
two. Here residual value is ignored. This method is often used in the U.S.A.
7. Revaluation Method
Assets such as Loose Toos, Pattern Copyright, Models Livestock, Packing
Materials, Bottles, Jigs etc, cannot be depreciated under. Straight Line Method or
Reducing
C—S
D= × Service Hours
n
This method is useful (1) where obsolescence is not a Primary factor (2) use of
asset can be measured interms of time and (3) the utility of the asset is directly
related to its working time.
3. Productive Output Method

In this method it is essential to make an estimate of the units of output the
asset will produce in its lifetime. For example, in case of a tract, estimated useful
life may be in terms of kilometers operated and for a stamping machine, a certain
number of stamps. Deprecation is calculated as under.
C—S
D= × units output
4. Diminishing Balance Method
n
This method is otherwise known as Reducing Balance Method or Written Down

Value Method. This method yields its diminishing annual depreciation charges by
applying a constant rate to the written down value of the cost of an asset. Here
depreciation is provided on the basis of a percentage. Though this percentage
remains the same, the actual provision drops year after year, because the
347
percentage is based on the diminishing value. Suppose the cost of an asset is Rs.
20,000. At the rate of 10% depreciation for the first year is Rs. 2,000. For the next
year it is Rs. 1,800
10
(20,000 — 2,000 = 18,000 × ).
100
It is clear that the Method, they do not depreciate uniformly. So they are revalued
at the end of each accounting year. The difference between the opening value and
the reevaluated amount is treated as used cost or depreciation. This method is
ideal for special utility assets purchased for use on a specific project and whose
utility at the end of the project is problematical. If the revaluation discloses any
appreciation in the value of asset it should be treated as capital reserve.
8. Replacement Method
This system is frequently utilised in public utility companies. This system
does not record depreciation until a unit is replaced. When unit is replaced at the
time, the amount equal to the cost of the new asset (less the residual value of the
old asset) is charged to depreciation.
9. Annuity Method
Barlier methods ignore interest on the capital sunk in the acquisition of the
asset. Hence, this method takes the case of the fact that the business decides
losing the original cost of the asset also loses interest (on the amount used for
buying the asset) which he would have earned had the same amount been invested
in some other form of investment. Under this system the amount of total
depreciation is determined by adding the cost of asset and interest thereon at an
expected rate. As the calculation of depreciation is difficult, a depreciation Annuity
Table has been specially constructed for this purpose. This shows the amount that
can be written down annually, as depreciation on the asset along with a certain
rate of interest on the capital sunk, in the asset. The depreciation to be written off
can be found out from the Annuity Table.
This system is an exact method of providing depreciation. It is applicable only
to leaseholds which generally involve considerable capital outlay over a specific
term of years. It is not applicable to plant and machinery as they are subject to
frequent calculation on account of additions and dismantling of them.
10. Depreciation Fund Method
The method is otherwise known as Sinking Fund Method. This system
combines both the depreciation of asset and its replacement under one
comprehensive approaches of providing ready cash for purchasing new asset at the
time of replacing the old one. For this purpose the depreciation amount is set aside
and invested in Government bonds, securities etc. Interest on these investments is
also invested on similar investments. When the life of the asset comes to an end,
348
the securities are sold and a new asset is purchased with the held of the sale
proceeds. The amount that is kept aside as depreciation and invested very year is
such that the accumulated amount with compound interest, will be equal to the
cost of the asset, less residual value if any, at the time when it becomes worthless
to the business. For this purpose “Sinking Fund Table” is used which shows how
much is to be invested every year to get Re. 1 for some years with certain
percentage of interest. Such figure is multiplied by the value of asset.
11. Insurance Policy Method

It is similar to Deprecation Fund Method Instead of making investments,
arrangements are made with an insurance company which will receive premium
annually and pay at the end of the fixed period the required amount. The premium
amount has to be paid in the beginning of each year. The annual premium is
treated as the annual depreciation. The amount is credited every year to the
Depuration Fund Account by debiting Depreciation Account. On Payment of the
premium, Depreciation Fund Policy Account is debited. Here there is no entry of
interest as no interest will be received from the insurance company.
12. Depletion method

This method is most suitable for mines, quarries etc., from which a certain
quantity of output is expected to be obtained. The value of mine depends only
upon the quantity of minerals that be obtained. When the whole quantity is taken
out, the mine loses its value. Hence one can say that the mine depreciates
according to the quantity mined. The rate of depreciation is worked out as so much
per tonne. It is obtained by simply dividing the cost of the mine by the total
quantity of the mineral expected to be available.
Income Tax Act and Depreciation

Though we have discussed various methods of depreciation, there are also
other method, that may be devised. The problem of the management is to choose
the best method for its concern. The management has to pay enough attention to
various factors in this regard, before selecting the method.
What the Income Tax Act of the country says in this matter is the most
important point. No doubt every entrepreneurs will try to minimise the tax burden
and choose the best method to suit this purpose. The Income Tax Act of our
country carries some provisions regarding depreciation. If the calculation of
depreciation is not made in accordance with these provisions, the returns field by
the business unit will not be accepted by the Income Tax Authority. The following
are the important points that should be noted in this connection.
1. Depreciation should be calculated on the written down value for assets (such
as building, plant and machinery or furniture) except ocean going ships, for
which it should be calculated on the actual cost. In other words Fixed
349
instalment Method is to be adopted for ocean-going ships and Diminishing

Balance Method for other assets.
2. If an asset is destroyed or discarded or sold in the year (other than the year in
which it is first brough into use), the excess of the written down value thereof
over the money payable in respect of asset together with the amount of scrap
value, shall be allowed as a deduction commonly known as Termination.
3. A special depreciation called initial depreciation at 20% is allowed on the actual
cost of building in addition is allowed only one in respect of the year of the
erection of the building. This is only to encourage the construction of building
either for residential purpose or for setting up hospital, school library etc.
Depreciation Accounting
From the financial accounting point of view Depreciation Accounting is
concerned the allocation of the cost of an asset sover its useful life and charge the
revenues of a period with the expenses of earning those revenues. From the
definition of Depreciation Accounting given in beginning, it is clear that the
valuation concept has been authoritatively rejected.
Objectives
1. The policy must be aimed at recapturing from period revenue a sufficient
number of monitor units either to provide for replacement of the asset or
recover the original investment viz.
2. The amortization charge for any given period should reflect the share of the
total asset service that has expired during that period.
Managerial Significance of Depreciation According.

The importance of Depreciation Accounting from the managerial point of view,
is complicated by the fact the depreciation measures the expenses of using a fixed
asset which would depreciate physically irrespective of its use The significance of
depreciation accounting can be discuses with reference to certain management
decisions, technique and areas of interest such as Internal Investment Decisions
Measuring of Performance, Funds generation, Make or But Decisions and
Processing Decisions.
Developing Depreciation Policy

The desirably of a systematic pre-established amortisation plan or the good a
sufficient reason of protecting the inventory against reliance on subjective and
possibly biased data has been strongly underlined by practical experience. One the
depreciation schedule is obviously realistic the plan should be immediately recast.
The maximum rates allowable under tax laws should not be treated as the most
important factor in developing data for use by either management or investors.
350
Next the recovery of the initial asset of plant assets must have been procedure
over the payment of taxes or dividends. If provision for depreciation is inadequate
from this point of view, such payments may become distribution capital rather than
earnings despite the fact that inadequate depreciation would certainly result in
losses at the time of retirement of the asses and in losses deductible for tax
purposes in the period at retirement. However this is not implied that depreciation
charges on existing asset should be directly related to the expected future cost of
replacing that asset.
Lastly in view of the fact that substantial variations an be expected in both the
output on operating characteristics of different types of plant, asset subject to
different deprecation methods, several system must be employed if periodic
deprecation charges are to serve as meaningful indices of the expiration of
productive capacity.
Depreciation Policy and Price Level charges

(Historical Vs Replacement cost)
All the methods of calculating depreciation already referred to, take the original
cost of the asset which is purely historical and hence, would not serve the purpose
of replacing and hence, would not serve the purpose of replacing the asset during a
period of rising prices. During periods of inflation, when the prices of fixed assets
go on rising, the amount of depreciation charged on the original cost will not be
sufficient to replace the asset. In order to obviate this, it is necessary to calculate
depreciation on the replacement cost. Whether depreciation is to be calculated on
the original cost of the asset or its replacement cost, is a matter of controversy and
arguments have been advanced for and against depreciating fixed assets at their
replacement values.
Arguments is favour:
1. If Fixed assets are depreciated at their replacement costs sufficient funds
would be available for replacing the assets.
2. When the value of money rapidly falls during periods of rising prices, book
profits get inflated and, as such, the original cost method would not show the
real profits.
3. The inflated book profits mislead share-holders employee and public.
4.
Since the inflated profits are paid away in the form of dividend, the interests of
preference shareholders and debenture holders are affected in the long run and
in turn they may affect the capital structure of the concern.
5. For ascertaining the true of the investment, it is necessary to take the
replacement value, but not the historical cost.
6. Depreciation, calculated on replacement values, maintains the capital in fact in
as much as cash is retained in the business.
351
7. Historical costs are of importance only when the assets are actually purchased.
Then they do not represent the true economic value of the fixed assets in the
use due to their decrease in value.
8. Depreciation rates at the replacement value produce true costs in cost
accounts, as the cost becomes comparable with the current selling prices.
9. Inflated profits attract higher taxation.
Argument Against
1. A depreciation charges represents the recovery of the original cost of the asset.
The only logical way of recovering the actual cost is by depreciation on the
actual cost.
2. There is no generally accepted method of ascertaining the replacement cost.
3. Replacement of assets is still a possibility even under the original cost method
by building up sufficient reserves.
4. Owing to technological development demanding more advanced types of assets,
replacement would not usually be made with equivalent asset at the pre-
estimated price.
5. Since replacement reserves are built up by following a conservatives dividend
policy, higher book profits need not necessarily mean high dividends.
6. The taxation authorities do not approve this method as depreciation should be
calculated only on the original cost.
7. For costing purposes, it is essential to take only the actual costs, and not the
future costs.
8. Lastly it is not sould accounting practice to charge to revenue an amount more
than the original cost of the asset.
Owning to the above, theoretical objections and practical difficulties, charging
depreciation on the original cost basis till appears to be popular.
QUESTIONS
1. Define depreciation
2. What is meant by Straight-line method?
3. Briefly explain the causes of deprecation
What are the reasons for providing depreciation?
352
LESSON - 28
MISCELLANEOUS
REPORTING FOR MANAGEMENT
OBJECTIVES
 Know the purpose of reporting
 Classify different kinds of reports
 Explain the characteristics of a good report.
 Evaluate duties & responsibilities of a controller.
STRUCTURE
28.1 Purpose of reporting
28.2. Classification
28.3. Characteristics of a good report
28.4. Controller
28.5. The controllership function
28.6. Duties of a controller
28.1. PURPOSE OF REPORTING

One of the most important functions of the Management Accountant is to keep
the management informed of all facts relating to the business so as to assist the
management in controlling the undertaking effectively and for managing the
business efficiently. This is done by the preparation of statements and reports
accompanied by charges, diagrams statistical data etc. The statement may be
prepared either for the use of the Board or for the use of Works Manger, This is
called ‘Repor5ting’. responsibility reporting has been described as a system of
reports for all levels of management designed to provide information which can be
used to control expenditure most effectively and which directly relates to the
reporting of expenditure to the individuals responsible for our control.
28.2. CLASSIFICATION
Reports may be classified into two: 1. Routine Reports and Statements and (2)
Special Reports.
Routine Reports
The following or covered
1. Budgets prepared for various departments and achievements and variations of
the same.
2. Cash budget and deviations therefrom.
353
3. Master budget incorporating therein the forecasts of sale and result of the
trading showing the variations.
4. Capital Budget showing details of proposed capital outlay and deviations
therefrom.
5. Reports as regards the utilization of labour and machines.
6. Particulars of the profitability of the capital expenditure on projects.
7. Financial statement analysis and the remarks thereon.
8. Budgets relating to production, work expenses, stock and their achievement
and variances.
9. Budgeted and actual hour and production in standard hours;
10. Efficiency and activity rations;
11. Particulars of orders received, executed and unexecuted.
12. Reports relating to research and development.
Special Reports
The following are cover by special reports.
1. Special investigations in relation to the several systems employed.
2. Capital Expenditure decisions;
3. Methods for investing surplus cash or to obtain funds:
4. Delays in production, machine breakdown etc.
5. Recommendations regarding cost reduction, whether to buy or make
components of products or whether to purchases fixed assets or hire them.
6. Recommendations as regards fixing of minimum price.`
7. Reports on the competition of production On the strength of the products, of
holding raw material and finished products.
8. Report in respect of closing down of any department;
9. Report on the study of idle capacity, on the profitability of the business, effect
of diversification or simplification of products, effect of labour disputes if any.
Special Reports should state

the reasons for the report
2. the nature of investigations made
4. the finding and conclusion along with recommendations.
They will vary according to the purposes of each case.
354
28.3. CHARACTERISTICS OF A GOOD REPORT

1. A report should cover broad treds only and not minute details.
2. Each report should be pertinent. It should contain the information from which
the management could take some action. It should contain only the particular
requirements and should serve as a guide for the future for taking necessary
action.
3. It should contain unbiased and not personal opinions.
4. It should be timely to enable the management to plan correct action
5. It should point out the unexpected achievements and show ‘what should have
happened and not what happened’. It should be directed towards those areas
where variances are most significant.
6. The report should be concise furnishing key figures avoiding minor details.
7. It should be analytical providing probable cause for variances thereby localising
the management’s attention to such areas.
8. They should be accompanied by appendix Containing figures and data;
9. Each report should have purpose to justify is preparation.
10. It should be easily understandable.
11. It should take into account the background and the inclination of the person to
use:
12. The intention of a report should be to permates the entire organisation.
13. It should be upto date.
28.4. CONTROLLER
In big concerns it becomes necessary to appoint a officer which maybe called
Controller or Budgetary Controller. as has been pointed out already, physical
supervision can be carried out only to a limited extent in big firms. Accounting
control or control through a regular flow of information is the relay effective way of
supervising the work of the staff. This along would necessitate a wholetime officer.
But there are some other duties also which can be profitably allotted to the
controller.
28.5. THE CONTROLLERSHIP FUCNTIONS
Although the position of a controller, also called “Management Acco0usntant”
differs from organisation to organisation partly because of differences in the
philosophy of management organisation and partly because of differences in the
personalities of the individuals occupying the specific position in the firm.
However, the Controller’s Institute Committee has recommended the following
organisation status of the controller.
355
a. The controller should be an executive officer at the policy-making level

responsible directly to the chief executive officer of the business. His
appointment or removal should require the approval of the Board of Directors.
b. The controller should be required by the Board of Directors to present directly
periodic-report convering the operating results and financial condition of the
business, together with such other information as it may desire.
c. The controller should preferably be a member of the Board of Directors and all
other to the policymaking groups. At the minimum be should be invented to
attend all meeting of such groups with a right to be beard.
Regardless of the differences in the position of the controller sin the
organisation, normally he performs that following functions:
1. To establish co-ordinate and maintain, through authorised management, an
integrated plan of the control of operations. Such a plan would provide to the
extent required in the business, cost standards expense budgets, sales
forecasts, profit planning and programmes for capital investment and
financing, together with the necessary procedures to implement the plan.
2. The measure performance against approved operating plans and standards and
to report and interpret the results of operations to all levels of management.
This function includes the design, installation and maintenance of accounting
and cost systems and records, the determination of accounting policy, and the
compilation of statistical records, as required.
3. To measure and report on the validity of the objectives of the business and on
effectiveness of its policies, organisation structure and procedures in attaining
these objectives,. This includes consulting with all segments of management
responsible for policy or action concerning any phase of the operation of the
business as it relates the performance of this function.
4. To report to government agencies, as required and to supervise all matters
relating to taxes.
5. To interpret and report on the effects of external influences on the attainment
of the objective of the business. This function includes the continuous
appraisal of economic and social forces and of government influences as they
affect the operations of the business.
To provide protection for the assets of the business. This function includes
establishing and maintaining adequate inteneral control and auditing and
assuring proper incurrance coverage.
356
28.6. DUTIES OF CONTROLLER

The most well known and authorities collection in this direction that of the
Controllers Institute of America who has defined the duties of the Controllers as
below:
1. The installation and supervision of all accounting records of the corporation.
2. The preparation and interoperation of the financial statements and report of
the corporation.
3. The continuous audit of all accounts and records of the corporation wherever
located.
4. The compilation of production costs.
5. The compilation of costs of distribution.
6. The taking and costing of all physical inventories.
7. The preparation and filling of tax returns and the supervision of all matters
relating to taxes.
8. The preparation and interpretation of all statistical records or reports, of the
corporation.
9. The preparation as budget director, in conjunction, with officers and
department heads, of an annual budget covering all activities of the corporation
for submission to the Board of Directors prior to the Beinning of the fiscal year.
The authority of the controller with respect to the veto of commitments or
expenditure not authorised by the budget, shall, from to time, be fixed by the
Board of Directors.
10. The ascertainment that currently the properties of the corporation are properly
and adequate incurred.
11. The initiation preparation and insurance of standard practices relating to all
accounting matters and procedures and the co-ordination of systems
throughout the corporation, including clerical office methods records, reports
and procedures.
12. The maintenance of adequate records of authorised appropriations and the
determination that all sums expended pursuant there to are properly
accounted for.
13. The ascertainment currently that financial transactions covered by minutes of
the Board of Directors and/or the Executive Committee are properly executed
and recorded.’
14. The maintenance of adequate records of all contracts and lessees.
15. The approval for payment (and/or countersigning) of all cheques, promissory
notes and other negotiable instruments of the corporation which have been
357
signed by the Treasurer or such other officers who have been authorised by the
by laws of the corporation or from time to time designated by the Board of
Directors.
16. The examination of all warrants for the withdrawal of securities from the values
of the corporation and the determination that such withdrawals are made in
conformity with the by-laws and/or regulations established from time to time
by the Board of Directors.
17. The preparation of approval of the regulations of standard practices required to
assure compliance with orders or regulations issued by duly constituted
Governmental agencies.
QUESTIONS
1. What is meant by management reporting?
2. What are the characteristics of a good report.
3. Discuss the importance of a proper system of reports.
358
MANAGEMENT ACCOUNTING
Response Sheet No.1
Time: 3Hours (Maxmimum:100 Marks)
Answer All Questions
All questions carry equal marks.

1. Discuss the functions and the limitations of Management Accounting.
2. Explain briefly techniques of analysing and interpreting financial statements.
3. Following is the Balance Sheet of Y Ltd. Balance Sheet as on 31sat December
1978.
Table -1
Rs. Rs.
Equity share capital 1,00,000 Cash in hand 2,000
6% Pref share capital 1,00,000 Cash at Bank 10,000
7% Debenture 40,000 Bills Receivable 30,000
8% Public Debt 20,000 Investments 20,000
Bank overdraft 40,000 Debtors 70,000
Creditors 60,000 Stock: 40,000
Outstanding creditors 7,000 Furniture 30,000
Proposed Dividend 10,000 Machinery 1,00,000
Reserves 1,50,000 Land and Building 2,20,000
Provision for taxation 20,000 Goodwill 35,000
Profit and Loss A/c 20,000 Preliminary expenses 10,000
5,67,000 5,67,000
During the year provision for taxation was Rs.20,000 Dividend was proposed
Rs.19,000. Profit carried forward from the last year Rs.15,000. You are required to
calculate (1) Short term solvency ratios and (2) Long term solvency ratios
X Ltd
Balance Sheet
(Rs. In cross)
Liabilities 1980 1979 Assets 1980 1979
Share capital 70 70 Fixed Assets 120 100
Reserves 120 70 Current Assets
Secured loans 20 25 Stock 80 60
Unsecured loan 10 15 Debtors 40 30
359
Current liabilities 30 20 Cash 10 10

250 200 250 200
Prepare comparative Balance Sheets.
5. Prepare a Fund Flow statement from the following dated
31st December 31st December

Liabilities 1978 1979 Assets 1978 1979
Rs. Rs. Rs. Rs.
Equity share capital 5,000 5,000 Cash 2,000 2,500
Long term debt 1,400 1,300 Account Receivable 2,400 2,700
Retained earnings 2,800 3,700 Inventions 3,100 3,200
Accumulated Other Assets 800 700
Depreciation 2,100 2,800 Fixed Assets 4,000 5,800
Accounts payable 2,000 2,100
13,300 14,900 13,300 14,900
1. Fixed assets costing Rs.1200 were purchased for cash.
2. Fixed assets (original cost Rs.400 accumulated depreciation Rs.150) were sold
at book value.
3. Depreciation for the year 1979 amounted to Rs.550 and duly debited to P & L
A/c.
4. Dividends paid amounted to Rs.300 in 1979.
5. Reported income for 1979 was Rs.1,200
QUESTIONS
1. Define liquidity. How do you analyze the liquidity position of a film using ratio
analysis.
2. White a short note on significance of financial ratios.
3. Define and distinguish between operating Ratio and Net Profit Ratio
4. What are the classifications of ratios? Explain it.
Calculate the following ratios:
(a) Gross Profit ratio (c) Stock Turnover ratio
(b) Operating Ratio (d) E.P.S.
360
Profit & Lost A/c
To Open. Stock 20000 By sales 400000

To purchase 24000 By closing stock 30000
To wages 60000 By Profit on sale of investment 4000
To carriage inward 10000 By Int. on int. 6000
To Salaries 4000
To Dels. Interest 10000
To Loss on Wale of mac. 5000
440000 440000
Share capital: 20000 shares of Rs.10 per share

6. From the following data, prepare balance sheet.
Sales Rs.3200000
Sales to networth 2.3 times
Current debt to network 42%
Total debt to network 75%
Current ratio 2.9 times
Net sales to inventory 4.7 times
Average collection period (assume 360 days) 64 days
Fixed assets to networth 53.2%.

193E140 MGMT Acctg PDF

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

193E140 MGMT Acctg PDF

Hochgeladen von

Copyright:

Verfügbare Formate

(i)

M.COM. COMPUTER APPLICATIONS

COURSE – IV : MANAGEMENT ACCOUNTING

Definition – Scope – Objective – Advantages and limitations of management

Find How analysis – Cash flow statements – Forecasting of fund requirements

Marginal costing – Variance analysis – Capital budgeting – Financial

M.COM. COMPUTER APPLICATIONS

M.COM. COMPUTER APPLICATIONS

COURSE – IV : MANAGEMENT ACCOUNTING

The whole accounting system can be classified as 1) Financial Accounting 2)

Cost accounting was introduced to avoid the shortcomings of financial

1.2. EVOLUTION OF MANAGEMENT ACCOUNTING

control of expenditure. Cost accounting began to play a vital role in maintaining

Reconciliation of cost and financial accounts

Business forecasting, budgeting and standard costing

1.3. DEFINITIONS OF MANAGEMENT ACCOUNTING

“Management Accountancy is the adoption and analysis of accounting

1.4. SCOPE OF MANAGEMENT ACCOUNTING

1. General or financial accounting

3. Budgeting and forecasting

4. Cost control procedures

5. Cost and statistics

7. Methods and procedures

10. Legal provision

1.5. OBJECTIVES OF MANAGEMENT ACCOUNTING

1.6. ADVANTAGES OF MANAGEMENT ACCOUNTING

1.7. FUNCTIONS OF MANAGEMENT ACCOUNTING

2. Analysis and Interpretation of Data

3. Facilitating Management Control

4. Formulation of Business Budgets

5. Use of Qualitiative Information

6. Satisfaction of Information Needs or Levels of Management

1. Lack of Knowledge and Understaning

2. Persistence of Intuitive Decision Making

1.8. IMPORTANCE OF MANAGEMENT ACCOUNTING

improvement in analytical and problem solving techniques and the availability of

9. The Financial Accounting Statements are prepared on some generally accepted

2.2. COST ACCOUNTING AND MANAGEMENT ACCOUNTING

2.3. TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING

2.4. IMPORTANCE OF MANAGEMENT ACCOUNTING THE INDIAN CONTEXT

2.5. MANAGEMENT ACCOUNTING IS A TECHNIQUE TO KEEP ALL ALERT

to achieve greater efficiency. It is supposed to notice all danger signals and to

Management Accounting serves as a tool for Decision Making

Mangement Accounting is a ‘Must’ for Managerial Planning

2.6. MANAGEMENT ACCOUNTING RAISES THE GENERAL STANDARD OF

3.1. CONCEPT OF FINANCIAL STATEMENTS

The term ‘financial statement’ refers to two statements-the Balance sheet or

3.2. NATURE OF FINANCIAL STATEMENTS

Recorded facts represent the data contained in the statements as found in

3.3. LIMITATIONS OF FINANCIAL STATEMENTS

PARTIES INTERESTED IN FINANCIAL STATEMENTS

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

business concern by regrouping and analysis of figures contained in financial

The analysis and interpretation of financial statements represents the last of

1. Analysis of each transaction to determine the accounts to debited and credited

Analysis and interpretation are interconnected because interpretation is

3.4. TYPES OF FINANCIAL ANALYSIS

External Analysis and Internal Analysis are differentiated according to material

PROFIT AND LOSS ACCOUNT

3. Operating expenses such as administrative, selling and distributive expenses

MULTIPLE-STEP INCOME STATEMENT

For the year ended 31 st December 1982

Net Sales 36,140