UNIT III

ANALYSIS OF FINANCIAL STATEMENTS

Analysis of financial statements – Financial ratio analysis, cash flow (as per Accounting
Standard 3) and funds flow statement analysis

Financial statement analysis (or financial analysis) is the process of understanding the risk and
profitability of a firm (business, sub-business or project) through analysis of reported
financial information, by using different accounting tools and techniques.
Financial statement analysis consists of
 reformulating reported financial statements,
 analysis and adjustments of measurement errors, and
 financial ratio analysis on the basis of reformulated and adjusted financial statements.
The first two steps are often dropped in practice, meaning that financial ratios are just calculated
on the basis of the reported numbers, perhaps with some adjustments. Financial statement
analysis is the foundation for evaluating and pricing credit risk and for doing fundamental
company valuation.

Meaning of Financial Statement Analysis:

The term ‘financial analysis’, also known as analysis and interpretation of financial statements’,
refers to the process of determining financial strengths and weaknesses of the firm by
establishing strategic relationship between the items of the balance sheet, profit and loss
account and other operative data.
“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating
the relationship between component parts of a financial statement to obtain a better
understanding of a firm’s position and performance.”

Financial Statement Analysis: Definition

Financial Statement Analysis is an analysis which highlights important relationships between
items in the financial statements. Financial Statement analysis embraces the methods used in
assessing and interpreting the results of past performance and current financial position as
they relate to particular factors of interest in investment decisions. It is an important means of
assessing past performance and in forecasting and planning future performance.

According to Lev: “Financial Statement Analysis is an information processing system designed

to provide data for decision making models, such as the portfolio selection model, bank
lending decision models, and corporate financial management models.”

Objectives of Financial Statement Analysis

1. Assessment of Past Performance: Past performance is a good indicator of future
performance. Investors or creditors are interested in the trend of past sales, cost of
goods sold, operating expenses, net income, cash flows and return on investment.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 These trends offer a means for judging management's past performance and are
possible indicators of future performance.
2. Assessment of current position: Financial statement analysis shows the current
position of the firm in terms of the types of assets owned by a business firm and the
different liabilities due against the enterprise.
3. Prediction of profitability and growth prospects: Financial statement analysis
helps in assessing and predicting the earning prospects and growth rates in earning
which are used by investors while comparing investment alternatives and other users
in judging earning potential of business enterprise.
4. Prediction of bankruptcy and failure: Financial statement analysis is an important
tool in assessing and predicting bankruptcy and probability of business failure.
5. Assessment of the operational efficiency: Financial statement analysis helps to
assess the operational efficiency of the management of a company. The actual
performance of the firm which are revealed in the financial statements can be
compared with some standards set earlier and the deviation of any between standards
and actual performance can be used as the indicator of efficiency of the management.

Purpose of Financial Statements

The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an enterprise that is useful to a wide range
of users in making economic decisions (IASB Framework).

Financial Statements provide useful information to a wide range of users:

 Managers require Financial Statements to manage the affairs of the company by
assessing its financial performance and position and taking important business decisions.
 Shareholders use Financial Statements to assess the risk and return of their investment in
the company and take investment decisions based on their analysis.
 Prospective Investors need Financial Statements to assess the viability of investing in a
company. Investors may predict future dividends based on the profits disclosed in the
Financial Statements. Furthermore, risks associated with the investment may be gauged
from the Financial Statements. For instance, fluctuating profits indicate higher risk.
Therefore, Financial Statements provide a basis for the investment decisions of potential
investors.
 Financial Institutions (e.g. banks) use Financial Statements to decide whether to grant a
loan or credit to a business. Financial institutions assess the financial health of a business
to determine the probability of a bad loan. Any decision to lend must be supported by a
sufficient asset base and liquidity.
 Suppliers need Financial Statements to assess the credit worthiness of a business and
ascertain whether to supply goods on credit. Suppliers need to know if they will be
repaid. Terms of credit are set according to the assessment of their customers' financial
health.
 Customers use Financial Statements to assess whether a supplier has the resources to
ensure the steady supply of goods in the future. This is especially vital where a customer
is dependant on a supplier for a specialized component.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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  Employees use Financial Statements for assessing the company's profitability and its
consequence on their future remuneration and job security.
 Competitors compare their performance with rival companies to learn and develop
strategies to improve their competitiveness.
 General Public may be interested in the effects of a company on the economy,
environment and the local community.
 Governments require Financial Statements to determine the correctness of tax declared
in the tax returns. Government also keeps track of economic progress through analysis of
Financial Statements of businesses from different sectors of the economy.

Parties Interested in Financial Analysis:

The following parties are interested in the analysis of financial statements:
1. Investors or potential investors.
2. Management.
3. Creditors or suppliers.
4. Bankers and financial institutions.
5. Employees.
6. Government.
7. Trade associations.
8. Stock exchanges.
9. Economists and researchers.
10. Taxation authorities

Limitations of Financial Statement Analysis:

Financial analysis is a powerful mechanism of determining financial strengths and weaknesses of
a firm. But, the analysis is based on the information available in the financial statements.
Thus, the financial analysis suffers from serious inherent limitations of financial statements.
The financial analyst has also to be careful about the impact of price level changes, window-
dressing of financial statements, changes in accounting policies of a firm, accounting
concepts and conventions, and personal judgment , etc.

Some of the important limitations of financial analysis are, however, summed up as below:
1. It is only a study of interim reports
2. Financial analysis is based upon only monetary information and non-monetary factors are
ignored.
3. It does not consider changes in price levels.
4. As the financial statements are prepared on the basis of a going concern, it does not give
exact position. Thus accounting concepts and conventions cause a serious limitation to
financial analysis.
5. Changes in accounting procedure by a firm may often make financial analysis
misleading.
6. Analysis is only a means and not an end in itself. The analyst has to make interpretation
and draw his own conclusions. Different people may interpret the same analysis in
different ways.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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REORGANIZING THE ACCOUNTING STATEMENTS: IN PRACTICE

Reorganizing the statements can be difficult, even for the savviest analyst. Which items are
operating assets? Which are no operating? Which items should be treated as debt? As equity?
In the following pages, we address these questions through an examination of Home Depot,
the world’s largest home improvement retailer, with stores located throughout North
America, and comparison with Lowe’s, a direct competitor of Home Depot. Home Depot has
grown rapidly over the past 10 years, generating strong returns and cash flow. But its core
markets have become increasingly saturated, the real estate market has soured, and the
company now faces new challenges.

TOOLS OR TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

1. Comparative Statement or Comparative Financial and Operating Statements.
2. Common Size Statements.
3. Trend Ratios or Trend Analysis.
4. Average Analysis.
5. Statement of Changes in Working Capital.
6. Fund Flow Analysis.
7. Cash Flow Analysis.
8. Ratio Analysis.
9. Cost Volume Profit Analysis

A brief explanation of the tools or techniques of financial statement analysis presented below.
1. Comparative Statements: Comparative statements deal with the comparison of different
items of the Profit and Loss Account and Balance Sheets of two or more periods.
Separate comparative statements are prepared for Profit and Loss Account as
Comparative Income Statement and for Balance Sheets.
As a rule, any financial statement can be presented in the form of comparative statement such
as comparative balance sheet, comparative profit and loss account, comparative cost of
production statement, comparative statement of working capital and the like.
2. Comparative Income Statement: Three important information are obtained from the
Comparative Income Statement. They are Gross Profit, Operating Profit and Net Profit.
The changes or the improvement in the profitability of the business concern is find out
over a period of time. If the changes or improvement is not satisfactory, the management
can find out the reasons for it and some corrective action can be taken.
3. Comparative Balance Sheet: The financial condition of the business concern can be
find out by preparing comparative balance sheet. The various items of Balance sheet for
two different periods are used. The assets are classified as current assets and fixed assets
for comparison. Likewise, the liabilities are classified as current liabilities, long term
liabilities and shareholders’ net worth. The term shareholders’ net worth includes Equity
Share Capital, Preference Share Capital, Reserves and Surplus and the like.
4. Common Size Statements: A vertical presentation of financial information is followed
for preparing common-size statements. Besides, the rupee value of financial statement
contents are not taken into consideration. But, only percentage is considered for preparing
common size statement.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 The total assets or total liabilities or sales is taken as 100 and the balance items are compared
to the total assets, total liabilities or sales in terms of percentage. Thus, a common size
statement shows the relation of each component to the whole. Separate common size
statement is prepared for profit and loss account as Common Size Income Statement and
for balance sheet as Common Size Balance Sheet.
5. Trend Analysis: The ratios of different items for various periods are find out and then
compared under this analysis. The analysis of the ratios over a period of years gives an
idea of whether the business concern is trending upward or downward. This analysis is
otherwise called as Pyramid Method.
6. Average Analysis: Whenever, the trend ratios are calculated for a business concern, such
ratios are compared with industry average. These both trends can be presented on the
graph paper also in the shape of curves. This presentation of facts in the shape of pictures
makes the analysis and comparison more comprehensive and impressive.
7. Statement of Changes in Working Capital: The extent of increase or decrease of
working capital is identified by preparing the statement of changes in working capital.
The amount of net working capital is calculated by subtracting the sum of current
liabilities from the sum of current assets. It does not detail the reasons for changes in
working capital.
8. Fund Flow Analysis: Fund flow analysis deals with detailed sources and application of
funds of the business concern for a specific period. It indicates where funds come from
and how they are used during the period under review. It highlights the changes in the
financial structure of the company.
9. Cash Flow Analysis: Cash flow analysis is based on the movement of cash and bank
balances. In other words, the movement of cash instead of movement of working capital
would be considered in the cash flow analysis. There are two types of cash flows. They
are actual cash flows and notional cash flows.
10. Ratio Analysis: Ratio analysis is an attempt of developing meaningful relationship
between individual items (or group of items) in the balance sheet or profit and loss
account. Ratio analysis is not only useful to internal parties of business concern but also
useful to external parties. Ratio analysis highlights the liquidity, solvency, profitability
and capital gearing.
11. Cost Volume Profit Analysis: This analysis discloses the prevailing relationship among
sales, cost and profit. The cost is divided into two. They are fixed cost and variable cost.
There is a constant relationship between sales and variable cost. Cost analysis enables the
management for better profit planning.

Ratio Analysis
Introduction
The analysis of the financial statements and interpretations of financial results of a particular
period of operations with the help of 'ratio' is termed as "ratio analysis." Ratio analysis used
to determine the financial soundness of a business concern. Alexander Wall designed a
system of ratio analysis and presented it in useful form in the year 1909.
Meaning and Definition
The term 'ratio' refers to the mathematical relationship between any two inter-related variables.
In other words, it establishes relationship between two items expressed in quantitative form.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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According J. Batty, Ratio can be defined as "the term accounting ratio is used to describe
significant relationships which exist between figures shown in a balance sheet and profit and
loss account in a budgetary control system or any other part of the accounting management."

Ratio can be used in the form of (1) percentage (20%) (2) Quotient (say 10) and (3) Rates. In
other words, it can be expressed as a to b; a: b (a is to b) or as a simple fraction, integer and
decimal. A ratio is calculated by dividing one item or figure by another item or figure.

The following principles should be considered before selecting the ratio:

 Ratio should be logically inter-related.
 Pseudo ratios should be avoided.
 Ratio must measure a material factor of business.
 Cost of obtaining information should be borne in mind.
 Ratio should be in minimum numbers.
 Ratio should be facilities comparable.

CLASSIFICATION OF RATIOS
Accounting Ratios are classified on the basis of the different parties interested in making use of
the ratios. A very large number of accounting ratios are used for the purpose of determining
the financial position of a concern for different purposes. Ratios may be broadly classified in
to:
 Classification of Ratios on the basis of Balance Sheet.
 Classification of Ratios on the basis of Profit and Loss Account.
 Classification of Ratios on the basis of Mixed Statement (or) Balance Sheet and Profit
and Loss Account.

This classification further grouped in to:

 Liquidity ratios
 Profitability Ratios
 Turnover Ratios
 Solvency Ratios
 Overall Profitability Ratios

A. LIQUIDITY RATIOS: Liquidity Ratios are also termed as Short-Term Solvency Ratios.
The term liquidity means the extent of quick convertibility of assets in to money for paying
obligation of short-term nature. Accordingly, liquidity ratios are useful in obtaining an
indication of a firm's ability to meet its current liabilities, but it does not reveal h0w
effectively the cash resources can be managed. To measure the liquidity of a firm, the
following ratios are commonly used:
1. Current Ratio.
2. Quick Ratio (or) Acid Test or Liquid Ratio.
3. Absolute Liquid Ratio (or) Cash Position Ratio.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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a. Current Ratio: Current Ratio establishes the relationship between current Assets and current
Liabilities. It attempts to measure the ability of a firm to meet its current obligations. In order
to compute this ratio, the following formula is used :

Current Assets
Current Ratio = ----------------------------------
Current Liabilities

The two basic components of this ratio are current assets and current liabilities. Current asset
normally means assets which can be easily converted in to cash within a year's time. On the
other hand, current liabilities represent those liabilities which are payable within a year. The
following table represents the components of current assets and current liabilities in order to
measure the current ratios :

Components of Current Assets and Current Liabilities

Current Assets Current Liabilities

Cash in Hand Sundry Creditors (Accounts Payable)

Cash at Bank Bills Payable
Sundry Debtors Outstanding and Accrued Expenses
Bills Receivable Income Tax Payable
Marketable Securities Short-Term Advances
( Short-Term) Unpaid or Unclaimed Dividend
Other Short-Term Investments Bank Overdraft (Short-Term period)
Inventories :
Stock of raw materials
Stock of work in progress
Stock of finished goods

Interpretation of Current Ratio: The ideal current ratio is 2: 1. It indicates that current assets
double the current liabilities is considered to be satisfactory. Higher value of current ratio
indicates more liquid of the firm's ability to pay its current obligation in time. On the other
hand, a low value of current ratio means that the firm may find it difficult to pay its current
ratio as one which is generally recognized as the patriarch among ratios.

Advantages of Current Ratios:

 Current ratio helps to measure the liquidity of a firm.

 It represents general picture of the adequacy of the working capital position of a
company.
 It indicates liquidity of a company.
 It represents a margin of safety, i.e., cushion of protection against current creditors.
 It helps to measure the short-term financial position of a company or short-term solvency
of a firm.
Disadvantages of Current Ratio:
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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  Current ratios cannot be appropriate to all businesses it depends on many other factors.
 Window' dressing is another problem of current ratio, for example, overvaluation of
closing stock.
 It is a crude measure of a firm's liquidity only on the basis Of quantity and not quality of
current assets.

Illustration

Calculate Current Ratio from the following Information

Liabilities Rs. Assets Rs.

Sundry creditors 40,000 Inventories 1,20,000
Bills payable 30,000 Sundry debtors 1,40,000
Dividend payable 36,000 Cash at Bank 40,000
Accrued expenses 14,000 Bills Receivable 60,000
Short-term advances 50,000 Prepaid expenses 20,000
Share Capital 1,50,000 Machinery 2,00,000
Debenture 2,00,000 Patents 50,000
Land & Building 1,50,000

Solution:

Current Ratio = Current Assets

Current Liabilities
Current Assets = Rs. 1,20,000 + 1,40,000 + 40,000 + 60,000 + 20,000
= Rs. 3,80,000
Current Liabilities = Rs. 40,000 + 30,000 + 36,000 + 14,000 + 50,000
Rs. 1,70,000
Current Ratio = 3,80,000
1,70,000

2.24 (or) 2.24 :1

b. Quick Ratio (or) Acid Test or Liquid Ratio: Quick Ratio also termed as Acid Test or Liquid
Ratio. It is supplementary to the current ratio. The acid test ratio is a more severe and
stringent test of a firm's ability to pay its short-term obligations 'as and when they become
due. Quick Ratio establishes the relationship between the quick assets and current liabilities.
In order to compute this ratio, the below presented formula is used:

Liquid Assets
Liquid Ratio = --------------------------------
Current Liabilities

Quick Ratio can be calculated by two basic components of quick assets and current liabilities.
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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  Quick Assets = Current Assets - (Inventories + Prepaid expenses)
 Current liabilities represent those liabilities which are payable within a year

The ideal Quick Ratio of 1:1 is considered to be satisfactory. High Acid Test Ratio is an
indication that the firm has relatively better position to meet its current obligation in time. On
the other hand, a low value of quick ratio exhibiting that the firm's liquidity position is not
good.

Advantages:
 Quick Ratio helps to measure the liquidity position of a firm.
 It is used as a supplementary to the current ratio.
 It is used to remove inherent defects of current ratio.

Illustration: 3

Calculate Quick Ratio from the information given below :

Amount (Rs)
Particulars
Current Assets 4,00,000
Current Liabilities 2,00,000
Inventories (stock) 25,000
Prepaid Expenses 25,000
Land and Building 4,00,000
Share Capital 3,00,000
Good Will 2,00,000

Solution:

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 Rs. 4,00,000 - (25,000 + 25,(00)
Quick Assets = ------------------------------------------,
Quick Ratio= ------------------ Rs. 2,00,000
Current liabilities
Rs. 3,50,000
Quick Assets = Current Assets - = ---------------------
(Inventories + Prepaid Expenses) Rs 2,00,000

= 1.75 (or) 1.75: 1

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM 10

c. Absolute Liquid Ratio: Abso.ute Liquid Ratio is also called as Cash Position Ratio (or) Over
Due Liability Ratio. This ratio established the relationship between the absolute liquid assets
and current liabilities. Absolute Liquid Assets include cash in hand, cash at bank, and
marketable securities or temporary investments. The optimum value for this ratio should be
one, i.e., 1: 2. It indicates that 50% worth absolute liquid assets are considered adequate to
pay the 100% worth current liabilities in time. If the ratio is relatively lower than one, it
represents that the company's day-to-day cash management is poor. If the ratio is
considerably more than one, the absolute liquid ratio represents enough funds in the form of
cash to meet its short-term Obligations in time.

The Absolute Liquid ratio can be calculated by dividing the total of the Absolute Liquid
Assets by Total Current Liabilities. Thus,

Absolute Liquid Assets

Absolute Liquid Ratio = ---------------------------------------------------
Current Liabilities

Illustration
Calculate Absolute Liquid Ratio from the following Information

Liabilities Rs. Assets Rs.

Bills Payable 30,000 Goodwill 2,00,000

Sundry Creditors 20,000 Land and Building 2,00,000
Share Capital 1,00,000 Inventories 50,000
Debenture 2,00,000 Cash in Hand 30,000
Bank Overdraft 25,000 Cash at Bank 20,000
Sundry Debtors 50,000
Bills Payable 75,000
Marketable Securities 10,000

Solution:
Absolute Liquid Assets
Absolute Liquid Ratio = -------------------------------
Current Liabilities

Absolute Liquid Assets = Cash in Hand + Cash at Bank +Marketable Securities

= Rs. 30,000 + 20,000 + 10,000 =Rs.60,000

Current Liabilities= Rs. 30,000 + 20,000 + 25,000 = Rs.75,000

Rs.60,000
Absolute Liquid Ratio = -----------------------
Rs.75,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 Absolute Liquid Ratio = 0.8

The ratio of 0.8 is quite satisfactory because, it is much higher than the optimum value of 50%.

II. PROFITABILITY RATIOS

The term profitability means the profit earning capacity of any business activity. Thus, profit
earning may be judged on the volume of profit margin of any activity and is calculated by
subtracting costs from the total revenue accruing to a firm during a particular period.
Profitability Ratio is used to measure the overall efficiency or performance of a business.
Generally, a large number of ratios can also be used for determining the profitability as the
same is related to sales or investments.
The following important profitability ratios are discussed below:

 Gross Profit Ratio.

 Operating Ratio.
 Operating Profit Ratio.
 Net Profit Ratio.
 Return on Investment Ratio.
 Return on Capital Employed Ratio.
 Earnings Per Share Ratio.
 Dividend Payout Ratio.
 Dividend Yield Ratio.
 Price Earnings Ratio.
 Net Profit to Net Worth Ratio.

Gross Profit Ratio: Gross Profit Ratio established the relationship between gross profit and net
sales. This ratio is calculated by dividing the Gross Profit by Sales. It is uSllally indicated as
percentage.

Gross Profit
Gross Profit Ratio = ---------------------------
Net Sales

Gross Profit = Sales - Cost of Goods Sold

Net Sales = Gross Sales - Sales Return (or) Return Inwards

Higher Gross Profit Ratio is an indication that the firm has higher profitability. It also
reflects the effective standard of performance of firm's business. Higher Gross Profit Ratio
will be result of the following factors.
 Increase in selling price, i.e., sales higher than cost of goods sold.
 Decrease in cost of goods sold with selling price remaining constant.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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  Increase in selling price without any corresponding proportionate increase in cost.
 Increase in the sales mix.
A low gross profit ratio generally indicates the result of the following factors :
 Increase in cost of goods sold.
 Decrease in selling price.
 Decrease in sales volume.
 High competition.
 Decrease in sales mix.
Advantages

 It helps to measure the relationship between gross profit and net sales.
 It reflects the efficiency with which a firm produces its product.
 This ratio tells the management, that a low gross profit ratio may indicate
unfavourable purchasing and mark-up policies.
 A low gross profit ratio also indicates the inability of the management to increase
sales.

Illustration: 7

Calculate Gross Profit Ratio from the following figures :

Rs.
Sales 5,00,000
Sales Return 50,000
Closing Stock 35,000
Opening Stock 70,000
Purchases 3,50,000

Solution:

Gross Profit Ratio = = Gross Profit x 100

Net Sales

Net Sales = Sales - Sales Return

= Rs. 5,00,000 - 50,000 = Rs. 4,50,000

Gross Profit = Sales - Cost of Goods Sold

Cost of goods sold = Opening Stock + Purchase - Closing Stock

= Rs. 70,000 + 3,50,000 - 35,000 = Rs.3,85,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 = Rs. 4,50,000 -3,85,000 = Rs. 65,000

65,000
Gross Profit Ratio = x 100
4,50,000

= 14.44 %

b. Operating Ratio: Operating Ratio is calculated to measure the relationship between total
operating expenses and sales .. The total operating expenses is the sum total of cost of goods
sold, office and administrative expenses and selling and distribution expenses. In other
words, this ratio indicates a firm's ability to cover total operating expenses. In order to
compute this ratio, the following formula is used:

Operating Cost
Operating Ratio = ----------------------- x 100
Net Sales

Operating Cost = Cost of goods sold + Administrative Expenses + Selling and Distribution
Expenses

Net Sales = Sales - Sales Return (or) Return Inwards.

Illustration: 8
Find out Operating Ratio :
Cost of goods sold Rs. 4,00,000
Office and Administrative Expenses Rs. 30,000
Selling and Distribution Expenses Rs. 20,000
Sales Rs. 6,00,000
Sales Return Rs. 20,000
Solution:

Operating Cost
Operating Ratio = x 100
Net Sales

Operating Cost = Cost of goods sold + Administrative Expenses+ Selling and Distribution
Expenses

= Rs. 4,00,000 + 30,000 + 20,000 = Rs. 4,50,000

Net Sales = Sales - Sales Return (or) Return Inwards

= Rs. 6,00,000 - 20,000 = Rs. 5,80,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 4,50,000
Operating Ratio = x 100
5,80,000

= 77.58 %
This ratio indicated that 77.58% of the net sales have been consumed by cost of goods sold,
administrative expenses and selling and distribution expenses. The remaining 23.42% indicates a
firm's ability to cover the interest charges, income tax payable and dividend payable.

c. Operating Profit Ratio: Operating Profit Ratio indicates the operational efficiency of the firm
and is a measure of the firm's ability to cover the total operating expenses. Operating Profit
Ratio can be calculated as :

Operating Profit
Operating Profit Ratio = x 100
Net Sales

Operating Profit = Net Sales - Operating Cost, (or)

= Net Sales -(Cost of Goods Sold + Office and

Administrative Expenses + Selling and Distribution Expenses)

(or) = Gross Profit - Operating Expenses

(or) = Net Profit+ Non-Operating Expenses -Non-Operating

Income.

Net Sales = Sales - Sales Return (or) Return Inwards

Illustration:
From the following information given below, you are required to calculate Operating Profit
Ratio : Rs.
Gross Sales 6,50,000
Sales Return 50,000
Opening Stock 25,000
Closing Stock 30,000
Purchases 4,10,000
Office and Administrative Expenses 50,000
Selling and Distribution Expenses 40,000

Solution:
Operating Profit
Operating Profit Ratio= x 100
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 Net Sales

Operating Profit = Net Sales - Total Operating Cost

Net Sales = Gross Sales - Sales Return

= Rs. 6,50,000 - 50,000 = Rs. 6,00,000

Total Operating Cost = Cost of Goods Sold + Office and Administrative Expenses +
Selling and Distribution Expenses

Cost of Goods sold = Opening Stock + Purchase - Closing Stock

= Rs. 25,000 + 4,10,000 - 30,000 = Rs. 4,05,000

Total Operating Expenses = Rs. 4,05,000 + 50,000 + 40,000 = Rs. 4,95,000

Operating Profit = Net Sales - Total Operating Expenses

= Rs. 6,00,000 - 4,95,000 = Rs. 1,05,000

1,05,000
Operating Profit Ratio= x 100 = 17.5
6,00,000

d. Net Profit Ratio: Net Profit Ratio is also termed as Sales Margin Ratio (or) Profit Margin
Ratio (or) Net Profit to Sales Ratio. This ratio reveals the firm's overall efficiency in
operating the business. Net profit Ratio is used to measure the relationship between net profit
(either before or after taxes) and sales. This ratio can be calculated by the following formula:

Net Profit after Tax

Net Profit Ratio = x 100
Net Sales

Net profit includes non-operating incomes and profits. Non-Operating Incomes such as dividend
received, interest on investment, profit on sales of fixed assets, commission received,
discount received etc. Profit or Sales Margin indicates margin available after deduction cost
of production, other operating expenses, and income tax from the sales revenue. Higher Net
Profit Ratio indicates the standard performance of the business concern.

Advantages
 This is the best measure of profitability and liquidity.
 It helps to measure overall operational efficiency of the business concern.
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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  It facilitates to make or buy decisions.
 It helps to determine the managerial efficiency to use a firm's resources to generate
income on its invested capital.
 Net profit Ratio is very much useful as a tool of investment evaluation.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 Illustration:
From the following Trading and Profit and Loss Account of Ramesh & Co. for the year 31 st ,
Dec. 2009
-- Rs. Rs.
To Opening Stock 60,000By Sales 4,00,000
To Purchase 2,75,000By Closing Stock 75,000
To Wages 25,000
To Gross Profit c/d 1,15,000
4,75,000 4,75,000
To Administrative Expenses 45,000By Gross Profit b/d 1,15,000
To Selling and Distribution
Expenses 10,000By Interest on Investment 10,000
To Office Expenses 5,000
To Non Operating Expenses 15,000
To Net Profit 50,000

1,25,000 1,25,000

You are required to calculate:

(1) Gross Profit Ratio.
(2) Operating Ratio.
(3) Operating Profit Ratio.
(4) Net Profit Ratio.

Solution:
Gross Profit
1. Gross Profit Ratio = x100
Net Sales

1,15,000
= x 100
4,00,000
= 28.75%

Total Operating Cost

2. Operating Ratio = x100
Net Sales

Total Operating Cost = Cost of goods sold + Operating Expenses

Cost of goods sold = Opening Stock + Purchases - Closing Stock

= Rs. 60,000 + 2,75,000 - 75,000 = Rs. 2,60,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Operating Expenses = Office Expenses + Administrative Expenses+ Selling and
Distribution Expenses
= Rs. 5000 + 45,000 + 10,000 = Rs.60,000

Total Operating Cost = Rs.2,60,000 + 60,000 = Rs. 3,20,000

3,20,000
Operating Ratio = X 100 = 80%

4,00,000

Net Operating Profit

3. Operating Profit Ratio = X 100
Net Sales

Net Operating Profit = Net Sales - Total Operating Cost

= Rs. 4,00,000 - 3,20,000 = Rs.80,000

80,000
Operating Profit Ratio = X 100 = 20%
4,00,000

Net Profit (after tax)

4. Net Profit Ratio = X 100
Net Sales

50,000
= X 100 = 12.5%
4,00,000

Answers
(1) Gross Profit Ratio = 28.75%
(2) Operating Ratio = 80%
(3) Operating Profit Ratio = 20%
(4) Net Profit Ratio = 12.5 %

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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e. Return on Investment Ratio: This ratio is also called as ROL This ratio measures a return on
the owner's or shareholders' investment. This ratio establishes the relationship between net
profit after interest and taxes and the owner's investment. Usually this is calculated in
percentage. This ratio, thus. can be calculated as :

Net Profit (after interest and tax)

Return on Investment Ratio = X 100
Shareholders' Fund (or) Investments

Shareholder's Investments = Equity Share Capital + Preference Share Capital + Reserves and
Surplus – accumulated Losses

Net Profit = Net Profit - Interest and Taxes

Advantages
o This ratio highlights the success of the business from the owner's point of view.
o It helps to measure an income on the shareholders' or proprietor's investments.
o This ratio helps to the management for important decisions making.
o It facilitates in determining efficiently handling of owner's investment.

Illustration:
Calculate Return on Investment Ratio from the following information :

Rs.
1000 Equity shares @ of Rs.l0 each 10,000
2000, 5% preference share @ of Rs. l0 each 20,000
Reverses 5,000
Net profit before interest and Tax l0,000
Interest 2,000
Taxes 3,000

Solution:
Net Profit after Interest and Tax
Return on Investment Ratio = x 100
Shareholders' Investment

Shareholders' Investment = Equity Share Capital + Preference Share Capital +

Reserves and Surplus - Accumulated Losses

Shareholders' Investment = Rs.I0,000+ 20,000 + 5,000 - Nil

= Rs.35,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Net Profit after Interest and Taxes = Rs. l0,000 -(2,000 + 3,000) = 5,000

5,000
Return on Investment Ratio = x 100 = 14.28 %
35,000

f. Return on Capital Employed Ratio: Return on Capital Employed Ratio measures a

relationship between profit and capital employed. This ratio is also called as Return on
Investment Ratio. The term return means Profits or Net Profits. The term Capital Employed
refers to total investments made in the business. The concept of capital employed can be
considered further into the following ways :

 Gross Capital Employed

 Net Capital Employed
 Average Capital Employed
 Proprietor's Net Capital Employed

(a) Gross Capital Employed = Fixed Assets + Current Assets

(b) Net Capital Employed = Total Assets - Current Liabilities

Opening Capital Employed + Closing Capital Employed

(c) Average Capital Employed = -------------------------------------------------------------------
2
(or)

Average Capital Employed = Net Capital Employed + 1/2 of Profit after Tax

(d) Proprietor's Net Capital Employed = Fixed Assets + Current Assets - Outside Liabilities
(both long-term and short-term)

In order to compute this ratio, the below presented formulas are used:

Net Profit After Taxes

(1) Return on Capital Employed = ---------------------------------x 100
Gross Capital Employed

(or)
Net Profit After Taxes Before Interest
(2)Return on Capital Employed = ------------------------------------------------X 100
Gross Capital Employed
(or)

Net Profit After Taxes Before Interest

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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(3) Return on Capital Employed = ------------------------------------------------------------ X100
Average Capital Employed or Net Capital Employed

Illustration:
The following is the Balance sheet of MIs Sharma Ltd. for the year ending Dec. 31st , 2003.

The following is the Balance sheet of MIs Sharma Ltd. for the year ending Dec. 31st 12, 2003.

Liabilities Rs. Assets Rs.

Equity Share Capital 4,00,000 Good Will 1,50,000

Reserves 40,000 Building 2,00,000
Profit and Loss Alc 80,000 Machinery 2,50,000
Debenture 1,00,000 Stock 80,000
Secured Loans 1,00,000 Sundry Debtors 60,000
Creditors 80,000 Bills Receivable 40,000
Provision for Tax 50,000 Cash at Bank 50.000
Bills Payable 40,000 Preliminary Expenses 60,000

8,90,000 8,90,000

 Current Ratio
 Liquid Ratio
 Gross Capital Employed
 Net Capital Employed
 Average Capital Employed
 Return on Capital Employed Ratio

Solution:
Current Assets
(a) Current Ratio = -----------------------------
Current Liabilities

Current Assets = Stock + Sundry Debtors + Bills Receivable + Cash at Bank +

Preliminary Expenses

= Rs. 80,000 + 60,000 + 50,000 + 60,000 = Rs. 2,50,000

Current Liabilities = Creditors + Provision for Tax + Bills Payable

= Rs. 80,000 + 50,000 + 40,000 = Rs. 1,70,000

2,50,000
Current Ratio = ---------------- = 1.47 (or) 1.47 :1
1,70,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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( b) Liquid Assets = Liquid Assets - (Stock and Preliminary Expenses)

= Rs. 2,50,000 - ( 80,000 + 60,(00) = Rs. 1,10,000

1,10,000
Liquid Ratio = ---------------- = 0.64 (or) 0.64 :1
1,70,000

(c) Gross Capital Employed = Fixed Assets + Current Assets

Fixed Assets = Goodwill + Building + Machinery

= 1,50,000 + 2,00,000 + 2,50,000 = Rs. 6,00,000

Current Assets = Rs. 2,50,000

Gross Capital Employed = Rs. 6,00,000 + 2,50,000 = Rs. 8,50,000

(d) Net Capital Employed = Total Assets - Current Liabilities

Net Capital Employed = Rs. 8,50,000 - 1,70,000 = Rs. 6,80,000

(e) Average Capital Employed = Net Capital Employed + ½ of Profit After Tax

½ of profit after tax = ½ (80,000 - 50,(00) = Rs.15,000

Average Capital Employed = Rs. 7,20,000 + 15,000 = Rs. 7,35,000

Net Profit After Tax

f) Return on Capital Employed = -------------------------------x 100
Gross Capital Employed

80,000 - 50,000
= --------------------------- x l00 = 3.52%
8,50,000
Alternatively
Net Profit After Tax
Return on Capital Employed = -------------------------------------- X 100
Net Capital Employed

30,000
= ----------------- x 100 = 4.16 %
7,20,000
Answers
(a) Current Ratio = 1.47 (or) 1.47 : 1
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 (b) Liquid Ratio = 0.64 (or) 0.64 :1
(c) Gross Capital Employed = Rs.8,50,000
(d) Net Capital Employed = Rs.7,20,000
(e) Average Capital Employed = Rs.7,35,000
(f) Return on Capital Employed = 3.52 % (or) 4.16 %

g. Earning Per Share Ratio: Earning Per Share Ratio (EPS) measures the earning capacity of the
concern from the owner's point of view and it is helpful in determining the price of the equity
share in the market place. Earning Per Share Ratio can be calculated as :

Net Profit After Tax and Preference Dividend

Earning Per Share Ratio =---------------------------------------------------------------
No. of Equity Shares

Advantages

 This ratio helps to measure the price of stock in the market place.
 This ratio highlights the capacity of the concern to pay dividend to its shareholders.
 This ratio used as a yardstick to measure the overall performance of the concern.

Illustration:

Calculate the Earning Per Share from the following data :

Net Profit before tax Rs.2,00,000. Taxation at 50% of Net Profit.

10 % Preference share capital (Rs. 10 each) Rs. 2,00,000,
Equity share capital (Rs. 10 each) Rs. 2,00,000

Solution:
Net Profit After Tax and Preference Dividend
Earning Per Equity Share = ---------------------------------------------------------------
No. of Equity Shares

Net Profit before Tax = Rs. 2,00,000

Taxation at 50 % of Net Profit = 2,00,000 X 50% = Rs. 1,00,000

Net Profit after Tax = Rs. 2,00,000 - 1,00,000 = Rs. 1,00,000

10 % of Preference Dividend = 2,00,000 X 10% = Rs.20,000

Net Profit after Tax and = Rs. 1.00,000 - 20,000 = Rs.80,000

Preference Dividend
2,00,000
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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No. of Equity Shares = --------------------- = 20,000 Shares
10

80,000
Earning Per Equity Share = ------------------------ = Rs. 4 Per Share
20,000

h. Dividend Payout Ratio: This ratio highlights the relationship between payment of dividend
on equity share capital and the profits available after meeting tax and preference dividend.
This ratio indicates the dividend policy adopted by the top management about utilization of
divisible profit to pay dividend or to retain or both. The ratio, thus, can be calculated as :

Equity Dividend
Dividend Payout Ratio = ----------------------------------------------------------------- X 100
Net Profit After Tax and Preference Dividend

(or)
Dividend Per Equity Share
= ------------------------------------------- X 100
Earning Per Equity Share
Illustration:

Compute Dividend Payout Ratio from the following data:

Net Profit Rs. 60,000

Provision for tax Rs. 15,000
Preference dividend Rs. 15,000
No. of Equity Shares Rs. 6,000
Dividend Per Equity Share = 0.30

Solution:
Equity Dividend
Dividend Payout Ratio = ---------------------------------------------------------------- X 100
Net Profit After Tax & Preference Dividend

Equity Dividend = No. of Equity Shares x Dividend Per Equity Share

= 6,000 x 0.30 = Rs. 1,800

Net Profit After Tax & = Rs. 60,000 - (15,000 + 15,000) = Rs.30,000
Preference Dividend

i. Dividend Yield Ratio: Dividend Yield Ratio indicates the relationship is established between
dividend per share and market value per share. This ratio is a major factor that determines the
dividend income from the investors' point of view. It can be calculated by the following
formula
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 Dividend Per Share
Dividend Yield Ratio = --------------------------------------- X 100
Market Value Per Share

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Illustration:
The following details have been given to you for MIs I.M. Pandey Ltd., you are required to find
out (1) Dividend Yield Ratio (2) Dividend Payout Ratio and (3) Earning Per Share Ratio.

10 % Preference Shares of Rs. 10 each Rs. 5,00,000

60,000 Equity Shares of Rs. 10 each Rs. 6,00,000
Additional Information
Profit after tax at 50 %
Equity Dividend Paid 20 %
Market Price of Equity Share Rs. 30

Solution:
Profit after Tax = 1,50,000

Less: Preference dividend (10% of 5,00,000) = 50,000

-------------------
Equity Earnings 1,00,000

Profit after tax and preference dividend = Rs. 1,00,000

No. of Equity Shares = 60,000 Shares

Dividend Per Share

(1) Dividend Yield Ratio = ---------------------------------X 100
Market Value Per Share

20 % of Rs. 10
= ----------------------- X 100 =6.66%
Rs.30

Net Profit after tax & preference dividend

(2) Earning Per Equity Share = ------------------------------------------------------X 100
No. of Equity Shares

1,00,000
= -------------------------- X 100 = Rs. 1.67 Per Share
60,000

Dividend Per Equity Share

(3) Dividend Payout Ratio = -------------------------------------- X 100
Earning Per Equity Share

2
= --------------- X 100 = 119.76%

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 1.67

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 Alternatively
Equity Dividend
= ------------------------------- Xl00
Equity Dividend

Net Profit After Tax and Preference Dividend = 20 % of Rs. 10 = Rs.2

Equity Dividend for 60,000 Shares = 60,000 x 2 = Rs.l,20,000

1,20,000
Dividend Payout Ratio = --------------------X 100 = 120%
1,00,000

j. Price Earning Ratio: This ratio highlights the earning per share reflected by market share.
Price Earning Ratio establishes the relationship between the market price of an equity share
and the earning per equity share. This ratio helps to find out whether the equity shares of a
company are undervalued or not. This ratio is also useful in financial forecasting. This ratio
is calculated as

Market Price per Equity Share

Price Earning Ratio = ------------------------------------------
Earning Per Share
Illustration:
Calculate (1) Earning Per Share (2) Dividend Yield Ratio and (3) Price Earning Ratio from
the
following figures:
Net Profit - Rs. 6,00,000
Market price Per Equity Shares Rs. 60
No. of Equity Shares = 40,000
Provision for Tax = Rs.1,60,000
Preference Dividend = Rs.50,000
Depreciation = Rs.70,000
Bank Overdraft = Rs.50,000
Solution:

Net Profit After Tax and Preference Dividend

1. Earning Per Share = ---------------------------------------------------------------

No. of Equity Shares

Net Profit After Tax and

Preference Dividend = Rs. 6,00,000 - (l,60,000 + 50,000)
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 = Rs. 6,00,000 - 2,10,000 = Rs. 3,90,000

3,90,000
Earning Per Share = ------------------------ = Rs.9.75
40,000

Earning Per Share

2. Dividend Yield Ratio = --------------------------------X 100
Market Value Per Share

9.75
= ----------------X100 = 16.25%
60

Market Price Per Equity Share

3. Price Earning Ratio = ------------------------------------------------
Earning Per Share

60
= ----------- = 6.15
9.75

Interpretations: The market price of a share is Rs. 60 and earning per share is Rs. 9.75, the
price earning ratio would be 6.15. It means that the market value of every one rupee of earning is
6.15 times or Rs. 6.15.

k. Net Profit to Net Worth Ratio: This ratio measures the profit return on investment. This
ratio indicates the established relationship between net profit and shareholders' net worth. It
is a reward for the assumption of ownership risk. This ratio is calculated as :

Net Profit After Taxes

Net Profit to Net Worth = ------------------------------------X100
Shareholders' Net Worth

Shareholder Net Worth = Total Tangible Net Worth

Total Tangible Net Worth = Company's Net Assets - Long-Term Liabilities

(or)
= Shareholders' Funds + Profits Retained in business
Advantages

 This ratio determines the incentive to owners.

 This ratio helps to measure the profit as well as net worth.
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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  This ratio indicates the overall performance and effectiveness of the firm.
 This ratio measures the efficiency with which the resources of a firm have been
employed.

Illustration:
Compute Net Profit to Net Worth Ratio from the following data :
Rs.
Net Profit 80,000
Provision for Tax 15,000
Shareholders' Fund 8,00,000
Dividend to Equity Shares 20,000
Dividend to Preference
Shares @ 10 % 10,000

Solution:
Net Profit After Taxes
Net Profit to Net Worth = ---------------------------------------- x 100
Total Tangible Net Worth

Net Profit after Taxes = Rs. 80,000 - 15,000 =Rs.65, 000

Total Tangible Net Worth = Shareholders' fund + Profit retained in business

Profit Retained in Business = Profit - (Taxes + Preference dividend + Equity dividend)

= Rs. 80,000 - (15,000 + 20,000 + 10,(00)

= Rs. 80,000 - 45,000 = Rs.35,000

Total Tangible Net Worth = Rs. 8,00,000 + 35,000 = Rs. 9,15,000

65,000
Net Profit Net Worth = ------------------X100 = 7.10%
9,15,000

Net Profit to Net Worth Ratio = 7.10 %

III. TURNOVER RATIOS: Turnover Ratios may be also termed as Efficiency Ratios or
Performance Ratios or Activity Ratios. Turnover Ratios highlight the different aspect of
financial statement to satisfy the requirements of different parties interested in the business. It
also indicates the effectiveness with which different assets are vitalized in a business.
Turnover means the number of times assets are converted or turned over into sales. The
activity ratios indicate the rate at which different assets are turned over.

Depending upon the purpose, the following activities or turnover ratios can be calculated:

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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  Inventory Ratio or Stock Turnover Ratio (Stock Velocity)
 Debtor's Turnover Ratio or Receivable Turnover Ratio (Debtor's Velocity)
o Debtor's Collection Period Ratio
 Creditor's Turnover Ratio or Payable Turnover Ratio (Creditor's Velocity)
o Debt Payment Period Ratio
 Working Capital Turnover Ratio
 Fixed Assets Turnover Ratio
 Capital Turnover Ratio.

1. Stock Turnover Ratio: This ratio is also called as Inventory Ratio or Stock Velocity Ratio.
Inventory means stock of raw materials, working in progress and finished goods. This ratio is
used to measure whether the investment in stock in trade is effectively utilized or not. It
reveals the relationship between sales and cost of goods sold or average inventory at cost
price or average inventory at selling price. Stock Turnover Ratio indicates the number of
times the stock has been turned over in business during a particular period. While using this
ratio, care must be taken regarding season and condition. price trend. supply condition etc. In
order to compute this ratio, the following formulae are used :

Cost of Goods Sold

a. Stock Turnover Ratio = -------------------------------------------
Average Inventory at Cost

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses - Closing Stock
(or)
= Total Cost of Production + Opening Stock of Finished Goods –
Closing Stock of Finished Goods

Total Cost of Production = Cost of Raw Material Consumed + Wages + Factory Cost
(or)
= Sales - Gross Profit

Opening Stock + Closing Stock

Average Stock = -----------------------------------------------
2

Net Sales
1. Stock Turnover Ratio = ----------------------------------------
Average Inventory at Cost

Net Sales
2. Stock Turnover Ratio = -----------------------------------------------------------
Average Inventory at Selling Price

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 Net Sales
3. Stock Turnover Ratio = -------------------------
Inventory

The above said formulas can be used on the basis of the information given in the illustration.

Advantages
1. This ratio indicates whether investment in stock in trade is efficiently used or not.
2. This ratio is widely used as a measure of investment in stock is within proper limit or not.
3. This ratio highlights the operational efficiency of the business concern.
4. This ratio is helpful in evaluating the stock utilization.
5. It measures the relationship between the sales and the stock in trade.
6. This ratio indicates the number of times the inventories have been turned over in business
during a particular period.

Illustration:

From the following information calculate stock turnover ,ratio:

Gross Sales Rs. 5,00,000

Sales Return Rs. 25,000
Opening Stock Rs. 70,000
Closing Stock at Cost Rs. 85,000
Purchase Rs. 3,00,000
Direct Expenses Rs. 1,00.000

Solution:
Cost of Goods Sold
Inventory Turnover Ratio = ---------------------------------------
Average Inventory at Cost

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses - Closing Stock

= Rs. 70,000 + 3,00,000 + 1,00,000 - 85,000

= Rs. 3,85,000

Opening Stock + Closing Stock

Average Stock = -------------------------------------------------
2

70,000 + 85,000
= ---------------------- = Rs. 77,500
2

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 3,85,000
Inventory Turnover Ratio = ------------------------ = 4.97 times
77,500

2. Debtor's Turnover Ratio: Debtor's Turnover Ratio is also termed as Receivable Turnover Ratio
or Debtor's Velocity. Receivables and Debtors represent the uncollected portion of credit sales.
Debtor's Velocity indicates the number of times the receivables are turned over in business
during a particular period. In other words, it represents how quickly the debtors are converted
into cash. It is used to measure the liquidity position of a concern. This ratio establishes the
relationship between receivables and sales. Two kinds of ratios can be used to judge a firm's
liquidity position on the basis of efficiency of credit collection and credit policy. They are (A)
Debtor's Turnover Ratio and (B) Debt Collection Period. These ratios may be computed as :

Net Credit Sales

1. Debtor's Turnover Ratio = -------------------------------------
Average Receivables (or)
Average Accounts Receivable

Net Credit Sales = Total Sales - (Cash Sales + Sales Return)

Accounts Receivable = Sundry Debtors or Trade Debtors + Bills
Receivable
Opening Receivable + Closing Receivable
Average Accounts Receivable = -------------------------------------------------------------------
2

It is to be noted that opening and closing receivable and credit sales are not available, the ratio
may be calculated as

Total Sales
Debtor's Turnover Ratio = --------------------------------
Accounts Receivable

Illustration:

Calculate Debtor's Turnover Ratio, from the following data:

Rs.
Sundry Debtors as on 1.1.2003 70,000
Sundry Debtors as on 31.12.2003 90,000
Bills Receivable as on1.1.2003 20,000
Bills Receivable as on31.12.20 03 30,000
Total Sales for the year 2003 7,00,000
Sales Return 20,000
Cash sales for the year 2003 1,00,000

Solution:
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
34
 Net Credit Sales
Debtor's Turnover Ratio = -----------------------------------
Average Account Receivable

Net Credit Sales = Total Sales - (Cash Sales + Sales Return)

=Rs. 7,00,000 -(1,00,000 + 20,(00) =Rs. 5,80,000

Opening Receivable + Closing Receivable

Average Accounts Receivable =------------------------------------------------------------------
2

(70,000 + 20,(00) + (90,000 + 30,(00)

= --------------------------------------------------
2
90,000 + 1,20,000
= ----------------------- = Rs. 1,05,000
2

5,80,000
Debtors Turnover Ratio =-------------------------- = 5.52 times
1,05,000

2.A Debt Collection Period Ratio: This ratio indicates the efficiency of the debt collection
period and the extent to which the debt have been converted into cash. This ratio is
complementary to the Debtor Turnover Ratio. It is very helpful to the management because it
represents the average debt collection period. The ratio can be calculated as follows:

Months (or)Days in a year

(a) Debt Collection Period Ratio = ------------------------------------------
Debtor's Turnover

(or)

Average Accounts Receivable

(b) Debt Collection Period Ratio = -------------------------------------- X Months (or) Days in a year
Net Credit Sales for the year

Advantages of Debtor's Turnover Ratio

 This ratio indicates the efficiency of firm's credit collection and efficiency of credit
policy.
 This ratio measures the quality of receivable, i.e., debtors.
 It enables a firm to judge the adequacy of the liquidity position of a concern.
 This ratio highlights the probability of bad debts lurking in the trade debtors.
 This ratio measures the number of times the receivables are turned over in business
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 during a particular period.
 It points out the liquidity of trade debtors, i.e., higher turnover ratio and shorter debt
collection period indicate prompt payment by debtors. Similarly, low turnover ratio and
higher collection period implies that payment by trade debtors are delayed :

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Illustration:

From the following information calculate:

(a) Debtor's Turnover Ratio, (b) Debt Collection Period Ratio.

Total Sales Rs. 1,00,000

Cash Sales Rs. 25,000
Sales Return Rs. 5,000
Opening Accounts Receivable Rs. 10,000
Closing Accounts Receivable Rs. 15,000

Solution:
Net Credit Sales
(a) Debtor's Turnover Ratio = ---------------------------------
Average Receivables

Net Credit Sales = Total Sales - (Cash Sales + Sales Return)

= Rs. 1,00,000 - (25,000 + 5,000) = Rs.70,000

Opening Receivables + Closing Receivables

Average Receivables =------------------------------------------------------------------

10,000 + 15,000
= --------------------------- = Rs. 12,500
2

70,000
Debtor's Turnover Ratio = -------------- = 5.6 times
12,500
Month (or) Days in a year
(b) Debt Collection Period Ratio = -------------------------------------------
Debtor's Turnover

12
= -------- = 2.14 months
5.6
Alternatively
Average Accounts Receivable X Months in a year
Debt Collection Period Ratio = --------------------------------------------------------------------
Net Credit Sales for the year

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

37
 12,500 x 12
= ------------------------ = 2.14 months
70,000

3. Creditor's Turnover Ratio: Creditor's Turnover Ratio is also called as Payable Turnover Ratio
or Creditor's Velocity. The credit purchases are recorded in the accounts of the buying
companies as Creditors to Accounts Payable. The Term Accounts Payable or Trade Creditors
include sundry creditors and bills payable. This ratio establishes the relationship between the net
credit purchases and the average trade creditors. Creditor's velocity ratio indicates the number of
times with which the payment is made to the supplier in respect of credit purchases. Two kinds
of ratios can be used for measuring the efficiency of payable of a business concern relating to
credit purchases. They are:

1. Creditor's Turnover Ratio

2. Creditor's Payment Period or Average Payment Period. The ratios can be calculated by the
following formulas:
Net Credit Purchases
(1) Creditor's Turnover Ratio = -----------------------------------
Average Accounts Payable

Net Credit Purchases = Total Purchases - Cash Purchases

Opening Payable + Closing Payable

Average Accounts Payable = ----------------------------------------------
2
Month (or) Days in a year
(2) Average Payment Period =--------------------------------------------
Creditors Turnover Ratio

(or) Average Trade Creditors

= ------------------------------------X 365
Net Credit Purchases

Significance: A high Creditor's Turnover Ratio signifies that the creditors are being paid
promptly. A lower ratio indicates that the payment of creditors are not paid in time. Also,
high average payment period highlight the unusual delay in payment and it affect the
creditworthiness of the firm. A low average payment period indicates enhancing the
creditworthiness of the company.

Illustration:
From the following information calculate (1) Creditor's Turnover Ratio and (2) Average
Payment Period
Rs.
Total Purchase 3,00,000
Cash Purchases 1,75,000
Purchase Return 25,000
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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Sundry Creditors 1.1.2003 30,000
Sundry Creditors 31.12.2003 15,000
Bills Payable 1.1.2003 7,000
Bills Payable 31.12.2003 8,000
Solution:
Net Credit Purchases
(1) Creditor's Turnover Ratio = -------------------------------------
Average Accounts Payables

Net Credit Purchases = Total Purchases - (Cash Purchases + Purchase Return)

= Rs. 3,00,000 - (1,75,000 + 25,000)

= Rs. 1,00,000

Opening payable + Closing payable

Average Accounts Payable = ---------------------------------------------------
2
(30,000 + 7,000) + (15,000 + 8000)
= ------------------------------------------------------
2
= Rs. 30,000

1,00,000
Creditor's Turnover Ratio = ---------------------- = 3.33 times
30,000

Month or Days in a year 12

(2) Average Payment Period = --------------------------------------- = --------- = 3.60 months
Creditor's Turnover Ratio 3.33

(or)
365 days
= ------------------- = 109.61 days
3.33

Alternatively Average Trade Creditors

Average Payment Period = ---------------------------------- X 365
Net Credit Purchases

30,000
= ------------------------ X 365 = 109.5 days
1,00,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
40
4. Working Capital Turnover Ratio: This ratio highlights the effective utilization of working
capital with regard to sales. This ratio represent the firm's liquidity position. It establishes
relationship between cost of sales and networking capital. This ratio is calculated as follows :

Net Sales
Working Capital Turnover Ratio = -------------------------
Work Capital

Net Sales = Gross Sales - Sales Return

Working Capital = Current Assets - Current Liabilities

Significance: It is an index to know whether the working capital has been effectively utilized or
not in making sales. A higher working capital turnover ratio indicates efficient utilization of
working capital, i.e., a firm can repay its fixed liabilities out of its working capital. Also, a
lower working capital turnover ratio shows that the firm has to face the shortage of working
capital to meet its day-to-day business activities unsatisfactorily.

Illustration:
Calculate Working Capital Turnover Ratio :

Current Assets Rs.3,20,000

Current Liabilities Rs.1,10,000
Gross Sales Rs.4,00,000
Sales Return Rs.20,000

Solution:
Net Sales
Working Capital Turnover Ratio = -------------------------------
Working Capital

Net Sales = Gross Sales - Sales Return

= Rs. 4,00,000 - 20,000

= Rs. 3,80,000

Working Capital = Current Assets - Current Liabilities

= Rs. 3,20,000 - 1,10,000

= Rs. 2,10,000

3,80,000
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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Working Capital Turnover Ratio = --------------------- = 1.80 times
2,10,000

5. Fixed Assets Turnover Ratio: This ratio indicates the efficiency of assets management.
Fixed Assets Turnover Ratio is used to measure the utilization of fixed assets. This ratio
establishes the relationship between cost of goods sold and total fixed assets. Higher the ratio
highlights a firm has successfully utilized the fixed assets. If the ratio is depressed, it
indicates the under utilization of fixed assets. The ratio may also be calculated as:

Cost of Goods Sold

Fixed Assets Turnover Ratio =------------------------------------------
Total Fixed Assets

(or)
Sales
= --------------------------------------
Net Fixed Assets

Components of Fixed Assets (or) Non-Current Assets

1. Goodwill
2. Land and Building
3. Plant and Machinery
4. Furniture and Fittings
5. Trade Mark
6. Patent Rights and Livestock
7. Long-Term Investment
8. Debt Balance of Profit and Loss Account
9. Discount on Issue of Shares
10. Discount on Issue of Debenture
11. Preliminary Expenses
12. Other Deferred Expenses
13. Government or Trust Securities
14. Any other immovable Prosperities

Illustration:

Find out Fixed Assets Turnover Ratio from the following information :

Total Fixed Assets = Rs. 6,00,000

Gross Profit = 20 % on sales
Net Sales = Rs. 8,00,000
Debenture = Rs. 2,00,000
Share Capital = Rs. 3,00,000

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Solution:

Cost of Goods Sold

Fixed Asset Turnover Ratio = -----------------------------------------
Total Fixed Assets

Cost of Goods Sold = Sales - Gross Profit

= Rs. 8,00,000 - 20 % on sales

= Rs. 8,00,000 - 1,60,000 = Rs. 6,40,000

Rs. 6,40,000
Fixed Assets Turnover Ratio = ----------------------------- = 1.06 times
Rs. 6,00,000

Alternatively
Sales
Fixed Assets Turnover Ratio = ------------------------
Net Fixed Assets

Rs. 8,00,000
= ------------------------ = 1.33 times
Rs. 6,00,000

6. Capital Turnover Ratio: This ratio measures the efficiency of capital utilization in the
business. This ratio establishes the relationship between cost of sales or sales and capital
employed or shareholders' fund. This ratio may also be calculated as :

Cost of Sale Sales

(1) Capital Turnover Ratio =---------------------------------- (OR) -----------------------------
Capital Employed Capital Employed

Capital Employed = Shareholders' Funds + Long-Term Loans

(OR)
Total Assets - Current Liabilities

Cost of Sales Sales

(2) Capital Turnover Ratio = ------------------------- (OR) ---------------------------
Shareholders' Fund Shareholders' Fund

Components of Capital Employed (Shareholders' Fund + Long-Term Loans)

a. Equity Share Capital
b. Preference Share Capital
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 c. Debentures
d. Long-Term Loans
e. Share Premium
f. Credit Balance of Profit and Loss Account
g. Capital Reserve
h. General Reserve
i. Provisions
j. Appropriation of Profits

Illustration:

From the following information find out (a) Cost of Sales (b) Capital Employed and (c) Capital
Turnover Ratio.
Rs.
Total Assets 10,00,000
Bills Payable 1,50,000
Sundry Creditors 75,000
Opening Stock 50,000
Purchases 3,00,000
Closing Stock 60,000

Solution:

(a) Cost of Sales = Opening Stock + Purchases - Closing Stock

= Rs. 5,00,000 + 4,00,000 - 60,000

= Rs. 3,90,000

(b) Capital Employed = Total Assets - Current Liabilities

= Rs. 10,00,000 - 2,25,000 = Rs. 7,75,000

Cost of Sales
(3) Capital Turnover Ratio = -----------------------------
Capital Employed

3,90,000
= -----------------------
7,75,000

= 0.50 times

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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IV. SOLVENCY RATIOS: The term 'Solvency' generally refers to the capacity of the business
to meet its short-term and long-term obligations. Short-term obligations include creditors,
bank loans and bills payable etc. Long-term obligations consists of debenture, long-term
loans and long-term creditors etc. Solvency Ratio indicates the sound financial position of a
concern to carryon its business smoothly and meet its all obligations. Liquidity Ratios and
Turnover Ratios concentrate on evaluating the short-term solvency of the concern have
already been explained. Now under this part of the chapter only the long-term solvency ratios
are dealt with. Some of the important ratios which are given below in order to determine the
solvency of the concern :

1. Debt - Equity Ratio

2. Proprietary Ratio
3. Capital Gearing Ratio
4. Debt Service Ratio or Interest Coverage Ratio

1. Debt Equity Ratio: This ratio also termed as External - Internal Equity Ratio. This ratio is
calculated to ascertain the firm's obligations to creditors in relation to funds invested by the
owners. The ideal Debt Equity Ratio is 1: 1. This ratio also indicates all external liabilities to
owner recorded claims. It may be calculated as

External Equities
(a) Debt - Equity Ratio =-----------------------------
Internal Equities
(OR)

Outsider's Funds
(b) Debt - Equity Ratio = -----------------------------
Shareholders' Funds

The term External Equities refers to total outside liabilities and the term Internal Equities refers
to all claims of preference shareholders and equity shareholders' and reserve and surpluses.

Total Long-Term Dept

(c) Debt - Equity Ratio = --------------------------------------
Total Long-Term Funds

(OR)
Total Long-Term Debt
(d) Debt - Equity Ratio = -----------------------------------------
Shareholders' Funds

The term Total Long-Term Debt refers to outside debt including debenture and long-term loans
raised from banks.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Illustration:

From the following figures calculate Debt Equity Ratio :

Rs.
Preference Share Capital 1,50,000
Equity Share Capital 5,50,000
Capital Reserve 2,00,000
Profit and Loss Account 1,00,000
6 % Debenture 2,50,000
Sundry Creditors 1,20,000
Bills Payable 60,000
Provision for taxation 90,000
Outstanding Creditors 80,000

Solution:

External Equities
(a) Debt Equity Ratio = ------------------------------
Internal Equities

External Equities = Debenture + Sundry Creditors + Bills Payable + Provision for

taxation + Outstanding Creditors

= Rs. 2,50,000 + 1,20,000 + 60,000 + 90,000 + 80,000 = Rs.6,00,000

Internal Equities = Preference Share Capital + Equity Share Capital + Capital Reserve +
Profit and Loss a/c

= Rs. 1,50,000 + 5,50,000 + 2,00,000 + 1,00.000 = Rs. 10,00,000

6,00,000
Debt Equity Ratio = ----------------------- = 0.6 (or) 3 : 5
10,00,000

Total Long-Term Debt

(b) Dept Equity Ratio = --------------------------------------
Shareholders' Fund

Total Long-Term Debt = Rs. 2,50,000

Shareholders' Funds = Rs. 10,00,000

Rs. 2,50,000
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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Debt-Equity Ratio = ---------------------------- = 0.25
Rs. 10,00,000

Total Long-term Debt

(c) Debt Equity Ratio = -----------------------------------
Total Long-term Funds

2,50,000
= -------------------------- = 0.2
12,50,000

Outsider's Fund
(d) Debt Equity Ratio = --------------------------------
Shareholders' Fund

Outsider's Fund = Total Outside Liabilities

= Rs. 6,00, 000

6,00,000
Debt Equity Ratio = ---------------------- =0.6 (or) 3 : 5
10,00,000

Significance: This ratio indicates the proportion of owner's stake in the business. Excessive
liabilities tend to cause insolvency. This ratio also tells the extent to which the firm depends
upon outsiders for its existence.

2. Proprietary Ratio: proprietary Ratio is also known as Capital Ratio or Net Worth to Total
Asset Ratio. This is one of the variant of Debt-Equity Ratio. The term proprietary fund is
called Net Worth. This ratio shows the relationship between shareholders' fund and total
assets. It may be calculated as :

Shareholders' Fund
Proprietary Ratio = -----------------------------------
Total Assets

Shareholders' Fund = Preference Share Capital + Equity Share Capital + All Reserves
and Surplus
Total Assets = Tangible Assets + Non-Tangible Assets + Current Assets (or) All
Assets including Goodwill

Significance : This ratio used to determine the financial stability of the concern in general.
Proprietary Ratio indicates the share of owners in the total assets of the company. It serves as
an indicator to the creditors who can find out the proportion of shareholders' funds in the
total assets employed in the business. A higher proprietary ratio indicates relatively little
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
47
 secure position in the event of solvency of a concern. A lower ratio indicates greater risk to
the creditors. A ratio below 0.5 is alarming for the creditors.

Illustration:
From the following information’s calculate the Proprietary Ratio :

Rs.
Preference Share Capital 2,00,000
Equity Share Capital 4,00,000
Capital Reserve 50,000
Profit and Loss Account 50,000
9% Debenture 2,00,000
Sundry Creditors 50,000
Bills Payable 50,000
Land and Building 2,00,000
Plant and Machinery 2,00,000
Goodwill 1,00,000
Investments 3,00,000

Solution:
Shareholders' Fund
Proprietary Ratio = ------------------------------
Total Assets

Shareholders' Fund = Preference Share Capital + Equity Share Capital+ Capital Reserve +
Profit and Loss Account

= Rs. 2,00, 000 + 4,00,000 + 50,000 + 50,000 = Rs.7,00,000

Total Assets = Land and Building + Plant and Machinery + Goodwill + Investments

= Rs. 2,00,000 + 2,00,000 + 1,00,000 + 3,00,000 = Rs. 8,00,000

7,00,000
Proprietary Ratio = ------------------- = 87.5% (or) 0.87
8,00,000

3. Capital Gearing Ratio: This ratio also called as Capitalization or Leverage Ratio. This is one
of the Solvency Ratios. The term capital gearing refers to describe the relationship between
fixed interest and/or fixed dividend bearing securities and the equity shareholders' fund. It
can be calculated as shown below:

Equity Share Capital

Capital Gearing Ratio= ----------------------------------------
Fixed Interest Bearing Funds

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Equity Share Capital = Equity Share Capital + Reserves and Surplus

Fixed Interest Bearing Funds = Debentures + Preference Share Capital + Other Long-Term
Loans

A high capital gearing ratio indicates a company is having large funds bearing fixed interest
and/or fixed dividend as compared to equity share capital. A low capital gearing ratio
represents preference share capital and other fixed interest bearing loans are less than equity
share capital.

Illustration:
From the following information, you are requited to find out Capital Gearing Ratio
Rs.
Preference Share Capital 5,00,000
Equity Share Capital 6,00,000
Capital Reserve 3,00,000
Profit and Loss Account 1,00,000
12% Debenture 3,00,000
Secured loan 1,00,000

Solution:
Equity Share Capital
Capital Gearing Ratio =------------------------------------------
Fixed Interest Bearing Funds

Equity Share Capital = Equity Share Capital + Capital Reserve + Profit and Loss Account

= Rs. 6,00,000 + 3,00,000 + 1,00,000 = Rs. 10,00,000

Fixed Interest Bearing Funds = Debenture + Preference Share Capital + Secured Loans

= Rs. 3,00,000 + 5,00,000 + 1,00,000 = Rs. 9,00,000

10,00,000
Capital Gearing Ratio = -------------------- = 10 : 9 (Low Gear)
9,00,000

4. Debt Service Ratio: Debt Service Ratio is also termed as Interest Coverage Ratio or Fixed
Charges Cover Ratio. This ratio establishes the relationship between the amount of net profit
before deduction of interest and tax and the fixed interest charges. It is used as a yardstick for
the lenders to know the business concern will be able to pay its interest periodically. Debt
Service Ratio is calculated with the help of the following formula :

Net Profit before Interest and Income Tax

Interest Coverage Ratio = --------------------------------------------------------------X 100
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 Fixed Interest Charges

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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Illustration:
Calculate Interest Coverage Ratio :
Profit before Interest Rs. 7,00,000
Income Tax Paid Rs. 50,000
Interest On Debenture Rs. 3,00,000
Interest on Long-Term Loan Rs. 1,00,000

Solution:

Net Profit before Interest} and Taxes

Interest Coverage Ratio = --------------------------------------------------X 100
Fixed Interest Charges

Net Profit before Interest and Income Tax = Rs. 7,00,000 + 50,000 =Rs. 7,50,000

Fixed Interest Charges = Rs. 3,00,000 + 1,00,000 = Rs. 4,00,000

7,50,000
Interest Coverage Ratio = ----------------X 100 = 187.5 % (or) 1.87 :1
4,00,000

Significance: Higher the ratio the more secure the debenture holders and other lenders would be
with respect to their periodical interest income. In other words, better is the position of long-
term creditors and the company's risk is lesser. A lower ratio indicates that the company is
not in a position to pay the interest but also to repay the principal loan on time.

V. OVERALL PROFITABILITY RATIO

This ratio used to measure the overall profitability of a firm on the extent of operating efficiency
it enjoys. This ratio establishes the relationship between profitability on sales and the
profitability on investment turnover. Overall all Profitability Ratio may be calculated in the
following ways:

Net Profit Sales

Overall Profitability Ratio = ------------------ X ----------------------
Sales Total Assets

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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FUNDS FLOW STATEMENT ANALYSIS

MEANING AND CONCEPT OF FUND

The concept of fund is explained by different accountants and accounting bodies in different
approaches. Accordingly, the word fund has different meanings as per the interpretations of
different accountants and accounting bodies. These different interpretations of the concept of
fund are discussed as follows:
i. Cash and bank: As per the interpretation of some accountants, Fund includes cash and
bank of the enterprise only. As per this concept, the inflows and outflows of cash
resources alone are considered as Flow of Fund. Accordingly, under this concept, the
Fund Flow Statement of an enterprise is prepared taking the inflows and outflows of cash
resources alone.
ii. Working Capital: As per this interpretation, Fund includes the Working Capital of the
enterprise only. The difference between total Current Assets and total Current Liabilities
of an enterprise constitutes its Working Capital (i.e., Working Capital = Current Assets –
Current Liabilities). As per this concept, the inflows and outflows of the Working Capital
elements alone (i.e., Current Assets and Current Liabilities) are considered as the Flow of
Fund. Accordingly, under this concept, the Fund Flow Statement of an enterprise is
prepared taking the inflows and outflows of Current Assets and Current Liabilities only.

MEANING OF FLOW OF FUND

Flow of Fund means the inward and outward movement of a Fund of an enterprise. For the
purpose, Fund refers to Working Capital and flow means movement or changes.
Therefore, Flow of Fund means movement of or changes in the Working Capital (i.e.,
current) items. Working Capital items are Current Assets and Current Liabilities. Hence,
where there is an inward or outward movement of Current Assets (e.g., debtors, stock, bills
receivable, cash, bank) and Current Liabilities (e.g., creditors, bills payable, outstanding
expenses), there is a Flow of Fund. In short, the Flow of Fund is identified by the means of
inward or outward movement of Current Assets and Current Liabilities.

 When Current Assets increase or Current Liabilities decrease—Inflows of Fund.

WHAT IS FUND FLOW STATEMENT?

A Fund Flow Statement is a summarized statement of the movement of Fund (i.e., Working
Capital) from different activities of a concern during an accounting period. It is prepared to
locate the various sources of Fund inflows into the business and also to identify the various
purposes of Fund outflows from the business, during two consecutive Balance Sheet dates.

As it is a summarized statement of Fund inflows and Fund outflows from different activities of
an enterprise during a particular period, the management gets a vivid picture of the
movement of Fund in between two consecutive Balance Sheet dates by preparation of a Fund
Flow Statement. One side of the Fund Flow Statement shows the various sources of Fund and
the other side shows the various applications of Fund during an accounting period. A Fund
Flow Statement acts as an important tool of Financial Analysis to the management. Thus, the
management can assess the movement of Fund from different activities of the business and
Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
52
 can draw up its future planning.

IMPORTANCE OR PURPOSES OF FUND FLOW STATEMENT

Fund Flow Statement acts as an important tool for Financial Analysis and shows the brief
reasons for change in the Working Capital between two Balance Sheet dates. It has more
importance from the viewpoint of the management of a concern. It serves the following
purposes:
 Fund Flow Statement explains how the financial position has changed from the beginning
of an accounting period to the end of that period.
 It acts as an important instrument for allocation of resources of a concern. It enables the
concern for making plans for optimum allocation of resources.
 It answers many intricate financial queries such as reasons for changes in Working
Capital position, various sources of repayment of loans, various sources of acquiring
capital, sources of Fund from non-operating activities, applications of Fund towards
various non-operating activities, Fund generation through operating activities and so on.
LIMITATIONS OF FUND FLOW STATEMENT
Although a Fund Flow Statement has more importance from the view point of the management
of a concern, yet it suffers from the following limitations:
 Fund Flow Statement is not a basic Financial Statement, but is a supplementary
statement. It does not disclose any new fact which is not reflected in the Income
Statement and the Balance Sheet.
 It provides a partial financial information to the management.
 It cannot present the continuous changes in the financial position.
 It does not indicate the structural change of an asset or a liability.
 It is prepared on the basis of historical data.
 It exhibits the changes in the Fund position, but does not indicate the changes in the cash
position, which is most important for every business concern.

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Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 Examples of "Flow of Funds"
Examples Transactions Involve Between Flow of Funds From
Current Asset and Non-Current Current to Non-Current
Purchase of Machinery for Cash Asset Account
Current to Capital
Issue of Share for Cash Current Asset and Capital Account
Current Asset. and Non-Current Current to Long-Term
Redemption of Debenture in Cash Liabilities Liabilities Account
Current Liabilities and Non-Current Non-Current Liabilities to
Creditors Paid off in Debenture Liabilities Current Liabilities
Land Transferred to Creditors for Current Liability and Non-Current Non-Current Assets to
their Statement Assets Current Liability

Components of Flow of Funds

In order to analyse the sources and application of funds, it is essential to know the meaning and
components of flow of funds given below :
 Current Assets
 Non-Current Assets (Fixed or Permanent Assets)
 Current Liabilities
 Non-Current Liabilities (Capital & Long-Term Liabilities)
 Provision for Tax
 Proposed Dividend

(1) Current Assets: The term "Current Assets" refer to the assets of a business of a
transitory nature which are intended for resale or conversion into different form during
the course of business operations. For example, raw materials are purchased and the
amount unused at the end of the trading period forms part of the current as stock on hand.
Materials· in process at the end of the trading period and the labour incurred in
processing them also form part of current assets.
(2) Non-Current Assets (Permanent Assets): Non-Current Assets also refer to as
Permanent Assets or Fixed Assets. This class of asset include those of tangible and
intangible nature having a specific value and which are not consumed during the course
of business and trade but provide the means for producing saleable goods or providing
services. Land and Building, Plant and Machinery, Goodwill and Patents etc. are the few
examples of Non-Current assets.
(3) Current Liabilities: The term Current Liabilities refer to amount owing by the business
which are currently due for payment. They consist of amount owing to creditors, bank
loans due for repayment, proposed dividend and proposed tax for payment and expenses
accrued due.
(4) Non-Current Liabilities: The term Non-Current Liabilities refer to Capital and Long-
Term Debts. It is also called as Permanent Liabilities. Any amount owing by the business
which are payable over a longer period time, i.e., after a year are referred as Non-Current

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

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 Liabilities. Debenture, long-term loans and loans on mortgage etc., are the few examples
of non-current liabilities.
(5) Provision for Taxation: Provision for taxation may be treated as a current liability or an
appropriation of profit. When it is made during the year it is not used for adjusting the net
profit, it is advisable to treat the same as current liability. Any amount of tax paid during
the year is to be treated as application of funds or non-current liability. Because it is used
for adjusting the net profit made during the year.
(6) Proposed Dividend: Like provision for taxation, it is also treated as a current liability
and non- current liability, when dividend may be considered as being declared. And thus,
it will not be used for adjusting the net profit made during the year. If it is treated as an
appropriation, i.e., an non-current liability when the dividend paid during the year.
(7) Provisions Against Current Assets and Current Liabilities: Provision for bad and
doubtful debts, provision for loss on inventories, provision for discount on creditors and
provision made against investment etc. are made during the year, they may be treated
separately as current assets or current liabilities or reduce the same from the respective
gross value of the assets or liabilities.

The list of Current Accounts and Non-Current Accounts are given below:
Current Accounts

Current Liabilities Current Assets

Bills Payable Cash in Hand
Sundry Creditors Cash at Bank
Outstanding Expenses Bills Receivable
Dividends Payable Sundry Debtors
Bank Overdraft Short-Term Investments
Short-Term Loans Marketable Securities
Provisions against Current Assets Stock of Raw Materials, Work
Provision for Taxation in Progress & Finished Goods
Proposed Dividend Prepaid Expenses
(May be Current or Non-Current Liabilities) Accrued Incomes

Non-Current Accounts

Non-Current or Permanent Liabilities Non-Current or Permanent Assets

Equity Share Capital Good will
Preference Share Capital Land
Debentures Building
Long-Term Loans Plant and Machinery
Share Premium Furniture and Fittings
Share forfeited Trade Marks
Profit and Loss Account Patent Right~

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 Capital Reserve Long-Term Investments
Discount on Issue of Shares
and Debentures
Preliminary Expenses
Other Deferred Expenses

Preparation of Fund Flow Statement

Fund flow analysis involves the following important three statements such as :
 Fund From Operations
 Statement of Changes in Working Capital
 Fund Flow Statement.

I. FUND FROM OPERATIONS

Fund From Operation is to be determined on the basis of Profit and Loss Account. The operating
profit revealed by Profit and Loss Account represents the excess of sales revenue over cost of
goods sold. In the true sense, it does not reflect the exact flow of funds caused by business
operations. Because the revenue earned and expenses incurred are not in conformity with the
flow of funds. For example, depreciation charges on fixed assets, write up of fixed assets or
fictious assets, any appropriations etc. do

not cause actual flow of funds. Because they have already been charged to such profits. Hence,
fund from operation is prepared to find out exact inflow or outflow of funds from the regular
operations on the basis of items which have readjusted to the current profit or loss. The
balancing amount of adjusted profit and loss account is described as fund from operations.

Calculation of Fund from Operations

Fund from operations is calculated with the help of following adjustments. The adjustments may
be shown in the specimen Proforma of profit and loss account as given below :

Particulars Amount Rs. Amount Rs.

Net Profit or Retained Earnings *****
(Closing balance of P & L a/c as given in the
Balance Sheet)
Add: Non-Fund and Non-Operating items which
have
already been debited to P & L a/c : *****
( I) Depreciation and Depletion
(2) Amortization of Fictious and Intangible Assets
etc.
(a) Good will, Patents written off
(b) Discount on Issue of shares written off

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57
 (c) Preliminary Expenses written off
(d) Premium on redemption of debenture
(3) Appropriation of Retained Earnings : *****
Profit transfer to General Reserve
Profit transfer to Sinking Fund
Profit transfer to Contingency
Provision for Taxation (not taken as current
liability)
Provision for Proposed Dividend}
(not taken as current liability)
Loss on Sale of Fixed Assets
Loss on Sale of Plant and Machinery
Loss on Sales of Land and Building
Loss on Sale of Furniture and Fixtures ***** *****
Total (A) ***** *****
Less: Non-Fund and Non-Operating items which
have already been credited to P & L a/c:
(1) Profit on sale of Fixed Assets *****
Profit on sale of Land & Building
Profit on sale of Plant & Machinery
Profit on sale of Furniture & Fixtures *****
(2) Appreciation or Revaluation of fixed assets
(3) Dividend received on investment *****
(4) Profit on redemption of Shares and Debentures *****
(5) Excess provisions written back *****
(6) Any other non-trading items already
*****
(7) Net Profit or Retained Earnings
*****
Total (B) ***** *****
Fund From Operations (Total A - B) *****

Alternative Specimen Format

The following is the specimen of adjusted profit and loss account to calculate fund from
operations :
Adjusted Profit and Loss Account
Amount Amount
Particulars Rs. Particulars Rs.
To Depreciation on Fixed Assets *** By Opening Balance of P & L A/c ***
To Loss on Sale of Fixed Assets *** By Profit on Sale of Fixed Assets ***
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 To Loss on Sale Investments *** By Excess provision written back ***
By Dividend received on
To Goodwill written off *** investment ***
To Discount on shares written off *** By Revaluation of fixed assets ***
To Transfer to reserve *** By Fund From Operations ***
To Preliminary expenses written
off *** (Balancing Figure) ***
To Provision for Tax ***
To Proposed Dividend ***
To Closing Balance of P & L a/c ***
*** ***

Illustration:
From the following Profit and Loss Account, Calculation fund from operation :
Profit and Loss Account
Particulars Rs. Rs.
To Rent 6,000 By Gross Profit bId 50,000
To Salaries 14,000 By Transfers to General Reserve 7,000
To Advertisement 3,000 By Preliminary Expenses 1,000
To Office Expenses 2,000 By Profit on Sale of Investment 2,000
To Depreciation on Plant 5,000
To Good will written off 3,000
To Loss on Sales of Plant 2,000
To Provision for Tax 4,000
To Interim Dividend 3,000
To Net Profit 18,000
60,000 60,000
Solution:

Calculation of Fund from Operations

Particulars Amount Rs. Amount Rs.

Net Profit or Retained Earnings 18,000

(Closing Balance of P & L A/C)
Add: Non-Fund or Non-Trading items already debited to P & L

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 a/c :
Depreciation on Plant 5,000
Goodwill written off 3,000
Loss on Sale of Plant 2,000
Provision for Tax 4,000
Interim Dividend 3,000
Preliminary Expenses 1,000
Transfer to General Reserve 7,000 25,000
43,000
Less :Non-Fund or Non-Trading items already
Credited to P & L Nc:
Profit on Sale of Investments 2,000 2,000
Fund From Operations 41,000
Note: Provision for tax and Interim Dividend are not treated as current liability.

II. STATEMENT OF CHANGES IN WORKING CAPITAL

It is also termed as Statement of Changes in Working Capital. Before preparation of fund flow
statement, it is essential to prepare first the schedule of changes in working capital and fund
from operations. Statement of changes in working capital is prepared on the basis of items in
current assets and current liabilities of between two balance sheets. This statement helps to
measure the movement or changes of working capital during a particular period. The term
working capital refers to excess of current assets over current liabilities. The working capital
may be "Increase in working capital" or "Decrease in working capital." An increase in the
amount of an item of current assets in the current year as compared to the previous year
represents to an increase in working capital. Similarly, a decrease in the amount of an item of
current assets in the current year as compared to the previous year would represent decrease
in working capital. In the same way over all changes in working capital is calculated and
presented in the schedule of changes in working capital. The final result of Net Decrease in
Working Capital refers to Source of Funds or Inflow of Funds. Like this, Net Increase in
Working Capital represent Application of Fund or Uses of Funds.

Principle or Rules for Preparation of Working Capital Statement

The following rules may be kept in mind while preparing working capital statement:

Increase in Current Asset Increases Working Capital

Decrease in Current Asset Decreases Working Capital
Increase in Current Liability Decreases Working Capital
Decrease in Current Liability Increases Working Capital

Specimen Form of Schedule of Changes in Working Capital :

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The following is a specimen form may be used for preparation of schedule of changes in
working capital.

Schedule of Changes in Working Capital (or) Statement of Changes in Working Capital

Current Effect on Working
Previous Year
Particulars Year Capital
Rs.
Rs. Increase Decrease
Current Assets :
Cash in Hand
Cash at Bank
Sundry Debtors
Bills Receivable
Short-Term Investments
Stock
Prepaid Expenses
Outstanding Incomes
Total Current Assets (A) ***** *****
Current Liabilities :
Sundry Creditors
Bills Payable
Bank Overdraft
Outstanding Expenses
Short-Term Loans
Total Current Liabilities (B) ***** *****
Working Capital ***** *****
(A -B) ....
Net Increase/Decrease *****
*******
In Working Capital --------- --------

Total ******* ****** ****** ******

Illustration:

From the following Balance Sheet of Gupta Ltd., prepare Schedule of Changes in Working
Capital:
Balance Sheet
Liabilities 2002 2003 Assets 2002 2003
Rs. Rs. Rs. Rs.
Creditors 55,000 83,000 Cash in Hand 15,000 10,000
Bills Payable 20,000 16,000 Cash at Bank 10,000 8,000
Share Capital 1,00,000 1,50,000 Debtors 1,60,000 2,00.000
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General Reserve 7,000 8,000 Stock 77,000 1,09,000
Debenture 1,00,000 1,00,000 Bills Receivable 20,000 30,000
2,82,000 3,57,000 2,82,000 3,57,000

Solution:
Schedule of Changes in Working Capital
Changes in Working
Particulars 2002 2003 Capital

Rs. Rs. Increase Decrease

Current Assets :
Cash in Hand 15,000 10,000 5,000
Cash at Bank 10,000 8,000 - 2,000
Debtors 1,60,000 2,00,000 40,000 -
Stock 77,000 1,09,000 32,000 -
Bills Receivable 20,000 30,000 10,000 -
Total (A) 2,82,000 3,57,000
Current Liabilities :
Creditors 55,000 83,000 28,000
Bills Payable 20,000 16,000 4,000 -
Total (B) 75,000 99,000
Working Capital (A - B) 2,07,000 2,58,000
Net Increase in Working
51,000 - - 51,000
Capital
2,58,000 2,58,000 86,000 86,000

III. FUND FLOW STATEMENT

In the analysis and interpretation of financial statements fund flow statement is one of the
important techniques. The statement of changes in working capital is prepared with the help
of current assets and current liabilities. Similarly, fund from operation is prepared on the
basis of profit and loss account to find out the exact movement of funds in different
operations. After preparing schedule of changes in working capital and fund from operations,
at the last stage a comprehensive fund flow statement can be prepared on the basis of
component of non-current assets, non-current liabilities of balance sheet and relevant
information. In other words, this statement is prepared with the help of the changes in non-
current assets and non-current liabilities of balance sheet.

Components of Sources and Application of Funds: The following are the components of
different sources and applications of funds:

1. Fresh Issue of Equity Share Capital.

2. Fresh Issue of Preference Share Capital.
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 3. Issue of Debentures and Bonds.
4. Long-Term Loans raised from bank, financial institutions and public.
5. Long-Term Loans on Mortgage.
6. Sale of Fixed Assets.
7. Sale of Long-Term Investments.
8. Non-Trading Incomes.
9. Fund From Operations.
10. Net Decrease in Working Capital (as per schedule of changes in working capital).

Components of Applications of Funds: Generated funds from various sources may be utilized
in the following ways for meeting the future productive programmes of the business:

 Redemption of shares and debentures.

 Repayment of loans raised from bank, financial institutions and public.
 Purchase of Fixed Assets.
 Purchase of Long-Term Investments.
 Non-Trading Expenditure. Payment of Tax;
 Payment of Dividend.
 Fund Lost in Operations.
 Net Increase in Working Capital (as per schedule of changing in working capital).

Specimen Form of Fund Flow Statement

The following are the two usual formats for preparation of Sources and Application of Fund is
presented below:

 Statement Form.
 Account Form.

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(1) Statement Form

Fund Flow Statement

Particulars Amount Rs. Amount Rs.
Sources of Funds :
Fund From Operations
Issue of Share Capital
Issue of Debentures
Long-Term Loans
Sale of Fixed Assets
Sale of Investments
Non-Trading Incomes
Decrease in Working Capital ***** *****
(as per schedule of changes in working capital)
Total Sources (or) Total Inflows (A) *****
Application or Uses of Funds:
Fund Lost in Operations
Redemption of Shares
Redemption of Debentures
Purchase of Fixed Assets
Repayment of Long-Term Investments
Non-Trading Expenditure
Payment of Tax
Payment of dividend
***** *****
Increase in Working Capital
(as per schedule of changes in working capital)
******
Total Application or Total Outflows (B)

(2) Account Form

Fund Flow Statement
Amount
Sources of Funds Rs. Application of Funds Amount Rs.
Fund From Operations Fund Lost in Operations
Issue of Share Capital Redemption of Shares
Issue of Debentures Redemption of Debenture
Long-Term Loans Purchase of Fixed Assets
Sale of Fixed Assets Repayment of Long-Term Loans
Sale of Investments Non-Trading Expenditure
Non-Trading Incomes Payment of Tax

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 Decrease in Working Payment of Dividend
Capital
(As per schedule of changes Increase in Working Capital
in working capital) (as per schedule of changes
in working capital)
Total Inflow *** Total Outflow ***

Illustration:

From the following Balance sheet of RR & Co. Ltd., you are required to prepare (a) Schedule of
Changes in Working Capital (b) Fund Flow Statement and (c) Fund From Operations.

Balance Sheet
Liabilities 2002 2003 Assets 2002 2003
Rs. Rs. Rs. Rs.
1,00,00
Equity Capital 0 1,00,000 Good Will 6,000 6,000
General Reserve 14,000 18,000 Patents 6,000 6,000
Profit & Loss a/c 16,000 l3,OOO Building 50 46
Bank Overdraft 3,000 2,000 Machinery 27,000 26,000
Sundry Creditors 5,000 3,400 Investments 10,000 11,000
Bills Payable 1,200 800 Stock 20,000 l3,400
Provision for Taxation 10,000 11,000 Bills Receivable 12,000 l3,200
Proposed Dividend 6,000 7,000 Debtors 18,000 19,000

Provision for Doubtful Cash at Bank 6,600 15,200

Debts 400 600
1,55,60
0 1,55,800 1,55,600 1,55,800
Additional Information

1. Depreciation Charged on Machinery Rs. 4,000 and on Building Rs. 4,000.

2. Provision for Taxation of Rs. 19,000 was made during the year 2003.
3. Interim Dividend of Rs. 8,000 was Paid during the year 2003.

Solution:

Calculation of Fund from Operations

Amou
nt
Rs Amount
Particulars . Rs.

Profit and Loss Nc (Closing Balance of 2003 l3,000

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 Add: Non-Fund or Non-Trading items already Debited to P&L a/c :
Depreciation on Machinery 4,000
Depreciation on Building 4,000
Interim Dividend Paid 8,000
Transfer to General Reserve 4,000
Provision for Tax 19,000
Proposed Dividend 1,000 40,000
53,000
Less :Non-Fund or Non-Trading items already
Credited to P&L a/c :
Profit and Loss a/c (Opening balance as per 2002) 16,000
Fund From Operations 37,000

Schedule of Changes in Working Capital

Paniculars 2002 2003 Changes in Working Capital
Rs. Rs. Increase Decrease
Current Assets :
Cash at Bank 6,600 15,200 8,600 --
Debtors 18,000 19,000 1,000 --
Stock 20,000 13,400 - 6,600
Bills Receivable 12,000 13,200 1,200 --
Total (A) 56,600 60,800
(-) Current
Liabilities :
Bank Overdraft 3,000 2,000 1,000 --
Sundry Creditors 5,000 3,400 1,600 --
Provision for Doubtful
Debits 400 600 -- 200
Bills Payable 1,200 800 400 --
Total (B) 9,600 6,800

Working Capital (Total

A - B) 47,000 54,000 --
Net Increase in
Working Capital 7,000 -- 7,000
54,000 54,000 13,800 13,800

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Fund Flow Statement
Sources of Fund Rs. Application of Funds Rs.
Fund From Operations 37,000 Purchase of Machinery 3000
Tax Paid (see Note 3) 18000
Investment purchased 1,000
(10.000 - 11,000)
Interim Dividend Paid 8000
Net Increase in working 7000
Capital
37,000 37,000

Building Account
To Balance bid 50,000 By Depreciation 4,000
By Balance c/d 46,000
50,000 50,000
Provision for Taxation
18,000 By Balance bid 10,000
To Bank By Provision for
(Balancing figure) Taxation 19,000
To Balance c/d 11,000
29,000 29,000

CASH FLOW STATEMENT

MEANING OF CASH FLOW AND CASH FLOW STATEMENT

Cash Flows are inflows and outflows, i.e., the movement of cash and cash equivalents.

The Cash Flow Statement is prepared according to Revised Accounting Standard-3 on cash flow
statement. The standard requires that cash flow be classified and shown in the cash flow
statement under three heads, namely:
 Cash Flow from Operating Activities
 Cash Flow from Investing Activities; and
 Cash Flow from Financing Activities.

OBJECTIVES OF CASH FLOW STATEMENT

The objectives of cash flow statement are:
 To ascertain the sources from activities (i.e., operating/investing/financing activities)
from which cash and cash equivalents were generated by an enterprise.
 To ascertain the uses by activities (i.e., operating/investing/financing activities) for which

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 cash and cash equivalents were used by an enterprise.
 To ascertain the net change in cash or cash equivalents indicating the difference between
sources and uses from or by the three activities between the dates of two Balance Sheets.

IMPORTANT DEFINITIONS AS PER ACCOUNTING STANDARD

 Cash comprises of cash in hand and demand deposits with banks.

 Cash Equivalents are short-term, highly liquid investments that are readily convertible
into known amount of cash and which are subject to an insignificant risk of change in
value.
 An investment normally qualifies as cash equivalent only when it has a short maturity of,
say (a) treasury bills,(b) commercial paper,(c)money market funds and (d)investments in
preference shares and redeemable within three months can also be taken as cash
equivalents if there is no risk of the failure of the company.
 Cash Flows are inflows and outflows of cash and cash equivalents.AS-3 requires a cash
flow statement to be prepared and presented in a manner that it shows cash flows from
business transactions during a period classifying the into:
1. Operating Activities;
2. Investing Activities;
3. Financing Activities.
1. Operating Activities: operating activities are the principal revenue producing activities of
the enterprise and other activities that are not investing or financing activities.
2. Investing Activities: Investing activities are the acquisition and disposal of long-term assets
and other investments not included in cash equivalents. These activities include transactions
involving purchase and sale of long term productive assets like machinery, land, etc., which
are not held for resale.
3. Financing Activities: Financing activities are the activities that result in change in the size
and composition of the owner’s capital (including preference share capital in the case of a
company) and borrowing of the enterprise.
Limitations of Cash Flow Statement
o Ignores Non-cash transactions
o Ignores the accrual concept
o Historical in Nature
o Not a Substitute for an Income Statement
o Not suitable for judging Liquidity of the enterprise

Cash And Cash Equivalents As Per Schedule III, Part I Of The Companies Act, 2013

1 Balance with banks

2 Cheque on hand
3 Cash on hand
4 Short-term marketable securities
5 Balance with banks held as margin money
6 Bank deposits with more than 12 months of maturity

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Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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 OPERATING ACTIVITIES

CASH INFLOW CASH OUTFLOW

 Cash Sales Cash purchase

 Cash received from Debtors Payment to creditors
 Cash received from commission Cash operating expenses
and Fees Payment of Wages
 Royalty. Income Tax
In the case of financial companies In the case of financial companies
 Cash received for Interest and Cash paid for interest
Dividends Purchase of Securities
 Sale of Securities

INVESTING ACTIVITIES

Cash Inflow Cash Outflow

 Sale of Fixed Assets Purchase of Fixed Assets

 Sale of Investments Purchase of Investments
(8) Interest received
(9) Dividends received
FINANCING ACTIVITIES

Cash Inflow Cash Outflow

1. Issue of shares in Cash Payment of Loans

2. Issue of Debentures in Redemption of preference shares
Cash Buy-back of Equity shares
3. Proceeds from Long-term Payment of Dividend
Borrowings Payment of Interest

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Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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Classification of Activities in Cash Flow Statement:

According to AS-3 (Revised), the cash flow statement should report cash flows during the period
classified by operating, investing and financing activities.

This classification of activities is described below:

(i) Operating Activities: Operating activities are the principal revenue-producing activities of
the enterprise and other activities that are not investing or financing activities.
The amount of cash flows arising from operating activities is a key indicator of the extent to
which the operations of the enterprise have generated sufficient cash flows to maintain the
operating capability of the enterprise to pay dividends, repay loans and make investments
without recourse to external sources of financing.
Information about the specific components of historical operating cash flows is also useful in
forecasting future operating cash flows. Cash flows from operating activities generally result
from the transactions and other events that enter into the determination of net profit or loss.

Examples of cash flows from operating activities are:

 Cash receipts from the sale of goods and the rendering of services, usually forming a
major share of cash inflow;
 Cash receipts from royalties, fees, commissions, and other revenue;
 Cash payments to suppliers for goods and services such as payment of rent, electricity
bill, fire-insurance premium, printing charges etc.
 Cash payments of salaries and wages to employees and also cash payments made on
behalf of employees to others like those of life insurance premium and tax deducted at
source.
 Cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities.
 Cash receipts and payments relating to future contracts, forward contracts, option
contracts and swap contracts when the contracts are held for dealing or trading purposes.
 Cash receipts and payments arising from the purchase and sale of dealing or trading
securities.
Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is
included in the determination of net profit or loss. However, the cash flows relating to such
transactions are cash flows from investing activities.

(ii) Investing Activities: Investing activities are the acquisition and disposal of long-term assets
(such as land, buildings, plant, machinery, furniture, fixtures etc.) and other investments not
included in cash equivalents.
It is important to make a separate disclosure of cash flows arising from investing activities
because the cash flows represent the extent to which expenditures have been made for
resources intended to generate future income and cash flows.
Examples of cash flows arising from investing activities are:
 Cash payments to acquire fixed assets (including intangibles) like payments made to

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 purchase goodwill, land, buildings, plant, machinery, furniture, fixtures, fittings,
trademarks, copy rights etc. These payments include those relating to self-constructed
fixed assets;
 Cash payments relating to capitalized research and development costs;
 Cash receipts from disposal of fixed assets (including intangibles);
 Cash payments to acquire shares, warrants, or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be
cash equivalents and those held for dealing or trading purposes);
 Cash receipts from disposal of shares, warrants, of debt instruments of other enterprises
and interests in joint ventures (other than receipts from those instruments considered to
be cash equivalents and those held for dealing or trading purposes);
 Cash advances and loans made to third parties (other than advances and loans made by a
financial enterprise);
 Cash receipts from the repayment of advances and loans made to third parties (other than
advances and loans of a financial enterprise);
 Cash payment for and cash receipts from futures contracts, forward contracts, option
contracts, and swap contracts except when the contracts are held for dealing or trading
purposes, or the payments are classified as financing activities.
When a contract is accounted for as a hedge of an identifiable position, the cash flows of the
contract are classified in the same manner as the cash flows of the position being hedged.

(iii) Financing Activities: Financing activities are activities that result in changes in the size and
composition of the owners’ capital (including preference share capital in the case of a
company) and borrowings of the enterprise. The separate disclosure of cash flows from
financing activities is important because it is useful in predicting claims on future cash flows
by providers of funds (both coital and borrowings) to the enterprise.
Examples of cash flows arising from financing activities are:
 Cash proceeds from issuing shares other similar instruments;
 Cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term
borrowings; and
 Cash repayments of amounts borrowed,
 Cash payments to redeem preference shares.

Other Items:
In addition to the cash flows described, AS-3 (Revised) also deals with certain other items
as outlined below:—
(a) Interest and Dividends: Treatment of cash flows from interest and dividends can be
described under two heads:
 In case of a financial enterprise, cash flows arising from interest paid and interest and
dividends received should be classified as cash flows from operating activities. Dividends
paid should be classified as cash flows from financing activities.
 In the case of other enterprises, cash flows arising from interest and dividends paid should
be classified as cash flows from financing activities while interest and dividends received
should be classified as cash flows from investing activities.
 In all cases, cash flows from interest and dividends received and paid should each be

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 disclosed separately. Also, the total amount of interest paid during the period is disclosed in
the cash flow statement whether it has been recognised as ah expense in the statement of
profit and loss or capitalised in accordance with AS-10: Accounting for Fixed Assets.
The following excerpt taken from an annexure to a letter issued by SEBI lists the
requirements laid down by SEBI regarding treatment of interest and dividends in cash
flow statement:
1. Interest and Dividends: Cash flows from interest and dividends received and paid should
each be disclosed separately. Each should be classified in a consistent manner from period
to period as either operating, investing or financing activities.
2. Taxes on Income: Cash flows arising from taxes on income should be separately disclosed
and should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities.
3. Extraordinary Items: The cash flows associated with extraordinary items should be
classified as arising from operating, investing or financing activities as appropriate and
separately disclosed, winning of a law suit or a lottery and receipt of claim from an
insurance company are examples of extraordinary items.
4. Investments in Subsidiaries, Associates and Joint Ventures: When accounting for an
investment in a subsidiary, an associate or a joint venture, the investor should restrict its
reporting in the cash flow statement to the cash flows between itself and the investee/joint
venture, for example, cash flows relating to dividends and advances.
5. Acquisitions and Disposals of Subsidiaries and other Business Units: The aggregate cash
flows arising from acquisitions and from disposals of subsidiaries or other business units
should be presented separately and classified as investing activities.
6. Foreign Currency Cash Flows: Cash flows arising from transactions in a foreign currency
should be recorded in an enterprise’s reporting currency by applying to the foreign currency
amount the exchange rate between the reporting currency and the foreign currency at the
date of the cash flow.

A rate that approximates the actual rate may be used if the result is substantially the same as
would arise if the rates at the dates of the cash flows were used. For example, a weighted
average exchange rate for a period may be used for recording foreign currency transactions.
The effect of changes in exchange rates on cash and cash equivalents held in a foreign currency
should be reported as a separate part of the reconciliation of the changes in cash and cash
equivalents during the period.

Examples of non-cash transactions are:

o The acquisition of an enterprise by means of issue of shares;
o The acquisition of a fixed asset, say machinery, on credit; and
o The conversion of convertible debentures into equity shares.

Format:
AS-3 (Revised) has not prescribed any specific format of cash flow statement. However,
suggested format can be inferred from the illustrations appearing in the appendices to the
accounting standard.

What is Cash Flow from Operations?

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Cash flow from operations is the section of a company’s cash flow statement that represents the
amount of cash a company generates (or consumes) from carrying out its operating activities
over a period of time. Operating activities include generating revenue, paying expenses, and
funding working capital. It is calculated by taking a company’s (1) net income, (2) adjusting
for non-cash items, and (3) accounting for changes in working capital.

Cash Flow from Operations Formula

While the exact formula will be different for every company (depending on the items they have
on their income statement and balance sheet), there is a generic cash flow from operations
formula that can be used:

Cash Flow from Operations = Net Income + Non-Cash Items + Increase in Working
Capital

Methods of Preparing Cash from Operations (With Specimen)

A I. Direct Method:

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A.II Direct Method:

A. III Direct Method:

B. Indirect Method:

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Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM
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Cash Flow Statement

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 Table of Difference between Funds Flow Statement and Cash Flow Statement

Basis of Funds Flow Statement Cash Flow Statement

Difference
1. Basis of Analysis
Funds flow statement is based Cash
on flow statement is based on narrow
broader concept i.e. working concept i.e. cash, which is only one of the
capital. elements of working capital.
2. Source Funds flow statement tells about the
Cash flow statement stars with the opening
various sources from where the balance of cash and reaches to the closing
funds generated with various uses balance of cash by proceeding through
to which they are put. sources and uses.
3. Usage Funds flow statement is more usefulCash
in flow statement is useful in understanding
assessing the long-range financial the short-term phenomena affecting the
strategy. liquidity of the business.
4. Schedule In
of funds flow statement changes Inincash flow statement changes in current assets
Changes in current assets and current liabilities and current liabilities are shown in the cash
Working are shown through the schedule of flow statement itself.
Capital changes in working capital.
5. End Result Funds flow statement shows the causes
Cash flow statement shows the causes the
of changes in net working capital. changes in cash.
6. Principal Funds
of flow statement is in alignment
In cash flow statement data obtained on accrual
Accounting with the accrual basis of basis are converted into cash basis.
accounting.

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Common-Size Statement: Meaning and Types| Method of Financial Analysis
Meaning of Common-Size Statement:
The common-size statements, balance sheet and income statement are shown in analytical
percentages. The figures are shown as percentages of total assets, total liabilities and total
sales. The total assets are taken as 100 and different assets are expressed as a percentage of
the total. Similarly, various liabilities are taken as a part of total liabilities.
These statements are also known as component percentage or 100 per cent statements because
every individual item is stated as a percentage of the total 100. The short-comings in
comparative statements and trend percentages where changes in items could not be compared
with the totals have been covered up. The analyst is able to assess the figures in relation to
total values.

The common-size statements may be prepared in the following way:

 The totals of assets or liabilities are taken as 100.
 The individual assets are expressed as a percentage of total assets, i.e., 100 and different
liabilities are calculated in relation to total liabilities. For example, if total assets are Rs 5
lakhs and inventory value is Rs 50,000, then it will be 10% of total assets
(50,000×100/5,00,000)

Types of Common-Size Statements:

 Common-Size Balance Sheet: A statement in which balance sheet items are expressed
as the ratio of each asset to total assets and the ratio of each liability is expressed as a
ratio of total liabilities is called common-size balance sheet.
 Common Size Income Statement: The items in income statement can be shown as
percentages of sales to show the relation of each item to sales. A significant relationship
can be established between items of income statement and volume of sales. The increase
in sales will certainly increase selling expenses and not administrative or financial
expenses.
In case the volume of sales increases to a considerable extent, administrative and financial
expenses may go up. In case the sales are declining, the selling expenses should be
reduced at once. So, a relationship is established between sales and other items in income
statement and this relationship is helpful in evaluating operational activities of the
enterprise.

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 UNIT IV
COST ACCOUNTING

Cost Accounts - Classification of manufacturing costs - Accounting for manufacturing costs.

Cost Accounting Systems: Job order costing - Process costing- Activity Based Costing- Costing
and the value chain- Target costing- Marginal costing including decision making- Budgetary
Control & Variance Analysis - Standard cost system.

MEANING AND SCOPE OF COST ACCOUNTING

Cost accounting is the process of determining and accumulating the cost of product or activity. It
is a process of accounting for the incurrence and the control of cost. It also covers classification,
analysis, and interpretation of cost. In other words, it is a system of accounting, which provides
the information about the ascertainment, and control of costs of products, or services. It measures
the operating efficiency of the enterprise.

COST ACCOUNTING – MEANING

Cost accounting is concerned with recording, classifying and summarizing costs for
determination of costs of products or services, planning, controlling and reducing such costs and
furnishing of information to management for decision making.

COST ACCOUNTING: The Institute of Cost and Management Accountant, England (ICMA)
has defined Cost Accounting as – “the process of accounting for the costs from the point at
which expenditure incurred, to the establishment of its ultimate relationship with cost centers
and cost units. In its widest sense, it embraces the preparation of statistical data, the application
of cost control methods and the ascertainment of the profitability of activities carried out or
planned”.

COST TERMINOLOGY:
 COST: Cost means the amount of expenditure incurred on a particular thing.
 COSTING: Costing means the process of ascertainment of costs.
 COST ACCOUNTING: The application of cost control methods and the ascertainment
of the profitability of activities carried out or planned”.
 COST CONTROL: Cost control means the control of costs by management. Following
are the aspects or stages of cost control.
 JOB COSTING: It helps in finding out the cost of production of every order and thus
helps in ascertaining profit or loss made out on its execution. The management can judge
the profitability of each job and decide its future courses of action.
 BATCH COSTING: Batch costing production is done in batches and each batch
consists of a number of units, the determination of optimum quantity to constitute an
economical batch is all the more important.

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Scope of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are many times used interchangeably. However, the
scope of cost accounting is broader than that of costing. Following functional activities are
included in the scope of cost accounting:
 Cost book-keeping: It involves maintaining complete record of all costs incurred from their
incurrence to their charge to departments, products and services. Such recording is preferably
done on the basis of double entry system.
 Cost system: Systems and procedures are devised for proper accounting for costs.
 Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the
important function of cost accounting. Cost ascertainment becomes the basis of managerial
decision making such as pricing, planning and control.
 Cost Analysis: It involves the process of finding out the causal factors of actual costs
varying from the budgeted costs and fixation of responsibility for cost increases.
 Cost comparisons: Cost accounting also includes comparisons between cost from alternative
courses of action such as use of technology for production, cost of making different products
and activities, and cost of same product/ service over a period of time.
 Cost Control: Cost accounting is the utilisation of cost information for exercising control. It
involves a detailed examination of each cost in the light of benefit derived from the
incurrence of the cost. Thus, we can state that cost is analysed to know whether the current
level of costs is satisfactory in the light of standards set in advance.
 Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports
are primarily for use by the management at different levels. Cost Reports form the basis for
planning and control, performance appraisal and managerial decision making.
Objectives of cost accounting
There is a relationship among information needs of management, cost accounting objectives, and
techniques and tools used for analysis in cost accounting. Cost accounting has the following
main objectives to serve:
 Determining selling price,
 Controlling cost
 Providing information for decision-making
 Ascertaining costing profit
 Facilitating preparation of financial and other statements.

 Determining selling price: The objective of determining the cost of products is of main
importance in cost accounting. The total product cost and cost per unit of product are
important in deciding selling price of product. Cost accounting provides information
regarding the cost to make and sell product or services. Other factors such as the quality
of product, the condition of the market, the area of distribution, the quantity which can be
supplied etc., are also to be given consideration by the management before deciding the
selling price, but the cost of product plays a major role.
 Controlling cost: Cost accounting helps in attaining aim of controlling cost by using
various techniques such as Budgetary Control, Standard costing, and inventory control.
Each item of cost [viz. material, labour, and expense] is budgeted at the beginning of the

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 period and actual expenses incurred are compared with the budget. This increases the
efficiency of the enterprise. 3. Providing information for decision-making: Cost
accounting helps the management in providing information for managerial decisions for
formulating operative policies. These policies relate to the following matters:
o Determination of cost-volume-profit relationship.
o Make or buy a component
o Shut down or continue operation at a loss
o Continuing with the existing machinery or replacing them by improved and
economical machines.
 Ascertaining costing profit: Cost accounting helps in ascertaining the costing profit or
loss of any activity on an objective basis by matching cost with the revenue of the
activity.
 Facilitating preparation of financial and other statements: Cost accounting helps to
produce statements at short intervals as the management may require. The financial
statements are prepared generally once a year or half year to meet the needs of the
management. In order to operate the business at high efficiency, it is essential for
management to have a review of production, sales and operating results. Cost accounting
provides daily, weekly or monthly statements of units produced, accumulated cost with
analysis. Cost accounting system provides immediate information regarding stock of raw
material, semi finished and finished goods.

Importance of Cost accounting

The limitation of financial accounting has made the management to realise the importance of
cost accounting. The importance of cost accounting are as follows:

 Importance to Management: Cost accounting provides invaluable help to management.

It is difficult to indicate where the work of cost accountant ends and managerial control
begins. The advantages are as follows :
 Helps in ascertainment of cost: Cost accounting helps the management in the
ascertainment of cost of process, product, Job, contract, activity, etc., by using different
techniques such as Job costing and Process costing.
 Aids in Price fixation: By using demand and supply, activities of competitors, market
condition to a great extent, also determine the price of product and cost to the producer
does play an important role. The producer can take necessary help from his costing
records.
 Helps in Cost reduction: Cost can be reduced in the long-run when cost reduction
programme and improved methods are tried to reduce costs.
 Elimination of wastage: As it is possible to know the cost of product at every stage, it
becomes possible to check the forms of waste, such as time and expenses etc., are in the
use of machine equipment and material.
 Helps in identifying unprofitable activities: With the help of cost accounting the
unprofitable activities are identified, so that the necessary correct action may be taken

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  Helps in checking the accuracy of financial account: Cost accounting helps in
checking the accuracy of financial account with the help of reconciliation of the profit as
per financial accounts with the profit as per cost account.
 Helps in fixing selling Prices: It helps the management in fixing selling prices of
product by providing detailed cost information.
 Helps in Inventory: Control Cost furnishes control which management requires in
respect of stock of material, work in progress and finished goods.
 Helps in estimate: Costing records provide a reliable basis upon which tender and
estimates may be prepared.
 Importance to Employees: Worker and employees have an interest in which they are
employed. An efficient costing system benefits employees through incentives plan in
their enterprise, etc. As a result both the productivity and earning capacity increases.
 Cost accounting and creditors: Suppliers, investor’s financial institution and other
moneylenders have a stake in the success of the business concern and therefore are
benefited by installation of an efficient costing system. They can base their judgement
about the profitability and prospects of the enterprise upon the studies and reports
submitted by the cost accountant.
 Importance to National Economy: An efficient costing system benefits national
economy by stepping up the government revenue by achieving higher production. The
overall economic developments of a country take place due to efficiency of production.
 Data Base for operating policy: Cost Accounting offers a thoroughly analyzed cost data
which forms the basis of formulating policy regarding day to day business.

ELEMENTS OF COST (OR) CLASSIFICATION OF MANUFACTURING COSTS

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 (1) Material,
(2) Labour, and
(3) Expenses.

1. Material: Material may be classified into direct material and indirect material.
 Direct Material: CIMA defines material cost as “the cost of commodities supplied to an
undertaking.” All materials, which becomes an integral part of the finished product and
which can be conveniently allocated to specific physical units is termed as direct
material.
 Some of the examples are all material components or spare parts specifically purchased,
produced or supplied from stores, primary packing materials, and purchased or partly
produced components. It is also called as process material or production material.
 Indirect Material: All material, which is used for secondary purposes and cannot be
allocated conveniently to specified physical units, is called as indirect material. A few
examples are consumable stores, oil and waste, printing and stationery material, and etc.
Indirect material may be used at the factory, office or selling and distribution divisions.
2. Labour: Human effort required to convert materials into finished products is termed as
labour. It may be classified into direct labour and indirect labour.
 Direct Labour: Labour, which plays an active and direct part in the production of a
particular product, is termed as direct labour. CIMA defines labour cost as “the cost of
remuneration (wages, salaries, commission, bonus, etc.) of the employees of an
undertaking.” Direct labour cost can be conveniently and specifically charged to specific
products.
 Indirect labour: It is employed to carry out tasks incidental to goods produced or
services rendered. Indirect labour cost cannot be practically traced to specific units of
output. A few examples indirect labour costs are wages of storekeeper, salaries of office
staff and salesmen, directors’ fees, etc. It may be incurred in the factory, office, and
selling and distribution divisions.

3. Expenses: CIMA defines expenses as “the cost of services provided to an undertaking and the
notional cost of the use of owned assets.” It may be classified into direct expenses and indirect
expenses.
 Direct Expenses: These are expenses, which can be directly allocated to a particular
job, product or unit of service; They are also called as ‘chargeable expenses.’
Examples of such expenses are hire charges paid to some special machinery required for
a particular contract, cost of designs or mould incurred in toy manufacturing, cost of
blocks needed in book publishing, etc.
 Indirect Expenses: hese are expenses, which cannot be conveniently and directly
allocated to a particular job, product or unit of service. They are incurred in common and
can be apportioned to various cost centers or cost units proportionately on some basis.
Examples of such expenses are factory rent, lighting, insurance, office and administration
expenses, selling and distribution expenses, etc.

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OVERHEADS: The aggregate of indirect material cost, indirect labour cost, and indirect
expenses is termed as overheads. Thus all indirect costs are overheads.

They may be classified broadly into types:

 Factory or Works Overheads: These are indirect costs incurred inside a factory or
works. Examples are factory supplies such as oil, consumable stores, lubricants, indirect
labour such as factory manager’s salary, timekeeper’s salary, etc., and indirect expenses
such as factory rent, factory lighting, factory insurance, etc.
 Office and Administration Overheads: These are indirect costs incurred in the general
and administrative office. Examples are indirect materials such as stationery, brooms,
dusters, etc, and indirect labour such as salaries of office staff, directors’ fees, etc., and
indirect expenses such as rent, insurance, lighting, etc., of the office.
 Selling and Distribution Overheads: These are indirect costs incurred in connection with
the selling and distribution of goods and services. Examples are indirect materials such as
packing materials, printing and stationery materials, etc., and indirect labour such as
salaries of sales staff and sales manager, commission, etc., and indirect expenses such as
advertising expenses, insurance, godown rent, etc.

MANUFACTURING COST ACCOUNTING

Manufacturing cost accounting encompasses several tasks that impact production operations and
the valuation of inventory. These activities can significantly boost the profits of a business, as
well as bring it into compliance with the applicable accounting standards. The following are all
elements of manufacturing cost accounting:
 Inventory valuation. This is the fully loaded cost of inventory at the end of
an accounting period, which is required under various accounting standards to place a
correct valuation on inventory. It is of little use in the day-to-day operations of the
manufacturing area. There are a number of ways to assign a valuation to inventory, such
as the standard cost, FIFO, and LIFO methods.
 Cost of goods sold valuation. This is closely related to inventory valuation. It is possible
to track the cost of specific production jobs (job costing), or in general for all units
produced (process costing). This cost tracking can be at the level of just those costs that
vary with changes in revenue (direct costing), or it can include a full allocation of factory
overhead costs (absorption costing).
 Constraint analysis. This involves finding the bottleneck in the manufacturing process
(if any) and advising the production department regarding the impact on throughput of
changes to the flow of work through that bottleneck. The analysis can include an
examination of the inventory buffer in front of the constraint and the existence of any
upstream sprint capacity. This can be among the most important functions of
manufacturing cost accounting.
 Margin analysis. This involves the compilation of all costs associated with a product and
subtracting them from product revenues to arrive at the margin of each product. Margin
analysis can also be applied to distribution channels, business units, customers, and
product lines. This is a traditional cost accounting role that is gradually giving way to
constraint analysis, since many businesses now realize that incorporating allocated costs
into margin analysis can lead to incorrect decisions to sell more or less of a product.

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 Instead, it is better to consider that all products usually have some amount of throughput
associated with them, so the real issue is to find the most profitable mix of products to
produce (including the option to outsource production).
 Variance analysis. This is the comparison of actual costs incurred to standard or
budgeted costs, and exploring the reasons for any variances. This aspect of manufacturing
cost accounting may not be necessary, since the baseline budget or standard cost may be
faulty. Thus, a favorable variance may simply mean that a standard was set to be so easy
to attain that all variances from it are bound to be favorable.
 Budgeting. The information derived from the preceding analyses can be used as the basis
for the annual budget for the manufacturing area, though this work is ultimately the
responsibility of the production manager, not the cost accountant.
The cost accountant is primarily responsible for manufacturing accounting activities.

COST SHEET

Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect
of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on
different items for a particular period. Additional columns may also be provided to show the cost
of a particular unit pertaining to each item of expenditure and the total per unit cost.
Cost sheet may be prepared on the basis of actual data (historical cost sheet) or on the basis of
estimated data (estimated cost sheet), depending on the technique employed and the purpose to
be achieved.
The techniques of preparing a cost sheet can be understood with the help of the following
examples.

Meaning:

Cost Sheet or a Cost Statement is "a document which provides for the assembly of the estimated
detailed elements of cost in respect of cost centre or a cost unit." The analysis for the different
elements of cost of the product is shown in the form of a statement called "Cost Sheet." The
statement summarizes the cost of manufacturing a particular list of product and discloses for a
particular period:

 Prime Cost;
 Works Cost (or) Factory Cost;
 Cost of Production;
 Total Cost (or) Cost of Sales.

Importance of Cost Sheet

 It provides for the presentation of the total cost on the basis of the logical classification.
 Cost sheet helps in determination of cost per unit and total cost at different stages of
production.
 Assists in fixing of selling price.

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  It facilitates effective cost control and cost comparison.
 It discloses operational efficiency and inefficiency to the management for taking
corrective actions.
 Enables the management in. the preparation of cost estimates to tenders and quotations.

Objectives of Cost Sheet

The importance of cost sheet is as follows:
 Cost ascertainment: The main objective of the cost sheet is to ascertain the cost of a
product. Cost sheet helps in ascertainment of cost for the purpose of determining cost after
they are incurred. It also helps to ascertain the actual cost or estimated cost of a Job.
 Fixation of selling price: To fix the selling price of a product or service, it is essential to
prepare the cost sheet. It helps in fixing selling price of a product or service by providing
detailed information of the cost.
 Help in cost control: For controlling the cost of a product it is necessary for every
manufacturing unit to prepare a cost sheet. Estimated cost sheet helps in the control of
material cost, labour cost and overheads cost at every point of production.
 Facilitates managerial decisions: It helps in taking important decisions by the management
such as: whether to produce or buy a component, what prices of goods are to be quoted in the
tender, whether to retain or replace an existing machine etc.

COST SHEET – FORMAT (DETAILED)

Particulars Amount Amount

Opening Stock of Raw Material ***
Add: Purchase of Raw materials ***
Add: Purchase Expenses ***
Less: Closing stock of Raw Materials ***
Raw Materials Consumed ***
Direct Wages (Labour) ***
Direct Charges ***
Prime cost (1) ***
Add :- Factory Over Heads:
Factory Rent ***
Factory Power ***
Indirect Material ***
Indirect Wages ***
Supervisor Salary ***
Drawing Office Salary ***
Factory Insurance ***
Factory Asset Depreciation ***
Works cost Incurred ***
Add: Opening Stock of WIP ***
Less: Closing Stock of WIP ***
Works cost / Factory Cost (2) ***

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Add:- Administration Over Heads:-
Office Rent ***
Asset Depreciation ***
General Charges ***
Audit Fees ***
Bank Charges ***
Counting house Salary ***
Other Office Expenses ***
Cost of Production (3) ***
Add: Opening stock of Finished Goods ***
Less: Closing stock of Finished Goods ***
Cost of Goods Sold (4) ***
Add:- Selling and Distribution OH:-
Sales man Commission ***
Sales man salary ***
Traveling Expenses ***
Advertisement ***
Delivery man expenses ***
Sales Tax ***
Bad Debts ***
Cost of Sales (5) ***
Profit (balancing figure) ***
Sales ***

Notes:-
 Factory Over Heads are recovered as a percentage of direct wages
 Administration Over Heads, Selling and Distribution Overheads are recovered as a
percentage of works cost.

COST SHEET – FORMAT (SIMPLEST METHOD)
Particulars Amount Amount
Opening stock of raw materials xxxx
Add—purchase xxxx
Less-- closing stock of raw material xxxx
Value of raw materials consumed xxxx
Wages xxxx
Prime cost xxxx
Factory overheads xxxx
Add-- opening stock of work in progress xxxx
Less-- closing stock of work in progress xxxx
Factory cost xxxx
Add-- Administration overhead xxxx
Cost of production of goods manufactured xxxx
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Add--opening stock of finished goods xxxx
Less-- closing stock of finished goods xxxx
Cost of production of goods sold xxxx
Add-- selling and distribution overheads xxxx
Cost of sales xxxx
Profit xxxx
Sales xxxx

Example 1
Following information has been obtained from the records of left center corporation for the period from
June 1 to June 30, 1998.
Cost of raw materials on June 1,1998 30,000

Purchase of raw materials during the month 4,50,000

Wages paid 2,30,000

Factory overheads 92,000

Cost of work in progress on June 1, 1998 12,000

Cost of raw materials on June 30, 1998 15,000

Cost of stock of finished goods on June 1, 1998 60,000

Cost of stock of finished goods on June 30, 1998 55,000

Selling and distribution overheads 20,000

Sales 9,00,000

Administration overheads 30,000

Prepare a statement of cost.

Solution
Statement of cost of production of goods manufactured for the period ending on June 30, 1998.
Particulars Amount Amount
Opening stock of raw materials 30,000
Add—purchase 4,50,000
4,80,000
Less-- closing stock of raw material 15,000
Value of raw materials consumed 4,65,000
Wages 2,30,000
Prime cost 6,95,000
Factory overheads 92,000
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 7,87,000
Add-- opening stock of work in progress 12,000
Factory cost 7,99,000
Add-- Administration overhead 30,000
Cost of production of goods manufactured 8,29,000
Add--opening stock of finished goods 60,000
8,89,000
Less-- closing stock of finished goods 55,000
Cost of production of goods sold 8,34,000
Add-- selling and distribution overheads 20,000
Cost of sales 8,54,000
Profit 46,000
Sales 9,00,000

Example 2
From the following information, prepare a cost sheet showing the total cost per ton for the period
ended on December 31, 1998.
Raw materials 33,000 Rent and taxes (office) 500
Productive wages 35,000 Water supply 1,200
Direct expenses 3,000 Factory insurance 1,100
Unproductive wages 10,500 Office insurance 500
Factory rent and taxes 2,200 Legal expenses 400
Factory lighting 1,500 Rent of warehouse 300
Factory heating 4,400 Depreciation--
Motive power Haulage 3,000 Plant and machinery 2,000
Director’s fees (works) 1,000 Office building 1,000
Directors fees (office) 2,000 Delivery vans 200
Factory cleaning 500 Bad debt 100
Sundry office expenses 200 Advertising 300
Expenses 800 Sales department salaries 1,500
Factory stationery 750 Up keeping of delivery vans 700
Office stationery 900 Bank charges 50
Loose tools written off 600 Commission on sales 1,500
The total output for the period has been 10000 tons.
Solution
Cost sheet for the period ended on December 31, 1998
Particulars Amount Amount
Raw materials 33,000
Production wages 35,000
Direct expenses 3,000
Prime cost 71,000
Add--works overheads:

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Unproductive wages 10,500
Factory rent and taxes 2,200
Factory lighting 1,500
Factory heating 4,400
Motive power Haulage 3,000
Directors’ fees (works) 1,000
Factory cleaning 500
Estimating expenses 800
Factory stationery 750
Loses tools written off 600
Water supply 1,200
Factory insurance 1,100
Depreciation of plant and machinery 2,000 29,550
Works cost 100550
Add-- office overhead:
Directors’ fees (office) 2,000
Sundry office expenses 200
Office stationery 900
Rent and taxes (office) 500
Office insurance 500
Legal expenses 400
Depreciation of office building 1,000
Bank charges 50 5,550
Office cost 106100
Add-- selling and distribution overheads:
Rent of warehouse 300
Depreciation on delivery vans 200
Bad debts 100
Advertising 300
Sales department salaries 1,500
Commission on sales 1,500
Upkeep of delivery vans 700 4600
Total cost 110700
Cost per ton Rs.1,10,700/10,000 = Rs.11.07

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What is a Cost Accounting System?
A cost accounting system (also called product costing system or costing system) is a framework
used by firms to estimate the cost of their products for profitability analysis, inventory valuation
and cost control.
Estimating the accurate cost of products is critical for profitable operations. A firm must know
which products are profitable and which ones are not, and this can be ascertained only when it
has estimated the correct cost of the product. Further, a product costing system helps in
estimating the closing value of materials inventory, work-in-progress and finished goods
inventory for the purpose of financial statement preparation.

The Five Parts of a Cost Accounting System

A cost accounting system requires five parts that include:
1. An input measurement basis,
2. An inventory valuation method,
3. A cost accumulation method,
4. A cost flow assumption, and
5. A capability of recording inventory cost flows at certain intervals.

These five parts and the alternatives under each part are summarized in Exhibit 2-1. Note that
many possible cost accounting systems can be designed from the various combinations of the
available alternatives, although not all of the alternatives are compatible. Selecting one part from
each category provides a basis for developing an operational definition of a specific cost
accounting system.

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1. Input Measurement Bases: The basis of a cost accounting system begins with the type of
costs that flow into and through the inventory accounts. There are three alternatives
including: pure historical costing, normal historical costing and standard costing. These
concepts are illustrated in Exhibit 2-2 and discussed individually below.

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  Pure Historical Costing: In a pure historical cost system, only historical costs flow
through the inventory accounts. Historical costs refers to the costs that have been
recorded. The term actual costs is sometimes used instead, but the term "actual" seems to
imply that there is one true cost associated with a particular output. But determining the
cost of a product, or service requires many cost allocations, e.g., allocating the cost of
fixed assets to time periods, and allocating indirect manufacturing costs, or overhead to
products. Since there are many alternative allocation methods, (e.g., straight line or
accelerated depreciation) the calculated cost of a unit of product or service simply
represents an attempt to approximate the true cost. A pure historical cost system is
symbolized in the top left section of Exhibit 2-2.
 Normal Historical Costing: Normal historical costing uses historical costs for direct
material and direct labor, but overhead is charged, or applied to the inventory using a
predetermined overhead rate per activity measure. Typical activity measures include
direct labor hours, or direct labor costs. The amount of factory overhead charged to the
inventory is determined by multiplying the predetermined rate by the actual quantity of
the activity measure. The difference between the applied overhead costs and the actual
overhead costs represents an overhead variance. The concept is represented in the top
right section of Exhibit 2-2. This type of cost system is illustrated in Chapter 4and
Chapter 5. Predetermined overhead rates and overhead variance analysis are discussed in
those and subsequent chapters.
 Standard Costing: In a standard cost system, all manufacturing costs are applied, or
charged to the inventory using standard or predetermined prices, and quantities. The
differences between the applied costs and the actual costs are charged to variance
accounts as shown symbolically in the lower section of Exhibit 2-2. The variances
provide the basis for the concept of accounting control, which is somewhat different from
the statistical control concept discussed in Chapter 1. This type of basic cost system is

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 illustrated in Chapter 9 and Chapter 10. Standard cost variance analysis is given
considerable attention in Chapter 10.
2. Four Inventory Valuation Methods: The four inventory valuation methods that appear in
Exhibit 2-1 are arranged in the order of the amount of cost that is traced to the inventory. The
throughput method involves tracing the least amount of cost to the inventory, while the
activity based method includes tracing the greatest amount of costs to the inventory. In direct
(or variable) costing, a greater amount of cost is traced than in the throughput method, but a
lesser amount than in the full absorption method. Direct costing and full absorption costing
are the traditional methods, while the throughput and activity based methods are relatively
new. These inventory valuation methods are very important because they control the manner
in which net income is determined. As we shall see is this chapter and subsequent chapters,
the amount of net income can vary tremendously for different inventory valuation methods.
The four methods are described below.
 The Throughput Method: The throughput method was developed to complement a
concept referred to as the theory of constraints. In this method only direct material costs
are charged to the inventory. All other costs are expensed during the period. The concept
is symbolized in the top left section of Exhibit 2-3. Sales, less direct material costs is
referred to as throughput which reflects how the method got its’ name. The throughput
method does not provide proper matching (as defined by GAAP) because all
manufacturing cost, other than direct material are expensed when incurred rather than
capitalized in the inventory. Therefore, the throughput method is not acceptable for
external reporting although advocates argue that it provides many advantages for internal
reporting. The throughput method is described in more detail in Chapter 8 along with the
broader concept referred to as the theory of constraints.

 The Direct or Variable Method: In the direct (or variable) method, only the variable
manufacturing costs are capitalized, or charged to the inventory. Fixed manufacturing

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 costs flow into expense in the period incurred as illustrated in the top right section of
Exhibit 2-3. This method provides some advantages and some disadvantages for internal
reporting, (as we shall see in Chapter 8, Chapter 11, and Chapter 13). However, it does
not provide proper matching because the current fixed costs associated with producing
the inventory are charged to expense regardless of whether or not the output is sold
during the period. For this reason direct costing is not generally acceptable for external
reporting.
 The Full Absorption Method: Full absorption costing (also referred to as full costing
and absorption costing) is a traditional method where all manufacturing costs are
capitalized in the inventory, i.e., charged to the inventory and become assets. This means
that these costs do not become expenses until the inventory is sold. In this way, matching
is more closely approximated. All selling and administrative costs are charged to expense
however, as indicated in the lower left section of Exhibit 2-3. Technically, full absorption
costing is required for external reporting, although many companies apparently use
something less than a pure full absorption costing system. The full absorption method is
also frequently used for internal reporting. The second major section of this chapter
compares the income statements for full absorption costing with those used for direct
costing because they are by far the dominant methods. Chapter 4, Chapter 5, Chapter 6,
Chapter 9 and Chapter 10 are based on full absorption costing. Chapters 8 compares all
four methods and includes a discussion of the behavioral implications of using the
different methods.
 The Activity Based Method: Activity based costing is a relatively new type of
procedure that can be used as an inventory valuation method. The technique was
developed to provide more accurate product costs. This improved accuracy is
accomplished by tracing costs to products through activities. In other words, costs are
traced to activities (activity costing) and then these costs are traced, in a second stage, to
the products that use the activities. The concept of ABC is illustrated in the lower right
section of Exhibit 2-3. Another way to express the idea is to say that activities consume
resources and products consume activities. Essentially, an attempt is made to treat all
costs as variable, recognizing that all costs vary with something, whether it is production
volume or some non-production volume related phenomenon. Both manufacturing costs
and selling and administrative costs are traced to products in an ABC system. Note that
treating selling and administrative costs in this way is not acceptable for external
reporting.

3. Four Cost Accumulation Methods: Cost accumulation refers to the manner in which costs
are collected and identified with specific customers, jobs, batches, orders, departments and
processes. The center of attention for cost accumulation can be individual customers, batches
of products that may involve several customers, the products produced within individual
segments during a period, or the products produced by the entire plant during a period. The
company’s cost accumulation method, or methods are influenced by the type of production
operation (See the Product-Process Matrix below and the Hayes & Wheelwright summaries
for more information), and the extent to which detailed cost accounting information is needed

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 by management. The four accumulation methods that appear in Exhibit 2-1 are discussed
below.

 Job Order: In job order costing, costs are accumulated by jobs, orders, contracts, or lots.
The key is that the work is done to the customer's specifications. As a result, each job
tends to be different. For example, job order costing is used for construction projects,
government contracts, shipbuilding, automobile repair, job printing, textbooks, toys,
wood furniture, office machines, caskets, machine tools, and luggage. Accumulating the
cost of professional services (e.g., lawyers, doctors and CPA's) also fall into this
category. Chapter 4 illustrates a cost accounting system that includes normal historical
costing as the basic cost system, full absorption costing as the inventory valuation method
and job order costing as the cost accumulation method.
 Process: In process costing, costs are accumulated by departments, operations, or
processes. The work performed on each unit is standardized, or uniform where a
continuous mass production or assembly operation is involved. For example, process
costing is used by companies that produce appliances, alcoholic beverages, tires, sugar,
breakfast cereals, leather, paint, coal, textiles, lumber, candy, coke, plastics, rubber,
cigarettes, shoes, typewriters, cement, gasoline, steel, baby foods, flour, glass, men's
suits, pharmaceuticals and automobiles. Process costing is also used in meat packing and
for public utility services such as water, gas and electricity. Chapter 5 illustrates a cost
accounting system that includes normal historical costing as the basic cost system, full
absorption costing as the inventory valuation method and process costing as the cost
accumulation method.
 Back Flush: Back flush costing is a simplified cost accumulation method that is
sometimes used by companies that adopt just-in-time (JIT) production systems. However,
JIT is not just a technique, or collection of techniques. Just-in-time is a very broad

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 philosophy, that emphasizes simplification and continuously reducing waste in all areas
of business activity. JIT systems were developed in Japan and depend on the
communitarian concepts of teamwork and continuous improvement. In fact, many of the
assumptions, attitudes and practices of communitarian capitalism are included in the JIT
philosophy. One of the many goals of JIT systems is zero ending inventory. In a
backflush cost system, manufacturing costs are accumulated in fewer inventory accounts
than when using the job order or process cost methods. In fact, in extreme backflush
systems, most of the accounting records are eliminated. The production facilities are also
arranged in self contained manufacturing cells that are dedicated to the production of a
single, or similar products. In this way more of the manufacturing costs become direct
product costs and fewer cost allocations are necessary. Thus, more accurate costing is
obtained in spite of the fact that the cost accumulation method is simplified. The just-in-
time philosophy and related accounting methods are discussed in Chapter 8.
 Hybrid, or Mixed Methods: Hybrid or mixed systems are used in situations where more
than one cost accumulation method is required. For example, in some cases process
costing is used for direct materials and job order costing is used for conversion costs,
(i.e., direct labor and factory overhead). In other cases, job order costing might be used
for direct materials, and process costing for conversion costs. The different departments
or operations within a company might require different cost accumulation methods. For
this reason, hybrid or mixed cost accumulation methods are sometime referred to as
operational costing methods.
4. Four Cost Flow Assumptions: A cost flow assumption refers to how costs flow through the
inventory accounts, not the flow of work or products on a production line. This distinction is
important because the flow of costs is not always the same as the flow of work. The various
types of cost flow assumptions include: specific identification (e.g., by job), first in, first out,
last in, first out and weighted average. Costs flow through the inventory accounts by the job
in a job order cost system which represents an example of specific identification. The
requirements of the various jobs determines the timing of the cost flows. Simple jobs tend to
move through the system faster than more complex jobs. The first-in, first-out (FIFO) and
weighted average cost flow assumptions are used in process costing. Since costs are
accumulated by the process or department in a process cost environment, a cost flow
assumption is needed to determine the treatment of the beginning inventory. When FIFO is
used, it is assumed that the units of product in the beginning inventory are finished first and
transferred to the next department before any of the units that are started during the period.
The group of units in the beginning inventory maintain their separate identity and prior
period costs. However, when the weighted average cost flow assumption is used, the
beginning inventory units lose their separate identity because they are lumped together with
the units of product started during the period. Process costing tends to be fairly challenging,
therefore you may find these introductory concepts to be confusing. Don’t worry, these
concepts will be easier to understand when we consider an operational process cost
accumulation system in Chapter 5.
Although last-in, first-out (LIFO) is frequently used for tax reporting purposes, it is not normally
used in the accounting records. For this reason, we consider the FIFO and weighted average
cost flow assumptions in Chapter 5, but leave the LIFO cost flow assumption for courses that
emphasize financial and tax reporting.

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5. Recording Interval Capability: Inventory records can be maintained on a perpetual or a
periodic basis. Conceptually, the perpetual inventory method provides a company with the
capability of maintaining continuous records of the quantities of inventory and the costs
flowing through the inventory accounts. The periodic method, on the other hand, requires
counting the quantity of inventory before inventory records can be updated. In the past,
manufacturers tended to keep perpetual inventories, while retailers used the periodic method.
However, today a variety of modern point of sale devices and dedicated microcomputer
software are readily available to provide any company with perpetual inventory capability.

Job Order Costing: Features, Objectives and Procedure

What is job order costing?

Job order costing system is generally used by companies that manufacture a number of different
products. It is a widely used costing system in manufacturing as well as service industries.
Manufacturing companies using job order costing system usually receive orders for customized
products and services. These customized orders are known as jobs or batches. A clothing factory,
for example, may receive an order for men shirts with particular size, color, and design.
When companies accept orders or jobs for different products, the assignment of cost to products
becomes a difficult task. In these circumstances, the cost record for each individual job is kept
because each job have a different product and, therefore, different cost associated with it.
The per unit cost of a particular job is computed by dividing the total cost allocated to that job by
the number of units in the job. The per unit cost formula is given below:

Per unit cost = Total cost applicable to job / Number of units in the job

Examples of manufacturing businesses that use job order costing system include clothing
factories, food companies, air craft manufacturing companies etc.
Examples of service businesses that use job order costing system include movie producers,
accounting firms, law firms, hospitals etc.

Definition: A job order cost accounting system uses job cost sheets, material cost flow
documents, labor cost flow documents, and overhead cost flow documents to track the production
expenses of producing a job or job lot. In other words, a job order cost accounting system tracks
each and every expenditure the company makes in order to produce a product.
Most manufacturers produce many different products. Each of these products requires a slightly
different production process. Each job or job lot has a specific budgeted cost to produce and an
estimated selling price.

Features of Job Order Costing:Under this method, costs are collected and accumulated for each
job, work order or project separately. Each job can be separately identified and hence it becomes
essential to analyse the costs according to each job.

The industries, where this method of costing is applied, must possess the following features:
 The production is generally against customer’s order but not for stock.
 Each job has its own characteristics and needs special treatment.

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  There is no uniformity in the flow of production from department to department. The
nature of the job determines the departments through which the job has to be processed.
The production is intermittent and not continuous.
 Each job is treated as a host unit under this method of costing.
 Each job is distinctively identified by a production order throughout the production stage.
 The cost of production of every job is ascertained after the completion of the job.
 The work-in-progress differs from period to period according to the number of jobs in
hand.
Thus, cost is ascertained for each job separately. This method is applicable to printers, machine
tools manufacturers, foundries, general engineering workshops, advertising, interior decoration
and case making etc.

Objectives of Job Order Costing:

Following are the main objectives of job order costing:
 It helps to find out the cost of production of every job or order and to know the profit or
loss made on its execution. This ultimately helps the management to judge the
profitability of each job and decide the future course of action.
 It helps the management to make more accurate estimates for costs of similar jobs to be
executed in future on the basis of past records. Management can easily and accurately
determine and quote prices of jobs of a similar nature which are in prospect.
 It helps the management to control the operational inefficiency by making a comparison
of actual costs with estimated ones.
 It helps the management to provide a valuation of work-in-progress.

The following factors must be considered before adopting a system of job order costing:
 Each job (or order) should be continuously identifiable from the stage of raw materials to
completion stage.
 This system should be adopted when it becomes absolutely necessary as it is very expensive
and requires a lot of clerical work in estimating costs, designing and scheduling of
production.

Pre-Requisites for Job Order Costing:

In order to achieve the purposes of job order costing a considerable amount of clerical work
will be involved and to ensure effective and workable system, the following factors
are necessary:
(а) A sound system of production control.
Comprehensive works documentation, typically this includes: work order and/or operation
tickets, bills of materials and/or materials requisitions, jig and tool requisitions etc.
An appropriate time booking system using either time sheets or piece work tickets.
A well organised basis to the costing system with clearly defines cost centres, good labour
analysis, appropriate overhead absorption rates and a relevant issue pricing system.

Advantages of Job Order Costing:

1. It provides a detailed analysis of cost of materials, wages, and overheads classified by
functions, departments and nature of expenses which enable the management to determine

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 the operating efficiency of the different factors of production, production centres and the
functional units.
2. It records costs more accurately and facilitates cost control by comparing actual with
estimates.
3. It enables the management to ascertain which of the jobs are more profitable than the others,
which are less profitable and which are incurring losses.
4. It provides a basis for estimating the cost of similar jobs taken up in future and thus helps in
future production planning.
5. Determination of predetermined overhead rates in job costing necessitates the application of
a system of budgetary control of overheads with all its advantages.
6. Identification of spoilage and defectives with the respective production orders and
departments may enable the management to take effective steps in reducing these to the
minimum.
7. The detailed cost records of the past years can be used for statistical purposes in the
determination of the trends of cost of the different types of jobs and their relative efficiencies.
8. It is useful in quoting cost plus contract.

Disadvantages of Job Order Costing:

1. It involves a great deal of clerical work in recording daily the cost of materials issued, wages
expended and overheads chargeable to each job or work order which adds to the cost of cost
accounting. Thus it is expensive.
2. The scope of committing mistakes is enough as the cost of one job may be wrongly posted to
the cost of other job.
3. Cost comparison among different jobs becomes difficult especially when drastic changes
take place.
4. Determination of overhead rates may involve budgeting of overhead expenses and the bases
of overhead apportionment and absorption but unless such budgeting is complete i.e.,
extended to material, labour and expenses, its advantages are considerably reduced.
5. Job costing is historical costing which ascertains the cost of a job or product after it has been
manufactured. It does not facilitate control of cost unless it is used with standard or estimated
costing.

Procedure of Job Order Cost System:

A cost accounting system should be so designed that it would be able to provide the necessary
information for achieving control of cost and performance. Thus it shows in detail their cost
components of the total cost of executing a job which may take the form of either a special order
or job or a batch of orders.
A job cost sheet is prepared for every job which is undertaken on the basis of material requisition
concerned. Labour cost on the basis of time clocked in respect of the job with the help of time
tickets and factory overheads are added to these cost components according to some rational
methods of overhead absorption.
The total cost of a job as indicated by the job cost sheet consists partly of direct cost and partly of
costs arrived at by assignment, allocation, apportionment and finally by absorption. Thus it is
clear that similar jobs executed during a certain time period are bound to have different units of
production. Unit cost is determined by dividing total cost by the number of units or a volume of
goods produced there under
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The procedure for job order cost system may be summarised as follows:
 Receiving an Enquiry: The customer will usually enquire about the price, quality to be
maintained, the duration within which the order is to be executed and other specification
of the job before placing an order.
 Estimation of the Price of the Job: The cost accountant estimates the cost of the job
keeping in mind the specification of the customer. While preparing estimate, the cost of
execution of similar job in the previous year and possible changes in the various
estimates of cost are taken into consideration. The prospective customer is informed with
the estimate of the job.
 Receiving of Order: If the customer is satisfied with the quotation price and other terms
of execution, he will then place the order.
 Production Order: If the job is accepted, a Production Order is made by the Planning
Department. It is in the form of instructions issued to the foreman to proceed with the
manufacture of the product. It forms an authority for starting the work.
 It contains all the information regarding production. It is prepared with sufficient copies
so that a copy of the same may be given to all the departmental managers or for man who
are required to take any part in the production.

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 A specimen of production order is given below:

 When an order is received, the Production Control Department allots a Production Order
Number to it. Sometimes, the work may be sub-divided and sub-numbers may also be
allotted to various works constituting it in addition to one master number.
 Recording of Costs:
The costs are collected and recorded for each job under separate Production Order Number.
Generally, Job Cost Sheet (or Card) is maintained for each job. This is a document which
is used to record direct material, direct wages and overheads applicable to respective
jobs.

The bases of collection of costs are:

 Materials: Materials Requisitions, Bill of Materials or Materials Issue Analysis Sheet.

 Wages: Operation Schedule, Job Card or Wages Analysis Sheet.
 Overheads: Standing Order Numbers or Cost Account Numbers. All the basic
documents will contain cross reference to respective production order numbers for
convenience in collection of costs.
 Completion of Job: On completion of a job, a completion report is sent to costing
department. The expenditure under each element of cost is totalled and the total job cost
is ascertained. The actual cost is compared with the estimated cost so as to reveal
efficiency or inefficiency in operation.
 Profit or Loss on Job: It is determined by comparing the actual expenditure or cost with
the price obtained.

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 

A specimen of Job Cost Sheet is as given below:

What is process costing?

A manufacturing unit that can differentiate its processes and produces a standard product will use
process costing method to determine cost of production. This is done by allocating all process
cost to the total units produced.
In simple words, if an unit passes through different processes and the processes are easily
distinguishable then the cost of the unit will be cost of process that it goes through.
In process costing a separate account is opened for every process and on completion of the
process the cost is transferred to the next process.

Definition: Process Costing is defined as a branch of operation costing, that determines the cost
of a product at each stage, i.e. process of production. It is an accounting method which is adopted
by the factories or industries where the standardized identical product is produced, as well as it
passes through multiple processes for being transformed into the final product.

In simple words, process costing is a cost accounting technique, in which the costs incurred
during production are charged to processes and averaged over the total units manufactured.
For this purpose, process accounts are opened in the books of accounts, for each process and all
the expenses relating to the process for the period is charged to the respective process account.
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Hence, it ascertains the total cost and unit cost of a process, for all the processes carried out in
industry. Further, the average cost represents the cost per unit, wherein the total cost is divided by
the total number of outputs produced during the period to arrive at the cost per unit. The cost per
unit can be calculated using First in First Out Method (FIFO), Average Method and
Weighted average Method.

Features of Process Costing

 The plant has various divisions, and each division is a stage of production.
 The production is carried out continuously, by way of the simultaneous, standardized and
sequential process.
 The output of a process is the input of another.
 The production from the last process is transferred to finished stock.
 The final product is homogeneous.
 Both direct and indirect costs are charged to the processes.
 The production may result in joint and by-products.
 Losses like normal and abnormal loss occur at different stages of production which are
also taken into consideration while calculating the unit cost.
 The output of one process is transferred to another one at a price that includes the profit
of the previous process and not at the cost.
 At the end of the period, if there remains the stock of finished goods, then it is also
expressed in equivalent completed units. It can be calculated as:
Equivalent units of semi-finished goods or WIP = Actual number of units in process
× Percentage of work completed

Process costing is employed by the industries whose production process is continuous and
repetitive, as well as the output of one process is the input of another process. So, chemical
industry, oil refineries, cement industries, textile industries, soap manufacturing industries,
paper manufacturing industries use this method

Process Losses and Gains:

It is usual that a certain amount of material introduced into the processes are lost, scrapped or
wasted. There are many ways in which losses may arise e.g., evaporation, shrinkage, breakages,
spoilage for various reasons.

The process loss can be categorized into:

 Normal process loss, and

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  Abnormal process loss.
 Normal Loss: The loss expected during the normal course of operations, for unavoidable
reasons is called ‘normal loss’ and this is due to inherent result of the particular process
and thus uncontrollable in the short-run. Management usually able to identify an average
percentage of normal losses expected to arise from the production process.
For example, 100 kgs. introduced into the production process and on an average 95 kgs.
comes out after the process, we can say that the normal process loss is 5%. The normal
losses are absorbed by the completed production.
The cost of normal losses should be borne by the good production. If any value can be
recouped from sale of scrap or wastage or spoilage etc., then this would be credited to the
Process Account thus reducing the overall cost of the process.
 Abnormal Loss: Abnormal losses are those losses above the level deemed to be the
normal loss rate for the process. The abnormal loss is the amount by which the actual loss
exceeds the normal loss and it is expected to arise under inefficient operating conditions.
For example, if 100 kgs. of material introduced into the process and the expected normal
loss is 5%, and if the actual output from the process is 92 kgs. the abnormal loss is
calculated as below:

The abnormal losses are not included in the process costs but are removed from the
appropriate Process Account and reported separately as an abnormal loss. The abnormal
loss is treated as a period cost and written off to the Profit and Loss Account at the end of
the period.
 Abnormal losses are credited out of the Process Account into an abnormal loss account at
the full unit cost value. Abnormal losses will be costed on the same basis as good
production and therefore, like good production, will carry a share of cost of normal losses.
 Abnormal Gain: If the loss is less than the normal expected loss, the difference is
considered as abnormal gain. Abnormal gain is accounted similar to that abnormal loss.
Abnormal gains will be debited to the Process Account and credited to Abnormal Gain
Account. The Abnormal Gain Account is debited with the figure of reduced normal loss in
quantity and value. At the end of the accounting year the balance in the Abnormal Gain
Account will be carried to Profit and Loss Account.
 Value of Scrap: The value of scrap, treated as normal loss, received from its sale is
credited to the Process A/c. But the value of scrap received from its sale under abnormal
conditions should be credited to Abnormal Loss A/c.

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 

Activity Based Costing

What is Activity Based Costing?

Activity-based costing systems (also known as ABC costing) is a type of cost allocation process
where it identifies all types of company’s costs and allocates them to the costs to the products on
the basis of actual consumption.
Examples include square footage that is used per product and the same would be used to allocate
the rent of the factory as well as the maintenance cost of the firm and similarly the number of
purchase orders (i.e. PO) used to allocate the purchasing expenses of the purchasing department.

Stages and Flow of Costs in ABC:

There are two primary stages in ABC— first, tracing costs to activities; second, tracing activities
to products.
The different steps in the two stages of ABC are explained below:
 Step 1: Identify the main activities in the organisation.
Examples include: Materials handling, purchasing, receipt, dispatch, machining, assembly and
so on.
 Step 2: Identify the factors which determine the costs of an activity. These are known as cost
drivers. Examples include: number of purchase orders, number of orders delivered, number
of set-ups and so on.
 Step 3: Collect the costs of each activity. These are known as cost pools and are directly
equivalent to conventional cost centres.
 Step 4: Charge support overheads to products on the basis of their usage of the activity,
expressed in terms of the chosen cost driver (s). For example, if the total costs of purchasing
were Rs 2, 00,000 and there were 1,000 Purchase orders (the chosen cost driver), products
would be charged Rs 200 per purchase order. Thus a batch generating 3 purchase orders
would be charged 3 x Rs 200 = Rs 600 for Purchasing overheads.
ABC follows a two-stage cost assignment procedure and assigns resource costs such as factory
overhead costs to activity cost centres or cost pools and then to cost objects to determine the
amount of resource costs for each of the cost objects. That is, resources (costs) are assigned
to activities. Activity cost is then assigned cost objects.

The flow of cost assignment in ABC is exhibited in Exhibit 4.1 below:

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Five Basic Components of ABC:
1. Resources
2. Resource Drivers
3. Activities
4. Activity Cost Drivers, and
5. Cost Objects
1. Resources: Resources are what organizations spend their money on—the categories of costs
that are recorded. Resource is defined as an economic or money element that is applied or used
in the performance of activities. Salaries and materials, for examples, are resources used in the
performance of activities. Additional examples of resources include repair, inspection, rent,
depreciation, utilities, insurance, and supplies. Most ABC systems currently exclude costs like
income taxes and interest expense that are not used in the performance of activities.
2. Resource Drivers: Resource drivers are the basis for tracing resources to activities. Resource
driver is defined as a measure of the quantity of resource consumed by an activity. An example
of a resource driver is the percentage of total square feet of space occupied by an activity. This
factor is used to trace a portion of the cost of operating the facilities to the activity.
Examples of common resource drivers for salaries/wages, rent, equipment, depreciation,
and utilities include the following:

3. Activities: An activity is a unit of work. If you go to u restaurant for lunch/dinner, a

waiter or waiters might perform the following units of work:
 Seat customer and offer menu

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 Take your order
 Send orders to kitchen
 Bring food
 Replenish beverages
 Determine and bring bill
 Collect money and give change
 Clear table

Each of these is an activity and the performance of each activity consumes resources that cost
money.
Activities represent work performed in an organization. The cost of activities is determined by
tracing resource to activities using the resource drivers. An example of how the salaries of a
receiving department of a manufacturing company might be traced to receiving department
activities is illustrated in Exhibit 4-2. In this example, the resource is receiving department
salaries.

Assuming that salaries were the only resource of the receiving department, calculating the cost of
receiving department activities would be quite simple. All that is required is to multiply the

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percentage of people’s time (resource driver) by the salary amount.

If receiving department salaries totaled Rs 20 lakhs, the cost of each activity would be as
follows:
 Receive materials – Rs 2, 00,000
 Unload trucks – Rs 4, 00,000
 Move material – Rs 2, 00, 000
 Schedule receipts – Rs 3, 00, 000
 Expedite material – Rs 4, 00, 000
 Resolve Vendor Errors – Rs 5, 00, 000
 Total – Rs 20, 00, 000

In practice, a single resource and resource driver would be rare. The receiving department of a
large organization is likely to have multiple resource and resource drivers. Total activity cost
would be determined by tracing each resource (using an appropriate resource driver) to the
receiving department activities. Once determined, activity costs can be traced to cost objects
using activity drivers.
4. Activity Cost Drivers: Like a resource driver that is used to trace resource to activities, an
activity cost driver is used to trace activity costs to cost objects. Activity driver is defined as a
measure of the frequency and intensity of the demands placed on activities by cost objects. An
activity driver is used to assign costs to cost objects.
A cost driver is an activity which generates cost. A cost driver is a factor, such as the level of
activity or volume, that causally affects costs (over a given time span). That is, a cause-and-
effect relationship exists between a change in the level of activity or volume and a change in the
level of the total costs of that cost object. Thus, cost drivers signify factors, forces or events that
determine the costs of activities. Based on activity usage (consumption), activity costs are traced
to cost objects.
In a manufacturing organization, the following are examples of some activity cost drivers:
Some Examples of Activity Cost Drivers:
1. Number of receiving orders for the receiving department.
2. Number of purchase orders for the cost of operating the purchase department.
3. Number of dispatch orders for the dispatch department.
4. Number of units.
5. Number of setups.
6. Amount of labour cost incurred.
7. Value of materials in a product.
8. Number of materials handling hours.
9. Number of inspections.
10. Number of schedule changes.
11. Number of parts received per month.
12. Number of machine hours used on a product.
13. Number of set up hours
14. Number of direct labour hours.
15. Number of sub-assemblies.
16. Number of vendors.
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 17. Number of purchasing and ordering hours.
18. Number of units scrapped.
19. Number of labour transactions.
20. Number of customer orders processed
21. Number of parts
22. Number of employees.
It should be understand that direct costs do not need cost drivers as they can be traced directly to
a product. Direct costs are themselves cost drivers. However, all other factory or manufacturing
costs need cost drivers. The cost driver of variable costs is the level of activity or volume whose
change causes the variable costs to change proportionately.
Costs that are fixed in the short run have no cost drivers in the short run but may have cost
drivers in the long run. For instance, costs of testing personal computers (which comprise costs
of testing department equipment and staff costs) may not change with changes in the volume of
production.
Therefore, these costs would be fixed in the short run. In the long run. However, an organisation
may need to increase/decrease testing department’s equipment and staff to the levels needed to
support future production volumes. So, in the long run, volume of production or activity
becomes cost drivers of these testing and staff costs.

Selection of Activity Cost Drivers:

In traditional product costing, the number of cost drivers used are few such as direct labour
hours, machine hours, direct labour cost, units produced. But ABC may use a multitude of cost
drivers that relate costs more closely to the resources consumed and activities occurring. There
are difficulties in choosing realistic cost drivers. There are no simple rules that pertain to the
selection of cost drivers.
The best approach is to identify the resources that constitute a significant proportion of the
product costs and to determine their cost behaviour. When identifying and selecting activity
drivers, match the activity to the activity level, which is defined as a description of how an
activity is used by a cost object (product/service) or activity. Some activity levels describe the
cost object that uses the activity and nature of its use.
Accounting to Hilton, the following three factors are important in selecting appropriate
cost drivers:
1. Degree of Correlation: The central concept of an activity-based costing system is to assign
the costs of each activity to product lines on the basis of how each product line consumes the
cost driver identified for that activity. The idea is to infer how each product line consumes
the activity by observing how each product lines consumes the cost driver. Therefore, the
accuracy of the resulting cost assignments depends on the degree of correlation between
consumption of the activity and consumption of the cost driver.
2. Cost of Measurement: Designing any information system entails cost-benefit trade-offs.
Tile more activity cost pools there are in an activity-based costing system, the greater will be
the accuracy of the cost assignments. However, more activity cost pools also entail more cost
drivers, which results in greater costs of implementing and maintaining the system.
Similarly, the higher the correlation between a cost driver and the actual consumption of the
associated activity, the greater the accuracy of the cost assignments. However, it may also be

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 more costly to measure the more highly correlated cost driver.
3. Behavioral Effects: Information systems have the potential not only to facilitate decisions
but also to influence the behavior of decision makes. This can be good or bad, depending on
the behavioural effects. In identifying cost drivers, an ABC analyst should consider the
possible behavioral consequences. For example, in a JIT production environment, a key goal
is to reduce inventories and material handing activities to the absolute minimum level
possible.
The number of material moves may be the most accurate measure of the consumption of the
material handling activity for cost assignment purposes. It may also have a desirable
behavioral effect of motivating managers to reduce the number of times materials are moved,
thereby reducing material.

Miller observes that tips for identifying activity drivers include the following:
 Pick activity drivers that correlate with the actual consumption of the activity.
 Minimize the number of unique drivers. Cost and complexity are directly correlated with
the number of drivers.
 Pick activity drivers that encourage improved performance.
 Pick activity drivers that are already available and/or have a low cost of collection.

Activity Based Costing Formula

Activity Based Costing is calculated as

Activity Based Costing Formula = Cost Pool in Total / Cost Driver

The ABC formula can be explained with the following core concepts.
 Cost Pool: This is an item for which measurement of the cost would require e.g. a product
 Cost Driver: It is a factor that will cause a change in the cost of that activity. There are 2
kinds of cost driver:
o Resource Cost Driver: It is a measure of the quantity of resources which shall be
consumed by an activity. This will be used to assign the cost of a resource to an
activity. E.g. Electricity, Staff wages, Advertising, etc.
o Activity Cost Driver: This is the measure of the intensity of demand and the
frequency that is placed on the activities by the cost pools. It will be used to assign
the activity costs to a product or a customer. E.g. Material ordering costs, Machine set
up costs, Inspection and testing charges, Material handling and storing costs, etc.

Types of Cost Drivers:

Customer demand is considered to be basic cost driver. Without customer demand for products
or services, the organisation cannot exist. To serve customers, managers and employees make a
variety of decisions and perform many actions/activities. These decisions and activities,
undertaken to satisfy customer demand, drive costs.

Morse, Davis and Hart-graves suggest that cost drivers should be divided into three
categories:

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1. Structural Cost Drivers: They are fundamental choices about the size and scope of
operations and technologies employed in delivering products or services to customers.
Decisions affecting structural cost drivers are made infrequently and once made, the
organisation is committed to a course of action that will be difficult to change.
For a chain of super market stores, the following may be structural cost drivers:
 Determining the size of stores. This will affect the types of merchandise that can be
provided to customers and operating costs.
 Determining the type of construction. A small size store will involve less cost. But it
may not be suitable to store many other needed items.
 Determining the location of the store. Location in a high class shopping complex will
cost more but will attract more customers.
 Determining the kind of technology used in the stores. A system involving clerks to
keep all records of sales, purchases and inventory may be cheaper. A computerised
systems in the beginning requires higher investment and fixed operating costs. But,
later, it may be less expensive due to high sales volume. Also, it will provide latest
information about all operations.
2. Organisational Cost Drivers: They are choices concerning the organisation of activities and
involvement of persons inside and outside the organisation in decision making. Like
structural cost drivers, organisational cost drivers influence costs by affecting the type of
activities and costs of activities performed to satisfy customer needs. Decisions that affect
organisational cost drivers are made within the context of previous decisions affecting
structural cost drivers. In a manufacturing organisation, previous decisions about plant,
equipment and location are taken as given when decisions impacting organisational cost
drivers are made.
In a manufacturing company, examples of organisational cost drivers are:
a. Preferring a limited number of suppliers. This may be useful in ensuring proper
supplies in proper quantities at proper time.
b. Authorising employees to make decisions and giving them cost and other data. This
will make employees customer-oriented, reduce costs and improve decision speed.
Production workers, for example, may take steps to reduce manufacturing costs and
defects and spoilage.
c. Deciding components of a product to fit them in the most correct manner. This will
save assembly time and cost and reduce defects.
d. Deciding to manufacture a low-volume product on low speed, general purpose
equipment; rather than high-speed, special purpose equipment.
e. Deciding to reorganise the existing equipment in the factory so that sequential
operations are nearer. This will reduce cost of moving inventory between different
machines.
3. Activity Cost Drivers: Activity cost drivers are specific units of work (activities) performed
to serve customer needs that consume costly resources. The customer may be outside the
organisation, such as a client of an advertising firm or inside the organisation, such as an
accounting office that receives maintenance services. Because the performance of activities
consumes resources and resources cost money, the performance of activities drives cost.

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4. Cost Object: Cost objects, can be any customer, product, service, contract, project, or other
work unit for which a separate cost measurement is desired. The most common cost object is
product or service cost. Activity drivers are used to trace activity costs to cost objects. An
example of how an activity of a sales department might be traced to customer segments (cost
object) is illustrated in Exhibit 4.4.
In this example, the activity of the sales department is ‘make sales calls’. The activity driver is
the number of sales calls. If the objective was to determine the selling cost associated with
costumer segments, then the cost objects might be large customers, medium-sized customers,
and small customers. Assume that the make sales calls activity costs Rs 5, 00,000 and was
the only activity of the department.

If the total sales calls made were 5,000, of which 1,000 were made on large customers, 500
on medium customers, and 3,500 on small customers, the cost of each customer segment
would be:
Large Customers – Rs 1,00,000
Medium Customers – Rs 50,000
Small Customers – Rs 3, 50, 000
Total Activity Cost – Rs 5, 00, 000

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Again, like the Resource Driver Example as displayed earlier, single activities and activity
drivers do not exist. It is only by tracing other sales department activities like prepare proposals,
answer inquires, and take orders that the total cost for each of the customer segments identified
as cost objects could be determined.
The foregoing examples were intended to be simple and to demonstrate the basic concepts of
ABC. Applications of these concepts in practice can be quite complex. Even the simplest of
ABC applications could involve 5 to 10 resources, 25 or more activities, and 10 to 25 cost
objects.
That is why it is important to resist the urge for perfection by defining activities and drivers at
too detailed a level, especially in the early stages of implementation. The goal of ABC is to
provide relevant information useful for decision making, measuring performance, and effecting
improvement. Do not give up relevance for precision.

In a survey conducted jointly by the APQC and CAM-I in USA of over 150 companies
known to have best practices in the area of ABM, the following information was learned:
 About forty percent of respondents indicated the total number of activities for their
organization was between 101 and 250; thirty percent had 26 to 100 activities.
 Thirty-two percent of respondents indicated the total cost objects as between 26 and 100.
Two companies identified over 10,000 cost objects.
 Forty percent of respondents indicated the number of activity drivers as 6 to 15, and
forty- five percent had identified five to ten resource drivers.
 Computers and commercially available ABC software can take much of the drudgery,
difficulty, and complexity out of using ABC methods. These commercial software
applications provide a structured way of identifying, entering, storing, and calculating the
data required for ABC.

Value Chain Analysis (With Diagram)| Cost Accounting

Meaning of Value Chain Analysis:

:
The term ‘Value Chain’ was used by Michael Porter in his book “Competitive Advantage:
Creating and Sustaining Superior Performance” (1985). The value chain analysis describes
the activities the organization performs and links them to the organization competitive position.
Value chain analysis describes the activities within and around an organization, and relates them
to an analysis of the competitive strength of the organization. Therefore, it evaluates which value
each particular activity adds to the organization’s products or services. This idea was built upon
the insight that an organization is more than a random compilation of machinery, equipment,
people and money.

Each of these primary activities is linked to support activities which help to improve their
effectiveness or efficiency. There are four main areas of support activities: procurement,
technology development (including R & D), human resource management, and infrastructure
(systems for planning, finance, quality, information management, etc.).

The basic model of Porter’s Value is as follow:

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The term, ‘Margin’ implies that organizations realize a profit margin that depends on their ability
to manage the linkages between all activities in the value chain. In other words, the organization
is able to deliver a product/service for which the customer is willing to pay more than the sum of
the costs of all activities in the value chain.

Primary Activities:

Steps in Value Chain Analysis:

Value chain analysis can be broken down into a three sequential steps:
 Breakdown a market/organisation into its key activities under each of the major headings
in the model;
 Assess the potential for adding value via cost advantage or differentiation, or identify
current activities where a business appears to be at a competitive disadvantage.
 Determine strategies built around focusing on activities where competitive advantage can
be sustained.
These linkages are crucial for corporate success. The linkages are flows of information, goods
and services, as well as systems and processes for adjusting activities.

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Their importance is best illustrated with some simple examples:
Only if the Marketing and Sales function delivers sales forecasts for the next period to all other
departments in time and in reliable accuracy, procurement section will be able to order the
necessary material for the correct date.
And only if procurement section does a good job and forwards order information to inbound
logistics, only then operations will be able to schedule production in a way that guarantees the
delivery of products in a timely and effective manner—as pre-determined by marketing.
In the result, the linkages are about seamless cooperation and information flow between the
value chain activities. In most industries, it is rather unusual that a single company performs all
activities from product design, procurement of components, and final assembly to delivery to the
final user by itself.
Most often, organizations are elements of a value system or supply chain. Hence, value chain
analysis should cover the whole value system in which the organization operates.
Within the whole value system, there is only a certain value of profit margin available. This is
the difference of the final price the customer pays and the sum of all costs incurred with the
production and delivery of the products/service (e.g. raw material, energy etc.).
It depends on the structure of the value system, how this margin spreads across the suppliers,
producers, distributors, customers, and other elements of the value system.
Each member of the system will use its market position and negotiating power to get a higher
proportion of this margin. Nevertheless, members of a value system can cooperate to improve
their efficiency and to reduce their costs in order to achieve a higher total margin to the benefit to
all of them (e.g. by reducing stocks in a Just-in-Time system).

A typical value chain analysis can be performed in the following steps:

 Analysis of own value chain—which costs are related to every single activity.
 Analysis of customers value chains—how does our product fit into their value chain.
 Identification of potential cost advantages in comparison with competitors.
 Identification of potential value added for the customer—how can our product add value
to the customer’s value chain (e.g. lower costs or higher performance)—where does the
customer see such potential.

Value Chain Analysis for Assessing Competitive Advantage:

Value chain analysis is a way of assessing competitive advantage by determining the strategic
advantages and disadvantages of the full range of activities that shape the final offering to the
end user. These activities include not only in-company activities but also activities outside the
company (e.g. at the supplier, distribution and disposal/recycling levels).
In other words, the company is viewed as part of an overall chain of value-creating processes
focused on the customer.
Value chain analysis enables a company to better understand which segments, distribution
channels, price points, product differentiation, selling propositions and which value chain
configurations (i.e., linkages between activities/processes within and outside the company) will
yield the greatest competitive advantage.
A key concept for value chain analysis is to de-emphasise functional structure and adopt a
process perspective—that is, a horizontal view of the organization beginning with product inputs
and ending with outputs and customers. Processes are structured and measured sets of activities
designed to produce a specified output for a particular customer or market.
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Emphasizing process means focusing not on what work is done but how it is done. Often this
perspective calls for reclassifying value activities—for example, if order processing is important
to a company’s customer interactions, then this activity should be classified under marketing.

Here’s how value chain analysis helps organizations assess competitive advantage:
 Internal Cost Analysis:Determining the sources of profitability and the relative cost
positions of internal value-creating processes.
 Internal Differentiation Analysis: Understanding the sources of differentiation
(including the cost) within internal value-creating processes.
 Vertical Linkage Analysis: Understanding the relationships and associated costs among
external suppliers and customers in order to maximize the value delivered to customers
and to minimize cost.

Vertical linkage analysis is aimed at developing competitive advantage through linkages between
a company’s value-creating activities and those of its suppliers, channels or users.
Understanding vertical linkages is not always easy—for example, calculating a rate of return on
assets requires obtaining information on operating costs, revenues and assets for each process
throughout the industry’s value chain—something that can be very difficult.
Evaluating opportunities for sustainable cost advantage involves gauging one’s competitive
position by knowing the competitor’s value chains (internal and external) and rates of return on
each. Internal cost, revenue and asset data for a competitor’s processes are generally unavailable,
so quantitative analysis will not usually be feasible.
However, qualitative information on a competitor’s value-creating processes and the strategies
for each usually exists. By understanding how other companies compete in each process of the
industry value chain, a company can use the qualitative analysis to seek out competitive niches
even financial data is unavailable.

Three Strategic Frameworks for Value Chain Analysis are:

To organize and analyse value chain information, and to summarize findings and
recommendations, three useful frameworks are:
 Industry Structure Analysis: The profitability of an industry or market—measured by
the long-term ROI of the average company—depends on five factors that influence
profitability. These are: bargaining power of buyers, bargaining power of suppliers, threat
of substitute products or services, threat of new entrants and intensity of competition.
 Core Competency Analysis: Core competencies are distinctive skills, intellectual assets
and cultural capabilities such as the ability to learn and team working.
Here the value chain approach rails for:
 Validating core competencies in current businesses.
 Exporting or leveraging them to value chain of other existing businesses.

Problems of Value Chain Analysis:

There are several problems when using VC analysis in relation to cost effective
management as given below:
 Incorrect Allocation of Costs within the Chain: Certain costs are extremely difficult to
allocate to certain individual products, but they are the costs of activities which are very

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 significant in relation to total quality and in turn competitive advantage. Failure of production
equipment is an example of this, affecting a number of products making them late for
delivery and causing priorities to change.
 Problem arises as how to allocate costs? As modern production systems are becoming more
complex, the ratio of overheads to total costs is likely to increase in relation to material and
labour. The absolute allocation of these overheads is difficult.
 Long and Time Consuming Process: If the total philosophy of value chain is not adopted,
there is risk of overlooking strategic aspects in decision making. This exercise needs to be
repeated again and again looking at competition, both in the present and in the future.
 Non Availability of Information regarding Competition, Product Lines and Structure:
The whole exercise of developing a value chain in practice may be very difficult as the
information required is very seldom available.
 Assumptions: Another problem inherent when using VC analysis is that management
accountant has to make lot of assumptions or suppositions because of non-availability of
information. These may be correct. However, very unlikely that they will be so in their
entirety, there is a danger that these inaccuracies could be magnified and lead to incorrect
strategic decisions.

For these reasons, VC analysis should not be seen as a cure for all the business costing strategy.
The role of VC, however, does give an insight which lays down a useful framework allowing us
to consider activities involved in production of service and products in relation to customer
significance.

Target Costing

Definition: Target costing can be viewed as a proactive cost management tool used to reduce the
total cost of the product, over its complete lifecycle, through production, engineering, research
and design. It helps the firm in managing the business in reaping profits in the extremely
competitive market.

Simply put, target costing is a process of ascertaining and attaining full stream cost, at which the
intended product with specific requirements, must be produced so as to realise the desired
profits, at an anticipated selling price over a specified period. It involves the discernment of
maximum cost to be incurred on a new product, followed by the development of sample that can
be profitably created for that target cost figure.

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Target Costing and Product Development Phase
In this technique, the costs are planned and managed out of the product or process early in the
introduction phase like development or designing, instead of performing it in the latter phase of
product development.
Target Costing applies to new products and succeeding generations of a product. It begins with
understanding the market thoroughly and an intention to satisfy customer needs, concerning
product quality, features, timeliness and price.

Target Cost
Target Cost = Anticipated selling price – Desired profit

Target Cost refers to an estimate of product cost reached by deducting a desired profit margin
from the competitive market price.

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Target Costing Process

Establishment Phase of Target Cost

1. Determine selling price for the new product and estimated output from market analysis
and target profit.
2. Ascertainment of the target cost by deducting the profit from the selling price.
3. Functional cost analysis for specific components and processes
4. Decide the estimated product cost.
5. Make comparison between estimated cost and target cost.
6. If the estimated cost is greater than the targeted one, then repeat cost analysis, to reduce
the estimated cost.
7. Final decision to be taken, on the introduction of the product, once the estimated cost is
on target.
8. Cost management while production is performed.

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Attainment Phase of Target Cost
In target costing process, the cost which is directly influenced by it is given priority, which
includes material and purchase parts, tooling cost, conversion cost, development expenses and
depreciation. Nevertheless, it is a comprehensive cost management technique, so all those cost
and assets which are influenced by initial product planning decision are taken into account.
Target Costing Principles
 Price-led costing
 Cross functional teams
 Customer focus
 Focus on product design and process
 Lifecycle cost reduction
 Value Chain involvement
Target Costing is all about planning or projecting the cost of a product prior to its introduction, to
make sure that products with low margin are not introduced, as they are not able to reap
sufficient returns. It is also used for controlling the design specification and production
techniques, and encouraging a focus on the customer.

Advantages of Target Costing:

Main advantages of target costing are:
1. It reinforces top to bottom commitment to process and product innovation to achieve
some competitive advantages.
2. It helps to create a company’s market-driven management for designing and
manufacturing products that meet the price required for the market success.
3. It uses management control system to support and reinforce manufacturing strategies, and
to identify market opportunities that can be converted into real saving to achieve the best
value for money rather than simply achieving the lowest cost.
4. Assures that products are better matched to their customers’ needs.
5. Aligns the costs of features with customers’ willingness to pay for them.
6. Reduces the development cycle of a product.
7. Reduces the costs of products significantly.
8. Increases the teamwork among all internal organizations associated with conceiving,
marketing, planning, developing, manufacturing, selling, distributing and installing a
product.
9. Engages customers and suppliers to design the right product and to more effectively
integrate the entire supply chain.

Problems with Target Costing:

Talk with customers about a new product concept, find out which features they like and don’t
like, and find out how much they would pay. Subtract an acceptable profit margin, and you’re
left with the target cost of the product. Now all you have to do is get everyone inside and outside
the company to adhere to this number. It sounds simple enough.
It is easier said than done. Yet, target costing-a cost-management process imported from Japan—
is helping a few dozen companies in the United States gain an edge by having them listen harder
to customers to gauge the right product or service price.
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Boeing, Eastman Kodak, and Honda of America, for example, as well as pioneers Daimler
Chrysler and Caterpillar, have implemented the strategy, reversing the way they traditionally
design, price, and sell new products.
Companies that have implemented the cost-management strategy insist they have boosted
profitability. But, although virtually the entire Japanese manufacturing sector has gone the target-
costing route since its inception in the 1970s, it hasn’t exactly taken root here in India.

Target Costing has a few problems that one should be aware of and guard against. These
problems are as follows:
a. The development of the process can be lengthened to a considerable extent since the
design team may require a number of design iterations before it can devise low cost
product that meets the target cost and margin criteria. This occurrence is most common
when the project manager is unwilling to discontinue a design project that cannot meet its
costing goals within a reasonable time frame.
b. Usually, If there is no evidence, it is better to either drop a project or at least shelve it for
a short time and then try again, on the belief that new cost reduction methods or less
expensive materials will be available in the near future that will make the target cost an
achievable one.
c. A large amount of mandatory cost cutting can result in finger pointing in various parts of
the company; especially if employees in one area feel they are being called on to provide
a disproportionately large part of the saving.
d. For example the industrial staff will not be happy if it is required to completely alter the
production layout in order to generate cost saving, while the purchase staff is not required
to make any cost reductions through supplier negotiations. Avoiding this problem
requires strong interpersonal and negotiation skills on the part of the project manager.
e. A design team having representatives from the number of departments can sometimes
make it more difficult to reach a consensus on the proper design because there are too
many opinions regarding design issues.
f. For every problem area outlined above the proper solution is retaining strong control over
the design team, which calls for a good team leader. This person must have a very good
knowledge of the design process, good interpersonal skills, and a commitment to staying
within both time and cost budgets for a design project.

Marginal Costing: Meaning, Features, Advantages and Limitations

Meaning of Marginal Costing:

Marginal costing is “The ascertainment, by differentiating between fixed cost and variable
cost, of marginal cost and of the effect on profit of changes in volume or type of output”.

Under this technique all costs are classified into fixed costs and variable costs.

Only variable costs are considered product costs and are allocated to products manufactured.
These costs include direct materials, direct labour, direct expenses and variable overhead. Fixed
costs are not considered for computing the cost of products or valuation of inventory.
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Fixed costs are mostly concerned with the period, hence they are called period costs and are
written-off in the Costing Profit and Loss Account of the period in which they are incurred.

Definition: Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost
is charged to units of cost, while the fixed cost for the period is completely written off against the
contribution.

The term marginal cost implies the additional cost involved in producing an extra unit of
output, which can be reckoned by total variable cost assigned to one unit.

It can be calculated as:

Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads

Features of Marginal Costing:

 This technique is used to ascertain the marginal cost and to know the impact of variable
costs on the volume of output.
 All costs are classified on the basis of variability into fixed cost and variable cost. Semi-
variable costs are segregated into fixed and variable costs.
 Marginal (i.e., variable) costs are treated as the cost of the product or service. Fixed costs
are charged to Costing Profit and Loss Account of the period in which they are incurred.
 Stock of finished goods and work-in-progress are valued on the basis of marginal costs.
 Selling price is based on marginal cost plus contribution.
 Profit is calculated in the usual manner. When marginal cost is deducted from sales it
gives rise to contribution. When fixed cost is deducted from contribution it results in
profit.
 Break-even analysis and cost-volume profit analysis are integral parts of this technique.
 The relative profitability of products or departments is based on the contribution made
available by each department or product.

Advantages and Disadvantages of Marginal Costing

1. Constant in nature: Variable costs fluctuates from time to time, but in the long run,
marginal costs are stable. Marginal costs remain the same, irrespective of the volume of
production.
2. Effective cost control: It divides cost into fixed and variable. Fixed cost is excluded
from product. As such, management can control marginal cost effectively.
3. Treatment of overheads simplified: It reduces the degree of over or under-recovery of
overheads due to the separation of fixed overheads from production cost.
4. Uniform and realistic valuation: As the fixed overhead costs are excluded from product
cost, the valuation of work-in-progress and finished goods become more realistic.
5. Helpful to management: It enables the management to start a new line of production
which is advantageous. It is helpful in determining which is profitable whether to buy or
manufacture a product. The management can take decision regarding pricing and
tendering.
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 6. Helps in production planning: It shows the amount of profit at every level of output
with the help of cost volume profit relationship. Here the break-even chart is made use of.
7. Better results: When used with standard costing, it gives better results.
8. Fixation of selling price: The differentiation between fixed costs and variable costs is
very helpful in determining the selling price of the products or services. Sometimes,
different prices are charged for the same article in different markets to meet varying
degrees of competition.
9. Helpful in budgetary control: The classification of expenses is very helpful in
budgeting and flexible budget for various levels of activities.
10. Preparing tenders: Many business enterprises have to compete in the market in quoting
the lowest price. Total variable cost, when separately calculated, becomes the ‘floor
price’. Any price above this floor price may be quoted to increase the total contribution.
11. “Make or Buy” decision: Sometimes a decision has to be made whether to manufacture
a component or a product or to buy it ready-made from the market. The decision to
purchase it would be taken if the price paid recovers some of the fixed expenses.
12. Better presentation: The statements and graphs prepared under marginal costing are
better understood by management executives. The break-even analysis presents the
behaviour of cost, sales, contribution etc. in terms of charts and graphs. And, thus the
results can easily be grasped.

Disadvantages
1. Difficulty to analyse overhead: Separation of costs into fixed and variable is a difficult
problem. In marginal costing, semi-variable or semi-fixed costs are not considered.
2. Time element ignored: Fixed costs and variable costs are different in the short run; but
in the long run, all costs are variable. In the long run all costs change at varying levels of
operation. When new plants and equipment are introduced, fixed costs and variable costs
will vary.
3. Unrealistic assumption: Assumption of sale price will remain the same at different
levels of operation. In real life, they may change and give unrealistic results.
4. Difficulty in the fixation of price: Under marginal costing, selling price is fixed on the
basis of contribution. In case of cost plus contract, it is very difficult to fix price.
5. Complete information not given – It does not explain the reason for increase in
production or sales.
6. Significance lost: In capital-intensive industries, fixed costs occupy major portions in the
total cost. But marginal costs cover only variable costs. As such, it loses its significance
in capital industries.
7. Problem of variable overheads: Marginal costing overcomes the problem of over and
under-absorption of fixed overheads. Yet there is the problem in the case of variable
overheads.
8. Sales-oriented: Successful business has to go in a balanced way in respect of selling
production functions. But marginal costing is criticised on account of its attaching over-
importance to selling function. Thus it is said to be sales-oriented. Production function is
given less importance.
9. Unreliable stock valuation: Under marginal costing stock of work-in-progress and
finished stock is valued at variable cost only. No portion of fixed cost is added to the
value of stocks. Profit determined, under this method, is depressed.
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 10. Claim for loss of stock: Insurance claim for loss or damage of stock on the basis of such
a valuation will be unfavourable to business.
11. Automation: Now-a-days increasing automation is leading to increase in fixed costs. If
such increasing fixed costs are ignored, the costing system cannot be effective and
dependable.

Managerial Uses of Marginal Costing:

The following may be listed as specific managerial uses:

 Cost Ascertainment: Marginal costing technique facilitates not only the recording of
costs but their reporting also. The classification of costs into fixed and variable
components makes the job of cost ascertainment easier. The main problem in this regard is
only the segregation of the semi-variable cost into fixed and variable elements. However,
this may be overcome by adopting any of the methods in this regard.
 Cost Control: Marginal cost statements can be understood easily by the management than
those presented under absorption costing. Bifurcation of costs into fixed and variable
enables management to exercise control over production cost and thereby affect
efficiency.
 In fact, while variable costs are controllable at the lower levels of management, fixed costs
can be controlled at the top level. Under this technique, management can study the
behaviour of costs at varying conditions of output and sales and thereby exercise better
control over costs.
 Decision-Making: Modern management is faced with a number of decision-making
problems every day. Profitability is the main criterion for selecting the best course of
action. Marginal costing through ‘contribution’ assists management in solving problems.

Some of the decision-making problems that can be solved by marginal costing are:
(a) Profit planning
(b) Pricing of products
(c) Make or buy decisions
(d) Product mix etc.

Characteristics of Marginal Costing

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  Classification into Fixed and Variable Cost: Costs are bifurcated, on the basis of
variability into fixed cost and variable costs. In the same way, semi variable cost is
separated.
 Valuation of Stock: While valuing the finished goods and work in progress, only
variable cost are taken into account. However, the variable selling and distribution
overheads are not included in the valuation of inventory.
 Determination of Price: The prices are determined on the basis of marginal cost and
marginal contribution.
 Profitability: The ascertainment of departmental and product’s profitability is based on
the contribution margin.
In addition to the above characteristics, marginal costing system brings together the techniques
of cost recording and reporting.

Marginal Costing Approach

The difference between product costs and period costs forms a basis for marginal costing
technique, wherein only variable cost is considered as the product cost while the fixed cost is
deemed as a period cost, which incurs during the period, irrespective of the level of activity.
Facts Concerning Marginal Costing

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  Cost Ascertainment: The basis for ascertaining cost in marginal costing is the nature of
cost, which gives an idea of the cost behavior, that has a great impact on the profitability
of the firm.
 Special technique: It is not a unique method of costing, like contract costing, process
costing, batch costing. But, marginal costing is a different type of technique, used by the
managers for the purpose of decision making. It provides a basis for understanding cost
data so as to gauge the profitability of various products, processes and cost centers.
 Decision Making: It has a great role to play, in the field of decision making, as the
changes in the level of activity pose a serious problem to the management of the
undertaking.
Marginal Costing assists the managers in taking end number of business decisions, such as
replacement of machines, discontinuing a product or service, etc. It also helps the management in
ascertaining the appropriate level of activity, through break even analysis, that reflect the impact
of increasing or decreasing production level, on the company’s overall profit.

Break-Even Analysis: Introduction, Assumptions and Limitations

Introduction to Break-Even Analysis:

Break-even analysis is of vital importance in determining the practical application of cost func-
tions. It is a function of three factors, i.e., sales volume, cost and profit. It aims at classifying the
dynamic relationship existing between total cost and sale volume of a company.
Hence it is also known as “cost-volume-profit analysis”. It helps to know the operating condition
that exists when a company ‘breaks-even’, that is when sales reach a point equal to all expenses
incurred in attaining that level of sales.

What is break-even analysis?

A break-even analysis is a useful tool for determining at what point your company, or a new
product or service, will be profitable. Put another way, it’s a financial calculation used to
determine the number of products or services you need to sell to at least cover your costs. When
you’ve broken even, you are neither losing money nor making money, but all your costs have
been covered.

There are a few definitions you need to know in order to understand break-even analysis.
 Fixed Costs: Expenses that stay the same no matter how much you sell.
 Variable Costs: Expenses that fluctuate up and down with sales.

Definition of Break-Even Point

Break-even analysis involves the study of revenues and costs of a firm in relation to its volume
of sales and specifically the determination of that volume at which the firm’s costs and revenues
will be equal. The break-even point (BEP) maybe defined as that level of sales at which total
revenues equal total costs and the net income is equal to zero. This is also known as no-profit
no-loss point.

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Assumptions Underlying Break-Even Analysis:
1. All costs can be separated into fixed and variable components,
2. Fixed costs will remain constant at all volumes of output,
3. Variable costs will fluctuate in direct proportion to volume of output,
4. Selling price will remain constant,
5. Product-mix will remain unchanged,
6. The number of units of sales will coincide with the units produced so that there is no
opening or closing stock,
7. Productivity per worker will remain unchanged,
8. There will be no change in the general price level.

Uses of Break-Even Analysis:

1. It helps in the determination of selling price which will give the desired profits.
2. It helps in the fixation of sales volume to cover a given return on capital employed.
3. It helps in forecasting costs and profit as a result of change in volume.
4. It gives suggestions for shift in sales mix.
5. It helps in making inter-firm comparison of profitability.
6. It helps in determination of costs and revenue at various levels of output.
7. It is an aid in management decision-making (e.g., make or buy, introducing a product
etc.), forecasting, long-term planning and maintaining profitability.
8. It reveals business strength and profit earning capacity of a concern without much
difficulty and effort.

Determination of the Break-Even Point:

Break-even point may be determined either in terms of physical units or in money terms, i.e.,
sales value in rupees.
 Break-Even Point in Terms of Physical Units:
This method is convenient for the single-product firm. The break-even volume is the number of
units of the product which must be sold to earn enough revenue just to cover all expenses—
both fixed and variable. The selling price of a unit covers not only its variable cost but also
leaves a margin (contribution margin) to contribute toward the fixed costs (costs remaining
fixed irrespective of the volume).
The breakeven point is reached when sufficient numbers of units have been sold so that the total
contribution margin of the units sold is equal to the fixed costs. The formula for calculating
the break-even point is as follows

BEP = Fixed cost/Contribution margin per unit

Where the contribution margin is selling price-variable costs per unit.

 Break-Even Point in Terms of Sales Value:
Multi-product firms are not in a position to measure the break-even point in terms of any
common unit of product. They find it convenient to determine their breakeven point in terms
of total rupee sales. Here, again, the break-even point would be the point where the
contribution margin (Sales value – Variable costs) would equal the fixed costs. The
contribution margin, however, is expressed as a ratio to sales.

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 BEP = Fixed cost/Contribution ratio

Break-Even Chart (BEC): Meaning, Assumption and Methods of Preparation

Meaning of Break-Even Chart (BEC):

The Break-Even Chart is a graphical representation between cost, volume and profits.
No doubt it is an important tool which helps to make profit planning. It has been defined as “a
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.”

BEC depicts the following information:

1. Cost (i.e., Fixed, Variable and Total);
2. Sales Value and Profit/Loss;
3. Break-Even Point;
4. Margin of Safety.

Certain Assumptions about the CVP Graph:

 Fixed Cost will remain constant during the relevant period;
 Semi-Variable Cost can be bifurcated into variable and fixed components;
 Variable Cost per unit also will not make any change during the relevant period;

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 Selling Price also will not make any change during the relevant period irrespective of the
quantity sold;
 Operating Efficiency also will remain constant;
 Product Mix will remain unchangeable;
 Volume of Production and Sales are equal.

Advantages of Break-Even Chart:

The following advantages may be offered by a BEC:
 Easy to Construct and Easy to Understand: A Break-Even Chart gives us a very clear-cut
information which helps the management to take correct decisions as it depicts a detailed
picture of the entire undertaking.
 Useful Tool to Help Management: We know that a BEC gives us the relationship between
Cost, Volume and Profit. Thus, the same may present the effect of changes in cost and selling
price due to the change in variable cost and fixed cost.
 Helps to Select the Most Profitable Product Mix: No doubt a BEC helps us to select the
most profitable product mix or sales mix for earning more profits.
 Helps to Ascertain the Strength of the Business: This chart helps us to determine profit
earning capacity after analysing together. Angle of incidence and Margin of Safety.

Limitations of a Break-Even Chart:

The BEC is not free from snags.
 Based on Unrealistic Assumptions:
o Selling price remains constant irrespective of the volume of sales;
o Production and sales are equal (i.e., without considering value of stock);
o Variable cost remains same;
o All indirect costs can be segregated into fixed and variable.
o In actual practice, however, all the above assumptions are not correct.
 Ignore the Concept and Effect of Capital Employed: BEC ignores the basic accounting
elements, i.e., Capital Employed which is very significant for calculating the rate of
profitability or earnings.
 Construction of Multiple BEC: If different variety of product & are produced, separate
BEC should be drawn up which creates a problem of fixed overhead allocation.

Formula for CVP analysis:

I. Profit Volume ratio: The Profit Volume (P/V) Ratio is the measurement of the rate of change
of profit due to change in volume of sales. It is one of the important ratios for computing
profitability as it indicates contribution earned with respect of sales.

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 Since:
Contribution = Sales – Variable Cost (or) Fixed Cost ± Profit, loss (or) Sales X PVR

II. BEP: The purpose of the break-even analysis formula is to calculate the amount of sales that
equates revenues to expenses and the amount of excess revenues.

A. BEP (in Units)

Where:
Contribution per unit = Selling price per unit –Variable cost per unit

B. BEP (in Rs.)

III. Profit: Profit formula is used to know how much profit has been made by selling a particular
product.
Profit = ( Sales X PV Ratio) – Fixed Cost

Profit = PV Ratio X Margin of Safety

IV. Margin of Safety: The margin of safety is the amount of sales over a company’s break-even
point

Margin of Safety = Present Sales- BEP Sale

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V. Sales to earn a given level of profit

VI. Profit When the Sales are given

Given Sales X PV Ratio

Profit = Contribution – Fixed Cost

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Budgeting and Budgetary Control

Introduction
Budgeting has come to be accepted as an efficient method of short-term planning and
control. It is employed, no doubt, in large business houses, but even the small businesses are
using it at least in some informal manner. Through the budgets, a business wants to know clearly
as to what it proposes to do during an accounting period or a part thereof. The technique of
budgeting is an important application of Management Accounting. Probably, the greatest aid to
good management that has ever been devised is the use of budgets and budgetary control. It is a
versatile tool and has helped managers cope with many problems including inflation.

DEFINITION OF BUDGET

The Chartered Institute of Management Accountants, England, defines a 'budget' as under:

" A financial and/or quantitative statement, prepared and approved prior to define period of
time, of the policy to be perused during that period for the purpose of attaining a given
objective."

According to Brown and Howard of Management Accountant "a budget is a predetermined

statement of managerial policy during the given period which provides a standard for
comparison with the results actually achieved."

Essentials of a Budget
An analysis of the above said definitions reveal the following essentials of a budget:

 It is prepared for a definite future period.

 It is a statement prepared prior to a defined period of time.
 The Budget is monetary and I or quantitative statement of policy.
 The Budget is a predetermined statement and its purpose is to attain a given objective.
 A budget, therefore, be taken as a document which is closely related to both the
managerial as well as accounting functions of an organization.

Forecast Vs Budget
Forecast is mainly concerned with an assessment of probable future events. Budget is a planned
result that an enterprise aims to attain. Forecasting precedes preparation of a budget as it is an
important part of the budgeting process. It is said that the budgetary process is more a test of
forecasting skill than anything else. A budget is both a mechanism for profit planning and
technique of operating cost control. In order to establish a budget it is essential to forecast
various important variables like sales, selling prices, availability of materials, prices of materials,
wage rates etc.

Difference between Forecast and Budget

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Both budgets and forecasts refer to the anticipated actions and events. But still there are wide
differences between budgets and forecasts as given below:

Forecasts Budgets
(1) Forecasts is mainly concerned with anticipated
or (1) Budget is related to planned events
probable events
Forecasts may cover for longer period or Budget is planned or prepared for a shorter
(2) years (2) period
(3) Forecast is only a tentative estimate (3) Budget is a target fixed for a period.
(4) Forecast results in planning (4) Result of planning is budgeting
The function of forecast ends with the The process of budget starts where forecast
(5) forecast of (5) ends
likely events and converts it into a budget
Forecast usually covers a specific Budget is prepared for the business as a
(6) business function (6) whole
Forecasting does not act as a tool of Purpose of budget is not merely a planning
(7) controlling (7) device
measurement. but also a controlling tool.

BUDGETARY CONTROL
Budgetary Control is the process of establishment of budgets relating to various activities and
comparing the budgeted figures with the actual performance for arriving at deviations, if any.
Accordingly, there cannot be budgetary control without budgets. Budgetary Control is a system
which uses budgets as a means of planning and controlling.

According to I.C.M.A. England Budgetary control is defined by Terminology as the

establishment of budgets relating to the responsibilities of executives to the requirements of a
policy and the continuous comparison of actual with the budgeted results, either to secure by
individual actions the objectives of that policy or to provide a basis for its revision.

Brown and Howard defines budgetary control is "a system of controlling costs which includes
the preparation of budgets, co-ordinating the department and establishing responsibilities,
comparing actual performance with the budgeted and acting upon results to achieve maximum
profitability."

The above definitions reveal the following essentials of budgetary control:

1. Establishment of objectives for each function and section of the organization.

2. Comparison of actual performance with budget.
3. Ascertainment of the causes for such deviations of actual from the budgeted performance.
4. Taking suitable corrective action from different available alternatives to achieve the
desired objectives.

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Objectives of Budgetary Control

Budgetary Control is planned to assist the management for policy formulation, planning,
controlling and co-coordinating the general objectives of budgetary control and can be stated in
the following ways:
 Planning: A budget is a plan of action. Budgeting ensures a detailed plan of action for a
business over a period of time.
 Co-ordination: Budgetary control co-ordinates the various activities of the entity or
organiza-tion and secure co-operation of all concerned towards the common goal.
 Control: Control is necessary to ensure that plans and objectives are being achieved.
Control follows planning and co-ordination. No control performance is possible without
predetermined standards. Thus, budgetary control makes control possible by continuous
measures against predetermined targets. If there is any variation between the budgeted
performance and the actual performance, the same is subject to analysis and corrective
action.
Scope and Techniques of Standard Costing and Budgetary Control

Scope:
 Budgets are prepared for different functions of business such as production, sales etc.
Actual results are compared with the budgets and control is exercised.
 Standards on the other hand are complied by classifying, recording and allocation of the
expenses to cost units. Actual costs are compared with standard costs.
 Budgets have a wide range of coverage of the entire organization. Each operation or
process is divided into number of elements and standards are set for each such element.
 Budgetary control is concerned with origin of expenditure at functional levels. Standard
costing is concerned with the requirements of each element of cost.
 Budget is a projection of financial accounts whereas standard costing projects the cost
accounts.

Technique:

 Budgetary control is exercised by putting budgets and actual side by side.

 Variances are not normally revealed in the accounts. Standard costing variances are revealed
through accounts.
 Budgetary control system can be operated in parts. For example, Advertisement Budgets,
Research and Development Budgets, etc. Standard costing is not put into operation in parts.
 Budgetary control of expenses is broad in nature whereas standard costing system is a far
more technically improved system by means of which the variances are analyzed in detail.

Requisites for Effective Budgetary Control

The following are the requisites for effective budgetary control:

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 1. Clear cut objectives and goals should be well defined.
2. The ultimate objective of realizing maximum benefits should always be kept uppermost.
3. There should be a budget manual which contains all details regarding plan and
procedures for its execution. It should also specify the time table for budget preparation
for approval, details about responsibility, cost centers etc.
4. Budget committee should be set up for budget preparation and efficient execution of the
plan.
5. A budget should always be related to a specified time period.
6. Support of top management is necessary in order to get the full support and co-operation
of the system of budgetary control.
7. To make budgetary control successful, there should be a proper delegation of authority
and responsibility.
8. Adequate accounting system is essential to make the budgeting successful.
9. The employees should be properly educated about the benefits of budgeting system.
10. The budgeting system should not cost more to operate than it is worth.
11. Key factor or limiting factor, if any, should consider before preparation of budget.
12. For budgetary control to be effective, proper periodic reporting system should be
introduced.

Organization for Budgetary Control

In order to introduce budgetary control system, the following are essential to be considered for a
sound and efficient organization. The important aspects to be considered are :

1. Organisation Chart
2. Budget Center
3. Budget Officer
4. Budget Committee
5. Budget Manual
6. Budget Period
7. Key Factor

 Organisation Chart: For the purpose of effective budgetary control, it is imperative on

the part of each entity to have definite "plan of organization." This plan of organization is
embodied in the organization chart. The organization chart explaining clearly the position
of each executive's authority and responsibility of the firm. All the functional heads are
entrusted with the responsibility of ensuring proper implementation of their respective
departmental budgets. An organization chart for budgetary control is given showing
clearly the type of budgets to be prepared by the functional heads.
 Budget Center: A Budget Center is defined by the terminology as "a section of the
organization of an undertaking defined for the purpose of budgetary control." For
effective budgetary control budget centre or departments should be established for each
of which budget will be set with the help of the head of the department concerned.
 Budget Officer: Budget Officer is usually some senior member of the accounting staff
who controls the budgetary process. He does not prepare the budget himself, but
facilitates and co-ordinates the budgeting activity. He assists the individual departmental
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 heads and the budget committee, and ensures that their decisions are communicated to the
appropriate people.
 Budget Committee: Budget Committee comprising of the Managing Director, the
Production Manager, Sales Manager and Accountant. The main objectives of this
committee is to agree on all departmental budgets, normal standard hours and allocations.
In small concerns, the Budget Officer may co-ordinate the work for preparation and
implementation of budgets. In large-scale concern a budget committee is setup for
preparation of budgets and execution of budgetary control.
 Budget Manual: A Budget Manual has been defined as "a document which set out the
responsibilities of persons engaged in the routine of and the forms and records required
for budgetary control." It contains all details regarding the plan and procedures for its
execution. It also specifies the time table for budget preparation to approval, details about
responsibility, cost centers, constitution and organization of budget committee, duties and
responsibilities of budget officer.
 Budget Period: A budget is always related to specified time period. The budget period is
the length of time for which a budget is prepared and employed. The period may depend
upon the type of budget. There is no specific period as such. However, for the sake of
convenience, the budget period may be fixed depending upon the following factors:
o Types of Business
o Types of Budget
o Nature of the demand of the product
o Length of trade cycle
o Economic factors
o Ava!lability of accounting period
o Availability of finance
o Control operation
 Key Factor: Key Factor is also called as "Limiting Factor" or Governing Factor. While
preparing the budget, it is necessary to consider key factor for successful budgetary control.
The influence of the Key Factor which dominates the business operations in order to ensure
that the functional budgets are reasonably capable of fulfilment. The Key Factors include.
o Raw materials may be in. short supply.
 Non-availability of skilled labours.
 Government restrictions.
 Limited sales due to insufficient sales promotion.
 Shortage of power.
 Underutilization of plant capacity.
 Shortage of efficient executives.
 Management policies regarding lack of capital.
 Insufficient research into new product development.
 Insufficiency due to shortage of space.

BENEFITS OF BUDGETS AND BUDGETARY CONTROL

Budgets provide benefits both for the business, and also for its managers and other staff:

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 The Budget Assists Planning: By formalizing objectives through a budget, a business can
ensure that its plans are achievable. It will be able to decide what is needed to produce the
output of goods and services, and to make sure that everything will be available at the right
time.
 The Budget Communicates And Co-Ordinates: Because a budget is agreed by the
business, all the relevant managers and staff will be working towards the same end. When the
budget is being set, any anticipated problems should be resolved and any areas of potential
confusion clarified. All departments should be in a position to play their part in achieving the
overall goals.
 The Budget Helps With Decision-Making: By planning ahead through budgets, a business
can make decisions on how much output – in the form of goods or services – can be
achieved. At the same time, the cost of the output can be planned and changes can be made
where appropriate.
 The Budget Can Be Used To Monitor And Control: An important reason for producing a
budget is that management is able to use budgetary control to monitor and compare the actual
results (see diagram below). This is so that action can be taken to modify the operation of the
business as time passes, or possibly to change the budget if it becomes unachievable.
 The Budget Can Be Used To Motivate: A budget can be part of the techniques for
motivating managers and other staff to achieve the objectives of the business. The extent to
which this happens will depend on how the budget is agreed and set, and whether it is
thought to be fair and achievable. The budget may also be linked to rewards (for example,
bonuses) where targets are met or exceeded.

LIMITATIONS OF BUDGETS AND BUDGETARY CONTROL

Whilst most businesses will benefit from the use of budgets, there are a number of limitations of
budgets to be aware of:
 The Benefit Of The Budget Must Exceed The Cost: Budgeting is a fairly complex process
and some businesses – particularly small ones – may find that the task is too much of a
burden in terms of time and other resources, with only limited benefits. Never the less, many
lenders – such as banks – often require the production of budgets as part of the business plan.
As a general rule, the benefit of producing the budget must exceed its cost.
 Budget Information May Not Be Accurate: It is essential that the information going into
budgets should be as accurate as possible. Anybody can produce a budget, but the more
inaccurate it is, the less use it is to the business as a planning and control mechanism. Great
care needs to be taken with estimates of sales – often the starting point of the budgeting
process – and costs. Budgetary control is used to compare the budget against what actually
happened – the budget may need to be changed if it becomes unachievable.
 The Budget May Demotivated: Employees who have had no part in agreeing and setting a
budget which is imposed upon them, will feel that they do not own it. As a consequence, the
staff may be Demotivated. Another limitation is that employees may see budgets as either a
‘carrot’ or a ‘stick’, ie as a form of encouragement to achieve the targets set, or as a form of
punishment if targets are missed.
 Budgets May Lead To Disfunctional Management: A limitation that can occur is that
employees in one department of the business may over-achieve against their budget and

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 create problems elsewhere. For example, a production department might achieve extra output
that the sales department finds difficult to sell. To avoid such Disfunctional management,
budgets need to be set at realistic levels and linked and co-ordinated across all departments
within the business.
 Budgets May Be Set At Too Low A Level: Where the budget is too easy to achieve it will
be of no benefit to the business and may, in fact, lead to lower levels of output and higher
costs than before the budget was established. Budgets should be et at realistic levels, which
make the best use of the resources available.

Types of Budgets
 Sales Budget: Sales Budget is one of the important functional budget. Sales estimate is
the commencement of budgeting may be made in quantitative terms. Sales budget is
primarily concerned with forecasting of what products will be sold in what quantities and
at what prices during the budget period. Sales budget is prepared by the sales executives
taking into account number of relevant and influencing factors such as :
o Analysis of past sales (Product wise; Territory wise, Quote wise).
o Key Factors.
o Market Conditions.
o Production Capacity.
o Government Restrictions.
o Competitor's Strength and Weakness.
o Advertisement, Publicity and Sales Promotion.
o Pricing Policy.
o Consumer Behaviour.
o Nature of Business.
o Types of Product.
o Company Objectives.

Illustration: 1
Thomas Engineering Co. Ltd. Manufactures two articles X and Y. Its sales department has three
divisions: West, South and East. Preliminary sales budgets for the year ending 3151 December
2003. based on the assessments of the divisional executives:
Product X : West 40,000 units: South 1,00,000 units and East 20,000 units
Product Y : West 60,000 units: South 8,00,000 units and East Nil
Sales Price X Rs. 2 and Y Rs. 3 in all areas.
Arrangements are made for the extensive advertising of product X and Y and it is estimated that
West division sales will increase by 20,000 units. Arrangements are also made to advertise and
distribute product Y in the Eastern area in the second half of 2003 when sales are expected to be
1,00,000 units.
Since the estimated sales of the South division represented an unsatisfactory target, it is agreed to
increase both the estimates by 10 %.
Prepare a sales budget for the year to 31" December 2003.

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

141
Solution:
Sales Budget for the year 2003

Product X Product Y
Division Qty. Price Value Qty. Price Value Total
Rs. Rs. Rs. Rs. Rs. Rs.
West 60,000 2 1,20,000 80,000 3 2,40,000 3,60,000
South 1,10,000 2 2,20,000 88,000 3 2,64,000 4,84,000
East 20,000 2 40,000 1,00,000 3 3,00,000 3,40,000
11,84,00
Total 1,90,000 3,80,000 2,68.000 8.04,000 0

Illustration: 2

Two articles A and B are manufactured in a department. Sales for the year 2003 were planned
as follows:

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Product
Units Units Units Units
Product A 5,000 6,000 6,500 7,500
Product B 2,500 2,250 2,000 1,900

Selling price were Rs. 10 per unit for A and Rs. 20 per unit for B respectively. Average sales
return are 10 % of sales and the discounts and bad debts amount to 2 % of the total sales.

Prepare Sales Budget for the year 2003.

Solution:
Sales Budget for the year 2003

Dr.N.RAMESH KUMAR, PROFESSOR, DEPARTMENT OF MANAGEMENT STUDIES, SVCCAM

142
Particulars 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total
Pric Pric Pric Pric Pric
Qty. e Value Qty. e Value Qty. e Value Qty. e Value Qty. e Value
Units Rs. Rs. Units Rs. Rs. Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
5,00 6,00 6,50 7,50 25,00 2,50,00
Product A 0 10 50,000 0 10 60,000 0 10 65,000 0 10 75,000 0 10 0
2,50 2,25 2,00 1,90 1,73,00
Product B 0 20 50,000 0 20 45,000 0 20 40,000 0 20 38,000 8,650 20 0
7,50 1,00,00 8,25 1,05,0 8,50 1,05,00 9,40 1,13,00 33,65 4,23,00
Total (I) 0 - 0 0 - 0 0 - 0 0 - 0 0 - 0
LESS
Sales
Return at
10% on 10,000 10,500 - 10,500 11,300 - 42,300
Sales
Discount
Discount &
Bad Debts - - 2,000 - 2,100 - - 2,100 - - 2,260 - - 8460
2% on Sales
Total (2) - - 12,000 - - 12,600 - - 12,600 - - 13,560 - - 50,760
Net Sales 3,72,24
(1) - (2) - - 88,000 - - 92,400 - - 92,400 - - 92,400 - - 0
Production Budget:Production budget is usually prepared on the basis of sales budget. But it
also takes into account the stock levels desired to be maintained. The estimated output of
business firm during a budget period will be forecast in production budget. The production
budget determines the level of activity of the produce business and facilities planning of
production so as to maximum efficiency. The production budget is prepared by the chief
executives of the production department. While preparing the production budget, the factors like
estimated sales, availability of raw materials, plant capacity, availability of labour, budgeted
stock requirements etc. are carefully considered.

Cost of Production Budget: After Preparation of production budget, this budget is prepared.
Production Cost Budgets show the cost of the production determined in the production budget.
Cost of Production Budget is grouped in to Material Cost Budget, Labour Cost Budget and
Overhead Cost Budget. Because it breaks up the cost of each product into three main elements
material, labour and overheads. Overheads may be further subdivided in to fixed, variable and
semi-fixed overheads. Therefore separate budgets required for each item.

Cash Budget: This budget represent the anticipated receipts and payment of cash during the
budget period. The cash budget also called as Functional Budget. Cash budget is the most
important of all the functional budget because, cash is required for the purpose to meeting its
current cash obligations. If at any time, a concern fails to meet its obligations, it will be
technically insolvent. Therefore, this budget is prepared on the basis of detailed cash receipts
and cash payments.

The estimated Cash Receipts include:

 Cash Sales
 Credit Sales
 Collection from Sundry Debtors
 Bills Receivable
 Interest Received
 Income from Sale of Investment
 Commission Received
 Dividend Received
 Income from Non-Trading Operations etc.

The estimated Cash Payments include the following :

 Cash Purchase
 Payment to Creditors
 Payment of Wages
 Payments relate to Production Expenses
 Payments relate to Office and Administrative Expenses
 Payments relate to Selling and Distribution Expenses
 Any other payments relate to Revenue and Capital Expenditure
 Income Tax Payable, Dividend Payable etc.
Master Budget: When the functional budgets have been completed, the budget committee will
prepare a Master Budget for the target of the concern. Accordingly a budget which is prepared
incorporating the summaries of all functional budgets. It comprises of budgeted profit and loss
account, budgeted balance sheet, budgeted production, sales and costs. The ICMA England
defines a Master Budget as "the summary budget incorporating its functional budgets, which is
finally approved, adopted and employed." The Master Budget represents the activities of a
business during a profit plan. This budget is also helpful in co-ordinating activities of various
functional departments.

Fixed Budget: A budget is drawn for a particular level of activity is called fixed budget.
According to ICWA London "Fixed budget is a budget which is designed to remain unchanged
irrespective of the level of activity actually attained." Fixed budget is usually prepared before
the beginning of the financial year. This type of budget is not going to highlight the cost
variances due to the difference in the levels of activity. Fixed Budgets are suitable under static
conditions

Flexible Budget: Flexible Budget is also called Variable or Sliding Scale budget, "takes both
the fixed and manufacturing costs into account. Flexible budget is the opposite of static budget
showing the expected cost at a single level of activity.

According to ICMA, England defined “Flexible Budget is a budget which is designed to

change in accordance with the level of activity actually attained.”

According to the principles that guide the preparation of the flexible budget a series of fixed
budgets are drawn for different levels of activity. A flexible budget often shows the budgeted
expenses against each item of cost corresponding to the different levels of activity. This budget
has come into use for solving the problems caused by the application of the fixed budget.

Advantages of Flexible Budget

(1) In flexible budget, all possible volume of output or level of activity can be covered.
(2) Overhead costs are analysed into fixed variable and semi-variable costs.
(3) Expenditure can be forecasted at different levels of activity.
(4) It facilitates at all times related factor can be compared. which are essential for
intelligent decision making.
(5) A flexible budget can be prepared with standard costing or without standard costing
depending upon What the Company opts for.
(6) Flexible budget facilitates ascertainment of costs at different levels of activity, price
fixation, placing tenders and Quotations.
(7) It helps in assessing the performance of all departmental heads as the same can be
judged by terms of the level of activity attained by the business.
Distinction between Fixed Budget and Flexible Budget

FIXED BUDGET FLEXIBLE BUDGET

It does not change with the volume of It can be recast on the basis of volume of
activity. cost.
All costs are related to one level of activity Costs are analysed by behaviour and variable
only. costs are allowed as per activity attained.
If budget and actual activity levels vary. cost Flexible budgeting helps in fixation of selling
ascertainment does not provide a correct price at different levels of activity.
picture.
Ascertainment of costs is not possible in Costs can be easily ascertained at different
fixed cost. levels of activity.
It has a limited application for cost control. It has more application and can be used as a
tool for effective cost control.
It is rigid budget and drawn on the It is designed to change according to changed
assumption that conditions would remain conditions.
constant.
Comparison of actual and budgeted Comparisons are realistic according to the
performance cannot be done correctly change in the level of activity.
because the volume of production differs.
Costs are not classified according to their Costs are classified according to the nature of
variability. i.e .• fixed. variable and semi- their variability.
variable.

Method of Preparing Flexible Budget

The following methods are used in preparing a flexible budget:

 Multi-Activity Method.
 Ratio Method.
 Charting Method.
 Multi-Activity Method: This method involves preparing a budget in response to
different level of activity. The different level of activity or capacity levels are shown in
Horizontal Columns, and the budgeted figures against such levels are placed in the
Vertical Columns. The expenses involved in production as per budget are grouped as
fixed, variable and semi variable.
 Ratio Method: According to this method, the budget is prepared first showing the
expected normal level of activity and the estimated variable cost per unit at the side
expected level of activity inaddition to the fixed cost as estimated. Therefore, the
expenses as per budget, allowed for a particular level of activity attained, will be
calculated on the basis of the following formula : Budgeted fixed cost + (Variable cost
per unit of activity x Actual unit of activity)
  Charting Method: Under this method total expenses required for any level of activity,
are estimated having classified into three categories, viz., Variable. Semi Variable and
Fixed. These figures are plotted on a graph. The expenses are plotted on the Y-axis and
the level of activity are plotted on X-axis. The graph will thus, help in ascertaining the
quantum of budgeted expenses corresponding to the level of activity attained with the
help of this chart.

Zero Base Budgeting (ZBB)

Zero Base Budgeting is a new technique of budgeting. It is designed to meet the needs of the
management in order to ensure the operational efficiency and effective utilization of the
allocated resources of a concern. This technique was originally developed by Peter A. Phyhrr,
Manager of Taxas Instrument during 1969. This concept is widely used in USA for controlling
their state expenditure when Mr. Jimmy Carter was the president of the USA. At present the
technique has for its global recognition for many countries have implemented in real terms.

According to Peter A. Phyhrr ZBB is defined as an "Operative Planning and Budgeting

Process" which requires each Manager to justify his entire budget in detail from Scratch (hence
zero base) and shifts the burden of proof to each Manager to justify why we should spend any
money at all."
In zero-base budgeting, a manager at all levels have to justify the importance of activity and to
allocate the resources on priority basis.

Important Aspects of ZBB

Zero Base Budgeting involves the following important aspects:

 It emphasizes on all requisites of budgets.

 Evaluation on the basis of decision packages and systematic analysis, i.e., in view of
cost benefit analysis.
 Planning the activities promotes operational efficiency and monitors the performance to
achieve the objectives.

Steps Involved in ZBB

The following are the steps involved in Zero Base Budgeting:
 No Previous year performance of inefficiencies are to be taken as adjustments in
subsequent year.
 Identification of activities in decision packages.
 Determination of budgeting objectives to be attained
 Extent to which Zero Base Budgeting is to be applied.
 Evaluation of current and proposed expenditure and placing them in order of priority.
 Assignment of task and allotment of sources on the basis of cost benefit comparison.
  Review process of each activity examined afresh.
 Weightage should be given for alternative course of actions.

Advantages of ZBB
1. Utilization of resources at a maximum level.
2. It serves as a tool of management in formulating production planning.
3. It facilitates effective cost control.
4. It helps to identify the uneconomical activities.
5. It ensures the proper allocation of scarce resources on priority basis.
6. It helps to measure the operational inefficiencies and to take the corrective actions.
7. It ensures the principles of Management by Objectives.
8. It facilitates Co-operation and Co-ordination among all levels of management.

Variance Analysis – Overview, Budgeting, Benefits

An overview of variance analysis as a process

Every business owner must have a budget which lays out the company’s future course of
activities. A budget helps to showcase from where the sales would come and how the funds
would be spent to achieve those sales, with the key objective of generating a profit. While
budgeting is a great planning tool, it is also a useful management tool for keeping the business
on track for meeting its objectives. For accomplishing this goal, budgeting and variance analysis
provides key insights to help the management in taking prompt and feasible decisions.

Budgeting
Preparing a budget at the commencement of the year is a critical exercise for a business and is
known as budgeting. It helps in gathering the input from various departments and brings every
stakeholder on the same page. It also works as an excellent medium of communication
conveying to everyone where the organization wishes to go and how it plans to get there.

Variance Analysis
After the year gets going and the actual results start coming, the management starts comparing
the actuals with the budgets. At this time variances from the budget are identified, and the
management has to dig deep to find out the reasons for such variances. This analysis is used for
maintaining a control over the business. For instance, if the budget for sales is INR 1,00,000 and
the actual sales are INR 80,000, variance analysis produces a difference of INR 20,000. This
analysis is effective when the management reviews the variance on a trend line. Sudden changes
in a month to month (MoM) variance are clearly visible. This analysis also requires
investigation of these variances which helps the management to interpret as to why such
variance or differences occurred.

How companies apply variance analysis?

Most of the companies are concerned with business planning and meeting their financial
commitments. Ultimately all want growth. Accordingly, they analyze the variances between:
  Previous-year actual results and current year’s budget, which helps them in planning and
this is also a part of the budgeting process.
 Existing budget (current financial year) and current-year actuals, which helps them in
meeting their commitments. This activity is performed at regular intervals throughout
the year like at close of every quarter and at year-end.
 Previous-year actual and current-year actual for analyzing growth. This is done at year-
end.

Application of Variance Analysis

 Comparing Budget with Actual: Variance analysis helps in managing the annual budgets
by monitoring the budgeted figures and comparing it with the actual revenue/cost. In case of
companies which are project or program driven, the financial data are evaluated at key
intervals such as month close, quarter end, ect. For example, the month end reports can just
provide quantitative data with respect to revenue and expenses or inventory levels.
However, variance analysis would help to understand the reasons behind the variances
between planned and actual revenue/cost which could lead to adjustments in the business
strategies and end objectives.
 Identifying Relationships: Relationship between a pair of variables/elements/items could
also be identified with the help of variance analysis. Correlations (both positive and
negative) are critical in business planning. For instance, variance analysis could reveal that
when the sale for Product A rises there’s a correlated rise in the sales for Product B.
Thereby, revealing a positive correlation between 2 products.
 Forecasting: Forecasting uses patterns of the past data for developing a theory about the
future business performance. Variances are placed into the context which helps analysts in
identifying factors. For example, seasonal change holidays could be a major cause of
positive/negative variances.

Most commonly used variances

 Purchase price variance: Purchase Price Variance results when actual price which is paid
for materials is different from the budgeted cost for such materials. It is usually used as a
lagging indicator for quantifying the efficiency of the procurement function. (How
efficiently can you procure/purchase required material)
 Labor rate variance: This variance shows the variance between the actual price which is
paid for direct labor that is used in the process of production and its standard labor cost (the
cost that is acceptable and usually a standard price). Unfavorable variances mean that cost of
labor exceeds the budgeted value, while favorable variances mean that labor cost was less
than planned. Such information could be used for the planning and budgeting for future
periods, and also works as a feedback for employees responsible for direct labor component
of the business.
 Material yield variance: This variance is the difference between actual quantity of material
used and the standard quantity expected to be used in course of production, multiplied by
the standard cost of such materials.
 Volume Variance: Volume variance measures the difference between actual quantities sold
or consumed and budgeted quantity expected to be consumed or sold, multiplied by the
standard price per unit. The volume variance is a general measure of whether the business is
generating the volume of products that it had planned.
Benefits of using variance analysis
Using variance analysis in the decision-making process renders the following positive impacts:
 Competitive advantage: Variance analysis helps an organization to be proactive in
achieving their business targets, helps in identifying and mitigating any potential risks
which eventually builds trust among the team members to deliver what is planned.
 Identifying the changes required in the business strategy: In some of the cases,
comparing budget with actual results may point out the requirement for re-evaluating the
target customer base or product line of the company. Several assumptions go into
developing a budget. In case those assumptions are blowing up the budget, it could be
because the budget-related projections are wrong for a variety of reasons. It could also be
due to changes in the economy or delays in getting the products/services sent to end
customers.
 Identifying any managerial concerns : At times, variance analysis could also provide
insight as to how well an organization is being managed. For instance in the case of
purchasing, the inability to negotiate volume discounts or securing the competitive bids
could indicate managerial problems within the purchasing department. Moreover, weak
sales could also be an indication that the salespersons are not trained properly or they lack
motivation. By addressing such issues, the variances could disappear as the organization
gets on track.
 Managing risk: With the help of variance analysis, the finance heads gather insights which
they require to understand the reasons for controllable and uncontrollable variances. Once
they’re aware of such variance, they’re in a position to implement policies to mitigate such
risks arising from such variances.
 Creating shareholder value: When an organization brings in proper internal controls, a
cross-functional environment, efficient internal audit process, and the culture of meeting
commitments, it increases the chances that the variances would be favorable which means
that the business commitments would be met or even exceed the expectations.

Problems associated with variance analysis

 Timing delay: The accounting staff gather variances at end of every month before
providing results to the management. In most of the cases, management requires the
feedback much faster, and so it tends to rely on warning flags or measurements which are
generated on spot.
 Source of variance: Most of the reasons for the variances aren’t available in accounting
records, so accounting personnel needs to go through the information like labor routings,
bills of material, and overtime records for determining the reasons for such variances. Such
add-on activity is cost-effective only when the management could actively fix the problems
based on the information provided.
 Detailed analysis: If budgeting isn’t performed considering the detailed analysis of every
factor, the budgeting process might be loosely done that would deviate from actual numbers.
Analyzing variances might not make sense in such scenario.

TYPES OF VARIANCES
There is a need of knowing types of variances before measuring the variances. Generally, the
variances are classified on the following basis.
A. On the basis of Elements of Cost.
1. Material Cost Variance.
2. Labour Cost Variance.
3. Overhead Variance.
B. On the basis of Controllability
1. Controllable Variance.
2. Uncontrollable Variance.
C. On the basis of Impact
1. Favorable Variance.
2. Unfavorable Variance
D. On the basis of Nature
1. Basic Variance.
2. Sub-variance.

A brief explanation of the above mentioned variances are presented below

 Material Cost Variance: t is the difference between actual cost of materials used and the
standard cost for the actual output.
 Labour Cost Variance: It is the difference between the actual direct wages paid and the
direct labour cost allowed for the actual output to be achieved.
 Overhead Variance: Overhead variance is the difference between the standard cost of
overhead allowed for actual output (in terms of production units or labour hours) and the
actual overhead cost incurred.
 Controllable Variance: A variance is controllable whenever an individual or a department
or section or division may be held responsible for that variance.
 According to ICMA, London,
 Controllable cost variance is a cost variance which can be identified as primary
responsibility of a specified person.
 Uncontrollable Variance: External factors are responsible for uncontrollable variances.
The management has no power or is unable to control the external factors. Variances for
which a particular person or a specific department or section or division cannot be held
responsible are known as uncontrollable variances.
 Favourable Variances: Whenever the actual costs are lower than the standard costs at per-
determined level of activity, such variances termed as favorable variances. The management
is concentrating to get actual results at costs lower than the standard costs. It shows the
efficiency of business operation.
 Unfavorable Variances: Whenever the actual costs are more than the standard costs at
predetermined level of activity, such variances termed as unfavorable variances. These
variances indicate the inefficiency of business operation and need deeper analysis of these
variances.
 Basic Variances: Basic variances are those variances which arise on account of monetary
rates (i.e. price of raw materials or labour rate) and also on account of non-monetary factors
(such as physical units in quantity or time). Basic variances due to monetary factors are
material price variance, labour rate variance and expenditure variance. Similarly, basic
variance due to non-monetary factors are material quantity variance, labour efficiency
variance and volume variance.
 Sub Variance: Basic variances arising due to non-monetary factors are further analyzed and
classified into sub-variances taking into account the factors responsible for them. Such sub
variances are material usage variance and material mix variance of material quantity
variance.
 Likewise, labour efficiency variance is subdivided into labour mix variance and labour yield
variance. At the same time, variable overhead variance is sub-divided into variable
overhead efficiency variance and variable overhead expenditure variance.

Variance Analysis: Material, Labour, Overhead and Sales Variances

The function of standards in cost accounting is to reveal variances between standard costs which
are allowed and actual costs which have been recorded. The Chartered Institute of Management
Accountants (UK) defines variances as the difference between a standard cost and the
comparable actual cost incurred during a period. Variance analysis can be defined as the process
of computing the amount of, and isolating the cause of variances between actual costs and
standard costs. Variance analysis involves two phases:

(1) Computation of individual variances, and

(2) Determination of Cause (s) of each variance.

We now turn to explain below the computation of material, labour and factory overhead
variances:

I. Material Variance: The following variances constitute materials variances:

a. Material Cost Variance: Material cost variance is the difference between the actual cost of
direct material used and standard cost of direct materials specified for the output achieved. This
variance results from differences between quantities consumed and quantities of materials
allowed for production and from differences between prices paid and prices predetermined.

This can be computed by using the following formula:

Material cost variance = (AQ X AP) – (SQ X SP)

Where AQ = Actual quantity

AP = Actual price
SQ = Standard quantity for the actual output
SP = Standard price

b. Material Usage Variance: The material quantity or usage variance results when actual
quantities of raw materials used in production differ from standard quantities that should have
been used to produce the output achieved. It is that portion of the direct materials cost variance
which is due to the difference between the actual quantity used and standard quantity specified.

As a formula, this variance is shown as:

Materials quantity variance = (Actual Quantity – Standard Quantity) x Standard Price

A material usage variance is favourable when the total actual quantity of direct materials used is
less than the total standard quantity allowed for the actual output.

c. Material Mix Variance: The materials usage or quantity variance can be separated into mix
variance and yield variance.
For certain products and processing operations, material mix is an important operating variable,
specific grades of materials and quantity are determined before production begins. A mix
variance will result when materials are not actually placed into production in the same ratio as
the standard formula. For instance, if a product is produced by adding 100 kg of raw material A
and 200 kg of raw material B, the standard material mix ratio is 1: 2.
Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix variance will be
found. Material mix variance is usually found in industries, such as textiles, rubber and
chemicals, etc. A mix variance may arise because of attempts to achieve cost savings, effective
resources utilisation and when the needed raw materials quantities may not be available at the
required time.
Materials mix variance is that portion of the materials quantity variance which is due to the
difference between the actual composition of a mixture and the standard mixture.

It can be computed by using the following formula:

Material mix variance = (Standard cost of actual quantity of the actual mixture – Standard
cost of actual quantity of the standard mixture)
Or
 Materials mix variance = (Actual mix – Revised standard mix of actual input) x Standard
price

Revised standard mix or proportion is calculated as follows:

Standard mix of a particular material/Total standard quantity x Actual input

d. Materials Yield Variance: Materials yield variance explains the remaining portion of the
total materials quantity variance. It is that portion of materials usage variance which is due to
the difference between the actual yield obtained and standard yield specified (in terms of actual
inputs). In other words, yield variance occurs when the output of the final product does not
correspond with the output that could have been obtained by using the actual inputs. In some
industries like sugar, chemicals, steel, etc. actual yield may differ from expected yield based on
actual input resulting into yield variance.
The total of materials mix variance and materials yield variance equals materials quantity or
usage variance. When there is no materials mix variance, the materials yield variance equals the
total materials quantity variance. Accordingly, mix and yield variances explain distinct parts of
the total materials usage variance and are additive.

The formula for computing yield variance is as follows:

Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per unit

Yield, in such a case, is known as sub-usage variance (or revised usage variance) which
can be computed by using the following formula:

Sub-usage or revised usage variance = (Revised Standard Proportion of Actual Input –

Standard quantity) x Standard Cost per unit of input

Materials yield variance always equal sub-usage variance. The difference lies only in terms of
calculation. The former considers the output or loss in output and the latter considers standard
inputs and actual input used for the actual output. Mix and yield variance both provide useful
information for production control, performance evaluation and review of operating efficiency.

e. Materials Price Variance: A materials price variance occurs when raw materials are
purchased at a price different from standard price. It is that portion of the direct materials which
is due to the difference between actual price paid and standard price specified and cost variance
multiplied by the actual quantity. Expressed as a formula,

Materials price variance = (Actual price – Standard price) x Actual quantity

Materials price variance is un-favourable when the actual price paid exceeds the predetermined
standard price. It is advisable that materials price variance should be calculated for materials
purchased rather than materials used. Purchase of materials is an earlier event than the use of
materials.
II. Labour Variances: Direct labour variances arise when actual labour costs are different from
standard labour costs. In analysis of labour costs, the emphasis is on labour rates and labour
hours.

Labour variances constitute the following:

Labour Cost Variance:

Labour cost variance denotes the difference between the actual direct wages paid and the
standard direct wages specified for the output achieved.

This variance is calculated by using the following formula:

Labour cost variance = (AH x AR) – (SH x SR)

Where:
AH = Actual hours
AR = Actual rate
SH = Standard hours
SR = Standard rate

1. Labour Efficiency Variance: The calculation of labour efficiency or usage variance follows
the same pattern as the computation of materials usage variance. Labour efficiency variance
occurs when labour operations are more efficient or less efficient than standard performance. If
actual direct labour hours required to complete a job differ from the number of standard hours
specified, a labour efficiency variance results; it is the difference between actual hours
expended and standard labour hours specified multiplied by the standard labour rate per hour.

Labour efficiency variance is computed by applying the following formula:

Labour efficiency variance = (Actual hours – Standard hours for the actual output) x Std. rate
per hour.
(i) Labour Mix Variance: Labour mix variance is computed in the same manner as materials
mix variance. Manufacturing or completing a job requires different types or grades of workers
and production will be complete if labour is mixed according to standard proportion. Standard
labour mix may not be adhered to under some circumstances and substitution will have to be
made. There may be changes in the wage rates of some workers; there may be a need to use
more skilled or expensive types of labour, e.g., employment of men instead of women;
sometimes workers and operators may be absent.

These lead to the emergence of a labour mix variance which is calculated by using the
following formula:

Labour mix variance = (Actual labour mix – Revised standard labour mix in terms of actual
total hours) x Standard rate per hour

Labour mix variance will be calculated as follows:

Labour mix variance = (Actual proportion – Revised standard proportion of actual total hours)
x standard rate per hour

(ii) Labour Yield Variance: The final product cost contains not only material cost but also
labour cost. Therefore, gain or loss (higher or lower output than the standard output) should take
into account labour yield variance also. A lower output simply means that final output does not
correspond with the production units that should have been produced from the hours expended
on the inputs.
It can be computed by applying the following formula:

Labour yield variance = (Actual output – Standard output based on actual hours) x Av. Std.
Labour Rate per unit of output.
Or
Labour yield variance = (Actual loss – Standard loss on actual hours) x Average standard
labour rate per unit of output
Labour yield variance is also known as labour efficiency sub-variance which is computed in
terms of inputs, i.e., standard labour hours and revised labour hours mix (in terms of actual
hours).

Labour efficiency sub-variance is computed by using the following formula:

Labour efficiency sub-variance = (Revised standard mix – standard mix) x Standard rate

2. Labour Rate Variance: Labour rate variance is computed in the same manner as materials
price variance. When actual direct labour hour rates differ from standard rates, the result is a
labour rate variance. It is that portion of the direct wages variance which is due to the difference
between actual rate paid and standard rate of pay specified.

The formula for its calculation is:

Labour rate variance = (Actual rate – Standard rate) x Actual hours

.
3. Idle Time Variance: Idle time variance occurs when workers are not able to do the work due
to some reason during the hours for which they are paid. Idle time can be divided according to
causes responsible for creating idle time, e.g., idle time due to breakdown, lack of materials or
power failures. Idle time variance will be equivalent to the standard labour cost of the hours
during which no work has been done but for which workers have been paid for unproductive
time.

III. Overhead Variances: The analysis of factory overhead variances is more complex than
variance analysis for direct materials and direct labour. There is no standardisation of the terms
or methods used for calculating overhead variances. For this reason, it is necessary to be
familiar with the different approaches which can be applied in overhead variances
.
Generally, the computation of the following overhead variances are suggested:

(1) Total Overhead Cost Variance: This overall overhead variance is the difference between
the actual overhead cost incurred and the standard cost of overhead for the output achieved.

This can be computed by applying the following formula:

(Actual overhead incurred) – (Standard hours for the actual output x Standard overhead rate
per hour)
Or
(Actual overhead incurred) – (Actual output x Standard overhead rate per unit)

(2) Variable Overhead Variance: It is the difference between actual variable overhead cost
and standard variable overhead allowed for the actual output achieved.
The formula for computing this variance is as follows:
(Actual Variable Overhead Cost) – (Actual Output x Variable Overhead rate per unit)
Or
(Actual Variable Overhead Cost) – (Std. hours for actual output x Std. Variable overhead rate
per hour)

(3) Fixed Overhead Variance: This variance indicates the difference between the actual fixed
overhead cost and standard fixed overhead cost allowed for the actual output.

This variance is found by using the following formula:

Fixed Overhead Variance = (Actual Fixed Overhead Cost – Fixed Overhead absorbed)
Or
(Actual Fixed Overhead Cost) – (Actual Output x Fixed Overhead rate per unit)
Or
(Actual fixed overhead cost) – (Std. hours for actual output x Std. fixed overhead rate per hour)

(4) Variable Overhead Expenditure (Spending or Budget) Variance: This variance indicates
the difference between actual variable overhead and budgeted variable overhead based on actual
hours worked.

This variance is found by using the following:

(Actual variable overhead – Budgeted variable overhead)

(5) Variable Overhead Efficiency Variance: This variance is like labour efficiency variance
and arises when actual hours worked differ from standard hours required for good units
produced. The actual quantity produced and standard quantity fixed might be different because
of higher or lower efficiency of workers employed in the manufacturing of goods.

This variance is found by using the following formula:

(Actual hours – Standard hours for actual output) x Standard variable overhead rate per hour

(6) Fixed Overhead Expenditure (Spending or Budget) Variance: This variance indicates
the difference between actual fixed overhead and budgeted fixed overhead.

The formula for computing this variance is as follows:

(Actual fixed overhead – Budgeted fixed overhead)

.
(7) Fixed Overhead Volume Variance: Volume variance relates to only fixed overhead. This
variance arises due to the difference between the standard fixed overhead cost allowed
(absorbed) for the actual output and the budgeted fixed overhead based on standard hours
allowed for actual output achieved during the period. The variance shows the over-or-under-
absorption of fixed overheads during a particular period. If the actual output is more than the
standard output, there is over-absorption and variance is favourable. If actual output is less than
the standard output, the volume variance is unfavourable.

The formula for computing this variance is as follows:

(Budgeted fixed overhead applied to actual output – Budgeted fixed overhead based on
standard hours allowed for actual output)
Or
(Actual production – Budgeted production) x Std. fixed overhead rate per unit

Volume variance is further sub-divided into three variances:

(8) Fixed Overhead Calendar Variance: It is that portion of volume variance which is due to
the difference between the number of actual working days in the period to which the budget is
applicable and budgeted number of days in the budget period.
If actual working days is more than the budgeted working days, the variance is favourable as
work has been done on days more than budgeted or allowed and vice-versa.

The formula is as follows:

(No. of actual working days – No. of budgeted working days) x Std. fixed overhead rate per day.
Calendar variance can be computed based on hours or output.

Then the formulae are:

Hours Basis:
Calendar Variance = (Revised Budget Capacity hours – Budget Hours) x Std. Fixed Overhead
rate per hour
If revised budgeted capacity hours are more than the budgeted hours, the variance will be
favourable. In the reverse situation, the variance will be unfavourable.

Output Basis:
Calendar Variance = (Revised budgeted quantity in terms of actual number of days worked –
Budgeted quantity) x Standard fixed overhead rate per unit

If revised budgeted quantity is more than the budgeted quantity; the variance is favourable; if
revised budgeted quantity is less, the variance will be unfavourable.

(9) Fixed Overhead Efficiency Variance: It is that portion of volume variance which arises
when actual hours of production used for actual output differ from the standard hours specified
for that output. If actual hours worked are less than the standard hours, the variance is
favourable and when actual hours are more than the standard hours, the variance is
unfavourable.
The formula is:
Fixed Overhead Efficiency Variance = (Actual hours – Standard hours for actual production) x
Fixed overhead rate per hour
Fixed Overhead Efficiency Variance = (Actual production – Standard production as per actual
time available) x Fixed overhead rate per unit

(10) Fixed Overhead Capacity Variance: It is that part of fixed overhead volume variance
which is due to the difference between the actual capacity (in hours) worked during a given
period and the budgeted capacity (expressed in hours). The formula is

Capacity Variance = (Actual Capacity Hours – Budgeted Capacity) x Standard fixed overhead
rate per hour

This variance represents idle time also. If actual capacity hours are more than the budgeted
capacity hours, the variance is favourable and if actual capacity hours are less than the budgeted
capacity hours the variance will be unfavourable.
In case actual number of days and budgeted number of days are also given, then budgeted
capacity hours will be calculated in terms of actual number of days and it will be known as
revised budgeted capacity hours, i.e., budgeted hours in actual days worked.

In this situation, the formula for calculating capacity variance will be as follows:

Capacity Variance = (Actual Capacity hours – Revised Budgeted Capacity hours) x Standard
fixed overhead rate per hr.

In the above formula, the variance will be favourable if actual capacity hours are more than the
revised budgeted hours. However, if actual capacity hours are lesser than the revised budgeted
hours, the variance will be adverse as lesser hours means that lesser actual hours have been
worked taking the actual days utilised into account.

Two-way, Three-way and Four-way Variance Analysis:

The above overhead variances are also classified as Two-way, Three-way and Four-way
variance.

The different variances under these categories are listed below:

(A) Two-way Variance Analysis: The two-way analysis computes two variances budget
variance (sometimes called flexible budget or controllable variance) and volume variance,
which means:
 Budget variance = Variable spending variance + Fixed spending (budget) Variance +
Variable efficiency variance
 Volume variance = Fixed volume variance
(B) Three -Way Variance Analysis: The three-way analysis computes three variances
spending, efficiency and volume variances. Therefore,

 Spending variance = Variable spending variance + Fixed spending (budget) variance

 Efficiency variance = Variable efficiency variance
 Volume variance = Fixed volume variance

(C) Four-way Variance Analysis:

The four-way analysis includes:
 Variable spending variance
 Fixed spending (budget) variance
 Variable efficiency variance
 Fixed volume variance.

IV. Sales Variances: Sales variance is the difference between the actual value of sales achieved
in a given period and budgeted value of sales. There are many reasons for the difference in
actual sales and budgeted sales such as selling price, sales volume, sales mix.

Sales variance can be calculated by using any of the following two methods:

A. Sales variance based on turnover

B. Sales variances based on margin (i.e.,contribution margin or profit)

The first approach i.e., sales variance based on turnover, accounts for difference in actual sales
and budgeted sales. The sales variances using margin approach accounts for difference in actual
profit and budgeted profit. In the margin method, it is assumed that cost of production is
constant, i.e., no difference is assumed between actual cost of production and standard cost of
production.
The reason for this assumption is that cost variances are calculated separately to analyse the
difference between actual cost and standard cost of production. Therefore, cost side of the sales
variance is assumed constant under the margin method.
Sales variances computed under these two methods show different amounts of variance.

The different sales variances under these two approaches and their formula are given
below:

A. Sales Variances Based on Turnover:

(i) Sales Value Variance: Also known as sales variance, this variance shows the difference
between actual sales value and budgeted sales value.

The formula is:

Sales Value Variance = (Actual value of sales – Budgeted value of sales)
Actual sales = Actual quantity sold x Actual selling price
Budgeted sales = Standard quantity x Standard selling price
Or
Sales value variance = (Actual quantity x Actual selling price) – (Standard quantity x Standard
selling price)
If actual sales are more than the budgeted sales, there is favourable variance and if actual sales
are less than the budgeted sales, unfavourable variance arises.

(ii) Sales Price Variance: This variance is due to the difference between actual selling price
and standard or budgeted selling price.

The formula is:

Sales price variance = (Actual selling price – Budgeted selling price) x Actual quantity
If actual selling price is less than the budgeted selling price, variance is favourable and if
actual selling price is more than the budgeted selling price, there will be unfavourable sales
price variance.
(iii) Sales Volume Variance: Sales volume variance arises when the actual quantity sold is
different from the budgeted quantity. If actual sales quantity exceeds the budgeted sales
quantity, there is a favourable sales volume variance and if actual quantity sold is less than the
budgeted quantity, the variance is unfavourable.

The formula is:

Sales volume variance = (Actual quantity – Budgeted quantity) x Budgeted selling price

Sales volume variance is divided into two variances:

(i) Sales mix variance
(ii) Sales quantity variance
(i) Sales Mix Variance: Sales mix variance is one part of overall sales volume variance. This
variance shows the difference between actual mix of goods sold and budgeted mix of goods
sold.

The formula is:

Sales Mix Variance = (Actual Mix of quantity sold – Actual quantity in standard proportion) x
Standard selling price
Or
Sales Mix Variance = (Budgeted price per unit of actual mix – Budgeted price per unit of
budgeted mix) x Total actual quantity.
If actual sales mix are more than the mix in standard or budgeted proportion, the variance is
favourable and if actual mix sales are less than the standard mix (of actual sales), the variance is
unfavourable. Similarly, if budgeted price per unit of actual mix is more than the budgeted price
per unit of budgeted mix, favourable variance will arise. In the reverse situation, variance will
be unfavourable.

(ii) Sales Quantity Variance: This variance is also a part of overall volume variance. This
variance shows the difference between total actual sales quantity and total budgeted sales
quantity. If total actual quantity is more than the total budgeted quantity, variance will be
favourable and if total actual quantity is less than the total budgeted quantity, there will be
unfavourable sales quantity variance.

The formula is:

Sales quantity variance = (Total actual quantity – Total budgeted quantity) x Budgeted price
per unit of budgeted mix
The total of sales mix variance and sales quantity variance will be equal to sales volume
variance.

B. Sales Variance Based on Margin (i.e., Contribution Margin or Profit):

The sales variances using margin approach show the difference in actual profit and budgeted
profit only whereas sales variances based on turnover show the difference between total actual
sales and total budgeted sales.

The following sales variances are calculated if margin or profit is the basis of calculation:
Sales Variances based on Margin or Profit

(i) Total Sales Margin Variance: This variance indicates the aggregate or total variance under
the margin method. This variance shows the difference between actual profit and budgeted
profit.

The formula is:

Total sales margin variance = Actual Profit – Budgeted profit

If actual profit is more than the budgeted profit, variance will be favourable and if actual profit
is less than the budgeted profit, unfavourable variance will arise.

(ii) Sales Margin Price Variance: This variance is one part of total sales margin variance and
arises due to the difference between actual margin per unit and budgeted margin per unit. It is
significant to note that, assuming cost of production being constant, the difference in the actual
margin and budgeted margin will only be because of the difference between actual selling price
and budgeted selling price. The formula for calculating sales margin price variance is

Sales Margin Price Variance = (Actual Margin per unit – Budgeted Margin per unit) x Actual
quantity
If actual margin per unit is more than the budgeted margin per unit, favourable variance will be
found and if actual margin is less than the budgeted margin, variance will be unfavourable.
(iii) Sales Margin Volume Variance: This variance shows the difference between actual sales
units and budgeted sales units.

The formula is:

Sales Margin Volume Variance = (Actual quantity – Budgeted quantity) x Budgeted Margin per
unit.

If actual sales units are more than the budgeted sales units, variance will be favourable and if
actual sales units are less than the budgeted sales units, unfavourable variance will arise.

Sales margin volume variance can be calculated using another formula which is:

Sales margin volume variance = (Standard profit on actual quantity of sales – Budgeted profit)
If standard profit exceeds budgeted profit, variance will be favourable and if standard profit is
less than the budgeted profit, unfavourable variance will emerge.

Sales margin volume variance consists of:

(i) Sales margin mix variance and
(ii) Sales margin quantity variance.

(i) Sales Margin Mix Variance: This variance shows the difference between actual mix of
goods and budgeted (standard) mix of goods sold.

The formula is:

Sales Margin Mix Variance = (Actual sales mix – Standard proportion of actual sales mix) x
Budgeted margin per unit.

If budgeted margin per unit on actual sales mix is more than the budgeted margin per unit on
budgeted mix, variance will be favourable. In the reverse situation, unfavourable variance will
arise.
(ii) Sales Margin Quantity Variance: This variance will be found when the total actual sales
quantity in standard proportion is different from the total budgeted sales quantity.

The formula is:

Sales Margin Quantity Variance = (Actual sales in standard proportion – Budgeted sales) x
Budgeted margin per unit on budgeted mix
If actual sales (in standard proportion) are more than the budgeted sales, variance will be fa-
vourable and if actual sales are less than the budgeted sales, unfavourable variance will arise.

Standard Costing

Definition: Standard Costing is a costing method, that is used to compare the standard costs and
revenues with the actual results, in order to arrive at the variances along with its causes, to
inform the management about the deviations and take corrective measures, for its improvement.
The term ‘standard cost’ can be defined as the expected cost per unit of the products produced
during a period, which is based on various factors. It aims at measuring the performance,
controlling the deviations, inventory valuation and deciding the selling price of the product
especially when quotations are prepared.

The three main elements of standard cost are Direct Material Cost, Direct Labor
Cost and Overheads.

Need of Standard Costing

 Future cost estimation: Standard Costs are determined after considering all the
possibilities that may arise in the future. It also helps in deciding whether a particular
project is to be undertaken, by determining its profitability.
 Performance check: Standard cost acts as targets to the cost centres which should not
be transcended. In such a situation, these targets are helpful in checking the performance
through comparison with the actual results.
 Budgeting: The standard costs are used to prepare budgets, and evaluate the
performance of the executive staff on the basis of these budgets.

The basic objective of standard costing is to measure the differences between standard costs and
actual costs, and analysing them to maintain the productivity of the organization.
Process of Standard Costing

1. Establishing Standards: First and foremost, the standards are to be set on the basis of
management’s estimation, wherein the production engineer anticipates the cost. In
general, while fixing the standard cost, more weight is given to the past data, the current
 plan of production and future trends. Further, the standard is fixed in both quantity and
costs.
2. Determination of Actual Cost: After standards are set, the actual cost for each element,
i.e. material, labour and overheads is determined, from invoices, wage sheets, account
books and so forth.
3. Comparison of Actual Costs and Standard Cost: Next step to the process, is to
compare the standard cost with the actual figures, so as to ascertain the variance.
4. Determination of Causes: Once the comparison is done, the next step is to find out the
reason for the variances, to take corrective actions and also to evaluate the overall
performance.
5. Disposition of Variances: The last step to this process, is the disposition of variances by
transferring it to the costing profit and loss account.

Standard costing can be helpful in ascertaining the profitability of the business at any level of
production. Further, it is also useful in practical management functions, i.e. planning and
controlling.

Objectives of Standard Costing:

The objectives of standard costing technique are as follows:
a. To provide a formal basis for assessing performance and efficiency.
b. To control costs by establishing standards and analysis of variances.
c. To enable the principle of ‘management by exception’ to be practised at the detailed,
operational level.
d. To assist in setting budgets.
e. The standard costs are readily available substitutes for actual average unit costs and can be
used for stock and work-in-progress valuations, profit planning and decision making and as
a basis of pricing where ‘cost-plus’ systems are used.
f. To assist in assigning responsibility for nonstandard performance in order to correct
deficiencies or to capitalise on benefits.
g. To motivate staff and management.
h. To provide a basis for estimating.
i. To provide guidance on possible ways of improving performance.

Types of Standards:
a. Current Standard: Current standard is a standard established for use over a short period of
time, related to current conditions. The problem with this type of standard is that it does not
try to improve on current levels of efficiency.
b. Basic Standard: Basic standard is standard established for use over a long period from
which a current standard can be developed. The main disadvantage of this type of standard
is that because it has remained unaltered over a long period of time, it may be out of date.
The main advantage is in showing the changes in trend of price and efficiency from year to
year.
 c. Ideal Standard: Ideal standard is a standard which can be attained under the most
favourable conditions. No provision is made, e.g., for shrinkage, spoilage or machine
breakdowns. Users believe that the resulting unfavourable variances will remind
management of the need for improvement in all phases of operations. Ideal standards are not
widely used in practice because they may influence employee motivation adversely.
d. Attainable Standard: Attainable standard is a standard which can be attained if a standard
unit of work is carried out efficiently, on a machine properly utilized or material properly
used. Allowances are made for normal shrinkage, waste and machine breakdowns. The
standard represents future performance and objectives which are reasonably attainable.
Besides having a desirable motivational impact on employees, attainable standards serve other
purposes, e.g., cash budgeting, inventory valuation and budgeting departmental performance. If
correctly set attainable standards are the best type of standards to use, since they provide
employees with a realistic target. Attainable standards have the greatest motivational impact on
the workforce.

Setting Standards: In order to use predetermined standard costs, standards have to be set for
each element of cost for each line of product manufactured or service supplied. Standard cost
shows what the cost should be keeping in mind the most favourable production conditions, and
on the assumption that plant will operate at maximum possible efficiency.
The collaboration of all functional departments is a must in setting standards. The quantities,
price and rates, qualities or grades, terms of purchase, product substitution etc. have to be kept
in mind while setting standards.
The success of standard cost system depends on the reliability, accuracy and acceptance of the
standards. Standards must be set and the system implemented whatever may be faults or delay
or cost, otherwise the whole exercise will go waste.

The methodology used in conventional approach to variance analysis is as follows:

 Setting of standards and construction of a budget based on them.
 Comparison of actual with budgeted outcomes.
 Factoring the variance into individual components and investigation of the significant
differences.

In this approach the standards are related to expectations over the budget period and do not
necessarily reflect optimal performance. Usually it is believed that standards should be
reasonably attainable in the circumstances envisaged.

Thus in this context conventional variance analysis is a postmortem exercise. If the standards
are tight then this will have a disincentive effect, whereas if the standards are loose then this
results in complacency.

The behavioural aspects and implications are generally ignored while setting the standards,
which cause the arbitrary investigation of variances. It does not give adequate guidance
regarding cost-benefit of variances investigated or cost of correcting errors. Thus the
conventional analysis is more a postmortem.
Development of Standard Costing:

Importance of Standard Costing cannot be ignored for the following and that is why the
same is well-developed in the present-day world:

 Compilation of Historical Cost is very expensive and difficult: A manufacturing firm

making large number of parts requires too much clerical work which is required in order to
compile the materials, labour and overhead charges to each and every cost of parts produced
for ascertaining the average cost of the product.
 Historical Costs are inadequate: In order to measure the manufacturing efficiency,
historical costs are not practically adequate. It fails to explain the reasons of increased cost
or any change in cost structure.
 Historical Costs are too old: In many firms, costs are determined and selling prices are
ascertained even before the production starts—which is not desirable.
 Historical Costs are not typical: This is due to the wide fluctuation in market for which
there is no relation between the selling price per unit and cost price per unit.
 UNIT V

ACCOUNTING IN COMPUTERISED ENVIRONMENT

Significance of Computerized Accounting System- Codification and Grouping of Accounts- Maintaining

the hierarchy of ledgers- Prepackaged Accounting software

Computerized Accounting System: Features, Advantages and Other Details

What is Computerized Accounting System?

Firstly, Computerized accounting systems are software programs that are stored on a company’s
computer, network server, or remotely accessed via the Internet. A firm prepares various
reports with the help of it.
Hence, it also helps to analyze the company’s operations, efficiency, and profitability. Most
importantly, firms prepare its reports as per Generally Accepted Accounting Principles (GAAP)
under this system.

Features of Computerised Accounting System

1. Very neat and accurate work
2. Need for less clerical work
3. Cost and time efficient
4. Less possibility of errors and omissions
5. Generated real-time comprehensive MIS reports

Need for Computerized Accounting:

The need for computerized accounting arises from advantages of speed, accuracy and lower cost
of handling the business transactions.

1. Numerous Transactions: The computerized accounting system is capable of large

number of transactions with speed and accuracy.
2. Instant Reporting: It is capable of offering quick and quality reporting because of its
speed and accuracy.
3. Reduction in Paper Work: Manual accounting system requires large storage space to
keep accounting records/books, and vouchers/documents. The requirement of books and
stationery and books of accounts along with vouchers and documents is directly
dependent on the volume of transactions beyond certain point.
4. There is a dire need to reduce the paper work and dispense with large volume of books
of account. This can be achieved with the help of computerized accounting system.
5. Flexible Reporting: The reporting is flexible in computerized accounting system. It is
capable of generating reports of any balance as when required and for any duration
which is within the accounting period.
6. Accounting Queries: There are accounting queries, which are based on some external
parameters. For example, a query relating to overdue customers’ accounts can be easily
 answered by using the structured query language [SQL] support of database technology
in the computerized accounting system. Such an exercise would be quite difficult and
expensive in manual accounting system.
7. Online Facility: Computerized accounting system offers online facility to store and
process transaction data so as to retrieve information to generate and view financial
reports.
8. Accuracy: The information and reports generated are accurate and quite reliable for
decision-making. In manual accounting system, as many people do the job and the
volume of transactions is quite large, such information and reports are likely to be
distorted and unreliable and inaccurate.
9. Security: This system is highly secured and the data and information can be kept
confidential, when compared to manual accounting system.
10. Scalability: The system can cope easily with the increase in the volume of business. It
requires only additional data operators for storing additional vouchers.

Requirements of the Computerized Accounting System:

 Accounting Framework: A good accounting framework in terms of accounting
principles, coding and grouping structure is a pre-condition. It is the application
environment of the computerized accounting system.
 Operating Procedure: A well-conceived and designed operating procedure blended
with suitable operating environment is necessary to work with the computerized
accounting system. The computer accounting is one of the database-oriented
applications, wherein the transaction data is stored in well-organized database.
The user operates on such database using the required interface. And he takes the
required reports by suitable transformations of stored data into information. Hence, it
includes all the basic requirements of any database-oriented application in computers.

Advantages of Computerized Accounting:

1. Better Quality Work: The accounts prepared with the use of computers are usually
uniform, neat, accurate, and more legible than manual job.
2. Lower Operating Costs: Computer is a labor and time saving devise. Hence, the
volume of job handled with the help of computers results in economy and lower
operating costs.
3. Improved Efficiency: Computer brings speed and accuracy in preparing the records and
accounts and thus, increases the efficiency of employees.
4. Facilitates Better Control: From the management point of view, greater control is
possible and more information may be available with the use of computer in accounting.
It ensures efficient performance in accounting work.
5. Greater Accuracy: Computerized accounting ensures accuracy in accounting records
and statements. It prevents clerical errors and omissions.
6. Relieve Monotony: Computerized accounting reduces the monotony of doing repetitive
accounting jobs, which are tiresome and time consuming.
7. Facilitates Standardization: Computerized accounting facilitates standardization of
accounting routines and procedures. Therefore, standardization in accounting is ensured.
8. Minimizing Mathematical Errors: While doing mathematics with computers, errors
are virtually eliminated unless the data is entered improperly in the first instance.
Disadvantages of Computerized Accounting:
1. Reduction of Manpower: The introduction of computers in accounting work reduces
the number of employees in an organization. Thus, it leads to greater amount of
unemployment.
2. High Cost: A small firm cannot install a computer accounting system because of its
high installation and maintenance cost. To be more economical there should be large
volume of work. If the system is not used to its full capacity, then it would be highly
uneconomical.
3. Require Special Skills: Computer system calls for highly specialized operators. The
availability of such skilled personnel is very scarce and very costly.
4. Other Problems: Frequent repair and power failure may affect the accounting work
very much. Computers are prone to viruses. Often time’s people will assume the
computer is doing things correctly and problems will go unchecked for long period of
time.

Problems Faced In Computerized Accounting System:

1. User Training: The user, for using computer accounting software, needs to understand
the concepts of the software. Hence, he should undergo proper training. A computer
operator must learn the basics of computer, concepts of software, working with the
operating system software [such as Windows/DOS] and the accounting software.
2. System Dependency: Using a computer solution makes the user to depend fully on the
computer system and necessitates the availability of computer at all times. If the system
is not available [due to hardware failure or power cut], it would be difficult to verify the
accounts.
3. Hardware Requirements: A full-fledged computer system with a printer is required to
operate the computerized accounting system. Most small organizations may not afford to
have such facility with necessary software.
4. System Failure: When there is a system crash [hard disk crash], there is high risk of
losing the data available on the hard disk drive at any point of time. It would be highly
painful, if the problem occurs at end of the financial year, when the financial statements
should be ready.
5. Backups and Prints: Backups of the data should be done regularly so that, when the
data is lost, it can be restored from floppies [backups]. Regular print outs of the system
information would be useful as manual records.
6. Voucher Management: Accounting software allows easy alteration of data. If a
voucher is wrongly placed in a wrong head, it would be very difficult to sort out and
bring back the voucher. A good voucher management is very essential.
7. Security: Additional security has to be provided because improper handling of the
system [hardware/software] could be dangerous. Passwords, locks, etc., have to be set so
that no unauthorized person can handle the system.

Features of Computerised Accounting Environment

This Accounting System and its awareness among entities have become a necessity in the
present environment. Businesses of whatever field and size are shifting from the practice of
maintaining accounts manually. The manual process is more time-consuming and exposed to
human error.
Storage and retrieval of data and generation of a report cannot be ensured in real time in the
traditional system. There is a need to shift to computerized accounting systems. They have
empowered business to project accurate information of financial performance.

1. Simple and Integrated: It helps all businesses by automating and integrating all the
business activities. Such activities may be sales, finance, purchase, inventory, and
manufacturing etc. It also facilitates the arrangement of accurate and up-to-date business
information in a readily usable form.
2. Accuracy & Speed: Computerised accounting has customized templates for users
which allows fast and accurate data entry. Thus, after recording the transactions it
generates the information and reports automatically.
3. Scalability: It has the flexibility to record the transactions with the changing volume of
business.
4. Instant Reporting: It can generate a quality report in real time because of high speed
and accuracy.
5. Security: Secured data and information can be kept confidential as compared to the
traditional accounting system.
6. Quick Decision Making: This system Generates real-time, comprehensive MIS reports
and ensures access to complete and critical information, instantly.
7. Reliability: It generates the report with consistency and accuracy. Minimization of
errors makes the system more reliable.

The importance of a Computerized Accounting System

Computer is an important part of an accounting system. Computerized accounting systems are
important to business in various ways. Computers helps businesses by making their staff
efficient productive and also save their valuable time. It helps to maintain business and all
financial information for the business is well-organized.

1) Time and cost savings : Using a computerized accounting system saves companies
time and money. The use of computer makes inputting accounting information simple.
Business transaction are entered into the system and the system posts transactions
accordingly.
2) Organization : A computerized accounting system help business to stay organised.
When information is entered into the system. it makes finding the information easy.
Employees can see any financial information whenever it is needed.
3) Storage : Storing information is vital to a business. In Computerized System data cam
be stored quickly. after information is entered into the system the information is stored
indefinitely. Companies perform backups on the system regularly to avoid losing any
information.
4) Distribution : Computerized accounting systems Allow companies to distribute
Financial information easily. Financial statements are printed directly from the system
and are distributed internally and externally to those needing the information.
 5) Management reports: Data within the computerized accounting system is accurate and
up-to-date. Management can request online report in real-time and that makes
management decisions more reliable and timely.
6) Regulatory Compliance : Reports are required on a regular basis from various
government Agencies. a computer system can organize their data and reports to comply
with this statutory requirements savings time.

Codification and Grouping of Accounts

Unlike a manual accounting system where account codes are rarely used a computerised
accounting system frequently uses a well defined coding system. However, it should not be
concluded that computerised account must always have account codes. There are many
accounting softwares available which support a non-coded accounting system. A coded
accounting system is more convenient where there are numerous account heads and the
complexity is high. It also to some extent reduces the possibility of the same account existing
in several names due to spelling mistakes or abbreviations used.

A proper codification requires a systematic grouping of accounts. The major groups or heads
could be Assets, Liabilities, Revenue Receipts, Capital Receipt, Revenue Expenditure, Capital
Expenditure. The sub-groups or minor heads could be "Cash" or "Receivables" or "Payables"
and so on. The grouping and codification is dependant upon the type of organisation and the
extent of sub-division required for reporting on the basis of profit centres or product lines.
There could a classification based on geographical location as well.

(a) The main unit of classification in accounts should be the major head which should be
divided into minor heads, each of which should have a number of subordinate heads,
generally shown as sub-heads. The sub-heads are further divided into detailed heads.
Sometimes major heads may be divided into 'sub-major heads' before their further
division into minor heads.
The Major heads, Minor heads, Sub-heads and Detailed heads together may
constitute a four tier arrangement of the classification structure of Accounts.

(b) Major heads of account falling within the Receipt Heads (Revenue Account) may
correspond to different activities or line of business of the company such as car
manufacture, servicing of cars, repairs and maintenance of cars, while minor heads
subordinate to them shall identify the specific manufacturing activity like
manufacture of car body, components and spare parts, etc. A manufacture of car
body may consist of a number of activities like the manufacture of the chasis, the
door, the front panel, the rear panel, etc. These will then correspond to 'sub-heads'
below the minor head represented by the main activity - car manufacture.
(c) A "detailed head'' is often termed as an object classification. In the expenditure
account being considered in the above example the main purpose of the detailed head
is to control expenditure on an item to item basis and at the same time group the
objects according to the nature. Example of such detailed head could be 'Salaries',
'Office Expenses', 'Salesman Expenses', 'Workshop Overhead', etc.
 (d) The detailed classification of account heads and the order in which the Major and
Minor heads shall appear in all account records should be approved by the top
management of the organisation and should be reviewed by the auditor before they
are introduced in the computerised accounting environment.

Grouping and codification of accounts

When the volume and size of the business increase, the number of transaction increases.

Grouping and codification of accounts

When the volume and size of the business increase, the number of transaction increases.
Therefore, it becomes necessary to have proper classification of data.

Grouping of accounts

In any organisation, the main unit of classification is the major head which is further divided
into minor heads. Each minor head may have number of sub-heads. After classification of
accounts into various groups namely, major, minor and sub-heads and allotting codes to each
account these are programmed into the computer system.
A proper codification requires a systematic grouping of accounts. The major groups or heads
could be Assets, Liabilities, Revenues and Expenses. The sub- groups or minor heads could be
capital, non-current liabilities, current assets, sales and so on.
In general, the basic classifications of different accounts embodied in a transaction are resorted
through accounting equation.

Assets = Liabilities + Capital + (Revenues – Expenses)

Each component of the above equation can be divided into groups of accounts as follows:

A. Liabilities and capital

Capital
 Capital
 Reserves and surplus

Non-Current Liabilities
 Long-term borrowings
 Other long-term liabilities

Current liabilities
 Short term borrowings
 Trade payables
 Other current liabilities

B. Assets
Fixed tangible assets
 Land and building
 Plant and machinery
 Furniture and fixtures

Intangible assets
 Goodwill
 Copyright
 Patents

Current Assets
 Short term investments
 Inventories
 Trade receivables
 Cash and cash equivalents
 Short term loans and advances
 Other current assets
C. Revenues
 Sales
 Other income

D. Expenses
 Material consumed
 Wages
 Manufacturing expenses
 Depreciation
 Administrative expenses
 Interest
 Selling and distribution expenses, etc.

Codification of accounts

Code is an identification mark. Generally, computerised accounting involves codification of

accounts. Codification of accounts is needed where there are numerous accounts heads in an
organisation. There is a hierarchical relationship between the groups and its components. In
order to maintain the hierarchical relationships between a group and its sub-groups, proper
codification is required.

The coding scheme of account heads should be such that it leads to grouping of accounts at
various levels so as to generate various reports. For example, the codes for various accounts
may be allotted as follows:

 Liabilities and Capital

 Assets
 Revenues
 Expenses
Under Liabilities and Capital
 Capital
 Non-current liabilities
 Current liabilities
Under Assets
 Non-current assets
 Current assets

The above codification scheme utilises the hierarchy present in grouping of accounts. Major
advantage of such coding is that if the account codes are listed in ascending order, these will be
automatically listed as per the desired hierarchy.
Methods of codification
Following are the three methods of codification.
a. Sequential codes
In sequential code, numbers and/or letters are assigned in consecutive order. These codes are
applied primarily to source documents such as cheques, invoices, etc. A sequential code can
facilitate document search. For example:

Code Accounts
CL001 ABC LTD
CL002 XYZ LTD
CL003 SCERT

b. Block codes
In a block code, a range of numbers is partitioned into a desired number of sub-ranges and each
sub-range is allotted to a specific group. In most of the cases of block codes, numbers within a
sub-range follow sequential coding scheme, i.e., the numbers increase consecutively. For
example:

Code Dealer type

100 – 199 Small pumps
200 – 299 Medium pumps
300 – 399 Pipes
400 – 499 Motors

c. Mnemonic codes
A mnemonic code consists of alphabets or abbreviations as symbols to codify a piece of
information. For example:

Code Information
SJ Sales Journals
HQ Head Quarters

Maintaining the Hierarchy of Ledgers

Once the classification of accounts into various groups is complete and codification is done
after formation of major, minor, sub and detailed heads the same is required to be inserted into
the computer system.
Account master files are created with codes and description of the accounts. Some accounting
software allows ledgers and subsidiary ledgers to be created from the main ledgers. The
Accounting subsidiary ledgers can further be subdivided to sub subsidiary ledgers thereby
allowing grouping under various profit centres. These are particularly useful where accounts are
maintained without codes. In a coded system this is easily achieved by alloting codes to major,
minor, sub and detailed heads and thereafter obtaining reports based on these codes.
Apart from the general ledger and the subsidiary ledger (or the sub-subsidiary ledger as is
available in some software) there are other ledger accounts that are automatically created by any
standard accounting software. These are the debtors ledger and the creditors ledger.
At the time of creation of the account heads some of account heads are indicated to the system
as cash account, bank account, debtors account and creditors account. Thereafter whenever an
entry is made say with a cash account and a bank account the computer automatically indicates
it as a contra in the reports. Similarly when a sale transaction is made, the reflection is given in
the debtors account and when a purchase transaction is made the reflection goes to the creditors
account.
Another important ledger which forms part of most standard accounting package is the
inventory ledger. In simple accounting softwares this may give only the movement of inventory
items without valuation of inventories. However, many of the packages give the option of
valuation of inventories based on the method of costing set like the FIFO, LIFO , weighted
average, etc.

Accounting Packages and Consideration for their Selection

 Account can be maintained in a computerised environment even by using a spread sheet

package.
 User will have to use his knowledge and skills of spread sheet software to keep control
of the figures.
 Special spreadsheet controls including physical spreadsheet controls like spreadsheets
locked on a protected shared drive with restricted access and read/write access controls
and password-protected cells and formulas with passwords should be used.
 Spreadsheet softwares allow grouping of accounts, replication of cell contents, formulas
and macros, pivot tables, calculations and functions which help in the maintainance of
the accounts.
 The limitations of a spreadsheet could be that double entry is not automatically
completed thereby requiring the users to set formulas or other means to complete the
double entry. Further, where large number of data is involved spreadsheet software may
not work. It may also be difficult in a lan environment where users may require to
simultaneously access a spreadsheet.

To sum up the advantages of a spreadsheet software as an accounting tool are:

1. It is simple to use and easy to understand
2. Most of the common functions like doing calculations, setting formulas, macros,
replication of cell contents, etc can be easily done in a spreadsheet.
3. Grouping and regrouping of accounts can be done.
4. Presentation can be made in various forms including graphical presentations like bar
diagram, histogram, pie-chart, etc.
5. Basic protection like restricted access and password protection of cell can be used to
give security to the spread sheet data.

The disadvantages of a spreadsheet as an accounting tool are:

1. It has data limitations. Depending upon the package they can accept data only up to a
specified limit.
2. Simultaneous access on a network may not be possible. Many of the modern
softwares allow locking of the table when updation is taking place. This is not
possible in a spread sheet.
3. Double entry is not automatically completed. Formulas or other means have to be
adopted to complete the double entry.
 4. Reports are not automatically formatted and generated but have to be user controlled.
Each time a report has to be printed, settings have to be checked and data range has
to be set. In many accounting software this is automatically taken care of by the
program.

Prepackaged Accounting Software

 There are several prepackaged accounting software which are available in the market
and are used extensively for small and medium sized organisations. These softwares are
easy to use, relatively inexpensive and readily available.

 The installation of these softwares are very simple. An installation diskette or CD is

provided with the software which can be used to install the software on a personal
computer. A network version of this software is also generally available which needs to
be installed on the server and work can be performed from the various workstations or
nodes connected to the server. Along with the software an user manual is provided
which guides the user on how to use the software.

 After installation of the software, the user should check the version of the software to
ensure that they have been provided with the latest. The vendor normally provides
regular updates to take care of the changes of law as well as add features to the existing
software.

 These softwares normally have a section which provides for the creation of a company.
The name, address, phone numbers and other details of the company like VAT
registration number, PAN and TAN numbers are feeded into the system. The accounting
period has to be set by inserting the first and the last day of the financial year.

Once the basic parameters are set and the master files are updated, the system is ready for use.

To summarise, any standard prepackaged software will have the following master file screens:
 Company master file
 Accounts master file
 Sub ledger master file
 Customer master file
 Vendor master file
 Product master file
 Division master file

The entry screens differ in look and feel from software to software and from vendor to vendor.

However, the basic entry screens are the following:

 Cash Receipts and Payment Entry

 Bank Receipts and Payment Entry
 Petty Cash Voucher Entry
 Journal Entry
  Purchase Order, GRN, Bill, Purchase return Entry
 Sales Order, Challan, Invoice, Sales Return Entry
 Debit Notes and Credit Notes Entry
 Cash Sales & Purchase Memos
 Production
 Consumption
 Stock Transfer

Each of the screens are provided with the add, modify or delete options. Special options like the
date modification and voucher number modifications are provided in some of the softwares.

The next section that the software provides is the reports section where the following reports are
common to most of the software’s:

 Cash Book
 Bank Book
 Petty Cash Book
 Purchase Book
 Sales Book
 Cash Sales Book,
 Cash Purchase Book,
 Sales Return register
 Purchase Return register
 Journal Book
 General Ledger
 Subsidiary Ledger
 Debtors Ledger
 Creditors Ledger
 Debit Note Register
 Credit Note Register
 Stock Ledger
 Stock movement register
 Production register
 Consumption register

Document printing options like printing of purchase orders, challans and bills, sales order,
challans and invoices, declaration forms and return forms.

 Trial Balance
 Profit and Loss Account
 Balance Sheet

Some of the software provide bank reconciliation options. In the entry screen date of clearances
can be inserted. Reports can thereafter be generated of all uncleared items to make the BRS
report.
There are special reports also provided by some software like the cash, bank maintenance
reports which shows any date on which the cash or bank by mistake had credit balance. There
are also MIS reports like aging of debtors, slow moving and non-moving stock, etc.
The last section also called the house keeping section of this software provides the system
maintenance features. Backup can be taken and restored under the housekeeping section. Clean-
up, fine tuning and re-indexing of the software is part of this section of the software.

Advantages of Pre-Packaged Accounting Software :

 Easy to install: The CD or floppy disk is to be inserted and the setup file should be run
to complete the installation. Certain old DOS based accounting softwares required some
settings to be added in the system configuration file and the system batch file. These
instructions are generally provided in the user manuals.
 Relatively inexpensive: These packages are sold at very cheap prices nowadays.
 Easy to use: Mostly menu driven with help options. Further the user manual provides
most of the solutions to problems that the user may face while using the software.
 Backup procedure is simple: Housekeeping section provides a menu for backup. The
backup can be taken on floppy disk or CD or hard disk.
 Flexibility: Certain flexibility of report formats provided by some of the software: This
allows the user to make the invoice, challan; GRNs look the way they want.
 Very effective for small and medium size businesses: Most of their functional areas are
covered by these standardised packages.

Disadvantage of Pre-packaged Accounting Software:

 Does not cover peculiarities of specific business: Business today are becoming more
and more complex. A standard package may not be able to take care of these
complexities.
 Does not cover all functional area: For example production process may not be
covered by most pre-packaged accounting software.
 Customization may not be possible in most such software’s: The vendors for these
software’s believe in mass sale of an existing source. The expertise for customization
may not have been retained by the vendor.
 Reports generated is not sufficient or serve the purpose: The demands for modern
day business may make the management desire for several other reports for exercising
management control. These reports may not be available in a standard package.
 Lack of security: Any person can view data of all companies with common access
password. Levels of access control as we find in many customized accounting
software packages are generally missing in a pre-packaged accounting package.
 Bugs in the software: Certain bugs may remain in the software which takes long to be
rectified by the vendor and is common in the initial years of the software.

Consideration for Selection of Pre-Packaged Accounting Software

There are many accounting software’s available in the market. To choose the accounting
software appropriate to the need of the organisation is a difficult task. Some of the criteria for
selection could be the following:
 Fulfillment of business requirements: Some packages have little functionality more
than the others. The purchaser may try to match his requirement with the available
solutions.
 Completeness of reports: Some packages might provide extra reports or the reports
match the requirement more than the others.
 Ease of use: Some packages could be very detailed and cumbersome compare to the
others.
 Cost: The budgetary constraints could be an important deciding factor. A package
having more features cannot be opted because of the prohibitive costs.
 Reputation of the vendor: Vendor support is essential for any software. A stable
vendor with reputation and good track records will always be preferred.
 Regular updates : Law is changing frequently. A vendor who is prepared to give
updates will be preferred to a vendor unwilling to give updates.

Customised Accounting Software

Customised accounting software is one where the software is developed on the basis of
requirement specifications provided by the organisation. The choice of customized accounting
software could be because of the typical nature of the business or else the functionality desired
to be computerised is not available in any of the pre-packaged accounting software. An
organisation desiring to have an integrated software package covering most of the functional
area may have the financial module as part of the entire customised system.

Advantages of a Customised Accounting Package

Advantages of a customised accounting package are the following:
 The functional areas that would otherwise have not been covered gets computerised.
 The input screens can be tailor made to match the input documents for ease of data
entry.
 The reports can be as per the specification of the organisation. Many additional MIS
reports can be included in the list of reports.
 Bar-code scanners can be used as input devices suitable for the specific needs of an
individual organisation.
 The system can suitably match with the organisational structure of the company.

Disadvantages of a Customised Accounting Package

The disadvantages which may arise in a customised accounting package are the following:
 Requirement specifications are incomplete or ambiguous resulting in a defective or
incomplete system.
 Inadequate testing results in bugs remaining in the software.
 Documentation is not complete.
  Frequent changes made to the system with inadequate change management procedure
resulting in system compromise.
 Vendor unwilling to give support of the software due to other commitments.
 Vendor not willing to part with the source code or enter into an escrow agreement.
 Control measures are inadequate.
 Delay in completion of the software due to problems with the vendor or inadequate
project management.

The choice of customised accounting packages is made on the basis of the vendor proposals.
The proposals are evaluated as to the suitability, completeness, cost and vendor profiles.
Generally preference is given to a vendor who has a very good track record of deliverables.

Accounting Software as Part of Enterprise Resource Planning (ERP)

Larger organisations often go for an ERP package where finance comes as a module. An ERP is
an integrated software package that manages the business process across the entire enterprise.

Advantages of Using an ERP

The advantages of using an ERP for maintaining accounts are as follows:

 Standardised processes and procedures: An ERP is a generalised package which

covers most of the common functionalities of any specific module.
 Standardised reporting: Majority of the desired reports are available in an ERP
package. These reports are standardised across industry and are generally acceptable to
the users.
 No Redundancy: Duplication of data entry is avoided as it is an integrated package.
 Better Information: Greater information is available through the package.

Disadvantages of an ERP
The disadvantages of an ERP are the following:

 Lesser flexibility: The user may have to modify their business procedure at times to
be able to effectively use the ERP.
 Implementation hurdles : Many of the consultants doing the implementation of the
ERP may not be able to fully appreciate the business procedure to be able to do a good
implementation of an ERP
 Very expensive: ERP are normally priced at an amount which is often beyond the
reach of small and medium sized organisation. However, there are some ERP coming
into the market which are moderately priced and may be useful to the small
businesses.
 Complexity of the software: Generally an ERP package has large number of options to
choose from. Further the parameter settings and configuration makes it a little
complex for the common users.
Choice of an ERP
Choice of an ERP depends upon the following factors:

 Functional requirement of the organisation: The ERP that matches most of the
requirements of an organisation is preferred over the others.
 Reports available in the ERP: The organisation visualises the reporting requirements
and chooses a vendor which fulfils its reporting requirements.
 Background of the vendors: The service and deliverable record of a vendor is
extremely important in choosing the vendor.
 Cost comparisons: The budget constraints and fund position of an enterprise often
becomes the deciding factor for choosing a particular package.

Outsourcing of Accounting Function:

Recently a growing trend has developed for outsourcing the accounting function to a third party.
The consideration for doing this is to save cost and to utilise the expertise of the outsourced
party. The third party maintains the accounting software and the client data, does the processing
and hands over the report from time to time.

Advantages of Outsourcing the Accounting Functions

The advantages of outsourcing the accounting functions are the following:
 The organisation that outsources is able to save time to concentrate on the core area
of business activity.
 The organisation is able to utilise the expertise of the third party in undertaking the
accounting work.
 Storage and maintenance of the data is in the hand of professional people.
 The organisation is not bothered about people leaving the organisation in key
accounting positions.
 The proposition often proves to be economically more sensible.

Disadvantages of Outsourcing the Accounting Functions

The disadvantages of outsourcing are as follows:
 The data of the organisation is handed over to a third party: This raises two issues,
one of security and second of confidentiality. There have been instances of
information leaking out of the third party data centers.
 Inadequate services provided: The third party is unable to meet the standards
desirable.
 The cost may ultimately be higher than initially envisaged.
 Delay in obtaining services: The third party service providers are catering to number
of clients thereby processing as per priority basis.
The choice of outsourcing vendor is made on the basis of the proposals received from these
vendors. The proposals are evaluated and the decision is often taken based on the following
criteria:
1. The amount of services provided and whether the same matches with the requirements.
2. The reputation and background of the vendor.
3. The comparative costs of the various propositions.
4. The assurance of quality.

After having discussed about the possible alternatives for having accounting in a computerised
environment it is important to understand how a choice can be made from all the alternatives
viz. spread sheet packages, pre-packaged accounting software, customised accounting package,
ERP package and outsourcing the accounting function to a third party. The possible
considerations are as follows:

1. Size of business operation: If the size of the operation is small or medium the
organisation can opt for a prepackaged accounting package. However, if the size is big,
the organisation may decide upon customized software or an ERP package.
2. Complexity of operation: If the operation is complex with several functional areas
which needs to be computerised the choice is usually a customized software or an ERP
package.
3. Business requirement:. If the organisation has several non-standard requirements then
customised software could be the solution.
4. Budgetary constraints: Cost consideration could also be a deciding factor for the
choice of a particular alternative. Normally the spread sheet and the prepackaged
accounting software works out to be the cheapest. The customised software and the ERP
are of higher cost considerations.

Generating Reports from Software

Spreadsheet software can be utilised to generate accounting reports. Formats have to be defined
by the user and can be used to view or print the reports.

In a pre-packaged accounting software reports are generated from the package.

The user is allowed to define the period of the report which should fall within the accounting
period for which the report is required. Reports as on a particular date should also be falling
within the accounting period.

The reports generally have the option of being viewed on the screen, or printed out through the
printer or saved on to a file. Saved file may be in the text format or spreadsheet format
depending upon the software being used.

Reports from the pre-packaged software are mostly in a pre-determined format. However, some
of the software allows certain customisation of the formats of the report. For example the look
of the invoice or challan can be printed according to the style normally used by the company.