Si.No.: Subject Code: U16BA5C7

GOVERNMENT ARTS COLLEGE (AUTONOMOUS), KARUR-05

B.B.A., - V SEMESTER – CORE COURSE - VII

(For the candidates admitted from the year 2016-17 onwards)

MANAGEMENT ACCOUNTING

UNIT- I Definition – Nature – Scope – Objectives – Merits – Limitations –Differences between Management Accounting and Financial Accounting

UNIT- II Financial Statement analysis – Comparative statements – Common sizestatements – trend percentages – ratio analysis – types.

UNIT- III Fund flow statement – Cash flow statement – Forecasting of workingcapital requirements.

UNIT- IV Marginal Costing – CVP analysis – Break even analysis – Managerialapplications.

UNIT- V Budget and Budgetary control – Production, Production cost, rawmaterial cost, sales, cash, flexible budgets, standard costing – Material and labourvariance only – overhead.

MANAGEMENT ACCOUNTING

UNIT- I Definition – Nature – Scope – Objectives – Merits – Limitations – Differences betweenManagement Accounting and Financial Accounting

Introduction to Management Accounting

One of the definitions of Management accounting says that it is the application of professional skills andknowledge in the preparation of financial and accounting information in a manner in which it will assist theinternal management in the formulation of policies, planning, and control of the operations of the firm.

The basic function of management accounting is to help the management make decisions. There is no fixedstructure or format for it.

Financial accounting, costing, business analysis, economics, etc are some tools and techniques ofmanagement accounting.

The only need for management accounting is that the data should serve its purpose, which is helping themanagement take important business decisions.

Definition of Management accounting

The Institute of Cost and Management Accountants, London, has defined Management Accounting as:“The application of professional knowledge and skill in the preparation of accounting information in such away as to assist management in the formulation of policies and in the planning and control of the operationof the undertakings.

“Similarly, according to American Accounting Association: “It includes the methods and conceptsnecessary for effective planning for choosing among alternative business actions and for control throughthe evaluation and interpretation of performances.”

Nature of Management Accounting:

(i) Technique of Selective Nature:

Management Accounting is a technique of selective nature. It takes into consideration only that data fromthe income statement and position state merit which is relevant and useful to the management. Only thatinformation is communicated to the management which is helpful for taking decisions on various aspectsof the business.

(ii) Provides Data and not the Decisions:

The management accountant is not taking any decision by provides data which is helpful to themanagement in decision-making. It can inform but cannot prescribe. It is just like a map which guides thetraveller where he will be if he travels in one direction or another. Much depends on the efficiency andwisdom of the management for utilizing the information provided by the management accountant.

(iii) Concerned with Future:

Management accounting unlike the financial accounting deals with the forecast with the future. It helps inplanning the future because decisions are always taken for the future course of action.

(iv) Analysis of Different Variables:

Management accounting helps in analysing the reasons as to why the profit or loss is more or less ascompared to the past period. Moreover, it tries to analyse the effect of different variables on the profits andprofitability of the concern.

(v) No Set Formats for Information:

Management accounting will not provide information in a prescribed proforma like that of financialaccounting. It provides the information to the management in the form which may be more useful to themanagement in taking various decisions on the various aspects of the business.

Scope of Management Accounting:

The scope of management accounting is very wide and broad-based. It includes all information which isprovided to the management for financial analysis and interpretation of the business operations.

(i) Financial Accounting:

Financial accounting though provides historical information but is very useful for future planning andfinancial forecasting. Designing of a proper financial accounting system is a must for obtaining full controland co-ordination of operations of the business.

(ii) Cost Accounting:

It provides various techniques of costing like marginal costing, standard costing, differential andopportunity cost analysis, etc., which play a useful role n t operation and control of the businessundertakings.

(iii) Budgeting and Forecasting:

Forecasting on the various aspects of the business is necessary for budgeting. Budgetary control controlsthe activities of the business through the operations of budget by comparing the actual with the budgetedfigures, finding out the deviations, analysing the deviations in order to pinpoint the responsibility and takeremedial action so that adverse things may not happen in future.

Both the techniques are necessary for management accountant.

(iv) Cost Control Procedures:

These procedures are integral part of the management accounting process and includes inventory control,cost control, labour control, budgetary control and variance analysis, etc.

(v) Reporting:

The management accountant is required to submit reports to the management on the various aspects of theundertaking. While reporting, he may use statistical tools for presentation of information as graphs, charts,pictorial presentation, index numbers and other devices in order to make the information more impressiveand intelligent.

(vi) Methods and Procedures:

It includes in its study all those methods and procedures which help the concern to use its resources in themost efficient and economical manner. It undertakes special cost studies and estimations and reports oncost volume profit relationship under changing circumstances.

(vii) Tax Accounting:

It is an integral part of management accounting and includes preparation of income statement,determination of taxable income and filing up the return of income etc.

(viii) Internal Financial Control:

Management accounting includes the internal control methods like internal audit, efficient officemanagement, etc.

(ix) Interpretation:

Management accounting is closely related to the interpretation of financial data to the management andadvising them on decision-making.

(x) Office Services:

The management accountant may be required to maintain and control office services in some organizations.This function includes data processing, reporting on best use of mechanical and electronic devices,communication, etc.

(xi) Evaluating the Performance of the Management:

Management accounting provides methods and techniques for evaluating the performance of themanagement. It evaluates the performance of the management in the light of the objectives of theorganisation. Thus, it helps in the implementation of the principle of management by exception.

Objectives / Benefits of Managerial accounting

Management accounting is very beneficial and hence is being used widely now. The benefits are asfollows:

Planning

In management accounting, the financial information and non financial information is presented at regularintervals say weekly, fortnightly to the management. This presentation includes forecasts, budgets and in-depth analysis. Hence it assists the management in planning the business activities.

Decision making

Since management accounting presents various charts, forecasts and analysis the management uses it fordecision making.

Identify early signs of problems

If a product is not performing well the management can identify it early on as the accounts are presented atregular intervals. This will aid in overcoming the constraints early on and avoiding future losses.

Strategic management

Based on the information presented in management accounting, the management can take decisions aboutcontinuing a product or modifying the sale strategy. Since management accounting is not regulated by anylaw, the management can decide the areas that require more analysis, investigation and accordingly drawup strategies.

Functions of managerial accounting

Managerial accounting performs the following functions in general

Profitability

Management accounting determines the profit from a particular product, project or line of business.

Break even analysis

It determines the number of units at which the organization will attain a no profit no loss situation.

Forecasting

It determines the bottlenecks in the organization and their impact on the organization.

New product analysis

It prepares analysis for the new product in terms of standard costs, actual cost and reasons for deviations.

Stock valuation

Determine the direct and indirect costs of stock in hand and presenting it to management

Variance analysis

Performing trend analysis for various costs incurred and understanding the causes for the variances.

Capital budgeting analysis

Understanding the need for acquiring fixed assets and the costs involved and allocation of finances to thebest available option.

Aids in Financial accounting

Management accounting presents financial information at regular intervals and hence it aids in thepreparation of financial statements at year-end.

Just as automation has touched every aspect of business so also ERP systems enable reporting undermanagement accounting. The various functions of management accounting like capitalbudgeting, variance analysis, profitability are performed by ERP systems and reports are generated. Themanagement accountant has to ensure correctness of the information inputted and reports generated.

Management accounting provides the management with better control of the business. Although notregulated by any law it provides the management an assurance. It provides the management the confidenceto face auditors and regulators. It aids in better management.

Limitations of Management Accounting

Data based on Financial accounting – Decisions taken by the management team are based on thedata provided by Financial Accounting

Less knowledge – Management has insufficient knowledge of economics, finance, statistics, etc.

Outdated data – Management team receives historical data, which may change eventually whenmanagement is taking the decisions.

Expensive – Setting up a management accounting system requires a lot of investment.

Management accounting different from Financial accounting

Today accounting is used as a tool in analysis of business and its activities. Accounting information ispresented in different ways in order to help in analysis by the different users of the information.

The two widely used types of accounting are:

Financial accounting

Management accounting.

Financial accounting is the presentation of accounting information for stakeholders and regulators. Itpresents the financial position for an entire time period.

On the other hand, Management accounting is the presentation of analysis of business activities to theinternal management to facilitate decision making.

UNIT- II Financial Statement analysis – Comparative statements – Common size statements – trendpercentages – ratio analysis – types.

Financial Statement Analysis:

Basis forComparison

Management accounting Financial accounting

Purpose It is used for internal purpose It is used for external reporting primarily,although the management also reviews it

Regulation It is not regulated by any law It has to be presented as per standards

Users Its users are the management of anorganization

Its users are shareholders, investors andregulators

Objective It aids in internal decision making It aids in investment decision by outsidersand monitoring by regulators

Mandatory Preparation and presentation of financialstatements is not mandatory

Preparation and presentation ismandatory.

Audit It is not subject to audit Financial statements must be audited

Frequency There is no defined frequency forpreparation and presentation of thestatements

Financial statements must be prepared forthe financial year and presented

Contents Management accounts include bothmonetary and non-monetary information

Financial accounts include only monetaryinformation

The term ‘financial analysis’, also known as analysis and interpretation of financial statements’, refers tothe process of determining financial strengths and weaknesses of the firm by establishing strategicrelationship 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 therelationship between component parts of a financial statement to obtain a better understanding of a firm’sposition and performance.”

In the words of Myers, “Financial statement analysis is largely a study of relationship among the variousfinancial factors in a business as disclosed by a single set-of statements and a study of the trend of thesefactors as shown in a series of statements.”

The purpose of financial analysis is to diagnose the information contained in financial statements so as tojudge the profitability and financial soundness of the firm. Just like a doctor examines his patient byrecording his body temperature, blood pressure, etc. before making his conclusion regarding the illness andbefore giving his treatment, a financial analyst analysis the financial statements with various tools ofanalysis before commenting upon the financial health or weaknesses of an enterprise.

The analysis and interpretation of financial statements is essential to bring out the mystery behind thefigures in financial statements. Financial statements analysis is an attempt to determine the significanceand meaning of the financial statement data so that forecast may be made of the future earnings, ability topay interest and debt maturities (both current and long-term) and profitability of a sound dividend policy.

The term ‘financial statement analysis’ includes both ‘analysis’, and ‘interpretation’. A distinction should,therefore, be made between the two terms. While the term ‘analysis’ is used to mean the simplification offinancial data by methodical classification of the data given in the financial statements, ‘interpretation’means, ‘explaining the meaning and significance of the data so simplified.’

However, both’ analysis and interpretation’ are interlinked and complimentary to each other Analysis isuseless without interpretation and interpretation without analysis is difficult or even impossible.

Most of the authors have used the term ‘analysis’ only to cover the meanings of both analysis andinterpretation as the objective of analysis is to study the relationship between various items of financialstatements by interpretation. We have also used the term ‘Financial statement Analysis or simply‘Financial Analysis’ to cover the meaning of both analysis and interpretation.

Significance of Financial Analysis

Finance Manager

Analysis of financial statements helps the finance manager in:

Assessing the operational efficiency and managerial effectiveness of the company.

Analyzing the financial strengths and weaknesses and creditworthiness of the company.

Analyzing the current position of financial analysis,

Assessing the types of assets owned by a business enterprise and the liabilities which are due tothe enterprise.

Providing information about the cash position company is holding and how much debt thecompany has in relation to equity.

Studying the reasonability of stock and debtors held by the company.

Top Management

Financial analysis helps the top management

To assess whether the resources of the firm are used in the most efficient manner

Whether the financial condition of the firm is sound

To determine the success of the company’s operations

Appraising the individual’s performance

evaluating the system of internal control

To investigate the future prospects of the enterprise.

Trade Payables

Trade payables analyze of financial statements for:

Appraising the ability of the company to meet its short-term obligations

Judging the probability of firm’s continued ability to meet all its financial obligations in the future.

Firm’s ability to meet claims of creditors over a very short period of time.

Evaluating the financial position and ability to pay off the concerns.

Lenders

Suppliers of long-term debt are concerned with the firm’s long-term solvency and survival. They analyzethe firm’s financial statements

To ascertain the profitability of the company over a period of time,

For determining a company’s ability to generate cash, to pay interest and repay the principalamount

To assess the relationship between various sources of funds (i.e. capital structure relationships)

To assess financial statements which contain information on past performances and interpret it as abasis for forecasting future rates of return and for assessing risk.

For determining credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate,and maturity date etc.

Investors

Investors, who have invested their money in the firm’s shares, are interested in the firm’s earnings andfuture profitability. Financial statement analysis helps them in predicting the bankruptcy and failureprobability of business enterprises. After being aware of the probable failure, investors can take preventivemeasures to avoid/minimize losses.

Labour Unions

Labour unions analyze the financial statements:

To assess whether an enterprise can increase their pay.

To check whether an enterprise can increase productivity or raise the prices of products/ services toabsorb a wage increase.

Objectives Financial Statement Analysis:

The primary objective of financial statement analysis is to understand and diagnose the informationcontained in financial statement with a view to judge the profitability and financial soundness of the firm,and to make forecast about future prospects of the firm. The purpose of analysis depends upon the personinterested in such analysis and his object.

However, the following purposes or objectives of financial statements analysis may be stated to bringout the significance of such analysis:

(i) To assess the earning capacity or profitability of the firm.

(ii) To assess the operational efficiency and managerial effectiveness.

(iii) To assess the short term as well as long term solvency position of the firm.

(iv) To identify the reasons for change in profitability and financial position of the firm.

(v) To make inter-firm comparison.

(vi) To make forecasts about future prospects of the firm.

(vii) To assess the progress of the firm over a period of time.

(viii) To help in decision making and control.

(ix) To guide or determine the dividend action.

(x) To provide important information for granting credit.

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 financialanalysis suffers from serious inherent limitations of financial statements.

Tools of Financial Statements Analysis

There are different tools of financial statements analysis available to the analyst. The following tools areused to measure the operational efficiency and financial soundness of an enterprise.The most common used techniques of financial analysis are:1. Comparative financial statements2.Common size statements3.Ratio analysis4.Cash flow statements

1.Comparative Financial Statements Statements used to compare the items of income statement i.e.profit and loss account and position statement i.e. balance sheet for ascertaining the trend of theperformance and profitability of an enterprise are known as comparative financial statements.(i)Comparative income statement It is a statement which shows in percentage term the total of incomeearned and expenses incurred during two or more accounting periods.Format of Comparative Income Statement

(ii)Comparative balance sheet It is a statement showing assets and liabilities of the business for two ormore accounting periods. It also shows the percentage change in the monetary value of the assets andliabilities.Format of Comparative Income Statement

2.Common Size Statement The statement wherein figures reported are converted into percentage to somecommon base is known as common size statement. Each percentage shows the relation of the individualitem to its respective total.(i) Common size income statement The statement in which sales figure is assumed to be 100 and all otherfigures are expressed as a percentage of sales is known as common size income statement.

(ii)Common size balance sheet In common size balance sheet, the total of assets or liabilities is assumed tobe 100 and figures are expressed as a percentage of the total.Format of Common Size Balance Sheet

3.Ratio Analysis The mathematical expression that shows the relationships between various groups ofitems contained in the financial statements is known as ratio analysis.

4. Cash Flow Statement It shows the inflows and outflows of cash and cash equivalents of an enterpriseby classifying cash flows into operating, investing and financing activities during a particular period andanalysing the reasons for changes in balance of cash between the two balance sheets dates.

Comparative Financial Statements

Preparing Comparative Financial Statements is the most commonly used technique for analyzing financialstatements. This technique determines the profitability and financial position of a business by comparingfinancial statements for two or more time periods. Hence, this technique is also termed as HorizontalAnalysis. Typically, the income statements and balance sheets are prepared in a comparative form toundertake such an analysis.

Furthermore, there is a provision attached to comparing the financial data showcased by such statements.This relates to making use of the same accounting principles for preparing each of the comparativestatements. In case the same accounting principles are not followed to prepare such statements, then thedifference must be disclosed in the footnote below.

Comparative Balance Sheet

A comparative balance sheet showcases:

Assets and liabilities of business for the previous year as well as the current year

Changes (increase or decrease) in such assets and liabilities over the year both in absolute andrelative terms

Thus, a comparative balance sheet not only gives a picture of the assets and liabilities in differentaccounting periods. It also reveals the extent to which the assets and liabilities have changed during suchperiods.

Furthermore, such a statement helps managers and business owners to identify trends in the variousperformance indicators of the underlying business.

What To Study While Analyzing A Comparative Balance Sheet?

A business owner or a financial manager should study the following aspects of a comparative balance sheet:

1. Working Capital

Working capital refers to the excess of current assets over current liabilities.This helps a financial manageror a business owner to know about the liquidity position of the business.

2. Changes in Long-Term Assets, Liabilities, and Capital

The next component that a financial manager or a business owner needs to analyze is the change inthe fixed assets, long-term liabilities and capital of a business. This analysis helps each of the stakeholdersto understand the long-term financial position of a business.

3. Profitability

Working capital refers to the excess of current assets over current liabilities.This helps a financial manageror a business owner to know about the liquidity position of the business.

Steps To Prepare a Comparative Balance Sheet

1. Step 1

Firstly, specify absolute figures of assets and liabilities relating to the accounting periods considered foranalysis. These amounts are mentioned in Column I and Column II of the comparative balance sheet.

2. Step 2

Find out the absolute change in the items mentioned in the balance sheet. This is done by subtracting theprevious year’s item amounts from the current year ones. This increase or decrease in absolute amounts arementioned in Column III of the comparative balance sheet.

3. Step 3

Finally, calculate the percentage change in the assets and liabilities of the current year relative to theprevious year. This percentage change in assets and liabilities is mentioned in Column V of thecomparative balance sheet.

Percentage Change = (Absolute Increase or Decrease)/Absolute Figure of the Previous Year’s Item) * 100

So, let’s understand a comparative balance sheet through an example. Consider the following balancesheets of M/s Kapoor and Co as on December 31st, 2017 and December 31st, 2018 for the illustration.

Balance Sheet of M/s Kapoor and Co. as of December 31, 2017, and December 31, 2018.

Comparative Balance Sheet of M/s Kapoor and Co. as on December 31, 2017, and December 31, 2018.

Analysis

As we can see in the comparative balance sheet above, the current assets of Kapoor and Co. have decreasedby Rs 35,200 in the year 2018 over 2017.

On the other hand, the current liabilities have decreased by Rs 27,000 only. Now, such a change does nothave a negative impact on the liquidity position of M/s Kapoor and Co. This is because current assets havedecreased by 33.9% whereas current liabilities have declined by 51.5%.

Secondly, the cash and bank balance of Kapoor and Co. have decreased by 91.5%. This indicates anegative cash position of the company. It further hints towards the fact that the company might find itchallenging to meet its short-term obligations.

Next, the long-term debt of M/s Kapoor and Co. has increased by 62.5%. On the other hand, the owner’sequity has improved by only 34%. This indicates that the company is way too dependent on the externallenders thus leading to a great financial risk for the firm.

Finally, there is a considerable increase seen in the fixed assets of the company. Accordingly, the fixedassets increased by Rs 79,000 or 64.9% from the year 2017 to 2018. This was on account of the hugeaddition made to the plant and machinery by the company in the given accounting periods.

Plant and machinery increased by Rs 95,200 that is by 153.5%. Such additional machinery leads to anincredible improvement in the production capacity of the company during the year. This expenditure wasprovided for by the company proprietors and the external lenders.

Comparative Income Statement

A comparative income statement showcases the operational results of the business for multiple accountingperiods. It helps the business owner to compare the results of business operations over different periods oftime. Furthermore, such a statement helps in a detailed analysis of the changes in line-wise items of theincome statement.

Comparative Balance Sheet Format

The format of the comparative income statement puts together several income statements into a singlestatement. This helps the business owner in understanding the trends and measuring the businessperformance over different time periods.

Apart from comparing income statements of its own business over different time periods, a business ownercan compare the operating results of its competitor firms as well.

Thus, this analysis helps the business owner to compare his business performance with other businesses inthe industry. So, business owners can also understand the various causes that lead to changes in differentaccounting periods. This is achieved by comparing the operating results of the business over multipleaccounting periods.

Analyzing A Comparative Income Statement?

1. Comparing Sales With Cost of Goods Sold

Changes in the sales in the given accounting periods should be compared with the changes in the cost ofgoods sold for the same accounting periods.

2. Change in Operating Profits

Change in the operating profits should be analyzed.

3. The profitability of a Business

Understanding the overall profitability of a business concern taking into consideration the changes in thenet profit of the given accounting periods.

Steps To Prepare A Comparative Income Statement

1. Step1

Firstly, specify absolute figures of items such as cost of goods sold, net sales, selling expenses, officeexpenses, etc. relating to the accounting periods considered for analysis. These amounts are mentioned inColumn I and Column II of the comparative income statement.

2. Step 2

Find out the absolute change in the items mentioned in the income statement. This is done by subtractingthe previous year’s item amounts from the current year ones. This increase or decrease in absolute amountsis mentioned in Column III of the comparative income statement.

3. Step 3

Finally, calculate the percentage change in the income statement items of the current year relative to theprevious year. This percentage change in items is mentioned in Column V of the comparative incomestatement.Now given this, let’s try to understand how a comparative statement is interpreted using anexample. Consider the following income statement for M/s Singhania for the years ended December 31st,2017 and December 31st, 2018.

Income Statement of M/s Singhania as of December 31, 2017, and December 31, 2018.

Comparative Income Statement of M/s Singhania For The Years Ended December 31, 2017, and December31, 2018.

Analysis

As is evident from the above comparative income statement, the sales of M/s Singhania increased by Rs20,400 during 2018 as against 2017. However, the cost of goods sold for the company increased by just Rs15,000 in the same period. If you see carefully, sales increased by 12% whereas the cost of goods soldincreased by 14.3%. Thus, the Gross Profit for M/s Singhania did not increase significantly. Now, therecan be several reasons for accounting lower Gross Profit during the year:

Increase In Cost of Goods Sold

Firstly, a higher increase in the cost of goods sold can be on account of either increased sales volume orhigher input cost. Furthermore, it is evident that the cost of goods sold for the company improved as anoutcome of increased sales volume. This is because the sales increased during the year.

Now, the sales value would have increased significantly if the company would have made sales at theprevious sales price. But that is not the case as sales value did not change to a greater extent. This hintstowards the fact that incremental sales have been made at a price lower than the sales price.

Furthermore, this analysis is supported by the increase in the advertisement expenses of the company forthe year 2018. These increased by 33% which is much higher as against the increase in net sales that wasjust 12%. Thus, this entire scenario indicates that it was quite challenging to sell the goods during 2018.

Hence, the company increased its advertisement cost significantly and reduced the selling price in order toachieve higher sales volume. Also, This scenario could be an outcome of a new product launch. In such acase, the company had to spend a huge amount on the advertisement and reduce the selling price formarket penetration.

Increase In Other Income and Decrease in Other Expenses

There has been a significant increase in “Other Income” both in absolute and relative terms. Also, there hasbeen a substantial decrease in “Other Expenses” both in absolute and relative terms. Thus, these items onthe income statement lead to an improvement in the Profit Before Tax for the year 2018 as against 2017.

Hence, such a fact indicates that the company gave more importance to earning non-operating profits overoperating one.

Common Size Statement

Common size statement is a form of analysis and interpretation of the financial statement. It is also knownas vertical analysis. This method analyses financial statements by taking into consideration each of the lineitems as a percentage of the base amount for that particular accounting period.

Common size statements are not any kind of financial ratios but are a rather easy way to express financialstatements, which makes it easier to analyse those statements.

Common size statements are always expressed in the form of percentages. Therefore, such statements arealso called 100 per cent statements or component percentage statements as all the individual items aretaken as a percentage of 100.

Types of Common Size Statements

There are two types of common size statements:

1. Common size income statement

2. Common size balance statement

1. Common Size Income Statement

This is one type of common size statement where the sales is taken as the base for all calculations.Therefore, the calculation of each line item will take into account the sales as a base, and each item will beexpressed as a percentage of the sales.

Use of Common Size Statement

It helps the business owner in understanding the following points

1. Whether profits are showing an increase or decrease in relation to the sales obtained.

2. Percentage change in cost of goods that were sold during the accounting period.

3. Variation that might have occurred in expense

4. If the increase in retained earnings is in proportion to the increase in profit of the business.

5. Helps to compare income statements of two or more periods

6. Recognises the changes happening in the financial statements of the organisation, which will helpinvestors in making decisions about investing in the business.

2. Common-Size Balance Sheet:

A common size balance sheet is a statement in which balance sheet items are being calculated as the ratioof each asset in relation to the total assets. For the liabilities, each liability is being calculated as a ratio ofthe total liabilities.

Common-size balance sheets can be used for comparing companies that differ in size. The comparison ofsuch figures for the different periods is not found to be that useful because the total figures seem to beaffected by a number of factors.

Standard values for various assets cannot be established by this method as the trends of the figures cannotbe studied and may not give proper results.

The common size statement format is as follows:Preparing Common Size Statements

(1) Take the total of assets or liabilities as 100

(2) Each individual asset is expressed as a percentage of the total assets, i.e., 100 and different liabilitiesare also calculated as per total liabilities. For example, suppose total assets are around Rs 4 lakhs, andinventory value is Rs 1 lakh. In that case, it will be counted as 25% of the total assets.

Limitations of Common Size Statement

Following are the limitations discussed

1. It is not helpful in the decision-making process as it does not have any approved benchmark.

2. For a business that is impacted by fluctuations due to seasonality, it can be misleading.

This concludes the topic of the Common size statement, which will be helpful for the students in getting abetter understanding of the concept. For more such interesting concepts, stay tuned to BYJU’S.

The following data is related to Cambridge Ltd.

(₹ in lakhs)

Particulars 31.03.2019 31.03.2018

₹ ₹

Equity Share Capital 16 16

Preference Share Capital 2 2

Reserves and Surplus 5.4 4

Non-Current Liabilities 14.4 14

Current Liabilities 7.2 4

Non-Current Assets 30.60 28

Current Assets 14.4 12

Now, you are required to prepare a Common Size Balance Sheet.

Solution:

CAMBRIDGE LTD.

COMMON SIZE BALANCE SHEET

As at 31.3.2018 and 31.3.2019

(₹ in lakhs)

Particulars NoteNo.

AbsoluteAmounts

% of Balance SheetTotal

2018 2019 2018 2019

₹ ₹ % %

EQUITY ANDLIABILITIES:

Shareholders’ Funds

Share Capital 18 18 45 (i) 40 (iv)

Reserves and Surplus 4 5.4 10 (ii) 12 (v)

Non-Current Liabilities 14 14.4 35 (iii) 32 (vi)

Current Liabilities 4 7.2 10 16

TOTAL 40 45 100 100

ASSETS

Non-Current Assets 28 30.6 70 68

Current Assets 12 14.4 30 32

TOTAL 40 45 100 100

Question 2

Following is the Statement of Profit and Loss of Crown Ltd. for the year ended 31.3.2018:

Particulars Amount (₹)

Income:

Revenue from operations 2,00,000

Other Incomes 15,000

Total Revenue 2,15,000

Expenses:

Cost of Materials Consumed 1,10,000

Other Expenses 5,000

Total Expenses 1,15,000

Tax 40,000

You are required to prepare a common size statement of P & L of Crown Ltd. for the year ended31.03.2018.

Solution:

CROWN LTD.

COMMON SIZE BALANCE SHEET

As at 31.3.2018

Particulars NoteNo.

AbsoluteAmounts₹

% of Revenue fromOperations

Revenue from Operations 2,00,000 100

Other Incomes 15,000 7.5

Total Revenue (Revenue fromOperations + Other Incomes)

2,15,000 107.5

Expenses:

Cost of Materials Consumed 1,10,000 55

Other Expenses 5,000 2.5

Total Expenses 1,15,000 57.5

Profit before Tax (Total Revenue –Expenses)

1,00,000 50

Less: Tax 40,000 20

Profit after tax (Profit before Tax –Tax)

60,000 30

Trend analysis: Trend analysis is an analysis of the trend of the company by comparing its financialstatements to analyze the trend of market or analysis of the future on the basis of results of pastperformance and it’s an attempt to make the best decisions on the basis of results of the analysis done.

Trend analysis involves collecting the information from multiple periods and plotting the collectedinformation on the horizontal line with the objective of finding actionable patterns from the giveninformation. In Finance, Trend Analysis is used for Technical analysis and Accounting analysis of stocks.

Types of Trend

#1 – Uptrend

An uptrend or bull market is when financial markets and assets – as with the broader economy level –move in the upward directions and keep increasing prices of the stock or the assets or even the size of theeconomy over the period. It is a time of booming where jobs get created, the economy moves into apositive market, and sentiments in the markets are favorable, and the investment cycle has started.

#2 – Downtrend

A downtrend or bear market is when financial markets and asset prices – as with the broader economylevel – move in the downward direction and prices of the stock or the assets or even the size of theeconomy keep on decreasing over time. It is the time when companies shut down the operation or shrinkthe production due to a slump in sales. Jobs are lost, and asset prices start declining, sentiment in themarket is not favorable for further investment, investors run for the haven of the investment.

#3 – Sideways / horizontal Trend

A sideways/horizontal trend means assets prices or share prices – as with the broader economy level – arenot moving in any direction; they are moving sideways, up for some time, then down for some time. Thedirection of the trend cannot be decided. It is the trend where investors are worried about their investment,and the government is trying to push the economy in the uptrend. Generally, the sideways or horizontaltrend is considered risky because when sentiments will be turned against cannot be predicted; henceinvestors try to keep away in such a situation.

The Use of Trend Analysis

It is used by both – Accounting analysis and technical analysis.

Popular Course in this category

#1 – Use in Accounting

Sales and cost information of the organization’s profit and loss statement can be arranged on a horizontalline for multiple periods and examined the trends and data inconsistencies. For instance, take the exampleof a sudden spike in the expenses in a particular quarter followed by a sharp decline in the next period, isan indicator of expenses was booked twice in the first quarter. Thus the trend analysis in accounting isessential for examining the financial statements for inaccuracies, to see whether the adjustment of thecertain heads should be made before the conclusion is drawn from the financial statements.

Trend Analysis in accounting compares the overall growth of key financial statement line item over theyears from the base case.

For example, in the case of Colgate, we assume that 2007 is the base case and analyze the performance inSales and Net profit over the years.

We note that Sales has increased by only 16.3% over 8 years (2008-2015).

We also note that the overall net profit has decreased by 20.3% over the 8 years.

For forecasting, estimated financial statements trend analysis is used for the head where no significantchanges have happened. For example, if employee expense is taken 18 % of the revenue and considerablechanges have not been made in the employees, then for estimated financial statements, employee expensecan be taken as 18 %.

Internal use of the trend analysis in accounting (the revenue and cost analysis) is one of the most usefulmanagement tools for forecasting.

#2 – Use in Technical Analysis

An investor can create his trend line from the historical stock prices, and he can use this information topredict the future movement of the stock price. The trend can be associated with the given information.Cause and effect relationships must be studied before taking concluding the trend analysis.

Trend analysis also involves finding patterns that are occurring over time, like a cup and handlepattern, head and shoulder pattern or reverse head and shoulder pattern.

In technical analysis, it can be used in the foreign exchange market, stock market, or derivativemarket. With slight changes, the same analysis can be used in all markets.

Examples of Trend Analysis

Examining sales patterns to see if sales are declining because of specific customers or products orsales regions;

Examining expenses report claims for proof of fraudulent claims.

Examining expense line items to find out if there are any unusual expenditures in a reportingperiod that require further investigation;

Forecast revenue and expense line items into the future for budgeting for estimating future results.

What is the Importance of Trend Analysis?

Trend analysis tries to find out a trend lie a bull market run, and make a profit from that trendunless and until data shows a trend reversal can happen, such as a bull to bear market. It is mosthelpful for the traders because moving with trends, and not going against them, will make a profitto an investor. The trend is the best friend of the traders is a well-known quote in the market.

A trend is nothing but the general direction the market is heading during a specific period. Trendscan be both growing and decreasing, relating to bearish and bullish markets, respectively. Thereare no criteria to decide how much time is required to find out the trend; generally, the longer thedirection, more is the reliable considered. Based on the experience and some empirical analysis,some indicators are designed, and standard time is kept for such indicators like 14 days movingaverage, 50 days moving average, 200 days moving average.

While there is no specified minimum amount of time required for a direction to be considered atrend, the longer the direction is maintained, the more notable the trend.

The following data is available from the P&L Account of Deepak Limited

Ratio analysis

Ratio analysis—the foundation of fundamental analysis—helps to gain a deeper insight into the financialhealth and the current and probable performance of the company being studied. For this insight, theanalysts use the quantitative method where the information recorded in the company’s financial statementsare compared and analyzed. And there are certain formulae that are used for the same.

In this blog, we shall discuss various Ratio Analysis, the various Ratios Formulae, and their importance.We would look into the classification of ratios, where we have explained the importance of using variousratios and the formulae to know how they are calculated. To help you learn better and for the easy revisionslater, you are provided here with the formulae for the ratios that we have discussed in this series. Let’smove on and look into Ratio Analysis – Ratios Formulae.

Liquidity Ratios

Also known as Solvency Ratios, and as the name indicates, it focuses on a company’s current assets andliabilities to assess if it can pay the short-term debts. The three common liquidity ratios used are currentratio, quick ratio, and burn rate. Among the three, current ratio comes in handy to analyze the liquidity andsolvency of the start-ups.

S. No. RATIOS FORMULAS

1 Current Ratio Current Assets/Current Liabilities

2 Quick Ratio Liquid Assets/Current Liabilities

3 Absolute Liquid Ratio Absolute Liquid Assets/Current Liabilities

Profitability Ratios

These ratios analyze another key aspect of a company and that is how it uses its assets and how effectivelyit generates the profit from the assets and equities. This also then gives the analyst information on theeffectiveness of the use of the company’s operations.

S. No. RATIOS FORMULAS

1 Gross Profit Ratio Gross Profit/Net Sales X 100

2 Operating Cost Ratio Operating Cost/Net Sales X 100

3 Operating Profit ratio Operating Profit/Net Sales X 100

4 Net Profit Ratio Operating Profit/Net Sales X 100

5 Return on Investment Ratio Net Profit After Interest And Taxes/ Shareholders Fundsor Investments X 100

6 Return on Capital EmployedRatio

Net Profit after Taxes/ Gross Capital Employed X 100

7 Earnings Per Share Ratio Net Profit After Tax & Preference Dividend /No ofEquity Shares

8 Dividend Pay Out Ratio Dividend Per Equity Share/Earning Per Equity Share X100

9 Earning Per Equity Share Net Profit after Tax & Preference Dividend / No. ofEquity Share

10 Dividend Yield Ratio Dividend Per Share/ Market Value Per Share X 100

11 Price Earnings Ratio Market Price Per Share Equity Share/ Earning Per ShareX 100

12 Net Profit to Net Worth Ratio Net Profit after Taxes / Shareholders Net Worth X 100

Working Capital Ratios

Like the Liquidity ratios, it also analyses if the company can pay off the current debts or liabilities usingthe current assets. This ratio is crucial for the creditors to establish the liquidity of a company, and howquickly a company converts its assets to bring in cash for resolving the debts.

S.No.

RATIOS FORMULAS

1 Inventory Ratio Net Sales / Inventory

2 Debtors Turnover Ratio Total Sales / Account Receivables

3 Debt Collection Ratio Receivables x Months or days in a year / Net Credit Sales forthe year

4 Creditors Turnover Ratio Net Credit Purchases / Average Accounts Payable

5 Average Payment Period Average Trade Creditors / Net Credit Purchases X 100

6 Working Capital TurnoverRatio

Net Sales / Working Capital

7 Fixed Assets Turnover Ratio Cost of goods Sold / Total Fixed Assets

8 Capital Turnover Ratio Cost of Sales / Capital Employed

Capital Structure Ratios

Each firm or company has capital or funds to finance its operations. These ratios, i.e., the Capital StructureRatios, analyze how structurally a firm uses the capital or funds.

S. No. RATIOS FORMULAS

1 Debt Equity Ratio Total Long Term Debts / Shareholders Fund

2 Proprietary Ratio Shareholders Fund/ Total Assets

3 Capital Gearing ratio Equity Share Capital / Fixed Interest Bearing Funds

4 Debt Service Ratio Net profit Before Interest & Taxes / Fixed Interest Charges

Overall Profitability Ratio

True to its name, these ratios measure how profitable a particular firm or company is, or how it can turn itsassets and capital into profits for future use.

S. No. RATIOS FORMULAS

1 Overall Profit Ability Ratio Net Profit / Total Assets

Problem ‐ 1

The following Trading and Profit and Loss Account of Fantasy Ltd. for the year 31‐3‐2000 is given below:

Particular Rs. Particular Rs.

To Opening Stock “ Purchases

“ Carriage and Freight “ Wages

“ Gross Profit b/d

To Administration expenses“ Selling and Dist. expenses“ Non‐operating expenses“ Financial Expenses

Net Profit c/d

76,250

3,15,250

2,000

5,000

2,00,000

5,98,500

1,01,000

12,000

2,000

7,000

84,000

2,06,000

By Sales

“ Closing stock

By Gross Profit b/d

“ Non‐operating incomes: “ Intereston Securities

“ Dividend on shares

“ Profit on sale of shares

5,00,000

98,500

5,98,500

2,00,000

1,500

3,750

750

2,06,000

Calculate:

1. Gross Profit Ratio 2. Expenses Ratio 3. Operating Ratio

1. Net Profit Ratio 5. Operating (Net) Profit Ratio 6. Stock Turnover Ratio.

Solution – 1 (Problem related to Revenue Ratio)

1. Gross Profit Margin = Gross profit

Sales

X 100

2,00,000

5,00,000 X 100

= 40%

2. Expenses Ratio = Op. Expenses

Net Sales

X 100

1,13,000

5,00,000 X 100

= 22.60%

3. Operating Ratio = Cost of goods sold + Op. Expenses

Net Sales

X 100

3,00,000 + 1,13,000

5,00,000 X 100

= 82.60%

Cost of Goods sold = Op. stock + purchases + carriage and Freight + wages – Closing Stock

= 76250 + 315250 + 2000 + 5000 ‐ 98500

= Rs.3,00,000

4. Net Profit Ratio = Net Profit

Net Sales

X 100

84,000

5,00,000 X 100

= 16.8%

5. Operating Profit Ratio = Op. Profit

Net Sales

X 100

Operating Profit = Sales – (Op. Exp. + Admin Exp.)

87,000

5,00,000 X 100

= 17.40%

6. Stock Turnover Ratio = Cost of goods sold

Avg. Stock

3,00,000

87,375

= 3.43 times

Problem ‐ 2

The Balance Sheet of Punjab Auto Limited as on 31‐12‐2002 was as follows:

Particular Rs. Particular Rs.

Equity Share Capital CapitalReserve

8% Loan on Mortgage Creditors

Bank overdraft Taxation:

Current Future

Profit and Loss A/c

40,000

8,000

32,000

16,000

4,000

4,000

4,000

12,000

1,20,000

Plant and Machinery Land andBuildings Furniture & Fixtures Stock

Debtors

Investments (Short‐term) Cash in hand

24,000

40,000

16,000

12,000

12,000

4,000

12,000

1,20,000

From the above, compute (a) the Current Ratio, (b) Quick Ratio, (c) Debt‐Equity Ratio, and (d) ProprietaryRatio.

Solution – 2 (Problem related to Balance Sheet Ratio)

1. Current Ratio=

Current Assets Current liabilities

Current Assets = Stock + debtors + Investments (short term) +Cash In hand

Current Liabilities = Creditors + bank overdraft + Provision forTaxation (current & Future)

CA = 12000 + 12000 + 4000 + 12000

= 40,000

CL = 16000 + 4000 + 4000 + 4000

= 28,000

= 40,000

28,000

= 1.43 : 1

2. Quick Ratio =

Quick Assets Quick Liabilities

Quick Assets = Current Assets ‐ Stock

Quick Liabilities = Current Liabilities – (BOD + PFT future)

QA = 40,000 – 12,000

= 28,000

QL = 28,000 – (4,000 + 4,000)

= 20,000

= 28,000

20,000

= 1.40 : 1

3. Debt – Equity Ratio = Long Term Debt (Liabilities) Shareholders Fund

LTL = Debentures + long term loans

SHF = Eq. Sh. Cap. + Reserves & Surplus + PreferenceSh.

Cap. – Fictitious Assets

LTL = 32,000

SHF = 40,000 + 8,000 + 12,000

= 60,000

= 32,000

60,000

= 0.53 : 1

4. Proprietary Ratio=

Shareholders’ Funds Total Assets

SHF = Eq. Sh. Cap. + Reserves & Surplus + Preference Sh.

Cap. – Fictitious Assets

Total Assets = Total Assets – Fictitious Assets

SHF = 40,000 + 8,000 + 12,000

= 60,000

TA = 1,20,000

= 60,000

1,20,000

= 0.5 : 1

Problem ‐ 3 [Sau. Uni. T. Y., April, 2000]

The details of Shreenath Company are as under:

Sales (40% cash sales) 15,00,000

Less: Cost of sales 7,50,000

Gross Profit: 7,50,000

Less: Office Exp. (including int. on debentures) 1,25,000

Selling Exp. 1,25,000 2,50,000

Profit before Taxes: 5,00,000

Less: Taxes 2,50,000

Net Profit: 2,50,000

Balance Sheet

Particular Rs. Particular Rs.

Equity share capital

10% Preference share capitalReserves

10% Debentures CreditorsBank‐overdraft Bills payable

Outstanding expenses

20,00,000

20,00,000

11,00,000

10,00,000

1,00,000

1,50,000

45,000

5,000

64,00,000

Fixed Assets Stock Debtors

Bills receivable Cash

Fictitious Assets

55,00,000

1,75,000

3,50,000

50,000

2,25,000

1,00,000

64,00,000

Beside the details mentioned above, the opening stock was of Rs. 3,25,000. Taking 360 days of the year,calculate the following ratios; also discuss the position of the company:

(1) Gross profit ratio. (2) Stock turnover ratio. (3) Operating ratio. (4) Current ratio. (5) Liquid ratio.(6) Debtors ratio. (7) Creditors ratio. (8) Proprietary ratio. (9) Rate of return on net capital

employed. (10) Rate of return on equity shares.

Solution – 3 (Problem related to Composite Ratio)

1. Gross Profit Margin =

Gross profit Sales

X 100

7,50,000

15,00,000 X 100

= 50%

2. Stock Turnover Ratio = Cost of goods sold

Avg. Stock

Avg. stock = Opening Stock + Closing Stock

2

COGS = Sales – GP

3,25,000 + 1,75,000

2

AS = 2,50,000

COGS = 15,00,000 – 7,50,000

7,50,000

= 7,50,000

2,50,000

= 3 times

3. Operating Profit Ratio =

Op. Profit NetSales

X 100

Operating Profit = Sales – (Op. Exp. + COGS.)

OP = 15,00,000 – (7,50,000 + 1,25,000 +

25,000)

= 6,00,000

(excluding Interest on Debentures)

= 6,00,000 15,00,000

X 100

= 40%

4. Current Ratio =

Current Assets Current liabilities

Current Assets = Stock + debtors + Bills receivable + Cash

Current Liabilities = Creditors + bank overdraft + Bills payable+

Outstanding expenses

CA = 1,75,000 + 3,50,000 + 50,000 + 2,25,000

= 8,00,000

CL = 1,00,000 + 1,50,000 + 45,000 + 5,000

= 3,00,000

= 8,00,000

3,00,000

= 2.67 : 1

5. Quick Ratio / Liquid Ratio =

Liquid Assets Liquid Liabilities

(Liquid) Quick Assets = Current Assets ‐ Stock

(Liquid) Quick Liabilities = Current Liabilities – BOD

QA = 8,00,000 – 1,75,000

= 6,25,000

QL = 3,00,000 – 1,50,000

= 1,50,000

= 6,25,000

1,50,000

= 4.17 : 1

6. Debtors Ratio = Debtors + Bills receivable Credit sales X 365 / 360 days

= 3,50,000 + 50,000

9,00,000 X 360 days

(60% of 15,00,000)

= 0.444 X 360 days

= 160 days

7. Creditors Ratio = Creditors + Bills payable Credit Purchase X 365 / 360 days

= 1,00,000 + 45,000

7,50,000

Notes: If credit purchase could not findout at that point Cost of Goods soldconsider Credit purchase

X 360 days

= 0.193 X 360 days

= 69 days

8. Proprietary Ratio=

Shareholders’ Funds Total Assets

SHF = Eq. Sh. Cap. + Reserves & Surplus + Preference Sh.

Cap. – Fictitious Assets

Total Assets = Total Assets – Fictitious Assets

SHF = 20,00,000 + 20,00,000 + 11,00,000 – 1,00,000

= 50,00,000

TA = 64,00,000 – 1,00,000

= 63,00,000

= 50,00,000

63,00,000

= 0.79 : 1

Notes:

Rate of Return on CapitalEmployed

Rate of Return onShare holders Fund

Rate of return on EquityShareholders Fund

= EBIT

Capital employed

X 100 = PAT

SHF

X 100 = PAT – Pref. Div.

ESHF

X 100

CE = Eq Sh. Cap. + Pref. Sh. SHF = Eq. Sh. Cap. + Pref. Sh. ESHF = Eq. Sh. Cap. +

Cap. + Reserves & Surplus +Debenture + Long Term Loan

– Fictitious Assets

Cap. + Reserves & Surplus –Fictitious Assets

Reserves & Surplus – FictitiousAssets

Sales

15,00,000

Less: Cost of goods sold 7,50,000

Gross profit 7,50,000

Less: Operating expenses (including Depreciation) 1,50,000

Earnings before Interest & Tax (EBIT) 6,00,000

Less: Interest Cost 1,00,000

Earnings before Tax (EBT) 5,00,000

Less: Tax liability 2,50,000

Earnings after Tax (EAT/ PAT) 2,50,000

Less: Preference share dividend 2,00,000

Distributional Profit 50,000

9. 10. 11.

Rate of Return on CapitalEmployed

Rate of Return onShare holders Fund

Rate of return on EquityShareholders Fund

= EBIT

Capital employed

X 100 = PAT SHF X 100 = PAT – Pref. Div.

ESHF

X 100

CE = Eq Sh. Cap. + Pref. Sh. Cap.+ Reserves & Surplus + Debenture+ Long Term Loan

– Fictitious Assets

SHF = Eq. Sh. Cap. + Pref. Sh.Cap. + Reserves & Surplus –Fictitious Assets

ESHF = Eq. Sh. Cap. +

Reserves & Surplus – FictitiousAssets

CE = 20,00,000 + 20,00,000

11,00,000 +10,00,000 –

1,00,000

SHF = 20,00,000 + 20,00,000

11,00,000 – 1,00,000

ESHF = 20,00,000 + 11,00,000 –1,00,000

= 60,00,000 = 50,00,000 = 30,00,000

= 6,00,000

60,00,000

X 100 = 2,50,000

50,00,000

X 100 = 50,000

30,00,000

X 100

= 10% = 5% = 1.67 %

Problem = 4

From the following particulars extracted from the books of Ashok & Co. Ltd., compute the following ratiosand comment:

(a) Current ratio, (b) Acid Test Ratio, (c) Stock‐Turnover Ratio, (d) Debtors Turnover Ratio, (e)Creditors' Turnover Ratio, and Average Debt Collection period.

1‐1‐2002 31‐12‐2002

Rs. Rs.

Bills Receivable 30,000 60,000

Bills Payable 60,000 30,000

Sundry Debtors 1,20,000 1,50,000

Sundry Creditors 75,000 1,05,000

Stock‐in‐trade 96,000 1,44,000

Additional information:

(a) On 31‐12‐2002, there were assets: Building Rs. 2,00,000, Cash Rs. 1,20,000 and Cash at Bank Rs.96,000.

(b)Cash purchases Rs. 1,38,000 and Purchases Returns were Rs. 18,000.

(c) Cash sales Rs. 1,50,000 and Sales returns were Rs. 6,000.

Rate of gross profit 25% on sales and actual gross profit was Rs. 1,50,000.

Solution – 4 (Problem related to find out missing item)

Notes: In this problem available information is not enough to solve ratios asked so that need to prepareTrading Account to identify values which are not given in the question.

Trading Account

Particular Amount

Rs.

Particular Amount

Rs.

To Opening Stock 96,000 By Sales: Cash: 1,50,000

To Purchase: Cash: 1,38,000 Credit : 4,56,000

Credit: 3,78,000 6,06,000

5,16,000 Less: S/R 6,000 6,00,000

Less: P/R 18,000 4,98,000 By Closing Stock 1,44,000

To Gross Profit 1,50,000

7,44,000 7,44,000

1. Gross Profit Margin =

Gross profit Sales

X 100

25% = 1,50,000

Sales

X 100

Sales = 1,50,000 X 100

25

Sales = 6,00,000

2. Current Ratio=

Current Assets Current liabilities

Current Assets = Stock + debtors + Bills receivable + Cash +Bank Balance

Current Liabilities = Creditors + Bills payable

CA = 1,44,000 + 1,50,000 + 60,000 + 1,20,000 + 96,000

= 5,70,000

CL = 1,05,000 + 30,000

= 1,35,000

= 5,70,000

1,35,000

= 4.22 : 1

3. Acid Test Ratio =

Cash & Cash Equivalent Assets Liquid Liabilities

Cash & Cash equivalent Assets = Cash + Bank + Shortterm Investments

(Liquid) Quick Liabilities = Current Liabilities – BOD

= 1,20,000 + 96,000

= 2,16,000

QL = 1,05,000 + 30,000

= 1,35,000

= 2,16,000

1,35,000

= 1.6 : 1

4. Stock Turnover Ratio = Cost of goods sold

Avg. Stock

Avg. stock = Opening Stock + Closing Stock

2

COGS = Sales – GP

96,000 + 1,44,000

2

AS = 1,20,000

COGS = 6,00,000 – 1,50,000

4,50,000

= 4,50,000

1,20,000

= 3.75 times

5. Debtors Ratio =

(Avg. debt collection period)

Debtors + Bills receivable Credit sales X 365 / 360 days

= 1,50,000 + 60,000

4,56,000

X 365 days

= 0.461 X 365 days

= 168 days

6. Creditors Ratio = Creditors + Bills payable Credit Purchase X 365 / 360 days

= 1,05,000 + 30,000

3,78,000

X 365 days

= 0.357 X 365 days

= 130 days

Problem ‐ 5

Following is the summarised Balance Sheet of Mona Ltd. as on 31‐3‐04.

Particular Rs. Particular Rs.

Equity Shares of Rs. 10 each 10%Pref. Sh. of Rs.100 each Reserves andSurplus

15% Debentures Sundry CreditorsBank Overdraft

10,00,000

4,00,000

7,00,000

5,00,000

2,40,000

1,60,000

30,00,000

Fixed Assets Investments Closing StockSundry Debtors Bills Receivable Cashat Bank

Preliminary Expenses

20,00,000

2,00,000

2,00,000

4,60,000

60,000

60,000

20,000

30,00,000

Summarised Profit and Loss Account is as under for the year ending on 31‐3‐'04:

Rs.

Sales (25% Cash sales) 80,00,000

Less: Cost of goods sold 56,00,000

Gross Profit 24,00,000

Net profit (Before interest and tax 50%) 9,00,000

Calculate the following ratios:

(1) Rate on Return on Capital Employed (2) Proprietary Ratio (3) Debt‐Equity (4) Capital gearing

Ratio (5) Debtors Ratio (365 days of the year.) (6) Rate of Return on Shareholders' Funds (7) Rate ofReturn on Equity shareholders fund

Solution ‐ 5 Statement of Profitability

Sales 80,00,000

Less: Cost of goods sold 56,00,000

Gross profit 24,00,000

Less: Operating expenses (including Depreciation) 15,00,000

Earnings before Interest & Tax (EBIT) 9,00,000

Less: Interest Cost 75,000

Earnings before Tax (EBT) 8,25,000

Less: Tax liability (50%) 4,12,500

Earnings after Tax (EAT/ PAT) 4,12,500

Less: Preference share dividend 40,000

Distributional Profit 3,72,500

1. 6. 7.

Rate of Return on CapitalEmployed

Rate of Return onShare holders Fund

Rate of return on EquityShareholders Fund

= EBIT

Capital employed

X 100 = PAT

SHF

X 100 = PAT – Pref. Div.

ESHF

X 100

CE = Eq Sh. Cap. + Pref. Sh. Cap.+ Reserves & Surplus + Debenture+ Long Term Loan

– Fictitious Assets

SHF = Eq. Sh. Cap. + Pref. Sh.Cap. + Reserves & Surplus –Fictitious Assets

ESHF = Eq. Sh. Cap. +

Reserves & Surplus – FictitiousAssets

CE = 10,00,000 + 4,00,000

7,00,000 + 5,00,000 – 20,000

= 25,80,000

SHF = 10,00,000 + 4,00,000 +

7,00,000 ‐ 20,000

= 20,80,000

ESHF = 10,00,000 + 7,00,000

– 20,000

= 16,80,000

= 9,00,000

25,80,000

X 100 = 4,12,500

20,80,000

X 100 = 3,72,500

16,80,000

X 100

= 34.88% = 19.83% = 22.17 %

2. Proprietary Ratio=

Shareholders’ Funds Total Assets

SHF = Eq. Sh. Cap. + Reserves & Surplus + Preference Sh.

Cap. – Fictitious Assets

Total Assets = Total Assets – Fictitious Assets

SHF = 10,00,000 + 7,00,000 + 4,00,000 ‐ 20,000

= 20,80,000

TA = 30,00,000 – 20,000

= 29,80,000

= 20,80,000

29,80,000

= 0.70 : 1

3. Debt – Equity Ratio = Long Term Debt (Liabilities) Shareholders Fund

LTL = Debentures + long term loans

SHF = Eq. Sh. Cap. + Reserves & Surplus + PreferenceSh.

Cap. – Fictitious Assets

LTL = 5,00,000

SHF = 10,00,000 + 7,00,000 + 4,00,000 ‐ 20,000

= 20,80,000

= 5,00,000

20,80,000

= 0.24 : 1

4. Capital Gearing Ratio = Fixed Interest or Dividend Securities Equity ShareholdersFund

FIS = Debentures + Preference share capital

ESHF = Eq. Sh. Cap. + Reserves & Surplus – FictitiousAssets

LTL = 9,00,000

ESHF = 10,00,000 + 7,00,000 ‐ 20,000

= 16,80,000

= 9,00,000

16,80,000

= 0.54 : 1

5. Debtors Ratio

(Avg. debt collection period)

=

Debtors + Bills receivable Credit sales X 365 / 360 days

= 4,60,000 + 60,000 X 365 days

60,00,000

= 0.461 X 365 days

= 31.63 days

= 32 days (Aprox.)

UNIT- III Fund flow statement – Cash flow statement – Forecasting of working capital requirements.

Fund flow statement

A fund flow statement is a statement prepared to analyse the reasons for changes in the financial positionof a company between two balance sheets. It portrays the inflow and outflow of funds i.e. sources of fundsand applications of funds for a particular period.

It is also righteous to say that a fund flow statement is prepared to explain the changes in the workingcapital position of a company.

Objectives of fund flow statement

A question arises as to why prepare fund flow Statement when we already prepare profit andloss and balance sheet. The need here arises because the profit and loss and balance sheet will not explainthe reasons for a change in the financial position.

Profit and loss a/c and balance sheet will give two years figures i.e., current years and previous years. Butit will not explain as to why the movement has happened, let’s say, the extent of use of long-term funds fora long-term needs and the use of short-term funds for a long term and short term. Here is why fund flowstatement is prepared.

Broadly, a fund flow statement will give us the following two information:

Sources of funds - From where the funds have come in

Application of funds - Where these funds have been used

Components of a fund flow statement

A fund flow statement comprises of :

Sources of funds: It talks about the extent of funds availed from

o Owners

o Outsiders

Application of funds: It talks about how the funds have been utilized

o Funds deployed in Fixed assets

o Funds deployed in Current assets

Fund flow statement explained with examples

National Enterprises raised its funds from the following equation listed below:

Long term funds for its noncurrent assets.

Explanation: Noncurrent assets are a company's long-term investments for which the full value will not berealized within the accounting year. Examples of noncurrent assets include investments in other companies,intellectual property (e.g. patents), and property, plant and equipment.

So, going by the accounting parlance, long term funds are generally raised by a company to meet its long-term requirements. So National Enterprises using its long-term funds for its non-current assets are the rightutilization of funds and these details are explained by fund flow statement.

What if National Enterprises uses its short-term funds to finance its long-term assets?

Here the fund flow statement when prepared conveys the users of financial information that the usage ofthe fund has not been made properly by the company as it is living dangerously by utilizing its short-termfunds for financing long term assets.

It means that when the company is in need for funds for repaying it to the short-term obligation, it will bein cash crunch situation since once an investment is made into long term assets by the company it, it willnot be in a position to convert it into liquid cash at a later stage due to the nature of the investment.

This is how the fund flow statement explains the source of funds and its utilization or applications,allowing the users of financial information interpret and know the impact on the business.

Benefits of preparing a fund flow Statement

It helps to explain the managers of funds as to why the company is sitting in liquidity strain despitemaking profits as reflected in profit and loss statement.

On the contrary, it helps the managers to understand as to how a company is financially strongdespite losses made by it in its operation front.

A fund flow statement helps us to analyze whether any short-term funds are being used for longterm purposes. The grey area which can only be highlighted by preparation of fund flow Statement.

Users of funds flow Statement

The most interested users of fund flow statements are the lenders of capital. They pay more attention to thefund Flow Statements than the Profit and Loss and Balance sheet.

For Example, Bankers who lend money to the company as Overdraft or Cash Credit in return for interest.The bankers use the information provided by the company in its profit and loss statement and balance sheetin preparing fund flow statements, which then enables them to take decisions as whether to provide itsoverdraft or cash credit facilities to its clients or not.

Fund flow statement format

Sources of Funds Application of Funds

Capital

Debts

Funds generated from operations

Sale of assets (if any)

· (Bal.fig) Excess usage of funds oversources.

[Decrease in working capital]

xxx

xxx

xxx

Funds utilised in creation of Fixed assets

Funds utilised in creation of other Non-current assets.

Funds utilised in repaying existing loans.

Funds utilised for paying dividends, taxes

*(Bal.fig) Excess of Funds over applicationof funds –

[ Increase in working capital]

xxx

xxx

xxx

xxx

xxx

Total xxx xxx

Increase in working capital

Possibilities may arise when long term sources are in abundance of uses or application resulting in a gap.Which we call in fund flow statement as ‘Increase in working capital’. As it is a free flexible source whichcan now be used by the company for funding its working capital requirements. Say short term loansoutstanding (if any) can be paid from the long-term sources slot or dividends be paid etc.,

Decrease in working capital

Possibilities that the company has more uses of funds, but it has very limited long-term source available.At that time, the company will go for funds which are available in the nature of working capital.

As a result, the company will reduce the funds available for working capital and divert it for long term uses.So, by decreasing the working capital, we get the funds which are available for long term uses which formpart of the source of funds.

The increase or decrease in working capital can be known by preparing a statement of changes in workingcapital. This statement compares the values of two years of the difference between Current assetand Current Liabilities and tells as to whether there is an increase or decrease in working capital.

How do modern businesses prepare a fund flow statement?

Given the importance of fund flow statements brings to the table, most of the businesses prepare andanalyze this statement more frequently. Today, most businesses use ERP software or accountingsoftware which automatically prepares the fund flow statement along with various other financialstatements. This allows business owners and other users of financial information to analyze and make on-time smart business decisions.

Problem 1:

The bank balance of a business firm has increased during the last financial year by Rs.1,50,000. During thesame period it issued shares of Rs.2,00,000 and redeemed debentures of Rs.1,50,000. It purchased fixedassets for Rs. 40,000 and charged depreciation of Rs.20,000. The working capital of the firm, other thanbank balance, increased by Rs.1,15,000 during the period. Calculate the profit of the firm for the year.

Solution:

1,50,000 = Profit + 2,00,000 – 1,50,000 – 40,000 + 20,000 – 1,15,000

∴ Profit = Rs.2,35,000

Problem 2:

X and Y purchased a secondhand machine for Rs.8,000 on April 1, 2013 and spent Rs.3,500 onoverhauling and installation. Depreciation is written-off 10% p.a. on original cost. On June 30, 2016, themachine was found to be unsuitable and sold for Rs.6,500. What is the loss to be written-off?

Solution:

Problem 3:

From the following balance sheets of XYZ Co. Ltd., prepare funds flow statement:

Additional Information:

(i) Proposed dividend made during 2015 has been paid during 2016.

(ii) Depreciation – (a) Rs.20,000 on plant and machinery, and (b) Rs.40,000 on land and buildings.

(iii) Interim dividend has been paid Rs.40,000 in 2016.

(iv) Income-tax Rs.70,000 has been paid during 2016.

Solution:

Problem 4:

From the following information of XYZ Ltd., prepare a statement showing changes in working capitalposition along with funds flow statement:

Additional information:

(i) A reconciliation of the balances in retained earnings is as follows:

(ii) Net income of the current year includes a loss of Rs.4,800 on the sale of a part of plant. The plant wasfor Rs.19,000 at the beginning of the year, accumulated depreciation being Rs.6,000.

(iii) Investments of Rs.15,000 were sold during the year at a loss. The loss was charged to the reserve forfuture losses on investments and did not appear on the income statement.

(iv) During the current year the 12% debentures were called for redemption. Most of them were refundedthrough the issuance of new 14% debentures, and the rest were retired for cash.

(v) The equity shares were issued in exchange of machinery. The rest of the plant and machinery werepurchased for cash.

Solution:

Working Notes:

* Alternatively the net amount of Rs. 4,400 (Rs. 43,400 – Rs. 39,000) can be shown as application.

Statement of Changes in Working Capital:

Cash Flow Statement:

A cash flow statement is a statement of changes in the financial position of a firm on cash basis.

It reveals the net effects of all business transactions of a firm during a period on cash and explains thereasons of changes in cash position between two balance sheet dates.

It shows the various sources (i.e., inflows) and applications (i.e., outflows) of cash during a particularperiod and their net impact on the cash balance.

According to Khan and Jain:

“Cash Flow statements are statements of changes in financial position prepared on the basis of fundsdefined as cash or cash equivalents.”

The Institute of Cost and Works Accountants of India defines Cash Flow statement as “a statementsetting out the flow of cash under distinct heads of sources of funds and their utilisation to determinethe requirements of cash during the given period and to prepare for its adequate provision.”

Thus, a cash flow statement is a statement which provides a detailed explanation for the changes in a firm’scash balance during a particular period by indicating the firm’s sources and uses of cash and, ultimately,net impact on cash balance during that period.

Features of Cash Flow Statement:

The features or characteristics of Cash Flow Statement may be summarised in the following way:

1. It is a periodical statement as it covers a particular period of time, say, month or year.

2. It shows movement of cash in between two balance sheet dates.

3. It establishes the relationship between net profit and changes in cash position of the firm.

4. It does not involve matching of cost against revenue.

5. It shows the sources and application of funds during a particular period of time.

6. It records the changes in fixed assets as well as current assets.

7. A projected cash flow statement is referred to as cash budget.

8. It is an indicator of cash earning capacity of the firm.

9. It reflects clearly how financial position of a firm changes over a period of time due to its operatingactivities, investing activities and financing activities.

Objectives of Cash Flow Statement:

Cash Flow Statement is prepared to fulfill some objectives.

Some of the main objectives of Cash Flow Statement are:

1. It shows the cash earning capacity of the firm.

2. It indicates different sources from which cash been collected and various purposes for which cash hasbeen utilised during the year.

3. It classifies cash flows during the period from operating, investing and financing activities.

4. It gives answers to various perplexing questions often encountered by management, such as why thefirm is unable to pay dividend instead of making enough profit? Why is there huge idle cash balance inspite of loss suffered? Where have the proceeds of sale of fixed assets gone? etc.

5. It helps the management in cash planning and control so that there are no shortage or surplus of cash atany point of time.

6. It evaluates the ability of the firm to meet obligations such as loan repayment, dividends, taxes etc.

7. A prospective investor consults the cash flow statement to ensure that his investment gets regular returnsin future.

8. It discloses the reasons for differences among net income, cash receipts and cash payments.

9. It helps the management in taking capital budgeting decisions more scientifically. 10. It ensuresoptimum use of funds for the maximum benefit of the enterprise.

Utility or Importance of Cash Flow Statement:

Cash Flow Statement is useful for short-term planning and control of cash. A business entity needssufficient amount of cash to meet its various obligations in the near future such as payment for purchase offixed assets, payment of debts, operating expenses of the business etc.

It helps the financial manager to make a cash flow projection for the immediate future taking the datarelating to cash inflows and cash outflows from past records. As such, it becomes easy for him to know thecash position which may either result in a surplus or a deficit one. Thus, cash flow statement is anotherimportant tool of financial analysis for the management.

Its main advantages are:

1. Evaluation of Cash Position:

It is very helpful in understanding the cash position of a firm. Since cash is the basis for carrying onbusiness operations smoothly, the cash flow statement is very useful in evaluating the current cash positionof the business.

2. Planning and Control:

A projected cash flow statement enables the management to plan and coordinate the financial operationsproperly. The financial manager can know how much cash is needed, from where it will be derived, howmuch can be generated internally, and how much could be obtained from outside.

3. Performance Evaluation:

A comparison of actual cash flow statement with the projected cash flow statement will disclose the failureor success of the management in managing cash resources. Deviations will indicate the need for correctiveactions.

4. Framing Long-term Planning:

The projected cash flow statement helps financial manager in exploring the possibility of repayment oflong-term debts which depends upon the availability of cash.

5. Capital Budgeting Decision:

A projected cash flow statement also helps the management in taking capital budgeting decisions.

6. Liquidity Position:

Liquidity position of a firm refers to its ability to meet short-term obligations such as payment of wagesand other operating expenses etc. From cash flow statement the financial manager is able to understandhow well the firm is meeting these obligations.

At the same time the ability of the firm in cash earning can be known from cash flow statement. As amatter of fact, a firm’s profitability is ultimately dependent upon its cash earning capacity.

7. Answers to Different Questions:

Cash flow statement is able to explain some questions often encountered by the financial manager such as,why is the firm not able to pay dividend in spite of making huge profit? Why there is huge cash balance inspite of loss etc.

Limitations of Cash Flow Statement:

Cash Flow Statement is, no doubt, an important tool of financial analysis which discloses the completestory of cash management. The increase in—or decrease of—cash and reasons thereof, can be known,However, it has its own limitation.

These limitations are:

1. Since cash flow statement does not consider non-cash items, it cannot reveal the actual net income of thebusiness.

2. Cash flow statement cannot replace fund flow statement or income statement. Each of them has aseparate function to perform which cannot be done by the cash flow statement.

3. The cash balance as disclosed by the projected cash flow statement may not represent the real liquidposition of the business since it can be easily influenced by the managerial decisions, by making certainpayments in advance or by post pending payments.

4. It cannot be used for the purpose of comparison over a period of time. A company is not better off in thecurrent year than the previous year because its cash flow has increased.

5. It is not helpful in measuring the economic efficiency in certain cases e.g., public utility service wheregenerally heavy capital expenditure is involved.

In spite of these limitations, it can be said that cash flow statement is a useful supplementary instrument. Ithelps management in knowing the amount of capital blocked up in a particular segment of the business.The technique of cash flow analysis—when used in conjunction with ratio analysis—serves as a barometerin measuring the profitability and financial position of the business.

Problem 1:

The bank balance of a business firm has increased during the last financial year by Rs.1,50,000. During thesame period it issued shares of Rs.2,00,000 and redeemed debentures of Rs.1,50,000. It purchased fixedassets for Rs.40,000 and charged depreciation of Rs.20,000. The working capital of the firm, other thanbank balance, increased by Rs.1,15,000 during the period. Calculate the profit of the firm for the year.

Solution:

1,50,000 = Profit + 2,00,000 – 1,50,000 – 40,000 + 20,000 – 1,15,000

∴ Profit = Rs.2,35,000

Problem 2:

A chemical company has net sales of Rs.50 lakhs, cash expenses (including taxes) of Rs.35 lakhs anddepreciation expenses of Rs.5 lakhs. If debtors decrease over the period by Rs.6 lakhs, what is its cashfrom operations?

Solution:

Cash from operations = Rs.50 lakhs – Rs.35 lakhs + Rs.6 lakhs = Rs.21 lakhs

There are two methods of converting net profit into net cash flows from operating activities:

(a) Direct method, and

(b) Indirect method.

Problem 3:

The following information is available from the books of Exclusive Ltd. for the year ended 31stMarch, 2016:

(a) Cash sales for the year were Rs.10,00,000 and sales on account Rs.12,00,000.

(b) Payments on accounts payable for inventory totalled Rs.7,80,000.

(c) Collection against accounts receivable were Rs.7,60,000.

(d) Rent paid in cash Rs.2,20,000, outstanding rent being Rs.20,000.

(e) 4,00,000 Equity shares of Rs.10 par value were issued for Rs.48,00,000.

(f) Equipment was purchased for cash Rs.16,80,000.

(g) Dividend amounting to Rs.10,00,000 was declared, but yet to be paid.

(h) Rs.4,00,000 of dividends declared in the previous year were paid.

(i) An equipment having a book value of Rs.1,60,000 was sold for Rs.2,40,000.

(j) The cash account was increased by Rs.37,20,000.

Prepare a cash flow statement using direct method.

Solution:

Problem 4:

Madhuri Ltd. gives you the following information for the year ended 31st March, 2016:

(a) Sales for the year totalled Rs.96,00,000. The company sells goods for cash only.

(b) Cost of goods sold was 60% of sales.

(c) Closing inventory was higher than opening inventory by Rs.43,000.

(d) Trade creditors on 31st March, 2016 exceeded those on 31st March, 2015 by Rs.23,000.

(e) Tax paid amounted to Rs.7,00,000.

(f) Depreciation on fixed assets for the year was Rs.3,15,000 whereas other expenses totalled Rs.21,45,000.Outstanding expenses on 31st March, 2015 and 31st March, 2016 totalled Rs.82,000 and Rs.91,000respectively.

(g) New machinery and furniture costing Rs.10,27,500 in all were purchased.

(h) A rights issue was made of 50,000 equity shares of Rs.10 each at a premium of Rs.3 per share. Theentire money was received with applications.

(i) Dividends totalling Rs. 4,00,000 were distributed among shareholders.

(j) Cash in hand and at bank as at 31st March, 2015 totalled Rs.2,13,800.

You are required to prepare a cash flow statement using direct method.

Solution:

Proceeds from issue of share capital:

Issue price of one share =Rs. 10 + Rs.3 = Rs.13

Proceeds from issue of 50,000 shares = Rs. 13 x 50,000 = Rs. 6,50,000

Problem 5:

The summary of cash transactions extracted from the books of Happy Ltd. are:

Solution:

Forecasting methods of working capital requirements

Working capital forecasting is a difficult task. The reason is that the total current assets requirementsshould be forecasted in estimating the working capital requirements. Working capital forecasting isbased on the overall financial requirements and financial policies of the concern.

The basic objective of working capital forecasting is either to measure the cash position of the concern orto exercise control over the liquidity position of the concern. In this context, any one of the followingmethods can be adopted for working capital forecasting.

Working capital forecasting methods:

1. Cash Forecasting Method.

2. Balance Sheet Method.

3. Adjusted Profit and Loss Method.

4. Percent of Sales Method.

5. Operating Cycle Method.

6. Regression Analysis Method

1. Cash Forecasting Method

Total cash receipts and cash disbursement for a particular period are taken into consideration linder cashforecasting method. Cash receipts may be estimated cash sales, cash collected from debtors, and billsreceivables, other miscellaneous cash receipts and sale of fixed assets and investments. Delay in cashreceipts is taken into consideration.

Cash disbursement may be relating to estimated cash purchases, payment to sundry creditors, repayment ofloan, payment over bills payable, payment of wages, salaries, bonus, advances, payable to suppliers,repayment of loans and advances interest and principal amount and the like. The minimum cash balance

designed to be maintained is added with the required disbursements and provision is also made foradditional borrowings and the like.

2. Balance Sheet Method

A balance sheet is prepared by adjusting the anticipated transactions for the ensuring year in the openingbalances. The closing balances of all accounts are arrived other than cash and bank balances. Theaccountant has confirmed that all the assets and liabilities are balanced and recorded in the balance sheet.Lastly, closing cash and bank balances are arrived to find the working capital.

3. Adjusted Profit and Loss Method

Working capital is forecasted on the basis of opening cash and bank balances. Under this method, some ofthe items are added and some of the items are deducted to arrive closing cash and bank balances i.e.working capital. The items like depreciation, preliminary expenses written off, deferred revenue expenses,goodwill written off, reduction in closing stock, decrease in sundry debtors and bills receivable, decrease ininvestments and marketable securities, increase in sundry creditors and other liabilities, increase in loansand accrued expenses are added with opening cash and bank balances.

4. Percent of Sales Method

The existing relationship between sales and working capital is identified for one or two years. If therelationship is steady over a period of time, certain percent is fixed to determine working capital over theforecasted sales. The relationship between sales and working capital and its various components may beexpressed in three ways:

as number of days of sales;

as turnover;

as percentage of sales.

This method is suitable for short period since the relationship does not vary for short period. Moreover, thismethod is not suitable for public limited companies and multinational corporation.

5. Operating Cycle Method:

The operating cycle refers to the period required to convert the cash back into cash. In the case of tradingconcern, cash is used to buy goods, goods are sold on credit to customers who become sundry debtors, thesundry debtors may accept bill of exchange i.e. Bills Receivable, conversion of bills receivable into cash.At this stage, one operating cycle is completed. Thus, a loop from cash back to cash is called the“Operating Cycle“.

The following formula may be used to express the frame work of the operating cycle:

T = (r-c)+w+f+b

Where,

t = The total period of the operating cycle in number of days.

r = Number of days of raw material and requirements of stores consumption held in raw materials andstores inventory.

c = Number of days of purchases in trade creditors.

w = Number of days of production held in work in progress.

f = Number of days of cost of sales held in finished goods inventory.

b = Number of days of sales in book debts.

The computations may be made as under

r = (Average inventory of raw materials and stores / Average per day consumption of raw materials andstores).

c = (Average Trade Creditors / Average Credit Purchase per day).

w = (Average work in progress / Average cost of production per day).

f = (Average inventory of finished goods / Average cost of sales per day).

b = (Average book debts / Average sales per day).

The average inventory, work in progress, trade creditors, book debts and finished goods can be computedby adding the opening balance and closing balance in the respective accounts at year end and dividing it bytwo.

6. Regression Analysis Method.

Under this method, an average relationship between sales and working capital (current assets) and itsvarious components has been established for the past years. Regression analysis can be carried out throughthe graphic portrayals (scatter diagrams) or through mathematical formula. There are three regressionanalysis methods.

1. Estimating Working Capital Requirement Using Operating Cycle Method:

Problem:

X Ltd Co. wants to know working capital by operating cycle methods when :

Estimated Sales 20,000 units @ $5 P.U.Production and Sales will remain similar throughout the year.Production costs: M – 2.5 P.U., Labour 1.00 P.U. Overheads $17.500.Customers are given 60 days credit and 50 days credit from suppliers. 40 days supply of raw materials and15 days supply of finished goods are kept in store.Production cycle is 20 days. All materials are issued at the commencement of each production cycle. 1/3on an Average of working capital is kept as cash balance for contingencies.

Solution:

(a). Total Op. Exp. for the year. $

R.M. 20,000 x 250 50,000

Labor 20,000 x 1 20,000

Overheads 17,500

87,500

(b). Period of Production cycle Days

Material storage days (Pds) 40

Finished goods storage pds. 15

Production cycle storage pds. 20

Av. collection pd. 60

135

Less: average payment (crs) 50

85

(c). No. of operating cycle in the year: 365 / 85 = 4.3

(d). Working Capital = 87,500 / 4.3 = $20,349

Add: Reserve for contingencies 1 / 3 = 6,789 / 27,132

2. Using Working Capital Method

Problem

$

Raw Material (needed) 10,000

Store Value 16,000

Average Credit givers:

Local sales 2 weeks credit 1,56,000

Outside sales 6 weeks credit 6,24,000

Time lag payment:

For purchase (4 weeks) 1,92,000

For wages (2 weeks) 5,20,000

Contingencies Allowances = 15%

Calculate Amount of Working Capital.

Solution:

Current Assets:

Inventories: R.M. $10,000

Stock of Store $16,000 $26,000

Account Receivables (Drs)

Local sales = (1,56,000 x 2) / 52 = $6,000

Outside sales = (6 x 6,24,000) / 52 = $72,000

Less: Current Liabilities

Accounts Payables (Crs.) = (1,92,000 x 4) / 52 = $14,770

O/S Wages = (5,20,000 x 2) / 52 = $20,000

Add: 15% for contingencies = 10,385

Total Working Capital Required = $79,615

3. Using Cash Forecasting Method

Problem

John Trading Co. wants you to prepare a working capital forecast from the following:

Issued Share Capital: $4,00,0008% Deb.: $1,50,000The fixed Assets are valued at $3,00,000Production: 1,00,000 units.Expected Ratio of cost to selling price are: R.M. 50%, Wages: 10%, O/Heads: 25% = 85%

Raw material remains in stores for two months, finished goods remain in stores for 4 months, creditallowed by crs. 3 months from the date of delivery of goods (Rm) credit given to Drs. is 3 months from thedate of dispatch. Production cycle is 2 months. Sale price per unit is $6. Production and sale are uniformduring the year.

Solution

3. Using Projected Balance Sheet Method

Libro Ltd. has $3,50,000 Share Capital, $70,000 G.R., $3,00,000 Fixed Assets, $30,000 Stock, $97,500Drs., $15,000 Crs.

It is proposed to increase the business the stock level by 50% at the end of year. Crs. are doubled.Machinery worth $15,000 is proposed to be purchased. Estimated profit during the year is $52,500 afterchanging $30,000 Depreciation and 50% of profit for taxation.

Advance income tax is estimated to be $45,000. Crs. are likely to be doubled 5% dividend be paid and 10%dividend for the next year to be proposed. Drs. are estimated to be outstanding for 3 months. Salesbudget shows $7,50,000 as sales for the year make a working capital forecast by projected BalanceSheet Method.

Solution

(i) Sh.Cap. Fixed Assets 3,00,000

Cap.(Given) 3,50,000 3,50,000 M. Proposed Purchase 15,000

Res. andsurplus

70,000 Less Dep. 3,15,000

17,500 30,000

Lessdividend10%

52,500 2,85,000

52,500 C.A.

+ Profitafter tax

1,05,000 70,000 Stock 30,000 + 50% Add. Drs.15,000

45,000

LessproposedDiv. 10%

35,000 Adv. Tax 45,000 1,87,500

Currentliabilities 2,77,500

Crs.15,000

+ (k)15,000 30,000

TaxProvision

52,000

ProposedDiv.

35,000

O/D(balancefigure)

25,000 1,70,500

5,62,500 5,62,000

UNIT- IV Marginal Costing – CVP analysis – Break even analysis – Managerialapplications.

MARGINAL COSTING

Definition: Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost is chargedto 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

Characteristics of Marginal Costing

Classification into Fixed and Variable Cost: Costs are bifurcated, on the basis of variability intofixed 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 aretaken into account. However, the variable selling and distribution overheads are not included in thevaluation of inventory.

Determination of Price: The prices are determined on the basis of marginal cost and marginalcontribution.

Profitability: The ascertainment of departmental and product’s profitability is based on thecontribution margin.

In addition to the above characteristics, marginal costing system brings together the techniques of costrecording 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 periodcost, which incurs during the period, irrespective of the level of activity.

Facts Concerning Marginal Costing

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 thepurpose of decision making. It provides a basis for understanding cost data so as to gauge theprofitability 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 thelevel 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 ofmachines, discontinuing a product or service, etc. It also helps the management in ascertaining theappropriate level of activity, through break even analysis, that reflect the impact of increasing ordecreasing production level, on the company’s overall profit.

Managerial Problems using Marginal Costing

The following points highlight the top eleven problems which are simplified using marginal costing. Theproblems are: 1. Fixation of Selling Price 2. Key or Limiting Factor 3. Make or Buy Decisions 4. Selectionof a Suitable Product Mix 5. Effect of Change in Price 6. Maintaining a Desired Level of Profit and Others.

Managerial Problem # 1. Fixation of Selling Prices:

Although prices are more controlled by market conditions and other economic factors than by decisions ofmanagement yet fixation of selling prices is one of the most important functions of management.

This function is to be performed:

(a) Under normal circumstances.

(b) In times of competition.

(c) In times of trade depression.

(d) In accepting additional orders for utilising idle capacity.

(e) In exporting and exploring new markets.

In Normal Circumstances the price fixed must cover total cost as otherwise profits cannot be earned. It canalso be fixed on the basis of marginal cost by adding a high margin to marginal cost which may besufficient to contribute towards fixed expenses and profits.

Thus, in the long run the selling price should cover all costs variable and fixed and bring the desiredmargin of profit. But under other circumstances, products may have to be sold at a price below total cost, ifsuch a step is necessary to meet the situation arising due to competition, trade depression, additional ordersfor utilising spare capacity, exploring new markets, liquidation of excess stock etc.

Thus, in special circumstances, price may be below the total cost and it should be equal to marginal costplus a certain amount (if possible). This is only a short term step taken with the hope that better times willcome when prices will be increased. Pricing decisions are thus affected by long term and short termobjectives.

Pricing in Depression:

Prices fall during depression and the product may be sold below the total cost. In case there is a serious buttemporary fall in the demand on account of depression leading to the need for a drastic reduction in pricestemporarily, the minimum selling price should be equal to the marginal cost.

If the selling price at which the goods can be sold is equal to marginal cost or more than marginal cost theproduct should be continued. Fixed expenses will be incurred even if the product is discontinued duringdepression for a short period. If the product can be sold at a price which is a little more than marginal cost,loss on account of fixed expenses will reduce because price will recover fixed expenses to some extent.

This can be made clear by giving the following example:

Suppose, marginal cost per unit is Rs. 10 and fixed expenses amount to Rs. 1,50,000. Selling price per unitis Rs. 11 and 40,000 units can be sold at this price.

Even though the selling price of Rs. 11 is below the total cost, yet it is advantageous to sell the product atthe selling price of Rs. 11 which is more than the marginal cost of Rs. 10.

This will reduce the loss on account of fixed expenses (if the product is discontinued) by Rs. 40,000 asshown below:

If the selling price is below the marginal cost, loss will be more than the fixed costs because variableexpenses will not be recovered fully. Hence, efforts should be made to sell the product at a price which isequal to the marginal cost or more than the marginal cost.

Production should be discontinued if the price obtained is below the marginal cost so that loss may not bemore than the fixed costs. But, in the following circumstances, production may be continued even if theselling price is below the marginal cost.

Selling Price below the Marginal Cost:

1. When a new product is introduced in the market. The new product is sold at a very low price to make itpopular. This is done with the hope that sales will increase with the passage of time and cost of productionwill come down as a result of increase in sales. Ultimately cost of production will be in line with the sellingprice and the concern will start earning profit from the new line of production.

2. When foreign market is to be explored to earn foreign exchange. Government sometimes allows importquotas against foreign exchange earned and profits from import quotas may be much more than the loss onexporting the product at a price below the marginal cost.

3. When the concern has already purchased large quantities of materials. It is better to convert the materialinto finished goods and sell these at a price below the marginal cost if the sale of materials will give rise toloss which is more than the loss incurred if the production is done.

4. When closure of business may mean breaking of business connections and connections may be re-established by a heavy expenditure on advertisement and sales promotion. In such a case, it is better tocontinue the production and sell the product at a price below the marginal cost.

5. When the sales of one product at a price below the marginal cost will push up the sales of otherprofitable products. The loss in one product will be made up by profits in other products.

6. When employees cannot be retrenched. In such a case, it is better to maintain the production even if theprice is below the marginal cost.

7. When weak competitors are to be eliminated from the market.

8. When facing severe competition from a new entrant into the firm’s line of business.

9. For publicity and advertisement. Price below marginal cost is only for a limited quantity.

10. When the goods are of perishable nature. It is better to sell the perishable goods at a price which theycan realise; otherwise these goods will perish and nothing will be realised.

Accepting Additional Orders, Exploring Additional Markets and Exporting:

When additional orders are accepted or additional markets explored at a price below normal price to utiliseidle capacity, it should be very carefully seen that they will not affect the normal market and goodwill ofthe company. The order from a local merchant should not be accepted at a price below normal pricebecause it will affect relationship of the concern with the other customers purchasing the goods at normalprice.

In case of foreign markets, goods may be sold at a price below normal price keeping in view the direct andindirect benefits of exporting such as import quotas, subsidies of Government, prestige of exporting etc.

Factors to be considered before Launching a Product in the New Market:

The following are the main factors to be considered before launching a product in the new market (whetherIndian or Foreign).

(i) Whether the firm has Surplus Capacity to meet the new demand.

(ii) What price is being offered by the new market? In any case, it should be higher than the variable costof the product plus any additional expenditure to be incurred to meet the specific requirements of the newmarket.

(iii) Whether the sale of goods in the new market will affect the present market for the goods. It isparticularly true in case of sale of goods in a foreign market at a price lower than the domestic market price.Before accepting such an order from a foreign buyer, it must be seen that the goods sold are not dumped inthe domestic market itself.

Illustration 1:

The Cost Sheet of a product is given as under:

The selling price-per unit is Rs. 12.

The above figures are for an output of 50,000 units, the capacity for the firm is 65,000 units. A foreigncustomer is desirous of buying 15,000 units at a price of Rs. 10 per unit. Advise the manufacturer whetherthe order should be accepted. What will be your advice if the order were from a local merchant?

The order from the foreign customer will give an additional contribution of Rs. 15,000. Hence, the ordershould be accepted because additional contribution of Rs. 15,000 will increase the profit by this amountbecause fixed expenses have already been met from the internal market.

The order from the local merchant should not be accepted at a price of Rs. 10 which is less than normalprice of Rs. 12. This price will affect relationship with other customers and there will be a general tendencyof reduction in the price.

Illustration 2:

A company manufacturing electric motors at a price of Rs. 6,900 each, made up as under:

(i) A foreign buyer has offered to buy 200 such motors at Rs. 5,000 each. As a cost accountant of thecompany would you advise acceptance of the offer?

(ii) What should the company quote for a motor to be purchased by a company under the samemanagement if it should be at cost?

From the above, it is clear that the offer gives Rs. 100 as contribution towards the recovery of fixed costbesides covering marginal cost. As it is an export order so there will be no incidence of central excise.Moreover, there will also be government incentive for export order, which will help the company torecover- further the fixed cost and balance, if any, the depreciation. If the order is not accepted, thecapacity remains unutilized. Other non-monetary aspects may also be viewed.

(ii) If the motor is sold at cost price, the price to be quoted will be the total price less selling overheads andprofit i.e., Rs. 6,300 – Rs. 1,100 = Rs. 5,200. Central excise duty may be added where payable.

Managerial Problem # 2. Key (or Limiting) Factor:

A key factor is that factor which puts a limit on production and profit of a business. Usually the limitingfactor is sales. A concern may not be able to sell as much as it can produce. But sometimes a concern cansell all it produces but production is limited due to the shortage of materials, labour, plant capacity, orcapital. In such a case, a decision has to be taken regarding the choice of the product whose production isto be increased, reduced or stopped.

Ordinarily, when there is no limiting factor, the choice of the product will be on the basis of the highestP/V ratio. But when there are scarce or limited resources, selection of the product will be on the basis ofcontribution per unit of scarce factor of production. In short, scarce resources should be utilised in thosedirections where contribution per unit of limited resources is the maximum.

For example, materials are limited in supply and products X and Y use the same materials. Three units ofmaterials are used for producing product X and five for Y. Suppose further contribution per unit is Rs. 12in case of product X and Rs. 15 in case of product Y.

In this case, contribution per unit of materials is Rs. 4 (i.e. Rs. 12/3) in case of product X and Rs. 3 (Rs.15/5) in case of product Y. Hence the available material should first be used for manufacturing product Xupto limit of demand for it and the balance of materials (if any) should be used for Y because product Xyields more contribution per unit of scarce resource i.e., materials.

In addition to limiting factor from the production side, limiting factor may also be difficulty in selling theitems produced. In such a case ranking of items produced will be based on relatives contribution per unit oflimiting factor of production but the number of units of a product to be produced getting rank one will berestricted to the number of units as per demand for that product and then the production of the otherproduct getting second rank will be done but restricted to sales demand if balance of limiting factor isavailable and so on.

Illustration 3:

A company manufactures and markets three products X, Y and Z. All the three products are made from thesame set of machines. Production is limited by machine capacity.

From the data given below, indicate priorities for products X, Y and Z with a view to maximisingprofits:

Illustration 4:

The following particulars are extracted from the records of a company.

Comment on the profitability of each product (both use the same raw material) when:

(i) Total sales potential in units is limited.

(ii) Total sales potential in value is limited.

(iii) Raw Material is in short supply.

(iv) Production capacity (in terms of machine hour) is the limiting factor.

(i) When total sales potential in units is limited, product B will be better as compared to A as itscontribution per unit is more by Rs. 17 (i.e. Rs. 87 – Rs. 70).

(ii) When sales potential in value is limited, product B is better as compared to A as its contribution perrupee of sales is more by 9 paise (i.e. 79 paise – 70 paise).

(iii) When raw material is in short supply, product B is better as compared to A as its contribution per kg.of material is more by Rs. 7.75 (i.e. Rs. 21.75 – Rs. 14).

(iv) When production capacity (in terms of machine hours) is the limiting factor, product A is better ascompared to B as its contribution per machine hour is more by Rs. 6 (i.e. Rs. 35 – Rs. 29).

Illustration 5:

A company manufactures and market three products A B and C. All the three products are made from thesame set of machines. Production is limited by machine capacity.

From data given below indicate priorities for products A, B and C with a view to maximising profits.

In the following year the company faces extreme shortage of raw materials. It is noted that 3 kg., 4kg. and 5 kg. of raw materials are required to produce one unit of A, B arid C respectively. Howwould products priorities change?

Managerial Problem # 3. Make or Buy Decision:

A concern can utilise its idle capacity by making component parts instead of buying them from market. Inarriving at such a make or buy decision, the price asked by the outside suppliers should be compared withthe marginal cost of producing the component parts. If the marginal cost is lower than the price demandedby the outside suppliers, the component parts should be manufactured in the factory itself to utilise unusedcapacity.

Fixed expenses are not taken in the cost of manufacturing component parts on the assumption that theyhave been already incurred, the additional cost involved is only variable cost. For example, the total cost ofmaking a component part comes to Rs. 8 consisting of Rs. 6 as variable cost and Rs. 2 as fixed cost.Suppose further an outside supplier is ready to supply the same component part at Rs. 7.

On the basis of total cost method, it appears that it is cheaper to buy the component. But on the basis ofmarginal cost, the offer of the outside supplier should be rejected because the acceptance will mean that thetotal cost of the purchased part from the outside supplier will come to Rs. 9 i.e., Rs. 7 (supplier’s price)plus Rs. 2 (fixed cost which cannot be saved even if the component is purchased from outside source).

Factors that Influence Make or Buy Decision:

In a make or buy decision the following cost and non-cost factors must be considered specifically:

Cost Factors:

1. Availability of plant facility.

2. Quality and type of item—which affects the production schedule.

3. The space required for the production of item.

4. Any special machinery or equipment required.

5. Any transportation involved due to the location of production i.e. the ‘Feeder Point’

6. Cost of acquiring special know how required for the item.

7. As to purchase of raw material the factors like market price, price trend, availability and other must bekept in view.

8. As to labour factors like availability of the required labour.

9. As to overhead expenses, adoption of lease for apportioning them must be taken into considerationincluding other factors.

10. As to application of the techniques of costing it must be viewed for marginal costing, differentialcosting or otherwise alike one.

11. In view of above and generally the production of an item will mean an outlay on machines and otherfacilities including employment of staff which may be permanent and of fixed nature. Thus fixed expensesburden may tend to increase.

So our production is kept at the estimated minimum requirement keeping in view the possible fluctuationsin demand and the excess quantity required to be purchased from outside. The effect is that, should demandfall orders from outsiders can be cut down; the cost to be incurred will then be in proportion to the effectivedemand.

12. Having decided to purchase, it is also to be seen whether the released capacity can be put to moreprofitable use or not.

Non-Cost Factors:

Among the non-cost factors specifically.

1. In favour of making, the factors like:

(i) Secrecy of company production.

(ii) Idle facility available

(iii) Quality and stability of market supply

(iv) Tax considerations

(v) Desirability of maintaining certain facilities.

2. In favour of buying factors like:

(i) Lack of capital required

(ii) Passing the know how to suppliers or not

(iii) Uneven production of end product

(iv) Wide selection.

3. Generally the following as:

(i) If quality cannot be ensured in our production, the article concerned should be purchased from outside;if outside supplier can not be relied upon in this respect the article should be produced by the firm itself,whatever be the cost.

(ii) In case there are large fluctuations in demand, it is better to purchase from outside, but if the demand islikely to increase substantially, own production may lead to lower costs latter.

(iii) Ensure the capability and reliability of the outside suppliers to supply without any interruption.

In this regard the following factors are to be considered:

(a) The general reputation enjoyed by supplier for reliability

(b) Financial position and reputation

(c) Technical know how and production facilities

(d) His relation with his workmen etc.

(iv) If the business secrecy is to be maintained the manufacturing know how should not be passed on to thesupplier, then it is better to produce,

(v) The outside supplier should not be a competitor.

In fact, it is a very crucial decision and both cost and non-cost factors must be weighted well.

Illustration 6:

A manufacturing company finds that while the cost of making a components part is Rs 10, the same isavailable in the market at Rs. 9 with an assurance of continuous supply. Give your suggestion whether tomake or buy this part. Give also your views in case the supplier reduces the price from Rs. 9 to Rs. 8.

The cost information is as follows:

Solution:

To take a decision on whether to make or buy the component part, fixed expenses being irrelevant costshould not be added to the cost because these will be incurred even if the part is not produced.

Thus, additional cost of the part will be as follows:

The company should produce the part if the part is available in the market at Rs. 9.00 because theproduction of every part will give to the company a contribution of 50 paise (i.e., Rs. 9.00 – Rs. 8.50).

The company should not manufacture the part if it is available in the market at Rs. 8 because additionalcost of producing the part is 50 paise (i.e., Rs. 8.50 – Rs. 8) more than the price at which it is available inthe market.

In some cases inspite of lower variable cost of production, there may be an increase in the fixed costs. Insuch a case increase in fixed cost becomes the relevant cost and should be considered for make or buydecision. It becomes essential to find out the minimum requirement of volume in order to justify themaking instead of buying.

This volume can be calculated by the following formula:

Increase in Fixed Costs/Contribution per Unit (i.e. .Purchase Price – Variable Cost of Production)

Illustration 7:

A firm can purchase a separate part from an outside source @ Rs. 11 per unit. There is a proposal that thespare part be produced in the factory itself. For this purpose a machine costing Rs. 1, 00,000 with annualcapacity of 20,000 units and a life of 10 years will be required.

A foreman with a monthly salary of Rs. 500 will have to be engaged. Materials required will be Rs. 4.00per unit and wages Rs. 2.00 per unit. Variable overheads are 150% of direct labour. The firm can easilyraise funds @ 10% p.a. Advice the firm whether the proposal should be accepted.

If there is no idle capacity and making of the spare part in the factory involves the loss of other work, theloss of contribution arising from displacement of work should also be considered alongwith variable costof production.

The loss of contribution is found with reference to key or limiting factor. If the purchase price is higherthan the total variable cost of production plus traceable fixed costs plus the loss of contribution ofproduction, it will be more profitable to manufacture.

Illustration 8:

K Ltd. produces a variety of products, each having a number of component parts. B takes 5 hours toprocess on a machine working to full capacity. B has a selling price of Rs. 50 and a marginal cost of Rs. 30per unit. ‘A-10’ component part used for product A, could be made on the same machine in 2 hours for amarginal cost of Rs. 5 per unit.

The supplier’s price is Rs. 12.50. Should K Ltd. make or buy ‘A-10’? Assume that machine hour is thelimiting factor.

Solution:

Contribution per unit of B = Rs. 50 – Rs. 30 = Rs. 20

Contribution per machine hour = Rs. 20/5 = Rs. 4

If one unit of ‘A-10’ takes 2 hours, then Rs. 8 (i.e., Rs. 4 x 2) contribution is lost.

... Full cost to make one unit of ‘A-10’ = Rs. 5 + Rs. 8 = Rs. 13.

This is more than the supplier’s price of Rs. 12.50. Hence it would be more profitable to buy ‘A- 10’ thanto make.

Illustration 9:

Ride-well Cogcle Ltd. purchases 20,000 bells per annum from an outside supplier at Rs. 5 each. Themanagement feels that these be manufactured and not purchased. A machine costing Rs. 50,000 will berequired to manufacture the item within the factory. The machine has an annual capacity of 30,000 unitsand life of 5 years.

The following additional information is available:

Material cost per bell will be Rs. 2.00

Labour cost per bell will be Re. 1.00

Variable overheads 100% of labour cost

You are required to advise whether:

(i) the company should continue to purchase the bells from the outside supplier or should make them in thefactory ; and

(ii) the company should accept an order to supply 5,000 bells to the market at a selling price of Rs. 4.50 perunit ?

Therefore, the company should manufacture the bells resulting in a saving of Rs. 10,000 annually for20,000 bells.

(ii) Marginal cost per bell is Rs. 4.00 as shown above. As depreciation of the machine is recovered on20,000 bells, there will be no additional depreciation on the extra 5,000 bells to be sold in the market.Further the machine has additional capacity too. Therefore, the company is advised to supply 5,000 bells tothe market at Rs. 4.50 per unit and make a profit of Re. 0.50 per unit i.e., total profit Rs. 2,500.

Managerial Problem # 4. Selection of a Suitable Product Mix:

When a factory manufactures more than one product, a problem is faced by the management as to whichproduct mix will give the maximum profits. The best product mix is that which yields the maximum

contribution. The products which give the maximum contribution are to be retained and their productionshould be increased.

The products which give comparatively less contribution should be reduced or closed down altogether. Theeffect of sales mix can also be seen by comparing the P/V ratio and break even point. The new sales mixwill be favourable if it increases the P/V ratio and reduces the break even point.

Illustration 10:

Present the following information to show to the management:

(i) The marginal product cost and the contribution per unit.

(ii) The total contribution and profits resulting from each of the following sales mixtures.

(iii) The proposed sales mixes to earn a profit of Rs. 250 and Rs. 300 with total sales of A and B being 300units.

Sales mixtures :

(a) 100 units of Product A and 200 of B

(b) 150 units of product A and 150 of B

(c) 200 units of product A and 100 of B

Recommend which of the sales mixtures should be adopted.

Illustration 11:

Small Tools Factory has a plant capacity adequate to provide 19,800 hours of machine use. The plant canproduce all A type tools or all B type tools or a mixture of the two types.

The following information is relevant:

Market conditions are such that no more than 4,000 A type tools and 3,000 B type tools can be sold in ayear. Annual fixed costs are Rs. 9,900.

Compute the product-mix that will maximise the net income to the company and find that maximum netincome.

Illustration 12:

A multi product Company has the following costs and output data for the last year.

A comparison of the old situation and proposed change shows that if product Z is replaced by product S itwould increase the profit by Rs. 15,000 and break even point will reduce by Rs. 21,760. The change isbeneficial and, therefore, product Z may be dropped.

Managerial Problem # 5. Effect of Change in Sales Price:

Management is confronted with the problem of cut in prices of products from time to time on account ofcompetition, expansion programme or government regulations. It is, therefore, necessary to know the effectof a cut in prices of the products. The effect of a cut in selling price per unit will be that contribution perunit will reduce.

Illustration 13:

Hansa Ltd. manufacturing a single product is facing severe competition in selling it at Rs. 50 per unit. Thecompany is operating at 60% level of activity, at which level sales are Rs. 12,00,000. Variable costs are Rs.30 per unit. Semi-variable costs may be considered as fixed at Rs. 90,000 when output is nil and thevariable element is Rs. 250 for each additional 1% level of activity. Fixed costs are Rs. 1,50,000 at thepresent level of activity, but if a level of activity of 80% or above is reached, these costs are expected toincrease by Rs. 50,000.

To cope with the competition, the management of the company is considering a proposal to reduce theselling price by 5%.

You are required to prepare a statement showing the operating profit at levels of activity of 60%,70%, 80% and assuming that:

(а) the selling price remains at Rs. 50; and

(b) the selling price is reduced by 5%.

Show also the number of units which will be required to be sold to maintain the present profits if thecompany decided to reduce the selling price of the product by 5%.

Illustration 14:

The revenue account of Goodwill Co. Ltd. has been summarized as shown below:

The licensed capacity of the company is Rs. 80,00,000 but the key factor is sales demand. It is proposed bythe management that in order to utilise the existing capacity, the selling price of the product should bereduced by 5%.

You are required to prepare a forecast statement showing the effect of the proposed reduction inselling price after taking into account the following changes in costs:

(i) Sales forecast Rs. 76,00,000 (at reduced prices).

(ii) Direct wages rates and variable overheads are expected to increase by 5%.

(iii) Direct material prices are expected to increase by 2%.

(iv) Fixed overheads will increase by Rs. 80,000.

Managerial Problem # 6. Maintaining a Desired Level of Profits:

Management may be interested in maintaining a desired level of profits. The volume of sales needed tohave a desired level of profits can be ascertained by the marginal costing technique as is shown in thefollowing illustration.

Illustration 15:

A company produces and markets industrial containers and packing cases. Due to competition thecompany purposes to reduce the selling price.

If the present level of profit is to be maintained, indicate the number of units to be sold if theproposed reduction in selling price is:

(a) 5%;

(b) 10%;

(c) 15%.

Managerial Problem # 7. Alternative Methods of Production:

Marginal costing is helpful in comparing the alternative methods of production, i.e., machine work or handwork. The method which gives the greatest contribution (assuming fixed expenses remaining same) is to beadopted keeping, of course, the limiting factor in view. Where, however, fixed expenses change, thedecision will be taken on the basis of profit contributed by each.

Illustration 16:

Product X can be produced either by machine A or B. Machine A can produce 100 units of X per hour andmachine B 150 units per hour. Total machine hours available during the year are 2,500.

Taking into account the following data determine the profitable method of Manufacture:

Managerial Problem # 8. Cost Indifferent Point:

Sometimes there are two alternatives—one having low variable cost and high fixed cost and the otherhaving high variable cost and low fixed cost. The cost indifferent point has to be determined by linking theincremental fixed overhead by the savings in variable costs.

At indifferent point the total cost of the two alternatives will be the same. In case of selection of machine,this point will be helpful in calculating the levels of sales at which both machines earn equal profits and therange of sales at which one is more profitable than the other.

This will be more clear from the following illustration.

Illustration 17:

(Selection of Machine). X Limited has been offered a choice to buy a machine between ‘A’ and ‘B’.You are required to compute:

(а) Break-even point for each of the machines.

(b) The level of Sales at which both machines earn equal profits.

(c) The range of Sales at which one is more profitable than the other.

The relevant data is as given below:

(b) As the selling price of the products produced A and B are equal, the machines will earn equal profitwhen total cost of operation of both machines are the same.

If x be the output when total cost of the machines are the same, we have total cost of machine ‘A’ = 4x +Rs. 30,000

and machine ‘B’ = 6x + Rs. 16,000

Therefore,

4x + Rs. 3,000 = 6x + Rs.16,000

2x = 14,000

x = 7,000

At a production level of 7,000 units the profits made by the machines ‘A’ and ‘B’ are equal.

(c) The breakeven point of ‘A’ is at 5,000 units compared to that of 4,000 units in case of B and at aproduction level of 7,000 units they earn equal profit. It is quite clear that the profit earning capacity formachine ‘B’ is more in the range of 4,000 to 6,999 units as it starts earning profit at lower point. But ‘A’will earn more beyond 7,000 units as it has a higher P/V ratio which will enable it to earn more incrementalcontribution on the increasing sales.

Illustration 18:

S manufactures a component that it sells for Rs. 8 per unit. The company is contemplating an increase inselling price to Rs. 9 per unit. If selling price is increased, the volume of sales is expected to decline.

Company is willing to increase the price if resulting net income is greater than Rs. 30,000, whichcompany earns presently as follows:

Managerial Problem # 9. Diversification of Products:

Sometimes it becomes necessary for a concern to introduce a new product to the existing product orproducts in order to utilise the idle capacity or to capture a new market or for other purposes. The newproduct must be profitable.

In order to decide about the profitability of the new product, it is assumed that the manufacture of the newproduct will not increase fixed costs of the concern and if the price realised from the sale of such product ismore than its variable cost of production it is worth trying.

If this data is presented under absorption costing method, the decision will be wrong. But if with theintroduction of new product there is an increase in the fixed costs, then such specific increase in fixed costsmust be deducted from the contribution for making any decision. General fixed costs will, however, becharged to the old product/products.

Illustration 19:

Evenheel Ltd., manufactures and sells a single product X whose selling price is Rs. 40 per unit and thevariable cost is Rs. 16 per unit.

(а) If the fixed costs for this year are Rs. 4,80,000 and the annual sales are at 60% margin of safety,calculate the rate of net return on sale, assuming an income-tax level of 40%.

(b) For the next year, it is proposed to add another product line Y whose selling price would be Rs. 50 perunit and the variable cost Rs. 10 per unit. The total fixed costs are estimated at Rs. 6,66,600. The sales mixof X, Y would be 7 : 3. At what level of sales next year, would Evenheel Ltd., break even? Give separatelyfor both X and Y the break even sales in rupees and quantities.

Managerial Problem # 10. Closing Down or Suspending Activities:

Sometimes it becomes necessary for a firm to temporarily suspend or close the activities of a particularproduct, department or factory as a whole due to trade recession. The decision to close down or suspend itsactivities will depend on whether products are making a contribution towards fixed costs or not.

If the products are making a contribution towards fixed costs, it is preferable not to close business orsuspend its activities to minimise the losses. If the business is closed down there may be certain fixed costswhich could be avoided but there will be certain expenses which will have to be incurred at the time ofclosing the operation like redundancy payments, necessary maintenance of plant or overhauling of plant onreopening, training of personnel etc. Such costs are associated with closing down of the business and mustbe taken into consideration before taking any decision.

Fixed costs may be general or specific. General fixed costs may or may not remain constant while specificcosts will be directly affected by the closing down of the operation. To conclude, if general fixed costs arelikely to come down in the event of closure or suspension of activities, the excess of contribution overspecific fixed costs will have to be compared with reduction in general fixed cost. If the former exceeds thelatter it is profitable to continue the activities and close down or suspend activities if the latter exceeds theformer.

In addition to cost consideration, there may be some non-cost considerations which may weigh in takingthe decision to close down or suspend its activities or not.

The following non-cost considerations are relevant in this respect:

(i) Once the business is closed down, competitors may establish their products and our business may belost. It may be difficult to recapture the lost market again; heavy advertisement charges may have to beincurred to recapture the business again.

(ii) Fear of retrenchment of workers. If workers are discharged it may be difficult to get experienced andskilled workers again at the restart of the business.

(iii) Plant may become obsolete with the closure of the business and heavy capital expenditure may have tobe incurred on restart of the business.

(iv) Reputation of the firm may suffer if some activities are closed down or suspended.

(v) Temporary closing down or suspending activities may not be desirable if the relationship with thesuppliers is adversely affected.

(vi) Fear of non-collection of dues from customers in case of close of business may not go in favour ofclosure of business.

Illustration 20:

The annual flexible budget of a company is as follows:

Owing to trade difficulties the company is operating at 50% capacity. Selling prices have had to be loweredto what the directors maintain is an uneconomic level and they are considering whether or not their singlefactory should be closed down until the trade recession has passed.

A market research consultant has advised that in about twelve months’ time there is every indication thatsales will increase to about 75% of normal capacity and that the revenue to be produced from sales in thesecond year will amount to Rs. 90,000. The present revenue from sales at 50% capacity would amount toonly Rs. 49,500 for a complete year.

If the directors decide to close down the factory for the year, it is estimated that:

(a) The present fixed costs would be reduced to Rs. 11,000 a year.

(b) Closing down costs (redundancy payments etc.) would amount to Rs. 7,500.

(c) Necessary maintenance of plant would cost Rs. 1,000 p.a.

(d) On reopening the factory the cost of overhauling plant, training and engagement of new personnelwould amount to Rs. 4,000.

Prepare a statement for the directors presenting in such a way as to indicate whether or not it is desirable toclose the factory.

From the above it is clear that the amount of loss can be reduced by Rs. 13,500 (i.e. Rs. 23,500 — Rs.10,000) if the factory is continued to operate at 50% capacity. There will be profit of Rs. 10,250 in thesecond year, so closing down of factory is undesirable.

Managerial Problem # 11. Alternative Course of Action:

When deciding between alternative courses of action, it shall be kept in mind that whatever course ofaction is adopted, certain fixed expenses will remain unaffected. The criterion, therefore, which weighs isthe effect of alternative course of action upon the marginal (i.e., variable) costs in relation to the revenueobtained. The course of action which yields the greatest contribution is the most profitable to be followedby the management.

Illustration 21:

The cost per unit of the three products, A, B and C of a concern is as follows:

Production arrangements are such that if one product is given up, the production of the others can be raisedby 50%. The directors propose that C should be given up because the contribution in that case is the lowest.Do you agree?

From the three production arrangements we see that the profit is the maximum when product B is given up.Therefore, we do not agree with the directors that C should be given up and recommend that product Bshould be given up in order to have the maximum profit.

COST-VOLUME-PROFIT (CVP)

Cost-Volume-Profit (CVP) Analysis is also known as Break–Even Analysis. Every business organizationworks to maximize its profits. With the help of CVP analysis, the management studies the co-relation ofprofit and the level of production.

CVP analysis is concerned with the level of activity where total sales equals the total cost and it is called asthe break-even point. In other words, we study the sales value, cost and profit at different levels ofproduction. CVP analysis highlights the relationship between the cost, the sales value, and the profit.

Assumptions

Let us go through the assumptions for CVP analysis:

Variable costs remain variable and fixed costs remain static at every level of production.

Sales volume does not affect the selling price of the product. We can assume the selling price asconstant.

At all level of sales, the volume, material, and labor costs remain constant.

Efficiency and productivity remains unchanged at all the levels of sales volume.

The sales-mix at all level of sales remains constant in a multi-product situation.

The relevant factor which affects the cost and revenue is volume only.

The volume of sales is equal to the volume of production.

Marginal Cost Equation

Equations for elements of cost are as follows:

Sales = Variable costs + Fixed Expenses ± Profit /Loss

Or

Sales – Variable Cost = Fixed Expenses ± Profit /Loss

Or

Sales – Variable Cost = Contribution

It is necessary to understand the following four concepts, their calculations, and applications to know themathematical relation between cost, volume, and profit:

Contribution

Profit Volume Ratio (P/V Ratio or Contribution/Sales (C/S))

Break-Even Point

Margin of Safety

Contribution

Contribution = Sales – Marginal Cost

We have already discussed contribution in Marginal Costing topic above.

Profit-Volume Ratio

Profit / Volume (P/V) ratio is calculated while studying the profitability of operations of a business and toestablish a relation between Sales and Contribution. It is one of the most important ratios, calculated asunder:

P⁄V Ratio = Contribution Sales = Fixed Expenses + Profit Sales = Sales−Variable Cost Sales

= Change in profits of Contributions Change in Sales

The P/V Ratio shares a direct relation with profits. Higher the P/V ratio, more the profit and vice-a-versa.

BREAK-EVEN POINT

When the total cost of executing business equals to the total sales, it is called break-even point.Contribution equals to the fixed cost at this point. Here is a formula to calculate break-even point:

B.E.P (in units) = Total Fixed Expenses Selling Price per Unit − Marginal Cost per Unit

= Total Fixed Expenses Contribution per Unit

Break-even point based on total sales: = Fixed Cost P⁄V Ratio

Calculation of output or sales value at which a desired profit is earned:

= Fixed Expenses + Desired Profit Selling Price per Unit − Marginal Cost per Unit =

Fixed Expenses + Desired Profit Contribution per Unit

Composite Break Even Point

A company may have different production units, where they may produce the same product. In this case,the combined fixed cost of each productions unit and the combined total sales are taken into considerationto find out BEP.

Constant Product - Mix Approach In this approach, the ratio is constant for the products of allproduction units.

Variable Product - Mix Approach In this approach, the preference of products is based on biggerratio.

Margin of Safety

Excess of sale at BEP is known as margin of safety. Therefore,

Margin of safety = Actual Sales − Sales at BEP

Margin of safety may be calculated with the help of the following formula:

Margin of Safety =

Profit P⁄V Ratio = Profit Contribution per Unit

Break-Even Chart

Break-Even Chart is the most useful graphical representation of marginal costing. It converts accountingdata to a useful readable report. Estimated profits, losses, and costs can be determined at different levels ofproduction. Let us take an example.

Example

Calculate break-even point and draw the break-even chart from the following data:

Fixed Cost = Rs 2,50,000

Variable Cost = Rs 15 per unit

Selling Price = Rs 25 per unit

Production level in units 12,000, 15,000, 20,000, 25,000, 30,000, and 40,000.

Solution:

B.E.P =

Fixed CostContribution per unit

=

Rs 2,50,000Rs 10 × (Rs 25 - Rs 15)

= 25,000 units

At production level of 25,000 units, the total cost will be Rs 6,25,000.

(Calculated as (25000 × 14) + 2,50000)

Statement showing Profit & Margin of safety at different level of production Break Even Sale =Rs 6,25,000 (25,000 x 25)

Production

(In Units)

Total Sale

(In Rs)

Total Cost

(In Rs)

Profit

(Sales - Cost)

(In Rs)

Margin of safety

(Profit/Contribution perunit)

(In Units)

12000 3,00,000 4,30,000 -1,30,000

15000 3,75,000 4,75,000 -1,00,000

20000 5,00,000 5,50,000 -50,000

25000 6,25,000 6,25,000 (B.E.P) (B.E.P)

30000 7,50,000 7,00,000 50,000 5,000

40000 10,00,000 8,50,000 1,50,000 15,000

The corresponding chart plotted as production against amount appears as follows:

APPLICATIONS OFMARGINAL COSTING

Everything you need to know about application of marginal costing. Marginal costing techniques assist themanagement in the fixation of the selling price of different products.

Marginal cost of a product is the guiding factor in the fixation of selling price. Generally, the selling priceof a product is fixed at a level which not only covers the marginal cost but also contributes somethingtowards fixed costs.

Hence, under normal circumstances for a long period, the fixation of selling price is done on the basis ofthe total cost of sales (i.e., by adding some margin of profit to the total cost).

Marginal costing helps management to decide whether the firm should itself manufacture a component partor buy it from an outside firm.

This is particularly so when a component part is available in the market at price below the firm’s own cost.This decision can be arrived at by comparing the supplier’s price with firm’s own marginal cost.

The most useful contribution of marginal costing is that it helps management in vital decision making.Decision making essentially involves a choice between various alternatives and marginal costing assists inchoosing the best alternative by furnishing all possible facts.

The information supplied by marginal costing technique is of special importance where informationobtained from total absorption costing method is incomplete. Sometimes the information revealed by totalcosting method is even misleading.

Application of Marginal Costing: Profitable Product Mix, Make or Buy Decision, Fixation of SellingPrice and a Few Others

Application of Marginal Costing – Fixation of Selling Price, Maintaining a Desired Level of Profit,Accepting of Price Less than the Total Cost and a Few Other Applications

We are now explaining the application of the technique of marginal costing in detail in certainimportant spheres:

Application # 1. Fixation of Selling Price:

Marginal cost of a product represents the minimum price for that product and any sale below the marginalcost would entail a cash loss. The price for the product should be fixed at a level which not only covers themarginal cost but also makes a reasonable contribution towards the common fund to cover fixed overheads.The fixation of such a price for a product would be easier if its marginal cost and overall profitability of theconcern is known.

Application # 2. Maintaining a Desired Level of Profit:

The industry has to cut prices of its products from time to time on account of competition, governmentregulations and other compelling reasons. The contribution per unit on account of such cutting is reducedwhile the industry is interested in maintaining a minimum level of its profits. In case the demand for thecompany’s products is elastic, the minimum level of profits can be maintained by pushing up the sales. Thevolume of such sales can be found out by the marginal costing technique.

Application # 3. Accepting of Price Less than the Total Cost:

Sometimes prices have to be fixed below the total cost of the product. This becomes necessary to meet thesituation arising during trade depression. It will be enough in such periods if the marginal cost is recovered.The selling price may be fixed at a level above this cost though it may not be enough to cover the total cost.This is because in such periods any marginal contribution towards recovery of fixed cost is good enoughrather than not to have any contribution at all.

A price less than the total cost but above marginal cost may be acceptable when a specific order has beenreceived and it shall not affect the home market. The additional sales revenue should be compared with theadditional costs (which are only marginal costs generally) and if the net revenue is greater, the order shouldbe accepted. In case the market is competitive and there is a fear of adverse impact on existing sales in thelong run, the decision should be taken after careful study.

Similar is the situation when order for exports is received by the concerns. Exports at a price above themarginal cost but below the total cost may be made since they don’t interfere in any way the sales in thehome market.

Advantages of such practices are:

(i) Idle capacity of plant and machinery can be utilised and prevented from deterioration.

(ii) Services of skilled labour and well trained employees could be secured which will be difficult to obtainlater, if discharged.

(iii) It prevents the competitors from securing the business of the firm.

(iv) The business would be ready to take advantage of favourable business environment whenever it ariseslater.

Selling at marginal cost or even below the marginal cost may be recommended in extraordinarysituations e.g.:

(i) When it is desired to eliminate weak competitors;

(ii) When the production is to be kept continuing because otherwise there is a danger of heavy losses onaccount of shut down;

(iii) When goods are likely to be perished by the passage of time;

(iv) When a new product is to be introduced in the market or an existing one is to be made more popular;

(v) When one product can be sold with profit in combination with some other product. The reduction inprice of one may enable the business to boost sales of other more profitable products;

(vi) When inventories have been piled up and recessionary trends are there in the market leading to fall inmarket prices. To save the carrying costs and safeguard against risk and uncertainty, it is advisable to selleven below marginal cost. The risk of obsolescence is there on one hand and uncertainty as to further fallin demand and consequently prices is there on the other.

Application # 4. Decisions Involving Alternative Choices:

CVP analysis helps the management in making decisions involving alternative choices.

This involves Cost Benefit Analysis as explained below:

Cost Benefit Analysis:

Cost Benefit Analysis (CBA) involves estimating the total benefits and costs of a project in terms of theirequivalent money value. It finds, quantifies and adds all the positive factors of a project. These are calledas Benefits from the project. Then it identifies, quantifies and subtracts all the Negatives i.e., Total Cost ofthe project.

The difference between the two indicates whether the planned action is advisable or not. It may please benoted that cost benefit analysis could be used for almost every decision which one undertakes, however, itis most commonly used for taking financial decisions involving alternative choices.

The following are the examples of such decisions:

(i) Should an additional sales person be hired or continue to work with the existing staff by allowing themovertime?

(ii) Whether manual labour is to be replaced by machinery, wholly or partly?

(iii) Whether free cash funds should be invested into securities or building additional capacity?

There can be many such decisions, as discussed below:

(a) Determination of Product or Sales Mix:

Presuming that fixed costs will remain unaffected, decision regarding sales/ production mix is taken on thebasis of the contribution per unit of each product. The product which gives the highest contribution shouldbe given the highest priority and the product, the contribution of which is the least, should be given theleast priority. A product giving a negative contribution should be discontinued or given lip, unless there areother reasons to continue its production.

(b) Exploring New Markets:

Decision regarding selling goods in a new market (whether Indian or foreign) should be taken afterconsidering the following factors:

(i) Whether the firm has surplus capacity to meet the new demand?

(ii) What price is being offered by the new market? In any case, it should be higher than the variable costof the product plus any additional expenditure to be incurred to meet the specific requirements of the newmarket.

(iii) Whether the sale of goods in the new market will affect the present market for the goods? It isparticularly true in case of sale of goods in a foreign market at a price lower than the domestic market price.Before accepting such an order from a foreign buyer, it must be seen that the goods sold are not dumped inthe domestic market itself.

(c) Discontinuance of a Product Line:

The following factors should be considered before taking a decision about the discontinuance of aproduct line:

(i) The contribution given by the product – The contribution is different from profit. Profit is arrived atafter deducting fixed cost from contribution. Fixed costs are apportioned over different products on somereasonable basis which may not be very much correct. Hence, contribution gives a better idea about theprofitability of a product as compared to profit.

(ii) The capacity utilisation, i.e., whether the firm is working to full capacity or below normal capacity. Incase a firm is having idle capacity, the production of any product which can contribute towards therecovery of fixed costs can be justified.

(iii) The availability of product to replace the product which the firm wants to discontinue and which isalready accounting for a significant proportion of total capacity.

(iv) The long-term prospects in the market for the product.

(v) The effect on sale of other products. In some cases the discontinuance of one product may result inheavy decline in sales of other products affecting the overall profitability of the firm.

(d) Make or Buy Decisions:

Whether a particular part of the finished product is to be manufactured within the industry or it has to bebought from outside will depend on the consideration of marginal costs. The marginal cost ofmanufacturing is to be compared with the purchase price of the relevant material and if the marginal cost ismore than the purchase price, a decision as to buying it from the market can be taken. However, there arecertain non-cost factors also which must be taken into account before making a final decision.

The factors are as under:

1. The part to be bought should be available whenever it is needed and at the same price at which we areconsidering to buy it at present.

2. If there is difference in quality, specification etc. of the component to be bought, it must be workable.

3. If production is not carried out, labour problems should not crop up. The surplus labour force should beabsorbed in other productive work.

(e) Shut-Down or Continue:

Sometimes a business is confronted with the problem of continuing or suspending the business operations.Such suspension of business operations may be of a temporary or a permanent nature. In the former case itmay be termed as ‘shut-down’ while in a latter case, it is termed as ‘closing down’ business operations.

Shut-down may be necessary due to some temporary difficulties viz., depression in the market, inadequateavailability of raw materials, power, etc. While deciding whether to shut-down or not, a comparison has tobe made between the costs e.g., lay off or retrenchment compensation to workers, loss of goodwill,packaging and storing, cost of plant etc., and benefits e.g., saving of fixed costs, avoiding operating lossesetc. on account of shut-down. In case the benefits exceed the costs it is advisable to shut-down or vice-versa.

In order to decide whether to continue operations or close down or give up the project altogether,comparison should be made between the revenues from continuing operations and revenues from completeclosing down and sale of the plant. In case the revenues from closing down exceed the revenues fromcontinuing operations of the business, it will be advisable to close down the plant.

Application of Marginal Costing – In Making Short Term Decisions: Make or Buy, Acceptance ofSpecial Order, Discontinuing a Product, Shut Down or Continuing

In short-term an organization is required to take many decisions to maximise profit. The best use ofexisting capacity must be made to do so. In short-term fixed costs remain same and decisions should bemade on the basis of contribution. In this situation, marginal costing technique is used extensively.

It may be used for the following types of short-term decisions:

1. Make or Buy,

2. Acceptance of Special Order,

3. Discontinuing a Product,

4. Selection of Product Mix when there is Limiting Factor(s);

5. Shut Down / Continuation.

1. Make or Buy Decisions:

Many organisations buy different items from outside suppliers. For example, in India, all automobilecompanies are buying different parts or components from different suppliers – car battery from Exide, tyre

from MRF, fuel injecting system from MICO, etc. Almost all automobile companies are buying at least30% of parts and components from outside suppliers.

A company may meet its own needs internally or may buy it from external sources. The decisions onwhether to manufacture components in-house or buy them from outside suppliers are called ‘Make or BuyDecisions’.

A detailed analysis of cost and non-cost factors are to be made. Before taking final decision, costs to‘make’ and costs to “buy’ must be calculated carefully.

Cost to make must be calculated on the basis of identical product specifications, quality standard andquantity to be manufactured. Cost to buy should include all cost to bring the product to the same conditionand location as if manufactured in-house. Freight, purchasing costs, handling costs, transportation costs,inspection costs and inventory holding cost are to be taken into consideration.

The following cost and non-cost factors must be taken into consideration in any ‘make’ or ‘buy’ decisions.

Cost Factors:

i. Cost of materials and its availability at affordable price.

ii. Availability of labour and cost related to labour.

iii. Cost of acquisition of new technology, plant, machinery and equipment.

iv. Cost of operation.

v. Cost of transportation.

vi. Cost of ordering and holding inventory.

vii. Cost to be paid to suppliers.

viii. Cost of stock out.

ix. Cost of construction of production facility.

x. Lease rent of production facility or machinery and equipment.

Non-Cost Factors:

i. Policy of the organization.

ii. Government’s policy (for example, present US government discourage outsourcing).

iii. Trade union’s resistance.

iv. Reliability of supply.

v. Availability of suppliers with required technology.

vi. Secrecy of company production.

vii. Capability of the supplier to supply required quantity and quality.

viii. Effects on workers’ morale.

ix. Possibility of using idle capacity for other profitable purposes.

Faced with a make or buy decision, the manager can evaluate alternative using marginal costing system.Based on marginal costing, comparison is to be made between cost of buying the product or service and the

marginal cost of manufacture. Common fixed costs are excluded from the analysis, as these are to beincurred in any way. However, any specific fixed cost (i.e., related to decision) must be taken intoconsideration.

Reasons for ‘Making’ vs. Reasons for ‘Buying’:

The following list of reasons are important to arrive at a decision to make or buy:

Reasons for Making in-House:

i. The variable cost of manufacturing is less than the price quoted by the suppliers.

ii. The design of the product or its processing is confidential.

iii. The technology and know-how is available with the organization.

iv. There is no shortage of skilled manpower.

v. The safety factor of the product is very important. If the law of the land is very strict in safety matters, asin USA, then it is better to manufacture in-house rather than buying from vendors. It is important tomention here that in 2009-10 many auto companies had to call back millions of cars for defective partssupplied by vendors. The companies are – Toyota, Maruti, Honda, etc.

vi. It is difficult to transport the parts or products because it is too heavy.

vii. Vendor’s failure to supply in time may upset your production and delivery schedule which may lead toheavy penalty or even loss of future contracts.

viii. Making will facilitate quality control and management of inventory.

ix. There is steady demand for the product.

Reasons for Buying:

i. The buying cost is less than in-house manufacturing cost.

ii. There is no idle capacity to manufacture the products or parts.

iii. The technology and know-how is not available with the company.

iv. The company cannot manufacture it from its own facility because of ‘environmental problem’.

v. The company wants to concentrate in its core area.

vi. The company wants that someone else to face seasonal, cyclical or risky market demands.

vii. The government policy may not allow to manufacture 100% in-house. Some portions must bepurchased from small-scale manufacturing enterprises.

Common Mistakes to Avoid in Decision Making:

At the time of making decision, the managers should not overlook the following:

i. Sunk Cost – Sunk costs cannot be changed by any current or future action, so ignore sunk cost fordecision making.

ii. Unitised Fixed Cost – Sometimes fixed costs are divided by some activity measure (number of units,number of machine hours or number of labour hours) and charged to each product for product costingpurposes. At the time of making decision, the total fixed cost should be taken into consideration rather thanas a ‘per unit cost’.

iii. Common Fixed Cost – Common fixed costs are allocated to different departments or product lines. Atthe time of making decision, common fixed cost should be ignored because these are to be incurred in anysituation. It cannot be avoided.

iv. Opportunity Cost – At the time of making decision, due importance should be given to opportunity cost.Many people treat opportunity costs as less important than out of pocket costs. Pay proper attention toidentify the opportunity costs and include it in decision making process.

2. Acceptance of Special Order:

A special order is a one-time order that is accepted without disturbing the present production and sales.Generally, this type of order is accepted when there is spare capacity. Sometimes special order can beaccepted even sacrificing the present sales. At the time of evaluating a special order, many technical andnon-cost factors are to be taken into consideration but cost of executing the special order will be ofparamount importance.

The cost of executing the order must be calculated on the basis of marginal cost. Any common fixed costsmust be excluded. However, specific fixed cost and tax benefit must be taken into consideration. Forspecial order, usually a lower price is charged than normal price. However, it must be greater than the costof executing the order.

3. Discounting a Product:

A company may produce several products. For different reasons (e.g., change in taste of the customers,competition etc.,) a product or more than a product may not perform up to the expectation of themanagement. In such a situation, the management may drop one / two product(s) temporarily fromproduction plan. At the time of dropping a product, marginal costing technique is widely used.

At the time of taking decision, the following points are to be taken into consideration:

i. No product will be discontinued if the contribution is positive.

ii. Total fixed cost (common) for the business as a whole will remain the same or decrease.

iii. Share of fixed cost of discontinued product will have to be borne by the remaining products.

iv. Effect on sale of other products because of discontinuation of a product.

4. Selection of Product Mix when there is Limiting Factor(s):

Resources available to an organisation is not unlimited. Managers are frequently faced with the problem ofallocating limited resources for maximising profits. A furniture manufacturing company, for example, hasa limited number of direct labour hours and a limited number of machine hours.

In the short run, it may not be possible to recruit more staff or to install new machinery. Because of thelimited resources, the company cannot manufacture the required quantity to satisfy the demand fully. Thislimitation in terms of resources, which restricts the company’s ability to satisfy demand, is called theLimiting Factor.

The limiting factor is also known as the Key Factor or the Principal Budget Factor. It is called the principalbudget factor because, the influence of this factor must first be assessed at the time of making functionalbudgets like production budget, purchase budget, etc.

CIMA, U.K. has defined “limiting factor” as – “The factor which, at a particular time, or even a period,will limit the activities of an undertaking. The limiting factor is usually the level of demand for theproducts or services of the undertaking but it could be a shortage of one of the productive resources, e.g.,skilled labour, raw material or machine capacity.”

The limiting factor may vary from time to time within an organisation. The limiting factor is governed byboth internal and external influences. For example, during 2009-10 in sugar industry, the shortage of sugarcane was a limiting factor for all sugar mills. It is an example of external influence. It may happen that in2010-11, the sugar cane may not be a limiting factor but production capacity may become a limiting factor.It is an example of internal influence.

In practice, many limiting factors are there. An organization may produce different products whichconsume scarce resources (limiting factors) in different proportions. At the time of allocation of scarceresources, care should be taken so that the overall profit of the organisation is maximised.

In short run, the fixed cost will remain same irrespective of the output. Therefore, the maximisation of totalcontribution will lead to maximisation of total profits. To maximise total contribution, an organisationshould not necessarily sell those products that have the highest contribution per unit.

The organisation should sell those products that have highest contribution per unit of limiting factors. Itmeans ‘higher the contribution per unit of limiting factor, the most profitable the product.’

For example, Tata Motors Ltd. manufactures two types of truck – 6 wheels and 10 wheels.

The selling price, variable costs and contribution are given below:

A glance at contribution per unit data suggests that 10 wheels truck is more profitable than 6 wheels truck.However, in this case, 6 Wheels Truck is more profitable than 10 Wheels Truck because contribution pertyre of 6 wheels truck is Rs. 1,00,000 (Rs.6,00,000 / 6) but in case of 10 wheels truck the contribution pertyre is Rs. 90,000 (Rs. 9,00,000/10).

Contribution per unit is to be taken into consideration only when there is no limiting factor and there isenough demand.

Selection of Product Mix:

There may be one, two or more than two limiting factors.

Allocation of scarce resources is easy when there is only one limiting factor (for example, either rawmaterial or direct labour hours is a limiting factor). If the number of limiting factors are two or more (forexample, both raw material and direct labour hours), the calculation of product mix is complex.

(i) There is only one limiting factor; and

(ii) There are two or more limiting factors.

(i) There is Only One Limiting Factor:

In this case, the priority of production will depend upon the contribution per unit of limiting factors.Product with highest contribution per unit of limiting factor should be given first priority. Similarly,product with lowest contribution per unit of limiting factor should be given last priority.

(ii) There are Two or More than Two Limiting Factors:

Computation of product mix is very complex when there are two or more than two limiting factors /products. In this case, it is not possible to use the approach based on contribution per unit of limiting

factors. If the number of limiting factors are limited to two, the simultaneous equation method can beadopted for calculating the optimal product mix.

If the number of limiting factors as well as number of products are several, the use of Linear Programmingtechnique should be adopted to get the optimal solution.

5. Shut Down / Continuation:

Temporary recession in trade or labour problem, etc., may compel the management to take the decisionwhether the operating activities are to be suspended or to be continued.

The marginal cost technique helps the management to take right decision in this situation. Total shutdowncost is compared with the loss to be incurred if the operation is continued. If the total shut down cost ismore than the loss to be incurred if the operation is continued, then the operation should be continued.

If the total shut down cost is less than the loss to be incurred if the operation is continued, then theoperation should be suspended.

However, before taking final decision, the following factors should be taken into consideration:

(i) The possibility of losing customers.

(ii) The possibility of losing the skilled labours.

(iii) The reaction of the labour unions and the Government.

(iv) The chance of obsolescence of raw materials in stock.

(v) The agreement with the suppliers.

(vi) The possibility of bad debts due to non-payment by the existing customers.

(vii) The chance of obsolescence / over-depreciation of plant and machinery. For example: In textileindustry, the depreciation is more during shut down period than the active period.

The shutdown cost includes the following:

(i) Unavoidable fixed cost;

(ii) Cost of maintenance of the plant and machinery;

(iii) Cost of overhauling the plant at the time of re-opening;

(iv) Cost of training of employees;

(v) Cost of new recruitment, etc.

Application of Marginal Costing – 11 Important Areas: Profitable Product Mix, Make or BuyDecisions, Diversification of Production and a Few Other Applications

One of the basic functions of management is to make decisions. Decision-making process generallyinvolves selecting a course of action from among various alternatives.

Some of the important areas where marginal costing techniques are generally applied, can be givenas follows:

Application # 1. Selection of a Profitable Sales Mix or Profitable Product Mix:

In case of a multi-product concern, there may arise a problem of the selection of the suitable or profitablesales mix i.e., the determination of the ratio in which various products are produced and sold.

For the purpose of determining the profitable sales mix, the amount of contribution available under eachalternative of sales mix is to be considered and the sales mix giving maximum total contribution will beselected. But the various problems arising out of change in the sales mix e.g., limiting factors etc., must beproperly considered.

Application # 2. Problem of Limiting Factors:

Limiting factor (also known as ‘key factor’) is a factor which limits production and/or sales and thusprevents the manufacturing concern from earning unlimited profits. The limiting factors or key factors maybe shortage of raw material, shortage of skilled labour and machine capacity, market for sales etc.

In case of the existence of a key factor, a problem may arise as to which product should be pushed more inorder to maximise profits. Selection of the profitable product shall be made on the basis of the contributionper unit of limiting factor. The profitability of a product with reference to limiting factor can be assessed asfollows –

Profitability = Contribution per unit/Limiting Factor per unit

The higher the contribution per unit of limiting factor, the more profitable is the product and vice versa.

Application # 3. Make or Buy Decisions:

Sometimes a manufacturer has to decide as to whether a certain component or spare part should bemanufactured in the factory (having unused installed capacity) or bought from the market. In taking such a‘make or buy’ decision, the marginal cost of the component or spare part should be compared with themarket price. If the marginal cost is lower than the market price, the component or spare part should bemanufactured in the factory itself.

However, the manufacturer must take into consideration any increase in fixed costs or any limiting factorwhich may arise if the production is undertaken in the factory. If the purchase price is lower than themarginal cost and provided regular supply and proper quality of the component are guaranteed by outsidesupplier, it should be purchased from outside supplier.

Application # 4. Diversification of Production:

Sometimes a manufacturer may intend to add a new product to the existing product or products to utilisethe idle capacity, to capture a new market or for some other purpose. In such a case, the manufacturer ormanagement is interested in knowing the profitability of the new product before its production can beundertaken.

It is advisable to undertake the production of the new product if it is capable of contributing somethingtowards fixed costs and profit after meeting out its variable cost of sales. Fixed costs are not to beconsidered on the assumption that the new product can be manufactured by existing resources withoutincurring any additional fixed costs.

But if the introduction of a new product involves some specific or identifiable fixed costs (which arise dueto the new product), these should be deducted from the contribution of the new product before making anydecision.

Application # 5. Fixation of Selling Price:

Marginal costing techniques assist the management in the fixation of the selling price of different products.Marginal cost of a product is the guiding factor in the fixation of selling price. Generally, the selling priceof a product is fixed at a level which not only covers the marginal cost but also contributes somethingtowards fixed costs. Hence, under normal circumstances for a long period, the fixation of selling price isdone on the basis of the total cost of sales (i.e., by adding some margin of profit to the total cost).

But in times of cut-throat competition, trade depression, in accepting additional orders for utilising unusedcapacity and in exploring foreign markets, the manufacturer may be ready to sell his products at a pricebelow total cost but not at a price below marginal cost. For fixing the price at a level below total cost ofsales, the manufacturer shall take into account the overall profitability or P/V Ratio of the business concern.

Thus, the fixation of selling price becomes easy where marginal cost, overall P/V Ratio and the level ofprofits expected, are known. In case of exports to foreign markets, the effect of various direct and indirectbenefits such as cash compensatory assistance, subsidies, import entitlements and other special favours orbenefits from the Government should also be taken into account.

Further, pricing at or below marginal costs may be considered desirable for a shorter period undercertain special circumstances given below:

(i) To introduce a new product in the market or to popularise it.

(ii) To drive out weaker competitors from the market.

(iii) To maintain production in order to avoid retrenchment of employees.

(iv) To keep the plant and machinery in gear.

(v) To avoid the loss of future markets.

(vi) To sell the goods of perishable nature.

(vii) To push up the sales of other conjoined profitable products.

Export Market vs. Home Market:

A firm engaged in supplying goods in the home market and having surplus production capacity, may thinkof utilising it to meet export orders at a price lower than that prevailing in the home market. Such adecision is made only when the local sale is earning a profit i.e., when its fixed costs have already beenrecovered by the local sales.

In such cases, if the export price is more than the marginal cost, it is advisable to enter the export market.Any reduction in the selling price in the local market to utilise the surplus capacity may adversely affectthe normal local sales.

However dumping in the export market at a lower price even below marginal cost in order to capture futuremarket, has no adverse effect on local sales.

Application # 6. Alternative Methods of Manufacture:

Sometimes a manufacturer is faced with the problem of the application of alternative methods ofmanufacture i.e., whether machine work or hand work, employment of hand-driven machine or power-driven machine or employment of one machine or another machine etc. For the purpose of selecting themethod of production to be adopted, a comparison of the amount of contribution available under differentmethods of manufacture shall be made.

The alternative providing the maximum contribution per unit shall be considered to be more profitable.However, the limiting factor, if any, involved in the method of production, must be given properconsideration.

Application # 7. Operate or Shut Down Decision:

In case of a multi-product concern, it may be found that the production of some of its products is beingcarried on at a loss. Under such a position, the production of non-profitable products shall have to bediscontinued.

But if the choice is out of two or more products, the decision shall be taken with reference to the amount ofcontribution or P/V Ratio of these products. Production of the product giving the least amount ofcontribution or least P/V Ratio should be discontinued on the assumption that production capacity thusfreed can be used to produce other profitable products.

Application # 8. Maintaining a Desired Level of Profit:

Sometimes the management may be interested in maintaining a desired level of profits under the conditionsof a change in the sales price. The volume of sales required to earn a desired level of profits can beascertained by applying marginal costing techniques. For ascertaining the sales required to earn a desiredlevel of profits, the following formulae are applied –

Application # 9. Alternative Courses of Action:

Sometimes the management has to select a course of action from amongst various alternative courses. Eachcourse of action has its own merits and limitations. The course of action to be selected should ensuremaximum profit to the business concern. The appraisal of the various courses of action available ispossible through the analysis of contribution. The course of action ensuring highest contribution isgenerally adopted by the management.

Application # 10. Profit Planning:

Profit planning is one of the important functions of management. It relates to the attainment of maximumprofit. Profit planning requires the management to have the proper knowledge of the inter-relationship ofselling prices, sales volume, variable costs and fixed costs. Marginal costing helps the management inascertaining the profit position at the various levels of operation through the technique of cost-volume-profit analysis. Thus, the management can plan its operations at the optimum level where profits aremaximum.

Application # 11. Appraisal of Performance:

Cost accounting deals with costs and profits of each department, product, branch etc., of the businessseparately. Marginal costing being a technique of cost accounting, presents the comparative profitability ofeach part or segment of the business to the management in an analysed form. Thus, the management canknow the efficiency or inefficiency of each segment of the business and can plan in such a way that theprofits made by an efficient segment of the business are not eaten away by some inefficient segment.

Application of Marginal Costing – Fixation of Selling Prices, Make or Buy Decisions, Selection of aSuitable Product Mix, Alternative Methods of Production and a Few Others

The most useful contribution of marginal costing is that it helps management in vital decision making.Decision making essentially involves a choice between various alternatives and marginal costing assists inchoosing the best alternative by furnishing all possible facts. The information supplied by marginal costingtechnique is of special importance where information obtained from total absorption costing method isincomplete. Sometimes the information revealed by total costing method is even misleading.

The following are some of the managerial decisions which are taken with the help of marginalcosting technique:

1. Fixation of selling prices.

2. Make or buy decisions.

3. Selection of a suitable product mix.

4. Alternative methods of production.

5. Profit planning.

6. Suspending activities, i.e., closing down.

1. Fixation of Selling Price:

Although prices are regulated more by market conditions of demand and supply than by market conditionsof demand and supply than by management, yet fixation of selling prices is one of the important functionsof management. While fixing prices, the management has to keep in view the level of profits to be earned.

In normal circumstances, the selling price fixed must cover total cost, as otherwise, the profit cannot beearned. But under certain circumstances, products may have to be priced below total cost. This type ofsituation may arise in trade depression when there is a serious fall in the demand for the products. Pricesfixed during depression may be below total cost but it should be equal to or more than marginal cost.

This is because fixed costs will have to be incurred even if production is discontinued for a short period. Ifthe products can be sold at a price above marginal cost, the loss on account of fixed cost can be reduced tothat extent. In other words, any contribution towards the recovery of fixed costs will reduce the losseswhich will be incurred if production is stopped. As a word of caution, fixation of prices below total costshould be made only on a short-term basis because no firm can afford losses on a long-term basis.

However, under the following circumstances, selling prices may have to be fixed even below themarginal cost:

i. When competitors are to be eliminated from the market.

ii. When a new product is introduced in the market and it has to be made popular.

iii. When goods are of perishable nature and there is a stock of such goods.

iv. When depression seems temporary and closure of business may mean breaking of business connectionsthat can be re-established only at a heavy expenditure.

v. When plant and machinery have to be kept in gear as idle machines are liable to deteriorate.

Marginal costing presents information in such a way so as to enable management to know the price limitswithin which it can operate.

2. Make or Buy Decisions:

Marginal costing helps management to decide whether the firm should itself manufacture a component partor buy it from an outside firm. This is particularly so when a component part is available in the market atprice below the firm’s own cost. This decision can be arrived at by comparing the supplier’s price withfirm’s own marginal cost. For example, if total cost of making a component part is Rs. 18, consisting of Rs.15 as variable cost and Rs. 3 as fixed cost.

3. Selection of a Suitable Product Mix:

When a concern manufactures more than one product, the management has to decide the proportion inwhich these products should be manufactured. This is known as product mix or sales mix. The productionand sales of those products should be pushed up which give the maximum profits and production of

comparatively less profitable products should be reduced. Marginal costing helps management in decidingthe best product mix so that profits can be maximised. The best product mix is one that yields themaximum contribution.

4. Alternative Methods of Production:

When management is faced with the problem of choosing from amongst alternative methods of production,marginal costing helps by furnishing relevant cost information for taking a right decision. For example,management may be faced with the problem of using an automatic machinery or manufacturing entirely bymanual labour. The method of manufacture which yields the greatest contribution should be selected, ofcourse, keeping in view certain other factors.

5. Profit Planning:

The aim of each business is to maximise profits. Marginal costing with the help of break-even analysisguides management about the profit position at various levels of output so that management can operate thebusiness at optimum level where profit is maximum. Thus it is helpful in profit planning.

6. Closure of Business:

The management, under certain circumstances, may be faced with the problem of suspending the activities,i.e., closing down the business. This type of situation usually arises when sufficient volume of businesscannot be secured.

The closure of business may take one of the two forms:

i. Temporary closure.

ii. Permanent closure.

i. Temporary Closure:

Temporary closure of business is a short-term concept. The object is usually to stop operations until tradedepression has passed. But if products are making a contribution towards fixed cost, then generallyspeaking, production should continue. In other words, if prices exceed marginal (variable) cost, losses willtend to be minimised by continuing production.

ii. Permanent Closure:

Permanent closure of business is decided when in the long run business is not earning sufficient profits tocover the risk involved.

Applications of Marginal Costing – In Various Fields to Aid Management in Arriving at ImportantPolicy Decisions

Marginal costing techniques may be applied in various fields to aid management in arriving at manyimportant policy decisions.

These can be stated thus:

Application # 1. Profit Planning:

There are four important ways to improve the profit performance of a business – (i) by increasing volume,(ii) by increasing selling price, (iii) by decreasing variable costs, and (iv) by decreasing fixed costs.

Profit planning is the planning of future operations so as to attain maximum profit. The contribution ratioshows the relative profitability of various sectors of the business whenever there is a change in selling price,variable costs or product mix.

Application # 2. Introduction of a New Product:

Sometime, a product may be added to the existing lines of products with a view to utilise idle facilities tocapture a new market or for any other purpose. The profitability of this new product has to be found outinitially. Usually, the new product will be manufactured if it is capable of contributing something towardsfixed cost and profit after meeting its variable costs.

Application # 3. Level of Activity Planning:

Marginal costing is of great help while planning the level of activity. Maximum contribution at a particularlevel of activity will show the position of maximum profitability.

Application # 4. Key Factor:

A concern would produce and sell only those products which offer maximum profit. This is based on theassumption that it is possible to produce any quantity without any difficulty and sell likewise. However, anactual practice, this seems to be unrealistic as several constraints come in the way of manufacturing as wellas selling.

Such constraints that come in the way of management’s efforts to produce and selling unlimited quantitiesare called ‘key factors’ or ‘limiting factors’. The limiting factors may be materials, labour, plant capacity,or demand. Management must ascertain the extent of the influence of the key factor for ensuringmaximisation of profit.

Normally, when contribution and key factors are known, the relative profitability of different products orprocesses can be measured with the help of the following formula –

Application # 5. Make or Buy Decisions:

A company might be having unused capacity which may be utilized for making component parts or similaritems instead of buying them from the market. In arriving at such a ‘make or buy’ decision, the cost ofmanufacturing component parts should be compared with price quoted in the market.

If the variable costs are lower than the purchase price, the component parts should be manufactured in thefactory itself. Fixed costs are excluded on the assumption that they have been already incurred, and themanufacturing of components involves only variable cost. However, if there is an increase in fixed costsand any limiting factor is operating while producing components etc. that should also be taken into account.

Application # 6. Suitable Product Mix:

Normally, a business concern will select the product mix which gives the maximum profit. Product mix isthe ratio in which various products are produced and sold. The marginal costing technique helpsmanagement in taking appropriate decisions regarding the product mix, i.e., in changing the ratio ofproduct mix so as to maximise profits.

The technique not only helps in-dropping unprofitable products from the mix but also helps in droppingunprofitable departments, activities etc.

UNIT- V Budget and Budgetary control – Production, Production cost, raw materialcost, sales, cash, flexible budgets, standard costing – Material and labour varianceonly – overhead.

Budget and Budgetary Control

Semester IV- CMA II

Dr. Mahasweta Bhattacharya

Introduction:

A budget is an accounting plan. It is a formal plan of action expressed in monetary terms. It could be seenas a statement of expected income and expenses under certain anticipated operating conditions. It is aquantified plan for future activities – quantitative blue print for action.

Every organization achieves its purposes by coordinating different activities. For the execution of goalsefficient planning of these activities is very important and that is why the management has a crucial role toplay in drawing out the plans for its business. Various activities within a company should be synchronizedby the preparation of plans of actions for future periods. These comprehensive plans are usually referred toas budgets. Budgeting is a management device used for short‐term planning and control. It is not justaccounting exercise.

Meaning and Definition:

Budget:

According to CIMA (Chartered Institute of Management Accountants) UK, a budget is “A plan quantifiedin monetary terms prepared and approved prior to a defined period of time, usually showing plannedincome to be generated and, expenditure to be incurred during the period and the capital to be employed toattain a given objective.”

In a view of Keller & Ferrara, “a budget is a plan of action to achieve stated objectives based onpredetermined series of related assumptions.”

G.A.Welsh states, “A budget is a written plan covering projected activities of a firm for a definite timeperiod.”

One can elicit the explicit characteristics of budget after observing the above definitions. They are…

It is mainly a forecasting and controlling device.

It is prepared in advance before the actual operation of the company or project.

It is in connection with definite future period.

Before implementation, it is to be approved by the management.

It also shows capital to be employed during the period.

Budgetary Control:

Budgetary Control is a method of managing costs through preparation of budgets. Budgeting is thus only apart of the budgetary control. According to CIMA, “Budgetary control is the establishment of budgetsrelating to the responsibilities of executives of a policy and the continuous comparison of the actual withthe budgeted

results, either to secure by individual action, the objective of the policy or to provide a basis for itsrevision.”

The main features of budgetary control are:

1. Establishment of budgets for each purpose of the business.

2. Revision of budget in view of changes in conditions.

3. Comparison of actual performances with the budget on a continuous basis.

4. Taking suitable remedial action, wherever necessary.

5. Analysis of variations of actual performance from that of the budgeted performance to knowthe reasons thereof.

Objectives of Budgetary Control:

Budgeting is a forward planning. It serves basically as a tool for management control; it is rather apivot of any effective scheme of control.

The objectives of budgeting may be summarized as follows:

1. Planning: Planning has been defined as the design of a desired future position for an entityand it rests on the belief that the future position can be attained by uninterrupted management action.Detailed plans relating to production, sales, raw‐material requirements, labour needs, capital additions,etc. are drawn out. By planning many problems estimated long before they arise and solution can bethought of through careful study. In short, budgeting forces the management to think ahead, to foreseeand prepare for the anticipated conditions. Planning is a constant process since it requires constantrevision with changing conditions.

2. Co‐ordination: Budgeting plays a significant role in establishing and maintainingcoordination. Budgeting assists managers in coordinating their efforts so that problems of the businessare solved in harmony with the objectives of its divisions. Efficient planning and business contribute a

lot in achieving the targets. Lack of co‐ordination in an organization is observed when a departmenthead is permitted to enlarge the department on the specific needs of that department only, althoughsuch development may negatively affect other departments and alter their performances. Thus,co‐ordination is required at all vertical as well as horizontal levels.

3. Measurement of Success: Budgets present a useful means of informing managers how wellthey are performing in meeting targets they have previously helped to set. In many companies, there isa practice of rewarding employees on the basis of their accomplished low budget targets or promotionof a manager is linked to his budget success record. Success is determined by comparing the pastperformance with previous period's performance.

4. Motivation: Budget is always considered a useful tool for encouraging managers to completethings in line with the business objectives. If individuals have intensely participated in the preparationof budgets, it acts as a strong motivating force to achieve the goals.

5. Communication: A budget serves as a means of communicating information within a

firm. The standard budget copies are distributed to all management people provide not only sufficientunderstanding and knowledge of the programmes and guidelines to be followed but also giveknowledge about the restrictions to be adhered to.

6. Control: Control is essential to make sure that plans and objectives laid down in the budgetare being achieved. Control, when applied to budgeting, as a systematized effort is to keep themanagement informed of whether planned performance is being achieved or not.

Advantages of Budgetary control:

In the light of above discussion one can see that, coordination and control help the planning. These arethe advantages of budgetary control. But this tool offer many other advantages as follows:

1. This system provides basic policies for initiatives.

2. It enables the management to perform business in the most professional manner becausebudgets are prepared to get the optimum use of resources and the objectives framed.

3. It ensures team work and thus encourages the spirit of support and mutual understandingamong the staff.

4. It increases production efficiency, eliminates waste and controls the costs.

5. It shows to the management where action is needed to remedy a position.

6. Budgeting also aids in obtaining bank credit.

7. It reviews the present situation and pinpoints the changes which are necessary.

8. With its help, tasks such as like planning, coordination and control happen effectively andefficiently.

9. It involves an advance planning which is looked upon with support by many credit agenciesas a marker of sound management.

Limitations of Budgetary control:

1. It tends to bring about rigidity in operation, which is harmful. As budget estimates arequantitative expression of all relevant data, there is a tendency to attach some sort of rigidity orfinality to them.

2. It being expensive is beyond the capacity of small undertakings. The mechanism of budgetingsystem is a detailed process involving too much time and costs.

3. Budgeting cannot take the position of management but it is only an instrument ofmanagement. ‘The budget should be considered not as a master, but as a servant.’ It is totallymisconception to think that the introduction of budgeting alone is enough to ensure success and tosecurity of future profits.

4. It sometimes leads to produce conflicts among the managers as each of them tries to takecredit to achieve the budget targets.

5. Simple preparation of budget will not ensure its proper implementation. If it is notimplemented properly, it may lower morale.

6. The installation and function of a budgetary control system is a costly affair as it requiresemploying the specialized staff and involves other expenditure which small companies may finddifficult to incur.

Essentials of Effective Budgeting:

1) Support of top management: If the budget structure is to be made successful, theconsideration by every member of the management not only is fully supported but also the impulsionand direction should also come from the top management. No control system can be effective unlessthe organization is convinced that the management considers the system to be important.

2) TeamWork: This is an essential requirement, if the budgets are ready from

“the bottom up” in a grass root manner. The top management must understand and give enthusiasticsupport to the system. In fact, it requires education and participation at all levels. The benefits ofbudgeting need to be sold to all.

3) Realistic Objectives: The budget figures should be realistic and represent logically attainablegoals. The responsible executives should agree that the budget goals are reasonable and attainable.

4) Excellent Reporting System: Reports comparing budget and actual results should bepromptly prepared and special attention focused on significant exceptions i.e. figures that aresignificantly different from expected. An effective budgeting system also requires the presence of aproper feed‐back system.

5) Structure of Budget team: This team receives the forecasts and targets of each departmentas well as periodic reports and confirms the final acceptable targets in form of Master Budget. Theteam also approves the departmental budgets.

6) Well defined Business Policies: All budgets reveal that the business policies formulated bythe higher level management. In other words, budgets should always be after taking into account thepolicies set for particular department or function. But for this purpose, policies should be precise andclearly defined as well as free from any ambiguity.

7) Integration with Standard Costing System: Where standard costing system is also used, itshould be completely integrated with the budget programme, in respect of both budget preparationand variance analysis.

8) Inspirational Approach: All the employees or staff other than executives should be stronglyand properly inspired towards budgeting system. Human beings by nature do not like any pressure andthey dislike or even rebel against anything forced upon them.

Classification of Budget:

The extent of budgeting activity varies from firm to firm. In a smaller firm there may be a sales forecast, aproduction budget, or a cash budget. Larger firms generally prepare a master budget. Budgets can beclassified into different ways from different points of view. The following are the important basis forclassification:

Functional Classification:

SALES BUDGET:

Sales Budget

Production Budget

Raw Materials Budget

Labour Budget

Purchase Budget

Production Overhead Budget

Selling & Distribution Budget

Administration Cost Budget

Capital Expenditure Budget

Cash Budget

The sales budget is an estimate of total sales which may be articulated in financial or quantitative terms. Itis normally forms the fundamental basis on which all other budgets are constructed. In practice,quantitative budget is prepared first then it is translated into economic terms. While preparing the SalesBudget, the Quantitative Budget is generally the starting point in the operation of budgetary controlbecause sales become, more often than not, the principal budget factor. The factor to be consider inforecasting sales are as follows:

Study of past sales to determine trends in the market.

Estimates made by salesman various markets of company products.

Changes of business policy and method.

Government policy, controls, rules and Guidelines etc.

Potential market and availability of material and supply.

PRODUCTION BUDGET:

The production budget is prepared on the basis of estimated production for budget period. Usually, theproduction budget is based on the sales budget. At the time of preparing the budget, the productionmanager will consider the physical facilities like plant, power, factory space, materials and labour,

available for the period. Production budget envisages the production program for achieving the sales target.The budget may be expressed in terms of quantities or money or both. Production may be computed asfollows: Units to be produced = Desired closing stock of finished goods + Budgeted sales – Beginningstock of finished goods.

PRODUCTION COST BUDGET:

This budget shows the estimated cost of production. The production budget demonstrates the capacity ofproduction. These capacities of production are expressed in terms of cost in production cost budget. Thecost of production is shown in detail in respect of material cost, labour cost and factory overhead. Thusproduction cost budget is based upon Production Budget, Material Cost Budget, Labour Cost Budget andFactory overhead.

RAW‐MATERIAL BUDGET:

Direct Materials budget is prepared with an intention to determine standard material cost per unit andconsequently it involves quantities to be used and the rate per unit. This budget shows the estimatedquantity of all the raw materials and components needed for production demanded by the productionbudget. Raw material serves the following purposes:

It supports the purchasing department in scheduling the purchases.

Requirementof raw‐materials is decided on the basis of production budget.

It provides data for raw material control.

Helps in deciding terms and conditions of purchase like credit purchase, cash purchase, paymentperiod etc.

It should be noted that raw material budget generally deals with only the direct materials whereas indirectmaterials and supplies are included in the overhead cost budget.

PURCHASE BUDGET:

Strategic planning of purchases offers one of the most important areas of reduction cost in many concerns.This will consist of direct and indirect material and services. The purchasing budget may be expressed interms of quantity or money.

The main purposes of this budget are:

It designates cash requirement in respect of purchase to be made during budget period; and

It is facilitates the purchasing department to plan its operations in time in respect of purchases sothat long term forward contract may be organized.

LABOUR BUDGET:

Human resources are highly expensive item in the operation of an enterprise. Hence, like other factors ofproduction, the management should find out in advance personnel requirements for various jobs in theenterprise. This budget may be classified into labour requirement budget and labour recruitment budget.The labour necessities in the various job categories such as unskilled, semi‐skilled and supervisory aredetermined with the help of all the head of the departments. The labour employment is made keeping in

view the requirement of the job and its qualifications, the degree of skill and experience required and therate of pay.

PRODUCTION OVERHEAD BUDGET:

The manufacturing overhead budget includes direct material, direct labour and indirect expenses. Theproduction overhead budget represents the estimate of all the production overhead i.e. fixed, variable,semi‐variable to be incurred during the budget period. The reality that overheads include many differenttypes of expenses creates considerable problems in:

1) Fixed overheads i.e., that which is to remain stable irrespective of vary in the volume of output,

2) Apportion of manufacturing overheads to products manufactured, semi variable cost i.e., thosewhich are partly variable and partly fixed.

3) Control of production overheads.

4) Variable overheads i.e., that which is likely to vary with the output.

The production overhead budget engages the preparation of overheads budget for each division of thefactory as it is desirable to have estimates of manufacturing overheads prepared by those overheads to havethe responsibility for incurring them. Service departments cost are projected and allocated to the productiondepartments in the proportion of the services received by each department.

SELLING AND DISTRIBUTION COST BUDGET:

The Selling and Distribution Cost budget is estimating of the cost of selling, advertising, delivery of goodsto customers etc. throughout the budget period. This budget is closely associated to sales budget in thelogic that sales forecasts significantly influence the forecasts of these expenses. Nevertheless, all otherlinked information should also be taken into consideration in the preparation of selling and distributionbudget. The sales manager is responsible for selling and distribution cost budget.

ADMINISTRATION COST BUDGET:

This budget includes the administrative costs for non‐manufacturing business activities like director’s fees,managing directors’ salaries, office lightings, heating and air condition etc. Most of these expenses arefixed so they should not be too difficult to forecast. There are semi‐variable expenses which get affected bythe expected rise or fall in cost which should be taken into account. Generally, this budget is prepared inthe form of fixed budget.

CAPITAL‐ EXPENDITURE BUDGET:

This budget stands for the expenditure on all fixed assets for the duration of the budget period. This budgetis normally prepared for a longer period than the other functional budgets. It includes such items as newbuildings, land, machinery and intangible items like patents, etc. This budget is designed under theobservation of the accountant which is supported by the plant engineer and other functional managers. Atthe time of preparation of the budget some important information should be observed:

Overfilling on the production facilities of certain departments as revealed by the plant utilizationbudget.

Long‐term business policy with regard to technical developments.

Potential demand for certain products.

CASH BUDGET:

The cash budget is a sketch of the business estimated cash inflows and outflows over a specific period oftime. Cash budget is one of the most important and one of the last to be prepared. It is a detailed projectionof cash receipts from all sources and cash payments for all purposes and the resultants cash balance duringthe budget. It is a mechanism for controlling and coordinating the fiscal side of business to ensure solvencyand provides the basis for forecasting and financing required to cover up any deficiency in cash. Cashbudget thus plays a vital role in the financing management of a business undertaken.

Cash budget assists the management in determining the future liquidity requirements of the firm,forecasting for business of those needs, exercising control over cash. So, cash budget thus plays a vital rolein the financial management of a business enterprise.

Function of Cash Budget:

It makes sure that enough cash is available when it is required.

It designates cash excesses and shortages so that steps may be taken in time to invest any excesscash or to borrow funds to meet any shortages.

It shows whether capital expenditure could be financed internally.

It provides funds for standard growth.

It provides a sound basis to manage cash position.

Advantages of Cash Budget:

1. Usage of Cash: Management can plan out the use of cash in accord with the changes of receiptand payment. Payments can be planned when sufficient cash is available and continue the business activitywith the minimum amount of working capital.

2. Allocation for Capital Investment: It is dual benefits such as capital expenditure projects can befinanced internally and can get an idea for cash availability of capital investment.

3. Provision of Excess Funds: It reveals the availability of excess cash. In this regard managementcan decide to invest excess funds for short term or long term according to the requirements in the business.

4. Pay‐out Policy: This budgetary system may help the management for future pay‐out policy in theform of dividend. In case the cash budget liquid position is not favourable, the management may reduce therate of dividend or maintain dividend amount or skip dividend for the year.

5. Provision for acquiring Funds: It gives the top level management ideas for acquiring funds forparticular time duration and sources to be explored.

6. Profitable Use of Cash: Business person can take decision for the best use of liquidity to makemore profitable transaction. It can be used at the time of bulk purchase payments and one get the benefit ofdiscount.

Limitation of Cash Budget:

1. Complex Assumption: Business is full of uncertainties, so it is very difficult to have near perfectestimates of cash receipts and payments, especially for a longer duration. It can be predicted for shortduration such as of three to four months.

2. Inflexibility: If the finance manager fails to show flexibility in implementing the cash budget, itwill incur adverse effects. If the manager follows strictly adheres to the estimates of cash inflow it maynegatively result in losing customers. Likewise, loyalty in payments may lead to deterioration of liquidposition.

3. Costly: Application of this technique necessitates collecting of statistical information from varioussources and expert personnel in operation research would be the costliest deal. It becomes expensive whichmay not be affordable to small business houses. In addition, finding out experts is not always possible. Inthis situation the long term predictions do not prove correct.

Methods:

1. Receipt and payment: It is most popular and is universally used for preparing cash budget. Theassumption of statistical data is arrived at calculated on the basis of requirements like monthly, weekly orfortnightly. On account of elasticity, this method is used in forecasting cash at different time periods andthus it helps in controlling cash distributions.

(a) Cash receipts from customers are based on sales forecast. The term of sale, lag in payment etc., aregenerally taken into consideration.

(b) Cash receipts from other sources, such as dividends and interest on trade investment, rent received,issue of capital, sale of investment and fixed assets.

(c) Cash requirements for purchase of materials, labour and salary cost and overhead expenses basedon purchasing, personnel and overhead budgets.

(d) Cash requirements for capital expenditure as per the capital expenditure budget.

(e) Cash requirements for other purposes such as payment of dividends, income‐tax liability, fines andpenalties.

(i) Estimating Cash Receipts: Generally main sources of cash receipts are sales, interest and dividend,sales of assets and investments, capital borrowings etc. The Company estimates time‐lag on the basis ofpast experience of cash receipts on credit sales while cash sales can be easily determined.

(ii) Estimating Cash Payments: It can be decided on the basis of various operating budgets preparedfor the payment of credit purchase, payment of labour cost, interest and dividend, overhead charges, capitalinvestment etc.

2. Adjusted Profit and Loss Account: This method is based on cash and non‐cash transactions. Thismethod estimates closing cash balance by converting profit into cash. The hypothesis of this method is thatthe earning of profit brings equal amount of cash into the business. The net profit shown by profit and lossaccount does not signify the actual cash flow into the business. This also leads to another assumption, thatis the business will remain static, i.e. there will be no wearing out or increase of assets and changes ofworking capital so that the total cash on hand for the business would be equal to the profit earned.

3. Budgeted Balance Sheet Method: This method looks like the Adjusted Profit and Loss Accountmethod only, except that in this method a Balance Sheet is projected and in that method Profit and Loss

Account is adjusted. In this method Balance Sheet is prepared with the projected amount of all assets andliabilities except cash at the end of budget period. The cash balance will find out balancing amount. Ifassets side is higher than liability side it would be the bank overdraft while liability side is higher thanassets side it gives bank balance. This method is used by the stable business houses.

4. Working Capital Differential Method: It is based on the estimate of working capital. It beginswith the opening working capital and is added to or deducted from any changes made in the current assetsexcept cash and current liabilities. At the end of the budget period balance shows the real cash balance.This method is quite similar to the Balance Sheet method.

Model of Cash Budget

Particular January February March

Opening Balance ‐ ‐ ‐Add: Receipts:

Cash Sales ‐ ‐ ‐Receipts from Debtors ‐ ‐ ‐Interest and Dividend ‐ ‐ ‐

Sale of fixed assets ‐ ‐ ‐Sale of Investments ‐ ‐ ‐Bank Loan ‐ ‐ ‐Issue Shares & Debenture ‐ ‐ ‐Others ‐ ‐ ‐Total Receipts (A) ‐ ‐ ‐Less: PaymentsCash Purchases ‐ ‐ ‐Payment to creditors ‐ ‐ ‐Salaries & wages ‐ ‐ ‐Administrative expenses ‐ ‐ ‐Selling expenses ‐ ‐ ‐Dividend payable ‐ ‐ ‐Purchase of Fixed Assets ‐ ‐ ‐Repayment of Loan ‐ ‐ ‐Payment of taxes ‐ ‐ ‐Total Payments (B) ‐ ‐ ‐Closing Balance (A ‐ B) ‐ ‐ ‐

FIXED AND FLEXIBLE BUDGET:

1. FIXED BUDGET:

A fixed budget is prepared for one level of output and one set of condition. This is a budget in whichtargets are tightly fixed. It is known as a static budget. It is firm and prepared with the assumption thatthere will be no change in the budgeted level of motion. Thus, it does not provide room for any

modification in expenditure due to the change in the projected conditions and activity. Fixed budgets areprepared well in advance.

This budget is not useful because:

The conditions go on the changing and cannot be expected to be firm.

The management will not be in a position to assess, the performance of different heads on the basisof budgets prepared by them because to the budgeted level of activity.

It is hardly of any use as a mechanism of budgetary control because it does not make anydifference between fixed, semi‐variable and variable costs

It does not provide any space for alteration in the budgeted figures as a result of change in cost dueto change in the level of activity.

2. FLEXIBLE BUDGET:

This is a dynamic budget. In comparison with a fixed budget, a flexible budget is one “which is designed tochange in relation to the level of activity attained.” An equally accurate use of the flexible budgets is forthe purposes of control.

Flexible budgeting has been developed with the objective of changing the budget figures so that they maycorrespond with the actual output achieved. It is more sensible and practical, because changes expected atdifferent levels of activity are given due consideration. Thus a budget might be prepared for various levelsof activity in accord with capacity utilization.

Flexible budget may prove more useful in the following conditions:

Where the level of activity varies from period to period.

Where the business is new and as such it is difficult to forecast the demand.

Where the organization is suffering from the shortage of any factor of production. For example,material, labour, etc. as the level of activity depends upon the availability of such a factor.

Where the nature of business is such that sales go on changing.

here the changes in fashion or trend affects the production and sales.

Where the organization introduces the new products or changes the patterns and designs of itsproducts frequently.

Where a large part of output is intended for the export.

Uses of Flexible Budget:

In flexible budgets numbers are adjustable to any given set of operating conditions. It is, therefore, moresensible than a fixed budget which is true only in one set of operating environment.

Flexible budgets are also useful from the view point of control. Actual performance of an executive shouldbe compared with what he should have achieved in the actual circumstances and not with what he shouldhave achieved under quite different circumstances. At last, flexible budgets are

more realistic, practical and useful. Fixed budgets, on the other hand, have a limited application and aresuited only for items like fixed costs.

Preparation of a Flexible Budget

The preparation of a flexible budget requires the analysis of total costs into fixed and variable components.This analysis of course is, not unusual to the flexible budgeting, is more important in flexible budgetingthen in fixed budgeting. This is so because in flexible budgeting, varying levels of output are consideredand each class of overhead will be different for each level. Thus the flexible budget has the following maindistinguishing features:

It is prepared for a range of activity instead of a single level.

It provides a dynamic basis for comparison because it is automatically related to changes involume.

The formulation of a flexible budget begins with analyzing the overhead into fixed and variable cost anddetermining the extent to which the variable cost will vary within the normal range of activity. In a simpleequation form it could be put as:

Y=a+bx and it is illustrated as below:

Cost Flexible budget Y = a + b x

Fixed Rs.5000 + Rs. 0(x)Variable Rs.0

+ Rs.2.5(x)Semi‐Variable Rs.500

+ Rs.1.0(x)

Rs.5500 + Rs.3.5(x)

There are two methods of preparing such a budget:

(i) Formula Method / Ratio Method:This is also known as the Budget Cost Allowance Method. Inthis method the budget should be prepared as follows:

(a) Before the period begins:

Budget for a normal level of activity,

Segregate into fixed and variable costs,

Compute the variable cost per unit of activity

(b) At the end of the period:

Ascertain the actual activity

Compute the variable cost allowed for this level, add the fixed cost to give the budget costallowance.

The whole process is expressed in the formula:

Allowed cost = Fixed cost + (Actual units of activity for the period) (Variable cost per unit of activity)

(ii) Multi‐Activity Method: This method involves computing a budget for every major level ofactivity. When the actual level of activity is known, the allowed cost is found “interpolating” between thebudgets of activity levels on either side.

Different levels of activity are expressed in terms of either production units or sales values. Thelevels of activity are generally expressed in production units or in terms of sales values.

The fixation of the budget cost gives allowance for the budget centres. According to CIMALondon, the budget cost allowance means, "the cost which a budget centre is expected to incur during agiven period of time in relation to the level of activity attained by the budget centre."

The determination of the different levels of activity for which the flexible budget is to be prepared.

(3) Graphic Method: In this method, estimates of budget are presented graphically. In this costs aredivided into three classes, viz., fixed, variable and semi‐variable cost. Values of costs are obtained fordifferent levels of production. These values are signified in the form of a graph.

Model of Flexible Budget

Capacity Utilization

Particulars 60% 80% 100%1. Prime Cost:

‐ Direct Material ‐ ‐ ‐‐ Direct Labour ‐ ‐ ‐‐ Direct expenses (if any) ‐ ‐ ‐

Total (A) ‐ ‐ ‐2. Variable overheads:

‐ Maintenance & repairs ‐ ‐ ‐‐ Indirect Labour ‐ ‐ ‐‐ Indirect Material ‐ ‐ ‐‐ Factory overheads ‐ ‐ ‐‐ Administrative Overheads ‐ ‐ ‐‐ Selling & distribution O/H ‐ ‐ ‐

Total (B) ‐ ‐ ‐3. Marginal Cost (A + B) ‐ ‐ ‐4. Sales ‐ ‐ ‐5. Contribution ( Sales ‐ MC) ‐ ‐ ‐6. Fixed cost

‐ Factory overheads ‐ ‐ ‐‐ Administrative Overheads ‐ ‐ ‐‐ Selling & distribution O/H ‐ ‐ ‐

Total (C) ‐ ‐ ‐7. Profit or Loss (C‐ FC) ‐ ‐ ‐

Zero Base Budgeting:

The ‘Zero‐Base’ refers to a ‘nil‐budget’ as the starting point. It starts with a presumption that the budget forthe next period is ‘zero’ until the demand for a function, process, or project is not justified for single penny.The assumption is that without such justification, no expenditure will be allowed. In effect, each manageror functional head is required to carry out cost‐benefit analysis of each of the activities, etc. under hiscontrol and for which he is responsible.

The method of ZBB suggests that the business should not only make decision about the proposed newprogrammes but it should also, regularly, review the suitability of the existing programmes. This approachof preparing a budget is called incremental budgeting since the budget process is concerned mainly withthe increases or changes in operations that are likely to occur during the budget period.

This method for the first time was used by the Department of Agriculture, U.S.A. in the 19th century. OtherState Governments of the U.S.A. found this method helpful and so almost all the states took deep interestin the ZBB method. A number of states of America use this technique even today. The ICAI has broughtout a research in the form of a monograph showing the application of the ZBB method that worries intandem with the concerns for national environment and its requirements. In India, however, the ZBBapproach has not been fully accepted and actualized.

"ZBB is a management tool, which provides a systematic method for evaluating all operations andprogrammes, current or new, allows for budget reductions and expansions in a rational manner and allowsre‐allocation of sources from low to high priority programmes."‐ David Lieninger

ZBB is a planning, resource allocation and control tool. It, however, presupposes that

(a) There is an efficient budgeting system within the enterprise.

(b) Managers can develop quantitative measures for use in performance evaluation.

(c) Among the new suggestions and programmes, along with old ones are put to a strict scrutiny.

(d) Funds are diverted from low‐priority suggestions to high priority suggestions.

Procedure of Zero‐base Budgeting:

(1) Determination of the objective: This is an initial step for determining the objective to introduce ZBB. Itmay result into the decreased cost in personnel overheads or debunk the projects which do not fit in thebusiness structure or which are not likely to help accomplish the business objectives.

(2) Degree at the ZBB is to be introduced: It is not possible every time to evaluate every activity of thewhole business. After studying the business structure, the management can decide whether ZBB is to beintroduced in all areas of business activities or only in a few selected areas on the trial basis.

(3) Growth of Decision units: Decision units submit their data as to which cost benefit analysis should bedone in order to arrive at a decision that helps them decide to continue or abandon. It could be a functionaldepartment, a programme, a product‐line or a sub‐line. Here the decision unit sexist independent of all theother units so that when the cost analysis turns unfavourable that particular unit could be closed down.

(4) Growth of Decision packages: Decision units are to be identified for preparing data relating to theproposals to be included in the budget, concerned manager analyzes the activities of his or her owndecision units. His job is to consider possible different ways to fulfill objectives. The

(5) Assessment and Grading of decision packages: These packages invented and formulated aresubmitted to the next level of responsibility within the organization for ranking purposes. Rankingbasically decides as to whether or not to include the proposals in the budget. The management ranks thedifferent decision packages in the order from decreasing benefit or importance to the organization.Preliminary ranking is done by the unit manager himself and for the further review it is sent to the superiorofficers who consider overall objectives of the organization.

(6) Allotment of money through Budgets: It is the last step engaged in the ZBB process. According to thecost benefit analysis and availability of the funds management has ranks and thereby a cut‐off point isestablished. Keeping in view reasonable standards, the approved designed packages are accepted andothers are rejected. The funds are then allotted to different decision units and budgets relating to each unitare prepared.

Advantages:

ZBB rejects the attitude of accepting the current position in support of an attitude of inquiring andtesting each item of budget.

It helps improve financial planning and management information system through varioustechniques.

It is an educational process and can promote a management team of talented and skillful peoplewho tend to promptly respond to changes in the business environment.

It facilities recognition of inefficient and unnecessary activities and avoid wasteful expenditure.

Cost behavior patterns are more closely examined.

Management has better elasticity in reallocating funds for optimum utilization of the funds.

Disadvantages:

It is an expensive method as ZBB incurs a huge cost every in its preparation.

It also requires high volume of paper work; hence sometimes it becomes a tedious job.

In ZBB there is a danger of emphasizing short‐term benefits at the expenses of long term ones.

This is not a new method for evaluating various alternatives, and cost‐benefit analysis.

The psychological effects can also not be ignored. It holds out high hopes as a modern technique,claiming to raise the profitability and efficiency of the business.

Budgets & Budgetary Control

Practical Problems (with solutions)

Flexible Budget

(1) Prepare a Flexible budget for overheads on the basis of the following data.

Ascertain the overhead rates at 50% and 60% capacity.

Variable overheads: At 60% capacity

(Rs)Indirect Material

6,000Labour 18,000

Semi‐variable overheads:

Electricity: (40% Fixed & 60% 30,000variable)Repairs: (80% fixed & 20% 3,000Variable)Fixed overheads:

Depreciation 16,500

Insurance 4,500

Salaries 15,000

Total overheads 93,000

Estimated direct labour hours 1,86,000

Solution:Flexible Budget

Items Capacity

50% 60%

Variable overheads: Rs Rs. .

Material 5,000 6,000

Labour 15,000 18,000

Semi‐variable

Electricity 27,000 30,000

Repairs 2,900 3,000

Fixed overheads:

Deprecation 16,500 16,500

Insurance 4500 4500

Salaries 15,000 15,000

Total Overheads 85,900 93,000

Estimated direct labour hours 1,55,000 1,86,000

Overhead Rate 0.55 0.50

Working Note:

Electricity

At 50% capacity = 18,000 * 50

60

= Rs. 15,000

Rs. 12,000 + Rs. 15,000 = Rs. 27,000

60% capacity = Rs 18,000 + Rs. 12,000 = Rs. 30,000

Repairs

For 60% capacity = Rs.600

=Rs. 2400 + Rs.600 =Rs.3,000

At 50% capacity : = 600/60 * 50

= Rs. 500 =Rs.2400 + 500 =Rs.2,900

(2) Prepare a flexible budget for overheads on the basis of the following data.

Ascertain the overhead rates at 60% and 70% capacity.

Variable overheads: At 60%

capacity(Rs)

Material 6,000

Labour 18,000

Semi‐variable overheads:

Electricity: 30,000

40% Fixed

60% variable

Repairs:

80% fixed 3,000

20% Variable 3,000

Fixed overheads:

Depreciation 16,500

Insurance 4,500

Salaries 15,000

Total overheads 93,000

Estimated direct labour hours 1,86,000

Solution:

Working:

Repairs

For 60% capacity Fixed 80/100 * 3,000 = Rs.2400

Variable = 20/100 * 3,000 = Rs. 600

=Rs. 2400 + Rs.600 =Rs.3,000

Electricity Exp.:

At 60% capacity Fixed= 40/100 *30,000 = 12,000

Variable = 60/100 * 30,000=18,000 At 70% capacity: Fixed = 40/100 * 30,000= Rs. 12,000

Variable = 18,000/60 *70 = Rs. 21,000Total Rs. =33,000

Flexible Budget

Items Capacity

60% 70%

Variable overheads: Rs. Rs.

Material 6,000 7,000

Labour 18,000 21,000

Semi‐variable

Electricity 30,000 33,000

Repairs 3,000 3,100

Fixed overheads:

Deprecation 16,500 16,500

Insurance 4,500 4,500

Salaries 15,000 15,000

Total Overheads 93,000 1,00,100

Estimated direct labour hours 1,86,000 2,17,000

Overhead Rate 0.50 0.46

(3) The expenses budgeted for production of 1,000 units in a factory are furnished below:

Particulars Per UnitRs.

Material Cost 700

Labour Cost 250

Variable overheads 200

Selling expenses (20% fixed) 130

Administrative expenses (Rs. 2,00,000) 200

Total Cost 1,480Prepare a budget for production of 600 units and 800 units assuming administrativeexpenses are rigid for all level of production.

Solution: Flexible Budget

Particulars For 600 units For 800 units

Per unit Rs. Total Rs. Per unit Rs. Total Rs.

Variable Cost:

Materials 700 4,20,000 700 5,60,000

Labour 250 1,50,000 250 2,00,000

Variable overheads 200 1,20,000 200 1,60,000

(A) 1,150 6,90,000 1,150 9,20,000

Semi variable cost:

Variable selling 104 62,400 104 83,200expensesFixed selling expenses 43.33 26,000 32.50 26,000

(B) 147.33 88,400 136.50 1,09,200

Fixed cost:

Administrative 333.33 2,00,000 250.00 2,00,000expensesTotal Cost(A+B+C) 1,630.66 9,78,400 1,536.50 12,29,200

(4) The budgeted output of a industry specializing in the production of a one product at the optimumcapacity of 6,400 units per annum amounts to Rs. 1,76,048 as detailed below:

Particulars Rs. Rs.

Fixed costs 20,688

Variable costs:

Power 1,440

Repairs etc. 1,700

Miscellaneous 540

Direct material 49,280

Direct Labour 1,02,400 1,55,360

Total cost 1,76,048

The company decides to have a flexible budget with a production target of 3,200 and 4,800 units (theactual quantity proposed to be produced being left to a later date before commencement of the budgetperiod)

Prepare a flexible budget for production levels of 50% and 75%. Assuming, selling price per unit ismaintained at Rs. 40 as at present, indicate the effect on net profit.

Administrative , selling and distribution expenses continue at Rs.3,600.

Solution:

The production at 100% capacity is 6400 units, so it will be 3,200 units at 50% and 4,800 units at 75%capacity. The variable expenses will change in that proportion.

Flexible Budget

Particulars 100 75% 50

% %

(i)Sales (per 2,56,000 1,92,000 1,28,000

unit Rs.40)

Cost of Sales:

(a)variable costs:

Direct material 49,280 36,960 24,640

Direct Labour 1,02,400 76,800 51,200

Power 1,440 1,080 720

Repairs 1,700 1,275 850

Miscellaneous 540 405 270

Total variable costs 1,55,360 1,16,520 77,680

(b)Fixed Costs: 20,688 20,688 20,688

(ii) Total Costs 1,76,048 1,37,208 98,368

Gross Profit(i)‐ (ii) 79,952 54,792 29,632

Less: Adm., selling 3,600 3,600 3,600

and

Dist. Costs

Net Profit 76,352 51,192 26,032

(5) A factory engaged in manufacturing plastic buckets is working at 40% capacity and produces 10,000buckets per month.

The present cost break up for one bucket is as under:

Materials

Rs.10 Labour

Rs.3

Overheads Rs.5 (60% fixed)

The selling price is Rs.20 per bucket. If it is desired to work the factory at 50% capacity the selling pricefalls by 3%. At 90% capacity the selling price falls by 5% accompanied by a similar fall in the price ofmaterial.

You are required to prepare a statement the profit at 50% and 90% capacities and also calculate the break‐even points at this capacity production.

Solution

Flexible Budget

Particulars Capacity

40% 50% 90%

Production and sales 10,000 12,500 22,500Units

Sales price per unit 20 19.40 19.00

Sales Amount 2,00,00 2,42,50 4,27,500 0 0

Marginal Cost:

Material: Rs.10 per 1,00,00 1,25,00 2,13,750 0 0

unit(at 90% ‐ Rs.9.50per unit)

Labour 30,000 37,500 67,500

Variable overhead 20,000 25,000 45,000

Total 1,50,00 1,87,50 3,26,250 0 0

Contribution 50,000 55,000 1,01,250

Less: Fixed Cost 30,000 30,000 30,000

Profit 20,000 25,000 71,250

Contribution per unit 5 4.40 4.50

BEP (units) (F /C) 6,000 6,818 6,667

CASH BUDGET

(1) Saurashtra Co. Ltd. wishes to arrange overdraft facilities with its bankers from the period Augustto October 2019 when it will be manufacturing mostly for stock. Prepare a cash budget for the aboveperiod from the following data given below:

Month Sales Purchases Wages Mfg. Exp. Office Exp. Selling(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) Exp. (Rs.)

June 1,80,000 1,24,800 12,000 3,000 2,000 2,000

July 1,92,000 1,44,000 14,000 4,000 1,000 4,000

August 1,08,000 2,43,000 11,000 3,000 1,500 2,000

September 1,74,000 2,46,000 12,000 4,500 2,000 5,000

October 1,26,000 2,68,000 15,000 5,000 2,500 4,000

November 1,40,000 2,80,000 17,000 5,500 3,000 4,500

December 1,60,000 3,00,000 18,000 6,000 3,000 5,000

Additional Information:

(a) Cash on hand 1‐08‐2010 Rs.25,000.

(b) 50% of credit sales are realized in the month following the sale and the remaining 50% in thesecond month following. Creditors are paid in the month following the month of purchase.

(c) Lag in payment of manufacturing expenses half month.

(d) Lag in payment of other expenses one month.

Solution:

CASH BUDGET

For 3 months from August to October 2019

Particulars August (Rs.) September (Rs.) October (Rs.)

Receipts:

Opening balance 25,000 44,500 (66,750)

Sales 1,86,000 1,50,000 1,41,000

Total Receipts(A) 2,11,000 1,94,500 74,250

Payments:

Purchases 1,44,000 2,43,000 2,46,000

Wages 14,000 11,000 12,000

Mfg. Exp. 3,500 3,750 4,750

Office Exp. 1,000 1,500 2,000

Selling Exp. 4,000 2,000 5,000

Total payments(B) 1,66,500 2,61,250 2,69,750

Closing 44,500 (66,750) (1,95,500)Balance(A‐B)

Working Note:

1. Manufacturing Expense:

Particular August September October

July (4000/2) 2000 ‐‐‐ ‐‐‐

August (3000/2) 1500 1500 ‐‐‐

September (4500/2) ‐‐‐ 2250 2250

October (5000/2) ‐‐‐ ‐‐‐‐ 2500

Total 3500 3750 4750

2. Sales

Particular August September October

June (180000/2) 90000 ‐‐‐ ‐‐‐

July (192000/2) 96000 96000 ‐‐‐

August (108000/2) ‐‐‐ 54000 54000

September ‐‐‐ ‐‐‐‐ 87000(174000/2)Total 186000 150000 141000

(2) S. K. Brothers wish to approach the bankers for temporary overdraft facility for the period fromOctober 2019 to December 2019. During the period of this period of these three months, the firm will bemanufacturing mostly for stock. You are required to prepare a cash budget for the above period.

Month Sales (Rs.) Purchases (Rs.) Wages (Rs.)

August 3,60,000 2,49,600 24,000

September 3,84,000 2,88,000 28,000

October 2,16,000 4,86,000 22,000

November 3,48,000 4,92,000 20,000

December 2,52,000 5,36,000 30,000

(a) 50% of credit sales are realized in the month following the sales and remaining 50% in the secondfollowing.

(b) Creditors are paid in the month following the month of purchase

(c) Estimated cash as on 1‐10‐2019 is Rs.50,000.

CASH BUDGET

For 3 months from October to December 2019

Particulars October (Rs.) November(Rs.) December(Rs.)

Receipts:

Opening balance 50,000 1,12,000 (94,000)

Collection from 3,72,000 3,00,000 2,82,000

Debtors

Total Receipts(A) 4,22,000 4,12,000 1,88,000

Payments:

Payments to 2,88,000 4,86,000 4,92,000

Creditors

Wages 22,000 20,000 30,000

Total payments(B) 3,10,000 5,06000 5,22,000

Closing 1,12,000 (94,000) ‐3,34,000Balance(A‐B)

Working Note: Collection from debtors

Particulars October (Rs.) November(Rs.) December(Rs.)

Sales

August 1,80,000 ‐

September 1,92,000 1,92,000 ‐

October ‐ 1,08,000 1,08,000

November ‐ 1,74,000

3,72,000 3,00,000 2,82,000

(3) TATA Co. Ltd. is to start production on 1st January 2019. The prime cost of a unit is expected to beRs. 40 (Rs. 16 per materials and Rs. 24 for labour). In addition, variable expenses per unit are expected to beRs. 8 and fixed expenses per month Rs. 30,000. Payment for materials is to be made in the month followingthe purchase. One‐third of sales will be for cash and the rest on credit for settlement in the following month.Expenses are payable in the month in which they are incurred. The selling price is fixed at Rs. 80 per unit.The number of units to be produced and sold is expected to be: January 900; February 1200; March 1800;April 2000; May 2,100; June 2400

Draw a Cash Budget indicating cash requirements from month to month.

CASH BUDGET of TATA LTD.

For 6 months from January to June 2011

Month Jan. Feb. March April May June

Receipts

Opening Balance (34,800) (37,600) (32,400) (5,867) (27,600)

Cash sales 24,000 32,000 48,000 53,333 56,000 64,000

Collection from 48,000 64,000 96,000 1,06,667 1,12,000

Debtors

Total receipts(A) 24,000 45,200 74,400 1,16,933 1,56,800 1,48,400

Payments

Creditors 14,400 19,200 288,00 32,000 33,600

Wages 21,600 28,800 43,200 48,000 50,400 57,600

Variable Exp. 7,200 9,600 14,400 16,000 16,800 19,200

Fixed Exp. 30,000 30,000 30,000 30,000 30,000 30,000

Total 58,800 82,800 1,06,800 1,22,800 1,29,200 1,40,400Payment(B)Closing Balance ‐34,800 ‐37600 ‐32400 ‐5867 ‐27,600 8,000

(4) Prepare a Cash Budget from the data given below for a period of six months (July to December)

138

(1) Month Sale Raw

s Materials

May 75,000 37,500

June 75,000 37,500

July 1,50,000 52,500

August 2,25,000 3,67,500

September 3,00,000 1,27,500

October 1,50,000 97,500

November 1,50,000 67,500

December 1,37,500

Collection estimates:

Within the month of sale: 5%

During the month following the sale: 80%

During the second month following the sale: 15%

(3) Payment for raw materials is made in the next month.

(4) Salary Rs. 11,250, Lease payment Rs. 3750, Misc. Exp. Rs. 1150, are paid each month

(5) Monthly Depreciation Rs. 15,000

(6) Income tax Rs. 26,250 each in September and December.

(7) Payment for research in October Rs.75,000

(8) Opening Balance on 1st July Rs.55,000.

CASH BUDGET

For the six months from July to December

Particulars July Aug. Sep. October Nov. December

Receipts

139

Opening Balance 55,000 80,100 1,53,950 ‐38450 24150 83000

Collection from 78,750 1,42,500 2,17,500 2,81,250 1,725,00 1,49,375

Debtors

Total receipts(A) 1,33,750 2,22,600 3,71,450 2,42,800 1,96,650 2,32,375

Payments

Payment to 37,500 52,500 3,67,500 1,27,500 97,500 67,500

suppliers

Salary 11,250 11,250 11,250 11,250 11,250 11,250

Lease payment 3750 3750 3750 3750 3750 3750

Misc. expense 1,150 1,150 1,150 1,150 1,150 1,150

Income tax 26,250 26,250

Payment for 75,000

Research

Total 53,650 68,650 4,09,900 2,18,650 1,13,650 1,09,900

Payment(B)

Closing Balance 80,100 1,53,950 ‐38,450 24,150 83,000 1,22,475

Note: Depreciation is a non‐cash item. It does not involve cash flow. Hence, depreciation will not beconsidered as payment through cash.

(5) Prepare a cash Budget of R.M.C. LTD. for April, May and June 2019:

Months Sales(Rs.) Purchases(Rs.) Wages(Rs.) Expenses(Rs.)

140

Jan.(Actual) 80,000 45,000 20,000 5,000

Feb.(Actual) 80,000 40,000 18,000 6,000

March (Actual) 75,000 42,000 22,000 6,000

April (Budget) 90,000 50,000 24,000 7,000

May(Budget) 85,000 45,000 20,000 6,000

June(Budget) 80,000 35,000 18,000 5,000

Additional Information:

(i) 10% of the purchases and 20% of sales are for cash.

(ii) The average collection period of the company is ½ month and the credit purchases are paidregularly after one month.

(iii) Wages are paid half monthly and the rent of Rs. 500 included in expenses is paid monthly andother expenses are paid after one month lag.

(iv) Cash balance on April 1,2019 may be assumed to be Rs.15,000

CASH BUDGET(For the months ending April, May & June 2019)

Particulars April (Rs.) May (Rs.) June (Rs.)

Receipts

Opening

Balance Cash 15,000 27,200 35,700

Sales

Collection 18,000 17,000 16,000

from Debtors

66,000 70,000 66,000

141

Total Receipts(A) 99,000 1,14,200 1,17,700

Payments

Cash Purchases 5,000 4,500 3,500

Payment to creditors 37,800 45,000 40,500

Wages 23,000 22,000 19,000

Rent 500 500 500

Other Exp. 5,500 6,500 5,500

Total Payments(B) 71,800 78,500 69,000

Closing balance 27,200 35,700 48,700