Professional Documents
Culture Documents
MP103 PDF
MP103 PDF
1
Course Development Committee
Chairman
Prof. (Dr.) Naresh Dadhich
Vice-Chancellor
Vardhaman Mahaveer Open University, Kota
Convener and Members
Subject Convener and Co-ordinator
Prof. P.K. Sharma
Professor of Management
Vardhaman Mahaveer Open University, Kota
1. Prof. P.N. Mishra 6. Prof. R.K. Jain
Professor, Professor (Retd.),
Institute of Management Studies JLN Institute of Business Management,
Devi Ahilya University, Indore Vikram University, Ujjain
2. Prof. Kalpana Mathur 7. Prof. Isphita Bansal
Professor, Professor, WISDOM,
Deptt. of Management Studies, Banasthali Vidhyapeeth, Banasthali
J.N.V. University, Jodhpur 8. Prof. Karunesh Saxsena
3. Prof. Nimit Chaudhary Professor,
Professor, Faculty of Management Studies,
Indian Institute of Tourism & Travel Mohan Lal Sukhadia Univeristy, Udaipur
Management, Gwalior 9. Dr. Mahesh Chand Garg
4. Prof. Kamal Yadav Associate Professor,
Professor, Haryana Business School,
School of Management Studies, Guru Jambeshwar University of Science &
IGNOU, New Delhi Technology, Hisar
5. Prof. Gitika Kapoor 10. Dr. R.K. Jain
Professor, Assistant Professor,
R.A. Podar Institute of Management, Vardhaman Mahaveer Open University,
University of Rajasthan, Jaipur Kota
CONTENTS
1.0 Objectives
After studying this unit you should be able to understand:
Objective and Need for accounting
Definition of accounting
Book-keeping
Types of accounting
Accounting as source of accounting to various users
Limitations of accounting
1.1 Introduction
A business enterprise engages itself in a number of activies, primarily in terms of money, with a view
to making profit and keeping it as a going concern for an indefinite period of time. A business enterprise of
even medium size deals with many customers, many employees and many suppliers and deals in many
business transactions. It is impossible to operate even a medium sized business just by remembering the
details of business transactions occuring therein. That is why there is a saying “ First record and then pay. If
errors, look what books say”.
A systematic and upto date record of varied and numemous business transactions, is therefore quite
essential to obtain the required information in respect of profit and loss, assets and liabilities and capital of
business and also to exercise control over various items of expenditure. Accounting plays a key role in
serving this purpose.
1.2 Need of Accounting
Accounting has rightly been termed as the language of business. The basic function of a language is
to serve as a means of communication. Accounting also serves this function. It communicates the results of
business operation to various parties who have some stake in the business viz the proprietor, creditor,
investors, government and other agencies. Though accounting is generally associated with business yet it is
not only business which make use of accounting. Persons like housewives, government and other
individuals also make use of accounting. For example, in case the housewife records her transactions
regularly, she can collect valuable information about the nature of her receipts and payments. For example
she can find out the total amount spent by her during a period on different items say milk, food, education,
entertainment etc. Similarly she can find the source of her receipt as salary, rent from property, cash gifts
from her relatives thus at the end of the period she can see for herself about her financial position i.e. what
she owes and what she owns. This will help her in planning her future income and expenses (or making out
a budget) to a great extent.
The need for accounting is all the more greater for a person who is running a business. He must
know: - (i) what he owns (ii) who he owes (iii) whether he has earned a profit or suffered a loss on account
of running a business (iv) what is his financial position i.e. whether he will be in a position to meet all his
commitments in the near future or he is in the process of becoming a bankrupt.
2.0 Objectives
After studying this unit you should be able to understand :
Generally Accepted Accounting Principles(GAAP)
Accounting Concepts or Assumptions:
- Business entity concept
- Money measurement concept
- Going concern concept
- Accounting period concept
- Cost concept
- Dual aspect concept
- Revenue recognition( realization) concept
- Matching concept
Accounting Conventions:
- Convention of full disclosure
- Convention of consistency
- Convention of conservatism(prudence)
- Convention of materiality
Different Systems of Accounting
2.1 Introduction
The accounting profession has developed over the years, from experience, usage and necessity a
number of rules or guidelines called concepts, conventions. assumptions, principles etc; with the objective
of achieving consistency and comparability between the financial information. These financial information
may be of different enterprises for a given accounting period or of a particular business enterprises for a
number of years.
Accounting principles are judged on their general acceptability rather than universal acceptability
to the makers and user of financial statement, so they are known as Generally Accepted Accounting
Principles (GAAP). The GAAP is used to describe the concepts, conventions, rules etc. The general
acceptance of accounting principles depends on how well they satisfy relevance, objectivity and feasibility
2.7 Summary
Accounting principles may be defined as those rules of action or conduct which are adopted by
accountants universally while recording accounting transactions. “They are a body of doctrines commonly
associated with the theory and procedures of accounting, serving as an explanation of current practices and
as a guide for selection of conventions or procedures where alternatives exist”. These principles can be
classified in two categories:
1. Accounting Concepts- The term 'concepts' includes those basic assumptions or conditions Upon
which the science of accounting is based.
2. Accounting Conventions- The term 'conventions' includes those customs or traditions which
guide the accountant while preparing the accounting statements
2.8 Key Words
Accounting Principles: rules of action or conduct adopted by the accountants universally while
recording accounting transactions
Accounting Concepts: basic assumptions or conditions upon which the science of accounting is
based.
Accounting Conventions: Customs and traditions which guide the accountants while preparing the
accounting statements.
Cash System of Accounting: A system in which accounting entries are made only when cash is
received or paid.
Mercantile System of Accounting: A system in which accounting entries are made on the basis of
amounts having become due for payment or receipts. It is also termed as Accrual System of
Accounting.
Revenue : revenue in accounting means the income of a recurring nature from any source.It consists
of the amount received from sales of goods and from services provided to customers.
3.0 Objectives
After studying this unit you should be able to understand:
Meaning of Double Entry System of Accounting
Meaning of Debit and Credit
Rules of Debit and Credit
Causes of popularity of Double Entry System
Effect of Transactions on Accounting Equation
Meaning of various Technical Accounting Terms
3.1 Introduction
A business transaction involves the transfer of value in the form of money, goods or services in terms
of money from one party to another. One party gives some value and another party receives the same in
exchange for an equivalent value. There is a reciprocal exchange of value between two parties, that is , each
party receives value and gives value in exchange. It must be carefully noted that the giving and receiving
aspects take place between accounts and in the same set of books.
In order to have complete record of each business transaction, its two-fold aspect must be recorded
simultaneously. The best known system which recognises the two-fold aspect of every business transaction
is called the Double Entry System. It is based upon the fact that just as every business transaction involves
atleast two parties so the record of each transaction must be made in the light of its two-fold aspects or two
accounts.
For example, if the Furniture is purchased in the business, Furniture is increased whereas the Cash
is decreased. Furniture and cash both are assets for the firm. Thus Furniture account is debited and Cash
account is credited.
Definition: - Double Entry System may be defined as follows:-
“The Double Entry System seeks to record every transaction in money or money’s worth in its
double aspect- The receipt of a benefit by one account and the surrender of a like benefit by another
account, the former entry being to the debit of the account receiving and the latter to the credit of that
account surrendering.”
- William Pickles
“Every business transaction has a two-fold effect and that it affects two accounts in opposite directions
and if a complete record were to be made of each such transaction, it would be necessary to debit one
account and credit another account. It is this recording of the two-fold effect of every transaction that has
given rise to the term Double Entry System.”
- J. R. Batliboi
Double Entry System is based upon the principle that “Every debit has a credit and every credit
has a debit.”
Example:
Mr. A sold goods for cash Rs. 2,000 to Mr. B. In this case the dual aspects of this transaction for
Mr. A and Mr. B are as follows:
Dual aspects for Mr. A Dual aspects for Mr. B
1. Receipt of cash Rs. 2,000. 1. Payment of cash Rs. 2,000.
2. Foregoing of goods of Rs. 2,000. 2. Receipt of goods of Rs. 2,000.
3.5 Summary
Double entry system of Book-Keeping refers to a system of accounting under which both the
aspects (i.e., debit and credit) of every transaction are recorded in the accounts involved.
The individual record of a person or thing is called account. Every debit has equal amount of credit.
So the total of all debits must be equal to the total of all credits. This duality is the basis of double entry
records.
Activity
A started business with a capital of Rs. 6,00,000/-. He introduced Rs. 16000/- during the
year as on additional capital, while personal drawings Rs. 6000/-. At the end of the year
closing capital Rs. 8,00,000/-. What is his profit for the year?
4.0 Objectives
After studying this unit you should be able to understand:
Types of Accounts
Meaning and Format of Journal
Rules of Journalising
Recording of Entries in a Journal
Recording of Transactions in Special Purpose Subsidiary Books
- Purchase Day Book
- Sales Day Book
- Cash Book
Posting from Journal to Ledger
4.1 Introduction
The ultimate objective of the financial accounting is to prepare two basic financial statements: the
income statement and the balance sheet. The accounting process helps in achieving that objective.
The details of each business transaction are first entered in source documents. Then there is recording
of economic effects of each business transaction chronologically in the journal before posting to the ledger
accounts pertaining to persons, properly, expenses and gains. Trial balance is extracted form the ledger
which is base for financial statements.
ACCOUNTS
TANGIBLE INTANGIBLE
Figure - 4.1
4.2.1 Personal Accounts
The accounts which relate to an individual, firm, company or an institution are called personal
accounts. Accounts of Mohan, Account of D. C. M. Ltd., Account of Delhi University, Bank Account,
Capital Account of the proprietor, Drawings Account of the proprietor etc., are examples of Personal
Accounts. Personal Accounts can be classified into the following three categories:-
(a) Natural Personal Accounts: Accounts of ‘Natural Persons’ means the accounts of human beings.
For example, Mohan A/c, Sohan A/c, Proprietor’s Capital A/c, Debtors A/c, Creditors A/c are
also included in this category.
(b) Artificial Personal Accounts: These accounts do not have physical existence as human beings
but they work as personal accounts. These are treated as artificial persons for the recording of
personal transactions. For example, any Firm’s account, any Company’s account, accounts of
government departments, any bank’s account, etc.
(c) Representative Personal Accounts: When an account represents a particular person or group
of persons, it is termed as a representative personal account. For example, if the salaries for the
month of December are not paid to the employees, the amount payable to theses employees will be
added and put under one common title “Salaries outstanding account”. This account represents the
accounts of all the persons to whom salaries have to be paid. This is therefore known as
“Representative Personal account”. Other examples are Prepaid Insurance Account, Unearned
Commission Account.
4.2.2 Real Accounts
The accounts of all those things whose value can be measured in terms of money and which are the
properties of the business are termed as Real Accounts, such as Cash Account, Furniture Account, Goodwill
Account, etc. These are of two types:-
(a) Tangible Real Accounts: These are the accounts of those things which can be touched, felt,
measured, etc. Examples are Cash Account, Stock Account, Furniture Account, etc.
(b) Intangible Real Account: These accounts represent such things which cannot be touched, but of
course their value can be measured in terms of money. For example, Goodwill Account, Patent
Account.
4.2.3 Nominal Accounts
These accounts include the accounts of all expenses and incomes. Examples - salaries paid, rent
paid, bad debts, etc.
Debit credit rules:
Classification Debit-Credit Rules
Personal Account Debit the receiver and Credit the giver
Real Account Debit what comes in and Credit what goes out
Nominal Account Debit expenses and losses and Credit revenue and
gains
Activity
Bank Account and prepaid insurance account are in the nature of ......................account.
Illustration 4.2.1:
Analyze the following transactions, according to double entry system:
(a) Ram started business with cash
(b) Purchased furniture
(c) Purchased goods for cash
(d) Sold goods for cash
(e) Received cash from Shayam
(f) Deposited into bank
(g) Withdrew from bank for office use
(h) Received a cheque from a customer Shayam
(i) Withdrew from bank for personal use
(j) Withdrew cash for personal use
(k) Sold goods to Shayam on credit
(l) Purchased goods from Raman on credit
(m) Purchased furniture from Mohan on credit
(n) Borrowed from Mahesh
(o) Deposited Shayam’s cheque next day
(p) Paid Raman by cheque
(q) Paid salary
(r) Paid rent by cheque
(s) Goods withdrawn for personal use
Activity
1. Patent account is a ........................................ account.
2. Rule for Nominal account is :
4.3 Journalisation
4.3.1 General Principles
There are four phases in the accounting process:
1. Journalisation of transactions and events.
2. General ledger posting and balancing.
3. Preparation of a Trial Balance.
4. Preparation of Final Account, i. e., the Profit and Loss A/c and the Balance Sheet.
In the first phase, the transactions and events are analysed and recorded in the journal. Accountants
use different types of journals, listed hereinafter, for recording different types of transactions and events.
1. Purchase day book : To record transactions relating to credit purchases of goods
in trade.
2. Sales day book : To record transactions relating to credit sales.
3. Purchase return book : To record transactions relating to purchase returns.
4. Sales return book : To record transactions relating to sales return.
5. Cash book : To record cash, bank and discount transactions.
6. Journal proper : To record other transactions for which no specific journal is
mentioned, and for recording entries to rectify mistakes in
books of accounts.
Transactions and events are recorded in the journal in chronological order. The ledger folio in which
the transaction is posted in the general ledger is entered in the journal for cross referencing. In addition, the
‘Journal Proper’provides a brief narration of the transaction or the event. Papers or documents that evidence
of the transaction or event should support each entry in the journal. Those papers and documents are
known as Vouchers.
4.3.2 Journal
The business transactions, after their analysis, are listed in a chronological order day-by-day and
first recorded in a book of accounts called journal. A journal is a chronological record of accounting
transactions showing the names of accounts that are to be debited or credited, the amounts of the debits and
credits, and any useful supplementary information about the transaction. Journal is referred to as book
of original or prime entry or simply subsidiary book. A journal is a form of diary for business transactions.
Functions of journal:-
(i) To keep a chronological (i.e., date-wise) record of all transactions.
(ii) To analyse each transaction into debit and credit aspects by using double entry system of book-
keeping.
(iii) To provide a basis for posting into ledger.
(iv) To maintain the identity of each transaction by keeping a complete record of each transaction at
one place on a permanent basis.
The format of journal is shown as follows:-
The columns have been numbered only to show how the Journal is written up; otherwise the columns
are not numbered.
1. Date Column: This column shows the date on which the transaction is recorded. The year and the
month are written once, till they change.
2. Particulars Column: Under this column, first the names of the accounts to be debited, then the
names of the accounts to be credited and lastly, the narration (i.e., a brief explanation of the
transaction) are entered.
3. L. F. i.e. Ledger Folio Column: All entries from the journal are later posted into the ledger
accounts. The page number or folio number of the ledger account where the posting has been made
from the journal is recorded in the L.F. column of the journal.
4. Debit Amount Column: Under this column, the amount to be debited is entered.
5. Credit Amount Column: Under this column, the amount to be credited is entered.
4.3.3 Journalising
The process of recording a transaction in the journal with the help of debit-credit rules of the double
entry system is called Journalising. The various steps to be followed in journalising business transactions are
given below:
Step 1: Ascertain what accounts are involved in a transaction.
Step 2: Ascertain what the nature of the accounts involved is.
Step 3: Ascertain which rule of Debit and Credit is applicable for each of the accounts involved.
Step 4: Ascertain which account is to be debited and which is to be credited.
Step 5: Record the date of transaction in the ‘Date column’.
Step 6: Write the name of the account to be debited, very close to the left hand side i.e. the line
demarcating the ‘Date column’ and the ‘Particulars column’ along with the abbreviation ‘Dr.’ on the
same line against the name of the account in the ‘Particulars column’, and the amount to be debited
in the ‘Debit Amount Column’ against the name of the account.
Step 7: Write the names of the account to be credited in the next line preceded by the word ‘To’ at
a few spaces towards right in the ‘Particulars column’ and the amount to be credited in the ‘Credit
Amount Column’ against the name of the account. The modern practice shows inclination towards
omitting “Dr.” and “To”.
Step 8: Write ‘Narration’ (i. e. a brief description of the transaction) within brackets in the next line
in the ‘Particulars column’.
Step 9: Draw a line across the entire ‘Particulars column’ to separate one journal entry from the
other.
Illustration 4.3.1
Record the following transactions in the journal of V:-
2010 Rs.
May 1 Commenced business with cash 5, 00,000
2 Goods purchased from M for cash 50,000
3 Goods purchased from A 1, 20,000
4 Goods returned to A 5,000
8 Goods sold to R 40,000
12 R returned 10% of goods
Solution:
Journal of V
Date Particulars L. F. Dr. Cr.
No. Amount (Rs.) Amount (Rs.)
2005 Cash A/c Dr. 5, 00,000
May 1 To Capital A/c 5, 00,000
(Amount brought in by V as Capital)
May 2 Purchases A/c Dr. 50,000
To Cash A/c 50,000
(Goods purchased from M for cash)
May 3 Purchases A/c Dr. 1, 20,000
To A A/c 1, 20,000
(Goods purchased from A)
May 4 A A/c Dr. 5,000
To Purchases Return A/c 5,000
(Goods returned to A)
May 8 R A/c Dr. 40,000
To Sales A/c 40,000
(Goods sold to R)
May 12 Sales Return A/c Dr. 4,000
To R A/c 4,000
(10% of goods sold to R returned by
him: 10% of 40,000 = Rs. 4,000)
Total Rs. 7, 19,000 7, 19,000
Periodical posting of the total of the sales day book to the general ledger should be made through
the following journal entry:
Trade Receivables A/c Dr. Rs. 51,300
To Sales A/c Rs. 51,300
Postings to personal accounts of trade debtors should be made in the subsidiary ledger for trade
debtors. As in the case of the purchase day book, the aggregate of balances in personal accounts in the
subsidiary ledger should agree with the balance in the ‘Trade receivables account’, in the general ledger.
Enterprises also maintain a ‘Sales Return Book’ to record inward return of goods from customers.
Illustration 4.7.2: A & Co. commenced business on Jan 1, 2010 with a cash balance of Rs. 2,000 as
capital. It had the following cash transactions for the month of Jan 2010. Prepare the cash book.
Rs.
Jan 1 Purchased furniture 200
Jan 2 Purchased goods 300
Jan 4 Sold goods 400
Jan 6 Paid to B & Co. 500
Allowed discount 20
Jan 15 Received from C & Co. 600
Allowed discount 30
Jan 20 Purchased calculator 200
Jan 31 Paid Salaries 500
Solution:
Cash Book of A & Co.
Dr. Reciepts Payments Cr.
Dt. Particulars L Discoun Cash Dt. Particulars L Discount Cash
F t (Rs.) (Rs.) F (Rs.) (Rs.)
2010 2010
Jan 1 To Capital A/c 2,000 Jan 1 By Furniture A/c 200
Jan 15 To C & Co. A/c 30 600 Jan 6 By B & Co. A/c 20 500
In a three-column cash book, additional columns are provided to enter bank transactions. This
helps to dispense with the ‘bank account’ in the general ledger. However, in case an enterprise operates
more than one bank account, it is better to have a separate ‘bank book’ or ‘bank accounts’ in the general
ledger. Illustration 4.7.3 presents a three-column cash book.
Illustration 4.7.3: A commenced business as A & Co. on Jan 1, 2010 with a cash balance of Rs. 2,000.
Record the transactions for the month of Jan 2010 in a cash book with discount and bank columns.
Rs.
Jan 1 Deposited cash with bank 1,500
Jan 4 Received cheque from B & Co. 1,000
Jan 5 C & Co. is paid by cheque. He allowed a discount of Rs. 20 330
Jan 6 Received cheque from M & Co. after allowing a discount of Rs. 50 450
Jan 10 Goods sold in cash to R & Co. 500
Jan 12 Cash drawn for office use 500
Jan 15 Paid for office expenses in cash 500
Jan 25 Paid salaries for Jan in cash 500
Jan 25 Cheque received from Y & Co. 400
Jan 31 Cheque received from Y & Co. returned unpaid by bank 400
Solution: Cash Book of A & Co.
Dr. Reciepts Payments Cr.
Dt. Particulars LF Dis. Cash Bank Dt. Particulars L Dis. Cash Bank
(Rs) (Rs.) (Rs.) F (Rs.) (Rs.) (Rs.)
2010 2010
Jan 1 To Capital 2,000 Jan 1 By Bank C 1,500
Bank A/c
D r. C r.
D ate Particulars L. F . A mount Date P articulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan 1 Jan 6 B y V ishwanath & Co 4,950
11 To balance b/d 8,000 Jan 17 B y V ishwanath & Co 2,000
14 To Sen & Co. 3,000 Jan 18 B y R oy & Co . 950
21 To Roy & Co. 950 Jan 31 B y R ent A/c 500
25 To Cash A/c 1,000 Jan 31 B y C apital A/c 500
To Loan fro m Jan 31 B y b alance c/d 24,050
New A ge Inv.
Co. A /c 20,000
32,950 32,950
Feb 1 To balance b/d 24,050
Stock A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan
1 To balance b/d 4,000 Jan 31 By balance c/d 4,000
4,000 4,000
Feb
1 To balance b/d 4,000
Machinery A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan 1
To balance b/d 20,000 Jan 31 By balance c/d 20,000
20,000 20,000
Feb 1 To balance b/d 20,000
Furniture A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan 1
To balance b/d 5,000 Jan 8 By Cash A/c 300
Jan 31 By balance c/d 4,700
5,000 5,000
Feb 1 To balance b/d 4,700
Roy & Co. A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan 1 Jan 5 By Cash A/c 1,900
4 To balance b/d 2,000 Jan 5 By Discount A/c 100
18 To Sales A/c 1,000 Jan 14 By Bank A/c 950
To Bank A/c 950 Jan 14 By Discount A/c 50
Jan 31 By balance c/d 950
3,950 3,950
Feb 1 To balance b/d 950
Sen & Co. A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan 1 To balance b/d 3,000 Jan 11 By Bank A/c 3,000
3,000 3,000
Loan from SBI A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan Jan 1 By balance b/d 10,000
31 To balance c/d 10,000
10,000 10,000
Purchases A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan
2 To Patel & Co. 2,000
10 To Cash A/c 1,000
11 To Vishwanath &
Co. 2,000 Jan 31 By balance c/d 5,000
5,000 5,000
Feb
1 To balance b/d 5,000
Patel & Co. A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan Jan 2 By Purchases A/c 2,000
31 To balance c/d 2,000
2,000 2,000
Sales A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan Jan 3 By Cash A/c 500
Jan 4 By Roy & Co. 1,000
31 To balance c/d 3,500 Jan 19 By Cash A/c 2,000
3,500 3,500
Advertisement A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan
26 To Cash A/c 500 Jan 31 By balance c/d 500
500 500
Feb 1 To balance b/d 500
Rent A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan
31 To bank a/c 500 Jan 31 By balance c/d 500
500 500
Feb 1 To balance b/d 500
Salaries A/c
Dr. Cr.
Date Particulars L. F. Amount Date Particulars L. F. Amount
(Rs.) (Rs.)
2010 2010
Jan
31 To cash a/c 500 Jan 31 By balance c/d 500
500 500
Feb 1 To balance b/d 500
4.9 Summary
In the double entry system, it was stated that it is possible to record all types of business transactions
in the journal in the chronological order before posting then to the ledger. Now-a-days, the vast majority of
transactions are recorded in the special journals such as cash book, purchase day book, sales day book,
cash book etc.
The ledger contains in a summarised and a classified form a permanent record of all business
transactions in the form of various accounts transferred to it from general journal and other books of original
entry.
5.0 Objectives
After studying this unit, you will be able to
State the meaning of trial balance
Assess the characteristics of trial balance
Enumerate the objectives of preparing trial balance
Define the preparation of trial balance
Identify steps to locate the Errors
Explain the types of Errors
5.1 Introduction
A Trial Balance is a statement, prepared with the debit and credit balances of the ledger accouts to
test the arithmetical accuracy of the books. J.R. Batliboi
All the businessmen after completion of postings from Journal or Subsidiary Books to the Ledger,
want to verify accuracy of the posting. On the basis of principal of accounting we know that for every debit
there will be an equal credit. If the sum of all debits equal the sum of all credits, it is presumed that the
posting to the ledger in terms of debit and credit amounts is accurate. The trial balance is a tool for verifying
the correctness of debit and credit amounts. It is an arithmetical check under the double entry system which
verifies that both aspects of every transaction have been recorded accurately.
5.2 Meaning of Trial Balance
A Trial Balance is prepared after having posted the journal entries into the Ledger and balancing the
accounts. The balance of an account is the difference between the total of the debit side and the total of the
credit side. It is called a ‘Debit Balance’, if the debit side total is greater. vice versa, it is called a ‘Credit
Balance’, if the total of credit side is greater.
A Trial Balance is a statement showing the balances, or total of debit and credit sides of all the
accounts in the Ledger with a view to verifying the arithmetic accuracy of posting into the Ledger accounts.
Trial Balance is an important statement in the accounting process, which shows final position of all accounts
and helps to prepare the final statements.
According to Carter, “Trial Balance is the list of debit and credit balances, taken out from ledger. It
also includes the balances of cash and bank taken from cash book.”
William Pickles defines the Trial Balance as, “The statement prepared with the help of ledger
balances, at the end of financial year (or at any other date) to find out whether debit total agrees with credit
total is called Trial Balance.”
Format of a Trial Balance
Trial Balance of ............ as on March 31, 2010
Account Title L.F. Debit Amount (Rs.) Credit Amount (Rs.)
Total
(i) Trial Balance is prepared on a particular date which should be written on the top.
(ii) In the first column, the name of the account is written.
(iii) In the second column, Ledger folio, i.e., the page number of the Ledger where the balance
appears.
(iv) In the third column, the total of the debit side of the account concerned or the debit balance, if any
is entered.
(v) In the fourth column, the total of credit side or the credit balance is written.
(vi) The two columns are totalled at the end.
Purchases Account
2010 Rs.
April 4 To Bank A/c 20,000
30 To Sundries as per
Purchases Book 4,70,000
(Credit Purchases)
Sales Account
Rs. 2010 Rs.
April 6 By CashA/c 24,000
30 By Sundries as
per Sales Book
(Credit Sales) 8,30,000
Rakesh
2010 Rs. 2010 Rs.
April 10 To Purchases April 8 By Purchase A/c
Return A/c 2000 (Credit Purchase) 4,70,000
23 To Bank A/c 4,10,000
23 To Balance c/d 58,000
4,70,000 4,70,000
May 1 By Balance b/d 58,000
Ravi
2010 Rs. 2010 Rs.
April 10 To Sales A/c April 20 By Bank A/c 4,50,000
(Credit Sales) 5,30,000 30 By Balance c/d 80,000
5,30,000 5,30,000
May 1 By Balance b/d 80,000
Rohit
2010 Rs. 2010 Rs.
April 11 To Sales A/c April 22 By Bank A/c 2,50,000
(Credit Sales) 3,00,000 30 By Balance c/d 50,000
3,00,000 3,00,000
May 1 By Balance b/d 50,000
Machinery Account
2010 Rs. 2010 Rs.
April 12 To Bank A/c 25,000 April 30 By Balance c/d 25,000
Salaries Account
Rs 2010 By Sundries as per Rs.
April 30 Purchases Return
Book 2,000
You are required to prepare the Trial Balance by the Balance Method.
SOLUTION
Trial Balance of Mukesh Bros.
as on 30th April 2010
Name of Accounts L.F. Balance Balance
Dr. Cr.
Rs. Rs.
Cash A/c 55,500
Bank A/c 3,95,000
Capital A/c
Purchase A/c 4,90,000 2,00,000
Sales A/c
Rakesh 8,54,000
Ravi 80,000 58,000
Rohit 50,000
Machinery 25,000
Rent A/c 4,000
Salaries A/c 14,500
Purchases Return A/c 2,000
Total 11,14,000 11,14,000
5.5.2 Total Amount Method
Under this Method, the total amount of debit side of each ledger account is put on the debit side of
the trial balance and the total amount of credit side of each ledger account is put on this credit side of the trial
balance. The total of debit column of trial balance should agree with the total of credit column in the trial
balance because the accounts are based on double entry system. Under this method trial balance can be
prepared immediately after the completion of posting to the ledger.
ILLUSTRATION 2.
Taking the same particulars as given in Illustration 1, prepare the Trial Balance by Total Amount
Method.
SOLUTION :
TRIAL BALANCE OF MUKESH BROS.
as on 30th April 2010
Name of Accounts L.F. Balance Balance
Dr. Cr.
Rs. Rs.
Cash A/c 2,24,000 1,68,500
Bank A/c 8,50,000 4,55,000
Capital A/c 2,00,000
Purchase A/c 4,90,000
Sales A/c 8,54,000
Rakesh 4,12,000 4,70,000
Ravi 5,30,000 4,50,000
Rohit 3,00,000 2,50,000
Machinery 25,000
Rent A/c 4,000
Salaries A/c 14,500
Purchases Return A/c 2,000
Total 28,49.500 28,49,500
5.5.3 Total-cum Balances Method
This method is a combination of total amount method and balances method. Under this method,
four columns are prepared for writing amounts. First two columns are used for writing the debit and credit
totals of different accounts and the next two columns for writing the debit and credit balances of these
accounts. This method is not used in practice because it is time consuming and it does not serve any special
purpose.
Illustration 3
Taking the same particulars as given in Illustration 1, prepare the Trial Balance by “Totals-cum-
balances Method’ :
SOLUTION :
TRIAL BALANCE OF MUKESH BROS.
as on 30th April, 2010
(Using Total-cum-Balances Method)
Name of Accounts L.F. Total of Total of Balance Balance
Debit Credit Dr. Cr.
Items Items
Rs. Rs. Rs. Rs.
Cash A/c 2,24,000 1,68,500 55,500
Bank A/c 8,50,000 4,55,000 3,95,000
Capital A/c 2,00,000
Purchase A/c 4,90,000 4,90,000 2,00,000
Sales A/c 8,54,000
Rakesh 4,12,000 4,70,000 8,54,000
Ravi 5,30,000 4,50,000 80,000 58,000
Rohit 3,00,000 2,50,000 50,000
Machinery 25,000 25,000
Rent A/c 4,000 4,000
Salaries A/c 14,500 14,500
Purchases Return A/c 2,000 2,000
Total 28,49.500 28,49.500 11,14,000 11,14,000
5.5.4 Difference between a Trial Balance by Balance Method and a Trial Balance by Totals
Method.
Trial Balance by Balance Method Trial Balance By Totals Method
1. It can be prepared after all the Ledger It can be prepared immediately after the
accounts have been balanced. completion of posting from books of
original entry to the Ledger.
2. It shows the balances of all the accounts It shows the total amounts of the debit and
in the Ledger credit sides in each Ledger Accounts.
It considers only those accounts which It considers all accounts of the Ledger.
show a balance. If an account shows no
balance, it will not be considered.
Activity -5.3
Which of the following do not affect the Trial Balance agreement and why ?
(i) Purchases of Rs. 2,500 from Naman entered in Aman’s account ?
(ii) Payment of Rs. 2,000 for repair entered only in Repair account.
(iii) Salary Account added up incorrectly by Rs. 1,000 being short totalled.
5.8 Summary
A Trial Balance is a statement of accounts appearing in the Ledger. It may be prepared either by
taking the balances of each account or the total amounts of debit and credit items.The agreement of Trial
Balance ensures arithmetical accuracy and not accounting accuracy. Functions of a Trial Balance are (i) to
ascertain arithmetical accuracy. (ii) to provide summary of ledger accounts. (iii) to help in the preparation of
final accounts. (iv) to help in locating errors. There are three methods of preparing a trial balance. These are
(i) Balance method (ii) Totals method (iii) Total - cum - balances method. There are two types of errors (i)
Errors affecting trial balance (ii) Errors not affecting trial balance. Errors not affecting trial balance are (a)
errors of commission (b) errors of omission (c) errors of principle (d) compensating errors.
6.0 Objectives
After studying this unit you will be able to understand :
Meaning of financial statements
Classification and distnction between capital and revenue items
Meaning and formation process of Trading Account and Profit & Loss Account
Meaning, importance and Preparation of Balance Sheet
How grouping, Marshalling of Assets and Liabilities can be done
Classification of Assets and Liabilities
Distinction between Trading and Profit & Loss Account
Methods of Preparing of Final Accounts
6.1 Introduction
Final Accounts refers to such statements which report the profitability and the financial position of
the business at the end of the accounting period. These statements are called as “financial Statements”
which is prepared to know profit or loss and also the financial position of the business. These statements are
prepared for users of accounting information for decision making. Financial statements are prepared from
the Trial Balance drawn taking the ledger balances and cash book balances. Final Accounts includes:
(i) Income Statement (Trading and Profit & Loss Account), which shows results of the business
operations during an accounting period.
(ii) Statement of Financial Position (or Balance Sheet) which shows final position of the business at a
specific point of time.
Objectives of preparing Final Accounts are :
(i) To present a true and fair view of financial performance of a business;
(ii) To present true and fair view of the financial position of the business.
Solution :
Trading A/C
(for the year ended 31 March 2010)
Notes: - (1) Those expenses which are not related to the business are not written in the Profit and Loss
Account such as (I) Domestic and household expenses of the proprietor, (II) Income- Tax, and (III) Life
Insurance Premium etc. These expenses are known as Drawings and deducted from Capital at the liabilities
side of the Balance Sheet.
Illustration 2
From the following particulars, prepare a Profit & Loss Account for the year ending 31st March
2010 : -
Rs. Rs.
Gross Profit 2,00,000 Discount allowed 3,000
Trade Expenses 2,000 Lighting 700
Carriage on Sales 10,000 Commission Received 800
Office Salaries 15,800 Bad-debts ,1200
Postage and Telegram 700 Discount (Cr.) 6000
Office Rent 7,500 Interest on Loan 3,600
Legal Charges 400 Stable Expenses 1,400
Audit fee 1,600 Export Duty 2,300
Donation 1,100 Miscellaneous Receipts 500
Sundry Expenses 300 Unproductive Expenses 4,100
Selling Expenses 5,300 Travelling Expenses 2,500
Solution :
Profit & Loss Account
for the year ending on 31st March, 2010
Dr. Cr.
Particular Amount Particular Amount
Rs. Rs.
To Trade Expenses 2,000 By Gross Profit 2,00,000
To Carriage on sales 10,000 By Commission received 800
To Office Salaries 15,800 By Discount 6000
To Postage & Telegram 700 By Miscellaneous Receipts 500
To Office Rent 7,500
To Legal charges 400
To Audit fee 1,600
To Donation 1,100
To Sundry expenses 300
To Selling expenses 5,300
To Discount allowed 3,000
To Lighting 700
To Bad - Debits 1,200
To Interest on Loan 3,600
To Export duty 2,300
To Unproductive expenses 4,100
To Travelling expenses 2,500
To Net Profit transferred to
Capital Account 1,45,200
2,07,300 2,07,300
Balance Sheet
as on 31st March, 2010
Purchases 80000
Less : Purchases Outwards 2000 78000
Direct Expenses 2000
Freight and Carriage 15000
Customs and Insurance 20000
Wages 20000
Gas, Water and Fuel 2000
Lighting and Heating 3000
Factory Expenses 2000
64000
152000
Less : Closing Stock 2000
Cost of Goods Sold 150000
Gross Profit 48000
The Vertical Format merely involves a rearrangement of the information shown by a Balance Sheet
presented in the Horizontal Format. The Vertical Format of a Balance Sheet is shown below (using
imaginary figures):
Balance Sheet of Z
as at 31st March, 2008
6.12 Summary
The term financial statements as used to denote ‘Final Accounts’ consists of two basic statements
: (1) Trading and Profit and Loss Account (Income statement) (2) Balance Sheet. The users of financial
statements are present and potential investors, lenders, short terms creditors employees, customers,
government, tax authorities, providers of loan, which satisfy their specific needs. Trading account contains
the revenue incomes and expenditures which are related to purchases or goods manufactured i.e. direct
expenses related to production. This account shows gorss profit or loss. Profit & Loss account contains all
indirect expenses related to business and all indirect incomes related to enterprise. It shows net profit or
loss. The Balance Sheet is a statement, which depicts the financial position of a business on a particular
date. Income statements is a period statement whereas Balance Sheet is a point statement. Grouping &
marshalling refers to collect same nature of items in one group and arrange them in a particular order.
Vertical presentation is a system of presentation of information of trading, profit and loss Account and
Balance Sheet instead of side by side, in such a way that important information are revealed to the readers
a a glance.
Rs. Rs.
Capital (Cr.) 3,600 Salaries 600
Machinery 700 General Expenses 200
Sales 8,200 Rent 500
Purchases 4,000 Purchases Returns 50
Sales Returns 100 Debtors 3,000
Stock on April 1, 2010 1,000 Cash 400
Drawings 400 Carriage Outward 200
Wages 1,000 Advertising 200
Carriage Inward 50 Creditors 500
Sales 8,00,000
Furniture and other Equipment 60,000
Trade Expenses 30,000
Cash at Bank 2,50,000
Wages and Salaries 60,000
Repairs 10,000
Purchases 5,00,000
Opening Stock 2,00,000
Sundry Creditors/Sundry Debtors 1,00,000 1,30,000
Purchases Returns 10,000
Rent 12,000
Discount 8,000
Drawings 35,000
Bills Receivable/Bills Payable 10,000 10,000
Bad Debts 45,000
Interest 4,000
14,97,000 15,82,000
The Stock on 31st March, 2010 was valued at Rs. 1,40,000.
7.0 Objectives
After studying this unit you should be able to understand :
Terminology of Cost Accounting
Objectives and Advantages of Cost Accounting
Cost Accounting differentiated from Financial Accounting and Management Accounting
Limitations of Cost Accounting
Types of Costing
Classification of Costs
Codification of Costs
Elements of Cost
Determination of Total Cost
7.1 Introduction
Priror to industiral revolution, there was a need of book-keeping, because business were small and
it is characterised between individuals. By the seventeenth century in France and eighteenth century in
England, the cost accounting information gathered by one or two manufacturing organisation. During world
war I and II the importance of cost accounting grew due to high defence expenditure of each country. The
emphasis of industry in general has very rightly turned to reduction in costs while improving internal
efficiencies and product quality. In the current scenario it has become difficult in the industry to sustain and
survive unless the costs are correctly accounted for, controlled and reduced so as to sustain and remain in
the industry. In the period of severe competition, financial accounting has failed to meet the exeptations of
owners in this regard. Issues such as cost determination, cost control, cost reduction and product pricing
paved the way for the emergence of cost accounting.
The production cost includes all direct costs plus indirect costs related to manufacturing operations.
The Administration cost is the sum of these costs associated with administrative functions. Selling cost is
cost of marketing a produce or service like advertisement. Distribution cost includeds the costs which are
incurred on goods or service made available to the customers. Research cost includes cost of searching
new ideas/products/process, improvement of exisitng products.Development cost is the cost which is
incurred for putting the research results on commercial basis.
(c) Classification of Costs for Decision Making:
(i) Product and Periods costs It is aggregate of costs that are associated with a unit of product. It
includes an element of overheads depending upon the types of costing system in force like
absorption or direct. Period costs are the costs which are associated with a time period rather than
level of activity. These are in the nature of fixed costs.
(ii) Explicit and Implicit costs Explicit costs involves payment to other parties, hence it is called as
“outof pocket cost. Implicit costs are the costs which do not require current cash payments like
depreciation. It is also called as ‘imputed’ or ‘book cost’ or economic costs”.
(iii) Sunk costs and Pre-determined cost Sunk cost is a past cost. Investment in plant, is a sunk
costs, which will not relevant for decisions. Pre-production costs are incurred at the time of trial run
production. These are generally treated as deferred revenue expenditure, except to the extent of
capitalised portion of such costs.
(iv) Opportunity cost It is a value of benefit forgone of an alternative course of action. Notional rent of
own-building is an example. It is used in decision making but not entered into books of accounts.
(v) Shut down cost It refers to the minimum fixed costs which are incurred even at the temporary
closure of dept., division. It is irrelevant for decision making.
(vi) Conversion cost The cost which is attributable for converting raw material into finished product.
Hence, it is production cost excluding direct material cost.
(vii) Replacement cost It is the cost of replacing existing capital asset with new one, which is usually
identical.
Activity - 7.2
Depreciation is an example of ....................... cost, while rent is an example of .........cost.
(D) Classification based on cost Behaviour :
Total Costs
Variable Fixed
Component Component
Variable cost is a cost which varies in accordance with the level of activity within relevant range and
within a given period of time. There is a linear relationship between volume and variable costs. These are
constant per unit. The fixed cost is a cost which is unaffected by the changes in the level of activity during a
given period of time and within relevant range. It has inverse relationship between volume and fixed cost
per unit. Semi-variable cost are neither perfectly variable nor absolutely fixed. These costs have neither
linear or curvilinear relationship with output but it moves in steps with the changes in activity levels. Such
classifaction affects C.V.P. analysis, direct costing, flexible budgeting and decision making. There are five
methods of segregating semi variable costs : (a) Graphical method (b) High & Low-point method (c)
Analytical method (d) Comparison by period or level of activity method (e) Least Square Method.
(E) Classification According to Controllability :
Total Costs
Controllable costs are the costs which can be controlled by the action of a specified person of an
organisation. But uncontrollable costs can not be influenced by the action of a specified person of an
organisation, such as price of raw material.
Overheads
Materials may be defined as substances from which products are manufactured. It may be direct or
indirect. The material which can be economically identified in the final product are called direct materials.
However, such materials which are not economically feasible to identify that quantity or which is of very
small value or is used in small quantity are called as indirect materials.
Labour may be defined as the human or machanical effort by which materials are converted into
final product. It may be direct and indirect. Labour cost which is economically identified or attributed wholly
to final product is called direct labour cost. Labour costs which cannot be allocated but can be apportioned
to or absorbed by cost unit or cost centre is called indirect labour cost.
Costs other than materials and labour cost are known as expenses. It may be direct or Indirect.
Expenses which are specifically incurred for a particular product other than direct material and labour are
called direct expenses. All the expenses which are other than direct expenses are known as indirect ex-
penses.
Overheads is the aggregate of indirect material costs, indirect labour costs and indirect expenses.
It may be classified into production (factory), administration (office) and selling and distribution
overheads.Some example items included in above:
Direct Direct Direct Factory office & Selling &
Material Labour Expenses Overheads Administration
Overheads Distribution
Overheads
-Raw Materials -Labour -Cost of -Consumable -office Printing -Salary of
-Parts and engaged special stores -Salary to sales dept.
Components in production patterns -Salaries of office staff -Traveling
-Primary -involved in drawings factory staff -Directors Exp.
packing direct -cost of patents -Overtime Salary -Warehouse
materials inspection -fees paid to bonus -Legal charges Charges
-Office rent
-Specific involved in consultant -Rent of factory -Carriage
Purchases for specific -cost of premises outwards
a product product -Power, fuel
operating -After sales
machine service cost
-Excise duty
-Samples &
free gifts.
Activity - 7.3
List out any three items, which are excluded from cost accounts:
The above statement is prepared to provide the classification of costs in summarised form, to
estimate the cost and to provide information for comparative study.
7.15 Summary
Cost accounting grew with the growth of each country with the advent of the industrial revolution
and large sized industries. The amount of expenditure either actual or notional incurred to a specific article
or activity is called cost. Costing is the technique and process of ascertaining costs. Cost accounting
involves all accounting procedures relating to recording of all income and expenditure. It also involves
preparation of reports for controlling the costs. Cost accountancy is used in a broader sense. It includes
costing, cost accounting and it is concerned with the formulation of principles, methods, techniques to be
applied for acertaining costs. The purpose of cost accoounting is to ascertain the cost, to fix the selling price
and to control and reduce the costs. Cost accounting and financial accounting have distinct features. Cost
accounting offers a number of advantages to management, employees, lenders, government and to society.
Cost accounting have some limitations like expenses, unnecessary, unrreliable etc. There are two major
methods of costing viz. Specific order costing, Process costing. There are different types of costing which
are adopted for controlling costs and for making mangerial decisions. Cost can be ascertained by grouping
of elements of cost.
7.16 Key Words
Cost Object: Anything for which a separate measurement of cost is desired like a customer, a
product, a service etc.
Cost Centre: A location, person or an item for which cost may be ascertained. It is of two types
one a personal cost centre which consists of a person or group of persons and an impersonal cost
centre which consists of a location or an item.
Production Cost Centre: Where raw material is handled for conversion into finished product.
Service Cost Centre: A centre where a cost of ancillary unit to a production such as : power
house, plant maintenance centre etc.
Cost Unit: A product, service or time (or combination of these) in relation to which costs may be
ascertained or expressed. Cost unit are usually the units of physical measurement like number,
weight, area, volume, length, time and value.
Profit Centres: The centres which have the responsibility of generating and maximising profits.
Investment Centres: The centres which are concerned with earning an adequate return on
investment.
Responsibility Centre: It is an activity centre of a business organisation for the purpose of
control. It can be classified into three categories : Cost centres,Profit centres and Investment
centres.
Imputed Costs: It is a hyphothetical cost, which is neither spent nor accounted in the books,
Examples: Interest on capital.
Discretionary Cost: Which may be reduced or partially dropped according to the policy of
management and need of hour. These are advertisement, research and development expenses.
Differential Cost: It represents changes in total cost due to change in activity level it may be
incremental or decremental.
7.17 Self Assessment Test
1. Define cost, costing, cost accounting and cost Accountancy?
2. What are the main objectives of cost accounting?
3. What are benefits of cost accounting to all segments?
4. What are the different types of cost centres?
5. What are the limitations of cost accounting?
6. What are the different methods of costing?
7. What are the different types of costing?
8. Distinguish cost and management accounting.
9. “Reducing costs is an imperative of an emerging competitive environment.” Discuss.
10. “Cost can be classified in a variety of ways.” Explain and discuss the statement giving examples.
11. State how you would allocate the following items under their headings of (a) factory overhead (b)
office overhead (c) selling an distribution overhead.
(i) Repairs and maintenance of factory.
(ii) Directors fees
(iii) Delivery van expenses
(iv) Depreciation of plant and machinery.
(v) Depreciation of office furniture.
(vi) Carriage outward.
8.0 Objectives
The main objectives of this unit are to make you familiar with-
The concept of Marginal Costing
Profit-Volume Ratio, Break-Even Analysis, relationship between Sales & Profit level.
The benefits & limitations of Marginal Costing
8.1 Introduction
The cost elements are mainly material, labour & overhead which are further divided into variable,
semi-variable & fixed. The cost of product is determined by total costing or marginal costing In marginal
costing only variable costs are considered. In calculating cost of product & fixed costs are charged against
the revenue of the period. In Marginal Costing we will consider only variable cost which changes in direct
proportion to the change in output.
Contribution X 100 C
Profit Volume Ratio (P/V) 100
Sales S
FP S- V
100 or, 100
S S
When sales & Profit of two years is Given-
Change in profit
P/V Ratio x 100
Change in sales
Estimation of sales value with contribution & P/V Ratio
Contributi on
P/V Ratio
Sales
Contribution = Sales - Variable Cost
= Rs. 300000 - Rs. 200000
= Rs. 100000
On X-axis, OX represents sales volume, on Y-axis OY represents profit while OY' loss, OFC
represents fixed cost. The line FCP represents fixed cost and profit as well as total contribution. BE is the
break-even point. The area BEX represents margin of safety while XBEP profit area. PBEX is the angle of
incidence.
Fixed Cost
B E P (in units)
Contributi on per unit
Fixed Cost
B E P(in value ) 100
P \ V Ratio
BE Sales
BEP (in terms of sales capacity) (%) 100
Sales 100% capacity
VC
P/V ratio or contribution ratio 1 - 1 - 0.70
Sales
= 0.30
Rs. 300000 x 75
X RS. 375000
60
Now we can compute, contribution earned when sales is Rs. 375000 Sales multiplied by P/V ratio
gives the contribution.
Contribution = Sales x P/V Ratio
= Rs. 375000x 30%
= Rs. 112500
Profit = Contribution - Fixed Cost
= Rs. 112500 - Rs. 90000
= Rs. 22,500
Activity
If Selling prices is Rs. 30 per unit, variable cost Rs. 18 per unit fixed cost Rs. 36000.
Calculate sales units at BEP.
Illutstration: 5
Ummaid Ltd. is manufacturing and selling four types of products, A,B,C,D. The sales mix and
variable costs are as follows:
Rs. 75000
Break Even Point (in Value) Rs. 150000
0.50
Output Variable cost Fixed cost Total cost Sales Rev. Profit
Rs. Rs. Rs. Rs. Rs.
0 0 90000 90000 0 -90000
80000 160000 90000 250000 240000 -10000
90000 180000 90000 270000 270000 0
100000 200000 90000 290000 300000 10000
110000 220000 90000 310000 330000 20000
120000 240000 90000 330000 360000 30000
Fixed Costs
BEP (in units)
Contribution Per unit
Rs. 120000
10000 Units
Rs. 12
Fixed Costs
BEP (in value)
P/V Ratio
Total Contributi on
P/V Ratio
Total Sales
Rs. 120000
0.40
Rs. 300000
Rs. 120000
BEP
0.40
= Rs. 300000
Rs. 300000
25000 units
Rs. 12
Fixed Cost
Required Sales Volume (in unit)
Selling price - (Variable Cost - Desired profit)
Fixed Cost
Required Sales Volume (in unit)
(VC Desired Profit Percentage on Sales)
1-
Sales
Fixed Cost
Selling Price per unit Variable Cost
Desired BEP
Illustration 8
The cost information computed by the cost accountant is as follows:
Sales = 1,00,000 units
Selling Price = Rs. 10 per unit
Variable cost or out of pocket- Cost = Rs. 6 per unit
Fixed Cost or Burden = Rs. 60,000 per annum
Compute the following:
(a) Make a profit of Rs. 40000
(b) Make a profit of Rs 2 per unit
(c) Make a profit of 30% on sales
Solution
(a) Sales volume required to earn a profit of Rs. 40000
In units
Fixed Costs
SP - (VC P)
60000
30000 units
Rs. 10 - (Rs. 6 Rs. 2)
Fixed Costs
1 - (VC PD)/SP
60000
1 - (6 2) / 10
60000
Rs. 300000
2 / 10
(c) Sales volume required to earn a profit of 30% on sales
In units
Fixed Cost
SP - (VC 30% of SP)
Rs. 60000
60000 units
Rs. 10 - (6 3)
In Value
Fixed Cost
1 - (VC 30% of SP) / SP
60000
Rs. 600000
1 - (6 3) / 10
8.7.3 Calculation of Sales Required to Maintain Present Profit
(i) Sales volume required to meet proposed expenditure
Proposed Expenditur e
Additional Required Sales Volume (in unit)
Contributi on per unit
Proposed Expenditur e
Additional Required Sales Volume (in value) 100
P/V Ratio
Illustration 9
Sales 10000 Units
Fixed Cost Rs. 100000
Variable Cost Rs. 200000
The selling price is Rs. 36 per unit. The company is spending Rs. 100000 on advertisement to
promote its product. Find the sale volume required to earn the present profit.
Solution:
Extra sales volume required to meet the additional publicity expenditure of Rs. 100000 so as to maintain the
present profit level is worked out as follows:
Rs. 200000
Variable Cost Per Unit Rs 20 per unit
10000 units
Contribution Margin = Rs. 36 - Rs. 20 = Rs. 16 per unit
Rs. 100000
Additional sales required (in units) 6250 units
Rs.16
When a company sells 6250 units extra, then present level of profit will be maintained. For example,
before spending money the company was earning a profit of Rs. 60000 which is as follows.
Profit = Contribution - Fixed Cost
= Rs. 16 x 10000 - Rs. 100000
= Rs. 160000 - Rs. 100000 = Rs. 60000
When sales volume increase to 16250 units (i.e. 10000 units + 6250) then profit will be
= Rs. 16 x 16250 - Rs. 200000 (F.C. 100000+ Advertisement Rs. 100000)
= Rs. 260000 - Rs. 200000 = Rs. 60000
(ii) Sales volume required to offset price reduction
Illustration 10
Jodhana Ltd. manufactures and markets a product whose cost data is as follows:
Material Cost = Rs. 32 per unit
Conversion (Variable Cost) = Rs. 24 per unit
Dealer's Margin = Rs. 8 per unit (10% of selling price)
Selling Price = Rs. 80 per unit
Fixed Cost = Rs. 8 per unit
Present sales = Rs. 90000 units
Capacity Utilisation = 60%
Management has the following two suggestions, which alternative is better so as to maintain the
present profit level?
(a) Reduction is selling price by 5%
(b) Increasing the dealer's margin by 25% over the existing rates.
Solution
Total variable costs = Rs. 32 + Rs.24 + Rs. 8 = Rs. 64 per unit
Contribution per unit = Rs. 80 - Rs. 64 = Rs. 16 per unit
Present Profit Level = Rs. 16x 90000 - Rs. 1000000 = Rs. 440000
(a) Price Reduction By 5%
New selling price = (Rs. 80 - Rs. 4) = Rs. 76 per unit
New Dealer's Commission = 10% of Rs. 76 = Rs. 7.60
New Contribution = Rs. 76 - (Rs. 32 + Rs. 24 + Rs. 7.60)
= Rs. 12.40 per unit
FC DP
Sales volume requires to earn a desired profit ( in units)
Contributi on per unit
Rs.1440000
116129 units
Rs.12.40
(b) Increasing dealer's commission by 25%
New Dealer's Commission = Rs. 8 + 25% of Rs. 8 = Rs 10 per unit
New Contribution = Rs. 80 - (Rs.32 + Rs.24 + Rs.10) = Rs.14 per unit
Rs. 1000000
Sales required (in units) Rs. 440000
Rs. 14
= 102857 units
In the second alternative, lesser units are required to be sold as compared to the first alternative.
Contribution margin is also high in the second alternative. Hence the second alternative is better in comparison
to the first.
(iii) New Sales volume or new selling price to offset the impact of change in variable cost and
fixed costs
New selling price with the same volume and to earn the same profit when variable costs changes-
New selling price = Old selling + New Variable Cost - Old Variable Cost
F DP
(a) New sales quantity required
SP - Vn
Where Vn is new variable cost
SP Fn - Fo
Q
SP is old selling price, Fn is new fixed cost and Fo is old fixed cost.
Fn DP
SP - Vn
(VCn - VCO)
SP Fn - Fo
Q
30
A Rs. 200000 Rs. 60000
100
50
B Rs. 200000 Rs. 100000
100
20
C Rs. 200000 Rs. 40000
100
Variable Cost Ratio (as variable cost per unit remains same)
Rs. 50000 5
A
Rs. 80000 8
Rs. 60000 6
B
Rs. 100000 10
Rs. 10000 1
C
Rs. 20000 2
Product A Product B Product C Total Rs.
Sales (Rs.) 60000 100000 40000 200000
Variable Costs (Rs.) 37500 60000 20000 117500
Contribution (Rs.) 22500 40000 20000 82500
Fixed (Rs.) - - - 50000
Profit - - - 32500
Profit 100
Margin of Safety (in value)
P/V Ratio
Contribution 200000
P/V Ratio 100 100 25%
Sales 800000
Profit 150000
M/S(in val ue) 100 100 Rs. 600000
P/V Ratio 25
Actual Sales - B.E. Sales 800000 - 200000
M/S(in %) 100 100 75%
Actual Sales 800000
Activity
If present sales is Rs. 300000, sales at BEP Rs. 240000, calculate margin of Safety in
terms of percentage.
Illustration 14
From the following data prepare the marginal cost statement and find out (I) P/V Ratio (ii)
B E P (iii) M/S
Direct Material Rs. 60,000
Direct Labour 48,000
Variable Factory Overhead 25 % of wages
Variable Administration Overhead 10 % of works cost
Fixed Expenses 48,000
Variable Selling Overhead 15 % of works cost
Sales 2,500 units @ Rs 80 per unit
Marginal Cost Statement
Rs. Rs.
Saels 2500 units @ Rs. 80 200000
Less: Marginal cost:
Direct Material 60000
Direct Labour 48000
Prime cost 108000
Add: Works overhead (variable 25% of labor) 12000
Marginal Works cost 120000
Add: admistration overhead (variable 10% of w.c) 12000
Marginal Cost of Production 132000
Add: selling overheard (variable 15% of w.c.) 18000
Total Marginal Cost 150000
Contribution 50000
Contributi on 50000
(1) P/v Ratio 100 100 25%
Sales 200000
Profit 2000
(3) M/s 100 100 8000
P/V Ratio 25
Profit = C-FC = Rs. 50000 - 48000 = Rs. 2000
Illustratin 15
Ashish Ltd., Multi Product company, furnishes the following data:
Particular Period I Period II
Sales (Rs.) 45000 50000
Total Cost (Rs.) 40000 43000
Assuming that there is no change in price and variable costs, fixed expenses are incurred equally in
the two periods. Calculate the following;
(i) Profit volume ratio.
(ii) Fixed expenses
(iii) Break even point
(iv) Percentage M/S to sales in Period II
(v) Sales required to earn profit = Rs. 10000
(vi) Profit when sales is Rs. 80000.
Solution
Particular Period I Period II Profit (Rs.)
Period II 50000 43000 70000
Period I 45000 40000 5000
Change 5000 3000 2000
Fixed Costs
(iii) Break Even point =
P/V Ratio
Rs. 13000
BEP ( in value) = Rs. 32500
0.40
(iv) Margin of Safety (M/S) = Actual Sales - BEP (in value)
= Rs. 50000 - Rs. 32500
= Rs. 17500
Rs. 17500
% of M/S to sales = 100 35%
Rs. 50000
(v) Sales required to earn a desired profit of Rs. 10000
FC DP
=
P/V Ratio
Rs. 13000 Rs. 10000
= Rs. 57500
0.40
(vi) Profit when sales is Rs. 80000
Contribution = Sales x P/V ratio
= Rs. 80000 x 0.40
= Rs. 32000
Profit = Contribution - FC
= Rs. 32000 - Rs. 13000
= Rs. 19000
Contribution
Profitabil ity
Key Factor
For example, if raw material is the limiting factor, the profitability of each product is determined by
contribution per kg of raw material. If machine capacity is a limiting factor then contribution per machine
hour is calculated. If electricity is the limiting factor, then contribution per unit of electricityof each product
is calculated.
8.10 Summary
Marginal costing involves computations of marginal cost. It comprises direct material, direct labour
and variable overheads. Marginal costing helps the management in taking various managerial decisions like
price fixation, profit planning, add and drop decisions, make or buy decision, sales mix decision etc. Marginal
costing technique has some limitations. The categorization of expenses into fixed and variable elements is
tedious and complex task. The behavior of per unit variable and total fixed cost is questionable as assumed
in marginal costing.
Break even analysis helps in ascertaining the level of production where total costs equals to total
revenue. Below this level of production, there are losses and above this point depicts the profit zone. It
represents the level of activity at which revenue from sale of goods and services is just equal to total cost
incurred to produce and sell the same. If sales volume exceeds the break even volume even by one unit the
company earns profit. The amount of profit is equal to total cost incurred to the product of excess of units
sold over and above break even volume. Similarly, if the sales volume falls below Break even volume even
by one unit, the company sustains loss. The analysis is based on cost classification into fixed and variable
costs. Break even analysis helps in measuring the effect of changes in volume, costs, selling price and
product mix on profit. It is expressed in terms of units or in value terms. This technique is very useful in profit
planning and decision making. It can be applied to estimate profits at a given sales volume, sales volume
required to earn a desired profit, calculating sale volume required to offset price reduction, ascertaining the
margin of safety, measuring the effect of changes in profit factors etc. The other tools in this analysis are
profit-volume ratio, margin of safety and angle of incidence.
Before taking a decision, one must analyze the alternatives available before him and then one should
take a decision, which is beneficial to the management. The decision should be in such a way that it increases
the profit of the company. When we take a decision for a short period, normally we look at the contribution
we received in all the available alternatives and compare them and one should accept the alternative, which
provides more contribution, as in shorter period it is presumed that fixed costs will not change.
X Y Z
Sales 30000 60000 80000
Direct Material 12000 25000 36000
Direct Labour 8000 10000 14000
Factory Overhead:
Variable 2000 3000 5000
Fixed 6000 8000 6000
Administrative
Overhead Fixed: 1000 2000 2000
Selling Overhead
Variable: 1000 3000 3000
Fixed 2000 2000 3000
(Ans: Profit: Rs. 16000, X:Rs. 2000, Y Rs. 7000, Z Rs. 11000)
7. Calculate (1) P/V Ratio, BEP, Fixed Overhead
(2) Sales of Earn a profit of Rs. 1.60 Lakh
(3) Profit Earned when sales are Rs. 2 Lakh.
Following information is taken out form books of company-
Period I Period II
Rs. Rs.
Sales 4,00,000 6,00,000
Profit 40,000 80,000
(Ans.: (1) 20%, Rs. 2 Lakh, Rs. 40000, (2) Rs. 10 Lakh (3) BEP)
8. Rudra Ltd. manufactures and sells four types of products under the brand names of P, Q, R and S.
The sale mix in value comprises 34%, 40%, 16% and 10% of P, Q, R and S respectively. The total
budgeted sales (100%) are Rs. 60000 per month. Operating costs are:
Variables costs ratio is (variable cost on % of sales)
P 60%
Q 65%
R 70%
S 40%
Fixed costs are Rs. 15,000 per Month. Calculate the break even point for the products on overall
basis. (Ans BEP Rs. 39062.50)
9. Explain from the following data, how the reduction in selling price would affect the break even point
and margin of safety.
Selling price per unit Rs. 10
Variable cost Material Rs. 3
Labour Rs. 2
Variable overhead Rs. 1
Fixed overhead is Rs. 4000. Full capacity of the plant is 5000 units. Reduced selling Price is Rs. 8
per unit.
(Ans: BEP increase by 1000 units and M/S decrease by Rs. 16000)
10 Ashish Ltd., has a margin of safety 37.5% with an overall contribution sale ratio of 40%. The fixed
cost is Rs. 5 lakhs.
Calculate the following:
(i) Break even point
(ii) Total Sales
(iii) Total variable cost
(iv) Profit
(Ans: i)Rs. 12,50,000 ii) 20,00,000 iii) Rs. 12,00,000 iv) Rs. 3,00,000)
11 The P/V ratio of a concern is 50% and margin of safety is 40%. Calculate the net profit of the sales
is Rs. 1,00,000.
(Ans : profit Rs. 20,000)
12. AXE Ltd. has earned a contribution of Rs. 200000 and net profit of Rs. 150000 on sales of Rs.
800000. What is the break even point and margin of safety?
(Ans: Rs. 200000 M/S is Rs. 600000)
13. From the following cost information:
2009 2010
Sales (Rs.) 1,50,000 2,00,000
Profit (Rs.) 30,000 50,000
Calculate:
(i) P/V Ratio
(ii) Break even point
(iii) Sales required to earn a profit of Rs. 80,000
(iv) Profit when sales is Rs. 2,50,000
[Ans: (i) 0.40 (ii) Rs. 75,000 (iii) Rs. 2,75,000 (iv) Rs. 70,000]
14 Chitragupt Ltd. furnishes the following data relating to year 2010
Sales Total Cost
Jan to June Rs. 1350000 1200000
July to Dec. Rs. 1500000 1290000
Calculate: (i) P/V Ratio, Break Even Sales, Fixed Cost, and Margin of safety.
(ii) Sales needed of proit of Rs. 4.40 Lakh
(iii) Profit when sales are Rs. 30 Lakh
(iv) Sales to earn a profit of 10% on sales.
[Ans: (i) 40%, Rs. 19.50 Lakh, Rs. 7.80 Lakh, 31.58% (ii) Rs. 34.75 Lakh (iii) Rs.
4.2 Lakh (iv) Rs. 26 Lakh]
15. Price during depression have reduced to increase sales, find the volume of sales to maintain the
same profit if reduction in S. P is 10%
Sales 20,000 Units @ Rs. 10 p.u.
Variable cost Rs. 7 p.u.
Fixed Cost Rs. 40,000 p.a.
[Ans: P/V Ratio before reduction 30% after 22.2%, 30000 Units be sold maintain profit
as Before]
8.13 Reference Books
Agrawal Sharma, Agrawal, Shah, Agrawal, Financial Accounting and Decision Making.
Agrawal M.R., Management Accounting.
Jain, Khandelwal, Pareek, Dave, Financial Accounting and Decision Making.
Unit - 9 Cost Analysis for Decision Making
Unit Structure
9.0 Objectives
9.1 Introduction
9.2 Meaning and Nature of Decision Making
9.3 Financial and Non-financial Considerations
9.4 Techniques of Decision Making
9.5 Summary
9.6 Key Words
9.7 Self Assessment Test
9.8 Reference Books
9.0 Objectives
After studying this unit you should able to understand:
Definition and stages of Decision Making
Financial and non-financial factors to be considered
Various techniques of Decision Making
Analysis of cost data for pricing decisions
Analysis of cost data for selection of optimum Product
Analysis of cost data for Make or Buy Decisions
Analysis of cost data for profit Planning
Analysis of cost data for plant shut down Decisions
Analysis of cost data for Further Processing or selling Decisions
Analysis of cost data for determination of optimum level of production
Analysis of cost data for Adding or Dropping a product line
Analysis of cost data for Replacement Decisions.
9.1 Introduction
One of the basic functions of management is decision making and decision making often involves
selecting a course of action from among a set of alternatives. There are two or more alternatives available
for each problem, of which one such alternative should be considered.
The most useful contribution of marginal costing technique, break even analysis, differential cost
analysis is to give assistance to the management in vital decision making. Specific areas where marginal
costing proves its worth is in decision making process for example operating decisions and establishment
decisions in which marginal costing and other techniques prove their role.
9.2 Meaning and Nature of Decision Making
Decision making is a process in which the best course of action is selected to get desirable results.
According to D.E. MC Forland “A decision is an act of choice when in an executive forms a conclusion
about what must not be done in a given situation.” A decision represents a course of behaviour chosen from
a number of possible alternatives. Decision is a dynamic process, it is a process of defining the problem,
identifying the possible alternatives and evaluating each alternative to get best course of action. It includes
forecasting too. It cannot be specified by any formula, it includes risk, uncertainty and opprotunity of action.
Stages of Decision Process :
1. Identifing the problem : First of all it is necessary to identify the problem in the correct Perspective.
2. Analysing the problem : Now the next step is to analyse the various aspects of the problem. It is
necessary to collect additional information, which is useful in decision making.
3. Identifying various alternatives : The next step is to develop the possible ways to take best
decision. It can be developed by a team which consists of experts in that field.
4. Screening the alternatives : After developing possible alternatives these should be screened on the
basis of risk, economy, timing and limitation of resources.
5. Considering non-cost factors : It is necessary to consider various non-cost factors, which will
affect the decision.
6. Making a decision : Now the best alternative is chosen on the basis of its merits.
7. Implementing and following the decision-Implementation is the important phase in decision making.
Practical efficacy of decision can be measured after implementing it.
9.3 Financial and Non-financial Considerations
Financial factors: During the course of decision making necessary facts are collected for each
alternative in numerical form or in term of money. It is called as financial consideration. It includes
factors like cost, revenue and capital employed for each decision.
Costs useful while taking decisions : Imputed costs, opportunity cost, relevant and irrelevant
costs, out of pocket costs, sunk costs, postponable costs, discretionary costs, etc. The meaning of
each costs has already been discussed in unit eight.
Non-Financial factors: Some of the other factors, which are not measurable numerically, are also
considerable for a decision. These factors can not be measured, but they have considerable effect
for a decision. These are as follows:
1. Employee Morale
2. Health, safety and working conditions.
3. Government policies, Regulations, control and incentives.
4. Nature of industry.
5. Economic Environment.
6. Effect on relation with customer, government and general public.
7. Stability, quality and reliability.
Activity
1. In a sugar industry which is the most considerable non financial factor, while
taking decision?
2. ‘Differential costing is useful for decision making’. Discuss.
9.4 Techniques of Decision Making
There are two techniques viz. costing techniques and statistical techniques. We are considering here
only costing techniques which are as follows:
1. Marginal costing - Seperately discussed in unit 14.
2. Break - Even Analysis -Seperately discussed in unit 14.
3. Differential cost technique : Differential cost is the difference in cost between one alternative and
another. It is obtained by substracting the cost of one alternative from the cost of another alternative.
Normally the differential cost is synomymous with the variable costs of producing the specific num-
ber of units. It is useful in the following decisions:
1. Determining optimum level of production.
2. Further processing.
3. Adding or dropping a product line.
4. Replacement decisions.
9.4.1 Specific Decision : Pricing Decision
In general condition of the market pricing decision is based on cost and normal profit. But it is
regulate by market conditions and other economic factors. The marginal cost approach is useful while taking
this decision. Sometimes price can be fixed lower than the normal selling price or lower than the total costs,
but it cannot be less than marginal cost in any case. These specific conditions are: (1) Trade depression and
competition (ii) use of unutilised capacity (iii) export sale decisions, (v) acquiring new customer.
Sometimes the pricing decision can be taken at lower than the marginal cost, but it should be for
very short term period. In the following conditions, such type of decisions can be taken (i) to dispose of
perishable goods (ii) to explore new market (iii) to aid new product in market (iv) to eliminate the competi-
tors from the open market.
Illustration: Marginal cost is Rs. 7 per unit, fixed cost is Rs. 1,00,000, selling price per unit is Rs. 8 and
50,000 units can be sold at this price. Say whether the decision of selling the product should be taken.
Solution:
(i) When 48000 kg of material is available, optimum production mix will be in sequence of B,C and
A on the basis of contribution per kg.
Full production of B 900 unit X 12 kg. = 10800 kg
Full production of C 800 units X 30 kg = 24000 kg
Remaining material (48000 - 34800) = 13200 kg
13200kg.
will be used for productionof A 660 units
20 kg.
Hence when material is in short supply, to get maximum profit 900 units of B, 800 units of C and
660 units of A should be produced.
(ii) If 9200 hours are available, optimum production mix will be in sequence of C, A and B (on the
basis of contribution per hr.) :
Full Production of C 800 units X 4 hrs. = 3200 hrs.
Full Production of A 1400 Units X 3 hrs. = 4200 hrs.
Remaining hours (9200-7400) = 1800 in the
1800 hrs
productionof B producti.e. 660 units
5 hrs.
Hence when raw material is in short supply, to get maximum profit 800 units of C, 1400 units of A
and 360 units of B should be produced.
9.4.3 Specific Decision: Make or Buy
Marginal costing renders useful assistance when a decision has to be taken by the management
whether a component should be manufactured internally to fulfil the idle capacity or purchased from the
open market. For such a decision marginal cost to make is compared with buying cost. If marginal cost is
less than buying cost, the decision taken is to make the component otherwise not we can learn it by follow-
ing example:
Illustration
Product M takes 20 hours on machine No. 51 It has a selling price of Rs. 150 and Direct material,
Direct wages and Variable overhead per unit are Rs. 50, 40 and 20 only. A component Y could be made on
machine No. 51 in 4 hours. The marginal cost of component is Rs. 9 and if it is purchased supplier price is
Rs. 15 per component.
Should one make or buy Y component. Assume machine hour is the key factor and there is no
unutilised capacity.
Solution
Contribution per unit of M product = [150-(50+40+20)] = Rs. 40
Rs. 40
Contribution per machine hour : Rs. 2 per hr
20 hrs.
If component Y takes 4 hours, the loss of contribution is Rs. 8 (i.e. 4 hrs. X Rs. 2). Hence total cost
of component will be Rs. 9 + 8 = Rs. 17. Hence it is better to buy it. If however, there was some unutilised
capacity, then there should be no loss of contribution and then decision of making is beneficial.
9.4.4 Specific Decsion : Profit Planning
Marginal costing is quite a useful technique in planning profit through cost - volume profit analysis
while taking such decisions the manager requires a thorough knowledge about inter-relationship of selling
prices, sales volume, variable costs and fixed costs. We can learn this by taking the following example. :
Illustration
A company is producing 60,000 pieces at 60 % capacity at a selling price of Rs. 14.50 per piece.
The cost details are as follows :
Direct material Rs. 4 per piece, Direct wages Rs. 1 per piece, factory overhead Rs. 6 per piece
(50% fixed), selling overhead Rs. 1 per piece (75% fixed.)
During the current year, he intends to produce the same number of units, but anticipates that (a)
fixed cost will go up by 10% (b) material and wages will go up by 5% each, (c) minumum profit Rs.
1,50,000 is required, what minimum selling price would you reommend?
Solution : Statement showing Marginal cost
Products A B C D
Sales revenue after further processing 1,20,00,000 40,00,000 60,00,000 48,00,000
(-) Sales revenue at split-off point 20,00,000 12,00,000 20,00,000 28,00,000
Incremental sales revenue 1,00,00,000 28,00,000 40,00,000 20,00,000
(-) Further processing cost 80,00,000 32,00,000 30,00,000 36,00,000
Profit/Loss arising due to further 20,00,000 (4,00,000) 10,00,000 (16,00,000)
Processing
Suggestion : From the above analysis product A & C should be further processed but product B & D
should be sold at split-off point.
(ii) Income Statement at best profitable situation:
Products A B C D Total
At 80% level of production, the profit is maximum becuase incremental revenue is higher than
differential costs upto this level only. After 80% level differential cost exceeds incremental revenue thereby
resulting in a loss.
9.4.8 Specific Decision : Adding or Dropping a Product Line
In a multi-product production unit, the management may have to decide on adding or dropping a
product line. If a new product line is added, its sales and certain costs will also be increased and the reverse
will happen when a product line is dropped. In order to arrive at a decision a comparative profit statement
should be prepared for both the conditions. It is explained by the following example.
Illustration :
The management of a company is thinking whether it should drop product ‘B’ due to less
contribution and replace it with another. Given below are cost and output data.
Product Sales price per unit (Rs.) Variable costs per unit (Rs.) Percentage ofSales
A 60 40 30%
B 100 60 20%
C 200 120 50%
Total fixed costs for the year Rs. 7,00,000
Total sales Rs. 25,00,000
If product ‘B’ is dropped a new product ‘D’ can be introduced, the manufacturer forecasts the following
cost and output data :
Product Sales price per unit (Rs.) Variable costs per unit (Rs.) Percentage ofSales
A 60 40 50%
C 200 120 10%
D 160 100 40%
Total fixed costs for the year Rs. 7,00,000
Total sales Rs. 27,00,000
Is this proposal to be accepted ?
Comparative Profit Statement
10.0 Objectives
After studying this unit you should be able to understand:
The concept and features of process costing.
Advantages and limitations of process costing.
Preparing Process Account when there is no loss and no stock
Treatment of wastage and scrap.
Preparing Process Accountwhen normal, abnormal loss and abnormal gain is given
Treatment of fully completed stock.
Methods of accounting joint products and by products.
Calculation of unrealised profit.
Valuation of work-in-progress under FIFO method and weight average cost method.
10.1 Introduction
Process costing is used where the production moves from one process or department to next until
its final completion. There is a continuous production of identical units through a series of processing
operations. Process is a check entity of an industrial unit in which specific work is done through the various
well defined stages of production. This method of cositng is used to know the cost of product in each
process. A standard product passes through various stages of production called as processes. It is also
called as continuous costing or average costing.
10.2 Definition and Characteristics
CIMA defines “The costing method is applicable to where goods or services result from a
sequence of continuous or repetitive operations or processes Costs are averaged over the units produced
during the period.” It is a method of costing in which costs are accumulated for each independent but inter
related process. It is used in such industries where the material has to pass through two or more processes
for being converted into final shape. This method of costing is useful in manufacturing concerns like steel,
soap, chemicals, varnish, cotton textiles, oil refinery etc.
Charecteristics : The distinctive features are as follows :
1. Factory is divided into a number of processes, which will be called as cost centres.
2. All the costs of each cost centre are accumulated.
3. Manufacturing activity is carried on continuously by means of one or more process as run
sequentially.
4. Each process has its own ledger, in which costs are charged.
5. The output of one process becomes input of another process till it become the final product.
6. Appropriate method is used in absorption of overheads to each cost centre i.e. process.
7. The total costs of each process are averaged over the total production of that process.
8. Normally output at the end may be a single product or a by product or a joint product.
Process B Account
Particulars Unit Amount Particulars Unit Amount
Rs. Rs.
To Process A (Transfer) - - By Transfer to
To Direct Materials - Finished stock* - -
To Direct Labour -
To Direct Expenses -
To Factory Overhead
- - - -
*It is assumed that there are two processes only if; there are more processes then instead of “Transfer to
finished sotck” “Transfer to next Process” will be shown.
Finshied Stock Account
Particulars Unit Amount Particulars Unit Amount
Rs. Rs.
To Process B (Transfer) - - By Sales - -
To Profit & Loss A/c (B/F) - By Profit & Loss Account
(if any) (B/F) -
- - - -
- - - -
Process X Account
Particulars U n it A m ount. Pa rticulars Unit Am o un t.
Rs. R s.
T o U nits introd uced 50 0 0 50 ,0 00 B y No rm al W astage 2.5 0 450
T o M aterial - 20,0 00 B y Ab no rm al w astage 50 890
T o W ages - 10,0 00 B y Transfer to Pro cess 4 ,70 0 83 ,660
T o M an ufactu rin g Ex p - 5,0 00 Y A ccou nt @ Rs. 1 7.8 0
5,000 85,0 00 5 ,00 0 85 ,000
Normal cost
Cost of Abnormal Loss Units of abnormal loss
Normal output
(50,000 20,000 10,000 5,000 - 450)
Cost of Abnormal Loss 50 Rs. 890
5,000 - 250
Process Y Account
Particulars Unit Amt. Particulars Unit Amt.
Rs. Rs.
To Transfer from Process ‘X’ 4,700 83,660 By Normal Wastage 470 940
To Material 15,000 By Transfer to finished 4,300 1,07,500
To Wages 5,000 Stock A/c @ Rs. 25
To Manufacturing Expenses 3,030
To Abnormal gain @ Rs. 25 70 1,750
4,770 1,08,440 4,770 1,08,440
(83,000 15,000 5,000 3030 - 940)
Cost of Abnormal Loss 70 Rs. 1750
4700 - 470
Process Loss Account
Particulars Unit Amt. Particulars Unit Amt.
Rs. Rs.
To Process X Account 50 890 By Cash (Sales) @ Rs. 1.80 50 90
By Costing P & L A/c (B/f) - 800
4,770 1,08,440 4,770 1,08,440
Process Gain Account
Particulars Unit Amt. Particulars Unit Amt.
Rs. Rs.
To Normal Wastage 70 140 By Process Y Account 70 1750
Costing P & L A/c (B/f) - 1610
70 1750 70 1750
Activity
Write one major distinction between Joint & By Products.
Closing stock of finished goods amounts to Rs. 1,40,000. The remaining goods were sold for Rs.
12,60,000. Show also the actual realised profit, which is to be transferred to Profit and Loss Account.
Assume that stock in each process has been valued at prime cost.
Solution :
Process ‘A’ Account
Particulars Cost Profit Total Particulars Cost Profit Total
Rs. Rs. Rs. Rs. Rs. Rs.
To Materials 140000 - 140000 By Process 280000 70000 350000
To Wages 210000 - 210000 ‘B’ A/c
Prime Cost 350000 - 350000
(-) Closing Stock 70000 - 70000
280000 - 280000
To P&L A/c - 70000 70000
(25% on cost) 280000 70000 350000 280000 70000 350000
6,30,000
Process ‘ B’ cost 1,40,000 Rs. 1,26,000
7,00,000
Profit = (1,40,000 - 1,26,000) = Rs. 1,4000
8,54,000
Process ‘ C’ cost 2,10,000 Rs. 1,70,800
10,50,000
Profit = (2,10,000 - 1,70,800) = Rs. 39,200
6,83,200
Process ‘ C’ cost 1,40,000 Rs. 91,093
10,50,000
Profit = (1,40,000 - 91,093) = Rs. 48,907
The profit (in finished stock A/c) has been calculated after deducting Rs. 10,50,000 out of Rs.
14,00,000 (total of credit side of finished stock a/c = Rs. 14,00,000, After writing this on debit side of
finished stock a/c as Total now B/F “To P&L A/c.Total of debit side of all the three columns of finished
stock A/c is shown as total of credit side of the same account. Hence difference is cost of sale and profit on
sales.
Total Profit = Process A + B+C+Finished stock A/c
70,000+1,40,000+2,10,000+3,50,000 = Rs. 7,70,000
Unrealised Profit : Rs.
Profit in closing stock of Process A Nil
Profit in closing stock of Process B 14,000
Profit in closing stock of Process C 39,200
Profit in closing stock of Process D 48,907
1,02,107
10.10 Equivalent Production
Equivalent production units represent the output of a process in terms of completed units. The
continuous nature of process implies that there always exists opening and closing work in progress. The
percentage of completion with regard to material, wages and overheads are not 100% on these incompleted
units. Hence equivalent units should be calculated seperately, so as to calculate cost per completed unit.
When work-in-progress and its degree of completion is given, the following statements are
prepared:
Step I - Statement of Equivalent Production
Step II- Statement of cost per Equivalent Unit
Step III - Statement of Apportionment of cost incurred during the period.
Step IV - Process Account : It is prepared either by using FIFO method or weighted Average cost method.
In FIFO method it is assumed that opening WIP units are completed and transferred first and then the
current period production is completed and transferred. In average cost method opening WIP costs are
combined with the current period costs. Hence for determination of average cost, both costs are included
and then the average rate is obtained.
These steps can be learnt through the following example;
Illustration
From the following information prepare : (a) Statement of Equivalent Production (b) Statement of
cost per Equivalent Unit (c) Statement of Apportionment (d) Process B Account.
The following data relates to process ‘B’
(i) Opening work-in-Progress 4,000 units.
degree of completion : Materials (100%)Rs. 24,000
Labour (60%) Rs. 14,400
Overhead (60%) Rs. 7,200
(ii) Received during month of June from process A 40,000 units Rs. 1,71,000
(iii) Expenses incurred in process ‘B’ during the month : Materials Rs. 80,000, Labour Rs. 1,38,230,
overheads Rs. 69,120
(iv) Closing work-in-progress 3,000 units.
Degree of Completion : Materials 100%, Labour and overhead 50%.
(v) Unit scrapped - 4,000
Degree of Completion : Materials 100%, Labour and overheads 80%.
(vi) Normal Loss : 5% of current input
(vii) Scrap realised Rs. 2.00 each
(viii) Completed units are transferred to warehouse, Use FIFO method.
Solution
(A) Statement Showing Equivalent Units
Input Particulars Output Equivalent Production
Materials Labour Overheads
% Units % Units % Units
4,000 Opening WIP 4,000 - - 40 1,600 40 1,600
40,000 Completed & Transferred
to warehouse 33,000 100 33,000 100 33,000 100 33,000
Closing WIP 3,000 100 3,000 50 1,500 50 1,500
Normal Loss 2,000 - - - - - -
Abnormal Loss 2,000 100 2,000 80 1,600 80 1,600
Equivalent Units 38,000 37,700 37,700
44,000 44,000
(C) Statement of Apportionment
Total Cost Cost per
Unit
Rs. Rs.
Materials Cost
From Previous process 1,71,000
Introduced 80,000
(-) Sale of normal loss(2 X 2,000) 4,000 76,000
2,47,000 / 38,000 2,47,600 6.50
Labour 1,38,230
Overheads 69,120
2,07,350 / 37,700 2,07,350 5.50
12.00
(A) Total cost of 37,000 completed units transferred to warehouse:
Opening WIP cost Rs. 45,600
Labour and overheads (1,600 X 5.50) Rs. 8,800
Completed Units (33,000 X 12) Rs. 3,96,000
Rs. 4,50,400
(B) Cost of Closing WIP
Materials (3,000 X 6.50) Rs. 19,500
Wages and overheads (1,500 X 5.50) Rs. 8,250
Rs. 27,750
(C) Cost of Abnormal loss
Materials 2,000 X 6.50 13,000
Wages and overheads 1,600 X 5.50 8,800
21,800
(D) Process ‘B’ Account
Particulars Units Amount Particulars Units Amount
Rs. Rs. Rs.
To Opening WIP 4,000 45,600 By Normal Loss 2,000 4,000
To Transfer from ‘A’ 40,000 1,71,000 By Completed Units 37,000 4,50,400
To Materials - 80,000 By Closing WIP 3,000 27,750
To Wages - 1,38,230 By Abnormal Loss 2,000 21,800
To Overheads - 69,120
44,000 5,02,950 44,000 5,02,950
10.11 Summary
Processing costing is applicable where production moves from one process to the next until final
output comes out. It is used basically in industries like chemicals, oil refining, textile etc., The costs are
accumulated to each process. The unit cost is the average cost of process for a given period. The process
losses may arise and it is categorised into Normal Loss, Abnormal Loss. If output of one process in trans-
ferred to another at the market price, then closing stock of each process is valued at market price, hence
profit of current year increases hypothetically. A provision for unrealised profit is made for such. When there
is work-in-progress at the end, the WIP is converted into equivalent fully completed units so as to derive
correct cost of production. When two or more products arise simultaneously in the course processing and
has a significant sale value, it is called “joint products”. Where a product which arises incidentlly and has a
relatively small value in comparison of the main product is called as “by-product.”
11.0 Objectives
After studying this unit you should be able to understand:
Meaning of management accounting
Relationship of management accounting to cost accounting and financial accounting
Origin of management accounting
Characteristics and Scope of management accounting
Functions and tools and techniques of management accounting
Limitations of management accounting
11.1 Introduction
Accounting is being used in the business world and is in existence in some from since the inception
of business. When the business grew in size and became complex, accounting began to take a systematic
shape. In the changed business scenario, various new requirements such as further planning, evaluation of
plan and policies, cost control, delegation of authority and responsiblity, timely decisions etc. have emerged
on account of increasing size of business, increased production level, technical complexities, government
interference and public awareness towards social responsibilities of industries. Management Accounting
has originated to serve the managers and to assist them in meeting their needs. Management Accounting is
not a separate accounting. It is only the use of accounting in solving the problems of management and taking
timely decision.
ANALYSING COST
COST
FOR CONTROL &
MAXIMISING ACCOUNTING
EFFICIENCY
ASSISTING
MANAGEMENT FOR MANAGEMENT
PLANNING DECISION ACCOUNTING
MAKING & CONTROL
11.4 Nature
It is clear from the definitions of management accounting that it is concerned with accounting data
that is useful in decision making. The main characteristics of management accounting are as follows:
1. Useful in decision making: The essential aim of management accounting is to assist management
in decision making and control. It is concerned with all such information which can prove useful to
management in decision making.
2. Financial and cost accounting information: Basic accounting information useful for management
accounting is derived from financial and cost accounting records.
3. Internal use: Information provided by management accounting is exclusively for management for
internal use. Such information is not to be given to parties external to the business like shareholders,
creditors, banks, etc.
4. Purely optional: Management accounting is a purely voluntary technique and there is no statutory
obligation. Its adoption by any firm depends upon its utility and desirability.
5. Concerned with future: As management accounting is concerned with decision making, it is related
with the future because decisions are taken for future course of action and not the past.
6. Flexibility in presentation of information: Unlike financial accounting, in management accounting
there are no prescribed formats for presentation of information to the management. The form of
presentation of information is left to the wisdom of the management accountant who decides which
is the most useful format of providing the relevant information, depending upon the utility of each
type of form and information.
Activity
Management Accounting is useful for ....................................
11.5 Scope
Management accounting has a very wide scope. It includes not only financial accounting and cost
accounting but also all types of internal financial controls, internal audit, tax accounting, office services, cost
control and other methods and control procedures. Thus scope of management accounting, inter alia includes
the following:
1. Financial accounting: Financial accounting provides basic historical data which helps the
management to forecast and plan its financial activities for the future. Thus for an effective and
successful management accounting, there should be a proper and well designed financial accounting
system.
2. Cost Accounting: Many of the techniques of cost control like standard costing and budgetary
control and techniques of profit planning and decision making like marginal costing, CPV analysis
and differential cost analysis are used by the management accounting.
3. Budgeting and forecasting: In order to plan business activities for the future, forecasting and
budgeting play a very significant role. Forecasting helps in the preparation of budgets and budgeting
helps management accountant in exercising budgetary control.
4. Tax planning: In order to take advantage of various provisions of tax laws, management accountant
has to depend upon tax accounting and planning to minimize its tax liabilities and save more funds
for the business.
5. Reporting to management: For effective and timely decisions, there should be a system of prompt
and intelligent reporting to management. But routine and special reports are prepared for submission
to top management, middle order management and operating level management depending on their
requirements.
6. Cost control procedures: Any system of management accounting is incomplete without effective
cost control procedures like inventory control, labour control, overhead control, budgetary control,
etc.
7. Statistical tools: Various tools of analyzing and presenting statistical data like graphs, tables, charts,
etc., are used in preparing reports for use by the management.
8. Internal control and internal audit: Management accountant heavily depends on internal financial
controls like internal audit and internal check to plug loop holes in the financial system of the concern.
9. Financial analysis and interpretation: Management accountant employs various techniques to
analyse and interpret financial data to make it understandable and useable to the management. Such
analysis helps management to achieve objectives of management in a more efficient manner.
10. Office services: Management accountant is expected to maintain and control office routines and
procedures like filing, copying, communicating, electronic data processing and other allied services.
11.6 Functions
The main functions of management accounting are as follows:
1. Planning: Information and data provided by management accounting helps the management to
forecast and prepare short-term and long-term plans for the future activities of the business and
formulate corporate strategy. For this purpose management accounting techniques like budgeting,
standard costing, marginal costing, probability, correlation and regression, etc. are used.
2. Coordinating: Management accounting techniques of planning also help in coordinating various
business activities. For example, while preparing budgets for various departments like production,
sales, purchases, etc., there should be full coordination so that there is no contradiction. By proper
financial reporting, management accounting helps in achieving coordination in various business
activities and accomplishing the set goals.
3. Controlling: Controlling is a very important function of management and management accounting
helps in controlling performance by control techniques such as standard costing, budgetary control,
control ratios, internal audit, etc.
4. Communication: Management accounting system prepares reports for presentation to various
levels of management which show the performance of various sections of the business. Such
communication in the form of reports to various levels of management helps to exercise effective
control on various business activities and successfully running the business.
5. Financial analysis and interpretation: In order to make accounting data easily understandable,
the management accounting offers various techniques of analyzing, interpreting and presenting this
data in non-accounting language so that every one in the organisation understands it. Ratio analysis,
cash flow and funds flow statements, trend analysis, etc., are some of the management accounting
techniques which may be used for financial analysis and interpretation.
6. Qualitative information: Apart from monetary and quantitative data, management accounting
provides qualitative information which helps in taking better decisions. Quality of goods, customers
and employees, legal judgements, opinion polls, logic, etc., are some of the examples of qualitative
information supplied and used by the management accounting system for better management.
7. Tax policies: Management accounting system is responsible for tax policies and procedures and
supervises and coordinates the reports prepared by various authorities.
8. Decision-making: Correct decision-making is crucial to the success of a business. Management
accounting has certain special techniques which help management in short-term and long-term
decisions. For example, techniques like marginal costing, differential costing, discounted cash flow,
etc., help in decisions such as pricing of products, make or buy discontinuance of a product line,
capital expenditure, etc.
Activity
Specify any two tools & techniques used in Management Accounting.
11.8 Limitations
Management accounting is a very useful tool of management. However, it suffers from certain
limitations as stated below:
1. Based on historical data: Management accounting helps management in making decisions for the
future but it is mainly based on the historical data supplied by financial accounting and cost accounting.
This implies that historical data is used for making future decisions. The accuracy and dependability
of such data will leave their mark on the quality of management decisions. In other words, if past
data is not accurate, management decisions may not be correct.
2. Lack of wide knowledge: The management accountant should have knowledge of not only financial
and cost accounting but also many allied subjects like economics, management, taxation, statistical
and mathematical techniques, etc. Lack of knowledge of these subjects on the part of management
accountant limits the quality of management accounting.
3. Complicated Approach: Management accounting provides mass of data using various accounting
and non-accounting subjects for decision making purpose. But sometimes management avoids this
complicated and lengthy course of decision making and makes decisions based on intuition. This
leads to unscientific approach to decision making.
4. Not a substitute of management: Management accounting only provides information to
management for decision making but it is not a substitute of management and administration.
5. Costly system: The installation of management accounting system in an organisation is a costly
affair as it requires a wide net-work of management information system, rules and regulations. All
this requires heavy investment and small concerns may not be able to afford it.
6. Developing stage: Management accounting is a relatively recent development and it has not fully
developed as yet. This limits the utility of this system to management in making perfect and correct
decisions.
7. Lack of objectivity: The interpretation of information provided by management accounting may
be influenced by personal bias of the interpreter of data. This tells upon the quality of managerial
decisions.
8. Resistance from staff: The existing accounting and management staff may not welcome the
introduction of management accounting system. This may be because they look at the system with
suspicion that it will add to their work and responsibilities.
11.9 Summary
Management accounting has originated to serve the managers and to assist them in meeting their
needs. In due course of time, accounting was being used as management tool and that in now-a-days called
“management accounting”. It was developed as branch of accounting but separate from financial accounting.
Though management accounting is not a separate accounting, it is only the use of accounting in solving the
problems of management and taking timely decisions.
Financial Accounting Financial Accounting is mainly concerned with recording business transaction
in the books of accounts for the purpose of presenting final accounts.
Cost Accounting Cost Accounting is a branch of accounting which specializes in providing
information about the detailed cost of products or services being supplied by the undertaking.
Management Accounting Management Accounting denotes every accounting technique which
may be useful to management in discharging its function viz planning, organising, directing co-
ordinating, comunicating and controlling.
12.0 Objectives
By the end of this unit you should be able to:
Describe the nature and purpose of standard costing;
Identify the main steps involved in implementing and operating a standard costing system;
Calculate standard costing performance measures;
Calculate sales, direct materials, direct labour, variable overhead, and fixed overhead variances;
Prepare a standard cost operating statement;
Outline the importance of standard costing and variance analysis.
12.1 Introduction
Costing is the determination of the value of resources used for specified goods or services. The
major purposes of costing are:
First to determine what amount of resources were required to provide the goods or services.
Second is to help to resource usage through the use of budgets that clearly identify managers’ work
responsibility. It is the second purpose that is considered in the following discussion:-
Methods of Costing Identified in Budgets
Budget figures may be based on actual, budgeted, or standard costs. These categories are not
mutually exclusive. For example, while a standard cost is a budgeted cost, a budgeted cost is not always a
standard cost. An actual cost may or may not be the budgeted cost.
Budgets based on actual costs reflect expense anticipated or planned for the level of resource use.
Budgeted costs are generally described as the best estimate or planning about what should be allowed for
next or upcoming activity. To establish budgeted costs, actual costs of the previous year, information from
department heads about where resources might be more efficiently and effectively used, and the decision
about the need to save resources are often considered. The main object of standard costs is to calculate the
costs that reflect the effective and efficient use of resources.
12.2 Need of Standard Costing
Standard costing is an important subtopic of cost accounting. Standard costs are usually associated
with a manufacturing company’s costs of direct material, direct labor, and manufacturing overhead. Standard
costs are costs established through identifying an objective relationship between specified inputs and budgeted
outputs.
Rather than assigning the actual costs to resources (direct material, direct labor) and manufacturing
overhead to a product, many producers assign the standard cost. This means that a manufacturer’s stock
and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a
product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always
differences between the actual costs and the standard costs, and those differences are known as variances.
Standard costing and the related variances is a valuable management tool. If a variance arises,
management becomes aware that manufacturing costs have differed from the standard (budgeted, expected
or planned) costs.
If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance
tells management that if everything else remains stable the company’s actual profit will be less than
planned.
If actual costs are less than standard costs the variance is favorable. A favorable variance tells
management that if everything else remains stable the actual profit shall be more than the planned
profit.
Variance analysis is usually associated with explaining the difference (or variance) between actual
costs and the standard costs allowed for the standard output. For instance, the difference in materials costs
can be divided into a materials price variance and a materials usage variance. The difference between the
actual direct labor costs and the standard direct labor costs can be divided into a rate variance and an
efficiency variance. The difference in manufacturing overhead can be divided into spending, efficiency, and
volume variances. Mix and yield variances can also be calculated. All theses variances are explained in
detail in this chapter.
Variance analysis helps management to understand the present costs and then to plan and control
future costs.
Variance analysis is also used to explain the difference between the actual sales and the budgeted
sales. Examples include sales price variance, sales quantity (or volume) variance, and sales mix variance
The sooner that the accounting system reports a variance, the sooner that management can direct its
attention to the difference from the planned amounts.
Usually there will be two variances computed for each input:
*The cotton comes on rolls that are one meter wide, so one meter (mts.) of cotton is the same as one square
meter of cotton.
The pants are easy to produce, and no pants are ever left unfinished at the end of any given day.
This means that your company never has work-in-process inventory.
12.5 Types of Variances
Direct Materials Purchased: Standard Cost and Price Variance
Direct materials refers to raw materials that are directly and clearly identifiable into a product. In
your pants business the direct material is the cotton. (In a food manufacturer’s business the direct materials
are the ingredients such as flour and sugar etc.)
Cotton Works purchases its cotton from a local supplier with terms of net 30 days, FOB destination.
This means that ownership to the cotton passes from the seller to Cotton Works when Cotton Works
receives the material. When the cotton arrives, Cotton Works will account the cotton received in its Direct
Materials Inventory at the standard cost of Rs.3 per meter (see standards table above) and will record the
liability at the actual cost for the amount received. Any difference between the standard cost of the material
and the actual cost of the material received is recorded as a purchase price variance.
Examples of Standard Cost of Materials and Price Variance
Let’s assume that on January 2, 2010 Cotton Works placed an order for 1,000 meters of cotton at
Rs.2.90 per meter. On January 8, 2010 CottonWorks receives 1,000 meters of cotton and an invoice for
the actual cost of Rs.2,900. On January 8, 2010 Cotton Works becomes the owner of the material and has
a liability of payment to the seller. On January 8 Cotton Works’ Direct Materials stock is increased by the
standard cost of Rs.3,000 (1,000 meters of cotton at the standard cost of Rs.3 per meter), Accounts
Payable is credited for Rs.2,900 (the actual amount owed to the supplier), and the difference of Rs.100 is
credited to Direct Materials Price Variance. In journal format the entry looks like this:
Date Account Name Debit Credit
The Rs.100 credit to the price variance account shows immediately (when the cotton arrives) that
the company is experiencing actual costs that are more favorable than the planned, standard cost.
In February, Cotton Works orders 3,000 meters of cotton at Rs.3.05 per meter. On March 1,
2010 Cotton Works receives the 3,000 meters of cotton and an invoice for Rs.9,150 due in 30 days. On
March 1, the Direct Materials Inventory account is increased by the standard cost of Rs.9,000 (3,000
meters at the standard cost of Rs.3 per meter), Accounts Payable is credited for Rs.9,150 (the actual cost
of the cotton), and the difference of Rs.150 is debited to Direct Materials Price Variance as an unfavorable
price variance:
Date Account Name Debit Credit
After the March 1 posting for transaction is done, the Direct Materials Price Variance account
shows a debit balance of Rs.50 (the Rs.100 credit on January 2 combined with the Rs.150 debit on March
1). A debit balance in a variance account is always unfavorable which shows that the total of actualcosts is
higher than the total of the planned standard costs. In other words, the company’s profit will be Rs.50 less
than expected unless you take some action to rectify the variance.
On June 1 your company receives 3,000 meters of cotton at an actual cost of Rs.2.92 per meter for
a total of Rs.8,760 due in 30 days. The entry is:
Date Account Name Debit Credit
Direct Materials Inventory is debited for the standard cost of Rs.9,000 (3,000 meters at Rs.3 per
meter), Accounts Payable is credited for the actual amount owed, and the difference of Rs.240 is credited
to Direct Materials Price Variance. A credit to the variance account indicates that the actual cost is less than
the standard cost.
After this transaction is recorded, the Direct Materials Price Variance account shows an overall
credit balance of Rs.190. A credit balance in a variance account is always favorable. In other words, your
company’s profit will be Rs.190 greater than planned due to the favorable cost of direct materials.
Direct Materials Usage Variance
Under a standard costing system, production and stocks are reported at the standard cost—including
the standard quantity of direct materials that should have been used to make the products. If the manufacturer
actually uses more direct materials than the standard quantity of materials for the products actually
manufactured, the company will have an unfavorable direct materials usage variance. If the quantityof direct
materials actually used is less than the standard quantity for the products produced, the company will have
a favorable usage variance. The amount of a favorable and unfavorable variance is recorded in a general
ledger account Direct Materials Usage Variance. (Alternative account titles include Direct Materials
Quantity Variance or Direct Materials Efficiency Variance.) Let’s understand this variance with the following
information.
January 2010
In order to calculate the direct materials usage or quantity variance, we start with the number of acceptable
units of products that have been manufactured. At Cotton Works this is the number of pants physically
produced. If Cotton Works produces 100 large pants and 60 small pants during January, the production
and the finished goods inventory will begin with the cost of the direct materials that should have been used
to make those pants. Any difference will be a variance.
NOTE: We are not determining the quantity of pants that Cotton Works should have made. Rather, we are
determining whether the 100 large pants and 60 small pants that were actually manufactured were produced
efficiently i.e. proper use of inventory and other resources. In the case of direct materials, we want to
determine whether or not the company used the proper amount of cotton to make the 160 pants that were
actually produced.
Standard costs are sometimes also termed as the “should be costs.” Cotton Works should be using
278 meters of cotton to make 100 large pants and 60 small pants as shown in the following table.
Large Small
Total
Pants Pants
Actual pants manufactured 100 60
2.0 1.3
Standard meters of cotton per pants manufactured
mts. mts.
Total standard meters of cotton for the actual good pants
78 278
manufactured—the number of meters of cotton that should 200
mts. mts.
have been used to make the good output
We determine the total standard cost of the cotton that should have been used to make the 160
pants by multiplying the standard quantity of cotton (278 meters) by the standard cost of a meter of cotton
(Rs.3 per meter):
Large Small
Total
Pants Pants
Total standard meters of cotton for the actual good 200 278
78 mts.
(pants) manufactured mts. mts.
Standard cost per meter Rs.3 Rs.3 Rs.3
Standard cost of cotton in the good output—the pants
Rs.600 Rs.234 Rs.834
actually produced in January
An stock account is debited for Rs.834; this is the standard cost of the direct materials component
in the pants manufactured in January 2010.
The Direct Materials Inventory account is reduced by the standard cost of the cotton actually
removed from the direct materials inventory. Let’s assume that the actual quantity of cotton removed from
the direct materials inventory and used to make the pants in January was 290 meters. Because Direct
Materials Inventory reports the standard cost of the actual materials on hand, we reduce the account
balance by Rs.870 (290 meters used Rs.3 standard cost per meter). After removing 290 meters of materials,
the balance in the Direct Materials Inventory account is Rs.2,130 (710 meters x Rs.3 standard cost per
meter).
The Direct Materials Usage Variance is: [the standard quantity of material that should have been
used to make the good output less the actual quantity of material used] X the standard cost per meter.
In our example, Cotton Works should have used 278 meters of material to make 100 large pants
and 60 small pants. Because the company actually used 290 meters of cotton, we say that Cotton Works
did not operate efficiently—an extra 12 meters of cotton was used (278 vs. 290 = 12). When we multiply
the 12 meters by the standard cost of Rs.3 per meter, the result is an unfavorable direct materials usage
variance of Rs.36.
Let’s put the above information into a format commonly used for computing variances:
Direct Materials Usage/Quantity/Efficiency Variance Analysis
1. Debit Inventory-FG
for the standard meters 2. Credit Direct
3. Direct Material
of cotton that should Materials Inventory
Usage Variance
have been used to make for the actual meters
(Std Yd - Act Yd) x
the good output x the of cotton used x the
Std Cost
standard cost per standard cost per
meter of cotton meter of cotton
Std Yd x Std Cost Act Yd x Std Cost Difference
278 std yd x Rs.3 290 act yd x Rs.3 (12 yd) x Rs.3
Rs.834 Rs.870
Rs.36 Unfavorable
The journal entry for the direct materials portion of the January production is:
Date Account Name Debit Credit
February 2010
Let’s assume that in February 2010 CottonWorks produces 200 large pants and 100 small pants
and that 520 meters of cotton are actually used. From this information we can compute the following:
L a r ge S m a ll
T o ta l
P a n ts P a n ts
A ct u a l pa nt s m an u f act ur ed 2 00 1 00 30 0
S ta n d ard m ete rs o f co tt o n p er p an ts m a nu fa ctu re d 2 .0 m ts. 1 .3 m t s.
T ot al s tan da rd m e te rs o f co tt on for t he ac tua l p an ts
4 00 m t s. 1 30 m t s. 53 0 m ts .
m a nu fac tu red
S ta n d ard co st p er m et er R s.3 R s.3 R s.3
S ta n d ard co st o f co tto n i n th e g o o d ou tp ut R s.1 ,2 00 R s.3 90 R s .1 ,5 9 0
The journal entry for the direct materials portion of the February production is:
Assuming that the actual direct labor in January adds up to 50 hours and the actual hourly rate of
pay (including payroll taxes) is Rs.9 per hour, our analysis will look like this:
Direct Labor Variance Analysis for January 2010:
1. Debit Inventory-
2. Actual FG for the standard
hours of direct 3. Direct hours of direct labor
4. Credit Wages labor used x Labor that should have been
Payable for the 5. Direct Labor the standard Efficiency used to make the
actual direct Rate Variance hourly pay Variance(Std good output x the
labor cost. Act Hr x (Std rate Hr - Act Hr) x standard hourly pay
Rate - Act Rate) Std Cost rate.
Act Hr x Act Act Hr x Std
Difference Difference Std Hr x Std Rate
Rate Rate
50 act hr x
50 act hr x Rs.9 50 hr x Rs.1 (8 hr) x Rs.10 42 std hr x Rs.10
Rs.10
Rs.450 Rs.500 Rs.420
Rs.80
Rs.50Favorable
Unfavorable
In January, the direct labor efficiency variance (#3 above) is unfavorable because the company
actually used 50 hours of direct labor—this is 8 hours more than the standard quantity of 42 hours allowed
for the good output. The additional 8 hours is multiplied by the standard rate of Rs.10 to give us an unfavorable
direct labor efficiency variance of Rs.80. (The direct labor efficiency variance could be called the direct
labor quantity variance or usage variance.)
Note that Cotton Works paid Rs.9 per hour for labor when the standard rate is Rs.10 per hour.
This Re.1 difference—multiplied by the 50 actual hours—results in a Rs.50 favorable direct labor rate
variance. (The direct labor rate variance could be called the direct labor price variance.)
The journal entry for the direct labor portion of the January production is:
Date Account Name Debit Credit
Jan. 31, 2010 Inventory-FG 420
Direct Labor Efficiency Variance 80
Direct Labor Rate Variance 50
Wages Payable 450
February 2010
In February your company manufactures 200 large pants and 100 small pants. The standard cost of
direct labor for the good output produced in February 2010 is computed here:
Large Pants Small Pants Total
Actual pants manufactured 200 100
Standard hours of direct labor per pants
0.3 hr. 0.2 hr.
manufactured
Total standard hours of direct labor for actual
60 hr. 20 hr. 80 hr.
pants manufactured
Standard cost per direct labor hour incl. payroll
Rs.10 Rs.10 Rs.10
taxes
Standard cost of direct labor in the good output Rs.600 Rs.200 Rs.800
If we assume that the actual labor hours in February add up to 75 and the hourly rate of pay
(including payroll taxes) is Rs.11 per hour, the total equals Rs.825. The analysis for February 2010 looks
like this:
Direct Labor Variance Analysis for February 2010:
2. Actual hours 3. Direct Labor 1. Debit Inventory-FG
4. Credit Wages of direct labor Efficiency for the standard hours of
Payable for the 5. Direct Labor used x the Variance(Std direct labor that should
actual direct Rate Variance standard Hr - Act Hr) x have been used to make
labor cost. Act Hr x (Std hourly pay rate Std Cost the good output x the
Rate - Act Rate) standard hourly pay rate.
Act Hr x Act Act Hr x Std
Difference Difference Std Hr x Std Rate
Rate Rate
75 act hr x
75 act hr x Rs.11 75 hr x (Rs.1) 5 hr x Rs.10 80 std hr x Rs.10
Rs.10
Rs.825 Rs.750 Rs.800
Rs.75 Rs.50
Unfavorable Favorable
Notice that for the good output in February, the total actual labor costs amounted to Rs.825 and the total
standard cost of direct labor amounted to Rs.800. This unfavorable difference of Rs.25 agrees to the sum
of the two labor variances:
Direct labor efficiency variance Rs.50 Favorable
Direct labor rate variance Rs.75 Unfavorable
Total Direct Labor Variance Rs.25 Unfavorable
The journal entry for the direct labor portion of the February production is:
Date Account Name Debit Credit
Feb. 28, 2010 Inventory-FG 800
Direct Labor Rate Variance 75
Direct Labor Efficiency Variance 50
Wages Payable 825
Later in Part 5 we will discuss what to do with the balances in the direct labor variance accounts
under the heading "What To Do With Variance Amounts".
Variable Mfg Overhead: Standard Cost, Spending Variance, Efficiency Variance
"Manufacturing overhead costs" refer to any costs within a manufacturing facility other than direct
material and direct labor. Manufacturing overhead includes such things as indirect labor, indirect materials
(such as manufacturing supplies), utilities, quality control, material handling, and depreciation on the
manufacturing equipment and facilities.
"Variable" manufacturing overhead costs will increase in total as output increases. An example is the
cost of the electricity needed to operate the machines that cut and sew the cotton. Another example is the
cost of the manufacturing supplies (such as needles and thread) that increase when production increases. In
our example we assume that these variable manufacturing overhead costs fluctuate in response to the number
of direct labor hours. Recall the original estimates made when CottonWorks was formed:
Large Pants Small Pants
Time required to cut and sew 0.3 hr. (18 min.) 0.2 hr. (12 min.)
Electricity and supplies used per hour of Rs.2
labor
January 2010
Let's begin by determining the standard cost of variable manufacturing overhead for the good output
that CottonWorks produces in January 2010:
Recall that there were 50 actual direct labor hours in January. Let's assume that the actual cost for
the variable manufacturing overhead (electricity and manufacturing supplies) during January is Rs.90.
Our analysis will look like this:
Variable Manufacturing Overhead Analysis for January 2010:
1. Debit
2. Actual hours of Inventory-FG for
direct labor used x 3. Variable the standard hours
4. Actual variable the standard manufacturing of direct labor that
manufacturing 5. Variable variable overhead should have been
overhead used manufacturing manufacturing efficiency variance used in the good
overhead overhead rate (Std Hr - Act Hr) x output x the
spending variance Std Rate standard variable
Act Hr x (Std manufacturing
Rate - Act Rate) overhead rate
Act Hr x Act Rate Difference Act Hr x Std Rate Difference Std Hr x Std Rate
50 act hr x 50 act hr x
50 act hr x Rs.2 (8 hr) x Rs.2 42 std hr x Rs.2
Rs.1.80* Rs.0.20
Rs.90 Rs.100 Rs.84
Rs.10 Favorable Rs.16 Unfavorable
*Actual cost of Rs.90 divided by 50 actual hours.
Notice that for the good output produced in January, the actual cost of variable manufacturing
overhead was Rs.90 and the total standard cost of variable manufacturing overhead cost allowed for the
good output was Rs.84. This unfavorable difference of Rs.6 agrees to the sum of the two variances:
Variable manufacturing overhead efficiency variance Rs.16 Unfavorable
Variable manufacturing overhead spending variance Rs.10 Favorable
Total Variable Manufacturing Overhead Rs. 6 Unfavorable
Variable Manufacturing Overhead Efficiency Variance
As the above analysis shows, CottonWorks did not produce the good output efficiently-it used 50
actual direct labor hours instead of the 42 standard direct labor hours allowed.
The additional 8 hours no doubt caused the company to use additional electricity and supplies.
Measured at the originally estimated rate of Rs.2 per direct labor hour, this amounts to Rs.16 (8 hours x
Rs.2). This is referred to as an unfavorable variable manufacturing overhead efficiency variance.
Variable Manufacturing Overhead Spending Variance
In the analysis above, item 2 shows that based on the 50 direct labor hours actually used, electricity
and supplies could reasonably add up to Rs.100 instead of the standard of Rs.84. (If the good output took
8 actual direct labor hours more than the standard hours to cut and sew the cotton, the company will likely
have additional electricity and supplies costs since it is operating the machines for an additional8 hours.) We
find, however, that the actual cost of the electricity and supplies is Rs.90, not Rs.100. This Rs.10 favorable
variance indicates that the company did not spend the planned Rs.2 per direct labor hour. (Perhaps electricity
rates were lower than the rates anticipated when the standard costs were established.)
Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits
are made to accounts such as Accounts Payable. For example:
Date Account Name Debit Credit
Another entry records how these overheads are assigned to the product based on standard costs:
As our analysis notes above and these entries illustrate, CottonWorks has an actual variable
manufacturing overhead of Rs.90, but only Rs.84 (the standard amount) was applied to the products. The
Rs.6 difference is "explained" by the two variances:
Variable manufacturing overhead efficiency variance Rs.16 Unfavorable
Variable manufacturing overhead spending variance Rs.10 Favorable
Total Variable Manufacturing Overhead Rs. 6 Unfavorable
February 2010
Recall that in February 2010 the company produced 200 large pants and 100 small pants. We use
that good output to compute the standard cost of variable manufacturing overhead for February 2010:
Large Pants Small Pants Total
Actual pants manufactured 200 100
Standard hours of direct labor per good pants
0.3 hr. 0.2 hr.
manufactured
Total standard hours of direct labor in the good pants
60 hr. 20 hr. 80 hr.
manufactured
Standard cost of variable manufacturing overhead per
Rs.2 Rs.2 Rs.2
direct labor hour
Standard cost of variable manufacturing overhead in the
Rs.120 Rs.40 Rs.160
good output
Given that there were 75 actual direct labor hours in February and assuming that the actual cost for
the variable manufacturing overhead in February was Rs.156, our analysis will look like this:
Variable Manufacturing Overhead Analysis for February 2010:
1. Debit
2. Actual hours Inventory-FG for
of direct labor 3. Variable the standard
4. Actual variable used x the manufacturing hours of direct
manufacturing 5. Variable standard overhead labor that should
overhead used manufacturing variable efficiency have been used in
overhead manufacturing variance (Std Hr the good output x
spending variance overhead rate - Act Hr) x Std the standard
Act Hr x (Std Rate variable
Rate - Act Rate) manufacturing
overhead rate
Act Hr x Std
Act Hr Act Rate Difference Difference Std Hr x Std Rate
Rate
75 act hr x
75 hr x (Rs.0.08) 75 act hr x Rs.2 5 hr x Rs.2 80 std hr x Rs.2
Rs.2.08*
Rs.156 Rs.150 Rs.160
Rs.6 Rs.10
Unfavorable Favorable
Step 3. Compute the standard fixed manufacturing overhead rate to be used in 2010.
= Expected fixed manufacturing ÷ Expected total standard direct
overhead for 2010 labors hours (DLH) for 2010
= Rs.8,400 ÷ 2,100 Standard DLH
= Rs.4 per Standard Direct Labor Hour
NOTE:
One of the reasons a company develops a predetermined annual rate is that the rate is uniform
throughout the year, even though the number of units manufactured may fluctuate month by month.
For example, if the company used monthly rates, the rate would be high in the months when few
units are manufactured (monthly fixed costs of Rs.700 ÷ 100 units produced = Rs.7 per unit) and low when
many units are produced (monthly fixed costs of Rs.700 ÷ 350 units = Rs.2 per unit).
Fixed Manufacturing Overhead Budget Variance
The difference between the actual amount of fixed manufacturing overhead and the estimated amount
(the amount budgeted when setting the overhead rate prior to the start of the year) is known as the fixed
manufacturing overhead budget variance. In our example, we budgeted the annual fixed manufacturing
overhead at Rs.8,400 (monthly rents of Rs.700 x 12 months). If CottonWorks pays more than Rs.8,400
for the year, there is an unfavorable budget variance; if the company pays less than Rs.8,400 for the year,
there is a favorable budget variance.
Fixed Manufacturing Overhead Volume Variance
Recall that the fixed manufacturing overhead (such as the large amount of rent paid at the start of
every month) must be assigned to each pants produced. In other words, each pants must absorb a small
portion of the fixed manufacturing overhead. At CottonWorks, the fixed manufacturing overhead is assigned
to the good output by multiplying the standard rate by the standard hours of direct labor in each pants.
Hopefully, by the end of the year there are enough good pants produced to absorb all of the fixed manufacturing
overhead.
The fixed manufacturing overhead volume variance compares the amount of fixed manufacturing
overhead budgeted to the amount that was applied to (or absorbed by) the good output. If the amount
applied is less than the amount budgeted, there is an unfavorable volume variance-there was not enough
good output to absorb the budgeted amount of fixed manufacturing overhead. If the amount applied to the
good output is greater than the budgeted amount of fixed manufacturing overhead, the fixed manufacturing
overhead volume variance is favorable. In brief, if CottonWorks applies more than the amount budgeted,
the volume variance is favorable; if it applies less than the amount budgeted, the volume variance is unfavorable.
Illustration of Fixed Manufacturing Overhead Variances for 2010
Let's assume that in 2010 Cotton Works manufactures (has actual good output of) 5,300 large pants and
2,600 small pants. Let's also assume that the actual fixed manufacturing overhead costs for the year are
Rs.8,700. As we calculated earlier, the standard fixed manufacturing overhead rate is Rs.4 per standard
direct labor hour. We begin by determining the fixed manufacturing overhead applied to (or absorbed by)
the good output produced in the year 2010:
Large Small
Total
Pants Pants
Actual pants manufactured 5,300 2,600
Standard hours of direct labor hours per pants
0.3 hr. 0.2 hr.
manufactured
Total standard hours of direct labor in the good pants
1,590 hr. 520 hr. 2,110 hr.
manufactured
Standard cost per direct labor hour for fixed
Rs.4 Rs.4 Rs.4
manufacturing overhead
Standard cost of fixed manufacturing overhead in
Rs.6,360 Rs.2,080 Rs.8,440
(applied to) the good output
Our analysis looks like this:
Fixed Manufacturing Overhead Analysis for the Year 2010:
1. Debit
2. Fixed Inventory-FG for
manufacturing 3. Fixed the standard
4. Actual fixed overhead budget manufacturing hours of direct
manufacturing 5. Fixed for the year 2010 overhead volume labor that should
overhead manufacturing variance be in the good
overhead budget output x the
variance Budgeted (1 - 2) standard fixed
Amount - Actual manufacturing
Amount overhead rate
Std Hr x Std
Actual Amount Difference Annual Budget Difference
Rate
2,110 std hr x Rs.4
Rs.8,700 Rs.8,400 Rs.8,440
Rs.300
Rs.40 Favorable
Unfavorable
This analysis shows that the actual fixed manufacturing overhead costs are Rs.8,700 and the fixed
manufacturing overhead costs applied to the good output are Rs.8,440. This unfavorable difference of
Rs.260 agrees to the sum of the two variances:
Fixed manufacturing overhead volume variance Rs. 40 Favorable
Fixed manufacturing overhead budget variance Rs.300 Unfavorable
Total Fixed Manufacturing Overhead Variance Rs.260 Unfavorable
Actual fixed manufacturing overhead costs are debited to overhead cost accounts. The credits are
made to accounts such as Accounts Payable or Cash. For example:
Date Account Name Debit Credit
12.7 Summary
Standard cost is a predetermined cost, which is computed, is advance of production on the basis of
specification of all the factors affecting cost. A standard figure is one which may be used as a yard stick for
measuring the efficiency or inefficiency of the actual preformance. Standards are set for each element of
cost viz. direct material, direct labour and overheads for each cost centre. The standards are determined
and set and are shown in standard cost statement. Actual result of performance are compared with the
standards by preparing a comparating statement of cost. The variations is actual and standards are ascertained.
When standard cost is compared with the actual cost a difference is found between them. This difference is
known as variance. Variance analysis is the process of analysing variances by sub dividing the total variance.
When the actual cost is less than standard cost the difference is termed as farourable (f) variance. On the
contrary, if actual cost is more than standard cost, the difference is called as adverase variance. The difference
between standard cost and the actual cost may be regregated element wise-direct material cost, direct
labour cost and overhead cost variances. Different variances are used in different industries.
Following formulas are used for calculation of variances.
(A) Direct Material Cost Variance
MCV = (SQxSP) - (AQxAP)
MPV = (SP - AP) x AQ
MUV = (SQ - AQ) x SP
Varification - MCV = MPV + MUV
When two or more than two materials are used:
MMV = (RSQ - AQ) x SP
MSUV = (SQ - RSQ) x SP
Verification - MUV = MMV + MSUV
(B) Labour Variances
LCV = (SH x SR) - (AH x AR)
LRV = (SR - AR) x AH
LEV = (SH - AH) x SR
LITV = (O - IH) x SR
LMV = (RSH - AH) SR
LSEV = (SH - RSH) SR
Verification - LCV = LRV + LEV
LEV = LMV + LSEV
(C) Variable Overhead Variances
(i) on the basis of unit of output
VOCV = (SR - AR) x AO
VO exp. V = (SO x SR) - (AO x AR)
VO Eff. V = (AO - SO) x SR
(ii) on the basis of standard hours
VOCV = (SH x SR) - (AH x AR)
VO Exp. V = (SR - AR) x AH
VO Eff. V = (SH - AH) x SR
Verification - VOCV = VO Exp. V + VO Eff. V
(D) Fixed Overhead Variances
(i) on the basis of units of output
FOCV = (SR - AR)
FO Exp. V = (BO - AO) x SR
FOVV = (AO - BO) x SR
FO Eff. V = (AO - SO) x SR
FOCV = (SO - BO) x SR
(ii) on the basis of standard hours
FOCV = (SH x SR) - ( AH x AR)
FO Exp. V = (BH x SR) - (AH x AR)
FOVV = (SH - BH) x SR
FO Eff. V = (SH - AH) x SR
FOCV = (AH - BH) x SR
Varification - FOCV = FO Exp. V + VOVV
FOVV = FO Eff. V + FOCV
(E) Sales Variances
(a) Sales turnover method.
(i) Sales Value Variance = (AP x AQ - SP x SQ)
(ii) Sales Price Variance = AQ (AP - SP)
Varifiaction = SVV = SPV + S vol. V
(b) Sales margin method
(i) Total sales margin variance = Actual margin - Budgeted margin
(ii) Sales margin price variance = AQ(Actual margin-Budgeted margin)
(iii) Sales margin volume variance = Budgeted margin (AQ - BQ)
Product R Product S
Sales Quantity (Units)
Standard 400 Units 400 Units
Actual 500 Units 900 Units
Selling price per units (Rs.)
Standard Rs. 12 Rs. 15
Actual Rs. 15 Rs. 20
(Ans.: SVV = 12700(f), SPV = 5500(f), SVV = 7200(f), SMV = 450 (f) SSVV6750 (f).
13.0 Objectives
The study of this unit will enable you to understand:-
The concept meaning and definition of budget and budgetary control.
Objectives, Characteristics, Advantages and Disadvantages of Budgetary Control.
Budgetary Control Process
Types of Budgets.
13.1 Introduction
The efficiency of management depends upon the accomplishment of the goals of an organization. It
is effective when it attains the objective with least cost and effort. A systematic approach for attaining
effective management performance is budgeting, which is on integral part of management. This is the
process of pre- estimation of cost, revenue, profit and other figures for the next year or period and on the
basis, actual expenses incurred revenue generated/earned. Afterwards budget is used as a standard for
measuring actual performance. The deviations are found out and responsibility is fixed for deviations.
Various budgets are prepared for different purposes.
Activity
Normally which budget is treated as key factor budget?
Illustration :1
Shri Ram and Delhi Manufacturers make two types of toys, Bunty and Babli and sell them in Jaipur
and Delhi markets. The followings information is made available for the current year 2009-2010:
Jaipur Delhi
Bunty Budgeted 400 600
Increase 40(+10%) 30(+5%)
440 630
Advertisement effect 60 70
500 700
Babli Budgeted 300 500
Increase 60(+20%) 50(+10%)
360 550
Advertisement effect 40 50
400 600
2. Production Budget The budget is basically based on sales budget. It forecasts quantity of
production in terms of items, periods, areas, etc. The works manager is responsible for the
preparation of overall production budget and departmental works manager is responsible for
departmental production budgets.
Illustration :2
Suraj Manufacturing Company wishes to prepare a production budget in respect of three products
A,B, and C, the sales farecast for which is 80,000 units, 72,000 units and 85,000 units respectively. The
estimated requirement of inventory both at the beginning and at the end of the budget period are shown in
the following Schedule:
Inventory Schedule
A B C
Ist January (Units) 16,000 12,000 20,000
3Ist December (Units) 20,000 11,000 27,000
Particular Products
A (Units) B (Units) C (Units)
Sales Budget 80,000 72,000 85,000
Add: Closing Inventory 20,000 11,000 27,000
Total Units required 1,00,000 83,000 1,12,000
Less: Opening Inventory 16,000 12,000 20,000
Planned Production 84,000 71,000 92,000
3. Purchase Budget: The budget forecasts the quantity and value of purchases required for
production. It gives quantity-wise and period-wise information about the materials to be purchased.
It correlates with sales forecast and production planning.
Budgeted purchase Quantity = Budgeted consumption Quantity + Required closing
Stock - Opening Stock
Illustration:3
The following information relates to a manufacturing company:
Targeted sales of product P 2,00,000 units. Each unit of product P requires 3 units of material X
and 4 units of material Y.
Estimated opening balance at the commencement of the next year.
Finished Product : 40,000 units
Material X : 48,000 units
Material Y : 60,000 units
The desirable closing balances at the end of the next year are:
Finished Product : 56,000 units
Material X : 52,000 units
Material Y : 64,000 units
From the above information prepare a Material Budget.
Solution:
The number of units to be produced.
Opening Stock + Production = Sales + Closing Stock
Units to be produced = Sales + Closing Stock - Opening Stock
2,00,000+56,000-40,000
= 2,16,000 units
Material required:
Material A = 2,16,000 x 3 = 6,48,000 units
Material B = 2,16,000 x 4 = 8,64,000 units
Material Purchase Budget (Units)
Particular Finished Product Material required
X Y
Budget Production 216000 648000 864000
Add: Opening Stock + 40000 (-) 48000 (-) 60000
Less: Closing Stock 256000 600000 804000
Estimated product for Sales (-) 56000 (+) 52000 (+) 64000
4. Personnel budget: The budget anticipates the quantity of personnel required during a period for
production activity. This may be further split up between direct and indirect personnel budgets.
5. Cost of Production Budget: It forecasts the cost of production. Separate budgets are prepared
for different elements of costs such as direct materials budgets, direct labour budget, factory overheads
budget, office overheads budget, selling and distribution overhead budget, etc.
Illustration: 4
The following information is abstracted form the books of Mahalaxmi Co. Ltd., for the six months
of 2010 in respect of products XX.
The following units are to be sold in different months of the year 2010.
January 2200
February 2200
March 3400
April 3800
May 5000
June 4600
July 4000
There will be work in progress at the end of the month. Finished units are equal to half the sales of
the next month's stock at the end of every month ( including December, 2009). Budgeted production and
production cost for the half-year ending 30th June, 2010 are as follows:
Production (Units) 40000
Direct material per unit Rs. 5
Direct Wages per unit Rs. 2
Factory Overheads apportioned to production Rs. 160000
You are required to prepare product Budget and production Cost Budget for the six months of the
year 2010.
Solution:
Production Budget (in Units)
January February March April May June Total
Estimated Sales 2200 2200 3400 3800 5000 4600
Add: Closing Stock 1100 1700 1900 2500 2300 2000
3300 3900 5300 6300 7300 6600
Less: Opening stock 1100 1100 1700 1900 2500 2300
Production 2200 2800 3600 4400 4800 4300 22100
Production Cost Budget
(Production : 22,100 units)
Rs.
Direct Material @ Rs. 5 for 22,100 units 1,10,500
Direct Wages @ Rs. 2 for 22,100 units 44,200
Factory Overheads @ Rs. 4 for 22,100 units 88,400
(Rs. 1,60,000/40,000 units)
Total Production Cost 2,43,100
6. Cash Budget:- The budget is a forecast of the cash position, for a specific duration of time of
different time periods. It states the estimated amount of cash receipts and cash payments and the
likely balance of cash in hand at the end of different periods,
Method of preparing cash Budgets
There are basically three methods for preparing cash budgets.
1. Receipts And Payments Method
2. Adjusted Profit And Loss Account Method
3. Balance Sheet Method
Activity
A company wants to know future liquidity position, so that liquidity can be arranged.
Which budget should be prepared by the company?
Illustration: 5
A company newly starting manufacturing operations on 1st January 2010 has made adequate
arrangement for funds required for fixed assets. It wants you to prepare an estimate of funds required as
working capital. It is to be remembered that:
(a) In the first month there will be no sale, in the subsequent month sale will be 25% cash and 75%
credit. Customer will be allowed one month credit.
(b) Payments for purchase of raw materials will be made on one month credit basic.
(c) Wages will be paid fortnightly on the 22nd and 7th of each month.
(d) Other expenses will be paid one month in arrear except that 5% of selling expenses are to be paid
immediately on sale being affected.
The estimated sales and expenses for the first six months, spread evenly over the period subject to
(a) above are us under:
Rs. Rs.
Sales 360000 Administrative Expenses 54000
Material Consumed 150000 Selling Expenses 42000
Wages 60000 Depreciation on fixed assets 50000
The article produced is subject to excise duty equal to 10% of the selling price. The duty is payable
on March 31, June 30, September 30, and December 31 for sales up to February 28, May 31, August 31
and November 30 respectively.
Prepare cash Budget for each of the six months indicating the requirement of the working capital.
Solution:
Cash Budget
For the six month ended on June 30, 2010
Particular January February March April May June
Rs Rs. Rs. Rs. Rs. Rs.
Receipts:
Opening Balance - (-)7500 (-) 45000 (-) 39200 (-) 26200 (-)13200
Cash Sales - 18000 18000 18000 18000 18000
Receipts from - - 54000 54000 54000 54000
customer
Cash Available (A) 10500 27000 32800 45800 58800
Payments:
Wages 7500 10000 10000 10000 10000 10000
Materials - 25000 25000 25000 25000 25000
Manufacturing Exp. - 8000 8000 8000 8000 8000
Administrative Exp. - 9000 9000 9000 9000 9000
Selling Exp. - 3500 7000 7000 7000 7000
Excise Duty - - 7200 - - 21600
Total Payments(B) 7500 55,500 66200 59000 59000 80600
Closing Balance (-) 7500 (-) 45000 (-) 39200 (-) 26200 (-) 13200 (-) 21800
(A-B)
Note:- The company needs overdraft facility to the extent indicated above for every month.
Illustration: 6
The following data are available to you. You are required to prepare a cash budget according to
Adjusted Profit and loss Method.
Balance Sheet As On 31st December, 2010
Liab ilities A mount A ssets A m ou nt
R s. R s.
Sh are C apital 10 0000 Pre mises 50 000
G en eral Re serve 20 000 M achinery 25 000
P rofit a nd L oss A /c 10 000 Debtors 40 000
Cred itor 50 000 C losing S tock 20 000
B ills P ayab le 10 000 Bills R ece iv able 5 000
O u tstand in g R en t 2 000 P repaid Com m ission 1 000
B an k 51 000
19 2000 19 2000
Projected Trading and Profit and Loss Account
for the year ending 31st December, 2010
Rs. Rs.
To Opening Stock 20000 By Sales 200000
To Purchases 150000 By Closing Stock 15000
To Ocori 2000
To Gross Profit C/d 43000
215000 215000
By Gross Profit b/d 43000
To Interest 3000 By Sundry Receipts 5000
To Salaries 6000
To Depreciation (10% on
premises and Machinery) 7500
To Rent 6000
Less: Outstanding
(Previous year) 2000
4000
Add: outstanding
(current year) 1000 5000
To Commission 3000
Add- Prepaid (Previous Year) 1000 4000
To Office expenses 2000
To Net profit c/d 1000
19500
48000
48000
To Dividends 8000 By Balance of Profit
(from last year) 10000
4000
To Addition to Reserves 19500
To Balance c/d 17500
29500
29500
7. Capital Expenditure Budget: The budget is the plan of the proposed outlay on fixed assets such
as land, buildings, plant and machinery. The budget is prepared after taking into account the
available productive capacities, probable reallocation of existing assets and possible improvement
in production technique. etc.
Capital expenditure budget serves the following purposes:
(a) It facilitates long term planning and policy-making.
(b) It facilitates replacing the old machinery by latest machinery or to change the methods of production
for reducing costs.
(c) It helps in the estimates of capital requirement after taking into account the disposable value of old
assets.
(d) It helps in preparation of cash budget and also assessing the capital cost of improving working
conditions or adopting safety measures, etc.
8. Master Budget: It is a summary budget incorporating all functional budgets in a capsule form. It
interprets different functional budgets and covers within its range the preparation of projected
income statement and projected balance sheet.
Illustration:8
A Glass Manufacturing Company requires you to calculate and present the budget for the next year
from the following information.
Sales:
Toughened glass Rs. 300000
Bent toughened glass Rs. 500000
Direct material Cost 60% of sales
Direct Wages 20 Workers @ Rs 150 per month
Store and spares 2.5% on Sales
Depreciation on Machinery Rs. 12600
Light and Power Rs. 5000
Factory Overhead:
Indirect Labour:
Works Manager Rs. 500 per month
Foreman Rs. 400 per month
Repairs and maintenance 10% on direct wages
Administration, selling and distribution expenses Rs. 14000 per year.
Solution
Master Budget
For the period ending on…………….
Sales (as per Sales Budget) Rs. Rs. Rs.
Toughened Glass……. Units @ Rs. 300000
Bent toughened glass …… Units@ Rs 500000 800000
Less: Cost of Production (as per Cost of Production Budget):
Direct Materials ( …… Units @ Rs. ….) 480000
Direct Wages 36000
Prime Cost 516000
Factory Overhead:
Variable: Stores and Spares (2.5% of Sales) 20000
Light and Power 5000
Repair and Maintenance 8000 33000
Fixed : Works Manager's Salary 6000
Forman's Salary 4800
Depreciation 12600
Sundries 3600 27000
Work Cost 576000
Gross Profit 224000
Less: Administration, Selling and Distribution Overhead 14000
210000
13.10.3 Classification According to Flexibility
Budget can also be classified in the following categories:
1. Fixed Budget: A budget prepared on the basis of a standard or a fixed level of activity is called a
fixed budget. It does not change with the change in the level of activity. If the output and sales do not
fluctuate from year to year or if an accurate prediction of the same can be made, a fixed budget can
be prepared.
2. Flexible Budget: A Budget designed in manner so as to give the budgeted cost of any level of
activity is termed as a flexible budget. Such a budget is prepared after considering the fixed and
variable elements of cost and the change that may be expected for each item at various levels of
operation.
llustration : 9
Prepare a flexible budget for production at 80% and 100% activity on the basis of the following
information:
Production of 50% capacity 5000 Units
Raw Material Rs. 80 Per Unit
Direct Labour Rs. 50 Per Unit
Expenses Rs. 15 Per Unit
Factory Expenses Rs. 50,000 (50% fixed)
Administration Expenses Rs. 60,000 (60% variable)
Solution
Flexible Budget
Particular Activity
80% 100%
(8000 Units) (10000 Units)
Rs. Rs.
A Fixed Expenses
Fixed factory expenses (50% of Rs. 50,000) 25,000 25,000
Fixed Administrative expenses (40% of Rs. 60,000) 24,000 24,000
Total 49,000 49,000
B Variable Expenses
Material @ 80 Per Unit 6,40,000 8,00,000
Labour @ 50 Per Unit 4,00,000 5,00,000
Expenses @ 15 Per Unit 1,20,000 1,50,000
Factory Expenses @ 5 Per Unit 40,000 50,000
Administrative Expenses @ 4.80 Per Unit 57,000 72,000
Total 13,06,600 15,72,000
Total ( A+ B ) 13,55,600 16,21,000
Calculation of Factory Expenses per unit
Total - Fixed
25,000
Rs. 50,000 - 25,000 @ 5 Per Unit
5,00
Calculation of Administrative Expenses per unit
36,000
Rs. 60,000 60% @ 7.20 Per Unit
5,00
Activity
When production of a Factory has a variation, then which budget is suitable to know
cost of production?
13.11 Summary
A budget is in the nature of an estimate for future actions to coordinate and control the use of
resources for a specified period. It is used as a standard with which actual performance is measured.
Budgeting is a process which includes both budget and budgetary control. Budget is a planning function and
budgetary control is a system and technique which uses budgets as a means of controlling all aspects of the
business and is designed to assist management in the measurement of actual performance, in the analysis of
deviations from the budgeted targets and to evaluate performance and efficiency of the operations. Agood
budgeting system requires good organizational system with the lines of authority and responsibility clearly
mentioned. The important essentials required for the establishment of a sound system of budgeting includes
budget centers, budget committee, budget officer, budget manual, budget period, budget key factor,
forecasting, determining level of activity and preparation of budget. Budget may be classified on the basis of
time, function and flexibility.
Budgeting is the main instrument for projecting the future costs and revenues and for financial
control of the organization. Preparation of budgets involves a number of forecasts or projections, it starts
with sales forecasting and ends with the compilation of master budget.
9. Jammu Co. Ltd. has three sales divisions at Jodhpur, Delhi, Patna. It sells two products-I and II.
The budgeted sales for the year ending 31st December, 2009 at each place are given below:
Jodhpur Product I 50000 units @ Rs. 16 each
Product II 35000 units @ Rs. 10 each
Delhi Product II 55000 Units @ Rs. 10 each
Patna Product I 75000 Units @ Rs. 16 each
The actual sales during the same period were:
Jodhpur Product I 62500 units @ Rs. 16 each
Product II 37500 units @ Rs. 10 each
Delhi Product II 62500 Units @ Rs. 10 each
Patna Product I 77500 Units @ Rs. 16 each
From the reports of the sales department it was estimated that the sales budget for the yea
ending 31st December 2010 would be higher than 2009 budget in the following.
Jodhpur Product I 4000 Units
Product II 2500 Units
Delhi Product II 6500 Units
Patna Product I 5000 Units
Intensive sales campaign in Delhi and Patna is likely to result in additional sales of 12500
units of product I in Delhi and 9000 Units of product II in Patna. Let us prepare a sales budget for
the period ending 31st December 2010.
(Ans:) Jodhpur Product I 54000 Units
Product II 37500 Units
Delhi Product I 12500 Units
Product II 61500 Units
Patna Product I 80000 Units
Product II 9000 Units)
10. Draw a Material Procurement Budget (Quantitative) from the following information:
Estimated sales of a product are 20000 units. Each units of the product requires 3 Units of material
X and 5 Units of Material Y.
Estimated opening balance at the commencement of next year:
Finished Product 2500 Kgs.
Material X 6000 Units
Material Y 10000 Units
Material on Order:
Material X 3500 Units
Material Y 5500 Units
The desirable closing balance at the end of the next year:
Finished Product
3500 Units
Material X 7500 Units
Material Y 12500 Units
Material on order:
Material X 4000 Units
Material Y 5000 Units
11. A company is expecting to have Rs. 500000 cash in hand on 1st April, 2010 and it requires you to
prepare an estimate of cash position during the three months, April to June 2010. The following
information is supplied to you:
Additional Information:
(a) The credit period allowed by supplies is two months.
(b) 25% of sales is for cash and credit period allowed to customers is one month.
(c) Delay in payment of wages and expenses is one month.
(d) Income tax Rs. 500000 is to be paid in June 2010.
(Ans: April Rs. 1060000, May Rs. 1620000, June Rs. 1820000)
12. From the following information, you are required to prepare cash budget according to Adjusted
Profit and Loss method as well as Balance Sheet Method.
Balance Sheet as on 01-01-2010
Liabilities Rs. Assets Rs.
Share capital 50000 Debtors 500000
Reserves 1000000 Stock & Store 300000
Debentures 300000 Fixed assets 1300000
Public deposits 200000 Cash balance 100000
Current liability 200000
2200000 2200000
Projected Trading and Profit and Loss A/c for the year ending 31-12-2010
14.0 Objectives
After studying this unit, you should be able to understand:
The concept of Ratio anaylsis.
Importance of Ratio anaylsis.
The various types of Ratio anaylsis and their calculations.
The various limitations associated with Ratio anaylsis.
14.1 Introduction
To make rational decisions in keeping with the objectives of the firm, the financial manager must have
analytical tools. The firm itself and outside providers of capital-creditors and investors-all undertake financial
statement analysis. The type of analysis varies according to the specific interests of the party involved. Trade
creditors (suppliers owed money for goods and services) are primarily interested in the liquidity ofa firm. The
claims of bondholders, on the other hand, are long term. Accordingly, bondholders are more interested in the
cash-flow ability of the firm to service debt over a long period of time. They may evaluate this ability by
analyzing the capital structure of the firm, the major sources and uses of funds, the firm’s profitability over time,
and projections of future profitability.
Investors in a company’s common stock are principally concerned with present and expected
future earnings as well as with the stability of these earnings about a trend line. As a result, investors usually
focus on analyzing profitability. They would also be concerned with the firm’s financial condition in so far as
it affects the ability of the firm to pay dividends and avoid bankruptcy.
Internally, management also employs financial analysis for the purpose of internal contol and to
better provide what capital suppliers seek in financial condition and performance from the firm. From an
internal control standpoint, the management needs to undertake financial analysis in order to plan and
control effectively. To plan for the future, the financial manager must assess the firm’s present financial
position and evaluate opportunities in relation to this current position. With respect to internal control, the
financial manager is particularly concerned with the return on investments provided by the various assets of
the company and in the efficiency of asset management. Finally, to bargain effectively for outside funds, the
financial manager needs to discuss all aspects of financial analysis that outside suppliers of capital use in
evaluating the firm. We see, then, that the type of financial analysis undertaken varies according to the
particular interests of the analyst.
14.2 Meaning
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to
interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical
performance and current financial condition can be determined. The term ratio refers to the numerical or
quantitative relationship between two variables.
14.3 Importance
1. Helps in evaluating the firm’s performance: With the help of ratio analysis conclusion can be
drawn regarding several aspects such as financial health, profitability and operational efficiency of
the undertaking. Ratio points out the operating efficiency of the firm i.e. whether the management
has utilized the firm’s assets correctly to increase the investor’s wealth. It ensures a fair return to its
owners and secures optimum utilization of firm’s assets.
2. Helps in inter-firm comparison: Ratio analysis helps in inter-firm comparison by providing necessary
data. An inter-firm comparison indicates relative position. It provides the relevant data for the
comparison of the performance of different departments. If comparison shows a variance, the
possible reasons of variations may be identified and if results are negative, the action may be initiated
immediately to bring them in line.
3. Simplifies financial statement: The information given in the basic financial statements serves no
useful purpose unless it is interrupted and analyzed in some comparable terms. The ratio analysis is
one of the tools in the hands of those who want to know something more from the financial statements
in the simplified manner.
4. Helps in determining the financial position of the concern: Ratio analysis facilitates the
management to know whether the firm’s financial position is improving or deteriorating or is constant
over the years by setting a trend with the help of ratios. The analysis with the help of ratio analysis
can know the direction of the trend of strategic ratio may help the management in the task of
planning, forecasting and controlling.
5. Helpful in budgeting and forecasting: Accounting ratios provide a reliable data, which can be
compared, studied and analyzed. These ratios provide sound footing for the future. The ratios can
also serve as a basis for preparing budgeting future line of action.
6. Helps in analyzing liquidity position: With the help of ratio analysis conclusions can be drawn
regarding the liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is
able to meet its current obligation when they become due. The ability to meet short term liabilities is
reflected in the liquidity ratio of a firm.
7. Helps in assessing long term solvency position: Ratio analysis is equally useful for assessing
the long term financial ability of the firm. The long term solvency is measured by the leverage or
capital structure and profitability ratio which shows the earning power and operating efficiency.
Solvency ratio shows relationship between total liability and total assets.
8. Helps in measuring operational efficiency: Yet another dimension of usefulness of ratio analysis,
relevant from the view point of management is that it throws light on the degree of efficiency in the
various activity. Ratios measures this kind of operational efficiency.
17.4 Classification of Ratios
Different ratios are used for different purposes. These ratios can be grouped into various classes
according to the financial activity. Ratios are classified into four broad categories.
14.4.1 Liquidity Ratio
Liquidity ratio measures the firm’s ability to meet its current obligations i.e. ability to pay itsobligations
when they become due. They compare short-term obligations to short-term (or current) resources available
to meet these obligations. From these ratios, much insight can be obtained into the present cash solvency
of the firm and the firm’s ability to remain solvent in the event of adversity. Commonly used liquidity ratios
are:
(A) Current ratio: Current ratio is the ratio, which expresses relationship between current asset and
current liabilities. It shows a firm’s ability to cover its current liabilities with its current assets. Current
assets are those which can be converted into cash within a short period of time, normally not
exceeding one year. The current liabilities are of short- term maturity.
Current Assets
Current ratio
Current liabilitie s
Ideal Ratio is 2:1
(B) Quick/ Liquid Ratio: Quick Ratio is the measure of the instant debt paying ability of the business
enterprise, hence it is also called ‘quick ratio’ or ‘acid test ratio’. It measures the ability of the firm
to meet its short term obligations as and when due without relying upon the realization of stock.
Quick ratio is considered to be superior to current ratio in evaluating the liquidity position of
the firm. Sometimes, a situation arises when the firm has to meet its current liabilities immediately. In
such cases, it can pay off these liabilities out of its quick assets of equal value without any difficulty.
Thus, quick ratio is an indication of a firm’s ability to meet unexpected demand for working capital.
Activity
Which ratio indicates the ability to meet unexpected demand of working capital?
Illustration 1:
Following is the Balance Sheet of SUN Ltd. as on 31st March 2010:
Liabilities Rs. Assets Rs.
Share Capital: Fixed Assets:
4,000 Equity Shares of Rs. 4,00,000 Buildings 1,70,000
100/-each.
Reserve & Surplus: Furniture 1,14,000
General Reserve 20,000 Machinery 1,10,000
Capital Reserve 8,000 Investments 20,000
Current Liabilities: Current Assets:
Creditors 6,000 Stock 10,000
Bills Payables 4,000 Debtors 7,000
Outstanding Expenses 2,000 Bills Receivable 5,000
Cash & Bank Balance 2,000
Marketable Securities 2,000
4,40,000 4,40,000
Proprietor’ s Fund
Proprietary Ratio
Total tangible Assets
This ratio shows how much capital is introduced by the owner in business. Higher ratio
means a sound position of business, because it shows that the organization is not running through
outside funds which mean less interference and pressure of outsiders.
(C) Interest Coverage Ratio: This ratio indicates the relationship between net profits before interests
and taxes on long term debt. The objective of calculating this ratio is to measure the debt servicing
capacity of a firm so far as fixed interest on long term debt is concerned.
Rs. 2,50,000
1.67 : 1
Rs. 1,50,000
Rs. 1,50,000
0.38 : 1
Rs. 4,00,000
Working notes:
1. External Liabilities = Debentures + Creditors + Bills Payable
= Rs. (2,00,000+30,000+20,000)
= Rs. 2,50,000
2. Net Worth = Share Capital + Reserve & Surplus
= Rs. (1,00,000+50,000)
= Rs. 1,50,000
3. Tangible Assets = Fixed Assets + Stock + Debtors + Cash at Bank
= Rs. (2,70,000+80,000+30,000+20,000)
= Rs. 4,00,000
Illustration 3:
From the following information, calculate interest coverage ratio:
Rs.
Net Profit after Tax 4,00,000
Rate of Income tax 50%
Fixed Interest Charges 60,000
Solution:
Rs. 8,60,000
14.33 Times
Rs. 60,000
Working Notes: Rs.
Net profit before tax 8,00,000
(4,00,000 100 )
50
Less: Tax @ 50% 4,00,000
Net profit after tax 4,00,000
14.4.3 Profitability ratio
Profitability ratios are the best indicators of overall efficiency of the business concern, because they
compare return of value over and above the value put into business with sales or service carried on by the
firm with the help of assets employed. Profitability ratio can be determined on the basis of:
Sales Investment
I. Profitability Ratios related to Sales:
(A) Gross Profit Ratio: The gross profit to sales ratio establishes relationship between gross profit
and sales to measure the relative operating efficiency of the firm to reflect pricing policy. Gross
profit ratio indicates the average margin on the goods sold. It shows whether the selling prices are
adequate or not. It also indicates the extent to which selling prices may be reduced without resulting
in losses.
A low gross profit ratio may indicate a higher cost of goods sold due to higher cost of
production. It may also be due to low selling prices. A high gross profit ratio, on the other hand,
indicates relatively low cost and is a sign of good management.
Sales - cost of goods sold
Gross profit to sales ratio 100
Sales
(B) Net Profit Ratio: The net margin indicates the management’s ability to earn sufficient profit on sales
not only to cover all revenue operating expenses of the business, the cost of borrowed funds and
the cost of goods or servicing, but also to have sufficient margin to pay reasonable compensation to
shareholders on their contributions to the firm.
Gross Profit
1. Gross Profit Ratio 100
Sales
2,00,000
100 30.77%
6,50,000
Net Profit
2. Net Profit Ratio 100
Sales
1,37,000
100 21.07%
6,50,000
II. Profitability Ratios related to Investments:
(A) Return on Equity or Return on Shareholder’s Fund: This ratio measures the return on the total
equity of the shareholders. This ratio is also known as ‘Return on Shareholder’s Fund’.
2,25,000
100 17.18%
13,10,000
2,25,000
100 24.85%
8,25,000
Activity
By which ratio can overall profitability be determined?
Net Sales
Inventory Turnover Ratio
Closing Stock
This ratio provides how many times purchases are made during the year. Higher ratio shows
that more sales are being produced by a unit of investment in stocks. Companies in which stock
turnover ratio is high generally work on comparatively low margin of profit.
(B) Debtors Turnover Ratio: This ratio shows how quickly debtors are converted into cash. The
objective of calculating this ratio is to determine the efficiency with which the trade debtors are
managed.
Average receivable s
Average Collection Period 365/52/12
Average Credit Sales
Activity
By which ratio can we judge the period for which the credit sales remain outstanding?
(D) Working Capital Turnover Ratio: This ratio shows the number of times the working capital turns
in trading transaction. If it has an increasing trend over the previous year it shows that the working
capital is being used efficiently.
The higher the ratio the less is the investment in working capital and the greater are the
profits. A very high ratio is a sign of over trading and a low ratio indicates under trading, i.e.,
working capital is not effectively used.
Rs. 1,00,000
2.86 Times
Rs. 35,000
Working notes:
Cost of Good Sold = Opening Stock + Purchases + Carriage Inwards - Closing Stock
= Rs. (40,000+80,000+10,000-30,000)
= Rs. 1, 00,000
Rs. 1, 50,000
Rs. 5 Times
Rs.30,000
Working notes:
Average Receivable s
3. Average Collection Period 365
Net Credit Sales
Rs. 30,000
365 73 days
Rs. 1, 50,000
Illustration 7:
From the following information given below, calculate Working Capital Turnover Ratio:
Particulars Rs.
(A) Current Assets
Stock 15,000
Debtors 10,000
Bills Receivables 4,000
Cash at Bank 12,000
Cash in hand 4,000
45,000
(B) Current Liabilities
Sundry Creditors 10,000
Bills Payable 5,000
Tax Payable 4,000
Proposed Dividend 4,000
Interest Payable 2,000
25,000
Sales
1. Working Capital Turnover Ratio
Working Capital
Rs.6,00,000
Rs.20,000
Working notes:
1. Working Capital = Current Assets - Current Liabilities
= Rs. (45,000-25,000)
= Rs. 20,000
14.5 Limitations
Inspite of many advantages, there are certain limitations of the ratio analysis techniques and they
should be kept in mind while using them in interpreting financial statements. The following are the main
limitations of accounting ratios:
1. Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of
one firm can not always be compared with the ratio of the other firm. Some firms may value the
closing stock on LIFO basis while some other firms may value on FIFO basis. Similarly there may
be difference in providing depreciation of fixed assets or certain provisions for doubtful debts etc.
2. False Results: Accounting ratios are based on data drawn from accounting records. In case that
data is correct, then only the ratios will be correct. For example, valuation of stock is based on very
high price, the profits of the concern will be inflated and it will indicate a wrong financial position.
The data therefore must be absolutely correct.
3. Effect of Price Level Changes: Price level changes often make the comparison of figures
difficult over a period of time. Changes in price affects the cost of production, sales and also the
value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before
any comparison.
4. Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus,
ignores qualitative factors, which may be important in decision making. For example, average
collection period may be equal to standard credit period, but some debtors may be in the list of
doubtful debts, which is not disclosed by ratio analysis.
5. Effect of window-dressing: In order to cover up their bad financial position some companies
resort to window dressing. They may record the accounting data according to the convenience to
show the financial position of the company in a better way.
6. Costly Technique: Ratio analysis is a costly technique and can be used only by big business
houses. Small business units are not able to afford it.
7. Misleading Results: In the absence of absolute data, the result may be misleading. For example,
the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales
are Rs. 20,000 and profit earned by the other one is Rs. 10,00,000 and sales are Rs. 40,00,000.
Although the profitability of the two firms is same yet the magnitude of their business is quite different.
8. Absence of standard universally accepted terminology: There are no standard ratios, which
are universally accepted for comparison purposes. As such, the significance of ratio analysis
technique is reduced.
14.6 Summary
Financial analysis, though varying according to the particular interests of the analyst, always involves
the use of various financial statements – primarily the balance sheet and income statement. The Balance
sheet summarizes the assets, liabilities and owner’s equity of a business at a point in time, and the income
statement summarizes revenues and expenses of a firm over a particular period of time.
A conceptual framework of Ratio analysis provides the analyst with an interlocking means for
structuring the analysis. For example, in the analysis of external financing, one is concerned with the firm’s
funds needs, its financial condition and performance, and its business risk. Upon analysis of these factors,
one is able to determine the firm’s financing needs and to negotiate with outside suppliers of capital.
Financial Ratios are the tools used to analyze financial condition and performance. We calculate
ratios because in this way we get a comparison that may prove more useful than the raw numbers by
themselves.
Financial ratios can be divided into five basic types: liquidity, leverage(debt), coverage, activity and
profitability. No one ratio is itself sufficient for realistic assessment of the financial condition and assessment
of the financial condition and performance of the firm. With a group of ratios, however, reasonable judgments
can be made. The number of key ratios needed for this purpose is not particularly large – about a dozen or
so.
The usefulness of ratios depends on the ingenuity and experience of the financial analyst who employs
them. By themselves, financial ratios are fairly meaningless; they must be analyzed on a comparative basis.
Comparing one company to similar companies and industry standards over time is crucial. Such a comparison
uncovers leading clues in evaluating changes and trends in the firm’s financial condition and profitability. This
comparison may be historical, but it may also include an analysis of the future based on projected financial
statements.
14.7 Key Words
Liquidity Ratios : Liquidity ratios are used to measure the ability of the firm to meet its short-term
obligations out of its short-term resources.
Leverage Ratios : Leverage ratios help in measuring the long-term solvency of the business.
Efficiency Ratios : Efficiency ratios helps the management to measure the effectiveness of the
resources for the command of the firm.
Profitability Ratios: Profitability ratios are used to measure the end result of business operations.
Return on Capital Employed: This ratio expresses the relationship between profit and capital
employed.
Gross Capital Employed : Total assets used in business.
Net Capital Employed: Total assets minus current liabilities.
14.8 Self-Assessment Test
1. What do you understand by ‘RATIO ANALYSIS’? What are its limitations?
2. What is the importance of ratio analysis? Explain any two ratios each for measuring Liquidity and
Profitability?
3. What are Capital Structure Ratios and Activity Ratios? Explain with illustration.
4. Following is the Balance Sheet of B Ltd. as on 31st March, 2010:
Liabilities Rs. Assets Rs.
Equity Share Capital 2,00,000 Plant & Machinery 2,50,000
Profit & Loss A/c 20,000 Stock 40,000
Debentures 80,000 Sundry Debtors 30,000
Sundry Creditors 50,000 Cash in hand 25,000
Provision for Taxation 10,000 Cash at Bank 10,000
Prepaid Expenses 5,000
3,60,000 3,60,000
Calculate the following ratios:
(a) Current Ratio
(b) Quick Ratio
(c) Absolute Liquidity Ratio
5. From the following Balance Sheet, calculate:
(a) Debt-Equity Ratio (b) Proprietary Ratio
Balance Sheet
As on 31st March, 2010
Particulars Rs.
Net Profit after Tax 7,00,000
Income Tax 3,00,000
Interest Charges 2,00,000
15.0 Objectives
After studying this unit you should be able to understand:
The concept of funds flow and cash flow statements.
Objectives behind preparing funds flow and cash flow statements.
The various limitations associated with funds flow and cash flow statements.
The various sources and uses of funds.
Difference between fund flow, cash flow statements and balance sheet.
Preparing funds flow and cash flow statements.
15.1 Introduction
The second portion of the tools of financial analysis and planning deals with the analysis of funds
flows and cash flows. A flow of funds statement (also known as a sources and used of funds statement or
a statement of changes in financial position) is a valuable aid to a financial manager or a creditor in evaluating
the uses of funds by a firm and in determining how the firm finances those uses. The purpose of the cash flow
statement is to report a firm’s cash inflows and outflows. Flow of funds is segregated into three categories:
operating, investing and financing activities. Although this statement certainly serves as an aid for analyzing
cash receipts and disbursements, important current period investing and financing noncash transactions are
omitted. Therefore, the analyst will still want to prepare a flow of funds statement in order to fully under-
stand the firm’s funds flows.
Every business concern prepares two basic financial statements at the end of accounting period,
namely, Balance Sheet or Position Statement and Profit and Loss Account or Income Statement. Balance
Sheet reveals the financial position of the business concern at a certain point of time. It reveals the financial
status of the business concern. The Profit and Loss Account reveals the net results of operations over a
period of time i.e., how much profit was earned (or loss sustained) by the business enterprise during the
accounting period.
The Balance Sheet provides only a static view of the business. It does not show the movement of
funds. In business concerns, funds flow from different sources and similarly funds are invested in various
sources of investment. The study and control of this fund flow process is the main objective of financial
management to assess the soundness and solvency of a business and little about its flow of funds, i.e.,
financing and investing activities over a related period. Like Balance Sheet, even Profit and Loss Account
does not depict the changes that have taken place in financial condition of a business concern between two
dates. Hence, there is a need to prepare additional statement to know the changes in assets, liabilities and
owner's equity between dates of two Balance Sheets. Such a statement is called Funds Flow Statement or
Statement of Sources and Uses of funds.
15.2 Meaning of Funds
Funds Flow Statement is widely used tool in the hands of financial executives for analyzing the
financial performance of a business concern. The term Funds has a variety of meanings:
(a) In a narrow sense- In a narrow sense funds means only cash. Funds Flow Statement prepared on
this basis is called Cash Flow Statement. In this type of Statement, only inflow and outflow of cash
is taken into account.
(b) In a broader sense - In a broader sense, the term fund refers to money value in whatever form it
may exist. Here fund means all financial resources in the form of men, money, materials, and
machines, etc.
(c) Popular Sense - In a Popular Sense, the term fund means Working Capital i.e., the excess of
current assets over current liabilities.
Current Liabilities:
Creditors 37,400 42,000 - 4,600
1,19,400 1,19,400
Working Notes
Particulars Rs. Particulars Rs.
To Balance b/d 93,400 By Depreciation 23,400
To Cash (Purchase of Fixed 96,000 By Balance c/d 1,66,000
Assets)
1,89,400 1,89,400
Illustration 2
From the following balance sheets of X Ltd. on 31st march 2009 and 2010, you are required to prepare:
(a) A Statement of changes in Working capital;
(b) A Funds Flow Statement.
Liabilities 2009 2010 Assets 2009 2010
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000
General Reserve 14,000 18,000 Building 40,000 36,000
P&L A/c 16,000 13,000 Plant 37,000 36,000
Sundry Creditors 8,000 5,400 Investment 10,000 11,000
Bills Payable 1,200 800 Stock 30,000 23,400
Provision for 16,000 18,000 Bills Receivable 2,000 3,200
Taxation Debtors 18,000 19,000
Provision for 400 600 Cash at Bank 6,600 15,200
Doubtful debts
1,55,600 1,55,800 1,55,600 1,55,800
The following additional information have also been given:
(a) Depreciation charged on Plant was Rs.4,000 and on Building Rs.4,000
(b) Provision for Taxation of Rs.19,000 was made during the year.
(c) Interim Dividend of Rs.8,000 was paid during the year.
Solution:
Funds Flow Statement
For the year ended 31st March, 2010
Sources Rs. Applications Rs.
Funds from Operations 36,000 Purchase of Plant 3,000
Purchase of Investment 1,000
Payment of Interim Dividend 8,000
Payment of Tax 17,000
Increase in Working Capital 7,000
36,000 36,000
Statement of Changes in Working Capital
52,000 52,000
Dr. Provision for Taxation A/c Cr.
Particulars Rs. Particulars Rs.
To Bank A/c 17,000 By Balance b/d 16,000
To Balance c/d 18,000 By Adjusted P&L A/c 19,000
35,000 35,000
Dr. Building A/c Cr.
Particulars Rs. Particulars Rs.
To Balance b/d 40,000 To Depreciation 4,000
To Balance c/d 36,000
40,000 40,000
Dr. Plant A/c Cr.
Particulars Rs. Particulars Rs.
To Balance b/d 37,000 By Depreciation 4,000
To Bank A/c By Balance c/d 36,000
(Balancing Figure) 3,000
40,000 40,000
Less: Extraordinary Items, if any, credited to Profit and Loss A/c xxx
Refund of Tax credited to Profit and Loss A/c xxx (xxx)
A. Net profit before taxation and Extra-Ordinary items Xxxx
(Adjustment for Non-Cash and Non-Operating Items)
B. Add :
– Depreciation xxx
– Preliminary expenses xxx
– Discount on issue of shares and debentures written off xxx
– Interest on borrowings and debentures xxx
– Loss on sale of fixed assets xxx xxx
C. Less :
– Interest income/received xxx
– Dividend income received xxx
– Rental income received xxx
– Profit on sale of fixed asset xxx xxx
Less:
– Rent income xxx
– Purchase of fixed assets xxx
– Purchase of investment xxx
– Purchase of intangible assets like goodwill xxx (xxx)
Net cash from (or used in) investing activities Xxxx
(iii) Cash Flow from Financing Activities
Add:
Proceeds from issue of shares and debentures xxx
Proceeds from other long term borrowings xxx xxx
Less:
Final dividend fund xxx
Interim dividend fund xxx
Interest on debentures and loans paid xxx
Repayment of loans xxx
Redemption of debenture preference shares xxx (xxx)
Net cash flow from (or used in) financing activities xxxx
(iv) Net increase/Decrease in cash and cash equivalent (i + ii + iii) xxxx
(v) Add: Cash and Cash equivalents in the beginning of the year
– Cash in hand xxx
– Cash at bank overdraft xxx
– Short term deposit xxx
– Marketable securities xxx xxxx
(vi) Less: Cash and Cash equivalents in the end of the year
– Cash in hand xxx
– Cash at Bank (by bank overdraft) xxx
– Short term deposits xxx
– Cash flow from operation xxx (xxx)
Nil
Activity
What are the main headings while preparing cash flow statement by indirect method.
15.16 Preparation of Cash Flow Statement
15.16.1 Operating Activities
Cash flow from operating activities are primarily derived from the principal revenue generating
activities of the enterprise. A few items of cash flows from operating activities are:
(i) Cash receipt from the sale of goods and rendering services.
(ii) Cash receipts from royalties, fee, Commissions and other revenue.
(iii) Cash payments to suppliers for goods and services.
(iv) Cash payment to employees
(vi) Cash payment or refund of Income tax.
Determination of cash flow from operating activities:-
There are two stages for arriving at the Cash Flow from Operating Activities:-
Stage-I
Calculation of operating profit before working capital changes, it can be calculated in the following
manner:-
Stage-II
After getting operating profit before working capital changes as per stage I, adjust increase or
decrease in the current assets and current liabilities.
The following general rules may be applied at the time of adjusting current assets and current
liabilities.
A. Current assets
(i) An increase in an item of current assets causes a decrease in cash inflow because cash is blocked in
current assets.
(ii) A decrease in an item of current assets causes an increase in cash inflow because cash is released
from the sale of current assets.
B. Current liabilities
(i) An increase in an item of current liability causes a decrease in cash outflow because cash is saved.
(ii) A decrease in an item of current liability causes increase in cash out flow because of payment of liability.
15.16.2 Investing Activities
Investing Activities refer to transactions that affect the purchase and sale of fixed or long term assets
and investments.
Examples of cash flow arising from Investing activities are:-
1. Cash payments to acquire fixed Assets.
2. Cash receipts from disposal of fixed assets.
3. Cash payments to acquire shares, or debenture investment.
4. Cash receipts from the repayment of advances and loans made to third parties.
Thus, Cash Inflow from Investing activities is:-
- Cash sale of plant and machinery, land and Building, furniture, goodwill etc.
- Cash sale of investments made in the shares and debentures of other companies.
- Cash receipts from collecting the Principal amount of loans made to third parties.
Cash Outflow from Investing Activities is:
- Purchase of fixed assets i.e. land, building, furniture, machinery etc.
- Purchase of Intangible assets i.e. goodwill, trade mark etc.
- Purchase of shares and debentures
- Purchase of Government Bonds
- Loan made to third parties
15.16.3 Financing Activities
The third section of the cash flow statement reports the cash paid and received from activities with
non-current or long term liabilities and shareholders Capital. Examples of cash flow arising from financing
activities are:
- Cash proceeds from issue of shares or other similar instruments.
- Cash proceeds from issue of debentures, loans, notes, bonds, and other short-term borrowings.
- Cash repayment of amount borrowed.
Cash Inflow from financing activities is:
- Issue of Equity and preference share capital for cash only.
- Issue of Debentures, Bonds and long-term note for cash only
Cash Outflow from financing activities is:
- Payment of dividends to shareholders.
- Redemption or repayment of loans i.e. debentures and bonds.
- Redemption of preference share capital.
- Buy back of equity shares.
15.16.4 Treatement of Special Items
(i) Payment of Interim Dividends The following procedure is followed:
- The amount of interim dividend paid during the year is shown as outflow of cash in cash flow
statement.
- It will be added back to the profits for the purpose of calculating cash provided from operating
activities.
- No adjustment is necessary if the cash provided from operating activities is calculated on the basis
of revised figure of net profit.
(ii) Proposed dividend The dividend is always declared in the general meeting after the preparation of
Balance Sheet. It is therefore, a non-operating item which should not be permitted to affect the
calculation of cash generated by operating activities. Thus, the amount of proposed dividends would
be added back to current year’s profit and payments made during the year in respect of dividends
would be shown as an outflow of cash.
(iii) Share Capital The increase in share capital is regarded as inflow of cash only when there is a
increase in share capital. For example, if a company issues 10000 equity shares of Rs.10 each for
cash only, Rs. 100,000 would be shown as inflow of cash from financing activities. Similarly, the
redemption of preference share is an outflow of cash. But where the share capital is issued to
finance the purchase of fixed assets or the debentures are converted into equity shares there is no
cash flow. Further, the issue of bonus shares does not cause any cash flows.
(iv) Purchase or sale of fixed Assets The figures appearing in the comparative balance sheets at two
dates in respect of fixed assets might indicate whether a particular fixed asset has been purchased
or sold during the year. This would enable to determine the inflows or outflows of cash. For
example, If the plant and machinery appears at Rs 60,000 in the current year and Rs.50,000 in the
previous year, the only conclusion, in the absence of any other information is that there is a purchase
of fixed assets for Rs.10000 during the year. Hence, Rs.10000 would be shown as outflow of cash.
(v) Provision for Taxation It is a non-operating expense or an item of appropriation in the Income
statement/Profit and Loss Account and therefore should not be allowed to reduce the cash
provided from operating activities. Hence, if the profit is given after tax and the amount of the
provision for tax made during the year is given, the same would be added back to the current year
profit figure. In the cash flow statement, the tax paid would be recorded separately as an outflow of
cash. The item of provision for taxation would not be treated as current assets.
Sometimes, the only information available about provision for taxation is two figures appearing in
the opening balance sheet and closing balance sheet. In such a case the figure in the opening balance sheet
is treated as an outflow of cash while the figure in the closing balance sheet is treated as a non-cash and
non-operating expense and thus is added back to net Income figure to find out the cash provided from
operating activities.
Illustration 3
From the summarized cash account of ABC Limited (Ltd.) prepare cash flow statement for the year
ended 31st December 2006 in accordance with AS-3 (Revised) using the direct method and indirect
method. The company does not have any cash equivalents:
Summarized Cash A/c
Particulars Amount Particulars Amount
(Rs. 000) (Rs. 000)
Balance on 1.1.2006 50 Payment to Suppliers 2000
Issue of equity shares 300 Purchase of fixed assets 200
Receipts from customers 2800 Overhead expenses 200
Sale of fixed assets 100 Wages and salaries 100
Taxation 250
Dividend 50
Repayment of Bank 300
Loan
Balance on 31.12.2006 150
3250 3250
Additional information: Net profit before tax for the year 2006 was Rs 5,00,000.
Solution:
Cash Flow Statement of ABC Ltd
for the year ended 31st December 2006 (Indirect method)
Rs ‘000 Rs ‘000
A. Cash flow from operating activities
Net profit before tax 500
Income tax paid (250)
Net cash from operating activities 250
B. Cash flow from investing activities
Purchase of fixed assets (200)
Sale of fixed assets 100
Net cash used in investing activities (100)
C. Cash flow from financing activities
Issue of equity shares 300
Repayment of bank loan (300)
Dividend paid (50)
Net cash used in financing activities (50)
Net increase in cash (A+B+C) 100
Add: Cash at the beginning of the year 50
Cash at the end of the year 150
Illustration 4
From the following information, you are required to prepare the cash flow statement of Classic Ltd. for the
year ended 31st March (both methods):
Balance Sheet
as at 31st March 2006
Liabilities 2005 2006 Assets 2005 2006
Rs. Rs. Rs. Rs.
Share Capital 70,000 70,000 Fixed Assets 50,000 91,000
Secured Loans - 40,000 Inventory 15,000 40,000
Creditors 14,000 39,000 Debtors 5,000 20,000
Tax payable 1,000 3,000 Cash 20,000 7,000
Profit & Loss A/c 7,000 10,000 Prepaid expenses 2,000 4,000
92,000 162,000 92,000 162,000
Profit and Loss Account
for the year ended 31st March 06
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
Opening Stock 15,000 Sales 100,000
Purchases 98,000 Closing Inventory 40,000
Gross profit c/d 27,000
1,40,000 1,40,000
General Expenses 11,000 Gross profit b/d 27,000
Depreciation 8,000
Provision for tax 4,000
Net Profit c/d 4,000
27,000 27,000
Dividend (interim) 1,000 balance b/d 7,000
balance c/d 10,000 Net profit b/d 4,000
11,000 11,000
Solution:
Cash Flow Statement (Direct Method)
for the year ended, March 31, 2006
Particular Amount Amount
Rs. Rs.
(A) Cash Flow from Operating Activities
Cash receipts from Debtors (see Debtors A/c) 85,000
Cash payment for :
Cash paid to suppliers (see creditors A/c) (73,000)
(73,000)
General expenses (13,000) (86,000)
Cash from operating activities (1,000)
Taxes paid (2000)
Net Cash outflow from operating activities (3,000)
(B) Cash flow from Investing Activities
Purchase of fixed Assets (49,000)
Net cash used in investing Activities (49,000)
(C) Cash flow from Financing Activities
Proceeds from Raising secured loans 40,000
Dividend paid (1,000)
Net cash from Financing Activities 39,000
Net Decrease in cash (– 3000 – 49000 + 39000) (13,000)
[A + B + C]
Working Notes:
Dr. Debtors A/c Cr.
Particulars Amount Particulars Amount
Rs Rs
To Balance b/d 5,000 By Cash A/c (Received) 85,000
(Bal. Fig.)
To Sales A/c (Credit) 1,00,000 By Balance c/d 20,000
1,05,000 1,05,000
Working Notes:
Dr. 1. Fixed Assets A/c Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Balance b/d 50,000 By Depreciation A/c (Given) 8,000
To Cash A/c (Purchases) (Bal. fig.) 49,000 By Balance C/d 91,000
99,000 99,000
Dr. 2. Provision for Tax Account (Tax Payable A/c) Cr.
Particulars Amount Particulars Amount
Rs Rs
To Cash A/c (Tax paid) 2,000 By Balance 1,000
(Bal Fig) c/d
To Balance c/d 3,000 By Profit & 4,000
(Given) (Provision made during the year) loss A/c
5,000 5,000
15.17 Summary
Funds flow statement is an analytical tool in the hands of financial manager. The basic purpose of
this statement is to indicate on historical basis the changes in the working capital i.e. where funds came from
and where they are used during a given period.
Cash flow statement is a statement of sources and use of cash and cash equivalents in an enterprise
during a specified period of time. A cash flow statement, summarises the causes of changes in cash position
of a business enterprise between dates of two balance sheets.
15.18 Key Words
Net Working Capital Net working capital means difference between current assets and current
liabilities.
Flow of Funds Flow of funds refers to increase or decrease in net working capital.
Cash Flow Inflows and outflows of cash and cash equivalents.
Cash Equivalents Cash equivalents are short term highly liquid investments that are readily
convetible into cash and their maturity so near that they present insignificant risk of changes in value
and interest rates.
15.19 Self Assessment Test
1. Explain the meaning of funds flow statement. What are its main objectives?
2. What are the various sources and uses of funds?
3. The following are the summarised Balance Sheets of Pratiksha Limited as on 31st December, 2004 and
31st December, 2005 respectively :
Assets (Rs. in Thousands)
2004 2003
Freehold Property at cost 33.00 24.00
Plant and Machinery (cost less Dep.) 20.80 60.30
Inventories 30.35 32.85
Sundry Debtors 20.10 24.75
Cash and Bank 9.25 16.80
Preliminary Expenses 1.20 0.60
114.70 159.30
Liabilities
Issued Share Capital 60.00 75.00
Share Premium Account - 5.00
Capital Reserve - 17.00
Profit and Loss Account 21.50 21.20
Sundry Creditors 27.20 32.60
Proposed Dividend 6.00 8.50
114.70 159.30
No Plant and Machinery was sold during 2005. Depreciation written off during 2005 was
Rs. 7,500. Net profit for the year was Rs. 8,200. Rs 6,000 dividend was paid during 2005 in resect
of previous year. Capital Reserve represents profit on sale of freehold premises.
Answer : Increase in working capital Rs. 9,300 ; Funds from Operations Rs. 16,300; Total
of Funds Flow Statement Rs. 62,300; Sale of Freehold Property Rs. 26,300. Purchase of plant an
Machinery Rs. 47.00]
4. What is a cash Flow Statement? How does it differ from the Funds Flow Statement?
5. Following are the comparative Balance Sheets of Asian Paints Limited as on 31st December, 2004
and 31st December 2005 :
Liabilities 2004 2005 Assets 2004 2005
Rs. Rs. Rs. Rs.
Equity Share Capital 2,00,000 2,00,000 Land 10,000 10,000
Profit and Loss A/c. (Cr.) 23,500 52,000 Building (at cost) 75,000 90,000
Debentures 40,000 35,000 Mahinery (at cost) 25,000 40,000
Outstanding Expenses 3,500 4,500 Investments 50,000 30,000
(Long-tem)
Creditors 33,000 40,000 Stock 32,000 40,000
Accumulated Depreciation Debtors 80,000 90,000
Machinery 3,000 7,500 Prepaid Expenses 2,000 2,000
Building 12,000 18,000 Cash 43,000 58,000
Prov. for Doubtful Debts 2,000 3,000
3,17,000 3,60,000 3,17,000 3,60,000
Additional Information
(i) Dividend paid during 2005 was Rs. 26,500.
(ii) Investments Costing Rs. 20,000 were sold in 2005 for Rs. 25,000.
(iii) Machinery costing Rs. 5,000 on which Rs. 1,000 depreciation was accumulated, was sold for Rs.
6,000 in the year 2005.
(iv) The provision for doubtful debts charged to profit was Rs. 1,500.
Prepare a Cash Flow Statement for the year 2005.
[Answer : Cash from Operating Activities Rs. 50,500; Investing Activities Rs. (4,000);
Financing Activities Rs. (31,500)]
6. The following are the balance sheets of Swaraj Ltd. for the year ended 31st March, 2005 and
2006. Prepare a Cash Flow Statement for the year 2005-06.
Balance Sheet
Liabilities 31.3.05 31.3.06 Assets 31.3.05 31.3.06
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 2,00,000 Goodwill 15,000 10,000
General Reserve 63,250 68,250 Plant 1,50,000 2,40,000
Depreciation Fund 50,000 55,000 Land & Buildings 20,000 40,000
Debentures 50,000 - Debtors 75,000 80,000
Sundry Creditors 1,22,750 1,14,850 Stock 1,08,000 60,000
Accrued Expenses 9,000 18,000 Bank Balance 29,000 28,000
Provision for Tax 5,000 5,400 Prepaid 3,000 3,500
Insurance
4,00,000 4,61,500 4,00,000 4,61,500
Additional Information:
1. Sales for the year 2005-06 amounted to Rs. 10,50,000. In arriving at the Net Profit, items
deducted from the sales includes among others : Cost of goods sold Rs. 8,25,000; Depreciation on
Plant Rs. 25,000; Wages and salaries Rs. 1,00,000; and a profit of Rs. 5,000 on sale of a plant.
The machinery was sold for Rs. 15,000 and had a cost of Rs. 30,000 (accumulated depreciation
Rs. 20,000).
2. The Company declared and paid dividends of Rs. 30,000.
3. Debentures were redeemed for Rs. 49,000.
[Answer : Cash from Operating Activities Rs. 1,03,000; Investment Activities Rs. (1,25,000);
Financing Activities Rs. 21,000]